Oh, Cisco!

Robert Cyran writes an interesting "Breakingviews.com" column in the New York Times, about Cisco Systems. This stock points out a number of evergreen issues that affect investors. First, there is the slowly receding aura of the charismatic, larger-than-life CEO. John Chambers famously claimed that Cisco could grow sales by 50% per year for the long term, whereas the actual growth rate has been 7% per year, with acquisitions, according to Cyran.

Next is the continuing froth surrounding acquisitions, including the mysterious "Cisco model," and its vaunted ability to "integrate acquisitions." If this were true, it would have shown up in increasing returns on capital employed, which usually merits sustained stock market out performance. Five years to date, Cisco is up about 15% which closely tracks the performance of the NASDAQ Computer Index. At the height of the 2007 bubble, Cisco diverged from the index and strongly outperformed before falling back into the pack. Over the same period, the prosaic IBM was up more than 30%.

Over ten years to date, the performance is worse. Cisco looks as if it lost about 40%, while IBM was up 30% over the same period. Clearly, the market did not see promises materialize, and apart from commodity-like trading cycles, Cisco's fundamental performance was not significantly different from its index.

Peter Lynch in his classic book, "One Up on Wall Street," coined the term "diworsefication." He was right then, and he's still right now. Conglomerates like Allied-Signal and Tyco failed with their models of acquiring companies in diverse industries. Cisco in theory is acquiring companies in its space. But what is that space today? Earlier marketing campaigns from Cisco touted the fact that the company provided the plumbing for the Internet. Today, it's unclear what Cisco's mission is, apart from getting bigger.

Shareholders can do a better job of diversifying their portfolios with less risk than can the management of a public company driven by short-term pressures like stock prices and option values. Cisco has always received plaudits for share repurchases, but what these have done, at best, is partially offset the hugely dilutive effect of option grants, which were supposedly integral to the ability of technology companies to retain and recruit talent.

Cisco clearly has overpaid for its $22 billion in acquisitions since 2002, and when it was enjoying high multiples itself, management could feel good about overpaying. The New York Times says that Cisco employs 59 internal boards and standing councils to "involve more people in decision making." Shareholders benefit when they know where the decision making buck stops, and the better they understand the minds of the decision makers. With these invisible councils, it's a crap shoot for them.

Cisco, like Microsoft, is a mature company. Paying a dividend, and hewing to the discipline of writing a quarterly check, is a good thing for shareholders because they can diversify as they choose. However, management has a hard time choosing this option because as a CEO might say, "It says that we're out of ideas, and that we can't grow any more." Certainly this is an overwrought sentiment, but not uncommon.

Talking about conglomerates, what about Berkshire Hathaway, isn't that a collection of diverse businesses? There are at least two distinct features of this company that are notable for me. First, when a business is acquired, it is for the management as well as the cash flows, and the management is incented and stays in place. Their performance almost always improves over time, as evidenced by the Annual Report commentary. Second, the real magic, in my opinion, is the redeployment of cash flows from the operating companies by Warren Buffett, Charlie Munger and the rest of the executive team. So a company like Sees Candies throws off consistent free cash flows which are then redeployed into buying other attractive businesses completely removed from confectionery. The net effect is that the portfolio diversifies and gets stronger.

Investing in mature technology companies looks like it's most efficiently done by buying the appropriate technology index, judging by the performance of bellwether Cisco Systems.