Jonathan Goldberg's  Instablog

 

It can be interesting to look to the darlings of a sector for guidance as to which sectors have favorable prospects, but then to spend time thinking about and analyzing the laggards in the sector for actual buying opportunities. Being a contrarian leaves room to make money through capital appreciation whereas buying the all-stars may leave the investor vulnerable to overpayment. An investor who bought Wal-Mart (WMT) 10 years ago has actually lost money, even though the company itself has performed remarkably well. The growth prospects were all priced into the shares back then and the company would have had to exceed already optimistic earnings expectations for the performance to be translated into share price appreciation.

 

Amazon (AMZN), the apparent darling in the book merchant space, is trading on extremely high multiples (P/E of approx. 60 vs BKS’ of approx. 14) as a result of high hopes for growth in the electronic segment of the market, sales of physical books via the web store as well as electronic books via the Kindle e-reader. These expectations are obvious and are likely already priced into the company’s shares as a result. Of the 32 analysts who cover the company, 13 have a buy rating and only 2 recommend selling it. It’s hard to imagine much movement in share price if the company merely meets expectations, and not so hard to imagine what could happen if the company misses these expectations to the downside.

 

BKS on the other hand used to be the largest player in the book market but has since fallen out of favor with the market as its base of operations is largely the company’s 800 bricks and mortar stores. The share price is currently less than half of what it was in 2006, and as mentioned, has dropped significantly even within the past two weeks. It’s hard to see where the positive aspects of the company’s outlook are priced in, if they are. Another benefit for investors of the depressed share price is the current dividend yield of almost 5%. As brought to my attention via the Wall Street Journal is the fact that BKS will actually be partaking in the growth of the e-book market right alongside AMZN. BKS may even have an advantage thanks to its bricks and mortar locations as many shoppers have never even seen an e-reader, and a physical location gives BKS the opportunity of putting these devices directly in the hands of the consumer. Even more interesting is that while AMZN’s e-reader operates on a closed format (only the Kindle can read titles purchased from AMZN), the books sold by BKS operate on a shared platform known as ePub which will allow the purchases to be read on any device including laptops.  BKS has already begun taking steps to compete with AMZN as it has acquired an independent e-book seller and will also be launching its own e-book store shortly.

 

Based on the fundamentals discussed here, BKS seems to be a compelling value play. As always though it is important to arrive at an estimate of intrinsic value so that a purchase decision is based on hard evidence of a discount as well as the incorporation of a margin of safety. I’ll be valuing BKS in the next couple of days as well as taking a closer look into the financial statements and management’s discussion and analysis. I will be sure to share my findings here with the community.

 

Many of us will be watching for evidence of increased revenues this quarter, alongside hopefully increased earnings. Last quarter's earnings may have met already decreased expectations, but much of the earnings came about by way of cost cutting rather than top line growth. Since businesses likely had a stronger call to action for cost cutting than ever in our recent history, I would be surprised if the majority didn’t trim all that they could as quickly as they possibly could. Going into this earnings season there likely aren’t too many avenues left to cut costs. If the consumer isn’t the heavy-lifter this quarter that the market is expecting, and if revenues stay flat or decline as a result, then there isn’t much hope for even meeting expectations this time around. I wouldn’t be too eager to see the effect such a disappointment would have, especially after the strong run-up we’ve just had in the markets since March.

 

Every time in the past that the P/E10 went from the 1st to the 4th quintile (quintiles divide the P/E10 into 5 groups with the 1st being the highest P/E group and the 4th being the lowest P/E group) it’s ultimately declined to the 5th quintile where it bottomed in single digits. In March, the P/E10 of the S&P hit the 4th quintile after a long way down from the 1st and we are currently back into the 2nd quintile where the market is looking expensive. If a drop to the 5th quintile was to occur, it would come about from either a decline in the S&P to below 600 or alternatively from a strong resurgence in corporate earnings. If Q3 earnings didn’t have you waiting in anticipation before…

 

As an aside, in the past these declines have lasted anywhere from 3 to more than 19 years. The current decline is in its 9th year. I wonder how long earnings can remain weak for until the market decides to take fate into its own hands. In this environment I wouldn’t bet on it taking its time.

 

The following is a summary of Seth Klarman's lecture, given to the Richard Ivey School of Business on March 17th, 2009.

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Klarman opened his speech by pointing out that people's investing temperament seems to be influenced by the state of the market when they graduated from school. As he said, "If you remember how cheap things can get, you don't easily forget that lesson." I attended this lecture in person while completing my MBA, and this statement had a direct impact on me as I would be graduating in one of the worst market climates in history.

 

In defining value investing, Klarman describes it as a risk averse approach. He says that it's a series of principles and a way of thinking about investing that forces you to first focus on risk, and only then on returns. As the downside is where the pain is for most people, value investing protects against that first.

 

Klarman's understanding based on research he has seen is that value investing via a mechanical approach (purely quantitative according to P/E, P/B, etc.) adds about 1% to 2% a year. He wonders, however, why anyone would trust a dumb formula when they can do even better through proprietary analysis and investigation. In doing so he can tell when some situations that look cheap (according to a mechanical method) aren't in fact that cheap. As such, his firm's approach to value investing is to follow the philosophy's principles while relying on their own fundamental and detailed research.

 

Klarman's approach to investing is based on three underlying pillars:

More information about Seth Klarman as well as insights into the Baupost Group's holdings can be found at GuruFocus.com.

 

 

Recently I recommended an investment in Lockheed Martin Corporation (NYSE: LMT). Since it's a high conviction investment of mine I tend not to follow the daily ups and downs in the share price. Rather I keep an eye out for any new press releases or industry news that may cause a significant change in the model. Today, however, I couldn't help but notice that while the S&P was down by more than 2%, my investment in LMT was actually up 0.83%! Granted, this is a daily fluctuation that I already stated no interest in, but barring significant news one would expect a large-cap security like this to move along with the market.

 

I would like to believe that LMT didn't suffer along with the rest of the market because it is one of the truly undervalued stocks in today's speculative and possibly overvalued market. While we value investors don't give notice to daily fluctuations in share price, it comforts me to know that we probably do have the upper hand when the market decides to go south.

 

LMT’s customers are split as follows: 84% of net sales to the US government, 13% to foreign governments, 3% to commercial and other customers. The US government is a very stable customer, as they have a military reputation to uphold and they can print money. Despite all the talk about decreased government spending on defense, this will not be sustained long term as our world slowly returns to a multi-polar system. These developments will only bring an increase in defense spending as governments attempt to maintain their countries’ defence capability in the global arena. This is already demonstrated by the high level of negotiated backlog LMT has; approximately $80.9 billion, of which 58% will still be remaining after one year. Regarding the uncertainty of government spending going forward, LMT feels it is well positioned to take advantage of areas where the government has already indicated increased funding; namely intelligence, surveillance, and reconnaissance (ISR) support for the warfighter, cybersecurity, helicopter maintenance and training, and lift, mobility, and refueling aircraft. LMT provides a diverse product offering to the industry and is well positioned to take advantage of these areas of increased spending while other segments may suffer. This company may have been knocked for being in an industry with such an uncertain near-term future, but it is well positioned to thrive within it. Additionally, the company is pursuing a strategy that will see it “expand and complement our existing products and services by moving into adjacent businesses in which we believe that our core competencies will enable us to successfully compete.” Areas of opportunity the company foresees are “the need for more affordable logistics and sustainment, expansive use of information technology and knowledge-based solutions, and vastly improved levels of network and cybersecurity,” all national priorities. The company expects revenue growth to exceed the growth in the Department of Defence’s budget, as LMT’s revenues historically have not been dependent on supplemental funding requests.

 

The current debt to capital ratio of approximately 57% is high due to a reliance on one major customer – this affects the estimated equity risk premium. Using 60% as the long run target debt/capital ratio, 5.2% as the cost of debt (current yield to maturity) and 11.1% as the cost of equity (equity risk premium added to cost of debt), yields a weighted average cost of capital (WACC) for the firm of 6.41%. As a quick return on invested capital(ROIC) is 24.3% for the last 12 months, earnings power on an equity value per share basis (EPV) is expected to be significantly greater than net asset value per share (NAV).

 

A thorough valuation of LMT shows an EPV of $85.4 and a NAV of $48.5. This is in line with ROIC (replacement value of balance sheet) of 9.27%, which is greater than WACC. The competitive advantage which gives rise to the EPV-NAV discrepancy seems highly sustainable as it is based both on relationships (government connections) and capabilities (proprietary technology). Additionally, there are high barriers to entry in this industry as the government is generally a captive customer of LMT for upgrades, parts and service. It would be very difficult if not impossible for a competitor to take away market share from any of LMT’s existing products.

 

The value of growth plays a part in the valuation of LMT as the company has a stated goal of growth, both organically and through acquisitions, which will add value with ROIC being greater than WACC. The 5-year average growth in net-income of 20%, while likely not sustainable in the long run, lends credibility to assuming a long-run growth rate of 3%. Applying a value of growth multiplier to EPV at this rate of growth yields an intrinsic value for LMT of $108.5 per share.

 

As always, I recommend incorporating a margin of safety in order to account for sensitivity in my calculations. A reasonable margin of safety implies an entry price of approximately $76. As such, I believe LMT is a great purchase at its current price of around $75.