Staying within your circle of competence is a central tenet of value investing. It's clear that you're more likely to succeed by investing in situations, companies and industries you know well rather than by dabbling in the unfamiliar. Over the years, however, we've seen many instances in which investors -- either because they're overconfident or because they're searching for "hot" new ideas -- swing at pitches outside of their investing strike zone. As in baseball, the results are often disappointing.
Which is not to say you can't expand your area of expertise. Legg Mason's Bill Miller put it this way when we interviewed him a few years ago: "There's no reason to say, 'Here's my circle of competence, and it's never getting any bigger because I'm not going to learn anything new.' We're trying to understand new things if we can." We agree and, in fact, can find far more investing opportunities today than when we started out -- in large part because of a much broader base of experience on which to draw for insight. (For more on the benefits of investing outside of your comfort zone, see Investor Psychology: Too Close To Home.)
Expanding Horizons
Three of our recent purchases illustrate the diversity of ideas we find appealing today. Microsoft (symbol MSFT) is years removed from being a sexy growth story, but the recent market turmoil has left the stock shockingly cheap, in our view.
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Despite excellent earnings prospects stemming from the continued rollout of Windows 7 and the new Office 2010 software, Microsoft shares, at $24 in mid July, traded for less than ten times estimated earnings for the fiscal year that ended June 2010 (that's after subtracting from the price the $40 billion, or $4.50 per share, of cash on Microsoft's balance sheet). Considering that we're nowhere near a high point in the technology-spending cycle, that's far too cheap for a company capable of increasing earnings at a mid-teens percentage rate for the next couple of years.
Commercial lender CIT Group (CIT) is a different story. Crushed by rising loan defaults early last year and unable to get credit, the company filed for bankruptcy. It emerged from Chapter 11 last December after shedding $10.5 billion in debt, shrinking its asset base and accumulating nearly $10 billion in cash. Its opportunity today rests in attacking the uninspiring 2.45% its average assets earn in net revenue spread. While borrowers pay a healthy 9.5% on the average CIT loan, the company's average cost of financing is a sky-high 7.05% (the comparable cost at a healthy bank is closer to 1%). We believe that by refinancing and paying off its existing high-cost debt, and by taking in more low-cost deposits to its bank subsidiary, CIT can get its net revenue spread to about 4%. That would translate to annual earnings of roughly $5 per share. Were that to happen, the shares, recently $37, would merit a price-earnings ratio of at least 12, suggesting they could rise to $60.
Our third pick, BP (BP), is obviously controversial. Our ownership of BP is in no way a defense of the company or its handling of the devastating oil spill in the Gulf of Mexico for which it's responsible. Instead, it reflects our belief -- based on such precedents as the Exxon Valdez tanker disaster in 1989 off Alaska -- that the market's decimation of BP's share price overestimates the ultimate financial toll of the spill and underestimates the company's ability to cover those costs.
In terms of sheer dollar amounts, BP is the world's fourth most-profitable company. It's expected to generate about $22 billion in net income this year (before factoring in costs of the spill), making it highly likely that BP will be able to cover cleanup costs, damages, fines and legal settlements resulting from the disaster. It's also important to note that BP will pay these costs over many years. If our optimistic view is right, we think the stock, $34 in mid July, could rebound to $40 by the end of 2010 and to $50 a year later.
Columnists Whitney Tilson and John Heins co-edit Value Investor Insight and SuperInvestor Insight. Funds co-managed by Tilson own shares of Microsoft, CIT Group and BP.
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