Seven Signs of Success

Tom Gardner

Alexandria, VA (Aug. 26, 1998) -- As promised in yesterday's report, today I'd like to show-and-tell the seven ways I measure the quarterly performance of our Cash-King investments.

Up front I'll make it clear that none of our work considers the recent direction of the stock price or P/E ratio. Even though the two are closely watched by many, they more reflect short-term momentum in the market than underlying business strength. We have a different charge as Cash-King investors -- to approach the stock market as a vehicle for business ownership. Given that, we're at least 100x more interested in the long-term prospects of a business than the short-term wiggles of its stock.

For a little context on that fairly rigid position, consider again a company like Americana music retailer, K-tel International. After announcing their intent to open an online music store in the Spring of this year, the stock went berserk. K-tel shares ran from $3 to $39 in just four weeks, marking a Peter-Lynch-style thirteen bagger in the blink of a smiling eye. The public market was sending the world a message that it believed K-tel had created substantial new value by hopping aboard the Internet train and riding it toward the next century.

In an effort to get a handle on the situation, Motley Fool News Writer Dale Wettlaufer dug through tangles of information and found that K-tel executives had sold the majority of their holdings at prices ranging from $30 to $35 per share, for more than $60 million. Apparently these executives had a different view of the forward merits of their business than did the public markets.

Guess who's been right since? From May 6, 1998 to today, K-Tel shares have tripped on themselves, falling from $39 down to $8 per share. That marks an 80% decline in just three months. The harrowing drama is mapped out neatly in this stock chart: K-tel stock weekly for 1 year. During a period of less than five months, "corporate executives" pocketed $60 million as the company's valuation ran from $23 million to $295 million back down to $60 million.

What that says about market efficiency, I leave to the academics; what it says about insider sales, I leave to regulators.

What it says to your Cash-King managers, though, is that the market often has a difficult time assessing business value in the short-term -- and that we shouldn't pay much mind to it. While an army of technical analysts and market strategists on Wall Street spend their days huddled over dozens of proprietary indicators, burping out buy-and-sell-and-buy recommendations on the hour, and cashing in commissions from their followers, here in Fooldom we take a different tact. Again, we're at least 100x more interested in the efficiency of operations and the momentum of the business than in the short-term direction of its stock price.

That does have consequences. It means that our approach misses out entirely on quick and profitable trades -- something that Wall Street and the media is much fascinated by. In exchange for missing out, we pay less in capital-gains taxes, less in commissions (which bro--err--financial consultants don't like), and less in opportunity costs (not having to follow the public markets by the hour).

That's a trade off we've decided to make -- dealing away the high cost of short-term excitement for the low cost of long-term profit.

It's a trade that has us searching for the sort of real, operational momentum that drove Muhammad Ali to the throne for years, that placed Robert Frost in a leadership position among American poets for five decades, that resulted in Harrison Ford starring in 20% of the world's top thirty blockbusters, and that helped the University of Tennessee's Lady Vols basketball team win six national championships in the last eleven years (as well as three consecutively, culminating in a 39-0 record last year).

The Cash-King Portfolio is in search of that sort of sustainable and expanding success, which we think is revealed most plainly in the direction of a public business' financial statements. With that in mind, I'd like to share the seven ways I analyze the directional force of our companies, from year to year.

#1. Rising Sales

Tracking sales growth is much more important to the investor studying an embryonic consumer franchise. It measures the immediate growth in new customers and repeat purchasers. For smaller companies, that's an extremely important metric. For larger businesses, pure earnings growth matters much more.

But that doesn't mean we should ignore sales growth altogether. Cash-Kings have to pursue new markets and fuel rising consumer demand, too. In fact, without question, my single greatest concern about The Coca-Cola Company today is not Pepsi's restructuring, or economic woes in Indonesia, or the price of the Dow Industrials -- in so far as they can be isolated from sales growth. My greatest concern is that Coke's top line has risen only 5.3% per year over the past three years, a growth rate that has been slowing recently.

Tracking this quarter's performance against the same period last year, here's what I look for in sales growth:

Ideal: > + 15%
Okay: + 5-15%
#2. Rising Gross Margins

As we move down off the top line, the quality of "getting better" becomes increasingly more important to us. Gross margins compare pricing power to the manufacturing cost of doing business. It asks us: How much does it cost Hasbro to make that Yahtzee board relative to the price it can charge for it?

Rapidly rising gross margins can indicate a company that is lightening up on the manufacturing burdens while raising prices into consumer demand (here, think Microsoft). And the higher the gross margins, the more cashola a business has to research new product lines, to promote its stuff during the Super Bowl, and to eventually pass down through to their shareholders.

Tracking this quarter against the same period last year, here's what I look for in rising gross margins (not in percentage points, but total percentage growth):

Ideal: > + 5%
Okay: + 0-5%

#3. Rising Net Margins

Watching out for rising net margins keeps us focused on how much cash the company is sending toward its balance sheet -- money which will help our businesses defend and extend their interests. When you can match up an increase in net margins with rising sales, you have double dip of chocolatey reward (here, think of Schering-Plough). It just means that more buyers are returning with greater frequency, and that the company is generating more profit per unit sold.

In the words of that lovable Sugar Smacks frog, "Dig um!"

Tracking one quarter against the same period a year previous, here's what I look for in rising margins:

Ideal: > + 5%
Okay: + 0-5%
#4. Cash Outgrowing Debt

Debt -- you know we don't like it. But debt financing has its merits. It can provide currency for our businesses to make attractive acquisitions; it can accelerate expansion; and, for Cash-King companies, it almost always represents cheaper financing than the sale of stock.

At the same time, internal financing (from earnings growth) is a considerably more attractive route to success, carrying with it no principal or interest payments. In the long run, long-term debt is a weakness. It shows operational impatience -- a weakness in competition. It's true that debt is more attractive than secondary stock offerings. But it's also true that debt is far less attractive than internal financing.

Comparing the ratio of cash-to-long-term-debt, quarter over quarter, here's what I look for:

Ideal: No debt
Okay: The ratio rises or holds even
Bummer: The ratio falls

#5. Lowering Flow Ratio

An extremely important metric for Cash-King stocks, The Flow Ratio tracks the power position that a company has in its markets. By stacking inventories and accounts receivable up against current liabilities, Flowie tells us whether a company is beholden to its suppliers and weak with distributors, or just the opposite.

In Foolishly contrary fashion, a falling Flow ratio represents an increasingly authoritative position, as a company turns product to cash instantly while delaying payment to its suppliers. A rising Flowie indicates a weakening position. Here's what I look for when comparing quarters:

Ideal: > -10%
Okay: minus 0-10%
#6. Share Buybacks

There's nothing quite so sweet as stock buybacks, as they reduce the total shares of ownership. This means that from year to year, the company is reducing the size of its pie, and by extension increasing the size and value of your slice. While popular opinion has investors celebrating stock splits (which don't affect ownership value), Cash-King Fools cheer stock buybacks.

Tracking one quarter against the year previous, here's what I look for in share buybacks:

Ideal: Fewer fully-diluted shares
Okay: - 3% > +3%
Bummer: > +3%

7. Expanding Possibilities

The final metric is the most subjective. I like to lie out on my hammock (if only I had a hammock and two trees to string it to) and, with a glass of lemonade and a bag of oatmeal-raisin cookies, ruminate over whether the company has realistic expansion plans. Do my friends know about and love their products? Is worldwide expansion believable for their stuff? And is my company accurately reflecting their growth by holding down accounts receivable? Strange musings, yes, but I'm allowed to call it work. What a life!

Here's what I look for in my answers to these questions:

Ideal: Yes to all
Okay: Not really clear
Bummer: No to many

And that, Fools all, is how I approach a quarterly statement from one of our Cash-Kings. It may sound like an awful lot of work, but it generally takes no more than 15 minutes of calculation and reflection -- even less if it's a mere button click on a spreadsheet. Piece o' cake.

But. . whew! That was a lot of theory to throw at you in a day, so tomorrow I'd like to walk through a single example. I believe I can show how following the operational momentum of your investments can be extremely rewarding (and can save your arse on occasion).

The company I'll review tomorrow is Nine West (Nasdaq: NIN). I encourage you to run their C-K numbers, study their direction in years past, hang on the hammock for awhile, and report back here tomorrow to compare notes. After all, all the numbers you'll need can be found right there at Fool Data on Nine West.

Tom Gardner

Cash-King Strategy Folder
Cash-King Companies Folder

08/26/98 Close

Stock  Change    Bid 
 AXP   +  5/16  97.19 
 CHV   -1 11/16 76.50 
 CSCO  -  5/16  103.63 
 KO    -  15/16 79.19 
 GPS   -3 5/8   60.38 
 EK    +  7/8   86.38 
 XON   -  1/16  70.31 
 GM    -  5/8   63.88 
 INTC  -1 27/64 83.00 
 MSFT  -  3/16  112.56 
 PFE   +1 1/2   108.00 
 SGP   -  1/4   101.88 
 TROW  -  11/16 35.31 
                  Day   Month    Year  History 
 C-K         (0.90%)   (0.56%)    14.93%      14.93%  
 S&P 500     (0.79%)   (3.26%)     7.77%       7.77%  
 Nasdaq      (1.66%)   (5.57%)     6.11%       6.11%  
 Cash-King Stocks 
     Rec'd    #  Security     In At       Now    Change 
     2/3/98   24 Microsoft     78.27    112.56    43.82% 
     2/3/98   22 Pfizer        82.30    108.00    31.23% 
    6/23/98   23 Cisco Syst    86.35    103.63    20.01% 
     5/1/98   37 Gap Inc.      51.09     60.38    18.17% 
    2/27/98   27 Coca-Cola     69.11     79.19    14.59% 
    8/21/98   22 Schering P    95.99    101.88     6.13% 
     2/6/98   56 T. Rowe Pr    33.67     35.31     4.87% 
    2/13/98   22 Intel         84.67     83.00    -1.98% 
    5/26/98   18 AmExpress    104.07     97.19    -6.61% 
 Foolish Four Stocks 
     Rec'd    #  Security     In At     Value    Change 
    3/12/98   20 Eastman Ko    63.15     86.38    36.78% 
    3/12/98   20 Exxon         64.34     70.31     9.29% 
    3/12/98   15 Chevron       83.34     76.50    -8.21% 
    3/12/98   17 General Mo    72.41     63.88   -11.78% 
 Cash-King Stocks 
     Rec'd    #  Security     In At     Value    Change 
     2/3/98   24 Microsoft   1878.45   2701.50   $823.05 
     2/3/98   22 Pfizer      1810.58   2376.00   $565.42 
    6/23/98   23 Cisco Syst  1985.95   2383.38   $397.43 
     5/1/98   37 Gap Inc.    1890.33   2233.88   $343.55 
    2/27/98   27 Coca-Cola   1865.89   2138.06   $272.17 
    8/21/98   22 Schering P   2111.7   2241.25   $129.55 
     2/6/98   56 T. Rowe Pr  1885.70   1977.50    $91.80 
    2/13/98   22 Intel       1862.83   1826.00   -$36.83 
    5/26/98   18 AmExpress   1873.20   1749.38  -$123.83 
 Foolish Four Stocks 
     Rec'd    #  Security     In At     Value    Change 
    3/12/98   20 Eastman Ko  1262.95   1727.50   $464.55 
    3/12/98   20 Exxon       1286.70   1406.25   $119.55 
    3/12/98   15 Chevron     1250.14   1147.50  -$102.64 
    3/12/98   17 General Mo  1230.89   1085.88  -$145.02 
                               CASH     $48.07 
                              TOTAL  $25042.13 
 *Please note: On 8/4/98 $2,000 cash was added to the
portfolio for future investment. This will be reflected
in the numbers as soon as possible.

*The year for the S&P and Nasdaq will be as of 02/03/98