Boring Portfolio

<THE BORING PORTFOLIO>
Gateway Country Wins Analyst
It Won Our Hearts

By Dale Wettlaufer (TMF Ralegh)

ALEXANDRIA, VA (Feb. 22, 1999) -- Shares of the Boring Port were up today as investors expect an imminent proposal to take over the Rule Maker portfolio. Boremeisters Dale Wettlaufer and Alex Schay refused comment on the specific situation but said, "We don't rule out any possibility to add to shareholder value..."

Sorry, just my sick sense of humor taking over there for a moment. The Bore Port did do well today thanks to Ashok Kumar of Piper Jaffray upgrading his earnings outlook for Gateway's (NYSE: GTW) first quarter to $0.90 per share from $0.59. As you know, we initiated our ownership of Gateway earlier this month with a "dy-no-mite!" rating, commensurate with our view of the company's strong cash flow and execution in the consumer market. According to Reuters, Kumar likes what's happening with the Country Stores. It's hard not to like them, in my opinion, when the cash-on-cash return on these investments is 100% in the first year of operation. That's higher than the company's overall return on invested capital, of course, which indicates these are value-creating investments for the company.

It's one thing to match the current cash-on-cash return in a business. That sort of maintains the status quo on building shareholder value. But when you add unexpectedly higher return investments to the mix, then you get the shareholder value creation that is comprised of intrinsic growth plus the revaluation coming from higher incremental returns on capital.

A note on valuation. Kumar's valuation depends partly on a P/E-to-growth rate metric, as far as I can see from the Reuters story. We don't ever look at a company in this way. A company that throws a ton of capital at a problem can grow EPS just fine, especially when it uses latent assets that are part of equity capital but not counted in invested capital. Even when the return on new investments is lower than the company's average rate of return or even below the hurdle rate of return on equity, you can still grow EPS. We're concerned with the quality of earnings and the quality of investments that are creating the new EPS.

Following are two examples of a company growing EPS:

Year 1: Equity capital $1,000; Earnings $150

Year 2: Equity capital $1,150; Earnings $161

Year 3: Equity capital $1,311; Earnings $170

The P/E on this company is going to go down, as each additional dollar of earnings is worth less than the core $150 in earnings. That's because each dollar of equity retained is worth less and less when incremental returns on capital decrease. I have no idea how that works into the whole "PEG" scheme. I don't really think it does. What we would prefer is a company looking like the following:

Year 1: Equity capital: $1,000; Earnings $150

Year 2: Equity capital: $1,006.25; Earnings $161

Year 3: Equity capital: $1,000: Earnings $171

The earnings growth rate is the same, but notice we have invested zero net capital in the business between year one and year three. We have the same level of earnings in both cases, but in the second case the company has returned capital to us via share buybacks or dividends. The PEG scheme isn't going to quantify these two companies differently, but other methods of valuation would. We'd have to take the second company, all else being equal.

Gateway will hold an analyst meeting this Wednesday in San Diego. Information covered in that meeting will probably be making its way out by Thursday morning.

Speaking of analyst meetings, Cisco Systems (Nasdaq: CSCO) presented at the BancBoston Robertson Stephens conference this morning in San Francisco. Since the stock was up $4 15/16 to $102 1/16, I assume they didn't say something like "Actually, we're going to have a bad quarter. We believe our stock is over-valued." Wouldn't it be refreshing to hear that? Actually, something along those lines (but not quite, check the link) was said by the Chairman of Berkshire Hathaway (NYSE: BRK.A), in the 1996 prospectus for the company's "B" shares no less.) Anyway, Cisco apparently talked about some products it will announce tomorrow. As usual, the new products will offer more features for less dollars, but I'll wait until they put out the press release tomorrow to make sense of the products. CBS Marketwatch did a story on it earlier today and it's so non-specific that I can't relay much from it.

Speaking of Berkshire Hathaway, the company is rolling out its Berkshire Hathaway Life Insurance Company of Nebraska website. This allows the company to raise money at the same cost as the federal government without paying commissions. Single premium annuities usually don't carry much of a premium, though, so I'm really hoping that we introduce variable annuities with full index fund options and other good sub-accounts. American investors could really use a no-commission variable annuity. Berkshire would have to add to infrastructure to do this, however, but it could really be worth the investment.

Some companies were moving on the radar today. None was really worthy of much comment so I will sign off. Again, just kidding about the takeover offer for the Rule Maker port. Actually, I'm not kidding, but I don't want word getting out and people driving up its price.

We hope to see you on the Boring message board sometime. We've got a pretty thoughtful bunch contributing and we'd like to hear from you, too.

Make a Living Foolin' Around.

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02/22/99 Close
Stock  Change    Bid
BRKb  -3       2402.00
CSL     ---    43.56
CSCO  +5 1/16  102.06
GTW   +6 5/16  79.19
                   Day    Month   Year  History
        BORING   +2.72%  -0.14%  -1.79%  31.88%
        S&P:     +2.66%  -0.59%   3.81% 112.00%
        NASDAQ:  +2.56%  -6.54%   6.81% 124.99%

    Rec'd   #  Security     In At       Now    Change
  6/26/96  225 Cisco Syst    23.96    102.06   326.05%
  8/13/96  200 Carlisle C    26.32     43.56    65.48%
   2/9/99  100 Gateway 20    72.38     79.19     9.41%
 12/31/98    8 Berkshire   2244.00   2402.00     7.04%


    Rec'd   #  Security     In At     Value    Change
  6/26/96  225 Cisco Syst  5389.99  22964.06 $17574.07
  8/13/96  200 Carlisle C  5264.99   8712.50  $3447.51
 12/31/98    8 Berkshire  17952.00  19216.00  $1264.00

   2/9/99  100 Gateway 20  7237.50   7918.75   $681.25


                             CASH   $7127.20
                            TOTAL  $65938.51

</THE BORING PORTFOLIO>