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Author: repoonsatad Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 18386  
Subject: The Rule-Maker flaw Date: 3/7/2001 3:23 AM
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I stumbled upon a message from the rule maker seminar:

I think that Pepsi has been long regarded as a somewhat inferior caddy to Rule Maker portfolio holding Coca-Cola (KO), but I have come to the conclusion that Pepsi is an amazing company that has a good chance of outperforming Coca-Cola in this century.
http://boards.fool.com/Message.asp?mid=14485321&sort=postdate

In my opinion the above quote illustrates the fundamental flaw of rule maker investing. Coca-Cola was picked by the rule maker portfolio on 2/27/98, more than three years ago at an adjusted $68.62. By today the stock has dropped to $49.80. During the same period of time Pepsi has risen from $36.26 to $45.81. The flaw is that Coca-cola looked great in 1998 based on the rule maker criteria that ignore valuation. I'm sure Coca-Cola looked good to many investors as a company back then and thus was richly valued in the market. Pepsi may have looked comparatively worse than Coca-Cola more than three years ago and thus was awarded relatively lower valuation by the market. During the past three years Pepsi may have improved as a company compared to Coca-Cola or it may not but because of its lower historical valuation PEP the stock has outperformed KO. The above quote suggests that some investors think Pepsi the company has indeed improved and thus it makes sense that Pepsi has received a substantially higher valuation in the market relative to Coca-Cola over the past three years. Unfortunately, whether PEP will outperform KO in the future depends on the current valuation relative to the future valuation and obviously the current valuation plays a major role. Because the rule maker approach doesn't deal with valuation it's unlikely to provide guidance for future winners in terms of stock returns. Pepsi the company may look good today compared to KO but may therefore already be priced so that PEP the stock will underperform KO in the future.

If you (like me approximately) believe that most companies are fairly priced in the market it's hard to find companies that will outperform in the market in the future. Thus rule makers will perform no worse than the market (in risk-adjusted terms obviously). If you believe there are frequent inefficiencies so that some stocks are undervalued in the market, some overvalued I submit that stocks that look good by criteria like the rule maker are likely overvalued in the market (like KO three years ago) and thus will underperform in the future while stocks that look worse (like Pepsi three years ago) are likely undervalued and thus will outperform in the future. There's no way I can imagine that good-looking stock with rich valuations (like rule makers) are undervalued in the market and worse looking companies are overvalued.

Suppose you can buy the Lakers or the Bulls. Looking at rule maker like criteria it's a no-brainer that the Lakers look best. However the valuations may be such that the Bulls is a superior investment for the future. To understand why consider that the Bulls looked like the current Lakers a few years ago. To outperform in the future you want to determine whether the Bulls of the Clippers (none of which are rule makers) is the team of the future based on your forward-looking skills. This is what the rule breaker portfolio is trying to get at but I'm not sure they have the right approach.

Datasnooper.
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