Boring Portfolio

<THE BORING PORTFOLIO>
We Love Buffett
But we don't deify him

By Dale Wettlaufer ([email protected])

ALEXANDRIA, VA (March 3, 1999) -- Incremental information gathering and processing is what we do in the Boring Portfolio. We don't come to any game with the entire thesis figured out. We have definite thoughts on some things, but they're always subject to modification with information flow, how much we learn about new companies, and how much we learn about investing in general. There are a couple situations today where I'd like to apply this.

On American Bankers Insurance (NYSE: ABI), I said the company's combined ratio is around the 80% range. I've re-thought how it divvied up the operating expenses on the income statement and pushed some of that into the combined ratio. If I pushed all operating expenses into the combined ratio, then it would bring it to 100%, and we know that wouldn't be right. So the company still writes business at a profit, but its float isn't as cheap as I thought, and its return on capital isn't as good as I thought.

However, the market is still paying only $0.75 for every dollar of capital invested in the business (as of the end of Q3 -- ABI didn't release a year-end balance sheet), which is cheap on its face if the company can show an economic return on capital. That's how I'm processing the incremental info that has entered my brain over the last couple of days. The standard against which we measure this sort of business is Berkshire Hathaway (NYSE: BRK.A), however. If we want to commit more capital to this sort of business, we'll just buy more Berkshire and continue to process ABI in the background.

As I've said before, we'll take years to get comfortable with something. ABI isn't so exciting that I feel the need to rush on gathering information. The more years you spend on something, the more you understand it, and the more equipped you are to deal with situations that pop up. I'm personally still into the phase of building "idea inventory" in investing, while a highly experienced guy like Warren Buffett, or a good fund manager, has a huge inventory of ideas and a matrix built up for comparing the economics and business models of companies. If you wanted to look at the inventory turnover of our idea factory, it really should slow down as the factory ages. We want more inventory and less action on those ideas, especially in the current market environment. Give us another 1974, 1981, 1988, 1990, or 1994 and our idea factory starts to turn the inventory a little faster.

In the PC and networking world, here's today's incremental information from 3Com (Nasdaq: COMS): "An unexpected slowdown in the U.S. and Latin American enterprise markets, a weakness in the traditional two-tier distribution channel, and lower than expected PC OEM sales all contributed to [lower-than-expected] third quarter results." That affects both Gateway (NYSE: GTW) and Cisco (Nasdaq: CSCO), as the company addressed both enterprise networking sales as well as the PC OEM business. Cisco shrugged off this news, as enterprise sales were already slow, with telcos and service providers having picked up that slack last quarter.

Also, as a sort of a loose rule, I discount what badly executing companies have to say about their industry. By their selective disclosures in the past and what I consider to be playing with the numbers (insofar as they had to reverse merger-related expenses and have written off a ton of inventory), I personally do not trust any information that comes out of the company.

If you're interested, we've been having a pretty fast and furious discussion on the Boring message board over the last 24 hours about the sustainability of the PC industry and the inherent dangers of a discontinuous technological innovation hurting the industry. Personally, I believe PCs have become such appliances, and I don't think of the PC business as "high tech." Relative to PC sales dollars, the amount of R&D done by the PC OEMs is tiny. A pharmaceutical company is more high-tech when you measure the amount of applied science the company engages in per dollar of revenues.

I've always argued that PC companies are less like "technology companies" than they are precision manufacturers. Much of the economics come from being a manufacturing service -- look at the economics of something like Jabil Circuit (NYSE: JBL) or Solectron (NYSE: SLR) to check this -- and some of the economics come from being the channel and not selling through the channel. As purely manufacturing companies, there is very little value to the option that these companies can extend their core strengths in manufacturing in other markets. I put a higher value on that than the market does. For Dell, some of the excess returns come from being a service company in addition to being just a plain vanilla manufacturer. You might ascribe that to their "brand value" but their superb logistics support and delivery of customized boxes (taking the value from value added resellers) is what differentiates them and creates extra return. So when you look at a company like a Gateway, it's part electronics manufacturer, part retailer, and part value-added reseller. The more service it can put into it, the more its business can look like Dell's. In all, sure, Gateway is subject to discontinuous innovations, but it's also run by people who are thinking about these things. They're not just on auto pilot.

We also don't subscribe to Warren Buffett's thinking on sticking to stuff where you know exactly where things are going to be in 20 years. Does American Express look like it did 20 years ago? Partly, but with some major market share revisions. Does the S&L industry look like it did 20 years ago? Not with Freddie Mac and Fannie Mae in the picture. Does The Washington Post's competitive environment and array of assets look like it did 20 years ago? No way, Jose. Does Berkshire look like it did 20 years ago? Not really.

Businesses re-direct their cash flows and invest in new things. I personally don't feel uncomfortable investing in things like Cisco or Gateway. I seek out higher growth situations that are undervalued in addition to looking for undervalued franchise companies. Just as a news flash, there aren't many Coca-Cola Companies lying around in 1999 selling at 15 times earnings. If we can pick up something at a multiple like that and it has excellent growth prospects and prospects for high returns on incremental invested capital, then we'll accept some technology risk.

By the way, the move down in American Power Conversion (Nasdaq: APCC) did not go unnoticed by us today. Expect a buy report from us on this company if we can get a few questions answered in the very near future. This is a company with very good returns, extremely high market share and associated installed base, and sustainable competitive advantages. At the end of this column is a breakdown of the company's income statement and balance sheet.

Current worries over PC industry growth are not new -- they're an annual event. It's amazing how this gets forgotten every year. Besides, APC has gotten to a price where any unit growth problems arising from purchasing decisions held back for Y2K worries are not a factor for us. I'm attaching the company's financials below. In particular, you might have some questions about the inventories and the cash flow items. I'll address those, if you'd like, on the Boring board.

Also, here's a link to the ABC interview with Berkshire Hathaway Chairman Warren Buffett:

http://www.abcnews.go.com/onair/nightline/transcripts/nl990302_trans.html 

Company:APCC

Market Cap...$2,833.65
Enterprise Value...$2,833.65
EV/Revenues...2.52
EV/Invested Capital...4.76
EV/Assets...3.25
Price/Book Value...4.16
PSR...2.52
EPS...$1.57
P/E...18.52
EV/Operating...13.36
EV/Net Income...18.52
Diluted Sharecount...97.71
Bore ratio...6.48%
ROIC...30.83%
Working Capital...$493.78
Inventory Turnover...3.73
Capital Turnover...2.39
Days in Inventory...134.39
Days Sales Outstanding...58.47
Days in Payables...44.19
Cash conversion cycle...148.68
Asset Turnover...1.49
Assets/Equity...1.26
Net Margin...13.59%
ROA...20.22%
ROE...25.44%

Cash/Share...$2.25
Current Ratio...3.72
Quick Ratio...2.46
LT Debt/Equity...0.00%
Debt/Total Capital...0.00%
Insider Holdings...18.3%

Begin Invested Capital...$344.96
End Invested Capital...$595.73
YOY IC Growth...72.69%
Avg. Invested Capital...$470.35
Invested Capital Turnover...2.39
ATOI...$145.02
Tax Rate...31.60%

Income Statement

Trailing Revenues...$1,125.84
COGS...$621.07
SG&A...$292.74
Operating Earnings...$212.02
Net Income...$153.02
Gross Margin...44.83%
Operating Margin...18.83%
SG&A/Sales...26.00%
Net Margin...13.59%

Balance Sheet

Cash & Equivalents...$219.91
Receivables...$180.36
Last Yr receivables...$131.12
Inventories...$228.68
Last Yr Inventories...$104.17
Payables...$75.19
Current Assets...$675.25
Current Liabilities...$181.47
Long-Term Debt...$0.00
Shareholder's Equity...$681.29
Last Yr Shareholder's Eq...$521.75
Total Assets...$871.98
Last Year Assets...$641.29
Avg. Assets...$756.64
Average receivables...$155.74
Average inventories...$166.43
Average Assets...$756.64
Average share equity...$601.52

($ in millions)
EV = Enterprise value

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