<THE RULE BREAKER PORTFOLIO>

Internet Stocks Decline... Yawn

by Jeff Fischer (TMFJeff)

ALEXANDRIA, VA (June 14, 1999) -- For every action, there is an equal and opposite reaction.

Nowhere is this more true than in the land of Wisdom, where stocks are master and the Wise are servants. Stocks rise, the Wise dutifully react. Stocks decline, the Wise react again. Stocks don't move, the Wise still react. In this case, I'm referring to Wise journalists -- individuals who write daily articles that are dictated by stock movements and little else. Wisdom of this sort reigns in droves today, covering the declining "Internet stocks." Let's consider headlines:

"Holy Hemorrhage!"
"Internets Smashed"
"Internet Stocks Sharply Lower"

Okay. There was an action today (declining stocks) and an immediate reaction (hyped up stories about it).

However, today should not be considered unusual -- no matter what the Wise write. Today doesn't deserve banner headlines and the attention of a nation. (Please.) In fact, reacting to today's decline in such a predictable way as the Wise have is strictly Pavlovian. Who is the master? Not the journalist. The stocks are. The stocks said "sit up," and the undisciplined minds (reactionaries, not thinkers) jumped in obedience.

They jumped all over themselves, but what was special about today? Nothing. Young companies almost always have the most volatile stocks, and all pure-play online companies are young. The business models are uncertain, the valuations granted can border on random, and the competitive landscape is undergoing tremendous daily change. Add to this newly-arisen momentum investors and even more volatility is present than in the past with young companies -- volatility to the upside, and to the downside.

So, today shouldn't come as a surprise -- at least not to readers of this column. To treat today as if it were unusual (we've seen volatility like this before, and we will again) is hypocritical. We repeat ad nauseum that our investments are and will be volatile. Amazon has lost over 50% from its high more than three times for us. AOL did the same in the past and has nearly done so again. Excite@Home joined the 50% Club last week. eBay nearly has, too.

Considering the names just listed, this is a respectable club, not a motley slew of third-tier companies. I don't believe that any of our companies have seen their best days yet by a long shot. As we wrote here one month ago, these companies' stocks could be net flat for the next four years (you never know), but brighter futures likely stretch ahead for the many years beyond, years turning into decades. And that's what we invest for: years that turn into decades. An investor shouldn't buy anything (at any price) unless they plan to hold it for year after year. This is especially true with new, much less predictable companies.

And our companies are not very predictable. But the more volatile that they are in their business practices (representing the act of taking chances), and the more volatile their stocks are (representing that they're being noticed), the better. In fact, if our stocks weren't volatile we would probably be doing something wrong. Rule Breakers by definition are volatile. Consider 3dfx and Iomega, two of our less volatile positions (possessing little upside volatility). Over the past few years, they've not appreciated.

So today was another day of volatility -- more volatility than usual, but mama said there'd be days like this, there'd be days like this, mama said. What more could mama add? Little. She shouldn't need to. People rarely ask for justification or an explanation when stock prices rise. They often want justification when stocks decline, however. Catering to that incongruency is Wise. The incongruency itself is Wise. Fools know that stocks go both ways in the near term. Taking the good without thought but then demanding an explanation for a downturn is akin to not appreciating life when you're healthy, but then wanting to experience life fully when you believe that you might not live much longer. Not an intelligent perspective, to say the least.

Let's look ahead. The Wise now say, "Look at the carnage. It keeps going. Will it finally all end badly?"

Well, no. On the contrary, it is beginning to appear that it might all transition (it will never end) "goodly" -- especially for potential investors and, yes, for long-term holders.

This weekend a discussion took place on the Rule Breaker board regarding valuation. I believe in two approaches regarding valuation and Rule Breakers. They are: 1) Up to a certain but variable point, valuation of a typical Rule Breaker is best ignored if it is going to hamper your buy decision, partly because these companies are so difficult to value. 2) Beyond a certain point, however, valuation takes on size enough to matter and not be ignored. Amazon at $880 million is not the same prospect as Amazon at $30 billion. (Not currently, anyway. Some year from now, Amazon at $30 billion could prove inexpensive just as Amazon at $880 million has for this portfolio.)

Rather than repeat everything here, visit the thread on valuation if you're interested. The discussion really begins here -- follow this thread -- and I've written four following posts on the same thread, trying to answer Fools' questions. (Read it when you have some time.)

I should point out: I'm most interested in discussing issues with Fools on the message boards, rather than writing extensively in a one-way column that by design has limited potential. If you have topics for all of us to discuss, please post them. We will actively discuss topics and this column will be shorter when necessary. The reward will be an ever richer message board discussion, one that directly benefits anyone who directly participates.

Spending today here, though, we'll consider some of our company valuations. The Rule Breaker lost over 8% today -- a large amount by any measure, but unfortunately not a record for us. (I like new records of all kinds and I'm not worried about daily results, so what the heck -- I'm rooting for records.) The portfolio is down over 20% this month, also not a record. Given the month-plus decline, however, share prices might begin to present some interesting situations for Fools not yet invested.

First, consider America Online (NYSE: AOL). Don't think of where it has been. ($175, but what does the high mean anyway? Very little.) Think of where it is and where it might go. The company is now at $90 per share and valued at about $99 billion (before future options dilution). In the past, we've run subscriber-based valuation measures on the company to come up with current and future "reasonable valuation" -- all unforeseens excluded, of course. If you run this subscriber-based metric now, you reach a current fair valuation for AOL of about $76 billion, or about $78 per share.

$90. $78. This ain't horseshoes (nor any exact kind of science), but...

This model values AOL subscribers at about $1,700 apiece (slightly higher than I previously did for a few reasons), CompuServe and overseas subs at $1,300 (higher, too), and commerce and ad revenue at a constant 20 times sales multiple; then you throw on the value of the network and over a billion in cash. Of course, if you project growth for the years ahead, you obtain increasing "fair prices." The point is that share prices, at least in AOL's case, are beginning to look more interesting (they've always been exciting -- we can't confuse the two).

Amazon.com (Nasdaq: AMZN) is now valued at just under $15 billion. The company will probably have $1.5 billion in sales this year, putting it at 10 times potential sales. "Big deal, it's losing money," you say. Sure. For $15 billion, though, you're buying the long-term potential. $15 billion gets you the leading online book, music, and video seller, its growing auction service, controlling stakes in Drugstore.com (a nice site, check it out), Pets.com (nice, too), HomeGrocer.com, 10 million registered customers, and much more. (Amazon will probably announce a toy store this month, too.)

Is Amazon's retail business going to be worth more than $15 billion in five years? As a customer who has spent almost $15 billion at Amazon already (it seems), I'd say yes. As an objective Foolanalyst, I'd say yes, too. (Otherwise, why would we own the stock?)

Eventually, we'll probably read Pavlovian articles -- after stocks bounce -- stating, "Stocks corrected enough, many down more than 50%, so buyers returned to the volatile sector." Maybe next week we'll read this. Maybe next fall. Maybe tomorrow.

All in all, it was another typical (meaning, volatile) day for our investments. Rather than become hyperactive about it as the Wise do, a Fool reminds oneself that one day never makes an investment career. One year doesn't. One decade doesn't. A career is lifelong. If you want a successful investment career, you should approach investing as a lifelong endeavor. That strategy in place, tonight is as good a night as any other to celebrate living. (And if you'd like to discuss our stocks while you're doing so, visit the Rule Breaker board.)

A closing quote: If money truly made the world go round, the world would cease to spin. Most people don't have any money to speak of. As Fools, we -- all of us -- must create change in order to improve lives.

Fool on!

06/14/99 Close

Stock  Change    Bid 
------------------ 
AMGN  +1 1/2     53.81
AMZN  -13 13/16  92.00
AOL   -9 3/4     90.13
ATHM  -7 1/2     78.50
CAT   +  1/2     59.94
CHV   +1 11/16   94.75
DD    +2 7/8     70.19
DJT   +  1/16     5.19
EBAY  -29 7/8   136.00
GT    +1 7/16    60.81
IOM   -  1/4      4.06
SBUX  +  1/8     35.13
TDFX  -1 1/8     14.38

                  Day     Month  Year   History   Annualized 
      R-BREAKER  -8.67% -20.73%   6.09%  964.82%   62.74%
        S&P:     +0.03%  -0.59%   5.60%  195.87%   25.02%
        NASDAQ:  -2.03%  -2.92%   9.38%  233.02%   28.11%


    Rec'd    #  Security     In At       Now      Change
   8/5/94  2200 AmOnline       0.91     90.13    9816.38%
   9/9/97  1320 Amazon.com     6.58     92.00    1298.34%
  5/17/95  1960 Iomega Cor     1.28      4.06     217.28%
  12/4/98   450 Excite@Hom    56.08     78.50      39.98%
  4/30/97 -1170*Trump*         8.47      5.19      38.75%
  2/26/99   300 eBay         100.53    136.00      35.29%
  2/23/99   300 Caterpilla    46.96     59.94      27.62%
   7/2/98   470 Starbucks     27.95     35.13      25.65%
 12/16/98   580 Amgen         42.88     53.81      25.51%
  2/23/99   290 Goodyear T    48.72     60.81      24.83%
  2/23/99   180 Chevron       79.17     94.75      19.68%
  2/20/98   260 DuPont        58.84     70.19      19.28%
   1/8/98   425 3Dfx          25.67     14.38     -44.00%

    Rec'd    #  Security     In At     Value      Change
   8/5/94  2200 AmOnline    1999.47 198275.00  $196275.53
   9/9/97  1320 Amazon.com  8684.60 121440.00  $112755.40
  2/26/99   300 eBay       30158.00  40800.00   $10642.00
  12/4/98   450 Excite@Hom 25236.13  35325.00   $10088.87
 12/16/98   580 Amgen      24867.50  31211.25    $6343.75
  5/17/95  1960 Iomega Cor  2509.60   7962.50    $5452.90
  2/23/99   300 Caterpilla 14089.25  17981.25    $3892.00
  4/30/97 -1170*Trump*     -9908.50  -6069.38    $3839.13
  2/23/99   290 Goodyear T 14127.38  17635.63    $3508.25
   7/2/98   470 Starbucks  13138.63  16508.75    $3370.13
  2/20/98   260 DuPont     15299.43  18248.75    $2949.32
  2/23/99   180 Chevron    14250.50  17055.00    $2804.50
   1/8/98   425 3Dfx       10908.63   6109.38   -$4799.25

                              CASH   $9924.87
                             TOTAL $532408.00
 
Note: The Rule Breaker Portfolio was launched on August 5, 1994, with $50,000. Additional cash is never added, all transactions are shared and explained publicly before being made, and returns are compared daily to the S&P 500 (including dividends in the yearly, historic and annualized returns). For a history of all transactions, please click here.

</THE RULE BREAKER PORTFOLIO>

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