Greetings, Fools. Other than my picture at the top of the page, I really like the new format we have for columnists, and I like having a regular Friday slot. As I'll be talking about a lot of companies over the coming months and (hopefully) years, I will from time to time also discuss some of my basic investing philosophies.
This can be useful to you because it will provide you with a frame of reference when I react favorably, unfavorably, or violently to a potential investment. A couple of weeks ago, for instance, I indicated that growth stocks are currently looking more attractive than they have in many years. So, now you know I'm not exactly in the bear camp when it comes to the state of the market in general and growth companies in particular.
What's a QuaVa?
Today, I want to wade into a debate I find very interesting: quality vs. value, and which is more important in an investing sense. In other words, when considering a potential stock, is the quality of the company more important than the valuation of the stock?
When our Rule Maker investing constructs were first laid out, the term QuaVa came into being. This philosophy placed paramount importance on quality, so much so that the original managers considered it 100 times more important than value. This, naturally, went over like rotten sushi with some in our Community. QuaVa became a lightning rod for criticism. The mistaken idea formed that price (value) didn't matter at all in the Ruler Maker Portfolio, and that we got our comeuppance when the bubble burst.
And so it is, with this as background, that I stretch my neck out (across the chopping block?) and say: Quality is still king.
Value does matter
Why in the world, with all that's happened recently -- the billions in market cap lost, the hundreds of companies gone under -- would I downplay the importance of value? Haven't the past three years taught us that value matters?
If you define value as a stock price low enough that buying it will provide you with market-beating returns over the long term, then, yes, value does matter. It always has, and it always will. (OK, that one was obvious.)
If you define value as a price derived from your best guess of a company's growth rate over many years, as in a discounted cash flow (DCF) analysis, then, yes, value does matter... but not as much as the quality of the company.
If you define value as a P/E ratio that's less than some arbitrary number -- say, 20 -- then, no, value doesn't matter much at all. While the P/E can be a useful tool, it most certainly has its limitations, and may do more harm than good for investors who see it as some sort of magic number.
There are a couple of other things to consider here, not the least of which is the extreme difficulty of coming up with an accurate fair-value price for a stock. Besides growth rate, value investors usually consider risk, dividend payouts, interest rates, and other factors. They'll be the first to tell you that it ain't easy. If you're off by a little here, and a little more there, then the intrinsic value you come up with for a stock is also off... sometimes by quite a lot.
In his book A Random Walk Down Wall Street, Burton Malkiel summed it up well: "The mathematical precision of firm-foundation value formulas is based on treacherous ground: forecasting the future." An even greater expert, Yogi Berra, said, "It's hard to make predictions, especially about the future."
Lessons from the bubble
As I mentioned earlier, many have viewed the pricking of the bubble and the subsequent three-year bear market as evidence that "price matters," and that the idea that quality is somehow more important than value is ludicrous. I don't hold that view for a simple reason: The bear market happened not because people woke up one day and decided to begin assigning reasonable valuations to stocks, but because the economy went into the crapper.
Companies the market thought were going to grow earnings by such-and-such percent suddenly began losing money. The market crashed because earnings crashed. And when that happens, it doesn't matter if your company has a P/E of 10, 100, or 1,000... it's going down, baby.
Let's look at an example. eBay
Taking the worst-case scenario, if you bought eBay at its absolute highest point in 2000, you'd be down about 28% right now. The S&P 500, on the other hand, was down roughly 43% during that period, while the Nasdaq has lost over 70% of its value. And beating the markets by that decent margin is really the worst case. If you had even a modicum of luck and bought a couple of weeks before or after this mid-March period, when eBay spiked up 60% on rumors it would be acquired by Yahoo!
Why has this company stood up so well over such a horrendous economic period? Because of the quality of its business. Its business model is superb, and it works in good times as well as bad. Management has steered the ship well and has, to our knowledge, remained honest.
Skinning a cat
Let me make this clear: I'm not saying value investors are "wrong," or that they're doomed to be less successful than those who place a greater emphasis on quality. Not at all, not in the least. There's more than one path to success in investing. Some of the Fool writers I value most place at least as much emphasis on valuation as quality.
So, what's my "QuaVa Quotient?" I don't know, but I don't buy the 100-1 line. Some stocks, like eBay in its earlier days (and even now, to a great extent), demand investors focus almost solely on quality. For most others, however, that's just not the case. You must take valuation into account, though I believe you shouldn't get too caught up in it when your research indicates you have a high-quality company.
And that's the way you'll see me leaning in the future, as we kick the tires on potential investments.
Rex Moore once actually kicked the tires of a car he considered buying. The salesman then kicked him off the lot. At press time, he owned shares of eBay and a few other companies, as well. The Fool has a disclosure policy.