The Cult of Value and Big Winners

It should come as no surprise to people that one of the reasons that technology stocks caught peoples' fancy by the end of the 1990s was the massive stock appreciation these companies had already enjoyed. It is in vogue at present to bash technology stocks, but the fact remains that the products and services offered by these companies have in fact changed how we work, how we communicate, and how commerce gets done. The key to investing is not to buy great companies, nor is it to buy cheap companies. It is to buy great companies cheap.

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By Bill Mann (TMF Otter)
February 26, 2002

James Glassman wrote a fascinating story in this past Sunday's Washington Post about the 20 companies that have seen the biggest stock appreciation over the last decade. There was something that was very curious about them: The companies had an average P/E of nearly 30 before they ever had their enormous run-ups.

He was referring to a study by ThinkEquity research analyst Michael Moe. I have spoken with ThinkEquity and have asked for a copy of this report, but was unable to get it by the time this article goes to press. As such I'm going to make some comments here on the summary of the study by Glassman, and then I hope to later be able to revisit this with some of the hard data produced by Michael Moe.

Glassman made two fascinating points about this study. First of which was that of the 20 companies, 14 were in the technology sector, including such big performers as Dell (Nasdaq: DELL), Emulex (Nasdaq: EMLX), and Applied Materials (Nasdaq: AMAT), all of which returned had several thousand percent of appreciation over the decade. The end date of the study was December 31, 2001, so this means that these companies were still among the top performers in spite of stock price declines averaging 60% since March 2000.

The second point is that of the top 20 companies, their average price at the beginning of the decade was a multiple of earnings of nearly 30. In other words, even before these massive gains, these stocks were on average not at all cheap. Perhaps you think that these companies went through a massive speculative boom? Well, perhaps en route, but at the end of the period the companies in aggregate had P/E's of 48. What this means is that investors still believe that these companies have their best years ahead of them.

I see a few things about this study. First of all, it reinforces one of the founding principles of The Motley Fool: quality rarely comes cheap. It is one of the things I have struggled most against in my urge to be a disciplined investor: I want to be able to spot a bargain when I see it, but I don't want to buy a pile of junk just because it happens to be cheap. If you look back over a decade, who was the "smarter" investor; the person who bought USX (NYSE: X) because the share price was depressed, or the one who bought Oracle (Nasdaq: ORCL), which was already profitable in 1992 and growing at triple digit rates?

Don't answer that question. Intelligence has nothing to do with it. It does not take smarts to do well in investing: Mark Twain, probably one of the smartest Americans in the 19th century, was taken to the cleaners by his investments on several occasions. But there is something to be said for someone who has the ability to see value in a company where Wall Street sees none. Oracle's net profit growth rate averaged more than 40% per year in the decade. Even those who bought at the absolute highest tick on the company in 1992 have done very, very well if they held on.

Of these companies, 17 were already profitable in 1992. They were as a group generating significant cash and reinvesting it back into the company.

I don't want to assign too much meaning to this list, because we are simply taking a list of 20 and applying rear-view mirror analysis. There were certainly hundreds of stocks that were more expensive, had better growth rates, and created more cash in 1992. But someone who practiced intuitive predictions about the direction of business in 1992 might have already seen the potential for the Internet, personal computing, distributed computing, and telecommunications technology. If this person had a basket of 20 stocks and 19 went bankrupt and the other was Dell, that person has made a boatload of money, even though he is only batting 5% as a stock picker.

Quality matters. Finding quality where others see no value matters even more. People screamed and shouted at me that I did not "get" Qualcomm (Nasdaq: QCOM) when I called it overvalued at its peak in January 2000. Oh, I get Qualcomm, I just saw no further opportunity for price appreciation. Now, however, may be a really, really good time to take a look at a Qualcomm, or an EMC (NYSE: EMC), or my personal favorite potential phoenix Cable & Wireless (NYSE: CWP), because they have been murdered by the market but still maintain products that people and companies want and need. These are companies providing technologies or services that have revolutionized how people transact business, and will continue to do so.

Ah, but once again we are not talking about jumping on the bandwagon for every Juniper (Nasdaq: JNPR) that comes down the pike, nor are we saying that one could buy any company at any price with impunity. I would imagine that the vast majority of people who bought any one of these companies a decade ago and still hold them were generally pretty lucky. I'm also sure that there were a certain subset of investors who looked at a Dell and said "PCs are going to become ever more prevalent, and this company has a great business model and makes great computers. I'll bet they have an advantage in a growing market." The rest is history.

The (admittedly unsatisfying) moral of this tale is that one should not be shackled by the cult of value to the point that one would not consider a stock that is relatively expensive based on current earnings. Companies will be valued on future earnings, and a company that looks like its market is growing by leaps and bounds that truly seems to have a competitive advantage just might be a bargain even at today's high price. It is impossible to make predictions that come true 100% of the time, but as the Dell example shows, one doesn't even have to have a good batting average as long as one of the hits is a really, really spectacular one.

Bill Mann, TMFOtter on the Fool Discussion Boards

Please excuse Bill from class. His dog ate his brain. Signed, My Mother. Bill owns shares of Applied Materials and Cable & Wireless. Please see his profile for a full list of holdings. The Motley Fool has a disclosure policy.