Over the last two months since David Forrest launched his "What to do With Rule Maker" column we've seen a great deal of discussion about the power and purpose of Rule Maker investing. Most of it has been generated not by any of the managers, but by the community. I am humbled at the passion with which people argue their convictions regarding this model portfolio, even if their convictions entail "You suck. Get rid of it."
Yes, change is coming to the Rule Maker portfolio. We are going to revise some assumptions, de-emphasize some things and add some discipline in other areas. If the Rule Maker is going to be of value, it has to adhere to its original goal: to teach people how to think about businesses and investments. When we're concerned about short-term performance and not long-term appropriateness of the strategy, well, we're not providing as much value as the Rule Maker could.
So let's get some brass tacks out of the way.
Q: Are you changing the Rule Maker or what?
A: Yep, we are, to some degree. The changes are going to be made really in the context of what was good and what was bad about how the portfolio has operated in the past. The managers have created a lot of confusion by expressly ignoring certain criteria when we made purchases. Sometimes this was to our detriment, in particular with Yahoo! (Nasdaq: YHOO) and JDS Uniphase (Nasdaq: JDSU), but in some cases the rationale for ignoring certain qualitative factors was sound. The changes we are going to make will include the following:
A reorganization of the criteria. We need to face the fact that some of the things the Rule Maker focuses on are not that important. I am convinced that the Rule Maker strategy is sound, but that's because I've got a pretty solid concept of what that strategy should be, and it differs slightly from what is on the page at present. The problem right now is that the Rule Maker criteria make the process look mechanical. It is not. When I look at the criteria, I see some that should absolutely positively be mandatory for an investment, and some that, you know, would be nice. We're going to organize them this way.
A valuation discipline. This may seem to be completely contrary to Rule Maker investing, and it is going to require a great deal of refinement. Laying valuation on top of Rule Maker investing needn't be the same thing as saving the village by destroying it. Valuation is extremely difficult to do, but I firmly believe that if you cannot make a case why a company's revenues, profits, and equity will grow at a rate that more than builds in the premium you are paying, then you are about to make an enormous mistake if you buy it. This valuation discipline will not, repeat not, work mechanically. There will be no P/E ceiling, price-to-book ceiling, or any other automatic elimination. Rather, we will look at these issues in the total study of the business, how much it has grown, how it stacks up with competitors, and what type of sustainable advantages it has in a growing addressable market. This means that Rule Maker investors will continue to discuss many more companies than they will own in their portfolios.
A sell discipline. I can go ahead and tell you what this is. Again, we're not going to put any absolutes, like "a PEG ratio of x equals sell." We will continue to stand firm on selling any Rule Maker company that breaks one of the six immutable rules that were listed in a June 2000 article called "When to Sell a Rule Maker." In our sell methodology, we're going to use a two-step process, with grades, which we can re-run periodically. The first step looks first at the company's "story" -- whether they are doing the things necessary to grow long-term earnings, whether their market is changing, and whether there are new competitive pressures that are conspiring to knock the company off of its pedestal. The second step will be to look at valuation, namely to determine whether a company is attractively priced relative to earnings, assets, the balance sheet, and so on. We will do this both with companies that are in our portfolio and with any number of other companies that qualify as Rule Makers.
De-emphasizing our portfolio. Despite efforts to the contrary, we continue to receive correspondence from people who believe that our real money portfolio constitutes stock recommendations. We are pretty blue in the face from repeating over and over that this is a teaching tool, not a portfolio full of recommended stocks that should be copied. So while I do not purport to be able to keep people from doing stupid things, I must also recognize the fact that for whatever reason, what should be a teaching portfolio is viewed quite differently by a significant subset of our readers. Where perception conflicts with reality, sometimes reality must budge first. I think that the real money portfolio is nice from a credibility standpoint, but is probably detrimental from a teaching standpoint. The Rule Maker is supposed to provide a construct so investors can think rationally about being business owners, and we should in no way feel limited to covering the companies we own. In fact, ownership of certain companies should almost be beside the point.
Q: OK, wait a minute. You're just getting rid of the portfolio because the Rule Maker has underperformed.
A: First of all, that wasn't a question. Second of all, we are in no way "getting rid" of the portfolio. It is going to remain in place, but we are going to modify how we run it as well as how we cover it. Stay tuned for further details because I'll go over them in the next few weeks.
I'm not particularly troubled by the underperformance. In fact, some of the best investors in the world have underperformed the S&P 500 for periods as long as six years (Rick Guerin's Pacific Partners, for one). And some of the great investors have shown significant losses in consecutive years. Charlie Munger's Wheeler, Munger & Co. partnership lost 31.9% in 1973 and then followed up with a 31.5% loss in 1974, badly trailing the S&P, which lost 14% and 26% in those years. But rest assured that both Guerin and Munger used those losses to learn, and that's what we're going to do as well. When we lose 35% in one year and follow that up with a 25% loss, you bet we're going to be introspective about it and make changes where they are necessary.
Q: Seriously, it's the underperformance, right?
Look, we do not expect to beat the S&P 500 EVERY year. In fact, I'd imagine that if we lost to it 40% of the time we'd come out OK. One thing that became clear was that the original stated goal of picking 10 companies and forgetting about them proved foolhardy, as evidenced by our experience with Gap Stores (NYSE: GPS), where a dynamite company started showing some real growing pains as it began to run out of obviously unaddressed markets in the United States and Canada. But just as we suggest that individual investors who want to try stock picking be uncompromisingly honest about their performance, it's high time that the Rule Makers do the same thing. So we're gonna, not because we're desperate, but because we must be able to eat our own cooking.
Q. So what now?
Well, as you may have noticed, the Rule Maker has been on hiatus for two weeks while David Forrest, who has been watching the store for a few months, took time to welcome his new baby into the world. Over the next few weeks I'm going to be distilling the criteria, the disciplines, and the purpose of the Rule Maker. In the end I hope that it will look essentially the same but be infinitely superior as a tool for teaching the art of understanding and valuing great businesses. I'd also like to make this a more collaborative process, where members of the community actively submit articles about Rule Maker companies or concepts that can be posted on the front page of the Fool website.
I've gone on too long for now. We'll talk more over the next few weeks.
Bill Mann, TMFOtter on the Fool Discussion Boards
Bill Mann invented the Internet. He owns none of the companies mentioned in this article. The Motley Fool is investors writing for investors.