Why We Sold a Great Stock

Back in February 2005, Intuit (Nasdaq: INTU  ) -- the leading manufacturer of personal and small-business financial software through its Quicken, TurboTax, and QuickBooks products -- was recommended in our Motley Fool Inside Value newsletter service.

Since then, Intuit has risen more than 80% in value. While that's boosted our overall performance (Inside Value is beating the S&P 500 by nearly eight percentage points), we recently decided to issue a sell recommendation after its impressive run-up.

It's worthwhile understanding why Intuit has been such a successful investment, because it can help you to identify other great stocks. It's achieved those excellent returns for four reasons.

1. A dominant position
Intuit has a strongly entrenched, particularly defensible position in the financial software market, because the costs for customers to move to a competitor are high. Suppose you've spent two years making budgets in Quicken, tracking your expenses, filing your taxes, and analyzing your stock portfolio. Would you really want to move your data to a new product -- and risk losing it -- and then go through the whole painful process of learning new software? There's no way it would be worth it. And the argument is even more applicable to Intuit's business customers.

This barrier against competition is nearly insurmountable. Microsoft (Nasdaq: MSFT  ) has tried for years to take over the market, yet Intuit remains one of the few companies that's not simply survived, but prospered during a Microsoft attack. In fact, Microsoft concluded that the best way to compete was to buy Intuit, but was blocked by the Department of Justice for competitive reasons.

2. Solid financials
Intuit had, and continues to have, solid financials. When we recommended it, the company had basically no debt and more than $750 million in cash on its balance sheet. And it was producing more cash each day, with free cash flow in excess of its earnings. In fact, since then, Intuit's cash hoard has increased to $1.2 billion. And management isn't the type to fritter away that cash on cheap booze. While the company doesn't pay a dividend, it has consistently been repurchasing shares.

3. A cheap price
The problem with great companies is their share prices tend to already reflect their superior economics. But back in February 2005, this wasn't the case with Intuit. In fact, even with very conservative growth estimates, Intuit was substantially undervalued. In other words, even in the worst-case scenario, Intuit was likely to be a profitable investment. The fact that it was so cheap provided a substantial margin of safety. And if Intuit simply performed as people expected, then it would provide excellent returns.

Thus, the cheap price both reduced the downside risk and provided a solid return even if the stock simply returned to fair value.

4. Growth potential
The fourth factor that Intuit had going for it was that the company still had substantial potential for growth. Intuit's market grows each year, as more people become comfortable with the idea of managing their finances and preparing their taxes using a computer. H&R Block (NYSE: HRB  ) has its own software and 12,000 offices, yet it's still struggling to maintain its customer base and its margins as the market transitions.

And Intuit's established position helps it expand into new markets. If a company uses QuickBooks for its accounting, it's natural for that company to look to Intuit for other services integrated right into the accounting package. Thus, Intuit's established position allows it to deploy outsourced payroll solutions to compete against Paychex (Nasdaq: PAYX  ) , ADP (NYSE: ADP  ) , and Ceridian (NYSE: CEN  ) . Without integrating this service with QuickBooks, Intuit would be crazy to compete with these large, established companies, but QuickBooks gives it a beachhead into the market. Similarly, QuickBooks provides a natural path for competing with Deluxe (NYSE: DLX  ) in supplying business forms and checks.

Since the recommendation, Intuit has successfully executed its growth strategy, increasing its service revenues at a particularly high rate.

Why it worked
Typically, we'd expect cheap stocks to increase in price to approach their fair value. This has happened with Intuit. But in addition, Intuit has grown its revenues, increased its profits, reduced the shares outstanding, and added even more cash to its balance sheet. Thus, the fair value of the stock has also increased substantially. The combination of these two factors has propelled Intuit's stock to its latest highs.

So why the sell recommendation? Well, we still love the company, but the price is just too high. We're focused on value, and at today's price, the potential upside isn't as large as it is for many of our other recommendations. That said, it's been a great pick.

That's why, at Inside Value, we're always on the lookout for wonderful companies with strong growth prospects trading at a cheap price. The fun part is that such opportunities arise every day. There are other companies out there right now with similar characteristics trading at a discount to their fair value. It's from these stocks that we'll find the next Intuit. If you're interested in seeing what I'm talking about, you can check out Inside Value here with a free pass.

Fool contributor Richard Gibbons used to track expenses with Quicken, but stopped because his wife wasn't really intuit.He owns shares of H&R Block, but does not own any other stocks discussed in this article. Microsoft is an Inside Value recommendation. The Fool has a disclosure policy.


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