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Well, I guess the Rule Maker board has the misfortune to get this post.

I have been very actively reading many areas of TMF for two years. I used to be much more active on the RM board until my attention was drawn to mechanical investing. Then, I had personal distractions that kept me away from the computer for several months. I returned in earnest about 6 months ago via the Retirement Seminar, and I just finished as a co-leader in the Beginning Investment Seminar. I decided I needed to catch up on the RM board as well. I guess I shouldn't have been surprised at the tone of the conversation.

As the stock market has gone down and down and down, the criticism of TMF has gone up and up and up. The criticism is throughout the TMF site. I just don't understand. Did TMF ever promise that the bull market would continue unabated forever? Did TMF say that we each should mimic the RM portfolio? Did TMF ever say that the RM approach was the best? Infallible? TMF did state the belief that the RM approach would beat the market and, at first, it did. Now, this belief is seriously questioned, and rightly so. The whole concept of QuaVA is seriously questioned, and rightly so. But does this justify criticism of TMF in general? Of criticism of the Gardners? I think not. Please don't misinterpret me. I wholeheartedly embrace constructive criticism. It is vital to progress in any endeavor. Constructive criticism of the RM approach is helpful and necessary to accurately determine its validity as an investment approach. Several Fools have posted very insightful questions and appropriate criticisms of TMF- your input is highly valued. Others, however, have posted pot shots and unwarranted derogatory comments. Why?

"Why" is difficult to answer, but my own opinion is that some people do not want to take responsibility for their own actions. The stock market has tanked, and some people need to blame anyone other than those responsible for their investments- themselves. It is much easier to blame someone else for leading them down the primrose path to investment success than to accept responsibility oneself. Well, there is no one to blame but ourselves. I was convinced that QuaVa was a legitmate concept, and I have paid a heavy price for that belief during the past year. Whose fault is this? Mine. TMF did not force me to accept the RM approach. In fact, I read rather extensively in other sources. I am a member of the AAII (American Association of Individual Investors), and I took one of their valuation seminars. I assimilated all the information and made my own choices. Do I resent TMF because my investments have done poorly? Absolutely not.

I applaud TMF for fulfilling its mission to "educate, amuse, and enrich." TMF has educated thousands of people on how to prepare to invest by eliminating debt and decreasing living expenses. Simply describing IRAs to people without them has been financially transformative. Promoting index mutual funds to those who have never invested before is laudatory and commendable.

TMF has always stressed, "Do your own research. Don't mimic us." In other words, take responsibility for your own actions. Has TMF made mistakes? Definitely. Will they make more mistakes in the future? Definitely. Is TMF responsible for the market or any individual financial success or failure? Definitely not.

Do I have blind faith in TMF and support it at all costs? No way. I'm critical and will certainly argue when I disagree.

Educated, amused, and enriched,

Doug
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No. of Recommendations: 30
TMF truly does provide a valuable service to the public in terms of educating them, amusing them, and hopefully enriching them. Before I learned about TMF I thought that someone should do what it does, which is to encourage people to take control of their finances...a worthy cause.

However, TMF was itself very critical of the investment industry, and pushed very hard on the idea that anyone could beat the professionals, and beat the market consistently, with their brain tied behind their back. One only has to read TMF Investment Guide to confirm that this was the attitude.

So when the RM portfolio falls behind the S&P by 27%, is it not likely that similar criticism will be invited upon TMF? Not only that, but it is if you got in at inception that you would be 27% down on the index - I'm not sure how much you would be down if you were unlucky enough to start more recently, before the latest NASDAQ plummetting, or perhaps in March of 2000?

Thus, I feel it is fair game to question, and criticize constructively the rule maker strategy (despite the rather negative reaction one gets if one says anything bad about TMF or the RM Portfolio). The point being missed is that the rule maker selection criteria should select stocks that will rise to the top in adverse conditions, because the criteria should select excellent companies. So, why is this not the case at the present time? I have some ideas if anyone is open to a sensible debate on the issue, and is able to discuss possible flaws in the RM strategy without taking critical comments as personal afronts.

If I were to propose a possible flaw in the RM theory, it would be that the criteria lead to very good companies indeed...so good in fact, that everyone wants to own them...and the result is that the prices of these stocks get driven up to unrealistic levels, from which they must inevitably plummet. Inevitably.

I mean, look at the companies in the RM portfolio...look at the P/E ratios on some of them, even now (Yahoo!, for example). Stocks can trade at levels where there is no hope of the company ever meeting the expectations, no matter how low its debt or how high its margins. The RM portfolio then becomes a victim of its own success.

The other thing I find rather strange about the RM stocks is that they are the obvious ones, the Intels, Microsofts, Yahoos!, American Excesses, etc. Meanwhile, there are some great companies out there that are reasonably valued, and have many of the characteristics of a RM stock, but do not get selected. (Tellabs for example)

This situation is all too familiar...it parallels the way mutual funds are managed...buy the big names, ignore the less glamorous, but no less financially solid, lesser known companies. In this way TMF seems to have fallen into the same trap as the professionals whom it so eloquently mocked and derided earlier in its existence.

I am in Canada, and believe me, I've seen it happen here too...look at the Nortel fiasco...there is no way that stock should have been trading above about $20 US, even with their growth projections of 25-30%/year...at least not if an investor wanted to see a doubling in value in five years (I'm talking intrinsic value here, not the hype, fear, and greed driven market price value.) Yet it went to about $80 US, and when it dropped to $40 everyone was recommending it as a buying opportunity. No one looked at the fact that the earnings were small to non-existent...

I tend to use discounted future earnings to estimate the future intrinsic value of stocks, along the lines of Warren Buffett's approach as discussed in the books "The Warren Buffett Way" and "Buffettology". Using that approach, there aren't many stocks in the RM portfolio that will double in intrinsic value in five years, given current growth rate projections, if bought at current prices (and if bought before the recent crash, good luck at breaking even). Of course, they may double or go back up ten times in stock market price terms, but if so they will be trading on pure hype and not on the underlying value of the company. If so, there's no need for the Rule Maker rules, just be a momentum investor.

Now, before signing off, let me clarify a couple of things -

- I don't follow the Rule Maker approach, and I know TMF is not holding a gun to my head to do so.
- I can handle the losses I have incurred in investing and am not being critical of the RM due to any losses as a result of using its rules (because I don't use them, have no intention of using them, am actually ahead of the index, and would only touch two of the stocks in the portfolio: Nokia and Intel, anyway)
- I am a fan of TMF, I recommend the books and website to my friends.
- I would enjoy an an inteligent debate on how the RM rules might be modified so that success (defined as beating the index consistently over the long term) might be obtained

Any comments?

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Thus, I feel it is fair game to question, and criticize constructively the rule maker strategy (despite the rather negative reaction one gets if one says anything bad about TMF or the RM Portfolio).

Absolutely correct, and I couldn't agree with you more. I was being critical of generalized, unwarranted, unhelpful, and, at times, almost personal criticism towards TMF, and not just on the RM board. I was thrilled to read the rest of your comments, because you offer very valid and thoughtful criticism of the RM strategy.

If I were to propose a possible flaw in the RM theory, it would be that the criteria lead to very good companies indeed...so good in fact, that everyone wants to own them...and the result is that the prices of these stocks get driven up to unrealistic levels, from which they must inevitably plummet. Inevitably.

Very interesting concept which raises several issues. First, RM used to require companies with at least $1 billion in annual sales (YHOO was an exception). Is this still true? Could RM criteria be applied to smaller, less well known companies. There was some investigation into "Mini-makers" in the RM area in September 1999, Part 1 http://www.fool.com/portfolios/rulemaker/1999/rulemaker990915.htm and Part 2 (I couldn't get the link for Part 2 to come up). These might be good to review as a starting point. Second, I think any legitimate criteria used to find excellent companies are subject to the momentum effect and inevitable stock price correction. This phenomenon is not unique to RM criteria. So finally, there might be a need to reconcile LTBH philosophy with a need to sell at some point. This is extremely difficult and starts to raise market timing issues. Personally, I lean heavily towards LTBH, and if valuations become very high, then I would not add to my position or perhaps sell some at a pre-determined time (ie annually) for asset allocation purposes.

This situation is all too familiar...it parallels the way mutual funds are managed...buy the big names, ignore the less glamorous, but no less financially solid, lesser known companies. In this way TMF seems to have fallen into the same trap as the professionals whom it so eloquently mocked and derided earlier in its existence.

I agree. But as I suggested above, perhaps the RM criteria can be slightly modified and applied to the lesser known companies. If successful, this may validate portions of the RM method of company analysis. This is a key point- that the main purpose of the RM portfolio is to educate about company analysis.

No question TMF would prefer that the RM portfolio was beating the overall market. But is the RM port a realistic portfolio for the average investor? In other words, has TMF suggested that holding only RMs is an appropriate diversified portfolio with no other holdings? Maybe TMF did state this, but I can't find the reference. I certainly didn't interpret it that way. I have little sympathy for investors who just mimicked the RM port without consideration of valuation, risk, or asset allocation. I still believe that there is a place for some RMs in a portfolio, and I would agree with you about NOK and INTC, especially at these prices. I also think there is a place for index funds, bonds, and individual small to mid cap companies.

Ron, thanks again for your very constructive comments. I hope that others will follow your lead.

Doug



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The idea of finding emerging rulemakers at good prices it seems to me would have a greater possibility of long term success in a sufficiently diversified portfolio (there would no doubt be a higher percentage of bombs as well!). Instead of 8-10 companies what would be a more adequate number of holdings?
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I think The Fool does a good job at educating beginning investors on how to invest for themselves. They should stick to that and not try and sell them an unproven "teaching strategy".

"Buy our Rule Maker Seminar for only $49 and learn how to beat the market! Nevermind that our RM portfolio has underperformed the market for the last three years. Oh, and that our RM strategy changes all the time (2x5y anyone?). So you'll probably have to take this seminar again next year."

Instead of trying to emphasize their own investment strategies, they should be emphasizing the strategies of investors who've actually done well. People like Buffett, Lynch, Graham, Fisher, etc. These guys have PROVEN investment strategies that actually work. Why reinvent the wheel?

I would rather learn from these guys than from The Fool any day.

All the best,

CashPhlo
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Instead of 8-10 companies what would be a more adequate number of holdings?

I'm not sure I understand your question. Are you saying that buying 20 potential RMs gives you a better chance for finding successful companies and that these will outweigh the negative impact of more bombs? If so, I'm not sure I would agree. You could continue that argument on and on until you ended up owning an index fund. OTOH, refining the RM criteria, applying them to smaller companies, lesser known companies, etc. may improve performance without having to move to a larger number of holdings. Also, I guess I'm more conservative than many around here in that I like to maintain diversity through index funds. Then, diversity is not a big consideration for me when evaluating individual stocks.

Doug
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Buy our Rule Maker Seminar for only $49 and learn how to beat the market! Nevermind that our RM portfolio has underperformed the market for the last three years.

Good point. TMF shouldn't make this claim.

Oh, and that our RM strategy changes all the time (2x5y anyone?). So you'll probably have to take this seminar again next year.

What's wrong with change? It would be foolish for the RM approach not to evolve as parts of it are found to be useful and others not. Besides, there have not yet been any fundamental changes in the RM strategy, just some tweaks IMO. Now, if QuaVa goes by the wayside, then that would be a big philosophical change.

Instead of trying to emphasize their own investment strategies, they should be emphasizing the strategies of investors who've actually done well. People like Buffett, Lynch, Graham, Fisher, etc. These guys have PROVEN investment strategies that actually work. Why reinvent the wheel?

I guess this is human nature. We always believe that we can improve on existing methods. Wheels were definitely improved when the switch was made from solid construction to vulcanized rubber. There was another improvement when tubes were replaced by tubeless tires, then along came radials, and now we have puncture resistant tires. If wheels hadn't been reinvented several times, then little progress would have been made in automobile transportation.

So, can you suggest some of the specific methods of the successful investors you mentioned and how those might be incorporated into RM strategy? That might generate some really useful ideas.

Doug


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So, can you suggest some of the specific methods of the successful investors you mentioned and how those might be incorporated into RM strategy? That might generate some really useful ideas.



Many of their strategies are too in-depth to list in one or two posts. But they are in the public record (e.g., books, letters to shareholders, articles on websites, newspapers, and magazines). One main theme that runs through all of their strategies is valuation. I and many others have criticized the RM strategy for deemphasizing valuation. Now they seem to be finally addressing it. Again, I don't see anything wrong with TMF having an experimental portfolio to see what might work and what doesn't. But I think it is disingenious to try to sell the strategy as if it is proven and works.

But that is what is great about this country. You can choose to believe or not to believe whatever you want. I choose not to follow the RM strategy because I have learned strategies that are far superior and proven. Like TMF, I am still learning. But unlike TMF, I am not selling my expertise while continuing my education.

All the best,

CashPhlo
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CashPhlo,

No question valuation is gaining popularity in RM area. Several long threads on this recently. I wanted to ask you about price/book value ratio, but I started a new thread. http://boards.fool.com/Message.asp?mid=14474528 What are your thoughts?

Doug
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Ron, you get a rec just for mentioning Tellabs.

: )

If I could, I'd give you more. Excellent post.

Zarley
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Thank you, and thanks to everyone who liked the original message. It has been a few days since I've been able to get back to this and read some of the postings.

Some of the ideas posted were just what I had in mind, ie.

1) Look for emerging Rule Makers
2) Apply some valuation criteria
3) Consider making an exit strategy part of the Rules

Actually, I think these three things are all linked together, or at least 2) and 3) are - I would think the appropriate time to sell a stock would be when its valuation cannot support the price it is trading at...and a nice place to start is to assume you want the intrinsic value of the stock to double in 5 years (hopefully the stock's market price will follow suit). In order for that to happen, the earnings stream over the next five years must equal the current stock price. Therefore, a $10 stock needs to have $10 in earnings over the next 5 years. If it is currently earning $1 per share, it must have an earnings growth rate of about 35% (Earnings stream = $1.00 + $1.35 + $1.83 + $2.47 + $3.35 = $10). I'm ignoring whether the stock pays out dividends, and discounting of these future earnings amounts, for simplicity.

There is reason to believe that a stock with a current P/E of 10, such as this one, and a 35% earnings growth would do very well indeed. For one thing it would have a PEG ratio of about 0.3. The market would likely immediately drive the price of this stock up to about $35, or a PEG of 1, if the stock existed. (And there may be some out there).

Another caution is it seems unlikely a stock could maintain 35% growth year over year for five years.

Regarding exit...similar calculations can be done to show that a stock with a P/E of say 35, and an earnings growth rate of say 10% takes about 16 years to double its intrinsic value...therefore it should be eliminated if one wants a fairly secure bet on doubling in 5 years.

Applying criteria such as this narrows the list of stocks that make the 2x5y goal down dramatically. Of course, the market may choose to price stocks much higher than their intrinsic value. But, using conservative valuation criteria at least allows one to sleep at night when the market turns nasty, as it has recently.

Have to run for now...Ron
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Excellent post. I just finished reading "RM, Rule Breakers." I found a number of interesting ideas on rating the quality of companies. At the end of the book, I had to ask, "What about valuation?"

With this in mind, I came to the site & reviewed the boards. I agree with your post.

Personally, my answer is simple. I'll look at the companies identified by the RM screen, then apply NAIC stock selection guide to them. If they pass, I may buy (after considering my diversity needs). If not, I'm on the sidelines.

Of the rulemakers, Intel begins to look interesting from a valuation standard. Sun may also fall also into a buy range. I recently bought TLAB, and agree that it has many characteristics of a rulemaker.

Fool on!


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