At Judge Samuel Alito's confirmation hearings this week, expect to hear two words repeated over and over -- and I'm not talking about "Roe" or "Wade."
No, "strict constructionism" is the order of the day in Washington. In legal circles, this term refers to a philosophy of judicial restraint that calls on judges to interpret laws according to their original meanings. Strict constructionists don't want to meddle with theories of evolving community morals, divine natural law, or seek out "penumbrae." Theirs is a code of strict adherence to the words on the page. What's law is law, and what isn't law -- well, go tell it to your congressman and get back to us after you've had it enacted.
In opposition to the strict constructionists stand the "activist judges" -- those who see a change that needs making, but who don't want to wait for politicians to get around to making it. Rather than wait, activist judges stretch the meanings of existing laws just enough to achieve their ends.
For example, in the late 1930s and early 1940s, the Supreme Court issued a string of decisions expanding the federal government's power to regulate "interstate commerce." To do this, the Court overruled previous decisions on the subject in order to, for instance, outlaw child labor -- an evil that the 1918 strict constructionist Court declined to stamp out in the case of Hammer v. Dagenhart. The New Deal Court's ends were admirable, but to achieve them, it had to deviate from a strict interpretation of the Constitution.
And all of this has what, exactly, to do with investing?
I'm getting to that. You see, in a way, investors are a bit like jurists. When we start out investing, we go in with a plan, our "original intent."
Sometimes it's as simple as "buy low, sell high." Sometimes it's a bit more refined: "Buy stocks whose projected growth rates exceed their P/Es." And generally, we aim to imitate investing masters, such as Benjamin Graham, Warren Buffett, and Peter Lynch, by buying to hold for the long term.
That, at least, is our original intent. But if, over time, that plan doesn't produce the hoped-for result -- stocks that go up -- a temptation to modify our original intentions can creep in. That's when we all feel the urge to become "activist investors."
Or more precisely, active traders
We trade into and out of stocks, grabbing a 3% gain, cashing out, and buying something that "hasn't gone up yet." Maybe we start with Yahoo! one day and switch to Microsoft (NASDAQ:MSFT) the next. Or we sell Dow Chemical to buy DuPont (NYSE:DD).
But at some point, we realize that despite all the trading, our stocks, sound of balance sheet and low in price, still seem stuck in a rut. Then we hear the siren's call of Bottle Rocket, Inc. (Ticker: PHZZT!), which jumped 30% after beating estimates by a penny. Or Moonshot Enterprises (Ticker: LOONY), which doubled on word of a big new contract with the Federal Space Agency of Upper Volta.
Up to this point, we've been investing only in sound, profitable companies. But if "growth stocks" are where the real action is, then perhaps we're being a bit too strict in our standards, we muse. Perhaps we need to loosen up a bit. Live a little. Bend the rules and modify the means through which we seek our investing ends.
That temptation becomes especially strong in a market like today's, one that seems magnetically tethered to Dow Jones 10,500. With the memory of the go-go 1990s still so fresh in our memories, we long for the days when stocks went up consistently -- and we begin to seek new ways to bring back those old days.
Here be dragons
That's dangerous thinking, my friends. Because as clearly as we remember the happy days of 1999, the memory of what followed our loosening investing standards -- March 2000 -- should be seared even more deeply into our investing consciousness.
Once you let go of your original investment plan, you risk sliding down the slippery slope -- a slope as steep as the one descending from Nasdaq 5000 down to Nasdaq 1200. We don't want that to happen again, do we? So before it does, let's pause and reflect on our original investing intent. The one we all start out with. The one we hold true to here at Motley Fool Inside Value.
Bill of Investor Rights
Every investor knows it's right to:
Think before you buy. Whatever the market does, whether it rises or plunges, if you can pin a reasonable, intrinsic value on a single company, you're much less likely to overpay for that company's stock. Moreover, if the market drops and takes your stock with it, you'll know whether you're being offered a chance to buy more stock "on sale" or just being handed a falling knife. So do your homework.
Demand a margin of safety. Acknowledge that you're fallible. After calculating what you think a stock is worth, refuse to buy it unless the price falls below your fair-value estimate. Does this mean you might not get a chance to buy the stock at all? Sure. But better safe than sorry.
Insist on free cash flow. GAAP earnings don't always reflect a company's true cash-generating prowess. Double-check your valuation math against the company's free cash flow. If your company is anything like Microsoft, you'll be pleasantly surprised to see that it's even cheaper than its P/E ratio suggests. Moreover, just because Sun Microsystems (NASDAQ:SUNW) didn't post GAAP profits last year doesn't mean it didn't earn money for its owners -- it generated positive free cash flow.
Be patient
Great investing ideas are the ones that no one else sees -- today. Everyone knows that Google is a great company -- that's why it's priced in the stratosphere. So what are you going to do -- buy high and hope some "greater sucker" comes along so you can sell it a bit higher?"
No, sir. Stick to your investing guns. Buy the great companies when everyone else is mad at them. When the analysts have been blinded by short-term news and can no longer see the big picture. When Motorola (NYSE:MOT) suffers repeated sell-offs despite rapidly growing its profits -- as happened several times last year -- buy. When American Eagle (NASDAQ:AEOS) issues an earnings warning (as it did in September) and the Wall Streeters say doomsday is nigh -- buy.
Sure, a bargain-priced stock may stay stuck in the basement for a while. It's been eight months since Inside Value first identified brew regent Anheuser-Busch (NYSE:BUD) as undervalued, and nine months since we recommended blue-chip pharma Pfizer (NYSE:PFE). Both of those stocks remain in Mr. Market's doghouse to date. But are we giving up on them? Not a chance.
Because we know what we bought. We know why we bought it. We're faithful to our original investment intent -- a value-oriented strategy that has us beating the S&P 500 average by four percentage points to date. We're strict constructionist investors here at Inside Value, and if you're one, too, we'd like to invite you to join us for 30 days, free. No confirmation hearing necessary -- just click right here and you're in.
This article was originally published on Sept. 21, 2005. It has been updated.
Fool contributor Rich Smith has no position in any of the companies mentioned in this article. Dow Chemical is an Income Investor newsletter pick; Microsoft is an Inside Value recommendation. The Motley Fool strictly construes itsdisclosure policy.
