Rule Breaker Portfolio

Investing in AOL
...Foolishly. Also, 3 + 8 = Videoconferencing

[Editor's introduction: The fool (small f) scheduled to write today's column instead drove to Iowa to stand in line for Powerball tickets. He didn't know that he could buy tickets in Washington, D.C., fifteen minutes from Fool HQ. Beyond that embarrassment, we won't mention the great risk he's taking. It's several thousand times more likely that he'll be in a highway accident (hit by a falling plane while cruising I-80 east) than that he'll actually win the drawing. (Today the Motley Fool provides an insightful take on the lottery.) Anyway, I won't tell you exactly which fool is standing in line right now, but for the column today, TMF Jeff wrote this:

"I have the distinct pleasure of introducing a guest Fool Port writer, Bill Swails, from Littleton, Colorado. Seven weeks ago we asked you, readers of the Fool column, if you were interested in being the opposite of a reader here -- if instead, you'd be the writer. Bill is the third guest columnist using this opportunity to share an investing experience and its lessons with us. I think you'll enjoy it...."

Before we hand the stage to Bill, let's cover today. The S&P continued lower and the Fool -- like getting smacked in the face by a wet sock -- lost 4.58%. The portfolio is still ahead handsomely for the year, however, having gained 42% vs. 15% for the S&P.

There was little news other than the announcement that 3Com (Nasdaq: COMS) is working with 8x8, Inc. (Nasdaq: EGHT) on videoconferencing products for general consumers, including video-phone technology. Also, the Fool announced its partnership with Market Guide. Together the two provide complete financial and business information on nearly all public companies in the country, for free, on the Fool's website.

That shared, do you remember when you first discovered the Fool, and how? Did finding it change your investment theories? Bill's personal story begins at nearly the same time as the Fool's beginning....]


by Bill Swails
(Bill14@aol.com)

LITTLETON, CO. (July 29, 1998) -- Before I discovered The Motley Fool in the fall of 1994, I had been playing with stocks and trying to time the market, with many more failures than successes. From August 1993 through November 1994, I made 24 trades and managed to lose $134, plus $480 in commissions. The net result was a 3.2% loss in the value of my portfolio. Not a spectacularly bad performance, but a losing performance nonetheless. Thankfully, I was using a discount broker rather than a full-service broker or my results would have been significantly worse.

I had always been fascinated by technology and the impact of technological change on society, and I was reading anything I could find about technology and investing. In late summer 1994, halfway through an MBA program at UCLA, my investment philosophy began to take shape. A major event that helped solidify my investment philosophy was discovering the Initial Fool Flash Report on America Online, posted August 4, 1994.

Excerpt from The Motley Fool AOL initial buy report:
"BUY AND HOLD, HOLD, HOLD. We are buying [AOL], and we are holding. And holding. And holding. Because when we come to like a company and its situation this much, we're very unlikely to let go inside of a decade."

I had been an active member of AOL since October 1990, and I completely agreed with the Fool's thoughts on AOL, but I had bought stocks in the past based on other people's great insight and I still managed to lose money. What would be different this time? AOL stock had grown over 500% from its IPO price of $11.50 on March 19, 1992, to over $70 in early August 1994. Had I missed the ride? Seventy dollars per share for AOL seemed absurdly high. Short sellers and naysayers were crawling out of the woodwork and littering every media outlet with reports of AOL's imminent demise.

The more I thought about it, the more I realized that I might have a shot at quantitatively valuing America Online. I had studied two topics in the UCLA MBA program that gave me the necessary tools to value AOL stock: 1) valuing companies using discounted cash flows and 2) forecasting the rate of adoption of new technologies. I realized that America Online's only significant means of generating revenue at that time was subscriber fees. At UCLA, I had learned a mathematical model for predicting the rate of adoption for new technologies. I simply predicted the monthly subscriber growth of AOL by using this model, and then multiplied the number of subscribers each month by AOL's profit per subscriber. This gave me a monthly cash flow that could be discounted to the present. I then divided the present value of the discounted cash flow by the number of AOL shares outstanding to determine a "fair" stock price.

My valuation model clearly indicated that AOL was undervalued. I also believed that AOL would begin to generate additional revenue from advertising and online commerce in the future, which would only add further to the "fair" stock price that I had calculated. This quantitative data, combined with my knowledge and experience with AOL, gave me the confidence I needed to buy and hold AOL stock for the long-term.

I posted my analysis of AOL subscriber growth and future cash flows on The Motley Fool America Online message board, and instead of playing the market, I began to invest in great companies. In November of 1994, I began selling all of my arbitrarily chosen stock holdings, and investing the proceeds in AOL. By March of 1995, I was 100% invested in AOL. For the next two years, I made zero trades. AOL was the only stock I held for the entire two year period! I know, diversification mitigates risk, but AOL was a stock I had thoroughly researched and totally believed in. It was a calculated risk I was willing to accept.

Through many ups and downs, including the gut-wrenching ride from a high of $70 on May 7, 1996, to a low of $24 on September 11, 1996, I held AOL. Remember the horrible headlines: class action lawsuits, busy signals, subscriber churn, MSN, the Internet threat, accounting irregularities, blah, blah, blah? The popular wisdom of the day was that AOL was clearly DOOMED.

I was concerned many times over the two year period, but whenever I analyzed the marketplace to see if the fundamentals had changed, I always drew the same conclusions:

1) Demand for AOL services exceeded supply. This was a much better problem than no one wanting the service! This was also a problem that AOL had faced and resolved several times previously.

2) Steve Case's management team was completely focused on creating the best online experience in cyberspace, and had successfully guided AOL through many crises in the past.

3) The Internet and online services were revolutionary technologies dramatically improving individual lives and profoundly changing society.

4) AOL was the marketplace leader and its main competitors -- CompuServe, Prodigy and MSN -- were clearly inferior.

Not until April of 1997, after a 220% gain, did I finally sell a few of my AOL shares, and began "planting seeds" in other promising companies. I still believe that AOL is an incredible investment opportunity and I will continue to hold the remaining two-thirds of my original AOL shares for a very long time. I only sold a portion of my AOL stock so that I could invest in other promising stocks.

As of market close on Friday, July 17, 1998, my Foolish portfolio has achieved the following performance levels:

--Annualized percentage rate (APR)
over the past 3 years 8 months: 110%

--Performance relative to S&P 500:
3.8 times the performance of the S&P 500

(Remember -- over 80% of mutual funds fail to
match the performance of the S&P 500.)

--Percent of investment portfolio
with positive returns: 96%

--Percent of Portfolio beating the
S&P 500: 93%

I attribute the ability to achieve this performance to simply adopting a Foolish investment philosophy. Don't worry about the day-to-day whims of the market. Avoid the herd mentality. Research your investments thoroughly. BUY AND HOLD stock in leading companies, and in revolutionary fields, that you know you'll still want to own five to ten years from now. Invest your money Foolishly, and you will be well on your way to achieving financial freedom. Of course, start with the Fool's 13 Steps -- and take your time. Enjoy.

Foolishly,
-Bill-

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Bookmark Live Fool Port Quotes

07/29/98 Close
Stock Change Bid ---------------- AMZN -11 3/16107.75 AOL -6 5/8 107.75 T - 3/8 58.69 DJT - 1/16 6.88 DD +1 1/4 62.38 XON +1 70.69 INVX + 1/8 13.63 IP - 5/8 42.31 IOM - 1/16 5.50 KLAC - 7/8 28.06 LU -3 1/4 89.00 SBUX + 13/16 47.06 COMS + 3/8 25.25 TDFX -1 14.50

Day Month Year History Annualized FOOL -4.58% -0.07% 42.61% 378.60% 48.19% S&P: -0.44% -0.76% 15.95% 145.47% 25.30% NASDAQ: -0.76% -0.70% 19.81% 161.25% 27.28% Rec'd # Security In At Now Change 8/5/94 710 AmOnline 3.64 107.75 2863.07% 9/9/97 580 Amazon.com 19.11 107.75 463.82% 5/17/95 1960 Iomega Cor 1.28 5.50 329.55% 10/1/96 84 LucentTech 23.81 89.00 273.82% 8/12/96 130 AT&T 39.58 58.69 48.28% 4/30/97 -1170*Trump* 8.47 6.88 18.82% 2/20/98 200 Exxon 64.09 70.69 10.29% 2/20/98 215 DuPont 59.83 62.38 4.25% 2/20/98 270 Int'l Pape 47.69 42.31 -11.28% 7/2/98 235 Starbucks 55.91 47.06 -15.82% 8/24/95 130 KLA-Tencor 44.71 28.06 -37.24% 1/8/98 425 3Dfx 25.67 14.50 -43.51% 8/13/96 250 3Com Corp. 46.86 25.25 -46.12% 6/26/97 325 Innovex 27.71 13.63 -50.83% Rec'd # Security In At Value Change 8/5/94 710 AmOnline 2581.87 76502.50 $73920.63 9/9/97 580 Amazon.com 11084.24 62495.00 $51410.76 5/17/95 1960 Iomega Cor 2509.60 10780.00 $8270.40 10/1/96 84 LucentTech 1999.88 7476.00 $5476.12 8/12/96 130 AT&T 5145.11 7629.38 $2484.27 4/30/97 -1170*Trump* -9908.50 -8043.75 $1864.75 2/20/98 200 Exxon 12818.00 14137.50 $1319.50 2/20/98 215 DuPont 12864.25 13410.63 $546.38 2/20/98 270 Int'l Pape 12876.75 11424.38 -$1452.38 7/2/98 235 Starbucks 13138.63 11059.69 -$2078.94 8/24/95 130 KLA-Tencor 5812.49 3648.13 -$2164.37 6/26/97 325 Innovex 9005.62 4428.13 -$4577.50 1/8/98 425 3Dfx 10908.63 6162.50 -$4746.13 8/13/96 250 3Com Corp. 11715.99 6312.50 -$5403.49 CASH $11876.47 TOTAL $239299.03

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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.