Wish you had a chunk of Apple amid all the excitement about new phones and tablets? You will feel better about that gap in your share portfolio after you have read this in-depth piece by RE:CM analyst Johannes Visser on US tech stocks.
Johannes explains how one of South Africa’s top asset managers has sized up some of the biggest technology companies for their investment potential. He reminds us that some might be good businesses but they are not necessarily good investments.
“A focus on price is the most reliable way of influencing future investment returns and managing risk. The lower the price paid, the higher the potential return and the lower the risk of permanent loss of capital,” he reminds us. – JC
By Johannes Visser
This article takes a look back at our investments in US technology companies namely Dell, Intel, Microsoft and Hewlett Packard. We described Dell, Intel and Microsoft as a group in ‘The Fat Pitch’ (RE:VIEW Volume 18, October 2011) after first writing about Dell in ‘Freebasing Free Cash Flow’ (RE:VIEW 14, October 2010). We invested in Dell at the end of 2008, Intel at the beginning of 2011, Microsoft at the end of 2011 and subsequent to our writings invested in Hewlett Packard at the end of 2012.
The key points we made about these technology businesses at the time were:
We had largely avoided tech firms in the past as they were difficult to value or vastly overpriced.
Certain technology businesses that were corporate infants 10, 20 and 30 years ago had established strong competitive positions over time that made them easier to value. These included Dell, Intel and Microsoft.
Over the past decade, in which their share prices went nowhere or declined, valuations had become attractive. These companies had produced stellar operating results, with Dell, Intel and Microsoft essentially tripling revenue and EBIT per share. Operating performance had finally caught up with dotcom era valuations. Investors were valuing businesses that generated three times the cash flow of 10 years ago for three times less. In fact, the market was implying that Dell, Microsoft and Intel were substantially worse businesses than the average business, valuing them at a 50% discount to the world market long-term average.
Why was this the case? Firstly, these companies, once the sexiest around, had become stock standard boring due to their mature, old tech status and because their share prices had gone nowhere for a decade. Investors were extrapolating this lacklustre share price experience into the future. Secondly, these companies were running into a headwind, which culminated in exaggerated negative sentiment. The ‘story’ was that Dell’s PCs, Intel’s chips and Microsoft’s software had not capitalised on the growth in smartphones and tablets, which posed a threat to their existing business.
These expectations were in direct contrast to the valuation of Apple, the market darling. High growth and positive opinion led to a high market valuation.
In summary, what we said about each investment in the earlier articles was:
Dell
We believed at the time that Dell’s direct sales model would be difficult for its large competitors to imitate. This was because of the competitors substantial physical and vested investment in legacy distribution channels. We felt this gave Dell a permanent negative working capital advantage, strong free cash flows and high returns on capital.
Intel
Intel’s advantage was its scale. It’s size helped it keep its technological advantage by spending more on research and development each year than the total market value of its nearest competitor, AMD. Interestingly, as a percentage of revenues, the numbers were similar. Sometimes scale can be a considerable competitive advantage.
Microsoft
Microsoft’s initial success had created a network effect that was self-perpetuating, creating ever-improving products and 90% market share. Switching from its products would be costly and disruptive for customers which gave Microsoft pricing power – free alternatives have been available for two decades yet customers still prefer to pay.
Hewlett Packard
We considered Hewlett Packard (HP) an average business available at a very attractive price. As the largest seller of PCs, servers and printers in the world, HP wasn’t going to just disappear overnight. Following years of board infighting, CEO turnover and a string of poor acquisitions in an effort to reinvent the business, the market had grown negative to the point of implying an excessively poor future outcome. Capital allocation looked set to improve with activist investor Ralph Whitmore stepping in as shareholder and Chairman, while new CEO Meg Whitman formulated the right strategy for shareholders: profitability over growth.
Apple
Apple’s success was largely attributable to its innovation and design as a consumer device manufacturer, rather than the stickiness of its iOS platform. We believed that this advantage would be difficult to sustain, particularly with commodity consumer devices like smartphones, which have short replacement cycles and where competitors have the ability to create near substitutes. Apple’s operating margins of 35% appear unsustainable considering that its competitors as a group have earned, at best, low double digit operating margins in the past.
While Apple’s competitive position and the value of the business was one element we looked at, the other was price. While there was a chance investors could make money if they bought Apple at the prevailing share price, we thought the risk of a permanent loss of capital was high enough to justify not investing.
What’s happened since then
Dell’s business model was easier to replicate than we expected
Dell’s business model didn’t turn out to be as impregnable as we initially expected. Low cost Asian competitors pressured profitability and the company’s ability to generate strong free cash flows. With hindsight, our quality assessment was optimistic and as a result we placed too high a value on the company. But our emphasis on price or margin of safety, stood us in good stead. We did most of our buying in Dell at a substantial discount to our estimate of intrinsic value. We bought at a price to normalised earnings of approximately six times, not adjusting for the significant amount of net cash on its balance sheet – 30% of its market value at the time.
Chart 1: Dell Price-to-Earnings (P/E) and Share Price
Source: Thomson Reuters Datastream
Chart 2: RE:CM Ownership of Dell
Source: Bloomberg, RE:CM
Chart 1 shows Dell’s Price-to-Earnings ratio (P/E), share price and the ownership period since 2008 and Chart 2 shows our buying and selling during the ownership cycle. Even though our estimate of Dell’s intrinsic value reduced, we avoided a permanent loss of capital by buying cheaply. Our investment in Dell earned an annual rate of return (IRR) of 11.2% over the ownership cycle, below the MSCI World Index return of 14.7%. Following the recent offer by Michael Dell and Silverlake to take Dell private in a leveraged buyout, we sold the last of our shares in the company. We sold somewhat below our estimate of intrinsic value with the view that if the deal went through there’d be no further upside from the current share price. On the other hand, if the deal did not go through the share price would most likely retreat.
Intel has pricing power and is investing into new markets
Intel continues to dominate consumer PC chips. Unlike Dell, it also has pricing power that it can use to offset potential volume declines from substitution of PCs and notebooks with smartphones and tablets. It’s also applying its research and development advantage in those areas. It already supplies chips to tablets and is making significant progress in smartphone chips. In addition, a substantial part of Intel’s business is supplying chips for servers where the outlook with the move to the cloud remains solid.
Chart 3: Intel P/E, Share Price and World Market Long-Term Average P/E
Source: Bloomberg
Chart 4: RE:CM Ownership of Intel
Source: Bloomberg, RE:CM
We’ve been very cautious in our current valuation, given the difficulty in estimating cyclicality versus secularity in the PC market. As a result, our estimate of Intel’s intrinsic value has grown at a slower rate over the past couple of years than might be expected from such a business. As Chart 4 shows, we sold two thirds of our position at the beginning of 2012 when the share price rerated and subsequently bought a large stake at the end of 2012, when the margin of safety widened. Intel has returned 18.0% over the period, ahead of the MSCI World Index return of 14.8%. Our work shows that it’s still undervalued and we continue to hold it on behalf of clients. It comprises 4% of the RE:CM Global Fund.
Strong pricing power and demand for its products should sustain Microsoft
Our assessment of Microsoft’s competitive position has not changed and the fundamental value appears to be intact. It continues to have a wide and durable moat for a large part of its business. The biggest risk to Microsoft remains that a proportion of its customers move to competitors – such as tablets and smartphones, where switching costs are lower to replace previously loyal customers. Still, this risk is somewhat offset by Microsoft’s pricing power. Microsoft continues to offer a vastly superior product than competitors at a relatively small price increment in relation to the benefit business users get from it.
As with Intel, we’ve erred on the side of caution given developments in the PC market. In addition, Microsoft has a penchant for ‘deworsifying’. In the past, these value destructive acquisitions of lower quality businesses were small relative to the company’s cash flows. Unfortunately management has spent even more of its free cash flow on such acquisitions than we anticipated, the most recent being their acquisition of Nokia’s handset business. For these reasons, our intrinsic value has grown at a slower rate than we expected when we bought the company.
Chart 5: Microsoft P/E, Share Price and World Market Long-Term Average P/E
Source: Thomson Reuters Datastream
Since first buying Microsoft two years ago, it’s returned 19.0% p.a. compared to the MSCI World Index return of 15.8% over the same period. With the margin of safety narrowing, we’ve sold down our position from a peak of 6.2% of the RE:CM Global Fund to 4.5%. We still estimate that it offers investors an attractive risk-reward profile. The market appears to be pricing in zero to negative future earnings growth whereas we believe that, with its strong pricing power and demand for its core products, it should be able to grow earnings in line with GDP. We’re cautiously optimistic on Microsoft’s future capital allocation given its recent signing of an agreement of cooperation with Value Act, a shareholder with sensible views around capital allocation. We believe this could be a catalyst to close the price to value discount.
Chart 6: RE:CM Ownership of Microsoft
Source: Bloomberg, RE:CM
Hewlett Packard has rerated, but little else has changed
Not much has changed fundamentally at HP, but since we bought a year ago the share rerated from its lows of one times book value to two times, the share price effectively doubling. HP has returned 154% over the past nine months compared to 25% for the MSCI World Index. Although the current market price reflects a view closer to our own we still estimate HP to be approximately 25% undervalued. However, as the discount to value narrowed, we reduced our position size in HP from 3% to the current 1% in the RE:CM Global Fund.
Chart 7: HP P/B and Share Price
Source: Thomson Reuters Datastream
Chart 8: RE:CM Ownership of HP
Source: Bloomberg, RE:CM
Apple’s advantages might be difficult to sustain
What has happened to Apple’s share price since we last wrote about it is somewhat irrelevant to us as it was the right decision at the time to avoid Apple shares. In short, Apple didn’t take over the world and reach the widely expected $1 trillion in market capitalisation. Instead, it fell back to $320 billion and then rose back to $410 billion, in the process underperforming the MSCI World Index and Microsoft, to which we compared Apple, by approximately 30%.
At the right price we’d buy Apple shares for our clients. Apple is still a good business, but not yet a good investment. We’d consider it a smart move by Apple to sacrifice short-term profitability to grow it’s number of handsets and hence the strength of it’s platform create a better long-term business. But most investors won’t relish declining margins. We can only hope that this creates an attractive buying opportunity for long-term investors like us.
Our remaining tech holdings still show good value
Collectively our US technology holdings returned 147% compared to the market of 101% over the past five years. This is an annualised return of 20.6% compared to the MSCI World Index performance of 15.6%, an outperformance of 5% per annum. Our US technology holdings peaked in March 2013 at 15.3% of the RE:CM Global Fund and currently comprise 9.4% of the Fund. We estimate the remaining holdings – Intel, Microsoft and HP – to be 25% to 30% undervalued.
These US Old School technology investments demonstrate many of the aspects of our investment process that we’ve written about before. They nevertheless bear repeating:
Profitable long term value investing depends on understanding the competitive position of businesses which is fundamental to understanding their basic risk and worth.
A focus on price is the most reliable way of influencing future investment returns and managing risk. The lower the price paid, the higher the potential return and the lower the risk of permanent loss of capital.
Scaling bets according to cheapness or rebalancing adds value.
Boring quality outperforms sex appeal. Behavioural finance has demonstrated that humans tend to give up a certain gain for an uncertain chance of an even bigger one. It’s telling that businesses that are fairly easy to understand can be significantly under-priced, while businesses that are harder to understand often attract very high valuations. This phenomenon manifests through the popular sentiment towards a company. This is why we’ve learned to avoid popular stocks and prefer to fish for bargains where the news is less favourable.
Ultimately, we aim to maximise investment returns and minimise the risk of loss. We do this by investing in businesses with wide and durable competitive positions as these earn sustainably high returns on capital. In addition, we try to pay less than our estimate of intrinsic value to translate those business returns into an even more favourable investment return and further curtail risk.
*Johannes Visser, analyst
Republished with the permission of RE:CM.
