Fool Portfolio Report
Wednesday, October 23, 1996


by Tom Gardner

ALEXANDRIA, VA - October 23, 1996 - The Dow fell forty points, the Nasdaq was flat, and, haffenhufflenstuff, The Fool Portfolio rose 2.72%, on strength from Iomega and our most recent addition, ATC Communications (NASDAQ:ATCT). Hoo-haah.

After taking our position in ATCT yesterday at $22 7/8, the stock did what every good Fool stock should do. It burst to all-time highs this morning, before closing up $1 to $23 7/8. Discussion in the ATC Communications stock folder has been outstanding over the past few days, reaching the sublime this morning when Drakes353 shared his thoughts about the investment. To paraphrase his statements:

This ain't a stock around which to build your portfolio.
The possibility exists that a small-cap like this
could lose up to 50% of its value. And, there's
no sense in trying to time the Nasdaq market,
looking for ideal entry and exit points.

Rather, use the market as a savings vehicle, buy quality
companies that look undervalued, and build your
portfolio around The Foolish Four Dow stocks,
which have thoroughly smashed market returns
over the past three decades.

Hey that could easily pass for modern poetry, with arbitrary linebreaks and its absence of rhyme, rhythm and meter. Robert Frost would be horrified. But we might be able to get it dropped in an anthology. Thanks, Drakes.

I think it important to add here that at this point, ATC Communications is up 700% over the past twelve months. You probably know where I'm going with this, but I'll take it there anyway. ATC Communications has basically matched Iomega Corporation's performance over the last year -- sans the heart-rending, mid-summer decline.

Why mention this?

1. Too much attention in Fooldom is concentrated on one impressive company and its wonderful stock. Iomega has taught numerous lessons about the stock market, fundamental values and long-term investing. But it isn't the only monstrous winner over the past two years. There are loads of great growth companies out there. The market trend will not always be up, some years you'll lose good money, but the long-term benefits will outweigh the short-term hiccups, if you focus on buying high-quality, profitably-growing businesses in enterprising industries.

2. The financial media has focused far too much attention on Iomega (up $1 3/8 today). Oddly enough, fully 95% of the business media's coverage of IOMG has lacked even a basic understanding of its business. C'est la vie when stock-pricing fluctuations are held dearer than the businesses that sit behind them. The main point here is that we ought not overlook the many companies that post market-walloping performances and ought not ignore the reasons why they excell. Past out-performances provide the breadcrumbs to future ones.

Now let's consider Microsoft's numbers, just to see if it mightn't teach us all a lesson or two about investing in long-term time horizons and companies that persistently pursue high profitability, strong cashflows, and intelligent branding.

Microsoft announced first quarter earnings for 1997 after market-close on Monday. Oddly enough, hours before that announcement hit the market, Reuters released a story that led with this opening line:

"Microsoft Corp. is expected to report a sharp slowdown in earnings growth Monday due largely to a sales surge last year when the software giant launched its Windows 95 operating system."

After Microsoft fell $1 1/2, Reuters included the following line in their description of MSFT's quarter the next day:

"Microsoft Corp.'s earnings of $614 million, while solid, were not as high as expected."

Gee whiz, sounds like it was all bad. Microsoft's earnings per share came in 5 cents above expectations, while hitting Street sales expectations. This 5.6% outperformance amounts to $33 million more in earnings than the Street anticipated. Not as high as expected? Hmph. Of greater educational value is the truth, no doubt.

To put this into the broader context, let's remember a few things about the Company. First, its stock has compounded over 60% annual growth over the past decade, meaning that if you didn't have a broker trying to get you into and out of the position every month for commissions, you'd have generated some pretty whopping growth numbers. $10,000 invested in Microsoft in 1986 would be worth $1.1 million today. $1 million ten years back would be worth $110 million today.

And those numbers, of course, include that horrifying drop in October, 1987 -- the one that was s'posed to terrify you out of your equities holdings. However, it doesn't account for the unfortunate trading commissions and annual taxes that full-service brokerage firms have been and are compensated to introduce into your account, Fool.

Ugh.

Let's look at da numbers. Microsoft's 1st Quarter showed the following:

1Q 1996 1Q 1995 Sales $2,300 $2,020 Earnings $614 $499 EPS $0.95 $0.78

Thus, profit margins rose to 26.6% from 24.7% a year ago. Gross margins have risen over the past year to an absolutely astonishing 89.1% from 84.0%. For some reference points, Coca-Cola's gross margins are a smashing 67%. America Online's are sitting at a respectable 41.3%. ATC Communications gross margins are 33%. Iomega's are hovering around 26.5%.

Microsoft's upfront costs are startlingly low for any company, all the more bewildering for a business with $9 billion in trailing revenues. From sky-high gross margins of 89% to startling profit margins of 26.6% for the quarter, Microsoft not surprisingly now has over $7 billion in cash in the bank. The Company plans to pump over $2 billion into research & development this year -- that means that R&D investments will run to 20% of sales. Nearly unthinkable.

All of this is not meant as hype. Microsoft certainly has challenges going forward, with the Internet platform changing entirely what we think a personal computer is. Additionally, the Company's reach into television presents them with entirely new mysteries to decipher on a (for them) new media platform. And none of their growth is taking place in a vacuum. If you're like me, you believe that the Justice Department will have to break this company up in the next five years. However, if you're like me, you expect the various components to continue to smash market-average growth, if it is separated out.

About six months ago, I wrote in SmartMoney Magazine that I believed Microsoft, trading around $100 per share then, had to be the most undervalued large-cap stock on the market, looking ten years forward. I don't think it takes prophetic insight to recognize this. That said, if you're inclined to agree, would you do me favor and help me in answering the flame emails I've received in the wake of that article? Today, the stock closed up $2 to $134 1/2. Even up some 35% over the past six months, I continue to believe that Microsoft is substantially undervalued looking ten years forward.

Again, the stock has compounded 60% per year over the past decade. Lest you think most of that came at the offering, or shortly thereafter. . . nay, Fool, 'tis not so. Microsoft has compounded 52% annual growth over the past three years as well, crushing the performance of the Foolish Four group, stamping the S&P 500 under heel, and giggling at the performances of, yes, every single mutual fund and model brokerage-firm portfolio on the market.

Our witless, addlebrained, Foolish advice: Buy and hold the ownership slips of highly-profitable, debt-free businesses sporting substantial growth opportunities ahead of 'em and the management team in place to go after 'em. With the Internet, Microsoft appears to have significant growth opportunities ahead of it. With its cash on hand and internal business controls in place, Microsoft certainly appears to have the capital and the expertise to dominate d'Net.

Y'know what, investing just ain't as difficult as Mother Manhattan wants us to think it is.

Tom Gardner, Fool

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Transmitted: 10/23/96

Today's Numbers


Stock Change Bid ------------------- AOL - 1/8 25.88 T -2 37.88 ATCT +1 3/8 24.00 CHV - 5/8 67.25 GM - 1/4 54.38 IOMG +1 3/8 23.38 KLAC + 3/8 23.75 LU + 5/8 48.38 MMM - 1/8 71.63 QDEK - 1/8 5.88 COMS +1 3/4 64.13
Day Month Year History FOOL +2.72% -1.67% 50.10% 180.27% S&P 500 +0.10% 2.90% 14.83% 54.29% NASDAQ +0.65% 0.08% 16.71% 70.50% Rec'd # Security In At Now Change 5/17/95 2010 Iomega Cor 2.52 23.38 827.96% 8/5/94 680 AmOnline 7.27 25.88 255.77% 8/13/96 250 3Com Corp. 46.86 64.13 36.84% 8/11/95 125 Chevron 50.28 67.25 33.74% 9/27/96 -890 Quarterdec 7.08 5.88 17.07% 8/12/96 110 Minn M&M 65.68 71.63 9.06% 10/22/96 600 ATC Comm. 22.94 24.00 4.64% 8/12/96 280 Gen'l Moto 51.97 54.38 4.62% 10/1/96 42 LucentTech 47.62 48.38 1.59% 8/12/96 130 AT&T 39.58 37.88 -4.30% 8/24/95 130 KLA Instrm 44.71 23.75 -46.88% Rec'd # Security In At Value Change 5/17/95 2010 Iomega Cor 5063.13 46983.75 $41920.62 8/5/94 680 AmOnline 4945.56 17595.00 $12649.44 8/13/96 250 3Com Corp. 11714.99 16031.25 $4316.26 8/11/95 125 Chevron 6285.61 8406.25 $2120.64 9/27/96 -890 Quarterdec -6304.75 -5228.75 $1076.00 8/12/96 280 Gen'l Moto 14552.49 15225.00 $672.51 8/12/96 110 Minn M&M 7224.44 7878.75 $654.31 10/22/96 600 ATC Comm. 13761.50 14400.00 $638.50 10/1/96 42 LucentTech 1999.88 2031.75 $31.87 8/12/96 130 AT&T 5145.11 4923.75 -$221.36 8/24/95 130 KLA Instrm 5812.49 3087.50 -$2724.99 CASH $8801.62 TOTAL $140135.87 Transmitted: 10/23/96