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Intuitive Surgical
Why I Sold ISRG

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By Luwingo
October 27, 2009

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In early February of this year, I bought 10 shares of a relatively small medical devices manufacturer called Intuitive Surgical, Inc. (When I write "relatively small", I should in fairness point out that my portfolio includes companies like PG, XOM, and JNJ, so a $10B company is kind of puny by comparison.) I liked its business model; I liked its laser-like focus on improving its products and growing organically; I liked the openness and honesty of its 10-K filings; and I absolutely loved its balance sheet. I was just starting out in investing for myself at the time; the markets were in a state of panic and everything was going straight down.

Which, as far as I was concerned, was absolutely brilliant, since this meant that everything was cheap (but not cheap enough, based on historical ratios).

Fast forward about 9 months to the present day. This afternoon I sold out of my stake in ISRG. The natural question is, of course, "why?". After all, nothing much about the company has really changed and I still have a very high opinion of it. It still commands a dominant position in a highly specialized industry with a wide competitive moat and a strong footprint within its client base. Its balance sheet is still nearly bulletproof, with zero leverage. Its ROE and ROA are outstanding and its cash flow management is superb.

The simple answer is that the price has just gotten too high for my liking. The stock does not pay a dividend, and its P/E ratio is now nearly 50. This is not quite near the nosebleed valuations that existed back in 2007 before the Great Collective Pants-Wetting of 2008, but it's still far too high for me.

Back when I first started out in investing, my father told me a useful tip: before buying a stock, write down at least 5 good reasons to buy and 5 good reasons to sell. ISRG met every one of my buying criteria: a dominant market position, high investment in R&D to maintain its moat, little to no debt, good management, and strong customer relations. In the last few months, it has met only one of my selling criteria: the price went over $240/sh.

I believe that much of the stock's current price run-up can be explained by the massive stock market bubble that is currently being fueled by very dangerous Federal Reserve monetary policy. After all, ISRG's beta is over 2, and the S&P has been on a tear of late, but take a look at this chart (http://www.zerohedge.com/article/omo-vs-sp5000) and you'll see why. The boom has been almost completely fueled by cheap credit and malinvestment caused by a shockingly loose Fed policy.

This is not sustainable. The Fed faces two extremely hard choices in the coming months. Either it tightens to avoid the inevitable hyperinflation which will follow its latest bout of insanity, or it continues on its present course and destroys future prosperity.

It is logical to argue that ISRG is far from the only stock affected by this phenomenon; after all, most of the S&P 500's components have experienced similar very sharp gains in the last 9 months. I agree with this, and indeed my portfolio contains several of the S&P 500's biggest components, but here is the crucial difference between my ISRG holdings and the rest of my portfolio: with the sole exception of my position in GLD, every other position pays dividends.

Dividends, as value investors well know, serve as a stabilizer of sorts for a company's stock price. They indicate efficient capital allocation, which leads to a surplus of earnings that can then be redistributed back to investors because the company itself can't really find a better use for them. Best of all, though, dividends allow an investor to use a Dollar-Cost-Averaging strategy by reinvesting dividends. If ISRG paid dividends, I would have been able to increase my holdings organically, with ever-diminishing amounts purchased on the way up and ever-increasing amounts purchased on the way down, resulting in a more financially stable position whenever an actual economic recovery begins. Without the ability to use a DCA strategy, there is no rational reason to hold on to an overpriced stock beyond a certain point.

There are several possible scenarios for ISRG in the near future. First, the company may well have made some catastrophic business decisions that we don't know about yet. I consider this very unlikely, given management's experience and its past excellence in allocating capital. Second, ISRG may be acquired- particularly by JNJ (in which I own an interest), which is desperately trying to find ways to goose its MD&D business. This seems unlikely, given that apparently JNJ once looked at ISRG back in the nosebleed days of $300+/sh and said "no thanks". Third, ISRG will continue to outperform the market by a handy margin, well past $300 and beyond. This is quite possible (and I will probably be kicking myself for selling at "only" $260) but the Law of Gravity applies just as strongly for stocks as it does for everything else. I have no more faith in my ability to successfully call a market top or bottom than in anyone else's, and I am almost certain that if I were to hold on past $300, the market correction would take me completely by surprise. Fourth, and most likely, ISRG's share price will crash like everything else in the near future when the markets wake up from the latest debt-fueled binge and the inevitable panic and correction set in. The difference between ISRG and most of the other high-fliers of the present bull market will be that ISRG is a very high-quality company, unlike some of the other dreck out there.

As I think I've made clear here, my decision to sell is in no way a reflection of my opinion of the quality of the company itself. I believe this is still a very high-quality company- just as it was when I bought the stock. It's simply too expensive for me today. If the price ever goes back down to below $140 or thereabouts, I would definitely look at it again as a possible holding, but today it's just too pricey. I would much rather sit pretty on my 115% return on the stock (before taxes, annoyingly) than continue to invest in what I believe to be an overpriced but very good stock.