Nokia is the same quality company today it was in February when the Rule Maker Portfolio first purchased shares, except now it's a lot cheaper. With high returns on equity, strong potential earnings growth, low debt, and a smart design edge, Nokia's recent sell-off gives the Rule Maker a chance to buy more shares at a 25% discount to our initial purchase price.
A little background: Nokia shares fell after the company warned of lower profit in the third quarter as a result of product delivery problems. Investors are also worried that cellular phone growth could be slowing.
I'm going to do something you don't see too often in the Rule Maker space. I think we should invest in Nokia because the shares are trading at an attractive price. We already know Nokia is a great company. That's why we bought it. And, while we argue that business quality is more important than price, we're not opposed to looking at valuation. Indeed, I'm in favor of doing so more often. As legendary buy-and-hold investor Ralph Wanger said, it's possible for a great company to be a lousy stock.
Of course, Nokia isn't a value stock. It's just more attractively priced than usual. Under the standard low-P/E criteria, Nokia doesn't even come close as a value play, with a forward P/E around 48.7, compared to a P/E of 27.7 for the S&P 500.
There's a lot more to value investing than a low P/E, but that's a subject for another story. What's clear is that Nokia has rapid growth priced into its shares. Let's take a look at some of the expectations built into the stock price to get an idea where we stand.
To justify paying $36 per share, investors are betting Nokia can grow its free cash flow about 20% annually for the next 10 years (using a discount rate of 10%), before the growth rate slows to 7%. It's certainly a bullish assumption. Is it impossible, or at least unlikely? Investors have to decide. Last year, Nokia grew its free cash flow almost 90%, and I expect very strong growth to continue -- despite inevitable hiccups in delivery schedules, component supplies, etc. -- over the next three to five years.
Still, I think it's worth pointing out what has to happen from an economic standpoint for Nokia to justify its price. If those numbers sound too high to you, or the discount rate sounds too low, be warned.
The theme in the market's growth assumption is simple: The market thinks Nokia will remain the market leader in one of the technology sector's fastest-growing markets, and that it will remain the most-profitable company in that space. It's not much more complicated than that. Based on the strength of the company's financials -- low debt, high returns on equity, and manufacturing excellence -- I, too, expect Nokia to dominate.
Unfortunately, investment history is littered with relics of fast-growing sectors that disappointed because market leaders failed to build a sustainable franchise: digital watches, carpet companies, disk drives. Will this happen to cellular phone companies? In this story I argued that it's not happening to Nokia.
But let's get back to value. Long-term investor George Michaelis, who ran the Source Capital mutual fund until his death in March 1996, used to hunt for companies with high returns on equity. (He looked for other qualities as well, but ROE was one of his favorites.) Once he found companies with high ROEs, he tried to determine the source of the returns and whether they were sustainable. This makes good sense to me.
Let's take a look at Nokia's ROE over the last five years.*
* Numbers from Value Line
Over this five-year period, Nokia has boosted its ROE five percentage points. How did it do that? ROE has three components: profit margins, asset turnover, and leverage. Here are the component formulas:
ROE = (Net Income/Sales) x (Sales/Average Total Assets) x (Average Total Assets/Average Equity)
Over the last five years, Nokia boosted profit margins 2.1 percentage points, boosted its asset turnover ratio to 1.63 from 1.22, and lowered its leverage ratio to 1.95 from 2.31. In other words, Nokia is more profitable, more efficient, and carries less debt than it did in 1995.
Of course, all this information is historical. There's no guarantee trends will continue to rise or even stay put. In all probability, Nokia's margins will get squeezed as prices fall and competitors vie for market share. But, I think there's room for Nokia's margins to shrink, given the company's efficiency and low debt. Consider that net profit margins stood at just 10.8% in 1995, yet Nokia managed a whopping 29% ROE.
In a 1996 Worth Magazine story, financial columnist Jim Jubak wrote a story about the Nifty Fifty, the group of pricey growth stocks investors jumped aboard in the early 1970s. The Nifty Fifty concept was simple: Buy the best companies and hold on for the long-term. Unfortunately, high inflation in 1973 took 40% off the S&P 500's value over the next two years, and many of the Nifty Fifty never recaptured their glory. Many investors realized they paid too high a price for Nifty Fifty growth.
Jubak compared the Nifty Fifty stocks that performed well over the next 22 years with those that floundered. One of the things he compared was the sustainable earnings growth rate of the winners and losers. He based it on an assumption that, over the long term, a company's earnings growth rate can't be higher than return on average equity.
As a rule of thumb, this makes sense to me. Over the long term, a company's maximum earnings growth rate shouldn't exceed the return being generated by its shareholders' investment. Why? Earnings growth should roughly correlate with the net income being generated by a company's equity.
Jubak did some fine-tuning to calculate a sustainable growth rate by netting out dividends to calculate ROE. He did this to capture the money actually being invested back into the company. Since reinvestment is critical for technology companies, I'm on board with this adjustment. It adds a measure of conservatism to the calculation.
What's it all mean? Analysts expect Nokia to grow earnings 27.8% over the long term, and its sustainable growth rate is 26.5%, according to Jubak's ROE formula. We're in the right ballpark here. Although this calculation doesn't tell me it's going to happen, it provides some comfort about the strength of Nokia's business and what's expected. I'd be a little worried, for example, if Nokia's projected growth rate stood much higher than its ROE. This was the situation for companies like Eastman Kodak (NYSE: EK) in 1972.
Finally, at about $36 per share, Nokia is trading at a 25% discount to our original purchase price of $47.50. I wouldn't call this a firesale, but it's an opportunity to add to our position at a price we may not see again.
Have a great day.