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Cisco Systems, Inc.
Comment on Valuation

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By NorthCarolinaKen
April 7, 2004

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Andy's reference (above) uses the common price to sales and price to earnings numbers to tell whether a stock is inexpensive or not. That's fine as far as it goes. If you look at earnings, for example, in the bubble year of 2000, it was $.36 and the stock was at $82 at the high point. The earnings projection this year is $.70 and the stock is trading in the low $20s. Further, the revenue looks like it is going up at something north of a 20% rate. So the stock is 25% of the top bubble price while earnings are 2x and revenue growing sharply. A replay of the bubble? That is not a rational conclusion as I read the numbers. Can the stock crash? Sure. Can it skyrocket again? Sure. Is it "bubble priced?" No.

The issue with any stock and particularly tech stocks is that you have to look ahead. Where you are today is a stake in the ground but you need to be looking much further than that to make good investment choices.

If you look at just price per share per year, you see an amazing story. Every year since 1994 the stock has been a multiple of between 2 and 4 from the highest price to the lowest in each calendar year. That suggests a general purchase strategy if you are interested in the stock. Given you believe the long-term business is solid, you buy at, near and below 52 week lows. If the stock is near 52-week highs or rising rapidly, you postpone purchases.

If you look at the historical forward price to earnings ratios, you see a similar story of people paying 2-4 times differentials for the same earnings in a year. The average low forward PE over the past 10 years is about 30 for Cisco and about 60 at the high minus 1998 to 2000. The current PE (trailing) is about 40 but the forward PE is about 20 at current prices and assuming the $.70 is correct.

If the stock hits its historic high forward PEs this year it will double from here. Looking just at this stock and ignoring the negative global financial commentary from the trolls under the bridge for a moment, is the upside or the downside more likely? One would have to say the upside has the greater probability just on a numerical basis.

Relative to the financial picture, I don't believe the trolls have it right. The economy is accelerating, investment dollars are starting to flow and the tech stocks are in a position to be a major beneficiary. The trolls have it wrong on bonds, the dollar and gold also. Gold ran up a little more than I expected. I sold my mining stocks when gold was in the high $380s. I also bought those stocks when gold was in the mid $250s and made large profits.

The trolls look at the debt in this country and predict the end of civilization, as we know it. The debt, both public and private is worrisome but will only become a major financial issue when rates rise a lot and the debtors can no longer cover their obligations. If the debt doesn't come more into line, you can indeed expect a severe correction driven by defaults but that is way off if ever.

The bubble today is the bond markets. Particularly exposed is the carry trade, people who borrow vast sums leveraging their holdings at the current negative US interest rates and lend long. When rates rise, the collateral worth of the long holdings will drop and we will see a rolling margin call as the distressed holders are forced to sell into a collapsing market. If you avoid stocks like Cisco and are buying bonds I believe you are making a horrendous error.

While we are on this subject, although there are many drivers to the price of the dollar, the main driver is the trillions of dollars in commerce that flows back and forth across our borders. In this is a natural brake to price movement and that is relative purchasing power. If you are building cars in both Europe and the United States, for example and if the relative purchasing power of the Euro is 20% greater than the dollar, then you will manufacture in Europe to sell in the US since you have 20% leverage in the transaction, which goes to profit.


In this transaction, you are selling Euros and buying dollars with the automobile as an intermediate trade. As that purchasing differential grows, so does the business transactions to take advantage of it and the Euro/dollar differential grinds to a halt. You can see that now over the past few months as the dollar has stabilized against other currencies. The United States is still the most credit worthy borrower in the world. When Uncle Sam wants money he crowds out any other borrower. As long as that is true the odds of massive currency revaluations like Argentina or Turkey are virtually zero. It is the fear of default on massive debt that drops the value of a currency.

So would I buy Cisco in here? That's not my investing style. I stalked Cisco for five years and when it fell below $11 I made large (for me) purchases of the stock. I never make a single buy. If I am going to buy 1000 shares of stock I know my ceiling price, $11 in this case, and will make 5 buys of 200 shares each. If the stock falls, great. I buy at a still lower price. In my investing style, Cisco is a hold here but I think a rational person can accumulate the stock at this price.

Ken


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