As well as enjoying a fortress-like trading position in its industry, ARM Holdings (LSE: ARM) (NASDAQ: ARMH.US) is tapping in to some powerful medium-term growth trends. To me, the most likely direction for the share price next year seems up.
What about the valuation
I always feel duty bound to mention valuation when talking about ARM Holdings. A high valuation is anathema for many, particularly those of us with a value-investing slant. Indeed, I had to brace myself before hitting the buy button on ARM earlier in the year but, so far, nothing bad happened to me as a result of committing my hard earned to the firm’s growth story. In fact, the longer I hold the shares, the safer my investment begins to feel.
It took me a long time to wake up to ARM’s potential as an investment. The firm’s potential as a business dawned on me long ago, but the always-high valuation scared me off. That’s a shame. My reticence to invest cost me several hundreds of percent in capital gains — what a painful missed opportunity.
It took further learning and a shift in investment philosophy to embolden me sufficiently to take the plunge with ARM. It was the writings of Philip A. Fisher that finally set my lights flashing over high-valuation growth opportunities. I don’t know why it took me so long to get around to reading his classic tome, Common Stocks and Uncommon Profits; after all, Warren Buffett had been citing Fisher as an influence on his own investing for decades.
From Fisher, we seem to find the origin of Buffett’s ‘buy-wonderful-companies-at-fair-prices’ mantra. To attempt to sum that up, Fisher seems to encourage us to expect a high valuation on a wonderful growth company enjoying a solid trading niche, such as ARM Holdings. We may view the valuation as a mark of quality, and there is no reason for an earnings multiple, such as the P/E rating, to contract, as long as the medium- to long-term growth prospects of the firm don’t diminish.
All guns blazing
ARM Holdings’ forward prospects seem as vibrant as ever. One area of excitement is the Internet-of-Things opportunity, where ARM’s solution resides in its Cortex-M Processors. The range of chips goes into smart sensors, embedded connectivity chips, microcontrollers, wearable devices and other Internet-of-Things applications. The firm reckons that around 50% of its signed licences last year involved the Cortex-M. That’s exciting progress, and if we see the market take off as some predict, that area alone could drive ARM’s share price higher in the medium term, or even in the shorter term if investors get a sniff of coming success in the air.
However, the Internet of Things isn’t the only opportunity ARM pursues. The company holds a well-defended position at the heart of its industry thanks to its licensing and royalty business model that sees ARM technology incorporated into the world’s consumer technology devices such as smart phones and tablets, whatever the end manufacturer. As the sector evolves, so does ARM, which is why the firm sees a healthy pipeline of opportunities, which it expects to underpin strong forward licence revenue and to increase order backlog. ARM cites market data indicating improving semiconductor industry conditions, which it thinks is driving acceleration in royalty revenue growth as we head towards year-end and into 2015.
There’s no sign of attrition in ARM’s trading advantage in the semi-conductor space, and every reason to expect further strong progress in the future. Why should the valuation contract and why shouldn’t increasing earnings cause the share price to adjust upwards?
What now?
If we want to invest in a proven growth proposition such as ARM Holdings, we must bite the valuation bullet. At today’s 932p share price the forward P/E rating runs at about 32 for year to December 2015, with City analysts predicting a 23% earnings uplift that year. I think that valuation can be justified by looking at averages for earnings growth over several years.
If ARM’s growth in earnings accelerates in coming years, as I believe it might, the current valuation may start to look less shocking.
