<THE FOOL PORTFOLIO>
by David Gardner (DavidG@fool.com)
ALEXANDRIA, VA (Nov. 20, 1998) -- No talk of how much Amazon rose today -- we're getting straight down to business.
Without any ado, The Fool Port (soon to be Rule Breaker Port) presents Rule Breaker Principle # 3:
We pay little to no attention to traditional valuation metrics, and neither do we pay much attention to market history.
Every price of every product in the world simply reflects the rate at which buyers and sellers have met, have shaken hands, and are willing to exchange ownership. That's as true of what sits on the grocery store shelf as it is of what's trading on the New York Stock Exchange. In a free and open market, pricing is efficient. It is one of the truisms of capitalism. Straight economics.
The single price you see on any given share of common stock accurately takes into account the entire spectrum of information and opinion, from the most bullish and unjustified hopes to the most bearish and doomsday forebodings. Heck, if this were NOT true, what would happen? Answer: Buyers or sellers would be unwilling to transact, causing the price to adjust quickly to whatever price they WERE willing to transact. That is efficient pricing, and in all but the very rarest and short-term exceptions, that is the dynamic of the marketplace.
Thus, the present price you find on any stock -- the latest quote - represents by definition the fairest value presently conceivable for that stock. Because this notion will be a radical one for some, we reiterate again that if the price were not fair and efficient, it would immediately be driven up or down by buyers or sellers eager to cash in on that inefficiency. Think of inventory sitting on a retail shelf; if no one bought it, sales volume would be zero and the price would have to drop to find buyers. To believe our market - or any open market - does NOT operate this way is to believe that the pricing systems of capitalism and of the stock market don't work, making the stock market not worth investing in at all.
Once an investor understands this, the third Rule-Breaking principle of portfolio management is easily understandable:
Valuation is overrated. Valuation is, at best, a secondary or tertiary concern. To many long-term investors, valuation should not be any concern at all.
That's right, for Foolish long-term shareholders, valuation 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.
You don't make serious money on the stock market that way.
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.
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 most prominently with Ben Graham's Intelligent Investor and continuing right through our own books. (The Fool Ratio, or PEG, is a prime example - and one we still believe in, as it remains one good tool in the toolbox of the small-cap investor.) Indeed, right here in our online area we have 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? Or, how many pilots ever have to deal with flames?
It is for this reason we de-emphasize valuation. Which breaks lots of rules, we know, including some of our own. Hey, welcome to some of the findings of our next book, Rule Breakers, Rule Makers, in which this portfolio's original philosophy is laid out for the first time in its fullest and most provocative rendering. Anyway, as you can see, in this part of Fooldom we celebrate the breaking of rules. We believe that those who are able to set rules are noteworthy; those able to break their own rules, the rules that they themselves have set, are growing. We are growing, and adapting as we go. We hope you are, too, and that we'll be able to say the same thing about ourselves ten, or twenty, or thirty years from now.
So, we severely downgrade the importance of valuation for Rule Breakers because of the market's efficient pricing mechanism. Given this efficiency, we do not worry about buying or selling at horribly misaligned valuations - the market's efficient pricing gives us a high degree of likelihood of obtaining a fair price. It's just the same when you buy a lawnmower, blind, at a large hardware store. You may not be getting the best price, or a perfect price, but you know that the store can't be THAT misaligned with its pricing simply because its mass of customers would never stand for it.
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: America Online, Amazon.com, Iomega - 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: They were SO "overvalued." So overvalued, just before those stocks went on to multiply many more times in value. So much for valuation.
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 six attributes shared by all true Rule Breaker stocks. Someone in the financial media thinks they're overvalued.
We begin to close by noting that just as we believe that long-term investors in Rule Breaker stocks should largely ignore valuation, 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 about 70 years ago, and it will never happen again. While a drop of similar magnitude can certainly occur some other day occur, it won't be for the same reasons 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 currently appears to be in the process of doing it a FOURTH consecutive year, confounding 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 of value to offer us. The Internet, with all its Rule Breaking possibilities, represents one of the great unprecedented revolutions of all time. We note with a smile that studies of past stock-market history would never have predicted the emergence of the Internet, nor have they predicted the incredible bull market that would be occasioned by it. The Internet emerged through technological revolution, was driven by entrepreneurs, and has already created and promoted forms of freedom that have simply never existed on Earth in the history of humankind. These things are all wildly good, and are unlimited in their possibilities. We love to study history, and we love to learn its lessons. We do NOT, however, hold up its past as direct antecedents of the future.
An example to close. Market history shows the market's average annualized return to be 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 as 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. Indeed, other portfolios in The Motley Fool use completely different presuppositions, and have beaten the market themselves. We do not hit anyone over the head with our approach to investing. We do teach it for those interested in learning, and we do handicap ourselves by exposing all our methodologies, telling people what we're doing ahead of time, etc. 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 business 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; rather, get more bullish when you see them. Finally, don't allow anyone to convince you that they know where the market or a given stock is headed, based on what has happened in the past. We have yet to see lightning strike the same place twice.
Phew! And there, Fools, is the skinny on Rule Breaker Principle #3. As always, this is a work in progress, subject to modification on your suggestions. If you have any thoughts to share regarding this Principle or the first two (linked in the top right of this page), please e-mail us. More to come next week. Have a great weekend!
-- David Gardner, November 20, 1998
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Today's FoolWatch: all the latest in Fooldom.
Day Month Year History Annualized FOOL +5.97% 26.74% 102.75% 580.44% 56.31% S&P: +0.95% 5.90% 19.90% 153.83% 24.23% NASDAQ: +0.44% 8.85% 22.79% 167.74% 25.79% Rec'd # Security In At Now Change 8/5/94 1420 AmOnline 1.82 85.63 4609.28% 9/9/97 580 Amazon.com 19.11 180.63 845.15% 5/17/95 1960 Iomega Cor 1.28 8.19 539.44% 10/1/96 84 LucentTech 23.81 86.50 263.32% 8/12/96 130 AT&T 39.58 63.31 59.97% 4/30/97 -1170*Trump* 8.47 4.75 43.91% 2/20/98 200 Exxon 64.09 72.00 12.34% 2/20/98 215 DuPont 59.83 60.88 1.74% 2/20/98 270 Int'l Pape 47.69 46.00 -3.55% 8/13/96 250 3Com Corp. 46.86 39.88 -14.91% 8/24/95 130 KLA-Tencor 44.71 36.88 -17.53% 7/2/98 235 Starbucks 55.91 43.88 -21.52% 6/26/97 325 Innovex 27.71 16.13 -41.81% 1/8/98 425 3Dfx 25.67 13.31 -48.13% Rec'd # Security In At Value Change 8/5/94 1420 AmOnline 2581.87 121587.50$119005.63 9/9/97 580 Amazon.com 11084.24 104762.50 $93678.26 5/17/95 1960 Iomega Cor 2509.60 16047.50 $13537.90 10/1/96 84 LucentTech 1999.88 7266.00 $5266.12 4/30/97 -1170*Trump* -9908.50 -5557.50 $4351.00 8/12/96 130 AT&T 5145.11 8230.63 $3085.52 2/20/98 200 Exxon 12818.00 14400.00 $1582.00 2/20/98 215 DuPont 12864.25 13088.13 $223.88 2/20/98 270 Int'l Pape 12876.75 12420.00 -$456.75 8/24/95 130 KLA-Tencor 5812.49 4793.75 -$1018.74 8/13/96 250 3Com Corp. 11715.99 9968.75 -$1747.24 7/2/98 235 Starbucks 13138.63 10310.63 -$2828.00 6/26/97 325 Innovex 9005.62 5240.63 -$3765.00 1/8/98 425 3Dfx 10908.63 5657.81 -$5250.81 CASH $12005.75 TOTAL $340222.06
</THE FOOL PORTFOLIO>