The Boring Portfolio, Feb. 1, 1999

<THE BORING PORTFOLIO>
And More on Value

by Dale Wettlaufer ([email protected])

ALEXANDRIA, VA (Feb. 1, 1999) -- We had some interesting moves in the Boring Universe today. We liked the tick down in Hershey (NYSE: HSY). We wish CS First Boston wouldn't get so antsy with their "buy" recommendation. We can see where they're coming from on the valuation, but we'd like to see a larger margin of safety between the market's quote and what we see as intrinsic value.

I also found the move down in M&T Bank (NYSE: MTB), headquartered in my hometown of Buffalo, interesting. That finished the day down a fraction, however. There are many more interesting banks out there, such as our little gem in South Carolina, First Citizens Bancorporation South Carolina (OTC: FCBN). Just to let everyone know, yes, I own this thinly traded OTC stock and don't recommend it in any way.

Costco (Nasdaq: COST) came back down about $3 1/2 today. That thing sucked up more than a year of performance since the last time I mentioned it, I believe about a week ago. Bull markets can be very frustrating at times when you would like to establish a position in something.

SAP (NYSE: SAP) and PeopleSoft (Nasdaq: PSFT) moved down again. Alex discussed the "uncertainty consensus" around the enterprise resource planning (ERP) software companies the other day -- I wanted to add something to that discussion.

We like companies that have some sort of competitive advantage -- this can be seen in our preference for companies that can earn super-normal returns on capital. What we want are companies that can extend their competitive advantages years or decades into the future. With SAP and PeopleSoft, competitive advantages can arise first from the very fact that the software business is very rewarding financially when your revenues blow by your fixed costs. Incremental sales past that point drop a lot of earnings to the operating income line. More cash to work with means more firepower to launch new initiatives and keep competitors at bay.

The longer a company's competitive advantage, the more it's worth. That's why Coca-Cola Co. (NYSE: KO) or Gillette (NYSE: G) trade at P/E multiples greater than their EPS growth rates (in addition to the current interest rate environment). When the Rule Maker portfolio says "traditional valuation measures" don't work well for those companies, that's what I personally take it to mean. I would lay odds that's what Alex thinks, too. The competitive advantage period of Coca-Cola is the longest of any I can imagine. That's why a temporary stall-out in the company's growth because of problems in emerging markets doesn't do all that much damage to the company's fortunes. The company's return on capital is still very high and the prospective returns on new investments once those economies get rolling again, whether it is two or five or ten years down the line, are tremendously high. Due to the power of compounding these large returns, the present value of this company is high. That's why it trades where it does.

With SAP and PeopleSoft, we want to find out if the market is making a mistake on the length of their competitive advantage periods. These are the sorts of companies that have a good shot at breaking out of the classical mold of "diminishing marginal returns" on capital. This states that competitive forces drive a company's returns down to the point where an X% increase in invested capital will bring about a smaller percentage increase in earnings. For some companies such as our Cisco Systems (Nasdaq: CSCO) or Microsoft (Nasdaq: MSFT), new additions to invested capital can actually increase the company's overall percentage return on capital.

When you look at a Cisco or a Microsoft or an Intel (Nasdaq: INTC), where your intellectual property gives you a lock-in on standards to the point at which switching costs are enormous for customers and vendors of complementary goods, the marginal return on new investments is actually higher than the company's average return on capital. Each new investment in higher return on capital projects increases the company's average return on capital -- which is why lagging indicators of value such as P/E are going to miss the boat on some companies' intrinsic value. As value investors, these are some of the things that I look for. They're extremely rare, however.

Just because something like a Cisco was selling at 60 times earnings when Alex and I took over the Boring Portfolio doesn't mean it was overvalued. That P/E tells you only a little about the intrinsic value of the company. By "intrinsic value," I mean the net present value of all the free cash flows the company can generate over its lifetime. Its competitive advantage is a lock-in on software that manages the flow of data across the Internet. Because it's encased in hardware means nothing. It's really the software. A software lock-in lends itself to new opportunities such as licensing to original equipment manufacturers in the consumer products industry, which Cisco is doing. There's not even a manufacturing component to that for Cisco, so the company becomes even more of a software company than it already is.

By the way, compare this to the definition of value put forth by Sam Jaffe, a Business Week contributor, in this piece on The Motley Fool's Rule Makers, Rule Breakers book. Mr. Jaffe states that the "problem with growth investing is that it's a style that it is difficult to quantify and mathematically analyze." We TOTALLY disagree. Growth investing is no different than value investing. We've spoken many times about the artificial distinctions between "value" and "growth." Growth is almost always a factor in value and we don't believe we will see much growth in our capital without acquiring companies at prices that offer value. We don't care if that's a company that makes golf cart wheels, routers, or underwrites insurance.

Mr. Jaffe continues: "Value investing, by comparison, is a much more spreadsheet-intensive endeavor because it compares a current stock price to a set of historical benchmarks that you, the investor, determine hold water." Not really. I would consider Warren Buffett, Chairman of our Berkshire Hathaway (NYSE: BRK.A), to be a value investor, and I know he doesn't even look at spreadsheets. Price/book and price/sales and that sort of thing don't tell you the answer to the question of what a company is worth. They inform an answer, but they're more beginning points than end-points. Mr. Jaffe is talking about asset arbitrage, which is not really "value investing." We appreciated the publicity, though, as much as we disagree with Mr. Jaffe's discourse on investing.

Earnings come out tomorrow after the bell for Cisco Systems and on the morning of Feb. 4th for Carlisle Companies (NYSE: CSL), our secret weapon hidden in one of the valleys of central New York.

Finally, Berkshire traded up today on the back of a New York Times article highlighting the work of PaineWebber insurance analysts Alice Schroeder and Gregory Lapin (we wanted to give her associate credit, too). Schroeder puts the company's intrinsic value, "using conservative assumptions, [at] $91,000-$97,000 per share. Valuing the equity securities in Berkshire's portfolio at a significant discount to their market valuations would reduce this number to $67,000-$92,000 (depending on the degree of discount)." Between $67,000 and $91,000 there's more than $36 billion in market cap, which some people have pointed out is nearly the size of the company's entire equity portfolio (which is around $41 billion as of late December, according to our estimate).

The way we understand this (we're waiting to look at Schroeder's work, which we hear is excellent from the rave reviews), a smaller discount to the equity portfolio can ripple throughout a valuation model. More than one year is affected by that. In any case, it appears as though her best work puts its value above $90,000. Our best estimate of intrinsic value is between $80,000 and just under $84,000 per "A" share. Our model assumes relatively tame return on capital performance and one year in which operating losses reach nearly $5 billion from a super catastrophe. After considering the company's opportunity cost of capital, that's negative value for that year of $16.6 billion. So we feel pretty safe in the margin of safety we've assumed in our calculations of the company's value and we can see where Schroeder is coming from on her numbers. But we're glad to have the work of an expert to look at and hope to learn some good stuff when we see her work.

We hope to see you on the boards.

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Change the World... work for the Fool.

Stock  Change    Bid
BRKb  +149     2299.00
CSL   +1 3/16  47.81
CSCO  +3 1/2   115.00
PNR   -  1/8   38.13

                   Day    Month   Year  History
        BORING   +3.34%   3.34%   1.64%  36.47%
        S&P:     -0.52%  -0.52%   3.88% 112.14%
        NASDAQ:  +0.17%   0.17%  14.48% 141.13%

    Rec'd   #  Security     In At       Now    Change
  6/26/96  225 Cisco Syst    23.96    115.00   380.06%
  8/13/96  200 Carlisle C    26.32     47.81    81.62%
 12/31/98    8 Berkshire   2244.00   2299.00     2.45%
  4/14/98  100 Pentair       43.74     38.13   -12.84%


    Rec'd   #  Security     In At     Value    Change
  6/26/96  225 Cisco Syst  5389.99  25875.00 $20485.01
  8/13/96  200 Carlisle C  5264.99   9562.50  $4297.51
 12/31/98    8 Berkshire  17952.00  18392.00   $440.00
  4/14/98  100 Pentair     4374.25   3812.50  -$561.75


                             CASH  $10594.54
                            TOTAL  $68236.54