We're Making Some Changes

By Phil Weiss

TOWACO, NJ (March 29, 1999) -- I was really hoping that tonight's byline was going to read "Tampa, Florida." For a while, it looked like I was going to be watching in person as my old school, Duke, takes the NCAA basketball championship tonight.

First, I had a place to stay and the possibility of a ticket. Then, I had a place to stay, the possibility of a ticket, and a way to get there. Unfortunately, the ticket never advanced beyond a possibility, so I'll be watching Duke play for its third national championship this decade with the same center court view that Jim and Billy have on CBS, just like the vast majority of college hoops fans. Tomorrow night, I'll have some more thoughts on the team of the '90s in college hoops.

Last Friday, Matt announced that we're changing the way we calculate the Flow Ratio. Later that same night, a prescient Fool who goes by the name of 4Coder Foolishly wondered on our Strategies message board whether we might also change the way we calculate the Cash-to-Debt ratio. Yes, indeed. Tonight, I'll be talking more about our new Flowie and Cash-to-Total Debt ratio.

I think these changes are great. We're raising the bar in our quest to invest in only the strongest companies that we can find. From time to time since we started this portfolio, I've raised the question of whether or not short-term and long-term debt should be lumped together. I even asked Tom why some of the variations of the Flow ratio that we've discussed in the past didn't find their way into Rule Breakers, Rule Makers.

Until now, we calculated the Flow Ratio using the following equation:

(Current Assets � Cash & Equivs.)
       Current Liabilities

From now on though, it will be:

   (Current Assets � Cash & Equivs.)
(Current Liabilities � Short-term Debt)

Similarly, the Cash-to-Debt Ratio used to be calculated using the following equation:

Cash & Equivs.
Long-term Debt

This equation is now persona non grata for the Rule Making investor. From now on it will be:

           Cash & Equivs.
(Short-term Debt + Long-term Debt)

You might be wondering why we're changing things around a bit. After all, our goal is to outperform the S&P 500, and so far, we've done just that. But that doesn't mean that our model can't be improved. Assuming our strategy is a sound one (and I certainly think it is or I wouldn't be writing here), a better model will lead to better companies in which to invest. And investments in better companies will lead to better portfolio performance.

One thing that I like best about what we're doing here is that we're expanding our definition of debt without changing the hurdle that we want our companies to cross. This means that when you see these changes reflected in the revised version of our steps (coming soon), you'll see that we're still looking for companies that have at least 1.5 times more cash than debt and a Flow Ratio of 1.25 or less.

Our expanded definition of debt deserves some explanation. We know that interest rates are low and debt is not all that expensive right now. Nevertheless, we strongly believe that the very best Rule Makers should be so profitable that they throw off more than enough cash to run and expand their businesses without any need for debt. Microsoft (Nasdaq: MSFT) serves as a dynamite example. Softy's business generates so much cash that as of December 31, 1998, our company had over $19 billion in its coffers. The strongest Rule Makers have no real reason to reduce earnings due to interest expense.

We really want to find the companies with the strongest businesses. The companies that have the fewest obstacles preventing them from generating gobs of profits -- the ones that have the greatest chance of being profitable whether the business environment is favorable or unfavorable.

Any list of reasons why we should always consider both long- and short-term debt in the same breath would have to include the fact that short-term debt can very easily turn into long-term debt. Just this past week I read about a company that did just this. AT&T (NYSE: T) completed the largest bond offering ever to hit the public markets. The company is issuing $8 BILLION worth of bonds (here's the press release). Even more unbelievable, the possibility exists that ultimately the offering will reach the $13 BILLION level. Do you think a company with this much debt could ever be a Rule Maker? All I can say to that is NO WAY!

The company plans to use the proceeds of the offering to pay off the short-term debt that arose as a result of the TCI acquisition. In other words, Ma Bell is simply replacing short-term debt with its long-term brethren. Using our old metric, that would have resulted in quite a change to both the Cash-to-Debt Ratio and the Flow Ratio. Using our new way of looking at these ratios, there would be no change to either one as a result of the conversion of short-term debt into long-term debt.

Here's a quick example of what I'm talking about:

Cash... $1 billion
Total Current Assets... $6 billion
Short-term debt... $1 billion
Total Current Liabilities... $5 billion
Long-term Debt... $2 billion

The Old Way of Looking at Things:

Flow Ratio = (6-1) / 5 = 1.0

Cash-to-Debt = 1 / 2 = 0.5

The New Way of Looking at Things:

Flow Ratio = (6-1) / (5-1) = 1.25

Cash-to-Debt = 1/ (2+1) = 0.33

Now let's say the company converts the $1 billion of short-term debt into long-term debt. Look what happens:

The Old Way of Looking at Things:

Flow Ratio = (6-1) / 4 = 1.25

Cash-to-Debt = 1 / (2+1) = 0.33

The New Way of Looking at Things:

Flow Ratio = (6-1) / 4 = 1.25

Cash-to-Debt = 1/ (2+1) = 0.33

What has happened here is that by looking at short-term debt and long-term debt together rather than separately, we've created a situation where converting short-term debt to long-term debt has no impact on our quantitative measurement criteria at all.

I've got to say that that sounds pretty Foolish to me. What do you think of these changes? Let's continue the discussion over on our Strategies message board.

That's all for tonight. Now repeat after me. "Let's Go Duke! Let's Go Duke!" and "Rip 'em up, tear 'em up, Give 'em hell Duke." My prediction on the game is Duke by 9. Final score: Duke 91 - U Conn 82.

Phil Weiss, Fool

Question of the Week:

We received a tremendous response to last week's Question of the Week regarding the best Rule Maker ads. At least 90% of you opined that Gap's ads are best. Here's how one of our Foolish posters, daddy0, described them:

"These ads are so bad that they are almost compelling. For a week I couldn't get the performance fleece jingle out of my head."

Congrats daddy0... drawstring pants -- these pants are fit to be tied... aughh! Any company that can so thoroughly tattoo itself upon our brains is one heck of an advertiser. Let's hear it for our Rule Maker, Gap Inc. (NYSE: GPS).

Click here for this week's question, err, challenge. This week's prize will be an autographed copy of Rule Breakers, Rule Makers.

See ya on the boards,

-Matt (TMF Verve)

03/29/99 Close

Stock  Change    Bid
AXP   +2 9/16  123.31
CHV   +3 1/8   89.94
CSCO  +4 13/16 110.00
KO    -  9/16  64.75
GPS   +1 3/16  67.44
EK    +  3/8   65.63
XON   +1 7/16  73.00
GM    -  7/16  87.50
INTC  +4 3/4   121.44
MSFT  +3 9/29  92.38
PFE   +6       141.00
SGP   -  1/16  55.63
TROW  +1       34.56
YHOO  +4 5/8   176.00
                   Day   Month    Year  History
        R-MAKER  +2.54%   9.08%  13.71%  43.88%
        S&P:     +2.13%   5.80%   6.90%  32.26%
        NASDAQ:  +3.05%   8.95%  13.69%  50.82%

Rule Maker Stocks

    Rec'd    #  Security     In At       Now    Change
    2/3/98   48 Microsoft     39.13     92.38   136.05%
    5/1/98   55 Gap Inc.      34.37     67.44    96.21%
   6/23/98   34 Cisco Syst    58.41    110.00    88.32%
    2/3/98   22 Pfizer        82.30    141.00    71.33%
   2/13/98   22 Intel         84.67    121.44    43.42%
   2/17/99   16 Yahoo Inc.   126.31    176.00    39.34%
   5/26/98   18 AmExpress    104.07    123.31    18.49%
   8/21/98   44 Schering-P    47.99     55.63    15.90%
    2/6/98   56 T. Rowe Pr    33.67     34.56     2.64%
   2/27/98   27 Coca-Cola     69.11     64.75    -6.30%

Foolish Four Stocks

    Rec'd    #  Security     In At     Value    Change
   3/12/98   17 General Mo    72.41     87.50    20.85%
   3/12/98   20 Exxon         64.34     73.00    13.47%
   3/12/98   15 Chevron       83.34     89.94     7.91%
   3/12/98   20 Eastman Ko    63.15     65.63     3.92%

Rule Maker Stocks

    Rec'd    #  Security     In At     Value    Change
    2/3/98   48 Microsoft   1878.45   4434.00  $2555.55
    5/1/98   55 Gap Inc.    1890.33   3709.06  $1818.73
   6/23/98   34 Cisco Syst  1985.95   3740.00  $1754.05
    2/3/98   22 Pfizer      1810.58   3102.00  $1291.42
   2/13/98   22 Intel       1862.83   2671.63   $808.80
   2/17/99   16 Yahoo Inc.  2020.95   2816.00   $795.05
   5/26/98   18 AmExpress   1873.20   2219.63   $346.43
   8/21/98   44 Schering-P   2111.7   2447.50   $335.80
    2/6/98   56 T. Rowe Pr  1885.70   1935.50    $49.80
   2/27/98   27 Coca-Cola   1865.89   1748.25  -$117.64

Foolish Four Stocks

    Rec'd    #  Security     In At     Value    Change
   3/12/98   17 General Mo  1230.89   1487.50   $256.61
   3/12/98   20 Exxon       1286.70   1460.00   $173.30
   3/12/98   15 Chevron     1250.14   1349.06    $98.92
   3/12/98   20 Eastman Ko  1262.95   1312.50    $49.55

                              CASH    $185.03
                             TOTAL  $34617.66

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.

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