"If you can buy the best companies, over time the pricing takes care of itself." - Charlie Munger, Berkshire Hathaway (OID)
I enjoyed reading Bill Mann's May 31 column "Do Big-Cap Tech Stocks Mean Big Risk" in the same way that I enjoy the programming that flows out from every tributary of Rupert Murdoch's News Corporation. It frightened. It exaggerated. It raised controversy! It rattled our little lives.
However, what it didn't do is knit threads of logic into a pair of shoes that would change my course toward financial independence, the pursuit of new opportunities, and a super-sized quality of life. The article's foundation -- with its premise that large-cap technology businesses are "sucker bets" for investors -- is thin and frail, feebly brittle, shatterable and weakly, flimsy, quavering or tottering, run-down, slipshod, jerrybuilt, and unsound (courtesy of the bam-bam power of a thesaurus!).
And while Bill remains a favorite of mine among the 100,000 or so weekly contributors at Fool.com and Soapbox.com, I'm gonna enjoy plucking apart his recent argument -- like a lion might pull asunder a hobbled roan or wildebeest on the plains during an African summer, like a four-year-old deals with her birthday cake. Piece by scrumptious piece. To make it fast food, I'll focus on three of the more vulnerable points in his article.
1. Underperforming Cliches
Bill's article trotted out and rode around on a theory that's one of my favorite investing cliches. He wrote:
"Past performance does not predict future performance for any company or any portfolio, much as we would like it to."
And he's right -- past performance isn't a clean predictor. But that's only one small step toward logical insight. Past performance may not predict anything, but it does correlate with future success. On average, in a free-market system, isn't it true that the longer the run of triumph, the more cash a great company will store up for investments in superior future results?
Microsoft (Nasdaq: MSFT) is the classic example of this. Its stock is down nearly 50% not because it failed to extend its prosperity, not because of a wane in its ability to roll up and pocket cash, but rather because -- rightly or wrongly -- the U.S. government is choosing to alter the rules of the game, to make the market a little less free. Long-term past performance in a free-market system correlates quite well with long-term future success. For years, it has for Microsoft and Cisco (Nasdaq: CSCO) and Intel (Nasdaq: INTC).
In that spirit, think about Rule-Making filmmaker Steven Spielberg. Past success doesn't guarantee that his next five movies will be blockbusters. But reputation, his level of experience, the loyalty of his creative teams, and his access to capital make it an odds on favorite. And that's what we're looking to own in this portfolio. We're buying Secretariat as he storms down the stretch at the Derby. We're investing in the final three seasons of Seinfeld.
And in corporate America, that odds-on-favoriteness, borne out of stellar past performance and strong present standing, leads naturally to the discounting forward of future values. The price goes up because the probabilities of success have gone way up. As investors in Rule Makers, we embrace that circumstance. We'd rather pay more for greatness -- watching it compound for years and years -- than get a fair price for mere competence, or score mediocrity on the cheap, neither of which is a great vehicle for compounding.
Which leads to point two.
2. What is Risk?
Bill writes that investing in Rule Maker technology companies is "okay, as long as we are going into these investment positions with eyes wide open to the outsized level of risk we are taking."
Another interesting choice of words. Murdoch would love this stuff. But what does it mean?
There are a wide variety of risks tied to stock-market investors, but virtually no existing taxonomic work to differentiate one from the other. For example, business schools and mutual fund companies have been suggesting for years that beta -- the volatility of a stock price -- is a measure of risk. It is, but only for traders. It isn't for investors. While America Online (NYSE: AOL) rose 150 times in value over the last ten years, did it matter how ziggy the price zigs were or zaggy the zags were along the way? To a short-term trader, yes. They made it risky. But to an investor, the price movements were not risky. Risk was tied to the company's level of performance and its valuation, not its temporary price movements.
So what is risk?
In the case of Rule Maker investing, I'd like to distinguish between valuation risk and performance risk. The former is the risk of paying too much for a company. The latter is the risk of not getting what you paid for. As a long-term investor, I'll shoulder the burden of valuation risk over performance risk every single time. Again, as a long-term business owner, I'll choose expensive greatness -- the best getting better -- over discounted mediocrity, every single time. Mediocre companies lose out over time in an open market.
To which, then, there's a reasonable argument: Well, what about buying greatness on pricing dips? What about minimizing valuation and performance risk?
I like the daring of it. I just haven't come across many that can do it well. I hereby encourage the valuation superstar out there who can use all the available data (there's tons of it) to show me the valuation methodology that:
- in 1980, proves Wal-Mart (NYSE: WMT) will be worth $260 billion today
- in 1990, proves Microsoft will be worth $350 billion today
- in 1994, proves Cisco will be worth $450 billion today
All of the data is available. Find a theorem that works. Put it for sale on Soapbox. I'll pay for it. We'll have you on the Fool Radio Show. You can take our Tuesday morning CNN segment. Until then, I'll just keep adding money to the greatest companies put up for sale on our public markets. I'll endure the valuation risk in order to dramatically reduce the performance risk.
In fact, I'd openly embrace valuation risk if I could find a way to fully eliminate performance risk! Wouldn't you?
3. Growth and Expectation
Okay, but what kind of returns should we look for?
Bill's article then rested on the expectation of 15% annual growth from large-cap technology stocks. Benchmarking off that annualized rate, he calculated tens of billions of dollars in earnings that these companies would need to stack up by 2010 to justify their valuation. There are a few logical flaws here:
- Why 15% a year? Couldn't I be happy with 13% growth per year? At that rate, with $500 added each month, our portfolio will grow from $49,000 today to more than $280,000 in 10 years. In 20 years, it'd be worth more than a million. Heck, I'd even settle for our brand of tax-deferred, commission-free 10% growth per year so long as that represented market-beating growth over the next 10 and 20 years (which it might!).
If you change the expected rate of compounded growth for us, you can imagine how dramatically it changes the anticipated rise in corporate earnings.
- Did I just say "earnings"? I did. And that confused me in Bill's article. He flipped between the concepts of earnings and cash flows as if they're interchangeable. They aren't. Remember, Fools, earnings and earnings-per-share (EPS) accounting doesn't reflect the balance sheet, which is critical to the analysis of any business.
If our Rule Maker companies are required to justify their valuations based on Wall Street earnings estimates, well, we're in trouble. But if our companies -- more than slips of tradable paper -- are to be evaluated as businesses, we should use cash flows and the Flow Ratio. When we do, I think right away it becomes clear that we'll need considerably less earnings growth than Bill does to justify today's valuations.
- Foolish aside: Because of the relative weakness of "earnings" as a measure of corporate success, I think we should slap a $10 fine on any writer in this space who suggests that the P/E ratio is a useful tool for investors. In fact, I propose that, due to its irrelevance, it henceforth be referred to by the authors of this column as the P-Wee Ratio.
Okay, I've gone on long enough. I'll conclude by saying that the market may still be overvalued. For long-term investors, it certainly is much more attractively priced after this 35% decline in the value of the Nasdaq, with Microsoft at $65 per share ($350 billion market cap) and Yahoo! (Nasdaq: YHOO) at $129 ($70 billion market cap). But it may still be 10% or 21.3% or 34.935% overvalued. I dunno. Do you?
But even if it is, what should we do now? Sell and take a 30% local, state, and federal tax hit on our gains -- then try to get back in at the right time? Or should we hold our $500 a month in cash and let inflation beat it up? Or should we now let valuation guide our decisions rather than performance?
Not from my vantage point.
I say we continue adding money to the greatest companies available to us. And once someone provides a valuation tool -- with substantial accompanying evidence that it works over ten- and twenty-year holding periods (e.g., just saying it's a discount cash-flow model doesn't count!) -- then we can work to reduce the valuation risk together.
Until then, I see nothing wrong with 1) continuing to enjoy 99% of what Bill Mann writes while 2) continuing to pursue the Rule Maker's labor-light, tax-deferred, commission-free growth -- whether that's 8%, 10%, 13%, or 15% a year. I think it'll beat the market's average return.
What do you think?
- I agree with Bill -- large-cap tech stocks are a sucker's bet.
- I agree with Tom -- buying quality matters most.
- I'm not sure I agree with either of them.
- I just don't know yet. Give me time to study more!
- Tom Gardner