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Thursday, May 20, 1999

An Investment Opinion
by Dale Wettlaufer

A View to a Sell

Talk about weird. Yesterday, I announced in the Boring Portfolio that we had decided to sell Cisco Systems (Nasdaq: CSCO) because I don't really understand the company as well as I would like. The emotional outpouring has been amazing to watch and it truly scares me. I haven't worried about the market in years, because thinking about the market as a whole isn't what I do with most of my time. Most of my time is spent on looking at individual companies and on figuring out what they're worth. To do that, you have to possess some quantitative faculty and know something about a company and an industry. The lack of specific knowledge about the industry and company that my detractors have exhibited is really beyond belief and I think it's probably a reflection of the level of knowledge of many people investing in these sorts of companies.

One of the biggest problems in securities analysis comes from anchoring on incorrect or irrelevant data and conclusions. For instance, a lot of people in the media have recently anchored on the belief that AOL is threatened because they don't own cable properties. That's anchoring on a somewhat irrelevant issue. AOL can run on top of any TCP/IP connection. AOL doesn't need to own the cable plant to get you into the community and charges you 55% less per month if you do not use the service as an access provider. The dynamics of a customer leaving or staying as a result of having cable access are not as simple as the headlines will have you believe.

Regarding Cisco, the dynamics of maintaining its competitive position are a lot more complex than just looking at its huge margins today and projecting that 15 years down the line. Most people don't even know what Cisco's margins are, anyway, since everyone looks through the writeoff of in-process R&D charges. It's totally unclear what the cost of maintaining the franchise is unless you engage in extensive revisions of the financial statements and have a good knowledge of the costs and benefits gained through the company's acquisitions. You don't get that from the outside.

Secondly, if you're listing the strengths of Cisco, you want to look at its unbelievable reputation for service. People at Cisco are given heavy incentives to make the customers happy. That's something I've found out through talking to the company's customers and that's a basic business attribute that you want to see in a company, whether it's a something like Frito-Lay, Home Depot, or a technology-intensive business. But what's totally blown me away is that less than one in ten people who have tried to tell me what an ass I am for selling the company have enumerated this among their reasons for how clueless I am on the company. That just blows me away. You don't get it if you don't understand this aspect of Cisco and name it as one of the top three reasons the company succeeds.

Third, if you're paying attention to what Cisco is talking about these days, they're talking about "the New World of integrated data, voice, and video communications." The company is not a gorilla in voice. The current access path for voice is through a Lucent switch. Combine Lucent's position there with Ascend's data access concentrator strengths, Lucent's obvious willingness to go out and use its equity to acquire other companies, and one of the most prolific research laboratories in the world, and you've got a pretty formidable contender to deal with. The reason why I would sell is very much due to this confrontation. The gorilla game doesn't reward second place very well. In a technology lock-down market, you either win or you come in a distant second place.

None of this is to say that Cisco won't win. This is just to say that I don't have a very clear picture of whether it will or not. I don't have much confidence in the hypothesis I've examined. Some people will tell you that's wrapped up by the company's Internet Operating System (IOS). Maybe so, but that points to the danger of entering into a new tornado and crossing a new chasm, to use the vocabulary of The Gorilla Game. What happens if the standards on the other side of the tornado aren't owned by Cisco? I believe I have zero confidence in my ability to answer that question and I also believe that most of the people that have taken time out of their busy days to flame me for my decision don't know any better than I.

If someone else wins the fight in the competition for owning the enabling technologies in the New World, and that's a necessarily technical question that is not answered by the fact that Cisco is a gorilla today, then the downside is unattractive in my calculation of the risk and reward of the situation. What are the probabilities of the situation? Let's say they are these:

Probability (first column) of 5-year return (second column):

5%... 1,050%
25%... 271%
25%... 76%
20%... 0%
20%... -25%
5%... -60%

Running the calculation using those numbers, the expected annual return over a five-year holding period is 12.7%. If we change the distribution to reflect higher probabilities of Cisco succeeding:

15%... 1050%
25%... 271%
40%... 76%
10%... 0%
5%... -25%
5%... -40%

Then the expected return is 26% per year. In the above scenario, there's a 15% chance the company will have a $1.8 trillion market cap in five years and a 40% chance it will have a market cap of nearly $600 billion and only a 20% chance it will be the same or smaller five years down the line.

What if we weight the possibility of the company losing the next gorilla game?

5%... 1050%
15%... 271%
25%... 76%
5%... 0%
25%... -25%
25%... -40%

The expected return falls to 6.3% per year.

You either have a clear thesis there or you don't. The middle of the road is kind of treacherous. Let's put it in these terms, though. For 16 years, I've been an owner of a company that manufactures printing blankets that go into the process of transferring images onto polyethylene containers. I could show you around the plant and teach you how the things are manufactured and converted, introduce you to some customers, and show you how the printing process works. Even if you took some time to read about the industry and I took an hour every 90 days to tell you what happened during the quarter, you still would not understand the business anywhere near as well as I or others in the industry do. And that's a slow-changing industry. If the pace of change in the industry were accelerated to Cisco's level, you would have little hope of ever gaining an understanding equal to mine, especially if I held back in discussions of what is going on in the industry and the company.

That's what I mean when I say I don't understand Cisco. I understand its current position fine. I don't have faith in my ability to forecast whether the company will dominate in the New World. Certainly, the rewards on the upside are great. But the rewards on the downside are unattractive. If you feel comfortable projecting Cisco's competitive position across the tornado and through the chasm, knock yourself out. But the decision to sell is a personal one that I don't think can be remedied by reading trade journals and knowing the exact growth rates of Cisco's target markets that are expected over the coming five years. With 38% of the portfolio invested in the company, I would be putting my eggs in a basket I know I can't watch all that well.

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