High Risk, High Reward

As the holidays and New Year approach, investors have a lot to be grateful for. After three years of a growling bear market, the broad-market averages have had a very good year indeed.

As with many of you, the bear years were not always kind to my own portfolio. That's why I was shocked yet happy to earn a return of 134% so far in 2003. This combines results from my tax-advantaged traditional IRA account (rolled over from a former employer) and taxable online brokerage account. Last week's column showed how biotech and e-commerce boosted those results.

Yes, biotech and e-commerce. Those particular selections fell in the second and third of the three categories in which I invest:

• "Sleep at night" (30%-40%): large, dominant companies, some of which offer dividends plus growth. Very little turnover.
  
  
• Value investments, usually small caps (40%-50%): at least decent businesses selling at a substantial discount to intrinsic value. Penny Stocks or Deep Values? explains. Buy at a discount, sell as the stock meets or exceeds its range of intrinsic value.
  
  
• Informed speculations (20%-30%): Rule Breakers, shorts, options, cyclical businesses. This puts risk in its place.

The idea is to invest 70%-80% of my money conservatively but take more risk with the rest in search of outsize returns. When this is successful, the effects are dramatic. And 2003 was a very good year for informed speculation, a.k.a. calculated high risk.

This year's speculations
For example, take three that worked out well: semiconductor manufacturer Atmel (NASDAQ:ATML), spoken-word content provider Audible.com (OTCBB: ADBL.OB), and XM Satellite Radio (NASDAQ:XMSR). While the total returns are happy, they came over short periods, so the compound annual growth rates (CAGR) are even better. Keep in mind that when you buy or sell stock in parts, computing a CAGR using internal rate of return (IRR, or the XIRR function in Excel) is the only meaningful way to express your return.

Atmel was a speculation on an upturn in the semiconductor market, but why not others? My colleague and Motley FoolIncome Investor author Mathew Emmert explained that the company had finished making huge capital investments in manufacturing the next generation of various products, so that any demand increases would bring increased margins. Not only that, but the company had just returned to free cash flow positive, and the market had yet to reward the stock.

I bought January 2005 ($2.50 strike price) call options at $0.70 instead of common stock at $1.70 because I believed that the cyclical upturn investment thesis would begin within a year or so and options would provide an outsize return. So far they have. The options closed Friday at $4.20 and the common at $6.22. I have another year or so to decide whether to sell the options or exercise them, which, if the company keeps turning in sequential revenue gains, I just might. (To learn more about the risks and potential rewards from options, get help from Fool analyst Jeff Fischer.)

I owe Audible.com to Rex Moore, who uses the service. The stock was selling for $1.14 with a market cap under $100 million -- a true penny company. That makes me wary unless the financials are very compelling. They were. Revenues have risen from 40%-64% year over year for the last four quarters, while expenses declined. The company has refinanced and sports some very favorable pacts with distribution channels. The investment has more than tripled in 2.5 months, producing the hilarious 43,205% CAGR. I loved writing that. I'm holding as long as the revenue continues growing. If and when the company becomes free cash flow positive, I'll likely buy or sell based on valuation.

Note: Audible.com trades on the over-the-counter bulletin board, not a place to troll for investments. But as with all rules, there are exceptions. Investors comfortable with financials may profit from this kind of special situation: When a listed stock is delisted for failing to meet requirements, it may be a temporary thing. Often, a company is dying and continues its decline, but it occasionally fixes the problem to eventually regain listing.

This happened to Bankrate (NASDAQ:RATE), one of the 10 top winners in the last two years, up over 18 times, which went from the Nasdaq to the bulletin board and back again. I'm not saying this will happen to Audible -- Bankrate was free cash flow positive as a bulletin board stock and Audible is not -- but I believe that Audible's improving financials favor relisting on the Nasdaq in 2004 and that the relisting will benefit the stock.

Readers know why I bought shares of XM Satellite Radio after reading XM and Sirius Get Busy and Beyond the Price-to-Dream Ratio. I had promised to update the analysis today of that company and competitor Sirius Satellite Radio (NASDAQ:SIRI). However, after last week's column went to Web press, Jeff Fischer and I scheduled our long-awaited visit to the XM's local headquarters. So our fun-filled XM tour took precedence over number-crunching. The place is a delight, the business a pleasure, and I can be bribed with company tchotchkes anytime (kidding!). Expect a recap of the trip soon.

Looking ahead: speculations
One day recently, Jeff quietly said to no one in particular, "Hmmm. Sun calls look interesting." Because I sit next to him, I get to be no one in particular. Call me crazy, but I recently bought some Sun Microsystems (NASDAQ:SUNW) January 2005 ($2.50 strike price) and January 2006 ($5.00 strike) call options when the stock was around $3.75, believing the downside risk minimal at the valuation.

A reader email led me to research and then purchase a substantial position in fiber optic subsystems and components maker Oplink (NASDAQ:OPLK). Contrarian investors are looking to this industry to benefit from any eventual telecom spending upturn. Oplink management has cut costs dramatically. The most recent quarter saw sales declines reversed and a 20% year-over-year gain, as well as a smidgen of free cash flow. Note that a "substantial" position for me is 10% of my portfolio (gulp!). Folks, this is high risk. Any change to the three factors I listed and I'm selling.

How many of you have been sniffing around Lucent Technologies (NYSE:LU), convinced that at some point the turnaround will come -- both due to executive cash management and cost savings as well as sales gains? It may have already started. The company turned in a free cash flow positive quarter ending Sept. 30, and its order backlog is up. It's definitely another candidate for speculating on a telecom equipment-spending turnaround.

If you read Jeff Fischer's excellent Why I Like iPayment, you may also join my interest in online payments processor iPayment (NASDAQ:IPMT), but would like to pay less -- closer to $20 a share. I may have missed the chance.

As a TiVo (NASDAQ:TIVO) user, I'm convinced that this company merits consideration as a speculation. But despite its accelerating subscriber growth and depressed stock price, I'd like a better handle on the barriers to business entry (are there any?) and sustainable competitive advantage (is there one?) before buying.

And finally, I would have to seriously consider buying shares of Google after its anticipated IPO.

This year and next: value
The small-cap value investment category of the port performed well, too:

For next year, my current two favorite value stock ideas go to buyers of Stocks 2004, our Motley Fool stock selection guide for the year ahead. But I'll give you a hint. I owe one of them to Boston-area analyst Hewitt Heiserman, author of the newly released -- shall I say instant classic? -- It's Earnings That Count: Finding Stocks With Earnings Power for Long-Term Profits.

Why is this book unlike any other? Heiserman tried to write what Benjamin Graham might have penned if he were a growth investor. He takes Graham's vital interest in a firm's balance sheet, adds critical information from the cash flow statement and footnotes, and produces two income statements -- what he calls the enterprising income statement and defensive income statement. The result is the only book I've seen geared for buy-to-hold investors that shows how to gauge the quality of a company's earnings from the way both a commercial banker (a defensive investor) and a venture capitalist (an enterprising investor) would look at them.

Graphing the two income statement results over time enables you to see in picture form whether a firm has authentic earnings power for long-term growth. You see how Heiserman's method not only would have tipped investors early to Enron and WorldCom in time to sell, but would have led to identifying Microsoft (NASDAQ:MSFT) and Paychex (NASDAQ:PAYX) in plenty o' time to participate in their growth. The latter two show up clearly as the best companies of quality earnings and growth -- those whose financial statements when graphed show a classic "staircase" pattern.

Hats off to Hewitt Heiserman for his excellent, clear, and wonderful addition to investing literature. I highly recommend it. Bill Mann plans a review in the near future.

Note on sleep-at-night
After selling a speculation or value investment, I plow part of the proceeds into more opportunities of the same category and the rest into sleep-at-night stocks if valuations are favorable, or cash or the S&P 500 if not. This year, that's meant more cash into Microsoft, Nokia (NYSE:NOK), and UST (NYSE:UST). The first has been flat and the latter two have returned over 20%.

Springtime in Riga
Friday will be my last day for now at this best of individual investor friends, The Motley Fool. (This means that my editors can't complain about the length of this piece, though you might.)

I'll then prepare for a spring move to Riga, the beautiful and historic capital of Baltic nation Latvia. My partner is an American son of Latvians, part of the third of the country displaced and devastated by World War II's destruction. The surviving Baltic Diaspora -- Estonians, Latvians, and Lithuanians -- raised their progeny to speak the native language in the hopes they all would someday return. Today, the parents have lived to see their homelands again free, but now that they have lived most of their lives elsewhere, it's their children often making the move.

Though I joke that Latvia has two seasons -- winter and dark -- it's a beautiful place changing at an astonishing rate to prepare to enter the European Union next May (when daylight exceeds 17 hours). And though my partner may be the instigator, I spent my twenties living and working in Kenya and Venezuela and never quite got over the desire to travel the world. With the Internet, you truly can live and do all kinds of work anywhere. We're off!

Foolish thanks!
I was hired here at the peak of the bull market stampede in 2000 and arrived a few months later as the bear began to growl, scared to death to have given up a secure career and comfortable life for the unknown at the not-so-young age of 44. But The Motley Fool invested in me, as it has in so many others, allowing us to hone analyst skills and learn together -- writers, analysts, and the unparalleled Fool Community. This adventure has changed my life. To single out some to thank would be to imply that others were not as generous, so let me offer thanks to all of you.

But enough with the group hugs. After all, while this active investor may be studying Latvian and walking the Daugava River in the mornings, I will continue assiduously analyzing businesses and valuing stocks the rest of the days and evenings. So perhaps you will hear from me again soon.

Have the most Foolish of holidays and New Year, and thanks for reading! Please stay in touch at [email protected].

You can find Senior Analyst Tom Jacobs' portfolio in his profile. Motley Fool analysts are investors writing for investors.