You are one among a number of value managers who have invested in Hewlett-Packard and Dell. What is the margin of safety in those businesses, and how does one determine when a value stock like those is a value trap?
We often find ourselves buying former investor favorites that have disappointed their erstwhile fans. We want to buy companies that, while not what they used to be, are still good enough to justify much higher stock prices. Understanding the difference between “permanently impaired and deteriorating” and “temporarily off-track but fixable” can be difficult. Turnarounds are not our favorite pursuit, but we invest in them occasionally.
We bought Dell several years ago and HP more recently. In both cases, the companies were generating very large amounts of free cash flow and had businesses that were at least stable and with potentially improving prospects but which had been given up for dead by most investors.
We have traded Dell successfully, and it is currently the focus of a potential LBO or leveraged recap that would give us a disappointing-but-positive result. HP is a tougher case, having been mismanaged and poorly governed for years, but we think the current risk/reward outlook is positive.
Your methodology involves estimating a company's future free cash flow and calculating a present value. How do you select the appropriate discount rate when central banks are essentially engaged in price-fixing of interest rates?
We use a 12% discount rate in all our discounted cash flow models. This gives us a “base case” business value. We want to buy shares in the company at a considerable discount to this value, and the size of the discount reflects the predictability of the business, its competitive position, balance sheet strength, etc. We might be willing to pay 70-75% of business value for a very high-quality, predictable business. Another business may be less predictable and have more flaws, and while we will consider buying it, we might be willing to pay only, say, 50 cents on the dollar of value.
Other investors who use DCF analysis may use different discount rates on different types of businesses but be willing to buy each at the same percentage of the DCF value. We are making the same adjustments but at a different point in the valuation process.
In your writings, you say that you like to see a stock price at 40% to 50% discounted to your valuation. How does the available supply of investment candidates that meet those criteria today compare with other times in your career?
Stocks today seem fairly-to-fully priced. Stock prices are a function of all sorts of unpredictable variables, and we have to be patient and take what the market gives us. Howard Marks’ recent commentary, Ditto, explained why stock prices are far more volatile than companies’ underlying business values. Investors tend to respond emotionally and drive stock prices way higher and way lower than is reasonable. The recent collapse in stock prices in late 2008 and early 2009 was a great example of mindless selling and was a great buying opportunity.
Extremely high prices like 1972, 1999 and 2007 and extremely low ones like 1974, 1982 and 2009 stand out in one’s memory, but every year brings some opportunities for investors with conviction about business values. The European debt crisis has already provided some mini-panics—most recently October of 2011—and it will probably provide more.