Why I am Selling Ituran
Hi folks, see my recent post on why I am selling out all of my Ituran Location & Control (ITRN) shares on Monday, just published on Seeking Alpha.
A Few Brief Thoughts on United Health Group, Inc.
This is a stock I purchased in my IRA on September 1, 2010, when it was trading at $32.48/share. Today it trades at $58.92/share. Needless to say, it has been a big winner for me. However, it was always a small position, at a $617.12 original cost basis. I only bought 19 shares. By comparison, I own over $4,000 in XOM stock, and have similarly “large” (for me) positions in MSFT, INTC, and BRK.B.
The position has remained small because I have been guilty here of price anchoring. I think I got afraid of the increased nominal price, and have failed to pay attention to the underlying business.
It’s time for an update. In my update, I conclude that the company is not wildly undervalued. It would be a strong buy at $54.88, not far below where it is today. If it goes above $82.32/share, and the fundamentals have not changed, it is time to say adios. It is obviously nowhere near that level.
Here is my most recent sheet. As you can see, I keep things fairly simple.
I have used a WACC of 11% here, which is in-line with consensus. I assume no debt or cash. (The actual net cash/debt position is about $4 billion of debt, but I assume based on its cash generation it can basically maintain that in perpetuity.) For my free cash flow growth rate, I’m only assuming 3% growth over the next ten years, even though in last nine years it has averaged 9.67% annualized growth. The problem is in the last three years that stalled to 7.59%, and in the last year, the annualized growth was only 3.12%. I attribute most of this decline to recent regulatory changes, but I never assume higher growth than present growth. In fact, even my 3% growth assumption may prove too optimistic, and is the thing I’m most worried about in my analysis.
On the other hand, it matches Morningstar’s analysis closely, and even if you assume 1% growth, the stock is worth around $61/share. My pessimism is also tempered by the fact the company has reduced its diluted share count by 16.2% in the past four years, which is great, and future such reductions should prove accretive to the value of future free cash flows attributable to my shares.
Substantively, my thesis from 2010 has not been blown: Obamacare will not destroy this company, its scale confers massive advantages in such a highly-regulated industry, and it is well-run. Nothing since 9/2010 has changed these basic assumptions. I actually think Morningstar in evaluating United Health’s ”moat” is probably being too pessimistic in assigning the company only a narrow moat, given the regulatory environment in which it operates. They likely attribute the declining free cash flow growth to moat issues, whereas I attribute it to regulatory changes.
That said, I think the massive gains here are likely done. That is because these gains were to be had before the world had digested Obamacare as fully as it has now. I do think the stock remains somewhat artificially depressed because of lingering and overblown concerns about the full implementation of Obamacare, which is why opportunity remains.
Also, the dividend is quite low — 1.44%, even after it was increased from a quarterly $0.13 dividend to a $0.21 quarterly dividend, or a 61.5% increase, in the time I have owned it. That seems to be the level this company wants to be at, and it is not enough to attract all those seeking yield in a ZIRP environment, so I do not attribute its share appreciation to a hunt for yield. The fact that its P/E ratio has not really increased much at all since 2011 (in a time when the S&P P/E ratio has gone from under 14 to the 18 neighborhood) supports this view.
In short, I think this company remains highly investable. I should consider doubling my position notwithstanding the recent share price appreciation I have seen, particularly since the share price has basically been stalled for the past year. However, before doing so I should conduct a deeper analysis of Humana (HUM), which appears to be performing even better than UHN has been.
Investors Must Preserve Emotional Capital Too
I’m a buy-and-hold fundamental investor, but I follow a lot of traders on Twitter. I do this for two reasons. First, a lot of them are interesting and funny dudes (they’re almost all guys). But second, I recognize that some traders do actually make money on a consistent basis, and that the reason the money-makers do so is because they follow rules, and possess wisdom. And that’s applicable to fundamental folks like me.
Sunrise Trader had a great tweet this morning, that encapsulated what makes a good trader:
- Our job is to look for opportunity, manage risk, consistently take profits out of the market while preserving emotional and financial capital.
This is very applicable even to buy-and-holders like me. I’m not taking profits out of the market often — only when I think a stock is really stretched beyond its fair value. Instead, I’m just adding new capital every month from my earnings. But sometimes I must take profits. The really important thing that struck me again though is the importance of preserving emotional capital.
Notice he put that before preserving financial capital. The first leads to the second. For the buy-and-hold guy like me, you preserve emotional capital in three ways:
- Size your positions appropriately. That means at a level you are comfortable with. I never hold more than 30 different companies. But never fewer than 10. That’s what I’m comfortable with. You may be comfortable with a different number. If I put all of my money in one or two names, I would not be preserving my emotional capital. This would leave me more prone to doing something stupid like selling on a dip even when I believe in the company. As I grow as an investor I hope to shrink the number of companies I own. But there is no reason to force it.
- Invest over time. I add money to my investments every month, incrementally. It is much harder emotionally to invest $100,000 or $1,000,000 or $1,000,000,000 all at once than it is to invest whatever your total capital is over a period of months. This also gives you additional time to scale up in positions as you gain comfort and additional knowledge of the companies and the industries in which they operate.
- Buy-and-hold. This itself is a means of preserving emotional capital. I am sitting on huge gains in Microsoft stock that I purchased at about $18/share during the financial crisis. I bought Intel for the first time at around $13/share during the financial crisis. I have held those positions. I bought Walmart under $50/share in 2010. I have held. Etcetera. This is not to say I never sell. Stocks I have sold at advantageous times include Hewlett Packard, Transocean, Tidewater and Exelon, and less smartly, Ebay and Disney. But if I think my qualitative thesis is blown or the stock is way overvalued, I sell. That’s my rule. Sometimes I win, sometimes I lose, but I follow a rule, just as traders do. (It’s just that my rule isn’t a price point based on technicals.) When you are a buy-and-hold investor, and you follow decent selling rules, and you sit on long-term winners in whose business models you still believe, you see a lot of green on your screen after a few years. This gives you emotional capital. This makes you more confident. This makes you less likely to do stupid things, even with your newer positions.
UPDATED IRA PORTFOLIO PERFORMANCE. Basically, I got hurt last fall by Intel and Apple, and I have been helped in the past few weeks by their rise, and the rise of Microsoft. This is only one account, but is the only one for which performance is easily available. In my other two accounts at Zecco/TradeKing and Firstrade, they did not properly account, respectively, for: 1) the Berkshire takeover of Burlington Northern (they gave me a $0 cost basis on the new BRK.B shares!) and the switch from Zecco to Tradeking, and 2) at Firstrade for a bunch of Phillip Morris stock I deposited physical share certificates for when I initially set that up as a drip account in the late 1990s. That’s what you get for being cheap with your online brokers. So the returns are screwed up. I’m eventually going to sell all of the screwed up holdings and consolidate those accounts at Merrill Lynch so that I can show true returns for my entire portfolio. Unfortunately, this may mean I have to liquidate the Zecco/Tradeking account entirely, because they are erroneously saying I made all of my purchases on a single day in 2010, so I’m worried that if I just transfer those holdings the failure to track will extend into the new account. It is really frigging irritating, because the Tradeking accoung is where I made all of my 2009 purchases, which means I’ll have to pay a bunch of capital gains tax for the privilege of being able to use an online broker that will correctly track my portfolio in the future. Not a fan of either of those two institutions…. I have recently been about $1,000 cash in this IRA, but recently added $2,000 more. I have just under $20,000 in this account in total.
A Brief Update on Coke
There has been a lot of talk about overvaluation of consumer stocks like Coke (KO) lately, some of it by me on Twitter. And I think inarguably stocks like this are somewhat leading the market right now. I therefore decided to take a quick check today to see if I should consider selling, if it was that overvalued. It has been awhile since I actually ran the numbers.
My results are here. What I found surprised me. I used a WACC of 7% as my discount rate, even though some sources put the WACC at 6%. Still I come out with a valuation roughly in the $39/share range. That puts me squarely in between Morningstar ($42) and S&P ($36) — I always check them AFTER I have run my numbers.
So as of today we’re around $42/share. Is the stock cheap? No. Is the stock wildly overvalued? No. I have pegged $48/share as a potential sell price, assuming the stock clears that level without further substantive improvement in the business. But for now, while there is always risk of a decline, I think the coast is fairly clear.
As many have said, part of what is driving stocks like $KO is the perception of safety, and the desire for the dividend. Fair enough. There has been talk of a “dividend bubble” lately, so I must note I first talked about the elevation in values of dividend stocks in a pitch on the fool.com website in 10/2010 for Intuitive Surgical (ISRG). Good thing I didn’t avoid dividend stocks since that time, though! This isn’t over. The Fed isn’t done what it’s doing, and we aren’t about to see ZIRP end, and the reality is, while dividend stocks are outperforming the market now, and some like Coke have been for years, this could go on for at least another year or two. And even when it ends, the reality is, Coke is not that overvalued. It’s not cheap, but at least part of what is going on here is a reach for moat, as well as a reach for yield. And the reach for moat won’t go away when ZIRP ends.
Learning my Lesson (Again) on Diversifying for the Wrong Reasons
In early 2011 I added small positions to my portfolio of EPI and BRF. In early 2012 I added to the EPI position at a much lower price. These, respectively, are small-cap ETFs focused on India and Brazil. At the time my thesis was that India and Brazil were fast growing economies, and that I even though I didn’t know a ton about the mechanics and details of their economies, I should “diversify” and capture some benefit from those markets, without taking on the risk of investing in individual stocks. Thus I made the same mistake I made in 2007.
I recently sold out of those positions. Who knows, maybe that will prove to be a mistake and those markets will roar in the next two years. But I don’t really care.
I sold because as I delved into their economies, I saw inflation and rampant corruption and particularly as to India, political sclerosis that makes US politics look exceedingly vibrant (which is saying something). I also was sitting on 40-odd points of under-performance vs. the S&P in each position. (A lot less in that later add to my EPI position.)
The kicker is that in 2007 I had bought a European index mutual fund for very similar reasons. It resulted in one of my largest-ever losses, and if I had held it, my performance relative to the S&P (which is my primary measure of performance) would have been lowered even further. It was a large position, and I sold it in fall 2008.
Thus I learn my lesson again. Even though I use a DumbMoney moniker to poke fun at those who say individual investors like myself are “dumb money,” sometimes I really am the dumb money. It hurts to say it but it’s true. I am not a hedge fund. I do not have dozens (or more) of analysts working for me to evaluate markets around the world. I have developed an expertise after years of work in what makes the US economy tick, and in how US companies work, and in how US companies interact with the world economy, as well as how to analyze companies both quantitatively and qualitatively. But every time I step out of my comfort zone, I get hammered, performance-wise and pride-wise at least (I didn’t lose a ton of money on these positions because they were quite small relative to my portfolio.)
I highlighted the bold text above because it shows my primary mistake. I think it is important that I recognize my limitations. I did not buy these ETFs because I knew a lot about the countries. I did not even buy these ETFs because I was simply wanted wanted rote diversification. I bought these ETFs because I made an ill-considered and uninformed bet that their economies would grow faster than the U.S. economy. In doing so I made two errors: I bought with inferior information and strategy, and I mistakenly assumed that stock prices are largely connected to GDP growth, even though I know in the context of the US economy that they are not.
Lesson (hopefully) learned. I do retain a position in VWO, Vanguard’s broad international ETF. I am keeping that because I bought it out of a more generalized sense of portfolio diversification. I am well aware, lest you worry, of contemporary ideas of correlation of asset classes, and the limited benefit of diversification, but I do allow myself this, wearing my hat as financial adviser to myself, rather than virtual fund portfolio manager. EPI and BRF were portfolio manager mistakes that I hope not to repeat a third time.
Profit Margin Mean Reversion Doesn’t Mean Lower Earnings in a Boom
We have heard quite about about how the profit margins of US companies are at all time historic highs and that they will mean revert. Lots of smart people believe this. See here, here, and most recently here, which is the article that prompted this post. I myself have worried a lot about it, and have spilled quite a few pixels on the issue in other blogs. And they — we, are almost certainly correct. But historical evidence suggests that even if and when profit margins mean revert, it does not follow ipso facto that profits will plunge.
Wait. What? The reason, as with so many things, is contained right there in FRED data. I owe Morgan Housel of The Motley Fool a credit for tweeting this chart to me in response to my tweet about the issue on February 14, 2013 in which I shared my instincts on this issue.
What Fred data shows on this chart, is that in the late 1990s, profit margins actually declined, and yet as we all know, profits boomed. The answer I think is that in a booming economy, the increase in the magnitude of goods and services sold can overcome the decrease in marginal profit on each good, just when talking about the cumulative amount of earnings/profit that companies report.
Now of course there is an alternative reading. Profit margins peaked in the final quarter of 1997, and the trend was of decline, then a rise through 2000, and then decline that lasted into the 2001-2002 recession. So one can construe the falling profit margins of 1998 and 2001 as a harbinger of lower profits. Still, it bears thinking about that profit margins basically declined for three years, from 1998-2000, while corporate profits nevertheless skyrocketed.
Just think about it when people speak of the inevitability of falling profit margins immediately and automatically leading to instantly lower corporate profits.
Checking in on Microsoft
I have been a holder of Microsoft shares since the financial crisis in early 2009. I have added to my position since then, and it is one of my four largest positions, along with ExxonMobil (holding and adding since 1998), Berkshire Hathaway (holding and adding since 2009), and Apple (holding and adding since 2011). Unlike those three, most of my Microsoft stock purchases over the last three years have strongly underperformed the market.
The issues are of course well-known. First, Microsoft is the epitome of “dead money.” The stock price has gone nowhere since July 1998, nearly fifteen years. I was in college in 1998. Bill Clinton was President. AOL and Timewarner had not merged. That is a long, long time. Second, the Wintel monopoly on the corporate and even moreso on the consumer market is ending. Duh. Thematically, Microsoft doesn’t work. It puts out crappy products like Zune, and overpriced (sorry, but it’s true) products like Surface.
It’s CEO looks like a titanic oompa loompa. He is anti-cool. He is kryptonite to cool. Worse, he does things like try to purchase Yahoo for too much money, pay tons of money for an ad company that leads Microsoft to the write-off billions of dollars. And of course the attempt to compete with Google in search has largely been a failure. Etc., etc.
So why do I own? Why do I continue to own? It’s important not to check one’s brain at the buy button. And it’s even more important not to check one’s brain once one has hit the buy button. Is my thesis wrong? What is my thesis? My thesis is fairly simple: The company still makes a bunch of money, will continue to make a bunch of money, and even as the Wintel monopoly ends, this is not the end-of-the-line for Microsoft. And because everyone thinks it is the end-of-the-line and Microsoft is going to go the way of Research in Motion, it’s cheap as hell.
Even during the disastrous fiscal year that ended in June 2012, the company generated record free cash flow of $29.321 billion, and $3.44 of free cash flow per share, also a record. And record revenue. Against around $11 billion in long term debt, it was holding over $50 billion in cash and cash-equivalents.
These aren’t really new facts to anyone who follows Microsoft. More recently, earnings-per-share were down from $0.78 per diluted share in 11/2011 to $0.76 per diluted share in 12/2012. The future is all that matters. The trend is all that matters. What’s the saying? — I’d rather pay up for a quality business than get a bad business for a good price. Something like that.
Well, let’s see more concretely what this last year hath wrought. I last checked in on Microsoft’s valuation in April 2012. (I’m a long term kind of guy, I don’t follow the ticker every day.) At the time, as you can see in that sheet, I assumed 4% yearly free cash flow growth for ten years and 1% thereafter. I assumed a WACC of 9.2%, and a share count, then-existing, of 8.593 billion diluted shares. I discounted the cash (less debt) that Microsoft was holding by 35% to assume Microsoft would eventually have to pay taxes on all of the cash it holds overseas, or else will blow some of its money on stupid acquisitions, and lose some to inflation. That gave me a valuation of around $45/share, give or take. (This isn’t a science, and anyone who tells you otherwise probably wants you to pay for some worthless subscription or newsletter.)
Note, by the way, that although I assumed 4% yearly free cash flow growth, in this actual first of my ten years from the above calculation free cash flow actually grew 19% from year-end 6/2011 to year-end 6/2012, from $24.639 billion, to $29.321 billion. We can’t really expect to see that repeated this coming year-ending 6/2013, but we shall see.
Now this year, from the 6/2012 starting-point, we have only 8.444 billion diluted shares outstanding, because of share repurchases. The WACC is still about the same. Some sources say only 9%, but I’ll stick with 9.2%. Note that debt is now up from last year, to over $14 billion, because Microsoft has taken advantage of stupid-low interest rates. And cash is up to $68.312 billion as of 12/2012. I continue to just write-off 35% of Microsoft’s cash when making my analysis, for the same reasons as above. The result I get is that Microsoft is now worth around $54.60/share, more than it was last year, and that it is nearly 50% discounted. Even if you completely write-off all of its cash, it’s still way undervalued by this analysis.
Can this be? Can Microsoft really be so cheap? I think so. That’s why it’s such a large position for me. If you think its earnings are about to fall off a cliff, as is its cash generation, you may disagree. But I’ve been covering Microsoft pretty extensively for four years now. If you think that now, you have probably thought it for four years, and that time, during the advent of the iPhone and the iPad and Google Chromebooks, etc., Microsoft has grown its free cash flow from $15.9 billion at the bottom of the financial crisis, to over $29 billion, yo.
So what say you? I still say it’s a buy. And while I wait for the market to agree with me, and hope that my thesis is correct, I’m happy to collect the 3% dividend yield, and happy to see that so far its actual free-cash-flow generation confirms my thesis.
Beware of Companies that Loathe Their Regulators
This is not an ode to Big Government and regulation. But I think most reasonable people recognize the need for some regulations. And the more complex or larger a system is, the more regulation is needed. It’s exactly like the difference between two country roads in the middle-of-nowhere, and an intersection in a city. The two country roads do not need a stoplight. There a stop sign is quite sufficient (still a form of regulation). But just try to imagine New York City without stoplights. It would be total bedlam. The current situation with JPMorgan has me thinking about this.
Now JPMorgan is a great company, and a very profitable one. And its CEO/Chairman, Jamie Dimon, has been in many ways wonderful. But he has been slamming the post-Crisis increased bank regulations quite a bit as well for some time. For example, he slammed the $1 billion cost of new regulations.
Of course, then his seemingly fake CIO, which really seems like it was a shadow proprietary trading desk, lost $5 billion. For the record, $5 billion is more than $1 billion. And JPMorgan lost that money arguably doing something the regulators prohibited.
There is a lesson here: Companies that constantly complain about regulation and have antagonistic relationships with their regulators probably want to engage in behavior that is against the best interests of long-term shareholders.
A great counterpoint exists in Warren Buffett’s most recent (as of this writing) 2012 letter to his shareholders. In it, on page 10, he wrote:
- “It is in the self-interest of governments to treat capital providers in a manner that will ensure the continued flow of funds to essential projects. And it is in our self-interest to conduct our operations in a manner that earns the approval of our regulators and the people they represent.”
Truer words were never spoken. He was writing in the context of his utility-like businesses, BNSF and MidAmerican Energy. However, the lesson is the same in banking. Banking is far more of a utility-like business than Jamie Dimon would like to admit. Most of the problems we have had with our banking industry in the last decade have arisen because bankers have succeeded in convincing many people that they are not utilities. And of course then they subsequently torched themselves. The lesson is not dissimilar to airlines, which used to be heavily regulated. Their record since deregulation has been absolutely miserable for shareholders, though wonderful for consumers.
The lesson for JPMorgan is clear. Stop whining. You lost far more money on your CIO office in a few months than you had made in its entire previous existence, and you did it while engaging in activities that arguably were designed to circumvent regulations you were complaining bitterly about the cost of. It was ironic, and unnecessary. It’s time to head Buffett’s advice. Stop whining, deal with a regulatory reality that impacts your competitors just as much as it does you, and move on.
Taking an Initial Look at Parker Hannifin Corp: Another Lubrizol?
Every so often I literally just start plugging various letters into morningstar.com’s quote box. I do this to help myself move beyond my cognitive biases, one of which is that I tend to focus a lot on the stocks of companies I already own, another of which is I tend to concentrate my energies in companies people are already talking a lot about, and still another of which is that I tend to focus on particular industries. I was doing that a few weeks ago and out popped Parker Hannifin Corporation (PH). This is a highly investable company, though my research is not yet complete. Here are some rough thoughts:
What are some cool things and interesting facts here?
- This is a $14 billion company that people rarely talk about.
- It’s the self-described #1 motion & control company. It makes things that go in other things, largely, and/or that are sold to other businesses instead of directly to consumers. It makes 816,000 different products, and employs 60,000 people in 40-some countries.
- It’s clearly a cyclical company with some lag. Revenue tanked hard in 2009 and even 2010.
- But revenue is more than double what it was nine years ago.
- Free cash flow is four times what it was nine years ago.
- Share count is down over 11% from nine years ago, including a big repurchase in the 2012 fiscal year.
- Earnings per share are up three-to-four times what they were nine years ago.
- During this time financial leverage has remained steady. And now debt-to-equity is in the 30% range.
- Dividends have more than tripled in the last nine years.
- 2012 was a record year.
- Company is about 100 years old.
What are a few warts?
- Highly cyclical, to the extent this counts as a wart.
- Exposed to defense industry cuts.
- Exposed to currency fluctuations.
- Pension underfunding. (Though see note 10 of the recent annual report, which indicates it has reduced the discount rate of its pension obligations significantly, to 3.91%. This is in response to ZIRP and pension-related laws, and likely means it is is over-estimating its pension liabilities.)
- Dividend yield is only 1.70%, and recent dividend growth has stalled.
What do we think of valuation here?
- On my quick-and-dirty chart I derive a valuation estimate of $119.60/share, with a range from $95 all the way up to $145/share. Current market appraisal is about $97/share, so it’s trading in the low range of my estimates.
- Assumptions: I’m using a WACC of 11% as my discount rate, as I believe is most appropriate. I’m assuming annual FCF growth of 6% for ten years, and 2% thereafter. That 6% matches annual FCF growth since 2008, through the Great Recession, but is significantly lower than it has shown if you look back for nine years.
- Caveat: There is no such thing as an accurate valuation of a company, and the future is unknowable.
Things I’d like to know:
- More about the individual business segments.
- How long the CEO has been in charge.
- More about compensation policies.
Conclusion: This is a great company and warrants further research. It is highly “investable.” It is only wildly undervalued if growth returns to a higher rate. But it’s a solidly-run shareholder-friendly business based in Ohio. I would have no problem initiating a position today. I may back-up-the-truck the next time we have a real cyclical downturn in this country. If I were buying the whole company I might even pay as much as $120 or even $130/share today. I think this is a “Lubrizol-like” company (and a similar market cap prior to acquisition) that just had a record year and is firing on all cylinders, and it would not surprise me at all if Berkshire Hathaway under Buffett bought it, assuming diligence on the management checked out.
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