A value hunter like Benjamin Graham might be overjoyed by the number of companies entering a “buy” range in the current market. In this Smart Money interview with Cabot Benjamin Graham Value Letter editor J. Royden Ward, Ward names two great American companies that meet Benjamin Graham’s value principals and should make great investments for 2008.
Transcript:
WSR: Cabot Benjamin Graham Value Letter. The markets have had a real rough start to 2008, but an investor who seeks value may be finding opportunity. What would Benjamin Graham think of the markets right now?
WARD: Ben Graham looked at stocks first and the market second. So I think he would see a lot of undervalued stocks to choose from and would be happy that there are some really good companies at undervalued prices. So I think he’d be happy with this market.
WSR: When stocks become undervalued, when do you typically know that they are undervalued? What are some of the key metrics that Benjamin Graham would really be focusing on, in times like this?
WARD: He’d be looking at PE ratios, certainly, and also price-to-book value ratios, and he would be very cautious about whether the outlook for any particular company or industry is going to be positive this year. He didn’t like investing in companies where the earnings might be down during a year.
WSR: So he would have to do some sort of forecasting to see if 2008 would be positive, that would rule out maybe many of the financial stocks at this point.
WARD: Yes, it would. I don’t think he’d be buying financial stocks, because number one, the outlook is cloudy, and number two, it looks like the earnings are going to be down on a majority of the banks and financial institutions.
WSR: Let’s discuss some of the stocks that you’ve covered in your newsletter. If you had to pick two stocks to buy in 2008, that really matched up with Benjamin Graham’s value model, which stocks would you pick, and give us the bulls’ case why they fit Benjamin Graham’s model?
WARD: I would pick a couple of stocks that I feel are undervalued and are undervalued using Ben Graham’s criteria, and those two would be AT&T and IBM. AT&T has really transitioned into the largest telecommunications company in the US. Lots of people don’t realize that their revenues have gone from $40 billion to $120 billion since 2004. There have been several mergers and several major acquisitions that now make up AT&T, and I think the potential for cost savings is tremendous there. When you triple your revenues, there is lots of room to cut costs, and I think that’s what AT&T is in the midst of now and will continue. The operating margins have been improving the last several years, and it looks like they are going to improve again in 2008, and that’s a very good sign.
WSR: You just mentioned one of Benjamin Graham’s principal criteria is a positive forecast for the coming year or years. Do you see that coming out of AT&T?
WARD: Yes. AT&T it looks like will earn $2.80 for 2007 as opposed to $2.34. That’s a jump of almost 20%. And then for 2008, I think we are looking at approximately $3.15, and that’s a jump of another 12% or 13%. So far things are looking pretty good.
WSR: Do you attribute some of these earning gains to the headwinds that they have made in the wireless market? They are really expanding wirelessly. Is that a benefit for them?
WARD: That’s their primary growth. You hit that right on the head. Their landline growth, of course, has diminished a great deal, but wireless really is looking good.
WSR: Today, we have the stock trading at $37.77 last I looked. Where could it possibly trade if multiples begin to expand back to their normal levels?
WARD:
In the Cabot Benjamin Graham Letter, we come up with buy targets and sell targets, and right now, my buy target for AT&T is $41.44. So it’s selling considerably below what I think the fair value should be right now. I think the potential in the stock within the next year to two years is at about $59.67, or about $60. So I think it’s got a 50% upside in the next year or two because it is well undervalued now and it should become fairly valued in the future.
WSR: Is their business somewhat insulated from a US recession, if we do indeed fall into one, or will people use their phone less or not buy a new cell phone, because of it? What is your opinion?
WARD: I think parts of the business will be affected, but I think other parts will continue to grow such as wireless will continue to grow at a rapid rate, so that when you put it in together I think the growth is going to be pretty strong for 2008, along the lines of revenue growth of about 4% to 5%, which for a big company like AT&T is good.
WSR: Your second name you mentioned was IBM. They had a very positive announcement. The market was really waiting for someone to affirm their 2008 guidance and kind of say, “Hey wait, everything is not bad for everyone”. And IBM did that and it actually may have sparked a market rally. So what is Benjamin Graham’s case for IBM in 2008?
WARD: Again, it’s selling at a very reasonable price, it’s actually about I have at a 12.6 times what I expect for earnings in 2008, and only 14.6 times of last year’s earnings. For a growing technology stock, that’s very inexpensive. It pays a good dividend. They increased their dividend recently, and has a 1.6% yield. The case is it’s undervalued at 12.6 times earnings.
WSR: I guess a lot of Wall Street had been discounting this stock because they saw slowed down business. Businesses would slow down if the consumers slowed down, that whole vicious cycle. What’s IBM’s business most closely tied to?
WARD:
They have transitioned from a hardware type of business to software and services. They’ve also expanded their overseas operations greatly. They get about 65% of their sales from overseas, especially emerging markets. And I think that combination with the service and the software and the overseas is going to keep their earnings growing even if the US economy slows a bit. I tend to agree with a lot of investors that technology could slow down along with most of other industries if the US economy slows, but I think in the case of IBM that it has got so much overseas business and they are in the right niche of service and software that they are going to see good earnings and sales growth in 2008 and beyond.
WSR: What are your buy and sell targets for IBM?
WARD: For IBM, it’s selling for $102 even right now, and that’s about where my buy target is. My buy target actually is $102.89, and my one to two-year sell target is $141.93 or about $142. So within a year to two years, I think IBM will quite easily hit that target.
WSR: That’s an estimated gain of maybe 40% for one of this country’s biggest and most well recognized technology companies.
WARD: Right. It’s not a 100%, so we are not trying to hit a huge home run here, but if you can make 40% in a year or even year-and-a-half or two years consistently, and that’s what Ben Graham always was striving for, if you can consistently earn 20% or so a year on all your stocks that’s a good goal to have. IBM and AT&T certainly fit into that scenario where we are looking for good steady growth that we can count on. END.
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