When an accounting lie comes up at a publicly traded company, I often think of Benjamin Graham’s advice to never consider the stock as a suitable investment because the accuracy of the numbers presented is a necessary component of estimating fair value. Knowledge of revenues, profits, and other critical figures form the basis of how we determine whether an asset is overpriced, fairly priced, or cheap.
It is also true that Graham’s thesis developed at a time when the majority of American success stories required heavy capital allocations as a source of value, whereas now the excellent businesses rely much more on the networking effect on users and are correspondingly asset light, i.e. if a water utility company lied and falsely claimed too many customers and profits, the disaster is that all sorts of debt provisions could cause the balance sheet to crumble its way to bankruptcy. Now, if a company like Google committed a similar mistake, the effects would be dramatically less because the business model is successful to the extent that you visit google.com when you want to look up a matter.
And broadly speaking, uncertainty is a compensated risk. Pepsi trades at 20x earnings not because it is growing so fast, but because you know exactly what you’re going to get: a 2-3% dividend and 5-9% long-term growth with similar capital gains. The predictability of the earnings streams is why businesses like Pepsi deliver shareholder returns that result from the business performance rather than P/E ratio/valuation expansion.
When future earnings are uncertain, and the price declines substantially, you are being paid well to “absorb” the uncertainty. As long as there is no impairment to the business itself, massive share dilution, or bankruptcy, the P/E ratio expansion when the business returns to normal delivers exceptional returns to the investors that moved in at the moment of uncertainty.
This investment philosophy context was on my mind as I considered Friday’s news item that Symantec had disclosed an internal audit of the accuracy of its numbers and the plaintiff’s bar has already begun soliciting Symantec shareholders to serve as the lead plaintiffs in a shareholder lawsuit that alleges breach of fiduciary duty for giving materially false information to investors. Symantec stock (SYMC), which had traded around $30 per share, lost a third of its value in a single day upon the disclose, and fell in price to $19.52.
Trying to figure out if the stock is one sale is not as simple as looking to the expected 2018 earnings of $1.82, seeing the price of $20, and conclude that the stock must be cheap at 10x earnings. We aren’t the “e” part of the P/E ratio is accurate, and therefore, cannot easily have that type of numerical analysis.
But we can look at the business broadly. Symantec operates within the cyber-security industry, protecting intellectual property and financial data from hackers, viruses, malware, and theft. It provides cypersecurity products to corporations, an area that earns 25% net profit margins in a field that is expected to rapidly increase over the next generation (the industry grew by 8% over the past decade, and the cybersecurity industry is currently growing at a 15% rate overall, suggesting a very nice tailwind).
Symantec also owns Lifelock, which has operating margins near 50% (granted, we do not known if these numbers are misstated, but identity protection companies do earn profit margins of around 42% as a class, and given Lifelock’s industry-leading position, I would expect it to have higher profit margins due to the economies of scale that it is able to harness).
If someone decides to purchase Symantec at this current level of $20 or below, I would call it an “intelligent speculation” or a “well-compensated high-risk investment.” I would not put money “I need to have” into this stock due to the unresolved accounting issues but I would take a hard look at it, otherwise. The cybersecurity class of investments have done well, are poised to do well, and throw off extreme amounts of cash on invested capital.
To the extent that Symantec can emerge as even a typical participant in this industry, the recovery “pop” plus the expected earnings growth for all industry participants is something that catches my attention. If I had to guess, I would say that Symantec has a two-thirds chance of dramatically outperforming blue-chips like Procter & Gamble and Coca-Cola over the coming three to five year stretch. The risk is the 1-in-15 chance of something really, really bad developing as the accounting issue. At $30, or even $25, I wouldn’t think this risk of the unknown was compensating investors enough. At $19 per share, new Symantec investors have a 1-in-15 chance of dramatic underperformance, a 3-in-15 chance of extended underperformance, a 1-in-15 chance of modest outperformance, and something like a 10-in-15 of very high outperformance.