Fool Portfolio Report
Tuesday, July 23, 1996
Tuesday, July 23, 1996 (FOOL GLOBAL WIRE)
by Tom Gardner
NORTHERN VERMONT, July 23, 1996 -- An otherwise blissful, pristine day up here in Vermont was clouded in on all sides by the market storming our Foolish stocks, touching us up to the tune of 8.75% in losses while the S&P 500 fell 1.09% and Nasdaq was off 2.98%.
After market-close yesterday, Microsoft posted strong 4th quarter numbers of $2.26 billion in sales, $559 million in net income, and 87 cents per share. The EPS figure came in two pennies above Street projections and these springtime profit margins of 24.7% exceeded all expectations. For the umpteenth quarter in a row, Microsoft steered down expectations at the end of the marking period and the market obliged, promptly dunking MSFT shares $7 3/4 to $112.
The Microsoft guidance again shook the land. The Nasdaq's sell-off today makes for an 11.5% drop in the month of July, and puts that index in the red for 1996. In mid-May, the NAZ was up nearly 20% for the year. Those gains are all gone now. During that erasure, The Fool Portfolio has seen its returns dissipate from a shocking 120% gain for the year amidst April and May flowers and showers down to its perch now, up 16.46% for 1996.
Before jumping into a review of Sears' 2nd quarter report, announced last Thursday, I'd like to consider this portfolio in its proper context, think for a few seconds about the performance of our stocks, and mumble on incoherently for a few minutes about what it all means to the financial world.
This morning I received notice that much of the financial world was focusing its eyes on our portfolio, its decline, and that there was great fanfare and merrymaking up and down the street of Wall in New York City. No Fool need wonder why that is so. We live in a relatively open and heatedly competitive marketplace. Mutual fund managers battle with one another, newsletter publishers grit their teeth over fax machines, full-service brokers needle discount brokers, and the financial media does its level best to make sense of the whole strudel.
Sadly, there is one creature that all but one of the aforementioned competitors despises: The autonomous individual investor. The bloke who believes he can make his own mind up. The housewife that statistics tell us is far more likely to use the stock market as a savings vehicle, as a haven for long-term capital growth, than as a money pit. The thirteen-year-old Phoenix Suns fan who has purchased $247-worth, or four shares, of Nike stock over the last twelve months. Your great uncle who, fed up with market underperformance, has transferred 90% of his savings into the Vanguard Index Fund and 10% into Intel, Microsoft, General Electric and General Motors over the past eight months.
What value is there in this for your average financial institution? Very little. Under the existing business models on Wall Street, patience and accountability and bottom-line performance records are tertiary at best. The patient investor does not generate commissions. The investor that holds management numerically accountable does not dive into the world of well-marketed mutual funds. And bottom-line performance records are currently unheard of in the land of financial newsletters, which are not presently required by law or conscience to report transaction costs, spreads, nor to compare their performance to the S&P 500.
If today Wall Street is looking in on us, the individual investor, hoping to expose fatal flaws, emotionalism and rampant underperformance, I would suggest they would do better to look out at the entire financial industry today. It's an industry that is badly in need of a restructuring heavily in favor of client service, of long-term bottom-line growth, education, and of rigorous accounting.
Today, brokers are still compensated based on the number of trades they make. Between 1986 when it went public and today, Microsoft has compounded 57% annual growth. An investment in the Redmond giant then would have turned $10,000 into over $900,000 today. Taxes would take it down just below $600,000. Now, had you been with a full-service brokerage firm, well, what in their business structuring would have motivated them to advise your holding on tight to this issue every step of the way? Very little. Compensated off the number of trades, they much prefer your activity. If the fee is $150 per trade, it hurts them to see your account rise $575,000 over ten years whilst earning them only $150 on the way in and $150 on the way out. Much more attractive is movement in and out of Microsoft two times each year, $600 in annual commissions, ten-year transaction fees of $6,000, and certainly considerably less than $575,000 in after-tax value in your account today.
This is bad business. It rewards activity for the sake of activity. It compromises long-term growth for the client, replacing it with short-term corporate profitability. It isn't fundamentally a service. And this isn't to say for a second that there aren't numerous individual brokers who have found ways to serve and reward their clients. I'm speaking of the system here. It's a system that puts those trying to do what is right, what is mutually profitable in excess of market-average growth, and what is beneficial at a disadvantage. Taking advantage of the system for the client's benefit is considerably more difficult than taking advantage of the system for the professional.
This is a point which I'm willing to debate publicly with anyone.
Another which follows neatly in tow is the present structuring of compensation in the mutual fund industry. Management is paid a percentage of total assets under management. For illustration's sake, let's settle on a 2% fee. The mutual fund with $100 million under its belt is then paid $2 million annually. The $500 million fund takes in $10 million annually. And the $5 billion fund earns its managers $100 million each year.
There are some interesting thresholds here. Which would be better for the $100 million fund to beat the market by 10% and end up with $125 million under management in year two or to flood the market with advertising and willingly underperform market average? You play the game for a second, Fool. Do you think that Joe and Joanne Average in America have any understanding of what market average growth means?
I can tell you that the mutual fund industry has an answer to that, and the answer is no. No clue. Now, sure, beating the market is advantageous, but market underperformance coupled with spectacular marketing. . . that's a nice business to be in right now. Heck, open up any investment magazine and you'll find handfuls of mutual funds gloating over 1-, 3- and 5-year records of underperformance. They flaunt it. That's their prerogative.
But what happens now in an open environment where education and customer service are the priority? I suggest that The Motley Fool has orchestrated the first step in what will at least be a ten-step, five-year remodeling of the financial towers that have looked out and down on America from Manhattan. It isn't a revolution, in my mind. This is work that will strengthen our nation, tug us out of consumer, budget and trade deficits and that will result in greater fiscal conservatism, self-responsibility, prudence and literacy.
And this isn't a one-company project. It's an undertaking that will take many hands. We have welcomed and will continue to welcome a number of corporate partners into this mission. And I would suggest that those on the institutional side regard this forum and ongoing developments as an opportunity, not a threat. Because out of necessity, the business models are being transformed rapidly. The lid is off the box, the ideas are being spread, and people with more than three years to invest are only going to pay up for market outperformance---since they can meet market average with the Vanguard Index Fund. Vanguard kicked off this radical shift. Don't expect that we're heading back from whence we came, with fewer total investors, absent any elementary financial education, and with amateur-style accounting from one firm to the next. The future holds higher education, more information, strict accountability, and an ongoing open and national conversation.
I say this because The Motley Fool is far more about this industry-level restructuring than it is about this portfolio. We have said this every step of the way, and I say it again now with our portfolio up 117% versus S&P gains of 37%. The rise and fall of America Online and Iomega over that time is of interest, but peripheral. And I would suggest that investors look at a few other outstanding and comparably popular managed and unmanaged portfolios here, from The Dow Dividend to Uptrend's Health Portfolio to The Edible Eight each of which is soundly outperforming the market, their comparable mutual funds, and yet each of which is primarily focused on the education of the client.
This is the future. We're not trying to take it all ourselves. But it is the future. Rather than denying that, we hope that the industry broadly will mobilize to participate in it. Many are in the process of it.
As I noted in last week's report, I wanted to give today over to coverage of Sears (NYSE:S), which announced earnings of $0.67 on Thursday, beating Street consensus figures of $0.63. Sears, one of the three Dow stocks that we purchased in August, 1994 and then added to---according to the model---again in August, 1995, has been an outstanding investment. The stock is up 41% since last August, and was up more than 25% for us in the previous year.
During that time, we've seen continuing and aggressive moves by Sears to pare back their exposure to non-retailing businesses. Gone are the days of insurance and investment banking. Sears is primarily a provider of home furnishing, apparel and automobile products and services. The focus has led to tighter quality controls, sharpened business models, greater efficiency, debt removal, and a rapid climb in shareholder value. This'll make for a great case study someday, titled "Doing What You Do Better" or "Don't Try to Be The Everything."
On Thursday, when Sears posted Street beating numbers, the stock was trading at $46 1/4. A few short weeks back, the stock was bouncing around above $50. With stronger numbers on the table, our retailing behemoth is a good deal squatter, a bit shrunken. The stock closed today at $40 3/4.
Some of it is certainly happening up at the macro level, where inflation meets the interest rate. Tough to quantify that but certainly the now 20% decline off recent highs isn't all the work of Mr. Market.
Sears announced $9.1 billion in quarterly sales, $274 million in earnings, and 67 cents in earnings. The company is sporting 3% profit margins, which should improve over the second half of 1996 with growth moving from their hard goods (tires, et cetera) to soft goods (school clothing, et cetera).
Disappointing for the quarter was certainly their international effort. Off $700 million in revenues, Sears lost $14 million abroad. Canadian and Mexican economies continue to struggle. And Sears offered that they would be scaling back inventory committments and cutting costs on foreign soil. Sears might do well to tug pages out of the GE handbook on this score, eliminating the worst-performing stores rather than waiting for stronger international markets to float all boats higher.
Good news on the credit side for the Company, though, with total number of active credit accounts ranging up to 25 million. Over the past decade, Sears has watched as use of its credit-card has deteriorated. Thus far in 1996, that trend has reversed. On the downside, personal bankruptcies were up significantly over the same period last year, and this has investors wondering about the health of recent sales and the limitations on future growth. Some propose that consumers don't quit, others propose that consumer debt is ranging high enough that they won't have much choice. One thing is for certain. . . there's plenty of growth for the national creditor willing to act contrarily and actually instruct customers to manage their exposure, to be more prudent.
So where to now for Sears? Analyst Alan Rifkin at Dain Bosworth upgraded estimates to $3.05 for 1996 and $3.45 for 1997. With greater controls in place internationally, aggressive management of its debt, and a move toward higher margins into the end of the year, I'd price Sears at 14x-15x year-forward earnings, $50-$52 a share into the New Year, or a potential for 20-30% growth from here.
As for the rest of the Fool Portfolio today, well, Dave and I lost some more money. Iomega and America Online continued their precipitous fall. The questions remain: Are these bottom-line growth companies? How well will they stave off competition? How identifiable and well-regarded are their brands? Are these merely 5% profit-margin businesses, or will the two eventually push profits up past ten cents off every dollar in sales?
Answers to these questions and more in the months ahead. In the meantime, if you're uneasy, click your shoes three times fast and repeat after me: Beating the Dow, Beating the Dow, Beating the Dow. The Motley Fool Portfolio may be 14% ahead of the market this year, but the Dow portfolio is 7% up with less volatility and less angst. Just read through the Chevron, Sears and General Electric folders as I do, and you'll see.
Both are presently ahead of more than 95% of mutual funds on the market.
--- Tom Gardner, July 23, 1996
Day Month Year History
FOOL -8.75% -27.54% 16.46% 117.46%
S&P 500 -1.09% -6.53% 1.78% 36.75%
NASDAQ -2.98% -11.47% -0.29% 45.66%
Rec'd # Security In At Now Change
5/17/95 2010 Iomega Cor 2.52 16.00 535.18%
8/5/94 680 AmOnline 7.27 26.00 257.49%
4/20/95 310 The Gap 16.28 28.75 76.65%
1/29/96 250 Medicis Ph 27.86 41.75 49.86%
8/5/94 165 Sears 28.93 40.75 40.88%
8/11/95 95 GenElec 57.91 79.63 37.49%
8/11/95 110 Chevron 49.00 58.13 18.62%
8/24/95 130 KLA Instrm 44.71 18.63 -58.34%
Rec'd # Security Cost Value Change
5/17/95 2010 Iomega Cor 5063.13 32160.00 $27096.87
8/5/94 680 AmOnline 4945.56 17680.00 $12734.44
4/20/95 310 The Gap 5045.25 8912.50 $3867.25
1/29/96 250 Medicis Ph 6964.99 10437.50 $3472.51
8/11/95 95 GenElec 5501.87 7564.38 $2062.51
8/5/94 165 Sears 4772.65 6723.75 $1951.10
8/11/95 110 Chevron 5389.99 6393.75 $1003.76
8/24/95 130 KLA Instrm 5812.49 2421.25 -$3391.24