Rule Breaker Portfolio

Fool To Buy SPY
December 31, 1997


Buying
STANDARD & POOR'S DEPOSITARY RECEIPTS
AMEX: SPY

Type: S&P 500 Index Trust
American Stock Exchange
86 Trinity PL
New York, NY 10006-1881

Phone: 1-800-THE-AMEX
http://www.amex.com
AMEX SPDR Info Closing price: $96 29/32
Yield: 1.40%

Trade: Buying $22,000 worth of shares

OVERVIEW
We're at least temporarily putting the portfolio's cash into the S&P 500 -- simple and Foolish

If we had stashed the portfolio's current cash into the S&P 500 until needed, the Fool Portfolio would have handily beaten the market in 1997. It would have been that easy. As it was, while our stocks were working hard -- our cash wasn't, and it was difficult to keep pace with the S&P having about 20% of the portfolio sitting on the sidelines.

Going into 1998 the portfolio has $24,500 in cash (not including the money needed to cover the Trump short at some point), and though we're actively working to decide on new positions, at least one of those new positions is going to be a short (so the $24,500 cash wouldn't be needed for that anyway). Long story short: We don't know how long it will be before all of our cash can be invested confidently in what we think will be market-beating stocks, but being long-term investors in the stock market, we don't want the money sitting out of the market any longer.

We don't try to make market calls; we know that stocks historically have returned nearly 11% annually. So if our money isn't in companies that we think can beat that return, for the time being we want it to be in the market as a whole through the S&P. As we find companies that we think can beat the S&P, we'll take some money from our S&P Depositary Receipts to buy the gilded shares.

This approach allows us the time to find great investments while not having to worry about losing to the market merely because we have too much cash out of the market. So now and in the future, as we don't make market calls and don't think that anyone has the proprietary knowledge to be able to do so, significant amounts of cash on hand will most likely be invested in the S&P. There are a few things that make this easy: One is discount brokers. Our commission to trade is so low that we're able to move the money in the S&P receipts in this fashion without significant expenses. Another thing that makes this easy is the depository receipts that we're buying. What exactly are these receipts affectionately named "Spiders"?(Ok, "affectionately" may not be the right word to go with "Spiders.") Let's take a look.

DESCRIBING THE SPIDER
Effectively these shares do the same thing as the Vanguard S&P 500 Index Fund, but are more easily traded

The Boring Portfolio bought shares of Spiders last year, and Greg Markus (TMF Boring) did such a good job describing the things that we're going to steal most of his work right here. Greg writes:

"Standard & Poor's Depositary Receipts, or "Spiders," were created by the American Stock Exchange in January 1993 as a convenient way for investors to buy and sell the aggregate stock of the companies represented in the S&P 500. The SPDR Trustee is the State Street Bank and Trust Company.

"Spiders represent a unit of ownership in the SPDR Trust, a long-term unit-investment trust that was established to accumulate and hold a portfolio of common stocks intended to track the price performance and dividend yield of the S&P 500 Composite Stock Price Index. Spiders are not an option or a future; their underlying value derives from ownership of stock, just like a mutual fund. SPDRs normally trade at a value approximately equal to 1/10th of the value of the underlying S&P 500 Index.

"SPDRs trade like stock and provide quarterly cash dividend distributions based on the accumulated dividends paid by the stocks held in the SPDR Trust, minus nominal Trust expenses. Essentially, Spiders are an alternative to an S&P Index Fund, such as the one offered by Vanguard.

"Advantages of Spiders over an Index Fund are convenience and liquidity: You can buy or sell Spiders just like a stock, any time of day, at an established price, in any amount -- even on margin if your account qualifies. (SPDRs also provide a convenient way to sell the S&P Index short, should one be so inclined.)

"SPDRs can also offer certain tax advantages as compared with an Index Fund because they give you control over distributions of capital gains. If you purchase Spiders through a deep discount broker, their total return is essentially indistinguishable from that of the Vanguard Index 500 Fund, an itsy-bitsy difference at most.

"Although relatively few folks know about SPDRs, some investment funds use them regularly, as do a growing number of individual investors. It's not unusual for them or their sibling, the MidCap SPDRs (AMEX: MDY) based on the S&P MidCap 400 Index, to be among the most active issues on the AMEX on any given day."

And finally, we agree with the Bore, who wrote: "I don't promise to keep this investment in SPDRs forever, however. If a compelling single stock purchase comes along someday and I need to raise cash, the Spiders may get exterminated -- or resettled humanely in someone else's account, I should say. On the other hand, spiders help keep the bugs in one's portfolio under control, so I'm happy to have the arachnid amigos around."

POSSIBLE PITFALLS
There are always a few

We suggest that you should never invest in stock unless you're investing for at least three to five years. The buying of these shares and then the very likelihood of selling at least a portion of them in the near future might seem to contradict the Foolish long-term approach. We see it this way:

We always want to be in the stock market. No other investment vehicle has done better than the stock market this century. The largest disadvantage of stocks, perhaps, is that no one can predict exactly what they'll do next. The way to conquer that disadvantage, though, is to always own them. Right now, we don't own stocks with a good percentage of our portfolio, and since April 17 of 1997 our cash has sat out while the S&P has gained 23%. By buying the S&P, we're guaranteeing that we'll always be in stocks, because we won't sell our S&P shares until we find something that we think is better. With this purchase we're also reiterating (though not intentionally) our belief that no one can predict the market.

So what happens if we buy the S&P 500 receipts, they go down 7%, and in the meantime we find something that we like better and sell $11,000 worth of S&P shares to make the purchase? Wouldn't we have been better off having the money sitting in cash before the purchase? Numerically, yes, of course. But we couldn't have foreseen that. We could also sit out of the market with the money and watch the S&P quickly rise 10% early this year.

Also, there is this to consider: If the S&P does decline, likely at the same time any individual stock that we were aiming to buy as a replacement for our S&P shares would be declining as well. So, though our S&P shares would be falling, we'd hopefully be replacing the sold S&P shares with a new stock bought at a lower price due to this. This is one aspect of being invested at all times: you're at the whim of market, and most boats rise and fall with the market's tide. We'd much rather have that, though, and be relaxed and think long-term than try to guess the market and jump in and out. So, we'll invest in the S&P knowing that we may sell some shares when they're down in order to buy another stock. We'll take the rolling sea that constitutes the S&P and all of its floating boats (individual stocks) and jump from boat to boat, rather than try to tread water (hold cash) and then jump into a single boat only when we've found a special kind. We'd rather always be boating. We want to be in the market, not in the water. Ok. End of boat analogy. Thankfully.

THE COMPANIES
And the price

The S&P 500 holds many of the largest and most successful companies in its ranks, from Microsoft to Coca-Cola, to Johnson & Johnson and Intel. It's the best means of tracking the performance of the majority of leading U.S. corporations, and if you believe that progress is imbedded in the future, you pretty much believe in the S&P for the long term.

At about 970 points, the S&P 500 trades at 20 times earnings while sporting a five-year earnings per share growth rate of 17%. (For all the cries claiming the market is overvalued that we've heard the past three years, it's really hard to see why by this measure.) The companies in the index are expected to collectively earn operating earnings of $48.63 per share in fiscal 1998, so the S&P trades at about 19.7 times that earnings estimate. That estimate does call for only 7% growth in 1998 from the $45.43 in earnings per share expected in 1997. Hopefully the companies can grow more than 7% collectively, but either way we're not sweating it.

As written of in the Fifth Step of the 13 Steps to Investing Foolishly and in The Motley Fool Investment Guide, a S&P 500 index fund is the best option for investors not buying individual stocks but wanting to invest in the market. In fact, the S&P 500 is good enough for a lifetime for many investors, and it should be. You're buying, after all, the leading companies in the country. Any investment should always be long term. With this approach, we're committing to keeping all of our money (or as much as possible) in the market at all times (moving it directly from the S&P to individual stocks), perhaps for the rest of our Foolish days.

Our policy is to buy within five days of the announcement.

Fool on!