This article was sparked by a recent conversation I had with Rule Breaker Rick Munarriz during The Motley Fool's annual meeting. We chatted about Bill Miller, the renowned Legg Mason fund manager, and his prognosticating ability. Many have criticized Miller for investing in stocks that fall outside traditional boundaries of value investing. But I think it is a good thing to break new ground because it offers individual investors a chance to learn something new.
Trust me, I am no Rule Breaker. I understand plenty about spotting "the next big thing," but I find it difficult to value such companies in their early stages. Fortunately, I always remember that I don't have to get in on the ground floor when investing in great, world-changing companies. Sometimes the market attaches too much uncertainty to their futures and gives me second and third chances to buy them at bargain prices.
Miller's mantra
Regardless of where he invests his shareholders' money, Bill Miller is a valuation purist. He knows that the value of an investment is based on the future cash flows discounted to the present and works very, very hard to model the economics of a business to estimate its value.
Part of his success comes from taking the time to think about companies' competitive advantages and then testing scenarios to see how their capital-allocation decisions could affect their values. The other part of his success is being willing to use modeling techniques from sources outside business, especially ideas spawned from the Santa Fe Institute, a leading-edge, multidisciplinary research center.
A simpler point of view
But I am a very simple kind of guy, and frankly, this article is not a dissertation on Bill Miller the investor. There's plenty of literature available to study him. What I want to do is share some thoughts on two stocks Miller holds today: Cisco Systems
Here's the idea: Let's determine how much value the market is placing on present operations and future prospects. To do so, let's adopt the following basic formula:
company value = present value + future value
In other words, a particular company's worth is equal to its current cash flow in perpetuity plus incremental future cash flows generated by new businesses or products the company launches down the road. The present value figure is calculated like this:
present value = free cash flow / discount rate / market capitalization
This formula gives us a percentage representing the portion of a company's overall value derived from current operations. Because we're working with percentages, "company value" in the first formula will always be 100%, and "future value" is simply 100% minus the present value percentage tallied by the second formula.
An unusually high present value percentage may indicate that a company's prospects are not being valued correctly.
The results
Bill Miller has at least four Rule Breaker-type stocks in his portfolio: Cisco, IAC, Google
| GOOG | YHOO | CSCO | IACI | |
|---|---|---|---|---|
| Market cap |
$70,400 |
$51,700 |
$126,800 |
$16,000 |
|
Free cash flow |
$622 |
$1,065 |
$6,500 |
$1,000 |
|
Discount rate |
15% |
15% |
15% |
15% |
|
Present value |
6% |
14% |
34% |
42% |
|
Future value |
94% |
86% |
66% |
58% |
|
Implied growth rate |
14% |
13% |
9% |
8% |
The market already expects Google to grow at 14% and Yahoo! to grow at 13%. Is that possible? Sure, but remember that discounted cash flows can get funky when the implied growth rate gets close to the discount rate. If you don't think Google or Yahoo! can exceed the implied growth rate, then neither stock is a value buy right now.
The question is: Can Cisco exceed a 9% growth rate and IAC exceed an 8% growth rate? The market seems to say no, but I say yes. If I'm right, we've got the potential for market-beating returns on our hands.
Cisco Systems
If you want a networking product, Cisco is your company. Its products are a huge reason why networking is so, well, huge. Despite the Internet bubble bursting and the slowdown in telecommunications spending, Cisco still spends more than $3 billion a year developing new products -- in areas including wireless networking and Internet telephone equipment. Not only does the company know how to develop technology, but Cisco also knows how to buy, integrate, and roll out technologies it acquires. Speed to market is a huge advantage in the fast-shifting networking technology landscape.
On the balance sheet, Cisco has $8.7 billion of cash and no long-term debt. That certainly gives CEO John Chambers significant flexibility to decide on which direction to take the company. And after several years of underperforming, return on net tangible assets (or total assets minus goodwill, current liabilities, and long-term liabilities) -- after accounting for $1.2 billion in stock option expenses -- has climbed back to 15%, showing that Chambers still has that "vision thang" and is putting shareholders' capital to good use again.
Nothing is without risk, however. If next-generation telecommunications investments slow because of the economy, that would certainly be bad for business. The other thing that could hurt Cisco is a disruptive technology. Fortunately, Cisco is always looking to buy the next big thing.
IAC/InterActiveCorp
To gain some insight into IAC, you have to alter your perspective. It is easy to think of IAC as a collection of Internet-based businesses, but a look at Barry Diller's history sheds light on why this company is more than that.
Diller's history is rooted in the content business. He made a huge name for himself at ABC Broadcasting, Paramount Pictures, and 20th Century Fox by allocating capital to produce shows such as Taxi and Cheers along with movies such as Saturday Night Fever and Raiders of the Lost Ark. Where the story takes a turn is when Diller ran QVC. Sure, it was a unique, enormously profitable retailing concept. But it's more than that: It was a new form of content that people wanted.
This leads me to IAC's content: Expedia, LendingTree, Ticketmaster, Home Shopping Network, Match.com, Hotels.com, and more. These businesses provide access to content that people want and are willing to pay for. And all the while, IAC takes a cut of every single transaction.
Thus far, IAC's overall returns have been limited because of the huge amounts of capital Diller has spent obtaining the properties and nurturing the brands. I am sure that the market was looking for a quicker payback (which could be why there is not much value placed on the future). But the investments seem to be hitting their stride, particularly as free cash flow remains positive and continues to grow.
The Foolish bottom line
As I have said before, value opportunities come in all shapes and sizes, and a study of Miller's method shows that the future growth of even great technology companies can be undervalued. In the Motley Fool Inside Value newsletter, Philip Durell looks in lots of different places to find great bargains that outperform the market. To find out where he is looking, click here for a risk-free, 30-day trial.
Fool contributor David Meier does not own shares in any of the companies mentioned. The Motley Fool has a disclosure policy.
