“January Stock of the Month … hold on to your hat”

Cabot says, "Add this one to your holdings now."

By Travis Johnson, Stock Gumshoe, January 17, 2013

The folks at Cabot are unabashed fans of growth and momentum, which can certainly work as an investment strategy even if it isn’t the strategy I tend to follow personally … the market loves businesses that are growing, and that love turns into higher prices if the growth builds on itself, even if the stocks often look too expensive.

And they try to pull out what they think is their best idea from across their several newsletters as the “Stock of the Month” for the Cabot Stock of the Month Report newsletter … which carries the subtle subtitle, “The best stock to buy right now.”

So what do they think is the best buy right now?

They compare every single one of these “stock of the month” picks to First Solar, which gets a bit tiresome, but they do make this pick sound appealing … here’s how they pitch it:

“Just Look at our January Stock of the Month and You’ll See Why I Can Make You this Money Doubling Guarantee

“Like First Solar, this company is also riding the wave of profit growth but in the unstoppable mobile computing sector where it profits from virtually every smart phone, tablet, digital TV and set-top box that’s sold in the world.

“How can this be?

“Because the company holds—hold on to your hat—a whopping 800 processor chip licenses that more than 250 BIG NAME companies MUST pay for in order to sell their digital products.

“I speak, for example, of Intel, Samsung, Texas Instruments, Atmel, Nvidia, and Qualcomm—not to mention Apple.

“So it’s no wonder the company has handed investors 1338% gains over the past 10 years as its technologies are used in 90% of all smartphones, 80% of all digital cameras, and 28% of all electronic devices of any kind—with 20 billion chips shipped to date.”

Need a bit more hintifying? Here you go:

“With the stock up 27% in the last 90 days, the company is clearly on the move.

“This is why insiders at JP Morgan and Fidelity, along with 18 other top institutional fund managers, together, own more than 70 millions of shares worth over $2 billion because they see what we do here: another First Solar that’s handed us 321% gain to date.

“That’s what makes this recommendation our January Stock of the Month.

“My advice: Add this one to your holdings now. Over the past five years, as the smart phone sector has grown, the company has out-performed virtually all of highflying clients (including Apple) by as much as $4-to-$1 with nearly 80% average annual returns.

“We see the company delivering another 80% rise in 2013.”

So … who is it?

Toss it all into the Thinkolator, and that’s plenty of clues for us to get a nice clear answer: This is Arm Holdings (ARMH)

Which has indeed been a favorite (off and on) of momentum and growth investors for a couple years now. They are a semiconductor design company, and more importantly a holder of patented basic chip architecture designs for some of the in-demand low-power mobile chips that everyone needs now for mobile phones, earning royalties on the manufacture and sale of chips based on their designs.

There are a lot of companies who design but don’t build semiconductor chips — they’re called fabless chip companies, meaning they create chips but outsouce the actual fabrication of those chips to someone else, typically the massive chip factories run by folks like Taiwan Semiconductor. Arm Holdings shouldn’t be tossed in a basket with the fabless chip companies, though, they don’t market or sell individual chips but do the background R&D for the design of whole classes of chips. You can see the basic outline of how the company works on their website here if you’re curious.

The argument for Arm Holdings is that they can turn relatively small investments in R&D into very long-lived designs that can be used by hundreds of customer companies and generate huge royalties over the life of the design. The chip companies don’t want to design basic architecture, with the exception of gigantic platform companies like Intel (INTC) it’s cheaper and easier to license an established design and tweak it for your needs. Arm Holdings has done extremely well over the past five or six years largely because of their dominant position in mobile chips — while Intel was designing faster and faster chips, Arm Holdings was still focused on what was the unglamorous pre-smartphone mobile chip business and therefore targeting more efficient chips that use less battery power, which is obviously a primary concern for mobile devices (but largely irrelevant for desktop PCs).

ARMH had a dramatic run into the pricking of the internet bubble back around 2000, though the company was a bit different back then, and has had a major, major run since the 2009 market bottom, going up by 700% or so in just the last three years. And frankly, it’s probably still my crustiness coming through but I’ve never been able to convince myself to buy this stock. To my regret, at this point. Louis Navellier teased them as his stock of the decade about two years ago, when the stock was around $25, and Patrick Cox teased ’em a few months before that below $20, so I can’t claim that I didn’t know about the company.

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Despite the fact that I love the royalty model in pretty much any business sector, I have always had some trouble getting my head around Arm’s growth potential — they have remarkable gross margins near 95%, since they have essentially no cost of goods for their core intellectual property, but they also consistently spend about 60% of revenue on R&D and on selling and administrative costs. Those operating costs have been coming down gradually over the years, but not dramatically so, they still need to (and do) spend a lot on the next designs and next generation products — and they license their designs to anyone and everyone, so there’s not a lot of pricing power. They don’t rely on selling a proprietary design at a premium price, they rely on volume.

They certainly seem to still be in the leading position in mobile chips, with a huge number of chips based on their designs continuing to be sold every year, but there is also continuing development and competition — Intel came late to the mobile business, but has been trying to break in with its Atom chips and next generation chips. Part of the challenge is that the mobile chip business is much less profitable than the PC chip business — the core chip of a PC might cost $25-50 while the similar core of a phone might sell for just $5-10, so volume and low cost are critically important. That suits Arm, since their royalties are relatively low and they don’t have to actually build the things profitably, but it’s a challenge for Intel, which, while it’s probably the best semiconductor manufacturer out there, has continued to focus on newer, faster, better rather than cheaper.

That’s not to say that you can compare Intel and Arm — they’re wildly different companies, a manufacturer versus an intellectual property and design company — just to point out that the arena is still quite competitive and change can come fairly quickly. Which has made it hard for me to justify buying ARMH in the past with its stratospheric PE ratio and growth that, while very good, has a hard time providing justification for their share price.

Right now, ARMH is expected to grow earnings by a bit over 20% a year for the coming several years, not much of a slowdown from the 25% growth it has enjoyed for the past five years, and it’s trading at a forward estimated PE of 47. You can make the case for the stock, it’s a great business and can continue to grow, but with very low sales (they trade at about 20X sales) I think you need to have an expectation that their operating margins will improve substantially to justify the current price. That might happen, or they may grow faster than analysts are predicting, but in a price-sensitive and (maybe) increasingly competitive mobile space, it smells like a risk for me.

Of course, I also didn’t buy it when it was at $5 or $10 a few years ago, and I felt like it was rather too pricey at $20-25 two years ago, so maybe I’m just being grumpy now that I look up and see the stock at $41. Clearly, the Cabot folks still see it growing further if they see an 80% gain for the stock this year, and they’re definitely more comfortable with paying growth prices for growth stocks than I am.

So … I don’t own the stock, I’m not going to rush out and buy it, but I’m not managing your money — what do you think? Have you enjoyed the run by ARMH, or do you think it’s still a good buy now? Let us know with a comment below.


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Jan
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Jan
January 17, 2013 2:02 pm

Is this the same stock that the Motley Fool is pushing today?

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ET
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ET
January 17, 2013 2:03 pm

Hey Travis ,
Any thoughts about the January 15th investment statement by Feronia regarding the stock purchases by the African Agricultue Fund?

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ezmony
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ezmony
January 17, 2013 5:56 pm

Have you ever looked into IDCC……been in it since 24 and holding.

apl16
Irregular
January 17, 2013 7:23 pm

It seems as if Intel should do themselves a favour and buy ARMH

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apl16
Irregular
January 17, 2013 7:41 pm

Yes, a bit late for Intel, and, for us as well……..too rich for my blood

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rkatz0
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