Streetwise for Sunday August 31, 2008

Streetwise

Lauren Rudd

Sunday, August 31, 2008

In The End Human Judgment Wins Out

One of the most often asked questions is how I go about selecting the companies that appear in this column. The hoped for answer is that I have an algorithm that spits out “guaranteed to win” investment prospects, analogous to being able to pick a winning race horse. Having recently delved into thoroughbred racing partnerships, I can see a definite parallel.

You can collect endless quantities of data, analyze fundamentals and employ computer technology to spit out a never ending series of projections. However, until the race is run and the performance is posted you do not know if your selection was right or wrong. Prior to that point, subjective human judgment becomes the deciding factor and must carry the day.

While computers can run complex algorithms and analyze reams of data, compared to the human mind the most advanced computer is no more powerful than a dim flashlight. Please do not misunderstand what I am saying. Modern investment analysis would be severely set back if it were not for the ability of computers to carry out innumerable mathematical tasks on a repetitive basis. However, after slicing and dicing the data there is no substitute for human judgment.

Unfortunately, the human intellect is not immune to expectations and expectations are the "coin of the realm" on Wall Street. Expectations often include a large dollop of hope, some dreaming and maybe a prayer or two. Yet, it is not until those expectations are bathed in the harsh light of reality that we see the true picture of where we are and how we got there.

Too often we try to mold our view of reality to meet our expectations, when we should be doing exactly the opposite. The specter of the unknown can be a driving force that strips away logic, lowers expectations and create bargains for those astute enough to see through the emotional hysteria that so often envelops Wall Street.

Consider, for example, Seagate Technology. A year ago when I discussed the company its shares were selling for $24.50. My fiscal year GAAP earnings estimate was for $2.05 per share. The company recently reported $2.36 per share, a number that included the $113 million amortization of purchased intangibles, along with restructuring charges of $0.16 per share.

Going forward, Seagate expects to report first quarter FY 2009 revenues of between $3.15 and $3.30 billion, with net income per share of $0.18 to $0.22. For the year, Seagate is forecasting industry revenue growth of between 10 and 15 percent, which means its revenue number should follow suit. Gross margin for the year is expected to be between 21 and 25 percent.

The earnings and revenues are there and yet the shares traded recently at $15.69. So why has the share price declined? You can break the answer down into two parts. On a macro economic basis, a number of exogenous variables have driven the overall stock market lower. This goes back to what was mentioned earlier about expectations.

Investors are preoccupied with the credit markets, a slowing economy, rising inflation and a host of other problems that only indirectly impact Seagate but are causing investors to delve into the antacids.

From a micro aspect, Seagate has stated that its average selling price has declined somewhat over the past year and will continue to be under pressure in its 2009 fiscal year, thereby putting pressure on its profit margin. However, keep in mind that this has already been built into the company’s guidance.

Looking at the company’s intrinsic value, a discounted earnings model with a 15 percent discount rate and an earnings growth rate of 9 percent produces a $41 per share result. The more conservative free cash flow to the firm model produces a $43 per share result.