<THE FOOL PORTFOLIO>
Principle # 4
Qualities that MUST exist in Rule Breakers

by David Gardner (DavidG@fool.com)

ALEXANDRIA, VA (Nov. 23, 1998) -- The Fool Portfolio continued its northerly November trek Monday. With our winter coats pulled on tight, the tennis rackets affixed to our soles, and the requisite Fool caps strapped around our ears, we tramped through the snow toward a rise of 8.09%, besting the market averages once again (S&P 500 up 2.12%, Nasdaq up 2.55%).

The reasons were essentially the same ones that have made November 1998 the best month in our portfolio's history: Amazon and AOL. Both stocks surged today, Amazon on continued bullishness about a blowout fourth quarter, its stock split, and its positioning as the Internet's #1 shopping site by sales volume. AOL rose in tandem with the developing story (have you NOT heard of this one by now?) that it may buy out Netscape. (Netscape, by the way, rose a couple bucks today on the takeover rumor, as well -- you can read the Foolish viewpoint via today's feature.)

I want to thank each Fool who wrote in to comment about our third principle of portfolio management for this portfolio, published Friday. As you know, each of our principles is being put up in "rough draft" form in order to solicit the commentary and thoughts of our Foolish readership at large. This principle was no exception -- lotsa good thoughts. I'll be incorporating that thinking into the final version once we publish them all in mid-December. Meanwhile, I do want to clarify one thing: The downgrading of the importance of valuation applies to Rule Breaker stocks -- not all stocks in general. Not Cash-Kings. Not our Foolish Four. Not Boring stocks, or our Foolish 8 small caps, etc.

We downgrade the importance of valuation for Rule Breakers precisely because they are so unpredictable that investors are better served trying to figure out whether (and how) the businesses will succeed in the long term -- not whether the market has them "accurately" priced today to account for all their future growth. In fact, anyone who found the third principle intellectually stimulating (or troubling, or whatever), should read a message-board posting I wrote in response to one bemused Fool, which restates the thinking in a form somewhat more effective, a second draft of the soon-to-be-published principle.

Today, we debut our fourth principle of Rule Breaking. But before we do, I'd like to address one recurring question -- call it the $64,000 question (or thereabouts) because it's an important one AND it's asked so frequently. Namely, what is our "exit strategy," what is our "selling discipline," what is our portfolio's approach to selling stocks?

The chapter I wrote in The Motley Fool Investment Guide entitled "Selling Strategy" remains the definitive answer to the question. If you own the book, go back and read that because it tells you most of what you need to know about how we think about managing our portfolio. Essentially, we believe that you should NOT set target prices for each of your stocks, as so many of the Wise would have you do. Instead, when we see a new investment that we like quite a bit -- so much, in fact, that we want to sell part or all of a current holding in order to buy it -- THEN we make our sell decision. Decisions to sell stocks are therefore never made on their own merit, but rather on a "demand" basis; when a new investment strikes us as sufficiently attractive that it "demands" to be bought, we sell what we need to buy it.

Then the question is, what do we sell? Simple. We sell whatever we like least. In that regard, we are simply moving money from things we don't like as much to new things that we like a good deal more. This is our portfolio management approach.

Every week since we bought AOL in 1994, Iomega in 1995, or Amazon in 1997, we've been told by one or another person that if we're smart, we'll sell the stocks because they're overpriced. But these suggestions do not address how we think about investing. We bought Amazon at $19. When it hit $40, we held. When it hit $80, we held -- in the face of many who derided us for not having any "exit strategy" for the stock. Same goes for $120, then $160, then $200. We understand that the stock won't keep going up like this forever. We also know that Amazon could get halved tomorrow should something extremely untoward occur. That said, we simply don't pick numbers out of the air and say, "I'll sell when it hits $100." To do so is fundamentally unFoolish, because it often fails to account for the changes -- the bullish changes -- in a company's story that occur in between your purchase price and your target price.

As you can see, our decision of when to sell Amazon or any of our stocks comes down not to picking the proverbial number out of the air, but rather, waiting till we find something we like more. The only exception to this rule is if we get way, way, way overweighted in a given stock. If that happens, we may sell a portion of that stock in order to move the money elsewhere (as we did with America Online and Iomega in 1997 -- some of that money, by the way, made our purchase of Amazon possible).

Anyway, we'll continue to explain our methods in hopes of educating our Foolish readers and contributors worldwide -- that's our mission. Whether you choose to agree or to disagree is your business -- in fact, our whole goal is to help you to think for yourself about investing. I think I'll add an additional (seventh) portfolio management principle in order to elucidate our thinking on selling.

Now, our fourth principle of Rule-Breaking portfolio management is a fun one, because it's a "sneak peek" that concisely lists the six attributes we're looking for in locating a Rule Breaker. The list you get here in the fourth principle is abbreviated, and therefore quite superficial compared to the full definition, exploration, and illustrations that I provide in our upcoming Rule Breakers, Rule Makers. But we'd be remiss if we didn't identify and share what those attributes are, as part of our portfolio management principles. So here tonight you get a short list -- a preview, if you will -- of the six attributes shared by all true Rule Breaker stocks. Every Rule Breaker must fulfill ALL SIX of these attributes to be called a Rule Breaker.

#####

To pick our growth stocks, we are using the Rule-Breaking principles laid out in The Motley Fool's Rule Breakers, Rule Makers, published by Simon & Schuster in 1999.

The Rule Breaker portfolio begins, as much of Foolish investing does, with the Foolish Four. We also occasionally short a stock or two. These concepts derive directly from The Motley Fool Investment Guide, which goes on to explain how most of the rest of our portfolio is growth stocks. For these, we use the principles listed, illustrated, and developed in the Rule Breaker section penned by David Gardner in the coming Foolish release of Rule Breakers, Rule Makers.

In short-list form, here they are. Any Rule-Breaking company needs to fulfill all six of these criteria:

  • The top dog and first-mover in an important, emerging industry...
  • Sustainable advantage gained through business momentum, patents, visionary leadership, and/or inept competition...
  • Excellent past share appreciation, measured by a relative strength of 90 or higher...
  • Good management and smart backing...
  • The greater the consumer brand, the better...
  • A significant constituent of the financial media is recently on record for calling it overvalued...

Each of these is explored as its own chapter in our new book, along with important introductory and concluding material to tie it all together. This short list serves as a superficial summary, but at least one that will give you some idea of what we're looking for in our stock selections.

Note that many of these criteria are qualitative, not quantitative... subjective, not objective. This is consistent with our wish to really get into the THINKING of investing, which is this portfolio's goal. Indeed, we believe that those who struggle with answering whether a given company truly fulfills our six attributes listed above will not only improve their investing results, they'll improve their understanding of investing, in general. It is this struggle to understand, rather than any rote attention given to a short list of numerical criteria, that characterizes the work in our upcoming book and the efforts being made in this online space each day.

#####

As you know, we will be making some changes to this, the Rule Breaker portfolio, in the upcoming weeks. These changes will be in order to more cleanly align this real-money portfolio with the teachings of our new book for more advanced investors. You may see some growth stocks in our portfolio today which do not seem to fit these principles; we'll probably jettison those stocks in favor of adding some new ones which more clearly exhibit the Rule Breaker attributes.

Why do we do this? Our true Rule Breakers have been our best stocks. By studying them, anatomizing them, and locating others like them, we hope to further increase our lead over the stock market from now till kingdom come.

As always, your input on these principles is solicited and appreciated. So if you have further thoughts or queries about this fourth principle, let us have them.

Fool on,

-- David Gardner, November 23, 1998

Order your copy of David and Tom Gardner's new book, Rule Breakers, Rule Makers, in advance. This Simon & Schuster beauty doesn't arrive until January, but you can reserve your copy today! The first half of the epic book, on Rule Breakers, elucidates the Fool Port's investment style; the second half, on Rule Makers, further explains Cash-King investing.

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Bookmark Live Fool Port Quotes

11/23/98 Close

Stock Change Bid ---------------- AMZN +37 3/8 218.00 AOL +4 89.63 T + 9/16 63.88 DJT + 3/16 4.94 DD - 5/16 60.56 XON --- 72.00 INVX - 1/8 16.00 IP - 5/16 45.69 IOM - 1/4 7.94 KLAC +1 37.88 LU +1 7/8 88.38 SBUX +2 1/8 46.00 COMS +2 1/16 41.94 TDFX - 3/4 12.56
Day Month Year History Annualized FOOL +8.09% 36.99% 119.15% 635.47% 59.03% S&P: +2.12% 8.15% 22.44% 159.20% 24.79% NASDAQ: +2.55% 11.63% 25.92% 174.57% 26.47% Rec'd # Security In At Now Change 8/5/94 1420 AmOnline 1.82 89.63 4829.28% 9/9/97 580 Amazon.com 19.11 218.00 1040.72% 5/17/95 1960 Iomega Cor 1.28 7.94 519.92% 10/1/96 84 LucentTech 23.81 88.38 271.20% 8/12/96 130 AT&T 39.58 63.88 61.39% 4/30/97 -1170*Trump* 8.47 4.94 41.70% 2/20/98 200 Exxon 64.09 72.00 12.34% 2/20/98 215 DuPont 59.83 60.56 1.22% 2/20/98 270 Int'l Pape 47.69 45.69 -4.20% 8/13/96 250 3Com Corp. 46.86 41.94 -10.51% 8/24/95 130 KLA-Tencor 44.71 37.88 -15.29% 7/2/98 235 Starbucks 55.91 46.00 -17.72% 6/26/97 325 Innovex 27.71 16.00 -42.26% 1/8/98 425 3Dfx 25.67 12.56 -51.06% Rec'd # Security In At Value Change 8/5/94 1420 AmOnline 2581.87 127267.50$124685.63 9/9/97 580 Amazon.com 11084.24 126440.00$115355.76 5/17/95 1960 Iomega Cor 2509.60 15557.50 $13047.90 10/1/96 84 LucentTech 1999.88 7423.50 $5423.62 4/30/97 -1170*Trump* -9908.50 -5776.88 $4131.63 8/12/96 130 AT&T 5145.11 8303.75 $3158.64 2/20/98 200 Exxon 12818.00 14400.00 $1582.00 2/20/98 215 DuPont 12864.25 13020.94 $156.69 2/20/98 270 Int'l Pape 12876.75 12335.63 -$541.13 8/24/95 130 KLA-Tencor 5812.49 4923.75 -$888.74 8/13/96 250 3Com Corp. 11715.99 10484.38 -$1231.62 7/2/98 235 Starbucks 13138.63 10810.00 -$2328.63 6/26/97 325 Innovex 9005.62 5200.00 -$3805.62 1/8/98 425 3Dfx 10908.63 5339.06 -$5569.56 CASH $12005.75 TOTAL $367734.88

</THE FOOL PORTFOLIO>

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