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You’ve Crunched the Numbers – Now What?
Posted by: Geoff Gannon (IP Logged)
Date: February 14, 2012 12:23PM
Someone who reads my articles sent me this email:
I was looking at the fundamental of 18 stocks; I own 5 of them: Apple (AAPL), Abbott Laboratories (ABT), Autodesk (ADSK), Cisco (CSCO) and Exelon (EXC). Others were ideas collected from places like news, etc.
… The ranking exercise (is) based on growth and fundamental analysis. EXC ranks at the bottom in both analyses…Top 4 results are Apple, BHP Billiton (BHP), Mosaic (MOS) and Rio Tinto (RIO). MOS was eliminated as it has one year of negative FCF.
Since AAPL is listed as No. 1, I went back and looked at P/E when I bought it at $333 in April and May 2011. The P/E was 11 - 13 times. It is currently 15 times… I think the iPhone 4s plus Sprint network addition plus iPad plus enterprise adoption of Mac will provide an impressive fabric of earning growth that is sustainable.
The other two on the list are basic materials, they could be… good long-term to my stock portfolio. Assuming scarcity as their global trend (need to learn more here.)
From the fundamental analysis: Rio is cheaper than BHP. But, RIO is qualitatively inferior when compared to BHP (ROIC, ROE, ROA). I have not looked at Vale (VALE), so maybe next weekend I will continue this exercise with VALE.
I am not confident what the next step can be.
Should I do more work or buy AAPL or EXC?
Thank you very much.
(I should mention here that Ning included some very extensive Excel tables with this email.)
Those are some extensive tables you included there. They are thorough. But I think the next step is not quantitative. It is qualitative. I would first look at the stocks you already own and feel you know best.
This sounds like Apple (AAPL) and Exelon (EXC).
I may be wrong about that. But it sounded to me like you had a lot of basic materials stocks show up for purely quantitative reasons, while you yourself didn’t have a strong feeling whether buying basic materials was a good idea or not. It could be. But you didn’t seem to have any special insight there. Am I right?
Where you did have some special insight – or at least a very clear opinion – was on Apple. Now, normally I wouldn’t encourage anyone to start with one of the most talked about, written about, gossiped about companies out there.
Everybody has an opinion on Apple. Everybody knows the company. It is hardly a hidden gem. But it might be a gem in plain sight. And it sounds like you have some ideas about Apple beyond the numbers. So, that’s where you should start.
The other company it sounds like you’re interested in is Exelon. Part of the reason why I’m saying you sounded interested in doing more work on Exelon is that you talked about the stock despite it finishing at the bottom of your purely quantitative comparison.
Is that really a good sign? Am I really saying you should spend more time studying a company that finished at the bottom of a comparison you drew up?
Here’s what I’m saying. You did a wonderful quantitative comparison of some very different stocks. A bunch of the stocks you’ve got there are basic materials stocks. This should tip you off that something is – amiss. When you do a purely quantitative survey of stocks you’re casting a net. When you get back a list of stocks that are all in the same industry, you need to take a good, long pause.
You may not be measuring what you think you’re measuring. Or at least you may not be catching what you wanted in that numerical net you threw.
I think Exelon and Apple are a good place to start.
They are very different companies. That's good. Apple is a very high profile company. While Exelon is not. Both are potentially very interesting companies.
You could argue that either has a wide moat.
I wouldn't disparage the quality of either business relative to its peers. However, I think the next step – for me at least – would be to look at the industries they operate in. Are Apple and Exelon predictable? Do they have sustainable competitive advantages – especially in regards to operating margins and return on equity. Look at the stocks found in GuruFocus’s Buffett-Munger Screener. Compare the stocks you’re interested in with those companies. Not just quantitatively, but qualitatively as well. Right now, it doesn’t look like either Apple or Exelon score very high in terms of business predictability (as GuruFocus measures it). Again, that’s a purely quantitative judgment – like your own Excel tables – but it’s worth keeping in mind.
I’ll tell you how I use quantitative measures. I don’t think of them as giving me the whole picture. I like to think of them more like vital signs. They are alerts. They let me know what areas of a stock I need to study more thoroughly. For example, Apple gets a 1-Star business predictability rating. Does that mean it’s a bad, unpredictable company?
Absolutely not. It just means that the trajectory Apple has had these last 10 years hasn’t been predictable. It has been phenomenal.
So you need to focus – this is always true, but it’s especially true with Apple – on whether or not the current level of sales, earnings, etc., are sustainable for the long-term. In Apple’s case, this means you need to do qualitative analysis. Probably competitive analysis.
The industry Apple operates in – consumer electronics – is not an especially predictable one. It is not one where competitive advantages – “moats” – tend to be especially durable. That doesn’t mean that Apple can’t maintain its terrific position. It doesn’t mean Apple lacks a moat. It just means that you need to investigate that issue.
Okay. Another good question to ask is what the risks are. What happens if your assessment of a company is wrong? What if you think Apple has a wide moat and it doesn’t? What if you think a barrel of oil will be $150 in 2013 and it ends up being $50? Often, investors focus on the probability of an event. That’s important. But it’s not more important than thinking about what happens if your assessment is wrong. Maybe $150 a barrel oil is way more likely than $50 a barrel oil. But – no matter how sure you felt about the future price of oil – would you really buy a stock that could go to zero if oil stayed at $50 for any length of time? Probably not. Likewise, however strongly you feel about Apple’s “moat” as of this moment – it’s important to be honest about what would happen to the stock (and your portfolio) if Apple’s moat were breached.
I wrote about mean reversion in one of my net-net posts. My point was that when you buy a company that's very cheap relative to its liquid and/or tangible assets any movement toward that company doing "about average" relative to American business generally is a positive for you. Well, these two stocks – Apple and Exelon – are far from net-nets. Any movement towards an "about average" business performance for stocks like Apple and Exelon will be very, very bad for you. That is because you are – in both cases – paying a high price to liquid and tangible assets (relative to the price you could buy many of their peers at).
That doesn't mean they are bad businesses. An insurer or bank that trades at a premium to tangible book value may be quite a bargain if it is something like Progressive (PGR) or Wells Fargo (WFC).
The important thing is not to confuse a temporarily wonderful competitive position with a competitive position like PGR or WFC that can probably be maintained for many, many years.
You may disagree with me here, but I think in the case of Apple you are really betting on the organization. And in the case of Exelon you are betting on the assets. Basically, you are saying that Apple's brand and people and culture working together are going to achieve things – like higher returns on investment – than competitors who seek to do the same thing. In the case of Exelon, I think you are saying that their assets are lower cost (higher margin) generators of power than their competitors. In fact, you are saying they are so much more efficient that it is worth paying a substantial premium to tangible book value.
I don't disagree with either claim. I think Apple has a superior organization. And Exelon has superior assets.
Exelon's assets are clearly carried at far below their economic value. So the issue with Exelon is how to value those assets.
Have you read Phil Fisher's "Common Stocks and Uncommon Profits?"
It is a good book to read if you are thinking about investing in Apple.
And "There's Always Something to Do" is a good book to read when thinking about Exelon.
After reading the information you sent me, I'd say that the most important thing for you to do now is get some distance from comparative numbers. Think about what it is you are buying in each case. What aspect of the business is providing you with your margin of safety?
It’s not the price.
These are not cheap stocks on an asset value basis if you consider only their tangible book value.
Therefore, either the tangible assets must be worth much more than they are carried for on the books – or the intangibles must be very valuable for you to buy these stocks.
In your final analysis I think you should focus on one question:
How comfortable would you be if you had to hold this stock forever?
This is an important question because you may have in mind that you have a lot of faith in Apple right now. That faith may be well founded. But if you have little faith in Apple four or five or six years out – do you really think you will be the first to spot the company's loss of leadership? Think about how quickly companies like Nokia (NOK) and Research In Motion (RIMM) saw their P/E ratios contract when investors realized just how far they were behind the competition. Do you really think you will be fast enough to spot a change in Apple's position? It’s not enough to see the writing on the wall. You have to see it faster than everyone else. You have to sell before they do.
That’s not the Phil Fisher way. The Phil Fisher way is to be very sure when buying a growth company. Then, yes, you do monitor the situation. But it is not about understanding the situation one or two years out. It is about understanding the qualities already present in the company that will prove durable.
Even if you've read Phil Fisher and Peter Cundill's books, I'd suggest looking at them again as they are good examples of the kind of investing you are trying to do in Apple (Fisher) and Exelon (Cundill).
Also, you might want to read a bit about Marty Whitman's philosophy and Mario Gabelli's philosophy. If you think Exelon is a buy, it is probably because you have reasons similar to the reasons those two investors have when they buy a stock.
Basically, Marty Whitman and Mario Gabelli try to find out the value of a company's assets in a private transaction. They don't try to figure out what public markets will pay for the stock. They try to figure out what private owners would pay for the business and they work back from there to figure out the stock's value.
So my advice is to step back from all the numbers. Zero in on just a couple companies. Don't look at more than one stock in the same day. If you are thinking about Apple today then think only about Apple for today. Exelon can wait until tomorrow. Think about what aspect of the company makes the stock clearly worth more than its current price. Then study that aspect. And don't add a dime to your investment in that stock until you are comfortable with betting on the permanence of that aspect.
Make sure you understand the value in the company. And make sure that value is durable.
Understanding often requires more than just numbers. So, I think your next step will be a qualitative analysis.
Talk to Geoff About What to Do After You’ve Crunched the Numbers firstname.lastname@example.org