BI > JUNE 2002

When Rear-View Mirrors Smoke

Stay the Course – Expect Reasonable Valuations

"Here I need to remind you about the definition of 'investing,' which though simple is often forgotten. Investing is laying out money today to receive more money tomorrow." -- Warren Buffett, chairman & CEO, Berkshire Hathaway, quoted in Fortune, Dec. 12, 2001.

What's one of the more profound forecasting errors that we can make on NAIC Stock Selection Guides? Warren Buffett provides a clue in that same Fortune article: "The answer lies in the mistake that investors repeatedly make -- a psychological force where people are habitually guided by the rear-view mirror and, for the most part, by the vistas immediately behind them."

Can you imagine driving your car with nothing other than what you see in your rear-view mirror to guide you? Ever tried it?

On second thought, please don't try this at home. But I'm fairly certain the operator in front of me this morning was using something other than the view via the windshield to select direction. The windshield is a wonderful invention. So is looking forward.

The Construction of Expectations

NAIC investors build expectations for our investments. We characterize those expectations in terms of things like projected average returns.

Our forecasts center on growth and profitability. We examine history for consistency and credibility and make assumptions about future opportunity. We rely on management to recognize and capitalize on opportunity in the form of growth and sustained profitability. The decisions that we make about future growth and profitability ultimately lead to an assessment of expected valuation. This expected valuation is often based on a comparison to industry peers and the track record we know as Section 3 of our Stock Selection Guides.

The decisions that we make in Section 4, with respect to future valuations (P/E ratios), are influenced by the findings in Section 3. Our NAIC educators encourage members to observe the results in Section 3 but to carefully consider the expectations for high (and average) P/E ratios as price forecasts are built in Sections 4 and 5. Our P/E expectations should necessarily include an awareness of expected growth rates, particularly when growth is expected to slow. A company that has grown at 20 percent per year that is expected to grow at 13 percent will generally experience lower P/E ratios going forward.

The use of relative value (the comparison of current P/E to a company's 5-year trailing average P/E) and the historical P/E profile delivered by Section 3 doesn't necessarily prepare you for that.

When Windshields Crack

We know that markets naturally erupt into periods of momentum-driven irrationality. The psychological force is immense and reliable, and cuts both ways. When the pendulum swings into a range of relative overvaluation (visible as reduced projected average returns on our SSGs), the herd can't find a stock that it doesn't like. When the pendulum swings just as mightily in the other direction and all investors seem to manufacture reasons to avoid stocks with attractive projected average returns.

With the passing of each eruption, investors promise themselves that they'll learn how to deal with the next eruption. When the inevitable eruption subsides again, we promise to "behave better" the next time.

Motley Fool David Gardner once observed, "Most people who analyze stocks use a rear-view mirror. I call it losing track of the road. Focus on the future, not the past. Go against the 'what have you done for me lately' perspective of human nature. Watch the road ahead."

What happens when the psychology has erupted and our rear-view mirrors start to smoke? The 5-year average trailing P/E of 2001 Growth Company of the Year, Bed Bath & Beyond, is 34.7x. Bed, Bath & Beyond is clearly a quality company and has an admirable track record. What are your expectations for a reasonable future average P/E for the company?

The 5-year average trailing P/E of current BI Top 100 most widely held stock, Intel, was 11.8x in 1995. The average P/E in 2000 was 36.1x. Was Intel's relative value in 1995 a potentially misleading roadblock? Might current relative values be dangerously misleading and prey to the very powerful psychology that we seek to avoid?

Behave better. Stick to the discipline of strategic long-term investing based on considered expectations for future valuations. It doesn't matter which way the pendulum is swinging. Stay the course.

Mark Robertson is director of online resources and senior contributing editor for BetterInvesting. He serves as a member of BetterInvesting Magazine's Editorial Advisory & Securities Review Committee. Mark can be reached at Robertson_Mark@comcast.net.