Micron (MU)

chip

Key Statistics

Enterprise Value = $59.959 billion

Operating Income = $13 billion

EV/Operating Income = 4.6x

Price/Revenue = 2.23x

Earnings Yield = 20%

Debt/Equity = 26%

The Company

Micron is a rapidly growing semiconductor manufacturer. It represents everything that investors are supposed to love in 2018. Micron manufactures semiconductors for everything from supercomputers to smartphones with a particularly strong niche in memory products.

Business has been fantastic over the last few years, driven by the global growth in tech spending. From 2016 levels, 2017 sales were up by 64%.

The business is in the midst of a massive boom, with revenues and earnings growing every quarter. The Q3 earnings report was the best in Micron’s history, pulling in $7.7 billion in revenue and $3.10 in earnings per share.

My take

In the current tech-obsessed mood, Micron is the kind of business that Wall Street should be infatuated with, but it’s not. Micron currently trades at an absurd P/E of 5.10 compared to industry average of 30.10, a discount of 83%. Micron’s 5-year average P/E is 14.58. An increase to this level would be a 185% increase from current levels.

The crazy valuation is not a result of a sell-off. Micron’s stock price has done well over the last few years. This is an odd situation where the actual earnings growth over the last few years has outpaced the stock price.

The major risk is that Micron’s business is at a cyclical peak. This is a view I am very sympathetic towards. Micron is mired in an extremely cyclical business. In the last twelve months, Micron posted a crazy operating margin of 46%, which is destined to decline. Eventually, the market will become saturated and prices will decrease.

Where are we in Micron’s business cycle? I have no idea. It’s entirely possible that we are at the peak in this business cycle for Micron. It’s also possible that we are in an early inning. I don’t know. The thing is: no one else knows, either.

This is also an industry facing constant and relentless pricing pressure. That’s why a ’90s supercomputer can now fit into your pocket. Tech gets better and cheaper as time goes by. It’s a bad place to be.

semi

Tech hardware: not a great business

This is a cyclical business with long-term pricing pressure on the downside. This begs the question: why am I buying this thing?

In my view, even if Micron’s business is at a cyclical peak and they are poised to lose pricing power: at 5x earnings, does it matter? What will the multiple go up to, 8x? 10x? That’s still very cheap for an S&P 500 tech company that is growing earnings and cash flow at such a rapid rate.

Why isn’t the same mentality applied to other amazing mega cap semiconductor companies like Nvidia, trading at a multiple of 39x earnings? Or Intel, trading at 19.85x earnings?

The expectations embedded in the stock price completely discount the possibility that the Micron’s good times might last longer. At such a cheap price, I am willing to take the other side of that trade.

There are no signs of financial distress with Micron, with a nearly perfect F-Score of 8 and a debt to equity ratio of 26%. Micron’s solid balance sheet and strong financial position also limit the possibility of a major blow up, limiting the risk on the downside.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

United Therapeutics (UTHR)

dna

Key Statistics

Enterprise Value =$4.454 billion

Operating Income = $998.2 million

EV/Operating Income = 4.46x

Price/Revenue = 3.06x

Earnings Yield = 13%

Debt/Equity = 10%

The Company

United Therapeutics is a biotech firm founded in 1996 by Martine Rothblatt. Rothblatt’s daughter suffered from pulmonary hypertension (high blood pressure within the arteries of the lung), and she founded United Therapeutics to try to find a treatment. They succeeded in creating Remodulin, which was approved by the FDA in 2002. UTHR sells many other drugs, but Remodulin remains the blockbuster core of the business. In 2017, it represented 39% of total revenue.

More recently, in 2015, the FDA approved one of UTHR’s latest drugs: Unituxin. Unituxin is a treatment for neuroblastoma, cancer affecting the kidney. Children often have this cancer. Unituxin helps the immune system fight cancer.

A few years ago, UTHR was a richly valued growth stock. To put the growth into perspective, in 2002 the company generated $50 million in sales. Last year, sales were $1.7 billion. In 2015, it traded at a P/E ratio of 50.

Since the 2015 peak, the stock is down 17%.

What happened? Several patents expired in 2017 and UTHR is facing increased competition from generics. Growth has slowed down, and the market is worried that there aren’t enough drugs in the pipeline to keep the growth going.

My Take

Growth for UTHR likely won’t continue at the intense pace of the last twenty years. The thing is: at this price; it doesn’t need to. The stock is priced like it is a dying business that is being destroyed by competition as if it is one of my beleaguered retail picks fighting the Amazon juggernaut. In reality, this is a Phil Fisher company trading at a Ben Graham price.

The stock now trades at a P/E of 7.63 (down from its 50x peak in 2015). The average for the biotech industry is 29.45, meaning that UTHR trades at a 74% discount to this. It is also a free cash flow machine generating an 11% yield based on its current enterprise value. The 5-year average P/E for UTHR is about 18.55 (which seems like a proper valuation for a growth company). An increase to 18.55 would be a 143% increase from current levels.

In the most recent quarter, year over year sales was mostly flat, and earnings were down. The recent performance deepens the worries that UTHR’s best days are in the past.

The consensus price implies that UTHR has nothing in the pipeline. In reality, they spent $264 million on research in 2017. They are working on many new drugs, but one of the most exciting areas of research is the manufacturing of organs. They are trying to develop the ability to generate engineered lungs, hearts, and kidneys. If they succeed, such a development could save a tremendous number of lives over the long run and, of course, generate significant business for the company.

UTHR is valued as if it is roadkill. It is priced for a no-growth future. Based on its past results and research pipeline, this seems to me like an unlikely fate. With a solid balance sheet and low valuation, the prospects of a significant decline are low. Meanwhile, any whiff of good news on the research front could send the company to a more normal valuation, potentially a 100%+ gain from current levels.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

 

ERUS & ENOR

Sold 72 shares of ERUS @ $31.61

Sold 57 shares of ENOR @ $27.64

I am going to replace it with positions in new companies that I have analyzed and understand.

This leaves my only international index as Singapore EWS.

Goodbye, cruel world. 🙂

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

Sanderson Farms (SAFM)

chicken

Key Statistics

Enterprise Value = $2.084 billion

Operating Income = $358.54 million

EV/Operating Income = 5.81x

Price/Revenue = .69x

Earnings Yield = 12%

Debt/Equity = 0%

The Company

Sanderson Farms is a classic, easy to understand, all American business.

Founded in 1947, it is the third largest poultry producer in the United States. Principal competitors include Tyson, Purdue, Pilgrim’s Pride. The company isn’t hated, but it is ignored because it is relatively small and operates in a commoditized industry that isn’t particularly glamorous.

With that said, they have a long operating history and have run the company with excellence and integrity throughout their history. They grow the company organically with cash flow, as opposed to relying on debt to fuel growth.

One factor fueling Sanderson’s recent price decline has been worries about Trump tariffs. This is bizarre because nearly all of Sanderson’s operations and customers are within the United States and tariffs will have little impact. While Sanderson sells some of their products to intermediaries who export overseas, most of their chickens are produced and sold here in the U.S. Regardless, Wall Street traders target the industry as a whole with a narrative, without regard to the underlying fundamentals of the individual companies within that group.

My Take

This isn’t the first time that I owned this stock. It was a part of the original lineup of stocks I purchased for this account in December 2016. I owned it through 8/30/17 and sold for a decent profit. The stock had an epic run up in 2017, and I got out when I thought the valuation no longer made sense.

Since then, the stock slid down to a level that I think is below its intrinsic value, bottoming at $95.97 in June. Since then, the price has hovered around $100. I picked up 16 shares on 8/15 @ $100.57.

From a relative valuation standpoint, Sanderson is cheaper than the industry as a whole. The current P/E is 8.54, while the industry average is 19.25. On a price/sales basis, it is .69x vs. an industry average of 1.49x.

Growth for Sanderson mirrors growth in the chicken industry, which ebbs and flows in the short term, but the long-term trajectory is towards growth. People aren’t going to stop eating chicken. With a growing global middle class, demand for chicken is only going to increase over time.

“People need to eat” is a familiar refrain when discussing the cyclicality of other industries vs. food essentials. Sanderson’s sales increase organically nearly every year (including during the Great Recession). Sales are up 94% over the last 10 years. Any earnings loss is usually caused by gyrations in chicken prices, which inevitably resolve themselves. With no debt, Sanderson can handle these temporary losses. With a solid product that will never go away and no debt, Sanderson should weather any recession with ease. Over the long term, it should continue to grow organically as it has since the 1940s.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

Thor Industries (THO)

rv

Key Statistics

Enterprise Value = $5.048 billion

Operating Income = $684.85 million

EV/Operating Income = 7.37x

Price/Revenue = .6x

Earnings Yield = 9%

Debt/Equity = .04%

The Company

Thor Industries, Inc. makes and sells recreational vehicles. They operate two principal segments: towable recreational vehicles and motorized ones. Business has been excellent in recent years due to twin demographic trends. To sum it up: Millennials are living in RV’s and taking wake-up selfies next to the Grand Canyon, while Boomers are retiring and using them for vacations. Cheap oil has also buoyed the expansion.

While the company has been consistently growing sales and earnings at a rapid rate for every year of the expansion, it currently trades at a 66% discount from its 52-week high set back in February. 2017 was the company’s best year in its history and investors are concerned they won’t be able to keep up the pace. The stock sold off because of fears over the Trump administration’s steel and aluminum tariffs.

My Take

Thor is not the kind of company that I usually buy. It is a fast-growing, well-performing firm. It certainly looks like a “wonderful company at a bargain price.” Thor is performing significantly better than most companies trading at a P/E of 11, EV/OpIncome of 7.37x and 60% of sales. It’s average P/E for the last five years was 16.62, which seems reasonable for its quality. Multiple expansion alone to its average level would fuel a 51% rise in price from current levels.

Thor is also outperforming its competitors in the RV industry. For the last ten years, it has maintained a 16.69% rate of growth in comparison to 9.41% for the industry as a whole and 12.25% in comparison to its biggest competitor (Winnebago). It is also achieving these results with less leverage. Thor has a low debt/equity ratio of .04%. Winnebago, in comparison, has a debt/equity ratio of 50%.

Sales have organically grown with every year in this expansion, and they appear to be increasing. Sales have increased by 123% from 2013. Earnings are up 147% over the same period. With an F-score of 7 and a Z-score of 7.98, the company is financially healthy.

One risk is that we have a recession, as that would trigger a contraction in credit availability for RV purchases. Of course, a recession is a risk for everything that I own.

Another risk factor is that the RV industry might be at a cyclical peak. 2017 was the best year for the RV industry in history, with $20 billion in sales and 504,600 units sold. Despite this, I think that the industry still has a lot of room to grow in popularity. I think it will have a continued appeal for families, Millennials who want to unplug, and Boomers who are retiring.

According to the RV industry association (I know, they have a bit of a bias), RV camping trips are much cheaper than the typical family vacation. Family RV trips are probably much more pleasant, too. Everyone hates flying, but I’m sure that flying with your kids in tow is a particularly miserable experience. So, this ought to have an appeal to families. Boomers continue to retire and they should continue to drive the growth of the industry.

The recent sell-off looks like a severe overreaction to some bad macroeconomic news with little regard to the actual performance of the underlying company. While tariffs are a problem, I don’t think they can derail this exceptional business that is being buoyed by a favorable business climate in the United States and current demographic trends.

Random

Speaking of RV’s, I can’t talk about them without thinking of this video:

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

TUR, EPOL, EIS, EWZ

I’m out. Turkey’s meltdown convinced me that I shouldn’t venture into things I don’t understand – like cigar butt international indexes.

Also dumping Poland and Israel. Israel has a close trading relationship with Turkey. I want minimal exposure to Europe, as the crisis looks likely to spread. I will probably sell Norway next month when I do the rebalance. I am also ditching Brazil. This will give me enough cash to buy at least 2 positions.

I know, I know. The US is overvalued. Home country bias. But, at least with a US company, I can wrap my head around it and hold through a tough time.

EPOL @ $23.1752

TUR @ $19.3653

EIS @ $53.5101

EWZ @ $33.7746

I’m going to replace it with actual companies that I understand.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

Did Ben Graham abandon value investing?

newspaper-595478_960_720

Did Ben Graham abandon value investing?

Benjamin Graham refined and changed many of his views at the end of his life in the 1970s.

Even though he was retired and surrounded by beautiful people and weather in California, he continued to conduct extensive research into the behavior of securities as an intellectual pursuit.

Reading some of his writings and interviews from the period, some have concluded that Graham abandoned his philosophy and embraced the efficient market hypothesis.

Here is a quote of his that led many to this conclusion:

“I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, 40 years ago, when our textbook ‘Graham and Dodd’ was first published; but the situation has changed a great deal since then. In the old days any well-trained security analyst could do a good professional job of selecting undervalued issues through detailed studies; but in the light of the enormous amount of research now being carried on, I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their cost.”

This is a quote that efficient market types will often throw in the face of value investors. To paraphrase these people: “See, even Ben Graham thought this was all a bunch of nonsense! Shut up an buy an index fund, idiot!”

Reading these quotes, many value investors are left stung in disbelief. It’s like suddenly discovering that the Pope is an atheist, Mr. Miyagi was secretly helping the Cobra Kai, Picard collaborated with the Romulans, or that Johnny eventually put Baby in a corner.

The Truth

The truth is more nuanced. Yes, Ben Graham didn’t think detailed, individual security analysis was as useful as it was when he originally wrote the book in the 1930s. That doesn’t mean he gave up on the concept of value investing.

In fact, Graham did not agree with the efficient market crowd. He had this to say about them:

“They say that the market is efficient in the sense that there is no practical point in getting more information than people already have. That might be true, but the idea of saying that the fact that the information is so widely spread that the resulting prices are logical prices – that is all wrong, I don’t see how you can say that the prices made in Wall Street are the right prices in any intelligent definition of what right prices would be.”

The behavior of markets is, indeed, crazy. You have to be slightly brainwashed by the beautiful, peer-reviewed, academic work of the Church of Beta to think that prices are logical. Look at all of the insane bubbles that have plagued securities markets in the last few decades. Look at the nonsensical valuation of stocks in early 2009.

Look at the activity in multiple asset classes. Dotcom stocks, crypto, even housing. Look at the wild ride that the S&P 500 had in the 1990s and 2000s. Was the late ’90s run up rational? Was the hammering that stocks endured in 2008 logical or emotional?

It was all irrational, it was crazy. It wasn’t a market unemotionally weighing information. It was herds of professional investors reacting emotionally to events.

Mr. Market is alive and still doing crazy shit. If you don’t believe me, just watch the cable coverage of market action every day. Cable financial news is a torrent of speculation, FOMO, greed, and fear.

If Mr. Market were a person, he would live in Florida.

Another important snippet from the quote really stands out: “the information is so widely spread.” Graham was writing in the 1970s. We tend to think of the 1970s as a time when people were using stone tablets in between bong hits and classic rock albums. The thinking is that modern markets are so much better because we have the internet, computers, financial Twitter, blogs. We are so sophisticated and technologically advanced!

This is a conceit of every generation. Everyone thinks that their era is remarkably sophisticated and eras of the past were the dark ages. The experiences of our ancestors are primitive and not useful. The reality is that history rhymes and human nature never changes, no matter our level of technological sophistication. Eventually, the innovations of every era are ultimately discarded and regarded as quaint.

In reality, the critical information people needed to know about markets was available in the 1970s. Just because there is more information and it is more convenient in today’s world, it doesn’t make modern investors any more sophisticated or less emotional than the investors of yore. Indeed, the critical information about stocks has been widely available for a long time.

There is a perception that because stock screening technology and the information is readily available, that the edge for value investors has been eliminated. I think that’s bunk. Whether it was Moody’s manuals in the 1950s, Value Line in the 1970s, or stock screeners today – it has never been hard to find cheap stocks. What’s hard is actually buying them, not discovering them.

The source of returns in value investing has never been informational, it has been behavioral. It has been revulsion towards companies that are in trouble contrasted with starry-eyed love for companies that are making all the right movies.

There is a perception that the cheap stocks of past markets were diamonds in the rough. With technology, the thinking goes, those diamonds have been scooped up. Nothing could be further from the truth. Cheap stocks were always ugly stocks. The idea that there were cheap situations without any hair on them is a myth. The reason that cheap stocks outperform in historical analysis is because they were ugly. It was because they had problems.

The only thing that has changed is the methods of gathering that information.

Quantitative Value Investing

Back to the topic at hand.

While Ben Graham thought that detailed individual security analysis was a waste of time, he also believed that the efficient market theory was bunk.

Graham supported quantitative value investing. In other words, systematically purchasing portfolios of cheap stocks. Within the portfolio, some stocks would undoubtedly be value traps. As a group, however, they would generate returns that would beat the market.

Graham sums it up in this quote:

“I recommend a highly simplified strategy that applies a single criteria or perhaps two criteria to the price [of a stock] to assure that full value is present and that relies for its results on the performance of the portfolio as a whole — i.e., on the group results–rather than on the expectations for individual issues.”

 In other words, he believed that investors should select a portfolio of cheap stocks and construct a portfolio of them to systematically take advantage of market inefficiency.

What quantitative criteria, then, did Graham recommend to select bargain stocks?

Net-Net’s

The first method, which Graham was most famous for, was purchasing stocks selling below their net current asset value. Graham referred to investing in net-net’s in the following fashion:

“I consider it a foolproof method of systematic investment—once again, not on the basis of individual results but in terms of the expectable group outcome.”

A crucial part of Graham’s quote is his point that the results of individual net-net’s are not dependable. Graham recommends buying a basket of them and allowing the portfolio to generate returns.

The problem with this approach is that they aren’t available in bulk frequently in the U.S. markets. As Graham pointed out, net-net’s should only be purchased as a portfolio. The only time that there are enough net-net’s to create a portfolio is in market meltdowns like the early 2000s or 2008-09.

I am eagerly anticipating the next decline so I can buy a portfolio of net-net’s.

Simple Graham: Low Price/Earnings & Low Debt/Equity

The next approach that Graham outlined was buying a portfolio of stocks with simultaneously low P/E ratios and low debt/equity. The great thing about this approach is that it is applicable in the United States outside of meltdowns, unlike the net-net approach.

This is the approach that I take with my own investments, albeit with other criteria (low price/sales, low EV/EBIT, high F-Scores, etc.) and qualitative analysis added to it.

Regarding price/earnings ratios, Graham recommended purchasing stocks that double the yield on a corporate bond. He suggested looking at the inverse of the P/E ratio, or earnings yield. A P/E of 10 would be a 10% earnings yield, for instance.

“Basically, I want to double the interest rate in terms of earnings return.”

“Just double the bond yield and divided the result into 100. Right now the average current yield of AAA bonds is something over 7 percent. Doubling that you get 14, and 14 goes into 100 roughly seven times. So in building a portfolio using my system, the top price you should be willing to pay for a stock today is seven times earnings. If a stock’s P/E is higher than 7, you wouldn’t include it.”

In other words, the value criterion was remarkably simple: a low P/E ratio.

Graham’s second criteria was a low debt/equity ratio.

“You should select a portfolio of stocks that not only meet the P/E requirements but also are in companies with a satisfactory financial position . . . there are various tests you could apply, but I favor this simple rule: a company should own at least twice what it owes. An easy way to check on that is to look at the ratio of stockholders’ equity to total assets; if the ratio is at least 50 percent, the company’s financial condition can be considered sound.”

Concerning portfolio management, Graham recommended holding onto the stock for either two years or a 50% gain. I think this is an important point: Graham never recommended holding shares forever. That’s Buffett’s approach. Graham, in contrast, suggested a high turnover portfolio: buy a large group of undervalued stocks, wait for them to return to a reasonable valuation, then sell and move on to the next situation.

Graham backtested this method going back to the 1920s and found that it generated a 15% rate of return over the long run.

Wesley Gray and his team at Alpha Architect also backtested Graham’s method and found that Graham was right. The technique delivered 15% rates of return over several decades.

Even with an exceptional 15% rate of return, the strategy underperformed at some key moments. In 1998, for instance, it lost 1.94%. The S&P 500 was up 28% that year. In 1999, it gained only 2.51%. The S&P 500 was up 21% that year.

There was similar underperformance in the Nifty 50 era. In 1971, the Graham strategy returned only 1.57%. The S&P 500 gained 14.31% that year.

I believe we are in a similar moment right now. Only time will tell if I am correct.

The Simple Ben Graham Screen

I run multiple screens, but I use Graham’s criteria as a cornerstone in my stock selection. Even if I am wrong in my analysis, I know that I am at least looking in the right neighborhood.

Here are ten stocks that currently meet Graham’s criteria for earnings yield and debt/equity:

graham stocks

I am not recommending that you go out and purchase any of these stocks. I am merely showing that even in a frothy market like the U.S. today, there are still opportunities which meet Ben Graham’s criteria.

Random

  • The source of Graham’s 1970s quotes featured in this blog post is The Rediscovered Benjamin Graham by Janet Lowe. The book is a collection of articles written about Graham, Congressional testimony, interviews, and articles written by Graham himself. Of particular interest are the bullish articles that he wrote in the early 1970s and early 1930s, discussing the deep undervaluation of American stocks. You can buy it here on Amazon. It’s a great read and gives you a clear perspective on how Graham’s thoughts evolved over time.
  • Captain Picard is coming back. I can’t express how much I am pumped about this. Here is Patrick Stewart explaining his enthusiasm for the role.
  • Turkey. Yes, I own the Turkey ETF. Fortunately, it is a small position. Here is an excellent article on the crisis.
  • I watched a random, weird, and goofy movie last night: The Final Girls. It’s a parody of ’80s slasher movies. If you’re familiar with all of the tropes of the genre and you’re in the mood for some lighthearted fun, I recommend it. If you’re not familiar with the genre, the jokes will probably not resonate.
  • Better Call Saul is back. If you’re not watching, you’re missing out. If you were a fan of Breaking Bad and aren’t watching this one, what the hell? As the series moves along, it is living up to its predecessor.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.