Boring Portfolio

Boring Portfolio Report
Wednesday, January 24, 1996

By Greg Markus (MF Boring)


The company is important, but the stock must also pass its own test, which can be summed up in one word: value. By "value," I simply mean paying a good price for something of good quality. Having identified a good quality company, we need to determine what price we'd be willing to pay for its shares. There are various approaches to determining what a "good price" is, and I don't insist on hewing to any single approach.

Mostly, I consider a company's short-term stream of per-share earnings (EPS) and multiply that by some appropriate valuation factor, or "multiple." The resulting product (plus an adjustment for dividends, if they're of non-negligible size) is my estimate of the stock's "fair price." Fine, but how do you determine the EPS, and where does the multiple come from? Entire books--big ones!--have been written to answer that question (see, e.g., "Graham and Dodd's Security Analysis"). There's a lot of art (or is it craft?) that comes into play here.

Most of the time, I use a "rolling EPS" for the first variable--that is, actual EPS from the past two quarters (adjusted for unusual charges) plus estimated EPS for the next two quarters (from First Call or Zack's or, occasionally, my own guesstimation). Value Line uses a rolling EPS to calculate p/e ratios.

As for the appropriate multiple, that gets trickier. Plausible candidates include estimated EPS growth over a two-year period (one year back, one year forward), 5-year estimated annualized earnings rate, the industry's historical earnings rate, the stock's historical p/e, and so on. I tend to use the one of these that "feels" like what the market will bear (there's that "Zen" part), or use some average of them all.

In the end, the multiple you select should look something like a "long-run" expected rate of annual growth in earnings, discounted to take into account the risk involved in actually realizing those earnings. (Another complication: the valuations of *all* stocks ebb and flow with changes in the rate of return that investors can get on so-called riskless investments, like U.S. government debt. If interest rates go up, then investors' willingness to accept risk on equities will go down. That's all I can say on that here.)

Here's a quick example: let's take Cisco Systems (NASD:CSCO), the hugely successful computer networking company. As I write this, First Call's estimated EPS for Cisco's FY96 (which is half over) is $2.60. Now for the multiple. Based on actual EPS of $1.73 for FY95, and estimated EPS of $2.60 for FY96 and $3.40 for FY97, we get an estimated annualized growth rate of 40% across the two-year span. First Call's estimated EPS growth rate for the next 5 years for CSCO is 30%. The stock's historical p/e (from Value Line) is 23. The industry-wide expected growth is 21%.

Okay, we've got (from low to high): 21, 23, 30, 40. The average is 28.5, which sounds like a plausible valuation for a moderately risky stock estimated to grow something like 30 to 40 percent annually over the next few years. So 28.5 x $2.60 = $74.10. Latest quote on CSCO is 75 3/4. Conclusion: CSCO is fairly priced where it is: a fairly-priced 30 to 40 percent (or so) grower (which are not all that common).

Cisco stock came out fairly priced in this example. It ought to be: its every twitch is monitored by nearly 30 analysts. For less closely-watched stocks (and even for the closely watched ones, occasionally), the market is pretty clearly not perfectly efficient in the short-run: stock prices can overshoot or undershoot fair value, sometimes substantially. Eventually, reality intrudes and the price moves into line. The trick is to identify stocks with prices that are (temporarily) out of whack with one's best judgment of fair value.

This can mean shorting an over-priced stock occasionally, as well as buying bargains. For example, I shorted Fastenal (NASD:FAST) recently. Fastenal is a wonderfully boring company that specializes in selling thousands of nuts, bolts, clips, and related tools through a rapidly growing chain of customer-friendly stores. It's even based in Winona, Minnesota--how quintessentially boring!

The only problem was that a whole lot of folks had fallen in love with Fastenal's story, and the stock was trading at an multiple well beyond any plausible estimate of its rate of sustained earnings growth. So I shorted the stock in the upper $30 range. FAST pushed into the low 40s ... and then plummeted in a series of sustained dives to the high 20s, where it was finally more or less fairly priced. Fastenal could well become a Boring "long" at that valuation.

As I mentioned earlier, no valuation procedure should be applied mechanically. Risk, historical cyclicity of sales, unusual prospects for growth, and other factors should be taken into account in determining a stock's fair value. Also, earnings can grow for various reasons: increased sales, increased profit margins, reduced internal business costs, and so on.

All sources of earnings growth should not necessarily be treated equally. For example, trimming internal business costs to boost the bottom line is fine, but cutting back on research and development or on capital upgrades simply to create the short-run appearance of prosperity is obviously unwise. Sales (and sustainably healthy profit margins) properly deserve priority when considering stocks for purchase.

Coming Tomorrow: When to Sell (part 4 of 4 in the Boring Approach: Boring Thoughts on Stocks).