Forget the Numbers!

There is a story, probably apocryphal, about a professor who asked his students to write a research paper about fish. Some students turned in brilliant charts of fish families, some quoted the most recent biological studies, some described the importance of fish in the global ecology. The professor turned all the papers back to the students ungraded, saying, "You quote all of the best research about fish, and yet you still know nothing about fish. If you want to learn about fish, sit down and observe a fish."

It makes sense, doesn't it? If you want to learn about something, observe how it lives, how it operates, what makes it work.

Should we not be able to do the same for businesses? Sometimes, in our drive to find good investments, we become so enamored with the financials, statistics, growth rates, and so on that we miss the most basic observations about the company. And when it comes down to it, there is nothing beyond the profitable growth of a company that will ultimately cause its stock price to rise.

And yet, here we are, slogging through the financials. Worrying about whether the company has a Foolish Flow Ratio of 1.25 or lower, fretting about its working capital expenditures or whether the company expensed or capitalized its software costs. Yes, all of these things are important. But one should not forget that each of these companies is a living, breathing organism. In the U.S., each has its own Social Security number (they're called something else, but run with me here). What good does a solid read of the financials do if you have no real idea about the company and its prospects?

Like running naked through the woods
Yes, I'm being a little libertine here. I certainly think that those who invest based solely on their impressions of a company are making an enormous mistake. Yet I'd suggest that those who do the opposite -- those who are too dependent on financial statements -- are doing the same.

In April 1996, former Rule Maker Portfolio component Yahoo! (Nasdaq: YHOO) held its initial public offering. Yahoo! came slightly ahead of the true Internet insanity IPOs, "only" increasing in share price on that first day by some 33% by the close. Please note my dripping sarcasm. At the end of that first day, Yahoo! shares were priced at $33 a stub, or, split adjusted for today, $2.75. Its market value at the end of that day was $1 billion. And the old-liners scoffed, saying: "How could a company completely devoid of assets be worth a billion?" "How could this company be priced at multiples in the high triple digits? Its shareholders are idiots!"

Well, maybe they were, in fact, idiots. Mathematically speaking, you'd have to assume that some of them were idiots. And yet, even through the highs and lows, if those same shareholders who bought at the close of Yahoo!'s first trading day still had their shares, they would have increased the value of their investment 550%. This compares somewhat favorably to the 40% total return generated by the S&P 500 over that same period, including reinvestment of all dividends.

So you'd have to look back and say, "Did the folks who bought Yahoo! as soon as it came public really make a mistake?" It's altogether too much navel gazing to answer yes or no. Certainly there are folks who did the same thing a year or so later with piles of dreck like theglobe.com, with a drastically different outcome.

But something made Yahoo!'s IPO resonate with investors. And it was a certain kind of investor -- one who had some Internet experience at that very early point in 1996, had played around with this portal and search engine called Yahoo!, and recognized it as having one of the most valuable pieces of real estate in cyberspace. In short, you would have to assume that there were people who bought Yahoo! as soon as they could because they saw the company's draw as the home base of millions of people making baby steps onto the Internet. They also must have figured, beyond anything a financial statement could have possibly told them at the time, that this meant something.

What do they do? How are they doing it?
None of this latent value was really reflected anywhere on Yahoo!'s balance sheet. Neither is the value of Coca-Cola's (NYSE: KO) secret formula or its brand equity. Neither is the fact that Disney (NYSE: DIS) subsidiary ESPN has an absolute vapor lock on sports television entertainment. But they're apparent to the person who chooses to observe the business. I don't care what you think -- Coca-Cola didn't become the No. 1 soft-drink brand in the world because it tastes best; rather, its marketing, particularly during World War II, was better than all its competitors'.

Last week, the Fool ran a duel on Home Depot (NYSE: HD) and Lowe's (NYSE: LOW). For whatever reason, the topic of Home Depot elicits an enormous amount of interest -- nay, passion -- from a subset of our readers. Every single one of those who wrote us has keen observations about what Home Depot is doing right and what it's doing wrong. These days, it seems that it is doing more wrong than right, and its stock reflects this -- down more than 55% from last year. But is Home Depot doing more or less right than it was a year ago? I suggest that whatever operational problems presently exist at the company have been in place for a while, such as the fact that it tried to do more with fewer associates on the floors of its stores. Remember, stock prices are anticipatory of growth, but they can also be quite responsive to problems.

What's wrong, what's right, what don't you know
I read a very interesting article in the New Yorker regarding U.S. efforts to collect information about Iraq, terrorism, and even our allies' nuclear programs. It became clear that our intelligence analysts were unable to predict such things as India's nuclear weapon test or the attacks on Sept. 11 not due to a lack of information, but by a poverty of expectations -- mistaking the unfamiliar with the improbable.

Investors, even good ones, have a tendency to do the same thing. Even with all the existing information in front of them, very few people expected the telecommunications industry to come apart at the seams. They thought that, with traffic coming onto the networks so fast, the billions in debt taken on to build them out would turn out to be a steal. Even the cynics did not predict collapse. And yet the signs were there. Flag Telecom, with the most direct cable route between Europe and Asia, was having trouble selling capacity. Global Crossing was actively shopping cashless traffic swaps to juice "revenues." WorldCom acquired every chance it could, but didn't even bother to integrate billing systems.

All of this information was there, available to the investor, who then chose not to stare at the rapidly expanding numbers, opting instead to just "watch the fish." The numbers made the end result seem improbable.

Bill Mann's willing to kill over chocolate. He does not own shares in any companies mentioned in this article. He is managing editor of The Motley Fool Select, where you can find his best Foolish stock ideas that you won't find anywhere else. Catch Bill on Online Tonight with David Lawrence every Tuesday and Thursday. The Motley Fool has a disclosure policy.

The Rule Maker Portfolio has had a cumulative investment of $44,500. As of Feb. 2003, its current value of all cash and equities is $30,542.98. This equals an internal rate of return of -12.0% since the launch of the portfolio in Feb. 1998.