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December 14, 2000

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Cheeze-O-Rama

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Subject:  Adventures in Valuation #3
Author:  TMFCheeze

I've been spending my days on the Fool boards for a long time now. It's been half a decade for me, watching people talk about money and business and investing and all the nutty frustrations and delusions and resentments that go with them. You see a lot of petty behavior on the boards, partly because the medium itself keeps people at enough of a distance where it is hard for them to physically hurt each other, and partly because it's so easy to type your first thoughts and click "submit" before considering what has actually been said. So people attack each other with words, because they aren't considering clearly the things they are saying, and because they can get away with it. It can be ugly to watch sometimes.

Conversation is a messy thing. What is said on the message boards should be considered carefully. Opinion is common; insight is rare.

I learned a lifetime's worth of investing lessons in my first six months as an Iomega shareholder, beginning in October 1995. You saw the whole gamut of human possibility on the Fool message boards in those days. I'm lucky to have seen that bubble close up, and to have been a part of a mania so early in my investment career. I was swept along with the madness and enthusiasm, and in that tornado I suffered most of the wide variety of delusions that only true believers can experience. The most instructive lesson I learned was the rude awakening at the end of it, when the stark difference between a mere feeling of certainty, and the actual, bona fide, kick-in-the-face kind, was demonstrated to me in as palpable a way as any physical pain can be.

I distinctly remember one afternoon, probably in May of '96, thinking to myself, hey, if the price of IOMG would only just triple, well, then I can quit my job. It actually seemed like a genuine possibility at the time.

After all, why shouldn't it triple? It had 14-bagged for me already, after all.

That's the nifty thing about losing your grip on reality: anything becomes possible. No wonder people caught up in bubbles seem so euphoric.

My error? Amid all the mayhem that was swirling around me, I never bothered to consider the value of the stock I happened to own. I didn't know better. In fact I didn't even know how to calculate it. Truth be told, I'm still trying to figure it out how it's done. Oh, obviously I looked at earnings projections and growth rates and multiples and all the rubrics and rules of thumb for deciding what the price of a stock should be. Problem was, the higher the prices got, the more elaborate the justifications for those prices became. When you make the mistake of dumping your hopes and dreams into what should be a sober and uncompromising calculation, in essence you are simply expecting the price to go higher because you want it to go there. Whatever tortured argument will justify a higher price, that is the one you are going to believe in. And those sorts of tortured justifications were being manufactured with impressive efficiency in the winter and spring of 1996.

A bubble, from the inside, is simply a cycle of increasingly more delusional justifications. Your conclusions become more and more divorced from reality because your calculations are based more and more on your hopes, and less and less on what you can observe and measure. When you reach the point where you can't tell the difference between a hope and an observation, then you've lost your ability to make an intelligent judgment. At that point, you are simply expecting the stock to continue to rise because you want it to, exactly the same way somebody who has read too many self-help books expects his lotto numbers to pay off because the books say that believing something will make it happen. Well, more power to those who can do it, but I haven't yet been able to make that particular trick work for me.

In Adventures in Valuation #2, I talked about the value of value (if that's not too circular a way to put it), and the importance of understanding what money can do for you if you are lucky enough to have a lot of it. Face it � money is not going to make your next Snickers Bar taste any better, no matter how much equity you happen to have in your Schwab account. If you're thinking that your life can be transformed � that winning this particular lottery drawing or buying that particular stock at the right moment is going to transport you to a land of lollipops and elves where everyone is happy and frolicking and grinning like jack-o-lanterns� well, you know what? Maybe money will make that difference for you. But if you're actually counting the elves and entering them into your valuation equation, you're in trouble. And that's what too many people do when they evaluate stocks (IOMG? PCLN? TDFX? YHOO? Anyone want to add a hundred other tickers to this list?).

That being said, the errors I speak of need not be as dramatic as any of the stock bubbles we've seen in recent years. Poor thinking may have no more dramatic result in your portfolio than mediocre performance. The real challenge is to learn a way to shake the delusions from your mind and, as much as possible, to see what is real, to be able to recognize true value when you see it. And with all the uncertainty that exists in the stock market, that can be a very hard thing to do.

Intelligent investment is in some way a quest to understand the relevant variables that make evaluating stocks meaningful. In my years on these boards, I've seen a lot of attempts to come to grips with that endeavor. Some are as delusional as my own have been. And I think they fall into four broad categories. Apart from those who use the stock market as just another variation of a slot machine or a bingo card, I think there are basically four schools of thought that attempt to address that question:

1. Technical Analysis
2. Growth Investing
3. Mechanical Investing
4. Value Investing

Each has its own vocabulary, and each has its own view of what is important in making investment choices. Some use identical words to convey widely divergent meanings, which is part of what leads to so much trouble on these boards. People are arguing with each other, imagining they are speaking the same language, when in fact they might as well be speaking Chinese to someone who speaks only Swahili. The greater understanding we have of our respective approaches to investing, the more pleasant the discussions on these boards are going to be.

My original plan was to elaborate on each of these approaches, because in my study of Value Investing I think it is important to consider it in the context of the other approaches. But this post is already too long, so I will save the discussion for a subsequent post, one I hope I will have ready later this week.

I also want to caution that there is nothing absolute about my four categories. You might have suggested others, and yours would be as valid as mine would be. Some would say that my categories are unnecessarily arbitrary, and they would be right. I only draw them to illustrate the points I intend to make� which I'll get to ASAP� promise.

Cheeze
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