Simple But Powerful Idea to Find Winners

By Ser Jing Chong - September 3, 2012 | Tickers: ATW, DLB | 0 Comments

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As an individual investor learning about investing by reading articles and books written by professional investors, there can sometimes be startlingly simple but yet effective ideas that can be put to use by individual investors. John Neff was widely considered to be a contrarian, value and low Price-Earnings (PE) investor whereas Shelby Davis and Peter Lynch are both considered to be Growth at Reasonable Prices or GARP investors. These professionals might think differently but all three have written about a simple yet powerful idea in their books - the idea of having the market bidding up the PE multiple of stocks by picking stocks with PE ratios that are below their growth rates.

Neff preferred to buy companies growing earnings at 8% but selling at a PE multiple of 5 while Davis and Lynch liked to buy 15-20% growers selling at PE multiples of 12-15. Both ideas basically take advantage of the market being myopic to the actual growth potential of the companies that they are invested in. Neff, Davis and Lynch typically looks at a company’s historical growth rates as well as possible forward growth rate and compares it with the current PE multiple of the company’s stock price. The math involved is simple but illuminating.

Table 1 – Financial exhibition of Fictional Company

It is quite stunning how a difference in the starting PE multiple can change a losing investment into a winning investment. Davis had a rather catchy name for such a situation; he called it the ‘Davis Double Play’. His investment in the company grows not just due to the earnings increase but investor perception as well, which manifests itself in a higher PE – clever!

There will actually be a lot of such opportunities out there but I would like to talk about two companies that I am familiar with and how I can apply that ‘larger growth, smaller PE’ idea to them. They are Atwood Oceanics (NYSE: ATW) and Dolby Laboratories (NYSE: DLB).

Atwood Oceanics

First up would be oil-driller Atwood Oceanics. Looking at the chart below, their compounded annual growth rate for TTM EPS for the past 5 years stands at approximately 11.2%. At first glance, it might seem like the market is pricing them correctly at a multiple of 12. However, what is interesting about Atwood is their story moving forward.

ATW Earnings Per Share TTM data by YCharts

They currently have 7 active rigs, 2 idled rigs and 6 new rigs that are scheduled for delivery from October 2012 to June 2014 with options to build 1 more rig which can be exercised at management’s discretion. Of the 6 new rigs, 1 is an ultra-deepwater semi-submersible, 2 are ultra-deepwater drillships and 3 are high-specification Pacific Class Jackups. These new rigs would contribute to earnings growth as they are built and delivered. For drillers, dayrates are their lifeblood as it is the revenue per day that they receive from contractors that rent their oilrigs for use. Dayrates are now at attractive levels for both ultra-deepwater rigs and jackups as they stand at approximately $520,000 and $145,000. Looking three years out from September 2012 to September 2015, these rigs can deliver approximately $340 million in earnings after taking into account the various delivery dates for the rigs. This $340 million would translate into an EPS of approximately $4.90. The table below would illustrate how Atwood’s earnings can benefit from their new rigs.

Table 2 – EPS table for Atwood Oceanics

As you can see, Atwood’s growth rate from just the new rigs alone in an off-the-cuff calculation would amount to 12.6%, even after discounting any growth in earnings from their current rigs. This suggests that Atwood’s current PE multiple of 12 is a tad low. I am banking on them being able to grow earnings even from their current rigs such that their earnings growth rate would be even higher than the current PE. Ultimately, the success of this investment hinges on Atwood’s ability to find drilling contracts for their ships, changes in dayrates and oil prices. I have confidence in Atwood’s management to find the contracts and as for the dayrates and oil prices, they are tied to the scarcity of rigs and oil respectively. Demand for rigs and oil are increasing while supply cannot keep up. This gives me confidence in the fact that dayrates and oil prices would most likely not face catastrophic falls, leaving Atwood safe to go about their business in a productive and profitable way.

Dolby Laboratories

Dolby provides audio technology to a variety of customers; including software makers, consumer products, film makers etc. They have been growing their earnings steadily at 16.3% per year for the past 5 years. However, their PE has contracted over the years due to concerns with Dolby’s revenue growth, as can be seen from the chart below.

DLB Earnings Per Share TTM data by YCharts

Dolby’s revenue is broken up into Licensing, Product and Others. Licensing makes up north of 80% of revenue on average. One of the main components of Licensing is the PC market, which includes licensing from Microsoft Windows operating systems and software DVD players. There have been talk of tablets eventually taking over PCs or at the very least, taking over significant market share from PC buyers. Since Dolby has yet to make significant inroads into the tablet market, there have been worries that Dolby’s licensing revenue might be adversely affected. In my opinion, though the fears are substantial and there is a cause for worry, they might be overblown.

Dolby has already started to enter the mobile market and attach-rates for smartphones using Dolby’s technology have been in the mid to low teens. There is sizable room for growth here. Furthermore, Dolby recently announced the release of Dolby Digital Plus for the mobile market, which includes tablets. If the adoption rate is healthy, Dolby can see significant growth in their licensing revenue in the Mobile segment.

I personally feel that sound is a very important component of media content consumption and as more data is being transmitted around, there will be a need for data-compression, coding and de-compression technologies which are the bread and butter of what Dolby does. Mobile gadget manufacturers should most probably not want to skim on offering decent audio experiences to their consumers and with the release of Dolby Digital Plus, which can work on both smartphones and tablets, the chances are good that the adoption rate of Dolby’s new technology offering will be high. The main concern here is that margins will be affected as the margins for the PC market have historically been very high. This concern can only be allayed when Dolby starts to report significant revenue coming in from the Mobile market (inclusive of smartphones and tablets) and what investors can do now is to place good faith in Dolby’s management, which has shown themselves to be rather capable in maintaining margins thus far.

Besides Dolby’s inroads into the mobile segment, they are also trying to position themselves as the de facto standard for digital broadcasting. This will induce TV manufacturers to include Dolby’s technology into the TVs they manufacture. Dolby has already made significant inroads into China and will continue to concentrate their efforts in China as well as in India.

In my opinion, this potential licensing revenue growth from the Mobile and Broadcasting markets has not been priced in by the market yet – setting up a good opportunity for Dolby’s investors to experience a Davis Double Play. Of course, Dolby’s performance also depends on the macroeconomic environment with most of their revenue depending on consumers being willing to spend discretionary income on electronic products and that is something that Dolby’s investors need to look out for.

Conclusion

It takes a little digging like I did with Atwood Oceanics and Dolby, but if you can find companies selling at a PE ratio that is substantially below their historical growth rate while still exhibiting a reasonable chance of sustaining its growth, you can take advantage of the simple and powerful 'Davis Double Play' and be richly rewarded. Good luck!

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