RULE MAKER PORTFOLIO

<THE RULE MAKER PORTFOLIO>

Investment Horror Story

By Matt Richey (TMF Verve)

ALEXANDRIA, VA (July 1, 1999) -- Back in January 1997, Micrion Corp. (Nasdaq: MICN) looked like a table-pounding buy. The company's focused-ion-beam technology did something related to the manufacturing of semiconductors and disk drives -- and anything related to those two sectors was on fire. Wall Street's analysts were bullish on the company's outlook, giving it a "strong buy" rating. And to top it all off, the stock was cheap! Based on the consensus estimate for earnings and five-year growth, the shares were selling at a forward price-to-earnings ratio well below the estimated growth rate. How could I go wrong?

At $25 per share, the stock had been moving up strongly, more than doubling over the past two months alone. Folks on the message boards said this puppy was on its way to $40. With such strong price momentum, the backing of influential analysts, and a red-hot disk drive sector, I knew I better get onboard, and quick!

At the time, I was rather new to the world of stocks and investing, but I certainly knew better than to take this kind of momentum-driven gamble. Even so, with dollar signs flashing in my eyes, I hit the buy button on Micrion in mid-January at $25. The shares hovered in the mid-$20s for a few weeks, but then began to plunge in February. By mid-March, the stock had fallen all the way to $15. At that point, I cut my losses -- all 40% of them.

Ouch! As you can see, my preferred method of learning is...

The Hard Way.

I thought I was a Fool. Heck, I'd read The Motley Fool Investment Guide! Shouldn't that make me Foolish? It should, but unfortunately, there's a vast gulf between the knowing and the doing. By definition, a fool is someone who knows the right thing to do, but does otherwise. I was definitely a fool. The red ink that flowed from my fling with Micrion can be summed up in the popular maxim:

"A little knowledge is a dangerous thing."

I knew just enough about Micrion to hurt myself. My mistakes began with the use of the Zacks monthly publication of analysts' earnings estimates. Not only did I use this guide for what are often faulty estimates of future earnings, but worse, I relied upon Zacks' stock ratings ("1" = strong buy; "5" = strong sell) to identify investment ideas. Horrible idea! An individual investor's greatest advantage is in having first-hand familiarity with a company's products or services.

If I'd used my daily experience as the source of investment ideas in 1997, I might've invested in America Online, Coca-Cola, Microsoft, or Gap -- among so many other exceptional performers. Perhaps the "buy what you know" strategy is too easy to seem true, but this cannot be over-emphasized: personal consumer experience is the best source of investment ideas. Nowadays, when I have a fantastic consumer experience, I go and check out the company's website, read the latest annual report, and see what others are saying on our message boards. Ya never know, it could be the next Rule Breaker or Rule Maker.

My next mistake with Micrion was focusing on valuation instead of business quality. I thought I'd uncovered an undervalued stock since its P/E ratio was well below its earnings growth rate. The PEG, or the price-to-earnings-to-growth ratio (a.k.a. The Fool Ratio), is a rule-of-thumb metric for identifying value in small-cap growth stocks. The Fool Ratio can be an effective tool for finding good small-caps, but one of the conditions for its proper use is a careful study of the company's financial statements, which leads us to my last and most important mistake.

If only I had taken a mere 15 minutes to analyze Micrion's financial statements, I would've discovered the company's deteriorating financial condition. Sure, using Zacks, I was aware of the annual revenues, net income, and earnings-per-share growth rates, but financial analysis that is not. In particular, I missed out on some eye-opening numbers on the company's balance sheet.

The balance sheet is where you'll find a company's financial foundation -- the cash and productive assets from which a company builds its business. A balance sheet awash in debt and without efficient use of cash is like a foundation of sand -- the company is sure to sink. If I'd only understood the critical importance of a healthy balance sheet, I never would've invested in this company -- no matter what the price. In the following table, check out the company's abysmal Flow Ratio and the deteriorating ratio of cash to debt. (If you're not yet familiar with these simple ratios, I strongly encourage you to venture over to the Rule Maker Criteria.)

                  1996           1995
Flow Ratio        3.29           3.77
Cash-to-Debt      1.5          104.9

These are the numbers I would've discovered, had I taken just a few moments to click into the company's 1996 10-K. Even though the Flowie is declining (improving), it is still terribly far from our benchmark of 1.25. There are a lot of colorful words I could use to describe a Flowie of 3.29, but let's just say that it is bad. For every $1 of "good" interest-free current liabilities, Micrion is carrying $3.29 of nasty non-cash current assets, such as accounts receivable and inventory, both of which are prone to collapsing value over time.

Similarly, looking at the relationship of cash to debt, Micrion's 1996 ratio of 1.5 exactly meets our benchmark, but the ominous direction of that metric between 1995 and 1996 tells us that something is amiss. Consider that, in 1995, Micrion had nearly $105 in cash for every $1 of debt -- very good. But, by 1996, the company had accumulated so much debt that it had only $1.50 of cash for each $1 of debt, which is just on the threshold of adequacy. Clearly, things are heading in the wrong direction. In the next table, you can see that, sure enough, Micrion's balance sheet was crumbling.

                    1998          1997
Flow Ratio          4.89          3.50
Cash-to-Debt        0.3           0.3

This is the picture of a cash-starved company that is trying to prop up its income statement with a collapsing balance sheet. Again, a simple analysis of the balance sheet would've tipped me off to the company's precarious financial standing.

There are probably dozens of lessons that can be taken from my tale of terror, but I'll leave you with these two:

  1. Familiar companies make the best investments.
  2. Study the balance sheet.

Think you've made an investment worse than Micrion? At the very least, you can still salvage a lesson learned by sharing it on the My Dumbest Investment message board. Good night!

07/01/99 Close
Stock Change    Bid
AXP   +3        133.13
CHV   +1 1/4     96.31
CSCO  -  1/8     64.38
EK    +1 15/16   69.69
GM    +1 5/8     67.63
GPS   -  3/8     50.00
INTC  +3 3/8     62.88
KO    +2 7/8     64.88
MSFT  +1         91.19
PFE   +1 32/97   37.50
SGP   +1 5/16    53.94
TROW  +  3/4     39.13
XON   +1 5/16    78.44
YHOO  +5 1/8    177.38


                  Day     Month  Year    History
        R-MAKER  +1.93%   1.93%  15.94%  46.71%
        S&P:     +0.60%   0.60%  12.92%  39.65%
        NASDAQ:  +0.77%   0.77%  23.42%  63.73%

Rule Maker Stocks

    Rec'd    #  Security     In At       Now    Change
    2/3/98   48 Microsoft     39.13     91.19   133.01%
   6/23/98   68 Cisco Syst    29.21     64.38   120.42%
    5/1/98 82.5 Gap Inc.      22.91     50.00   118.22%
   2/13/98   44 Intel         42.34     62.88    48.51%
   2/17/99   16 Yahoo Inc.   126.31    177.38    40.43%
    2/3/98   66 Pfizer        27.43     37.50    36.70%
   5/26/98   18 AmExpress    104.07    133.13    27.92%
    2/6/98   56 T. Rowe Pr    33.67     39.13    16.19%
   8/21/98   44 Schering-P    47.99     53.94    12.39%
   2/27/98   27 Coca-Cola     69.11     64.88    -6.12%

Foolish Four Stocks

    Rec'd    #  Security     In At     Value    Change
   3/12/98   20 Exxon         64.34     78.44    21.92%
   3/12/98   15 Chevron       83.34     96.31    15.56%
   3/12/98   20 Eastman Ko    63.15     69.69    10.36%
   3/12/98   17 General Mo    72.41     67.63    -6.60%

Rule Maker Stocks

    Rec'd    #  Security     In At     Value    Change
    2/3/98   48 Microsoft   1878.45   4377.00  $2498.55
   6/23/98   68 Cisco Syst  1985.95   4377.50  $2391.55
    5/1/98 82.5 Gap Inc.    1890.33   4125.00  $2234.67
   2/13/98   44 Intel       1862.83   2766.50   $903.67
   2/17/99   16 Yahoo Inc.  2020.95   2838.00   $817.05
    2/3/98   66 Pfizer      1810.58   2475.00   $664.42
   5/26/98   18 AmExpress   1873.20   2396.25   $523.05
    2/6/98   56 T. Rowe Pr  1885.70   2191.00   $305.30
   8/21/98   44 Schering-P   2111.7   2373.25   $261.55
   2/27/98   27 Coca-Cola   1865.89   1751.63  -$114.27

Foolish Four Stocks

    Rec'd    #  Security     In At     Value    Change
   3/12/98   20 Exxon       1286.70   1568.75   $282.05
   3/12/98   15 Chevron     1250.14   1444.69   $194.55
   3/12/98   20 Eastman Ko  1262.95   1393.75   $130.80
   3/12/98   17 General Mo  1230.89   1149.63   -$81.27

                              CASH     $70.09
                             TOTAL  $35298.03

Note: The Rule Maker Portfolio began with $20,000 on February 2, 1998, and it added $2,000 in August 1998 and February 1999. Beginning in July 1999, $500 in cash (which is soon invested in stocks) is added every month.

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