Valuation Edge® Analyst Interview Series
Dhaval Sanghavi CFA, CPA
Senior Fundamental Analyst, Partner, Applied Finance
Dual B.S. from the University of Illinois at Urbana-Champaign
The Valuation Edge® Analyst Interview Series seeks to pick the brains of Applied Finance analysts and relay their thoughts on the overall market, specific sectors/stocks, quantitative patterns, or trending topics in the market with our readers.
While each member of our analyst team brings a unique expertise and skillset to the table, they are all experts in Applied Finance’s Economic Margin framework and Valuation Driven® investment process that avoids the problems with traditional DCF models and moves beyond less rigorous approaches such as those relying on price multiples or price momentum.
For the first installment of our interview series, we interviewed the Senior Fundamental Analyst in charge of the Technology sector, Dhaval Sanghavi to discuss his thoughts on the overall market, the Tech sector and the Valuation 50 portfolio including some insight into a recent trade decision.
Hi Dhaval, thank you for taking the time to sit down with us and share your thoughts!
2020 has been an extremely crazy year by all accounts, can you start off by giving us your thoughts on the overall stock market and what we’ve been experiencing so far this year?
When I think about the current market, I can’t help but think of the famous Dickens quote from “A Tale of Two Cities“ that says “It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of Light, it was the season of Darkness, it was the spring of hope, it was the winter of despair, we had everything before us, we had nothing before us.”
Economic activity has declined dramatically around the world due to COVID, yet the stock market continues to do very well as the S&P500 is up approximately 10% YTD through the end of August. The main driver of the rise is tech stocks – if you look at the technology and healthcare heavy Nasdaq 100 QQQ ETF – it is up 39% through the same period.
These companies have continued to generate healthy cash flow while many non-tech focused companies in industries such as airlines, restaurants and energy are burning cash and COVID restrictions continue to weigh heavily on sales.
Given that you cover the Technology sector for Applied Finance and with all the chatter lately surrounding the increasing market caps/weights of the Tech sector, can you share some of your views on the sector?
Technology companies have experienced an extreme amount of investor exuberance that has resulted in huge increases in their valuations.
For example, Apple reached $2 Trillion in market value, doubling its share price for the year. The company has done well in its shift to bundling services with its products. Their service revenue helps maintain a recurring growth driver while the upcoming 5G transition occurs over the next few years. Investors are also excited that it had a strong balance sheet and cash flow to support ongoing share buybacks and dividends.
A couple areas that have done quite well in the current environment are Software as a service providers (SaaS) and E-commerce players. Zoom, Docusign, Shopify, Etsy, MercadoLibre’s share prices have done very well YTD. Social distance protocols and closed physical stores have made their services more essential. While the sales have increased dramatically for these companies – the valuation has also run up to astonishing levels for some.
Zoom’s stock price has increased over 500% year to date, valuing the company at $132 billion with sales for the last 12 months ~$1.3 Billion and operating cash flow of $759 Million, almost as much Cisco which has $50Billion in Sales and operating cash flow of $15.4 Billion. Though Zoom has experienced faster growth, the stock is priced for the company to achieve over $20 Billion in revenue by 2024 (15x last 12 months) and to achieve Microsoft’s EBITDA margin levels of 46%. Cisco’s current valuation on the other hand, is priced to have its sales decline by 4% annually to $42B. Both scenarios are quite plausible but the valuation risk of Zoom underperforming its growth trajectory is higher than Cisco underperforming.
The main takeaway is that there are still some attractive names in Tech in the current market, but it is important to understand the embedded expectations priced-in to current levels and not get caught chasing trendy names.
Why do you think growth companies have done so well?
I believe growth stocks have done so well because they have better stories built into their narrative that many value stocks do not – higher growth businesses are more exciting, and dynamic compared to their “old school” lower growth peers. In addition, the increase in passive investing has led to fewer sellers of mispriced growth stocks, more marginal buyers of growth stocks leading to higher bids for these companies.
In general, Applied Finance does not pay much attention to traditional value/growth designations, as we view the world in a market-oriented manner. Cash flow and capital levels are significantly more important than headline earnings in our view.
In the last edition of The Valuation Edge, the co-founder of Applied Finance mentioned the Valuation 50 portfolio and the recent trade of NVDA in the portfolio. Can you elaborate on the portfolio and the details of the NVDA trade?
The Valuation 50 is a portfolio Applied Finance launched in 2004 of 50 stocks benchmarked against the S&P500. Our focus is on long-term investing with lower turnover – investing in companies that provide long-term good risk/reward opportunity. We look to spread exposure across diversified holdings within each sector.
We recently sold Nvidia (NVDA), a long-term Valuation 50 holding – as its valuation level reached a point where much of its growth was built-into its price already. The company had been in our portfolio since December 30, 2011 when we added it for $13.86. We sold the company on August 28, 2020 at $525.91, a total return of 4024%. Nvidia’s stock price had increased over 116% year to date and 215% over the last 12 months.
Our model had the company’s intrinsic value at $518 per share and that is with 22% Compound Annual Growth rate in its Sales and improved asset efficiency (as a fabless chip company, it has a very scalable business). NVDA’s products – the GPU chip and its associated software, has 3 big secular drivers for it – increase in electronic gaming, artificial intelligence utilizing its products, and autonomous vehicles. While we still believe the company will do well operationally in the years ahead, the risk/reward was tilted as the near-term growth built into the stock price was already very high (40% sales growth for 2020 & 30% for 2021, 20% annually thereafter) and upside was more limited than downside risk.
We chose to replace it with KLA Corp (KLAC) as the company’s stock was trading at a discount to its growth potential. KLA is a semiconductor equipment company that works with companies that design and manufacture chips. KLA provides tools and services to help companies find issues with their chip manufacturing process and help resolve these issues to improve their yields which helps lower the costs for these semi-companies. As complexity and diversity of chips increase, their services will be in higher demand. The company’s management team is stable and has a track record disciplined execution. The company’s management believes it can achieve 7% CAGR, building in a margin of safety of 5% CAGR – we calculated a stock price of $272. The semiconductor capital equipment industry recently took a hit when US government announced that possible additional sanctions would be placed on Chinese chip manufacturers – leading to fears of lower sales. While the current exposure is a potential weakness, the increased geographic diversification by KLA’s clients in the future could provide KLA with increased revenue potential as these companies would need to purchase additional equipment to furnish those new plants.
You mentioned Apple (AAPL) earlier, can you give us your outlook on the company?
Like NVDA, another Valuation 50 holding, Apple (AAPL), had a tremendous year. As I mentioned earlier, AAPL returned over 100% this year, but we chose not to sell that holding. We continue to hold Apple as the current stock price has 6% annual sales growth and margins of 30% priced in, which Apple can achieve and might be able to surpass given some long-term catalyst – 5G, Augmented Reality, Health care devices (next version of Apple watch has pulse-ox and ECG embedded), low market share in emerging markets such as India. The big risks for Apple currently are whether justice department/regulators force Apple to reduce the app commission they are currently charging (30%) to companies such as the Fortnite creator, Epic Games or if companies such as Epic boycott Apple – will customers follow. The other big risk is Apple has a big stake in China as many of its products are assembled in that region and over 15% of its sales are from greater China. We felt the risk/reward was balanced for Apple and the stock still has good upside potential long-term.
Any concluding thoughts?
Overall, the Technology and the Communication Services sector have done well this year as many companies have benefitted from the digitization of processes worldwide, however some stocks have very high growth expectations built into their prices.