Price on Value
March, 1999

It was the best of companies. It was the worst of companies. If Charles Dickens was writing this article instead of his historical novel A Tale of Two Cities, he might have started with these words. Actually the two companies that I am going to write about are both excellent companies. Their difference is in how they are evaluated by the market place and this is what concerns us here. The article is not directly motivated by a desire to analyze two specific companies. Rather it is an attempt to understand the mechanics of how the market sets the level of stock prices.

Over the past ten years, the growth in earnings per share of these companies have been as smooth as silk. The growth in earnings for ABC, the first company, have been a few cents either side of 14% while the growth of XYZ, the second company, has hovered around a remarkable 24%. Current return on equity for ABC is around 21% and return on capital 15%. The corresponding figures for XYZ are 24% and 19%. In both cases these ratios have been fairly constant.

What about surprises and analysts predictions? Each quarter the earnings for ABC have been close to the consensus predictions, with a few negative surprises, and for the next 5 years they predict a growth in earnings of 16%. Company XYZ has provided small positive earnings surprises in four out of the five past quarters. For the next 5 years, the consensus is that earnings will grow by 13%.

Debt? In both cases it is below average. The long-term debt ratio for ABC is 29.5% while that for XYZ is 21.2%

What else do they have in common? Well, last year they both had a high on July 10, and within 3 months they both lost around 50% of their value. Specifically, ABC had a high of 62.56 and by September 21 it was down to 36.25. (All figures are based on daily closing prices.) Similarly, a high for XYZ was 64.94 and by October 7 it was down to 27.81. (XYZ also had an earlier peak of 72.88.)

But this where the two companies say farewell to each other. Company ABC has returned to its 1998 highs and in mid February was around $57. In contrast, XYZ made an attempt in November and another in January to recover its prices, but is now languishing around the mid to high 30s. This gives ABC a price-to-earnings ratio of 58 and XYZ a ratio of 11.

Any ideas what these companies are? Here’s a hint. ABC is a world-wide company with a name that is known everywhere. There would be few houses in the developed world that would not have at least one of its products in it at one time or another. In contrast, XYZ, although also dominant in its field, is only in the U.S.A. and its use is restricted to a comparatively small section of the population.

Give up? Company ABC is Gillette which, apart from its razor blades and shaving equipment, markets Braun products and Duracell batteries. Company XYZ is MGIC Investment Corporation. Approximately 80% of its revenues come from private mortgage insurance to lenders to protect against defaults on low down payment housing loans. It extends the possibility of home ownership to people with less than 20 percent down payments.

Why does Gillette sell at such a premium to MGIC? To answer this, let us consider what gives a company its long-term value. Following the greats such as John Burr Williams, Benjamin Graham and Warren Buffett, this value is the present value of the cash that can be taken out of the company during its lifetime.

I will write about ways of doing the numbers on this in another article. But however we do them, we have to have confidence in them. This is based on the certainty with which:

1. we can evaluate the long-term economic characteristics of the company,
2. management can be relied upon to realize the full potential of the company and to employ wisely its cash flows,
3. management can be depended upon to channel the profits of the company to its shareholders.

Let us start with the second requirement. The shareholders equity in MGIC grows substantially each year with little debt. Yet it maintains a uniformly high level of return on capital indicating that management is using the profits well to build the business. The same applies to Gillette. Also, in both cases, as far as we can judge from the outside, management recognizes the strengths of their companies and builds on them

Regarding the third requirement, Gillette pays out 34% of its earnings as dividends, which is quite a high level. It is engaged in share buybacks but its purchases do not quite match the awarding of options to management and employees. MGIC is buying back shares at a slightly high rate than they are issuing options as compensation. It only pays a token 4% of earnings in dividends. But since management maintains such a high level of return on equity and capital, this seems reasonable.

So it appears that we can have confidence that the last two requirements are being met. This leaves the first requirement. Warren Buffett once said that he goes to bed feeling very comfortable just thinking about two and a half billion males with hair growing while he sleeps. Sixty percent by value of razors sold around the world are made by Gillette. No matter what you think might happen in the future in almost any area of life, it is very likely that men’s shaving habits are not going to change drastically. This, coupled with the fact that Gillette seems to be remarkably successful in getting men to move periodically to more expensive blades, gives investors great confidence in Gillette continuing with its excellent earnings growth.

If Gillette is viewed so favorably by the market, clearly the opposite is true of MGIC, even though MGIC dominates its own industry even more than Gillette dominates its industry. What is going on? We could look at technical issues such as the decline in insurance persistency rates, the proportion of insurance remaining from one year to the next. But underneath I think there are two main issues. Firstly, there is a concern amongst investors that because housing is an area sensitive to the economy and to government intervention, future profits of MGIC are uncertain. Secondly, the success of MGIC depends to a large extent on the actions of Freddie Mac and Fannie Mae. For example, MGIC had a major drop in share price when Fannie Mae announced lower mortgage insurance costs on January 15. One of its main competitors is CMAC Investments whose share price has followed a similar pattern.

This, of course, is not the end of the story for much more can be done in analyzing these companies. But the ground work has been laid. In the end, each investor has to decide for himself or herself the merits of any stock. However, I cannot resist saying just a little more. The average p/e for Gillette over the past 10 years is 22. So buying Gillette at a p/e of 58 seems extremely optimistic. In contrast, the historical average p/e for MGIC is 13.6. So the current trading level with a p/e of 11 is likely an overreaction to the possibility of any sustained reduction in earnings. Time will be the final arbiter. Let’s make a date for twelve months time when I will write about these companies again.

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Next month’s article "Conscious Investing: Putting your money where your beliefs are" will examine the trend towards investors favoring investments congruent to their beliefs. If you have any questions, about any of my articles, please contact me at johnp@sherlockinvesting.com.