The Rewards of Revolution (Fool on the Hill) February 22, 2000

An Investment Opinion

The Rewards of Revolution

By Tom Gardner
February 22, 2000

To invest well, we have to manage risk well. That seems so obvious, but it's a concept that can elude professional money managers, the baby-boomer directing her IRA, the investment club in San Luis Obispo, the lawyer-turned-daytrader (gasp), the computer programmer assessing his company stock-option plan, yes, even the Nobel-Prize-Winning economist.

All of these, all of us are engaged in some form of financial risk. How well we calculate and handle that risk will largely determine how much or how little success we'll have. Drive your disposable income into the lottery over the next ten years, and basic risk-reward analyses show you're likely to be poor. Very poor. Drop it, instead, down on the roulette table and, at intervals along the way, you'll probably be way ahead. You'll be damned happy. But 10 years from now, the highest probability is that you'll be digging in your pockets for dimes.

Risk. Reward. At the root, they're pure mathematical puzzles. Put x-dollars in for y-length of time at z-rate of return and, presto, you have an estimate of your future success. And fixing on variable "x" above is easy. How much money do you have to invest? Guessing at variable "y" can be tricky. How long do you have to invest it? And settling on variable "z" is quite difficult. What rate of return are you expecting?

If we're talking about the lottery, then z is an average rate of negative 50% per wager. If it's roulette, z is around negative 2.5% per wager. And if it's stocks we're interested in, z is a positive rate of 11% per year. You and I know, though, that all of these are long-term projected rates of return. Over the long haul, the first two will make you very poor. The third, stocks, will not. But, in the short-term, the rates of return on the lottery, the roulette wheel, and the stock market are predicated on chance. Gambling it all on a single wager, you could double or triple your money (or far more) in an instant. Trading options or betting on stocks over a one-week, one-month, or one-year period, you could do the same. You could also be wiped out.

But since so many of us here are committed to building wealth and security over the whole of our lives -- unwilling to risk it all in an instant, or a year -- then figuring out the mathematics of the long-term risks and rewards of available investments makes a heckuva lot of sense. With stocks, we have to find the right questions about risk and reward. And that's easy, though finding their answers isn't. How much money do I have to invest? When will I need the money? Do I thoroughly understand what I'm invested in? What are the tax consequences of my strategy? What will I do if the market falls 35% from here? And why the heck was Hee Haw a television draw for more than 20 years?

Each -- or at least all but one -- of these concerns provides a building block to our future opportunity. And more people than ever before need to be asking these questions because the U.S. stock market, with its 9,000 flavors of business, is drawing hundreds of millions of risk-takers from around the world today. They come looking at the technology in Silicon Valley and Austin, Texas; at media and finance in Manhattan; at the biotechnological and network developments in Northern Virginia and Maryland; and at hundreds of other points of enterprise around America.

I know that many of the readers of this column have asked the basic questions about risk and have plans for what to do if the market (and your portfolio) rises or falls 10%, or 20%, or 40% over the next three years. And because of that, I want to move beyond portfolio management issues today and focus instead on the riskiest and potentially most rewarding element of our investment approach: Rule Breaker investing. It's a river that all of us should fish. A stream into which we should all cup our hands.

The more experienced we get as investors, the more willingly we should search for revolutionary new businesses. These emerging corporations, the children of the public markets, will grow the fastest and the farthest over any five-year period. Some will lose their way. Some will turn vandals. Others will flame out, like a moth in a candle. But many will be moderately successful. And enough will grow into our nation's commercial leaders over the next 20 years that we should not ignore them.

Here are three examples from the world of technology in the 1990s:

  • From April 1990 to April 1994, Cisco Systems rose more than 20 times in value -- from a $680 million company to a more than $15 billion company.
  • From March 1992 until March 1996, America Online rose more than 30 times in value -- from a $330 million company to an $11 billion company.
  • From April 1996 until April 1999, Yahoo! rose more than 45 times in value -- from a $1 billion company to a $46 billion company.
Those who owned shares of these saw their dollars multiply in step with the tremendous rise of the revolutionaries. During the intervals above, $10,000 became $200,000 in Cisco; $10,000 became $300,000 in America Online; and $10,000 became $450,000 in Yahoo!

And then, just when a number of pundits were labeling the companies overvalued -- citing lofty P/E and price-to-book ratios and mocking their asset-less businesses -- lo and behold, their economic models drove them beyond revolution into the status of ruler in their marketplace. Yahoo! is a $78 billion company today. America Online is a $110 billion company. And Cisco Systems is worth $421 billion. And the original $10,000 in each held through to today is worth $765,000 in Yahoo!, $3 million in AOL, and $5.6 million in Cisco.

Investors simply cannot derive this sort of growth from tried-and-true Rule Making companies. Over the next five years, Microsoft, a $500 billion company, will not grow 20 times in value; General Electric, a $420 billion company, will not rise 30 times; and neither America Online, Cisco, or Yahoo! will measure up to their returns over the past decade. They are simply too big now to rise three-, five- or ten-fold in five years' time. That speed and scope of growth is really only available to companies capitalized today from $500 million to $20 billion.

Do I think you should allocate the majority of your portfolio to these up-and-comers? Certainly not. But do I think you should learn as much as you can about the seeds of commercial revolution? Yes, I do. When David and his Rule Breaker research team roll out their seminar this week, they'll teach thousands of investors about finding these companies. You can join in the seminar (with our guarantee that if you don't enjoy the experience, you can have all of your money back -- no questions asked) by clicking this link: Rule Breaker Seminar. And if you don't have an interest in that, you can learn about Rule Breaking Investing by reading the Rule Breaker Report each day.

The revolutions in biotechnology, fiber optics, the Internet, wireless, and eventually space exploration will transform the human experience and redefine the commercial world over the next century. As we become veterans of the public markets, far more -- not fewer -- opportunities are open to us. And we'll be rewarded, often over-rewarded, for calculating the risks and investigating the opportunities of the next caravan of revolutionary businesses coming down the path. In doing so, profit and knowledge (in reverse order of priority, in my opinion) will be our fair reward.