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The Boulevard of Broken Charts

Submitted by Vitaliy Katsenelson on 05/27/2011 11:28 -0400

Markets are inefficient, or so we’ve been told. I am not here to put a rebuttal to this academic nonsense, but let me give you one of the core reasons why markets are and will remain inefficient: because human beings are efficient.

To function in everyday life, our brains are used to simplifying complex problems, through pattern recognition. We become accustomed to drawing straight lines when we see two points, and if we get a third or fourth point that fits the line, our confidence about the longevity (continuity) of the line increases exponentially. We become excited, even certain, about prospects of the company we’ve invested in when its stock has gone up for a long period of time, while we often dismiss stocks that have declined or flat-lined, especially if that happened for a considerable period of time.

Imagine an analyst bringing a “fresh” stock idea to a portfolio manager at a large mutual fund. He’d say something among these lines: Cisco is a buy, it has a bulletproof balance sheet with $25 billion of net cash (cash less debt), the stock is cheap – trading at 9 times earnings (excluding net cash), it’s providing double-digit returns on capital, and it is a dominant player in the industry, which is poised to grow at a faster rate than the economy, since, thanks to iPads, Androids, Kindles, Hulus, and Netflixes, we’ll all continue to consume digital content.

I can just see the portfolio manager’s smile, his laugh and comment that “This stock is a value trap, it has gone nowhere in more than a decade.” I’m glad I’m not that analyst, as I’d have a huge burden to overcome. After all, Cisco has shattered the dotcom dreams of many investors in the years following 1999, when it hit $80 a share and, for a brief moment, was one of the most valuable companies in the world, sporting a modest P/E of 100+. Since then, gravity has caught up with Cisco’s stock (it always does), and it has declined almost 80% from its highs, to $17. Most investors who bought the stock since ’99 either lost or made no money. Draw a straight line through its chart (you have more than a decade’s worth of data points), and you see it’s either going to zero or at least will continue to go nowhere. Now, you add to this performance a few quarters of disappointing Wall Street guidance, and you have an untouchable, un-recommendable stock.

However, fundamentals – take any metric: revenues, earnings, cash flows – will tell a very different story: they either tripled or quadrupled since 1999. Through no fault of its own, Cisco’s stock was too expensive in 1999, and it took time for the stock to catch up to its fundamentals. Of course, as usually happens, investors get overexcited on both sides of valuation. The same investors who could not get enough of Cisco at over 100 times a little more than decade ago, don’t want touch it at 9 times earnings with a ten-foot pole. (Here is efficient market for you). The dark shadow of the stock performance hides an attractive investment.

Cisco is not a spring chicken anymore, it has over $40 billion in sales. It will likely see some margin compression as parts of its business mature. Its revenue and earnings will grow at a slower rate than they did over the last decade. But at its current price Cisco doesn’t have to do anything heroic to justify its valuation, it just needs to show that it has a pulse.

It is very difficult to get a unique insight into Cisco’s business or that of any large-cap stock; after all, they are followed by a small army of analysts (Cisco is followed by some 40 analysts). Some sell-side analysts undoubtedly know what John Chambers’ (Cisco’s CEO) favorite cereal is, and can recite the model number of every Cisco router by heart. Most of us cannot compete with that, nor do we need to.

First of all, you need to have a time horizon longer than Wall Street’s. Wall Street is very short-term-oriented, and mutual fund managers are judged and compensated on their monthly and quarterly performance. Sell-side analysts are there to serve their buy-side masters, and thus expend their energy analyzing the next quarter, not the next five years. Therefore a time horizon longer than Wall Street is significant competitive advantage in itself. Cisco’s earnings three, five years from now are likely to be significantly higher than they are today.

It is also important to understand that even a much-followed stock like Cisco will suffer from inefficiency (which as a value investor I welcome), due to investors confusing the lousy stock with the company’s fundamental performance. That is how you find high-quality companies at bargain-basement prices.

Understanding what happened in the past is important, not because it is the precursor to the future, but because it helps to build the analytical bridge, through our own analysis, from today into the future. Be inefficient – don’t draw straight lines.

Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo. He is the author of The Little Book of Sideways Markets (Wiley, December 2010). To receive Vitaliy’s future articles by email, click here or read his articles here.

See also:

*Microsoft Just Pulled Another “Microsoft” with its Purchase of Skype »
*I am back! »
Copyright Vitaliy N. Katsenelson 2011. This article may be republished only in its entirety and without modifications.

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Fri, 05/27/2011 - 14:22 | 1317657 Clowns on Acid

Decent article Vitaly, but:

Fundamentals do not matter when real interest rates are negative, and wing nut socialists are printing money 24/7.

Cisco has fallen way behind technically versus its peers (JNPR, Brocade, Arista). In the electronic trading game, where networks rule, Cisco is the lame pony in the race.

Talk about CRM, if you want people to pay attention.

Fri, 05/27/2011 - 14:25 | 1317644 chartcruzer

Most stocks follow the general direction of the market. And, the market is following the flow of luqidity being made available to humongous bank and broker (largely by the FED). Here's proof.

http://stockcharts.com/def/servlet/Favorites.CServlet?obj=ID3225058&cmd=show[s206018187]&disp=P

As the shadow inventory of real estate builds up on the books of the banks, get ready for more bank accounting standards to be relaxed.

Fri, 05/27/2011 - 14:19 | 1317619 Lionhead

Frankly, Mr. Katsenelson, CFA, I don't give a damn. The FED is controlling the market up, down or sideways. Fundamentals & intrinsic value don't mean anything. Besides, when the USA goes bankrupt, whatever ideas you have cooked up will be moot.

Good Luck on your plans, dreams & schemes of a by-gone era in history. ;)

Fri, 05/27/2011 - 13:52 | 1317502 ebworthen

Cisco is complicit in helping the Chinese government (Peoples Liberation Army or PLA) to spy on their citizens, jail them, execute them ("Golden Shield").

If you haven't noticed, the router and WiFi market is dying as the Millenials move to 3G and 4G smartphones to get their Matrix fix.

Look for Verizon to buy out Cisco at some point in the not too distant future.

Fri, 05/27/2011 - 22:03 | 1318687 Libertarian777

i'm sure they helping enforce the Patriot Act and FBI no-warrant wiretaps too.

At least in China you get to be jailed before being executed. The USA just sends a drone and bombs you. No sham trial needed.

Fri, 05/27/2011 - 13:47 | 1317479 Sherman McCoy

Cisco reminds me of Tandem Computers - a former high flyer that let time pass it by. It was eventually taken over by Compaq, which was eventually taken over by HP. Cisco is a takeover candidate at $10/sh - probably by Larry Ellison.

Fri, 05/27/2011 - 13:36 | 1317408 Yossarian

I like a lot of what you write but I recall a specific value trap of your's: Jackson Hewitt. Can we get the post-mortem on that one?

Fri, 05/27/2011 - 12:46 | 1317183 Captain Willard

Vitaliy:

Go back and look and the prior five decades at the performance of the biggest tech stocks. It is the rare company that can sustain dominance from one decade to the next. Technology is a business of creative destruciton.

There are plenty of value traps in large-cap tech right now. You will learn the hard way the lessons older technology investors (of my era) learned in blood in the 80's. Digital Equipment, Wang and Control Data looked cheap too.

You are a smart guy with good instincts. But you tend to invest before you investigate. A simple portfolio of the top ten technology stocks by market cap at the end of each decade, held to the end of the next decade, would have destroyed any portfolio over the past 40 years.

Fri, 05/27/2011 - 12:44 | 1317157 osgo

Don't forget that Cisco has a huge 'people' problem...all the kids starting out in SV are going to Google, FB and game companies. Intellectual torrent loss, supplicated by mediocre acquisitions.

It's difficult to innovate surrounded by dinosaurs. They get fat and big and slow.

Fri, 05/27/2011 - 12:30 | 1317108 MrBoompi

The real "owners" buy stock for the dividends it provides. Everyone else who buys the lowly common stock is just hoping the price is manipulated in their favor.

Fri, 05/27/2011 - 12:29 | 1317104 New American Re...

You start out with a heading about charts (technicals) and then you go right into a dissertation on fundementals, not that I disagree with your story, but charts are ok, they would have told you to bail on CISCO. So my only suggestion is to change your title. Cheers.

Fri, 05/27/2011 - 12:09 | 1317038 chrisd

I don't understand the line 9x earnings less net cash, how are you calculating that? (Market Cap / (Net Income - Cash))?

Fri, 05/27/2011 - 11:58 | 1316962 cowdiddly

How you find bargain basement stocks is be in the bonus pool where about 40% of all the corporate profits are funneled off. As for buying them, nope your the mark.

The Boulevard of Broken Charts

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