All of this leads me to what I think is the best element of the Rule Maker approach: Rule Maker investing demands a commitment, and it virtually guarantees that a Rule Makin' Fool will get to know his or her companies like old friends. Through the process of reviewing each company's quarterly announcements and spending perhaps a little extra time each year reading through annual reports, Fools achieve the confidence and peace of mind that comes with understanding how their companies make money and why they will likely continue to do so.
Rule Maker investing, by definition, requires that investors focus on a limited number of companies. Quite naturally, this leads to concentrated portfolios. The Rule Maker portfolio, for example, consists of 15 companies, of which 10 are Rule Maker holdings and five are the result of allocating a portion of the portfolio to the Foolish Four mechanical strategy. The three largest holdings (Cisco, Microsoft, and Intel) now account for over 40% of the RM portfolio. Cisco has been the #1 performing stock in our portfolio, and our position in this fine company has now grown to over 15% of the portfolio. In addition, Cisco is responsible for about 28% of the portfolio's appreciation since inception.
I guess you're probably starting to wonder whether there is a point to my meandering thoughts. Well, I'm getting there. My point is that the larger the weight a company occupies in one's portfolio, the more confidence one needs to resist the temptation of lightening up on it (i.e., selling), and buying shares of a different company (one that may not be of the same high quality). Specifically, the more one understands the reasons for the company's success and likelihood of continued success, the better one sleeps at night. A Rule Maker investor can lean on this knowledge at times of market panic, and resist the urge to sell and run screaming into the night.
I bring this up in light of the fact that Dale Wettlaufer, the recently departed manager of the Boring Portfolio, sold Cisco (Nasdaq: CSCO) early this year specifically for the reason that he didn't feel comfortable with having a very large portion of his portfolio invested in a company that he didn't understand as well as he would like. This was quite interesting to me, even more so because Dale demonstrated in his writings that he understands the business to an extent that is likely well beyond what most owners of Cisco stock will ever attain. I mean, if a smart guy like Dale admits he doesn't understand the company to an acceptable degree, what business does an average Fool like myself have owning the company? Indeed, we don't spend a lot of time in this space plumbing the depths of Cisco's business and products, or in examining the industry environment in which Cisco competes. Are we just being naive?
After giving this a bit of thought, I was reminded of something I read that has nothing to do with finance, but with baseball. Yep, that's right, baseball. The author was Bill James, one of the great baseball writers of all time, the man who introduced logical statistical analysis to baseball. Bill James did for baseball what The Motley Fool aims to do for investors, which is to demystify the process of using statistical evidence to make rational decisions. The book was Bill James 1987 Baseball Abstract. For those of you who don't like baseball, please bear with me on this short digression.
The topic was Willie Wilson, the one-time great center fielder of the Kansas City Royals. Back in those days, baseball announcers and even managers and coaches (the Wise of the baseball world) weren't really very enlightened in the statistical evaluation of players beyond the use of batting average, which is of limited use in evaluating a player's effectiveness (the financial equivalent of the P/E ratio, which also has limited use in determining a good stock investment). The Kansas City Royals were, at the time, coming off several seasons of championship-level baseball, but the team had started to age and performance had begun to deteriorate. The KC management was in denial about this, and were very slow to replace or augment the aging but longtime performers that had played a key role in the Royals' past success.
At the time, Wilson was considered one of the fastest men in baseball, and sportscasters were talking about how he hadn't lost a step in his later years (Wilson was well into his thirties at the time). Wilson himself admitted he probably wasn't quite as speedy as in his younger days, but that likely nobody but he was able to notice the difference. The manager and coaches of the team were also under the impression that Wilson was just as effective as he had been in his late twenties.
Bill James, who happened to be a longtime Royals fan, wrote a compelling argument that, simply by looking at the statistics, one could tell without a shadow of a doubt that Wilson was drastically losing effectiveness on the field. Where in the early 1980s, Wilson would get 200 hits a year, he was down to about 150 by 1987. Where he previously had stolen 80-90 bases a season, by 1987 he was down to under 50. James went on to point out that in virtually every category, from doubles and triples to defensive plays per game, Wilson had deteriorated as a player and was by 1987, in fact, no better than mediocre in his contribution to winning baseball games.
Let's now segue back to the Rule Maker portfolio in general, and Cisco in particular. What connection can be made between the example of Willie Wilson and Cisco? Well, we at the Rule Maker Portfolio won't be making decisions about whether to sell Cisco based upon our feelings about how well we know Cisco's business. It is my opinion that even if we spent a tremendous amount of time on the subject, it would add little practical value to our decision-making.
In fact, I would argue that we should all be realistic about how much we know about our businesses. Just because I understand and love Coke doesn't mean I understand anything beyond the absolute basics of Coca-Cola the business. Instead, the Rule Maker approach is very much a Bill James-like exercise. Bill James doesn't know Willie Wilson the person. Has no idea whether Willie Wilson spends the winter running windsprints and lifting weights or eating pizza. All he needed to know, he was able to gather from a careful evaluation of the numbers.
This is also the Rule Maker way. I have no clue as to whether Cisco's new router is better than that of the competitors, but I will certainly be able to gauge whether Cisco's sales are growing. I couldn't tell you whether Linux is a real threat to Microsoft's business, but I'll notice if Softy's gross margins drop by two percentage points next year. We have faith that by viewing our companies through the objective lens of the Rule Maker criteria, we will notice when performance begins to deteriorate. Phil and Matt's recent investigation about Pfizer's Flow Ratio is a case in point.
Similarly, we have confidence that if some detrimental change were to occur in the markets in which Cisco competes, we would see the impact of that change via our quarterly review of the company's financials. With this confidence, we don't lose sleep thinking about the performance and features of Cisco's routers versus those of competitors or worrying about whether Linux is going to be the silver bullet that wounds Microsoft. Unless such an event is awfully sudden, we'll pick it up in the numbers. And if it is so sudden that we don't see it coming in our periodic reviews, it is unlikely that we would have been able to avert the consequences anyway, regardless of our level of expertise in a given industry.
Just to say, none of this should in any way be construed as criticism of Dale's decision to sell Cisco. The Boring Portfolio is even more concentrated than the Rule Maker portfolio, and Cisco accounted for almost 40% of the Boring's holdings at the time that Dale liquidated his position. Dale's approach as an investor is quite a bit different from what we do over here in the Rule Maker, and therefore his conclusions as to what actions he should take as an investor will differ from ours.
What do you think?
Come post your thoughts about tonight's report on our Rule Maker Strategy board. Alternatively, if you have ideas, analysis, or questions about a particular Rule Maker company, take a seat at the roundtable discussion on our Rule Maker Companies board. Finally, if you're new to all this stuff, the Rule Maker Beginners board is the place to get your questions answered.