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The Stock Picker's Guide to ARM Holdings

LONDON -- Successful investors use a disciplined approach to picking stocks, and checklists can be a great way to make sure you've covered all the bases.

In this series I'm subjecting companies to scrutiny under five headings: prospects, performance, management, safety, and valuation. How does ARM Holdings  (LSE: ARM  ) (NASDAQ: ARMH  ) measure up?

1. Prospects
ARM designs microchips. It licenses designs to microchip manufacturers for an upfront fee, and receives royalties on every device sold. It has a near-monopoly on low-powered chips suitable for smartphones (where it has a 95% market share) and digital cameras (80% global market share).

ARM's market stranglehold and intellectual property library give it a wide economic moat. Potential risks come from disruptive technology, backward integration by chip manufacturers such as Intel, or possibly IP theft.

ARM's market is driven by smartphone and tablet computer volumes. When those markets eventually mature, it faces tougher competition in the PC and server market.

2. Performance
ARM has enjoyed 24% per annum compound growth in sales over the past three years. Essentially a design factory, its costs are largely fixed. That gives it high operational leverage, so margins have doubled over the same period as revenues drop straight through to the bottom line.

In that time, the shares have gone up 500%.

3. Management
ARM's move into low-powered chips, when industry giant Intel chose not to, proved a shrewd and lucrative move. Much credit has to go to CEO Warren East who has run the company since 2001.

His impending departure might be cause for concern. He is being replaced internally, by Simon Segars. Currently head of the IP division, he is a chip designer by background so is unlikely to usher in major change.

4. Safety
ARM has over 500 million pounds of net cash on its balance sheet, against net assets of 1.2 billion pounds.

Tangible net assets are just a fraction of ARM's valuation, though its IP doesn't appear in the balance sheet and that must have real, tangible value.

ARM's profits are mostly turned into cash and with little cap ex, no debts and modest dividends, the cash just piles up.

5. Valuation
Trading on a prospective price-to-earnings ratio of 52, buy-and-hold investors can best analyze the valuation by considering how long ARM must sustain extraordinary growth to justify its rating.

A tripling of earnings over the next five years -- in line with some forecasts for revenues -- would bring the P/E down to 17 in the absence of share price growth. The smartphone and tablet markets may well have cooled by then, and ARM will be in a more normal competitive position.

That explains the valuation, but to my mind doesn't leave enough upside to compensate for the downside risk of market disruption.

ARM is eye-wateringly expensive, but has rewarded its fans handsomely.

If you're looking for a safer growth story, I suggest you look at the Motley Fool's top growth share for 2013. Digital technology has disrupted its industry but it has adapted and flourished.

It has strong cash generation, has increased or held its dividend every year since 1988, and there could be considerable value that isn't reflected in the share price. To discover the identity of the company, you can download a free in-depth report just by clicking here -- it's free.

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