Morningstar GrowthInvestor Subscriber Q&A

As editor of Morningstar GrowthInvestor, one of the best parts of my job is interacting with my subscribers. An occasional feature of GrowthInvestor is a subscriber Q&A in which I answer questions from my subscribers. Here are a few of the questions I have received recently.

Q: I currently have a position in  Medtronic (MDT), and the stock took a real hit this week. This could be an opportunity to add more shares. My concern is the timing of the upcoming earnings release. Do earnings releases impact your decisions on when to purchase stocks for your portfolios? How do you view these situations?

A: The market certainly did not hesitate to punish Medtronic when it warned that sales of implantable cardioverter defibrillators would decline by 6% in the first quarter and total revenue would come in below Wall Street estimates. I think your initial reaction to the price decline is the right one, given that this wide-moat stock is now well into 5-star territory and that the defibrillator slowdown is likely to be a temporary speed bump. All other things equal, the larger the discount to intrinsic value, the more you should be willing to buy a stock. As fund manager Bill Miller likes to say, "Lowest average cost wins!"

In regard to your timing question, I understand your concern. It is no fun to purchase a stock right before a quarterly earnings release and then watch it plummet because some bad news was announced. However, as an investor, you should focus only on what matters and what is knowable, and then have a margin of safety to compensate for your errors. In the case of Medtronic, what matters is the firm's ability to innovate over the long term. Ten years from now, the performance of your investment will depend on that fact, not on the company's results during an arbitrary three-month period.

Moreover, even if you knew exactly what Medtronic was going to report in its quarterly earnings, could you know how the market would react to it? I've seen stocks react in a seemingly random fashion after earnings releases, which is why Ben Graham was spot on when he said, "In the short run, the market is a voting machine--reflecting a voter registration test that requires only money, not intelligence or emotional stability." Since short-term price movements are unknowable, why waste brain cycles thinking about it? Especially when the same brain cycles can be used on an important task, such as analyzing Medtronic's business. So to answer your question: No, the timing of earnings releases does not affect my decision to buy or sell a stock. The primary determinants of whether I purchase a stock are the margin of safety and other opportunities in the market.

Q: How does a company like  Qualcomm (QCOM) get an "A" rating on stewardship when top leadership is passed within a family from one generation to the next? While there may be good experience gained by working in the family business, I always find it hard to believe that a company has put the very best person in charge when the board allows a family member to take over the reins. I certainly understand how and why it happens, but it seems to me that the overall stewardship should be questioned.

A: I agree with your assessment about dynastic management. Promotion by surname is not likely to produce the most capable leaders, especially when the apple falls far from the tree. However, after speaking with analyst John Slack, who covers Qualcomm for us, I think Qualcomm deserves an "A" Stewardship Grade (although it's a borderline "A"--the company scores 90 out of 100 on the scale for Morningstar's Stewardship Grade, which is the lowest possible "A"). Qualcomm's options issuance has been fairly small in recent years, and its financial performance disclosure is arguably some the best in the industry. In addition, the company eliminated its staggered board of directors earlier this year. Each director will now stand for election annually. That said, grading a company's stewardship is more an art than a science. If you think Qualcomm's management succession should disqualify it from receiving an "A," I would not argue with you.

Q: Could you possibly indicate whether  Maxim Integrated Products  is still a buy?

A: Yes, I absolutely think Maxim is still a buy. Along with  Symantec (SYMC), Maxim is one of the two purchases I've made since taking over the Growth Portfolio, and I don't regret the decision. Sure, it would have been great to have waited and purchased at a lower price, but I do not attempt to predict short-term stock movements (because I can't). Instead, I let a company's operating results, not the market price, tell me how my investment is performing, and nothing has happened in the last three months that would change my mind about Maxim. Yes, the company appears to have improperly granted stock options and such behavior is unequivocally wrong. But, in this case, I think the good far outweighs the bad.

Maxim revealed yet another year of steady value creation when it reported results in early August. For fiscal 2006, Maxim increased sales by 11% to $1.86 billion and generated $463 million of free cash flow. In addition, the company increased its quarterly dividend by 25% to $0.156 per share, or a 2.3% yield at current prices. Maxim is still a dominant wide-moat analog semiconductor company with excellent growth prospects--the only difference is that it is now available at an even cheaper price. As an investor, you should welcome this development.

Q: I am considering a purchase of  Activision  but am concerned about the high price/earnings and price/cash flow numbers. Why are these ratios so high?

A: According to Morningstar.com, Activision's P/E and price/cash flow ratios are 88 and 40, respectively, or high enough to make any value investor blush. These numbers, however, do not tell the whole story. With any ratio calculated by dividing the stock price by some annual figure, you need to ask whether the past year is a "normal" one in which nothing particularly good or bad happened to the business or the industry. Otherwise, the ratios will give you a distorted view of the situation, as they do currently with Activision.

The video game publishing industry is cyclical, and the past year has been a rough one in which profit margins have been squeezed from both directions. When the industry makes a transition to new game consoles such as  Microsoft's (MSFT) Xbox 360,  Sony's (SNE) PlayStation 3, and Nintendo's (NTDOY) Wii, sales of video games slow as consumers wait for the new consoles. As if that is not enough, Activision has to increase spending to develop games for the new consoles, even though the installed base of new consoles is not yet large enough to generate significant video game sales. Needless to say, the past year as not a "normal" one for Activision. In fact, the transition year is the worst year of the roughly five-year industry cycle. Accordingly, I think this is a bad starting point for an analysis of any video game publisher.

To effectively use price ratios to evaluate cyclical companies, you should take an average of earnings or cash flow over the entire industry cycle, or, if you're up to it, try to forecast the company's sales and profits in a normalized year. I've mentioned this before, but it bears repeating here. Ratios are a quick way to screen a large number of companies, but they cannot tell you what a stock is worth. To get an estimate of intrinsic value, you have to discount all of a company's future free cash flow to the present, and that is exactly what the analysts at Morningstar have done for more than 1,800 stocks. Despite a high P/E ratio, our detailed model for Activision gives a fair value estimate of $18 per share, and that seems entirely reasonable to me.