Think back a little bit. Back to a time when day traders bragged about their daily winnings, when newly minted undergraduates received BMWs as signing bonuses to work for dot-com start-ups, and when Qualcomm (NASDAQ:QCOM) had a $1,000 price target.
Think back to the first quarter of 2000.
I know, I know. For most investors, that's a painful time to recall. The three-year slide that followed was brutal, and many stocks slid from the ranks of would-be Silicon Valley titans to Chapter 11 has-beens. Nevertheless, there are lessons to be learned some five years after the peak of the bubble.
When software company Websense (NASDAQ:WBSN) announced its fourth-quarter earnings, it included an enticing tidbit about its success. It was one of only seven companies that went public in the first quarter of 2000 (out of my count of 137) and boasted positive returns from the stock from the day of its IPO.
So with apologies to Akira Kurosawa, I decided to examine those "Magnificent Seven." I went back into the history books to study those lucky seven and see whether there were lessons that investors could apply to today's market.
The "Magnificent Seven"
First, lets take a brief look at the survivors.
Readers should note that this list reflects a particular moment in time and, depending on when they read this, one or two additional stocks may have climbed above the cutoff point.
- PetroChina (NYSE:PTR): a major Chinese oil company that produces two-thirds of the country's oil and gas.
- ICICI Bank (NYSE:IBN): the second-largest commercial bank in India.
- Packaging Corp (NYSE:PKG): a producer of containerboard and other packaging products.
- ValueClick (NASDAQ:VCLK): an Internet advertising and marketing company.
- Websense: a provider of employee Internet management solutions.
- Beasley Broadcast Group: (NASDAQ:BBGI): an operator of AM and FM radio stations.
- Fargo Electronics: (NASDAQ:FRGO): a maker of equipment for producing custom identification badges.
At first glance, there's not much in common among these seven companies. The market capitalizations range from enormous (PetroChina) to tiny (Fargo), and no two companies are in the same line of business. There was no common banker involved, nor was any venture capitalist involved in all seven.
Looking deeper, you still won't find a lot of similarities. Four were profitable at the time of IPO; three were not. The stocks of Packaging Corp and PetroChina were more or less stable right out of the chutes, but most of the others got crushed initially as the Nasdaq sank.
What they DO have in common is that all seven stocks recovered strongly in 2003. Not surprisingly, that is when the Nasdaq got up off the mat and posted some gains, and investors began once again bidding up the shares of quality companies.
I would like to say that there is a magic formula lurking beneath the success of these seven companies -- an easy algorithm that explains why they made money for shareholders and others did not. Alas, it just doesn't seem to be the case.
The lessons -- investor, think for thyself
The real lessons seem to be twofold. First, there are no shortcuts to successful investing, and, secondly, investors must be patient.
Everybody hopes to find shortcuts to profitable investing. The shelves of bookstores bulge with titles that promise you the secrets of stock selection and promise to make you as rich as you want to be. All you need to do, according to the authors, is follow their carefully back-tested stock selection strategy.
Hogwash.
Simply plugging numbers into a stock screener and blindly investing in the results gets you nowhere. Numbers can be inflated because of one-time items, the data provided can contain errors, and no search engine on Earth can tell you whether management is competent or whether the company still has growth ahead of it.
So, too, with following various automated guru approaches. Although there is no shortage of vendors promising prebuilt search criteria that will "pick stocks like Buffett" or duplicate Peter Lynch's approach, those criteria are based on a failed assumption -- the notion that famously successful investors always follow a rigid series of reproducible steps for evaluating investments.
One look at uber-investor Warren Buffett's investment history shows the folly of such a notion.
Many investors were shocked years back when Buffett (of Berkshire Hathaway fame) made a sizable trade in silver. While the reasons underpinning that trade were predictably Buffett-esque (silver was trading at an historically low valuation), I don't recall hearing any gurus predict the move in advance. What I do recall is a few articles written by wet-behind-the-ears journalists asking whether Buffett had "lost it" by investing in silver and ignoring tech stocks.
Similarly, Buffett's activities in bond trading and arbitrage are fundamentally based on principles of value and margin-of-safety, but no database available to retail investors is going to replicate that.
What's more, even gurus are sometimes wrong. If you read back issues of Berkshire's annual letter to shareholders and Buffett's other writings, you will see him lament his involvement in U.S. Air (NASDAQ:UAIRQ.OB) and his lack of involvement in pharmaceutical stocks.
Automatic systems are undeniably appealing. After all, if they remove the requirement to think and make judgments, they should remove the possibility of incorrect thoughts and judgments. Worse, many blind strategies appear to work just long enough to get some press.
The Dogs of the Dow is one such approach -- the notion that buying the highest-yielding (or lowest-priced amongst the highest-yielding) stocks of the Dow Jones will produce outsized returns. Unfortunately, the results just don't support that. Even The Motley Fool tried this once -- with the Foolish Four portfolio -- and learned the same lesson.
When you look at the Magnificent Seven of 2000, I don't believe there was any group of criteria that you could have punched into a stock screener to produce those seven stocks. Instead, investors had to keep their eyes open, evaluate each one on its own merits, and then purchase the shares when the opportunity seemed right for each stock.
Now before I get a flurry of angry emails, let me state definitively that screening for stocks that meet certain criteria (like the Foolish Eight) can lead you to some very solid investment ideas. The point is, though, that you must take the next step and do your own research on each one before you add it to your portfolio.
Computer searches and handy formulas like "20%-plus return on equity, 10%-plus net margin, PEG below one" will lead your horse to some very promising waters, but you must THINK for yourself and investigate the merits of each stock that comes up on such a screen.
The virtues of patience
The second lesson we learn from the Magnificent Seven of 2000 is the value of patience. While investors in Packaging Corp and PetroChina had a fairly smooth ride in the stock market, others were not so lucky. In fact, investors in the other stocks saw them drop precipitously early on, as the Nasdaq was taken out and shot on a daily basis. In fact, despite their various appealing attributes, most of the stocks only began showing positive returns when the market recovered in 2003.
Does this mean that investors should hold out until the bitter end, no matter what happens to the price of the stock? No, certainly not. But it does suggest that investors must follow both the fundamentals AND the valuation of each stock. In the case of Websense or ICICI Bank, for example, the stocks each got crushed for a few years, even though the fundamentals of the business were actually improving.
It has often been said that the stock market measures popularity in the short term and quality in the long term. Perhaps this is often said because it happens to be true. While fads come and go and bring bubbles and busts along for the ride, true value almost always wins out in the end. So while it is prudent indeed to prune away stocks whose fundamental performance looks to be on a long-term slide, selling only because a stock is down will almost guarantee poor long-term performance for an investor.
Conclusion
While my research into the Magnificent Seven didn't produce the sort of results I was expecting, the investigation was not for naught. In looking for some sort of easily reproducible pattern or shortcut, I reminded myself that successful investing rarely ever springs from taking the easy or lazy way out. Instead, good old-fashioned, roll-up-the-sleeves fundamental research still matters.
So, bottom line, what does this group of seven stocks have to teach? (1) Successful stock selection needs to be a one-by-one process of evaluating candidates. (2) There are no shortcuts. (3) Investors have to have patience -- even the brightest diamonds can be periodically thrown into the Wall Street pig sty.
So in the end, we arrive back at the beginning. In this case, the beginning of The Motley Fool, itself, or rather its philosophical underpinning. With hard work, diligent research, and patience, you too can build a portfolio of stocks that will give you magnificent returns over time.
Is value investing your thing? Do discounted cash flow analyses get your blood pumping? Take a free trial to Motley Fool Inside Value today.
Fool contributor Stephen Simpson, CFA, owns shares of PetroChina. The Motley Fool has a disclosure policy.
