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Fool’s Paradise

TIMES STAFF WRITER

David and Tom Gardner have become, in a scant 2 1/2 years, the undisputed crown princes of online investing.

Co-founders of the Motley Fool section of America Online, the brothers have swept through the stodgy world of stock market news and analysis like a pair of wise-cracking renegades to become popular sources of humor, education and inspiration to hundreds of thousands of new and experienced investors.

They’ve also taken their lumps from established market pros, who have accused the brothers and their legions of hyperactive fans of irresponsibly hyping stocks. The charges sound like sour grapes, since it is hard to argue with their success: A portfolio they manage in full public view has trounced the broad-market averages since its launch in August 1994, rising 153.8%, compared with a 77.1% increase in the Standard & Poor’s 500 index in that period. So far this year, however, the Gardners have been humbled with a 4.9% decline in their portfolio, versus a 9.6% rise in the S&P; 500.

David, 30, and Tom, 28, grew up in Washington, D.C. Their father was an international banking lawyer; their mom a homemaker and painter. The brothers will appear at 11:30 a.m. Saturday in the California Ballroom of the Westin Bonaventure hotel in Los Angeles as featured speakers at the Los Angeles Times Investment Strategies Conference, which is sold out.

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Question: How did you guys get started in investing?

David: Our father taught us about the stock market in our mid-teens preparatory to giving us a bit of money when we turned 18 for us to invest on our own.

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Q: How much?

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David: Enough to be dangerous but not enough for us to destroy our future.

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Q: What did you do with it?

David: We invested in stocks. It was a process of learning that I expect to continue my whole life. I took a fairly numerical approach because my father taught us out of Value Line--what net profit margin and earnings growth rate were, for instance, and return on equity. The financial ratios that make for good building blocks. Most of my first few purchases were companies I was familiar with. My best early one was TCBY--back when frozen yogurt was a big growth industry. The stock went up three times.

Q: What did you learn?

David: Investors can find a lot of success in buying great restaurant concepts early, but often make a mistake in holding them too long. If you open up something competitive with Taco Bell, you can meet with success as you expand rapidly, but eventually Pepsi will strip you of your success by duplicating your competitive advantage.

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Q: What was your biggest early failure?

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David: I lost money on EDO Corp., a company I picked out of Value Line because of the growth of its profit margins. But it was not a business I understood. They were creating sonar buoys to detect mines. But my inability to tell you what the whole business did illustrates the lesson.

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Q: You could have bought Intel without understanding what they made and you’d be rich today.

David: Quite right. You can have success with companies you don’t understand, but given that there are a lot of businesses that you do understand, you’re more likely to understand when to sell, and you’re going to learn more and have more fun. For most investors starting out, when they buy their first stock they should make it in an industry in which they work or have a hobby.

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Q: How did you start the Motley Fool?

David: After college I spent a lot of time reading, traveling and writing as a freelancer. A lot of my friends were off at med school or employed on Wall Street. I felt anxiety, but looking back it was an incredibly important time because I was figuring out what I wanted to achieve. I read the first Peter Lynch book (“Beating the Street”) and Michael O’Higgins’ “Beating the Dow” and the William O’Neil Book “How to Make Money in Stocks.” Then I finally took my first job, writing for Louis Rukeysers’ Wall Street newsletter, which I didn’t enjoy. I resigned after 10 months and started the Motley Fool in July 1993 as a newsletter with Tom and Erik Rydholm, who’s now our chief operating officer. We basically wrote it for our parents’ friends. We had no intention of making it into a business. We never did market research or bring in venture cap money. We charged $48 a year.

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Q: Where does the name Motley Fool come from?

David: Shakespeare’s “As You Like It.” The foremost reason was that we were all English majors and we loved Shakespeare’s conception of the Fool. He was the character in Elizabethan courts who could tell the king the truth. He was the only one to do so without losing his head, and he did so through amusement and by telling contrarian truths. That was a character that appealed to us because we felt there was a lot of bad conventional wisdom on Wall Street. We could tell contrarian truths amusingly; the whole goal of the enterprise is education.

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Q: How did you get started on America Online?

Tom: David and I were transferring files for the Motley Fool newsletter on AOL when I was a linguistics graduate student at the University of Montana in Missoula. We came to recognize that AOL had skeletal offerings, very little presentation of ideas, mostly chat groups. I posted a note in November 1993 about our newsletter and made the offer that if anyone wanted a free copy, drop us their e-mail address. We soon began to find ourselves more interested in conversations online than in getting our newsletter out each month. Then we got an e-mail from AOL saying that they noticed what we were doing, and asked us to put together a formal site. We launched in August ’94 and had 750 readers in the first week.

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Q: What is the Foolish philosophy?

Tom: The investment philosophy is a concentration on valuing businesses with an eye to the long term, shooting to double our money over three years. Additionally, it’s cooperative research.

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Q: You guys have a somewhat contrarian approach--advising folks to dump their mediocre mutual funds and instead buy individual stocks in an attempt to beat the broad-market indexes rather than match them.

Tom: Diversification is overrated. When you buy the Vanguard Index Trust 500 fund, you get 500 stocks. Warren Buffett wants 10. If you

diversify too much, you will pay more of your money in commissions and it’ll be more difficult to follow the companies closely. If you buy GE, you get so many businesses that to think you’ve only made one investment is an oversimplification--you get a broadcast and cable network in NBC; you get GE Capital, the nation’s largest financial services company; you get light bulbs, refrigerators, jet aircraft engines. Plus, GE does something like 45% of its revenue overseas, so you’re getting an international play as well.

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Q: Why do you recommend that individuals use O’Higgins’ “Beating the Dow” strategy as a foundation for their portfolios?

Tom: David read that book when it came out, and we subsequently did a lot of back-testing on it. We’ve modified his 10-stock strategy down to a four-stock portfolio of out-of-favor, high-yielding, low-priced Dow stocks that bring better returns and lower commissions. When you have those stocks, you have conglomerates with a lot of businesses. That’s not too small a portfolio.

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Q: Let’s say a young couple decides you’re right, cashes out of $50,000 in mutual funds from their IRA and is now ready to buy individual stocks. What portfolio should they build?

Tom: “Beating the Dow” should be the backbone for any individual investor. It’s not very volatile, puts you in large, familiar companies, and it has historically crushed the market: 25 years of 22% annual compounded growth, versus 12.5% per year for the Dow in total return. With dividends reinvested, the Beating the Dow Foolish Four have returned 15,000% over 25 years, vs. 1,928 growth for the Dow 30 with dividends.

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Q: OK, so they put $25,000 or $30,000 of their cache into your recommended “Foolish Four” high-yield Dow stocks. Then what?

Tom: We then advise they look for profitable, rapidly growing small businesses in blossoming industries.

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Q: What has been your best investment recently?

Tom: Our top success in the past year was Medicis, a pharmaceutical company that markets skin-care products. We found it by screening Investor’s Business Daily and Zacks for companies without debt, with profit margins above 10%, with sales and earnings growth above 25% per year, and a price-to-earnings ratio below their projected annual growth rate. Medicis met all the criteria: We bought at $18.50 and sold at $39.75. In a period of eight months we more than doubled our money.

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Q: How did you decide to sell? That’s always a harder decision.

Tom: We stuck to our model that says when the P/E equals your projected annual growth rate, the stock is fairly priced and should be considered for sale. It’s not a hard and fast rule, though, and Medicis is up another 25% since selling it.

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Q: How about your losers--what went wrong?

Tom: ATC Communications. It’s in the telemarketing business, with 75% of its revenue from handling other businesses’ incoming calls. The industry is growing rapidly, [because] so many companies are outsourcing. Relative to its competitors, it looked undervalued. It met our criteria of being profitable, with rapidly growing earnings and revenue and no debt. But it did not meet our P/E-growth rate pricing model. Our justification was that it had the potential for a free rise in earnings. However, earnings did not freely rise; they slightly underperformed and the stock fell. We bought [at] around $23. It’s now at $6.50, down 71.6%. We still own it.

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Q: What enticed you to ignore your strategy?

Tom: There are a lot of precedents for companies which, from the day that they have $200 million in sales to the day they have $2 billion in sales, are always overvalued. These companies have so much momentum and unforeseen opportunities, and strong management, that investors give them a higher P/E multiple than they would normally deserve, an example of irrational exuberance. Our mistake was not having outlined or defined clearly what free rise in earnings means. Also, many successful high P/Es have proprietary technology. With ATC, we’re talking about people answering telephones.

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Q: What was the lesson?

Tom: Only consider buying ownership positions in rapidly growing small companies that are overvalued if they have a proprietary product or service.

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Q: How has the Internet leveled the playing field for private investors?

Tom: It has commoditized information and democratized the flow of information. And we’re still in the first inning on that.

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Q: What’s the future hold for the Fool, considering AOL’s network problems?

Tom: We are going to blow out our services on the World Wide Web (https://fool.web.aol.com). Without the revenue from subscriptions, we’ll move to an advertising model, though merchandising and syndication and books are not insignificant.


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