Fool.com: When to Sell a Rule Maker[Rule Maker] June 6, 2000

RULE MAKER PORTFOLIO
When to Sell a Rule Maker

By Bill Mann (TMF Otter)
June 6, 2000

One of the major criticisms of Rule Maker investing is that we have largely ignored defining our selling criteria. I'd go so far as to say that this is a good thing. If we are practicing business-centric investing then we should not be crafting a portfolio with an eye toward cashing out. Rule Makers are supposed to be top dogs in industries with expanding possibilities. The rules for paring a company so designated as a Rule Maker should therefore be quite loose and used sparingly. That is, all rules save one: You should sell if you have a better place to put your money, or if it will help you sleep at night. Of all of the rules, those are the ones that are wholly subjective.

Beyond that, we've actually written a fair amount within the Fool about selling. Below, I'm linking to five articles from the past 12 months, three of them very good, the other two I wrote. At the end I'm going to give my opinion on the proper methodology for selling a Rule Maker. We're looking for your opinions as well. Tell us how you would go about selling an existing Rule Maker in your portfolio.

Keep in mind that the one thing we will not focus on here is share price. We are business-centric, and Rule Maker tautology states that investors holding excellent businesses should, in the long term, be rewarded for their decision to do so. Poor share price appreciation could be a sign of a faltering business, but it is by no means the deciding factor. Rule Makers can have share prices that languish for years, only to leap skyward with no warning. The key is time in the market, not timing the market. Our reverence for Philip Fisher's philosophy to this regard has not changed. We still intend to hold our companies for 10 years or more, but a company that fails one or more of the tests below is eligible for review.

Some of the "Line of Death" reasons to sell a Rule Maker:

  1. Crooked Management

    We will not tolerate deceit from management. In fact, a company violating this standard is an outright sell. Less-than-honest management can rear its ugly head in many forms, including a criminal history, bad accounting, and hype-and-bail executives. We need not see the management break the law to determine that they are "crooked." The troubles facing MicroStrategy (Nasdaq: MSTR) and its 90% deterioration in price is a classic case of a company that used aggressive (and as it turns out, potentially illegal) accounting methodology to pump up its books. Not on my nickel, thank you.

  2. Mergers & Acquisitions

    When a Rule Maker is involved in M&A activity, you should re-evaluate the combined company, or conversely the leftover from a spinoff. If the new entity does not pass the Rule Maker criteria, a sell may be in order.

  3. To Rebalance your Portfolio

    I'm not a big fan of this one. But if you have a huge winner that grows to be an outsized part of your portfolio, you may wish to reduce the risk of most of your losses being attributable to one company. In hindsight, someone who did so with Qualcomm (Nasdaq: QCOM) in January this year would feel pretty smart right now. Someone who did so with Microsoft (Nasdaq: MSFT) in 1989 would not. Your call.

  4. Flawed Original Purchase Decision

    We all make mistakes. If you realize that in your original decision to invest you misjudged the business prospects or the Rule Makerness of a company, get out of it. It doesn't do you any good to hold a company if you later believe you made a mistake. Unring the bell and move on.

  5. Company No Longer a Top Dog

    Some companies respond well to competition, others fail to do so. A former Rule Maker is just that, a has been. Most has-beens do not make it back to the top, though there are exceptions, such as reborn Texas Instruments (NYSE: TXN). On the other hand, Bethlehem Steel (NYSE: BS) and Venator (NYSE: Z), the holding company for Woolworth, are great examples of former greats that have dimmed. They are yesterday's news, former kings of the hill. Those who hold such declining companies should not let avoidance of capital gains taxes drive their decisions. Avoiding taxes on an appreciated asset that now lacks potential for further growth is, in my mind, cutting off the nose to spite the face.

  6. Deteriorating Financials

    Even industry-leading Rule Makers are subject to the constant threat of declining product/service demand and encroaching competition. Whether the threat is external competition or internal stagnation, we rely upon the financial statements to show any signs of business weakness. Thus, we endorse checking up on the performance of Rule Makers on at least an annual basis, by reading the company's 10-K (or even better, all of the 10-Qs on a quarterly basis) and taking it through the Rule Maker criteria once again.

    Lucent (NYSE: LU) is a highly respected company in its industry and among investors, but its still unrepentant penchant for packing its supply chain so that it can book revenues does not bode well for its investors. Lucent's Flow Ratio currently stands at an ungodly 2.80 (the minimum threshold for RMs is 1.25) and has worsened by nearly 100% over the last 10 quarters. Contrast this to Cisco (Nasdaq: CSCO), which has improved its Flowie from 1.44 to a gaudy 0.87 in the same period. Lucent's got to clean up its own financial house before it stands a chance to overcome the fierce competition in its industry. (For more on Cisco and Lucent, see tonight's Fool on the Hill.)

    Deteriorating financials cuts to the heart of the matter specific to Rule Maker investing. The Rule Maker managers agree that failure to meet the RM Criteria for a prescribed period warrants a sell. We're prepared, with your assistance, to apply this methodology to our current holdings, and sell any that miss the targets. The rule of thumb we propose is "Four for Four." That is, a current holding that fails any four of the six quantitative tests for Rule Makers for four consecutive quarters is eligible for sale. This conservative nature recognizes the fact that even the best companies have down quarters, or even down cycles. But poor performance for a full year is reason enough to question the quality of any company, even one we bought intending to hold for decades.

    For review, the quantitative tests are:

    • Flow Ratio of 1.25 or lower
    • Minimum Sales Growth of 10%
    • Gross Margins of 50%+
    • Net Margins of 7%+
    • Cash no less than 1.5x total debt
    • Cash King Margin greater than 10%

    To review these criteria, go to the explanations in the Rule Maker Criteria. As always, we're looking for your input, and if you have found that any current holding in the Rule Maker portfolio falls on the wrong side of the criteria, bring it up on the Rule Maker Strategies Discussion Board.

    We're not opposed to selling, but we are mindful that Rule Makers are rare enough that, once identified, they should be sold only with great forethought.

Fool on!
Bill Mann, TMFOtter on the Fool Discussion Boards

Related Links:

  • Rule Maker "When to Sell? Part 1/Part 2
  • Rule Maker "A Reason to Sell"
  • Fool on the Hill "When to Sell"
  • Fool on the Hill "Bad Reasons to Sell"

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    Rule Maker Portfolio

    6/6/2000 Closing Numbers
    Ticker Company Day Chg % Chg Price
    AXPAMER EXPRESS-1 5/8-2.92%$54.00
    CSCOCISCO SYSTEMS-1 15/16-3.06%$61.31
    GPSGAP INC-5/16-0.90%$34.38
    INTCINTEL CORP-3-2.26%$129.56
    JDSUJDS UNIPHASE CORP-2 1/16-1.89%$107.00
    KOCOCA-COLA CO-3/8-0.72%$51.63
    MSFTMICROSOFT CORP3/44.11%$69.63
    NOKNOKIA CORP ADS-1 3/8-2.41%$55.63
    PFEPFIZER, INC11/161.61%$43.44
    SGPSCHERING-PLOUGH7/81.97%$45.25
    TROWT.ROWE PRICE ASSOC-1 1/16-2.43%$42.63
    YHOOYAHOO INC-2 1/4-1.64%$135.06

      Day Week Month Year
    To Date
    Since
    2/2/1998
    Annualized
    Rule Maker -1.40% -1.85% 6.56% -1.34% 65.83% 24.09%
    S&P 500 -.67% -1.31% 2.62% -.78% 48.72% 18.45%
    S&P 500(DA) -.67% -1.31% 2.62% -.78% 50.49% 19.05%
    S&P 500(DCA) n/a n/a n/a n/a 24.73% 9.89%
    NASDAQ -1.71% -1.49% 10.45% -7.69% 131.97% 43.19%

    Trade Date # Shares Ticker Cost/Share Price LT % Val Chg
    6/23/1998150CSCO16.432$61.31273.12%
    2/13/199865INTC53.762$129.56140.99%
    2/17/199939YHOO76.196$135.0677.26%
    2/3/199866PFE27.433$43.4458.34%
    5/1/199882GPS22.708$34.3851.38%
    5/26/199866AXP35.999$54.0050.00%
    2/3/199859MSFT49.352$69.6341.08%
    2/3/199856TROW33.673$42.6326.58%
    2/15/200068NOK47.500$55.6317.11%
    2/15/200032JDSU100.750$107.006.20%
    8/21/199844SGP47.993$45.25-5.72%
    2/27/199827KO69.107$51.63-25.30%

    Trade Date # Shares Ticker Cost Value LT $ Val Ch
    6/23/1998150CSCO$2,464.86$9,196.88$6,732.02
    2/13/199865INTC$3,494.54$8,421.56$4,927.02
    2/17/199939YHOO$2,971.64$5,267.44$2,295.80
    2/3/199859MSFT$2,911.79$4,107.88$1,196.09
    5/26/199866AXP$2,375.95$3,564.00$1,188.05
    2/3/199866PFE$1,810.58$2,866.88$1,056.30
    5/1/199882GPS$1,862.06$2,818.75$956.69
    2/15/200068NOK$3,230.00$3,782.50$552.50
    2/3/199856TROW$1,885.70$2,387.00$501.30
    2/15/200032JDSU$3,224.00$3,424.00$200.00
    8/21/199844SGP$2,111.70$1,991.00($120.70)
    2/27/199827KO$1,865.89$1,393.88($472.01)
      Cash: $528.20  
      Total: $49,749.95  


    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.