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Author: Inane One star, 50 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 74344  
Subject: The Big Picture Date: 2/25/2002 6:17 PM
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Been reading all the hullaballoo on this board regarding the value of valuation when playing the gorilla game or investing in new paradigm tech stocks. For those who read the Washington Post, I thought James Glassman's investing column in this Sunday's business section was very relevant to this discussion. You can find it at:

http://www.washingtonpost.com/wp-dyn/articles/A55863-2002Feb23.html

Some excerpts from this article and my 2 cents follow. The article may restate the obvious for most folks on this board, but I found the article provided an important "big picture" viewpoint given how much we've all been questioning our own investing approaches (including valuation) in this tech downturn. Here goes:

...a fascinating new study by Michael Moe, a former Merrill Lynch & Co. education-stock analyst who now runs ThinkEquity, a boutique investment firm in San Francisco. Like all the best research, Moe's was elegantly simple. He compiled a list of the 20 stocks whose share prices increased the most for the 10 years ended Dec. 31, 2001.

Fourteen of the 20 companies were in high technology, nearly all of them benefiting from the Internet boom. No. 1 on the list was Dell Computer Corp., whose sales have increased from less than $1 billion to more than $30 billion in a decade...No. 2 Emulex makes sophisticated connected connectors that speed the storage of electronic data. No. 8 Cisco Systems Inc. is the prime manufacturer of Internet infrastructure. Other well-known tech names on the list include EMC Corp. (4), Applied Materials Inc. (5), Oracle Corp. (6) and Maxim Integrated Products (10). The performance of the 20 stocks was astronomical...an investment [in Dell] of $1,000 grew to $79,900 in 10 years...Even the No. 19 stock, Intel Corp., rose 1,668 percent -- not including dividends, which alone rose by a factor of 10...For example, Analog Devices Inc., a chipmaker that finished 15th in Moe's survey, was a 24-bagger over the past decade even though its price dropped by more than half from mid-2000 to the end of 2001...

The results of this study are interesting for two reasons:

1) We've all heard about Dell's stellar returns the past decade. But who knew that the top ten or twenty stocks with the highest returns were the gorillas, like Cisco, Oracle and Intel, and kings, like EMC and Emulex, that won their gorilladom or kingdom over the past decade?

2) Who knew that even after the worst of the carnage of the tech bear market, these gorillas and kings still dominate the lists of the top ten or top twenty stocks with highest returns?

Lesson: Based on past experience, rising gorillas and kings (along with other tech companies in growth markets with strong competitive advantages like Dell) will potentially be our best long-term investments -- even through a tech down-cycle.

...In his 1989 book, "One Up on Wall Street" Peter Lynch referred to his quest for "tenbaggers"..."In my business," Lynch wrote, "a fourbagger is nice, but a tenbagger is the fiscal equivalent of two home runs and a double." Intelligent investing is a quest not for the companies that will be 50 percent gainers in one year, but for companies that will be tenbaggers in 10 years...

...How do you find such humongous winners? Not simply by scouring balance sheets, cash flows and income statements -- after all, many of these firms don't have much history to examine. Instead, look also for great business ideas, wonderful market niches with little competition and good managers with lots of integrity...

This is an interesting opinion. Before worrying about a lot of accounting details (as important as they may be), it's critical that investors understand the competitive landscape of various industries and find the best business ideas within those competitive landscapes.

I won't say who's right or who's wrong in the valuation debate between Andrew on one side and Mike and Alex on the other (I honestly don't know). However, the line of thinking in this article would seem to support the position that it's more important to do the kind of competitive advantage analysis that Mike and Alex advocate than the valuation analysis that Andrew advocates, at least if you're investing for the long-term (5-10 years plus). The valuation analysis that Andrew advocates can help juice your returns or certainly avoid short-term blunders, but time heals wounds and having the strongest competitive advantage in a growth market appears to be the key driver of high return stocks, at least according to the study mentioned in Glassman's article.

Lesson: Identifying growth industries, understanding their competitive landscapes, and finding the companies with the best ideas and competitive advantages in those growth industries is the key driver of high-return stocks over the long-term (5-10 years).

...Why did the stocks rise? Mainly for the most old-fashioned of reasons: Their profits rose. The average annual increase in earnings per share for the 20 companies was 34 percent; the average annual increase in stock price was 41 percent. Again, this is just what you would expect...Oracle stock has risen an average of 43 percent a year because its earnings have risen an average of 42 percent a year...

...But what do these huge winners tell us about price-to-earnings (P/E) ratios? "What's interesting," write Moe in a letter to his clients, "is that the average P/E of the top 20 [stocks] was almost 30 at the beginning of the 10-year period." In fact, six of the companies had P/Es in 1991 that were over 40. A reasonable conclusion is that a high P/E is no reason to eliminate a stock. By the way, average P/Es rose to 48 by 2001, an indication that investors still think these firms will do well in the years ahead...

Andrew has been an advocate of more detailed and useful valuation techniques than simple P/E ratios (some of which I'll admit I'm still learning about). However, this study would seem to indicate that some valuation exercises for these kinds of companies can be futile. These companies will appear to be overvalued compared to the market for long periods of time when, in the long-term, they are undervalued. (I personally try to avoid this problem through dollar cost averaging, but that's just me.)

Lesson: Except maybe in the case of extremely overvalued stocks (like QCOM a couple years ago), when selecting the companies with the best ideas in a growth market, you may be better off ignoring valuation if you can invest for the long-term (5-10 years).

...Over the past few years, ridiculing high-tech companies has become a popular sport...Ultimately, stock prices depend on the real-life success of companies themselves. The problem (if you can call it that) with tech was that the companies, being relatively young, were extremely risky. The ratio of losers to winners was high, but the gains of the winners -- for investors with perspicacity and patience -- more than made up for the losses of the losers.

Imagine, for instance, that 10 years ago you had bought a portfolio of 20 technology stocks, investing $1,000 in each. Nineteen of them go broke -- straight to zero -- but one of them is EMC Corp. You buy 80 shares at $12.50 each. The stock undergoes six splits, and at the end of 2001 you own 3,840 shares at $13.44 each. So your $20,000 portfolio has grown in value to more than $52,000...

Although it doesn't directly impinge on the valuation debate, this point is interesting for those of us who worry when we see lots of one- or two-year losers in our portfolios. The Fool has said this before too -- one or two big winners, because their upside is relatively unlimited compared to the downside of your losers, will make up for the losers over time. The example in the study is an extreme case -- only 5% of the portfolio was a winner while 95% went to zero so the portfolio as a whole only doubled over ten years. However, the fact that it doubled under such extreme conditions still supports the point that winners more than make up for losers.

Lesson: When investing in growth industries or tech via the gorilla game or other methods, expect to lose some, maybe more than in other industries or using other methods like value investing. However, your winners should more than make up for your losers over time.

One last point, the study in Glassman's article also noted some of the non-tech winners among the 20 stocks with the greatest return over the past 10 years. They included Best Buy, Harley-Davidson, Eaton Vance, and Clear Channel Communications. For the sake of balance (and in case some of us aren't the great gorilla game or tech investors we think we are), it's probably best to also put some money into other sectors or use other methods (nothing like an index fund for diversification).

Hope this is helpful. Again, this post probably reiterates a lot of what most of us already knew, but it's also helpful to revisit the big picture when bear markets force us to question our investing methods (e.g. valuation) in the short-term. Comments/criticism welcome.

-Inane
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