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by Dale Wettlaufer (TMF Ralegh)

ALEXANDRIA, VA (May 21, 1999) -- Yesterday, I further explained my rationale for selling Cisco Systems (Nasdaq: CSCO). A couple of points bear some even further explanation for the purposes of archiving the thought process that went into this decision.

What I'm saying about understanding Cisco is not that I don't understand it. I believe I do. The point is that I don't understand it well enough that I have confidence in my ability to forecast and weigh the returns that this company can generate over its lifetime. Any company's value today is highly dependent on what it will do (the business, not the stock) this year, next year, in the next five years, and what it can do over a number of decades. If you change any of those variables, you can come up with a very different result in valuing the company.

If you think the company's competitive advantage (its ability to generate returns on capital in excess of cost of capital) ends five years down the line, you're not going to pay a big multiple to this year's earnings. Hence the historical valuations of PC companies, the relatively low valuation of Intel (Nasdaq: INTC), and the historically low valuation of Cisco. Obviously, Cisco has been hugely undervalued over the last five years. If it were valued properly, you wouldn't have seen the excess returns in the stock and you would have seen a mind-bogglingly high valuation back in 1994. The market has historically underestimated Cisco's ability to keep dominating its market and new markets. The best PC companies, Intel, and Cisco are high return on capital businesses, but when they get to low valuations, that means the market doubts their ability to continue to generate these high returns on capital.

Using the market at a signaling mechanism, it becomes obvious that at the current valuation, the market is more confident that Cisco will keep on dominating. That makes sense, given that Cisco's economic attributes are very close to those of a software company, where marginal costs of producing an extra dollar of revenue are low and marginal returns on capital are huge. It's also a lock-down sort of business, where owning enabling standards allows you to capture the majority of unit and revenue growth in your markets. When you look at basic standards such as chip architecture or operating systems, those are winner-take-all markets. Second place is usually not a fun place to be. So I categorically reject the reasoning that Cisco will do fine if it doesn't lock down new markets. It may, but the underperformance risk is high if it does not.

If you're subject to discontinuous technology changes, you face the prospect of losing your competitive advantage. Just because Cisco rules the networking market today doesn't mean it's a sure thing they will rule a market with different standards five years from now. In my opinion, which I freely admit is based on imperfect information and a disadvantaged position in understanding many issues facing its industry, Cisco is priced as if there is a significant probability that it will set those standards. If you handicap it differently, increasing the possibility that it won't, the attractiveness of the stock diminishes. I don't know that Cisco will dominate those new markets. And I don't even know how to handicap it with a reasonable degree of confidence. Some investors handicap it very much in Cisco's favor, which would of course yield a very attractive prospective return since the market for communications equipment is growing so rapidly and since a huge installed base of voice communications infrastructure is up for grabs.

In selling Cisco, I'm not saying the company will not succeed at crushing the market. And I'm not saying it will fail. There is a significant probability it will crush the market's return over the next five to ten years. I'm trying not to think in terms of single-point probabilities just as I try not to think in terms of single-point valuations. In other words, I don't look at a company and say "here is exactly what I think it will do over ten years" and I don't just pull a P/E multiple out of the air and say "that's what I think the company is worth."

My conception of value is not what many people understand to be "value." Just because something has a P/E of 5 and a price/book value of 0.7 doesn't make it a value in my book. A company with no earnings or a price/earnings ratio of 200 and price/book of 400 might very well be selling beneath its intrinsic value and be able to provide a return that meets our requirements. Arbitrary definitions of "cheap" and "dear" don't interest me if they can't be demonstrated with valuation work. So, you have to be able to figure out a lot of very complex issues with a company like Cisco. As a generalist whose best industry knowledge is in industries other than this one, all I can say is that we sold it because I believe I was getting a fair value and that the company was undervalued when we took over the portfolio in 1998. As a buy-and-hold value manager, I don't believe there's ever an end to the "hold" part of the equation. I just think you had better know a lot about a company such as this when it's priced the way it is.

By the way, I read today in a article that BancBoston Robertson Stephens analyst Paul Silverstein wrote a note to Cisco Systems on May 14th that he disagrees with the company's stance on poolings versus purchase treatments for mergers & acquisitions. Alex and I have written about that numerous times and we agree with Silverstein. There is no economic difference in the structure of the deal except that companies engaging in poolings of interests are forced to observe artificially constraining rules on share buybacks, dispositions of assets, and other requirements that diminish a company's options. I think Alex and I have beaten this one to death, actually:

The Evening News 10/22/98: Jump In the Pool
The Evening News 02/25/99: Financial Karma's Gonna Get You
The Evening News 02/26/99: Financial Karma, Part 2
The Evening News 03/01/99: Financial Karma, Part III
The Evening News 04/22/99: Get Out of the Pool!

Bottom line on this is that the new FASB (Financial Accounting Standards Board) rules will assist investors in assessing how much capital needs to be deployed to generate cash flow and what the company's real return on capital is. The market will figure it out even if some people are disadvantaged in their abilities to look at a company's real cash flows rather than GAAP (generally accepted accounting principles) earnings. As a complex adaptive system, the market will price these companies more efficiently given the better information. The issues are not trivial, I believe.

Regarding another holding, if you haven't seen the new desktop computer Gateway (NYSE: GTW) is selling in Japan, check out this article. It's essentially a PC packed inside the back of a 15-inch LCD monitor. It's basically a fat laptop on a stand. I can say that I wouldn't mind ditching the CRT monitor on my desk. Our techies treated me to a top-of-the-line monitor, but it's like having a big screen TV on my desktop. I was pleased to read in another article yesterday that CEO and Chairman Ted Waitt "hinted that the company is eyeing ways to enter the market for information appliances." Waitt commented that they "...feel the technology now allows for us to develop very low-cost products and we are going to definitely play in that market." This matches my thesis on the direct PC companies that they contain multiple economic attributes, which account for their supernormal returns on capital:

1. They are precision manufacturers with service and logistics components.
2. They are distributors (second and third tier).
3. They are retailers.

Manufacturing information appliances is a direct outgrowth of their core competencies and feeds into the second and third attributes, which are themselves growing.

Since I'm out of space, that does it for today. I'm certainly open to questions, comments, and flames on the Boring message board. And I can't forget to wish the Buffalo Sabres well.

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05/21/99 Close
Stock Change   Bid
APCC  +1 5/16  34.94
BRKb  +31      2431.00
CSL   -  1/4   46.88
GTW   +  1/16  61.31

                  Day     Month   Year  History
        BORING   +0.72%  -0.15%   4.75%  40.65%
        S&P:     -0.64%  -0.37%   8.54% 121.35%
        NASDAQ:  -0.84%  -0.87%  14.96% 142.16%

    Rec'd   #  Security     In At       Now    Change
  8/13/96  200 Carlisle C    26.32     46.88    78.06%
  4/20/99  230 American P    28.95     34.94    20.67%
 12/31/98    8 Berkshire   2244.00   2431.00     8.33%
   2/9/99  100 Gateway 20    72.38     61.31   -15.28%

    Rec'd   #  Security     In At     Value    Change
  8/13/96  200 Carlisle C  5264.99   9375.00  $4110.01
 12/31/98    8 Berkshire  17952.00  19448.00  $1496.00
  4/20/99  230 American P  6659.25   8035.63  $1376.38
   2/9/99  100 Gateway 20  7237.50   6131.25 -$1106.25

                             CASH  $27334.40
                            TOTAL  $70324.27