Portfolio Construction – published in the Stanford GSB Reporter

Portfolio Construction
by Alec Mazo
After spending some time brainstorming various topics of interest relating the Sloan class to the GSB, I knew that I could highlight any one of my classmates and tell their unique stories in this column. But I decided to go a different route. As it turns out, 21 public companies are represented by senior management in our class. If accurately picked with an appropriate equity investments mix, some of these companies would diversify risk and offer good potential for growth in this uncertain macro economy. Here are two highlighted companies from the Sloan class and the investment valuation rationale behind them. I use discount cash flows based on owner’s earnings, a term pioneered by Warren Buffett (Net Income + Depreciation – CAPEX + special charges).
1. Cummins (CMI) – Global reach diversification
Sloan – Beau Lintereur joined the company in 1998 and since worked in the Power Generation Division in the US, China, and most recently India where he was the VP of the Power Generation Division.
Cummins is a $17B cap company that makes engines, engine components, and power generators. Company products can be seen in trucks, heavy machinery, rural farms, and power plants. Cummins has a global distribution business that manages sales and services around the world. The company global footprint includes strong positions in the emerging markets, especially China, India, Brazil, and Russia. 60% of its revenues are generated outside North America. India is responsible for 10% of revenues and China for over 20%. Cummins is making increasing investments in Africa.
At the right price, the firm is a safe investment with a sizable competitive moat consisting of brand name, technological know-how, and entrenched world distribution system. Cummins enjoyed a 10 year 8.3% annual revenue growth and a 10 year 20% annual book value growth. The company is profitable, with average ROE above 20% since 2004. Relating 20% ROE to 14.6% ROA reveals that Cummins isn’t leveraged, its’ debt/equity ratio is 14% ($665m debt), and current assets less total liabilities yield $1B. If we assume that Cummins maintains 8.3% revenue growth for the next 10 years and proportionately increases its’ owner’s earnings, the firm’s intrinsic value is $124.31 with a 9% hurdle rate. The margin of safety is 30% based on $87.30 Dec. 16 selling price.  
2. Baidu – Growth, Chinese internet
Sloan – Dan Guo is a founding member, Senior Director of Engineering and Product at Baidu.com
Baidu ($40B cap) is a Chinese internet search company with control over 70% of the Chinese search market. Its major revenue comes from paid-for-performance services (P4P), the online marketing services based on users’ search queries and customers’ relevant advertisements. China is one of the fastest growing markets in the world and advertisers will continue to invest in search related expenses, so P4P market should grow at double digit rates in the next few years. The overall growth potential for Baidu is attractive; it only serves 300,000 customers with the potential to involve 40,000,000 small/medium registered businesses in China.
In addition to paid search, Baidu is using its position as an online traffic hub to attract younger users with music and online communities. It further looks to develop in mobile search, localized e-commerce, travel, and online video by utilizing its search operation as a beach head for expansion. Competitive environment is tense with Alibaba, Sohu, and Tencent looking to take share away from Baidu. One of the keys for Baidu’s successful expansion to other verticals is increasing its penetration rate in search while fending off competition.
In my opinion, Baidu is currently selling at a premium. Baidu’s phenomenal revenue growth from 2003-2011 ($4.9m-$1.55B) lends itself to optimistic projections and investors think that a 30 P/E ratio is within norms for this kind of investment. Value investors would have trouble justifying an investment in a company selling at anything over 20 P/E for extended periods of time because the long-term market average P/E is 16. Baidu’s current P/E is 44, meaning that an investor would need 44 years to recover his investment using Buffett’s look through earnings (investor’s stock ownership % and it’s corresponding eps). So the story is growth, if the company grows at double or triple rate of a good 15 P/E company, then the market price would be closer to value, but at 26.2 price to tangible book value ratio, the investment community is very optimistic . Given China’s economic characteristics and Baidu’s penetration rate, huge growth is achievable but also risky, considering that an economic slowdown causing advertiser pullback may substantially alter investor projections and the market will adjust the company’s valuation. There is no safety margin for this type of event.
However, Baidu has a strong balance sheet with solvency ratios of .31 total debt/equity, and 3.44 current ratio. It also shows great profitability numbers, 27% ROE & 21% ROA from (’05-’10), and the company boasts a 45% net income margin in 2011. Fair value is $99.37 based on owner’s earnings (453m) with a 47.8% 10 year annual growth rate, 3% terminal rate and 15% hurdle. The company is selling at $115.56. Given current valuation, investors assume phenomenal growth of 48% a year which is difficult to sustain consistently over the next 10 years.

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