Fed model in the world
of low inflation and low interest rates, this model
doesn't work. How much truth in this?
Talking Technology Stocks with Garrett
Van Wagoner
With his top fund up more than 55%, Van Wagoner is a
manager worth listening to
After a disastrous 1997 and a scramble back last year,
fast-trading aggressive growth-stock specialist Garrett
Van Wagoner blasted his way back up the mutual-fund
performance charts in the quarter that ended on Mar.
31. His flagship Van Wagoner Emerging Growth Fund
(VWEGX) returned 55.8%, while each of its four
siblings raced ahead, too.
What worked? Where's he investing now? What
would make him blink? I asked him all that and more
when I reached him this week by phone in his San
Francisco office, where he manages $575 million. See
the accompanying table for a look at some of his top
holdings, plus some stocks he sees as up-and-comers.
Here are excerpts from our discussion:
Q: How did you bounce back?
A: We spread out into where I traditionally played --
the new and innovative companies. It led us pretty
heavily to the Internet in the spring of last year.
Q: Are you still bullish on the Net?
A: We are pretty highly weighted in technology. We're
about 55% or 60% in technology, broadly speaking. A
lot of those companies are either directly or indirectly
related to the Internet. The number of companies that
are directly related like AOL (AOL, $150.12) and
Amazon (AMZN, $171) and Yahoo! (YHOO,
$179.75) has been cut down significantly because they
reached valuation points where we just think it makes
sense to keep those as small positions.
Q: What's taking their places?
A: Some new Internet companies, particularly in the
infrastructure and content side, peripheral second- and
third-tier plays on Internet.... So we've played
everything from semiconductor companies, like PMC
Sierra (PMCS, $75.50) and Vitesse (VTSS, $51.44),
and TranSwitch (TXCC, $49.62) to companies
providing system-solutions products like Aware
(AWRE, $47.62) and Com21 (CMTO, $25.31) and
SDL (SDLI, $85.25) and Uniphase (UNPH,
$121.56), to companies that are providing the service,
the telecom service, like Qwest (QWST, $74.50) or
Metromedia Fiber (MFNX, $54.75). [There are] all
sorts of different ways to play on this explosion of
people getting on the Net hooking up for business, for
commerce, for play, for whatever they're doing.
Q: What about the big companies -- Microsoft
(MSFT, $92.69) and Dell Computer (DELL,
$41.19) -- that you've owned?
A: I don't think it's too crazy an idea to think that a lot
of PCs, particularly for the home, are not being bought
just to play some more games. People are hooking up
and going online. I just recently bought a PC for my
mom. She just retired. She wants a PC to go on the
Net. She wants to go visit the Louvre and everything
else, and that's the way she's going to be able to do it.
Q: Is the craze for Internet stocks topping out?
A: We're going to get more and more selective as
these valuations go up, but I think it's still a very valid
overall macro theme. There still are a lot of
opportunities for new companies that are providing
new products or services. I don't think it's going to die
any time soon.
Q: What strikes you as the dominant feature of
the current market?
A: This is really a market of the haves and the
have-nots. There is a very limited number of stocks
that continue to do well. When I look through all my
chart books on the weekend, it's clear how many
pretty decent companies are just going nowhere in the
market.
Q: I saw in your portfolio that you purchased
shares of iVillage (IVIL, $99.31) in December at
the equivalent of $8.55. How did you manage
that?
A: We do private investments here as well as public,
and that was one of the private investments we bought.
It came public [last] quarter. I think I've learned as
much from talking to iVillage over the last six months
about where the Net is headed as I have from anything
else. It has been extremely valuable to have that insight.
As private companies, they tend to say more than
when they're public. They're feeling a little bit less
constricted; the lawyers don't have them in a
stranglehold.
Q: How much did it add to your performance in
the first quarter?
A: For the flagship [Van Wagoner Emerging Growth]
fund, it probably added 150 or 180 basis points. It's
helpful, absolutely it's helpful, but it's not why we had a
good quarter.
Q: What other stocks...
A: Rocked and rolled for us?
Q: Yes.
A: Our largest position, OnHealth Network, (ONHN,
$14.31) has tripled in the quarter.
Q: Do you remain bullish on the stock?
A: Yes. That stock, I think, that's going to be our
biggest stock of the year.
Q: Do you still have more than 26% of the
company?
A: We haven't sold any. That has been a huge
contributor. We've made a tremendous amount of
money on an alternative local telephone company.
They go out and beat the bushes and try to get local
telephone accounts. That's been a double. That
company is called Allegiance Telecom (ALGX,
$26.50). We've made a tremendous amount of money
in a semiconductor company that provides chips mainly
to Nokia (NOKA, $158.75) ... That's been more than
a double. We've taken some profits there, but again
that's been a big one.
Q: What's it called?
A: RF Micro Devices (RFMD, $45.75). What else?
Oh, SDL, they make components for laser systems, so
they're a sub-system manufacturer to Lucent (LU,
111.69) and others that are making these big systems
that help add capacity to telephone networks.
Q: What about up-and-comers?
A: Cement, as it's known, or Computer Network
Technology (CMNT, $15.69) and QLogic (QLGC,
$66.06) are kind of playing on the same thing, storage
area networking, broadly. APEX PC Solutions
(APEX, $14.12) is an up-and-comer. They make
servers that go into these big server racks that allow
servers to control servers. They do some private-label
as well as the Compaq product. I like that one quite a
bit because the fundamentals are intact [but] the stock
has gotten absolutely creamed because PC stocks
have not done well over the past six or eight weeks.
The stock is way down, and we think the numbers are
going to be very strong this year, and we think we can
make a 100% or so in that one.
Q: What would turn you bearish?
A: I'll tell you what would get me very worried is what
always gets me very worried, and that is if I believe the
Federal Reserve would have to hike short-term interest
rates to slow the economy down.... It seems to me the
economy is likely to slow during the rest of the year, so
I think we're going to be O.K.
Q: You'd wait to see the actual tightening?
A: I don't think it pays to anticipate Alan Greenspan
very much.
Q: Your biggest misstep the past couple of years
may have been a big stake in engineering and
design software maker Avant! (AVNT, $17.25).
What's happened?
A: That was one of the names that we gave up on. I
follow that industry very closely. I am tempted from
time to time to buy a little bit back. The people that I
speak to in and out of the company say business is
great. They still have all these lawsuits, and the stock is
selling at under 10 times earnings now. I still believe
they're a leader in the business as far as the quality of
their tools, but as long as lawsuits are hanging over
their head, I don't think anybody's going to care. And it
took this old dummy -- me -- a long time to figure that
even at a cheap multiple, nobody was going to care. I
was concentrating on the business fundamentals, and
they've come through as beautifully as I ever could
have wanted, [but] I'm glad I've sold the stock and
moved on to other things because no one seems to
care.
Barker covers personal finance for Business Week
from Melbourne Beach, Fla.
The Market: Too High? Too Low?
Why so many valuation models are so wrong
Wonder if the stock market is out of whack? Click
onto Dismal Scientist at www.dismal.com and slide
your mouse over to the market-valuation calculator.
Plug in a couple of commonly used figures--a 5%
growth rate for earnings, say, and a yield of 5% on the
10-year Treasury bond--and the calculator offers up
some distressing news: The Standard & Poor's
500-stock index, it says, is 11.2% overvalued, even
after the Mar. 23 plunge.
But if you'd like to make the worry go away, assume a
higher earnings-growth rate, 7.5%, and a lower interest
rate, 4.5%, and voila, the market is 2.1% overvalued,
close enough to say it's fairly valued. ''You have to
examine the inputs'' to figure out whether a model
makes sense, says Mark Zandi, chief economist at
Regional Financial Associates in West Chester, Pa.,
which runs the Dismal site on the Web.
As the stock market has made a run on Dow 10,000, it
has also made fools of the folks who use statistical
models to divine where the market is headed. Most of
the models have been warning for months, and some
for years, that the market is unsustainably high and
heading for a fall. ''This is a speculative bubble,''
cautions Ronald J. Talley, director of financial
forecasting for WEFA Inc., an economic consulting
firm in Eddystone, Pa., arguing that the market is still
twice its fair value.
DANGEROUS PLACE. But if the market continues
to thumb its nose at the models' forecasts, then perhaps
it's the models that are out of whack. ''The traditional
model is flawed if you think that people's attitudes
toward risk are changing over time,'' says Kevin A.
Hassett, a resident scholar at American Enterprise
Institute. He and AEI fellow James K. Glassman have
developed a model that finds the market to be sharply
undervalued. Their argument: Investors don't see the
stock market as the dangerous place they once did and
thus will bid up stocks to far higher prices.
If the new modelers are right, the change overturns
statistical relationships that have held true for decades.
It would throw doubt especially on the long-held view
that stocks are riskier than bonds.
Consider the so-called Fed model, which Deutsche
Bank economist Edward Yardeni teased out of a
report to Congress by the Federal Reserve in 1997,
seven months after Chairman Alan Greenspan warned
of the market's ''irrational exuberance.'' This model
compares the earnings yield on stocks to the current
yield on bonds, the idea being these are competitive
investments. The earnings yield is the forecast operating
earnings for the stocks in the S&P 500 over the next
12 months divided by the price of the index. On Mar.
23, that was $52.59 divided by 1262, or 4.17%.
Compare that with the interest rate on a 10-year U.S.
Treasury bond, which is 5.16%. Under this model,
Treasuries are a better buy--they yield more. Only
when these two numbers are equal are stocks fairly
valued. Right now, this model says stocks are 24%
overvalued.
The model's beauty is its simplicity--and the fact that
the variables, market level, interest rate, and consensus
earnings forecast are not subject to the whim of the
modeler. There's an underlying assumption in the model
that the ideal earnings yield for stocks is the 10-year
bond yield. But Greg A. Smith, investment strategist for
Prudential Securities Inc., argues that the tight
relationship between rates and earnings yield holds
when the bond rate is above 6%, but is less clear at
lower levels. It could be, says Smith, that in the world
of low inflation and low interest rates, this model
doesn't work.
That's also the rap on the Campbell-Shiller model, a
valuation method advanced by John Y. Campbell of
Harvard University and Robert J. Shiller, a professor at
Yale University's School of Management. They use
market history to come up with an average p-e ratio for
stocks and argues that when p-e's are historically
high--as they are now, at 33 times last year's
earnings--stock prices will fall toward the long-term
average of 15. The problem with this approach is that it
overlooks changes in the U.S. economy. Tech stocks,
for example, which have high growth rates and high
p-e's, make up nearly 20% of the S&P 500. A decade
ago, the S&P was dominated by autos, oil, and other
cyclical stocks, while tech accounted for just 8.4% of
that index.
Other models that grapple with market valuation focus
on the ''risk premium.'' The risk premium is the
difference between the risk-free interest rate, usually
the return on U.S. Treasury bills, and the return on a
diversified stock portfolio. Over more than 70 years,
the return to stocks averaged 11.2%, and T-bills, just
3.8%. The difference between the two returns, 7.4%,
is the risk premium. Economists explain this extra return
as investors' reward for taking on the greater risk of
owning stocks. Most market watchers believe that in
recent years, the premium has fallen to somewhere
between 3% and 4% because of lower inflation and a
long business upswing that makes corporate earnings
less variable.
Looking ahead, the risk premium is critical in valuing
equities. Charles M. Lee of Cornell University's
Johnson Graduate School of Management closely
examines the 30 stocks in the Dow Jones industrial
average. He estimates a risk premium for each stock
by measuring the price volatility of that stock's industry
group. For instance, Lee says the risk premium for
General Motors Corp. (GM) is 9.48%, while for
General Electric Co. (GE) it's just 4.48%. (Auto stocks
have a higher risk premium because their earnings and
stock prices swing more dramatically than a diversified
company such as GE.) Lee then estimates future cash
flows for each Dow stock and uses a combination of
the risk premium and risk-free interest rate to discount
that cash to a present-day ''intrinsic value.''
When the Dow oversteps this value, the market is too
rich. And even with the Dow dropping back from the
10,000 climes, the price-to-value ratio for Dow 9700
is 1.61, or 61% above intrinsic value. Over the past 20
years, that ratio averaged 1.08. Although this ratio
peaked last April at 1.74, it's still well above the 1.41
registered before the 1987 collapse.
DIRT-CHEAP DOW. But like most models, the
Cornell approach looks back to forecast the future.
Hassett and Glassman say that's crazy, because the risk
premium is shrinking. They argue that stocks have
become a lot less risky than bonds, and in fact they
posit that the risk premium is heading toward zero. In
any model that uses a risk premium to calculate the
proper discount factor, lowering that premium from 3%
to zero is the same as slashing interest rates by three full
percentage points. ''In time, stocks and bonds will
converge,'' predicts Hassett. ''The opportunity is being
in the stock market as the market revalues stocks.''
That's why Hassett and Glassman argue that the Dow
is dirt cheap; their forthcoming book is called Dow
36,000.
Most analysts scoff at the notion that stocks are no
riskier than bonds. ''There's still a lot of uncertainty in
today's world,'' says Leah Modigliani, a Morgan
Stanley Dean Witter equity strategist. ''The risk
premium has moved down, but it's not zero.''
Forecasters everywhere concede that old models are
suspect. Merrill Lynch & Co.'s quantitative analysts,
for instance, look at five valuation models; only one of
them suggests that the market is anything but wildly
overvalued. The optimistic model is based on long-term
earnings estimates by the firm's analysts, and since
analysts tend to be optimists, Merrill economists take a
dim view of its output. ''We definitely don't think it's the
best measure of valuation,'' says Kari E. Bayer, a
quantitative strategist at Merrill. And Prudential
Securities' Smith has told clients that as long as rates
remain steady and earnings accelerate, they can ''forget
the models.''
That may be sound advice. There are no market
watchers and investors more humble than those who
heeded the models and yanked their money out only to
see the bull stampede ahead.
By Joseph Weber in Toronto, with Jeffrey M.
Laderman in New York |
