How To Be A Great Investor, Part Four: Compare Effectively

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Part I: Fundamentals Versus Expectations

Mauboussin begins:

Investors compare all day: stocks versus bonds, active versus passive, value versus growth, stock A versus stock B, and now versus later. Humans are quick to compare but not very good at it. Perhaps the most important comparison an investor must make, and one that distinguishes average from great investors, is between fundamentals and expectations. Fundamentals capture a sense of a company’s future financial performance. . . . Expectations reflect the financial performance implied by the stock price. Making money in markets requires having a point of view that is different than what the current price suggests. Michael Steinhardt called this a “variant perception.” Most investors fail to distinguish between fundamentals and expectations. . . . But great investors always distinguish between the two.

Let’s pretend that you had to choose between investing in Intel (INTC) and Advanced Micro Devices (AMD).

Intel’s ROE is 27% and its margins are massive. It has low debt, plenty of cash, pays a nice and growing dividend, and has solid growth in both sales and EPS.

AMD, on the other hand, has an ROE of 14% and its margins are pretty poor. Its sales and EPS growth have been in a steep decline lately. Its debt-to-EBITDA ratio is close to 3, which is pretty high; it doesn’t look like it’ll be paying any dividends in the foreseeable future.

Let's look a little deeper. Both Intel and AMD are spending plenty of money on R&D, which is good. AMD has huge projected EPS growth for the next quarter while Intel is projected to have negative growth. AMD has significantly better asset turnover, another point in its favor; on the other hand, it has the highest share turnover of any company in the S&P 500, which is a point against it. AMD’s cash conversion cycle is growing too fast for my liking; on the other hand, their net operating assets are only 40% of their total assets, which is a good thing. Lastly, AMD’s cash-flow accruals are appallingly high, while Intel’s are quite low.

What are the market’s expectations for these two firms? As of market close on 9/4, Intel is selling at an 18% discount to its 52-week high, while AMD is only 13% from its high. AMD’s price has risen 10% in the last year; Intel’s has risen 2%. Intel’s enterprise value is $239 billion, which matches my estimate of its intrinsic value based on its free cash flow and EBITDA, $246 billion. AMD’s enterprise value is $35 billion, which is more than five times higher than my estimate of its intrinsic value, $5.8 billion. Institutions are, overall, selling shares in Intel and buying shares in AMD. Clearly the market has significantly higher expectations for AMD than for Intel.

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Disclosure: My CAGR since 1/1/16: 33%. My top ten holdings right now: RMNI, MIXT, PERI, PALDF, SPNS, PCTI, VISI, TTEC, QMCO, GTS.

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