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October 6, 1999

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Drip Investing

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Subject:  Choosing Drips
Author:  TMFRunkle

As I was doing the research on my column for the "Pathfinder" companies, I decided to back test all of the financial measures available from Value Line. I used the "Correlation" measure that is available in Microsoft Excel. The formula for Correlation is rather difficult to do by hand, but it's no problem on a spreadsheet. The way the function works is you can compare two sets of data - if there is a perfect linear correlation, you get a "1.0". If there is no correlation, you get a "0".

You can compare two sets of any data, and you will probably get some minor correlation showing up. So, you really want something to correlate very close to one. Here is the results from 4 measures I tested:

Return-ROE 0.237099259
Return-Sales Growth 0.497748793
Return-Net Margin 0.456972653
Return-Debt/Equity -0.199934912

I obtained the data from Value Line for the historical information on the financial measures, which are from 1994. The returns I used were from the historical quotes I got from AOL for five years back. No dividend reinvestment is included.

There's some argument for the correlation between Sales Growth and Net Margin to the return, so if you are considering several companies and can't decide, you may want to use those measures to cast the deciding factors.

"The dilemma I see is this, we have an extremely long time horizon."

Here are the companies I looked at in order of returns:

INTC - 969%
IBM - 615%
HWP - 382%
NT - 373%
CPQ - 256%
BLS - 225%
FON - 283%
SFA - 151%
BEL - 131%
SBC - 126%
MOT - 75%

These are total returns over five years.

Guess what IBM's Net Margin was in 1994? 4.6% It's five year Sales Growth rate was 7% (annualized). Yet, it still came in as #2 in returns of the companies I studied. I suspect it is the turn around under Gerstner and the growth of the Internet that started a demand for the types of products and services IBM provides.

Guess where Motorola was in 1994? It had a Net Margin of 7% (not so hot from the companies studied) and a very respectable five year revenue growth rate of 15%, which placed it third on the list. Intel and Compaq beat it there.

The dilemma as I see it for us Drippers is this, we have an extremely long time horizon. All of the studies I've read that compare different measures against return use a time horizon of one year. O'Shaughnessy in his book "What Works on Wall Street" and Sheard's book "The Unemotional Investor" both use a year for their studies. This eliminates the randomness of price movements you would experience in short-term trading. However, it is short enough that measures you find today will affect where the company will be in one year.

Where are you at in a Drip in one year? It takes two to three months to set one up. If you are putting in $50 a month, you've only invested $450 in that first year, most of it in the past six months. So, a one year horizon is really not long enough. How long is a Dripper going to be investing?

Assume you get into a no fee Drip and buy your first share through Temper. The cost is $20, and you want to get your costs down to 2% of your investment. To do this, you need to put in $1000. If you are putting away $50 a month, this will take you 20 months. Assume as a minimum it take you 2 months to set up the Drip (this is very optimistic), you are now up to 22 months.

Now, to avoid short term capital gains, you want to hold everyting for one year before you sell. Your horizon is now up to 34 months. That is quite a bit of time - look back 34 months and see what the outlook was on Coke, or Apple (which has no Drip by the way) for that matter. Coke was the investment of the century, Apple was going to die. Now the Wise love Apple and think Coke has lost its fizz.

"We have to sit back with some detachment and not fall in love..."

Here is where I think it's important to know the company. We all know something, those of us that work on the Internet know the explosive growth of this medium. Companies like IBM were going to see demand for the types of products they provide. People that have used both Apples and Wintel computers know that Apple has a superior interface and is easier to use. It is not a product to disappear easily. I've been around the world from Japan to Honduras to Abu Dhabi, and drank Coca-Cola everywhere. I'm still sending money to my Coke Drip. I know it hasn't lost its fizz.

Also, it's important not to be deluded by your investment. Go take a trip to the Iomega board and see what I mean. A couple of years ago we all thought the Zip drive was the product of the century. However, hard drives are way down in price, and networks have grown. Even in my house I have a network, so the Zip drives sit unused. We back up from hard disk to hard disk. We have to sit back with some detachment and not fall in love with the company we hold shares in.

This is a hard thing to do - choose companies we know, and not rationalize a bad investment. The best way in my opinion is look at things you use everyday. Look at companies you patronize, who make products you love. Assume you are somewhat like everybody else - and that means others must like the product too. For me, that means Intel, Home Depot, Coke, and others. I like Lucent because I know the demand for band width on the Internet.

I have my exertise, you certainly have yours. Look around and see what you can find.

George