<THE BORING PORTFOLIO>
Our Reasons for the Sale
by Dale Wettlaufer (TMF Ralegh)
ALEXANDRIA, VA (May 19, 1999) -- As I mentioned last week, we were contemplating the sale of Cisco Systems (Nasdaq: CSCO), a holding that now occupies 38% of the portfolio. When Alex Schay and I took over the Boring Portfolio in October of 1998, we reviewed each business in the portfolio and valued them to the best of our abilities. We do not believe in selling businesses that we think are priced beneath their intrinsic values nor do we believe in selling good businesses when they become overpriced. So our decision has nothing to do with the valuation of Cisco. From all we can tell, it's fairly priced at the moment.
Our method of valuing a company requires that we know a company well enough to have some sort of confidence in our ability to forecast where the company may be more than three years down the line. It's nowhere near enough to look at Cisco's margins, outstanding customer service (which is a basic attribute of the company's performance that I think a lot of people miss), end-user market growth, and current products position. I don't like to take a base case and project financials forward just because a company is a leader today. If we can make a case as to why the company will be a leader tomorrow, then that's another thing, but there are tons of reasons why Cisco might not be a leader in its marketplace five years down the line. There are many very good reasons why it will, as well, but the point is that we don't have the required fundamental knowledge to come up with these and weigh them well enough.
When I say we don't understand Cisco, that's a comparative statement. It's not the hardest thing in the world to figure out what Cisco does, but we are at a severe disadvantage to many other investors in figuring out the company's competitive position. Yi-Hsin Chang and I recently talked with Legg Mason Focus Trust manager Robert Hagstrom about the subject of focus investing. On Warren Buffett's attitude toward investing in technology-oriented companies, Hagstrom had the following thoughts:
"Buffett's not saying that it can't be done, but that he doesn't feel competent enough to do it at the level where he thinks he has a high win rate. I think he's being modest; he's got a Rolodex to kill for. He can look at a bank or an insurance company and say, 'There are probably only five guys on the planet that can do it better than me, and I can be number one or two.' Then he sees technology and he knows that there are many people that can do it better than he. In his rational mind, he doesn't want to play a game where he doesn't think he's going to be one of the best at it. So he says, 'I'll pass.'"
Not that I think I have the comparative advantage in analyzing the PC industry that Warren Buffett has in looking at things he knows well, but I stand at a much greater comparative disadvantage in looking at Cisco than I do in analyzing something like Gateway or Berkshire Hathaway. Warren Buffett has a very good way of distilling his thoughts on the competitive advantage situation. He says that if you've been in the card game for 30 minutes and you don't know who the patsy is, you're very likely the patsy. In the game of analyzing Cisco and its competition, we may very well be in that patsy cohort. Things could change pretty quickly and we wouldn't know it. When I look at the fall of Cabletron or especially Bay Networks, I have to say I didn't see those coming. What do I know about Ascend's taking a share in ATM WAN switches? Zero. I read about it on TheStreet.com. That's not a position of strength.
To some extent, investing in public companies from the standpoint of being an insignificant minority interest is always going to be akin to a representative democracy. You elect leaders who will handle affairs for you. They're acting pretty much autonomously in your best interests. That's fine. I don't want to be in the position of having 38% of this portfolio invested in a company where I can't analyze very well how these leaders are doing on my behalf. I can't, for instance, tell the difference between spin and reality when Cisco takes the position that no one is as well equipped to build out a voice-over IP (VoIP) world. How the heck do I know? Because Cisco's margins are huge and its cash hoard is large? No. Lucent is very willing to use its equity to acquire the technologies to enhance its competitive position in the marketplace and its current position in central office switching is strong. Combined with Ascend's position in WAN switching and remote access concentration, I fear the threat from Lucent. If I can't effectively dissect that sort of threat, then I have no business keeping 38% of the portfolio in this company.
At the heart of this problem lies a very interesting matter of investing psychology. An overconfident investor anchoring on the wrong issues can do a lot of damage. On the other hand, an investor practicing a focused portfolio strategy must be confident in his or her analysis; otherwise he or she is going to get knocked off the ball pretty easily. The line is not so fine, though. You either know the issues or you don't when a third of your portfolio is invested in one company. In that light, I would say I don't.
The other issue in focus investing relates to the concentration of your best ideas. If you think something is worth investing in, it's worth more than 1-3% of your portfolio. The reason I relate to this sort of strategy is that it makes sense in the realm of small business. Most people who run their own company are focus investors. Their economic fortunes are tied to the fortunes of one business. Your local McDonald's franchisee very likely has most of his or her capital invested in that one business. As a result, he or she knows that business very well. But when it comes to investing their accumulated savings in publicly traded common stocks, he or she might "take a flyer" on a stock tip. The disconnect is crazy.
When I think of any stock holding, I ask myself if I would be happy if my financial fortunes were entirely tied to that company. I also ask if I would pull cash out of my pocket to acquire the entire company. These are two of the smell tests for me. In answering those questions with regard to Cisco, I might say yes, but not an enthusiastic yes. It doesn't pass the smell test, then. And if it doesn't, then it's not worth having exposure to the situation. Reducing our exposure to 10% or 5% of the portfolio is an option, but that doesn't pass the test of focus investing, either. We either know it and like it, and thus take a large position, or we don't get involved.
Of course, all of this flies in the face of modern portfolio theory, but I don't see many modern portfolio theorists on the list of the best businesspeople of the century. Since we're not in the game of guessing how the companies in our portfolio will do, and since we're not in the game of trying to reduce risk by taking small positions when we're unsure of things, we will accept what we think is a fair price for Cisco in selling it within the next five business days.
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Stock Change Bid APCC +1 3/4 33.94 BRKb +38 2412.00 CSL + 7/16 45.06 CSCO + 3/8 116.56 GTW -1 3/4 65.06
Day Month Year History BORING +1.02% -0.83% 4.03% 39.69% S&P: +0.82% 0.68% 9.67% 123.59% NASDAQ: +0.74% 1.36% 17.55% 147.60% Rec'd # Security In At Now Change 6/26/96 225 Cisco Syst 23.96 116.56 386.58% 8/13/96 200 Carlisle C 26.32 45.06 71.18% 4/20/99 230 American P 28.95 33.94 17.21% 12/31/98 8 Berkshire 2244.00 2412.00 7.49% 2/9/99 100 Gateway 20 72.38 65.06 -10.10% Rec'd # Security In At Value Change 6/26/96 225 Cisco Syst 5389.99 26226.56 $20836.57 8/13/96 200 Carlisle C 5264.99 9012.50 $3747.51 12/31/98 8 Berkshire 17952.00 19296.00 $1344.00 4/20/99 230 American P 6659.25 7805.63 $1146.38 2/9/99 100 Gateway 20 7237.50 6506.25 -$731.25 CASH $999.27 TOTAL $69846.21
</THE BORING PORTFOLIO>