"No investment philosophy, unless it is just a carbon copy of someone else's approach, develops in its complete form in any one day or year. In my own case, it grew over a considerable period of time, partly as a result of what perhaps may be called logical reasoning, and partly from observing the successes and failures of others, but much of it through the more painful method of learning from my own mistakes." -- Philip Fisher, Developing an Investment Philosophy
Fisher wrote those words in 1979 after more than 50 years of investing experience. Granted, I'm a little earlier in the crystallization of my own philosophy, having only opened my first brokerage account a little over seven years ago. But while seven years isn't an especially long period of time, I've found that when real money is being made and lost, lessons tend to be learned quickly and remembered well. In thinking back over my progression as an investor since 1995, six key lessons come to mind:
1. Successful investing starts with understanding businesses.
To this day, I continue to re-learn this lesson on a deeper level. The reality here is that the better you know a company's business, the better equipped you are to make a buy/sell/hold decision on the stock. But when I first started investing, this lesson was much more fundamental. Originally, it was important for me to establish that a stock is not just a ticker symbol whizzing by on a screen, gyrating at random; rather, it was a piece of ownership in a living, breathing business.
I confess that when I first became interested in the stock market, I actually signed up for a free penny stock email newsletter. I didn't know any better and, hey, it promised quick riches! Luckily, I never bought any of that junk, and within a few months I was reading books like Peter Lynch's Beating the Street and Robert Hagstrom's The Warren Buffett Way, which forever convinced me that the only real form of investing is business-focused investing. All the rest is mere gambling.
2. Consumer experiences are only a starting point for successful investments ideas.
Given the importance of Lesson No. 1, some of the most natural investment candidates are the companies we know as consumers. But a positive consumer experience will only get you so far. I learned this lesson best in the aftermath of my very first stock purchase -- AOL (now AOL Time Warner (NYSE:AOL)) in late 1996.
AOL's stock had just crash-landed to the low $30s from its spring '96 highs of above $70 per share (pre-split prices). As a strong fan of the online medium, I saw an enormous opportunity in AOL's stock decline. I recognized that AOL was revolutionary, and as the easiest on-ramp to the online world, it was going to be huge. Of course, I didn't know a thing about AOL's financials or valuation, and therefore I had no real knowledge of what AOL's shares might be worth. Nevertheless, by March '97, my consumer instincts had proven sufficient for a 50% gain, at which time I sold.
This was a nice profit, but nothing compared to the gains I could've had if I'd held on. After factoring in four two-for-one splits that have taken place since then, I sold my shares at today's equivalent of about $2.81 per share. If I'd really understood the economics of AOL's business, I probably could've foreseen that the company was on track to generate substantial free cash flow within a few years. If I'd known how to analyze the business and the valuation, I could've made a much more intelligent decision about the stock. But given that my investment thesis was based only on my consumer perceptions, I was actually lucky to have made out with a profit.
3. Valuation outside the context of business quality is worthless.
Even at the time I sold AOL, I knew I needed to get my arms around this whole valuation thing. I just didn't know where to start. My first efforts involved use of an old rule of thumb that a stock, when fairly and fully valued, should have a price-to-earnings (P/E) ratio equal to the percentage growth rate of its earnings per share (EPS). For example, if a company's EPS growth were 20%, then it should reasonably be worth a P/E of 20.
Using that logic, I went out and found a company called Micrion (no longer public), which looked like a real bargain. The only problem was that in my new zeal for paying attention to valuation, I'd forgotten Lesson No. 1 -- I had no clue what this company did other than something related to semiconductors. Without getting into the whole story, I soon lost 40% of my investment. I could've prevented this loss entirely if I'd spent just 15 minutes inspecting the company's balance sheet, which I later discovered was in horrible shape. I had learned another important lesson -- as one Fool writer once put it, "Cheap crap is still crap."
4. Cash is king.
After my experience with Micrion, I began to realize that my focus on valuation was a case of putting the cart before the horse. Before trying to value a stock, I first needed to learn how to identify quality businesses. One of my most memorable turning points at this stage came on Sept. 4, 1997 when I read Tom Gardner's original introduction of the Flow Ratio. This opened my eyes to the profound importance of the balance sheet and especially a company's cash position. Here I discovered a vital lesson: Rapid growth of sales and earnings on the income statement has little merit if it doesn't translate into greater cash (and/or less debt) on the balance sheet.
Over the next several years (1998-2000), I grew in my knowledge of how to analyze businesses. It was at this stage, in February '99, that I ditched my consulting job and became a full-time Fool. In my work with the Rule Maker Portfolio, I benefited greatly from Tom's influence and began to understand that the world's best businesses are characterized by high barriers to entry, reliable recurring revenues, and high returns on invested capital. All of these qualities ultimately reveal themselves in the form of strong free cash flow -- proving that at the end of the day cash is indeed king.
Nevertheless, my personal investment performance was mediocre during this period, hinting at the possibility that my philosophy was still lacking in some key area.
5. Business quality is of paramount importance, but by itself is insufficient as a basis for investment.
After the bear market took hold in 2000, it became clear that in the course of my zealous focus on business quality, I had come to pay too little attention to valuation. Where I'd once put the cart before the horse, now I'd fallen into the trap of doting on the horse and neglecting the cart altogether! This too was bad.
After the Nasdaq's crash, it had become clear that my enthusiasm for high-quality but highly valued stocks such as Yahoo! (NASDAQ:YHOO) was totally wrong. The lesson was clear, however: Business quality is of paramount importance, but it ain't worth squat when the price becomes too dear.
6. There's a price at which almost any business becomes an attractive investment.
By 2001, these first five lessons had begun to sink in and influence how I looked at high-quality companies. As an example, when I assessed eBay (NASDAQ:EBAY) in May '01, I thoroughly examined both its business and valuation.
Also in 2001, I began to dabble in lower-quality companies that sold at extraordinarily low prices. One of these "deep value" stocks was ValueClick (NASDAQ:VCLK), which I first recommended at $2.74 in late 2001 (as part of the Fool's year-end Industry Focus publication). This is a company I never would've considered for investment a few years ago. Not only does it trade below $5 per share, making it a penny stock, but its business (until recently) had only breakeven profitability.
Still, at the time of my recommendation, ValueClick had net cash of $2.92 per share. Thus, at a stock price of $2.74, a buyer was actually getting ValueClick's business for free. Even a mediocre business is worth more than nothing. Since that time, ValueClick shares have appreciated nearly 15%.
Conclusion
Obviously, my investment career has only just begun, and I'm sure I'll be adding to these six lessons in the years ahead. For the time being, my preferred investment approach is one of seeking high-quality, growing companies that sell for reasonable prices. That said, on certain exceptional occasions I'm willing to sacrifice business quality when the price is cheap enough. Next Monday, I'll lay out the specific investment criteria that currently guide my thinking.
Matt Richey ([email protected]) is a senior analyst for The Motley Fool. At time of publication, he held shares of ValueClick. For Matt's best Foolish stock ideas and in-depth analysis that you won't find anywhere else each month, check out our newsletter, The Motley Fool Select . The Motley Fool is investors writing for investors.
