May 2005
The combination of rising inflation and a slowing economy have confused and intimidated investors in recent weeks. Despite first quarter corporate earnings that have been better than expected, many stocks have been selling off on reduced expectations for the remainder of the year. While the market is fretting over decelerating earnings growth, we are focusing on cash flows and hidden asset values and finding some interesting investment opportunities.
We are not surprised by the difficulty the stock market is having this year. Our 2005 outlook suggested that the combination of rising inflation and slowing earnings growth would be a serious impediment to the high returns that most investors were expecting to see. In preparation for this, we sold quite few stocks late last year and parked the proceeds in cash to wait for better buying opportunities.
With the Federal Reserve increasing short-term interest rates a quarter of a percent eight times in under a year, investors are wondering when they will stop. They are worried about the effect of higher rates on the economy. Most economists think we could see these interest rates go up another percentage point before the end of the year and we think that is a strong possibility.
Recent inflation numbers have been reported at 2.5%-3.0% so real (after inflation) short-term interest rates are still too low for an economy (real GDP) growing at over 3.0%. The only thing that would stop the Fed from raising rates would be indications that the economy is slowing too much. Retail and wholesale inventories rose in the first quarter of this year as consumers pulled back on spending to make up for the amount of money they are having to spend on gasoline. A rise in gas prices from here might make the Fed rethink its rising interest rate policy.
The decline in the stock market this year reflects a lot of these concerns so we are a little more comfortable increasing our clients' exposure to the stock market at this time. We recently put a lot of the cash to work as nervous investors sold a number of stocks with a vengeance, providing us the ability to invest in some wonderful businesses at substantial discounts to what we think these companies are worth. As a result, we are very excited about the upside potential in our clients' portfolios despite our unexciting forecast for the stock market in general.
Finding Hidden Values
The reason we can have high expectations for our clients' equity portfolios even when we have low expectations for the market is that we try to find other sources of value in a company that may be ignored or underestimated by the market. To do that, we spend a lot of time looking over balance sheets and cash flow statements. With most investors focused on earnings growth and price/earnings ratios, we have found a number of companies that have something of value on their balance sheet that is not being reflected appropriately by the market, in our opinion.
Normally, cash would not be considered a hidden treasure but it tends to not get much respect from the investment community when the company holding it isn't showing growth. We can be very attracted to slow growing companies that have a big pile of cash and little debt because the cash provides the companies' management with internal funding for all sorts of possibilities for increasing shareholder value in the future. And if that pile of cash is combined with strong cash flows...Yabba Dabba Doo!!! (as Fred Flintstone would say.)
Microsoft is a company that seems to have lost the admiration of Wall Street despite the fact that they have almost $40 billion in cash ($3.50 a share), no debt, and annual free cash flow of about $12 billion. Granted the company's growth rate has dramatically slowed from where it was 10 years ago but the stocks current valuation seems to be predicting very little growth in the future. We strongly disagree with that assessment and point out that the cash can be used to do some wonderful things for shareholders in the future. How about a doubling of the quarterly dividend for starters? They could easily afford it.
Using Cash to Create Value
Another great example of a company whose cash and cash flow seemed to be underappreciated by everyone except us is a smaller company called United Online (UNTD). Despite the fact that this company has about $125 million in cash less debt (about $2.00 a share) and expects at least $90 million (or $1.40 a share) in annual cash flow, the company's stock price languished well below $10.00 or at 6 times that cash flow. The market was focused on the lack of recent earnings growth and the fact that their business (dial-up internet access provider) was highly competitive and losing share to broadband. It did not recognize this company as a "cash generating machine" to quote the company's CEO.
We recognized the value of the cash and cash flow and took a full position in UNTD for our clients' portfolios. We were pretty confident that management would take action to use some of that cash to try to increase shareholder value because of actions they had taken in the past.
In fact, our expectations were surpassed. Management announced better than expected revenues and cash flow for the first quarter, exciting new product announcements, and best of all, the initiation of a very large quarterly dividend (representing a 9% yield!). We responded to this great news by purchasing even more shares for our clients from uninformed or misguided sellers in after-hours trading. The shares were up 20-30% the next day.
Other examples of hidden or underappreciated assets on balance sheets that we have come across that can add a significant amount to the intrinsic value of a company include obvious things like real estate (K-Mart - we missed that one) and investments in other companies (Liberty Media).
Less obvious assets are past net operating losses (SkillSoft PLC) that allow companies to pay a lot less in taxes in the future or life insurance policies with large death benefits on the elderly founders (we are keeping this company a secret for now.)
These "little gems" seem to go unnoticed by the most investors and many highly-paid Wall Street analysts for that matter. However, any Chief Financial Officer will tell you these assets have real value and should be reflected in the price of the stock.
Patience Is Required
Discovering undervalued assets on balance sheets does not automatically lead to great investment returns. But it does an important thing. It provides us with a margin of safety and greater potential for gains.
Often times, these overlooked items need some event to occur to bring it to the attention of the investment community. It can take time and it usually requires some patience. However, taking the time to analyze a balance sheet can lead to us finding of good investment opportunities that do not depend on earnings estimates being realized or a good economy.
John W. Gudritz, CFA
john@frontstreet.com