I'm losing sleep these days. I'm up frequently in the middle of the night -- and the problem is, well, I guess you'd have to say that the problem is "growth." Looking around at some formerly high-growth companies and their stocks -- including current Rule Maker holding Yahoo! (Nasdaq: YHOO) and former resident of the portfolio JDS Uniphase (Nasdaq: JDSU) -- I'm sure I'm not the only one losing sleep over the mysteries of growth.
I started out my research for this column wanting to discuss what I consider to be one of the most valuable Warren Buffett quotes that I've come across, which is saying quite a bit. It can be found in his 1989 letter to shareholders of Berkshire Hathaway (NYSE: BRK.A), one which you may remember as being of the same year in which Buffett -- legitimately -- wove into an investing lesson the country song title, "My Wife Ran Away With My Best Friend and I Still Miss Him a Lot." (Not even his best joke in the letter. Taken merely as a writer, the man never ceases to amaze.)
At any rate, in a subchapter of the letter entitled, "Mistakes of the First Twenty-Five Years (A Condensed Version)" we come across what Buffett terms his most surprising discovery as a seasoned investor and student of businesses, the existence of "the institutional imperative:"
"For example: (1) As if governed by Newton's First Law of Motion, an institution will resist any change in its current direction; (2) Just as work expands to fill available time, corporate projects or acquisitions will materialize to soak up available funds; (3) Any business craving of the leader, however foolish, will be quickly supported by detailed rate-of-return and strategic studies prepared by his troops; and (4) The behavior of peer companies, whether they are expanding, acquiring, setting executive compensation or whatever, will be mindlessly imitated.
"Institutional dynamics, not venality or stupidity, set businesses on these courses, which are too often misguided."
I would submit to you that the institutional imperative, particularly element #4 listed above, holds much of the key to the mistakes of individual investors, and, perhaps, even of online real-money portfolios.
Which brings us back to growth. I wasn't around when the managers of the Rule Maker Portfolio made their decisions to invest in companies such as Yahoo! or JDS Uniphase in 1999 or 2000, and in putting this column together, I didn't talk to those that were involved. I can only speak for myself -- and what I can say is that those purchases are ones that I quite likely would have supported at the time.
Why? I would have been captivated by an institutional imperative -- specifically the imperative that a portfolio needs some really fast-growing companies. "We need to be adding some hypergrowth stocks to this port. That's what everybody else is doing, and they're doing very well with it." That just might have been my answer had I been at the secret Grand Council meeting where Yahoo! and JDS Uniphase were considered by the Rule Maker teams at the times of their purchases.
Yikes.
In retrospect, of course, it's quite easy to see the enormous risk that was undertaken by investing in highly priced hypergrowth companies during the last couple of years. Such insight was available not only in retrospect, however. Bill Mann pointed out the risks last May in his article entitled "Do Big-Cap Tech Stocks Mean Big Risk?" The answer, by the way, was yes.
And the risk was in valuing growth -- and especially in trying to value hypergrowth. In one Rule Maker column last year, "Yahoo! in Hypergrowth," Matt Richey noted that what Yahoo! had to do was double its free cash flow every year for the next five years, and that would easily justify its then-price of $200 a share.
In re-reading that sentence, I am now struck (though admittedly I wasn't at the time) by words at least fifty years old. Legendary investor Benjamin Graham noted long ago the difficulties in trying to value quickly growing companies: "There was nothing wrong with these ideas, except that it was almost impossible not to carry them too far. With encouragement from the past and a rosy prospect in the future, the buyers of 'growth stocks' were certain to lose their sense of proportion and pay excess prices. For no clear-cut arithmetic sets a limit to the present value of a constantly increasing earning power. Such issues could become worth any value set upon them by an optimistic market."
To be sure, this was what the market engaged in for a while, and many were seduced by the imperative of needing to be a participant in the growth segment of the market. You need look no further than the speculation of straight years of 100% free cash flow growth from above. That has to be considered supremely optimistic. Indeed -- Yahoo! is in the process of diminishing its annual free cash flow, as opposed to growing it at 100% and setting itself up to do likewise for another four years.
Investing in companies that need to accomplish pretty much unprecedented growth to justify their valuations is not playing a high probability game. It is the case that throughout the last year and a half, while Yahoo!'s price has been spiraling downward, the company has continued to innovate and to exist in an exciting and revolutionary space. Yahoo! has continued to have the "expanding possibilities" that are a hallmark of Rule Maker investing. But is that enough? Again, I turn to Buffett's insights:
"The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage."
Yet it seems to me that it is growth that is the concept that is constantly being analyzed, measured, revised, hoped for, and obsessed over well before turning to the question of whether that growth is sustainable -- which it is only likely to be given significant competitive advantages.
To get back to where I started this, I am losing sleep over growth. But for me it is the growth of a three-week old son who is currently engaged in a little bit of hypergrowth himself. This is growth that is pretty easy to understand and react to, though simply understanding it isn't going to help me get any more sleep.
Individual investors are in a better position to maintain their beauty rest than I, whatever the complications of growth may be. They should be investing in what they understand best, and this understanding should include a methodology of the import to place on growth, and a conservative formula to value it. Again, I rely on Warren Buffett's words to finish things off:
"There are all kinds of businesses that [Berkshire Vice Chairman Charlie Munger] and I don't understand, but that doesn't cause us to stay up at night. It just means we go on to the next one, and that's what the individual investor should do."
Finally, speaking of trying to understand businesses, that's exactly what we're going to be doing in an upcoming online seminar. Anyone is welcome to enroll. We promise it won't keep you up all night.
Bill Barker named his son Clyde. Seriously. Bill's other holdings (though not the name of his other child) can be found online along with the Fool's complete disclosure policy.
