Rule Breaker Portfolio

Rule Breaker Portfolio
No Soothing Comment
That wouldn't be Foolish

By Jeff Fischer (TMF Jeff)

ALEXANDRIA, VA (Oct. 15, 1999) -- The stock market declined this week on inflation concerns that were partially validated on Friday. Wholesale U.S. prices rose 1.1% in September, the highest increase in nine years. The jump was driven by prices of cars, energy, and "tobaccey" (er, smokes). Excluding those components, inflation was modest. A warning from Greenspan about asset devaluation (yeah, assets can decrease in value, too) helped to spook the market anyway. Hence, it tumbled like Mary Lou Retton.

Worries aren't without some merit. For one, the average valuation of the stock market is relatively high unless you subscribe to the notion that "old" valuation metrics don't matter. Second, economic conditions have been pristine the past five years. That doesn't mean these conditions won't or can't continue -- not at all -- but we should remind ourselves that less than perfect conditions can exist and can mean lower stock prices.

Inflation of Concern?

The United States has enjoyed low inflation and strong growth most of this decade, and weak international economies have assisted in keeping inflation in check. However, some numbers argue that many international economies are improving, and this can add to product demand that can fuel inflation. At the same time, the strong U.S. dollar has finally been softening. This makes imports more expensive for the country, which can add to inflation as well.

Inflation is not the meanest monster in the closet, but it isn't a friend to stocks or to the consumer in general. When inflation is high, your dollar buys less. This is true for a company, too. A dollar of year 2000 earnings at the Coca-Cola Company will be worth much less at the end of year 2000 if inflation rises 4% during the year. Coke will need to pay more to run its business, so the power of its net income is less. This makes sense: As inflation rises, future earnings streams at companies are worth less. A company's stock is traditionally valued on future earnings streams, so it declines.

Adding more potential downside to this equation is the idea that as interest rates rise, stocks become less attractive. If you can receive a guaranteed, risk-free return of 8% at a bank versus a risk-inherent return of 11% in the stock market, and if your time horizon is less than five years, you should probably accept the bank's return. However, we argue that if your time horizon is longer than five years, and ideally at least 10 years, the only place for you to be is the stock market.

Therefore, in most cases when the stock market declines sharply, The Motley Fool runs articles discounting the event while espousing the notion of long-term investing. I don't disagree. I've written many of these articles myself. Long-term investing removes most, if not all, of the short-term risk involved in the market. However, it is unFoolish for anyone to say in a sweeping generalization for all of us that "everything will be fine."

There Are No Guarantees

Investing in the stock market involves risk even for long-term investors. One risk is volatility and, in relation to that, valuation concerns (or a lack thereof) and the use of margin (borrowing to buy stock).

Volatility alone is not a danger. It is natural in a two-way auction market. Volatility is a danger, however, when it is coupled with a limited time horizon. That danger is compounded when stocks are bought at high valuations and especially when they're bought on margin. When the time comes to withdraw your money from stock -- be that in 5, 10, or 20 years -- volatility could prove your worst enemy. Assuming that we begin with high stock valuations, all we need to add is the pinch of a recession, a good belt of inflation, or a lasting downturn in investor confidence to result in flat stocks for many companies for many years. Even for 10 years? Sure.

In worst-case scenarios, stocks have been flat for over two decades at a time when measured against inflation. During these periods, if you invested in the average stock it took 20 years (or 25 years after 1929) before you saw "even" money again, let alone a positive return. If your time horizon is at least as long as the downturn, and if you're adding money to stocks regularly (perhaps via a commission-free Drip), this downtime isn't so horrible. It is simply a part of life that an investor must accept. If, however, you only had a 10-year horizon and you invested in merely average stocks (many great companies do well even during a poor market), you could need to withdraw your money after 10 years with a loss.

This has happened many times and it almost certainly will again. After a record bull market, stock prices don't look cheap by traditional valuation measures. You may argue that traditional measures no longer matter, but I can just as easily counter-argue that such an opinion doesn't matter. The stock market will do whatever it will do. It could double again in the next seven years for what would be an average return, or it could be 30% lower in seven years. A Fool needs to buy the best companies that they can find and ideally have a time horizon that stretches at least a decade, hopefully more. If your time horizon is that long, your potential reward compounds and your risks are diminished.

Unless you use margin.

Perils of Margin

Buying stock on margin can ruin your investing career as quickly as David Caruso's movie career was ruined, even if you have a 50-year horizon. Imagine that you buy $100,000 worth of stock with $50,000 cash and $50,000 in margin, i.e., borrowed funds from your broker. Imagine that your stocks fall 25% the first year. If you invest in volatile equities such as America Online, Starbucks, and even Intel or Cisco Systems, this decline can easily happen. It has happened with all of these stocks in the past two years. So, after losing 25%, your account value is now $75,000, but your net worth is only $25,000. You have lost 50% of your net worth even though your stocks lost only 25%.

Of your $75,000 in stock holdings, you own only $25,000 and the remaining $50,000 in stock belongs to your broker. (The broker doesn't take any real risk when you buy stock with their money!) Plus, you already have a margin call because your assets don't represent 50% of the total assets in your account. On this margin call, you need to add $12,500 to your account, or you need to sell stock. Assuming that you don't have the money, you need to sell enough stock to cover the margin call.

How can you get back to having 50% personal equity-to-total-assets in your account? You need to sell $25,000 worth of stock at prices 25% below where you bought it one year ago. Doing this leaves you with only $50,000 in stock and only $25,000 of it belongs to you. With one 25% loss, you have lost 50% of your net worth and you have decreased your stock holdings by 50%. One more year of the same would not be any prettier. Assume the next year your stocks fall 20%. You now have $40,000 in stock and only $15,000 of it belongs to you -- the remainder belongs to the broker. You have lost 40% of your net worth when your stocks fell 20%. Plus, you have another margin call. You're already close to cleaned out -- and you owned great stocks.

Margin can be beneficial in a strong stock market. It can essentially double your buying power and therefore double the gain that you make off your investment base. It does the same in reverse, however. It will double your loss off the same base. During extreme volatility, margin can wipe you out completely and quickly if you're invested in, for example, certain Nasdaq stocks at 100% (twice your asset base) margin. Consider the above example. If the Nasdaq market fell 25%, a stock that is twice as volatile as the market (Amazon, AOL, eBay) may fall at least 50% (each of these has fallen that much at one point this year). If you buy on full margin and your stocks fall 50%, your account is closed with zero dollars and zero cents to your name if you can't cover the loss with extra funds. If you don't have margin, you can ride out the decline as long as you believe in your companies.

Where Is All This Going?

If you avoid high levels of margin and if you have a long time horizon and buy world-leading companies, then the most that we should say is that history indicates that you'll do well. History says that you will make good money over 20 years, and almost certainly over 30. Stocks should be your vehicle. However, regarding any shorter term -- including 10 years -- there is much less that we can or should say. Even history does not offer much support in the case of one decade, because there are too many 10-year periods that proved fruitless for stock investors who had to sell. It would be a disservice for us to write soothing words to the contrary.

Besides, one might question why we should write soothing words at all. First, we're just investors, like you. We may have more experience than some readers, but that doesn't mean that we have more foresight. We don't know what will happen to the stock market even over a 20-year period. Second, money shouldn't be an issue for which one regularly needs soothing anyway -- at least not ideally.

Money may be liberating, but for many people it is instead a form of imprisonment. How much money is enough? A content person may say each morning: "Do I have enough money for today? Then that's all I need." So why do people always seek more money, especially money for which they don't have a planned use? Insecurity? Or because they equate money with living "well"? Money may represent opportunity, but opportunity can only be captured when you have freedom of action. Chasing money can lead to the opposite of that freedom.

Invest in the stock market for a term of at least 10 years and ideally at least 20. If you invest in leading companies for at least a few decades and you don't try to "time" the market, use excessive margin, or flip-flop on what you think are great companies (thereby trading too often), history indicates that you will succeed monetarily in the end. In the meantime, accept that the stock market will go up and down. It may peak and then decline for a number of years. Maybe 5. Maybe 10. Don't give the money so much importance that investing isn't fun anyway. Whatever value your assets end at, they will be of little value to you if you don't enjoy the ride all these years.

Fool on!

--Jeff Fischer, TMF Jeff on the boards.


As always, share any thoughts about tonight's recap in our Rule Breaker Strategies board. And if you are looking into, or for, any new Rule Breaker prospects, the conversation always continues on our Rule Breaker Companies message board.






Rule Breaker Portfolio

10/15/99 Closing Numbers
Ticker Company Dly Pr Chg Price
AMGNAMGEN INC-4 21/32$80.75
AMZNAMAZON.COM-4 17/32$75.06
AOLAMERICA ONLINE-6$109.00
ATHMAT HOME CORP CL A-2 5/16$40.81
CATCATERPILLAR INC7/16$56.06
CHVCHEVRON CORP5/16$88.31
DDDU PONT (EI) DE NEMOURS-1 13/16$62.44
EBAYEBAY INC-7 1/2$134.13
GTGOODYEAR TIRE & RUBBER CO-1 3/4$46.19
IOMIOMEGA CORP1/16$3.38
SBUXSTARBUCKS CORP-5/8$22.00
TDFX3DFX INTERACTIVE-1/8$8.06

  Day Week Month Year
To Date
Since
8/5/94
Annualized
Rule Breaker -4.86% -11.71% -.93% 29.41% 1,201.36% 63.85%
S&P 500 -2.81% -6.63% -2.75% 1.48% 172.12% 21.25%
S&P 500(DA) -2.81% -6.63% -2.75% 2.06% 186.38% 22.44%
NASDAQ -2.67% -5.36% -.52% 24.59% 279.33% 29.25%

Trade Date # Shares Ticker Cost/Share Price LT % Val Chg
8/5/942200AOL0.917$109.0011,785.29%
9/9/972640AMZN3.188$75.062,254.89%
5/17/951960IOM1.280$3.38163.59%
12/16/98580AMGN42.889$80.7588.28%
12/4/98900ATHM28.040$40.8145.55%
2/26/99300EBAY100.527$134.1333.42%
2/23/99300CAT46.964$56.0619.37%
2/23/99180CHV79.169$88.3111.55%
2/20/98260DD58.844$62.446.11%
2/23/99290GT48.715$46.19-5.19%
7/2/98470SBUX27.955$22.00-21.30%
1/8/98425TDFX25.667$8.06-68.59%

Trade Date # Shares Ticker Cost Value LT $ Val Ch
8/5/942200AOL$2,017.62$239,800.00$237,782.40
9/9/972640AMZN$8,415.03$198,165.00$189,750.00
12/16/98580AMGN$24,875.50$46,835.00$21,959.50
12/4/98900ATHM$25,236.13$36,731.25$11,495.13
2/26/99300EBAY$30,158.00$40,237.50$10,079.50
5/17/951960IOM$2,509.63$6,615.00$4,105.37
2/23/99300CAT$14,089.25$16,818.75$2,729.50
2/23/99180CHV$14,250.50$15,896.25$1,645.75
2/20/98260DD$15,299.44$16,233.75$934.31
2/23/99290GT$14,127.38$13,394.38($733.00)
7/2/98470SBUX$13,138.63$10,340.00($2,798.63)
1/8/98425TDFX$10,908.63$3,426.56($7,482.06)
  Cash: $5,954.23  
  Total: $650,447.70  



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.