DST Systems Incs (DST) State Street Investment Portfolio Makes The Stock Undervalued, According To Scharf Investments Founder
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Jeffrey R. Scharf is the founder and managing member of Scharf Investments LLC. After graduating from the University of California with a degree in Economics, he became a successful private investor. During his years of private practice, he saw that performance did not always match promise in the financial services industry.
Scharf Investments was founded in 1983 with the goal of filling this gap. Mr. Scharf writes a bi-weekly newspaper column entitled "Everybody's Business" for the Santa Cruz Sentinel. He has had articles published in Barron's magazine. He has been a lecturer in Economics at the University of California at Santa Cruz and has been a featured speaker at investment symposia in New York City and Santa Cruz.
TWST: What about international exposure in the growth area? Do you have international companies or do you favor companies with international operations?
Mr. Scharf: We do favor international exposure. Our four themes are high quality, recurring revenues, global exposure and low valuations. Global exposure doesn't mean you have to own a stock with headquarters domiciled outside the U.S., but a global business footprint is definitely desirable. We are expecting a rather Japanese-like economy in the U.S. for a number of years, so growth should be faster in emerging, developing markets. Companies that are exposed to those markets should do better than purely domestic U.S. companies. So we own Nestle (NSRGY); we own Cadbury (CBY); we own Alcon (ACL); we own Novartis (NVS). We own Canadian National Railway (CNI), although CNI is North American rather than global.
TWST: What are some examples of stocks you've bought in the past year that are representative of your investment approach? Did you buy them at a low price?
Mr. Scharf: About a year ago, we bought Alcon. Alcon has a very good business in ophthalmology, has excellent growth, has good demographics, and the aging population needs more cataract procedures and supplies. Nestle sold 25% of the company to Novartis for $143 a share in 2008, and in the 2009 panic, Alcon stock collapsed all the way into the $80s. Novartis had a second-stage deal where they could buy Nestles remaining 50% interest for $181 a share. So you had a stock that a presumably intelligent buyer had an option to buy at $181 that was selling in the $80s.
The $80s were about 13 times earnings. You look at that and you ask, "How can that be right?"; Novartis would have had to be extremely stupid to have paid that much money if Alcon was only worth $80. If the value of the stock was anything close to what Novartis paid, it was worth a lot more than it was selling for. That was a really great opportunity. We also bought a more mundane company like Wal-Mart (WMT), which was then in the upper $40s. Wal-Mart's earnings have held up much better than other retailers. The stock was selling for between 12 and 13 times what we think they will earn in their 2011 fiscal year, which was extremely low by historical standards.
Wal-Mart is a much better-than-average company; 20% to 25% of their business is overseas, growing at about 15% a year. Maintaining that pace results in 3% to 4% growth plus another 2% to 3% from same-store U.S. sales, maybe a little bit from growing square footage in the U.S. plus some additional EPS kicker from share buybacks. You could have dependable 10% or 11% growth for 12 or 13 times earnings. That's very attractive in an economic environment where consumers are going to be frugal for a long time to the benefit of companies like Wal-Mart.
TWST: You are overweight in technology. What areas of technology are attractive to you at this time?
Mr. Scharf: This goes back to our theme of looking for recurring revenues in a slow economy. A business that has recurring revenues, whether it's ongoing data processing or McDonald's selling hamburgers every day, or a food company like Nestle selling food every day, we think that business will hold up much better in the economy that we foresee than cyclical businesses will. Within the technology area, we own ADP, which processes payroll and beyond payroll with services related to the miscellaneous deductions that employees make.
It's a very steady business and although high unemployment and low interest rates hurt them, overall it's very stable and generates a lot of free cash flow. The stock at this point is fairly valued and toward the upper end of where we expect it to be. So it's not something we are buying more of, but it is something we're holding onto. Fiserv does processing for financial institutions. Like ADP, they collect revenue for providing services that are needed and will continue to be needed. DST's primary business is processing mutual fund information.
In addition, they have an investment portfolio, the largest element of which is State Street. At the low for DST last year, which was around $28 - I think we bought it in the low $30s - you could isolate the investment portfolio and pay seven times earnings for the operating business. We felt this was unreasonably low. There was a double discount because the value of the investment portfolio at that point was also unreasonably low. We feel that if you do the same analysis on DST today, you're paying about 10 to 11 times earnings for the business and getting an investment portfolio, primarily State Street, that's somewhat undervalued as well.
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