INVESTING COMMENTARY

• Every Dog Has Its Day
• Tell Me I'm Wrong
• Costco's Consistency and Competition
• Making a Million Over Coffee

Every Dog Has Its Day

Imagine being able to run a fairly simple stock screen that will outperform the market by 7.5%. To put this in perspective, if you expect the market to return 7% annually for the next 30 years, then a 7.5% outperformance is the difference between the $10,000 you invest today growing to $76,000 or growing to $580,000. And if you have more than $10,000 to invest? Well, then you have 30 years to think about what color you want your Ferrari to be.

Separating wheat from chaff
Before delving into the workings of the winning screen mentioned above, we need some context. Many stock screens focus on identifying out-of-favor companies that have the potential to bounce back, such as the Dogs of the Dow and Pigs of the Dow strategy. These methods can work nicely in situations where the market becomes unrealistically pessimistic about the prospects for a company or an industry.

The challenge, however, is that sometimes companies are unpopular for good reasons, and never do bounce back. Maybe they face new competition in the market, or they are displaced technologically. Whatever the case, it's important that these companies do not ruin the results of the entire portfolio.

The Dow strategies rely on the fact that the companies in the Dow Jones Industrial Average, like Intel (Nasdaq: INTC), General Electric (NYSE: GE), and Pfizer (NYSE: PFE), are big enough and have enough competitive advantages that they're unlikely to collapse. But dealing with this issue is nonetheless a requirement for most value screens.

Enter Joseph Piotroski, currently at the University of Chicago. Academically, it's well known that stocks with a low price-to-book value ratio tend to outperform the overall market. But Piotroski observed that the superior performance of low price to book stocks was due to a small number of exceptionally performing firms, while the majority of such firms actually underperform. He thought about it a bit, and realized that if he could just find some way of eliminating the underperforming firms, then the remaining portfolio could potentially realize Buffettesque returns. After a bit of tinkering and tweaking, Piotroski eventually came up with a set of criteria that beat the performance of an index by 7.5%. And business at Ferrari dealerships has never been better.

Spinning lead into gold
By this point, you might be curious as to what Piotroski's criteria are. He first ranks all the firms by price-to-book value, and then eliminates all but the lowest 20% (the most bargain priced). He then filters the remaining firms by nine profitability, liquidity, and operating efficiency criteria to focus on the firms most likely to outperform in the future. Each stock is assigned a "pass" or "fail" for each of the nine criteria, and all stocks that receive eight or nine passes are considered a "buy."

The profitability criteria focus on the idea that if a company is making money and improving its performance, then it is likely to be able to sustain itself on its internal cash flows. With this in mind, his first four criteria are:

1. Return on assets greater than zero.
2. Cash flow from operations greater than zero.
3. Return on assets in the most recent year higher than the year before.
4. Cash flow from operations greater than income.

The liquidity criteria represent the belief that companies that can manage their current liabilities and that are decreasing their leverage have less need for external cash, have more flexibility, and are less likely to go bankrupt. The criteria are:

5. The ratio of long-term debt to assets has decreased in the last year.
6. The current ratio -- current assets divided by current liabilities -- has increased in the past year.
7. The firm did not issue shares in the past year.

The remaining two operating efficiency criteria are indications that the firm's operational performance is improving. It will help to eliminate firms being squeezed by competition or that are slowly going out of business.

8. Gross margins have improved in the past year.
9. Asset turnover -- revenue divided by total assets -- has improved in the past year.

What's the screen picking now?
Right now, there are 64 companies that meet eight or nine criteria. The companies have market caps ranging from $12 million to $75 billion, and are in a variety of industries, from tech and communications to mining and retail. There's even a licorice manufacturer. Some of the better-known names include cable operator Comcast (Nasdaq: CMCSA), Japanese electronics manufacturer Hitachi (NYSE: HIT), computer memory manufacturer Micron (NYSE: MU), and toy retailer Toys "R" Us (NYSE: TOY).

The Problems
For the lazy investor, Piotroski's screen might seem like the ideal tool. All you have to do is spend a few hours each year purchasing the picks and then look on smugly as professional fund managers struggle to achieve a fraction of your returns. That seems pretty sweet to me. But there are still challenges with the screen.

First, there are 64 stocks in the screen this year. This is typical, which means that you'd generally have to make about 128 trades a year -- 64 sells and 64 buys -- in order to implement the strategy. With that many trades, commissions would really add up unless you have a huge portfolio. The other downside with yearly trading is tax inefficiency. If you hold Coke (NYSE: KO) for 30 years, your capital gains compound tax-deferred until you actually sell. With this screen, you're paying tax on your gains every year.

One other problem with screens is potential over-fitting. This happens when a researcher takes a set of data and tries a multitude of different screens to predict future winners. Eventually, they find a good screen. But the screen never works on any other set of data, either because it was optimized for that particular set of data or because it just happened to find random correlations. For example, if a researcher in the first quarter of 2000 tested a stock screen exclusively using data from the 1990s, then a "buy technology stocks only" screen might look great. That researcher would now be selling pencils on a street corner somewhere.

Over-fitting may be less of an issue when the logic behind the screen seems reasonable, as it does for Piotroski's screen. However, the data Piotroski used to test his screen, a 21-year time period starting in 1976, may not be representative of the long-term performance of the market either. And when stock screens suddenly "stop working" it's not always clear whether the problem was an over-fitted screen or that enough traders are using the screen to negate any potential advantages.

The other major problem with screens, which fans of mechanical investing may see as a strength, is that they do not fully leverage investors' abilities to make reasoned decisions. In effect, investors who rely exclusively on screens are saying that they believe their ability to reason about equities is inferior to their ability to instruct a machine to reason about equities. This strikes me as odd, though I'll admit that the argument "but it works" is persuasive.

Overall, I believe that investors will outperform if they supplement screens with well-reasoned analysis. Investors who successfully identify stocks with strong competitive advantages trading below intrinsic value, like those that Philip Durell analyzes every month in his Inside Value newsletter, will have superior long-term performance. In fact, if you're looking for stocks trading below intrinsic value, you should seriously consider taking advantage of a no-risk, free trial subscription to Inside Value.

Conclusions
For large portfolios, where transaction and tax costs don't outweigh potential benefits, Piotroski's screen may be worthwhile. For smaller portfolios, it may make more sense to not buy the entire screen, but rather use the screen to find companies worthy of further fundamental research.

For more on this topic, check out:

For those who would like to continue this discussion elsewhere, visit our dedicated discussion board.

While writing this article, Richard Gibbons was surprised and disappointed to learn that that tobacco companies are the primary purchasers of licorice. Before now, he thought he was. He owns none of the companies mentioned in this article.

Tell Me I'm Wrong

I'm in a particularly masochistic mood this week. I'm up to slapping on a red rubber clown nose, strapping on some outlandish polka-dot overalls, and straddling the ledge above the carnival dunk tank. I'll let out a heckle or two -- just to appease my inner sadist -- only to beg you to take your best shot.

See, I realize that some of the financial predictions for 2005 that I'm about to make are going to cut so far against the grain that even contrarians will be branding me a renegade. I don't mind. And to make things interesting, this is the first of a two-part series only next week's follow-up looks like an empty page right now. That's because I'm going to need you to step up to the dunk tank and hurl something fierce my way.

I've always been pretty accessible. Most people who have bothered to click on my byline or written me using the email link at the end of my articles can vouch for that. This week, it's actually going to be a requirement because your counter-arguments -- whether clear, righteous, or venomous -- will help me complete the second part of this interactive experiment.

So if you're ready to aim, here come the targets.

Shares of Apple will fall in 2005

Yes, I know. I'm pissing off a whole lot of people with this call. That's the point. Apple Computer (Nasdaq: AAPL) fans are a pretty loyal lot and after recent stock market gains, Wall Street has also taken a shine to the company that Steve Jobs built. But Apple's shares have risen fivefold over the past two years -- with its enterprise value fetching a dozen times more than it did back in 2003 -- and it's only natural to question if the company's fortunes have appreciated by the same amount. Is Apple really 12 times the company it used to be?

Apple did put up an incredible quarter last week. Spectacular margins. Strong earnings. It was already booming in digital music thanks to its iPod and tune-peddling online storefront, and now its bread-and-butter computer niche is percolating. But where do we grow from here? I'm not sure that the iPod as an appliance lends itself to the same perpetual upgrade cycle as PCs. I'm not the only one left unimpressed with Apple's pipeline of micro gadgetry. And as fond as I have been of Apple in the past -- and continue to admire it as a company -- scooping up Apple at 55 times trailing earnings no longer has that limited downside cushion that the stock once had.

Sirius will be signing up more new users than XM by year's end

Heresy? After all, despite the Howard Stern, NFL, and Mel Karmazin hype Sirius Satellite Radio (Nasdaq: SIRI) signed up just 440,000 subscribers during the December quarter whereas XM Satellite Radio (Nasdaq: XMSR) landed 700,000 more to its market-thumping digital army. How can a service that costs more than its larger rival make a significant move when the 4.3 million people most likely to sign up for satellite radio have already pledged their receiver allegiance?

Easy. Stern's migration won't take place until the end of this year. That will give Sirius a big marketing tool during the 2005 holiday quarter. You also have a programming guru in Karmazin to help differentiate Sirius' content offerings over XM while many of the factory-installed equipment deals that XM benefited from early in the adoption cycle are now working for Sirius as well. I think both companies will lap their 2005 subscriber targets, but on an absolute basis I believe Sirius will sign up more new users in this year's final quarter than XM.

Krispy Kreme will bounce back

I'll admit that this prognostication seemed more radical before CEO Scott Livengood announced that he was stepping down earlier this week, even though the words "Krispy Kreme" and "bankruptcy" are being used in the same sentence even now by some folks who were right on target in slamming the company last year. A head transplant to save the day? It obviously isn't enough to erase the excruciatingly long list of corporate miscues at Krispy Kreme (NYSE: KKD) but I'm probably not the only one who believes that if a turnaround has to start somewhere, the top is usually a pretty worthy starting place.

The problems at Krispy Kreme run deep. While financial restatements, inappropriate channel stuffing, loan defaults, and questionable franchise sales have muddied up the company's corporate image, its doughnut sales aren't doing so hot either. That's the real problem, long after the class-action lawsuits are done rolling off the litigious conveyor belt and glazed doughnut halos float above boardroom heads.

Back in May I wrote about how Krispy Kreme could be saved by things like revamping its retail distribution and upgrading its java offerings. I still believe it can happen -- and I think it's going to happen sooner than later. I wouldn't be surprised to see Krispy Kreme close out the year as one of 2005's best performing stocks.

TiVo will bounce back

How many buzzwords are dressed as penny stocks these days? Trading shy of the $5 mark, maybe we can try TiVo (Nasdaq: TIVO) on for size. The company's had a rough run lately, especially after DirecTV -- which accounted for most of TiVo's user base -- announced that it was going to phase out TiVo as the provider of its digital video recorder. Yet was it an overreaction that culminated in the company's CEO ultimately stepping down earlier this month?

I think so. For starters, DirecTV actually accounted for a tiny chunk of the company's subscription business. Sure, its financials look sloppy now as it continues to digest the gargantuan new unit rebates, but that's simply laying down the groundwork for growing its installed base of users.

Amazon won't enter this country's DVD rental market alone

The very whiff of Amazon (Nasdaq: AMZN) entering the domestic DVD rental market sent its two largest established players into a bitter price war. I think it will be enough to either keep Amazon out completely or force it to team up with one or the other if it does make the stateside plunge. Let's analyze the United Kingdom service that Amazon did roll out. Priced at the dollar equivalent of $18.63 a month, the company has the gall to cap the total monthly rentals at only six discs in its standard three-disc plan. While I can see Netflix (Nasdaq: NFLX) and Blockbuster eventually capping their "unlimited" plans as a way to control costs, there is no way that Amazon could roll out an overpriced plan on this side of the pond while these two companies are willing to fight to the death.

Today's Amazon isn't looking to repeat its early days of youthful indiscretion and razor-thin gross margins. It would sooner enter into the airline industry before it takes on the price war insanity going on domestically between Netflix and Blockbuster.

Your turn

So what are you waiting for? Did I miss the mark on any of these? All of them? The ball is in your hands. I'm perched above the dunk tank, taunting you with that childhood nickname that you thought you would never hear again. Behind the makeup I'm that harmless buddy who will help you spot the next great stock trend in our Rule Breakers newsletter service, but today I'm a clown -- and I'm laughing because you couldn't hit the tank's bull's-eye no matter how hard you try, bub. So why are you still waiting around? Take a shot, pal. Prove -- once and for all to those around here -- that I'm all wet.

Longtime Fool contributor Rick Munarriz really does want your feedback -- as long as you heave it his way before Monday, January 24, 2005. Sign your email the way you would like to be referred to if he used your response. He owns shares in Netflix but not in any of the other companies mentioned in this story. He is also a member of the Rule Breakers analytical team.

Costco's Consistency and Competition

David Gardner: You say, "What have you done for me lately?" But Jim Sinegal, one thing we notice about you (is) your consistency. In fact, I think you received quite a bit of attention for (it), and we have always noted it. You answer your own phone. You take care of scheduling your own appointments, and to say that is unusual among today's CEOs is quite an understatement. Is this part of keeping your costs down, Jim Sinegal, or is there some other reason?

Jim Sinegal: I think it is that. It is the persona that we want to establish for our business, that we are bare-bones, that we don't have a public relations department, that we handle these things ourselves on an individual basis. We think it is all part and parcel of how we run our business and the type of image that we create in our business, which is a bare-bones business.

David Gardner: The free publicity from, I don't know, people like me can't hurt much on it, either, eh?

Jim Sinegal: We like that. (Laughs.)

David Gardner: And speaking of test and learn, did you ever have an assistant and it just didn't work out? You just realized it doesn't work for me?

Jim Sinegal: No, I have an assistant, but my assistant takes care of things for me that are things that I can't get done when I am on the road, so answering the phone when I am not here and taking the messages, following up on customer and/or supplier and/or employee issues, answering mail.

David Gardner: Travel booking.

Jim Sinegal: Yeah, lots of travel booking. Lots of it. Lots of things that have to be done, and the people that I use for that are very good.

David Gardner: What is more profitable for Costco (Nasdaq: COST) today: food, household goods, or appliances?

Jim Sinegal: I think in totality it is probably food, although all of those are extraordinarily important categories for us. Part of the whole package with us is just that, the package. The reason for shopping with Costco isn't just that you can save 25 cents a jar on peanut butter but that you can save $350, $400 on a Movado watch or that you can save $1,000 on a plasma TV. It is that total package that makes it appealing to a customer. Customers come back because they can buy a pair of Calvin Klein jeans for $20 below the department store price, and that is what keeps them coming back.

David Gardner: I have a friend who was just marveling the other day, she bought something for her mattress that normally costs $500 or so and she was paying $140 for it, which really occasions the question to me: Jim, do you make a profit on everything you sell, or are there loss leaders that are in there in your business, you are taking a loss on them to get people in the door?

Jim Sinegal: No, we as a matter of fact, as a matter of policy, don't carry loss leaders. We think that is a deceptive practice, and we insist on making money on everything we sell. Now that doesn't include mistakes. Obviously if we bought something and made a big mistake with it and have to mark it down, we will sell that below cost, but that is a clearance item when you make those kinds of mistakes. But aside from that, we try to make money on every single -- it is our intention and it is our policy to make money on everything that we sell.

David Gardner: And Wal-Mart is sometimes criticized for supposed strong-arm tactics it uses, almost controlling the prices of what is being sold to it by suppliers. Costco doesn't strike me as having gotten that kind of publicity. Do you agree, and if so, why?

Jim Sinegal: We like to think of ourselves as very tough in negotiations. We would take a position with our suppliers that we are going to negotiate very hard and make a very tough deal, but that it is going to be a fair deal, and when we are done, we are going to honor the deal. They can count on us. We think that if you have a relationship with a supplier, you had better be prepared to respect them, and you had better recognize that no deal is good unless both parties are going to make some money on it. If both parties aren't going to make some money on it, some bad things are going to happen.

David Gardner: Looking over the competitive landscape, you have managed to avoid a price war with Sam's Club so far. How do you see that competition evolving in the future?

Jim Sinegal: We think that there will always be tough competition. I mean there will always be Sam's, there will always be Wal-Mart Superstores, there will always be Targets, there will always be very tough competitors out there that we have to watch, and we do watch. Competition, and this sounds very trite, and I am sure oftentimes people say, "Well, that is a bunch of baloney, and he doesn't mean it," but competition is healthy. You may not like it at the moment that it is happening to you, but in essence, if you don't have competition, you are not going to get better. You get lazy, and when you look at it in the final analysis, competition keeps you on your toes.

David Gardner: I guess you can lose your whole market share, not just a piece of it, if you get lazy.

Jim Sinegal: Absolutely. We have all seen examples of that. The competition, as I say, if we didn't have a Wal-Mart or a Sam's, I don't know what we would do. They are constantly keeping us on our toes.

David Gardner: Jim, Kmart announced bankruptcy not too long ago, has re-emerged and seems to be doing OK. What is your take right now on Kmart just as an observer of business?

Jim Sinegal: Well, I think most of what has been happening is from the real estate standpoint. I have been watching their operations, and we are going to watch them very closely through this fall season to see how they are doing, but clearly they have a very tough job to do to turn that around and to regain consumers' respect and confidence; but if it is well-run and if the management is well-done, they can do it. Consumers can be very forgiving if they think there is a sincere effort to bring the right products and the right prices to marketplace, so it is going to be an interesting study.

David Gardner: I am going to ask a question that touches on something that we talked about earlier. We may use that or we may reframe it this way so don't feel self-conscious if you are redundant in how you respond at all. It is just for our editing purposes.

Jim Sinegal: OK.

David Gardner: Here we go; 3-2-1, go. With Thanksgiving right around the corner, quickly followed by the rest of the holiday shopping and entertaining season, Jim, how important is this time of year to your business?

Jim Sinegal: It is very, very important. This is the time of year when our sales will jump up, and during that five-week period they will jump up to about 140% of what we ordinarily would be doing. Obviously any retail or any business person knows when you can pump out more revenues through your facility, you take advantage of those fixed costs that you have implanted in your business. It makes you more profitable, so it is a very important time of the year.

It is not just important from the standpoint of what it does in terms of revenue growth, but you build more reputation with your customers, and you also, if you are in this business and you don't enjoy the holiday season, you ought to get into something else.

David Gardner: Jim, you are pretty good at traveling and looking at your own stores on a regular basis. Now that it is holiday season, do you see, does a typical Costco make extra special preparations for this season, or given that you just mentioned that you get about 40% more business during these five weeks than usual, do you just kind of sit back and say, "Hey, we will get it"?

Jim Sinegal: No, obviously you have to plan, you have to have the right number of people, and you have to have the right amount of merchandise in there. At that point in time, your inventory turns go up, so do logistics and the art form of replenishment is extraordinarily important at this time of the year, particularly in building; in a business like ours, many of our high-volume warehouses will have less than a two-week supply on hand, so getting that goods in and out onto the floor is all part of the process and very, very important. It is the lifeblood of the business.

Stay tuned for Part Four of our interview tomorrow, and check out Part One and Part Two if you missed them earlier this week.

Costco is a Motley Fool Stock Advisor pick. Want to learn more? Subscribe today without risk for six months. The Motley Fool is investors writing for investors.

Making a Million Over Coffee

Maybe it was my Catholic upbringing or maybe it was my no-nonsense parents. But I have always been more of a rule follower than a rule breaker.

So why then am I such an enthusiastic advocate of our new Motley Fool Rule Breakers service? Because the Rule Breaker strategy of identifying great companies early and then holding them for the long term is the best way I know of earning huge returns. To see how, let's consider the instructive example of Starbucks (Nasdaq: SBUX) and the three stooges.

Starbucks and the Three Stooges
Imagine it's the summer of 1992 and you've just received an inheritance of $100,000. You decide to invest in the stock market for the very first time. To better your chances, you buy a newsletter titled High Growth Investor 1992, and you allocate your money in the following stock picks from the newsletter:

After one year, your four-stock portfolio has lost 16%. Three of your four stocks were from the rapidly growing technology sector, but they performed poorly nonetheless. The market punished them when they failed to deliver on their bold promises. Fortunately for you, the flier you took on that obscure coffee company out of Seattle prevented a total meltdown in your portfolio.

A passive strategy of investing in the S&P 500 would have earned you a return of $9,000 (9%) during the same period, so you're understandably a bit disappointed with your initial foray into the markets. Maybe this whole investing thing isn't for you. You do, however, decide to hang in there.

And today in January 2005, you are glad you did. Alas, three of your companies went bankrupt over the last 13 years, but one of those picks, Starbucks, has more than made up for the failure of the others.

So Starbucks and the Three Stooges would have made you a millionaire over the past 13 years. Just like Larry Bird and four other guys putting Indiana State into the NCAA championship game back in 1979.

Swinging for the fences
At Motley Fool Rule Breakers, the mission is to find the next Starbucks, although that's hardly the only company that makes the point. Had you chosen Dell (Nasdaq: DELL) instead of Starbucks in your hypothetical portfolio, you would have earned $3,034,848. AOL (NYSE: TWX) instead of Starbucks? $4,625,000. And Microsoft (Nasdaq: MSFT) instead of Starbucks? A still respectable $312,260.

We're not looking for value or dividends or turnarounds or whatever. In the words of David Gardner, the lead analyst for Rule Breakers, we are looking for the greatest companies of the current (evolving to next) generation.

This is a tall order. And there will be some stooges along the way. But the discovery of just one great company will make it all worth it. To paraphrase Mickey Mantle, we're not just looking to hit home runs in clutch situations; we're looking to hit home runs with every single swing of the bat.

Improving the odds
Isn't it all a matter of luck finding the next Yahoo (Nasdaq: YHOO) before it becomes prohibitively expensive? No, we think with hard work you can discover the great companies long before the conventional wisdom gives them its blessing. And David Gardner has a track record, having invested in AOL, Dell, and Amazon (Nasdaq: AMZN) at a time when the experts were laughing at these companies.

But David's not doing this alone. We've assembled a first-class group of analysts who will be assisting him in the hunt for the great ones. Longtime Fool and analyst Rick Munarriz is our in-house expert on emerging technologies and early adopters. Charly Travers covers the complex and potentially lucrative field of biotechnology. If you can't pronounce such words as merimepodib or ribavarin (let alone understand them), but want to profit from all of biotech's possibilities, Charly's your man. Finally, we have enlisted the expertise of Carl Wherrett and John Yelovich, who will keep us abreast of the latest in the Nanotech Universe. Like biotech, nanotech offers potentially outsized profits for those with a good dictionary and sound guidance.

So there they are, our five-man team. Five men, one goal... OK, I'll stop with the sports clichés.

Keeping score
So far, our Rule Breaker recommendations are down 2% since the first issue in October. One of our picks, a provider of spa services for cruise ships, is up 45%. On the other hand, a promising biotech firm with a potential blockbuster in its pipeline, is down 35%, having been negatively affected by the increasingly cautious regulatory environment.

We provide a scorecard in order to hold ourselves accountable. But picking Rule Breakers isn't about watching a scorecard, is it? How many Red Sox fans (just one last sports metaphor, I promise) remember that Johnny Damon batted .171 in the ALCS against the Yankees last fall? Now how many fans do you think remember the two homers (one of which was a grand slam) he hit in game 7 of that series?

CNBC in 2015
Ten years from now, a group of CNBC analysts will be sitting around talking about how this or that company defied all the odds and became a world-beater stock. And I'm confident that some of those world beaters will have been identified long before by one of our Rule Breakers analysts.

The conventional wisdom crunches some numbers and then reports back that it is folly to predict the future. We disagree. Sure, no one can accurately see the future, but you can certainly make informed predictions about who will succeed and who will fail. Yes, we respect the numbers, but we also know that the present has much to teach us about the future. As Wordsworth said, "The child is the father to the man."

John Reeves does not own any of the companies mentioned in this article. The Motley Fool has a disclosure policy.

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