Crushing the Market in 2003

At the turn of the year, I wrote four columns detailing my investing style and how to balance risk and reward (start with Hidden Red Flags and check the related links box on the right for the rest). As 2003 roars to a finish, I'm happy to report that this portfolio management strategy turned in a terrific year: My taxable discount brokerage account saw a 206% return and the traditional IRA 131%, with an overall return of 134% (yes, the huge majority of my portfolio is in the IRA).

This is, of course, without adding new money -- I add only to a small Roth that was up over 50% using internal rate of return, but it would only affect the results here by about 1%. The numbers stack up thus:

And going back to Dec. 31, 2001, not too shabby either:

Not all roses
The curious thing is that these results came despite at least one big loser each year. In 2002, my worst move was buying a substantial position in defunct, scandal-plagued African car logistics company ACLN. I should feel a little better that Peter Lynch also confessed to taking a bath on this, but I don't. I had as much as 10% of my portfolio in what I thought was an astounding value investment, and it went to pennies as the fraud unfolded and the principals vanished. But this is proof that even with one disaster, the rest of your portfolio can mitigate the damage. Lynch himself has written that you only need to bat .600.

This year brought a bad apple, too. I had about 5% of my portfolio short Guitar Center (NASDAQ:GTRC) via common stock and put options. I believed that high leverage and decreasing return on invested capital with each new store opening meant disaster. But my opinion mattered not: The capital markets disagreed, refinancing the company's debt from over 11% towards 4%. With reduced interest payments, cash flow from operations improves dramatically and eliminates the short thesis at least for the next few years. I covered my short at a loss 100% of the initial price (ouch!) and was out significant money on my put options.

Now, having broken the cardinal rule of financial writing -- never admit your mistakes -- I feel perfectly blameless in trumpeting the successes. Wouldn't it be nice if life's sins were so easily dispensed with? (Cue Church Lady, "How convenient!")

So this week and next, in my last two columns as a full-time Motley Fool (I'll tease you by saving the news of my exciting personal life for next week to make sure you come back!), I'll examine those successes, find some lessons, and look ahead to 2004.

Biotech: drugs and diagnostics
Last year, I selected Ligand Pharmaceuticals (NASDAQ:LGND) for The Motley Fool's Stocks 2003. As of yesterday, it returned 181% to earn the No. 1 spot -- and that's measured from the price of $5.16 at publication, before the stock dipped as much as 40% lower. (For our best ideas for the year ahead, get Stocks 2004 today -- I'm gunning for top honors again, so look out!) Readers got a better price than I did, but I sold this year for a happy 95% gain (an August column explains my rationale):

In March, I started noticing that anything "biotech" had been dumped on the trash heap without regard to quality, and that two companies offered the opportunity for a quick double -- drug maker QLT (NASDAQ:QLTI) and diagnostics and protein supplier Meridian Bioscience (NASDAQ:VIVO)(see Diagnosing a New Prospect). These were not speculations. Both were each growing free cash flow at a rate faster than their valuations implied -- and that trend appeared sustainable.

I sold QLT when the market brought the company in line with its growth and provided a double. I simply did not feel confident in my knowledge of the market for its lead drug Visudyne to know what the risk-reward tradeoff would be after that. If I can't evaluate risk and reward, I don't own the stock.

Meridian, meanwhile, has not doubled, but I'm holding. While the growth rate has slowed, the stock still has a higher intrinsic value and pays you more than 3% while you wait. The period returns:

Internet e-commerce
Even before abandoning biotech, investors deserted Internet e-commerce. In May 2002, I recommended online lending exchange LendingTree at $14.02. Barry Diller's InterActive Corp. purchased the company at $21.52 a share at Aug. 8, 2003 market close, for a 53% gain. I averaged down earlier this year when the stock dropped close to $10, ending up with these returns versus the S&P 500:

This year, another abandoned online vendor captured my attention for its Sex, Drugs, 'n' Rockin' Ratios -- drugstore.com (NASDAQ:DSCM). The company had for a number of quarters grown revenues and reduced expenses, and it appeared odds-on that those trends would cross and lead to positive cash flow from operations either in Q2 this year or soon thereafter. However, when the numbers went the other way dramatically in the following quarter, I sold for a 119% gain, versus 11% for the market. The company has resumed its expense and revenue trend, and if the price were to drop toward $4, I'd look seriously again.

Taxes, shmaxes
One thing to note is that with most of my assets in a tax-advantaged IRA, I can buy and sell without regard to tax consequences. But even if you assume capital gains at the highest short-term rate, the returns trounced the market averages. Value investors more or less buy on valuation and ignore tax consequences. This is no advocacy of short-term trading. Far from it. But as you gain more confidence in financial analysis, you can take advantage of opportunities -- and that may not mean holding for long-term capital gains -- and do quite well.

Thanks on Flow Ratio and Able Labs
Several readers wrote in response to my column on using the Flow Ratio as one of many tools that can help you examine management's cash management. Special thanks to rawnoc2 and money manager Todd McKee for their comments about drug maker Able Laboratories. They pointed out first that the Flow Ratio is more important for large, profitable, established companies than for newer or smaller ones. Good point -- it was clearly identified in the links provided -- but could have used an explicit mention in the column. But keep in mind that it's a useful tool no matter the company size -- just don't overemphasize it for the little fish.

Though my intent was only to screen, if you want to study the company more, you could heed their suggestions that negative cash flow from operations that's less than research and development spending is a positive, and that R&D spending versus drug approval for Able is excellent. Can't agree enough -- the latter especially is important. Fool Community member Greg Carlin (ElricSeven) developed a biotech drug maker analysis that Zeke Ashton and I stressed a while back in the Biotech investing seminar.

They also thought my comment that with the financing the company "cheated death" a little strong, and argued that the company had no credit problems at the time it received new cash. My response is that it is never, ever, positively ever certain that financing, let alone at a reasonable rate, will come your way. Especially when you most need it.

All of which points precisely to the original column's thrust: The Flow Ratio is but one of many useful screens for management cash expertise, but it is only a screen. If you want more, you must dig deep. Thanks for the help, guys!

More on 2003's returns next Tuesday -- including another look at XM Satellite Radio (NASDAQ:XMSR) and competitor Sirius Satellite Radio (NASDAQ:SIRI), always sure to set off sparks -- and an eye to some opportunities for 2004.

Have a most Foolish week, and thanks for reading!

Senior Analyst Tom Jacobs owns shares of Meridian Bioscience, but after 10 days on the beach in Puerto Rico, he's not sure what he owns. He'll remind himself by viewing his profile , prepared according to the delicious recipe of The Motley Fool's disclosure policy.