2003 Investment Update February 11, 2003
Most investors were very happy to put 2002 behind them. In fact, the S&P 500 lost over 40% for the three-year period ending 12/31/02. Many of you may have stocks that are down significantly during this time. While the temporary loss of capital is never easy to accept, this bear market has presented us with a timely opportunity to reinforce our rationale for the stocks we select. It is very important to realize that bull markets are irrational to the upside in overpricing stocks. In the same way, bear markets push stocks below fair value on the downside. Peter Lynch was recently quoted as saying; “If I calculate fair value at $40 and buy the stock at $12 do I really care in the short-term if the price goes to $2 per share?” The answer is no. To paraphrase Benjamin Graham; the stock market is a voting machine in the short-term and a weighing machine in the long-term. This idea brings us to an important point. The process by which you make investment decisions is the determinant of your long-term performance (notice I didn’t say short-term performance!).
In making an investment the price you pay as it relates to the underlying business will largely determine how profitable your investment will be. To make a purchase decision there needs to be a disconnect between the stock price and the calculated intrinsic value of the business so that you are able to buy the underlying business at a discount to its fair value. Intrinsic value is simply an assessment of the value of a company’s underlying business. This can be done by calculating the stream of future earnings, or better yet, the cashflow that a company generates. It can be calculated using the book value of the business which, in generic terms, is the assets of the company minus its liabilities. Other important factors to be considered before buying a stock are comfort and confidence in the company’s leaders, management that is shareholder-oriented, and a favorable position in an industry which can be understood with a strong degree of confidence. Most of the investments we make contain some combination of these characteristics.
An example of this investment decision-making at work is our past purchase of Best Buy. Best Buy is a leader in electronics retailing. The company possesses many great qualities. They have excellent management. Many retail analysts have gone on record to say that Best Buy’s top management is hands-down the best in retail. The employees are owners of the company. They do not use options in an excessive fashion. The electronics industry is undergoing a revolution. Not since the color TV has so many new television products flooded the market. HDTV (High-Definition TV) and plasma screens are the new rage.
DVD is replacing videocassettes at an incredibly rapid pace. People are purchasing MP3 players, Palm Pilots and Blackberries, and Wi-Fi technology. This is all being done at unbelievably low prices.
We thought Best Buy was priced attractively at prices higher than where it currently trades at just over $27 per share. It actually reached a low of around $18 in October and then again in November. There were concerns about competition from Circuit City and the new entry into the electronic retailing field; Wal-Mart. Consumer spending and confidence were said to be waning. The newspapers ran headlines proclaiming “2002 was the worst retail season in the past 30 years!” What they failed to mention was that this was true strictly in a year-over-year comparison. On an absolute basis, sales were actually quite strong. Because of the lofty expectations set, most of the other electronic retailers did report sales and earnings that disappointed Wall Street. Best Buy, however, issued a press release that said they were very pleased with their sales this past holiday season. They also predicted 10-12% sales growth in 2003. During tough times the better managed, better-capitalized companies usually succeed. As companies lose pricing power, margins get lower. Only those who are extremely efficient and well run can operate at these lower margins and still be profitable.
Best Buy’s financial position is very strong with a billion dollars in cash on their balance sheet. They have less than $800 million in debt. They expect to earn approximately $2.00 per share in 2003 and they produced over $3 of free cashflow per share in 2002. To put their current valuation in perspective, they earned $920 million before interest and taxes on an enterprise value (market cap + debt – cash) of $8 billion versus earning $351 million with a similar enterprise value in 1999. By that measure the company currently earns three times us much as it did three years ago but the trading value of the business is unchanged during that time. As we progress during this upcoming year, we will be watching consumer spending closely. Most importantly, we expect to continue to see Best Buy’s advantage grow in the electronics retailing business.
We recognize that it is not a comfortable feeling owning stocks that are held at a loss. However, it is our belief that business values and stock prices must eventually converge. This is what gives us confidence in our investment selections even as prices have fallen during this bear market.
Thank you for your trust and confidence in the past and we look forward to working with you in the years ahead.