We took a pounding in the Rule Maker portfolio last year, losing to the market by a wide margin. The Rule Maker fell 35.6% in 2000 compared to 10.1% for the S&P 500. Worse, since inception in February 1998 the Rule Maker's internal rate of return is suddenly just 2.2%, well short of the S&P 500's 8.9% return.

That's a real pasting. Buried in this underperformance are two lessons to highlight.

First, we need to do better. In my opinion we stepped off the beam to buy JDS Uniphase (Nasdaq: JDSU) last February. I'm not saying this because the shares now trade at about $41, meaning we're down over 50% since paying $100.75 per share. I'd be saying the same thing if the shares traded at $150.

From my point of view, the optical components industry is too hard to understand, too early in its lifecycle, and too much in flux. (The reasons are detailed in stories on optics companies and the dot-com demise, as well as this optical networking discussion.) The Rule Maker is an investing approach based on simplicity, and a requisite of this, it seems to me, is that we have a basic understanding of a company's roadmap, potential returns, and profitability. We don't have this with JDS.

That doesn't mean we have to understand the nuances of Intel's (Nasdaq: INTC) Pentium 4 processor. But the PC industry was well established when the Rule Maker bought shares of Intel in March 1998 and Intel was clearly the dominant player. It had more than 50% market share in the PC business, a particularly strong position in the lucrative corporate market, and over $10 billion of cash and short-term investments on its balance sheet. What's more, it generated about $5.3 billion in free cash flow (FCF) the previous year, meaning it traded at about 26x FCF when we bought it. Intel was minting money.

As good a company as JDS seems to be, it's unclear how profitable it can become, yet it must become extraordinarily profitable based on the enormous multiple we paid for the shares. JDS had a market value in the $100 billion range in February, which puts it in the company of very elite stocks. For example, Rule Maker American Express (NYSE: AXP) has a market capitalization of $73 billion, yet it has produced $6.6 billion of FCF over the last year and trades at a price to free cash flow level around 11x. As for JDS , the price to FCF multiple can't be calculated since the company isn't generating FCF at this early stage. Look back at FCF over the last 12 months and JDS has negative FCF in the range of $110 million.

JDS could become the next Intel, but the Rule Maker strategy isn't best suited for moonshots. There are too many high-quality, cash-rich companies that can be purchased at reasonable prices, if not margins of safety. Rather than looking for the next Intel, I think the Rule Maker will best be served buying Intel at reasonable prices, so long as it continues to perform. Over time, the market provides patient investors with opportunities. Even in a strategy where quality comes first, price matters.

The second takeaway is a look at risk. With just 11 stocks in the Rule Maker, we are running a very focused portfolio considering the average mutual fund holds over 100 stocks. Intuitively, it makes sense to focus our investing dollars on the companies we believe have the best opportunity to outperform the market long term. Does it make sense to diversify, to broaden a portfolio simply to mitigate risk, even if it means investing in companies we feel less favorably about? We don't think so -- at least not for us given our time horizon and confidence in the companies we've invested in.

The downside to a focused approach, of course, is volatility, and as you can see by looking at our returns, the Rule Maker and focus investing is a very volatile strategy. The investment community as a whole equates risk with volatility. The more volatility, the higher the risk. Berkshire Hathaway (NYSE: BRK.A) Chairman Warren Buffett has a different definition of risk than the investment community, one that better matches the Rule Maker approach.

He defines risk as an attribute intrinsic to the business itself, not to swings in the price of its shares. Can the company sustain its competitive advantage? Will it continue to reward shareholders by producing healthy cash flow and investing it at a high rate of return? These are the facts we're concerned with as business owners, not day-to-day or even year-to-year price swings. That doesn't mean returns don't matter, just that business fundamentals matter more.

Over the long term, stock returns and business performance meet in the middle. This year's 39% plunge in the Nasdaq hasn't convinced us to sell the high-quality companies in our portfolio. Why should it when it has nothing to do with the long-term returns we expect companies like Intel, Pfizer (NYSE: PFE), and Microsoft (Nasdaq: MSFT) to produce?

For the most part I'm pleased with the companies we have in the portfolio and confident they will produce strong returns over the long haul. I think we can boost the performance by paying better attention to prices, and better defining our monthly investing process.

But this kind of year -- when we're way down and well behind the S&P 500 -- is to be expected with a focused portfolio. This kind of year is exactly why most investors are wise to broadly diversify in a proven vehicle like an index fund. Despite Buffett's common-sense definition of risk, volatility and risk feel like the same thing when the market is tanking. They are the same thing if you let market sentiment tell you what your shares are worth.

If we couldn't face this kind of storm and stay the course, then we'd invest strictly in index funds. We think we can do a little better, and that's what this teaching portfolio is all about. It's not a three-year experiment, but a 20-year marathon. We have much to learn, and our strategy, aimed at helping curious investors branch out from index funds, needs sharpening. But the framework is very solid.
The good news with a down market is that we haven't lost a dime since we haven't sold any of our holdings, and the market is currently giving us a chance to purchase Intel at about 33x trailing free cash flow. That isn't cheap, but it's reasonable for a company with proven management, enormous financial strength, and perhaps the most efficient processes in the business. My recommendation for this month's $500 investment is Intel.

Have a great day.