Rule Maker Portfolio A Core Investing Value

We've got some housework to do before we get into the nuts and bolts of making decisions on individual companies. In this installment we're looking at the core value that should drive the Rule Maker approach: getting great companies at good prices. Because these companies are obviously great, we have to look for temporary inefficiencies. Merck offers us a good example to examine.

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By Bill Mann (TMF Otter)
January 16, 2002

I'd like to thank many of you for the messages of support I've received as we seek to turn the S.S. Rule Maker around. I do hope that no one is expecting a quick fix, because at this moment I am perfectly content with letting the portfolio itself float on autopilot. We've got some groundwork to lay first, and that may take a few weeks. After this process is done we'll start reviewing individual companies, but I don't see much need to jump in there just yet.

I thought that I'd use this column to lay out some expectations for the Rule Maker, what we should hope to achieve and (as importantly) what cannot be done nor expected from the strategy. If we do not set out the philosophy in advance, then any decisions we make later on will seem groundless.

What we want to do in Rule Maker is acquire pieces of great businesses at good or great prices. We do not try to time the market, we do not even care if a company's price takes plenty of time to readjust. Our preferred length of time for holding a company is forever, though we are more than willing to sell if we are given the opportunity to do so at a price that seems excessive, or if the company shows signs of degradation from a business standpoint. The Rule Maker deals in the realm of large-cap companies, the titans of industry, the companies that stand on mountaintops kicking pretenders back downhill.

Rule Maker investing should not be viewed as a short cut to superior investment returns, and unfortunately an awful large number of people are looking for just that: short cuts. I like to think about being a business owner when I purchase a stock. The only thing I care about is this: If I were to buy the whole company, is the current price one that I would accept? So many people are focused so intently on what someone else will be willing to pay for the same company tomorrow. Not figuratively tomorrow, but literally 24 hours from now. I've been sucked into that trap before, and nothing good came of it. We're not going to focus on price, we're going to focus on value. Price is what you pay, value is what you get. Big difference. There are some businesses that I will likely never be able to own, no matter how much I admire them. One such example is American International Group (NYSE: AIG), which is a dominant insurer and an obvious Rule Maker. Yet I doubt that AIG will ever come to a price at which it would be comfortable for me to own it.

Does that mean that I should not study AIG and see what it is doing right? Not at all. That's what I think we should be doing with Rule Maker, and that's what I think every person who has decided to select stocks for him or herself should do with regularity.

But Rule Maker investing is going to require an enormous amount of patience and an ability to analyze the prospects of a company. Moreover, it requires that an investor be able to do so while looking at the universe of the most admired companies in the world, so rest assured these are beasts that are being poked and prodded at by millions of investors at any one time. By investing in a Rule Maker, you will never, ever have the rush of discovering the "next big thing." What you're holding is just "the big thing."

This means that we will no longer be worried so much about deploying monthly amounts into stocks. We'll still add the $500 per month, because that ought to be consistent with the way that most people manage their portfolios -- they add more investment capital as they go. But I am perfectly content to let that money sit until I see a good opportunity for deployment. But rest assured that we are not timing the market, and the Rule Maker will remain as fully invested in equities as possible at all times.

That said, because the market is manic-depressive, there are always going to be some opportunities and mispricings out there. Generally these events will happen in conjunction with some near-term or short-term concerns about a company. For example, at this moment it would be safe to say that Merck (NYSE: MRK) is one of the oligarchs of the pharmaceutical industry, one of probably five different Rule Makers in that group. Right now Merck is being priced at multiples to free cash flow below the average company on the S&P 500, despite the fact that its operating margins are nearly double the average company. The stock has been hammered as of late due to pipeline concerns. But Merck is deploying more than $2 billion in research and development this year alone to refill that pipe. Do we really think that Merck is somehow permanently impaired? Well, I don't, and further I believe that its position in the industry makes its future cash flows much more predictable than, say, most technology companies.

The key is the focus on the business. Getting a cheap price for a Merck, which has problems that by most accounts are temporary, is way different from getting a cheap price on Polaroid, a company that managed itself right into obsolescence and then into Chapter 11. While we would like to find companies that are cheap on an asset basis, or on a book value basis, we are content to find companies that are low priced in relation to their earning potential. Since we are dealing with Rule Makers, that is likely as good as we are going to get. Still, even with companies that dominate their industries, the annual variance in stock price can be 50% or higher. Opportunities exist for those who seek but do not chase.

This is not a new concept, rather it is how some of the great investors have made their fortunes. There is a great difference between talking about a strategy and implementing it. What we want to find are companies that satisfy the qualitative criteria for Rule Maker (which we will begin exploring next week), and build out our universe of companies from which we can begin valuation work. We use Rule Makers because they are the easiest to find. They are the obvious companies, ones everybody knows. From this list, we can then begin looking at companies from a valuation perspective, begin to build out 10-year net margin data (which is a long enough period to work take into account business cycles), and make rough estimates of value.

We may not succeed. It may be that the concept of individual investors looking for inefficiencies in large-cap company pricing is simply unworkable. But interestingly enough, of the 30 most valuable brand names in 1976, 23 of them remain on the list today, though the brands are now worth manyfold more than they were 25 years ago. In that stretch of time we have had two wars, three recessions, double-digit inflation, and four KISS farewell tours. None of these things unseated the majority of the incumbent brands, or the companies that own them.

I do not purport to try to run this portfolio with an eye on macro economic situations, beta, or even quarterly returns. I'm betting that at least half of the brands that are on the list today will still be there in the year 2020. If a company that we have identified as being undervalued grows MORE undervalued, I want to have the confidence in our collective valuation efforts that we can get more excited and deploy more capital into the opportunity. Conversely, we can come to a point when a stock valuation ceases to offer much obvious reward and sell it.

In the next week we're going to start refurbishment of the qualitative criteria. If you've got questions or comments, shoot 'em over to the Rule Maker Discussion board.

Bill Mann, TMFOtter on the Fool Discussion Boards

Contrary to popular belief, Bill Mann was not a signatory on the Declaration of Independence. He did not own shares in any company mentioned in this article. The Motley Fool is investors writing for investors.


 

Rule Maker Portfolio

We are currently changing providers for our portfolio data. During the transition, we won't be able to show updates of our overall returns. Thank you for your patience.
 Ticker Company Price
 Change
 Daily Price
 % Change
 Price 
 MSFT MICROSOFT CORPORATION (1.68) (2.42%) 67.87 
 NOK NOKIA (0.78) (3.46%) 21.76 
 YHOO YAHOO! INC. (1.6) (8.22%) 17.87 
 AXP AMERICAN EXPRESS COMPANY (1.25) (3.31%) 36.50 
 SGP SCHERING-PLOUGH CORPORATION (0.09) (0.26%) 34.11 
 INTC INTEL CORPORATION (0.97) (2.8%) 33.71 
 PFE PFIZER INC (0.41) (1.01%) 40.00 
 CSCO CISCO SYSTEMS, INC. (0.74) (3.76%) 18.94 
 TROW PRICE T ROWE GROUP INC (0.95) (2.57%) 36.03 
 KO THE COCA-COLA COMPANY (0.55) (1.24%) 43.80 
 JNJ JOHNSON & JOHNSON 0.18 0.30% 59.35 
      
 Trade Date # Shares Ticker Cost/Share Price  Total % Ret  
02/03/98 59 MSFT 49.35 67.87  55.37%
02/15/00 132 NOK 40.21 21.76  -43.85%
02/17/99 106 YHOO 57.60 17.87  -60.21%
05/26/98 95 AXP 35.38 36.50  4.42%
08/21/98 44 SGP 47.99 34.11  -28.66%
02/13/98 147 INTC 27.44 33.71  33.20%
02/03/98 66 PFE 27.43 40.00  46.45%
06/23/98 182 CSCO 24.72 18.94  8.07%
02/03/98 75 TROW 34.12 36.03  5.98%
02/27/98 27 KO 69.11 43.80  -36.35%
04/03/01 10 JNJ 43.65 59.35  35.97%
      
 Trade Date # Shares Ticker Total Cost Current Value  Total Gain  
02/03/98 59 MSFT 2,911.79 4,004.33  1,092.54 
02/15/00 132 NOK 5,307.79 2,872.32  -2,435.47 
02/17/99 106 YHOO 6,105.74 1,894.22  -4,211.52 
05/26/98 95 AXP 3,360.87 3,467.50  106.63 
08/21/98 44 SGP 2,111.70 1,500.84  -610.86 
02/13/98 147 INTC 4,033.23 4,955.37  922.14 
02/03/98 66 PFE 1,810.57 2,640.00  829.43 
06/23/98 182 CSCO 4,498.76 3,447.08  -1,051.68 
02/03/98 75 TROW 2,559.06 2,702.25  143.19 
02/27/98 27 KO 1,865.89 1,182.60  -683.29 
04/03/01 10 JNJ 436.50 593.50  157.00 
Cash:1,616.00 
Total:30,876.01 


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Notes
The Rule Maker Portfolio began with $20,000 on February 2, 1998, and it added $2,000 in August 1998 and February 1999. Beginning in July 1999, $500 in cash (which is soon invested in stocks) is added every month.