Rule Maker Portfolio Parsing Our Potential Buys

War may be coming, and companies may be floundering. Bill Mann looks at some companies that are not very popular at the moment and describes why he thinks common wisdom is missing something. Rule Makers tend to be obvious companies, but that doesn't mean they don't get mispriced, particularly when everyone is fretting about external threats like an impending war.

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By Bill Mann (TMF Otter)
January 22, 2003

Last week, I listed a few companies I would like to research in greater depth as potential Rule Maker investments. Since then, I've received a number of questions and come up with additional comments. So, let's parse the list a little further.

First, for purposes of this discussion, let's include the companies that the Rule Maker bought in 2002. Of the 10 companies -- Costco (Nasdaq: COST), Johnson & Johnson (NYSE: JNJ), General Dynamics (NYSE: GD), Nokia (NYSE: NOK), McDonald's (NYSE: MCD), MGIC (NYSE: MTG), Comcast (Nasdaq: CMCSA), Disney (NYSE: DIS), AOL TimeWarner (NYSE: AOL), and Home Depot (NYSE: HD), only one -- MGIC -- isn't immediately recognizable by a large portion of the population. This is quintessential Rule Maker investing. There's nothing fancy about this list of companies. None of them is small or obscure. But I believe some companies in this list offer compelling bargains.

How can that possibly be? Do I think I'm smarter than the overall market? It's not like these companies are uncovered -- you will never, ever see Disney in a list of "hidden gems." These companies aren't just familiar to me, nor merely to investors, like a JDS Uniphase (Nasdaq: JDSU). They're familiar to everyone.

The answer is that I'm not smarter than the market. Heck, in some ways, I'm not even as smart as my dog. But I may be looking for different things than the market on the whole, and if I'm patient, that leads to a potential advantage. In a market where the average hold time for a stock is less than 300 days, I have the leisure of not caring in the slightest about what business looks like over the short term, unless that short term includes the dreaded word "bankruptcy." Obviously, none of the above companies are at risk of that. That leads to a set-in-stone advantage that individual investors have over fund managers and other institutions: We have no need to worry about our own quarterly results. They fluctuate. Big deal.

The biggest risk thus becomes that these are companies not in a downturn, but rather in a long slide as they fall into oblivion. It happens even to enormous companies. Forty years ago, no one would have believed that Bethlehem Steel would be the next-best thing to worthless. Of these companies, only McDonald's shows the potential of sliding away at the moment. Does that seem like a probable outcome? Not to me. In fact, I'd say McDonald's biggest problems aren't strategic -- they're operational.

In the same vein, I can look at Disney and its multiple businesses with incredible competitive advantages, even if those businesses happen to be struggling at the moment. I can look at the fact that the current management team at Disney has created billions in shareholder value. I know, I know -- Michael Eisner is one of the most hated CEOs in America, and everyone thinks he's an overpaid bozo. Well, he's the overpaid bozo who saved Disney from itself in the late 1980s and turned its underutilized catalog of animated and live films into enormous wealth for the company. What -- did he suddenly become stupid? That's the common wisdom, and when that wisdom doesn't seem to jibe with reality, opportunities can crop up. You just have to do your best to determine whether the common wisdom is, well, accurate, and more importantly, relevant to your time frames.

But what about the war?!? A couple of people said they're not about to buy any stocks, much less one like Disney that's so dependent upon tourism, when the threat of a long-lasting military engagement is nigh. Everyone is thinking about this, it seems. One headline from yesterday said "Stocks sink as war jitters overshadow earnings," and in the article, you see Disney having dropped more than 3% based upon this fear.

But wouldn't this be more of a problem for Disney investors if the stock were priced as if everything were hunky-dory? At $17 per share, Disney stands at 17 times 2002 free cash flow, and 2002 (as everyone knows) was awful for Disney. This year may be also, but the share price seems to discount it and the likelihood that next few years will be, too. So, assuming that I have the time to wait -- which I do -- then wouldn't it be just fine for me to think about buying Disney at a discount and then wait for the company and its environment to sort themselves out?

McDonald's is in the same boat. It's got some real operational difficulties, but it also derives a large percentage of revenues from overseas. And heck, every time some yahoos protest something, it seems that the local McDonald's gets something thrown through its front window. But these aren't the biggest problems.

According to AnalystCall.com, in an investor meeting last week, new CEO James Cantalupo discussed at length McDonald's operational problems as being more crucial right now than any new store growth strategy, saying, "Growth isn't just new units; it's growth in existing restaurants." Could it be that McDonald's biggest problems are low food quality, slow times, and dirty bathrooms? Absolutely. And though these things aren't easy to fix in a 30,000-restaurant chain, it's not like you're dealing with a product sliding into obsolescence.

Another thing about the war: Just as the headline above implies, people are nervous, and thus keeping their money out of the market. This is a form of artificial depression on stock prices. Yes, a long, protracted war may have a profound impact on the economy, but for the stock market, which anticipates economic returns, the war is already priced in. Seriously, are you nervous about the war and its effect on stocks just because everyone else is?

Try a different path. Be interested in stocks for the single reason that people are running scared. Wars, once again, are not permanent impairments upon these businesses. So, we shouldn't treat them as such. And no, I wouldn't get particularly excited about Johnson & Johnson or General Dynamics, or even Nokia, because of the prospects of sales going up due to war, either. The markets react to surprises -- none of this would be a surprise. I bought General Dynamics for the Port because I found it to be a bargain, whether the United States goes to war or not.

I might have gone off on a tangent here. But it's pretty important to demonstrate, at times, that good investing ideas needn't be complicated, nor do the companies need to be obscure or opaque. Good investing ideas can be as close as your refrigerator or your favorite programs. These are the companies Rule Makers focus upon. In fact, the Rule Maker Portfolio ran into its biggest trouble when it lost sight of this fact. Finding great companies isn't hard. Finding great companies and having the patience to wait for a good price can be. But you can do it.

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

Bill Mann's second-least-favorite sport is track. His least favorite is field. He owns shares in Costco and has beneficial interest in McDonald's. He is managing editor of The Motley Fool Select, where you can find his best Foolish stock ideas you won't find anywhere else. The Motley Fool has a disclosure policy.

The Rule Maker Portfolio has had a cumulative investment of $44,500. As of Jan. 14, 2003, its current value of all cash and equities is $31,685.61. This equals an internal rate of return of -11.1% since the launch of the portfolio in February 1998.


 

Rule Maker Portfolio

  Ticker Company Price
 Change
 Daily Price
 % Change
 Price 
  AXP AMERICAN EXPRESS COMPANY (0.87) (2.42%) 35.08 
  KO THE COCA-COLA COMPANY (0.17) (0.38%) 44.55 
  NOK NOKIA CORP. 0.03 0.20% 14.94 
  JNJ JOHNSON & JOHNSON 0.01 0.02% 54.00 
  PFE PFIZER INC 0.21 0.69% 30.71 
  GD GENERAL DYNAMICS CORPORATION (8.86) (11.97%) 64.85 
  TROW PRICE T ROWE GROUP INC (0.68) (2.47%) 26.81 
  SGP SCHERING-PLOUGH CORPORATION (0.6) (2.81%) 20.75 
  COST COSTCO WHSL CORP NEW (0.23) (0.79%) 29.05 
      
  Trade Date # Shares Ticker Cost/Share Price  Total % Ret  
 05/26/98 95 AXP 35.38 35.08  -0.84%
 02/27/98 27 KO 69.11 44.55  -35.53%
 02/15/00 250 NOK 27.21 14.94  -45.10%
 04/03/01 30 JNJ 47.28 54.00  14.21%
 02/03/98 66 PFE 27.43 30.71  11.95%
 10/24/02 25 GD 79.98 64.85  -18.92%
 02/06/98 75 TROW 34.12 26.81  -21.42%
 08/21/98 44 SGP 47.99 20.75  -56.76%
 07/24/02 41 COST 35.89 29.05  -19.06%
      
  Trade Date # Shares Ticker Total Cost Current Value  Total Gain  
 05/26/98 95 AXP 3,360.87 3,332.60  -28.27 
 02/27/98 27 KO 1,865.89 1,202.85  -663.04 
 02/15/00 250 NOK 6,802.85 3,735.00  -3,067.85 
 04/03/01 30 JNJ 1,418.50 1,620.00  201.50 
 02/03/98 66 PFE 1,810.58 2,026.86  216.28 
 10/24/02 25 GD 1,999.50 1,621.25  -378.25 
 02/06/98 75 TROW 2,559.06 2,010.75  -548.31 
 08/21/98 44 SGP 2,111.70 913.00  -1,198.70 
 07/24/02 41 COST 1,471.49 1,191.05  -280.44 
Cash:11,132.36 
Total:28,785.72 


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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.