The evening news was mostly focused on politicians bickering over the debt ceiling when we sent the November 2013 issue of Investor Advisory Service out to our subscribers. Although we couldn’t ignore the subject completely, we tried to look past the politically-charged headlines and focus our energy on material more relevant to the stock market. Analyzing the underlying state of the economy, we noted that U.S. growth remained a little tepid and that most of the growth that was happening seemed to be concentrated in sectors that are highly leveraged to interest rates, like autos and housing. It was good to see those sectors responding strongly to falling interest rates, but we would have liked to see broader-based growth. Meanwhile, the S&P 500 was up almost 30% over twelve months. We noted that stock valuations had finally rebounded to their long-term averages. With the S&P 500 trading at a forward P/E of 14.3, up from 12.9 the year before, we could no longer safely say that stocks were “cheap” by historical metrics. Still, we counseled our readers to stay the course, saying:
With the market fairly-valued and modest earnings growth, investors need to select high-quality companies with above average earnings prospects at reasonable prices. The payoff for this is far greater than watching any sideshow in Washington.
You can’t argue with that advice. If we saved anybody from reacting to the negative political headlines and selling, then we did them a favor. Over the past twelve months, the S&P has gained another 15%.
Each month we feature three companies we think are especially interesting and possibly timely investments. Let’s take a look back at one feature stock from the November 2013 issue, EMC Corporation (NYSE: EMC). EMC is a tricky company to understand. It owns VMware, a highly-prized maker of virtualization software which allows computers to run multiple operating systems simultaneously. VMware trades independently as its own independent company, and investors can buy its shares without owning any of parent EMC. However, EMC continues to own about 80% of VMware. Outside of its VMware ownership, parent EMC is a slow and steady growth technology company with a focus in storage, plus businesses in data analytics and security. On its own, parent EMC is a bit late in its natural lifecycle for our taste. It is past its growth stage and well into maturity by now. VMware on its own is still a growth company, but it is a little expensive for our tastes. The two companies combined offer sufficient growth and maintain to keep our interest, however.
The first reporting period after our feature brought a combination of slow sales growth, up just 5%, and surprisingly good cash flow growth, up 25%. Investors seemed not to know what to do with that mixed performance. Shares declined at first while the broader market moved, then they bounced back sharply as the market traded sideways into early 2014.
Fiscal Q4 2013 results were a different kind of mixed bag. Sales growth rebounded, up 11%. EPS increased 23% to $0.48. Forward guidance stunk, with sales expected to be up 5%-6% and EPS up just 4%, even with some benefit from share buybacks. VMware went on to lay an egg in Q1, reporting merely mid-teens sales and earnings growth. VMware shares dropped sharply, which hurt EMC shares as well. It takes more than mid-teens growth to satisfy investors when your P/E is hovering around 50. For its part, parent EMC had a good quarter and raised its dividend a little.
The next quarter, Q2, wasn’t very good, but EMC shares got almost a 10% boost because an activist hedge fund called Elliot Management started agitating for a breakup of EMC and VMware.
The breakup proposal piqued our interest. Whenever breakups can be accomplished naturally and neatly, we tend to like them. When companies are big and over-diversified, the different divisions can start stepping on each other’s toes. We’ve long believed that EMC shares trade at a discount to their intrinsic value, while standalone VMware trades above its intrinsic value. Part of the difference probably reflects VMware’s “favored status” as the growth engine within greater EMC. Simply put, we suspect that within the combined company, VMware gets whatever it wants while EMC pays a disproportionate share of the bills. We would view a breakup as modestly negative for VMware shares, but probably modestly positive for EMC shares. That’s simply our best guess. No breakup is in the works, and EMC management doesn’t seem particularly keen on dividing its empire anytime soon. Still, the stock has mostly held the gains from when the breakup idea first came out. At a recent price of $28.39, plus $0.43 in dividends, EMC has gained 14% during the past twelve months, almost exactly matching the broader market’s performance. 2014’s mediocre performance has put EMC on thin ice with us, but for now we continue to follow the company for our subscribers.