When it comes to an investment strategy it's a fine line between validation and violation. Last week, David Forrest became just the latest to kick the Rule Maker while it was down. I see Bob Bobala shadow boxing behind me. Whether he'll hold a defensive stance tomorrow or take his best shots is anybody's guess. Me? I come in peace.
Right off the bat, I don't want to come off as a Rule Maker apologist. I realize that we are looking at gains in just three of the eleven current holdings in our portfolio. Scroll down a little lower and you'll be treated to more red than a Friday the 13th slasher flick. It's not pretty. It demands to be addressed. If every loss, more so than every gain, carries with it an investing lesson then our Rule Maker is an Ivy League institution of higher learning.
But what gives? There seems to be a groundswell of criticism for the Rule Maker's lack of a legitimate valuation criteria. It now seems near-sighted that we were buying quality companies rather than quality stocks. But why is today's pessimism based on the over-sold condition of our holdings any better grounded than our earlier optimism when they were over-bought?
Yes, we paid too much for most of our Rule Maker stocks, but that doesn't mean that they were overvalued. Let me repeat myself, we coughed up too much on eight of these puppies, but the reason we overpaid was because the stocks were eventually marked down. Simple enough?
There is no cut and dry yea or nay in terms of valuation metrics. Market is what Market does. Even if you boil it down to fetching an attractive P/E relative to a company's historical growth rate, you're out of luck. Microsoft (Nasdaq: MSFT), Johnson & Johnson (NYSE: JNJ), and Pfizer (NYSE: PFE) -- our three Rule Makers in the black -- are all fetching earnings multiples that are more than twice their respective growth rates. What does that mean?
So while fiscal coroner hobbyists might be quick to write up a lack of stringent valuation parameters as the cause of our Rule Maker's decline, it's an incomplete assessment. For starters, what is valuation anyway? In its simplest form, one would define a company's worth as its future income streams. But that's just not possible. Forget the folks trying to sell you a discounted cash flow stream based on today when the numbers are bound to change tomorrow.
Let's have an Intel (Nasdaq: INTC) flashback. Back in 1998, folks like us who paid dearly for Intel figured the company was good for $1.14 a share (split-adjusted) in earnings the following year. It would grow earnings at a 20% annual clip. So, in 1998 theory, the chipmaker would be set to earn $1.65 a year this year. But, you know, what? It was an overachiever. Intel earned that sum a year early!
Okay, I don't want to start a buying panic here, but I just pulled up a quote on Intel and you're not going to believe this. It is going for less than 15 times 1998's vision of what Intel would earn this year. Carry the same 1998 logic with Cisco (Nasdaq: CSCO) and we're talking bargain city here for a 30% grower at roughly 25 times what the company should have been earning by now.
But, as the story goes, if your conclusions don't make sense you have to check your assumptions. Right now, 1998 is so far away. This year, Intel and Cisco are set to earn just $0.51 and $0.19 a share, respectively. A month ago the bar was a little higher. A month before that, higher still. That's the fatal flaw of relying solely on valuation. The only constant is change and determining the future value of earnings based on current presumptions is like trying to predict the wind's direction a week from now by taking out a kite today.
So are we going to fault Rule Maker for bending the rules to let Yahoo! (Nasdaq: YHOO) cross the velvet rope because the online advertising market would fall apart a year later? Wasn't it the fiber-optic meltdown, and not the multiples we paid on JDS Uniphase (Nasdaq: JDSU), that ultimately led to that downfall?
It's so easy to look at the rear-view mirror and explain the roadkill. Show me a time machine and I'll show you this real neat trick on how to get rich with your bookie.
Is there anyone out there who thinks Rule Breaker fared so well with AOL Time Warner (NYSE: AOL) because it nailed it on valuation? No, it nailed it on vision. I've seen dirt cheap value stocks go to zero and seemingly ludicrously priced ones climb the wall of worry to appear like bargains in retrospect.
Do we need more stringent benchmarks in buying? Do we need to formulize a standard for selling? Should we can ourselves and let a screen-munching automaton take over? While I think it's important to learn something from all of our past mistakes my answer remains "No!" on all three counts. Show me strict purchasing criteria and I'll come back with countless winners who would've flow under the radar. Show me a robotic dismissal policy and I'll return with even more long-term winners where a blip would have cut the payday short.
There has to be a human underbelly to all this. Since the market is a collection of everyone's sentiment at any given time, there needs to be that vision that looks ahead and sees things slightly askew -- for better or worse.
Last week, Microsoft topped third-quarter estimates but hosed down fourth-quarter expectations. While the mixed report might be zigging and zagging at Wall Street's heart strings, it's relevant only in developing today's assumptions. How well this week's XP operating system rollout is received over the years and if the .NET initiative is a winner will go a much longer way in crafting tomorrow's assumptions, and tomorrow's valuations. Got a feel for it? You're one step ahead from the valuation hounds with the actuary tables.
Next month it's the company's Xbox that bids for the video game spotlight. If it's unpopular, how badly will it hurt Microsoft's prized gross margins? If it's unpopular, how much will Microsoft be willing to spend before pulling the plug? Valuation models are never laid out on write-protected spreadsheet cells. You see, there is always something we don't know. There is always some variable that will be, well, variable.
The XP will be the most substantial upgrade to Windows since Windows 95. Under a more free-spending economic climate it would be a lay-up. Right now, nothing is a sure thing. Well, there is one sure thing and that is that there is no sure thing.