As I promised in last week's column, today I'll share with you one of my less-than-finer moments in investing. I hope you'll find, as I do, that postmortem examinations of investing decisions often lead to new insights that are useful in making future decisions. As I noted last week, investors in small companies must be prepared to review company performance on at least a quarterly basis, and while we always buy with an intention of holding as long as the business is performing well, we need to be ready to sell if the situation dictates selling.
On to my first episode in small-cap investing: the story of how the perfect sell presented itself to me and how I ignored it. The stock market, patient though it sometimes can be, is not merciful forever. Eventually, it took back the money that it had let me think was mine.
The perfect sell started with the perfect buy. Plantronics (NYSE: PLT), a fine little company that makes lightweight communication headsets, first appeared on the Foolish 8 list on August 24, 1998, at $18 per share (all historical share prices are adjusted for splits.)
Plantronics was and is a company with a history of strong performance. It had been growing consistently for many years at the 20-25% growth rate that we look for here in small-cap country. Gross profit margins were well above 50% and had been expanding. Net margins had risen from the low teens to almost 20% over the previous several years. The company had lots of cash and no debt. The balance sheet looked decent for a small manufacturing company, with a Foolish Flow Ratio ranging from 1.50 to 1.80. Importantly, operating cash flow and free cash flow were both consistent with and sometimes better than reported net income. The table below shows how the reported net income compared with operating and free cash flow (which is defined as operating cash flow minus capital expenditures) for the four fiscal years of 1997 through 2000 (fiscal years ending in March; all numbers in millions of dollars):
'97 '98 '99 '00 Net income $29.7 39.2 54.2 64.5
Operating cash flow $34.6 39.2 86.9 81.1 Free cash flow $26.4 33.3 83.1 65.9
Finally, the company had a large insider ownership, with more than 50% of the shares insider-owned, and Plantronics had been a consistent repurchaser of its own shares. In short, everything looked good. I watched the company for a while before making my first purchase in February of 1999 at $23 a share. At the time, I noticed that most of my colleagues had begun using headphones in order to carry on business conversations while simultaneously using their computers.
The perfect buy came towards the end of September 1999, when Plantronics announced that it wouldn't meet analyst projections for the quarter, and the stock sold off to the mid-teens on a split adjusted basis. After carefully analyzing the situation, I came to the conclusion that the problems were likely temporary, and that the stock, now selling at about 13 times earnings, was a bargain. I doubled down at $16 a share.
The next month, the company announced that earnings for the September quarter were up only 13.5%, but that it was accelerating its share buyback program. The balance sheet looked good, with inventories and accounts receivable under control, and still lots of cash. The December quarter brought another double-digit increase in earnings along with strong improvement on the balance sheet as measured by an improving Flow Ratio of 1.69. By the March quarter of 2000, Plantronics was hitting on all cylinders again. Sales were up 26% and earnings up 33% over the year before, and the Flow Ratio had improved to 1.57. By that time, the stock price -- at $20 -- had begun to improve.
It got better. On June 29, the company announced a three-for-one stock split, followed by strong earnings on July 18. The price raced up to over $100 before the split, and sold for $42 on the day of the earnings release (or $126 pre-split.) At that point, I had more than doubled my money. The stock continued to blaze through August and September at around $50, helped by the buzz of Bluetooth. On September 15, amid rumors that Plantronics wasn't going to make its quarterly estimates, the company's press release deemed the September quarter to be "on track". Sure enough, Plantronics announced outstanding earnings on October 17 -- or that's what it looked like on the surface, anyway. Sales were up 44% and EPS grew 39% from the previous year. The stock was now selling at $38 a share. In retrospect, the date of October 17 marks the first day of what would be about a 100-day window of opportunity that Mr. Market was giving me to take my winnings off the table. But, naturally, I paid Mr. Market no mind.
While the income statement was all roses and chocolates, the October 17 earnings release harbored an axe murderer hiding in the balance sheet. Take a look at the increase in inventories and receivables compared to sales: (All dollar numbers in millions.)
June 30 Sep 30 %change Sales $100.3 $103.9 3.5 % Accounts receivable $40.1 $48.4 21.0 % Inventory $56.8 $63.6 11.9 %
As you can see, sales went up slightly, while both receivables and inventories grew big-time. The Flow Ratio, which I could have calculated with the balance sheet provided on the press release, had ballooned from 1.57 to 2.25. Preferring to bask in the glory of the income statement, I decided to hold on.
On November 14, with the stock trading at $40 per share, Plantronics released its quarterly 10-Q filing. It would have been a five-minute exercise to print out the cash flow statement and take a little gander. I surely would have noticed that while the reported net income for the quarter was $20.7 million, cash flow from operations was only $6.5 million. And, even worse, of that $6.5 million, $5.8 million came from tax benefits from employee stock options. In other words, only $0.7 million of the operating cash flow was attributable to the business.
At this point, I had benefited from the double dip of 1) increasing earnings and 2) an increasing multiple. The stock had almost tripled from my average purchase price. Clearly, Plantronics would have to keep executing perfectly to justify the stock price. The company had reached not only fair valuation but a significant over-valuation. Whereas the Price/Earnings ratio was about 14 when I last purchased the stock, and the historical multiple had been in the high teens, the stock was now changing hands at above 35 times earnings -- a very rich valuation. This alone would have been reason enough to consider selling off at least some of the position. The combination of an overvalued stock and the ticking bomb that was evident from the balance sheet and cash flow statements should have had me running for the exits. Mr. Market continued to give me every opportunity to do just that.
On January 16, Plantronics announced quarterly earnings for the December quarter, and once again reported record sales and income. The Flow Ratio was still at 2.13. The stock price stayed above $50, 250% above my cost, for most of January and February. A Plantronics investor would have had another three weeks to react. On February 12, the bad news came: The company issued an earnings warning for the upcoming quarter. Still, the stock price slowly drifted from $30 on down to the low 20s, where it remained until the next earnings warning on March 19, which knocked the stock for another loop down into the teens.
In retrospect, the market gave me the perfect sell, and waved it in front of my face for almost four months. From October 17 until February 11, I could have sold my shares for anywhere from $38.75 to $54.50 each, which would have meant my investment would have doubled or tripled with an average holding period of a little over 18 months.
Unfortunately, I didn't sell, despite the presence of three classic warning signs:
1) excessive valuation of the business
2) inventories and receivables increasing much faster than sales
3) sudden drop off in operating cash flow
That's it for today's episode from my small-cap investing X-files. I hope you'll come back for more next week.
Zeke Ashton is still holding his shares of Plantronics. Zeke would like to remind you that The Motley Fool's best small-cap investing idea is published each month in The Motley Fool Select. The Fool is investors writing for investors.