Rule Breaker Portfolio

Fool Portfolio Report
Thursday, September 4, 1997

by Tom Gardner (TomG@fool.com)


ALEXANDRIA, VA (Sept. 4, 1997) -- The Fool Portfolio skipped right alongside the S&P 500 today, both posting gains of 0.33%. Our account was carried by the $1 9/16 gain from America Online and the $3/8 gain from Iomega. Time and time again, our two best-performing investments have continued rising on the strength of their business. The best have gotten better. Apologies to those of you who don't follow football, but the same simple theory holds true in the NFL.

Tune into the National Football League, and you'll find many of the same dynasties gaining momentum as they dominate. If you'd put a stop-loss on the Pittsburgh Steelers in 1976, "getting out" of steel-curtain shares during their first loss after the Super Bowl win in 1975, you would've missed out on greatness. They won three of the next four world championships. Not every great pro-football team gets greater. But enough do that you should be skeptical of their naysayers.

I'm going to leave the football comparison in a second, but success in American business is like a winning NFL franchise in a second way - greatness in both relies on superior management. Consider the performance of the New York Jets this past Sunday. After losing 15 of 16 games last year, the team signed Bill Parcells - the best coach in the game - to "manage" their team in 1997. What happened in game one a few days back? Parcells led the NY Jets to a 41-3 victory over the Seattle Seahawks. Five-star coaching wins games, creates excellent season records, and leads eventually to decade-long domination.

That makes sense but, getting back to stocks, you might be asking yourself, "How am I to adjudge the merits of my company's management team?"

Do you have to stand outside of corporate headquarters hoping to come upon an executive leaving for a midday walk? In between enduring a tongue-lashing from your boss (a nod to Dilbert), an emergency phone call about your daughter's behavior in KinderMusic class, and your ever-expanding e-mail obligations -- should you be expected to phone company management and chat with them about the vision thing?

You can't do all that, but I'd like a chance to convince you that one simple balance-sheet ratio can set you on a path to rightly assessing your management team. We have named it -- in our next book due out in January -- The Foolish Flow Ratio, and readers of the Cash-King folder on the Web have been working with it through the summer. The Foolish Flow Ratio measures the flow of products out of a business and the concurrent flow of cash into a business. Tennis shoes out, cash receipts in. Computer software boxed and sent, cash from distributors flowing back to the seller. The nice thing about the Flow Ratio is that your daughter, nephew, or great-grandson (over the age of 10) could complete the tasks necessary to its calculation. (Aside: If your ten-year-old daughter, nephew, or great grandson isn't yet investing, uh-oh, that's a mistake -- head to The Family Fool.)

Well, okay, what is the Flow Ratio? Ladies and Gentlemen, here it is:

Current assets minus cash _____________________ = The Flow Ratio Current liabilities

Let's take an example. We'll start with Dell Computer in June, 1997 - noting that, over the past three months, their stock has risen over 50% versus S&P 500 gains of 10%. Let's run the numbers and then ponder what they mean.

Dell Computer on 06/01/97 Cash$1.35 billion Current Assets$2.74 billion Current Liabilities $1.66 bilion $2.74 - $1.35 The Flow = ___________ $1.66 1.39 The Flow = ____ 1.66 The Flow = 0.837

I haven't done much explaining. Thus far, the most interesting piece of research is that Dell Computer has risen over 50% in three months. But does their Flow Ratio in June have anything to do with that? It's certainly too short of a time period, but it's useful data nonetheless. Let's consider what The Flow does, step by step.

By removing cash from current assets, we've honed our sights on two primary components of current assets: inventories and accounts receivable. But are these really "assets"? Are these strengths? I don't think they are. A high inventory count indicates a lot of stuff that your company hasn't yet sold. Whether the items are high on a warehouse shelf in finished form or moving around a workshop floor as raw materials, they aren't bringing in the money. They aren't yet directing profits back to shareholders. Beyond inventories are accounts receivable, and hey, there's another bonafide liability. Receivables represent product "loans" -- personal computers sold to distributors in Thailand who haven't yet made their payments to your business. That "cash outstanding," listed as an asset, is actually a liability. Your company has loaned product to a customer, banking on payment in the weeks or months ahead. Your company doesn't have the cash yet.

So, when we have subtracted out the cash from current assets, we're left with detrimental assets. If cash truly is king, then current assets are fiendish and foul knaves.

Conversely, the denominator of The Flow Ratio measures outstanding payments that your company hasn't yet made. Let's say you've invested in Froosh, mixer and retailer of fruit sorbet. If current liabilities are high, then your company team has the ice, sugar, and natural fruit juice to blend and freeze their sorbet, but they haven't yet paid for those materials. Meanwhile, they're selling half-pints through to distributors and getting cash for it. So, to restate, inventory is coming in -- in the form of ice, sugar, and juice - -but cash hasn't yet headed out the door. In a competitive business world where cash is king, outstanding payments are listed as a liability, but instead are an asset.

Whoa there, wait one second. The Fool is not championing those companies that violate contracts by paying bills past due. We've suffered that unprofessional treatment by a partner or two, and that's a damage to their reputation, not a business strength. But what we are celebrating are those companies that have the authority to contract longer pay periods with their suppliers and shorter pay periods with their distributors. Think about that for a second. It simply means that we like to find sorbet companies that don't have to pay upfront for their materials but that get paid upfront by mini-marts across the country because their sorbet is in such great demand. If that's not clear, consider Dell Computer in June, 1997.

Dell Computer on 06/01/97 Current Assets less Cash$1.39 billion Current Liabilities $1.66 bilion

What does this indicate? Here are some reasonable inferences. Dell very aggressively assembles inventory and gets it out the door (low inventory). Dell demands speedy payments from customers (low receivables). Because Dell's machines are so popular, they can buy time on payments to suppliers (high payables, or high current liabities). The result is that Dell has very large amounts of cash rapidly flowing into the business as they fight to slow the flow of cash out of their business.

Ok, if you're with me this far, you might be asking, "If Dell's Flow Ratio of 0.837 is excellent and, in some way, contributed to the latest 50% run (and the 980% growth in the value of the company since August, 1995), what's a poor Flow Ratio?

To my eye:

Any Flow Ratio below 1.00 reflects a company that appears to be very aggressively managed and whose products are in great demand. Conversely, any Flow Ratio above 2.00 reflects a company that appears to be managed sloppily and whose products aren't coveted.

On this basis, I constructed the MoneyHeavy Portfolio in May, 1997. And under similar pretenses, I built the Cash-King Portfolio in July, 1995. I sought out companies that manage their cash aggressively, that work hard to sell superior products rapidly, and that do not "book" substantial amounts of sales unless they've received cash payment for them (i.e. have low accounts receivable). Below, I list the performance since inception of these portfolios relative to the S&P 500, and I do so to provide objective numerical accountability for a model that I believe in.

Since July, 1995 Since May, 1997 Cash-King +227% MoneyHeavy +17% S&P 500 +67% S&P 500 +10%

Is The Flow Ratio the only thing I used to evaluate these businesses - is it all-powerful? Certainly not. But this balance-sheet ratio will concentrate your attention on your company's long-term gameplan, on what frame or model they've constructed for their business. Conversely, your focus on the income statement and on analysts' earnings estimates will reveal your company's short-term operational might. Put another way, the shorter your investment horizon, the more intently and immediately you should attend to quarterly earnings reports. And the longer your horizon, the more emphasis you should place on the sturdiness of the balance sheet -- on how well your company collects cash, on how attractive is its product line, on how hungry is your company's chief financial officer.

Now, let me restate that The Flow is not an all-powerful model. It doesn't account for long-term debt nor for cash. And it doesn't reflect the direction of a company's balance sheet. If a low Flow Ratio is ideal, well, which is better:

a) a company whose Flow has risen from 1.10 to 1.40
b) a company whose Flow has fallen from 2.49 to 1.72

Direction is more important than location, and The Flow Ratio acts only as a snapshot of the financial location of a company.

And finally, the Flow Ratio doesn't directly recognize new products, research & development success, brandname value, new management, et al. On its own, it is a weak model (as many are in the financial world). But it does provide clues to a company's present standing and financial gameplan. Many of our greatest corporations -- from Coca-Cola to Microsoft to Intel and Schering Plough -- have low Flow Ratios. Oppositely, a number of wounded companies -- from Sunglass Hut to Bombay Company to GranCare Inc and Digi International - have notably high Flow Ratios.

Flow Ratios for Fool Portfolio stocks will not help you answer questions about these investments but will put you into position to ask intelligent questions about them. Are inventories being sufficiently managed at 3Com? Can Innovex be more aggressive in its collection of international receivables? Is America Online one of our nation's top-tier businesses? Good luck in your search for answers. And. . .

Fool on!

Tom Gardner

P.S. If you are thoroughly confused after this report (or genuinely interested), drop by our Cash-King folder on the Web and post your questions and comments.

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TODAY'S NUMBERS
Stock Change Bid ---------------- AOL +1 9/16 70.31 T + 3/16 40.00 ATCT + 1/4 4.38 CHV - 5/16 79.88 DJT + 3/8 11.56 GM + 5/16 65.50 INVX -1 1/8 31.69 IOM + 3/8 28.13 KLAC + 1/8 71.75 LU +1 11/16 82.13 MMM + 1/8 92.50 COMS + 3/8 49.00
Day Month Year History FOOL +0.33% 3.55% 20.85% 222.54% S&P: +0.33% 3.49% 25.67% 103.07% NASDAQ: +0.40% 2.35% 25.84% 125.59% Rec'd # Security In At Now Change 5/17/95 980 Iomega Cor 2.52 28.13 1016.07% 8/5/94 355 AmOnline 7.27 70.31 867.16% 10/1/96 42 LucentTech 47.62 82.13 72.47% 8/24/95 130 KLA-Tencor 44.71 71.75 60.47% 8/11/95 125 Chevron 50.28 79.88 58.84% 8/12/96 110 Minn M&M 65.68 92.50 40.84% 8/12/96 280 Gen'l Moto 51.97 65.50 26.03% 6/26/97 325 Innovex 27.71 31.69 14.36% 8/13/96 250 3Com Corp. 46.86 49.00 4.57% 8/12/96 130 AT&T 39.58 40.00 1.07% 4/30/97 -1170 *Trump* 8.47 11.56 -36.53% 10/22/96 600 ATC Comm. 22.94 4.38 -80.93% Rec'd # Security In At Value Change 5/17/95 980 Iomega Cor 2594.53 27562.50 $24967.97 8/5/94 355 AmOnline 2581.87 24960.94 $22379.07 8/12/96 280 Gen'l Moto 14552.49 18340.00 $3787.51 8/11/95 125 Chevron 6285.61 9984.38 $3698.77 8/24/95 130 KLA-Tencor 5812.49 9327.50 $3515.01 8/12/96 110 Minn M&M 7224.44 10175.00 $2950.56 10/1/96 42 LucentTech 1999.88 3449.25 $1449.37 6/26/97 325 Innovex 9005.62 10298.44 $1292.82 8/13/96 250 3Com Corp. 11714.99 12250.00 $535.01 8/12/96 130 AT&T 5145.11 5200.00 $54.89 4/30/97 -1170*Trump* -9908.50 -13528.13 -$3619.63 10/22/96 600 ATC Comm. 13761.50 2625.00-$11136.50 CASH $40625.59 TOTAL $161270.47








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.