The Wall Street Transcript Interview Excerpts

I was interviewed by The Wall Street Transcript, here are some excerpts from the interview:

Investing vs. speculating

Let’s talk about financial stocks for a second, because I’m sure they are on investors’ minds right now. You want to be an investor rather than a speculator; at least I am talking about investing. If you own financial stocks, you want to make sure that you own the ones that you can analyze. I dare anybody to analyze Citigroup (C) or Bank of America (BAC). Those stocks could be cheap and they may end up having great returns, but most generalists, including myself, can’t analyze those companies; they are too complex.

If you are buying a company whose fair value you can determine, you can analyze and access risk and required margin of safety – you are investing.   If you’re buying a company because it’s declined a lot and has a good reputation, and you think it’s going to go up but can’t fully determine how much it’s worth (or can barely analyze it), you are speculating. I encourage to only own financial stocks that you can analyze. Take American Express (AXP)– it is  a credit card company and processing company that you can actually sit down, look through the financial statements and figure out how much it’s worth – it is analyzable.  That’s just one example of that.  

Here is a very detailed analysis of American Express I completed in April (PDF).

Profit margins, profit margins, and profit margins

Another point, and this is where I spend a lot of time right now: when you look at companies you want to make sure that you normalize their profit margins. For a lot of companies, especially “stuff” stocks that have very high margins, you have to look at where they were historically, you have to look at their business and say what would happen if the global economy slowed down. (Though I believe the slowdown is a question of when, not if.) Would they be able to maintain these high margins? If not, you have to figure out their normal margin over a long-term cycle and value them that way. This way you’re going to avoid buying a lot of companies that see their margins contract and sudden, like housing stocks, go from 10 times earnings to 50 times earnings overnight.

 On selling

Even if you don’t want to become an active value investor, you should at least become a buy and sell investor. Selling is like a four letter word in a bull market.  Investing is about buying and selling; even long-term investments are about buying and selling. You want to buy companies when they are undervalued, and when they get fairly valued you want to sell them.  If you don’t sell them, you’re just going to see their PE keep contracting and contracting. So you want to be an active investor, a buy and sell investor.  Also realize this: return for any company or any stock really comes from three sources: dividends, earnings growth and P/E contraction or expansion. If you consider a stock that you are sure will continue to pay dividends and grow earnings, ask yourself a question: is it going to see PE contraction or expansion?

If you buy a company that is undervalued and whose P/E is undervalued and you receive dividends while you hold it and you receive return from earnings growth, and P/E goes from low to relatively normalized, guess what? You’ve already captured one source of return that may not be there in the future, the P/E expansion. Initially all you’re going to get is dividends and earnings growth. The sell question remains – “Is this company’s growth rate and dividend going to be high enough to justify holding the stock?” If the answer is yes, keep holding it. If the answer is no, move on to a different stock.  Exercise “sell” discipline.  Once P/E is normalized (increased) is not your friend, not anymore – the margin of safety is gone.

A stock idea

There is this little company that nobody ever heard of, Microsoft (MSFT). I’d tell you there are so many reasons to hate Microsoft. Their Vista product is a flop (at least there is a perception that it is a flop), Google (GOOG) is coming out with a new competing browser, the company’s too big, nobody understood what their Seinfeld and Gates advertisements were about. So the stock is hated.  I used Vista and hated it, at least at first; they have improved it since. By the way, think about the kind of competitive advantage the company must have to sell 160 million copies of Vista,  a failed product. Imagine what would happen if they actually had a successful product! This company has a tremendous competitive advantage.  

Google is coming out with a new browser, and it may possibly hurt Microsoft’s search and  advertisement businesses. However, Microsoft is losing money in its advertising business, in its online business. These businesses are not priced into the stock, they actually detract from its earnings and valuation. Even if Microsoft gives up and shuts them down, it should only be a positive. My point is, Microsoft may lose the war with Google on advertising (and that’s very possible), but it’s almost irrelevant. This is a company that’s trading at about 12 times earnings. If you take out cash, which they have $20 billion of, it’s trading at 11 times earnings.

There is another argument that Microsoft cannot grow at a very fast rate. In the last quarter they grew their earnings and sales in the mid-teens. How many companies do you know that actually can trade at 11 times, 12 times earnings; have returned capital in the mid-30s; have a competitive position that no other company in the world can match; have grown earnings in mid teens; and are trading at that valuation. But it gets better. When you value Microsoft, even if you take their earnings growth rates to zero, the stock is still too cheap. If I’m wrong on the growth rate and they say they’re going to start growing at 6% to 8% a year, even at that point the company still will be too cheap. In this economic environment, where you want to own very strong companies with bulletproof balance sheets, this is a perfect stock.  And yes, I do own it – as do my clients.

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