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Friday, April 16, 1999

An Investment Opinion
by Warren Gump

Patience, Dear Fool

The stock market has recently tested any investor attempting to be patient for a reasonable valuation. While conventional financial wisdom holds that you should usually wait until a stock's valuation is fair (or even a bargain), investors ignoring that advice have been enjoying the most glorious success recently. The Motley Fool's own real money Rule Breaker portfolio, one of the most successful portfolios I've ever seen with an annualized return of 81% since its 1994 inception, has as one of its investing criteria that "a significant constituent of the financial media is recently on record for calling [the proposed stock] overvalued." (The portfolio only recommends this disregard for valuation in stocks that fit its other criteria, which means first-mover companies in emerging industries with strong backing and management.)

While investors shunning valuation measures have been using their profits to buy new cars and houses, investors holding stocks with understandable valuations have generally seen returns well below the S&P 500. Over the past year many of the Internet stocks have soared over 1,000%. Major technology and communication stocks, such as Dell Computer (Nasdaq: DELL), Sun Microsystems (Nasdaq: SUNW), and MCI Worldcom (Nasdaq: WCOM) are up 90%-175% over the past year. While there was a very brief period in the fall where these stocks were beaten down, most of the securities appear to be solely on an upward trajectory. On the other hand, smaller-cap stocks in the Russell 2000 index, about which many traditional value people are swooning, have returned zilch this year after being down 2% last year.

The urge to jump on board a rising ship is strong. When something starts moving and keeps going up, it is understandable to want a piece of the action. Nonetheless, long-term investors will usually benefit from showing restraint. While excellent companies (at least those that are not crazily priced) invariably see their stock price increase over periods of twenty or more years, history is littered with quality companies that hit roadblocks at some point. These bumps occur for myriad reasons, such as investor concern about future performance, temporary company missteps, a weak macroeconomic environment, or other negative surprises. Once you've found a company with terrific long-term prospects, these periods tend to be the best time to step up to bat and throw the stock into your portfolio.

This investing perspective is probably related to when I came of age as an investor. While I have been following the markets closely since the mid-1980s, I graduated from college and actually started making money in 1993. The summer of 1993 was interesting, because a lot of great companies were in serious trouble. At that time, you could buy wonderful companies like Merck (NYSE: MRK), Nike (NYSE: NKE), and IBM (NYSE: IBM) at substantial discounts to their historical valuations. All of them had severe short-term problems, yet each proved to be superb investments.

In the summer of 1993, IBM recorded one of the biggest losses in corporate history, thanks to a one-time restructuring charge of $8 billion. Excluding that hit, the company still posted an operating loss and revenue was down from the prior year. Beyond financial problems, Louis Gerstner had just joined the company as CEO and was implementing a complete overhaul of IBM's strategy and corporate culture. The stock traded as low as $20, down from nearly $70 in early 1991 (all prices adjusted for subsequent splits). Right now, almost six years later, those efforts have proven fruitful and IBM is up over eight-fold from the depths of 1993.

Merck's stock, along with those of all the major pharmaceutical makers, was depressed in the summer of 1993 over fear of the universal health care initiates proposed by newly elected president Bill Clinton. Had these proposals been enacted, investors feared that profit margins of the drug makers would have been squeezed. While the companies were expected to continue showing profit growth, the dizzying expectations priced into the stocks didn't appear likely to be met. Merck stock hit a low of $14 5/16 in the summer of 1993, down from $28 in early 1992. Today, with plans for universal coverage just a memory, the company is again enjoying solid profit growth and its stock is selling for more than five times the 1993 nadir.

The summer of 1993 was also an active time for Nike -- shareholders were running for the doors, dumping the company's stock. The company had warned that it wouldn't meet earnings estimates and the outlook for the next year was downbeat, with economic problems in Europe and a slowdown in U.S. sales being blamed. Its stock fell to $10 13/16 from a peak of $22 9/16 in December 1992. Six years later (and after another scare over the past couple of years), Nike is on the rebound, trading at over five times its 1993 low.

Having seen the melee surrounding these stalwart stocks in the early 1990s, I feel that just about every company is susceptible to being knocked at some point. Sometimes the problems will be caused by company screw-ups, at other times they will emerge from Capitol Hill. Our friends on Wall Street, ever vigilant about short-term performance, also regularly raise concerns about the next quarter that have little bearing on a company's long-term fundamentals. When these situations occur, I become more enthusiastic about putting my money into high-quality companies.

You usually don't have to rush in and scoop up companies trading at attractive valuations (the dip last fall being a major exception). IBM and Merck both fell for two and a half years from their peaks to troughs. Nike's fall was more rapid, lasting for over a year from its high in 1992 to its low in 1993. You can generally take your time evaluating the company's business model, financial structure and reputation before investing your money.

Paying prices that assume perfect execution in both the near-term and hereafter doesn't make a lot of sense to me. While investors who got into the above-mentioned stocks at their pre-crisis peaks did fine if they bought and held through the decade, I find it preferable to invest my dollars when investors are overly pessimistic about a stock rather than overly optimistic. Such an attitude will keep you out of the highest-flying stocks, yet you will be saved from experiencing the negative impact of a turn in investor sentiment (which will happen at some point).

If you can't resist the urge to be where the action is, you can always allocate a portion of your portfolio (that you don't and won't need) into "crazy money." Invest those dollars into "story" stocks where the financials don't make any sense but the story sounds great. You'll often lose most, if not all, of your investment in these stocks, but every once in a while you'll hop in on an America Online (NYSE: AOL) or (Nasdaq: AMZN) and earn phenomenal returns. Having just a little exposure to these kinds of stocks should make it easier to stick to a long-term value strategy while adding a little pizzazz to the investing process.

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