I will be participating on a value investing panel at a College of Charleston conference on April 7th (more info here). My first time in Charleston – very excited. I am told it’s a beautiful city.
We have finally set the date for VALUEx Vail 2017: June 21-23. If you are a diehard value investor, you can apply here: http://valuexvail.com. This is a not-for-profit but for-learning event, and we limit the conference to only 40 attendees.
Michael Mauboussin: Challenges and Opportunities in Active Management And Using BAIT #MICUS
We’ve been eyeing investment opportunities in business process outsourcing for a while; lately, our interest is on the rise because of the industry’s declining stock prices.
Cognizant stands out as a shining star. Its revenue has quadrupled since 2008, and the company is growing at a faster pace than very competent competitors such as India’s Infosys and Wipro. Even as Cognizant’s growth slows from its explosive level of more than 30 percent a year in previous decades, the Teaneck, New Jersey–based company’s revenue should still increase at 8 percent to 10 percent annually.
There are several reasons for that continuing strong growth. The world is getting more and more IT-heavy every day, and old applications need to be maintained as well as new ones written. Developed countries like the United States don’t produce enough software engineers to satisfy the insatiable demand for new IT solutions.
There are other things we like about Cognizant. Its business is very sticky and requires very little capital — people are hired as needed — and thus it has a very high return on capital.
Cognizant, which is still managed by its young co-founder, 48-year-old Francisco D’Souza, has about $6 a share of net cash on the balance sheet and is expected to make $3.64 a share this year. Excluding cash, we paid roughly 14 times 2017 earnings. Not expensive for a high-quality and still growing company but not mouthwateringly cheap.
Now enter activist hedge fund firm Elliott Management. As we were analyzing the industry, Elliott Management announced that the firm had taken a 4 percent position in Cognizant and published a letter that they had written to its management, laying out a plan to improve the company’s operating performance.
Elliott Management has a history of being a good catalyst for unlocking value in investments it makes. The firm takes a position in a company that it believes is undervalued and undermanaged and then tries to convince management to improve operations or sell it outright. Our most recent encounter with Elliott was when it took a position in LifeLock and persuaded the board to sell the company.
In its letter to Cognizant, Elliott Management made a case that, although it’s very well-run, it is still managed as the newcomer it was in the mid-’90s, which doesn’t align well with reality.
Cognizant is one of the largest outsourcing providers in the industry and should have the cost structure of one. Its peers, such as Infosys and Tata, have operating (pretax) profit margins of 25 percent to 26 percent and have publicly stated aspirations to drive their margins to 28 percent to 30 percent. Cognizant’s pretax profit margin is at 18 percent — and Elliott thinks that, with small operational changes, Cognizant can achieve a margin of 23 percent.
In our analysis of the industry, we concur with Elliott Management. If Cognizant reaches a 23 percent margin, which may take a few years, and revenue continues to grow 8 percent to 10 percent, we get earnings of around $5 a share in 2019. By that time Cognizant should generate at least $10 of additional cash per share, putting its total cash pile close to $16 a share. At a conservative valuation multiple of 15 times earnings, we get a share price in 2019 of about $90.
Are these forecasts pie in the sky? Elliott Management is an activist investor and has a very long history of getting what the firm wants. If Elliott fails and Cognizant’s margin remains at 18 percent, our fair-value estimate for Cognizant’s stock in 2019 is about $70 to $75. Not a home run, but still a respectable return for a “failed” investment.
The company, which traded at $58.62 on February 21, was started in the U.S. as an in-house technology unit of Dun & Bradstreet. It began serving external clients in 1996 and went public in 1998.
President Donald Trump’s rhetoric about immigration and H-1B visas may create volatility in shares of Cognizant, whose workforce is based largely in India and elsewhere in Asia, but it’s very unlikely to pose a permanent-loss-of-capital type of risk.
Per MyVisaJobs.com: “H-1B Visa is a nonimmigrant visa which allows U.S. employers to temporarily employ foreign professionals in specialty occupations for three years, extendable to six years. . . . To qualify for an H1B Visa, the foreign professional must hold a bachelor’s or higher degree from an accredited college or university in the specialty occupation.”
First of all, the bulk of H-1B visa immigrants come from nonthreatening countries. Second, U.S. companies desperately need these H-1B visa holders, since the U.S. lacks sufficient qualified workers to fill highly specialized IT jobs. Also, the unemployment rate in the IT industry is incredibly low, and a ban would not only have a substantial impact on the likes of Cognizant but would devastate Silicon Valley royalty such as Apple, Google, Facebook, and others that depend on H-1B workers. An H-1B visa ban is not going to help the U.S. fight terrorism or help the economy grow. But for now we see any volatility that Trump’s immigration rhetoric causes in Cognizant’s shares as a buying opportunity.
P.S. Before your pawn your mother-in-law’s cat, sell your car, and take out a second mortgage on your house to buy every last share of Cognizant, please read this.
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My family is an avid user of Spotify – every family member with the exception of 3-year-old Mia has an account. Every time we get in my car, Mia says, “Dad, can you play ‘Wheels on the Bus Go Round and Round’?” so my Spotify-suggested playlist also features some odd music for three-year-olds. Personally, I am a Spotify junkie and listen to it all day long. Having all this music at your fingertips is mind-boggling.
We recently discovered that Spotify has an interesting feature: it can turn any album into a radio station. For instance, take Tchaikovsky’s Piano Concerto No. 1 and turn it into an “album radio,” and Spotify will create a random playlist of tracks by composers who lived plus or minus 50 years (my guess) around the time of Tchaikovsky, and who composed piano music and symphonies etc.
Hannah is a very happy and always smiling eleven-year-old who would do anything to spend time with me, even if she has to listen to classical music. Coming home from our last skiing day trip at Beaver Creek, Hannah and I created a new classical music game. We took one of those “album radios,” and each of us had to guess who composed the track that was playing. Hannah had to guess first. Every time, we’d discuss the music. If it was Mozart I’d tell her to notice how happy and light it was. If it was Tchaikovsky, I’d call attention to the enormous, bigger-than-life melodies. With Liszt I’d point out how the piano often sounds like the whole orchestra.
My son Jonah is on spring break, so I don’t have to drive him to school at 7 AM. Instead, this whole week I let my wife sleep in and drove Hannah to school at 8. We used this opportunity to turn each 20-minute ride into a session of our guess-this-classical music game. She absolutely loves it – she’s learned a dozen new composers. In all honesty she just loves the game element of it and is incredibly happy when she gets the composer right (which is now about half the time). We talked so much about Liszt, Tchaikovsky, and Chopin that this weekend we are planning to watch lectures on The Great Courses by (great!) Robert Greenberg about them, and she is actually looking forward to it.
Today I wanted to share with you Frederic Chopin’s Piano Concerto No. 2. Chopin wrote this concerto when he was only 20 years old. Though this was the first piano concerto he wrote, it was the second one to be published; thus it is known as his second piano concerto.
Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo. He is the author of Active Value Investing (Wiley) and The Little Book of Sideways Markets (Wiley).
His books were translated into eight languages. Forbes Magazine called him “The new Benjamin Graham”.