In 1988, when Warren Buffett (Trades, Portfolio) purchased a large amount of stock in Coca-Cola (KO, Financial), many Wall Street professionals thought “he was downright crazy” to do so. After all, the stock price had risen at least 20% a year for eight consecutive years and was not cheaply valued based on traditional measures of valuation. Yet, despite what the skeptics thought at the time, that purchase has gone on to become one of the legendary investments of all-time. Coke still remains the iconic consumer brand today that it was 16 years ago when Mr. Buffett made his famed investment.
What did Warren Buffett (Trades, Portfolio) see in Coca-Cola in 1988 that we can learn from and put to work for us today? He saw the real value of a business with products that imbedded themselves into the daily existence of its customers to the extent that they would be unwilling or unable to easily extract them. He also understood the significance of this characteristic in terms of building future value for the business.
What we should understand as investors today is that even though Warren Buffett (Trades, Portfolio) applied this thinking to a consumer brand business in 1988, we can apply the same thinking and analysis in assessments of certain technology businesses today. Microsoft (MSFT, Financial) is possibly the epitome of this practice with their Windows operating system and the Microsoft Office Suite of software that allows consumers around the world to exchange business and personal correspondence and information seamlessly with each other from one computer to another. How would you conduct your affairs with other businesses or associates without access to Microsoft products. Even if you don’t particularly like them, they are probably something that is deeply imbedded into your daily life.
But there are other, less obvious examples of this type of business that are known on a lesser scale and not as widely viewed in this same context. This lack of recognition as being an irremovable provider of a critical need can allow similar businesses to trade at amazing values that are only apparent when analysts are willing to dig a bit below the surface. Cognizant Technology Solutions (CTSH, Financial) is one of those businesses today and prudent investors will be well served if they are willing to dig below the surface and discover the true current valuation of the business compared to its real intrinsic value.
But the first step in this process must be to determine the durable nature and characteristics of this business and why they are critical to the prosperity and survival of its customers.
What Makes Cognizant A Durable Business?
For me to consider a business to be durable, it must possess and deliver products and services that not only fill a critical need for its customers, they must be products and services that become embedded within the day to day functions of the business and its operations. They must also be difficult, if not impossible to extract once they have become an integral part of the customers’ operations.
Cognizant presents itself as an information technology outsourcing and consulting business operating across four basis business segments: financial services, healthcare, manufacturing and retail and logistics. But, it is really much more than that, Cognizant is also a data management and analysis business. If you have heard the term “big data” you need to look no further than Cognizant to find a prime example. Businesses today survive and thrive in large part based upon their ability to use the customer data they collect in order to target their inventory, advertising and pricing decisions to the areas where they will provide the most benefit to the overall profitability of the business.
Even better, Cognizant is a one stop shop for these data collection and management services and well as the analytic side of the process that helps a business how to achieve the most economically beneficial results from having all of this data. These services and the analysis of data without which they are of little value are what Cognizant provides to its customers.
Revenue growth is an excellent metric for determining the perceived value of products and services offered by a business as businesses that fill critical needs for customers tend to grow sales at a rapid pace. With an annualized revenue growth rate of 33.7% over the past 10 years, it is safe to say that Cognizant’s customers like the menu the company is serving.
For a value investor, we need to view Cognizant as the business equivalent of Coca-Cola in 1988 and the analytical equivalent of Microsoft in the mid-1990’s. The era of really using big data to its maximum economic benefit is still in its early stages and Cognizant is and has been signing up the customers and providing them with the products and services that allow them to benefit from this emerging field. Their massive revenue growth over the last 10 years proves it to be so. As more and more businesses come to realize the value contained within their huge stock piles of un-analyzed data held within their computer files, more and more of them will turn to Cognizant Solutions to provide the keys required to unlock this treasure trove of potential profits.
Great Investments Require More Than Great Products
The only aspect of a business that can assure long-term survival and prosperity is profitability. Without profit, there is little reason for the business to exist and even less reason for investors to allocate capital to it.
Profits and the ability to expand them have not been an insurmountable problem for Cognizant Technology over the past 10 years. From a net profit of about $6 million in 1998, the company has increased profitability to a level of $1.2 billion for 2013 and projected profits of $1.434 billion in 2014. Even a cursory glance at this chart reveals the divergence between the earnings growth trajectory and the share price. It also clearly illustrates the history of explosive upside moves every time in the past that this sort of divergence has appeared.
However, as any value investor would be, I have to have some level of concern over the P/E ratio of 20.7 times earnings. This metric is where just a little bit of digging deeper is required to obtain the real, meaningful facts. Even with its history of meeting and exceeding analysts’ estimates for earnings, having met or exceeded them 8 of the last 8 quarters, the existing P?E ratio of 20.7 is a bit pricey for a business projected to grow at only 16.8% annually over the next 3-5 years. I really don’t like to pay more than a PEG ratio of 1.2 at the most. If we look a bit closer though, we find that this business has cash, short term investments and receivables on its balance sheet of $6.25 billion against total liabilities of only $1.696 billion. This leaves what is essentially a net cash balance of $4.55 billion or 15.3% of the entire market capitalization of the business.
If this cash balance is subtracted from the market value of the business, it lowers the price to earnings ratio to 17.53 for 2014 and 15.38 for 2015. Now I have more realistic calculation of the current pricing of the stock and one that meets my criteria for this particular valuation metric. Another attractive attribute of a business with a large pile of cash on the books is that they do not tend to go bankrupt and they are always in a position to take advantage of compelling opportunities when they come along.
As Warren Buffett (Trades, Portfolio) showed with his 1988 purchase of Coca-Cola stock, value-oriented investors must train themselves to recognize undervalued businesses even when the business does not appear on the surface to be cheap. In the case of Cognizant, what appears on the surface to be a high-priced valuation actually becomes quite reasonable when compared to the present and future prospects for the business.
So How Do We Value A Business Like Cognizant?
Even though there are no guarantees regarding the future share price of any business, we can certainly mitigate our risk through effective due diligence. A significant part of the due diligence process is to ensure that less than obvious opportunities are not overlooked due to our preconceived perceptions regarding fair value calculations. We have accomplished a portion of that with the consideration of the cash and receivables contained in the balance sheet and subtracting that number when calculating the price to earnings multiple we considered.
Another aspect of effective due diligence requires that we consider our expected rate of return on our investment capital rather than just simply looking at the current valuations. In other words, we must be cognizant of the fact that high growth expectations can justify above average current valuations and still qualify for the portfolio of a serious value investor. If we buy businesses that are trading right around a PEG ratio of 1, we can reasonable expect our return on allocated capital to be something approximately equal to the projected annual growth rate of the earnings for the next three to five years or 16.8%/year in this case. This rate of return will not make you rich overnight but it certainly represent a spectacular rate of return when it can be realized through a very reasonable valuation metric.
Can We Buy Today At A Discount To Current Fair Value?
Buying great businesses with exceptional products is a good start. That alone, however, does not assure that we will profit from a position opened at any particular time. To maximize our prospects for capital appreciation, we need to endeavor to buy great businesses when they are trading below their fair value. While future values will be determined by future performance, current value is best established by past performance with just an eye toward the future prospects. The reason I evaluate the future prospects first in my analysis process is that the past and present have no meaning for a new investor if there is not a bright outlook for the future of a particular business.
To evaluate present value, I like to use the past five year averages for company performance in terms of management returns on equity, assets and capital. Over the past 5 years, Cognizant has delivered average annual returns on equity, assets and capital of 23.3%, 17.8% and 23.3% respectively. One of my calculations for establishing an estimated fair value of a business is to average these three numbers and multiply the result by the current year’s projected earnings figure. The resulting average of these three measures of performance is 21.467% and, if multiplied by the current year’s projected earnings of $2.36 produces a current fair value estimate of $50.66/share with an increase to $57.74/share within the next 12 months. This represents an expected return of 18.2% from the current price of $48.85. Interestingly enough, this figure aligns very closely with the increase we would project using the analysts’ projected long-term growth rate of 16.8%.
I completely understand those who will believe these estimates are on the optimistic side. I thought the same thing until I realized that between 2004 and 2013 the company increased its sales from $586.67 million to an astounding $8.84 billion and per share earnings from a paltry $0.18/share to $2.05/share. Considering the past history of performance, 16.8% a year going forward suddenly looks much more believable.
Accept Value Where We Find It And Act
As Warren Buffett (Trades, Portfolio) proved in 1988 with his investment in Coca-Cola and Cognizant shows us today, value investing doesn’t always have to be a stock that looks cheap by traditional valuation measures. Good investments are made by selecting those stocks that are cheap compared to the realistic future expectations of the business and not overpriced based on past performance. Stocks with the past history and future prospects of a business like Cognizant can easily be valued at twice the expected growth rate multiplied by the current year earnings. It is quite unusual to find one trading at a multiple of 1. When the projected growth rate is 16.8%/year and all that is required to collect that level of return on capital is to maintain the current and fair multiple, investors who can set aside preconceived notions of “value” and act now will collect exceptional returns even if the current price multiples do not increase beyond today’s very reasonable levels.
As I always prefer having multiple attractive ways to open new positions, I am pleased that Cognizant offers that opportunity as well. For those who prefer the traditional approach of buy and hold, shares can be purchased at the market today and held until the market assigns a P/E multiple to the shares of 24 or greater.
Investors who simply insist on getting discount prices for everything they buy can sell (1) August 16, 2014, $47.50 strike price call option for each 100 shares they wish to purchase and collect a premium of about $0.75/share or 1.5% of the capital required to purchase the shares. This represents an annualized return on total capital of 20.49% and would require the seller to purchase 100 shares of the stock for each option sold at a price of $47.50 each or $4,750 per contract sold. Should the seller be assigned the shares on August 16th, the purchase price would represent a discount of 3.9% to the current market price.
So, we have an excellent business with a great history of superior results. We have an attractive valuation based on present facts and future prospects and three superb ways to open a new position. Is there anything else needed in order to motivate investors to take action now? There shouldn’t be. Cognizant today presents a compelling opportunity to buy and hold shares in an excellent business well-positioned in one of today’s most exciting growth sectors, big data management and analysis, that should grow and prosper for the foreseeable future.
