RULE MAKER PORTFOLIO

Rule Maker Portfolio
Wiggle Room

By Rob Landley (TMF Oak) (TMFOak)

NEW JERSEY (Oct. 22, 1999) -- Yesterday, Phil talked about Pfizer's (NYSE: PFE) third-quarter results, and the fact that the company chose to take a large expense related to the tightened regulatory issues facing antibiotic Trovan. Pfizer wrote off $310 million of Trovan inventories from its balance sheet, and treated this loss as a one-time charge on the income statement. They were willing to count the revenue generated by Trovan in previous quarters as income, but wanted to take this expense -- for a drug they will still be selling in the future -- out of their calculations for current operating income. This, understandably, annoyed Phil a bit. I'd like to talk about why I think Pfizer did it.

The fact is, companies today are under huge pressure from stock traders to produce consistent, predictable, ever-increasing earnings. A single bad quarter can have an enormous impact on a company's stock price, as was demonstrated yesterday by IBM's (NYSE: IBM) double-digit drop.

With most stocks trading at historically high multiples to their earnings, traders are nervous and skittish. Earnings and cash in the bank indicate what a company is worth today; everything higher than that indicates unrealized potential. The economy is doing wonderfully; we have great hopes for the future, and we're fairly certain that these companies will all grow to be much larger than they are today. We believe this enough to pay for some of this growth before it actually happens.

But with extremely high multiples, most of what we're buying is potential and not present-day reality. Determining exactly how much future potential you're willing to pay for depends on how much future you're willing to include in your calculations. We at the Rule Maker Portfolio tend to have a longer time horizon than most investors, so we don't pay a whole lot of attention to the venerable price-to-earnings (P/E) ratio as long as we think this company will still dominate its field 10 years from now. So we in the Rule Maker continue to invest in these expensive companies because we think that what they will be 10 years from now is cheap at today's price. We call our philosophy QuaVa.

Investors with a shorter time horizon are being squeezed out of many attractive investment opportunities by the price of the shares. If Microsoft went out of business in two years, it would certainly not be worth the multiple people pay today. People continue to pay Microsoft's lofty multiple because they don't think Bill Gates & Co. will face bankruptcy anytime soon. But when the price requires an investor to predict three, four, or even five years ahead, a lot of investors just can't see that far into the future.

The result is that a large body of investors can't empirically justify why their money is invested in a given stock. Even the ones trying very hard to think long term, the ones who sneer at day traders, are still placing their money in some of the highest growth stocks simply because that's what they see everybody else doing.

Following the herd does not provide an investor with any kind of resolve to stay invested through a bad quarter. Or through a bad dream. As valuation increases, so does volatility. Thus companies with high valuations try very, very hard not to post a bad quarter, because the results can be extremely disproportionate. It would spook the herd.

Capitalism is, by its very nature, uncertain. No company can guarantee that customers will buy its products, whether it's a mom and pop corner bookstore that simply has no customers one day or a huge defense contractor that gets outbid for a lucrative contract. There are such things as down quarters, quite naturally. Economic activity often behaves like an ocean, with ebbs and flows and strange little swirls of consumer sentiment that mean absolutely nothing, but still wind up on the quarterly income statement as earnings fluctuations.

So how does a company keep its investors from getting spooked? First off, by turning its stock analysts into well-trained pets. It's much easier to "meet expectations" when corporate management is setting those expectations. Who remembers that the earnings estimates were revised downward a few weeks before the results were released? As long as the company didn't come in beneath what some suit on CNBC said they'd come in at this morning, all is well with the world. For an extra margin of safety, a company can try to persuade the analysts to produce low estimates, so that reality can "beat expectations" and the investors get doubly reassured.

Playing with the contents of the SEC filings is a more dangerous game, because the Securities and Exchange Commission audits them and has enough enforcement clout to make life very unpleasant for a company that lies in its 10-K or 10-Q. But within those constraints, a company can strive for as much wiggle room as possible.

One-time charges are often a matter of opinion. For example, building a new factory or purchasing another company might arguably be treated as a one-time charge, despite the fact it's part of the very growth for which investors bought the company in the first place. Adjusting the company pension plan is another one-time charge, although the company still employs the same people afterward. And expenses related to the Year 2000 problem, flooding, or hurricane damage? There are certainly cases for them, which isn't to say similar things won't happen in the future.

The fact is, every "one-time charge" is still money the company actually spent, and part of the cost of doing business for that company. Sweeping it into a special corner of the income statement doesn't mean the money came from some wealthy relative. And if companies are happy to count one-time gains (like the sale of a subsidiary) as part of earnings, why aren't one-time charges considered similarly? So as not to spook the herd, that's why.

One-time charges are just the tip of the iceberg of games companies play with their reported numbers. Phil can tell us about capitalized leases, and long-term debt converted to regularly refinanced short-term debt (or even preferred stock). Money comes in, money goes out, and in the meantime it plays dress-up.

A company's 10-K and 10-Q filings contain some of the most valuable information we as investors have to evaluate the performance of our investments, but we have to read the footnotes. And if we have questions, we can call investor relations, or come to the message boards. SEC filings are like tax returns: Their accuracy is enforced by law, but they're still prepared by people who will exploit any wiggle room they have. We need to have our grain of salt handy while reading them.

In closing, more Rule Maker earnings came out yesterday. Coca-Cola (NYSE: KO) "met" Wall Street earnings estimates for $0.32 per share. Forget not that last month the company warned analysts that third-quarter earnings would fall short of the original $0.34 consensus. The beverage giant is still struggling to find growth. Unit case volume for the quarter rose 2.5% on a comparable basis to a year ago. When you include the recent acquisition of 25 Cadbury Schweppes beverage brands -- Canada Dry, Crush, Dr. Pepper, and others -- reported unit case volume increased 3.5% for the quarter.

All in all, sales grew 9%, but each dollar of sales was less valuable than a year ago because of shrinking margins. Gross margins fell to 67.2% and net margin dropped to 15.1%. Those figures are well above our standards, but the direction is disconcerting. Though no balance sheet is yet available, debt appears to be outgrowing cash, as indicated by the increasing net interest expense that ate up $27 million this quarter, up from $16 million last year and $8 million in Q3 of 1997. The Q3 earnings release has all the details.

One last thing -- our annual charity drive is off and running. In the past two years, you've helped donate $320,000 to Share Our Strength, an organization that fights hunger in creative ways. But this year's drive has a unique twist: You get to help choose the charities. To get involved in this year's Foolanthropy effort, please click into our Fool Charity Drive.

- Oak

What do you think?
Come post your thoughts about tonight's report on our Rule Maker Strategy board. Alternatively, if you have ideas, analysis, or questions about a particular Rule Maker company, take a seat at the roundtable discussion on our Rule Maker Companies board. Finally, if you're new to all this stuff, the Rule Maker Beginners board is the place to get your questions answered.


 




Rule Maker Portfolio

10/22/99 Closing Numbers
Ticker Company Dly Pr Chg Price
AXPAMER EXPRESS3/4$148.63
CHVCHEVRON CORP1/16$93.75
CSCOCISCO SYSTEMS-2 5/8$66.56
DPHDELPHI AUTOMOTIVE SYSTEMS5/8$15.56
EKEASTMAN KODAK11/16$68.63
GMGENL MOTORS7/16$65.81
GPSGAP INC-1 3/8$33.94
INTCINTEL CORP3/4$73.44
KOCOCA-COLA CO15/16$55.25
MSFTMICROSOFT CORP-3/8$92.69
PFEPFIZER, INC-1/8$41.63
SGPSCHERING-PLOUGH-1/8$48.63
TROWT.ROWE PRICE ASSOC5/8$31.06
XONEXXON CORP13/16$76.88
YHOOYAHOO INC-3 13/16$178.13

  Day Week Month Year
To Date
Since
2/2/98
Annualized
Rule Maker -.20% 5.41% 3.78% 12.30% 40.36% 21.80%
S&P 500 1.41% 4.35% 1.48% 5.89% 32.78% 17.93%
S&P 500(DA) 1.41% 4.35% 1.48% 6.47% 34.55% 18.84%
S&P 500(DCA) n/a n/a n/a n/a 19.61% 10.98%
NASDAQ .52% 3.10% 2.56% 28.45% 73.93% 37.98%

Trade Date # Shares Ticker Cost/Share Price LT % Val Chg
6/23/9875CSCO32.865$66.56102.53%
2/3/9859MSFT49.352$92.6987.81%
2/13/9852INTC46.928$73.4456.49%
2/3/9866PFE27.433$41.6351.73%
5/1/9882GPS22.708$33.9449.45%
5/26/9818AXP104.067$148.6342.82%
2/17/9916YHOO126.309$178.1341.02%
3/12/9820XON64.335$76.8819.49%
3/12/9815CHV83.343$93.7512.49%
3/12/9817GM60.399$65.818.96%
3/12/9820EK63.148$68.638.67%
8/21/9844SGP47.993$48.631.32%
2/3/9856TROW33.673$31.06-7.75%
3/12/9811DPH17.202$15.56-9.53%
2/27/9827KO69.107$55.25-20.05%

Trade Date # Shares Ticker Cost Value LT $ Val Ch
2/3/9859MSFT$2,911.79$5,468.56$2,556.77
6/23/9875CSCO$2,464.86$4,992.19$2,527.33
2/13/9852INTC$2,440.28$3,818.75$1,378.47
2/3/9866PFE$1,810.58$2,747.25$936.68
5/1/9882GPS$1,862.06$2,782.88$920.81
2/17/9916YHOO$2,020.95$2,850.00$829.05
5/26/9818AXP$1,873.20$2,675.25$802.05
3/12/9820XON$1,286.70$1,537.50$250.80
3/12/9815CHV$1,250.14$1,406.25$156.11
3/12/9820EK$1,262.95$1,372.50$109.55
3/12/9817GM$1,026.78$1,118.81$92.04
8/21/9844SGP$2,111.70$2,139.50$27.80
3/12/9811DPH$189.22$171.19($18.03)
2/3/9856TROW$1,885.70$1,739.50($146.20)
2/27/9827KO$1,865.89$1,491.75($374.14)
  Cash: $181.37  
  Total: $36,493.25  


Notes
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.