FOOL ON THE HILL
My Best Investment in 2002

Even winning investments can involve mistakes and lessons learned. Such was the case with Mothers Work. This stock presented a short-lived bargain and then took off like a rocket. The lessons are: 1) Make big bets and be willing to average up; and, 2) Let your winners run and sell based on fair value estimates.

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By Matt Richey (TMF Matt)
December 31, 2002

It's New Year's Eve: a time for reflection, a time for looking back in the context of thinking ahead, and, yes, a time for college football (go, Vols!) -- but stay with me here.

In the Foolish spirit of self-improvement, it's a time for setting financial resolutions for the New Year. In that vein, I've been looking back at my investment performance in 2002 and taking note of lessons learned.

My portfolio self-evaluation? Consider me satisfied-discontent. In a year when the S&P 500 is en route to being down some 23%, I'm modestly gratified to have posted a gain of nearly 3%. This is a relative success -- to be sure -- but it's not without some teeth-gnashing mistakes made along the way. Curiously, my mistakes showed up not only in my worst stock pick of the year (which I recounted yesterday), but also in my best.

Step back with me to March 19, 2002. That day, Mr. Market gave me my fattest pitch of the year when he served up Mothers Work (Nasdaq: MWRK) for only five times free cash flow (FCF). [Mothers Work would become the second highest percentage gainer on the Nasdaq for 2002, according to the Wall Street Journal.--Ed.] Upon encountering this stock at such a strikingly low valuation, I decided to do a few minutes of surface research to see if the company had any traction. It did. I discovered that Mothers Work is the largest U.S. specialty retailer of women's maternity clothing, with an estimated 50% market share.

I also discovered that Mothers Work continues to be run by its founder, Rebecca Matthias, who in 1982 started the company from the front closet of her Philadelphia, Pa., home with an investment of $10,000 of her own savings. Matthias' motivation came from the fact that she, a civil engineer and pregnant with her first child, was unable to find clothing appropriate for her role in the business world. In addition to her child, a business was born, and Mathias remains chief operating officer to this day.

More than a little intrigued by this entrepreneurial success story, I put my other projects on hold and immediately dove into more serious due diligence. A run-down of the historical financials revealed a company with consistently rising sales, positive same-store sales over the past year, improving gross margins, and a successful campaign underway to reduce inventory and debt.

All of these factors were fueling impressive FCF generation, which was far higher than reported net income. At the stock's March 19 price of $15.50, the P/E was 22.7, but the P/FCF was only 5.3. Admittedly, the company had a fair amount of debt, but this multiple was still too low for one with such stellar market share and cash generation.

Even with the fickleness of apparel retailing, it seemed reasonable to me that Mothers Work should deserve a P/FCF multiple of at least 10, if not 12. In studying the company's historical FCF, my conservative forecast was for $12 million in 2002 FCF, or $3.19 per share. At a P/FCF of 10 to 12, that would yield a stock price of somewhere between $32 and $38. Upon that thesis, I bought shares on March 19 at $15.50 per share.

Unlike most value investments, this one didn't take long for the value to be unlocked. The catalyst came on April 4, when Mothers Work announced strong, positive March comparable store sales growth of 7.6% and total sales growth for the month of 20.8%. This news sent the stock blasting off to a 33% one-day gain. And that was just the beginning. Over the next month, the moon shot continued, carrying the stock to above $30. Thus, only a month after purchasing Mothers Work, the stock was already within my estimated fair value range.

So I began selling. On April 25, I sold a third of my position for $31.78. Then on May 7, I sold another third for $32. Finally, on May 17, I disposed of my final third for $35.15. All told, my average gain was 112.8%.

At this point, you might be wondering where the mistakes are in this investment. A double in little over a month -- how can you improve on that? I'm not complaining, but my gains could've been far better had I heeded the following two lessons:

Lesson 1: Make big bets and be willing to average up
My biggest mistake with Mothers Work was simply not buying enough of it! At the time of this investment, I was aiming for a portfolio of 20 equally weighted holdings, thus making a 5% allocation a "full position." The problem, however, was that I couldn't find anywhere close to 20 great ideas at any one time. I had perhaps five gems -- including the likes of Mothers Work -- but at 5% per position these would only represent 25% of my investment capital; the remaining 75% of my capital was in less-inspiring opportunities.

Largely through my experience with Mothers Work, I realized that in order to maximize my best investment ideas, I needed to put a larger capital allocation into each idea. As a result, I resolved to target a portfolio of eight to 10 positions. Practically speaking, this means buying in 10% allocations. Had I done this with Mothers Work, I could've added 5.6% to my 2002 portfolio return.

From another perspective, I also wish I'd given consideration to averaging up in my Mothers Work position. It was during the time of my investment in Mothers Work that I was coming to realize the advantages of a concentrated portfolio. Having reached these new conclusions, I should've considered adding to my position, even at higher prices. Given that I saw minimum fair value of $32, I could've paid up to $21 and still had 50% upside potential.

My rule now is that when I find an investment opportunity that I confidently believe has fair value upside of 50%, I'm willing to make that investment a 10% position. And if I happen to start with a  smaller position, I'll allow myself to average up to 10% as long as there's at least 50% upside to my estimate of fair value.

Lesson 2: Let your winners run and sell based on fair value estimates
I employed this lesson to about 75% satisfaction with Mothers Work. When the stock took off, running from $15 to $20, and then quickly from $20 to $25, I never once thought about selling. I knew there was minimum fair value of around $32, and I was determined to wait patiently for that value to be recognized. As a side note, I believe the only way to confidently let a winner run is to have an understanding of the company's intrinsic value.

Partly through my experience with Mothers Work, my rule now is to sell half of my position when it reaches the bottom-end of the fair value range, and then wait to sell the other half when it reaches the top-end of fair value. Normally, if a stock is on the rise, the inertia alone can help push a stock to the top-end of fair value. In the case of Mothers Work, the stock eventually went as high as $43. Had I been more patient, I would've had a chance to sell a portion of my shares at the $38 price that I considered a reasonable high-end intrinsic value estimate.

Of course, making this lesson work is dependent upon good valuation work, but that's another lesson for another day.

Here's wishing Fools a happy New Year and prosperous 2003.

Matt Richey is a senior investment analyst for The Motley Fool. He greatly appreciates your feedback (MattR@fool.com). At time of publication, he had no position in any of the companies mentioned in this article. For Matt's best Foolish stock ideas and in-depth analysis that you won't find anywhere else each month, check out our newsletter, The Motley Fool Select. The Motley Fool is investors writing for investors.