Fool Portfolio Report
Wednesday, July 2, 1997
Jeff Fischer (TMF Jeff)

ALEXANDRIA, VA, (July 2, 1997) -- The stock market rose sharply after the Fed left interest rates unchanged. The Fool Portfolio continued to rise but lost to the S&P today, though it still leads for the week. The Fool is up 2.9% and the S&P is up 1.9% over the past three days.

3COM (Nasdaq: COMS) was the Fool's big winner, rising with tech and networking stocks. Also, an analyst raised the stock to a "Buy" from "Hold." Better late than never. KLA-TENCOR (Nasdaq: KLAC) also rose and hit a new 52-week high.

TRUMP (NYSE: DJT) rose from $10 3/8 to hit $11 3/8 at 1:36 in the afternoon. Why? Donald Trump was interviewed on CNBC. The promo for the piece stated that Donald was going to tell shareholders how he would increase the stock's value. The stock actually rose before the interview took place. Donald said that he was looking at Las Vegas property, but that he was finished building. He talked about depreciation of his property as a key factor, but he didn't say anything new. The stock surrendered the gain and closed down a fraction.

Should we blame CNBC for "off-line hype" that caused people to buy Trump and lose money today?

CNBC presented a fair interview with both bearish and bullish points (the bullish from Donald). The fact that the stock rose sharply before the interview even took place -- during the promotion for the interview -- tells you a great deal about some CNBC viewers. The cable network can't be blamed any more than online bulletin boards can be faulted for a person's actions.

The Headlining Topic. Last Friday we reviewed the guidelines behind the Fool Portfolio's allocation of stocks (60% small and mid-cap, 30% Foolish Four, and 10% short).

Finding and investing in smaller cap stocks takes extra time and work, which is why this portfolio might be considered more "actively managed" than Tom Gardner's coming large-cap portfolio -- for example. Tom plans to buy giant world leaders and hold them nearly indefinitely.

The Motley Fool Investment Guide defines small and mid-cap stocks, but in the past eighteen months some definitions have been modified. The initial table below is from page 117 of the Investment Guide. Looking at the old table:

Large cap Over $1.5 billion Mid cap $200 million to $1.5 billion Small cap $50 million to $200 million Micro cap Below $50 million

That's been changed and updated in the new paperback edition of the book to:

Large cap Over $5 billion Mid cap $500 million to $5 billion Small cap $50 million to $500 million Micro cap Below $50 million

The definitions were originally too generous by granting any company valued at over $1.5 billion a "large-cap" status. It now takes $5 billion.

The Fool Portfolio has bought nine small and mid-caps: America Online, Boston Technology, Sonic Solutions, Iomega, Ride Snowboard, Medicis, KLA-Tencor, ATC Communications, and Innovex. America Online has since become a large cap.

Today we'll look at the slightly tweaked Foolish "Eight Item Checklist" that we use when considering small and mid-caps. This list isn't a final means to any decision, but it represents the general guidelines we use when considering growth stocks. Let's run through the list (which begins on page 129 of the Investment Guide) and put INNOVEX (Nasdaq: INVX) through the paces as we go.

1. Company Sales: $200 million or Less. When looking for growth in small-caps, a company that is on track to double or triple sales in the near future more likely has trailing sales below $200 million -- so we keep an eye peeled for companies with growing sales below that amount.

Iomega had $141 million in 1994 sales, and $1.2 billion last year. America Online had $52 million in 1993 sales, $115 million in 1994, and over $1 billion last year. Innovex had $69 million in sales last year and is on track to have over $140 million in sales this year.

2. Daily Dollar Volume: $3 million or less. This number has been updated -- increased -- and, well, actually flip-flopped.

Daily dollar volume represents the number of shares traded on an average day, multiplied by the stock price. $3 million or less limits us too much, we've found, and so we've actually changed this to $3 million or more -- within limits, and depending on the stock. The number represents liquidity and also indicates how "well-known" or discovered a stock may be.

In the end, it's a judgment call. You want enough liquidity but you also may not want a stock trading an enormous amount each day, as its story may be "out" and taken advantage of. But at the same time, you do want a story that has some basis beneath it, and so the stock probably trades decent volume.

A stock like McAFEE (Nasdaq: MCAF) had daily dollar volume of $33 million to begin this year. Old Fool stock MEDICIS (Nasdaq: MDRX) had daily dollar volume of $9.6 million, much higher than when the Fool first bought the lethargic, unknown thing. When we first looked at Innovex the stock had average daily dollar volume of $4.8 million -- nice and low, but not too low. Volume has increased steadily over the past months.

3. Low Share Price: Between $5 and $20. As stated in Investment Guide, Fools don't worry too much about this point. The one consideration was that the percentage gains from a less expensive stock can be more dramatic, assuming that the stock is ready to appreciate. But how much validity there is to this statement -- well, hard to say. You can watch McAfee go from $48 to $65 pretty quickly, or you can hope that Iomega -- bought by the Fool at $14 before any split -- goes to $50 that year. It did. But stock price isn't a big sticking point. What's important is the company and its prospects (and underlying valuation), not the stock price.

Innovex was $27 5/8 when purchased.

4. Net Profit Margin: 10 Percent or More. Pretty straight forward. You want to invest in companies that bring a large portion of sales to the bottom line -- resulting in profits. A company like BEST BUY (NYSE: BBY) had $2.3 billion in sales in one quarter but brought only eight million measly bucks to the bottom line, for a whopping 0.4% profit margin. At that rate, Best Buy would need to increase sales by $2.3 billion more simply in order to bring another comparatively menial $8 million to the coffer. Not Foolish.

We look for 10% and higher net profit margins, and the higher the better. Innovex has trailing net profit margins of nearly 22%, having increased from 18% to 26% over the last four quarters. When we bought ATC COMMUNICATIONS (Nasdaq: ATCT) we broke the rule slightly, because net profit margins were only around 9% -- at the company's very high point. It appeared that margins were improving, but probably we assumed too much. I mean that in an educational way -- there is some level of assumption in every investment, but assuming too much can occur and needs to be guarded against.

But do consider, when the Fool bought IOMEGA (NYSE: IOM) the company was losing money -- no net profit margin at all. The assumption was that the Zip drive would be a hit. A well-calculated risk.

5. Relative Strength: 90 or Higher. This number is listed in Investor's Business Daily each day. It measures a stock's performance against all others on the market. Ninety or higher means that a stock has performed better than 90% of all stocks in the past twelve months. (One contention I have is that twelve months is too short a time-period.) Anyway, the number is a measure of past performance, so while we like it, it likely doesn't weigh much on future performance. Winning stocks continue to be winners, though not due to their relative strength -- but due to their fundamentals.

When high relative strength is coupled with strong fundamentals -- great -- but when it isn't, that high number may actually be a warning sign. We look for both shorts and longs using high relative strength numbers. ATC Communications had a 99 relative strength when we bought it -- the highest possible -- as did Iomega. ATC Communications now has a relative strength of 5 -- near the worst possible. Innovex has a relative strength of 95.

6. Earnings and Sales Growth: 25 percent or Greater. In our most recent stock searches we've upped the ante to 50 percent or greater. We want small and mid-cap stocks that are growing earnings and sales at least 50% per year. That's a tall order, and should result in a strong stock, but it isn't easy to find and we still consider stocks that are growing somewhat more moderately. Great companies like TELLABS (Nasdaq: TLAB) and McAfee can't be ignored merely because they're only growing between 30 and 40% per year.

Innovex has been growing at an average rate of 77% annually over the past five years, and is expected to grow sales over 100% this fiscal year. Going forward, it's expected that it can keep growing 30% annually -- and we like the projected forward price-to-earnings ratio of only 11 on that growth, following September earnings.

7. Insider Holdings: At least 15 Percent. Simple and logical. We like small-cap stocks that the management likes to own as well. The more confidence that management has in a stock, the better -- and if management has lately been buying their own stock, that's an extra bonus. Insiders at Innovex own about 8% of the stock -- below what we look for. The company states that 48% of the shares out are owned by institutions, though -- which is perhaps positive and negative.

For one, it may mean that the stock has been "discovered," but for another, that 7 million shares is owned by several funds and only one fund owns an amount close to 5% of the shares outstanding. Having many shares somewhat "locked up" in many funds makes the stock more volatile (less shares available for trading), but also might make it more prone to rise when buying interest mounts.

But with insider ownership we're looking only at company insiders, of course. We like to see at least 10% of shares owned by management when considering small and mid-caps.

8. Cash Flow from Operations: A Positive Number. Another straight forward factor. We want companies that are cash flow positive. Innovex is highly cash flow positive. ATC Communications was only marginally, and had been cash flow negative beforehand. But consider again, our best investment had been cash flow negative: Iomega. You of course need to consider the story behind the investment and the likely outcome regarding cash flow.

Those are the eight factors that we always look at when we're considering growth stocks for the portfolio. They aren't be-all and end-alls, but they are important. In this Fool's opinion, the most important of the eight are sales and earnings growth, net profit margins, and cash flow. Of equal importance, but much more difficult to measure, is the management and the intrinsic value represented by their company's business and vision.

How we find the stocks to run through this checklist is another story. We'll talk about that tomorrow, and we'll also look at some past Fool stock considerations.

For the Fourth of July holiday, please note that the U.S. stock market closes at 1:00p.m. Eastern Time tomorrow.

Fool on!

--Jeff Fischer, July 2, 1997

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Stock Change Bid ---------------- AOL +1 7/16 61.00 T - 3/8 36.00 ATCT + 1/16 5.00 CHV + 1/16 75.50 DJT - 1/16 10.63 GM + 9/16 56.94 INVX - 7/8 27.50 IOM - 3/8 19.94 KLAC +1 1/8 53.25 LU - 3/4 73.31 MMM + 1/4 101.00 COMS +3 3/4 48.13
Day Month Year History FOOL +0.81% 2.70% 8.31% 189.06% S&P: +1.46% 2.13% 22.05% 97.22% NASDAQ: +1.21% 0.94% 12.75% 102.12% Rec'd # Security In At Now Change 8/5/94 355 AmOnline 7.27 61.00 739.06% 5/17/95 980 Iomega Cor 2.52 19.94 691.17% 10/1/96 42 LucentTech 47.62 73.31 53.97% 8/12/96 110 Minn M&M 65.68 101.00 53.78% 8/11/95 125 Chevron 50.28 75.50 50.14% 8/24/95 130 KLA Tencor 44.71 53.25 19.10% 8/12/96 280 Gen'l Moto 51.97 56.94 9.55% 8/13/96 250 3Com Corp. 46.86 48.13 2.70% 6/26/97 325 Innovex 27.71 27.50 -0.76% 8/12/96 130 AT&T 39.58 36.00 -9.04% 4/30/97 -1170 *Trump* 8.47 10.63 -25.46% 10/22/96 600 ATC Comm. 22.94 5.00 -78.20% Rec'd # Security In At Value Change 8/5/94 355 AmOnline 2581.87 21655.00 $19073.13 5/17/95 980 Iomega Cor 2594.53 19538.75 $16944.22 8/12/96 110 Minn M&M 7224.44 11110.00 $3885.56 8/11/95 125 Chevron 6285.61 9437.50 $3151.89 8/12/96 280 Gen'l Moto 14552.49 15942.50 $1390.01 8/24/95 130 KLA Tencor 5812.49 6922.50 $1110.01 10/1/96 42 LucentTech 1999.88 3079.13 $1079.25 8/13/96 250 3Com Corp. 11714.99 12031.25 $316.26 6/26/97 325 Innovex 9005.62 8937.50 -$68.12 8/12/96 130 AT&T 5145.11 4680.00 -$465.11 4/30/97 -1170*Trump* -9908.50 -12431.25 -$2522.75 10/22/96 600 ATC Comm. 13761.50 3000.00-$10761.50 CASH $40625.59 TOTAL $144528.47