The Winner's Touch

I'm back this month with a look at two more past picks from David and Tom Gardner's Motley Fool Stock Advisor newsletter. Only by seeing what's worked and what hasn't can we learn to separate winners from losers going forward.

So what's on tap? We're going to join Mr. Peabody and Sherman in the Wayback Machine and warp back to July 2002, when David recommended Time Warner (NYSE:TWX) and Tom recommended Corporate Executive Board (NASDAQ:EXBD). Both picks are beating the market to date, but Tom's has been by far the more lucrative of the two:

The big winner
Corporate Executive Board has, by all accounts, been a solid recommendation. The company has nearly tripled in value for Stock Advisor subscribers and continues to post substantial quarterly and annual growth in its SEC filings -- 30.1% year-over-year revenue and 34.7% income growth in the June quarter. How did Tom identify this substantial market-beater?

In the wake of the uncertainty and corporate fraud that was sinking the market in 2002, Tom decided he wanted a piece of a firm that had steady growth, benefited from subscription revenues, and eschewed outlandish press releases. Corporate Executive Board fit the bill.

So why wasn't every investor and his uncle's poodle buying? For one, Corporate Executive Board was a fairly small company at the time -- capitalized at just $1.2 billion -- and the broader market tends to pay less attention to smaller firms. Moreover, the company's trailing P/E of 50 made it appear overvalued. But remember that P/E does not measure free cash flow (FCF) and cash is the very best resource any firm can have. Corporate Executive Board was priced at just 28 times FCF in 2002, and FCF growth was (and continues to be) one of the company's strongest suits.

The takeaways from this big winner are:

• Look for companies that benefit from growing subscription revenues.
• Although the P/E ratio is popular with individual investors, it should never be used as the only criterion to judge a company.
• Cash is good. Very good.

The modest winner
Time Warner has not kept pace with Corporate Executive Board -- much to David's chagrin, I know. The reason for this is that David's investment thesis for the company has yet to play out.

As David saw it, Time Warner stock had dropped 13% in late June because of market rumors that the company would lower earnings guidance. This immediately piqued the curiosity of David's inner value hound (admittedly a small part of his investing consciousness), particularly when the stock in question was that of the largest media company in the world.

Next, he pointed out that Time Warner was a victim of the "Conglomerate Discount Theory," a cousin of the better-known "Ewing Theory." It basically states that HBO alone plus CNN alone plus Warner Brothers Entertainment alone plus all of Time Warner's others interests as standalone entities are worth more than Time Warner's market cap at the time ($65 billion). Moreover, this value would only be unlocked if the businesses were spun off -- as Altria (NYSE:MO) did with Kraft (NYSE:KFT) in 2001 and as Wendy's (NYSE:WEN) is planning to do with its Tim Horton's cash monster in the near future. The key question at the time, then, was: What are the chances of a spinoff? David believed that they were fairly good given CEO Richard Parsons' plans to simplify.

But Time Warner has yet to spin off anything of note -- although rumors are flying that Microsoft (NASDAQ:MSFT) is interested in AOL and that Time Warner Cable could be on the block -- and the company continues to inch along with the market. The takeaway from this modest winner is simply:

• You can find value in conglomerates, but you could be waiting a long time before that value is unlocked.

Foolish final thoughts
Going forward, I think Corporate Executive Board will continue to widen its gap over both Time Warner and the S&P 500. It's a well-run company with an excellent business model. As for Time Warner, I don't see any catalysts on the immediate horizon that could spur it out of its current malaise. That said, a spinoff or two could really put this stock in the winner's column. The key, as always, is patience.

But that's just my opinion. If you'd like to see what the brothers think, consider a 30-day free trial to Motley Fool Stock Advisor. Despite differing investment strategies, both are soundly beating the market. (Tom's up an average of 68% to David's 56% to the market's 18%.) They identify two recommendations each month for subscribers, and if you click here right now, you'll be able to access today's brand-new issue when it is released at 4:00 p.m. EST this afternoon. There is no obligation to subscribe.

Although David and Tom compete against each other, you win no matter what.

Tim Hanson is marrying into shares of Time Warner and owns shares of Wendy's. At the Fool, no writer is too cool for disclosure ... and Tim's pretty darn cool.