Summer 1996
by Peter Fortune

LIBERTé, FRATERNITé, EGALITé! So cry Frères David and Tom Gardner in The Motley Fool Investment Guide. Don't listen to the Wise Men of Wall Street. Embark on the Fool's way of investing, the CyberSpace Investment Club. In this brave new world, the Wise are fools, and the Fools are wise.

In the Fools' philosophy, the information autobahn is the escape route from the mediocre performance and handsome fees charged by the professional money managers. Released from serfdom, attached at the modem to other like-minded souls, investors can share in the vast pool of information, both data and methods, collected by the Many.

There are two ramps onto the autobahn: America Online's Motley Fool folder, and The Motley Fool website (www.fool.com). The website reports all transactions in the Gardners' Motley Fool portfolio, and their rationale. The AOL folder adds an extensive dialogue among Fools on specific stocks and strategies. This is the electronic town hall which gave rise to the by-now-well-known investment in Iomega Corporation, maker of Zip and Jaz disk drives. Though they considered Iomega's stock pricey in May 1995, the Gardners were persuaded by the People to buy: Some Fools living near Roy, Utah, saw that the Iomega parking lot was full on a Sunday, a sure sign of success; others visited the plant, liked what they saw, and reported this news. The reader gets an image of long lines of pilgrims visiting a shrine, reporting to others in the back of the line. An investment at $2.50 per share (split-adjusted) grew into $55 per share in one year. As of mid-July, it had subsided to a still respectable $26. Power to the People!

Though the Motley Fool's success is impressive, a one-year history is no history, and there are serious questions about the merits of such a free and unfettered flow of information. Bottom-line-oriented investors have little incentive to reveal valuable information; disinformation might be more profitable. Is it wise to expand the tipster's audience to a global network when trades now can occur far more quickly than corrections are announced? If one cannot frivolously shout "Fire!" in a theater, isn't it antisocial to shout it in a global information network? How does an intelligent person wade through the mass of often conflicting, and often wrong, information? The Gardners say it is all self-correcting, that informed chatters rat on the misinformers. That sounds autotherapeutic; if true, we could dispense with the SEC.

These are questions with which society will have to grapple. But one thing is clear from the experiment thus far: Democracy is messy, and the social veneer is pretty thin in the chat room. People become downright nasty when they encounter dissidents, and there have been charges of death threats and harm to loved ones. This hardly greases the wheels of investing.

But having taught you that democracy is the best way to discover valuable information, the Gardners turn to the other leg of the Foolish stool. What should you do to become a wisely Foolish investor?

The Gardners warn against managed mutual funds, which generally perform abysmally relative to market averages and, moreover, charge you to do so. Instead, invest in Vanguard's S&P 500 Index Fund, which turns in a market performance with no load and low turnover costs. But don't stop there, they say. You can do even better by buying high-yield Dow Industrial Average stocks; a "high five" strategy has more than doubled the market's rate of return.

Using virtually no time and very few of Hercule Poirot's "little gray cells, " you can significantly outperform the market. Wow! But you can do even better. Reading The The Investor's Business Daily, doing a bit of research into the financial statements of small cap ($50-$200 million) companies, and using eight Foolish rules, the Gardners claim you can earn an annual 30 percent or more. These rules focus your attention on small, inactively traded companies with high profit margins, high recent stock price increases, and a low Fool Ratio (the price-earnings multiple divided by anticipated growth in earnings per share). But you can do even better...read on!

In spite of this cheery hubris, the jury is out on much of this gospel. For example, the Fool is a momentum investor, buying after the price has risen and selling after it has fallen. This can have its season, as Iomega illustrated until its recent decline. And there is some history to the idea. In prior epochs, it was known as the Greater Fool theory, resting on the hope that there are pilgrims still remaining on the road to riches. During the heady 1980s, it was a strategy embedded in portfolio insurance programs that were designed to minimize risk. It is unwise, we agree, to cut our profits short and let the losses run. But buying after the barn door is closed is hardly a New and Improved idea.

The Gardners direct our attention to small, as yet undiscovered, firms. This certainly has some appeal, for all big firms once were small and we all know about the small firm effect (share prices grow more rapidly for small firms than for large firms). But few small firms get big, and betting the farm on a few small, thinly traded companies entails risks for which even high current performance might not compensate. The Gardners also urge their readers to sell stocks short. But again, short selling is a questionable approach for the small investor. The Gardners' clients are, after all, not well-heeled rentiers with tuned suspension on their financial wheels.

The book's focus on comparing the average annual returns for various strategies will not sit well with the Wise. Wisdom, and much financial research, tells us that risk-adjusted returns should be the basis of comparison. Consider Iomega. Its options imply an annual volatility of 100 percent, compared to the S&P 500's 15 percent volatility. This creates a wide "risk cone," as shown in the chart. The range of outcomes is extremely wide, because high risk usually accompanies high returns. It is no surprise that risky stocks did well in the strong bull market of 1995-96. But small investors should be particularly aware that this is a two-way street.

Internal consistency is not a hallmark of the Motley Fool philosophy. Of the eight stocks it currently owns, The Gap, by the Gardners' own admission, violates their investment rules. Chevron, General Electric, and Sears were picked, in part, as high-yield Dow stocks, following a contrarian strategy; the two big winners, America Online and Iomega, were chosen because of their relative strength, following a momentum strategy. Not only is there an apparent conflict in these strategies, but the continued holding of Iomega and America Online also seems inconsistent with the rules. They are no longer small-cap stocks, and their high daily volume indicates that they have been discovered by institutional investors. Only the most optimistic earnings forecasts would not produce a Fool Ratio signal to sell, or sell short. Apparently, the wise Fool must not only know the rules, but also know when not to use them.

Les Frères Gardner have written an entertaining, stimulating, and sometimes provocative book. It can serve as the beginning of a novice investor's education, for there is a foundation of good sense. It might also be appreciated by the experienced investor. Only time will tell whether the online investment club or the specific investment advice are useful contributions. Directing small investors to small, undiscovered firms, however, might also direct them to long-term ruin. Their advice about Dow stocks and index funds should be taken to heart; the rest should be taken with salt.

Peter Fortune is a senior economist at the Boston Fed.