Why I Believe Dolby Will Outperform

One of the great maxims of traders and Wall Street pros is to follow the "smart money."

I'm not much for the thesis that institutional shoppers tend to make smarter investing decisions, but many of you who've read my ruminations on insider buying say you'd also like to know how the Big Money is betting. Your wish is my command.

Next up: Dolby Laboratories (NYSE: DLB). Are institutions bullish or bearish when it comes to this leading developer of audio technology?

Foolish facts

Data current as of April 6.

Allow me to admit a bias before we begin; I was impressed by the bulk of what I saw at Dolby's demonstration suite at January's Consumer Electronics Show in Las Vegas.

Between its new 7.1 version of surround sound, an impressive networked gaming system, and an advanced sonic filtering system for laptops, Dolby showed why it's been the dominant name in audio technology for nearly four decades.

And yet investors want more than great technology. They want great growth, too. So when the company gave weaker-than-expected 2011 revenue guidance in February, the stock took an almost immediate 12% hit.

Fools who bought on the dip did so with the understanding that consumers demanding more immersive video experiences would also need more immersive audio -- Dolby's specialty. They've yet to be rewarded. The stock is down 20% over the past two months and 26% year-to-date.

Should bulls run for the hills as if they were the streets of Pamplona? Hardly. Dolby trades for just over 19 times normalized earnings, a level not seen since early 2009, during the height of a panic-ridden Great Recession.

Dolby also trades about in line with analysts' expectations for long-term profit growth, resulting in a perfectly reasonable 1.09 PEG ratio. Selling this high-quality company at panic prices isn't just unfair; it's stupid.

Institutional ownership history

Source: Capital IQ, a division of Standard & Poor's.
*Indicates the number of shares owned.

And I'm not the only one who thinks so. Big Money buyers have substantially increased their bets on Dolby since the 2008 market meltdown. BlackRock and American Century, in particular, have loaded up on shares.

Among mutual fund investors, Robert Bartolo's highly rated T. Rowe Price Growth Stock (PRGFX) fund boosted its position in Dolby by 13% in the December quarter. Colleague Brian Berghuis of Rowe's Mid-Cap Growth (RPMGX) fund also bought a big chunk of shares in the fourth quarter.

Competitor and peer checkup

Source: Capital IQ. Data current as of April 6.

Judging by this table, Dolby also has the most engaged stewards. Insiders still own more than half of the business. Actually, "insiders" is a misnomer here. Founder Ray Dolby still owns more than half the business, and you can bet he wants to see it succeed.

Managers don't have nearly as much of the company but I don't find that troubling. CEO Kevin Yeaman and Dolby board members tend to sell according to 10b5-1 programmed trading plans. They've no input as to timing or valuation; they're merely diversifying.

That makes sense. Selling for any other reason doesn't, especially when Dolby transforms $0.27 of every dollar of revenue into cash for reinvesting into this outstanding business. I believe this is sustainable efficiency, and as such, I've rated the stock to outperform in my Motley Fool CAPS portfolio.

Do you agree? Disagree? Let me know how you would rate Dolby Laboratories using the comments box below. You can also recommend other stocks for me to evaluate by sending me an email or replying to me on Twitter.

The Motley Fool recently introduced a free My Watchlist feature that allows users to stay ahead of the curve and receive up to date news on companies like Dolby, or any of its competitors. To get up-to-date Dolby news and analysis, add the company to your watchlist today:

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