Warren Buffett may be the most emulated money manager in the history of finance, let alone the past century. Unlike his mentor Benjamin Graham, Buffett believed that companies don’t have to be bought at a bargain to generate exceptional returns. Assuming a company is fairly priced, generates consistent profits, and has a competitive advantage stemming from a unique or low cost product/service, there is always an opportunity to beat the market. In most cases, Buffett and his team hold onto these companies for at least 5, 10, or even 20 years, so that’s why it was so surprising when the they sold their entire Intel Corporation (NASDAQ:INTC) position less than year after initiating it.
While many on the blogosphere were quick to point out that this was a direct violation of Buffett’s claim that “our [Berkshire’s] favorite holding period is forever,” this quote is almost always used out of context. The entire statement, which was made in a Berkshire Hathaway Inc. (NYSE:BRK.A) (NYSE:BRK.B) Chairman’s Letter in 1988 is:
We expect to hold these securities [Freddie Mac and Coca Cola] for a long time. In fact, when we own portions of outstanding businesses with outstanding managements, our favorite holding period is forever. We are just the opposite of those who hurry to sell and book profits when companies perform well but who tenaciously hang on to businesses that disappoint. Peter Lynch aptly likens such behavior to cutting the flowers and watering the weeds.
First off all, this claim was in context of two stocks that Buffett held for the better part of two decades, and The Coca-Cola Company (NYSE:KO) is still his top holding, worth $15.6 billion and 21% of his total 13F portfolio. Secondly,the case can be made that Intel lost its outstanding management when CEO Andy Grove in 1998. Grove, who invented the term “strategic inflection point,” built Intel into one of the world’s largest microprocessor producers. In short, a strategic inflection point occurs when an entire business shifts toward a new direction, and industry stalwarts can either sink or swim. Often times, failure and success are separated by the tiniest of margins, and a single product can make the difference in these situations. In Intel’s case, the company is facing a scenario that Grove warned of, and opinions are split on whether the company can maintain its dominance.
On September 7th, Intel cut its Q3 sales guidance by close to $1 billion, and now expects to generate between $12.9 billion and $13.5 billion in quarterly revenues on the back of disappointing inventory data and below-average PC sales. Since the announcement, shares of Intel are down over 13%, falling flatter than competitors like Advanced Micro Devices, Inc. (NYSE:AMD), Texas Instruments Incorporated (NASDAQ:TXN), and ARM Holdings plc (NASDAQ:ARMH). Only Hewlett-Packard Company (NYSE:HPQ), which has lost 17.7%, sports a darker shade of red over this time.
While it appears that Buffett’s decision to sell out of Intel was correct over the short run, it comes in contrast to other prominent financial philosophers like Ken Fisher, Jim Simons, and Cliff Asness. Here’s a complete look at every fund that is long Intel. Of these bulls, Fisher is the most committed, holding close to 20 million shares. While Fisher himself has described himself as “crazy bullish” in a recent interview with Forbes, it’s still notable that he believes in the same company that Buffett seemingly ditched his main strategy to dump.
The question then remains: how can Intel outperform the market between now and the next, let’s say, five years?
Well, there are a few ways this is possible, but it all starts with the company’s ability to create microprocessors for tablets and smartphones. For all intensive purposes, Intel is late to this scene, as competitors like ARM Holdings, which is estimated to account for close to 90% of all 32-bit RISC processors used in certain types of tablets, smartphones, digital music players, handheld video systems, and just about anything else that can be classified as a mobile electronic device.
Earlier this year, Intel finally released the first smartphone with its Atom processor, via a partnership with the India-based Lava International. The chip is also expected to be featured in Microsoft’s new Windows 8 tablet, which will be released on October 26th. The company is touting the Atom as one of the lightest, longest-lasting, and greenest chips on the market today, but the real kicker may be in what techies term “the Cloud.”
Other than the gradual shift from PCs to smartphones and tablets, the other primary inflection point in Intel’s industry is the shift from physical data storage to virtual data storage. The company’s newest chip iterations – the Atom D2500 and Atom D2550 – are geared toward serving as cloud storage devices. These versions of Atom are lower-power than those used in mobile devices, but are decidedly less expensive, and can be used by small business as well as larger customers. Consequently, we believe that Intel is more than adequately diversifying its next generation of microprocessors, and is set to capitalize on both the booming smartphone and cloud storage markets, despite being rather late to the former.
From a valuation standpoint, we can see that Intel has been beaten down by the bears, and may be a splendid value-play at the moment. The company’s stock currently trades at trailing (9.2X) and forward (9.9X) P/Es that are below the majority of its competitors, including Texas Instruments (19.8X, 13.3X) and ARM Holdings (55.4X, 30.4X). Only Advanced Micro Devices (9.3X) and Hewlett-Packard (3.9X) have lower forward-looking earnings multiples.
From a growth standpoint, Intel does expect its EPS expansion to slow down over the next five years, predicting annual growth of 10.7% compared to 22.8% a year over the past half-decade, but it appears that investors are over-discounting this pullback. Using five-year estimates, Intel is currently trading at a PEG ratio of 0.86; typically any figure below 1.0 signals undervaluation.
More importantly, this PEG is below the likes of Texas Instruments (2.20) and ARM Holdings (2.80). Advanced Micro Devices have earnings growth valuations more or less in line with that of Intel, but both are expecting EPS growth in the mid-to-low single digits over the next five years. We’ll gladly take Intel, the company that has the best combination of growth and value in its entire industry. From a book, sales, and cash flow perspective, the company’s stock is also trading below industry averages by discounts between 10%-33% depending on the metric.
Though margins have been compressed by higher-than-normal R&D spending to create its Atom chips, Intel still enjoys healthy leads in terms of both operating (31.2%) and net (22.7%) margins, above those of Texas Instruments (16.3%, 12.1%), Advanced Micro Devices (-4.6%, -9.9%), and Hewlett-Packard (-3.1%, -4.5%). For all intents and purposes, we expect Intel to challenge ARM Holdings as the industry’s mega-cap leader as it continues to complete its development of the Atom chip.
Though Buffett pulled out of this stock, individual investors may be best served by following the herd of funds that are still in Intel, from Fisher to Simons. It appears that there’s a deep discount here, and the company’s Atom chip can successfully navigate through the mobile microprocessor world while having an edge in the cloud storage industry. For a complete look at the hedge fund industry’s sentiment toward this stock, continue reading on Insider Monkey.
