Ah, the good old days. If you're familiar at all with value investing, you'll know that some of the key value gurus often complain, especially during bullish periods like this one, that "the market is overpriced." The implication is that it's almost impossible to find anything that measures up (or down, as the case may be) to their standards of a true bargain.
As an up-and-coming miser and geezer myself, I also like to reminisce about the before time, the long long ago, when everything was better, before all these young whippersnappers came along and made things crazy. Grousing of this kind is a long and cherished tradition (even Machiavelli complained of such complaints), and it's the right and privilege of all of us whose few remaining hairs are fading to gray.
There are a couple of major beliefs that inform my own investing strategy, and the strategy of my compatriots at our bargain-hunting newsletter Inside Value. First is that there are alwaysgood deals out there, especially for us small players who are willing to look. Next, we learn by discussion and reflection -- which is why we don't just offer picks, but tap communal brainpower on our unique discussion boards.
Just about any tale can teach us something, even the babbling of enfeebled geezers, and I believe there are a few worthwhile lessons to be found in the golden age of value. So pull up a stool next to my rocking chair, children, and let me tell you about a beautiful value stock I owned in the long long ago, a little company called Nokia (NYSE:NOK).
In the before time
It started in the savage April of 2004. The sea was angry that day, my friends -- the sea, or whatever force of nature it is that punishes capitalist hubris. In the first week of the month, Nokia issued an earnings warning, retracting most of the bonny picture it had painted before. Nokia had misjudged the consumer market's unyielding fascination with Captain Kirk's flip-open communicators, with the result that Nokia's butt-dialing-prone candy-bar models were losing market share to familiar nemeses like Motorola (NYSE:MOT) and Ericsson (NASDAQ:ERICY), along with upstarts like LG. The street's retribution was swift, and the stock plummeted 20% -- even though there was good evidence that the firm was a reasonable value even before that cliff dive.
Then, as it often does, the news got worse. Just when investors thought all the skeletons were out of the closet, new bones kept working their way up. The reported losses in market share kept being revised for the worse, and Nokia skipped its way down to a multi-year low. The firm promised to revamp its lines, cut back, and compete at lower price points. Few listened, and those who did heard a swan song of dwindling margins and fading relevancy. And lo, the streets ran red with blood, and most of the important-sounding fellows in ties, who'd been so bullish just weeks before, warned everyone to stay away from the company. Nokia, the headlines would have it, was finished.
This was, in short, exactly the kind of situation that would pique the interest of the contrarians on the Inside Value team, though it couldn't, because the newsletter didn't exist back then. But the cheapskate in me said this was a situation worth watching.
I'm horrified, yet I cannot look away
As Nokia took knock after knock, I got more and more interested. After all, only a few weeks before, Nokia had been trading at a mighty cheap enterprise value-to-free cash flow ratio of 14. After the first round of carnage, this key metric dropped to around 11, or well under half of the overall market's usual EV-FCF multiple of 25.
In late July, at $12 a share -- and there was plenty of time that you could have purchased shares for a lot less than that -- subtracting debt-free Nokia's net cash and short-term investments yielded the interesting fact that the market-leading cell phone business was selling for just under $40 billion. At that point, the trailing free cash flow was $5.7 billion, meaning the business was valued at only seven times free cash flow. That's almost unheard of. It was a huge discount to the multiples of other successful global brands, including powerhouses like McDonald's (NYSE:MCD), Coke (NYSE:KO), Home Depot (NYSE:HD), or Altria Group (NYSE:MO).
Too good to be true?
Though I was giddy with greed even before Nokia hit those late-summer lows, I decided to take the bear side of things. I'm not the first Fool to suggest this, but I repeat it here. Go ahead and savage the company -- and don't be afraid to continue to do so even after you own it. Look for every problem and potential problem. I started by reading everything I could on the Fool's own Nokia board -- where there are experts on the telecom industry who use more high-tech acronyms than the crewcut and shoe-polish crowd at NASA.
After a couple weeks of digging and playing devil's advocate, I ranted about my chief worries for Nokia in a Fool duel. To me, Nokia's most imminent danger was a continual loss of market share, not just to its big rivals, but to localized upstarts in foreign cultures, where cell phones are more of a quick-changing commodity, a fashion accessory. While Nokia seemed overly concerned with high-end gadgets, Chinese upstarts were producing phones from easily procured parts, and these phones were resonating with the local populations precisely because the firms were able to tap into cultural trends unfamiliar to the design gangs back in Finland.
In the end, I was awfully glad I spent the time worrying, because Nokia was due for another painful drop from $14 down to near $11.
Enough is enough
While some of the more sophisticated value guys won't make a move without a painstaking spreadsheet DCF and a precise calculation of their margin of safety, I'm usually too lazy for that. Instead, I just compared the stock to the overall market's valuation and its peers. Not only did that put the firm into "ridiculous value" territory on absolute terms, the stock was now an absolute steal relative to Nokia's own average valuations, as shown in the table below.
| Nokia Valuations | Price/ Earnings | Price/ Sales | Price/ Free Cash Flow | Enterprise Value/FCF | Price/ Book |
|---|---|---|---|---|---|
| Mid Summer ($12) | 12.1 | 1.48 | 14.6 | 7 | 3.1 |
| 5-Year Average | 35.7 | 3.75 | 34.2 | -- | 9.5 |
| Today | 16.1 | 1.84 | 18.7 | 9.4 | 3.8 |
At the same time, news began leaking out of Finland that Nokia was indeed trimming its product lineup. New, lower-priced smartphone handsets were getting good reviews. The firm continued to open offices in important new markets, like Kazakhstan, and, most important to me, it expanded its R&D in China. I was convinced that Nokia was not going to cede these giant new markets without a good fight, and I was confident that the firm could survive several bruising quarters of aggressive pricing and marketing, if necessary.
When Nokia hit $12 a share, I could no longer control myself. This company was still the market leader everywhere in the world. It had an enormous pile of cash. And it was working on fixes for most of its transgressions. I knew it was time for me to get in. I grabbed some LEAPS -- long-term call options -- as well as common stock. I figured this $12 stock would be worth at least $16 within a year or two, giving me a nice 35% gain. In the meantime, there was a 3% dividend, so I'd be paid better than bank interest to wait.
Wrong, in a good way
Of course the funny thing about the market is how quickly it will change its mind. While everyone else was still horrified by the market share losses and the "technicals" of the stock's trading pattern, those of us with the guts to buy ended up with some pretty quick rewards. Nokia started to nose up very strongly in the late summer, and when market share was reported to stabilize, the stock rose steadily through November, cresting above $16 only a couple of months after I'd made my purchase.
I lightened the load a few weeks back, because I'm not exactly in love with companies with market caps in the $70 billion range. As opposed to smaller companies I may never want to sell, Nokia was always destined to be a short-term fling. I still hold the LEAPS, because Nokia still looks cheap to me compared to its past self and its competitors, over whom it has key advantages in margins and return on equity.
| The Cell Situation Today | Price/ Earnings | Price/ Sales | Enterprise Value/ Free Cash Flow | Net Margin | Return on Equity |
|---|---|---|---|---|---|
| Nokia | 16.1 | 1.84 | 9.4 | 11.6% | 23.7% |
| Motorola | 30.4 | 1.18 | 11.3 | 4.1% | 10.4% |
| Ericsson | 26.4 | 2.72 | 15.9 | 10.2% | 20% |
The golden age of value
By this point in the story, it ought to be clear that I'm convinced the golden age of value is any time. Even better news, anyone can do this. My success with Nokia wasn't owed to better information or more brains than the rest of the market. I can guarantee you I've got neither. It was owed only to the fact that I took the time to see through the panic, crunched a few basic numbers, and had the courage to act on the obvious.
This is exactly the kind of common sense and discipline that's practiced by the folks at Inside Value. I've no doubt that there are other strong firms out there being unduly punished by the quivering herds. Firms with great balance sheets. Firms that are leaders in their markets. Firms that are poised to make comebacks and can't fall much further. All you need to do is find them and have the nerve to buy. I encourage you to keep your eyes open, and take a free trial if you'd like some company on the quest.
For related Foolishness:
- It starts with a warning.
- Then it gets worse. People panic. Some call for calm.
- Some run against the herd.
- The more I thought about it, the more I thought "Nokia? No way."
- Then the bruised leader makes a comeback.
- Careful Nokia doesn't slip a Trojan in your pocket.
Seth Jayson considers himself a connoisseur of cheap goods even though his portfolio also contains firms with nosebleed P/Es. At the time of publication, he had positions in Nokia but no other company mentioned. View his stock holdings and Fool profile here. Fool rules are here.
