Boring Portfolio

Equities as Bonds
Conservative Assumptions

by Dale Wettlaufer (TMF Ralegh)

ALEXANDRIA, VA (April. 28, 1999) -- A couple of issues today. So let's just get going.

We're running our Stocks for Mom collection and I've submitted Costco Companies (Nasdaq: COST) as this year's idea. Depending on your discount rate, the company is either undervalued or overvalued, which kind of reveals what I think of the term "intrinsic value." Intrinsic value depends very much on your required return. If you don't want any more than a 10% compounded annual return from some of the niftiest companies out there, then you can pay today's price. Price is still ridiculously important to us. I plan to write the Fool on the Hill (FOTH) column about this subject tomorrow. This doesn't mean, by the way, that all the "nifty" companies out there are undervalued. It just means that I don't think you can just do a cursory look at a company and buy it on blind faith that returns of the last ten years will continue for the next 10 years.

Anyway, back to Costco. What I wanted to talk about in tomorrow's FOTH is equating equities with bonds. You see some of that in the Costco piece, but I had to cut out some of the draft I did because it was way too long for the format we planned. In essence, if you're looking at an equity in the same way you calculate a bond's yield to maturity, then the current earnings yield, the inverse of the P/E, is only one point in the overall valuation scheme of things. If you're paying 4.5 times invested capital and the company returns 14% on invested capital, then your current Bore ratio (which is somewhat like a calculation of earnings yield, but not quite), is 14% divided 4.5 = 3.1%.

That works in the balance sheet and the earnings statement together, somewhat like a bond. If you pay par for a bond that has a face yield of 6%, then you're paying one times invested capital for an instrument yielding 6% on invested capital. Ignoring for purposes of simplicity the tax issues (which are, I caution, substantial), the Bore ratio on that would be 6%/1 = 6%.

On the initial capital outlay, the yield to the investor can be low, just as if you're buying a 9% bond in a 6% interest rate environment. The bond yields 9% at par, but is priced somewhere around 150% of par for a current yield of 6%. You're buying above par because the bond's return at par would be higher than comparable instruments. In a bond's calculation of yield to maturity, though, you assume the coupon income is reinvested in bonds whose yields match current interest rates. In other words, your return on reinvested capital is assumed to be the same as current interest rates.

With equities, however, your return on incremental capital can be huge multiples of the return on capital that you're getting on your initial outlay. If you're investing in a company with a 40% return on capital and good growth prospects, you'll likely be paying around 10 times or more the amount of capital current invested in the business. That would put your current earnings yield at 4%. But the reinvested earnings, or coupon income in this example, is being reinvested in new capital projects, at par, that yield 40%. If you run that out over a long period of time, then you can pay a big multiple of earnings today and still show supernormal returns on your initial investment.

The reason why a guy like Buffett doesn't just look for companies with high returns on capital is because not all companies with those high returns can be easily seen generating those returns 15 years down the line. Which gets me to the second topic I wanted to talk about -- the conservatism of value investors.

One reason many value investors won't invest in the most dynamic enterprises today is due to their unwillingness to pay above certain, arbitrary multiples to earnings or book value. The reason why the Rule Maker portfolio makes sense in many ways is because Tom Gardner and the guys that run it are very cheerfully optimistic about the future. They figure these globally-dominant companies can keep on pouring on the capital and returning above 20% on capital. If you have a company growing invested capital 25% per year for 30 years and returning 25% on invested capital, you can pay huge multiples to earnings or capital today and do very well over that holding period. Value investors by nature feel uncomfortable forecasting those growth rates, because they often don't happen. It's an uncommon thing to see that happen.

But it doesn't mean that sort of growth doesn't happen. It has and it does. The value investor wants a margin of safety, however. The goal of the value investor, though, shouldn't be to purposely underestimate what a company can realistically do, just as no "investor" should purposely overestimate what a company can do and then attach a big discount rate to that to compensate for over-enthusiasm.

The goal of investors should be to develop the best guess possible as to what a company can do going forward and then attach whatever hurdle rates they feel matches their requirements. With a company like Wal-Mart (NYSE: WMT), you would have been called insane by your colleagues if your 20 year model of the company in 1970 forecasted exactly what the company did do over the ensuing 20 years. But you could have discounted your cash flows at 20% per year and still paid huge multiples to 1970's earnings and balance sheet and you would have crushed the market.

What we want to do with the Bore is be approximately correct in what we think a company can do. Costco at more than 40 times earnings is an interesting challenge. I don't think I am on Mars when one possible growth path has the company doubling invested capital every 3.5 years. The reason why is because people love, absolutely love, Costco. And it's so well managed that it's not outside the realm of possibilities when you look at the company's competitive position. If you assume that it goes through two 3.5 year cycles (essentially quadrupling invested capital a little beyond the end of year 7) growing invested capital at 20% per year and then that drops off to 10% per year, the company's selling at 16 times earnings in year 15, ROIC is assumed to be 14% throughout, and you discount equity at 13%, then that would yield an intrinsic value roughly equal to today's price.

That's impounding performance into today's price. What we have to do is judge whether that can be done. I definitely think it can, but I see it at the outside of probabilities. If you wanted to do a Bayesian analysis of that, we would attach whatever probability of that happening we feel is appropriate. If I did do a probability distribution, which is a good idea, I would probably have an even more aggressive model to go along with the others. As it stands now, I'm pretty comfortable with the work on it I did recently. In that work, I've tried to model what I think is most possible, giving the company a lot of credit for what it can do in the future. So, if it would come to us, we'll get involved, but I don't see ourselves chasing any company ever.

Finally, a couple of notes.

Financial guarantor MBIA Inc. (NYSE: MBI) reports earnings coming up. They announced their conference call number today. I would recommend listening if you follow insurance companies. Here's the link to the company press release.

I noticed Veterinary Centers of America (Nasdaq: VCAI) below $14. I think that's an interesting company. We'll look at that on Wednesday.

In the meantime, have a good Monday night, congratulations to the Buffalo Sabres on the sweep, and we hope to see you on the Boring message board.

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04/28/99 Close
Stock Change   Bid
APCC  -1 7/8   33.50
BRKb  -6       2484.00
CSL   +1 5/8   47.81
CSCO  -3 5/16  111.75
GTW   -2 1/2   68.63

                  Day     Month   Year  History
        BORING   -1.61%   4.19%   4.48%  40.29%
        S&P:     -0.87%   5.02%  10.22% 124.67%
        NASDAQ:  -2.00%   3.60%  16.31% 144.99%

    Rec'd   #  Security     In At       Now    Change
  6/26/96  225 Cisco Syst    23.96    111.75   366.49%
  8/13/96  200 Carlisle C    26.32     47.81    81.62%
  4/20/99  230 American P    28.95     33.50    15.70%
 12/31/98    8 Berkshire   2244.00   2484.00    10.70%
   2/9/99  100 Gateway 20    72.38     68.63    -5.18%

    Rec'd   #  Security     In At     Value    Change
  6/26/96  225 Cisco Syst  5389.99  25143.75 $19753.76
  8/13/96  200 Carlisle C  5264.99   9562.50  $4297.51
 12/31/98    8 Berkshire  17952.00  19872.00  $1920.00
  4/20/99  230 American P  6659.25   7705.00  $1045.75
   2/9/99  100 Gateway 20  7237.50   6862.50  -$375.00

                             CASH    $999.27
                            TOTAL  $70145.02