Thursday, November 22, 2007

Happy Thanksgiving!!

Happy Thanksgiving wishes to our American readers! Certainly, no matter what the circumstances that life may bring you, there is always much for which to be thankful.

It has been said that the hardest arithmetic to master is that which enables us to count our blessings. Albert Schweitzer described the importance of gratitude,

" To educate yourself for the feeling of gratitude means to take nothing for granted, but to always seek out and value the kind that will stand behind the action. Nothing that is done for you is a matter of course. Everything originates in a will for the good, which is directed at you. Train yourself never to put off the word or action for the expression of gratitude."

America's National Day of Thanksgiving actually was proclaimed by President Lincoln in October of 1863 which set apart the last Thursday of November "as a day of Thanksgiving and Praise." The nation was still in the midst of civil war and the battle of Gettysburg had occurred just several months prior. Lincoln had not yet delivered his Gettysburg address.

Despite the horrible anguish of war, Lincoln delivered the following proclamation:

"The year that is drawing towards its close, has been filled with the blessings of fruitful fields and healthful skies. To these bounties, which are so constantly enjoyed that we are prone to forget the source from which they come, others have been added, which are of so extraordinary a nature, that they cannot fail to penetrate and soften even the heart which is habitually insensible to the ever watchful providence of Almighty God"...

"It has seemed to me fit and proper that they should be solemnly, reverently and gratefully acknowledged as with one heart and one voice by the whole American People. I do therefore invite my fellow citizens in every part of the United States, and also those who are at sea and those who are sojourning in foreign lands, to set apart and observe the last Thursday of November next, as a day of Thanksgiving and Praise to our beneficent Father who dwelleth in the Heavens. And I recommend to them that while offering up the ascriptions justly due to Him for such singular deliverances and blessings, they do also, with humble penitence for our national perverseness and disobedience, commend to His tender care all those who have become widows, orphans, mourners or sufferers in the lamentable civil strife in which we are unavoidably engaged, and fervently implore the interposition of the Almighty Hand to heal the wounds of the nation and to restore it as soon as may be consistent with the Divine purposes to the full enjoyment of peace, harmony, tranquility and Union."

Though war rages in many parts of the world, though terrorism remains an ever-present concern to all of us, though there remains "lamentable civil strife" in many nations, the magnificent words of Lincoln ring true today.

My Thanksgiving wishes for all of us include for you and yours the full enjoyment of peace, harmony and tranquility.We have much for which to be grateful and thankful. I count your loyal readership among my blessings! Have a good one!

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Wednesday, November 14, 2007

Fear Brings Opportunity and Digging for Value

Whitney Tilson is the founder and Managing Partner of T2 Partners, a hedge fund, as well as a mutual fund operation. He has co-founded a terrific newletter and established a semi-annual investment conference, Value Investing Congress, where he features a number of legendary investors. As an extension of the conference, he has introduced a new blog to highlight value investment thinking. One of the recent posts is, in my opinion, quite demonstrative of the "inverse emotionalism" that is required to be a successful value investor.

Zeke Ashton of Centaur Capital describes the fear that has infected financial services stocks very aptly:

"Clearly, we’ve got fear now, and at the epicenter of that fear is the U.S. real estate market. This fear is reflected in extraordinary volatility and stock price declines for those companies seen most vulnerable to the real estate bust – most notably homebuilders, mortgage lenders, and mortgage guarantors – coupled with all-time high prices for disaster protection on these names."

If there is a single mantra for value investors, Ashton nails it here:

"But as all value investors know, fear brings opportunity. One of the axioms of fear-based selling is that everything viewed as being in proximity to the danger gets sold."

Indeed, fear brings opportunity, and panic is never discriminating. Damage occurs at the periphery of the disaster and securities are unjustly marked down. True value investors sift through the rubble to unearth the bargains that were caught in the cross-fire. Timing is impossible, but strict adherence to a discipline and patience will provide great long-term returns. In a behavioral sense, it is always difficult to overcome the social pressure to conform. Being ostracized by others (especially clients who don't yet "get it") is a difficult position to maintain. No wonder closet-indexing is so prevalent; closet indexers turn out to be momentum players, just like the indices they hug! But, doing your own thing, ignoring the noise, celebrating the fear of others is a good high probability bet if your decisions are disciplined.

Here is the direct link.

Friday, November 09, 2007

Where Have All the Deals Gone? and Star Wars Thinking

There is an interesting dichotomy that exists in capital markets. Not so many months ago, pre-August, there was a widespread perception that we were running out of stocks. Private equity interests were gobbling up anything that had a reasonably steady cash flow. Such companies were easily leveraged by the accommodating banks and investment bankers. Needless to say, the music stopped in the takeover waltz (as all of us can see, Chuck Prince has stopped dancing) In one of the more memorable and now infamous quotes that have come out of this capital market era, Chuck told the FT:

When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.

Despite the fact that liquidity had a major hiccup, and deal cancellations have been fairly rampant, U.S. private equity firms are still dancing. They have bested last year's record of $258 billion and have passed the $263 billion mark with a month and a half to spare, according to Dow Jones' Private Equity Analyst.The majority of the capital, just over $200 billion has gone to leveraged buyout shops.

I think this is an important factor to bear in mind. Certainly, every time markets go sour, similar behavior occurs. Fear leads us to truncate our investment horizons, long-term growth is set aside, growth forecasts are reduced, earnings multiples are brought down, required rates of return are brought up. Prices collapse.

But what is different this time is that there is more private equity firepower than ever that is ostensibly on the sidelines for now. Buyouts will continue to occur but will require greater equity funding and less leverage. Returns on equity driven by leverage may well be less than historical returns but perhaps prices to effect a takeover may well be less demanding.

The world has changed as financial institutions are taking hits from CDOs. But it ain't entirely over. At The Deal's M&A conference this week, Leon Black observed, "there's no question that this summer the world changed for private equity" as the credit markets that allowed "private equity to go from being 3% of the M&A market to 35% in 2007 shut down for doing highly leveraged deals." "The ability of private equity and acquisitive strategic buyers to innovate in terms of financing is almost unlimited."

One other observation re innovation in capital markets. Equity capital markets issuance globally totaled $445 billion over the first six months of 2007 on 3,000 deals, the highest dollar volume since the record set in 2000. As some of you may recall, this wasn't exactly a precursor for positive markets for the next two years. Much of the capital raise has occurred in Asia and emerging markets. In the third quarter, a total of 248 IPOs raised $46.8 billion world-wide in the quarter, up from 179 that raised $40.71 billion in the same period last year.

But outside of public equity lives the PIPE market, private investment in public equity, a market that has historically been viewed as a last-ditch source of financing. Historically, small cash-starved tech or healthcare companies that couldn't secure more conventional debt financing utilized this market. According to financial research company Sagient Research Systems, the PIPE market hit historic highs in the third quarter of 2007, with $38.8 billion, or 996 transactions, 33% greater than the volume of PIPE transactions through the same period in 2006.

Private placements such as PIPEs can be done at lower cost than traditional equity deals. Because such deals are sold to accredited or institutional investors, the securities do not require registration with the SEC. Consequently, a great deal of time and expense can be saved. As banks try to value their existing loan and structured portfolios, PIPEs are finding a way to infuse capital into deals.

Credit problems remain a thorny issue for capital markets. But market innovations are more available than ever. Nasty markets will put prices into the gun sights of some of these participants. Prices can be silly and exaggerated at either end of the spectrum, both way too expensive and way too cheap. Technicians may worry about falling knives but decent businesses that have been hacked by fearful sellers may create great buying opportunities.

Consider yesterday's Restoration Hardware news. A private equity company is doing a buyout at 2.5 times Wednesday's price! Though this business has struggled in the retailing slump, obviously there still appears to be some franchise value that many investors missed.

As an investor, don't rely on the short-term trends in a stock to tell you what it is worth. Earnings surprises, earnings revisions represent noise. We cannot guess the unknowable future. We are far better equipped to understand the present and what it means for the future. Use market weakness to rethink your analysis. But analyze rather than rationalize...hang onto your companies that have enduring competitive advantage and great returns on invested capital. Stick with ROIC and dismiss growth for now. A high return on invested capital is the signpost of a great franchise. Ensure that cash flow generation is there, don't rely on earnings and especially earnings forecasts.

Remember that an equity represents a long-term claim on assets. Yet most analysts base their opinion on next year's or maybe two years of forecasts.
That's not how anyone should value a stock.

There is a great line from Obi Kenobi in Star Wars that comes to mind, "Who is more foolish? The fool or the fool who follows him?"

Stay calm, relaxed and aware. There's lots of fat pitches coming our way.

Disclaimer: I, my family, and friends do not have a current position in any securities mentioned in this post.

Thursday, November 08, 2007

IT Services and Technology

Cisco Systems (CSCO)'s results of last night have cratered a lot of tech stocks today, particularly hardware. IBM. EMC, Network Appliance (NTAP) have all had a good drubbing in today's marketplace.

Though the sector has exhibited standout performance relative to most other sectors, notably the ailing banks, there are concerns that the impact of credit markets may lead to a decrease in orders for both tech goods and services.

One of the tech sectors that makes the most sense to me under most economic scenarios is IT Services. The notion of consultative help rather than having permanent staff is attractive in any slowdown scenario.

Cognizant (CTSH) was clipped today on mixed fourth quarter guidance. Cognizant, as well as other Indian IT services providers enjoy an attractive cost advantage that could benefit from additional demand from an economic slowdown. Cognizant is known for its high quality consultative approach. What seems to concern investors about the outlook is commentary from CTSH that it was not seeing a fourth quarter "budget flush." As most of us have experienced, managers have a tendency to spend out whatever remains in their current year budget to ensure that this becomes the base for next year's budget. The flushing through of budgets does not appear to be occurring for CTSH. I believe that one area of particular concern for IT providers is the spending plans of financial services companies.

Concerns about financial services reducing demand for IT may be somewhat misguided in my opinion. Cognizant cited a survey to assess clients' budget plans for 2008 involving about 150 decision makers representing a broad cross section of clients. According to management, 92% of clients do not expect overall IT budgets to decline for 2008. . Clients were also asked what would occur to offshoring budgets in the event of a decline in overall IT budgets. Only 19% felt that an overall budget reduction would meaningfully impact offshore spending plans. Among financial services customers, about 90% do NOT expect outsourcing budgets to decline.

Valuations in the sector are all over the map. CTSH has TTM EPS of $1.13 , equal to its operating cash flow per share. Free cash flow is $0.56 per share.At a 1.8% FCF yield currently, it does not represent a bargain.

On the other hand, Accenture (ACN) has trailing EPS of $2.06, operating cash flow of $2.67, and free cash flow of $2.58. Based on today's close, that's a free cash flow yield of 7.3%! I like the high conversion of operating cash flow into free cash flow. Just over 10% of each dollar of revenue for ACN is free cash flow, slightly higher than CTSH's 8.6%.

Both companies have active buyback programs with CTSH just announcing a $100 million buyback. Last fiscal year, ACN bought back a total of $2.3 billion in stock. There remains an authorization for $1.65 billion.

About 22% of ACN revenues came from financial services in the most recent fiscal year. About 57% of ACN's revenues come from outside the Americas. On the other hand CTSH, unique among Indian IT outsourcers generates some 80% of its revenues from the States. Its reliance on the financial services sector is also somewhat heavier at about 47% for FY 2006 and the most recent quarter.

In my view, Accenture with a market cap of $27 billion, only about $760 million in debt, and cash of $3.5 billion represents excellent value. Its enterprise value to TTM EBITDA is only 8.4 times.

Disclaimer: I, my family, or clients own a current position in ACN. None have a current position in CTSH.

Monday, November 05, 2007

Some Thoughts on Formulaic Investing

As some of you know, I am an occasional contributor to Shai Dardashti's "Reflections on Value Investing." I think you will be impressed with the quality of serious contributors to the investment thinking that characterizes this blog. I commend it to your attention.

In today's edition, I discuss formulaic investing based on an article written some time ago by my friend Geoff Gannon.

Formulaic investing provides an important discipline to the investing process. It attempts to disengage us from the emotions that are so frequently associated with future poor results. Though not a substitute for thinking about other parts of the mosaic that comprise every investment, formulaic approaches form a very important backdrop to valuing a business. Necessarily, they are backward looking...valuations that depend entirely on formulaic approaches are extrapolating the past into the hereafter, not a sensible approach to looking at a business. After all, a stock's value consists of some sort of discounted value of all future cash flows. The past is, well it's passed. In immutable businesses, of which there are none, the thinking could end there. Remember the Buffett aphorism "The investor of today does not profit from yesterday's growth." Another one comes to mind, " If past history was all there was to the game, the richest people would be librarians." But as a starting point to the question, "What is this business worth?" formulas represent a useful benchmark for the economic reality of a business. Where it goes from here, what competitive influences will do, how it finances itself, how long the competitive advantage period will last are all unaddressed questions that are the add-ons that are needed to fully understand a business.

I apologize for my long absence from the blogosphere. Work expands, time contracts. Market opportunities are expanding with the crescendo of fear. Within portfolios, I continue to uphold the cornerstone of a value investment style, lethargy bordering on sloth.I appreciate your patience!

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