Okay, now it’s your turn to call me a charlatan. But before you do, let me share with you two examples: one that has already played out and one that is still very actionable.
In May 2012 I made the case for Redwood City, California, gamemaker Electronic Arts. My firm’s original premise in buying EA was that it looked expensive statistically, but statistics did not capture the company’s true earnings power. EA is transitioning from selling packaged games to digital ones. Digital games come with much higher profit margins; thus, even with little revenue growth, EA’s margins should go up. And they have. In fact EA’s fundamental story worked as we expected.
During the third quarter of 2013, we sold Electronic Arts in two tranches, the first time in the mid-20s, the second time in the high 20s.
However, right after we bought the stock, it declined nonstop for more than six months. Here is where the lesson comes in: A stock decline is not necessarily a bad thing, even if it happens right after you buy (assuming fundamentals have not collapsed). When we buy stocks, we believe they are irrationally priced — that is, selling at a discount to their fair value. But just because we bought a stock doesn’t mean it will not become even more irrationally priced. At the time we buy a stock we believe it is undervalued — otherwise we would not have bought it — but we have no idea whether it will go lower.
There was a lot of good that came out of EA’s stock decline. First off, we had an opportunity to buy more. Second, EA bought a lot of its own stock. This share repurchase created value for shareholders and allowed us to reset our second sell target to the high 20s. (We were initially willing to part with all shares in the mid-20s.)
The same thing is happening with the stock of another company that I’ve discussed in the past: Xerox Corp. The case for Xerox that I laid out to you was straightforward: Investors put this company in the same has-been wastebasket as Eastman Kodak Co.: obsolete technology, leveraged balance sheet, two steps away from the grave. This perception creates an opportunity, because Xerox (XRX) is not Kodak.
Roughly half of Xerox’s revenues comes from services. About 30 percent of revenues comes from copier supplies — which are very recurring and not going anywhere — and only 20 percent comes from selling copiers. Old habits formed over decades die hard; so business printing, though it isn’t growing, is at worst a very slowly declining annuity (and color printing is actually growing). In the meantime, Xerox’s nonprinting business is growing quite well and has been offsetting the decline in printing. The company’s net debt, at $6.5 billion, appears to be high, but it isn’t; two thirds of it is financed debt used by Xerox to pay for its copiers. Xerox’s corporate debt is less than $2 billion.
Despite the false appearances, Xerox is a solid company. Its free cash flow exceeds earnings by a third (we put them at about $1.50 a share).
After we bought Xerox, it declined for about a year. We bought more shares. The company has taken advantage of its stock price decline and bought back 7 percent of its shares over the past six quarters. At the same time it has reduced its debt by almost $2 billion. On last quarter’s earnings call, Xerox’s management discussed increasing share buybacks.
When a stock trades at a bit more than six times (stable) free cash flow, you can create an enormous amount of value through buybacks. In fact, as paradoxical as it may sound, we don’t want Xerox stock to go up much; we want the company to buy as many shares as it can, and cheaper prices help that. Xerox’s stock will be doing nothing, stagnating or, hopefully, declining, until one day investors wake up and realize that the company’s free cash flow per share has exploded, and then so will its stock price.
It may be painful to see your newly minted position show losses right away or remain below your purchase price for a long time. But if a company is taking advantage of its stock’s cheap valuation through share repurchases, the intrinsic value of what you own is actually enhanced by the price decline. In fact, a stock price decline might be the best thing that happened to you since you bought the company, especially if your time horizon is longer than a few quarters. Call me a charlatan, but that’s investing for you.
About the author:
Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo. He is the author of The Little Book of Sideways Markets (Wiley, December 2010). To receive Vitaliy’s future articles by email or read his articles click here.
Investment Management Associates Inc. is a value investing firm based in Denver, Colorado. Its main focus is on growing and preserving wealth for private investors and institutions while adhering to a disciplined value investment process, as detailed in Vitaliy’s book Active Value Investing (Wiley, 2007).