Fool community member norationalbasis wrote an intriguing post on the Rule Maker Strategy Discussion Board that I thought I'd answer here. His post contains some extremely important concepts, and some issues which, quite honestly, I had not put much thought to as they related to Rule Maker investing.
The post warned of two things: first, that the Rule Maker was formed as part of a 10-year project, which we are far from reaching, and making drastic changes would be premature. Second, he makes the point that plenty of people are covering value-based investing and there would be little differentiation if we go that way with Rule Maker as well. I don't think there's too much risk of that, personally. One need not be a Warren Buffett disciple to believe that the best course in investing is to try to get a great company at a good price. In fact, Rule Maker's going to be focused primarily on the "great company" part, with the price coming way later in the process. That is Rule Maker Rule #1: Demand quality.
This is the one issue in which I do not intend to bend: the company must have a business that has shown a historical imperviousness to competition and a future that looks like more of the same. These companies by definition can demand higher multiples because their competitive advantage period is longer.
Wharton professor Jeremy Siegel's Stocks for the Long Run, (modestly subtitled "The Definitive Guide to Financial Market Returns and Long-Term Investment Strategies") has a fascinating chapter entitled "The Nifty Fifty Revisited." The Nifty Fifty, if you can open up your financial history books, was a group of 50 large-cap companies that were touted as "one-decision stocks" in the late 1960s and early 1970s. These companies boasted massive P/E ratios, some exceeding 100, but came crashing to earth in the last protracted bear market in 1973-74. This experience has been held up by wags for 25 years as the definitive proof that one could overpay for "great companies."
The thing is, even though the companies suffered massive market cap losses during the downturn, in the long run, they have essentially matched the return of the S&P 500. In fact, counting dividend reinvestment, if you bought a basket of the Nifty Fifty at their absolute speculative peaks in December 1972, when the companies sold at an average P/E of 41.9, your returns would have beaten the S&P 500 on an after tax basis for all investors in or above the 28% income tax bracket.
Keep in mind here that we are talking about buying into stocks at the perfect height of a speculative mania. However, by 1975, investors who had done just this had no way of knowing whether or not they had made monumental mistakes. All signs at that moment said they had, as their portfolios were in a shambles, but 25 years later these investors would have made out quite well. Siegel's conclusion was this: good growth stocks are often worth the price you pay.
At any rate, norationalbasis' point was that we had embarked upon a similar path as the Nifty Fifty, an experiment to see whether we could buy companies on a qualitative basis and sit on them for 10 years and beat the market. His concern is that, by changing the criteria, we are short-circuiting the experiment, where we could in fact be at the same point as Nifty Fifty investors were in 1975.
Errrr, good point. There are some reasons why we're going to go about making changes anyway, but I think that his point should be taken into account. In a way we've already done that with reviews of the original Simpleton Portfolio, from which the Rule Maker derived. We should do more so for this science experiment.
But at the same time, people are looking to the Rule Maker (probably in fewer numbers than in times past) as a construct to learn about investing. What we have created is a tech-heavy portfolio that I believe sends the wrong message. Also keep in mind the corollary from Siegel's book: just picking a few of the Nifty Fifty companies was quite dangerous. Some of these companies, for example MGIC Investment and Polaroid, went bankrupt; others, like Xerox (NYSE: XRX), have badly trailed the market. We can keep the science fair part of the Rule Maker intact, but if it is to be a viable investment strategy, we need to address some glaring weaknesses. In fact, we're going to be emphasizing some characteristics and de-emphasizing others PRECISELY because the ones as written point us to a portfolio concentrated in some pretty volatile industries.
I've gone on too long here without getting to the point of the article. Actually, I take that back. The above IS the point of this article. The single most important component in identifying a Rule Maker company is excellence. We are looking for companies that you and everyone around you knows and uses. Given the choice, what is the default? Is the default in jewelry Tiffany & Co (NYSE: TIF)? You bet. Tiffany, like Coca-Cola (NYSE: KO), has no problem at all worrying about whether or not its products are going to be obsolete 20 years from now. It doesn't have to worry about upgrade cycles, there's no looking over the shoulder at a company that has come up with a better type of gold. Tiffany is the brand, and the brand has power that will essentially only be ceded if Tiffany screws up royally.
Coke is no different, and neither is H.J. Heinz (NYSE: HNZ). Oh, sure, Tiffany's got competition, Coke's got Pepsi (NYSE: PEP) -- a Rule Maker in its own right -- and Heinz has Hunts, part of ConAgra (NYSE: CAG). But these companies rule their respective markets, have done so for a long time, and are highly unlikely to be pushed off their pedestals anytime soon.
From an identification standpoint, this is the single most important thing for Rule Makers. They have had power in the past, they have power now, and the power for retaining power lies with them. (Boy, my editor's going to have a field day with that sentence!) Nothing else matters as much as that sustainability. It is for this reason that Rule Maker investment in so much technology was a mistake: high-tech companies have some of the least sustainable attributes.
A little less than a decade ago a modem was not going to go anywhere unless it was "Hayes compatible." Hayes Corporation controlled an industry with massive growth characteristics and some sweet economics. But the mistake in immediately branding Hayes a Rule Maker would have been this: widespread usage of modems was so new that no one had any idea what twists and turns the market was going to take next. As it turns out, competitors such as Megahertz, Cardinal, and 3Com (Nasdaq: COMS) turned Hayes into an anachronism in less than three years.
To the long time followers of the Rule Maker this will hardly qualify as earth shattering news. Looking for competitive advantages has always been the first and foremost in our quest for investments. The reason I am bringing this up once again is that even though we will be placing some valuation regimen into the Rule Maker diet, this single criterion, the sustainable competitive advantage, will increase, not decrease in importance.
Bill Mann, TMFOtter on the Fool Discussion Boards
Bill Mann's horoscope said something about staying away from guys named Eddie. If you're named Eddie, stay away. For now. Bill owns shares of Tiffany. The Motley Fool is investors writing for investors.