How do great companies get so cheap? The Valuations of Microsoft, ADP, and Wal-Mart
Deep value investor Arnold van den Berg started out as an insurance agent in 1970s. He founded Century Management after he found that things were not done right by most of the financial advisors. Over the past 30 years he has been buying quality companies that are sold at low price/sales and price/earning ratios, and built a fortune out of it.
The portfolio we listed here on GuruFocus is CM Value I Composite, which we obtained directly from Century Management each quarter.
Century Management wrote great newsletters which cover the state of economy, housing, national debt, corporate cash and liquidity, debt and household debt. They publish just one newsletter a year. You can read the most recent newsletter here, which was published in Nov. 2010.
Ever wonder why large caps continued to lag the market? Why do large companies sold cheap? Will they ever get back to normal valuations? Let’s hear the insight from an long term value investing veteran – Arnold Van Den Berg.
The following are excerpts from the newsletter.
Our Portfolio: Large‐Cap Perspective
The stocks highlighted in this newsletter are just a few of the many examples of value present in our portfolios. Like Microsoft, ADP, and Wal-Mart, we have purchased many other stocks over the past few years that we believe were, and still are, selling at wide discounts to their true intrinsic values. Throughout our 36-year history as an all-cap manager, we have found some of our best bargains in smaller companies and believe this will continue into the future. Typically they are less followed, less understood, and therefore more likely to be mispriced. It is only over the last few years that we have found a greater number of large quality companies selling at wide discounts to their intrinsic values.
These larger companies bring with them a greater global footprint, easier access to capital, greater economies of scale, dominant competitive positions in the market place, and the ability to attract great talent. When you can buy all of this at a bargain price, it is hard to pass up. It is for this reason that our typical portfolio currently holds between 55% and 60% of its assets in larger, high quality names. This is only the third period of time in our firm's 36-year history where we have had this higher percentage weighting to large-cap stocks in our portfolios.
How can such well-known, highly followed companies be so mispriced by the marketplace relative to their true values? For many who invested in large-cap stocks over the past decade, these stocks have been nothing but a disappointment. For example, investors who bought the S&P 500 ten years ago have no profits to show for it. Add to this four major market declines and two severe recessions in the past ten years, many investors have become psychologically and emotionally exhausted, and in some cases, financially devastated. How do great companies get so cheap? Are there not thousands of other analysts, money managers and market participants looking at these stocks every day? Why are these professionals and market participants not seeing the same values we are and snapping up the bargains?
How do great companies get so cheap? Are there not thousands of other analysts, money managers and market participants looking at these stocks every day? Why are these professionals and market participants not seeing the same values we are and snapping up the bargains?
These questions can be answered by explaining the four emotions that investors often go through when owning stocks:
1. Apathy. Many people have no interest in owning companies that have declined or gone sideways for an extended period of time, as is the case for Microsoft, Automatic Data Processing, and Wal-Mart, as well as numerous other stocks, especially in the large-cap space.
2. Disgust. After having watched an investment drop significantly or go sideways for an extended period of time, or both, many investors reach the emotional stage of disgust and they just want to sell such a stock as they are tired of looking at it in their portfolios. In addition, many investment managers or brokers will throw in the towel as they are tired of taking heat from their clients on stocks that have behaved in this fashion and they no longer wish for them to appear on monthly statements.
3. Fear or panic. In times of great concern and anxiety over the state of our economy, investors who have not truly quantified the value of the company will often times sell their stock for non-business reasons. Without the analysis to determine a company's true price potential, many investors and even processionals succumb to their emotions that in turn can lead to panic selling. This happens more than you might think.
4. Anger. Investors who have watched their stocks go nowhere but down, often reach the emotional stage of anger. Typically, this occurs at or around the time when a stock's price reaches what we call capitulation. Financially hurt and psychologically wounded, investors are ready to surrender and just give up. It is at this time that stocks are priced as cheap as they are going to sell as many furious investors just want out regardless of price.
Microsoft Corp. (MSFT) Microsoft Corp. is the largest independent maker of software. With over 89,000 employees, it generated over $62 billion in annual sales in fiscal 2010 from a wide variety of products and services. Specifically, it generated 29.8% of its sales through Microsoft Business, 29.6% through Windows and Windows Live, 23.8% through its Servers and Tools, 12.9% through its Entertainment and Devices, 3.5% from its Online Services, and 0.4% from other products and services. Importantly, Windows finished the year with roughly a 92% market share, as well as an 80% market share among enterprise customers and a 63% market share in web browsing through Internet Explorer.
We realize that many believe Microsoft has fallen behind Apple on smart phones and tablets and that there is uncertainty surrounding the impact of Cloud computing on its business. We believe that smart phones and tablets address different needs and different markets than PCs, and thus expand the computing device market. PCs are primarily input and productivity devices while smart phones and tablets are primarily output and content consumption devices, though there is overlap. In other words, Apple has been extremely successful in expanding the overall market, not only for its devices, but also for computing devices such as PCs and Internet servers sold by Microsoft, Intel, and Dell, among others. Regarding Cloud computing, we believe that while there is considerable excitement surrounding it (much the same way there was excitement over the Internet 10 years ago), to the degree that it is adopted, it will make PCs more valuable and drive additional demand for PCs and laptops (as well as for other computing devices). We also believe that Microsoft is extremely well positioned to be a dominant player in Cloud computing. However, Wall Street has the attitude of 'shoot first and ask questions later', creating opportunities for patient long-term investors.
One quick and easy way to estimate whether Microsoft is cheap or expensive is to review the 24- year P/E history shown on Chart 40. Microsoft's median P/E over the last 24 years has been 33.67. This P/E is higher than what we would expect today given that this company does not have the same growth rate it had in the past. However, considering its average P/E over the last five years, which includes one of the worst years in market history, was 18.14, and its average P/E over the last two years, one of which was the lowest valuation in the company's history, was 13.6, its current P/E of 11.66 and forward-looking P/E of 10.42 both seem very cheap. As a matter of fact, at the bottom of 2009, Microsoft's P/E only dropped below 10 for a few months before turning around.
Automatic Data Processing (ADP) ADP is more than a payroll processor. It is one of the largest outsourced solutions providers offering a wide range of payroll, human resource, tax, and benefits administration solutions to more than 570,000 clients around the world. ADP is also rapidly expanding its international presence targeting multinational business with its multilingual, multicurrency solutions.
ADP's annuity-like business is a great model. For starters, it can bundle many of its services. This has helped ADP maintain fairly consistent after-tax profit margins in the 12% to 15% range for more than 10 years. Furthermore, this company has a reasonably predictable recurring revenue stream, as well as a very "sticky" business. For example, ADP has a 90% client retention rate; and the average client relationship is more than 10 years old. This is a sign of a great company.
ADP also has the opportunity to earn money on what is referred to as "float." This is the money that ADP collects for payroll taxes from its clients each pay period. It then holds this money on behalf of its clients until it is time for them to send these payroll taxes into the government. In other words, until this money is due to the government, ADP basically escrows this money for its clients throughout the year. The average daily balance or "float" it has at any given time is approximately $15 billion. Thus, ADP can ladder this "float" or "escrowed money" into various bonds and keep the interest income generated as profits. The investment income gained from this float currently provides approximately $600 million in pretax income to ADP. Eventually when interest rates go up, so will its profits on this float. This company will likely do well in an inflationary environment. ADP also has significant competitive advantages because it is the largest in the industry and because of the scale and depth of its products. For example, ADP has the ability to service the small local employer of 1 to 50 employees, as well as the multinational firm with thousands of employees spread throughout the world. Currently, with only 20% of sales coming from outside the U.S., ADP has plenty of room to grow for many years to come.
Wal-Mart (WMT) Wal-Mart Stores is the world's largest retailer, employing roughly 2.1 million people and generating more than $400 billion in annual revenue (sales). It operates approximately 2,747 supercenters (which include sizable grocery departments), 803 discount stores, 596 Sam's Clubs, and 158 neighborhood markets in the U.S. In addition, it operates more than 4,112 foreign stores, mainly in Latin America, Asia, Canada, and the U.K. According to the U.S. Census Bureau, Wal- Mart is responsible for nearly 10% of all retail sales in the U.S. and 20% of all grocery sales. It is safe to say that Wal-Mart is an important part of consumers' budgets. Wal-Mart's foothold continues to grow. Currently, Wal-Mart-U.S. operations account for 63% of sales. While this is a maturing portion of its business, it is well entrenched.
Next, there is Sam's Club that makes up 12% of sales. The real bright spot and fastest growing portion of Wal-Mart's business is coming from outside the U.S. Currently, international sales represent roughly 25% of total sales. While U.S. based sales are basically flat, international sales are currently growing at an impressive rate of 11%. We believe these international sales can continue to grow at an annualized rate of 9% to 11% for an extended period of time.
Wal-Mart operates its business with tremendous efficiency and consistency. For example, over the past 10 years its profit margin has ranged between 3.1% and 3.6%. Its return on capital has been between 13.6% and 14.8%, and its return on equity has been between 19.1% and 20.8%. In addition, Wal-Mart has a free cash flow yield of 4.4%, a dividend yield of 2.2% and it continues to buy back stock. Year-to-date, cash returned to shareholders through stock buy backs and dividends has been $9.37 billion, or $2.57 per share. Assuming no more share repurchases, Wal-Mart will have paid shareholders $3.28 per share for the full year. This is 82.4% of the yearly earnings and represents a yield to shareholders of 6.4%.
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