Vendit, from Barron's last issue. Discussion on AOL & Internet stocks. Interesting,
TA
==============================================
interactive.wsj.com
January 25, 1999
Reality Check
There's nothing virtual about the values our panel targets
Roundtable Participants
The nine superlative investors who, on the morning of January 11, gathered for the 31st annual Barron's Roundtable came well prepared -- in the tradition of their many illustrious predecessors -- to speak volumes on the art of market analysis and the craft of stockpicking. And speak volumes they did. But consider this as you peruse this rendering of the day-long session's middle part -- featuring Art Samberg, Archie MacAllaster, Oscar Schafer and Scott Black: Perhaps the most telling thing about what was said was what our panelists didn't want to talk much about. And assiduously avoided recommending. Not just the Internut stocks -- which were soaring to unprecedented heights as we met, only to swoon as dramatically in the days since -- but practically the entire tech sector. Nothing virtual need apply. But neither should any of the big-cap consumer-product and financial names that, along with the techs, powered 1998's heady but narrow gains in the major indexes.
We know, for instance, no more ardent partisan of all things tech than Art Samberg, whose stockpicking turn leads off this second installment of the Roundtable. Just look at Art's career path, starting with the undergraduate degree from MIT, the MS from Stanford and the MBA from Columbia. Then Wall Street. A partnership at Weiss Peck & Greer. Formation of his first hedge-fund company, Dawson-Samberg Capital Management -- with $3 million in assets -- back in 1985. Art's concentration on techs only intensifying with his formation, under the Dawson-Samberg umbrella, of hedge fund Pequot Partners the next year. The astonishing growth of Pequot and its numerous offshoots. Assets under Art's management now total nearly $5 billion, all run -- since the beginning of the year -- under a shingle that reads: Pequot Capital Management. Art is the Westport, Connecticut-based firm's chairman and CEO.
Barron's: Let's talk tech-like every other investor on the planet, it seems. What are we to make of the mania, Art? Is it virtual reality or real value?
Samberg: You want to start in on virtual reality?
There were humongous plays to be made, but it's getting harder to do that in tech. The big guys are really strong, really powerful. I mean, the Justice Department might, or might not, have a case against Microsoft. But there is clear reason to believe they are barking up the right tree. So you've got really good companies and they are selling at really high prices. I have no problem owning a Cisco. I have no problem owning an America Online. I have no problem owning a Dell. I mean, [Legg Mason Value Trust portfolio manager] Bill Miller and I are the only two value investors left in America who do well every year -- because we think AOL and Dell are value stocks . So I am not going to make any apologies for where the techs sell.
Dell grows 50% a year, its share of the PC market is up to 15%. The way I count it, by itself, Dell will account for 7 1/2 % of the growth in an industry that is going to grow about 16% this year. Why bash this thing? Dell has the better model. It wasn't about PCs. It was about understanding the distribution channel, understanding what the consumer wanted. Dell has been just brilliant in what they've done and what they are continuing to do well. Will there be a slowdown at some point? Sure. Do I worry about it? Sure, I do, because people are pulling two years, three years, four years of PC shipments into this period of time, because they have to be Y2K-compliant by the end of the year. So I don't really want to talk about tech stocks, if you'll allow me not to.
Samberg: As Mario said, neither he nor I like to let cash sit around. So I am on margin on the longs, about 130%-135% long. I'm 50%-55% short. In managing my growth funds, I really want to be in these companies, but I really don't want to lose money. So I'm willing to continue to stay in those I think are really great companies and not try and outguess the world on when they are going to be fully valued. I've been coming to meetings like this for three years and hearing everybody tell me the techs are overvalued -- and nobody has been right yet. But I take the excess returns on those stocks and go out and buy index puts with strike prices that are 1%-3% below the market. And I actively manage those positions.
It is clear what happened last year, which is that everybody figured out that the Internet was not a media model, it's an E-commerce model. That it wasn't about advertising, it was about doing transactions over the 'Net. So when they figured that out, they just bought Amazon.com. Every single day. The amount of venture capital that has been raised in this area is staggering. And it's hard to understand how it is all going to get deployed profitably. But so far, it is happening, because you seed the company at $5-$10 million and somebody comes in and does a second round of financing at $80 million. Then it goes public at $200 million and it opens for trading at a billion.
Gabelli: Only in America!
"I do not want to tackle the job of valuing a conundrum."
Samberg: I love it, it's terrific. This is Mario's creative destruction. The cost benefits it'll bring to running the American industrial machine in the long term are phenomenal. So you can fret over the valuation of the stocks, or you can just say, "This is fantastic, because it is going to keep this engine going forever."
Schafer: It does seem like the 'Net is another industrial revolution.
Samberg: Oh, absolutely.
Schafer: So some companies are going to survive and some are really going to get killed.
Samberg: Very few will survive.
Neff: It's the looniness, too. When somebody ordinary announces that it's going on the Internet, like that Books-A-Million, why, the stock goes up 800%.
Schafer: John, you've been around long enough. This is like when people went piling into biotech. Remember when people went into bowling alleys? How about fast food? This is the same thing.
Black: Except that the market caps today are a lot higher.
Samberg: No, no, no. Absolutely not -- or at least, not relative to the economic impact they'll have.
Gabelli: It's the same in terms of the way the stocks are trading, not in terms of the fundamentals -- because the fundamentals are terrific.
Samberg: I want to divorce myself from that. I think there are maybe five Internet companies out there today that will still be around in 10-15 years -- and there are hundreds around today. What are they? One is America Online. I can't believe there's a soul in this room who doesn't believe that is a brand name with an economic future. I think Yahoo is clearly in that category. Call me crazy. I could mention a couple of others, but that would start to get me in more trouble. Amazon has a crack. But Amazon still has to prove they can make money. We've been big fans of Amazon -- I own Amazon. But I was disappointed that they didn't show a bit more progress last quarter in bringing it to the bottom line. Gradually, people are going to start to focus on --
Schafer: Is Amazon's business basically books?
Gabelli: It has nothing to do with books or CDs, it's basically consumers buying things over the Internet. And the number of Internet subscribers is growing exponentially.
Samberg: The investment question about Amazon is all about whether they can get enough gross margin. I mean, Dell had continually shrinking gross margins, and yet they were able to get enough profitability by getting their direct costs down. The real question with Amazon is whether they are going to be able to branch out into new things, like gifts, where they don't have the distribution as well set as they do in books. Where there isn't an existing infrastructure of other people supplying the back end. Will they have real-time computer links to those factories, so that they can fulfill orders in a timely way -- not get orders screwed up and customers ticked off at them? Can they just dominate that space? If they can dominate that space, Amazon can still be exciting. But I don't want to talk about the price today, because nobody can defend what's going on, on a daily basis. The only day these stocks have ever gone down is when Knight Securities [which executes stock trades for many of the largest online brokerage firms] had a computer outage one morning and they all went down 20%. I mean, there is nobody in this room who owns the Internet stocks, except for me, I guess. There are very few institutions that own these things. The individual either owns index funds, or -- when he buys something off Yahoo, he says, "Gee, that is pretty good, maybe I'll buy the stock." Then you get the day traders. Who's to say they are right or wrong?
Neff: Okay, but who ends up owning those stocks at the end of the day, if the institutions don't own them?
Schafer: The night traders.
Samberg: The institutions are going to cave in. Mario is going to own them and Fidelity is going to own them. The Internet stocks are going to go down 50% in three days and then the institutions are going to come in. Because there isn't an institution alive that in two or three years won't have to own these stocks. I don't know at what price, but I refuse to believe these stocks are a bottomless pit, that they are all going to go to zero. There are about 200 of them that will go to zero. But not all.
MacAllaster: Isn't there a fundamental difference between Amazon selling books, where the best margins are 5%, and Microsoft, with its 45% margins?
Samberg: This could be the old joke about the way to make money in something where you have slim margins is to make more of something on which you're losing money. Don't know. But Amazon's cash flow has been close to break-even.
Gabelli: The fundamental driver is E-commerce. The number of active online users, the subscribers to the 'Net and the dramatic change to the world. Creative destruction. People are going to lose money, and they are going to lose a lot of it, Oscar. But money is rolling into this arena, it is attracting talent. It's attracting resources. We are allocating capital very inefficiently, but efficiently. It's the great conundrum of the capitalist system.
Samberg: I do not want to tackle the job of valuing a conundrum.
Q: We get the impression that as much as you love tech, you don't find the stocks attractive at hyper-valuations.
Samberg: Just because I like tech stocks and am basically right, why do you want to humiliate me at this point in the cycle?
"Colt Telecom was up around 400%."
Q: That's not the point at all.
Gabelli: There are Barron's readers out there who want to know about the 'Net.
Samberg: They should get onto a chat room and talk to their friends about their stocks. Because what do I bring to them? It is truly amazing. I don't know if any of you have read any of that stuff. I have had my name faked, used in the chat rooms. When you are in a regulated industry and you see what is going on in those chat rooms, you just scratch your head and wonder how you are supposed to deal with it. I am rarely speechless, but I really don't know what to tell you. I talked about two stocks, in '94 or '95. I don't remember. America Online and CMG Information Systems [now CMGI Inc.]. Split-adjusted, each of them was trading at $3-and-change when I talked about them. America Online is up another 6 or 8 today. It's at 160. CMG is up to 240. The guy who runs it is brilliant. David Wetherell. He's the guy who seeded Lycos. He seeded GeoCities. A bunch of stuff. He is not responsible for the stock's valuation. But if you were to look at the value of CMG today, and look at the value of its percentage ownership in other publicly traded stocks and private holdings -- in other words, do the kind of analysis that Mario would do and that I usually don't do -- you'd find that the liquid stocks are worth about $55 a CMG share. And that is as of Friday [January 8], because God knows what is happening today. But then CMG also has a bunch of illiquids and venture-capital investments that look like they might make it. If you assign really generous valuations to them, they add up to $26.50.
Q: Really generous?
Samberg: Well, I happen to be a venture investor, on my own, in one of his venture deals. We put money into it -- $12 million. Six months later, some money came in at a $90 million valuation. And I see looking at my spreadsheet here that we are valuing that deal at a lot more than that. Anyway, I have the combination of the liquid and the illiquid stakes generously valued at about $81 a CMG share. It also fully owns some companies they are trying to develop. Those things produce humongous cash-flow losses. So CMG is reporting $80-$100 million a year in real cash losses. What are you going to do with those? You have to subtract them from that $81, I guess. Say two years of those losses, because it will take two years to get these things to make money. Then, there is a little bit of debt. So you end up with an enterprise value of about $70. This is just the way the world is. The stock closed at $200 on Friday. It was up 40 this morning. And I don't know what the defining event was that made it go up 40.
Neff: Defining or divine?
Samberg: What do you want me to say? On the other hand, I'm not particularly upset by America Online going from 3 to 160. They are now earning money. They've transitioned from a subscription model to a content model. They have superior management. They are executing, whether the Netscape acquisition causes a bump in the road in 1999 or not. I don't know. But if AOL is going to be a long-term player, it probably should have that asset so it can compete against Microsoft, which will never give up. There are real things and then there is the mania. I am fully aware of the mania. It worries the hell out of me -- because I love this whole play. I started talking about it four years ago. I can't, any longer.
Q: So let's talk about what you are buying.
Samberg: These names are going to surprise you. I still believe the trend that is in motion is going to stay in motion. Volatility is going to be all over the place this year. My approach to investing in this environment is I would like to be able to pick off the cyclicals at the right moment. So we do a little bit of that. But I would rather just make sure I own great growth companies that have catalysts, sort of like Mario's old approach to finding catalysts for value stocks. Where is a catalyst to growth and where is it going to continue? I'd rather not worry too much about exactly where a stock's price is. So my first idea is Home Depot, which has been a big stock; it's doing great. The growth rate has been about 22% a year for the last five years. It grew this past year at about 35%. I think that growth rate can actually be stepped up. Everybody knows Home Depot; it is executing really well. It opened a new distribution center, handled it well. It's increasing its inventory turns. But what makes Home Depot interesting, in my mind, besides low interest rates and a flush U.S. consumer, is its new format, called Expo Design Centers. Any of you who has ever bought a new house and had to go to showrooms knows it is one of the most painful experiences in the world. You can't visualize anything. You go to all these different shops. It's the most inefficient thing in the world. So Home Depot has opened six of these Expos, which have lots and lots of showrooms set up within them. Their margins are higher in the Expos. They have opened some very close to existing Home Depots -- and, where they've done that, have seen a 30% pop in comps in the old Home Depots. There is good synergy between the two formats.
Neff: The big home builders have done something similar, though. They have design centers now, where you can sit down and use computer graphics to visualize what you're doing.
Samberg: I looked at a venture-capital company called Building Blocks, which has terrific technology to do that. This is the old dilemma. Are the really good retailers who use Web-enabled approaches going to keep their markets or are Web-based retailers going to take them? I think that, as Gap has proven with its Internet strategy, a good retailer can keep its customer base. I know there will be competition for Home Depot's Expos, but it is a huge market. There are 500-700 Home Depots. There are only six Expos. They are going to roll it out quickly. So, over the next three years, I see an assured growth rate, at a minimum, of 35%. Yes, the stock is a little bit expensive. But Home Depot, we think, should earn at least $1.40-$1.45 this year. The Street is at about $1.30. In the year 2000, we see them earning about $1.95. So the stock, in the mid-50s, I don't think it is that expensive. |
