Rule Breaker Portfolio

<THE RULE BREAKER PORTFOLIO>

Foolish Take on Amazon's Earnings
Plus, sector ro-TAY-tion

by David Gardner (DavidG@fool.com) and Jeff Fischer (JeffF@fool.com)

ALEXANDRIA, VA (April 28, 1999) -- THWACK!

So ends another trading day out there on the public markets. And...

THWACK!

We got thwacked. Yep. No question about it. No mincing words.

America Online  down $10
eBay            down $16 11/16
@Home           down $10 1/4
Amazon.com      down $13

But also:

DuPont      up $4 3/8
Chevron     up $2 13/16
Goodyear    up $1 1/4
Caterpillar up $1

Do you see? It's HAPPENING AGAIN.

SECTOR RO-TAY-TION

Now, a lot of people are probably wondering exactly what this means. I confess sometimes to asking myself the same question. Oh, we know what it means, of course. It means that investment money (a.k.a. capital) is being sold out of one "sector" and moved into another. Here we may define "sector" variously as things like:

"semiconductor equipment"
"fast-food restaurants"
"retail"

...and of course, that hardest to pin down of all "sectors":

"the Internet"

So on the face of it, what we have here is "the Internet" being sold in order to purchase cyclical industrial manufacturers. Another way we might view this, from our unique perspective, is that Rule Breakers are being sold in order to purchase Rule Makers. OK, I grant you that my bro wouldn't call Goodyear a "Rule Maker" by his demanding (rightfully so) definition. But I ask you: Who else is making so many tires? You get the point. Rule Breakers were out of favor today, and have been treated very teasingly by the market for the past few weeks; we've had other nearly identical days of such "rotation."

Is the whole market selling off? Are people dumping equities because they believe that "stocks are overvalued," or bonds or T-bills or other competing investments are more attractive? Not really. As we can see, over the past few weeks money has simply been shifted, rotated, into other stocks. No surprise for any of us who own Foolish Four stocks. We've watched the Foolish Four approach come back with flaming-sword prominence, cutting a fiery swath as it blazes through the investment landscape, leaving sparks and embers in its wake. The sleepy ol' Foolish Four approach is now up 26.3% for the year, versus an S&P 500 up 10.22% and a Nasdaq now up 16.31%. You can read about it tonight and every day in our Foolish Four Portfolio report.

But back to that question, before we cut to our take on Amazon's earnings and future today, scribed by Jeff Fischer. The question was, "What does this mean?"

To a long-term investor?

Not much, if you ask me. These sector rotations are short-term phenomena based on short-term trends and developments. Here, "short-term" may mean as much as 2-3 years, but more often than not it's 2-3 months -- these days, especially. So, again, for those of us invested for 2-3 decades or more, what does sector rotation mean? Not much. Stay invested in great companies that you think will be dominating their industries ten years from now.

Over short-term periods, the market will turn against even these companies. We have seen great stocks to hold like America Online drop by 40% or more several times during our four-and-a-half years of running this portfolio. That should speak eloquently enough.

Before turning it over to Jeff, I want to acknowledge an outstanding post in our Rule Breaker message board, referring to my "Sisylana" report last night, about how analysts are becoming increasingly short-term focused to their, and their followers', detriment. The posting comes from an analyst himself, who's worked in that industry for years. Do click in and read it.

OK, so Amazon.com announced earnings after the bell. What did we think of it, besides that Amazon's corporate communications director should receive a severe reprimand for putting a solecism in the mouth of CEO Jeff Bezos? (Yep, here's the line -- do you see the error? Bezos is quoted as saying: "We're particularly pleased with Amazon.com Auctions, which is off to a very fast start -- we had more participants during our first month then even with music.")

To more important things, here's the other Jeff.

Amazon's Future Flood?

Amazon.com (Nasdaq: AMZN) is granted a $30 billion valuation because its scope is worldwide and it is the most popular retail store online. That puts the company in a more enviable long-term position, arguably, than a leading offline retailer with 2,000 stores spread across the country. Those 2,000 stores -- imagine they're Best Buy -- compete with dozens of others, including CompUSA, Circuit City, Electronic Avenue, Wal-Mart and more. Which store do you shop at? Typically the closest or the one having a sale. The shopping experience at each is usually similar.

On the Internet, discounted prices will be perpetual, and instead of going to the closest store as you often do offline, you'll visit the site where you have an account and good experiences -- a site you trust. Partially because of this, I believe that the retail market is going to be much less diluted online than it is in the physical world. One or two giant companies, sharing a market of potentially 300 million online shoppers within 5 years, could dominate entire niches of online retail markets.

Offline, the situations that bring a customer to a store vary. They vary enough that many different stores, in thousands of locations, can survive (at least for now, we'll see how the Internet impacts them). Your physical location on a specific day might mean that you visit Best Buy rather than CompUSA. On another day, or when in another city, you might shop at CompUSA instead. Online, your situation is the same each day: you're at your desk. You have your Web browser. You usually visit your favorite bookmarked places.

The Web effectively removes the "random" side of shopping -- the randomness of physical location, both yours and the stores -- that exists offline. This is partially why 66% of Amazon's first quarter sales were repeat purchasers. Offline, I buy on impulse after wandering into Crown Books, or Borders, or Barnes & Noble depending on where I am in the city. Online, I go to Amazon.

People argue that shopbots and search engines will make shopping the Web even more random than offline shopping. ("It's so easy to click from site to site.") Experience hasn't shown this to be true, however, and trends actually suggest otherwise. Prices are competitive enough online that people cotton to a site that they've used in the past. It's easier, and people know that prices will be close, if not equal, to prices available elsewhere. This is holding true (from what I've seen) with retail commerce as well as with auctions. People, whether bidding on eBay or Amazon, know the value of an item.

Given the relative uniformity of prices, the leading retail sites -- sites that lead for reasons other than price, including reputation and technological features -- stand to receive a tremendous amount of the Internet's total retail traffic in the future. These retail leaders needn't worry about location, location, location to attract business, as the industry relies on offline. They only need worry about reputation, reputation, reputation -- and Amazon has it.

There is another tremendous asset weighing in Amazon's favor.

In the offline world, when a store like Target offers a wide variety of products (including food), it becomes a more convenient place to shop. You can buy beverages and some food at Target. The only reason that you'd go through the trouble of driving to a grocery store is to get something Target doesn't sell. The same will hold true online. In fact, Amazon has already shown this in action. It became easy to buy music at Amazon alongside books. So why not? Therefore Amazon, having the largest customer base, quickly became the leading online music seller. And then videos. And now other items, including the latest: free e-mail postcards. (These are a great attract mechanism. Amazon customers will send free postcards to non-customers, who then visit Amazon to read the postcard and might become a customer.)

The point is this: Amazon is in a position to expand its business into as many products as it wishes and -- if history is a guide -- a majority of customers will accept Amazon as their new source for each new product line to come, no questions asked. It's a matter of convenience for the Amazon customer. Easy as that. And we needn't remind anyone that Amazon is in the best medium possible for adding business lines: with one tab atop its mainpage, it opens a whole new business. It has been doing so almost every quarter for the past year. That's almost impossible offline.

You begin to see the potential for immense sales when you consider that the Internet is very young, e-commerce is growing so quickly that it is becoming the most common use for the Internet (other than e-mail), and Amazon's 8.4 million users (up 2.2 million from December) could become 20 million in 3 years while its product offerings could jump from 4 categories to 8. With 8.4 million customers, Amazon achieved $293 million in sales this quarter, up 236% from last year, meaning that the average customer spent over $34 this quarter. The company is on a run-rate to top $1.1 billion in sales in 1999. Last year, most analysts didn't expect $1 billion in sales until 2001.

In today's conference call, Amazon said that sales growth will slow in future quarters. This is a boilerplate warning that the Wise always jump and shout about anyway. Of course, as any company grows larger it will experience slower sequential growth on a percentage basis (on an absolute dollar basis, we're sure that Amazon will achieve record sales for a long time to come, year-over-year). Management also said that losses could exceed expectations in future quarters as they continue to invest in new businesses. (We're actually glad to hear this.) Numbers are impossible to project, however, because the losses will depend on quarterly sales amounts. This quarter, the $0.23 per share loss was considerably better than the $0.29 loss expected.

Amazon's stock has done so well -- as have eBay (Nasdaq: EBAY) and America Online (NYSE: AOL) -- that is isn't surprising to hear that Amazon will likely trade lower tomorrow, just as it isn't surprising to see eBay and AOL lower, given the recent gains. We could focus on the short-term volatility in the stock, but then the Wise wouldn't have anything to do. Besides, it's a waste of our time. We invest to build wealth over the long term -- true wealth, not trading profits -- and therefore we focus on the long term when we consider our businesses (we don't focus on the stock price). This approach has given the Rule Breaker portfolio its market-trampling success with relatively little effort.

Amazon's first quarter numbers are available here: click me! To discuss the results or if you have questions, please visit the Rule Breaker message board. We'll be there regularly to respond, as usual. Interaction is one of the best parts of Fooldom.

For more Foolishness, check out today's Dueling Fools and our new Stocks for Mom feature. Mother's Day is fast approaching. Wrap her flowers with a stock certificate. And Fool on!

What's up with Harry Jones today?

04/28/99 Close
Stock  Change    Bid 
------------------ 
AMGN  -3 13/16   65.94
AMZN  -13       192.88
AOL   -10       145.00
ATHM  -10 1/4   144.00
CAT   +1         64.56
CHV   +2 13/16  101.75
DD    +4 3/8     73.50
DJT   +  1/8      4.50
EBAY  -16 11/16 192.56
GT    +1 1/4     55.50
IOM   -  1/32     5.00
SBUX  -2 9/16    36.44
TDFX    ---      16.25


                  Day     Month  Year   History   Annualized 
      R-BREAKER  -5.59%   6.04%  68.53% 1591.58%  81.88%
        S&P:     -0.87%   5.02%  10.22%  208.26%   26.88%
        NASDAQ:  -2.00%   3.60%  16.31%  254.12%   30.66%


    Rec'd    #  Security     In At       Now      Change
   8/5/94  2200 AmOnline       0.91    145.00   15854.23%
   9/9/97  1320 Amazon.com     6.58    192.88    2831.57%
  5/17/95  1960 Iomega Cor     1.28      5.00     290.50%
  12/4/98   450 @Home Corp    56.08    144.00     156.77%
  2/26/99   300 eBay         100.53    192.56      91.55%
 12/16/98   580 Amgen         42.88     65.94      53.79%
  4/30/97 -1170*Trump*         8.47      4.50      46.86%
  2/23/99   300 Caterpilla    46.96     64.56      37.47%
   7/2/98   470 Starbucks     27.95     36.44      30.35%
  2/23/99   180 Chevron       79.17    101.75      28.52%
  2/20/98   260 DuPont        58.84     73.50      24.91%
  2/23/99   290 Goodyear T    48.72     55.50      13.93%
   1/8/98   425 3Dfx          25.67     16.25     -36.69%

    Rec'd    #  Security     In At     Value      Change
   8/5/94  2200 AmOnline    1999.47 319000.00  $317000.53
   9/9/97  1320 Amazon.com  8684.60 254595.00  $245910.40
  12/4/98   450 @Home Corp 25236.13  64800.00   $39563.87
  2/26/99   300 eBay       30158.00  57768.75   $27610.75
 12/16/98   580 Amgen      24867.50  38243.75   $13376.25
  5/17/95  1960 Iomega Cor  2509.60   9800.00    $7290.40
  2/23/99   300 Caterpilla 14089.25  19368.75    $5279.50
  4/30/97 -1170*Trump*     -9908.50  -5265.00    $4643.50
  2/23/99   180 Chevron    14250.50  18315.00    $4064.50
   7/2/98   470 Starbucks  13138.63  17125.63    $3987.00
  2/20/98   260 DuPont     15299.43  19110.00    $3810.57
  2/23/99   290 Goodyear T 14127.38  16095.00    $1967.63
   1/8/98   425 3Dfx       10908.63   6906.25   -$4002.38

                              CASH   $9924.87
                             TOTAL $845788.00

Note: The Rule Breaker Portfolio was launched on August 5, 1994, with $50,000. Additional cash is never added, all transactions are shared and explained publicly before being made, and returns are compared daily to the S&P 500 (including dividends in the yearly, historic and annualized returns). For a history of all transactions, please click here.

</THE RULE BREAKER PORTFOLIO>

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