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I’ll Take the Double

ctsh

On May 28, 2013, we purchased our position in Cognizant Technology Solutions at $64.20 (which split 2 for 1 on March 10, 2014) and today hit $64.71, up 10% on the day. We were able to double our investment for a bit over a 100% gain in under two years.

As you look at the chart above, there is one thing that really stands out to me – during 2014, this company traded in a side ways to down pattern, with a loss on the year of about 20%. We opted to hold onto our shares during this time because our analysis of the company showed that it was operating at the top of its game.

Below I’ve excerpted some of the items from our internal analysis of the company:

1. Operating Performance

ctsh-operating-performance

Earnings Per Share growing at > 21%
Sales growing at > 25%
Book Value growing at > 21%

These are great metrics and indicate that the company is operating on all cylinders.

2. Operating and Valuation Ratios

ctsh-key-statistics

As you can see from our Key Statistics grid, this is a company that is an investors dream. A couple of highlights from this grid are: 1) Its return on invested capital – a measure of how efficiently management is using investor capital to generate returns – is three times is cost of capital, a truly amazing achievement; and 2) Its PEG ratio is 1.29, indicating this company is currently trading at just 29% above its growth rate, making it somewhat of a bargain particularly in light of #1 above.

3. Valuation

ctsh-over-under-valued

The grid above is one measure of how I calculate whether a company is over-valued or under-valued at current prices. I like to compare the current price of the company’s stock to its historic price multiple – but for this calculation I blend together the price-to-book, price-to-cash flow, and price-to-earnings multiples for the past 10 years. You can see that based upon this calculation, the company is undervalued even after its run higher over the past two years.

4. Proprietary Ranks

ctsh-ranks

I’ve written on the blog several times in the past about our proprietary ranking system that ranks a universe of 6,000+ stocks on a bell curve based upon two sets of ratios. One set of 18 ratios provides an Earnings Growth rank and the other set of 10 ratios provides a Financial Strength rank, with zero being the worst and 100 being the best. Since it is a bell curve rank, the bulk of the ratings fall in the middle with few companies at each end. Cognizant ranks quite high on both measures, providing that enviable position of having strong and sustainable earnings growth while not taking too much risk from a balance sheet perspective.

5. Free Cash Flow

ctsh-free-cash-flow

Free cash flow is the amount of cash available for dividends, share buybacks, book value growth and future shareholder rewards AFTER investment in property, plant and equipment. It is an important metric in a large cap company and I prefer to look at it in comparison to its history. As you review the bar graph above, you can see that CTSH has had a steadily growing FCF over the past decade and is supportive of the return on invested capital calculation above in identifying how efficiently management is operating the company to the benefit of the shareholders.

After a review of the financials I am comfortable continuing to hold onto this investment even though we have doubled our initial investment in it. In today’s investment world, investors have too short of a time-frame for their investments. The price performance during 2014 likely caused many investors to sell out of this holding without analyzing its operating performance.

The pressure on investment managers to beat the index on arbitrary time-frames like monthly, quarterly and yearly cause many to dump potentially lucrative holdings in favor of a momentum stock that is doing great today but might not have the operating performance to sustain a price move like Cognizant’s.

The lesson to be learned from this investment is that stock price will ultimately reward superior operating performance. It is not always easy to stick with a company whose stock price is not following the market, even when the company’s operating performance shows that the market is mispricing it. The mispricing is actually an opportunity to buy (or hold onto it if you bought earlier) that will ultimately reward you in a meaningful way – maybe the mispricing will not resolve itself as quickly as CTSH did but ultimately it will. Investors and investment managers just need to look longer term and not surrender to the pressures of trying to beat the index in the short-term.

Mark