In every conceivable dimension -- short of age and waist size -- I am the junior member of the Rule Breaker team. Even so, I have no problem stepping up to the plate and admitting the obvious: We've been getting crushed over the last year. Fool co-founder David Gardner's original $50,000 stash at one point last spring appeared headed for the $1,000,000 mark. Today it's worth less than $400,000. And I hasten to add that this is real money, not the pretend stuff.
I'm comfortable making this admission. I don't even have to check with David. After all, he's the guy who decided to put his every investing move online, completely in the open, with a daily summary of returns in every Rule Breaker column.
What I'm not comfortable with, however, is the recommended lesson from this beating -- at least according to many of our critics. The message appears to be that we're finished, that we should just throw up our hands, admit that the strategy has been exposed as a fraud, and walk away. I don't claim to have learned any such lesson.
Hasn't this guy learned anything?
In the past I agreed wholeheartedly with our critics who said, "The early success of the Rule Breaker Portfolio is no proof of the strategy. You guys haven't yet seen a bear market." Given that our strategy has no provision for separating bull from bear markets, I would be crazy to argue otherwise. I would have to turn myself into one of those fringe, new-economy lunatics who once claimed that bear markets were gone forever.
Clearly, for this long-term strategy to be judged successful, it will have to hold up over the long term, and the long term will always include bear markets. Just as our early bull results proved nothing, our recent bear results prove nothing either. This thing is just getting started.
So I'm not learning much from the down market. Have I learned nothing?
Rule Breakers and valuation
"If you're going to actively invest, I think that mitigation necessarily includes a strong eye toward value, margin of safety, predictability of future cash flows, and likely portfolio covariance. Without that, a severe bout of volatility will almost inevitably have you groping for an entirely new set of lessons from the roulette wheel."
This well-delivered lesson came from a Fool who calls himself howardroark. He is one of our most knowledgeable and most eloquent discussion board critics, and when he accuses us of "profoundly subordinating valuation to business quality" (emphasis his), I sit up and take notice.
First off, let's state the obvious. Value, margin of safety, and predictability of future cash flows will never be cornerstones of the Rule Breaker strategy. We look for companies that are -- almost by definition -- unpredictable. These companies are priced according to purely speculative future earnings, typically years into the future. The odds of pairing such an investment with a comfortable margin of safety are pretty slim, to say the least.
Now, you may argue that, given this fact, individual investors should avoid such speculative stocks, and I won't argue that point here. Either way, though, if you want to talk about "groping for an entirely new set of lessons from the roulette wheel," the ultimate example would be the Rule Breaker Portfolio singing the "margin of safety" song.
Moreover, we're not really interested in "getting in and out" of Breakers at the right time, at least not as a defining feature of the strategy. So we'll continue to be more focused on business quality than on price. But perhaps, as howardroark puts it, we're guilty of a "general overreaction to the dangers of both market timing and ill-conceived trading motivated by vig-seeking brokers reciting the morning's squawk box." (For those not up on their Russian, "vig" is short for "vigorish," a term for fees paid to a bookie or moneylender.) Perhaps -- in our attempt to unmask Wall Street's sales-motivated shenanigans -- we have gone too far in ignoring value.
Our recent adoption of a 10x/5y purchasing criterion adds the right dash of value to our buying strategy. Our selling strategy, however, calls out for a bookend addition. Actually, our sell strategy has an implicit value angle already. When we say that we sell when we find a better place for our money, we include a broad market index fund as one of these potential better places. What we don't make clear, however, is exactly when the index is a better place, and this is an awfully important oversight given the difficulty of finding new Rule Breakers.
I don't claim for a moment that I have the answer, or that I've worked out all the details surrounding valuation of highly speculative stocks. Any attempt to determine a "fair value" for such stocks would be akin to playing the lottery. There has to be some reasonable upper limit on price, however, and this is a strategic element that I think we should explore, both as portfolio managers and in the Rule Breaker community at large.
As a tentative first step in this direction, I can only offer my old idea: the YGBFKM analysis (YGBFKM=You Gotta Be Freakin' Kidding Me). This process told me to sell Amazon.com (Nasdaq: AMZN) last year, not because it was "overvalued" or "at a peak" but because its stock price appeared to have pierced the bounds of any reasonable long-term, business-focused projection. Not selling Amazon last spring is the only flat-out "mistake" that I'll admit to.
(I'll let my colleagues -- all of whom have been at this longer than I have -- speak for themselves. Consistent with YGBFKM, however, I must also admit that I favor holding our Amazon stake at the current price, even if it costs me the only fans I have left -- both of them.)
Everything I needed to know...
What have I learned in my first year on the Breaker team? I'm not sure, but I think I've learned the difference between the natural ebb and flow of the economy and of stock markets (which we'll continue to ignore) and of clearly irrational pricing (which ought to prompt us to take profits). Certainly, with 20/20 hindsight, this seems like the thing to have done, but I won't claim that I was jumping up and down last spring yelling, "We gotta sell Amazon!" I wasn't. Next time, however...
For more thoughtful criticism of our strategy, check out this recent thread from our Strategies discussion board, where we attempt to define "long-term."
If you're in the mood to stretch "long-term" to ridiculous extremes, take our poll and give us your thoughts regarding immortality. Heading off wiseacres everywhere at the pass, I'll state here that we're not turning to immortality as a means of saving us from this down market. It may take a long time to get back the dough, but not that long.
The writer is often accused of doing too much "navel gazing," which is OK by him since he doesn't yet trust his stock-picking skills. To see what stocks he has bought -- in rare bouts of activity -- you can always look at his profile. Motley Fools are individual investors who like to think and write about investing.