Thursday, September 17, 2009 7 comments ++[ CLICK TO COMMENT ]++

A value investor takes a quick look at Lexmark

UPDATE: Fixed a tiny grammar mistake as suggested by reader Guest.

A little less than a month ago, I e-mailed Geoff Gannon and inquired about Lexmark (LXK). I don't usually do that but decided to ask him about his opinion of Lexmark because he was wrong with his initial view a few years back. I was curious about his views of how the company has changed (apparently for the worse if the stock price was an indicator) in the last few years. Geoff Gannon was kind enough to post a lengthy response detailing his thoughts and I thought readers would benefit from his comments (used with permission.) Even if you could not care less about Lexmark, read this post because it illustrates the thinking and approach of a value investor.

He also responded to a follow-on questoin and another unrelated question pertaining to Coca-Cola which I will quote in future blog entries. The topics of the other e-mail were slightly different and it is useful to read them as a stand-alone piece. This first entry covers Gannon's quick look at Lexmark; the second post will cover the type of investments that Gannon feels are suitable as a Buffett-style concentrated investment; and the final post will deal with why Warren Buffett may have purchased Coca-Cola in 1989 instead of in 1987 (during the crash), 1986, or earlier (I may not post the Coca-Cola e-mail because it is highly speculative and I don't agree fully with Gannon. It also may not be benefitial to many.)

I am not quoting the full e-mail and I have bolded some text to emphasize what I feel are insightful points made by Geoff Gannon. My emphasis may not be consistent with what Gannon feels. Also, note that none of this should be construed as a recommendation (either long or short) and the details, such as prices/interest rates/etc may have changed.

Thanks to Geoff Gannon for taking time to write up lengthy responses—he's a good writer BTW—and for giving me permission to liberally quote his e-mail.

Gannon On Lexmark

When asked about Lexmark, Gannon took a quick stab at its valuation as follows:

Lexmark is cheap based on past performance. And diversified group operations (buying a lot of stocks like Lexmark) usually work out. Here's the math based on data provided by GuruFocus (see the actual 10-Ks and most recent 10-Q if you're serious about Lexmark, I'm just using GuruFocus to answer this email):

5 year average EPS: $3.98
5 year average FCF: $3.44
Book Value: $11.69 (From most recent 10-Q not from GuruFocus)

A basic earnings power calculation - more similar to Benjamin Graham than later Warren Buffett - goes as follows:

Book Value of $11.69/share * Investment Grade Bond Yield (5.33% according to Bloomberg) = $0.62/share

In other words, if Lexmark earned 5.33% on equity it would earn $0.62 a share. Take this number and add it to the 5-year average EPS ($3.98) and 5-year average FCF ($3.44) and the average is $2.68.

What cap rate should you apply to this? A good range is the yield on investment grade bonds (5.33%) to the yield on junk bonds (11.18% again courtesy of Bloomberg). The multipliers work out to 8.94x at junk bond cap rate and 18.76x at investment grade cap rate.

We calculated our triangulated earnings power (that is we used three different sources: income statement, cash flow statement, and balance sheet) for LXK at $2.68. Applying the above multipliers we get a range of:

Low end: $23.95/share
High end: $50.28/share

And the last trade was: $17.32/share. That's $6.63 a share or 27.68% less than the low end of an honest appraisal based on past performance alone.

If you did this calculation for all stocks (took 5-year average EPS and free cash flow and Investment Grade Bond Yield * Book Value Per Share) you'd find that most stocks do NOT trade below the low end. It's quite rare.

I hope readers learn something from the method utilized here. I usually just take normalized earnings and multiply it by some low P/E multiple (usually between 8.5 and 10) but Gannon uses more of a classic value investing technique that averages various sources. It's an interesting technique that relies heavily on published financial statments—as Gannon points out, it's triangulated off all three financial statements—and hence is rooted in solid, albeit, historical, numbers.

You can see how this method (or any similar method that relies on historical financials) stacks up against my simplistic method of applying a somewhat arbitrary P/E multiple. In my rough estimate from a while ago, I came up with Lexmark as being around 30% undervalued. Gannon's quick estimate yields an undervaluation of around 27.68% based on the low value.

You can see the disadvantage of financial statements in this example. Gannon's estimate, which is similar to my base estimate, may turn out to be wildly optimistic if sales, and hence profits, fall off a cliff. In the post with my estimation, I speculated that the share price should be worth much less if sales decline substantially. Since Lexmark had strong historical numbers while the present market position looks poor, value investors relying heavily on financial statements may be vulnerable to downward surprises. This is where qualitative judgement comes in.

Value Trap?

I was wondering whether Lexmark was a value trap and Gannon had this to say:

As for whether it's a value trap or not - I don't know. That's an interesting term. It's a business facing challenges. Historically, there's little evidence to suggest that businesses move in only one direction.

An important point here is Lexmark's financial position. How good is it? Generally, "value traps" are NOT operationally challenged ONLY. They tend to be financially challenged. Very, very few businesses that have rock solid balance sheets end up in trouble. A great many businesses with debt do. Lexmark's balance sheet is not perfect. For instance, it doesn't have a positive Net Current Asset Value (NCAV). Usually, a positive NCAV is a good sign for a value investment.

I notice that value investors, including successful ones, often downplay the notion of value traps. I don't know why. To me, value traps are the achilles heel of value investing. Anyway...

Gannon makes the very insightful point that value traps tend to have financial problems on top of operational problems. I think contrarians should keep that in mind. A lot of contrarian, or beaten-down, stocks have serious financial problems. In the past I have looked at financially distressed firms but I have pretty much come to the conclusion that I should stay away from them. For example, I have done some preliminary research on MegaBrands (TSX: MB), which is a toy company on the verge of bankruptcy due to some product recall issues (basically a textbook case of a horrible buyout that literally bankrupted the firm,) but have essentially crossed it off my list because it has serious financial problems. It is possible that MegaBrands may never be able to pay off their debt (they took on huge debt as an emergency during the crisis) and the shareholders will lose most of the company to the bondholders. Similarly, one company I have looked at in the past, Eastman Kodak (EK), which has been hobbled by debt, just announced that KKR, a private equity outfit, is buying Kodak debt as well as up to 20% of the company.

Having said that, do keep in mind that some types of distressed situations involve potential financial problems that are hard to discern. This is usually the case with financial companies (e.g. Citigroup or AIG) or non-financials that are exposed to financial instruments, often through derivatives or off-balance-sheet obligations that are not obvious (e.g. Enron or GE). My investment in Ambac (ABK) is one such case. Ambac was vulnerable to huge financial losses but it wouldn't be too obvious looking at financial statements. Contrarians like me bought Ambac after its problems were evident (we misjudged the scope) but those investing in it 2 years ago were probably shocked by its exposure. Similarly, anyone investing in GE, Morgan Stanley, Wells Fargo, American Express, and the like, have to make a judgement call about the financial strength.

As for whether operational problems are "better" than financial problems, I don't know. You can lose a fortune if problems persist in either area. Financial problems appear to be worse because the damage occurs quickly: usually the company goes bankrupt or ends up diluting shareholders heavily due to emergency capital injections. In contrast, operational problems may take longer to play out but the end-result is similar.

This Ain't A Benjamin Graham Investment

Basically, an investment in LXK is a bet on the past earnings and cash flow rather than a bet on the balance sheet. It would be nice if LXK had no debt and a lot of current assets. That would make this a very easy decision. Unfortunately, that isn't the case. It may be the case that LXK is a once wide-moat company now in constant decline.

Yep. As Gannon alludes to, Lexmark clearly isn't a Graham-type investment. I'm ok with this but classic value investors in the Graham mold will likely ignore situations like these.

The only thing I would say is that most Graham-type investments are terrible businesses. It is extremely rare for a company of any standing to trade below NCAV or have a strong balance sheet with low debt while posting good profits. This doesn't mean that these are poor investments but it does mean that the analysis likely has to be completely different. At a minimum, anyone investing in something like Lexmark cannot rely on the balance sheet as a backup in case the investment doesn't work out (because the liquidation value is so far below the current price.)

I have decided not to be a Graham-type investor (whatever that means ;) ).

Final Suggestion

Gannon closes off by suggesting that Lexmark is not the type of investment for concentrated investors:

Lexmark isn't the kind of business it's easy to own. Therefore, my suggestion is that if you buy it you should buy it and not reconsider it again for a certain amount of time - I would suggest two years - so if you buy it now, don't look at it again until September of 2011.

Lexmark is an appropriate investment at say a 5% of portfolio position size, because 20 or so investments at price to past performance relationships similar to LXK will almost certainly work out. As for LXK alone, I don't know if it will be a success because that depends on a lot of qualitative judgements I can't make.

An honest appraisal based purely on past performance would be something in the $25 - $50 a share range. Beyond that, you are speculating as to future performance. And that's really a personal call. If you can limit your position to say 5%, it's definitely a good investment in the sense that the probabilities clearly favor you.

Will Lexmark prove a value trap dwindling to nothing? Probably not. That's relatively rare. You see that mostly with highly leveraged businesses. Value traps are really more cheap looking growth stocks than Graham and Dodd type bargains. If you pay a low enough price for a sound enough balance sheet you will rarely suffer really large permanent losses.

Lexmark's issues as an investment are that it still trades quite a lot above book - because it's historically earned high returns on equity - and it's balance sheet is not as liability free as you'd like in this kind of investment.

To sum up, Gannon suggests that an investment like Lexmark will likely work out in a diversified portfolio. He doesn't feel comfortable making a concentrated bet on it without some qualitative reasoning. For what it's worth, I'm trying to be more of a Buffett-type investor so I have been trying to improve my skills on qualitative business analysis. In particular, I have been reading up on competitive advantage, moats, brand creation, barriers to entry, consumer perceptions, and so on.

I think my original wording on the value trap could have been better. I wasn't really implying that they "dwindle to nothing," although those are the words I used; I was really wondering about the possibility of a waterfall-type, continuous, decline over a few years.

I actually disagreed with Gannon and wondered why he felt this type of investment was not worthy of a concentrated bet. I questioned his answer in light of Warren Buffett's investments and Geoff Gannon was kind enough to respond to that. In a future post, I'll quote Gannon's thoughts on the type of investments he feels are worthy of concentrated bets in a Buffett-like manner.

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7 Response to A value investor takes a quick look at Lexmark

September 18, 2009 at 10:11 AM

Nice and provocative thoughts! Without entering into the merits of Gannon's approach, it is instructive to apply it to the whole market and see what happens. Take the S&P 500, for instance. The 5-yr EPS averages $65 (roughly from Cresmont Research), and let's assume the FCF coincides with it. With a book value around $580, and the average of the three quantities Gannon mentions is about

1/3*65+1/3*65+1/3*580*.053 = $53.6/share

(Here one could argue that EPS/FCF are abnormally high from a historical point of view, but then also the return on equity could be higher, so that all factors sort of compensate).

Finally, using the same multipliers Gannon considers, one gets for the S&P 500
Low end:   479
High end: 1005

Which suggests --as you often mention--, that the whole market is overvalued. (Many other worthwhile people, say Grantham or Hussmann, put fair value at around 800-900). In which case one could argue that there is significant market risk for most investments, unless one has an arbitrage-like investment. But I don't really know.

The same way you are moving towards Buffett-like investments, I seem to be moving towards passive index investing with the caveat that one should invest *only* if the price is low (say, when capitalization is below 50% of GDP or the dividend yield is above 4%). It's work in progress.

Sivaram Velauthapillai
September 18, 2009 at 10:55 AM

Thanks for the insightful thoughts. Good idea trying to analyze the whole market.

I don't know why you decided to pursue passive investing but it is definitely the way to go if you don't have time to dedicate to investing and/or you are not a good stockpicker. If I come to the conclusion that I'm not a good investor, I'll go passive for sure.

Anyway, it's interesting that you are going passive now beause there is a big battle brewing in the background, with many saying "buy & hold", which I interpret to mean passive investing, is dead. I think the question to ponder is, if you are a passive investor, what do you do if the market is not cheap?

Are you planning to overweight bonds? If so, that is kind of risky too because government bonds may be in a big bubble if you don't believe in deflation. Corporate bonds aren't cheap right now but that depends on details.

Or do you go into cash (possibly gold)?

Or do you become a pure passive investor (one that simply divideds up portfolio into different assets and does not make any valuation, sector, or country judgement at all)?

I'm really curious what passive investors would pursue right now. Passive investing is easy after a major crash. But the current situation is quite different. Even after the collapse, many assets (gold, govt bonds, China/emerging markets, commodities) may be in bubble territory (or at least nowhere near cheap) depending on macro assumptions. If you look at Benjamin Graham's "active" passive investing, he recommended rotating between stocks and govt bonds. But govt bonds are not cheap right now (unless you believe in deflation.) Other successful passive investors, such as endowments at Harvard, Yale, etc, recommended investing in alternative assets like timber, private equity, etc. I haven't done any analysis on the endowments but I suspect that if you strip out alternative assets, the endowments probably didn't do as well as they appear. But those alternative assets are not easy to access and it's not clear if they are anywhere near being cheap.

Jae Jun
September 19, 2009 at 4:40 AM

Interesting post.
Although I don't bother with earnings as it usually always overstates the real operations, I get pretty similar results.
I remember I provided some valuations last time but from my numbers I get
DCF: $29.10
Ben Graham: $27.53
EPV: $28.56

So I can confidently say that the value of LXK is in the upper 20's but I've invested in these types of companies and as Gannon says, I wouldn't make a big bet on this type of investment.

It's just an incredibly hard battle. I say don't check for 3 years min. Don't think 2 years is long enough.

September 20, 2009 at 3:33 PM

What to do as a passive investor when the market is overvalued is, I guess, the one-million-dollar question. My inclination is to go for cash (where I leave I get about 3% interest in my CD) and govt bonds with a duration of around 5 years. 5-yr bonds are now at around 2.5%, roughly in line with the current GDP nominal growth, which is not too bad in itself. Longer durations are more likely to suffer from all types of disasters and being cash itself is a good protection against deflation. Moreover, one keeps one's powder dry. Alternative investments and gold are --to me-- against the key assumptions for passive investing: reduce the costs, diversify, be safe and not be too fancy.

More generally, and even though I sort of agree with the key ideas behind value investing, I think ignoring the overall market level is risky. For one, the correlation of any stock with the whole market is not negligible, and large overvaluations are likely to lead to sharp declines in the overall market, including one's value ideas. (See 1929,1987,2001,2008). I appreciate that a proper consideration of this is tricky, but trickiness is no reason to ignore it.

A good part of Graham's value investing career took place in undervalued markets. My claim would be that where undervaluation like Lexmark is both more meaningful and safer in undervalued markets than in overvalued markets. More meaningful, because there is somehow the chance that undervaluation overshoots when the whole market is pessimistic. It seems more likely that periods of irrational exuberance are better at accurate pessimistic valuations than periods of irrational pessimism. And safer because the downside risk because the market goes down is also lower, including here the stock price itself and the opportunity cost of have some capital already deployed.

But as I said before, I don't really know. And incidentally, let me wish you all the best both in investing and your new job, whichever it turns out to be.

Sivaram Velauthapillai
September 25, 2009 at 10:50 AM

Thanks for the good wishes on my job pursuit and my investing. All the best to you as well...

I think value investors ignore market valuation and get away with it because they are confident that the fundamentals of their business will produce a good profit. Even if the market doesn't recognize it and the stock price goes nowhere, they are probably ok sitting on it for years. For amateurs, this is easier said than done. Although I shouldn't do it, I am still influenced by the share price. If it declines, I get the feeling that fundamentals deteriorated or I mis-analyzed something.

The question, if you pick individual stocks, is to get a good sense of the fundamentals. That's very difficult but someone like Buffett or Munger see the reality.

September 25, 2009 at 7:10 PM

I know it's a nitpicking an otherwise thoughtful, lengthy piece, but the correct phrase you intended to use in the first paragraph is "couldn't care less" or "could not care less". 

Sivaram Velauthapillai
September 26, 2009 at 12:59 PM

I'm trying to improve my writing so I welcome corrections... thanks...

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