Rule Maker Portfolio Valuing Rule Makers

The fundamental belief among writers and managers of this column is that business quality is the primary consideration for Rule Maker investors. If it's not a top-notch business run by top-notch managers... well, the ocean is wide, move on to better fishing grounds. That said, ignoring price completely takes the matter of quality too far and puts investors at a disadvantage. Today we introduce a new way to think about the prices of Rule Maker companies.

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By Richard McCaffery (TMF Gibson)
November 7, 2000

There has been a lot of talk about valuation recently in Rule Maker columns and in other spots on our website, such as the Fool on the Hill column.

We've given this issue a lot of thought, and it's worth taking on in the Rule Maker Portfolio. First, a little background. The fundamental belief among writers and managers of this column is that business quality is the primary consideration for Rule Maker investors. If it's not a top-notch business run by top-notch managers... well, the ocean is wide, move on to better fishing grounds. The Rule Maker -- an investing strategy that focuses on simplicity, pushes investors to think like business owners, and hold shares for the long term -- wants to identify dominant companies with sustainable advantages.

These are critical issues of quality, not valuation, so we have focused our efforts on helping you locate excellent businesses. Indeed, people often err on the side of unwillingness to pay up for truly great companies. Investors that missed out on a chance to buy Coca-Cola (NYSE: KO) in 1972 because they didn't want to pay top dollar for a pricey-looking business committed a grave error, underestimating the power of the Coke franchise. From this point of view, I hope the Rule Maker has stripped a few investors of the idea that you have to buy cheap stocks to be successful. In my opinion that's a recipe for disaster.

That said, completely divorcing the concept of price from quality is a little bit like shopping with a credit card. At some point, no matter how good the merchandise you purchased, the bill comes due and price becomes a key issue, intricately related to the value of the merchandise itself. That's economic reality.

In that sense, no matter how good the company you bought, its ability to reward you in the future depends on how much the stock will appreciate based on future cash flows, and that's directly related to the price you paid today. Pay too much, and you can burden a great company with expectations even the ablest enterprise will be unable to meet.

With this in mind, what should the Rule Maker Portfolio do? My take is that we need to introduce a valuation ground rule, at least one tool investors can use to start thinking about price, stock price appreciation, and future cash flows. Keep in mind, there are two times when price is an issue for the Rule Maker Portfolio: When we buy companies, which doesn't happen often, and when we invest additional dollars, which happens every month.

Fortunately, there doesn't have to be too much heavy lifting up-front to start thinking about this issue, because the Rule Breaker team has done a good chunk of work for us. (Click here to read today's Rule Breaker chat, which outlines their thinking regarding this issue.) They have developed a handy formula we could convert and use in the Rule Maker, one that should open the door to a new vista for investors. It's not a silver bullet, but it's a useful start.

The Rule Breaker managers call it 10x5y. What does it mean? They want to invest in companies that can increase market value 10-fold in five years. It's a back-of-the-envelope calculation that helps investors start thinking about headroom, playing field, and expectations.

Of course, in the Rule Breaker Port, they're investing like venture capitalists and trying to catch tomorrow's giants today. We don't expect or require that kind of upside for Rule Makers over a five-year horizon. We're looking for well-established performers -- but those with room to grow. For our purposes, Matt Richey and I kicked around a few ideas and we think 2x5y is in the right ballpark. We want to hunt for companies that can double in value over the next five years -- that's a 14.9% annualized return.

Let's put this in the context of our present portfolio to get a feel for its usefulness. Cisco Systems (Nasdaq: CSCO) currently trades at about $55.50 per share, down about 32% from its 52-week high of $82 last spring. Were we to invest this month's $500 in Cisco, would we be getting it at a bargain -- 30% off, so to speak? Well, it's only a bargain from one very isolated point of view, one that looks solely at the market's short-term pricing mechanisms. I'm not convinced the market prices companies efficiently in the short term, to say the least, so this metric is a very poor barometer.

Another way to look at things is from a market value point of view. At $55.50 per share, Cisco has a market value of roughly $412 billion, making it the second-largest company by market capitalization in the S&P 500. Do you really think it can double in value over the next five years, becoming a company with a market value of $824 billion -- much bigger than today's General Electric (NYSE: GE) or, in fact, anything we've ever seen?

Let's look at a few numbers to see what would have to happen for Cisco to achieve this feat. Over the last four quarters, Cisco has produced $4.6 billion of free cash flow, and currently trades at 90 times that cash flow number. (Don't know what free cash flow is? See this article.) We all know Cisco's growth will slow in the coming years based on the size of the company. Just so we're working with round numbers here, let's say Cisco will trade at 50x free cash flow (FCF) in five years, which is do-able, but very aggressive.

For Cisco to have a market share of $824 billion and trade at 50x FCF in five years, it will have to generate $16.5 billion in FCF ($824/50). That means Cisco will have to nearly quadruple FCF over the next five years to hit the target. The math works like this:

  1. Trailing annual FCF = $4.6 billion
  2. Target FCF in five years = $16.5 billion
  3. Factor increase needed to meet target (B / A) = 3.59
  4. Annual rate of FCF growth needed (C ^ (1/5)) = 29.1%
As you can see, Cisco will have to grow FCF at 29% annually for the next five years to pull this off. Not only that, it will have to continue growing rapidly for investors to be willing to pay 50x FCF for a slice of those future cash flows.

It could happen, but I don't want to make that bet. That's what I like about the 2x5y measure. It gives investors a sense of how much headroom is built into the current price of a company's stock, and forces you to think about probabilities.

Clearly, 2x5y has its shortcomings. First, this is a subjective exercise that depends on your estimate of what the future free cash flow multiple might be. Second, it doesn't tell you how much a stock is worth -- a very tricky and subjective process -- or layer in expected growth rates unless you do it yourself, the way I did above with free cash flow. Still, I like the direction of the thinking process, especially in that it helps investors see the forest for the trees.

Keep in mind, it's just an idea at this point, not a new criterion. What do you think? Post your thoughts on the Rule Maker Strategy Discussion Board.

Speaking of monthly investments, I'd like to lower our cost basis on Yahoo! (Nasdaq: YHOO) a little more by investing this month's $500 installment in the online media giant. We already know it's a great company. Currently the market is giving it to us at a lower price than we originally paid. I can see this company doubling its value in the next five years.

 

Rule Maker Portfolio


11/7/00 as of ~8:30:00 PM EST

Ticker Company Price
Change
Daily Price
% Change
Price
AXPAMER EXPRESS0.310.52%60.94
CSCOCISCO SYSTEMS1.632.95%56.75
INTCINTEL CORP(0.38)(0.81%)46.19
JDSUJDS UNIPHASE CORP(3.31)(4.28%)74.13
KOCOCA-COLA CO(0.44)(0.72%)60.06
MSFTMICROSOFT CORP1.001.44%70.50
NOKNOKIA CORP ADS(0.44)(1.03%)41.88
PFEPFIZER, INC0.310.70%44.81
SGPSCHERING-PLOUGH(0.94)(1.80%)51.06
TROWT.ROWE PRICE ASSOC(0.50)(1.05%)47.06
YHOOYAHOO INC2.884.38%68.50

  Day Week Month Year
To Date
Since
1/6/1998
Annualized
Rule Maker0.65%(0.33%)2.75%(15.78%)38.88%12.26%
Comparable S&P 500n/an/an/an/a31.71%10.19%
S&P 500(0.02%)0.36%0.17%(2.54%)46.55%14.41%
S&P 500 (DA)(0.02%)0.36%0.17%(2.51%)48.32%14.89%
NASDAQ(0.01%)(1.04%)1.37%(16.06%)114.27%30.79%

Trade Date # Shares Ticker Cost/Share Price Total % Ret
6/23/98182CSCO24.7256.75128.83%
2/13/98130INTC26.8846.1971.82%
5/26/9866AXP36.0060.9469.27%
2/3/9866PFE27.4344.8163.35%
2/3/9859MSFT49.3570.5042.85%
2/3/9856TROW33.6747.0639.76%
8/21/9844SGP47.9951.066.40%
2/15/00102NOK42.1041.88(0.54%)
2/17/9961YHOO74.9868.50(8.64%)
2/27/9827KO69.1160.06(13.09%)
2/15/0032JDSU100.7574.13(26.43%)

Trade Date # Shares Ticker Total Cost Current Value Total Gain
6/23/98182CSCO4,498.7510,328.505,832.78
2/13/98130INTC3,494.556,004.382,509.83
5/26/9866AXP2,375.954,021.881,645.92
2/3/9859MSFT2,911.794,159.501,247.71
2/3/9866PFE1,810.572,957.631,147.05
2/3/9856TROW1,885.702,635.50749.80
8/21/9844SGP2,111.702,246.75135.05
2/15/00102NOK4,294.544,271.25(23.29)
2/27/9827KO1,865.891,621.69(244.20)
2/17/9961YHOO4,573.604,178.50(395.10)
2/15/0032JDSU3,224.002,372.00(852.00)
 
Cash: 
Total: 
28.42
44,825.98
 


Notes
The Rule Maker Portfolio began with $20,000 on February 2, 1998, and it added $2,000 in August 1998 and February 1999. Beginning in July 1999, $500 in cash (which is soon invested in stocks) is added every month.