Fool Portfolio Report
Monday, January 26, 1998
by Jeff Fischer (JeffF@fool.com)

ALEXANDRIA, VA (Jan. 26, 1998) -- It was good to see the underdog Denver Broncos slap Green Bay for a loss in yesterday's Super Bowl, and now I believe that we're looking at another underdog right here: the Fool Port. Today was another bruiser as almost nothing went our way.

After three years of heady market outperformance, what we've seen here over the past eighteen months isn't that unusual. (That's not an excuse -- this type of performance after a period of great success just truly isn't unusual, and we'll explore why.) This portfolio actually sets a good example as to why buying what was the hottest mutual fund over the past two or three years is usually a bad idea.

Although the Fool Port crushed the market in 1994, 1995, and 1996, and beat the Nasdaq and nearly tied the S&P in 1997 even while having a load of cash on the sidelines, it actually hasn't appreciated all that much since mid-1996. There are a few reasons for this, aside from mistakes made, just as there are reasons that a hot mutual fund usually cools off for at least a period of time.

There are not many ways to get solid, consistent outperformance from the stock market, and the ways that do exist are not easy to find (which is why the Dow Approach is a potential blessing). These methods include:

1. Buying inefficiently priced stocks that eventually will rise more quickly than the market.

2. Buying near the bottom of economic or market cycles -- the "bottom" being when you, as a Foolishly knowledgeable investor, see value that you can't pass up.

3. Buying stock in businesses that have been underestimated by the market. (Only time proves this, so it's your logic against theirs -- and this is another form of inefficiency, obviously.)

4. Buying a stock early in its upcycle, catching the majority of the gains that come on the back of a tremendous business boom. (The overriding theme again: you've caught something before the general market has.)

No big surprises.

In order to beat the market, you often need to be correct when others are wrong. You find inefficiencies or what you think are inefficiencies and capitalize on them. Buffett did so buying the Washington Post Co. at outrageously cheap prices in the early 1970s, and again by buying Coca-Cola in the late-1980s when most investors disliked the company. These types of opportunities don't come along frequently, especially not with the mind-bending success that the Fool Port has had with America Online and Iomega. Both of these stocks were rather Foolishly and brilliantly bought very inexpensively compared to the business potential that a couple of punk Fools saw inherent in them -- and that has come true.

Just how unusual are these great stocks?

Iomega holds the title of "the company to grow most quickly from $200 million in sales to over $1 billion in sales," and it was one of the top-performing stocks on the Nasdaq in each of the past three years, and the number one stock on the Nasdaq in 1995. While over the past seven years America Online is the number one, bar none, top-performing stock on the New York Stock Exchange. Bar none. (I said that already, I know. But I reiterated it because of the thousands of stocks, AOL was number one, and the statistical likelihood of the Fool Port ever investing in the number one stock on the NYSE again in its lifetime is slim to none.)

Where are we going with this?

There is a large but compact schematic investing matrix that I'm only now putting onto paper, but that when complete I hope will be comprehensive in explaining appreciation, depreciation, risks, and time horizons all in relation to individual Fools and their attempt to understand why things happen as they happen -- and how they can invest on that knowledge. (In short, there is a matrix that I believe can capture the history of investing within it coherently and precisely enough to provide an excellent guide going forward, while providing enough framework to support an encompassing knowledge about the market and how it works through all time).

Within this work, there are several different kinds of appreciation that one can capture in the market, and when many of those are put together at the same time the outcome is usually a tremendous gain. There is no way to easily spot these gains before they happen, but if you know the general criteria to look for, you're much more likely to find them just as they are beginning to occur. But more important than finding short-term gains is finding those alongside consistent long-term gains.

Anyway, some of the appreciation that exists on the market is economic appreciation (which can raise all boats), business appreciation (a growing industry or specific business, one that is expanding regardless of the economy), and then there is also situational appreciation and sustainable appreciation. For now, let's just look at these few things, not minding the others on the list.

What we've just seen with America Online and Iomega is a tremendous amount of situational appreciation alongside of business appreciation. First, though, what the heck is situational appreciation?

That's when one item or, more frequently, an entire series of items, conspire at once to make for appreciation well beyond what normally could be achieved. (There is also situational depreciation, which often presents an opportunity, but more on that some other day.) The difference between situational appreciation and sustainable appreciation is exactly that: situational appreciation is rarely if ever sustainable for more than a period of a few years. While sustainable appreciation is what results when a business becomes an ongoing success (something like Johnson & Johnson has accomplished during this century).

So...

What were the situations with AOL and Iomega? There were many, and today we'll just take up the most obvious and save the in-depth stuff for later. The situations included, though, that the market widely didn't know about or believe in the stocks for a long period of time, which kept the prices depressed long enough for confident investors to get stakes in promising "new" businesses at a fraction of later prices, even while the strong possibility of success was written on the wall. More obvious situations: the birth and boom of the Internet and the personal computer (a boom that is now becoming the "cheap, sub-$1000 personal computer boom"), and the need, with the Internet, for more storage space; while the online and Internet revolution helped AOL grow a giant market space in a matter of a few years.

If you were online four years ago it was relatively quiet, but you knew of the potential because you kept signing on again, and again, and again. AOL had less than one million subscribers in 1994 compared to over ten times that now. The situation that investors were presented with back in 1994 was a tremendous opportunity to invest in what was a new industry. And that is still very much the case now, but there is a key difference:

It has been recognized.

The potential is now widely recognized and so the prices of Internet stocks like AOL and Yahoo! (and Iomega's price at one point) have largely taken the potential into account. The "situational appreciation" has perhaps, for now, come and gone. And if the situational appreciation is behind them, the stocks might actually have more risk on some levels than they did when they were "young," because the expectations (and so valuations) are now much higher. The stocks may match the market, but the odds of them now crushing the market are much lower, while the risks are increased. Meanwhile, now we are beginning to see some Internet stocks rise or fall on the basis of the business fundamentals as they come about, though there is still a lot of situational premium built into the stocks of these companies due to their industry.

Other examples of appreciation that is the result of several contributing factors conspiring at once include Coca-Cola from the 1980s to now, and Microsoft and Intel during that same time period. These are world-class operations that have the obvious potential to continue to outperform, but expecting the same past ten-year 60% annualized growth from Microsoft for the next ten years would of course be insane, or the same 34% annualized growth from Coca-Cola. Coca-Cola began ten years ago at a relatively low valuation and hence the company was able to buy back more shares. By introducing Diet Coke it nearly doubled earnings per share growth right off the bat, and as it raised net margins from 7% to 22%, Coca-Cola saw its valuation multiple expand generously (another type of appreciation -- "multiple apprecation," which conspires with business appreciation if a company is improving its efficiency as it grows, and if the economy and investing mood allow it).

Meanwhile, Microsoft began from IPO status -- small cap -- to come to dominate the PC operating system market. This is a situation that no other company will be able to duplicate in our lifetimes, but one that has obviously been recognized by now in old Softy. Are the best of times behind Microsoft, though? I doubt it. There are new markets to dominate. Investors once thought that Netscape had a chance at one of them.

In all, this is a roundabout way to say that stocks and portfolios outperform because of inefficiencies in pricing and due to special situations. To consistently capture those situations is not easy, which is why most stocks and portfolios and mutual funds revert back to the averages when the "situations" or inefficiencies have been played out. (The Fool Four or Dow Dividend Approaches might be the only models that consistently win, because they are consistently investing in both business appreciation and situational appreciation scenarios. The stocks have high yields due usually to business slowdowns or uncertainties that are situational, while the businesses often become unfairly priced to the downside at the same time.)

Anyway, there are always standout outperformers and the companies that we talked about today are a small handful of them, but there are time periods when, after incredible situations conspire to cause incredible gains, the stocks often only do as well as the market, at best, until another great situation or inefficiency comes about. The large gains attained and the resulting increased valuations often help guarantee this "market performance" in recent great performers.

This was also a roundabout way to avoid writing about Amazon.com's fourth quarter. (No, I didn't mean to do that.) Tom and David Gardner have written about the earnings report, the business, and the stock on the Amazon message board in the community area. Yesterday Tom posted several interesting thoughts on Amazon, so I direct you to those tonight (share your thoughts!), while I'll write about Amazon the next chance that I get.

Fool on!

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TODAY'S NUMBERS

Stock Change Bid ---------------- AMZN -1 1/2 57.75 AOL -3 1/16 92.19 T -3 13/16 61.56 CHV +1 9/16 75.56 DJT + 5/8 9.75 GM + 1/16 57.13 INVX - 9/16 20.56 IOM - 3/16 8.63 KLAC -1 9/16 36.00 LU - 1/16 82.94 MMM + 7/16 82.00 RTN.A +2 5/16 51.38 COMS - 3/4 30.13 TDFX -1 22.13 SPY - 9/32 95.66
Day Month Year History FOOL -2.47% -9.52% -9.52% 203.66% S&P: -0.07% -1.39% -1.39% 108.76% NASDAQ: -0.92% -0.57% -0.57% 116.82% Rec'd # Security In At Now Change 8/5/94 355 AmOnline 7.27 92.19 1167.55% 5/17/95 1960 Iomega Cor 1.28 8.63 573.61% 10/1/96 42 LucentTech 47.62 82.94 74.18% 8/12/96 130 AT&T 39.58 61.56 55.55% 9/9/97 290 Amazon.com 38.22 57.75 51.09% 8/11/95 125 Chevron 50.28 75.56 50.27% 8/12/96 110 Minn M&M 65.68 82.00 24.85% 8/12/96 280 Gen'l Moto 48.74 57.13 17.20% 1/8/98 115 S&P Depos. 95.91 95.66 -0.26% 12/19/97 17 Raytheon 53.21 51.38 -3.45% 1/8/98 425 3Dfx 25.67 22.13 -13.80% 4/30/97 -1170 *Trump* 8.47 9.75 -15.13% 8/24/95 130 KLA-Tencor 44.71 36.00 -19.48% 6/26/97 325 Innovex 27.71 20.56 -25.79% 8/13/96 250 3Com Corp. 46.86 30.13 -35.72% Rec'd # Security In At Value Change 8/5/94 355 AmOnline 2581.87 32726.56 $30144.69 5/17/95 1960 Iomega Cor 2509.60 16905.00 $14395.40 9/9/97 290 Amazon.com 11084.24 16747.50 $5663.26 8/11/95 125 Chevron 6285.61 9445.31 $3159.70 8/12/96 130 AT&T 5145.11 8003.13 $2858.02 8/12/96 280 Gen'l Moto 13647.92 15995.00 $2347.08 8/12/96 110 Minn M&M 7224.44 9020.00 $1795.56 10/1/96 42 LucentTech 1999.88 3483.38 $1483.50 1/8/98 115 S&P Depos. 11029.25 11000.47 -$28.78 12/19/97 17 Raytheon 904.57 873.38 -$31.20 8/24/95 130 KLA-Tencor 5812.49 4680.00 -$1132.49 4/30/97 -1170*Trump* -9908.50 -11407.50 -$1499.00 1/8/98 425 3Dfx 10908.63 9403.13 -$1505.50 6/26/97 325 Innovex 9005.62 6682.81 -$2322.81 8/13/96 250 3Com Corp. 11715.99 7531.25 -$4184.74 CASH $10740.46 TOTAL $151829.86