Rule Breaker Portfolio


Change Happens Everywhere
...even to institutionalized concepts

by Jeff Fischer (

CHICAGO, IL (Feb. 10, 1999) -- One hundred years ago you couldn't wake up on the East Coast at four in the morning and be in Chicago by six in the morning. Now you can. One hundred years ago you couldn't type a letter into a computer and send it completely around the world in mere seconds. Now you can. One hundred years ago you couldn't do anything, because you weren't born yet.

But that wasn't the point. The point is: things change, and drastically.

Change is as constant as aging; every second that we live, we age. Every moment that we experience, we can never have again. However, as constant as change is, we often try to sublimate it in our lives, or discount it. We probably do this because on some level everybody fears change. Society, in many instances, likes to harken back to the status quo in times of turbulence (and even in times of peace). Our culture enjoys searching for patterns and a steady routine; it even enjoys the notion that history can, in essence, be revisited or repeated. ("This happened in the past and it will happen again," you'll hear stock market analysts quip.)

Yet, change has made certain that nothing is ever repeated, and change makes certain that nothing even remains constant.

This century, the fingers of change scrubbed every hair on the world's scalp. Nothing was left unchanged to some degree. Technology represents the most obvious and mind-boggling change put upon us: we've gone from horse-drawn carriages to space shuttles in the span of 100 years, or 36,500 days. The 1900s also brought social and business change (progress!) in leaps and bounds, from equality for women as well as between all races, to new international diplomacy practices and larger economic and trading relationships. Beyond that, this century grew industry and with it pollution, but as soon as we began to realize the ramifications we began to discover ways of correcting the situation. Recycling is still nascent in the world, as are environment-friendly products. There's plenty of room for improvement here, but at least the issue is being addressed and change is taking place.

What might also be changing, some people argue, is how we should value stocks. The old notion that a stock should trade at a P/E ratio equal to its earnings growth rate is being questioned. Perhaps it's much more logical that a stock like Coca-Cola trades at 50 times earnings, or even at 75 times earnings per share, while even second-tier companies that are growing earnings modestly should perhaps trade at P/E ratios significantly above their rate of earnings growth. Many readers will immediately discount this notion and say that it is the result of a long bull market. I'm not here to persuade you otherwise, but beginning today we'll address some points regarding valuation.

Late this summer Kevin Hassett (a resident scholar at the American Enterprise Institute) and James Glassman (a resident fellow and Washington Post columnist) will publish a book that hypothesizes that the fair value for average-growth companies should be somewhere around 50 to even 100 times earnings, especially when inflation and interest rates are low, as they have been for several years.

Using a simple and accepted measure to find the present value of cash flows, the authors compare stocks to their debt-based sister, long-term bonds. The formula equates to the following: given inflation of 2.8% annually, an economy and earnings growth rate of 2.1% per year (which is conservative), and long-term T-bonds that pay 5.9% (about what they have been paying), the P/E on stocks growing earnings at the same rate as the economy would need to average around 100 to equalize the value of their long-term cash flow to the value of the same cash flow from bonds.

Of course, there are caveats. The economy needs to grow 2.1% annually while bond and inflation rates remain steady, and this needs to happen for about 20 years. If you're invested in stocks for less time there's risk involved, the argument states, so a risk premium would eat into the P/E ratio granted stocks. But even given these above conditions, an argument can clearly be made that the old-line of thinking on stock valuations (that P/Es should equal growth rates) can be contested -- and contested mathematically. We'll detail the numbers explaining the paragraph above next time. First off, we want to consider some of the old thoughts on valuation, then next time we'll address new (and improved?) considerations...

The Old School. Since early in this century, the argument has stood that stocks should trade at P/E ratios that equal their growth rates. (And why, exactly? The flaw with this, in my opinion, is that it doesn't allow for premium prices on companies whose earnings growth is far more certain and steady than other companies. The stock market has arguably adjusted for this flaw over time, however, regardless of the pundits' old maxim. Many strong companies consistently trade at prices well above growth rates.) The old notion of stock valuation also holds that stocks are risky. Perpetuating this belief in the past was the fact that most people couldn't readily obtain stock information; knowledge was kept in the hands of the professionals.

Ask yourself, how risky are stocks? The answer is truly several-fold and is found by asking more questions: 1) For how long are you holding your shares? 2) In what kind of companies do you invest? 3) Do you use margin? 4) What have stocks returned historically? (Answer: 11% per year, on average, since 1926. How risky does that sound?)

The New School. We'll consider this the next time I write.

As for today's stock market: didn't see it. Everyone else in the world seems intent upon summarizing a single day on the stock market as if it truly mattered. No single day in stock market history has ever mattered. Only when accumulated does the past have any lasting importance.

Catch Tom and David on their book tour for Rule Breakers, Rule Makers. For details, click here. Invest for the long term and Fool on!

What's happening with Harry? Click here to find out.

02/10/99 Close
Stock  Change    Bid 
AMZN  -2 9/16  97.44
AMGN  +1 1/16 116.75
AOL   +2 3/4  150.63
T     -1 1/4   85.81
ATHM  +3 3/4   96.13
DJT   +  1/16   4.56
DD    +  11/16 54.50
XON   +  3/8   72.56
IP    -  1/4   42.19
IOM   -  1/8    6.63
LU    +1 1/16  97.19
SBUX  -  13/16 48.00
TDFX  -  3/8   11.13

                   Day   Month    Year  History  Annualized 
      R-BREAKER  +0.21% -12.72%  -2.09%  882.69%   65.84%
        S&P:     +0.61%  -4.38%  -0.14%  180.48%   25.65%
        NASDAQ:  -0.06%  -7.84%   5.33%  220.68%   29.43%
 Note:  Yearly, historical and annualized returns for the 
S&P include dividends

    Rec'd    #  Security     In At       Now      Change
   8/5/94  1100 AmOnline       1.82    150.63    8186.57%
   9/9/97  1320     6.58     97.44    1380.98%
  5/17/95  1960 Iomega Cor     1.28      6.63     417.41%
  10/1/96    84 LucentTech    23.81     97.19     308.21%
  8/12/96   130 AT&T          39.58     85.81     116.82%
  12/4/98   450 @Home Corp    56.08     96.13      71.41%
  4/30/97 -1170*Trump*         8.47      4.56      46.13%
 12/16/98   290 Amgen         85.75    116.75      36.15%
  2/20/98   200 Exxon         64.09     72.56      13.22%
  2/20/98   215 DuPont        59.83     54.50      -8.91%
  2/20/98   270 Int'l Pape    47.69     42.19     -11.54%
   7/2/98   235 Starbucks     55.91     48.00     -14.15%
   1/8/98   425 3Dfx          25.67     11.13     -56.66%

    Rec'd    #  Security     In At     Value      Change
   8/5/94  1100 AmOnline    1999.47 165687.50  $163688.03
   9/9/97  1320  8684.60 128617.50  $119932.90
  12/4/98   450 @Home Corp 25236.13  43256.25   $18020.12
  5/17/95  1960 Iomega Cor  2509.60  12985.00   $10475.40
 12/16/98   290 Amgen      24867.50  33857.50    $8990.00
  10/1/96    84 LucentTech  1999.88   8163.75    $6163.87
  8/12/96   130 AT&T        5145.11  11155.63    $6010.52
  4/30/97 -1170*Trump*     -9908.50  -5338.13    $4570.38
  2/20/98   200 Exxon      12818.00  14512.50    $1694.50
  2/20/98   215 DuPont     12864.25  11717.50   -$1146.75
  2/20/98   270 Int'l Pape 12876.75  11390.63   -$1486.13
   7/2/98   235 Starbucks  13138.63  11280.00   -$1858.63
   1/8/98   425 3Dfx       10908.63   4728.13   -$6180.50

                              CASH  $39332.55
                             TOTAL $491346.30

Note: The Rule Breaker Portfolio was launched on August 5, 1994, with $50,000. Additional cash is never added, all transactions are shared and explained publicly before being made, and returns are compared daily to the S&P 500 (including dividends). For a history of all transactions, please click here.


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