The market fell 1.33% as measured by the S&P 500 benchmark, while the Rule Breaker Portfolio fared far worse, down 5.7%. (That takes us below the 60% return mark for the year.) Outside of our Dow behemoths, pretty much all our investments got pasted, particularly America Online (NYSE: AOL), which dropped almost 8%. Here's a nice community Frequently Asked Questions (FAQ) post for AOL, just updated today. Many of our most popular message boards have FAQs generated by the Fool community, helping to answer questions about companies or addressing common issues associated with analyzing them.
Does the FAQ explain why AOL dropped about $6 today? Certainly not. Anyway, the company announced that it would float a $1.25 billion zero coupon convertible subordinated debt. Yowser. What in tarnation does that mean? Let's take it word by word, dissecting "$1.25 billion zero coupon convertible subordinated debt."
First, "$1.25 billion." Well, that's simply a large sum of money. Second, "zero coupon." That means that these bonds do not pay semiannual interest payments, the way that most bonds do. "Coupon" is a fancy way to say "interest payment." It stems from the fact that in the past you tore an actual coupon off a bond periodically (like clipping a coupon) to turn in for an interest payment. The new AOL bonds are zero coupon bonds. Instead of getting regular interest, you buy them at a discount to their $1,000 face value. Upon maturity, you can sell them at face value. (To account for this gain at tax time, you do receive "phantom interest income" every year -- a less than ideal situation for investors in these bonds.) Our next term, "convertible," means that these bonds can be converted into another asset, in this case equity in the form of AOL stock. In 20 years, the bonds come due; however, in 2004 AOL will offer to convert the bonds to cash or stock.
Next, "subordinated" means that these bonds are low on the rungs of repayment should the company fail. Subordinated bonds rank like equity, or stock. If AOL goes belly up, equity shareholders and subordinated bond holders are not likely to see any repayment. Primary debtors (companies, lawyers, preferred shareholders if AOL has them) will be paid first and foremost if the company liquidates its assets. (No, we certainly don't believe AOL will get into this position!) Finally, the word "debt" finishes the whole term "zero coupon convertible subordinated debt." The word debt alone typically strikes fear in the hearts of Foolish investors, but in this case it shouldn't.
Convertible debt is most often seen as a positive for both a company and investors. Why? Because investors buying convertible debt receive the superior protection that comes with owning a bond alongside an opportunity to generate a substantial capital gain when the bond converts to stock; meanwhile, the issuer (AOL) is able to raise capital at a moderate rate of interest and without diluting earnings per share in the near term. Of course, this debt isn't all roses. The underlying stock could decline to the point where conversion of the bond is a bad proposition for the debt holder (ugly!), and the issuing company will dilute its earnings per share in the future if all its convertible debt is converted into stock. In AOL's case, however, this $1.25 billion in debt can't do noticeable damage to earnings per share given AOL's large market value. This debt is worth well less than 1% of AOL's market value.
AOL is raising 1.25 billion clams via convertible debt for "general corporate purposes." Several young companies have used convertible debt this year to raise funds. Amazon (Nasdaq: AMZN) raised $1.25 billion itself early this year with convertible debt, and Apple Computer (Nasdaq: AAPL), CNET (Nasdaq: CNET), and Mindspring (Nasdaq: MSPG) all recently issued convertible debt. AOL will likely issue more in the future, too. Today's news may have played a role in the stock's decline, but primarily we think that AOL merely declined with its so-called peers.
Let's now turn our focus away from this single company (a company that has been one of the best investments of the decade and, we're hoping, will continue to be a market smasher in the next 10 years) and let's talk about Rule Breaker strategy.
I like to leave an occasional reminder here that four of our BreakerPort holdings are not in fact Rule Breakers, but Foolish Four stocks. What -- you thought we think that Caterpillar breaks all the rules? Well, maybe some of them. But Caterpillar is a Foolish Four stock, and Foolish Four companies have been in this portfolio every year since day one.
Going back to the publication of our first book, The Motley Fool Investment Guide, we have espoused a multistep approach to investing:
- Start with the index fund. For a tiny fee and tiny turnover, you get the market's average. You beat 90% of managed stock funds, and you pay less to do so.
- Stop there... UNLESS you love the market, love investing, love business, and want to invest in individual stocks. If so, go to step 3.
- Consider the Foolish Four. This conservative and dependable approach has years of backtested data showing superior returns well in excess of the market averages (of the index fund). Also, this is a great starting point for investors who are buying their first-ever stocks. You wind up owning the Unsinkable Molly Browns of American capitalism at times when they are typically out of favor.
- Stop there... UNLESS you want to take on more risk. If so, you're ready to venture out into the realm of stock picking Select Rule Makers, Rule Breakers, Foolish Eight stocks, or any one of a number of other methods taught at Fool.com. Invest in a portfolio that you're comfortable with, and invest for the long term.
Now that you've read the oft-reiterated skinny on Foolish investing, you can see why we have the Foolish Four here in this portfolio. We have consistently treated this approach as a foundation, a baseline. In good times like the past five years, we want the rest of our portfolio beating the Foolish Four. (And yet the Foolish Four itself will have beaten mutual funds handily over almost any five-year period.) And in bad times, the Foolish Four will be something to rally around -- "safe-haven" stocks, as the jargon sometimes goes.
In a small way, the Foolish Four is a Rule-Breaking phenomenon in that it posits that through mechanically investing in beaten-down Dow heavyweights, you can outperform the many mutual funds that are charging you on average 1.7% annually and turning over their portfolios 100%... handing those capital gains to you.
One thing to keep in mind with The Four is that they turn over annually themselves, making your tax bill more sizable compared to a purer buy-and-hold Rule Breaker approach. Like most things, the risk you take (lower) correlates with the reward you get (lower).
In all cases, though, when we take that step OUTSIDE of Step 1 listed above, we do so intending to beat the stock market. Otherwise... why bother?
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