<THE RULE MAKER PORTFOLIO>

Good Product, Bad Stock?

By Rob Landley

AUSTIN, TX (March 16, 1999) -- Yesterday, I touched on an interesting topic (if I don't say so myself!): how Advanced Micro Devices (NYSE: AMD) can produce wildly popular microchips, sell boatloads of them, and still manage to lose money. This is a fairly common theme in investing, which can be summed up as follows: Good products, by themselves, do not necessarily indicate good investments.

Good products are an important part of a good investment, but liking a company's products is not the same as liking the company's stock. From Snapple to Apple and from Boston Chicken to AMD, many companies have made their customers happy without living up to the expectations of their investors. Even Iomega (NYSE: IOM) wound up in this category eventually. This is why we look at income statements and balance sheets, and why we try to truly understand the businesses we invest in beyond the raw numbers.

Sometimes the reason for a company's lack of financial success is obvious from the start. This was the case in AMD's perpetual pricing pressure from market leader Intel. Sometimes a company doesn't follow through with its plans or respond to emerging trends. Iomega failed on both fronts as its "give away the drive, sell the disks" strategy for continuing income was undermined by its failure to bring down rapidly the price of its popular Zip drive. This problem became acute during the rise of ultra-cheap PCs which required low-priced offerings that Iomega simply refused to develop.

In the case of Apple (Nasdaq: AAPL), the company was proudly run by engineers who brought plenty of technical skill to their products, but who had little or no clue when it came to running a business. And when "the suits" finally did arrive and imposed financial discipline, they drove out the creative people who had made the company successful in the first place. The loyal following the company's products engendered kept it afloat for years, but floating was all the stock did until recently.

The classic investing disaster story of our time is Boston Chicken (OTC: BOSTQ). Investors lost their shirts, yet I still eat there from time to time (even though they insist on calling themselves "Boston Market" now). Why did the company crash and burn? Lots of reasons, starting with the fact that the restaurant business is generally a terrible industry in which to invest.

Although food is a product with a steady demand and often considered a conservative investment, the reality is that the restaurant market is supersaturated. Existing restaurants already have more capacity than customers, and for new restaurants to be successful they must take away business from existing ones. While this doesn't necessarily spell doom for any new venture, each new restaurant chain faces an uphill battle. Food is considered a conservative investment because it's relatively easy to stay in business, not because it's easy to grow.

In the case of Boston Chicken, both the rise and fall of the stock was due to, shall we say, "creative accounting." The company made itself look profitable by moving all its debt onto the balance sheets of its franchisees, which paid the parent company royalties using money borrowed from the parent company in the first place. With cosmetically pleasing financial statements, the parent company was able to raise a lot of money selling equity during its IPO and plow that money into expansion. But it kept accumulating real debt in an attempt to look profitable, and eventually collapsed under the weight of that debt.

The interesting part is that the article I linked to was from BEFORE Boston Chicken collapsed into bankruptcy. Many investors knew all along that the reported earnings were a polite fiction, but went along with it anyway. As long as everybody else believed it, the stock kept going up, and pointing out the logical flaws in a theory that was obviously working would have made them look Foolish. :)

Are you a new Fool? Do you have questions about investing the Rule Maker way? If so, join us on the Rule Maker Beginners message board.

- Oak

(P.S. I don't care what the macro says, I'm not Al! He wrote last week! Nyeah.)

Al

03/16/99 Close

Stock  Change    Bid
AXP   -2 3/16  123.56
CHV   +1       85.38
CSCO  +1       106.00
KO      ---    68.69
GPS   -  15/16 68.38
EK    +  15/16 67.69
XON   -  9/16  73.13
GM    -  7/16  89.13
INTC  +2 3/8   120.25
MSFT  +3 3/16  169.06
PFE   +1 5/16  142.00
SGP   +1 3/8   58.88
TROW  +1 7/32  38.34
YHOO  -4 9/16  174.88
                   Day   Month    Year  History
        R-MAKER  +0.50%   9.03%  13.66%  43.82%
        S&P:     -0.07%   5.49%   6.59%  31.88%
        NASDAQ:  +0.32%   6.61%  11.25%  47.58%

Rule Maker Stocks

    Rec'd    #  Security     In At       Now    Change
    2/3/98   24 Microsoft     78.27    169.06   116.00%
    5/1/98   55 Gap Inc.      34.37     68.38    98.94%
   6/23/98   34 Cisco Syst    58.41    106.00    81.47%
    2/3/98   22 Pfizer        82.30    142.00    72.54%
   2/13/98   22 Intel         84.67    120.25    42.02%
   2/17/99   16 Yahoo Inc.   126.31    174.88    38.45%
   8/21/98   44 Schering-P    47.99     58.88    22.67%
   5/26/98   18 AmExpress    104.07    123.56    18.73%
    2/6/98   56 T. Rowe Pr    33.67     38.34    13.87%
   2/27/98   27 Coca-Cola     69.11     68.69    -0.61%

Foolish Four Stocks

    Rec'd    #  Security     In At     Value    Change
   3/12/98   17 General Mo    72.41     89.13    23.09%
   3/12/98   20 Exxon         64.34     73.13    13.66%
   3/12/98   20 Eastman Ko    63.15     67.69     7.19%
   3/12/98   15 Chevron       83.34     85.38     2.44%

Rule Maker Stocks

    Rec'd    #  Security     In At     Value    Change
    2/3/98   24 Microsoft   1878.45   4057.50  $2179.05
    5/1/98   55 Gap Inc.    1890.33   3760.63  $1870.30
   6/23/98   34 Cisco Syst  1985.95   3604.00  $1618.05
    2/3/98   22 Pfizer      1810.58   3124.00  $1313.42
   2/13/98   22 Intel       1862.83   2645.50   $782.67
   2/17/99   16 Yahoo Inc.  2020.95   2798.00   $777.05
   8/21/98   44 Schering-P   2111.7   2590.50   $478.80
   5/26/98   18 AmExpress   1873.20   2224.13   $350.93
    2/6/98   56 T. Rowe Pr  1885.70   2147.25   $261.55
   2/27/98   27 Coca-Cola   1865.89   1854.56   -$11.33

Foolish Four Stocks

    Rec'd    #  Security     In At     Value    Change
   3/12/98   17 General Mo  1230.89   1515.13   $284.24
   3/12/98   20 Exxon       1286.70   1462.50   $175.80
   3/12/98   20 Eastman Ko  1262.95   1353.75    $90.80
   3/12/98   15 Chevron     1250.14   1280.63    $30.48

                              CASH    $185.03
                             TOTAL  $34603.09

Note: The Rule Maker Portfolio began with $20,000 on February 2, 1998, and it adds $2,000 in cash (which is soon invested in stocks) every six months.

Read More Rule Maker Reports
 
Spacer