Wall St. vs. Main Street
Value over valuation

by Tom Gardner (TomG@fool.com)

Alexandria, VA (Nov. 27, 1998) -- The Cash-King Portfolio -- soon to be renamed The Rule Maker Portfolio -- has earned us more than $5,000, or 24%, since our February launch. Certainly, our eight-dollar discount-brokerage commissions and our deferral of capital-gain taxes have helped make that possible. But the driving force behind our growth has been the selection of first-rate businesses -- from Microsoft to Gap and from Coca-Cola to American Express. There's been very little disagreement that we've collected shares in some of the world's greatest companies.

Where there has been disagreement, though, is over the prices that we've paid to own pieces of these companies. Back in February, when we made most of our investments, these stocks were trading at all-time highs in price and price-to-earnings multiples. We became owners of some of the most expensive large companies in the world, as measured by traditional valuation tools. One after the other, they were trading at twelve times sales or fifteen times sales and forty times earnings or fifty-two times earnings. And, at the time and ever since, not a few critics have cited our belief that "the valuation of the shares matters hundreds of times less than the quality of the business" as indicative of massive overvaluation throughout a stock market drowning in untrained individual investors.

After four years of controversy, I have to say that this issue of stock valuation is the only claim against The Motley Fool that interests me. There have been plenty of others offering little more than passing amusement. First, we were charlatans for suggesting that individuals could beat the professionals at their own game. Then, we were buffoons for believing that common-stock ownership held a world of more potential for the average American than did the slather of expensive, underperforming mutual funds. Then we were petty hypesters for suggesting that the Internet would be home to a number of wonderful investments in the 1990s. And, of course, we were always Fools for asking whether the House, I mean the Street, might not actually be out to methodically take advantage of individuals rather than to serve them.

Through this series of manufactured complaints against The Motley Fool and against your decision to manage your own money, the only one that really interests me is this matter of stock valuation. At the root of it lies incredible opportunity for long-term business owners. At the root of it lies the greatest pricing inefficiencies that our stock market has to offer. At the root of it lies, I believe, the primary reason that the Rule Maker Portfolio will consistently and significantly outperform the market's average return, without much effort.

It's a simple concept, which holds that enduring quality matters more than present price.

To shed light on the precept, we should walk down Wall Street and understand why the professionals might attack our notion. Today, the Street is still compensated primarily through trading commissions and margin interest, meaning that your average equities professional is cheering for his clients to trade frequently and to borrow money to buy funds and stocks. That's the bread-and-butter of the equities business -- borrow and trade -- both of which introduce a lot of short-term thinking into the marketplace. For the Street to make money, it has to get you to reallocate over and again.

Now, the Street doesn't want you to lose money in the process, but if they're to put caviar on the table and a third BMW in the garage, they have to trade your account -- from one loaded fund to the next, from stock to stock, from the stock market to the money market, and back. To pull money out of thousands of accounts each week, firms on Wall Street naturally focus an increasing amount of their attention on stock valuation. What's the P/E ratio? What's the price-to-sales multiple? What's its 200-day moving average? Is there a cup or a handle or a candlestick on the stock chart?

When should you get out? When should you get back in?

I think you'll find that those two questions are of primary importance to the Street because their business model is predicated upon your getting out and getting back in, with increasing frequency. Naturally, then, stock valuation and its promotion becomes absolutely crucial. Their analysts line up their recommendations -- strong buy, accumulate, market perform, hold -- each providing the sales force with a reason to contact investors. In this circus atmosphere, where financial television sends a reporter to the trading floor and traders bounce her about, the game is about picking the high for the quarter and the low for the year, and Wall Street's aim is the commission. Clearly, it's far more valuable on Wall Street to guess at next week's stock prices than to search for the ten best businesses to own for the next decade. "Own for a decade? Huh?" the financial consultant asks. "Why do that?"

Indeed, on the Street, stock valuation is one hundred times more important than the enduring quality of a business, if not more. Trained as Fools, we know to seek truths in contrary corners.

Wall Street: "Stock valuation is one hundred times more important than business value."


Main Street: "Business value is one hundred times more important than stock valuation."

Here again, remember that on Wall Street, professionals will benefit most from active trading, margin interest, and short-term thinking. But now consider that on Main Street -- where the average American is just 34-years-old -- investors will most benefit from compounded growth, interest-free investing, and long-term thinking. With those in mind, you will understand why The Rule Breaker Portfolio has bought and held companies like America Online and Amazon.com, riding them literally to 50x and 10x their initial investment, respectively. That's one commission, on one investment, for one reason -- David and Jeff believe in the merits of the business.

This is a nightmare on Wall Street.

Over here in The Rule Maker Portfolio, home to slower and steadier growth, we also have purchased our companies with little regard for their present stock valuation. Or at least their present stock valuation as measured by the tools (err, tricks) of the trade. Our company evaluations aim to measure the durability of a business model. Wall Street's stock valuations aim to measure the one-year direction of the stock price. The two are at loggerheads. It's just a simple battle between Trading Commission and Compound Interest. This is why the Street first asks about the price of a stock while The Fool first asks about the purpose of the business.

Valuation versus Value.

Trading versus Compounding.

Today it is, unfortunately, the Institution versus the Individual.

It's Wall Street versus The Motley Fool.

And that is the subject of next week's columns -- Wall Street vs. Main Street. Tune back in. I think you'll be shocked at what we've come up with. Until then, we'll see you on the Boards.

Tom Gardner, Fool

Order your copy of David and Tom Gardner's new book, Rule Breakers, Rule Makers, in advance. This Simon & Schuster beauty doesn't arrive until January, but you can reserve your copy today! The first half of the epic book, on Rule Breakers, elucidates the Fool Port's investment style; the second half, on Rule Makers, further explains Cash-King investing.

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11/27/98 Close

Stock  Change    Bid
AXP   -  1/8   103.44
CHV   +5 1/4   85.63
CSCO  +2 3/4   79.81
KO    -1 5/8   71.69
GPS   +1 5/8   76.63
EK    -  5/16  74.75
XON   +1 11/16 74.38
GM    -  1/2   71.44
INTC  +  1/4   110.00
MSFT  +3 13/16 128.06
PFE   -  3/8   114.00
SGP   +1 13/16 109.75
TROW  +1 7/8   36.75
                 Day     Month   Year    History
        C-K      +1.63%  12.87%  25.46%  25.46%
        S&P:     +0.46%   8.52%  18.52%  18.52%
        NASDAQ:  +1.57%  13.83%  21.01%  21.01%

Cash-King Stocks

    Rec'd    #  Security     In At       Now    Change
    2/3/98   24 Microsoft     78.27    128.06    63.62%
    5/1/98   37 Gap Inc.      51.09     76.63    49.98%
    2/3/98   22 Pfizer        82.30    114.00    38.52%
   6/23/98   34 Cisco Syst    58.41     79.81    36.64%
   2/13/98   22 Intel         84.67    110.00    29.91%
   8/21/98   22 Schering-P    95.99    109.75    14.34%
    2/6/98   56 T. Rowe Pr    33.67     36.75     9.14%
   2/27/98   27 Coca-Cola     69.11     71.69     3.73%
   5/26/98   18 AmExpress    104.07    103.44    -0.60%

Foolish Four Stocks

    Rec'd    #  Security     In At     Value    Change
   3/12/98   20 Eastman Ko    63.15     74.75    18.37%
   3/12/98   20 Exxon         64.34     74.38    15.61%
   3/12/98   15 Chevron       83.34     85.63     2.74%
   3/12/98   17 General Mo    72.41     71.44    -1.34%

Cash-King Stocks

    Rec'd    #  Security     In At     Value    Change
    2/3/98   24 Microsoft   1878.45   3073.50  $1195.05
    5/1/98   37 Gap Inc.    1890.33   2835.13   $944.80
   6/23/98   34 Cisco Syst  1985.95   2713.63   $727.68
    2/3/98   22 Pfizer      1810.58   2508.00   $697.42
   2/13/98   22 Intel       1862.83   2420.00   $557.17
   8/21/98   22 Schering-P   2111.7   2414.50   $302.80
    2/6/98   56 T. Rowe Pr  1885.70   2058.00   $172.30
   2/27/98   27 Coca-Cola   1865.89   1935.56    $69.67
   5/26/98   18 AmExpress   1873.20   1861.88   -$11.33

Foolish Four Stocks

    Rec'd    #  Security     In At     Value    Change
   3/12/98   20 Eastman Ko  1262.95   1495.00   $232.05
   3/12/98   20 Exxon       1286.70   1487.50   $200.80
   3/12/98   15 Chevron     1250.14   1284.38    $34.23
   3/12/98   17 General Mo  1230.89   1214.44   -$16.45

                              CASH    $120.62
                             TOTAL  $27422.12

*Please note: On 8/4/98 $2,000 cash was added to the
portfolio. $2,000 will be added every six months.

*The year for the S&P and Nasdaq is as of 02/03/98