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I believe that the CSCO debate should be framed in a different way. When making decisions under a fair level of uncertainty, we all develop scenarios or mental models to help us with our decision. Certainly when allocating investment capital, we are always dogged by a fairly high level of uncertainty. I think people do generally think in terms of best case, worst case and 1, 2 or maybe even 3 intermediate scenarios when allocating capital.

Mr. Tilson's argument, and the subsequent rebuttals, here and on the CSCO and RM boards, both bull and bear, all seem to hinge on a debate of what I would consider details involving the "intermediate scenarios" for Cisco in the next 5-10 years. And I don't necessarily disagree with any of them.

What bothers me is that no one is discussing the potential "worst case" scenario for CSCO here at TMF. How you frame the CSCO buy/sell decision in terms of different scenarios comes back to [1] what you consider to be your significant time horizon for investment results, and [2] what is your definition of investment. The line separating "investing" from "speculating" is pretty thin much of the time. But I still like Ben Graham's definition because it is short, simple, and to the point:

"Investment is an operation, which upon thorough analysis, indicates both safety of principle and an adequate return on capital."

I have read a lot over many years, but I still have yet to hear anyone define investing in 20 words or less in a more elegant way.

You notice that there are two parts to that definition - return, and safety of principle. Included is the concept of thorough analysis. How can one complete a thorough investment analysis without looking at the potential downside, i.e. the worst case scenario?

The arguments here about CSCO all seem to focus on the expected return. There is no mention of margin of safety or the potential for permanent impairment of capital employed. Again from Graham:

confronted with a challenge to distill the secret of sound investment into three words, we venture the motto, MARGIN OF SAFETY (Individual Investor, 1973).

Margin of safety was considered by Graham as the central concept of sound investment and I personally concur with that. The margin of safety, as defined by Graham, is a quantitative concept, and constitutes the purchase of a security or business at a sufficiently large discount from intrinsic value. Again from Graham,
the function of the margin of safety is, in essence, to render unnecessary an accurate estimate of the future. If the margin is a large one, then the investor's principle capital will be sufficiently protected against the vicissitudes of time.

Now in my view, there is no one magical formula for what constitutes an adequate margin of safety in relation to intrinsic value. For weakly capitalized secondary businesses, a 35-50% discount may not be enough while for well capitalized, competitively advantaged businesses a 15-25% discount may be more than adequate. But to evaluate whether there is an adequate margin of safety you have to look at the worst case scenario!

Is Cisco a great company? Absolutely!
Does Cisco have great management? Yes!
Does Cisco possess enormous competitive advantage? You betcha!
Is Cisco conservatively financed? Of course!
Is Cisco's ROIC high? Certainly!

Now don't get me wrong, I am not against speculation, and in fact speculate all the time. In fact, Ben Graham stated several times that it was not speculation per se that bothered him, but that investors often unknowingly acquired speculative habits in bull markets. Personally, i think that the markets provide a useful forum for speculation. But there is a difference between investment and speculation.

Could Cisco be a great speculation at today's price? You bet. It could wallop the S&P the next 5 years. Sure it could. But in my book CSCO does not qualify as an investment because there is the potential, and there are plenty of analogs out there, IBM comes to mind, for a very large (70% or more) decline in Cisco common if a few things were to go wrong with the business. Cisco may possess great competitive advantages, but it is a technology company and is still subject to any number of business risks such as disruptive innovations, capital spending cycles, technology pushback, commoditization pricing pressure, substitution threats et cetera. Not that Intel, Microsoft, Dell, Applied Materials or other great businesses are not subject to these same threats - they are. But the price paid relative to capital employed in the business offers no margin of safety at today's market cap for Cisco even for a realtively long time horizon - say 5 years.

Anyway that's my $0.02.

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