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Gabriele Grego
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Managing partner of Quintessential Capital Management, an investment fund, and Zanshin Capital, an asset management company both focusing on long-only, absolute return, equity investments with a value approach. I have started investing from an early age, but only in 2005 did I discover the... More
My company:
Quintessential Capital Management
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  • Healthcare, energy, for-profit education stocks still showing value (JNJ, TEVA, STRA)

    Stocks as a whole are not overvalued at the moment. As of 6/3/11, The Wall Street Journal reports the trailing 12 month P/E of the Dow Industrial stocks at a reasonable 13.82.

    However, it has been surprisingly hard to find high quality, deeply undervalued securities as buy candidates for my portfolio. Although I am very skeptical of my (or anyone else’s) ability to forecast short term market-wide fluctuations, I can’t help but notice that each time I find myself in a similar situation with a scarcity of attractive value stocks, the market tends to head for a correction. The market had a significant fall at the end of last week (6/1-6/3). Again, the fact that valuations are still reasonable overall should probably act as a shock absorber and provide a floor to any steep fall.

    Some sectors do retain some degree of attractiveness as worthy of long term investments, with healthcare probably retaining a leadership position here. Long term demographics are favorable in this sector: the story of baby boomers entering their old age and needing more healthcare and assistance has been mentioned many times before, but this does not make it any less true.

    Save for a timid rebound during the last month or two, healthcare stocks generally continue to trade at very attractive multiples. Even some of the large pharmaceutical companies seem to be facing a brighter future as their pipelines are improving. Such companies are blessed with a number of competitive advantages that make them sturdy long term contenders, including powerful economies of scale from R&D and marketing, protected cash flows through patents, captive consumers and non-cyclical products.

    The energy sector has rebounded to some extent from the irrational lows of one year ago. The dreams of an imminent alternative energy revolution have proven premature and a slowly rebounding economy coupled with little new supply is causing prices to increase. I believe the entire story did not unfold yet and that there is still significant upside remaining in this sector, particularly among the integrated oil majors, still trading at relatively low valuations, and the oil drillers.

    At Zanshin we also aim to capitalize on the for-profit education industry, under threat from a regulatory change by the Department of Education. Scared investors fled the sector en masse and this has resulted in attractive valuations across the board. We picked the best-in-class company and are confident it will have both the staying power to withstand the DoE rules and thrive in an environment where a number of weaker competitors will be likely crippled by the new rules.

    I am skeptical of predicting short term macroeconomic developments. That is why I prefer to acquire shares in companies that tend to perform well in most economic conditions, and to use an investment horizon much longer than a typical business cycle. In any event, my mid-term view of the economy is optimistic. Albeit slowly, recovery has been in place for almost two years now, consumers are progressively de-leveraging and companies are flush with cash.

    The missing link in the chain is the housing market, which might well begin to recover within the next 12 months. Once that happens, due to the massive size of the real estate sector and its related industries, GDP should receive a significant boost and unemployment should start decreasing in a sustained pace (the housing sector is labor intensive). That will be the beginning of the real recovery and will likely translate favorably in the stock market’s performance.

    While we wait, the Zanshin portfolio holds solid franchises with strong recent earnings. 
    Tags: VALUE
    Jun 15 8:11 AM | Link | Comment!
  • Value in the for-profit education industry

    Value in the for profit education industry


    In a not so distant future, the United States was the country that could boast the highest ratio of college degree holders relative to the general population. Unfortunately this is no longer so. The US ranks number 11 right now, far behind counties such as Russia, Korea and even Spain.


    As a country’s economy develops and shifts from manufacturing to services, the level of higher education becomes a critical factor in productivity and success. Accordingly, the value of college education has been steadily increasing over the years and the average salary gap between college educated and non-college educated workers clearly reflects that. Higher educated workers earn more and increasingly more so over time.


    This tendency has translated in a steady increase in demand for higher education. Of course, most people earn their degrees in universities, most of which are either public or non-profit organizations. Unfortunately, these two entities alone cannot possibly meet the enormous existing demand (only about 28% of US citizens have a college degree) and the gap is currently being filled (partially) by other players: for-profit education institutions. These are exactly what they sound: profit seeking corporations whose product is education and whose clients are students. Typically, but not exclusively, these institutions tend to cater the needs of adults students, which prefer evening, online or evening classes and do not necessarily need on-campus accommodation, dining and extracurricular activities.


    These companies have benefitted handsomely lately from increased demand, not least because of the economic downturn and its stubborn unemployment rate: when there is no work out there, it is a good time to go back to school.


    The entire for-profit education sector has been under the spotlight for the past year or so. In order to understand why we need to first understand how the typical education is financed. While a minority of affluent students can pay their tuition out of their own pockets, a majority takes out student loans. These loans have a typically high default rate and banks would not be as forthcoming without an existing federal guarantee that effectively reimburses the bank in the event that students fail to meet their obligations. In practice, the system uses taxpayers money to subsidize the tuition of students who default.


    So far so good. However, given the latest financial difficulties of the US government, politicians are trying hard to reduce expenses and their watchful eye has fallen on the education sector as well. In all fairness, it must be said that, at least in some cases, the system has been abused. Encouraged by strong demand and lucrative gains some for-profit universities have embarked on an aggressive marketing campaign trying to recruit as many perspective students as possible regardless of their academic qualifications or their chance of finding employment post-graduation. Some have even resorted to compensating admission officers with bonuses tied to the number of students they admit. This phenomenon has led to the sad result of having many students burdened with debt and unable to obtain a job. The response of the government has been to threaten a large-scale reform limiting access to the federal loan guarantee only to those schools that meet certain parameters such as the percentage of students who default after graduating or the percentage of students who started repaying their loans after a number of years.



    Obviously the threatened reform has had a tremendously negative impact on the stock prices of companies in this sector, that suddenly saw their survival in jeopardy (in most institutions the percentage of students benefitting from such loans is above 70%).


    After years of investing in the stock market, I have learned to pay close attention to the arising of situations where there may be a “baby thrown out with the bathwater”. In other words, a state of affairs where all stocks of a given subgroup are sold indiscriminately by the market because of some perceived threat regardless of the quality of individual issues. This situation usually presents juicy profit opportunities for those patient and brave enough to dare.


    According to this line of though, I reasoned that it was highly unlikely that the department of education would put the entire for-profit sector out of business, as the huge need to increase the education level of the average American still stands. Rather, the new legislation would likely aim to weed out the less efficient as well as the dishonest players. Following the reform then, with some competitors out of the way, the surviving companies would find a free field of action in a rapidly growing industry.


    Among the many players in the for-profit segment, I think I singled out one of the most impressive institutions: Strayer Education. I particularly liked the company for a number of reasons: first, it enjoyed the widest profit margins and return on capital of the entire industry. Second, it has a strong brand image deriving from its being in the business for over one hundred years. Third, it focuses on BA and Masters degrees, unlike some of its competitors which concentrate on two-year professional degree (students enrolled in four year programs tend to have higher graduation rates and higher subsequent salaries). Fourth, unlike some of its peers which have already nationwide presence, Strayer operates in roughly only 20 US states, leaving plenty of room for future growth. Fifth, he company can boast a strong balance sheet with plenty of cash reserves. And last, the quality of the management team. I have come across few companies with better leaders. The CEO is Mr. Robert Silberman. I was very impressed with the clarity with which he described Strayer’s business model, corporate strategy and the threat of reform from the department of education. Additionally, rather than wasting cash on dubious projects, the management has been returning as much as 80% of cash to shareholders, further proving the high profitability of the company which has been growing at double digit rates with only 20% of reinvested cash. In short, we have a rational, honest, transparent leadership that seems committed to the long term profitability of the company.


    The threat of DoE reform caused Strayer’s valuation to drop at a multiyear low with a P/E ratio of only 12.5 and EV/Ebitda of roughly 6.5 (both measures suggest undervaluation for a company expected to grow at double-digit rates).


    The reform eventually did go through, but it did so in a highly watered down version. Rightly, the stock prices jumped across the board on the news. Fortunately for new investors the recent market correction means that most of these stocks lost a good part of their recent gains. Perspective buyers have the opportunity to buy in a growing industry at a good price point without the overhang risk of the DoE regulation.


    DISCLOSURE: the author is long Strayer Education

    Jun 15 8:09 AM | Link | Comment!
  • The case for J&J

    When investing in the stock market, if you are out chasing the latest market fads, chances are you’ll get in trouble. Just ask speculators of the ’90s or real estate investors of the last decade.

    In my opinion, the best way to consistently outperform the market and make a nice profit is to overcome the herding instinct; and one way is to look in places everybody is running away from. Most often, you will find only junk there. But, every now and then, you will come across some hidden gems. I believe that Johnson & Johnson (J&J) today is one such gem.

    The company is well known. It is composed of three main divisions, all of which enjoy leading positions in their respective fields: pharmaceuticals, consumer products, and medical devices. It has a decade-long legacy of superior management and exceptional returns.

    Operational Issues Fixable
    Lately, however, its reputation has been tested repeatedly from several large-sized products recalls, mostly originating from apparently widespread manufacturing problems at certain facilities. This created a particularly serious image problem for J&J, as many of the products involved are iconic brands such as Tylenol or Motrin. The issue has even attracted the attention of the FDA who has apparently mandated tight inspections and monitoring at the facilities.

    Needless to say, these issues have contributed to a disappointing stock price performance that is now several years old.

    Now, I believe that however serious and disturbing J&J’s current problems may be, they are indeed fixable and temporary in nature. We are not talking about a loss of competitive advantage, as it happened to Kodak upon the advent of digital photography or a permanent adverse regulation, as was the case with the online gambling industry in the United States.

    Rather, J&J has some serious operational difficulties, but also enormous financial and managerial resources to overcome them. Now, the only question is, what kind of company are we going to have on our hands once these short-term problems are solved? The answer: a cash machine.

    Strong Products, Strong Financials
    The industries J&J operates in are mostly blessed with good long-term economics. All will benefit from two important demographic trends, namely, emerging markets shifting to westernized health care and consumption patterns and an aging world population. This means sustained demand for all sorts of drugs and medical devices.

    Also, unlike most of its industry peers, J&J no longer suffers from a significant drug patent expiration problem, and on the contrary has the advantage of strong pipelines of new drugs hitting the market very soon, several of these have blockbuster potential. Clearly, patent protection is one of the strongest possible competitive advantages as they secure hefty returns for many years to come. Finally, J&J enjoys significant economies of scale due its significant R&D budget and efficiency.

    The consumer products divisions, including both products such as shampoos or over-the-counter medications, is benefiting from high levels of customer loyalty as many brands have been in existence for decades, promoting strong habit formation. J&J’s sheer size also creates economies of scale in marketing. Although this division is suffering from product recalls and diminished consumer spending, I believe these issues are bound to reverse in due time.

    The medical devices division too, with all of its present woes, is benefiting from an aging population and a larger client base thanks to emerging markets. Increased competition should be kept at bay since there is a significant degree of customer captivity: just ask a surgeon how time and effort consuming it can be to shift from one artificial hip product to another (it involves long retraining and changing of toolsets).

    Another huge plus for J&J is its pristine finances. The company is one of the few in the world to boast a triple-A rating, reflecting generous cash generation, large cash reserves, modest leverage, and operating in very stable, noncyclical, and diversified industries.

    J&J management and corporate governance is mixed, in my opinion.

    On the one hand, you have very established and ingrained management practices with a long history of efficiency and shareholders returns (to the extent of J&J frequently being the subject of case studies for many business schools). On the other hand, there is no single, large shareholder that can vigorously exercise its power over the management team when things go wrong. This potentially can be a problem, and a symptom could very well be the resilience of the current CEO to hold on to his seat despite the number of significant setbacks the company went through.

    Finally, valuation. The Earnings Power Value of the company, assuming no growth whatsoever, is somewhere between $55 and $62 per share. This value is calculated by taking 2010 earnings, capitalizing them with a certain discount rate, and adding back cash net of debt. At a present price of $60, factoring in a modest level of organic growth of 3 percent per year, an 18 percent return on invested capital (NASDAQ:ROIC), a 50 percent reinvestment rate, and a 16 exit PE, you get an expected long-term return of approximately 17.5 percent.

    I believe it is rare to get the chance of investing in an AAA-rated company with this kind of expected return.

    DISCLOSURE: The author is long Johnson & Johnson.


    Mar 11 7:13 AM | Link | Comment!
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