Boring Portfolio

Done With Tenets
Really. I distilled them.

By Dale Wettlaufer (TMF Ralegh)

ALEXANDRIA, VA (July 21, 1999) -- "Many times, the businesses that are such a layup that only an idiot could not tell you that they will be worth much more ten years from now are priced such that a 15% return isn't available. You have a couple options in that type of situation, which I'll discuss on Wednesday."

In a pari-mutuel system such as the stock market or wagering on sporting events, the most heavily favored companies don't pay big odds. The more favored they become, the less they pay off, both in the short run and in the long term. Berkshire Hathaway Vice-Chairman Charlie Munger has noted that over the long run, the economics of a business will outweigh the economics of your entry price. That's true to a point, but if you have a teeter-totter with long-term economics on one end and price paid on the other end, and each is represented by a 50-pound child under equilibrium conditions, the long-term economics child is going to fly off the teeter-totter when a price-paid person the size of a sumo wrestler jumps on the other side.

In other words, you can overpay to the extent that the favorite horse is only going to pay less than 1-for-1 odds if it wins. In addition to increasing your odds of underperformance, you also decrease your margin of safety by increasing the chances of a sustained quotational loss.

The Boring Portfolio approach to these problems has a couple of different dimensions. First, one must attempt to assess the intrinsic value of a business and not buy above the price you feel is right, even if you're madly in love with the underlying business. The second is to get to know a number of different industries and kinds of companies so that you increase the odds that something is severely mispriced once in a while.

This second feature of the approach requires long-term intellectual discipline, because it may not seem like you're making a lot of progress in the short run. If your circle of competence is small at first, you might not see severe mispricings within that circle of competence for a number of years.

The third part of the approach deviates from what Warren Buffett has to say about things, which might seem to be colossally arrogant and is a point where I've gotten a lot of flack for being the seeming value heretic. It entails not having a historical guide as to what the company can do in the future and not having a layup on how the company will look ten years or twenty years in the future. Intel or Dell, for instance, are going to look a lot different in the future than they do today. So coming up with discounted cash flow that will match within a small envelope of confidence what will actually happen isn't really a realistic goal.

The way to approach that, in my opinion, is to come up with a range of different operating scenarios using one's general knowledge of industry to inform a range of intrinsic values for a company. I've discussed "impounded value" before. What this means is that you look at the operating and financial performance necessary to get to today's price and make a judgment on the feasibility of such assumptions. For instance, will Yahoo! grow? Not a tough one. Will it grow at 100% per year for 20 years? That's harder to tell. Will it grow at 10% per year for 10 years and 7% per year thereafter? I would say that's a layup. I love Yahoo! as a company, but at the current market price, I wouldn't buy it. If the market price were to reach a level where all it would have to do is something closer to that last set of assumptions to meet my 15% return target, that would be an easy layup as far as I'm concerned.

Perhaps this only applies to my own peculiar experiences in life, having worked for an Internet-based company for a number of years and actually having capital on the line in one. If we were talking about a certain kind of application software company, I wouldn't have the background for judging the specifics of the business and would thus be less equipped to judge whether it's truly cheap or dangerously cheap (a condition where something is cheap based on cash flow or assets because its intrinsic value is deteriorating).

So what I'm saying here is that I don't need certainty. I DO want a solid thesis and a good background in industries where I'm looking at an immature company. In the context of new industries or technologies cropping up, a strong general understanding of industry and business models is also necessary to get an idea of the possible future of a company where there is no historical guide to help out. Given the asymmetric nature of prospective returns, where percentage returns are measured in thousands of percent and the greatest downside is 100 percent, I don't think a value investor should totally avoid situations where the future is uncertain.

I'm willing to trade off some downside for big upside. As long as one has some rational basis for assessing a business and its economics and not just taking wild cuts at "hot stocks," I think there's room for a rational value investor in the realm of more speculative companies.

Overall, though, the majority of the portfolio's holdings will be represented by companies that are profitable, have a history we can look at, are high return on capital businesses with good prospective investment opportunities facing them, and that are mispriced in our opinion. As in golf, we will shoot for par (meet the S&P 500 or broader market measures), try to minimize bogies and double bogies (avoid overpaying for companies), and capitalize on birdie and eagle opportunities (devote large amounts of capital to situations where I know the company and industry well and where a severe mispricing exists). If I had to distill it down to a few phrases, those would be:

1. Demand value
2. Pay attention to downside, not just upside
3. Read
4. Read some more
5. Study many companies, invest in few

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

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07/21/99 Close
Stock Change   Bid
APCC  +  9/16  22.50
BRKb  -9       2243.00
CSL   +  1/16  48.88
GTW   -1 5/8   65.75

                  Day     Month   Year  History
        BORING   +0.12%   2.92%   6.93%  43.59%
        S&P:     +0.16%   0.48%  12.79% 129.75%
        NASDAQ:  +1.08%   2.83%  25.95% 165.31%

    Rec'd   #  Security     In At       Now    Change
  8/13/96  200 Carlisle C    26.32     48.88    85.66%
  4/20/99  460 American P    14.48     22.50    55.42%
 12/31/98   12 Berkshire   2276.17   2243.00    -1.46%
   2/9/99  100 Gateway 20    72.38     65.75    -9.15%

    Rec'd   #  Security     In At     Value    Change
  8/13/96  200 Carlisle C  5264.99   9775.00  $4510.01
  4/20/99  460 American P  6659.25  10350.00  $3690.75
 12/31/98   12 Berkshire  27314.00  26916.00  -$398.00
   2/9/99  100 Gateway 20  7237.50   6575.00  -$662.50

                             CASH  $18177.16
                            TOTAL  $71793.16