OK, Rule Maker investors, today is your last chance to sign up for the Rule Maker Online Seminar, hosted by Tom Gardner and the Rule Maker managers. The month-long, 12-lesson seminar will study the prospects of a half dozen businesses and show investors how to apply the simple Rule Maker criteria. We're not handing out fish here; we're showing you one way to bait the hook. Come have some fun, develop your ability to think critically about investing, and interact with your peers and Rule Maker managers on the discussion boards. Hope to see you there.
Now, on to today's topic: When is a successful company a bad investment?
Many Wall Street darlings have fallen from grace, including IBM (NYSE: IBM), Digital Equipment Corporation -- now part of Compaq (NYSE: CPQ) -- Apple (Nasdaq: AAPL), SGI (NYSE: SGI), and Oxford Health (Nasdaq: OXHP). Sometimes they recover, sometimes they crash and burn, but why do they stall out in the first place? This is at the very essence of Rule Makerdom. We're looking for companies that get to the top of the heap and stay there. Those that don't have either lost their "Makerness," or they never had it in the first place. In either case, once you are convinced that a company is not a Rule Maker, and you own it, you can, without equivocation or mental evasion, move elsewhere.
We have introduced a rule here, called the "Four-for-Four," which says that if a company fails four out of the six quantitative Rule Maker criteria for four consecutive quarters, it is eligible for sale from the official Rule Maker Portfolio. Your guidelines may differ, but the concept is simple -- some companies are pretenders, and some companies lose their edges. Once identified, they should be avoided like the plague. Only on rare occasions do former Rule Makers come back.
IBM, Digital Equipment Corporation, and Apple were all bad investments at one time or another. In 1992, IBM's stock dropped 75%. Apple's stock sulked for years. And DEC fell so far it was bought out by Compaq. What happened? IBM was king of the mainframes. When Digital Equipment Corporation came out with the VAX minicomputer that undercut IBM's mainframe business, IBM made a common mistake: It focused on the most profitable large accounts that a minicomputer just couldn't handle. This sort of upward retreat to the high end of the market sacrifices volume and diversity in the name of profits, and can easily reduce a once-mighty empire to a niche market. Paying attention to where the money is doesn't mean you can ignore where the customers are.
When Apple brought forth the personal computer and started nibbling away at DEC's low end, IBM saw DEC perform the same upward retreat it had done and realized this was a bad thing. Luckily for IBM, it realized its predicament early enough to do something about it. First it tried to jump on board the PC revolution, but this merely gave rise to thousands of clones of the "IBM PC," all cheaper than IBM's own offering. A cheap commodity market simply couldn't provide IBM with the margins it was used to. Instead IBM underwent a costly reorganization that caused its stock to crash 75% in 1992, but allowed IBM to become the service-based solutions provider it is today.
DEC was too busy stealing market share from IBM's mainframes to realize or care that PCs were doing the same thing to its minicomputers. Why waste time defending the low end when the high end has room for expansion? Symbolically, DEC's shriveled carcass was eventually purchased by Compaq, the largest maker of the PCs that had consumed its market share.
Apple faded from the limelight when its visionary (if egomaniacal) founder, Steve Jobs, was ousted by the board for financial irresponsibility. Their choice was to replace an innovative leader and salesman with a person much more adept at bean counting than managing a company with such huge needs for research and development. The point is, understanding finances is vital to running a business, but it's no substitute for an understanding of what the company does for a living.
Apple's strengths have always been unique products, a well-marketed brand, and loyal customers. It survived in a viciously competitive commodity marketplace because that's not where it competed: It wasn't just another PC. Without a visionary leader, it WAS just another PC, and the company drifted rudderless for years. Eventually, the board realized that managing money well wasn't useful if there wasn't any income to manage, and they begged Steve Jobs, on their hands and knees, to come back.
SGI virtually owned a market niche -- high-end graphics workstations -- but it wanted to expand. To do so, it bought Cray supercomputers, another big iron manufacturer nibbled to death by the PC revolution. Unfortunately, digesting Cray brought SGI all the growing pains Salomon Brothers once felt, and SGI spent literally years focusing on the Cray acquisition and ignoring its core business. By the time it was ready to bring Cray's technology to its graphics workstation market, most of the customers were long gone.
Finally, the lesson from Oxford Health is a simple one. Fraud. The management of that company lied to investors, and when the deception unraveled the stock crashed. The people who run a company are vital to that company's success, and if we don't want to partner with management, we shouldn't invest in the company.
We believe that there are as few as 50 true Rule Makers in all of commerce. Over time, some make it to the top and then get blown back off either through their own poor judgment, superior competition, missed inflection points, or a combination of these and other reasons. Rule Making is not static, just as Rule Makers should not be considered self-fulfilled prophesies.
Fool on!
