Is Rule Maker a Valid Strategy?

"Experience is a hard teacher. She gives the test first and the lessons afterwards."
          - Anonymous

For the past few years I've sat in my ivory investment tower and watched the various real-money portfolios in action here at the Fool. Like a mischievous eight-year old dropping water balloons from the balcony above, I've oft lobbed quips and quibbles at the managers of our portfolios, just to throw my two rubles in. Today, I descend from that tower and try and answer the question, for myself and anyone else who cares to listen, is Rule Maker a valid strategy?

It's hard to look at the poor annualized returns of the Rule Maker portfolio and not question the validity of the strategy, or at the very least the discipline with which we've executed the strategy. After all, this money could have been invested in an index fund and produced gains rather than 30% losses. But, as the quote above says, the test comes first and the lessons are learned afterwards. How can we learn from what's gone wrong and right this ship? What mistakes have we made in execution? Are there underlying problems with the strategy itself? I'm not here to mince words, so here's my take:

1. We have made mistakes in our discipline.
2. There are some very basic investment principles that are ignored.

Mistakes in discipline
The difference between order and chaos is our ability to recognize and operate within certain understood rules or principles. It's when we abandon these overarching rules, however flexible or inflexible they may be, that chaos takes over and we're unable to evolve and grow in any logical fashion.

How does this have any bearing on the Rule Maker portfolio? One word: Yahoo! Quoting from the buy report: "We'll abide our investment principles when it is to our maximal benefit to do just that, yet bend them if we believe doing so can lead to greater reward." That's kind of like saying "I'll adhere to my principle of not buying options, except when I think I can make a killing." While potentially lucrative, without the backdrop of some basic principles, you'll have no idea why you were met with success or failure and you'll certainly have no idea how to replicate or avoid it in the future.

While the notion of taking on additional risk is nice, it's irrelevant to the whole mantra of the portfolio. The idea of the Rule Maker portfolio is to buy large cap stocks that dominate their industries. By investing in the "tweener" that was Yahoo! (Nasdaq: YHOO) the portfolio subjected itself to unnecessary risk. Looking back now, down 74%, the only lesson I'm able to take away from the Yahoo! purchase, which has any bearing on this discussion, is that it wasn't a Rule Maker to begin with, we knew it, but invested in it anyway. All we really can do is look back and say "better not do that again." Not a great lesson to learn, and not something that allows us to really hone our skills in any specific way.

Missing link
Believe it or not, my biggest issue with the Rule Maker portfolio is not in past mistakes in discipline. Heck, we're human and imperfect ourselves. What's most daunting to me is the lack of two of the most basic principles of investing:

1. Valuation
2. Defined sell criteria

Valuation -- Rule Maker, especially in the early days of the portfolio (less so lately, especially with the writing of Rich McCaffery and Mike Trigg), largely ignored the whole issue of valuation, and it's maddening to me. One of the reasons it almost entirely disregarded valuation is because of the mentality that we'll be holding these stocks for a decade. Unfortunately, there's no logical connection between the two. 

In his recent column on selling Coke (NYSE: KO), fellow colleague and ping-pong whipping boy Mike Trigg wrote:

"[P]aying 30 times TTM free cash flow for a company that expects long-term earnings growth of between 11% and 12% doesn't exactly strike me as a great investment opportunity."

Indeed, when the company was first purchased, it was trading at a 41 P/E with optimistic growth rates of 17%. The reality was much worse and the stock has gotten beaten to death over the past three years.

The last principle of the Rule Maker philosophy states:

"The 2x/5y pursuit is not so much a matter of stock valuation, but rather of business e-valuation. In order to assess the likelihood of a company's market cap doubling in the next five years, you need a solid understanding of the underlying business and its future prospects."

No, this is wrong. It's entirely about stock valuation and current price. While I agree that you have to understand the underlying business and its future prospects, your decision to buy or sell should be based on where the current valuation is relative to what you believe it might be. You mitigate risk by purchasing stocks as low on that continuum as possible.

Sell Criteria -- There isn't one. At least not one that's explicitly stated anywhere. I guess the sell criteria should be that we'll sell a stock when the things that made it attractive as a purchase in the first place are less attractive or no longer valid. In hindsight, we look back at Cisco and remember how Matt Richey was alerted to rising receivables and inventories, not to mention crazy, freaky valuation. But, we didn't sell. That should have been a clarion call to re-evaluate and perhaps take some money off the table, if not all of it. We didn't in part because there was no discipline forcing us to evaluate our sell criteria as rigorously as we do our buy criteria.

We're all geniuses in hindsight
It doesn't take a hero to take pot shots with perfect 20-20 hindsight. You could even argue that I'm cowardly for doing so and I might accept that label. Why am I coming down from my tower, writing my first Rule Maker report ever, and being so critical? Simple. I think this is the perfect time for us to step up and re-evaluate. In the spirit of Learning Together that we embrace here at da Fool, what better time to admit mistakes, make changes, right wrongs, and forge ahead with our heads high? What better time than to work through it together so that we don't make the mistakes again and so we'll look back at this difficult period with appreciative eyes and not disdainful ones. As one person wrote in a recent email to me:

"If the ports [are] genuinely there as educational tools, [s]how people how to take a  flawed port and change it into a good one."

I started this column asking if Rule Maker is a valid strategy. I think it can be, with some increased attention to valuation and selling criteria, as well as a more responsible adherence to the underlying principles. Short of that, however, I have issues.

In a recent discussion board post, a member of the Fool community, [Norationalbasis], had the following to say:

"[I]t seems that the Fool suffers from a problem that all of us have. That problem, clumsily put, is a failure to be introspective with regard to the deficiencies we can spot all around us, and a failure to recognize and/or ignoring these deficiencies in our own affairs until it's too late."

I don't think it's too late.

David Forrest has a lot of wind, but we like him anyway. After all, The Motley Fool is investors writing for investors. Bogey doesn't own any of the stocks mentioned in this article.