Hey, Fools! Today, I'd like to address one of the most common criticisms of how we Rule Makers invest in stocks, namely that we don't pay a lot of attention to current valuation in our stock selection. This is something that has yet to come back to haunt our portfolio, though some people are dead sure that it eventually will. We are convinced, however, that what tends to haunt investors most are those stocks that they didn't buy because of overblown concerns about short-term valuations. I'll give you an example from my own experience.
A couple of years ago, after several months of reading everything I could get my hands on about investing, I decided to take the plunge and manage my own money. In starting out, I often discussed ideas with several friends who are experienced, sophisticated investors. One of my friends, Rick Schumacher, is one of those guys that I really envy. He always seems to know about great companies light years before anybody else. Rick owned EMC (NYSE: EMC) about five years before most people had even heard of the company.
During one conversation, Rick tossed out a company for me to consider, and I dutifully looked into it. I printed out the 10-Ks, the 10-Qs, and I read the annual report. I calculated a bunch of ratios and margins and filled about two pages with what looked like hieroglyphics. At the end, however, I decided not to purchase this particular stock, despite the very high growth rates and excellent financials. My decision not to purchase the stock of this great company was based upon one primary reason: the price-to-earnings ratio was too high. The name of that company was Qualcomm (Nasdaq: QCOM).
There it was, one of the best performing stocks of the past two years, and I missed it even though I spent at least 10 hours looking right at it, and all because of that darned P/E ratio. I would guess that many of you have made similar mistakes. For this reason, we in the MakerPort tend to downplay current valuation and instead concentrate on putting together a portfolio of the highest quality companies we can find based upon on our criteria.
So, does that mean that Rule Maker investors should always just ignore valuation entirely? Isn't there any way to add a value component to Rule Maker investing? I think that the answers are "No" to the first question, and "Yes" to the second.
The longer I invest, the more I have learned to relax and accept the opportunities that the market is providing. By taking what the market is offering at the time that investment funds become available, I stay pretty much fully invested while enjoying the benefit of not having to work so hard with each and every deployment of money into the market. I keep a list of companies that I consider either bona fide Rule Makers or companies that are emerging as new Rule Makers. Most of these are companies I already own, but some of them are companies that I don't own but have already decided that I want to buy. I keep this list limited to about 20 companies.
Every month when it comes time to invest, I basically note the current prices, and review quickly each company on the list, paying particular attention to recent financial direction among our RM criteria. From that information, I decide which offers me the best value for the money at that particular time. What I've discovered is that just about every month, the market offers at least one good opportunity to purchase a company on my list at a reasonable price.
Most often it only takes about three minutes to determine which company it is. I then purchase shares of that company with whatever amount of savings I have available to put into the market. At various times in 1999, for example, each of the following companies had temporarily depressed prices that made my investment at the time a fairly easy decision: Amgen (Nasdaq: AMGN), AOL (NYSE: AOL), Yahoo! (Nasdaq: YHOO), Cisco (Nasdaq: CSCO), Sun Microsystems (Nasdaq: SUNW), and Gap Inc. (NYSE: GPS).
So, my suggestion to those investors who want to add a value element to their Rule Maker investing is to create a list of those Rule Maker companies that you either currently are or really want to become a partner with for the long term. Make the list without any consideration of the current valuation of the company. Concentrate entirely on the quality of the business, and give extra attention to financial direction. Once you've got the list, each time you are ready to buy, look and see what prices the companies are selling for at that moment in time, and make a determination about which company offers the most value for your investment at that time. I think you'll find that often the market makes this an easy decision for you.
Before going further, let me point out that there are a lot of different ways to construct a Rule Maker portfolio. For aggressive investors who want to up the reward profile by taking on more risk, a very concentrated portfolio composed of only the strongest six or maybe eight Rule Maker companies is likely the way to go. Because of the smaller number of holdings, this Fool may need to raise some of our Rule Maker standards even higher than our published benchmarks. For example, an aggressive Fool may require higher sales growth than 10%, a lower Flow Ratio than 1.25, or a Cash-King Margin of at least 15%.
Using this more aggressive Rule Maker approach, new money would likely be added to the companies on the basis of performance and business momentum as measured by the RM criteria. This Fool would likely have to be comfortable with holding a portfolio comprised almost entirely of technology companies, and should also expect to see that one or more of the stocks could grow to represent a quarter or even more of the total portfolio value. The risk/reward profile of this portfolio would actually morph into something more like that of the Rule Breaker Portfolio. If you choose to go this route, then you can largely continue to ignore valuation in your stock selection, concentrating instead on allocating your new savings to the best performer in your portfolio.
At the other extreme, another Foolish Rule Maker investor could choose to hold between 15 and 20 Rule Makers and emerging Rule Makers. This would most likely reduce the portfolio's volatility and risk somewhat, and would also likely dilute the returns to some degree. Even so, I still think this is a very valid approach for many investors. Finding 15-20 Rule Making candidates shouldn't be too tough. Our portfolio has 12 positions currently, and there is no question that we could add three new ones without much effort or compromising of our rigorous standards.
Under this more conservative approach to Rule Maker investing, new money could be allocated on the basis of either business momentum or current valuation, and an effort could be made to invest new money in a manner that keeps the portfolio from getting extraordinarily overweighted in one or two stocks. The risk/reward profile would continue to be higher than that of an index fund, and would likely outperform the S&P over time. This portfolio would not, however, have the performance potential of the concentrated Rule Maker approach.
Our Rule Maker portfolio is at something of a crossroads right now, and is positioned squarely in the middle of the above spectrum. On one hand, we have traditionally allocated new money almost entirely on the basis of business momentum. This approach has served us quite well in the past two years, and the rapid stock price appreciation of Cisco (Nasdaq: CSCO), Intel (Nasdaq: INTC), Microsoft (Nasdaq: MSFT), and Yahoo! (Nasdaq: YHOO) has caused these companies to each grow to become greater than 10% of the overall portfolio value. Combined, these four companies comprise 56.4% of Tom's assets, based upon last night's prices.
On the other hand, we have also recently added two new companies: JDS Uniphase (Nasdaq: JDSU) and Nokia (NYSE: NOK). This move obviously pulls our portfolio back towards the less-focused end of the spectrum. The Rule Maker portfolio has always found a happy medium between the two extremes, where I personally feel quite comfortable.
I have provided the relative weighting of each company in our portfolio in the table below.
Cisco 20.1% Intel 15.2% Microsoft 11.1% Yahoo! 10.0% JDSU 8.8% Gap Inc. 7.3% Nokia 7.3% American Express 4.9% Pfizer 4.3% T. Rowe Price 3.9% Schering-Plough 3.1% Coca-Cola 2.7%
In my judgment, this month the market is giving away drug manufacturers and financial companies. By allocating this month's $500 to one of these four companies, we will also be bulking up one of our underweighted positions, giving our portfolio another slight nudge towards the diversified Rule Maker approach that I described earlier. While I believe that both Pfizer and Schering-Plough are good values at current prices, I am more compelled by the excellent recent business performance of our financial services Rule Makers.
Because Phil, Matt, and Bill have already sung American Express's praises this week, I will only add that I also feel T. Rowe Price (Nasdaq: TROW) merits an additional $500 investment in the near future. Even so, I find myself swayed by the logic of my fellow managers, and I believe that the market is making at least this month's $500 decision a fairly easy choice: American Express.
Let's take a poll on this topic: Do you think we should make a "valuation" and "portfolio allocation" based investment (e.g. AmEx or Pfizer), or do you think we should make a "growth rate" and "economic model" based investment (Yahoo!, Microsoft, Cisco, JDSU, etc). Vote here.
And finally, be sure to tune into this weekend's Fool Radio Show, in which Tom and David will be talking with Built to Last author Jim Collins, JDS Uniphase CEO Kevin Kalkhoven, Sequoia Venture Capitalist Michael Moritz, and eBay (Nasdaq: EBAY) CEO Meg Whitman.
Y'all stay Foolish!