gameguru (38.22)

No More Mister Nice Guy: My First Red Thumb

April 09, 2007 – Comments (2)

I just gave up my "Yes-Man" charm by calling underperform on my first stock since joining CAPS. Personally, I wish that charm wasn't quite so strict, perhaps indicating individuals who "primarily" (by some measure that we could debate) call outperform. So why a red thumb from me now? Have I discovered some insanely over-valued stock or a scam of a company that is sure to plummet toward bankrupcy? Have I uncovered the next great short opportunity?  Not in the least.

My initial red thumb is, perhaps paradoxically, on a company that I consider an absolutely wonderful company, who produces products that I use and love, and that I believe will continue to steadily grow for years and years. It's a company I've been investing in since the post-Bubble years, and have made some decent returns on (about 13.5% annualized over the last 6 years). The company is Adobe (ADBE).

Have I gone nuts? I'm red-thumbing a company I love and that I think will continue to do well into the future? I keep asking myself this question, but I can't be honest with myself and NOT red-thumb it.

The way I approach CAPS, and the reason all my calls to date have been on the outperform side, is that CAPS is an interesting way to provide a public record (albeit somewhat impoverished) of my thinking and decisions as they relate to investments (this is why I nearly always give a pitch for my calls - when I don't, I intend to come back and provide one later). Because I have never shorted a stock, I focus on stocks that I believe will outperform on average. This creates a selection bias - if a stock doesn't look like it may be a candidate for outperformance upon my first examination (which may take all of 5-10 minutes), then I move on. If it does look like a potential candidate, before making an investment decision, I'll spend time looking into the financials and the company's prospects, creating a valuation model, and estimating the potential for growth. All of this can take quite a bit of time, and I personally have to go through that process before I can convince myself that I have the confidence to either invest real money in the stock or publicly declare that I believe the stock will outperform. Because of that selection bias, I don't go through this process with stocks that might be potential underperform candidates, and so I am unable to form a confident opinion on whether such stocks will outperform or will merely match the market (they might also outperform, but my initial instincts told me that this is unlikely). Hence, no red thumbs from me. 

Usually, I try to take a somewhat Buffett-esque approach by "eliminating the sell decision" through trying to select stocks with sustainable current cash generation and growing future prospects that I can buy and hold forever. Many times, when I have new money, my best investment idea is a stock already in my portfolio - again limiting the number of stocks I'm likely to rate in CAPS. (Two stocks already in my portfolio that I've been focusing on recently are COF and CCRT. CCRT recently became a super-bargain when it dropped below $28 - it has since recovered - and if my mother asked me for one stock to invest in, I'd tell her about Capital One. Both are in negative territory for me in CAPS, but I'm willing to wait...) I had bought multiple positions in ADBE in 2001, and thought that this could be a stock with a "forever" holding period. However, the recent valuation has simply become unjustifiable to me (and I may be wrong, of course), to the extent that I couldn't confidently continue to hold the stock. So I sold my entire position earlier today. Since I do want CAPS to reflect my thinking (if not always my actions), the corresponding action to take in CAPS was obviously to red-thumb Adobe, and that's just what I did. If this is a stock that I'm not willing to hold (and will take the LTG tax hit on), then I'm obviously fairly confident that it will underperform.

I must admit, there was a small psychological hurdle in losing that "Yes-Man" charm (and maybe that's actually a drawback for CAPS, since it might discourage others from contributing their underperform ideas) and to stepping over to "the Dark Side" (red does seem a more ominous color than green...). But I'm past it now, and hopefully I'll be more likely to call underperform when I happen across a similar situation (it may be some time, since my investment decisions tend to move at a tortoise-like pace, and I don't actively search for underperforms, as explained above).

If you're like me, let me encourage you now to throw off your "Yes-Man" mantle and to embrace your inner Grouch - if you have a company you think is poised for a fall, or just a stagnant period (and you think the S&P will ascend) - paint your thumb red and let us know about it. What was your first red-thumb stock and why? What other psychological barriers have you encountered in CAPS?

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I've copied my ADBE pitch below for those interested in the full reasoning, but not willing to search out the individual pitch:

I love Adobe’s products and I’ve been an investor since just after the Bubble deflated in 2001. Historically, Adobe has had fantastic ROE and ROIC numbers (20-30%), but they have recently dropped off to about 10%. I do expect management to push those numbers back up, and the Adobe growth engine to chug along at about a 15-20% rate. They are building a virtual monopoly, and I believe that Adobe will continue to be the leader in cross-platform solutions for design and content-viewing (e.g., e-Books and the paperless office). So why my first thumbs-down in CAPS? Valuation, plain and simple - I just can’t justify a stock price of more than about $30-32, which means at current prices, Adobe is about 30% higher than my highest value estimate. Even with the lauded introduction of Creative Suite 3, management is anticipating only 15% top-line growth. Yet, my models (11.3% discount rate, 2% terminal rate and using forward estimates as the starting value) estimate that ADBE would require 20-26% growth for the next several years to justify a $42+ price tag. Even in the best case, I don’t think that kind of growth is sustainable over years, and if there are any hiccups, the stock will certainly suffer.

I also don’t like management’s continued reliance on stock options. Adobe was very resistant to options expensing, adopting it only at the beginning of 2006 and choosing not to adjust prior results for comparative purposes. Options expenses were ~$170.5 million in 2006, or about 25% of unadjusted income (adding expenses back into income). To mitigate the dilution from options (diluted shares rose by 20% from 2005 to 2006), they have been aggressively buying back shares, spending over $1 billion at an average price of $34.10/share in 2006. If I’m right that shares are overvalued, management’s insistence on continued repurchase agreements becomes a material cost to investors. Hopefully, Adobe will change its behavior to minimize option expenses going forward, but I’m not optimistic on this point. (In fact, they just announced another $500M in buybacks today – stated reason: to offset dilution from issuing shares. Rebuttal: Don’t issue so many shares!)

I think this is a case of a generally well-run and growing company temporarily selling at an unsustainable level, so I’m putting a short time-frame on my underperform call and will end it if the stock falls to a more reasonable valuation in the mid-to-low $30s. I’m also selling my real-money stake and taking my ~120% gains (about 13.5% annualized – not great but not too shabby given the tech environment for the last several years).