Rule #1 Finance Blog

With Investor Phil Town

HOMEWORK/4M COMPANY: COGNIZANT TECHNOLOGY (CTSH)

Phil_town_130 Dave Thomas is a realtor who is doing a little diversification of all that real estate money he's been making.  His pick is Cognizant Technology. CTSH does outsourced Information Technology solutions.  They just blasted through the tech downturn in 2001.  If anything it accelerated their business.  What that could mean is that the worse the economy the more business they pick up.  Pretty cool. 

The reason I'm writing about them now is because I've been getting a number of emails from people like Dave who have seen the potential of CTSH as a Rule #1 business. I will now confess that I've had this one on the side for some time, think the business is wonderful and that it's available at an attractive price.  So let's get this beauty out of the closet and show it the light of day.

MEANING:


If you don't mind digging into the Meaning of the business, you'll find it isn't all that hard to understand.  I'm telling you right now: This is worth reading up on.  IT ain't rocket science.  Far from it. I invested way too much money once in a business that could have but did not branch into custom IT software development.  I understood it and so can you.  So while Meaning is something that you have to come to grips with, if a river guide can do it, you can do it. 


This isn't a technology company like Micron where you don't know how they do what they do and you are right to be worried about whether someone can come out of nowhere and do what Micron does but better.  This outsourcing IT sort of business doesn't lend itself well to companies coming out of nowhere with a better mousetrap.  It's very relationship oriented. I like that about it.  Once you're into a client, you pretty much have to screw it up to get kicked out.  That means the business model is much more predictable and therefore much easier to put a value on.

MOAT:


CTSH has a whole bunch of really smart, mostly Indian, software engineers who do fantastic work, are experts in their field (the Secret Moat) and work for about 20% of what European and American engineers make (the Price Moat).  Their great expertise and fantastic price was combined by Mr. Narayanan, the CEO, with onsite consultancy right out of the IBM playbook.  That combination gives CTSH its Brand Moat as the only "onsite-offshore" company in the world. 


But do the numbers back up this big moat?  Do they ever!  With ROIC over 20% and all four growth rates over 40%, on all levels the whole Big Five is seriously off the chart.  And consistent?  Beautifully, wonderfully consistent.  So yeah.  Big moat.

MANAGEMENT:


It is run by Lakshmi Narayanan, who came on board about ten years ago when the business was founded as a division of Dow Jones.  He's pretty much awesome.  Put it like this: In India, the guy is a god with a small g.  His BAG (Big Audacious Goal) is to be the best IT outsourcing company in the world and by most accounts he's doing it.  How good is he?  Forbes named CTSH the best small business to work for in America.  For the third time in 5 years. He's that good.

MARGIN OF SAFETY:


So can we get this consistently fast growing, big moated, well led wonderful business at an attractive price?  If we lived in a rational world the answer would have to be "No".  But we don't necessarily live in such a place, and from time to time Mr. Market can make a big goof, especially on a business with a new kind of business model like CTSH.  So let's let the numbers do the talking and see if we can get that all important MOS:


First let's collect the ingredients for the cake:
 

  • We need the current trailing twelve months EPS (TTM EPS)
  • A reasonable PE
  • And a growth rate we're comfortable with for the next ten years. 
  • The EPS is a given. Just look it up on Investools or MSN. $0.95.
  • The growth rate is pretty easy given the consistency.  It's running about 40%.  Nobody can keep that up for ten years, though, so I'd dial it back to say 29% and still feel like I was pushing it a bit.  I pick 29% because it looks so much more conservative than 30% (and for another little reason I'll tell you below.)  29%, 30%, whatever. I just love it when I'm estimating way below the historical rate.  It adds a layer of safety to the numbers.  And remember we have to use the lower of the analyst's estimates or the historical.  I doubt the analysts are going to put up a 40% growth rate, but let's take a look:  It's automatic on Investools.  32%.  And at MSN you go to earnings estimates,  then click on the far right bar that says Earnings Growth Rates,  and then look at the far right of the table.  Same number: 32%.  So we can use that or our best guess.  Let's use the 29% thing.
  • The historical PE is automatic on Investools at 46 but you can dig it out of MSN Money by looking at Financial Results, Key Ratios, Price Ratios.  Our Rule # 1 PE is the lower of historical PE or two times the growth rate (not to exceed 50), which in this case is 58 — which exceeds both our 50 max PE and the historical 46.  So 46 it is.  Now we can bake the cake.
  • TTM EPS:  .95
  • Growth Rate:  29%
  • PE:  46

Now we can bake the cake.

A 29% growth rate divided into 72 (yup, its rule of 72 time) goes 2.5 times.

Now you know my dirty little secret about why I preferred 29% over the analysts' 32% – because it divides cleanly into 72 and gives me a number that works well for 10 years.  (Of such flimsy logic are these great projected edifices built.)  So at 29% we'll double our EPS every 2.5 years.  In ten years that's 4 doubles.

So here we go doubling away.  Let's call the $0.95 EPS $1 for us math challenged. Life gets so much easier when you round off.  1 to 2, 2 to 4, 4 to 8 and 8 to 16.  EPS in ten years for CTSH is going to be $16.

Multiply the $16 by the PE.  What'd we say?  46?  That's up there, but hey, it happens, and will if CTSH is still rolling.  That gives us $736 a share.  (And of course they'll split the stock if it gets that high, but it works out the same.)

Now some more Rule #1 magic:  Since we know our minimum acceptable rate of return is 15% compounded, we just divide the $736 by 4 to get our Sticker Price — because 15% per year will give us 2 doubles in ten years, which is one quarter of the future price.  Try it out.  It works.

STICKER:


$736 divided by 4 is $184.
That's the retail value or Sticker Price today if you want a 15% return and the analysts are right about the future. Pay more than that and even if things work out you'll get less than a 15% return.  The more you pay the lower your return will be. We don't like that. 

MOS:


We also don't like to take risk, so, since we've got a fast growing business that can slow down on us, we better put in a nice big margin of safety.  Half off sounds good.  So fifty percent of $184 is $92 and that, my friends is my MOS Price.  $92.

So what's this baby selling for today?  Ready for this?  It's selling for $49.  WOW!  Half off of half off!  I kinda get excited when I see that because I've seen it before on businesses that exploded up to where they should be priced in just a few years and produced returns like 45% compounded for 5 years.  (Go look at URBN in the year 2000 for an example.) So I gotta be liking this thing a lot.  A very lot.

So if things work out and we're in at such a huge discount to value what's our return going to be?


Let's assume that things do work out and the business is priced properly in ten years at $736 per share.  Since we're buying it today for one quarter of what it's worth, what's our compounded ten year return? Well, we got in at say $50 and in ten years we sold at say $736.  How many doubles is that?  50 to 100, 100 to 200, 200 to 400 and 400 to 800.  Just short of 4 in ten.  That's a familiar sounding number – like

2.5 years per double.  And we already know that that is 29% per year.  Wow!

29% per year. 4 doubles in ten years.  So $10,000 in this one could give us back somewhere around $160,000 in ten years.  You can get retired doing that. Don't believe me? Put in $20,000 and in ten years you could have $320,000, right? And if you make 15% a year on the $320,000, you're bringing in about $48,000 a year. $4000 a month. That's 'sit on the beach in Mexico drinking tall ones forever' time for a lot of folks. Isn't that amazing? You can go from being 50 and forever away from retirement to retired on a beach in ten years with one wonderful business that you got at a very attractive price. That's a pretty compelling reason to learn this stuff, me buckos.

So yeah, I'm in on this one, Dave.  I'm buying when it goes green again and I'm out on the reds. (It went all red a couple of days ago so I'm outta there simply because the bad news – if there is any — gets to the big guys first, and they create the red arrows as they sneak out of what might turn out to be a burning theater, if you follow my analogy… so I gotta go when they go to keep from getting burned … ever. Obviously most of the time the theater wasn't on fire at all. These guys smell smoke sometimes when it's being blown by other fund managers and they can't tell the difference so they bail.  Oh well.) 

For you folks who are on MSN doing this, you'll need to reprogram the MACD and Stochastics and you're stuck with a bit too fast of a Moving Average, but all three tools are in the ballpark.  I teach you how to reprogram MSN in my book Rule # 1, so I'm not going to go into it here. The book comes out in a couple of months.  Until then, use the defaults and wait for the lines to cross.  Granted it's not nearly as easy to read as on Investools but it has the advantage of being free — and when you ain't got no money you gotta do what you gotta do. 

So y'all, use what you got, pay attention, especially when you've got your hard earned money in there, and let's see what happens with Mr. Narayanan and gang.

Now go play!

Phil Town