What Happened to Cash-King?

Performance is the News
Value, not valuation

By Tom Gardner (TomGardner@aol.com)

Alexandria, VA (Dec. 28, 1998) -- The Rule Maker Portfolio gained 4% last week, outpacing the S&P 500 and adding more than $1,000 to our account. You could be extremely happy about this news, if it weren't for the fact that the Rule Breaker Portfolio seems to ring up that percentage gain on a daily basis and that dollar gain on an hourly basis. Over in the Rule Breaker Portfolio, America Online (NYSE: AOL) and Amazon.com (Nasdaq: AMZN) each gained more ground today.


Truly, your Maker managers are humbled in the presence of the market-obliterating returns from our sister portfolio. By market close today, the Breaker portfolio will be nearing a 200% gain in 1998 alone -- comparing nicely with the 26% gain in the S&P 500 this year. During that time, Merrill Lynch's "Global Collective Wisdom Portfolio," a veritable advertisement for the discount brokerage industry, is up just 6.4%.

Somewhere in that mix of runners, the Rule Maker Portfolio has risen more than 31% since our launch in February, resulting in a ten-percentage-point lead over the S&P 500. Pfizer, Intel, Gap, Cisco, and Microsoft have each risen more than 40%. Microsoft, what I consider to be the principal Rule Maker on the planet, has climbed more than 80% since February. I hope you view these Foolish gains as having come not through a series of "hot picks" but rather through reason, logic, and a little Foolish glee.

The basic thinking behind their selection is pretty simple, particularly in a world where so many investment "experts" make it sound so complex. In public-market tradition, the best just kept getting better in 1998. More investment dollars flowed their way, expanding shareholder value for managers and employees, as well as institutional and individual owners. But somewhere in all the hoopla about the stock-market's gains in the 1990s, I think that one simple and critical message may have been lost:

On average, the best companies keep getting better.

After all, let's remember that equity values are not on the rise across the board. Planet Hollywood is staring bankruptcy in the face, having fallen from $29 to $2 per share. This year, Boston Market filed for Chapter 11 protection. Nike has been cut in half over the last eighteen months. Over the past six years, Kmart has fallen more than fifty percent. All of this even as the stock market has risen more than 350% over the past decade.

Equity values are not everywhere on the rise. Understanding why is not terribly difficult. Throughout our public, free markets, business success (not stock-chart readings or P/E ratios) is the determining factor in equity value. Time and time again, it is business models and operational momentum that have driven equity values. Amazon.com keeps rising because -- if you look at its numbers, from quarter to quarter -- its operations are gaining momentum and efficiency. The Gap always looks absurdly overpriced because, year after year, its business growth improves. Microsoft is trading at what seems an outrageous 70x earnings, and yet, if I had money to sock away for five years or more, I would buy more today.

The valuation of companies is much more about prospects for business growth over the next decade than about a traditional evaluation of past performance. And investors must study smaller companies as Rule Breakers and larger companies as Rule Makers. They are very different animals.

At the outset, small companies need to grow their customer base and their sales line. As they mature into larger companies, they have to expand their base of pure earnings and build up substantial cash reserves. The larger the company, the more money they'll need to change directions -- because inevitably they will need to change directions. Amazon.com's concentration must be on the next ten million people to use its service. Alternately, Microsoft needs to double its $17 billion cash reserve and enrich its product lines to extend its real earnings (accounting for accounts receivable and inventories).

When I hear folks say that the Internet is absurdly overvalued, I believe they're missing the distinction in these two phases of business growth. Most of the Internet businesses are in the early stage of customer acquisition and sales growth. Amazon.com should continue to rise over the next five years as long as it adds millions of new customers who return each quarter to buy stuff. On the flip side, a lot of technology value is wrapped up in more mature business models, where cash and control are the determining factors. Accordingly, Microsoft's stock should continue to rise in value over the next five years as long as it stockpiles billions more in cash by generating pure earnings growth.

For these and all other public companies, positive and sustainable business momentum is MUCH more important than temporary stock valuation. I think many investors still concentrate too much on price and not enough on value -- even though the 20th century public market is a testament to value, not valuation. I hope the Rule Breaker and Rule Maker portfolios have helped to make this abundantly clear, as well.

I'll be back tomorrow with a word on the holiday and your finances, then more investing stuff for the rest of the week. Fool on!

Tom Gardner

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12/28/98 Close

Stock  Change    Bid
AXP   -1 7/16  101.94
CHV   +  5/8   85.31
CSCO    ---    94.19
KO    -  9/16  68.88
GPS   +1 7/16  55.56
EK    -  7/8   72.25
XON   -  1/8   74.50
GM    -  7/8   72.56
INTC  -2 7/8   122.13
MSFT  +  5/8   142.38
PFE   +  1/16  119.44
SGP   -1 1/16  53.88
TROW  -  5/8   34.50
                 Day     Month   Year    History
        R-MAKER  -0.40%   7.41%  30.77%  30.77%
        S&P:     -0.06%   5.32%  21.82%  21.82%
        NASDAQ:  +0.80%  11.84%  30.84%  30.84%

Rule Maker Stocks

    Rec'd    #  Security     In At       Now    Change
    2/3/98   24 Microsoft     78.27    142.38    81.91%
    5/1/98 55.5 Gap Inc.      34.06     55.56    63.13%
   6/23/98   34 Cisco Syst    58.41     94.19    61.25%
    2/3/98   22 Pfizer        82.30    119.44    45.13%
   2/13/98   22 Intel         84.67    122.13    44.23%
   8/21/98   44 Schering-P    47.99     53.88    12.26%
    2/6/98   56 T. Rowe Pr    33.67     34.50     2.46%
   2/27/98   27 Coca-Cola     69.11     68.88    -0.34%
   5/26/98   18 AmExpress    104.07    101.94    -2.05%

Foolish Four Stocks

    Rec'd    #  Security     In At     Value    Change
   3/12/98   20 Exxon         64.34     74.50    15.80%
   3/12/98   20 Eastman Ko    63.15     72.25    14.41%
   3/12/98   15 Chevron       83.34     85.31     2.36%
   3/12/98   17 General Mo    72.41     72.56     0.22%

Rule Maker Stocks

    Rec'd    #  Security     In At     Value    Change
    2/3/98   24 Microsoft   1878.45   3417.00  $1538.55
   6/23/98   34 Cisco Syst  1985.95   3202.38  $1216.43
    5/1/98 55.5 Gap Inc.    1890.33   3083.72  $1193.39
   2/13/98   22 Intel       1862.83   2686.75   $823.92
    2/3/98   22 Pfizer      1810.58   2627.63   $817.05
   8/21/98   44 Schering-P   2111.7   2370.50   $258.80
    2/6/98   56 T. Rowe Pr  1885.70   1932.00    $46.30
   2/27/98   27 Coca-Cola   1865.89   1859.63    -$6.27
   5/26/98   18 AmExpress   1873.20   1834.88   -$38.33

Foolish Four Stocks

    Rec'd    #  Security     In At     Value    Change
   3/12/98   20 Exxon       1286.70   1490.00   $203.30
   3/12/98   20 Eastman Ko  1262.95   1445.00   $182.05
   3/12/98   15 Chevron     1250.14   1279.69    $29.55
   3/12/98   17 General Mo  1230.89   1233.56     $2.67

                              CASH    $120.62
                             TOTAL  $28583.34
*Please note: On 8/4/98 $2,000 cash was added to the
portfolio. $2,000 will be added every six months.

*The year for the S&P and Nasdaq is as of 02/03/98


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