Rule Breaker Portfolio
Rule Breaker Information and Principles
Principle 3

By David Gardner
updated March 20, 2001

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Rule Breaker Principles

Our third principle is a controversial but important one:

We pay little attention to traditional valuation metrics, and neither do we pay much attention to market history.

This is a key feature of the Rule Breaker portfolio, and one that is very important to understand. To us, valuation is, at best, a secondary or tertiary concern. To many long-term investors in growth stocks, traditional methods of valuation should not be any concern at all. It's important to note, though, that downgrading the importance of valuation applies to Rule Breaker stocks -- not all stocks in general. Not Rule Makers. Not Drip Port stocks or our Foolish 8 small caps, etc.

This notion that valuation is at most a secondary concern is rather outrageous, no? After all, valuation has been a key focus of investment literature throughout this century, starting with Ben Graham's Security Analysis and The Intelligent Investor and continuing right through our own books. Indeed, we have right here at the Fool what we believe to be the most user-friendly and sophisticated material for teaching valuation that you can find, period. And certainly it's important stuff for investors to learn, just as it's important for baseball players to learn how to bunt, or for airplane pilots to know what to do in case of a fire. But the question naturally arises, how often do ballplayers bunt?

It is for this reason we de-emphasize valuation. Which breaks lots of rules, we know, including some of our own. Hey, welcome to Rule Breakers, Rule Makers

In the Rule Breaker portfolio, we are decidedly not looking for pricing inefficiencies in the market. It's great when they come along, and bully for you if you spot them when they do, but we don't seek them out. We think valuation is overrated for three reasons:

  1. market pricing is fairly efficient,
  2. great stocks will almost perpetually look overvalued, and
  3. great business are much more compelling than low prices.

We downgrade the importance of valuation for Rule Breakers precisely because they are so unpredictable that investors are better served trying to figure out whether (and how) the businesses will succeed in the long term -- not whether the market has them "accurately" priced today to account for all their future growth. That is a mostly uninteresting short-term variable. We don't find present-day valuations compelling reasons to act (whether to buy or to sell); we let the market reward us, or penalize us, as it will. In the same regard, we don't predict the market over the short term. Not only do we not believe short-term price movements are logical or can be predicted, but we wouldn't want to waste our time guessing at them anyway.

Instead, we spend our time studying the much more interesting long-term variables: What's the company's industry, what's its business, what's its profit model, and will this company "win?" Once these questions are answered to our satisfaction, we invest and then find out in time whether we were right or not. THAT is the way the market rewards or penalizes long-term shareholders -- on their ability to forecast whether a company will make increasing, long-term profits or not. Over the long term, value will out.

Note the implications of downgrading the importance of valuation. One of our dumber, oft-repeated past mistakes as investors has been to fail to buy stock in a great company because it looked "overvalued." Indeed, this is a mistake made by MANY investors, who otherwise love the products or prospects of a particular company but do not invest in it because its price-to-earnings ratio is high.

Well, no surprise that it's high, right? Great companies almost always look overvalued, simply because they will trade at higher multiples and richer so-called "valuations" than their lesser peers, the not-so-great companies. Many unfortunate investors buy those not-so-great companies instead. Why? Their own "valuations" -- their present, accurate price taken as a multiple of earnings or book value -- is lower and therefore more "attractive." They avoid the one and buy the other, generally to their detriment.

The best Rule Breaking investments have been made when we closed our eyes to valuation: AOL Time Warner (NYSE: AOL), Amazon.com (Nasdaq: AMZN), Iomega (NYSE: IOM) -- stocks that had already multiplied a few times in value before we ever bought them, to the point that the Wise called us crazy for buying in the first place because they were SO "overvalued." So overvalued, just before those stocks went on to multiply many more times in value.

Learn the business. Ignore the pundits. Or even better, actively look for and HOPE the pundits are calling your Rule Breaker "overvalued." As you'll find later on, in another of our principles, this is a great contrary sign, one of the attributes shared by all true Rule Breaker stocks: Someone in the financial media thinks they're overvalued.

We similarly reject the deterministic power of market history so frequently claimed by market gooroos. "This is 1929 all over again" -- that's a typical example. Sorry, but 1929 ended more than 70 years ago, and it will never happen again. While a drop of similar magnitude can certainly occur again, it won't be for the same reasons or under the same conditions that occurred in 1929.

Market historians are very good at telling you what has happened in the past; they err when they begin to attribute past performance to future results. A classic example was the conventional wisdom at the beginning of 1997, which said that the market had never gone up more than 20% three years in a row, and therefore couldn't. And of course, it did. In fact, the market went on to accomplish this for a fourth consecutive year in 1998, confounding both the market historians and the bears.

Every year is new, with new possibilities and new situations. Business is constantly evolving, often in unpredictable ways. Because Rule Breaking investors consciously seek out dynamic growth companies that are quite literally creating new industries as they grow, backward-looking pundits have little value to offer us.

One final example: Market history shows the market's average annualized return to be nearly 11% over the course of the 20th century. When we learn that lesson, it causes us to buy stocks, and has us believing that 11% is as good a guess as any as to what the average annualized return will be for the 21st century. That does NOT mean that we therefore emphatically predict that next year the market will rise 11%. Nor do we believe that the market's return in 1901 will be repeated in 2001. Nor do we believe in 7-year cycles, 13-year cycles, 30-year cycles, etc.

Gimme a break.

To close, we note again that this is only our way of investing right here in this space in Fooldom. There are many ways to lead a normal, healthy life and invest successfully, and the Rule Breaker portfolio represents only one type of effort. Other portfolios in The Motley Fool use completely different presuppositions. We do not hit anyone over the head with our approach to investing. We do teach it for those interested in learning, and we handicap ourselves by exposing all our methodologies, telling people what we're doing ahead of time, and so forth. Our numbers have been pretty good, but as always, your mileage may vary.

To sum up, because pricing is efficient it renders valuation largely irrelevant. Choose good long-term businesses to invest in, and commit regular amounts to those stocks, buying at the present, efficient price. Don't get scared by articles about stocks being overvalued. Finally, don't allow anyone to convince you that they know where the market is headed based on what has happened in the past. We have yet to see lightning strike the same place twice.

Next: Rule Breaker Principle 4 »