How Western Digital (WDC) Can Be a Good Investment – Even When It’s Not a Net-Net

by Geoff Gannon


Geoff once expressed a controversial opinion that he would only buy Western Digital (WDC) as a net-net. I totally agree with him. I consider buying WDC as one of the mistakes I made during the period that I formed my investment style. But defending his opinion is not the purpose of this post. On the contrary, I think WDC can be a good investment. So, I’m going to ponder over my mistake and talk about what changed my mind.

I bought Western Digital in September 2010 at $26. Without a full understanding of its margin of safety, I bought WDC for these reasons:

 

  • Return on invested capital was always high, even in 2009.
  • WDC is the best managed company in the industry.It has a more stable margin than its competitors.
  • WDC had steadily grown market share while maintaining high profitability in an extremely competitive market. And became market leader soon after my purchase.
  • P/E ratio was low and I thought Mr. Market’s view  would turn once  supply and demand balanced.
  • I thought the iPad and other mobile devices are complementary goods, not substitute goods to the PC.
  • I thought it would take a long time for solid-state hard drives to replace hard disk drives (HDDs), and WDC would have time to catch up with the first comers.

 

Another reason I bought WDC was its better financial position than Seagate (STX), which I bought later after a LBO rumor (another mistake!). I actually made 40% and 25% from WDC and STX, respectively, but those are my biggest mistakes. Why?

 

Buying The Right Stock is Not Enough – You Have to Hold It Too

Holding WDC and STX was stressful.

I waited for the balance between supply and demand. But then the earthquake in Japan disrupted the supply chain that affected PC sales.

Then data proved that I was wrong about mobile devices. Mobile devices did hurt PC sales. Lesson: don’t ever bet on something uncertain. You can be either right or wrong. I was wrong in this case. Perhaps a diversified portfolio of stocks with higher upside (when we are right) than downside (when we are wrong) will perform well but I think holding such a portfolio is too hard for most humans.

And a bigger problem. A lot of WDC’s assets are tangible assets, which has little use other than producing HDDs. With the condition at the time I bought, WDC  could have been undervalued but what if HDDs became obsolete by the time the stock price returned to intrinsic value? Its plants would become useless. Its past earnings would be meaningless. That’s why buying WDC at lower than net current asset value can provides a margin of safety. I’m not sure buying at a low P/E will.

A more simple risk, what if something bad happens to the plants? Then came the Thai flood which severely interrupted WDC’s operation. I was right about buying WDC as a cyclical. Earnings did increase by double digits. But the stock price hit a new low because of an unexpected flood.

WDC was simply in a bad business. Many possibilities can happen, and each can  have a material effect. I gave little thought to te chance  when I purchased the stock. But the black swan usually appears more often than people expect.

Somehow human misjudgment tendencies kept me from selling the stocks. I finally sold at a profit. That was an inexpensive lesson.

But why did I say WDC can be a good investment?

 

Why the Innovator Doesn’t Always Win – And Western Digital Still Can

My biggest concern is technological obsolescence. However, recently I read a book named Fast Second which breaks the myth that successful companies are usually the first to innovate new products. Basically, the book says innovative products are usually brought to customer through supply-push processes. There is no clear idea about what might appeal to customers. As a result, manufacturers have to makes guesses, resulting in plenty of designs. Then, a dominant design emerges, and the dominance is reinforced by standardization, and the development of infrastructure and complementary goods that support the dominant design. The winners of new markets are the companies that can scale up the dominant design. Established companies usually have the necessary skills to scale. Those skills include the ability to produce at low cost, brand building, distribution, and creating alliance with suppliers and producers of complementary goods.

What does WDC have?

WDC has shown the ability to steadily gain market share and become a leader in a cut-throat business. It is a low cost producer. It bought a small company to get technology knowhow and quickly introduce its own solid-state drive in early 2009. With the acquisition of Hitachi, it gets the partnership with Intel (INTC) to produce solid state drives.  I think after mobile products, solid state drives will reach the enterprise market and then the consumer market. And WDC has all the distribution channels to these markets.

So, WDC can be the eventual winner in the solid state drive market.

 

Why I Won’t Buy Western Digital Again

Will I consider buying WDC again? No, never. I don’t understand the organization enough. And my investment style has changed. I want companies with better economic characteristics and easier to hold. But using Phil Fisher-type research can help to answer the WDC puzzle. WDC can be a good buy.

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