RTCrawford's Weblog

I don't make this stuff up. I'm not that smart.

Adam(s) and SLP Question

with 2 comments

It has been some time since my last posting, but a question posted by Adams1135 on Yahoo! Finance concerning Simulations Plus (SLP) caught my attention.

Summarizing, Adam(s) questions whether the stock is fairly valued, and, if so, wonders whether the company can grow sufficient to warrant holding the stock.  It caught my attention because my earlier analysis of the stock was referenced in response by another poster.  Not referenced was a brief addendum.

With that as background, I’d like to respond to the question, because it provides an opportunity to explain something I increasingly view as important — the link between strategic management and financial management.  Having analyzed the question of fair value in the first blog posting, this entry will focus on making the strategic/financial link.  Consequently, there is just one graph, one graphic, and little quantitative analysis.  This will surely please most and annoy few.

Adam(s),

First, allow me to congratulate you on your stock-selection prowess in 2002.  If you purchased at the average for that year of $.35 per share (adjusted), your investment has earned a compounded return of 29.2% annually.  That is impressive by any measure.

Looking back on my earlier analysis, it should be understood that, while I own the stock, I chose it to serve as an example because of its likely inappropriateness for most investors (price below $10, small daily volume, large price appreciation since my first purchase, no dividend, small cap, tech and pharma exposure, etc.).  If using MSFT or JNJ as the example, the motive for writing the piece would have been suspect (and reasonably so).

Instead, my intent was to explain an analytical approach, and I did so for a fairly selfish reason.  During that time, I was engaged in a discussion with Tom Gardner and others about the value of management degrees and MBAs, in particular.  While Tom was more balanced, others asserted that management degrees provide little of value, and that intelligent, self-initiating, life-long learners can easily acquire the same knowledge through self-study.

Well, as a management professor and having been the academic adviser to as many as 250 Masters of Healthcare Administration and Public Health students (MHA and MPH), I reverted to what I’ve consistently told my students – that, for me, the largest difference between an undergrad in business and a masters in business is decision analysis and spreadsheet modeling.  So, I wrote the SLP piece, using examples from the area of business offering the strongest  argument favoring my position and best supported by the blog format (i.e., I could produce, for reader consideration, an assortment of charts and graphs demonstrating several of the tools – with sensitivity analysis as the “hook”).

Now, I should mention two further items.  First, I now believe the most valid case favoring formal management-training is the more nuanced recognition that executive and investor success relies on connecting each of the sub-disciplines of management and understanding their inter-connectedness.  The best example of this is the challenge associated with linking Porters Five Forces of competitive strategy with, both, financial management and quality controls – connecting the qualitative with the quantitative.  This, however, is not easily described in one or a small number of blog postings, but I will reference a portion of this later.

Second, the blog was started to chronicle my journey as a largely inexperienced investor – answering the question of whether an MBA could apply value-investing successfully, if willing to assume that a masters in management represents the minimum knowledge necessary to be financially dangerous.  So, the blog was designed to document my post-grad learning and experience.  What I couldn’t have anticipated at the start was the market crash of 2007/8 or my ability to sit in on any of the other classes taught through my program – providing a refresher on topics largely forgotten following grad school.

Why mention all this?  Well, as with most stocks, posters on message boards possess partisan perspectives (long and short), and some voice their views strongly.  Not me.  I have no stake or interest in your decision, but I will take a stab at answering your question.

I’ve run the numbers based on the latest data, and, in my view, the stock is, either, fairly valued or undervalued, but I question whether it is over-valued (as some assert).  The sensitivity analysis provided in the original blog entry still applies; although, with the passage of time and improvement in financial strength, the best-case value may be moderately higher (perhaps, significantly, but this will rely on management execution in the future).  Personally, I have not sold a single share and have no plans to do so at present.

Much is made of the cash position of the company, and it is an important consideration, but for reasons not addressed by those referencing it on the stock discussion boards.  First, the absence of debt makes calculating the Weighted Average Cost of Capital exceedingly easy, because there is no cost associated with debt.  Consequently, you need only determine the cost of capital associated with equity – a figure that should fall within the 10%-to-15% range, but only if you can identify alternative investment opportunities capable of reliably generating returns that exceed it (net of the tax hit suffered if selling the stock).  Think of WACC as the Opportunity Cost – which was precisely why Modigliani and Miller created it in 1958 … earning both the Nobel Prize (separately and in different years).  As long as SLP produces Returns on Invested Capital greater than this imputed cost of equity capital, management is increasing stockholder value.  The difference between these two figures is between just over 3% and just over 8%, depending on how you calculate WACC.

Note, as well, that, just as not all liabilities are created equal, not all assets possess equal importance when determining intrinsic value.  For example, short-term debt is a greater threat to a cash-strapped firm than long-term debt – which is why the statement of cash flows warrants consideration by investors.  When it comes to assets and determining the comparative importance of each asset class, one category stands head-and-shoulders above all others – namely, cash and cash equivalents.  This was the conclusion of Ben Graham in Security Analysis (1934) in his calculation of liquidation value (the value of a company in bankruptcy), and the generation of cash is at the core of the Dividend Discount Model created by John Burr Williams in 1938 – which, with modification, becomes Discounted Cash Flow analysis.

In the case of Graham, he applied discounts to every asset class to account for their fire-sale value during liquidation.  The only category for which no discount was taken was cash and cash and equivalents.  So, inventories and accounts receivable are worth around $.70 on the dollar and plant, property, and equipment are worth less than $.50 on the dollar at liquidation.  Cash and equivalents, on the other hand, are valued at 100%.

Williams, on the other hand, was interested in the cash an investor can take out of the business over its lifetime, discounted back to present dollars.  Unlike Graham, he was not interested in the net asset value of the company but, rather, the cash available for deployment as dividends.  He recognized that many firms reinvest this capital to promote growth, however.  So, he focused on cash generated in excess of the capital expenditures needed to maintain the business.  Interestingly, this is why Buffett calculates Owner Earnings and uses it instead of Free Cash Flows (which is not something they taught me in business school, by the way).

Regardless, cash is first among all asset categories for the investor.  In fact, the ideal investment is one that generates a truckload of cash and has $0.0 in overhead, operating, or carrying costs (no PPE, inventories, accounts receivable, etc.).  Given a choice between a company that generates $200 in cash based on $100 in plant, property, and equipment versus one that generates $100 in cash and has no overhead, I’d chose the second, even though both generate $100 in cash.  Why?  The difference in maintenance costs.

Next, consider how the positive of cash is generated and employed.  If using:

  • Depreciation as a surrogate for Maintenance CapEx,
  • The difference between CapEx and depreciation as a surrogate for Growth CapEx, and
  • Cash from Operations net of CapEx as deployable cash not invested to maintain or grow the business,

you gain a better feel for why the cash stockpile is increasing.  The company’s depreciation levels have been reliable/consistent, while Growth CapEx has “flighted” over the past decade (to use a marketing term, from that “worthless” academic discipline of management).  Even in years where Growth CapEx has been significant, cash contributions have exceeded $1 million per year in most years.  In other words, the company has invested to grow through, both, acquisition and internal R&D on new product offerings, and it has not been spent on M&A or internal growth to the detriment of increasing cash or ROIC>WACC.

This (ROIC vs WACC) is how you should measure the competency of management.  All this give and take on the discussion boards about “Walt”, the company’s founder,  is BS.  His name could be Beauregard G. Schmudlap for all I care.  If ROIC isn’t greater than WACC, he is yanking money from my pocket (as part-owner), by destroying organizational and shareholder value.  Well, in 8 of the last 10 years, Beauregard has been successful at the 10% WACC level (which I believe is the right threshold for this company, given its financial strength and competitive position).

Do a search for stocks averaging ROIC>10% over the last five years.  I come up with 1202 out of 9573 (using the Interactive Data database).  This means that 87+% of companies are destroying stockholder value, and SLP is among the 12.5% that are provably adding value.  We don’t need to personify the company with the founder’s name to draw this conclusion.  We can just do the math and leave personalities out it.

Now, recognize what ROIC>WACC means when it comes to the company’s strategic position.  When ROIC is greater than WACC, the company has demonstrably possessed differential competitive advantages.  The problem with this, as a measure of competitive advantage, is that the data is dated (i.e., backwards-looking).  It tells us that SLP has enjoyed considerable competitive advantages over the last decade, but it tells us little about whether those advantages can be grown or sustained in the future.  To determine that, we need to consider the company’s competitive prospects in light of Michael Porter’s Five Forces, paying particular attention to the threat of new competition.

Among the Five Forces, we already know about existing competition (that is baked into the prior data).  I’m aware of no threat from substitutes (let me know if you discover one).  The pricing power of suppliers is minimal, unless expecting the price of CDs, packaging, or data transfer to increase significantly.  The pricing power of buyers is undermined by networking and switching costs, to say nothing of the exclusivity of the principle product and its preferred status by oversight and regulatory authorities.

So, among the five forces, that leaves the threat of new entrants.

Well, when it comes to combating the threat posed by new entrants, there is patent exclusivity, networking and switching costs, regulator preference, etc.  And, even if these barriers can be overcome by new competitors, the company has that cash hoard with which to increase advertising, withstand a pricing war, expand R&D to increase functionality, and promote further economies of scale in product production (i.e., operating leverage).  Of course, operating leverage is less of a defensive advantage for SLP than the other items just mentioned, but, collectively, this is the moat designed to dissuade competition and continue increasing the cash stockpile.

That cash stockpile serves as a store of kinetic energy … with a storage cost.  Just sitting there, it represents a threat to would-be competitors, as well as a deployable resource with which to productively grow the company in the future.  The fact that management has not spent it foolishly (toward efforts not capable of sustaining or expanding ROIC>WACC) means management can be trusted with our money – based on past performance.  This is not true of most companies (i.e., the 87+% mentioned earlier).

The storage cost of that cash comes in the form of inflation and the opportunity cost (which, combined, is reflected in WACC and ROIC).  This storage cost is largely reduced with the share repurchases (which is a more tax-efficient use of excess capital than paying a dividend, from the shareholder’s perspective).   Again, Beauregard is looking out for me in ways that most corporate leaders do not.

Now, let’s consider the company’s growth prospects.  The current healthcare situation is dicey for pharma and bio-pharma, as the last protected piece of healthcare costs.  Even the novel-therapeutics market recognizes that the salad days are coming to an end, and they are taking steps to limit future pain and bleeding (cutting back on unfocused R&D, preemptively lowering prices on selected products, providing coupons and discounts to providers and patients to cover co-pays, etc.).  This reduction in forward margins will place a premium on the importance of cost-effective R&D.  Now, connect the dots with SLP and its principle product.

This suggests (but does not prove) that market demand for SLP’s tenured products may continue to expand.  It certainly supports the argument that SLP enjoys pricing flexibility sufficient to keep pace with inflation and currency exchange rates for products sold overseas.

Next, consider the latest product offering — providing computer navigation based on the user’s eye-gaze.  While this might seem a small product, the target consumer would include MS, cerebral palsy, carpel tunnel, paraplegic, and hand injury patients, along with the lazy, the sedentary, and those suffering from persistent and chronic Fascination with Information Technology Syndrome (FITS) – sorry, I made that up, but I say let’s make it viral so I can have my own page on Wikipedia.  Given the size of the demand compared with the size of the company, the growth prospects are substantial if Beauregard can execute and take advantage of first-mover status.

Plus, we have the R&D uncertainties associated with the company’s cash hoard.  The company has a proven track-record of innovation (also a differential competitive advantage, with suspect sustainability).  In other words, we don’t fully know what is in the pipeline until the company releases the news (I bought the stock without any knowledge of the heads-up computer-navigation product).

So, that addresses the original question, Adam(s) – sorry, I don’t know whether your moniker references a first or a last name.  Now, lets think about what wasn’t in your question.  Specifically, are there costs associated with selling the stock?

Well, you mentioned being a long-term owner.  If your shares are in a tax-protected account (retirement, etc.), you’ve already taken the tax hit or have delayed it until withdrawal after retirement.  If not protected, figure on sharing 15% of the proceeds with government (more, if not living in the US).  Of course, you already knew this, but you’ll also need to add that 15% to the minimum-required upside of your follow-on investment, plus a further 15% to accommodate market uncertainties (economic, stock market, industry, and company).  This second 15% is your required Internal Rate of Return (IRR) — as they teach in those useless business school classes on financial management.  Regardless of the tax implications, you’ll still have the commission cost (which is negligible), the time-investment to identify the replacement opportunity (significant, since only 12.5% of available equities warrant consideration), and you’ll be changing horses in Cat IV rapids – if believing the market is over-valued and likely to witness a  correction this year.

In fact, compare the Wilshire 5000 to US GDP.

The market (Wilshire) tends to fluctuate between 70% and 90% of GDP.  This chart projects GDP growth through 2011.

GDP vs Wilshire 5000.

[In general, the Wilshire 5000 meanders between 70% and 90% of US GDP.  When falling below that level, the market is undervalued.  Results that are significantly above that, indicate the market is over-valued.   It appears we are close to over-valued territory today.]

So, if you require a 50% margin of safety between intrinsic value and market price, you’ll need to increase that by a further 15% to become agnostic on whether to sell SLP versus purchase of a replacement.  This, by the way, is the reason Warren Buffett is loathe to sell until the stock is over-valued by something approaching 20%.  Otherwise, he is happy to let management compound value while covering the tax burden.

And, finally, there is the re-marriage cost.  Ever wonder why 70+% of those who have been divorced once will get divorced a second time?  Answer:  That alluring strumpet that seduced you from your first spouse has baggage, as well, and will age just as poorly.  In other words, you know the positives and negatives of SLP better than you are likely to know them for the replacement (if the replacement is other than a pre-existing holding).  Personally, I’ve been buying more of other stocks in my portfolio when exiting over-valued positions.

Quick Note:  Let me know which stocks you think are superior to SLP as investments – i.e., little debt, strong strategic position, a consistent history of ROIC > WACC, and undervalued.  I’ve been crunching the numbers and the pickings are slim (a decent indication that the market is over-valued).  There are still some nice opportunities among large-caps.  Otherwise, I’m with Beauregard and sitting on cash, SLP, a small number of long-standing positions, a handful of large-caps, and buying the occasional investment property.  [With real estate, however, be careful (make certain you have a guaranteed Margin of Safety).]

Under the “I’ll show you mine if you show me your’s” rule of investing, here are my current holdings and their price appreciation results since purchase (as of January 1, 2011):

Recognize that the market is up since 1/1/11 and this list references only open positions.  Over the past five-years, averaged annualized stock-market results were 35.7% after commissions and before dividends and taxes.

If you sell SLP, it has been a pleasure having you as a business partner.  You can hold or sell your stake secure in the knowledge that the stock will rise or fall on the company’s merits, whether we own it or not.

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Written by rcrawford

January 13, 2011 at 9:06 am

Posted in General

2 Responses

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  1. WOW!!!
    Robert great reply to my post and what a wealth of information you delivered in your analysis of ADAM’s request. Thank you very much.
    As you know Robert I make each and every stock buy or sell based on MY decision. I hold you not responsible. I am a totally responsible for these decisions. But I RESPECT greatly your imput.
    A personal note. I am a retired construction labor/carpenter for over forty years and I am not much on statistics and graphs, but I can read a “Stanley Tape” with the best.
    I struggle with the ROIC and WACC formulas but know there value.
    In short I am asking you to remove your “value” hat and think of SLP as a “growth” company which I believe is the situation at this time.
    Now, if SLP is a growth company what meterics would you look to to determine if it has growth potential?
    Investing in SLP at this time may be more of an art than a fundamental story.
    Once again you reply posts are excellent and thought provoking. This 64 year newbie investor appreciates your guidance.
    On Friday, I E-mailed SLP regarding their stock splits and got a prompt rely stating that said splits where made to “increase public float,trading volume,liquidity thereby attracting larger investors.” As you know they where almost delisted, but management seemed forthright in their assessment.
    Any response, time permitting, will be welcomed. Thanks again,Mike

    Mike

    January 16, 2011 at 2:58 am

    • Mike, the answer is exceedingly complex because it requires factoring in most (if not each) of the major sub-disciplines of management. You need to anticipate the ferocity of current competitors, the likelihood of new competition arriving, and the prospect of obsolescence due to substitutes. You’ll need to anticipate the economic forces unrelated to competition and the Five Forces. You’ll need to anticipate pricing, revenues, and expenses to forecast margins. This introduces market demand, which requires understanding the likely effectiveness of marketing and advertising efforts. Operating capacity, efficiency, and costs come into play, as does human capital, as well. Individually, these represent the sub-disciplines of strategic management, operations, marketing, and HR, and finance and accounting enter the picture when calculating the capital necessary to purchase the resources needed to generate growth. Collectively, they are the five core subjects taught in every reputable MBA program.

      All of this is why value investors conclude that it is nearly impossible to make such projections over more than a year or two, and, even then, it may not be possible to predict growth over that period of time because market crashes and economic declines (the steering winds of company valuation over the short-term) are exceedingly hard to anticipate with precision (both degree and timing). If it is impossible, then you are left with Ben Graham’s admonition to require a sufficient margin of safety to accommodate these uncertainties.

      So, it isn’t uniquely the case that valuing the growth prospects of SLP is more art that science. That challenge applies to valuing the growth of every company. Which is why I introduced the idea of performing sensitivity analysis, using SLP as the example case. In fact, the goal of sensitivity analysis is to promote better decision-making under states of uncertainty.

      Thanks, Mike.

      Robert

      rcrawford

      January 16, 2011 at 1:35 pm


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