I find Tilson to be an excellent source of ideas. Not just because I respect his thinking, but also because he is willing to borrow the best ideas of other investors.
And why not ? His directive is to make as much money as possible for his investors as safely as possible.
I was forwarded his September investor letter, and thought I’d share the interesting parts.
Performance
Our fund rose 1.7% net in September vs. 8.9% for the S&P 500, 7.8% for the Dow and 12.1% for the Nasdaq. Year to date, our fund is up 14.1% net vs. 3.9% for the S&P 500, 5.6% for the Dow and 5.0% for the Nasdaq.
Hurt By Short Book in September
Nevertheless, having our short book move against us so much and therefore trailing the market by such a large margin in September is annoying – but nothing more than that. It was only three months ago, in June, when we outperformed the market by nearly 10 percentage points (+4.5% vs. -5.2%), so it”Ÿs important not to read too much into any one month.
It was ugly for us on the short side – not surprising since it was the best September for the S&P 500 since 1939. The homebuilders and for-profit education companies, which have been very profitable shorts for us this year, bounced a bit (a dead-cat bounce, in our opinion). Also hurting us were DineEquity (+40.9%), Lululemon Athletica (36.0%), Netflix (29.2%), OpenTable (27.9%) and InterOil (16.5%).
Individual Stock Discussion
Iridium
After bottoming in February at $6.36, Iridium”Ÿs stock went on a tear, rising more than 70% to $10.87 in July, but has been weak recently, closing September at $8.54. We are not aware of any change in the company”Ÿs fundamentals that would explain this decline, but we have heard some talk about the competitive threat posed by Inmarsat”Ÿs new IsatPhone Pro so we wanted to share a report that Iridium commissioned comparing Inmarsat”Ÿs phone with Iridium”Ÿs. You can read the entire 14-page report here and a summary is attached in Appendix C. Here”Ÿs the key paragraph:
In Frost & Sullivan”Ÿs testing and analysis, the Iridium 9555 satellite phone was found to be a superior device to the Inmarsat IsatPhone Pro in all locations. Iridium”Ÿs satellite network also offered better coverage, including the ability to use a satellite phone in Anchorage, Alaska, where the Inmarsat phone was inoperable. The Iridium phone provided better call quality, and was faster to find the satellite network and make a call. The Iridium phone offered the ability to receive an incoming call with the antenna down - something the Inmarsat phone could not do. The Iridium phone also offered the ability to use the phone as a modem for a laptop for email or Web access. However, the Inmarsat IsatPhone Pro was less expensive than the Iridium 9555 and also had lower per minute usage charges.
Because the report was commissioned by Iridium, we of course take it with a grain of salt, but our own research leads us to believe that it is correct. We continue to believe that Iridium has bright future prospects and that the stock is deeply undervalued, so it remains among our largest positions.
ADP
We recently added another high-quality blue-chip stock, Automatic Data Processing (ADP), to our portfolio. ADP”Ÿs core business is payroll processing and we believe that it is one of the world”Ÿs great companies. It is more than four times the size of its nearest competitor and there are very high switching costs for its customers, so ADP has fabulous 20% operating margins and unlevered returns on equity in the mid-20% range. It is such a pillar of financial strength that it is one of only four companies left that still have the highest AAA credit rating (we happen to own the other three, Microsoft, Exxon Mobil and Johnson & Johnson, though only the former in any size). Finally, ADP has excellent management and is very shareholder friendly, returning cash to shareholders via a healthy 3.2% dividend and share repurchases (17% of shares have been retired in the past five years).
So what”Ÿs not to like? Two things: 1) Growth has disappeared (EPS in FY 2010, which ended on June 30th, declined 9% from the previous year, and the company only expects 1-3% revenue and EPS growth in FY 2011); and 2) The stock doesn”Ÿt appear particularly cheap, trading at 17.4x trailing EPS.
ADP historically has been a solid growth story – in the 13 years through FY 2009, for example, earnings per share grew 245% (10.0% annually) – so what happened? In short, ADP has been hit recently by two macroeconomic factors: high unemployment (meaning fewer paychecks being processed) and low interest rates, which reduce ADP”Ÿs earnings from its float.
Float? ADP isn”Ÿt an insurance company, so why does it have float? Allow us to explain: as a payroll processor, ADP collects cash from its customers and then issues paychecks, makes deposits in retirement accounts, and transfers funds for taxes. All of this happens quickly, but at any given time, ADP is sitting on more than $18 billion of cash, on which it can earn interest (it appears as a liability on the balance sheet under “Client funds obligations”, offset by an asset called “Funds held for clients”). Each dollar that comes in goes out very quickly, but is replaced with another dollar, so this is, in effect, perpetual (and growing) float.
Of course ADP invests these funds very conservatively – this isn”Ÿt long-term float like much of Berkshire Hathaway”Ÿs that can be invested in stocks – so ADP”Ÿs earnings from this float are highly dependent on short-term interest rates. Today, one-month Treasuries are paying a microscopic 0.15% vs. 5.05% only 38 months ago on August 1, 2007 (my, how the world has changed!).
Of course ADP isn”Ÿt investing all of its float in one-month Treasuries – it”Ÿs laddered such that the company generated $543 million of revenues in FY 2010 from “Interest on funds held for clients.” ADP”Ÿs float averaged $17.1 billion in FY 2010, so it earned a 3.2% return. Imagine that interest rates rise 300 basis points over time to more normal (although still low) levels – this would translate into an extra $540 million in pre-tax profits for ADP, boosting earnings by nearly 30%. In addition, someday employers in this country will begin to hire again, which will also fuel ADP”Ÿs growth. For both of these reasons, we think ADP”Ÿs earnings are depressed right now, making the stock cheaper than it appears.
While we think robust economic growth and a rise in interest rates is unlikely in the near term, when the economy eventually recovers, ADP should have turbocharged earnings growth. We are prepared to be patient, collecting a healthy dividend, because we believe the stock is worth at least $60, more than 40% above current levels, in even a remotely normal economic environment.
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