I received a few bags of hate mail after last week's Rule Maker article, "Was JDS Uniphase (Nasdaq: JDSU) a mistake?"
The criticism can be divided, more or less, into four categories:
1. I'm just making excuses for poor performance in the Rule Maker Portfolio
2. I don't know anything about JDS Uniphase or finance
3. JDS Uniphase is a great company in a fast-growing industry
4. If it's not a Rule Maker, why did you buy it?
It's not worth spending much time on number one or two since, if you believe it, I won't change your mind here. (For what it's worth, I investigated the optical components industry for our recently published Industry Focus 2001.) If you're really interested in seeing my responses to number two, check out this post.
Most of the mail fell into category number three, however, and it's worth addressing since this issue bears on the way investors make decisions. (I'll talk about number four at the end.) Whatever kind of investor you are, whether you look for blue chips or small caps, whether you look to put an exact value on an investment or ignore price altogether, you've got to have a decision-making process that allows you to analyze mistakes and put different investments in context.
That might sound obvious, but if you think all you have to do to beat the market long-term is identify great companies, you might end up being disappointed. Why? In the Rule Maker universe, there are very few surprises. Everyone already knows the earnings power and market might of Cisco Systems (Nasdaq: CSCO), Intel (Nasdaq: INTC), and Pfizer (NYSE: PFE). Investors willing to make long-term bets about these companies have an advantage over less-patient investors, to be sure, but I believe it will require something more than just identifying Rule Makers and holding on for the long term to beat the market over the next 20 years.
The issue for JDS Uniphase and the Rule Maker Portfolio, in the article, wasn't whether JDS was a great company in a fast-growing industry, but whether it was an appropriate investment for this portfolio.
My conclusion was that it isn't. JDS doesn't generate enough free cash flow at this point to give us a fair idea of its profitability potential. Further, the price we paid for it leaves us with great risk regarding our 2x5y valuation concept -- introduced in November, admittedly well after the JDS purchase.
This means that we must believe JDS will double its market value in five years, or become roughly a $200 billion company by 2006. Based on the company's cash flow at this point, that's not a good bet for the Rule Maker Portfolio.
Importantly, few readers who wrote in seemed to distinguish between JDS as a leading optical components company -- which it is -- and JDS as an investment with a high degree of risk, one that isn't right for every portfolio or investor mindset. (Some readers understand this difference very clearly. Check out this post from Markandsusanv.)
In fact, I'd argue it's inconsistent with the Rule Maker approach, since we're willing to exchange valuation (price) risk in exchange for owning a piece of a company that's a proven and profitable winner, but we shouldn't be willing to trade both away, at least we can't do so and adhere to the Rule Maker strategy.
This leads to the next complaint. Many readers asked why we bought the company in the first place if we think it's not a Rule Maker. Good question. For starters, I'm not sure if the other Rule Maker writers agree with me. Keep in mind the Rule Maker managers at the time of the JDS purchase (I wasn't part of the team at the time) fully realized they were investing in an emerging Rule Maker, and knew about the risks. They understood it was a stretch of the Rule Maker philosophy to invest in JDS, yet they believed it was worth the risk. Here's a link to a story that summarizes the team's thinking at the time of the buy.
Anyway, we have complete freedom to express our own opinions in this space, which is useful since there are areas where we disagree. In fact, what you see each day in this space is a piece of an ongoing conversation. My opinion here on JDS will be weighed and considered by my fellow port managers. I'm sure we'll be revisiting this issue as we weigh JDS's Rule Maker potential in future columns. As for me, I think JDS's business potential is enormous, although I'm not certain it's enormous enough to justify the company's current valuation. My preference for the Rule Maker Portfolio is that we wait for a fatter pitch.
If JDS was a mistake for the Rule Maker, it's a good lesson since the hardest part of any investment strategy is applying it consistently -- yet flexibly -- in a world where everything doesn't fit cleanly. This is a central issue for our portfolio, and for the decision-making process in general.
I recently read a quote in a logic textbook that summed the issue succinctly. "It has been argued very plausibly that every problem, no matter how abstract, arises from some conflict between a belief and a situation to which the belief seems inappropriate."
And finally, yesterday we purchased 17 additional shares of Intel (Nasdaq: INTC) for the portfolio, as we announced we would do last week. The details of the trade are recorded in our Rule Maker Trade History log.
Have a great day.
