Valuation STILL Matters

Are companies such as Siebel Systems the best bet for the Rule Maker Portfolio? Whitney Tilson is wary of tech stocks that are priced to perfection, and fears that focusing on everyone's favorite stocks -- at the expense of valuation -- is a sure path to underperformance. He likes the idea of identifying dominant businesses with strong franchises, but prefers to wait until the price is just right.

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By Whitney Tilson
February 20, 2001

Almost exactly a year ago, I wrote a column called Valuation Matters. In it, I said:

"I believe in The Motley Fool's core investment philosophy of buying the stocks of quality companies (or index funds), holding for the long run, and ignoring the hype of Wall Street and the media. But if I were to level one general critique of the Fool, it would be that there is not enough emphasis on valuation... The experience of the past few years notwithstanding, [the] 'pay any price for a great business' attitude is a sure route to underperformance."

Since I wrote those words on February 7, 2000, here's what has happened:

Portfolio/Index      % change
S&P 500 -9% Nasdaq -44% Rule Maker -48% Rule Breaker -45% Berkshire Hathaway +36%

My goal in showing these figures is not to gloat, but to make a point that I've made over and over again: valuation really does matter.

Regular readers might think, "You're beating a dead horse, Whitney. After the events of the past year, everyone already understands and agrees with you." I'm not so sure.

As evidence, consider that in a survey conducted recently to determine which stocks its readers wanted more articles about, 47 of the top 50 were tech stocks. The Fool's own Rule Maker portfolio has dedicated three recent columns to a potential purchase of Siebel Systems (Nasdaq: SEBL) -- an exceptional company, but also one whose stock is trading at either 126 or 264 times trailing earnings per share (depending on whether you use the company's adjusted figures or actual GAAP numbers) and 85x analysts' (very optimistic, in my opinion) estimates for 2001.

Siebel is almost certainly overvalued
My answer to the question posed by the title of the Rule Maker's most recent column on Siebel, "Is Siebel Overvalued?," is "Almost certainly, yes." In my mind, Siebel falls into the same category of stocks I raised questions about in a column last October. That column named some of the most poplar tech stocks at that time -- Cisco (Nasdaq: CSCO), Oracle (Nasdaq: ORCL), EMC (NYSE: EMC), Sun Microsystems (Nasdaq: SUNW), Nortel Networks (NYSE: NT), and Corning (NYSE: GLW) -- and claimed:

"It is a virtual mathematical certainty that these six companies, as a group, cannot possibly grow into the enormous expectations built into their combined $1.2 trillion dollar valuation... Even if the companies perform exceptionally well, their stocks -- in my humble opinion -- are likely at best to compound at a low rate of return, and there's a very real possibility of significant, permanent loss of capital. Investing is at its core a probabilistic exercise, and the probabilities here are very poor."

I received more hate emails from that column than any other -- which should have been a clue that I was on to something. Less than five months later, here's how these stocks have performed:

Stock      % change

Cisco -50% Oracle -29% EMC -39% Sun -57% Nortel -68% Corning -64% Average -51% Nasdaq -28%

These numbers certainly highlight the dangers of investing in the most popular stocks that are priced for perfection -- like Siebel.

Does valuation still matter?
One might argue that with so many stocks so far off their highs, perhaps one needn't focus as much on valuation today. I think the opposite is true. A year ago, you could argue that even if you bought an overvalued stock, it didn't matter since someone would come along and buy it from you at a higher price. As silly as that argument might sound, a rapidly rising stock market over the previous few years had lulled many into believing it. But today, with the market psychology broken, I don't think a reasonable argument can be made that the "greater fool theory" of investing is likely to be very rewarding going forward.

My kind of Rule Maker: IMS Health
So am I rejecting Rule Maker investing? Not at all. I wholeheartedly agree with the strategy of buying and holding for many years the stocks of exceptionally high-quality companies. But I won't pay any price. In fact, I will only buy a stock when I think it is so undervalued that I'm trembling with greed. Let me give you an example: a stock I bought last summer and still own, IMS Health (NYSE: RX).

IMS Health is the world's leading provider of information solutions to the pharmaceutical and healthcare industries. Its core business -- in which it has built approximately 90% market share over the past half-century -- is providing prescription data to pharmaceutical companies, which use the data to compensate salespeople, develop and track marketing programs, and more. More than 165 billion records per month flow into IMS databases worldwide.

The company has offices in 74 countries, tracks data in 101 countries, and generates 58% of sales overseas. IMS Health has a near-monopoly and there are very high barriers to entry. As a person I interviewed at one of the largest pharmaceutical companies (who is in charge of its relationship with IMS) said, "There will be no more entrants into this market."

Due to its powerful competitive position, IMS mints money: It has a healthy balance sheet, very high returns on capital, huge 19% net margins, and solid growth. Revenues in the first three quarters of 2000 (IMS reports Q4 00 earnings after the close today) increased 14%, or 16% in constant currency, and net income rose 16%. With large share buybacks -- in the latest quarter, shares outstanding fell 7% year-over-year -- EPS grew 25% in the first three quarters of 2000 and is projected to grow 19% in 2001. (All figures are pro forma, as IMS has spun off a number of entities.)

At Friday's close of $25.45, I don't think the stock of IMS Health is cheap enough to buy at this time, but it sure was last July when I bought it for $16, equal to approximately 16x estimated 2001 EPS. It was cheap because management was widely disliked by Wall Street, due in large part to an ill-conceived merger that was subsequently called off.

While I wasn't thrilled with the management team either, I figured this was already reflected in the stock price, and I could not find a single element of weakness in IMS' financials. I couldn't see much downside to owning the stock and, over time, if the business continued to grow strongly, I suspected that management and Wall Street would smooth out their differences. This is exactly what happened. Even better, new management is now in place.

This was my kind of Rule Maker: a company with a bulletproof franchise that meets most of the key Rule Maker criteria, but which is priced very attractively due to the market overreacting to a short-term issue.

-- Whitney Tilson

Guest columnist Whitney Tilson is Managing Partner of Tilson Capital Partners, LLC, a New York City-based money management firm. He owned shares of IMS Health at the time of publication. Whitney appreciates your feedback at To read his previous columns for The Motley Fool and other writings, visit