Someone who reads my articles sent me this [email protected]:
Geoff,
…I want to ask your opinion about Western Digital (WDC, Financial). WDC is a computer hard drive maker, essentially in a commodity business in an industry which in time has exhibited bad competition and irrational price behavior. Nevertheless, the company has maintained reasonable profitability and ROE over the last 10 years. It's now traded around 30. After adjusting for net cash of close to 10-15 dollars, you are paying 15 - 20 dollars for a business that I think have earnings power of at least 3 dollars in a normal year, with a range of 1 - 6 dollars, give or take. That seems cheap. With the flooding in Thailand, WDC was briefly trading lower around 25. That seemed extremely cheap since no one really expected the damage to last more than a few quarters. Some might say the cash of $3.5 billion is already spoken for with the pending purchase of Hitachi’s hard drive business, and as is normally the case, WDC is likely to have overpaid. But we could account for that in 2 ways, either reduce the cash value from $15 to $10, or not account for the cash, but instead give WDC more earning power due to that purchase and the resulting reduced industry competition, say $4 to $5.
Their largest competitor, Seagate Technology (STX), is also purchasing another industry competitor. After the completion of these deals, WDC and STX will be largely what's left and enjoy much better pricing power. In any case, I thought WDC was very cheap at 25, and still do around 30.
Apparently the market thinks otherwise. Perhaps they think the PC market is going to the dead and WDC/STX will soon follow the way of Research in Motion (RIMM). That might be. Anything could happen in the investment world, but the odds of that outcome are low, in my opinion. I feel the market is mispricing the risk/reward in this case, especially when it was trading at 25. I'm wondering if you have any opinion here and care to share.
Regards,
Chaoran
(I should note – so far – Chaoran has been proven right. WDC now trades at $39. Today’s price is about 30% higher than where WDC traded when that email was written.)
I can't disagree with your take on Western Digital. But I'm not the best person to ask about this kind of stock. Other people have mentioned it before. It's obvious why value investors would be attracted to it.
But as you can probably guess from somebody who includes operating margin variation coefficients in his net-net newsletter, I focus a lot on predictability. The business Western Digital is in is a business I would normally not buy into unless it traded for around net cash. Margins have been extremely variable.
Also, if you look at 10-year average operating margins you'd have operating margins which after taxes would lead to earnings of about $2.27 a share on the current sales level. This is lower than your estimate of a $3 a share earning power. Now, I have no confidence in taking 10-year operating margins, multiplying them by 0.65 (1 minus the 35% corporate tax rate), and then applying that net margin estimate to current sales. I have no reason to believe that is a remotely good gauge of earnings power. But, like I said, it comes in below $2.50 a share.
The other issue here is the way Western Digital is not insanely cheap on either an asset value measure or an earning power measure. What it seems to be is insanely cheap when you combine the two. In other words, a measure like EV/EBITDA makes it look very, very attractive. And that's fine. Because as a recent study shows yet again - EV/EBITDA is a very good value indicator. One of the best.
Anyway, I have two concerns:
1) How important is surplus cash to the company's cheapness – is the earning power to stock price (not EV) cheap enough?
2) When you apply long-term averages in terms of margins to today's sales and long-term average return on invested tangible assets to today's book value is the company still very cheap?
The picture is mixed here.
Western Digital’s upside on a price-to-sales basis is not that high. Maybe 50%. In other words, you could expect maybe a 50% increase in the stock price to get it to an appropriate price-to-sales ratio. Book value is more complicated. Past returns on equity suggest a very high price-to-book ratio would be appropriate. I like to only consider what the right price-to-book ratio would be if the company were unleveraged. In that case, you'd still expect a price close to 2 times book value would be appropriate for a company with Western Digital’s kind of past returns.
I’m getting this from a return on assets range of about 7% to 25% over the last 10 years. Western Digital’s 10-year average ROA has been about 15%. So, even without the use of leverage – Western Digital’s return on equity suggest it could be worth two times book value.
So on a historical basis, it's cheap. But what if the company's history tells us nothing here? After all, when we buy a stock – we’re buying future earnings. Not past earnings.
We need to check and see if Western Digital is cheap on generic price ratios. In other words, it should be cheap relative to sales, tangible book value, net current assets, etc. for an average company – not just the above average company it was in the past.
On a stock price – not enterprise value – basis Western Digital isn't cheap enough to be a screaming buy. If we consider enterprise value, it's a different story.
And so that's what it comes down to for me. While the stock price may be reasonable even without any cash – it’s not insanely cheap by any means. So this only really qualifies as a bargain investment when we factor in the cash.
This raises the issue of the company's size. This is a big stock. The market cap is around $9 billion. I'm going to let you in on a little secret. In a back test of net-nets – which WDC isn’t, but bear with me – I found that one of the best (if not the very best) method of ordering net-nets to know which would perform best and which would perform worst was simply to take the amount of insider ownership and divide it by the amount of institutional ownership.
The worst decile of net-nets in terms of insider vs. institutional ownership underperformed the best decile by – I’m not making this up – about 30% a year. The highest insider to institutional ownership decile returned 40% a year. The lowest returned 10%. Randomly chosen net-nets returned around 21% over the same time period. In other words, you can shave 10% a year off a net-net portfolio's returns just by picking those net-nets with the very highest institutional ownership relative to insider ownership.
This is important because of the kind of net-nets Graham bought. As Walter Schloss said later – many of the companies Ben Graham bought in the 1940s were family controlled companies. There was no way to take them over. This is one of the reasons people neglected these stocks even when they got super cheap. No one expected them to liquidate. Or to be bought out. They were assumed to be stuck in place because of family ownership.
Now there's no rule that says a family owned net-net is better than a professionally managed net-net. But it's interesting to consider the problem surplus cash presents. Families are likely to hoard cash. They tend not to blow cash. At least not families that control net-nets. If they were risk takers, they wouldn't have current assets greater than total liabilities.
We see this at a company like Imation (IMN). I picked Imation for the Ben Graham Net-Net Newsletter. That was earlier in the year. And I have to admit one factor I did not pay enough attention to was management. I didn't think enough about how likely they were to spend cash on acquiring other companies. I didn't consider whether they'd try to preserve the size of the company as best they could.
I've gone on too long about this. It's just something to keep in mind. I do worry about stocks with lots of cash that are really, really big stocks. I worry they are more likely to do something proactive and unintelligent with their money. If you're buying a pure earnings power bargain where – absent the cash – you are very confident in the long-term earning power of the business to more than justify your purchase price, this isn't a big deal.
With Western Digital it is a big deal.
According to Western Digital's 14A officers and directors of the company own just 1.2% of the company's shares.
That's not the kind of insider ownership I like to see. Now, that doesn't mean Western Digital won't do good things with its cash. And obviously there's a lot of room for error here. You are buying at an EV/EBIT (based on the past) that means WDC can do worse in the future than it did in the past – some cash can get blown on stupid things – and you can still have an investment that works out okay or even better than okay.
You mention the market mispricing the risk/reward. That's very possible. For me, that's only part of the question. As you know, I look for comfort. How comfortable am I owning this stock? There are some stocks where I think the market made odds are wrong but I'm unlikely to buy, because I'm not comfortable. Western Digital might be one of those stocks.
As far as the technology, I really can't say. Personally, I've gotten to a place in my own use of media where I don't want to have much storage of my own. I want to use Amazon, Netflix, etc. to store things for me. So I guess I'm kind of a symptom of what's happening to stocks like WDC, IMN, etc. where I'm not interested in personal physical storage. I actually consider it hassle I'd rather avoid. But I'm not good at knowing how technology will shake out, when people will change their habits, etc. So don’t listen to me on the issue of technological change.
But even if you knew how customer behavior would change, it's unclear what this would mean. Western Digital is in a commodity type business. Loss of demand is easier to chart out in a business that is different from this one. In WDC's industry, margins are not just driven by customer behavior and company behavior.
Competitor behavior is very important. And obviously WDC is far from the weakest competitor. This was something I had to think about with Barnes & Noble (BKS). I knew Borders was in a much weaker position. I knew there would be industry consolidation. There would be fewer players in the future. You have the same situation now with Western Digital. This complicates the analysis.
Which is a fancy way of saying…
I don't know.
I'm not the best person to ask about WDC, because it's just not the kind of situation I'm normally drawn to. I think it is about handicapping a risk/reward situation rather than buying a stock you feel comfortable is worth more than you are paying. Instead, you are saying it could be worth more or less but the probabilities and the payoffs clearly favor a positive outcome.
I tend to agree with that. Western Digital certainly looks interesting.
Charlie Munger has talked about how picking stocks is like picking horses – you can think of it as a form of pari-mutuel betting. In both cases, there are frictional costs you have to overcome (“trading costs”). But beyond that you are betting against others. So you are handicapping the situation. It’s not necessarily about picking the best company.
It’s about picking the stock with the most mispriced odds.
Of course, that isn’t the way Ben Graham thought about stocks. He wanted to find stocks he knew were worth more than they were selling for.
I don’t think Western Digital falls into that category. It’s not a Ben Graham bargain.
But it may be a mispriced bet.
[email protected]: Talk to Geoff About Western Digital (WDC)
Geoff,
…I want to ask your opinion about Western Digital (WDC, Financial). WDC is a computer hard drive maker, essentially in a commodity business in an industry which in time has exhibited bad competition and irrational price behavior. Nevertheless, the company has maintained reasonable profitability and ROE over the last 10 years. It's now traded around 30. After adjusting for net cash of close to 10-15 dollars, you are paying 15 - 20 dollars for a business that I think have earnings power of at least 3 dollars in a normal year, with a range of 1 - 6 dollars, give or take. That seems cheap. With the flooding in Thailand, WDC was briefly trading lower around 25. That seemed extremely cheap since no one really expected the damage to last more than a few quarters. Some might say the cash of $3.5 billion is already spoken for with the pending purchase of Hitachi’s hard drive business, and as is normally the case, WDC is likely to have overpaid. But we could account for that in 2 ways, either reduce the cash value from $15 to $10, or not account for the cash, but instead give WDC more earning power due to that purchase and the resulting reduced industry competition, say $4 to $5.
Their largest competitor, Seagate Technology (STX), is also purchasing another industry competitor. After the completion of these deals, WDC and STX will be largely what's left and enjoy much better pricing power. In any case, I thought WDC was very cheap at 25, and still do around 30.
Apparently the market thinks otherwise. Perhaps they think the PC market is going to the dead and WDC/STX will soon follow the way of Research in Motion (RIMM). That might be. Anything could happen in the investment world, but the odds of that outcome are low, in my opinion. I feel the market is mispricing the risk/reward in this case, especially when it was trading at 25. I'm wondering if you have any opinion here and care to share.
Regards,
Chaoran
(I should note – so far – Chaoran has been proven right. WDC now trades at $39. Today’s price is about 30% higher than where WDC traded when that email was written.)
I can't disagree with your take on Western Digital. But I'm not the best person to ask about this kind of stock. Other people have mentioned it before. It's obvious why value investors would be attracted to it.
But as you can probably guess from somebody who includes operating margin variation coefficients in his net-net newsletter, I focus a lot on predictability. The business Western Digital is in is a business I would normally not buy into unless it traded for around net cash. Margins have been extremely variable.
Also, if you look at 10-year average operating margins you'd have operating margins which after taxes would lead to earnings of about $2.27 a share on the current sales level. This is lower than your estimate of a $3 a share earning power. Now, I have no confidence in taking 10-year operating margins, multiplying them by 0.65 (1 minus the 35% corporate tax rate), and then applying that net margin estimate to current sales. I have no reason to believe that is a remotely good gauge of earnings power. But, like I said, it comes in below $2.50 a share.
The other issue here is the way Western Digital is not insanely cheap on either an asset value measure or an earning power measure. What it seems to be is insanely cheap when you combine the two. In other words, a measure like EV/EBITDA makes it look very, very attractive. And that's fine. Because as a recent study shows yet again - EV/EBITDA is a very good value indicator. One of the best.
Anyway, I have two concerns:
1) How important is surplus cash to the company's cheapness – is the earning power to stock price (not EV) cheap enough?
2) When you apply long-term averages in terms of margins to today's sales and long-term average return on invested tangible assets to today's book value is the company still very cheap?
The picture is mixed here.
Western Digital’s upside on a price-to-sales basis is not that high. Maybe 50%. In other words, you could expect maybe a 50% increase in the stock price to get it to an appropriate price-to-sales ratio. Book value is more complicated. Past returns on equity suggest a very high price-to-book ratio would be appropriate. I like to only consider what the right price-to-book ratio would be if the company were unleveraged. In that case, you'd still expect a price close to 2 times book value would be appropriate for a company with Western Digital’s kind of past returns.
I’m getting this from a return on assets range of about 7% to 25% over the last 10 years. Western Digital’s 10-year average ROA has been about 15%. So, even without the use of leverage – Western Digital’s return on equity suggest it could be worth two times book value.
So on a historical basis, it's cheap. But what if the company's history tells us nothing here? After all, when we buy a stock – we’re buying future earnings. Not past earnings.
We need to check and see if Western Digital is cheap on generic price ratios. In other words, it should be cheap relative to sales, tangible book value, net current assets, etc. for an average company – not just the above average company it was in the past.
On a stock price – not enterprise value – basis Western Digital isn't cheap enough to be a screaming buy. If we consider enterprise value, it's a different story.
And so that's what it comes down to for me. While the stock price may be reasonable even without any cash – it’s not insanely cheap by any means. So this only really qualifies as a bargain investment when we factor in the cash.
This raises the issue of the company's size. This is a big stock. The market cap is around $9 billion. I'm going to let you in on a little secret. In a back test of net-nets – which WDC isn’t, but bear with me – I found that one of the best (if not the very best) method of ordering net-nets to know which would perform best and which would perform worst was simply to take the amount of insider ownership and divide it by the amount of institutional ownership.
The worst decile of net-nets in terms of insider vs. institutional ownership underperformed the best decile by – I’m not making this up – about 30% a year. The highest insider to institutional ownership decile returned 40% a year. The lowest returned 10%. Randomly chosen net-nets returned around 21% over the same time period. In other words, you can shave 10% a year off a net-net portfolio's returns just by picking those net-nets with the very highest institutional ownership relative to insider ownership.
This is important because of the kind of net-nets Graham bought. As Walter Schloss said later – many of the companies Ben Graham bought in the 1940s were family controlled companies. There was no way to take them over. This is one of the reasons people neglected these stocks even when they got super cheap. No one expected them to liquidate. Or to be bought out. They were assumed to be stuck in place because of family ownership.
Now there's no rule that says a family owned net-net is better than a professionally managed net-net. But it's interesting to consider the problem surplus cash presents. Families are likely to hoard cash. They tend not to blow cash. At least not families that control net-nets. If they were risk takers, they wouldn't have current assets greater than total liabilities.
We see this at a company like Imation (IMN). I picked Imation for the Ben Graham Net-Net Newsletter. That was earlier in the year. And I have to admit one factor I did not pay enough attention to was management. I didn't think enough about how likely they were to spend cash on acquiring other companies. I didn't consider whether they'd try to preserve the size of the company as best they could.
I've gone on too long about this. It's just something to keep in mind. I do worry about stocks with lots of cash that are really, really big stocks. I worry they are more likely to do something proactive and unintelligent with their money. If you're buying a pure earnings power bargain where – absent the cash – you are very confident in the long-term earning power of the business to more than justify your purchase price, this isn't a big deal.
With Western Digital it is a big deal.
According to Western Digital's 14A officers and directors of the company own just 1.2% of the company's shares.
That's not the kind of insider ownership I like to see. Now, that doesn't mean Western Digital won't do good things with its cash. And obviously there's a lot of room for error here. You are buying at an EV/EBIT (based on the past) that means WDC can do worse in the future than it did in the past – some cash can get blown on stupid things – and you can still have an investment that works out okay or even better than okay.
You mention the market mispricing the risk/reward. That's very possible. For me, that's only part of the question. As you know, I look for comfort. How comfortable am I owning this stock? There are some stocks where I think the market made odds are wrong but I'm unlikely to buy, because I'm not comfortable. Western Digital might be one of those stocks.
As far as the technology, I really can't say. Personally, I've gotten to a place in my own use of media where I don't want to have much storage of my own. I want to use Amazon, Netflix, etc. to store things for me. So I guess I'm kind of a symptom of what's happening to stocks like WDC, IMN, etc. where I'm not interested in personal physical storage. I actually consider it hassle I'd rather avoid. But I'm not good at knowing how technology will shake out, when people will change their habits, etc. So don’t listen to me on the issue of technological change.
But even if you knew how customer behavior would change, it's unclear what this would mean. Western Digital is in a commodity type business. Loss of demand is easier to chart out in a business that is different from this one. In WDC's industry, margins are not just driven by customer behavior and company behavior.
Competitor behavior is very important. And obviously WDC is far from the weakest competitor. This was something I had to think about with Barnes & Noble (BKS). I knew Borders was in a much weaker position. I knew there would be industry consolidation. There would be fewer players in the future. You have the same situation now with Western Digital. This complicates the analysis.
Which is a fancy way of saying…
I don't know.
I'm not the best person to ask about WDC, because it's just not the kind of situation I'm normally drawn to. I think it is about handicapping a risk/reward situation rather than buying a stock you feel comfortable is worth more than you are paying. Instead, you are saying it could be worth more or less but the probabilities and the payoffs clearly favor a positive outcome.
I tend to agree with that. Western Digital certainly looks interesting.
Charlie Munger has talked about how picking stocks is like picking horses – you can think of it as a form of pari-mutuel betting. In both cases, there are frictional costs you have to overcome (“trading costs”). But beyond that you are betting against others. So you are handicapping the situation. It’s not necessarily about picking the best company.
It’s about picking the stock with the most mispriced odds.
Of course, that isn’t the way Ben Graham thought about stocks. He wanted to find stocks he knew were worth more than they were selling for.
I don’t think Western Digital falls into that category. It’s not a Ben Graham bargain.
But it may be a mispriced bet.
[email protected]: Talk to Geoff About Western Digital (WDC)
