Joel Greenblatt is the founder of the hedge fund Gotham Asset Management. Before setting up this New York City-based fund, he served as chairman of Alliant Techsystems' board. Joel Greenblatt is considered a value investor. He is widely recognized for having developed the "Magic Formula", a quantitative investment strategy to pick stocks. Greenblatt describes this formula in his best seller "The Little Book that Beats the Market".
The Magic Formula produced returns of 30.8% from 1988 to 2004, surpassing the 12.4% return set by S&P 500. Apart from founding Gotham Asset Management, he also cofounded the Value Investors Club. The Value Investors Club is a website where value investors can exchange investment ideas.
What about Greenblatt's approach? He only looks at the return a company generates on its capital and at the firm's earnings yield, which is similar to the inverse of its price-earnings ratio. The strategy then ranks all the stocks of the categories and adds the numerical ranking together. The lower the combined numerical ranking, the better.
According to Greenblatt, beating the market is not complicated. What is hard is to support an approach and maintain it in both bad and good times. He stresses discipline, patience and confidence when investing in superb-quality Companies.
From an individual investor's perspective, I find it truly interesting to focus on stocks in the Technological sector that are large holdings in Greenblatt's portfolio. I analyzed them and found some reasons why Greenblatt could have been attracted to invest.
Analog Devices, Inc. (ADI):
ADI is a leading supplier company that manfactures original equipment of semiconductor devices, specifically, analog, mixed signal and digital signal processing (DSP) integrated circuits. It is considered the second analog chip manufacturer across the United States.
In the last period, although earnings exceeded the estimations, revenue dropped. The reason why revenue fell short can be attributed to supply chain related issues driven by the earthquake in Japan. Fortunately, the company started restructuring activities that made cost structures lower, thus enabling the company to generate a stable gross margin. The ability to generate a stable gross margin also let the company limit margin erosion and the ability to generate earnings growth.
Why did Joel Greenblatt invest in it? ADI has a strong position in the market and is highly focused on secular growth markets, which can, in turn, provide high returns and ample room for further expansion. In addition, management has turned to higher-margin products to improve the business' margin profile. Based on this management approach, gross margins could expand 495 bps and operating margins 692 bps. All together, this boosted a 7.7% compound annual growth rate in earnings between 2006 and 2010. Furthermore, the company was able to correctly manage receivables and inventories.
Financially speaking, Analog Devices is healthy. It has a strong balance sheet with $3.51 billion in cash and marketable securities. Despite the general economic crisis that affected the company in 2009, ADI has been able to generate a solid free cash flow. Most importantly, Analog Devices is shareholder friendly. It pays a regular dividend that is not expected to be interrupted.
Analog Devices' trailing P/E is 12.0x compared to 13.9x for the peer group and 16.3X for the S&P 500. The shares are trading in the lower half of the historical range of 9.7x to 32.6x earnings. This seems to indicate that there is potential upside in this solid Company.
Dell Inc. (DELL):
DELL is the global leader in the direct marketing of computing products and services. Dell is analyzing the possibility of transforming itself into an enterprise solutions provider. It wants to stop making commodity boxes due to the deterioration of the PC market driven by the economic situation. Dell´s strategy is to enter the data center technology segment because it offers better switching costs and drives consulting services.
Management widely knows, however, that the commodity hardware is still its flagship, while storage only represents 3% of revenue. A change in this relationship will definitely mean spending time and significant costs.
In terms of quarterly results, as of October 2011, Dell reported $26 billion of cash and investments and $8 billion in debt on its balance sheet. Quarterly results were decent. Earnings per share increased but revenue remained flat. The lack of growth in revenue can be attributed to the uncertain economic situation and the shortage in the hard disk supply, among other issues. In addition, the flood in Thailand created a new problem for HDD supplies.
Fortunately, acquisitions have been a growth driver for Dell. At the beginning of 2011 the company acquired Compellent Technologies Inc., a storage solution provider. The acquisition of Compellent aims at increasing pro forma earnings in 2012.
Last but not least, Dell has a strong cash position which enables it to permanently generate cash flows. Cash flow from operations increased to $2.4 billion from $1.3 billion reported in the year-ago quarter. At the end of the quarter, Dell had $15.1 billion in cash and short-term investments.
Dell's revenue growth y/y stands at 16.24%, higher than the average of 6.47% from 2008-2012. Also, Dell's operating income growth (y/y) is the highest in the last 3 years, showing that the business is getting traction.
In terms of valuation, I think DELL is undervalued relative to its historical multiples and peers. For example, DELL current P/E is 9x compared to its Industry average of 13.2 and DELL's 5 year average of 13.2. Also DELL P/S is just 0.5x, while the peer group trades at 1.8x sales. Another important ratio that shows that shares are undervalued is DELL's P/B, which is 3.7x compared to Industry average of 4.8x.
To sum up, a solid Company, with good fundamentals and a conservative margin of safety valuation is what really attracted Joel Greenblatt to invest.
Teradyne Inc. (TER):
TER is a leading provider of automated test equipment founded in 1960 and located in Massachusetts. The company is primarily focused on the semiconductor test market, which generates much of its revenue. It also provides specialized system testing equipment for specific end markets.
Third quarter results were not as good as expected for TER. There was a slowdown in the semiconductor automated test equipment (ATE) market, which caused revenues to drop 16.1%, thus amounting to $344.4 million. Since June, revenue has dropped about 31%. Fortunately, this amount was better than management's expectations of $320 to $340 million. Most of this revenue (70%) is represented by semiconductor testing platforms, and the remaining (30%) is represented by system testing. The segments were down 29.7% and up 51.5% respectively from the June 2011 quarter. Furthermore, the semiconductor test segment also suffered a decline of 46.2% in the y/y comparison.
What are the expectations for the quarter to come? Management expects revenue to be between $270 million and $300 million. These expectations are not high because management is cautious about ATE demand from chipmakers. This management view is consistent with the downturn that the whole chip equipment industry is undergoing.
The industry is facing important headwinds. Anyway, the firm has made every endeavor to reduce costs, which should help TER face this slowdown. However, the uncertainty in semiconductor markets and low exposure to the memory segment will probably affect shares.
Although results have not been positive in the last quarter, Greenblatt decided to bet on Terdayne. Why did he choose this stock? Its products are still popular among consumers and the acquisition of LitePoint will enhance its portfolio, thus boosting revenue and margins.
KLA-Tencor Corporation (KLAC):
KLAC is an original equipment manufacturer of process diagnostics and control equipment and yield management solutions required for the fabrication of semiconductor integrated circuits or chips.
Financially speaking, KLA is healthy. In terms of quarter results, the firm reported $2.1 billion in cash and investments and only $746 million in debt. KLA has a solid cash position which has provided the company flexibility, particularly in R&D expenditures and strategic acquisitions. Furthermore, KLA reported $796.5 million in revenue. This means a drop of 10.8% but it is still between management's guidance of $770 to $820 million.
I am sure that what attracted Greenblatt is that KLA-Tencor is a leader in each of its served markets. KLAC offers complete yield management solutions, including hardware, software and services that help improve throughput and reduce overall production costs. Cost reduction solutions experience high demand generated from the overall trend of margin improvements programs from KLAC clients. Since yield management solutions improve manufacturing costs, demand for the product line remains strong at any point in the business cycle. KLAC revenues are generally more stable than other equipment suppliers and its performance can be sustained in weak economic conditions. Yield issues are becoming even more important in the current environment, since the adoption of the new EUV lithography tools has been slower than expected. This, along with the growing complexities of semiconductor devices, will tend to extend demand for the current generation product.
In terms of valuation, shares of KLA-Tencor trade at just 9.0x earnings, compared to 10.4x for its peers and 16x for the SP&500. So, there is some discount in KLAC. One point to pay attention to is that expected earnings growth rate over the next 5 years is just 9.5% compared to 12.6% for the peer group and 10.7% for the S&P 500.
Applied Materials, Inc. (AMAT):
AMAT is one of the world's largest suppliers of equipment for the fabrication of semiconductor, flat panel liquid crystal displays (LCDs), and solar photovoltaic (PV) cells and modules.
Greenblatt decided to invest in Applied Materials because the company has a leg up on its competitors. It is considered a leader in the semiconductor equipment industry with unmatched scale and a broad portfolio. It competes in nearly every segment of the market as it is uniquely positioned in chip production. It is considered a one-stop shop for chip manufacturers. Competitors are usually specialists in their segments. As regards to the market, AMAT represents 15% of it.
To boost growth, AMAT has established its solar equipment business. Most importantly, the semiconductor equipment market's good performance has significantly benefitted the company. Unfortunately, the company is currently facing generally poor economic conditions. The company depends on customers in the deeply cyclical chip industry. Also, Applied must maintain its technological innovation to keep up with the latest trends in chip manufacturing.
Financially speaking, AMAT is in a very good position. At the end of 2011, it reported $7.2 billion in cash and investments and $1.9 billion in debt. In June, the company took $1.75 billion in debt, whose proceeds jointly with cash on hand, enabled the company to acquire Varian for $4.9 billion. This deal closed at the beginning of 2012.
