Rule Breaker Portfolio

Fool Portfolio Report
Thursday, May 29, 1997

by Tom Gardner (TomGardner)


ALEXANDRIA, VA., (May 29, 1997) -- The Fool Portfolio fell nearly a full percentage point today, alongside drops on the S&P 500 and the Nasdaq of 0.37% and 0.51% respectively. America Online and Chevron bucked the trend for us today. Chevron rose $3/4 to $70 7/8. The stock is now up 41% for The Fool Portfolio. AOL rose $5/8 to $55 1/4, and is leading all of our holdings by a good bit. The Big-Blue Triangle is up 660% since entering the portfolio in August, 1994.

On the losing side, 3COM (Nasdaq: COMS) fell back $3 1/4 without a peep of news. Profit-taking is the most reasonable assumption here, with the stock up from $29 since market open on May 1st. Even given today's decline, the networker has risen 64.7% in four weeks. Shazam!

The Fool Portfolio is now up 7.31% for the month of May. We've outpaced the S&P 500 this month, but not the Naz. It'd be almost impossible to beat the Nasdaq, unless you were a proud shareholder of Dell, Intel, Cisco and Microsoft which, along with other networking stocks, have just been on a blistering pace.

Those three stocks do sit in the Cash-King portfolio, about which I inked a Fool Port report a few weeks back (cf. 05/01/97: The Simpleton Leads). The market has had a wonderful month, but I'm pleased to say that the Cash-King portfolio clobbered it again. Heck, our one loud barker, Silicon Graphics, even rose nearly 20%. The best performers for May have been Dell, Cisco, Sun Microsystems, and America Online. Here are the numbers as of market close, May 29th:

Purchase Present Total Company Price Price Gain Dell Computer $16.06 $110.38 +587% Microsoft $47.81 $125.88 +163% Sun Microsystems $12.69 $32.75 +158% Intel $68.25 $163.75 +140% Cisco Systems $27.63 $66.75 +142% America Online $26.56 $55.25 +108% Gap $17.38 $34.25 +97% Hewlett Packard $39.94 $52.25 +31% Texas Instruments $70.94 $91.88 +30% Silicon Graphics $43.25 $18.63 -57% TOTAL n/a n/a +139.9% S&P 500 556 844 +51.8%

Now I'm not back here three weeks later to party down, celebrate, and talk trash about The Wise. By now, good Fool, you know that the S&P 500 returns of 51.8% above have been underperformed by the vast majority of mutual funds. A study we plan to publish later this summer shows that fully 91% of all stock mutual funds have underperformed the S&P 500 over the last five-year period -- making the index fund look sweet, and the cash-heavy-business portfolios sweeter.

You'll be happy to know that, while mediocrity on Wall Street is being paid tens of millions of dollars in management fees, right here in The Motley Fool we've tossed up The Fool Port and The Cash-King Portfolio, which have both dramatically outperformed the S&P 500 during their tenure. These features come to you free, Fool. Got to love that. We hope you'll take the time to tell all of your friends and colleagues, who are loaded up on poor-performing mutual funds, that Foolishness -- which will one day walk about the orb like the sun, shining everywhere -- has presented clean and simple models that are subverting high-priced financial advice.

Again, though, hey I dare not use this space to gloat since the future has a way of toying with pride. Also, it's just not as much fun as taking the time out to build a second portfolio of cash-rich companies. After publishing the report on May 1st, I received a number of e-mails asking if I would suggest investing in these same ten companies at their present prices. This is an excellent question.

Given that the proposed model at the outset restricted out all trading and demanded that the ten stocks be held for a decade, the underlying philosophy says, "Yes." And I still believe in that underlying principle: Very wealthy, very cutting-edge, very enterprising companies have a way of returning their shareholders more and more money, and more.

To make that concept easier to grasp -- carry it over to human beings. Those qualities travel well with individuals. In fact, all of the greatest lessons about business are transferable to the people around us, and vice versa.

People that are greedy, intelligent, clever, disorganized, competitve, bureaucratic, wealthy, adventuresome, leveraged, aloof, etc. Any of these or, can't imagine it but, all of them. One way to train yourself as an investor is to consider how fairly-, over-, or underpriced are the people around you -- at work and at play. You needn't be harsh with this; it just provides you a better context for understanding the businesses out there that people run. People do run them, still.

For example, if you meet a young woman who has made a good deal of money, is fascinated by the newest technology, and dares to aim for progress -- you might want to get in on any private financing she's trying to land.

Conversely, if you meet a young dude who just borrowed from four credit cards to make downpayments on a hot new (depreciating) automobile, and who neatly tucks five LottoBall tickets into his shirt pocket before work each morning, you might want to ask him if, when he incorporates himself, there will be any shares available for borrowing.

People run businesses. The same qualities that make our businesses great, make our people great to invest in. For these reasons, yes, I think the ten-stock Cash-King portfolio is still a buy for someone looking out ten years.

That said, the group was rather technology-heavy, and I'd like to submit a second list of potentially-great investments. As I unveil the second group, the MoneyHeavyportfolio -- a less technology heavy group -- it's important that I lay out some ground rules and then explain broadly the reason behind the ten selections.

The Ground Rules

Just as with the first group, the ten stocks will have cost bases set at today's market-close prices. I'll agree not to make a single trade for ten years -- come heck or high water. Though the market may fall 10% in total over the next ten years, this group will remain untouched by anxious human hands. The portfolio will, thus, hold commission costs down to a minimum (on the order of $100-$150 for the total portfolio at deep discounters) and the structure will require no capital-gains taxes for ten years.

Oftentimes it's the costs associated with investing that ruin the private investor's portfolio.

But what stocks will go in this?

The Chosen Qualities

The stocks that follow have been selected because they represent companies that have posted strong sales and earnings growth over the past five years. They have shown no need to borrow money to support operations. They have more than $300 million in the bank. In many cases, they are showing very aggressive management of their money -- extending payables, reducing receivables, and showing low current ratios, even below 1.0. A low current ration (current assets divided by current liabilities) indicates very aggressive management of cash-flow in operations. That's what I think an investor in the giants should look for.

Additionally, almost all of these companies sell directly through to the consumer, and thus have brand values which I believe the investing community underrates -- sometimes dramatically. Because these companies have a wide range of buyers, they're protected against the loss of any one or few customers.Yesterday's Daily Trouble on GALILEO CORP (Nasdaq: GAEO) rather perfectly showed what happens to even great companies that have few buyers, few sources for distribution. Lose one or two, and blammo! It may take years to heal those wounds. When you're running the football downfield against the Chicago Bears, you want as many strong blockers (buyers) as possible. Billions, if possible.

So this model is rather simple, and duplicable by anyone with access to an S&P Stock Guide and Zacks' Analyst Watch. Simply weed out companies without the $300 million in cash; remove any companies with less than 7% profit margins; strip away any businesses with more long-term debt than cash; and cast very skeptical eyes on any businesses with a high current-ratio. You'll want inventories and accounts receivable as low as possible. Once you add in the consumer-demand element to the equation, you might well end up with a list that looks something like this:

1. Microsoft, $125 7/8

Yep, I'm including Microsoft into this second portfolio as well. Since we opened our digital doors, it's been my position that Microsoft is one of the strongest businesses in the history of man. No great genius on that call. Where I part company with many, though, is that I believe Microsoft is also one of the most dramatically undervalued large-capitalization companies.

With $10 billion in cash, no meaningful debt, with profit margins that run well above 25%, and with a young management team -- Microsoft has the equation of a rapidly growing small company. With the Internet laying before them, Microsoft has the task of creatively and neatly integrating the entire thing into its operating system. They are the spider to the World Wide Web.

True, the stock is trading at what seems an unthinkable multiple. True, MSFT could fall by, heck, 40% over the next eighteen months. And yes, they probably will either have to buy out the Justice Department or split out components of their business. But when you consider the demands for software will shoot through the roof over the next ten years, when you consider how perfectly positioned Microsoft is, when you think on their policy of hiring smart, young people, and when you remember that they have $10 billion in cash supporting their moves today. . . well, I won't try to convince you. It just sits number one on my list.

2. Coca-Cola, $67 1/2

Another giant company trading at a whopping multiple. Heck, are we in the early-70s here, talking "Nifty Fifty" or what? Well, I see two primary differences today. First, because so much of Coke's business is international, it isn't unreasonable to consider them a global mid-cap. It may even be a planetary small-cap, given all the opportunities out there.

Secondly, companies like Coke are managing their capital much more aggressively and intelligently than twenty-five years previous. Drop your eyes on Coke's financials and you'll see a business that has been turning over inventory more rapidly, holding off payments longer, and driving up profit margins consistently over the past decade. Ten years ago, Coke made around 10 cents of profit off every dollar. Today, they turn over 21 cents in profit.

The greater efficiencies and the global opportunities are driving our nation's larger companies to higher valuations these days. Corporate America is taking the message of enterprise all over the planet.

KO is another stock that may, heck, drop 40% over the next eighteen months. The MoneyHeavy portfolio will be carrying it for the next ten years, though.

3. Gillette, $87 3/4

Gillette doesn't seem to fit on this list, with cash down and long-term debt up. But, as one Fool in the office often preaches, the balance sheet is but a snapshot. Precisely, yes. Gillette paid $7.3 billion to acquire Duracell earlier this year. The acquisition adds more 'round the counter stuff for the company to sell. With margins and sales moving higher, Gillette is another international powerhouse that may be overpriced here but that offers the long-term investor a great opportunity.

This is a play on management, margins, and business model -- selling inexpensive stuff that people need to buy regularly.

4. Intel, $163 3/4

David has written and spoken quite eloquently about Intel's business over the past year. I'm excited to be adding this stock to the MoneyHeavy portfolio. Speeding up the PC and multimedia applications can't ever happen enough.

For investors, Intel and Microsoft are the perfect quarreling lovers -- shouting at each other all day and making up before midnight. Intel is the second of four technology companies on this list. They are in an extraordinary competitive position; they are supported by a first-class management team; and they have done a bang-up job of putting themselves in front of the consumer. As long as everyone stays healthy over there, Intel should be trading at the same sort of growth multiple that the other cash-laden, global-growth technology businesses are.

5. Oxford Health Plans, $65 1/8

I needn't talk much about Oxford Health -- particularly given the fact that we want to get this up nearly on time tonight! May I suggest you peruse the Oxford Health folder and read through Greg Markus' excellent coverage of the stock in the Boring Portfolio.

6. Dell Computer, $110 3/8

Yes, the best-performing Cash-King stock finds its way into this portfolio as well. Dell Computer turns over its inventory seemingly overnight; they are managed by their 32-year-old founder and a young, aggressive management team; they have $1.2 billion in cash, a mere $18 million in long-term debt, a tight hold over inventories and receivables -- and yes, a rich valuation. We'll revisit this one in ten years, though. . .when the entire globe is networked into The Motley Fool each day via their Dell (or Compaq, or Gateway, or IBM).

7. Gap, $34 1/4

Here's one that not everyone agrees with. Some say that Gap has saturated the States and that the business has nowhere left to go. Others hate their latest line of clothing and think the nation's youth is turning against it.

The bulls see enormous international opportunities for Gap and celebrate the high-margin familiar Gap shtuff -- from jeans to khakies, button-downs to t-shirts. Don't forget that ole Gap has $622 million in cash and no-debt.

8. Cisco Systems, $66 3/4

Here's another to simply refer to Greg Markus' Boring Portfolio for excellent coverage. Cisco is the premiere networking company on the planet, runs extremely high margins, races into new technologies headlong, has acquired smaller players intelligently, and with $1.1 billion in cash has avoided debt like the plague. One of Cisco's challenges over the next five years is to get themselves in front of the consumer.

9. Johnson & Johnson, $58 7/8

Started over 100 years ago to provide surgical dressings in a medical world where a huge percentage of post-operative patients died from infectious disease, Johnson & Johnson has been a wonderful company for shareholders, employees and customers since its inception. With $2.2 billion in cash and $1.4 billion in debt, it isn't as sturdy as many of the others, but the Company has plenty of opportunity. From Tylenol to Motrin, from Band-Aids to Neutrogena, Johnson & Johnson is the world's largest manufacturer of healthcare products. Margins are on the rise. Consumers love the brand. I'm running out of time! JNJ is in. :)

10. Pioneer Hi-Bred Intl., $69 5/8

Whoa there! Who are these guys?

Well, I had to add one wildcard just to keep things interesting. Pioneer Hi-Bred has been in business since 1927. They started out as an agricultural geneticist -- producing hybrids of corn; they have since moved into genetically-altered sorghum, sunflower and veggies. They are financially-strong, with $333 million in the bank and almost no debt. Over the past five years, the stock has compounded 27% annual growth. I'm adding NYSE:PHB for kicks. I'm so confident the nine stocks above will, as a group, outperform the market over the next decade. It'll just be fun to learn more about Pioneer's business. Here's the web page, for anyone interested: Pioneer Hi-Bred International, Inc. Home Page.

Market View

Are we engaging in the same-ole, same-ole Nifty Fifty approach to investing? When the market really heats up, just buy the biggest companies and expect that they can't go down? Gloss over more careful valuations and buy at any cost?

Well, I think a little of that is good, actually. Buying the right businesses at the wrong price is much more rewarding than buying mediocrity at a great price.

While I don't expect the next ten years to bring the sort of growth that has the last ten, I continue to believe that buying great companies which have proven time and again that they're bent on rewarding their shareholders is a solid strategy for the private investor.

Man, it sure beats churned brokerage accounts or expensively undperforming mutual funds! It'll be good fun keeping an eye on these ten stocks. See you in a decade! :)

Fool on,

Tom Gardner

Evening News -- Nike sweating?
Fool Four -- These giants are... giant.
Boring Portfolio -- Cisco, Oracle and more.
Daily Double -- Why did it double?
Daily Trouble -- Is there value in this beaten down stock?


TODAY'S NUMBERS
Stock Change Bid -------------------- AOL + 5/8 55.25 T - 3/8 36.63 ATCT --- 3.88 CHV + 3/4 70.88 DJT - 1/4 9.75 GM -1 56.75 IOM - 1/2 17.50 KLAC -1 3/4 48.00 LU - 1/2 63.50 MMM - 3/8 92.63 COMS -3 1/4 47.75
Day Month Year History FOOL -0.95% 7.31% 2.85% 174.49% S&P: -0.37% 5.33% 13.95% 84.14% NASDAQ: -0.51% 11.29% 8.68% 94.82% Rec'd # Security In At Now Change 8/5/94 355 AmOnline 7.27 55.25 659.97% 5/17/95 980 Iomega Cor 2.52 17.50 594.44% 8/12/96 110 Minn M&M 65.68 92.63 41.03% 8/11/95 125 Chevron 50.28 70.88 40.95% 10/1/96 42 LucentTech 47.62 63.50 33.36% 8/12/96 280 Gen'l Moto 51.97 56.75 9.19% 8/24/95 130 KLA Tencor 44.71 48.00 7.36% 8/13/96 250 3Com Corp. 46.86 47.75 1.90% 8/12/96 130 AT&T 39.58 36.63 -7.46% 4/30/97 -1170 *Trump* 8.47 9.75 -15.13% 10/22/96 600 ATC Comm. 22.94 3.88 -83.11% Rec'd # Security In At Value Change 8/5/94 355 AmOnline 2581.87 19613.75 $17031.88 5/17/95 980 Iomega Cor 2594.53 17150.00 $14555.47 8/12/96 110 Minn M&M 7224.44 10188.75 $2964.31 8/11/95 125 Chevron 6285.61 8859.38 $2573.77 8/12/96 280 Gen'l Moto 14552.49 15890.00 $1337.51 10/1/96 42 LucentTech 1999.88 2667.00 $667.12 8/24/95 130 KLA Tencor 5812.49 6240.00 $427.51 8/13/96 250 3Com Corp. 11714.99 11937.50 $222.51 8/12/96 130 AT&T 5145.11 4761.25 -$383.86 4/30/97 -1170*Trump* -9908.50 -11407.50 -$1499.00 10/22/96 600 ATC Comm. 13761.50 2325.00-$11436.50 CASH $49020.02 TOTAL $137245.15








Note
The Fool Portfolio was launched on August 5, 1994, with $50,000. It was renamed the Rule Breaker Portfolio in October 1998. The investing strategy began with the first investments of the Fool Port and has evolved with time and experience. In July 2001, the portfolio began adding $12,500 each quarter (We missed Jan. 2002, so we added $25,000 in April 2002). We skip a quarter if we have enough uninvested cash or cash available in stocks we would prefer to sell to make new investments. All transactions are shared and explained publicly before being made, and returns are compared in each week's column to the S&P 500 (including dividends where noted) and the Nasdaq composite. For a history of all transactions, please click here.