The following is an analysis of Intel (INTC) and the semiconductor industry. The analysis will use a system that I designed that is based on the ratio that Mr. Warren Buffett released to the public in 1986, which he coined “Owner Earnings.” For those new to this analysis please refer to my introduction by going here. My goal is ultimately to analyze all non-financial industries and then to subsequently re-analyze them every quarter. My purpose in writing these articles is to show the power of Mr. Buffett’s ratio in analyzing industries, stocks, ETFs, mutual funds and individual portfolios. If one can fill their portfolios with companies that score high using my system and avoid those which fail, one should be able to increase the probability of becoming a successful investor, in my opinion.
The semiconductor industry, with Intel as its flagship, has had to deal with some serious natural disasters lately that have affected their industry negatively. If the earthquakes and tsunamis in Japan were not bad enough, they also have to deal with the major flooding in Thailand. On top of the natural disasters, their "book to bill ratio" has been unable to break 1.0 since September 2010 and now sits at .74. This is the key ratio for the industry and when it’s below 1.0, it means that things are going to get worse before they get better. Even Microsoft (MSFT) yesterday announced that PC sales would be worse than expected in the quarter that just ended due to the flooding in Thailand.
Semiconductor stocks are very volatile to start with, having an average beta of about 1.25 as a group. Beta for those who don’t know is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole. The beta for the market is 1.0 so the higher the better in bull markets and the worse in bear markets. Industry leader Intel, which was having its best performance in decades until they recently warned that profits during the fourth quarter would be hindered because of shortages in hard disk drives. That’s a shame, because for the first time in a long time Intel has been able to control their CapFlow numbers and I thought that it would really take off and be a strong performer for the next five years. Here is a table of Intel’s owner earnings from 1972-2011:
As you can see from the table above, it took Intel 24 years before they achieved a CapFlow of below 50% and received a "1" from my system in that category. From 1996-1999 they led the technology boom during the dot.com bull market but were also one of the key players causing the bust that soon followed in 2000. Then in 2001 they fell off the cliff and scored a terrible 94% CapFlow. I had strong hopes for the company in 2010 as they hit their historic low CapFlow of 25%. This told me that “Economies of Scale” were in full force and I had high hopes that good times would be coming Intel. So now, with potential recessions affecting Europe and the USA, it will be interesting to see how Intel turns out.
For those interested in seeing what can happen when you start controlling costs in operations, you can see the results in the chart below of Intel.
Cumulative Owner Earnings (COE) is a ratio I created to replace book value per share. What it does is cumulatively add all previous years' owner earnings numbers per share of a company together and then come out with a final dollar figure that you can compare to the stock price. A company that trades at or below its COE is one that is very oversold. COE is more powerful than book value per share because with book value one can never really know what the assets on the balance sheet are really worth. John Paulson and Bruce Berkowitz found that out last year when they loaded up on financials. COE, on the other hand, adds up all the owner earnings that a company made over its history. I have data on COE going back to 1969, but because this information is not readily available and even took me years to gather, I have decided not to include it as part of the system I am using to analyze stocks here at SA.
Where COE is extremely useful is in shorting stocks. I proved that in a previously published article here on Seeking Alpha called “5 Stocks That Warren Buffett Would Hate”. In that article, I showed how Cree Inc. (CREE), one of the stocks on the semiconductor industry table above, should not do very well as management consistently was unable to control their capital spending and as a result had terrible owner earnings year over year. In that article I mentioned that at a $39.24 stock price that the stock was overvalued, but just four months earlier on January 20, 2011 I wrote an article on Cree where I explained that at $52.36 it was even worse. So Cree today at $23.06 (some -55.96% lower than what it traded at just a year ago) still cannot control their costs and as a result get a zero on my system because:
CapFlow = 96%
FROIC = 0.48%
Price to Owner Earnings = 230.60
When you have some free time, take the stock prices that I quoted in that article at the time and open a one year chart on each. Once you do that you will see the power of owner earnings analysis in shorting stocks.
Even Cree with their lavish capital spending, on their worst day is not as bad as Rambus (RMBS) is on their best day. Except for a brief year of glory in 2010, Rambus is the poster boy for poor owner earnings management:
In getting back to the original table above you will notice that there are a lot of good companies in that table. One thing I love about this industry is that most companies operate with zero total debt, so when they have a great owner earnings year or a consistent string of good years in a row, their stock prices tend to do well (Altera (ALTR) for example). But this industry is definitely not a long term buy and hold investors industry as it is extremely volatile. The stocks also tend to go up and down as a group so sometimes you get situations where the best players go down just as much as the worst ones in an industry downturn, like we had in 2008-2009. Those investors who did their owner earnings research ahead of time could have made an absolute killing getting in after the market settled down in March of 2009. Because markets are extremely inefficient you could have seen gains like the following:
So much for the efficient market theory! With owner earnings as your base, you would definitely not have invested in these stocks in 2000, but would have been drooling in 2009. Since most investors do little if any research at all when they buy stocks, those having a system like this in their arsenal and who also do the macro-economic analysis as well, have a good chance of outperforming the markets over the long haul. But when it comes to the semiconductor industry, one has to pick their spots to enter and usually after the proverbial “baby has been thrown out with the bath water”.
Disclaimer: Always remember that these are the results of our research based on the methodology that I have outlined above and in other articles previously published. This research is provided as an educational tool and should not be considered investment advice, but just the results of our research. There are many ways to analyze a stock and you should never blindly follow anyone’s work without doing your own due diligence or by seeking the help of an investment advisor, if you so need one. As Registered Investment Advisors, we see it as our responsibility to advise the following: We take our research seriously, we do our best to get it right, and we “eat our own cooking,” but we could be wrong. Please note, investments involve risk and unless otherwise stated, are not guaranteed. Past performance cannot be used as an indicator to determine future results. Strategies mentioned may not be suitable for everyone. We do not know your personal financial situation, so the information contained in this communiqué represents the opinions of Peter “Mycroft” Psaras, and should not be construed as personalized investment advice. Information expressed does not take into account your specific situation or objectives, and is not intended as recommendations appropriate for you. Before acting on any information mentioned, it is recommended to seek advice from a qualified tax or investment adviser to determine whether it is suitable for your specific situation.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.