Last week, in my article "Lesson 2000: Valuation Matters," I proposed some ideas for laying a valuation framework on top of our usual business-quality-oriented Rule Maker criteria. I asked for feedback from our readers, and after reviewing your opinions and comments, I'd like to use today's article to take a second crack at the topic. Hopefully, this will clarify my position on valuation a little more.
Point # 1: Business quality is more important than valuation
Here in the Rule Maker Portfolio, we've always been of the opinion that quality is more important than valuation. This argument still stands. I still believe that it is much more important to invest in the right companies than to try to pick the perfect price.
In last week's example using Intel (Nasdaq: INTC), whether an investor paid $75 or $40 for their shares this year, each would have created a lot of wealth over a 20-year investing horizon. In this regard, I believe that, even though 2000 was not the Rule Maker's best year for portfolio performance, if our focus on choosing market dominators kept an investor focused on buying companies like Intel and Cisco Systems (Nasdaq: CSCO), or even Yahoo! (Nasdaq: YHOO), rather than companies like Pets.com (Nasdaq: IPET), Lernout & Hauspie, Quepasa.com (Nasdaq: PASA), or any of a dozen other short-lived market darlings, I feel like we did that investor a service. Let me say it again: In Rule Maker investing, the companies are chosen based on business quality, not valuation.
Point # 2: Stay fully invested
I also believe that the best thing a long-term investor can do is stay fully invested. This means, for most of us, making small periodic investments as we add savings to our brokerage account. Where valuation comes in is in making an effort to get the most value possible from our monthly investments. In other words, for the Rule Maker Portfolio, I would like to see us use current valuation more to choose which stock gets our monthly $500.
It could be that, in given months, all 11 companies we consider might be trading at current prices that don't appeal to us. If this is the case, I'd rather hold the money for another month than toss money in because we feel like we have to. Again, the small universe of Rule Maker companies from which we select our monthly investments are chosen on the basis of our Rule Maker criteria. In my experience, just about every month, the market offers us an attractive price for at least one or two of our Rule Maker companies.
Point # 3: The goal is to avoid overpaying, not to get the "best" or perfect price
This is really what I am saying, rather than "wait for a perfect price" or "try to time the market." If we make an investment in Intel at $40, and the market gets crazy and values the company at $25 the next day, I won't particularly worry about it as long as I feel we paid a price that allows us a good opportunity to achieve our goals. Since we aim to beat the broad market averages, we need to ensure that we buy at a price that allows us a reasonable chance of a 10-15% annual return.
The goal is not to wait until we get a perfect price on a business that might never come. Rather, when Intel is selling at 60 times earnings, I'd much rather we put our money in one of the other choices on our Rule Maker menu that we feel offers more value for our investing dollar.
Point # 4: Because Rule Makers are superior businesses, they will usually be selling at premium prices
This is important. It's not like we ever expect Intel, Microsoft (Nasdaq: MSFT), Pfizer (NYSE: PFE), or Coca-Cola (NYSE: KO) to ever trade at a huge discount to intrinsic value as many smaller companies do. These companies are just too well-known and too well-regarded for their stock prices to show up on the discount rack, at least the vast majority of the time.
Normally, our Rule Makers will trade at a premium to the S&P 500. That doesn't mean it's OK to buy them at any price. It does mean that we don't mind paying an above-market multiple for a company like Cisco Systems, Yahoo!, or Pfizer -- as long as we believe that the company will continue to outperform in the long run.
Point #5: Keep investing for the long term
The Rule Maker approach is still all about a long-term approach to investing. We are putting our money in now, and we hope to enjoy the fruits of that investment two, three, or four decades from now. We aren't unduly concerned that the prices of our stocks have gone down this past year. However, as the Intel example in my previous article pointed out, the price you pay today still determines the return you get down the road. Even if that road is two decades long, it matters. Therefore, it makes sense to try and get the best value we can on each of our investments at today's prices.
Point #6: Re-evaluate your holdings at reasonable intervals
While ideally we would like to never sell a company in the Rule Maker Portfolio, we do give a good checkup to each of our Rule Maker companies occasionally to ensure that the company is still creating value for investors and finding opportunities for more value creation in the future. Our sell decisions will likely never be based on valuation, but rather will be made when we feel a company has deteriorated to the point where it is no longer a Rule Maker and isn't likely to become one again.
In closing, I'd like to thank all the folks who voiced their opinions on our discussion boards.
By the way, for some good valuation perspective on small caps, I encourage you to check out this week's article in our new Small Cap Foolish 8 investing strategy area: Setting Expectations for Small-Caps.
And finally, I'd like to extend the free offer for you to Become a Fool, and enjoy the full benefits of Fooldom.
Have a great weekend!