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No. of Recommendations: 5
Hi Jim,

I'm (slowly, but getting there) coming to realize that valuation is the weakest of my list of reasons to sell a company, because Mr. Market doesn't have to agree with my model.


I agree with pretty much everything you've said, both here, and over in HG. I think my particular bug-a-boo (not being a shareholder) is that I'm not facing the 'sell' side of the equation, and being on the 'buy' side, the farther that NILE has run up, the more bullish I see folks (with the exception of HG, where I think I've historically poured enough cold water on the company).

The example I've used in a couple of places is Quality Systems. Formerly owned that one. Made a 4.5-bagger on that one between capital appreciation, and selling calls when I thought it had run too far. The stock, of course, ran about $30 past my call strike price, and I let it go (the company has since split 2:1).

QSII, as you know, is a darling of SA, and the first two recommendations were at just dumb valuation levels. Problem was, by the time of the third recommendation, the company had been rather significantly bid up, and the multiples people were paying had more than tripled (at the second recommendation, investors were paying about 17x owner earnings....at the third, over 58x). But thing was, the euphoria (harkening back to Hewitt's original theme) that met the third rec was palpable; investors looked at the magnificent returns of the previous two picks, and extrapolated that from the third; returns that would have required similar expansion to, say, 200x owner earnings in order to accomplish.

It's been nearly two years, and that third rec has underperformed the market nearly 20%. Not because QSII is a bad company (indeed, far from it - their hiccup of a quarter last week has me nearly ready to jump back in again...if it can only get a little cheaper). But because, as the value chorus is wont to say, "Price Matters".

With QSII there had been some clashes at the board level, and some attempts at sweetening the executive comp. But you still had two guys owning nearly 40% between them, a terrific cash flow engine, and a huge market opportunity.

At NILE, you don't have the board issues, but the exec comp is...well...generous; more generous than QSII had been. You have a similarly terrific cash flow engine, by all accounts a great opportunity, and excellent management execution. However, you also have a higher (relative) price than QSII at that point, slower growth (it's true) than QSII at that point, narrowing margins versus widening margins then at QSII, and analysts tripping over themselves to upgrade. And QSII had begun returning some of that tremendous cash generation via dividends, versus via repurchases at premium prices.

QSII has gone pretty much no where for the last 7 quarters, during a period when the stock market as a whole has done pretty well. And I fear that is to become NILE's fate; that investors buying now are captivated by the dazzling returns of the past, and won't receive commensurate forward returns.

Anyway, while I advocate the "sell almost never" mantra (particularly for what I term 'core' portfolio holdings, I'm not sure that what I know about NILE's management compensation ethos, and misleading manner of free cash flow presentation would have ever let me regard them as 'core'. Thus, if someone sold for a 'good' reason, at a valuation they felt 'overly generous' in the past, then I say job well done! And shun that hindsight bias telling us we've "lost" money (difficult, I know).

Best,

Jim
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