Breaking the Valuation Rules
The RB perspective

By David Gardner (MotleyFool)

ALEXANDRIA, VA (June 16, 199) -- Another day of recovery for the Rule Breaker portfolio, as the manic-depressive market came bounding back. The BreakerPort fired forward full-speed-ahead, recording a 10% gain. We reasserted ourselves in the battle to beat the market in 1999. It was interesting to watch Amazon partner with Sotheby's on auctions, AOL and Excite@Home register double-digit-dollar gains, and Iomega creep pathetically back over $4, even as the COO retired.

But back to the question I'm asking myself: Just who IS jumping in and out of our stocks so spasmodically over the space of a few days or weeks? Personify the stock market and I think you're looking at a fellow drooped over a couch in a psychiatric lounge. Bringing it down to an individual level, if you take a look at the actual faces of those lying in the couches I think you're staring at daytraders and institutional managers. These are the only people who trade in such volume, with such fury. It's amazing to watch.

Or, then again, you could ignore them altogether, and just check in with your stocks from time to time. If you've made good investments in good companies, this is really all you have to do.

I wanted to take up a topic of frequent recent discussion on our Rule Breaker message board, which is where I increasingly go for some of the most intelligent and compelling exchanges in Fooldom. A few posters feel that our Rule Breaker approach states, emphatically, that "Valuation does not matter." So I want to talk tonight about valuation.

First off, this is a straw-man argument. Neither Jeff nor I, nor anyone at The Motley Fool, nor anyone contributing to that discussion, feel that "valuation does not matter." Valuation always matters. Many people who buy and sell stocks -- the people who are de facto setting the prices through their actions -- are using various measures of valuation when they transact. Valuation is a very significant factor in market pricing, in investor expectations, etc. Valuation, in this regard, absolutely matters.

My Rule Breaker philosophy on valuation, on the other hand, does not use it as a meaningful criterion for investment decision. If you're not already aware of our critical third principle of this portfolio's management, please read it here. It begins, "We pay little to no attention to traditional valuation metrics, and neither do we pay much attention to market history."

In brief, we believe the market is a Huge Brain that factors in all viewpoints as it creates prices on which buyers and sellers are willing to shake hands minute by minute, day after day. As Rule-Breaking investors, we do not believe we are smarter than the market -- this is an overt statement of humility. I honestly didn't know whether Rule Breaker holding Amgen -- which I have been following for 10 years -- should have been priced where it was in 1990, 1992, 1994, or even on this very day. It is really only evident in retrospect, at which point we can all shake our heads knowingly and say, "Of course, it was in a biotech bubble there in 1992," or confidently state, "Yes, it was quite evidently undervalued in 1994."

With most of our best stocks, they almost always look overvalued all the way up, for years and years. If you were listening to the Wise, you would simply never have bought.

I believe, simple as this, that the market does a good job of showing fair prices. It is fairly short-term-oriented in its viewpoint, always good news for long-term investors able to take advantage of its manic-depressiveness. But anyone who contends that the market is idiotic, or that a given stock is ridiculously priced, is implicitly stating that they are "smarter" than the market, smarter than the Huge Brain. That's OK with me -- it's a bold statement, but I don't believe it's an impossible one to make. However, it's not one I'll make, personally.

As an investor, my beating the market is not predicated on reading valuation. My beating the market is predicated upon reading business -- knowing what works and what doesn't, in business -- who works, and who doesn't. I am aided by being a quick adopter of technology, together with bringing some common sense and marketing savvy as I try to piece together whether a given product or service or company will succeed or not.

In this regard, I think many of us can be smarter than the market, and for this reason will (and do) beat it over time. When I saw professional journalists and money managers stating that "AOL will get crushed" in 1994 -- I felt with firm conviction (though never certainty -- one is always playing percentages) that they were wrong, that the business would succeed, and that the stock -- partly being held down by their loudly-spouted conventional wisdom -- would follow through. This is the essence of Rule-Breaking investing -- it is a process that repeats itself again and again. For instance, it was the same when Money magazine wrote, in May 1997, "Clearly, though, there are many reasons to think Amazon.com is overvalued at Thursday's closing price of $4 [post-split]."

Amazon closed today at $111, just two years later.

So one has to ask: Overvalued, eh? Clearly, eh? Please take a minute out and just think about Money mag's use of the word "clearly." How did "clearly" function, in this context? What does "clearly" mean?

To recap, these are the reasons that, in the Rule Breaker portfolio, we do not focus on valuation in our buying decisions: (1) the Huge Brain, (2) the lack of useful valuation criteria for revolutionary companies in dynamic opportunities, and (3) the emphatic statements made by Wise people as they tell the world that "clearly" a given Rule Breaker is overvalued. If you're familiar with our approach, you know that we have actually incorporated that last bit into one of our six criteria necessarily present before we will buy a Rule Breaker stock.

Each of us has unique perspectives and skills to bring to his or her investing. The key is to align your investment decisions with who you are, how you think, what you bring.

Speaking only for myself, here, I consider my own strengths as an investor to be these three: (1) little to no fear of risk, rooted in belief in capitalism and a long-term focus, (2) rapid adopter of technologies (including my willingness to read up lots and understand new ones, even if I'm not personally adopting them), and (3) some horse sense in business (particularly with regard to marketing). This is my take on me, and I invest accordingly. My own strengths are not numerous, nor are they particularly highly developed. (I do have a willingness to learn more, always.)

Yours are different. That's why we teach people to think, and invest, for themselves! Indeed, across the whole population of Fooldom and the outside world at large, there's a huge variety of strengths and talents that people have to bring to their investing.

Your portfolio should be a natural expression of you. That means much more to me, again, than "valuation."

To end where I began: Of course valuation matters. However, we do not make valuation a factor in our Rule-Breaker decisions. If this isn't your bag, that's fine with me! Valuation IS a factor in a number of other approaches featured here in Fooldom (see today's Drip Port or the Boring Port any day) -- I am only providing our Rule Breaker point of view. We do not believe we can price stocks smarter than the market. Therefore, we take up the battle we think we can win: judging businesses, and making calls on who will succeed (and who won't) over the long term.

Goes without saying that we're wrong a bunch of times on that, as well. No investor is always, or totally, right. You would like to be right as often as possible, no? But, good news: As a Foolish long-term investor, you only need to be right... really, really right... a few times.

Fool on,

David Gardner, June 16, 1999

06/16/99 Close

Stock  Change    Bid 
AMGN  +  5/16    55.63
AMZN  +15 3/16  111.69
AOL   +12 1/4   106.75
ATHM  +14 11/16  94.75
CAT   +  1/2     58.94
CHV   -  3/16    95.81
DD      ---      70.50
DJT   -  1/16     4.88
EBAY  +13 1/4   148.75
GT    -  7/16    58.31
IOM   +  3/16     4.13
SBUX  +  11/16   37.38
TDFX  +  13/16   16.25

                  Day     Month  Year   History   Annualized 
      R-BREAKER +10.70%  -9.36%  21.30% 1117.50%   67.20%
        S&P:     +2.25%   2.20%   8.56%  203.82%   25.68%
        NASDAQ:  +4.27%   1.91%  14.83%  249.61%   29.36%

    Rec'd    #  Security     In At       Now      Change
   8/5/94  2200 AmOnline       0.91    106.75   11645.61%
   9/9/97  1320 Amazon.com     6.58    111.69    1597.57%
  5/17/95  1960 Iomega Cor     1.28      4.13     222.16%
  12/4/98   450 Excite@Hom    56.08     94.75      68.95%
  2/26/99   300 eBay         100.53    148.75      47.97%
  4/30/97 -1170*Trump*         8.47      4.88      42.44%
   7/2/98   470 Starbucks     27.95     37.38      33.70%
 12/16/98   580 Amgen         42.88     55.63      29.74%
  2/23/99   300 Caterpilla    46.96     58.94      25.49%
  2/23/99   180 Chevron       79.17     95.81      21.02%
  2/20/98   260 DuPont        58.84     70.50      19.81%
  2/23/99   290 Goodyear T    48.72     58.31      19.70%
   1/8/98   425 3Dfx          25.67     16.25     -36.69%

    Rec'd    #  Security     In At     Value      Change
   8/5/94  2200 AmOnline    1999.47 234850.00  $232850.53
   9/9/97  1320 Amazon.com  8684.60 147427.50  $138742.90
  12/4/98   450 Excite@Hom 25236.13  42637.50   $17401.37
  2/26/99   300 eBay       30158.00  44625.00   $14467.00
 12/16/98   580 Amgen      24867.50  32262.50    $7395.00
  5/17/95  1960 Iomega Cor  2509.60   8085.00    $5575.40
   7/2/98   470 Starbucks  13138.63  17566.25    $4427.63
  4/30/97 -1170*Trump*     -9908.50  -5703.75    $4204.75
  2/23/99   300 Caterpilla 14089.25  17681.25    $3592.00
  2/20/98   260 DuPont     15299.43  18330.00    $3030.57
  2/23/99   180 Chevron    14250.50  17246.25    $2995.75
  2/23/99   290 Goodyear T 14127.38  16910.63    $2783.25
   1/8/98   425 3Dfx       10908.63   6906.25   -$4002.38

                              CASH   $9924.87
                             TOTAL $608749.25
Note: The Rule Breaker Portfolio was launched on August 5, 1994, with $50,000. Additional cash is never added, all transactions are shared and explained publicly before being made, and returns are compared daily to the S&P 500 (including dividends in the yearly, historic and annualized returns). For a history of all transactions, please click here.


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