Boring Portfolio

Prospective Investments
Understanding what they are, and why

by Dale Wettlaufer (TMF Ralegh)

ALEXANDRIA, VA (Oct. 2, 1998) -- Let's examine for a moment what we understand "boring" to be. The idea of "boring" started off with people investing in things they understand. And it happened at the time that these things were in boring, mature industries, such as construction aggregates, furniture, steel, railroad cars, and that sort of thing. The central tenet in that way of doing things is understanding the business in which you're making an investment.

With something like Microsoft (Nasdaq: MSFT), Cisco Systems (Nasdaq: CSCO), or various medical technologies companies, I can tell you what they do. I understand where these companies make money and how they can continue to make money, but it's very hard for me to gauge the entire competitive landscape in these industries. Microsoft, for example, faces threats from Sun Microsystems (Nasdaq: SUNW), Linux, and Java, but I have no idea of the magnitude of these threats. Sure, Microsoft is late with NT 5.0, and sure, the best technical solution doesn't always win, but what sort of assurance do I have that Microsoft will have the right enterprise operating system to continue its dominance into the next century?

I don't have a clue. I would have to accept on faith alone that Microsoft will continue to dominate its industry segment. Looking at their cash flows, I know what a powerhouse they are, but I really don't have any insights into the merits of Linux and the demerits of NT 5.0. Operating with that lack of knowledge, can I reasonably expect to forecast earnings and cash flow? No, not as well as I'd like. What we see as "boring" is the methodical ability to dissect the company in which you propose to make an investment. When it comes to intellectual property enterprises, we want to have an idea of how well the company can perpetuate its position and reinvest cash flows to benefit shareholders in the future.

"Boring" is a methodical process of thinking about and analyzing things. We do discounted cash flows, we do Economic Value Added analysis, we do lots of comparative analyses, and we do lots of tearing around balance sheets and cash flow statements. Alex and I are both quantitative people. We like to measure how companies operate because we wouldn't otherwise be able to make an informed decision on how well they can do in the future. In addition, we want to figure out if the current price being offered by the market offers us a margin of error, or margin of safety, as the term is used. We believe very strongly that the price at which we acquire something will play a significant part in the returns that we can expect.

That is a common sense concept to us. Would we invest in a company that doesn't care what price it pays for something? Well, we wouldn't want a management team that gets hung up on a $5 million difference in a $200 million acquisition. But we shun companies that dilute the excellent economics of a pre-existing business by paying up for overpriced acquisitions. Now, that doesn't mean that we'll criticize Cisco Systems for paying $250 million for companies with little in the way of sales or earnings. Cisco's many acquisitions each year serve as part of R&D. And while many of these acquisitions probably turn out not to bear much fruit in the products or intellectual property that they bring to Cisco, some of these acquisitions turn out to be ridiculously profitable from a return on investment point of view.

If one of these no-earnings, no-sales companies cranks out $50 billion in revenues and $10 billion in cash flow over ten years, then the $250 million acquisition price is well worth it. So, we can't hold Cisco to the same metrics to which we hold, say, DuPont in acquiring a mature company like Conoco. The oil exploration and production business is relatively mature and isn't going to grow like a new product in the data communications equipment industry. You can't overpay for companies, and even companies that are highly profitable, and expect to do as well as someone that is patient with capital and moves when prices are more reasonable. If I can acquire a company with an intrinsic growth in cash flows of 10% per year and pay 80% of intrinsic value, then I'm going to do better than the person that buys at 120% of intrinsic value. We might both do well on the investment, but we will pay the extra time premium to buy margin of error insurance.

By that, I mean we'll wait around for months on end if we can't find things that meet our investment criteria. That will come at the expense of short-term performance, no doubt. That is margin of error insurance premium that we will pay. Not that we are value freaks, though. We think it's ludicrous to think that no company is ever worth more than 15 times earnings and two times book value. We just don't understand that line of thinking. We don't really care what the hard-core value investors so vaunted in places like Outstanding Investors Digest are doing. They have their thoughts on what value represents and we have ours. Was Cisco not a value at 200 times earnings in 1991? You bet. You could have paid much more for the company than its then-current market value and have done very well over the intervening seven years.

P/E is a function of the current market price and the current earnings of the company. The intrinsic value of the company can be way above or way below the current market price. Say Mobil is selling for 0.5 times sales, one times book value, and five times earnings. Is that a bargain? Maybe so, maybe not. If a hydrogen fuel cell costing $500 were introduced the next day, it's very likely that many companies in the oil industry would offer no more intrinsic value than the net realizable value of the company upon liquidation.

That's our modus operandi. Our goal here is find out what makes a company tick. That goes for how its suppliers, customers, and competition tick. Without the quality of research needed to find out the economics of a company and the industry in which it operates, we'll never get to the second stage of valuing the company. It's just not possible. If we get through the first stage, then we can get to the second state of valuing the company. Sure, things will come onto our radar screen because they might look cheap. But that's as far as something will get if we can't understand how the company can build value in the future.

We hope to see you on the Boring message board for discussion, and we'll see you here on Monday.

10/01/98: The New Boring Port Transitions Facts

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10/02/98 Close

Stock  Change    Bid 
 ANDW  +1 1/16  13.56 
 CGO   -1 3/8   26.00 
 BGP   +2 9/16  23.94 
 CSL   -  3/4   36.75 
 CSCO  -1 1/2   55.75 
 FCH   -1       22.63 
 PNR   +  3/16  31.63 
 TBY   +  1/8   6.13 
 
                   Day   Month    Year  History 
         BORING   +0.80%  -3.47% -17.40%   3.94% 
         S&P:     +1.64%  -1.42%   3.32%  61.29% 
         NASDAQ:  +0.16%  -4.66%   2.84%  55.14% 
  
     Rec'd   #  Security     In At       Now    Change 
   6/26/96  225 Cisco Syst    23.96     55.75   132.72% 
   2/28/96  400 Borders Gr    11.26     23.94   112.66% 
   8/13/96  200 Carlisle C    26.32     36.75    39.60% 
    3/5/97  150 Atlas Air     23.06     26.00    12.76% 
   4/14/98  100 Pentair       43.74     31.63   -27.70% 
   5/20/98  400 TCBY Enter    10.05      6.13   -39.02% 
   11/6/97  200 FelCor Sui    37.59     22.63   -39.81% 
   1/21/98  200 Andrew Cor    26.09     13.56   -48.02% 
  
     Rec'd   #  Security     In At     Value    Change 
   6/26/96  225 Cisco Syst  5389.99  12543.75  $7153.76 
   2/28/96  400 Borders Gr  4502.49   9575.00  $5072.51 
   8/13/96  200 Carlisle C  5264.99   7350.00  $2085.01 
    3/5/97  150 Atlas Air   3458.74   3900.00   $441.26 
   4/14/98  100 Pentair     4374.25   3162.50 -$1211.75 
   5/20/98  400 TCBY Enter  4018.00   2450.00 -$1568.00 
   1/21/98  200 Andrew Cor  5218.00   2712.50 -$2505.50 
   11/6/97  200 FelCor Sui  7518.00   4525.00 -$2993.00 
  
                              CASH   $5750.59 
                             TOTAL  $51969.34 
 

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