Rule Breaker Portfolio Nine Stocks to Watch

In 1994, the Gardner brothers started the Fool Portfolio. Over the years, David Gardner refined his investing philosophy, and in October 1998 rechristened it the Rule Breaker Portfolio. We close our real-money portfolios this week and take the temperature of the port's nine stocks -- seven long and two short.

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By Tom Jacobs (TMF Tom9) and Jeff Fischer (TMF Jeff)
February 25, 2003

We announced last week that The Motley Fool is closing its online real-money portfolios, and co-manager Jeff Fischer devoted a column to answer questions. These stocks are definitely not going away. Our vast and growing Motley Fool Community will continue to debate them and others in our discussion boards, while our writers will analyze them in their columns.

Fine, but what do we think about the stocks right now? Here are snapshots of where all nine stand today, and what investors should watch in the coming months and years.

Tom starts with four companies and then yields the flickering pixels to Jeff for the rest. It's a long column, but the last Rule Breaker Port piece is no place to mince words!

Lute loot or lout?
I expected Q4 to show huge dents in Guitar Center's (Nasdaq: GTRC) Fender, but the balance sheet and income statement in the company's Q4 press release show at most scratches. Guitar Center's Q4 presented four key pieces of information for shorts -- one bad, two good, one maybe good.

Bad news for shorts first: Gross and net margins increased both sequentially and year over year. This may be a sign of some pricing power. My bad. I was convinced that Guitar Center could not achieve anything close to 3.8% net margins in Q4, and unaudited numbers show them over 4%. Ouch.  

On the short good side are two measures of capital management: The Flow Ratio increased year over year again, from 2.04 in Q4 2000 to 2.16 in 2001 to 2.35 in 2002. (Anything above two is a warning sign.) Ditto the company's cash conversion cycle, from 73 days in Q4 2000 to 78.9 days in 2001 to 88.3 days in 2002. On the maybe good side, inventories increased more than sales, as they have for six of the last eight quarters. Some say that this reflects Guitar Center's expansion. If it does, it is expansion not well managed.

In the absence of a catalyst -- and I expected Q4 to provide one -- it can take a long time for a short based on increasing debt, rising inventories, and poor cash management to yield results. I will be prepared to cover whenever Guitar Center's financials show that the short analysis is no longer correct. I'd like to see Q1's numbers, due in a quarterly report filed with the SEC by May 15, before determining whether Q4 was an anomaly or the beginning of better health.

They compete. You win?
I think that the stock in our port with the best prospects for whomping appreciation is online lending exchange LendingTree (Nasdaq: TREE), which I analyzed last May in The Motley Fool Select and we bought for the port in June. The company, which was near death 12 to 18 months ago, has done an about-face so rapidly it must have whiplash. It quickly turned GAAP profitable and free cash flow positive ahead of schedule, in large part on the wave of home mortgage refinancings that comprised $0.13 of Q4's $0.19 EPS. With over $22 million in cash, and another $4.8 million in restricted cash, it could pay off its entire convertible debt tomorrow. Jeff recently lauded the company's hot Q4

There were at least three pleasant surprises in Q4. First, the realty services business grew. I thought this was a loser from the start, and that's clearly wrong. Second, the company proved sharp by adding a phone channel for borrowers who do not use the Internet. There may be added cost, but the firm says that so far it's also come with higher conversion rates. Third, it is beginning to show some of the pricing power that can juice operating cash flow for its light and scalable business model, which earns fees both on forwarding completed borrower forms to lenders and then when any resulting loan closes.

With a $247 million market cap, LendingTree trades at 13 times forward estimated free cash flow. I'll be writing regularly about this company, which I also own in my personal portfolio. 

Free cash flow river
Readers know that I've ranted about biotech drug maker Amgen's (Nasdaq: AMGN) absurd valuation for several years. Like Genentech (NYSE: DNA), Amgen's business, based on best-selling biologics (large molecule drugs), produces extraordinary free cash flow. But their valuations reflect future growth assumptions that may be excessive because the stocks have become the must-have biotech drug makers -- "pay any price, you gotta have 'em."

Before it bought Immunex, Amgen was valued at 50 to 60 times free cash flow, but growing it most recently at half that rate. Not an unheard-of premium, but one that leaves no room for error, and certainly none for Rule Breaker returns of 10 times in five years. We'll need a few quarters of the new combined company's numbers before we know whether the valuation has come down to earth relative to growth.

Buy anything online
I'll admit that I don't know a great deal about Amazon (Nasdaq: AMZN), though I'm an inveterate customer. We're happy that the stock certainly has rebounded from 2001 lows, reflecting sales growth and improved finances. Our Amazon discussion board dissects its business and results, most recently showcasing a spirited debate about the potential effects of charging sales tax.

Now, Jeff chimes in on the rest of the port's holdings. 

Millennium Pharmaceuticals (Nasdaq: MLNM) was our most recent purchase and has been one of our worst performers -- chopped in half with the biotech index. We knew this could happen and it could be a long time before it rebounds. Although it has growing partnership revenue, Millennium is still a development-stage company, with only a few drugs in late-stage trials and only one on the market.

This month, Millennium filed its fast-track drug, Velcade, for approval for multiple myeloma. An FDA decision could arrive within six months. Approval would be a large boon for Millennium. On the flip side, denial would be a significant setback for a drug it is also testing for cancers with much larger patient populations, such as non-small cell lung cancer, than multiple myeloma. Such drama comes with biotech.

You need to be especially patient to hold a company that's still trying to develop initial revenue streams. You need to believe in management's vision and, more than that, management needs a tangible plan and the assets to achieve it: enough cash, enough smart personnel, enough partnerships, enough promise in the pipeline. I think Millennium has all this.

Management expects about $353 million in sales this year, up 43%, mostly due to sales of cardiovascular drug Integrilin that came with its purchase of COR Therapeutics. Execs predict a breakeven performance in 2006. That assumes a few drug approvals, not unreasonable given 12 products in clinical trials. We're willing to hold Millennium in hopes that its promise comes to fruition -- but no one should discount the huge risk here.

eBay (Nasdaq: EBAY) has been my favorite company since 1998. Its business model is by nature a competition-blocking moat, it has skillful worldwide execution, and it's been profitable from day one. As we speak, the stock is near a 52-week high. This means it isn't cheap. The secret is out. eBay is a worldwide success story.

The company expects $5 billion in 2005 revenue and $1 billion in 2005 free cash flow, with around 35% operating margins. It's valued at about 80 times current free cash flow, and trades at roughly 23 times the forward (two years forward, yes) 2005 free cash flow estimate. It is priced for perfection; it is priced to continue to top estimates.

One misstep and the stock will no longer outperform as it has since its IPO. However, lacking a misstep, we believe it could continue its above-average ways. We don't have plans to sell our shares in what could be one of the best success stories of this decade, and longer. eBay is still a young operation.

An aside from Tom: Back in December 2000, when eBay dipped under $30 a share, I sneered to Jeff that I wouldn't touch eBay until it moved towards $20. Don't I look silly now!

Starbucks (Nasdaq: SBUX) is another company that people continually view as overvalued, yet even during one of the worst bear markets in history, as with eBay, the stock held up and even rose. The shorts must be dumbfounded. We're happy. Starbucks continues to report excellent same-store sales, month after month, and it keeps growing by opening new stores. International opportunities are only beginning.

As with eBay, Starbucks isn't inexpensive by any stretch, but it's hard to imagine us not owning a piece of the coffee king for the next few decades. Time can make expensive prices of yesteryear look low in retrospect, and that Starbucks held up during the market's slide might say something. At any rate, this well-run company will likely stay in the port a long time.

We shorted Sirius Satellite Radio (Nasdaq: SIRI) in January 2002, hoping to profit on a declining stock. Since then, Sirius has fallen about 90%, becoming our most successful short return (we've had other shorts go to $0 after we covered). Although we believe the company could end up defunct or sold for peanuts, leaving shareholders with worthless stock, we're not against closing the position now, taking our profit and moving on victoriously.

The amount of additional profit to be gained on the short is very limited now, and risks remain that it could turn and run on us. So, we'd be happy to take our 90% gain and move on; perhaps David Gardner will do it. That said, risk-seeking investors hoping to score a perfect short (100%) could hold on and hope for this in a year or two. We don't believe Sirius will sign enough subscribers to make its business last. (Tom sez: P.S. Most individual investors can't short Sirius today because most brokerage firms won't permit an individual to short a stock under $5.00 a share. However, we're checking into this in response to an email from a TMF community member.)   

Finally, AOL Time Warner's (NYSE: AOL) story is over-versed by now: management shuffles, declining AOL subscribers, falling advertising revenue, huge losses, and giant debt. Will it turn around? David Gardner opined so in a mid-2002 issue of Motley Fool Stock Advisor. He's holding the stock, believing it can't get much worse than this -- thinking eventually it'll get better. This portfolio probably wouldn't sell it anytime soon.

Parting words
Now it's time to say goodbye to the Rule Breaker Portfolio, but not to its stocks and not to the investing strategy, which will live on in our columns and discussion boards. We thank you for your interest in The Motley Fool and invite you to say a cheery hello to new content changes next week. (Hint: Tom's picture indicates that modeling is not in his future.) Next week, Tom writes on Tuesday and Jeff on Thursday, because it takes him a few days to get going. Our friendly stock rivalry continues.

Final portfolio returns below. Have a most Foolish week!

Tom Jacobs (TMF Tom9) and Jeff Fischer (TMF Jeff) are both Survivor fans and would be happy to open Fool Amazon and an insect repellent concession. For now, they must be satisfied with our very busy Survivor discussion board.  Tom owns shares of LendingTree and Millennium Pharmaceuticals and is short Guitar Center. Jeff owns shares of eBay and Millennium Pharmaceuticals. The Motley Fool has a  disclosure policy.

Rule Breaker Portfolio Returns as of 02/24/03 Market Close:

            RB        S&P     S&P 500
            Port      500      DA*    Nasdaq
Week        1.24%    -0.29%    --      0.92%
Month      -0.39%    -2.70%    --      0.10%
Year 2.24% -5.37% -- -0.99%
IRR** since 8/4/94*** 20.16% 7.22% 9.07% 7.35%
10/20/98***-0.22% -5.56% -4.94% -6.08%

*Dividends added. Or, danger ahead. Whatever.

**Internal Rate of Return. This performance measure is more meaningful than total return because we began adding cash occasionally in July 2001. In a total return calculation, or ((Current Value - All Cash Deposited)/All Cash Deposited), cash added would show up as returns. And that wouldn't be cricket!

***What's this? The Rule Breaker Portfolio's precursor, the Fool Portfolio, was born Aug. 4, 1994. In a 10/20/98 column, David Gardner announced the name change of the Fool Portfolio to the Rule Breaker Portfolio. Here we provide returns as if the RB Port started on either date. Remember, don't mimic any online portfolio. Most individual investors should restrict any positions as risky as these to under 20% of their portfolio -- and could have a long and happy investing life with 0%.

Rule Breaker Portfolio

  Ticker Company Price
 Change
 Daily Price
 % Change
 Price 
  AMZN AMAZON.COM, INC. 0.10 0.46% 21.88 
  AOL AOL TIME WARNER INC. 0.37 3.68% 10.43 
  TREE LENDINGTREE INC 0.47 4.25% 11.52 
  EBAY EBAY INC (0.1) (0.13%) 77.65 
  MLNM MILLENNIUM PHARMACEUTICALS INC 0.07 0.99% 7.13 
 SHORT  SIRI SIRIUS SATELLITE RADIO INC (0.04) (4.55%) 0.84 
  SBUX STARBUCKS CORP 0.31 1.38% 22.82 
  AMGN AMGEN INC 0.71 1.34% 53.86 
 SHORT  GTRC GUITAR CENTER INC 0.42 2.06% 20.89 
  SPY SPDR TRUST;1 0.67 0.80% 84.47 
      
  Trade Date # Shares Ticker Cost/Share Price  Total % Ret  
 09/09/97 1320 AMZN 3.20 21.88  591.49%
 08/05/94 4020 AOL 0.46 10.43  2,272.96%
 06/03/02 916 TREE 13.72 11.52  -15.97%
 02/26/99 1145 EBAY 46.54 77.65  66.87%
 09/27/01 2260 MLNM 14.69 7.13  -51.44%
 SHORT 01/24/02 2500 SIRI 6.90 0.84  87.83%
 07/02/98 940 SBUX 13.98 22.82  63.36%
 12/16/98 1160 AMGN 21.44 53.86  151.24%
 SHORT 08/21/02 1000 GTRC 16.49 20.89  -26.76%
 04/24/02 290 SPY 110.16 84.47  -23.28%
      
  Trade Date # Shares Ticker Total Cost Current Value  Total Gain  
 09/09/97 1320 AMZN 4,220.20 28,881.60  24,661.40 
 08/05/94 4020 AOL 1,860.42 41,928.60  40,068.18 
 06/03/02 916 TREE 12,565.44 10,552.32  -2,013.12 
 02/26/99 1145 EBAY 53,294.44 88,909.25  35,614.81 
 09/27/01 2260 MLNM 33,207.00 16,113.80  -17,093.20 
 SHORT 01/24/02 2500 SIRI 17,258.26 2,100.00  15,141.74 
 07/02/98 940 SBUX 13,138.62 21,450.80  8,312.18 
 12/16/98 1160 AMGN 24,875.50 62,477.60  37,602.10 
 SHORT 08/21/02 1000 GTRC 16,488.00 20,890.00  -4,418.00 
 04/24/02 290 SPY 31,945.00 24,496.30  -7,448.70 
Cash:573.54 
Total:306,123.81 


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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.