The Motley Fool: The Boring Portfolio

ALEXANDRIA, VA (Nov. 23, 1998) - On Friday, Motley Fool co-founder and rule breaker David Gardner explained the Fool Portfolio's approach to valuation:

"We pay little to no attention to traditional valuation metrics, and neither do we pay much attention to market history."

To some, this may appear heretical at first glance. How can you not pay attention to "traditional valuation metrics" when looking at a company? The Boring portfolio pays tons of attention to valuation. Why would we want to buy even the finest of companies at 150% of their intrinsic value? We wouldn't. But when the term "traditional valuation metrics" is brought up, we really have to clarify what is meant by that.

I won't clarify what David meant by it, because I don't know, but I will give my interpretation of what it means. Traditional valuation metrics of price/earnings, price/sales, and price/book to us are not the bottom line. We calculate them in the spreadsheets we use when we look at companies, but they are just three of many data points we use. In fact, they aren't all that important as individual data points. For instance, one of the things I always find interesting is when a publication takes a bunch of companies, such as Yahoo! <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: YHOO)") else Response.Write("(Nasdaq: YHOO)") end if %> and CBS Corp. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: CBS)") else Response.Write("(NYSE: CBS)") end if %> and Gannett <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: GIC)") else Response.Write("(NYSE: GIC)") end if %>, and compares their price/sales and price/book ratios. You want to talk about misleading?

When you look at a company, you want to measure the firm value, not just the company's equity market capitalization. You have to add debt to the market cap, less any excess cash, to get to firm value, which is the more apt comparison. If my firm is worth $20 billion and I have just LBO'd it to the extent that the equity at market is worth $5 billion and the debt is worth $15 billion, my firm's value hasn't changed (not counting the tax shield created by interest expenses). With $20 billion in revenues, by the way some people calculate it, my firm's price/sales ratio just went from 1.0 to 0.25, when in fact the firm's multiple-to-sales hasn't changed one lick.

When you look at Yahoo!, CBS, and Gannett side-by-side, you have to consider that Yahoo! has no net debt whereas CBS has debt (and other long-term obligations such as post-retirement obligations) equal to about a third of its market cap. So, first, mechanical calculations of "value" can be misleading and irrelevant if you don't know what data is being fed into the machine. It's the opposite of politics and sausage -- you definitely want to see what goes into the making of these data.

I agree with David, traditional valuation measures are not useful. And that's even for traditional companies. Two companies with the same P/E and price/book and the same forward-looking growth rate are not necessarily worth the same thing. We will always go with the company with the better management operating in the better industry. We would rather invest in the cosmetics industry, for instance, than in the steel industry, because we see more margin of safety in a decently run cosmetics company.

If there is any measure of corporate performance that we look at first, it's return on invested capital, not growth in per-share earnings. Lots of companies can put together earnings per share growth if they have enough access to capital markets to increase their resources year after year. But if they don't earn a return on the capital, they'll eventually fall back to earth. I don't know if that's traditional or non-traditional, but that's what we look at and we also think it reduces a lot of other arbitrary decisions on what comprises value.

To wit: High margins doesn't necessarily mean a higher-quality business. Take, for instance, Sam Walton and Wal-Mart. He had the gumption to underprice his competitors, taking a lower gross margin on products to start with. But what he lacked there, he made up partly in lower overhead spending. Consumer response was overwhelming -- customers beat a path to Wal-Mart and kept coming back. As a consequence, inventory didn't sit on shelves for more than two weeks on average. Pricing things at lower margins meant that Wal-Mart would move more units. What does that mean to financial results?

If "retailer A" turns over its assets once a year (revenues divided by average assets) and achieves gross margin of 25% and net margin of 7%, this company is not preferable to us if it's priced at the same P/E ratio and price/book ratio as competing "retailer B" that turns its assets 2 1/2 times per year and achieves gross margin of 19% and net margin of 4%. Here's why: ROA is asset turnover times net margin. Return on assets (ROA) for "retailer A" is turnover of 1.0 times net margin of 7% = ROA of 7%. Not bad, not great. ROA for "retailer B" is asset turnover of 2.5 times net margin of 4% = ROA of 9%.

In the retail sector, the company that has lower gross margin and better overhead control is the preferable company. Why? Because customers will eventually come to the company with lower prices if its service is not in some way inferior. That doesn't happen overnight, of course, when the competition is a better merchandiser and has far and away better service. But if those aren't factors, then the pricing leader has the competitive advantage. The company that can turn its inventory much faster than it turns its accounts payables will have to issue less debt or equity to finance the same dollar value of store expansion as its competitors. That's because the company with the better asset turnover is generating a float on its working capital while the other is generating less of a float or no float at all.

Vendor financing is an important source of non-equity and non-debt financing that plays directly into the valuation of a company. Think of working capital investment the same way that you think of fixed capital investment. They both require outlays of cash. In a discounted cash flow model, a cash outflow for working capital will directly reduce the value of a company, while another company that generates a float on working capital will not have its valuation penalized by this. Look at the free cash flows of Amazon.com <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: AMZN)") else Response.Write("(Nasdaq: AMZN)") end if %> versus Barnes & Noble <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: BKS)") else Response.Write("(NYSE: BKS)") end if %> and Borders <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: BGP)") else Response.Write("(NYSE: BGP)") end if %> over the last three years:

By the way, Barnes & Noble's progression is not linear. Its free cash flow is negative $26 million over the last twelve months. Borders was free cash flow negative to the tune of $123 million over the year (both of these are through Q2 1998). Amazon.com, on the other hand, ran negative free cash flow of $18 million last quarter (treating interest expenses as cash charges) and grew a heck of a lot faster than these companies. At a run-rate of negative $72 million, Amazon is building a worldwide business whereas Borders didn't even get into international expansion until 1997. B&N's 10-K doesn't even contain the word "international" with respect to sales.

Cash flow characteristics should be the main driver in valuation of Amazon.com. Not this year's earnings and not this year's multiple to sales. Now, don't get me wrong -- I think the pricing in Amazon has been totally ridiculous in the past two days following the company's stock split announcement. But when the company was valued in the $1 billion range, I didn't have a problem with the valuation. That's because Amazon.com eats up very little cash to grow its business while its main competitors eat up hundreds of millions in cash each year to finance inventory expansion. This is for inventories, by the way, that turn twice or three times per year versus inventories that turn something like 30 times per year for Amazon.

So when the Fool Port talks about "traditional valuation" measures, I assume it is not talking about discounted cash flow models. We can capture these dynamics in a discounted cash flow. And I don't know what's untraditional about a DCF model -- so I would disagree with David there. But I heartily disagree with him when he criticizes the model of slapping a P/E on something and saying, yup, it's overvalued. I also think it's just about the dumbest thing in the world to say Bethlehem Steel is more of a value at 0.5 times sales or whatever versus Amazon.com at 10 times sales. That does nothing to address the intrinsic value of a company.

Intrinsic value is the net present value of all the cash, or all the value, that can ever be pulled out of that company. When you're growing a business at sequential growth rates of 30%, it adds up very quickly. A price/sales ratio of 8.16 becomes a price/sales ratio of 1.0 in two fiscal years when sales are growing at this sequential rate. We're not talking mathematical progressions here, we're talking about geometric progressions. You know, the sorts of progressions by which you measure the spread of cancer, bacteria, and the destructive power of nuclear bombs.

As for the PEG or Fool ratio, I pointed out in a June 1998 article why there are some applications where the Fool ratio, or Price to Earnings Growth (PEG) ratio, is not worth very much in looking at hypergrowth situations. The Fool ratio works fine for companies that are in stable or lower-growth situations, but not for companies in Amazon.com's position or even the position of something like 3-D graphics accelerator chip designer 3Dfx. A company like 3Dfx can get blown away by a better chip or a software standard, for instance. The competitive position of this company can change virtually overnight. Frankly, I think the company's strategic emphasis on mindshare is odd. Remember Creative Technologies? Everybody knew its SoundBlaster sound card. If consumer awareness were the decisive factor in building shareholder value for technology-oriented companies, then Creative's record of building shareholder value would not be so abysmal.

There's more that I will have to say about this topic, but I've already taken up enough space here. I will finish these thoughts next Monday and turn the column over to Alex for the rest of this week, as he's doing much of our valuation work and assessment of Borders Group <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: BGP)") else Response.Write("(NYSE: BGP)") end if %>.

As a final note, I've done some work on TCBY Enterprises <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: TCBY)") else Response.Write("(Nasdaq: TCBY)") end if %>. An interesting company. Definitely Boring. While there's not tons of growth, the management is doing lots of things we like to see. The company is basically doing a slow motion buyout of the outstanding shares, buying back shares at a good clip and running a pretty efficient ship. I'm satisfied that we don't need to be concerned with a buy or sell decision on the company at this time, so it's staying right where it is in keeping with our policy of trying to keep turnover as low as possible.

Have a great Thanksgiving and we hope to hear from you on our Boring message board.

FoolWatch -- It's what's going on at the Fool today.

11/23/98 Close

Stock Change Bid ANDW - 5/8 16.06 BGP - 7/16 22.81 CSL + 9/16 46.25 CSCO +1 9/16 76.19 FCH + 1/2 23.00 PNR - 13/16 38.50 TBY + 1/16 7.06

                   Day   Month    Year  History
        BORING   +0.34%   6.48%  -2.60%  22.56%
        S&P:     +2.12%   8.15%  22.44%  91.14%
        NASDAQ:  +2.55%  11.63%  25.92%  89.96%

    Rec'd   #  Security     In At       Now    Change
  6/26/96  225 Cisco Syst    23.96     76.19   218.04%
  2/28/96  400 Borders Gr    11.26     22.81   102.67%
  8/13/96  200 Carlisle C    26.32     46.25    75.69%
  4/14/98  100 Pentair       43.74     38.50   -11.98%
  5/20/98  400 TCBY Enter    10.05      7.06   -29.69%
  1/21/98  200 Andrew Cor    26.09     16.06   -38.43%
  11/6/97  200 FelCor Sui    37.59     23.00   -38.81%

    Rec'd   #  Security     In At     Value    Change
  6/26/96  225 Cisco Syst  5389.99  17142.19 $11752.20
  2/28/96  400 Borders Gr  4502.49   9125.00  $4622.51
  8/13/96  200 Carlisle C  5264.99   9250.00  $3985.01
  4/14/98  100 Pentair     4374.25   3850.00  -$524.25
  5/20/98  400 TCBY Enter  4018.00   2825.00 -$1193.00
  1/21/98  200 Andrew Cor  5218.00   3212.50 -$2005.50
  11/6/97  200 FelCor Sui  7518.00   4600.00 -$2918.00

                             CASH  $11273.22
                            TOTAL  $61277.90

</THE BORING PORTFOLIO>