Boring Portfolio

Boring Portfolio Report
Wednesday, October 9, 1996

by Greg Markus (MF Boring)

ANN ARBOR, Mich. (Oct. 9) Stocks fell again on Wednesday, despite a generally encouraging semiconductor book/bill report last night. Major market indices began today's session strongly enough, but traders soon began selling into the rally, sending the Dow down sufficiently to trigger loss-limit collars.

At day's end, the Dow was off 36 points, the S&P 500 index had dropped nearly 4 points (-0.53%), and the Nasdaq was lower by 2 (-0.17%). Long-term interest rates headed north slightly, to 6.82%

The situation was even worse for the Boring Portfolio. Oxford Health, Cisco, and Carlisle recorded small gains, but the balance of the port was down, including a dollar loss from Borefolio leader Borders Group and nearly a half-point slip in the Spiders. All tolled, Boring stocks lost 0.91% in net value.

A scan of the wire services and the pile of newspapers on my desk reveals no specific news on any Borefolio holdings. A fresh round of earnings projections were posted in First Call today (available on AOL), however. Based on my calculations, all Borefolio stocks remain below fair value, although a few of our leaders are getting close.

Consider Borders Group. Its FY runs January to January. Analysts are projecting that the company will makes something like $1.61/share in the coming FY (i.e., the one ending Jan. '98). That means that BGP is currently trading at 23-times projected earnings. That's certainly higher than the overall market multiple, but then Borders is expected to grow EPS 27% or so in the coming year, and 25% or so looking even further ahead.

This suggests to me that BGP still has a bit more room to run, at least until we can get a better read on how the all-important Christmas season is shaping up. At the same time, however, unless EPS estimates for Borders were revised upward noticeably, asking the stock to get much above $40 near-term is perhaps asking more than is reasonable.

If you've followed the Boring Portfolio much, it should be abundantly clear that I selected BGP not simply because I thought it was a "hot stock," but also because I genuinely like Borders bookstores -- a lot. I want to own stocks of companies that I enjoy following and learning about. Often, I buy stocks of companies I know something about first-hand.

I'm not saying that this is the way you should invest. I'm simply saying that it's the way I do it personally -- as well as here with the Borefolio's funds. It's worked out pretty well for me financially, and it's rewarding in other ways that I value, as well.

That said, I try to discipline myself not to fall in love with a stock and hold it beyond the point where the numbers tell me the stock has gotten ahead of itself. You can always buy it back later, even at a higher price, if it makes sense down the road. The stock and the company are two different things -- closely inter-related, to be sure, but ultimately two different things. There are stocks of lots of great enterprises that I don't own now and have never owned because basically I just can't bring myself to pay what I consider to be an inflated price.

Speaking of inflated prices, I've indicated in a couple of Borefolio recaps recently that I'm getting somewhat antsy about the valuation of "the market" in general. When I say that, I'm *not* referring to technical considerations but rather to fundamental ones: i.e., valuing the market (or a market indicator) more or less as one would value a stock.

"Why bother valuing the market?" you might ask. "After all, we're buying stocks, not the market." Fair enough. In reply I offer two considerations.

First, in a narrow sense, the Borefolio *is* invested in "the market." It's got 100 Spiders worth around $7,000, or nearly 12% of total assets. When I bought those Spiders back in July, I explicitly noted that this was not intended to be an investment for the ages but rather a place to sock away some cash (and earn a fine 8.58% return in less than three months!) until I decided it was time to move the funds elsewhere. A decision to cash in the Spiders is based in part on what new investment ideas I manage to turn up in the meantime; but it also depends on my estimate of whether the Spiders have themselves passed "fair value," just as in the case of any single stock. I'm not cashing in right now, but I may -- possibly pretty soon.

Second, even though we are investing in individual stocks rather than in "the market" (Spiders aside), about one-third of the variation in an individual issue is coincident with variation in the broader market. Stated another way, it's certainly possible to pick great stocks that go up even in a down market, but the risk/reward ratio is working against you.

The action implication of that, for me, is *not* to move out of the market entirely (or even a whole lot). But I am marginally more likely to sell (at least part of) nearly fully-valued stocks in an over-valued market than I am under more benign overall conditions.

We've got to close this out for tonight, but I certainly ought to at least point to a datum or two in support my (provisional, always provisional) conclusion that the market is pushing the boundaries of fair value.

Datum number one is perfectly homely. It's simply the p/e on the S&P 500. The trailing p/e recently moved over the 20 mark -- a good 18% above where it was this time last year, and undeniably above any plausible estimate of (dividend adjusted) sustainable EPS growth for those 500 gorilla companies. That certainly doesn't suggest any crash of Garzarellian proportions (it *is* October, after all); but it does offer at least some reason to be extra-careful.

Datum number two is more esoteric. It's a chart provided by Michael Barnes in the current issue of Barron's.

Now I take second place to no one in viewing with a skeptical eye the stream of snarling pronouncements that have emanated from "Bear-ons" over the past few, uh, *years*. As the old saying goes, Barron's has successfully predicted eight of the last three market corrections.

The chart on page 29 does get my attention, however. In it, Barnes shows that based on pooled EBIT (earnings before interest and taxes) relative to market value, the S&P is at least 20% beyond fair value.

That gets my attention because it uses what I consider to be a useful gauge of valuation, as opposed to the other (less useful) indicators that the permabears regularly wheel out: price to dividends, price to book, Tobin's Q, and such.

So is the mother of all crashes right around the corner? How in the world should I (or anyone else) know? The market is fundamentally chaotic, and forecasting its behavior is a chump's game. Note, in particular, that even by Barnes's plausible EBIT to market value ratio, the market's been overvalued since early 1995. We'd have lost out on a heckuva lot of gains if we moved into cash back when the indicator first moved into the warning zone.

But am I watching the situation a bit more carefully than I usually do? Uh-huh.

Transmitted: 10/9/96