Drip Port Hit by Scandal

Have you ever stood next to a pool and been splashed -- drenched -- when someone cannonballed into the water? Have you ever stood near train tracks and been blown back a few feet by the rush of wind as a train sped by? Have you ever stood under a falling boulder and been pelted by pebbles it dislodged?

Odds are, you answered "yes" to two of the questions. We've all been splashed by water, and we should all try to stand under falling boulders. Or so my friends tell me.

Mellon Financial (NYSE: MEL) has been hit by recent Wall Street scandals in this sort of second-hand, pebble-falling way. Except Mellon was doing business with a cheat, WorldCom (Nasdaq: WCOME), so it goes something like this: Mellon hailed a taxi, hoping to benefit from the ride, but the taxi hit a puddle and swamped Mellon when it picked it up.

Enough with metaphors. The fact is that Mellon is writing off a $100 million unsecured WorldCom loan. One hundred million dollars. Say that slowly. Let it roll off your tongue. One... hun-dred... mil-lion.... That's a lot to lose because you were misled -- lied to -- with phony accounting.

What's Mellon's recourse? The same recourse that most WorldCom lenders and investors have: Realistically, none whatsoever. Write it off. Take the loss. So, in Drip Port, where we've been diligent, done our homework, and kept current with our companies, we've been hit by the scandals, too. And we only own five companies!

This demonstrates the wide reach of scandals at immense companies. Your investments were likely hit, too, whether you know it or not. You may have owned Enron or WorldCom in a mutual fund without knowing it, and you did own them if you bought the S&P 500 index fund. And then there are the banking and finance stocks you may own individually, or in funds, that will lose hundreds of millions, Mellon included.

Thankfully, and remarkably to me, Mellon still reported a second-quarter profit of $106 million, or $0.24 per share. That was $100 million shy of estimates. Thanks, WorldCom.

WorldCom isn't bankrupt yet (although today it agreed to freeze its assets), but Mellon isn't holding its breath. Rather than breaking some kneecaps, Mellon took a provision for a big, bad loan. Doing this, Mellon's nonperforming assets rose to $176 million from $75 million one quarter ago. On the plus side, even during a miserable time for everything financial, Mellon's assets under management rose from $546 billion last year to $588 billion today.

And despite the $100 million writeoff, Mellon's stock hasn't tanked, although it is at a 52-week low. The company's business remains strong, intact, and growing. To me, this resilience demonstrates one of the principles that we outlined when we launched in 1997. That is:

When investing in stock, your best offense is a strong defense.

When you're putting money in stock, you're putting your savings into a vehicle that can much more quickly decline than rise. Therefore, unless you love taking big chances, you need to be defensive. This doesn't mean be afraid. This means understand what you're buying well before you buy it, and it means make your purchases at attractive prices. Protect yourself against downside risk.

We've attempted this by focusing first on knowing our businesses, and then on price-to-earnings and price-to-free cash flow multiples (and book value with Mellon). We try to buy our stocks at prices near the low end of their historical valuation ranges, as outlined in our columns Buying Stocks at Good Prices, and Buying at Better Prices.

When Intel (Nasdaq: INTC) soared to 40 times earnings in 2000, we waved it by. When it declined to 25 times earnings, we bought some. We're still down on that purchase, but only marginally. We've done the same with most other purchases, whether they be Johnson & Johnson (NYSE: JNJ), Mellon, or what have you: Buy more when the valuation multiples are lower. This is a large benefit of steady dollar-cost averaging.

Despite the 70% slide on Nasdaq and 34% decline on the S&P (down 20% this year alone), our oldest holdings are showing declines that we can live with, and eventually overcome: We're down about 23% on Intel and Mellon (both now at multi-year lows), 7% on Pepsi (NYSE: PEP), and we're up on J&J. This isn't to boast -- heck, we're still losing to the S&P 500 -- but it reiterates that by averaging into familiar companies at more favorable prices (and pausing at higher prices, as we usually do), your downside risk can be substantially mitigated.

With most large, consistent companies, you should follow the business foremost, and then its multiples to earnings and free cash flow. Know its average valuation multiples and, the business faring well, invest more at the lower end of its historic price range. Five-year high and low P/Es are available on MultexInvestor under "research; then ratio comparisons," as well as several other places. We recommend a greater focus on free cash flow.

Paychex "news," J&J, Intel report results, and our recent buys
Paychex (Nasdaq: PAYX) was chopped today when competitor Automatic Data Processing (NYSE: ADP) reported weak results and said the payroll market looks poor. Paychex's results were OK. We might buy more soon. J&J and Intel also reported second-quarter results. J&J's were "all good," as we wrote in Fool News. While Intel was a non-event. The most unfortunate news is Intel will lay off 4,000 workers.

Meanwhile, Mellon is at the low end of its five-year value range, near 3.5 times book value and 14 times earnings estimates on continuing operations. We bought more at $30 last week. We'll likely buy more soon. We also bought more J&J at $53 and Paychex at $29. (We've bought some Paychex at a "rich" multiple, but we wanted to start averaging into this historically well-valued stock.) We sent checks the end of June and bought in early July. We have a Pepsi purchase in process, too. And next week we may have more decisions to make. Our stocks are moving.

Be grateful for all you have, help others, and stay Foolish. 

Jeff Fischer manages and owns the Drip Port stocks. His other investments are shown online. He can't remember the last time he used high school algebra, but it's still important to learn, kids. The Fool has a disclosure policy. It also has a brand new book: The Motley Fool's Investment Guide for Teens (it does not have algebra).

Drip Port's Simple Returns since 7/28/97, as of 7/17/02 Market Close:

Drip Port: -10.9%
S&P 500:    -3.2%
Nasdaq:    -10.6%