Boring Portfolio

Boring Tenets, Part 3
Value Philosophy, Part 1

By Dale Wettlaufer (TMF Ralegh)

ALEXANDRIA, VA (July 14, 1999) -- There's no way I can cover the subject of valuing a company in an introductory series such as this, so I think it would probably be more instructive to identify some of the influences on the Boring approach to value.

First, my definition of value is: The net present value of all future cash flows a company can produce, discounted at the expected rate of return to investors. Value is not:

  1. Buying something based on a certain, low price/earnings ratio
  2. Buying something based on low multiples to other accounting-based values such as book value.

Those data can be instructive and helpful, but they're not answers unto themselves. The value of a company is not decided based on those things alone but only when they can say something about the cash that can be taken out of a business. Now, if you establish that a company is selling for half of book value and you've adjusted that book value to reflect the real-world value of the assets and the costs of winding up that business, then maybe book value can tell you something. Or if you've discovered hidden assets that understate book value and you think the value of those assets can be somehow realized, then book value might also be useful. But to say something is selling at book value without knowing the company's return on equity and some likely scenarios as to where those cash flows are going, it's not a "value stock" just because it's selling at the usual "value" multiple.

The Boring approach also doesn't rely upon comparative valuation approaches. We do look at companies in an industry side-by-side to see who's the more efficient company and to get an overall picture of how things look in a particular industry, but we won't look at five companies in a particular industry and bid for one just because it's selling at a discount to its peers. That's particularly true in sectors with lots of momentum in stock prices. We won't look at one company that has a lot of hot air under it and look at a competitor with less hot air under it and conclude that the latter is undervalued based on the price of the former.

To the greatest extent possible, we try to use everything available to assess the discounted net present value of cash that can be generated by a business over its life, with supplemental methods of valuation falling into the mix. Measuring and discounting cash flow is the centerpiece of what we do, though. To that end, I would suggest the following:

Chairman's Letters to Shareholders, by Warren E. Buffett. Buffett is the biggest influence on the Boring approach, though we're quick to point out that the goal here is not to be just like Warren Buffett. I differ in some areas of thought. As a practitioner and an investment thinker, Buffett is the best, in my opinion and this should be the cornerstone of all investment reading.

Security Analysis; The Intelligent Investor, by Ben Graham. These are two bulwark texts in security analysis and introduce the reader to concepts that are necessary in building a base of knowledge and a vocabulary for the further study of valuing companies. One can depart from Graham on some things, just as one shouldn't treat the word of Warren Buffett as the word of God, but one's education in security analysis is not complete without reading these.

Valuation: Measuring and Managing the Value of Companies, by Tom Copeland et. al. A good all-around introduction to discounted cash flow analysis.

The Quest for Value: The EVA Management Guide, by G. Bennett Stewart III. Economic Value Added (EVA) analysis is just another way to measure cash flows, but this is a vital explanation of what real profits are about. That is, a profit over the long-term is not an economic profit unless it's higher than the cost of capital invested in the business. For debt, this is a pretty straightforward concept, but for equity, it's not as apparent, since the cost of equity does not show up on the income statement. This is a vital concept in the way we think about companies in the Boring Port. website, by BancBoston Robertson Stephens analyst Paul Johnson and CS First Boston analyst Michael Mauboussin. This is used as the contact point between Mauboussin and Johnson and their students at Columbia University, where the two are visiting professors, teaching the same class Ben Graham taught starting over 70 years ago. Of particular interest:

Introducing ROIC as an Economic Measure, which explains some of the same things you'll find in the Stewart book.

Does Valuation Matter. Answers the following thesis statement: "Notwithstanding the fascination Wall Street has with EPS growth rates, there is neither a statistical relationship nor a common sensible relationship between EPS growth rates and stock prices, in our opinion." Also addresses some of the issues mentioned above.

What Have You Learned in the Past 2 Seconds?" A classic essay on investor behavior. Answers why "most people get into trouble from their inability to sit quietly and do nothing," according to T.S. Eliot.

Of course, the Peter Lynch books are excellent for beginners, though it's been a while since I've read them (I'm not making any claims as to my progress in investing skill here). I do remember them as being very engaging and reflective of Lynch's passion. Among books on investing that I read many years ago, these are some of the few that stick out in my memory.

In sum, there's no black box that I use. And nowhere above are you going to get what I believe is the best recipe for learning to look at financials and getting a feel for a lot of different business models -- that is, looking at the financial statements of literally hundreds and probably thousands of companies over a number of years. Intelligent repetition is most useful, as in learning the piano, learning how to golf or play tennis or field a baseball, or learning a language. The language of commerce is accounting, and I think you must be at least semi-fluent in it (which means you can speak it and understand it without consciously thinking about every word you're hearing or speaking) to understand what you're doing. That's something that requires a lot of hard work on one's own, though certainly our forums are always a pretty good place to go when you get stuck.

Have a good Wednesday night. Questions, comments, and lower-intensity flames are welcome on the Boring Port message board.

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07/14/99 Close
Stock Change   Bid
APCC  +  1/8   21.56
BRKb  +15      2286.00
CSL   +1 3/16  51.00
GTW   +4 11/16 73.00

                  Day     Month   Year  History
        BORING   +1.31%   4.57%   8.65%  45.88%
        S&P:     +0.33%   1.85%  14.32% 132.79%
        NASDAQ:  +1.43%   4.92%  28.51% 170.70%

    Rec'd   #  Security     In At       Now    Change
  8/13/96  200 Carlisle C    26.32     51.00    93.73%
  4/20/99  460 American P    14.48     21.56    48.95%
   2/9/99  100 Gateway 20    72.38     73.00     0.86%
 12/31/98   12 Berkshire   2276.17   2286.00     0.43%

    Rec'd   #  Security     In At     Value    Change
  8/13/96  200 Carlisle C  5264.99  10200.00  $4935.01
  4/20/99  460 American P  6659.25   9918.75  $3259.50
 12/31/98   12 Berkshire  27314.00  27432.00   $118.00
   2/9/99  100 Gateway 20  7237.50   7300.00    $62.50

                             CASH  $18091.65
                            TOTAL  $72942.40