Boring Portfolio Cisco, Apple, and Probabilities

If you pay too high a price for a business, even a great business, you may undo the effects of years of favorable business developments. Consider Cisco and Apple: While Cisco may be the better business than Apple, Cisco's price may make it a worse investment than Apple in the long run.

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By: Whitney Tilson
October 16, 2000

Boy! My column last week sure struck a nerve! Some people didn't take too kindly to being warned -- OK, maybe "Be very, very afraid" was a little dramatic -- about owning hugely valued technology stocks, especially when (in my opinion anyway) this sector is experiencing a speculative bubble bursting, Friday's rebound notwithstanding.

I want to be clear that I was not forecasting a general stock market decline, or even a blow-up of the entire technology sector. In fact, I think much of the market -- and even large swaths of the tech sector -- are reasonably valued. But simple math makes it virtually certain that the great majority of stocks -- tech or not -- trading at multiples of hundreds of times earnings (in some cases, hundreds of times sales) will severely disappoint. When and how quickly this will happen, I have no idea.

If I were to summarize my earlier column in one (long) sentence, it would be: I believe that the probabilities are very low that over time the six companies I cited (and many more), however fine, will be able to grow quickly enough, given their sizes, for their extremely richly valued stocks to compound at much of a rate at all -- and if they so much as hiccup, there's a long way to fall (see Intel (Nasdaq: INTC), Nokia (NYSE: NOK), Home Depot (NYSE: HD), and many more). I guess it's a sign of the times that this is viewed as controversial or offensive.

Some of the more eloquent emails I received were: "Loser" and "You are an idiot. Thanks a lot you jerk." Or "You are an idiot. Don't try and drive down the prices with your 'foolish' scare tactics.  Nobody is listening to you." But those were the exception. Most people who took the time to email appreciated a reasoned argument -- whether they agreed with it or not -- that made them think. And that's all I'm trying to do: Get people to think sensibly about stocks.

The first step to doing so is to distinguish between a stock and a company. Many of the people who emailed me argued that I just didn't understand what a great business Cisco (Nasdaq: CSCO) is -- or EMC (NYSE: EMC) or Oracle (Nasdaq: ORCL) -- and what a fool I am for buying a dog like Apple (Nasdaq: AAPL). Well, as I pointed out more than once, I don't quibble that Cisco is a fabulous business -- certainly superior to Apple -- but price matters! Brian Graney touched on this topic in last week's column, "Great Company, Bad Stock," and Warren Buffett put it succinctly in his 1982 annual letter to shareholders: "For the investor, a too-high purchase price for the stock of an excellent company can undo the effects of a subsequent decade of favorable business developments." (Incidentally, I highly recommend that you take the time to get the best investment education available -- and it's free! -- by reading Warren Buffett's annual letters from 1977 to 1999.)

Over time, there are three primary drivers of a stock's return: what the market does, how the company performs, and how much you paid for the stock. I don't spend much time thinking about the former, as I think interest rates, overall economic growth, the public's enthusiasm for stocks and the like are inherently unpredictable. But thinking sensibly about what a company's future might hold and to what degree its current valuation reflects that future is far more predictable. That doesn't mean there's any certainty, but one can certainly develop scenarios and assign probabilities to them. Doing this sensibly is the key to successful investing, as investing is at its core a probabilistic exercise. 

Let's take a look at Cisco and Apple, two of the companies I mentioned in last week's column. Today, I'll give a quick overview of each company, and then next week I'll try to develop some future scenarios and estimate their probabilities. (I picked Cisco because it is a well known, widely held stock, but I could just as easily make the same arguments for any of the other five stocks I highlighted last week -- and dozens more.)

Cisco
Cisco is one of the finest companies of all time. It dominates its markets, is growing at a phenomenal rate, is hugely profitable, and has an exceptional management team. It has very attractive financial characteristics, as the company generated robust free cash flow of $2.1 billion on $18.9 billion in sales in the past year, an 11.2% margin. (I define free cash flow as cash flow from operations minus cap ex.  I also subtracted Cisco's $2.5 billion in tax benefits from the employee stock option plan -- nearly equal to net income of $2.7 billion. More on this in a future column.)

The market certainly agrees with my assessment of Cisco, awarding it a market cap of $395 billion at Friday's closing price of $56.06. If you subtract cash and short-term investments of $5.5 billion and very conservatively estimate that Cisco's $15.0 billion in non-cash investments is worth $5.0 billion, then the company's enterprise value is $384 billion, equal to 182 times trailing free cash flow.

Apple
Apple isn't nearly as good a business, even when it's firing on all cylinders, as the company relies on a steady stream of innovative new products to fuel its growth, many of which are very popular but some aren't, making its earnings a bit erratic. Of course, each time the company hits a rough spot, as it has recently, it's hard to know whether this is just a bump in the road or the beginning of a terrible decline back to the dark days of 1996 and 1997. In a spooked market that panics at even the slightest hint of uncertainty, the questions around Apple's future have crushed the stock.

With its stock at $22.06 on Friday, Apple's market cap was $7.2 billion. If you add $300 million of long-term debt and subtract $3.8 billion of cash and value $1.2 billion in non-cash investments at a conservative $400 million, then Apple's enterprise value is $3.3 billion. The company generated $722 million of free cash flow (assuming a full 35% tax rate; the actual figure was $807 million) on sales of $7.4 billion in the most recent 12 months, a 9.7% margin, so it is now trading at a mere 4.6 times trailing free cash flow.

Next week, I will continue with my analysis of Cisco and Apple.

-- Whitney Tilson

Whitney Tilson is Managing Partner of Tilson Capital Partners, LLC, a New York City-based money management firm. Mr. Tilson appreciates your feedback at Tilson@Tilsonfunds.com. To read his previous guest columns in the Boring Port and other writings, click here.

Boring Portfolio


10/16/00 as of ~8:30:00 PM EDT

Ticker Company Price
Change
Daily Price
% Change
Price
APCCAMER POWER CONVERSION0.754.11%19.00
BRK.BBERKSHIRE HATHAWAY'B'(3.00)(0.16%)1890.00
COSTCOSTCO WHOLESALE CORP(0.13)(0.39%)32.00
CSLCARLISLE COS1.443.59%41.44
GTWGATEWAY INC(2.34)(4.41%)50.77

  Day Week Month Year
To Date
Since
10/1/1998
Annualized
Boring0.15%0.15%(3.44%)(11.60%)25.18%11.61%
S&P 5000.03%0.03%(4.31%)(6.44%)35.16%15.87%
S&P 500 (DA)0.03%0.03%(4.26%)(6.37%)36.86%16.58%
NASDAQ(0.80%)(0.80%)(10.42%)(19.14%)94.25%38.36%

Trade Date # Shares Ticker Cost/Share Price Total % Gain
8/13/96200CSL26.3241.4457.41%
2/9/99200GTW36.2850.7739.95%
4/20/99460APCC14.4819.0031.25%
9/13/99220COST34.5532.00(7.38%)
12/31/9812BRK.B2,278.331890.00(17.04%)

Trade Date # Shares Ticker Total Cost Current Value Total $ Gain
8/13/96200CSL5,264.998,287.503,022.51
2/9/99200GTW7,255.5010,154.002,898.50
4/20/99460APCC6,659.258,740.002,080.75
9/13/99220COST7,601.147,040.00(561.14)
12/31/9812BRK.B27,340.0022,680.00(4,660.00)
 
Cash: 
Total: 
10,490.51
67,392.01
 

Key
• S&P 500 (DA) = dividend adjusted. Dividends have been added to the total return of the index.