Boring Portfolio

A Near Miss
Exercising our Discipline

by Dale Wettlaufer (TMF Ralegh)

ALEXANDRIA, VA (May 24, 1999) -- It's a happy day in the Boring Portfolio, as Costco Companies (Nasdaq: COST) is coming into range. I almost pulled the trigger earlier today, but upon reflection, I arrived at the conclusion that that decision would be a rushed one, probably because the portfolio is loaded with cash at this point. If I don't follow a discipline on the way I value companies, then the approach isn't going to mean too much. Certainly, I allow a margin of error on valuing a company, but that's reflected in the cash flow forecasts I do. Waffling on the back-end of the decision making process isn't going to do me any good when I've already done the work on the front-end.

Last month, I outlined in my Stocks for Mom valuation of Costco some of the valuation parameters. I like the company so much that I was thinking of going outside the high end of what I consider to be a margin of safety. This is in part due to my desire for this excellent company to be part of this public portfolio. Even with very aggressive assumptions, in which the company doubles its invested capital over the next 3 1/2 years and quadruples invested capital over seven years (which implies a 20% annual growth rate in invested capital over that time period), it's still not in the range I believe will return 15% per year for the Boring Portfolio.

Part of this is due to the fact that the world now "gets" Costco. I came in a little late on the story in the third quarter of last year, at which time the market had the better part of the idea. With that being the case, then the excess returns over an appreciable time horizon get sucked out of a stock. In other words, my opinion about how ridiculously well run Costco is no longer qualifies as any sort of insight. By its very valuation in the market, that's become an accepted fact. What's left there for a value investor is no longer valuation plus quality. The quality is still there, but the valuation that allows for a 15%+ compound return over five years is less assured.

One of the ways I've tested this is to do a rough pro-forma of what my financials would look like if I were a company acquiring Costco, using purchase accounting and assuming no synergies. Using the same operating assumptions I've made for Costco alone, I would not be able to overcome the cost of issued equity for at least 15 years. That assumes return on operating capital of no lower than 14% over the 15 year period, by the way. So I need to see a better price before the Boring Portfolio gets involved, but that's not to say that this company won't beat the market over five years. That's just to say it doesn't quite meet my 13-15% annual return requirement. That makes all the sense in the world from the perspective of equity market pricing, in my opinion, since the cost of equity for someone looking to match the market's return is 11%.

I agree that there are no called strikes in investing. I won't have a strike called on me today because I didn't swing at Costco. That's how this portfolio has been run until this point and I'm not going to change that. Call that the choice between trying to stretch a base hit into a double and stopping on first. Or call it teeing off with a 3-wood on the 18th at Oakland Hills in the final round with a two-shot lead. There's really no reason here to try to stretch out a single or hit driver when valuations are stretched.

I will say, however, that there is an implied called strike when you are carrying so much cash, and that is the opportunity cost that you pay for keeping the cash in a money market fund rather than in the general equity market. So the called strike thing doesn't count the opportunity cost in it. Assume this, however. I keep cash earning 3.06% after tax for two years rather than investing in the market in general (all equity returns here will be pre-tax, implying a buy-and-hold approach). At the end of year two, I find something that indeed returns 15% over the ensuing three years. That's versus a base-case scenario of capital invested in the S&P 500 earning 11% per year over five years.

In the first case, an accounting starting at $1 at the beginning of year one will be worth $1.615 at the end of year five. The base case accounting, having appreciated 11% yearly, will be worth $1.685. The difference in the compound annual return on the two accounts will be 94 basis points -- one will have appreciated 10.06% per year, and the other 11% per year. Assuming, however, that years six and seven see further 15% appreciation and the base case continues to appreciate at 11%, then the account will be worth $2.136 at the end of year seven and the base case account will be worth $2.076. That's a 45 basis point advantage over the base case account. Somewhat negligible looking, but it does mean that it pays to wait for the pitch you want. The longer you wait, the less it pays, but I'm pretty sure I can get something I want in the next 24 months or less.

By the way, I see Berkshire Hathaway (NYSE: BRK.A) is rumored to have traded in and out of Chubb Corp. (NYSE: CB). Back in the days of the Buffett Partnership, there were three categories of investment: generally undervalued securities (called generals), work-outs, and control situations. From the 1964 Partnership letter, the generals are explained this way:

"A category of generally undervalued stocks, determined primarily by quantitative standards, but with considerable attention also paid to the qualitative factor. There is often little or nothing to indicate immediate market improvement. The issues lack glamour or market sponsorship. Their main qualification is a bargain price; that is, an overall valuation on the enterprise substantially below what careful analysis indicates its value to a private owner to be. Again, let me emphasize that while the quantitative comes first and is essential, the qualitative is important. We like good management -- we like a decent industry -- we like a certain amount of 'ferment' in a previously dormant management or stockholder group. But we demand value. The general group behaves very much in sympathy with the Dow and will turn in a big minus result during a year of substantial decline by the Dow. Contrarywise, it should be the star performer in a strongly advancing market."(1)

The previous year, Buffett elaborated on the holding periods of these commitments:

"Sometimes these work out very fast; many times they take years. It is difficult at the time of purchase to know any compelling reason why they should appreciate it price. However, because of this lack of glamour or anything pending which might create immediate favorable market action, they are available at very cheap prices. A lot of value can be obtained for the price paid. This substantial excess of value creates a comfortable margin of safety in each transaction. Combining this individual margin of safety with a diversity of commitments ["We usually have fairly large positions (5% to 10% of our total assets) in each of five or six generals, with small positions in another ten or fifteen"] creates a most attractive package of safety and appreciation potential. We do not go into these generals with the idea of getting the last nickel, but are usually quite content selling out at some intermediate level between our purchase price and what we regard as fair value to a private owner."

I think the Chubb trade, if Buffett were actually doing this, fits in here, though the company's sales of assets, buybacks, and other capital management moves could make it a "work out" sort of situation. This is pretty much what a lot of value investors practice today. As for the Boring Portfolio, it's largely impractical for us to engage in this sort of thing, partly because there are restrictions to how quickly we can move and because we have to announce things ahead of time, which can burn off returns. Indeed, we had to give up a number of months' returns on American Power Conversion when we entered that situation. More importantly, however, we're not really engaging in valuation arbitrage. We generally want to acquire companies we would like to hold onto indefinitely.

I should say I'm thinking out loud on this one. I won't say there are situations in my private portfolio that I've bought something that I thought was undervalued but which became longer-term holdings as I learned more about them. And I will say there are situations where I've bought undervalued situations where further investigation on them lead to the conclusion that they didn't represent value at all. For a portfolio of this type, though, that's not what we're shooting for, though I'm sure we won't be able to totally avoid these sorts of situations. If that's cleared anything up for anyone, great. And if that has confused anyone, sorry to do so.

There are a couple of other issues I wanted to get to today, but I'm already running long, so I guess those will have to wait. So, congratulations to the Sabres on game one and good luck tomorrow night.

(1) Just as a note... I cannot publish these letters at this time, as the intellectual property doesn't belong to me to publish. If we can distribute these via the Internet in the future, we will, and I hope that's the case. But we don't have the organizational resources or permission to distribute this via the mail or Internet right now. When I say we don't have the resources, that means that I'd try to accommodate requests to mail these, but even with reimbursement for the mailing costs, I don't want to get into a situation where we accommodate the first 50 requests and then turn down the next 100 requests.

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05/24/99 Close
Stock Change   Bid
APCC  +  1/16  35.00
BRKb  -30      2401.00
CSL   -  3/4   46.13
GTW   +  1/8   61.44

                  Day     Month   Year  History
        BORING   -0.52%  -0.67%   4.21%  39.92%
        S&P:     -1.78%  -2.14%   6.62% 117.55%
        NASDAQ:  -2.66%  -3.51%  11.90% 135.71%

    Rec'd   #  Security     In At       Now    Change
  8/13/96  200 Carlisle C    26.32     46.13    75.21%
  4/20/99  230 American P    28.95     35.00    20.88%
 12/31/98    8 Berkshire   2244.00   2401.00     7.00%
   2/9/99  100 Gateway 20    72.38     61.44   -15.11%

    Rec'd   #  Security     In At     Value    Change
  8/13/96  200 Carlisle C  5264.99   9225.00  $3960.01
  4/20/99  230 American P  6659.25   8050.00  $1390.75
 12/31/98    8 Berkshire  17952.00  19208.00  $1256.00
   2/9/99  100 Gateway 20  7237.50   6143.75 -$1093.75

                             CASH  $27334.40
                            TOTAL  $69961.15