My Last Bore (Bore Port) October 22, 1999

Boring Portfolio
My Last Bore
Our Approach Graded

By Dale Wettlaufer (TMF Ralegh)

ALEXANDRIA, VA (Oct. 22, 1999) -- Well, I don't know what I'm going to write for the last Bore Port, since I'm already half in the bag from a farewell party that commenced prematurely. No, just kidding there. That's after I finish today's report. So I have no excuse for acting like an idiot today.

My departure from the Fool has led me to introspect over the last year+ of managing this portfolio. A couple of things pop up. One of the things I'm most proud of in taking over this portfolio is that Alex and I didn't just show up and hack the portfolio to pieces right away so we could buy the companies we preferred. Before selling anything, we looked at each company, trying to understand the business and put a value on the company, and then went from there.

I chose to do this, in part, because I think one of the worst things a new money manager can do upon taking over somebody's portfolio is to look at that collection of businesses as just a portfolio of stocks that can just be chucked overboard at the push of a button. I've heard enough stories of brokers taking over people's portfolios and dumping long-held positions in solid blue-chip companies to fill up on the broker's favorites.

Mutual fund managers do this all the time and individual investors too often make buy and sell decisions too quickly as well. Barber and O'Dean have done enough studies on overconfidence and rapid turnover -- I think the antidote to that is not approaching a portfolio as one might approach a gin rummy hand, to use a Buffett metaphor. Following our philosophy that the portfolio is much more like a holding company than it is a trading vessel, we took a look at each of our "divisions" and tried to make businesslike decisions in what we were going to do with the companies.

Our Concept of Value Investing

Forget the typical definitions of value investing. They're either wrong or tangential to the true meaning of value investing. Value investing centers upon purchasing a business at a discount to the net present value of all the cash flows it can ever produce for investors. That's the textbook definition. It doesn't mean "don't buy technology companies" and it doesn't mean "stick to poor companies that look cheap on a P/E or price/book basis." That's all nonsense.

I know some believe value investing is useless, but I don't agree. Alex and I have never been anything but value investors, but I was able to tear apart AOL's financials in 1995 and show why the company was undervalued, rather than just saying "It's got a great brand! Who cares about 'valuation'?" Both Alex and I were able to show how the business model of Amazon.com works and were early and avid supporters of the company. "You can't value Amazon.com" is one of the bigger analytical heaps of garbage of the last two years.

While we didn't put an exact number on Amazon, we could come up with a range of values we felt were fair for the company. And that wasn't built on shortcuts like price-to-sales ratios or similar blather. That was built on models that took into account the way the company was being financed, its basic business model, and a lot of thinking about its ability to deploy capital and where the company might be in the return on capital department a number of years down the line. It wasn't this perversion of Peter Lynch's investment principles that passes for investment thinking: "Love the company, love the stock."

Valuation also matters because it allows investors to measure strategic "big picture" thinking against verifiable yardsticks. "It's got a great brand" is nice and all, but you eventually want to measure just how great the brand is in terms of financial results. When you measure return on capital, it's not just big margins that matter and it's not just having a low level of working capital that matters, either. Invested capital includes all invested capital, which means long-term assets, which means goodwill, which means you have to measure the market value of stock that you're trading in a deal such as Yahoo!'s acquisition of Broadcast.com, for example.

If you're looking at Cisco Systems, for another example, you can't just forget that the company has traded tens and tens of billions of dollars in stock for acquisitions, even though the company writes off acquired R&D and even though the pooling-of-interests method of accounting leaves almost no discernible trace (on the balance sheet) of the amount of capital the company has had to shell out to generate cash flow. I'm not trying to tell anyone that they're wrong, and I'm not saying Yahoo! or Cisco are overvalued. Our approach to valuation isn't that deterministic and Alex and I were never the kind of investors to spend time ranting about how overvalued certain things might be. I'm just saying you've got to go deep to find and understand the value.

Business people analyze cash flow, return on capital, the business plan, the entire balance sheet, and lots of other objective, quantifiable aspects of businesses rather than just indulging a feel-good approach to making an investment. Accounting is the language of business -- if you know how to speak it, you can get a fully rounded picture of what's going on. If you refuse to learn it, you're like the ugly American in Paris that yells in English, expecting people to understand you. They may understand you, but you're certainly not going to understand them when they don't want to be understood. If you want to take the easy way out, learning "margins" and "earnings growth" is like learning how to say "hello" and "goodbye" in another language. It's a fine start, but it won't get you through a lifetime of living in a foreign country. Any investment program that systematically ignores valuation, which to me is a systematic ignorance of business principles and the language of commerce, is an incomplete program.

Our Report Card

Here's the report card from 9/30/98 through the end of today:

Bore Port, without accounting for some accrued investment income over the last 90 days or so: 28.65%
S&P 500, dividends reinvested: 29.5%

For some, investment returns over a 12 to 24 month time horizon justify an investment philosophy. I leave the Boring Port without having any quantitative evidence to justify the value philosophy, even with the market-beating return of the Bore Port since Alex and I took it over last year. To claim we were right if we were ahead of the market over 12+ months is as plainly absurd as if we were to get down on ourselves for trailing a market advance of 29.8% by 110 basis points (1.1 percentage points) since our taking over. The time to measure it is way too short to make any useful conclusions as to the effectiveness of the investment program. Given the liquidity (cash equal to 15% of assets as of today) we have carried in the portfolio (which would have been deployed when and only if we came across a good business opportunity), I think things have gone fine over the last year.

The chief thing we wanted to do was not beat the market, though we want that to be a natural outcome of good analysis. The chief goal of the Boring Port was to help people sharpen their abilities to analyze businesses as business people. Since announcing my departure from the Fool, I've been overwhelmed by the sincere notes from people who have said we've met our goal. I'm very glad to have heard it. The Boring Port was always a niche thing, but I think it's reached some people that have truly come to the Fool to learn how to fish rather than looking for fish handouts. I think that's great and it's been tremendously heartening for me as I head into the sunset.

With that, I publish my last daily dispatch from the Fool, which is a bittersweet occasion for me. Thanks to all our customers and everyone here at Fool HQ for making it a very stimulating four years.

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