The Value Trade Is in Big Tech

 | Feb 28, 2012 | 1:30 PM EST  | Comments
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It probably has something to do with Warren Buffett saying that he avoids technology stocks because he doesn't understand them that causes many value investors to dismiss them as well.

What the CEO of Berkshire Hathaway (BRK.A, BRK.B) means is he can't model future cash flows with a degree of comfort. Indeed, when I look at my investment holdings, I hardly ever find myself owning tech names. Yet if you ask a value investor to describe what they seek in a value investment, the answer will usually have to do with buying an asset at a significant discount to all the cash that can be taken out of the business.

While Buffett seems to have dipped his toe in tech-land with his purchase of 5% of International Business Machines (IBM), big tech stocks are, according to a strict definition of value, the best bargain in today's not-so-cheap market. With enormous levels of free-cash-flow generation, today's tech giants seem very well insulated from any storms that may surface. And because every tech investor is so focused on Apple (AAPL) and how soon its shares will mark a new milestone, the boring names are being neglected.

That neglect creates opportunities for very attractive, risk-adjusted returns in any economic scenario.

For example, Dell (DELL) is so ridiculously cheap, it's no wonder both the company and its founder and CEO, Michael Dell, have bought back boatloads of shares over the past year. A quick glance at Dell shows a business that is trading at less than 8x earnings once you strip out cash. A closer examination reveals that Dell pulled in $5.5 billion in operating cash flow for the fiscal 2012 year, nearly $2 billion of which it generated in the fourth quarter alone. Going forward, Dell will likely pull in $6 billion to $8 billion a year in cash flow. While Dell currently has a market cap of $31 billion, as of Feb. 3, 2012, the balance sheet reflects $18 billion in cash and investments and $9 billion in total debt. With an enterprise value of $22 billion, Dell is changing hands at less than 4x cash flow. So, Dell could effectively buy back the entire company in four years.

Last year, the company repurchased 10% of its outstanding shares (due to equity grants, shares outstanding declined by 5% year over year). I would expect the company, under the leadership of Michael Dell, to continue buying back tons of shares as long as shares remain this cheap. Assuming Dell buys back 15% more of the business over the next two years, investors today would not only own a larger stake of a cash cow, but at today's price of $17 a share, a company that could be generating close to $5 a share in operating cash flow in the next two years. Michael Dell has made it clear that Dell should not be viewed as a slow-growing PC company but as a faster-growing IT business, and his growth strategy is focused on that part of the market.

For similar reasons, both Hewlett-Packard (HPQ) and Microsoft (MSFT) offer very attractive risk-adjusted returns going forward. Microsoft may be the least attractive in terms of valuation, but that is mainly due to a nearly 30% stock price appreciation in the past year. And don't forget to add in the nearly 3% annual yield to that total return. H-P, while not a fun name to own, is a business with tremendous potential to generate cash flow. Seth Klarman, the risk-averse investor behind Baupost Group, owns big stakes in both tech names.

Risk aversion is something that I think about all the time, not only for Gad Capital but also for the Gad family. I like what I see from big tech. Today's tech giants sit at a very attractive inflection point: they are generating tons of cash despite showing the glamorous growth that many investors want to see. But relative to most U.S. equity classes today, they offer some of the best risk-adjusted returns in a world oozing with risk beneath the surface.

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