Cisco, Intel, Microsoft, H-P: Tech Value Stocks?

No technology? Ever?
It’s no secret that Warren Buffett avoids technology stocks, saying he prefers to invest in businesses he can understand. While nobody can argue with his success, is General Electric (300,000+ employees, 325 mergers/acquisitions in the 1990s) any less complicated than Intel? Regardless of the reasoning, technology companies have come a long way, and many are no longer upstarts. In fact, four out of the 30 DJIA component stocks are technology companies: Intel, Microsoft, Hewlett-Packard and IBM. Over the last 15 years, the first two have matured and become very well respected members of the corporate establishment. Is it possible there could be a value stock lurking in their midst? Let’s take a look.

The fabulous four
For the analysis, I was tempted to choose the four DJIA technology stocks. Instead, I decided to swap IBM with Cisco Systems, primarily because IBM’s business has changed significantly during the last few years and besides, IBM has been around for nearly 100 years (1910). Based on its age (founded in 1939), I was also tempted to swap Hewlett-Packard with Dell Computer, but decided to leave HPQ on the list since they have a broader reach into peripherals and they’re about twice the size of Dell. Some other thoughts:

• Apple: I’ve analyzed them in recent articles, and besides, they’re much smaller than the four companies above (only 2/3 the size of CSCO)
• Google: Unquestionably a significant player in technology, but they are still a relatively young company
• Tech-oriented retailers (EBay, Amazon, etc.): While largely enabled by technology, I see these guys more as retailers than technology companies per se

To summarize, we’re going to look at Intel, Microsoft Corp., Cisco Systems, and Hewlett-Packard. They’re all large (the ‘smallest’, Cisco and Intel, had about $35 billion in sales last year) and stable (as a group, their shares split 21 times during the 1990’s but only four times since 2000).

Measure of value?
To determine if any of the four are value stocks, let’s look at them through the lens of value. This will tell us if they’re the cigar butts that Warren Buffett likes. First by comparing the companies to some well-known ‘value’ yardsticks and then by looking at their intrinsic value vs. current price. This will help us determine if there are some puffs left in the cigar butts. In short, we’re going to look backward at trailing measures and look forward at earnings growth. For the first part, let’s use some fairly standard criteria, based on the work of value investing guru Ben Graham:

1. Price to book: 1.2x or less (preferably below 1.0)
2. P/E: 12 or lower (preferably below 10) based on trailing 12 months (TTM) earnings
3. Little or no debt: Long term debt (LTD) to capitalization less than 30% and under control
4. Strong balance sheet: Quick ratio > 1.2
5. EPS growth: Greater than 33% during the last 10 years
6. Dividends: Does the company pay a dividend?

Right off the bat, none of the companies meet the first or second criteria. All meet the third and fifth criteria. Intel, Microsoft and Cisco meet the fourth criteria. All but Cisco meet the last criteria. Let’s now take a look at intrinsic value.

Estimating intrinsic value, the cash that can be pulled out of a company over its lifetime, can be both complex and subjective. There are analysts who spend all their time estimating and analyzing intrinsic value for ONE of these companies, so I’m really going to simplify things by using a straightforward equation borrowed from Warren Buffett’s mentor, Ben Graham. If we’re off, at least we’ll be consistent and in good company:

Intrinsic Value = EPS * (2r + 8.5) * 4.4/γ

Where:

EPS = Trailing 12 months earnings per share
r = Estimated annual rate of EPS growth (e.g., for 10 years)
γ = Yield on AAA-rated corporate bonds

The last variable, which is ostensibly the risk-free rate of return, was estimated at 5%. Using the last five years as a guide, I estimated EPS growth as follows: 20% for INTC and CSCO, 15% for HXP and MSFT. This part of the analysis is subjective and could easily lead to lots of discussion. Here are the results:

• Intel: Estimated intrinsic value is $50.40/share, about 148% above current levels
• Cisco Systems: Estimated intrinsic value is $55.10/share, about 134% above current share price
• Hewlett-Packard: Estimated intrinsic value is $90.80/share, about 117% above current share price
• Microsoft: Estimated intrinsic value is $28.56/share, about 61% above current levels

Based on this, it looks like Intel is much more undervalued than Microsoft, with Cisco and Hewlett-Packard somewhere in between.

Analysis
For the most part, these companies are still growing robustly, which is reflected by their high intrinsic value. They are hardly the cigar butts that Warren Buffett talks about. Even at 10% EPS growth, the stocks are priced below their intrinsic value.

None of the stocks meet the P/E and price/book criteria, with Intel and Hewlett-Packard come the closest. To really get in the value stock comfort zone, P/E<12 style="font-weight: bold;">Conclusions
None of the four stocks are priced at value stock levels. While they’re all strong, stable and mature companies, their prices still reflect plenty of future growth. This is very interesting given that the prices for these companies have for the most part been flat since the dotcom bust. What has this accomplished? It has allowed earnings to catch up with share price. To be considered real bargains, shares of Intel and Hewlett-Packard would have to drop about 30%. Cisco and Microsoft would have to drop even more.

Disclosure: The author has no positions in the four stocks mentioned in this article.

Apple on an innovation treadmill

Why are we so excited?
My recent analysis comparing Apple Inc. (AAPL) to a microcap stock, Air T, Inc. (AIRT), has definitely drawn the ire of Apple fanatics. The analysis leads me to believe AAPL is priced at or somewhat above its intrinsic value. In saying this, I’m focusing strictly on earnings and basing this on: (1) it will be extremely challenging for AAPL to grow earnings at 20% annually for the next 10 years, and (2) AAPL's on a major product development treadmill. In the analysis, I focused strictly on quantitative considerations. In this post I’m going to look at some of the more qualitative aspects of Apple’s business.

Cause and effect
Let’s elaborate on the first point above by looking at AAPL's financials. As we do this, keep in mind that the need for growth is why Apple is on the innovation treadmill. During the last 10 years, Apple’s revenue has increased at a rate of about 20% annually (from $5.9B in 1998 to $24B in 2007). Net income has increased much faster—at a rate of 30% annually (from $309 million in 1998 to $3.5B in 2007). This is phenomenal. The difference? Growing margins. In 1998, Apple Computer was strictly a computer company—making computers and, for the most part, the software as well. Their market share was in the low single-digits and their margins were about 5%. In 2007? Margins are running at about 15%. Again, this is phenomenal. To increase margins, Apple Inc. is focusing on high-margin businesses (iTunes, videos, etc.). In short, they had to reinvent their business, and the reinvention runs deep: They even changed their name last year, to reflect their expansion beyond the computer business.

In the meantime, Apple has wisely focused on 'value pricing' their products—getting top dollar for products that appeal to the under 30 segment (and those of us who wish they were under 30). They have used the halo effect from their music player/music distribution franchise to launch phones and reinvigorate their computer products. Can it go on? That gets me to the 2nd point.

Cash is king—for two reasons
AAPL is on an innovation treadmill. The cash it's sitting on serves two purposes. First, it provides an insurance policy (a hedge of sorts, if you will) in case they make a bad bet. Second, the cash might come in handy in case Apple has to make a major acquisition. Let’s look at the insurance policy part with an analogy: MSFT and the XBox. How much has Microsoft plowed into the XBox? Has it paid off? The jury is still out. At some point they will obtain the return they seek or they will exit the business, possibly selling it off. Regardless, Microsoft placed their bet and it may or may not pay off. In a similar way, Apple has made some good bets recently. To continue on their trajectory, Apple has to plow the earth to retain their prime mover status. In other words, to retain their fat margins, Apple must continue to take risks and innovate, continuing to push the envelope. In the eyes of consumers, as they expand their space beyond computers, Apple will have to use its brand (its promise to its customers) as collateral. They will have to increasingly risk their name to grow their business (remember the “New Coke”?). There is a high likelihood that Apple will eventually get in over their heads and the odds will catch up with them. In other words, Apple will eventually come up snake eyes—does anyone remember Betamax? How about the Newton? The Corvair? Polaroid? Their cash helps them fund these types of ventures, especially the ones that don’t pan out.

Getting back to Apple’s results, my sense is that 20% earnings growth for the next 10 years would be remarkable. At that rate, I’m estimating the intrinsic value at about $90/share (see my prior post). If you really want to, you can pile on the cash and deferred revenues and you might get about $20 to $25/share which puts you closer to where the stock is currently trading. Is it a bargain? At best I think it's priced at fair value with a ton of execution risk.

Name your poison
Looking at it pragmatically, Apple is priced roughly 20% above its intrinsic value because the cash should be kept on hand to continue funding growth. Why? At some point, they will be large enough that 20% growth in revenue won’t come easy (in fact, they may already be there) and Apple will have to make a major acquisition. Funding options will include: (1) issuing more stock (potentially diluting the value of their stock), (2) paying with cash, or (3) assuming debt. This is why the roughly $20/share of cash/deferred revenues on AAPL’s books will likely be gobbled up by the growth treadmill. In short, Apple is (rightly) holding on to cash to fuel further growth, but I wouldn’t get too excited about this. It’s not as if they have a choice. Without growth, their stock would quickly tank.

What’s a value investor to do?
As Apple’s products (iPods, computers, phones) mature, the company will have to enter new markets. We have already seen some cracks in the foundation (we don’t know yet if they’re structural or cosmetic). For example, Apple has found it much harder to incorporate movies than music into their iTunes platform. In fact, iTunes has become “the establishment” that it once competed against. Others are now challenging this distribution model, and the availability of free music is continuing to grow.

How will Apple continue to grow? They will have to figure this out. Their business will become more complex and scaling it successfully will be a challenge. Meanwhile, the value of the company is what it is. At times, Mr. Market will undoubtedly become exuberant and overestimate the value, especially after favorable ‘analyst reports’. Conversely, Mr. Market may also become pessimistic and underestimate the value, creating a bargain. One thing is for sure: without continued growth in earnings, which will get increasingly harder and riskier as Apple expands beyond its core (no pun intended), the value of the enterprise will drop.

Intrinsic Value - Pt. 2: Air T vs. Apple Inc.

Intrinsic value in action
To better help us understand Intrinsic Value, let's look at two completely different companies. Both are making money and doing fairly well. One is well known and one is not. The first one is Apple Inc. The second one is a small ($70 million in annual sales) company that focuses on regional delivery of air freight and aircraft servicing equipment (such as deicing and catering lifts). For simplicity, we are not going to look at their balance sheets. Instead, we are only going to focus on earnings. To summarize their earnings picture:

• Apple's 2007 earnings increased by 71% ($4.04/share vs. $2.36/share in 2006); trailing 12 month earnings are $4.56/share
• Air T's 2007 earnings increased by 22% ($.94/share vs. $.77/share in 2006); trailing 12 month earnings are $1.29/share

If we were to take these numbers and extrapolate them for the next 10 years, AAPL would have earnings of $567.57/share and AIRT would be earning $7.72/share. This is probably not realistic, especially for Apple--just consider how many computers and iPods have already been sold.

How much growth?
If instead we assumed earnings growth of 20% per year for the next 10 years for each company, you would get the following (I'm discounting using 5%, which is roughly the current yield on high quality corporate bonds):

AAPL:

• Year 10 earnings of $28.11/share, present value is $17.26/share
• The discounted earnings for the next 10 years add up to $101.74/share

AIRT:

• Year 10 earnings of $9.42/share, present value is $5.78/share
  
• The discounted earnings for the next 10 years add up to $32.26/share

Keep in mind that we are not looking at any assets as part of intrinsic value, just earnings. While it would cost money to do so, the Apple brand clearly has a lot of value (goodwill) that could be monetized through licensing, royalties, etc.

Is this good or bad?
What does all this mean? As of yesterday (2/5/08), AAPL closed at $129.36/share and AIRT was at $10.83. Assuming these companies can grow earnings at 20% per year (10 years is a long time--life in prison sometimes lasts only 7 years), we can say the following:

• AAPL's current price, about $130, indicates it's going to grow earnings at about 25% for the next 10 years
• AIRT's current price, about $10, implies it's going to grow earnings at about 1% for the next 10 years

How fast are earnings going to grow? This is where stock research comes into play. Clearly 71% is not a sustainable rate of earnings growth. For 10 years, I would say that 20% is more likely. At this growth rate, earnings in 10 years would be a little over 6x higher than today. If AAPL kept the same margins, their sales in 10 years would make them as large as GE today. Why not 25%? At 25% earnings growth (assuming the same margins), AAPL would be approaching the size of today's Wal Mart--I'm having a little bit of trouble seeing this.

This leads me to believe that even 20% earnings growth may be optimistic. Still, let's leave the 20% earnings growth estimate for both companies. Here are some additional thoughts, starting with Air T Inc:

• If 20% earnings growth is sustainable, AIRT is currently priced at about 40% of its intrinsic value
• Even if earnings grow at only 3% per year, AIRT is still about 10% below its intrinsic value
• AIRT has a great financial position (see my previous post) which, combined with the upside potential, provides a nice margin of safety
• About half of AIRT's business depends on Fed Ex (risk); with that being said, they have been working with Fed Ex since 1980 (stability)
  

Here are some thoughts on AAPL:

• Assuming a 20% earnings growth for 10 years, at $130, AAPL is still priced about 30% above its intrinsic value
• At $130, AAPL's earnings will have to grow at about 25% for the next 10 years to justify this price (i.e., for the Intrinsic Value to be about $130/share)
• AAPL also has a great financial position, although it needs lots of cash to constantly reinvent itself and its products (I have 4 Apple computers; each one was only sold for about a 6-7 month period before being replaced by a newer model)
  
• Ten years is a long time; about 10 years ago, rumors of AAPL's demise and even bankruptcy were widely circulating

Summary
While I am inherently bullish on both companies, AAPL has lots of execution risk and most (if not all) of the upside is already built into its current price. As it's currently priced, AAPL's earnings will need to continue to growing at about 25% despite economic downturns, competitive pressures, and shrinking margins--not to mention the vagaries of consumer likes and dislikes. In contrast, AIRT is priced very attractively. Even at modest single-digit earnings growth, AIRT is below its intrinsic value. The company's strong financial position also provides a nice margin of safety.

Intrinsic Value - Pt. 1: Why So Important?

One of the most elusive and least understood investment terms is Intrinsic Value. You can go to Investopedia, a great source of information, and see their definition here. From an owner's perspective, the Intrinsic Value of a company is the true measure of the worth of an enterprise. With that being said, let's consider several additional points:

• The market may or may not be valuing the company based on its intrinsic value (for example, undervaluing the company based on its intrinsic value creates a value investing opportunity)
• The book value may or may not be related to the Intrinsic Value (book value is the current value of assets less liabilities)
  
• Determining the Intrinsic Value usually requires consideration of qualitative (subjective) and quantitative (measurable) aspects of the company
  

Let's look at one of my favorite ways of explaining Intrinsic Value. This example comes from the Berkshire Hathaway Owners Manual (that's right, Warren Buffet actually put together a 5 page guide to owning shares--talk about expectation setting). You can find it here. In his explanation, Buffett illustrates the intrinsic value of a corporation by comparing it to the intrinsic value of a college education. He calculates the intrinsic value of a college education as follows (I'm paraphrasing here):

The difference in earning power over a lifetime of working, in current dollars, less the cost of the college education, in current dollars

In other words, to calculate the intrinsic value of a college education, you would consider the wage differential over a work career of, 40 years, and covert it to current dollars. Let's say this is $1 million. If a college education currently costs $100,000, the intrinsic value of the college education is $900,000.

For a company, you would similarly determine how much cash you could pull out of the company in the future (profits, earnings, dividends, etc.), and discount this to determine current dollars (in $/share). This amount would then be compared to the current share price. These two amounts can then be compared on an apples-to-apples basis to determine the attractiveness of a stock.

In my next post, I'm going to take a look at a couple of different companies and contrast their Intrinsic Value. This will help us see the importance of future earnings on calculating Intrinsic Value.

January's Results

Your intrepid blogger finished his first month of DEA’s Value Investing, and quite a first month it was: For yours truly and even moreso for Mr. Market. Due in large part to the difficulties with the mortgage industry, markets remain in a quandary, trying to assess the fallout. The uncertainty of confusing news is such that recently it has seemed to take Mr. Market a day or more to fully digest the latest developments. Just yesterday he was trying to understand the resilience of a troubled bond insurer when surprise employment and consumer confidence data, both negative, were reported. Mr. Market was in a good mood at the end of the day, having brushed aside these key indicators.

For the month of January, our benchmark, the S&P 500 index, was down 6.3%. It was a good month to take your time squeezing the tomatoes at the vegetable aisle.

I like machine shops--they remind me of my GE days. WSI Industries was a pleasant surprise. They’re very solid and are growing the right parts of their business nicely. So far, J.M. Smucker is proving to be a fine defensive play. The most positive surprise was Arkansas Best. This well-run trucking company is poised to benefit from lower fuel costs, and the market is beginning to see their value.

As a foil to the favorites, and probably somewhat fortuitously, all three of the “unfavorables” turned negative after they appeared in the blog. I love their products, but Apple is going to have a tough time reconciling expectations in today’s challenging market conditions.

Below is a summary of the month’s results:



Back in my Air Force days, pilot friends would say it is better to be lucky than to be good. With that in mind, all six favorites were in the black at the end of the month—I’ll leave it to our readers to opine which of the two applies. Given the short timeframe, the month’s results are nearly inconsequential and come perilously close to quantifying the market’s daily gyrations.

We will be in a better position next month to evaluate results. Yours truly will also continue to watch our favorites closely to ensure Mr. Market stays in check. Like an overripe fruit, the idea is to avoid his exuberance getting the best of him vis-à-vis the favorites, less their intrinsic value is forgotten and we become like the analyst who, with dame fortune, plays a duet on the speculative piano, allowing the fickle goddess to call all the tunes.

Disclosure: The author is long on PG, WSCI, and the Vanguard S&P 500 Index Fund

Which is Sweeter: J.M. Smucker ot Tootsie Roll?

There are quite a few well-known brands in the U.S. food industry yet few have managed to survive for over 100 years. One example is J.M. Smucker’s (NYSE: SJM). Another well-known centenarian is Tootsie Roll (NYSE: TR). In some ways the similarities are remarkable: (1) TR was started in 1896 and SJM began making jams/jellies in 1897; (2) both have their roots in the heartland: J.M. Smucker in Orrville, Ohio and Tootsie Roll in Chicago; and (3) the two companies are incredibly stable.

First Pass
Given their ability to endure the test of time, let’s look at these two companies through our 5-criteria filter:

(1) Straightforward business, preferably with a repeat purchase model: Both companies manufacture branded food products. J.M. Smucker’s goods are typically sold in the center aisles of supermarkets. Their brands include Jif peanut butter, Crisco shortening/ cooking oil, J.M. Smucker jam and jelly, Pillsbury baking ingredients, and PET evaporated milk. Tootsie Roll’s products are also sold in the aisles and near checkout registers at supermarkets. They are also frequently used as promotional material. Besides their namesake candy, TR manufactures dozens of brands including Andes Mints, Cella’s Cherries, Charms Blow Pops, and Junior Mints. Their business is to manufacture the products and maintain their brand recognition.

(2) Stable business: Having been around for over 100 years, it’s safe to say that both businesses are stable. J.M. Smucker has paid a dividend continuously since 1949 and Tootsie Roll has done the same since 1943. Amazingly, one Tootsie Roll still costs a penny—the same price the candy it sold for in 1896.

(3) Decent balance sheet: Looks good (more on this later).

(4) Top notch management team: J.M. Smucker is still run by the descendants of the original J.M. Smucker. The founding family has operated the company since its inception. Tootsie Roll is run by Melvin and Ellen Gordon. Mr. Gordon has been CEO since 1962. If their ability to endure is any indication of their competence, both companies are in good hands.

(5) Industry leadership: Given their strong brand recognition, both companies are leaders in their respective markets.

Since both companies are successful, operate in good, stable businesses and have strong management, let’s try to understand if this translates to a reasonable financial margin of safety by looking at 7 valuation-oriented parameters.

Margin of Safety
Margin of safety affords the business owner room for error if things go wrong. Companies with a good margin of safety are on stable ground and can be expected to withstand unforeseen difficulties. In practical terms, this means the company can continue to pay its bills while it works through issues. The following 7 data are provided for TR, with SJM’s values in parentheses:

• Price to book: 2.11 (SJM is 1.34)
• Cash on hand: $55 million or $1.55/share (SJM has $200 million or $3.60/share)
• Annual cash flow: $1.31/share (SJM has $4.04/share)
• %LTD/capitalization: TR has no long-term debt (SJM’s is 17.9%)
• Price to earnings: 25.2 (SJM’s P/E is 14.6)
• Common stock dividend yield: 1.27% (SJM’s dividend yield is 2.65%)
• Revenue growth (since 2004): 18.1% (SJM: 56.8%)

Margin of safety appears to be decent for both companies. Despite their age, both companies continue to grow revenue. For the most part, they have expanded their footprint by acquiring new brands. TR purchased Concord Confections, a Canadian candy maker, in 2004. SJM expanded its business by purchasing White Lily (flour and cornmeal) in 2006 and Eagle Family Foods (condensed milk) in 2007 while divesting Brazilian operations in 2004 and Canadian operations in 2005 (to Cargill). To summarize their businesses at a very high level:

Tootsie Roll:
• Very narrowly focused product base (confectionery products)
• US, Canada and Mexico exposure; negligible exposure outside North America
• Sensitive to raw materials and supply chain costs

J.M. Smucker:
• Focused products, primarily dealing with food preparation; some ready to eat foods
• US and Canada exposure; limited exposure outside North America
• Sensitive to raw materials and supply chain costs

Given that margin of safety is acceptable, which company is better? It appears to be a mixed bag. Even though they carry no debt, Tootsie Roll’s P/E is quite a bit higher than SJM’s. Still, both companies have steady, positive cash flow. Perhaps the hallmark of value investing, intrinsic value, can help us find out.

Intrinsic Value
Intrinsic value has been defined as how much cash can be taken out of each company during its remaining life—a powerful way to measure the value of owning a company. For simplicity, let’s use an equation borrowed from Warren Buffett’s mentor, Ben Graham:

Intrinsic Value = EPS * (2r + 8.5) * 4.4/γ

Where:

EPS = Trailing 12 months earnings per share
r = Expected earnings growth rate
γ = Yield on AAA-rated corporate bonds

Based on this, I estimate Tootsie Roll’s intrinsic value at about $6/share (recent stock price is $25.25). Similarly, J.M. Smucker’s estimated intrinsic value is about $46.80/share (recent price is $45.72). This is a significant point of differentiation. Tootsie Roll is priced significantly above its intrinsic value while J.M. Smucker is priced at very close to its intrinsic value. How can this be? The two key variables used to calculate intrinsic value are: (1) trailing 12 months EPS, and (2) expected earnings per share (EPS) growth rate. The former is straightforward enough: Current (TTM) EPS is $1.01/share and $3.04/share, for TR and SJM, respectively. The latter (expected earnings growth) is an entirely different story.

Profitability is Key
Expected earnings growth hinges on a company’s ability to either increase top line (sales), reduce costs, or a combination of the two. Looking at the last five years, TR has had flat earnings, so my expected earnings growth rate is 0%. In fact, indications are that earnings growth will be negative in the near future due to exchange rate-related cost pressures arising from production at their Canadian facilities. On the other hand, J.M. Smucker’s earnings have been growing more steadily. Their 2003 EPS was $2.02/share and current (TTM) EPS is $3.04, which means that EPS, up 50% in four years, is growing at about 11% per year. To be conservative, I’ve estimated earnings growth at 8% to arrive at the intrinsic value figure above.

It’s a Jungle Out There
Business is tough: without adequate growth in revenue, costs eventually eat away at profitability, diminishing value for owners (shareholders). Failure to sufficiently grow revenue, in light of cost increases due to energy, raw materials and foreign exchange fluctuations, can take a hefty toll. J.M. Smucker has been able to negotiate these troubled waters by investing carefully in the growth of their business, avoiding excess debt, and paring non-value adding operations. In contrast, it appears Tootsie Roll is struggling to grow their business enough to also increase earnings. The good news is that they have available cash and no debt to help grow the business. If they fail to do this, someone else may seize on the opportunity.

Disclosure: The author has no positions in TR or SJM.

Microcaps that Warren Buffett Would Love?

Below the Radar
Early on, Warren Buffett took control of a small New England textile mill that became the namesake for his new company. Since then the company bearing the mill’s name, Berkshire Hathaway, has witnessed incredible growth because of its ability to invest effectively. With a market capitalization in excess of $220 billion, Berkshire Hathaway no longer buys small companies. What if they did? Perhaps they would invest in microcaps, but which ones?

Tough Hurdle
Chances are they would focus on intrinsic value, which Buffett says, “is an all-important concept that offers the only logical approach to evaluating the relative attractiveness of investments and businesses” and has been equated to the discounted cash that can be taken out of a business during its remaining life. Even though he is famous for buying stocks that were “cigar butts” with a few puffs left, Buffett has also invested in companies with strong growth prospects (e.g., Coca Cola moving into overseas markets) provided there was a nice margin of safety. With that in mind, consider these guidelines:

• Price/book: Less than 3 and preferably below 2
• % LTD/capitalization: Less than 30%
• 4-year revenue growth: Greater than 20%
• Quick ratio: Greater than 1.0
• P/E: Below 25 and preferably below 13
• Positive cash flow for at least the previous 12 months

Then There Were Four
In keeping with Buffett’s famous aversion, technology stocks were omitted from our search. Although the criteria initially identified numerous microcaps, those with poor earnings (defined as having had one more years of negative revenue in the past four years) or with complicated business models, were removed. The search resulted in the following four microcaps. Given that Buffett sees himself as buying the business as opposed to buying a stock, let’s take a look at what each company does:

• Electro-Sensors (NASDAQ: ELSE): Designs and builds speed sensing equipment for manufacturers. Anyone who has seen high-speed manufacturing has probably looked with amazement at how everything flows smoothly. ELSE helps its customers manufacture more efficiently, optimizing production rates. Customers include many Fortune 500 companies such as ADM, 3M, Anheuser-Busch, GM, GE, Ford, and Exxon-Mobil.

• WSI Industries (NASDAQ: WSCI): Manufactures very low tolerance (high precision) machined parts. They serve various industries that require highly precise parts: defense, aerospace, medical, etc. In business since 1950, WSI has recently entered new markets that offer tremendous growth opportunities. Current customers include: Polaris Industries and General Dynamics.

• Dryclean USA (Amex: DCU): Founded in 1963, DCU is all about dry cleaning. They have subsidiaries that: (1) franchise/ license over 400 dry cleaners, (2) design and build equipment for laundry/dry cleaning facilities, and (3) broker the purchase and sale of dry cleaning businesses. Headquartered in Miami, they serve markets in the U.S., the Caribbean and Latin America.

• Air T (NASDAQ: AIRT): Has two business segments, both dealing with aviation services: (1) contracted express air cargo delivery, and (2) manufacturing aircraft support equipment such as scissor-lifts and deicing equipment. The contracted air cargo express air cargo service operates 95 aircraft that provide overnight delivery for companies such as Federal Express.

In Closing
As always, each investor needs to perform their own due diligence, especially when dealing with microcaps. With that being said, all four of these companies have strong financials and a demonstrated ability to focus on growth while limiting debt. Based on a quick analysis, each company appears to be trading below its intrinsic value and provides a nice margin of safety due to a straightforward business model and solid management, resulting in reasonable debt levels, positive cash flow, and consistent earnings. Hopefully Warren Buffett would agree there is opportunity here.

Disclosure: The author has a long position in WSCI. The author has no position in any of the other three stocks and will not trade (buy, sell, short) any stocks in this post for a minimum of two weeks.

J.M. Smucker vs. P&G: Solid Defensive Stocks

Several months back, Barron's featured an article on J.M. Smucker (NYSE: SJM). The article highlighted the company as a solid opportunity, intimating it might be a good defensive play. I thought it would be useful to evaluate SJM through our value investor lens and also to compare it to its much larger Ohio-based neighbor, P&G (NYSE: PG). Keep in mind that SJM's annual revenue is $2 billion vs. $76 billion for P&G. Nevertheless, I thought it would be interesting to compare these two companies as defensive plays. In keeping with our value investing approach, let's look at SJM as if we were buying it by starting with our 5-criteria filter:

(1) Straightforward business, preferably with a repeat purchase model: Definitely; J.M. Smucker is in the food products group. Chances are you're already using their products (JIF peanut butter, Crisco shortening/cooking oil, J.M. Smucker jam and jelly, Pillsbury baking ingredients, PET evaporated milk, etc. ). Their business is geographically focused, as well--sales of their products are focused on the US and Canada.
(2) Stable business: Business is as steady as peanut butter and jelly--which I would have to say is recession-proof.
(3) Decent balance sheet: Looks pretty good (more on this later).
(4) Top notch management team: If it means anything to stay with the horse that got you here, then the team is top notch and proven. The co-CEOs are both descendants of the original J.M. Smucker. The founding family has operated the company since its inception.
(5) Industry leadership: If brand recognition counts for anything in the retail food industry, J.M. Smucker is clearly an industry leader.

Some additional insight: While I was working in the logistics field, J.M. Smucker was one of our accounts. Without violating any confidentiality, I'd like to share a little bit of what I learned. For example, J.M. Smucker started out with their jam/jelly/preserves and has added additional brands over the years. For example, they purchased the Crisco brand from their Ohio neighbor, P&G , when P&G was convinced consumers were moving away from preparing foods and moving towards prepared foods. While working with this account, I visited several SJM facilities. I have seen hundreds of manufacturing facilities in nearly every continent, yet I came away very impressed with their focus and operational excellence. Also, they are definitely on top of their logistics game--nothing to sneeze at given the high cost of fuel right now. By the way, P&G was also a customer.

Looking at selected J.M. Smucker's financials, let's compare them to their larger brethren, P&G:

• Price to book: 1.34 (P&G is 3.04)
  
• Cash on hand: $200 million or $3.60/share (P&G has $5,556 million or $1.77/share)
  
• Annual cash flow: $4.04/share (P&G had $4.40/share)
  
• LTD/cap: 17.9% (P&G's is 25.9%)
• Revenue growth since 2004: 56.8% (P&G has grown their revenue by 48.6%)
• Price to earnings: 14.6 (P&G's P/E is 20.5)
• Common stock dividend yield: 2.65% (P&G's dividend yield is 2.17%)
  

Clearly, much of P&G's revenue growth is due to their 2005 acquisition of Gillette. Interestingly, on a percentage basis, J.M. Smucker has actually grown their revenue even more during the same period. To summarize their business at a very high level:

J.M. Smucker:

• Focused products, primarily dealing with food preparation
• US and Canada exposure; limited exposure outside North America
• Sensitive to raw materials and supply chain costs
  

P&G:

• Broad product base (everything from Pringles, Folgers and Pampers to Pantene shampoo)
• Significant international exposure
• Sensitive to raw materials and supply chain costs

So where does this leave us? Based on its valuation, the market has recognized P&G's virtue as a defensive play. Still, based on its business, J.M. Smucker bears strong consideration as a defensive stock play. SJM's strong financials imply it will have no problems weathering the current economic storm. In fact, if one believes the US economy will eventually rebound from the subprime mess, it could be argued that SJM has even less risks than P&G.

While it's one thing to be a short term defensive play, it's another to be a true value play. SJM is slightly above our maximum price/book of 1.2. Likewise, SJM's p/e is borderline--we like to see it no higher than 12. While SJM's balance sheet is good as a defensive stock, it's not quite in the compelling zone for a value play.

In closing, SJM bears consideration as a defensive stock, especially as bond yields begin feeling pressure from interest rate cuts. Long term, it's slightly above our stringent criteria, but the stock bears watching.

ABFS Analysis Wrap-up

To wrap-up the analysis on ABFS:
Pros:

• Mr. Market appears to be undervaluing ABFS; it's trading below book value
• The company has a good financial position
• ABFS is a stable, focused company, with good management
  
• Has a straightforward, well-established business

Cons:

• ABFS is in a hypercompetitive, commoditized industry
• The company is very sensitive to fuel prices

I would like to conclude with one last bit of analysis: intrinsic value. Graham/Dodd use the following formula:

Intrinsic Value = E (2r + 8.5) x 4.4/gamma

Where E = earnings per share; r = expected earnings growth rate; gamma = current yield on AAA corporate bonds
Using the following values: E = 2.51/share; r = 8% (this is conservative; earnings have doubled in the last 4 years, which means it's been increasing by 18%); gamma = 7% (again, another conservative figure)

Based on this, intrinsic value is $38.65/share, which would price ABFS at about 15x 2007 earnings. This is a bit richer than some competitors (YRCW, ODFL), but less than others (FWRD), and represents a valuation that's nearly 100% higher than current levels--a significant margin of safety.

Will it be iPods for Dinner?

Many are starting to see lots of opportunities in the US equities markets. Conventional wisdom states that a correction is a dip of no more than 10% from recent highs (for the DJIA, that’s 14,279) and that a bear market is usually more than that. Well, right now we’re down about 15%. The DJIA is about 3.7% above its 52-week low. So where does that leave us? Many traders seem very pessimistic and quite a few have capitulated, stating that the market will continue correcting. Meanwhile, economic data continues to paint a mixed picture. What should an Intelligent Investor do? Continue to focus on value. The same guiding principles hold: (1) a straightforward business preferably with a repeat purchase model, (2) a stable business, (3) decent balance sheet, (4) top notch management team, and (5) industry leadership. This is boring.

Consider Apple (AAPL). I own 4 Macs (I’m writing this using an iBook) and 6 iPods. I love their products (obviously), but their stock has dropped from about 200 down to 160. Many people were thinking it ‘had to’ rise to 300. Many of these people weren’t around in 1999 or in 1987. They refer to AAPL’s cash position–guess what: it needs cash to fund growth. The company is on a treadmill and needs the cash to continue to fund growth. If they have a disappointing “show” and fail to release the products the market expects (and let’s recall that AAPL has a history of doing this), they get crucified. It’s really high risk/reward. When, in the life cycle of the company, they no longer need the cash, they can declare a sizable dividend–which is what Microsoft did a few years back. Still, it is very hard for a company to support a mid-double digit P/E ratio for long periods of time. The market will not pay a high multiple for very long, especially if the company shows the slightest disappointment in future cashflows (earnings) due to issues with products, markets, etc. If in the midst of this the economy gets tough (recession or worse), consumers may have to choose between necessities (food, shelter, water and clothing) and discretionary purchases. Which do you think they’ll choose?

Many companies focus on relatively mundane products. Their money is just as green as the money that comes from glitzier companies. I will be highlighting a couple of these shortly. One is in the food industry and the other one specializes in high tech machining.

Risks of Investing in ABFS

The last post showcased the opportunity that exists with Arkansas Best (ABFS:NYSE). As with any investment, there are risks. Given the nature of their business (shipping via trucks), several risks come to mind:

• Capital investment: ABFS has $461M in fixed assets (net of depreciation), which works out to about $18.40/share--this is clearly not a "light" business; additionally, investment may be required track assets/deliveries (IT infrastructure) and to support the trucks (maintenance and repair)
• Repeat business: There's a lot of competition in trucking; while customers repeatedly use the trucking, they may choose from a bevy of other carriers
• Differentiation: Since trucking services are ostensibly commoditized, ABFS has to differentiate itself (products, service, price) in the marketplace to establish their brand
• Margins: Their net profit margin (3.18% is below the industry average of 6.58%)

There are plenty of other risks as well (many of these are generic in nature): rising labor costs, increasing regulatory burden, management skill and modal conversion (i.e., shippers switching to other methods of shipment such as rail).

With that being said, it appears that ABFS is quite effective in dealing with many of these risks. Even though one of its subsidiaries is in a union stronghold (Clipper Exxpress is in Woodbridge, Il), Arkansas Best seems to have done a good job of avoiding labor strife. To keep costs low and service level high, Arkansas Best has set up two subsidiaries, Data-Tronics and Fleet Net. these two subsidiaries provide 2 essential services to Arkansas Best: shipment tracking and truck breakdown/repairs. Facing the option of doing this in-house vs. outsourcing, they appear to have launched these 2 services as standalone businesses (similar to how Ford spun off Visteon). Hopefully they will meet with more success than Ford!

Differentiation appears to be along the lines of operational excellence and scale. For the most part, ABFS appears to promote from within (they recently appointed a new president of Data-Tronics, a 28 year company veteran). Nevertheless, there is a major red flag with respect to margins, which are significantly below the rest of the industry. This bears more research, as it points to differentiation on price (which requires persistent, focused efforts to maintain low costs).

Lastly, ABFS has mitigated the modal conversion risk with their Clipper Exxpress subsidiary which operates in the intermodal space (intermodal shipments are the trailers you see riding on flat railroad cars).

Overall, they appear to have a good command of their business (they've won their share of trucking awards) and a decent amount of industry credibility. The only real red flag appears to focus on their low margins, which will be explored in more detail. Nevertheless, at current valuations, there appears to be a decent bit of Margin of Safety with Arkansas Best.

ABFS: Logistics Opportunity?

One of the potential value stocks being looked at is Arkansas Best (ABFS: NYSE). The stock has been driven down recently by 2 forces: slowing economy (lower traffic growth) and rising fuel prices (higher costs). To be clear, ABFS is a holding company that operates several subsidiaries, the largest of which is probably ABF Freight System, Inc. ABFS is a trucking company and they focus on LTL (less than truckload) shipments. Increasingly, they are focusing more on regional markets (this is important given the wide use of regional distribution centers). The stock had a significant run-up on 1/14, but still looks attractive for several reasons:

• Undervalued at .8x book value with a P/E around 7.7
• The company is kicking off cash ($5.01/share cashflow)
• Business is fairly straightforward; trucking is definitely a repeat business
  
• ABFS has very little debt ($1.7M); quick ratio of 1.4

Additionally, it appears the company is pretty well run and takes its operations seriously--it had the forethought to set up an IT subsidiary (Data Tronics). This is important for several reasons: (1) ABFS can keep track on their assets (i.e., trucks), (2) ABFS can generate data on their shipments that they can use to streamline their operations, and (3) it allows shippers/consignees to track shipments which is crucial to supply chain management.

ABFS also, it has the advantage of being in a very central part of the country where there's a high availability of moderately priced labor. All this sounds good--in my next post I'll look at possible downsides to ABFS' business.

Interesting Stocks

Looking at things from a value perspective, there are several interesting stocks. This is actually a particularly tricky time since P/E’s are coming down pretty quickly and book values are increasing. The challenge is to separate the proverbial wheat from the chaff. Some criteria being considered here include: (1) a straightforward business preferably with a repeat purchase model, (2) a stable business, (3) decent balance sheet, (4) top notch management team, and (5) industry leadership. Without getting into too much arcane language on intrinsic value and obscure techniques on valuation, the goal is to use a common sense approach while being selective.

DEA Value Investing–the human side of value investing

It appears the market is hovering between sporadic good news (Dow Chemicals last week and IBM today) and constant bad news (subprime, weak dollar, inflation). Today, the market is up based on IBM’s good news. Mr. Market seems to have ignored the bad news from Sears–sales are disappointing and don’t bode well for continued consumer spending. The broad sentiment is that the economy has been propped up by consumers. About 2 years ago, the same was said about housing.

This shouldn’t matter to a value investor, but it does. Because we’re not machines, we care about the economy, our jobs, and our surroundings. While we might try to focus on balance sheet assets with underrepresented value, most of us are also worried about paying for our kids’ education, mortgages, etc.

Being comfortably away from Wall Street (almost 1,000 miles), I’m about 25% closer than Omaha, NE. With that being said, the goal is to keep a realistic perspective on things. Right now, I’m watching several interesting companies that seem to offer a reasonable value play. They’re in industries we all touch in one way or another. More on these in future posts.