It's only been two weeks since we crossed the threshold of time into 2010 so it isn't too late to talk about one large cap stock that did very well in 2009 and its continued prospects for this year. As the author of the a book about spectacular mistakes you may inquire as to my qualifications for writing about investments that worked out. My response is: read on.
The Billion Dollar Mistake: Learning the Art of Investing Through the Missteps of Legendary Investors (John Wiley and Sons, January 2010), profiles average mistakes committed by superior investors with often devastating financial results. The theory behind the book is best expressed by the combined observations of George Santayana, who said “Those who cannot remember the past are condemned to repeat it,” and Eleanor Roosevelt who proffered that it took less time to learn from the mistakes of others than to make them herself. Undoubtedly, it can be just as valuable to learn from the success of others. This article discusses Richard Pzena, a summa cum laude graduate of Wharton who possesses the discipline of a Tibetan monk as he screens for attractive investment opportunities. Pzena took a detour through the oil fields before finding Wall Street. It was a destination worth working toward as his family of long only funds significantly bested the S&P 500 in 2009, returning between 38% and 51%.
Pzena first showed his chops as a value investor while a student at Wharton when he and two classmates “re-did” the research on net-net working capital originally set forth by Graham and Dodd. Graham and Dodd enjoy the same relationship to value investing that Freud has with psychiatry, Ford with autos, Edison with electricity – you get the picture. After Wharton, Pzena joined Amoco, and was eventually sent to New Orleans to be part of a team mandated to acquire energy properties. It was the early 1980’s and crude prices were at their peak, driving up acquisition costs. Pzena recounts one auction where his team made an initial recommendation to acquire a leasehold but the price they wanted to bid exceeded their dollar authority requiring a review by more senior managers. The transaction kept getting kicked up to the next highest level of management, enthusiasm for the property continuing to increase. By the time the Board of Directors approved the offer, the momentum had driven the price to 100 times the next highest bid, much to Pzena’s amazement. Amoco never made money on the deal. Momentum investing being as offensive to value investors as an all you can eat buffet is to anorexics, Pzena left industry for Wall Street. He would eventually launch his own firm, Pzena Investment Management, and compile a track record of performance that is the envy of most fund managers. 2009 would turn out to be his best year yet. Pzena’s success is due to the investment discipline that he so ardently adheres to; his intensive screening for companies that fit precisely into a time tested definition of value. He only buys the equity of a company that is priced at a significant discount to its historic earnings stream and future earnings potential.
Pzena calls Boeing (NYSE: BA) “a classic value stock.” The stock hit a low of $29.05 on March 3, 2009, its performance in virtual lockstep with the overall market. BA currently trades at $63.56, representing more than a double from the bottom. Listening to Pzena present the investment case for BA, it’s easy to understand why he has made it one of his fund’s largest positions. The company is part of a global duopoly with seemingly insurmountable barriers to entry. There is a built-in replacement cycle particularly since newer planes are much more fuel-efficient to operate. Emerging opportunities in hyper growth countries such as India and China will spur increased air travel, as will higher personal wealth and income, appearing to legitimize Boeing’s forecast that the size of the global fleet will double to 36,000 by 2025. With a cash up-front order book that takes root years in advance, the company has enviable visibility to its capital needs. If a customer wants to be higher in the queue, Boeing charges a premium yet that won’t lock in a price since the cost for raw materials and labor are passed through. More than half the company’s $60 billion in revenue is derived from the defense business, a less cyclical industry and a nice balance to the commercial plane segment.
So what are the negatives, the holes in the story? The first is the economy. Despite the powerful secular case for air travel, it is still a cyclical business as proven by the global recession. Double dip? I don't think so but it could happen. Although Boeing exits the hard times with an excellent balance sheet, their order book has suffered. Additionally, with four million parts on each plane, the complexity of an aircraft’s design and development offers challenges.
What it all comes down to for Pzena is valuation. He calculates that even at a below average 500 planes a year Boeing’s earnings power can approach $8.00 a share. At current levels, the stock is still inexpensive, trading at a price to earnings ratio of less than 8X peak EPS, a significant discount to previous cycles. With relatively new management, a recovering global economy and strong market leading businesses, there is every reason to believe, as Pzena does, that the multiple, and stock price, can double from current levels.
Disclosure: No Positions