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Re: Comparing Tom's Performance with Himself

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By TMF1000
December 1, 2004

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Your HG picks are up an average of around 45% over the last 18 months (which is amazing!), but your SA picks over the same period are only up around 15% (still not shabby by any means, but a lot less than 45%).
Your question was interesting to me because I grew up believing you bought the largest companies with the longest track records. I started investing when I was 12 some 37 years ago. With limited sources of information available at the time that path was probably the best for me. But with the introduction of the Internet, I believe I can successfully wade through the small cap jungle where I now feel represents the best opportunities going into the future.

The last 10 years, I noticed that my portfolio, which was very diversified with large cap stocks, was not appreciating in value. Every stock in my portfolio was sort of sitting there and my total portfolio value was not climbing. In fact it had stayed pretty stagnant for several years. I had never had a decade go by with no growth. I could not figure out exactly what happened.

Then I made probably my first sizable investing mistake. I tried to apply what I thought created my success in the past. I would sell off about 10% of my stocks and start buying faster growing large cap stocks. Back in 2000, the big names were JDSU, RBAK (now bankrupt), Cisco and Intel and a few other interesting large cap stocks that are now selling for under $5.00. It was a big mistake. Fortunately option premiums were high and I was bringing in enough option cash to negate some of the damage that occurred when the stocks dropped. I had plenty time to exit them, but I held because I always believed long-term was the best way to go. That too was a wrong assumption in this case. I learned a very valuable lesson. (Lesson Learned - Earnings are important. Cash flow is not the whole story. And buy and hold does not mean buy and forget.)

At first, I questioned the "buy and hold" strategy. Then I questioned large cap stocks as being the best vehicle for growth. My conclusion was that my approach was not particularly flawed but rather my stock selection in this case that was flawed. I chose large caps whose stock price was growing but whose earnings were not growing in proportion to the stock price rise. My picks were those that had no earnings and slim prospects, despite the hype surrounding them. But not hype in the bad sense because things could have been different if just a few factors had been changed. (But that is a story for another time) ( Lesson learned � don't value stocks by the rise in their stock price but rather value them by earnings growth and cash flow.)

Intel did Ok, and Cisco did OK, but they had earnings. And they finally bottomed and started rebounding. I now placed more emphasis on a long track record and companies that I believed would outgrow the economy. (Lesson learned � when choosing large cap stocks consider those with long track records of success and pay attention to value.)

I then studied stocks in industries that carried me through the 80's. They had moved up some, but certainly nowhere near the growth I was accustomed too. I started questioning the maturity factor of stocks. I started looking at the stock market as a whole and the growth of the economy over the last 40 years.

I concluded from this that valuation mattered and that secular bear markets were a real phenomenon and that we may indeed be entering one. Or at least, I had to consider the possibility that the signs did look as if we might be entering a secular bear. We might define a secular bear as a long period of time when the majority of stocks don't appreciate much. This period could last a decade or more.

I checked my books that I had collecting dust on my shelves that contain information on companies that I grew up with back in the sixties and seventies. And I noticed something very interesting. Many of the large cap companies that I liked were much smaller than today. I also noticed that the worse secular bear in history produced the best future investments in our history. (Lesson learned) So, it was not secular bear markets that should be feared, but rather poor stock selection.

I will give you an example. In 1966, Kellogg's, one of my past big winners, was only an 800 million market cap company. Today, that is not very large. In fact, this at first made me think I had found the answer. I check other companies that proved to be good investments for me after holding for 20 years or better and I found the same, none of them were over 1 billion in market capitalization. I thought I had found the answer -Small cap companies. Yes, that is what I thought was the answer. But it was not the complete answer.

I examined further. I found out back in 1966, there were very few companies that had over $1 billion in market capitalization. I was stunned. Kellogg's, even back then, was a fairly large company by comparison to the giants of that time. To make a good comparison, we had to examine the economy size by the companies that existed.

Here is a shocker. J. C. Penny's was a $1.5 billion market cap company back in 1966. Sears was a $6 billion. GM was a $20 billion Market cap company. I believe they were among the largest. Bristol-Myers Squibb was a $1 billion market cap company. It would take quite a hunt to find one larger than GM. I believe they were one of the largest back during that time. In comparison, today Walmart has a market cap of 221 billion and they are not the largest company today. And that is scary. The GDP has not grown that much. There are a lot missing pieces of the puzzle. I found a few more.

As I continued my investigation, I decided I had to find a way to shift funds out of the old guard stocks and into the new guard stocks. My first step was to sell all of my old guard stocks, create cash, and buy bonds to support me, as I grew older. But, I wanted to duplicate my earlier success. I have one handicap, I am much older, and I cannot assume that I will have another 37 years to invest. But I am convinced that I must concentrate on shifting money into smaller companies, and larger companies that will be important decades into the future. (Lesson learned � The past does have many answers but we must be careful not to draw the wrong conclusions from the past.)

I am convinced that even in a secular bear market, one can do well, but they must find stocks that can grow faster than the economy. That immediately rules out a lot of large cap stocks. Many stocks that made up the largest stocks when I was young, no longer exist at least not in the same form. Many have been purchased by larger companies, and some went bankrupt while others were supplanted in importance by better ran companies. (Lesson learned size alone is not the determining factor to long-term success. Competitive forces, changes in technology and continued importance in our society are huge factors in long-term success of companies.)

Many really good companies got replaced by better companies. Walmart caused a lot of obsolescence in the retail industry. GM and Ford are not the forces they once were in the auto industry. The steel industry giants have been replaced by more competitive companies, with new technologies such as Nucor and their mini-mills. The world is in constant change.

Back in my time, population growth created much of the value in stocks that we see today. Consumer product companies piggybacked on population growth. It is interesting to see just how much stock market growth can be produced by X amount of population growth. And just as interesting which companies benefited from that growth. So, keeping up with population growth figures probably is just as good an idea as it was back in my day. Not that I did that. (Lesson learned � It is important to determine drivers of growth and what industries are most likely to benefit.) The Motley Fool, in my opinion, offers the best chance for investors to keep up with changes that affect our investments and future investments. I get a lot of benefit from reading daily Takes and examining different business models.

New technologies can create entire industries from nothing. The personal computer has changed our lives and created a huge number of successful companies, many that we seldom hear about, but they are there nevertheless. The Internet has changed the way we do business and communicate with each other, it created a lot of new companies, but most of the value it created was in the form of making it less expensive to do business for many of the already existing companies. In the years, to come, the Internet will create a strong retail environment that might rival the brick and mortar stores that dot our landscape. I love shopping online. I can find things that I could never find in stores. But I like collectibles and other weird things that most people would not want. The Internet may yet spawn new important industries that are still on the drawing board.

Back to your question � finally. Philip (Admiraltroll) once warned me that I should answer questions before drinking coffee. 

I believe TomG has done well with Hidden Gems and will continue to do well because small caps are stocks that will generally grow faster than the economy as a whole. But, as I found out, that is only one small part of the puzzle. It is more important that the companies represented will be important to our economy years and decades from now. TomG does something that I believe is more important than just choosing the right asset class, but more importantly he uncovers important businesses. And the community, through the message board systems keeps us updated to whether the companies stay on track and clues us to changes in the competitive landscape than might affect them. The message board system, as promoted by The Motley Fool, will prove of great importance as the years pass. Don't disregard this channel of information.

The stock advisor stocks are good stocks too, but they are larger and growth is likely to be slower particularly in the beginning. In the end, the important factor is not size so much as which companies will be important to the US economy 20 years from now. Each of the newsletters do a good job in this respect.

We must also be on the watch for any new technologies. One thing, I am certain that the companies that make up the S&P 500 will not be the same ones that make it up 40 years from now. With small caps, you have another advantage. Much of the return that investors enjoy from small caps is the premium received in takeovers. Most of the companies in the S&P 500 back in 1966 have disappeared. They did not all go bankrupt, but they were bought out by other larger companies. With small caps you have a variety of factors that will help you succeed. They are generally growing faster than large cap stocks and the best ones are always takeover targets. In fact, even the not-so-good ones are takeover targets. It provides some downside protection and that is important.

Then there is the rare chance that we might hook into a company that leaves the realm of small capitalization companies and becomes a true giant. This is what makes small cap investing so exciting to me. Back in 1967, when I began investing and up to the 1990's I really could not successfully attempt the small cap market. There was very little information concerning them, no Internet to help me keep up with them, or basically just not enough sources of information. The Motley Fool has changed that if we take advantage of the resources available here in the Hidden Gem community. These resources will help assure success.

Each board dedicated to a Hidden Gem stock creates an environment where people share information and news and analysis that goes far beyond anything that I encountered in my investing career. There may be some HG companies that will become giants 20 � 30 years from now. And I believe I will find them by keeping my ears open and read clues from the message boards. When I started, I thought TACT and BWLD were the best HG growth stories, but later I learned that FARO had to be added (thanks to a tip from a fellow Foolish investor) to my list of companies that had the best long-term potential. The tip caused me to investigate deeper. (Lesson learned: rely on Fellow Fools for information and allow their help to guide further investigation.)

Also, I have found that many of the HG recommendations have an interesting growth hook that could lead to far greater success for those that hold long-term. The true long-term stories may appear apart from the three I have always considered the best. In MSA, I see the potential for growth in the mostly new homeland-security market that may spawn a huge industry.

The next generation of successful super investors I believe will come from the Foolish ranks. The Motley Fool is still in its infancy. Compared to the investing world we are still a very small group of dedicated investors. The best financial education I have encountered has been from my association with fellow Foolish investors. The opportunity to be successful, going into a much tougher market than I grew up in, will be through The Motley Fool.

tom


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