Saturday, November 13, 2010

Cisco Systems - Big Drop

Wednesday after the closing bell, Cisco Systems announced their results for 2011 Q1. Revenue and earnings were in line with expectations, but projected revenue was down. The result? The stock got nailed with a 16% decline when it open on Thursday and is now down closer to 20%.

Personally, when I hear of a drop like that it gets my attention (similar to Manulife's (MFC) big drop after Q2 that also got my attention). I took a look at Cisco's past ten years and while the drop was large, it wasn't large enough to warrant action. Cisco has averaged 18% ROE over the past 10 years which is decent but the current price is 2.6 estimated year end book value.

I am a book value investor. As Walter Schloss stated, always use book value as the starting point when valuing assets. I don't mind paying a multiple to book value if the company has a consistent operating history. But in the case of Cisco I don't have that faith.

Warren Buffet doesn't invest in technology is because of the constant change that takes place. Change is the enemy of the investor. You cannot make any predictions about the future without some degree or assurance of stability. It is easy to look back over the past few decades and seek the constant change. Cloud computing is the latest paradigm shift and companies are constantly changing areas of focus. Oracle has now shifted into hardware.

Buffett understand how change in the industry makes the investment process very difficult. It adds to the assumptions you have to make. The only way you can pay a huge premium to book is by finding a company with an outstanding competitive advantage and generates high return on equity. This is what Buffett considers paying a reasonable price for an outstanding business with outstanding economics.

Manulife, as compared to Cisco, sells for book value and normally earns 13-14% on equity. Less than a couple weeks ago it was selling for tangible book value. It has a strong franchise in Canada and owns John Hancock in the USA. Their asian insurance business has been growing very fast. They have had some issues with reserving on some variable annuities but the company will get through the problems. I listened to one their Q2 conference call and I wouldn't consider management to be a huge strength, but not terrible either.

Now the insurance industry is a lot more predictable, but does carry some risks. With that said, Manulife appears to be a decent value at current prices and it will again someday sell for two times book value. Or to put it another way it's like buying Manulife for 6 times normalized earnings.


Have a Great Weekend,

Kevin Graham

Disclosure: No position in any stock mentioned.

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