Elwood, since I know you will be asking about Barron's, I did not see anything about CPQ today. Susan Byrne of Westwood was interviewed though, she thinks the 'nifty fifty' are overvalued and has sold Dell and others. Andrew Bary also talked about the disparity between growth and value names. Anyway, here is an excerpt from the Byrne interview...
John
Q: This rally's a head-fake?
A: Well, it happened so fast and has been so sharp that we tend to forget how
concerned people were, post-Russia, about deflation and tight credit markets
-- and, pre-Russia, about overheating and a possible tightening by the Fed.
That was only about three months ago, but it seems like a lifetime ago.
Conversely, three weeks ago, people thought the Fed would have to cut the
fed-funds rate by a half-percentage point every week. However, we think the
long cycle favoring financial assets is still in place. We do not think we are in a
long-term bear market. But we do think we are not quite through a corrective
phase, as we transit away from a large-cap growth style to a small- and
mid-cap growth and value style and a large-cap value style. That can be
bumpy. But it represents tremendous opportunity for the stockpicker.
Q: So you're reasonably optimistic?
A: Yes, as we went through the exercise of setting up our risk matrix, and
looking at different scenarios for '99, it became clear to us that the most likely
one is "muddle through."
Q: Meaning?
A: We've been concerned all year that this economy is going to weaken --
especially since a trip I took in late January and early February to Indonesia
and Thailand -- part business, part pleasure. We saw firsthand that this isn't
just a little currency adjustment, a la Mexico; this is much more profound. So
we felt that if this economy were to err, it would err to the weak side. And
that, should interest rates do anything, they would go down -- that the Fed
would have to cut rates. That said, we are finding tons of names in which we
can find what we call "value." Not in the 50 biggest names in the S&P, but in
the others, the S&P bottom 450. We see certain sectors where the valuations
are so extreme, in our opinion, that 1999 should bring some sort of
rationalization -- which usually means that somebody is going to take over
somebody else. At the same time, we continue to believe that a lot of the
larger-cap, growth-oriented names -- which are not necessarily our bailiwick,
anyway -- certainly appear fully valued. After all, based just on consensus
estimates for '99, the top 50 names are selling at 26 times, versus a 22
multiple on the entire S&P 500 -- and the bottom 450 are trading at 17 times.
The forward P/E on the Russell 2000, meanwhile, is also 17. The
price-to-sales ratio on the S&P is almost two times, the price/sales on the
Russell is 1.2. I don't remember ever seeing such a huge disparity. So it may
be that only certain securities are overheated and that there are actually some
pretty exciting opportunities, outside of the new Nifties.
Q: Assuming, as you say, that your muddle-through scenario plays out.
A: Absolutely. We are in the slow-growth, modest-profits-in-'99 camp. On
those assumptions, at the lows of August 31 and October 8, at about 950 on
the S&P and 7400 on the Dow, we felt the stock market was undervalued by
15%20%.
Q: And now it's not, again.
A: Right. Fast-forward to mid-November, and our muddle-through theory has
become the dominant think, at least for this week. And I believe the market is
efficiently pricing that scenario. So I have some concerns: A) I don't think the
economy is as strong as everybody thinks it is. And B), maybe not so much in
the small-cap or mid-cap names, or even in the S&P bottom 450 -- but I
think there is significant risk in the larger-cap names, where the excesses are
and where there is very little margin for error. One of the bad things about
getting older is that you get older, of course. One of the good things about
having almost 30 years in this business is that you have seen a lot. And this
reminds me -- it feels to me -- as if we may be setting up for a scenario that
we last saw in the mid-'Seventies.
Q: Not another oil crisis?
A: Nothing that specific. But if you remember, we had a stretch back then
when the market went up to 1000, went down, went back up to 1000 and
then started to really correct. In 1974, if you owned that generation's Nifty
Fifty, you had watched them double. But if you owned some of previous
cycle's names -- which had done very well in the 'Sixties -- you had already
started getting clobbered on a very regular basis. Your portfolio was in a bear
market long before the final double bottom in the third and fourth quarters of
'74. The broad market had really peaked in the early 'Seventies. Yet the
narrowing of the market continued for two or three years. And the most
vicious part of the correction, in selected high-profile names, didn't happen
until they were slammed in September of '74 and then crushed in December.
That may or may not be what happens now. Inflation was a problem then,
deflation is the worry now. The dominant owners of securities then weren't the
mutual funds, they were bank trust departments. It was a completely different
time. However, after 1974, the first time many of those former Nifty-Fifty
names even lifted their little heads was in the spring of '78 -- and you didn't
actually start to make money in any of those names until 1982. In 1975, the
S&P 500 performed more or less in line with the smaller-cap names. In 1976
the smaller- and mid-cap names outperformed the S&P, and in 1977, the
S&P was down 7% while the mid- and small-cap technology and smaller
industrial names gained 8%-10%. Essentially, I'm positing the question
whether we are moving into a period in which the S&P, which is driven by the
very large-cap names, won't be as relevant to portfolio performance as it has
been. Maybe there'll be more of a correction in them, or maybe it'll just move
sideways for the next year or year and a half. After all, these companies that
are so overvalued are terrific companies. They are excellent, successful
growth vehicles. Wal-Mart and Dell, for example, are obviously leaders in
their fields, premier companies.
Q: So were Avon and Xerox.
A: If only we knew then what we know
now. But the question, for us, going
forward is always not what do we know
now, but how are the stocks priced
today? What kind of future are those
prices anticipating? And, as portfolio
managers, do we know of anything that
might disappoint those anticipations?
Certainly, in the case of Dell, which we
were fortunate enough to own for a very
long time, I must admit that selling it
100% ago might have been a little early.
It's not that there is anything wrong with
any of these new Nifties. The trouble is that the market knows they are
excellent. To own them, one has to expect that over the next three to five
years, they will stay excellent. They may not. Considering the values we see in
other areas of the market, we don't feel like taking that risk.
Q: What are you doing in your portfolios?
A: Now, looking forward to '99, in our balanced accounts, we've recently
started selling some of the five-year Treasuries we added in August when the
long bond hit our target, and have been moving back out to the long end of
the curve as rates have moved up. We have not yet reversed our August
move in which we took bonds down to 35% from 40% and put that 5% in
equities. But our work would indicate we are close. On the other hand, if the
markets continue to go to new highs and we have no other information, we'll
stay invested because we are finding attractive areas and tremendous
undervaluations in some of the smaller and mid-cap names, as well as in some
of the big-cap sectors that have done very poorly this year, such as REITs
and energy -- and where the stock prices and the fundamentals are out of
whack.
Q: Let's talk bonds first. They were really ground zero when everything
went into the soup.
A: Exactly. The credit crunch was all in the spread markets. When the liquidity
preference became overwhelming, everyone moved into Treasuries -- then
when the spreads between governments and corporates and asset-backeds
widened immensely, people went back into them. We are now at a point
where we think the Treasury-market yield curve is quite rational; where there
is value on the corporate side -- where there certainly wasn't six months ago.
Then you were looking at single-A paper trading 50 to 60 [basis points, or
hundredths of a percentage point] off the curve. That same paper now,
depending on maturity, might be trading at 150 to 180 off. Nothing has
changed. The company is fine. Your money is good.
Q: What stocks catch your eye?
A: In the large- and mid-cap product that I do, we have been sifting through
the ashes of the financial stocks to see if there's something attractive there. My
colleagues have been doing the same in the small-cap area. We're finding that
one of the big opportunities for next year -- one way or another -- will be in
the REITs.
Q: They're definitely in the doghouse.
A: Which actually will turn out to have been a good thing, I think. Not that it's
like one of those life lessons, when you look back and realize it's a good thing
you didn't get into MIT after all, because you were never meant to be a
engineer. But in the sense that the equity market is now the real-estate
industry's lender at the margin -- and will increasingly become so -- and that
means you can be positive.
Q: It does?
A: Sure. Everybody is afraid of being the last guy out of the door in the
real-estate business, including REIT investors. But I recently heard Sam Zell
make a very good point about the discipline of the marketplace, which is that
equity markets are much more efficient clearers of information than bankers.
A banker reacts, and looks at what is going on presently. They tend to be
asset-based lenders and they are looking at current appraisals. By contrast,
the equities markets look ahead and take a broader view.
Q: How so?
A: In other words, if a real-estate developer wants to raise money for a new
hotel, the equity investor is more likely to say: "Gee, I know of three or four
other guys who are putting up hotels. How is all this going to work? Aren't
there an awful lot of apartments around?" They tend to look ahead. Which is
what the equity market did this past year, after incredibly good years for
REITs in '95, '96 and '97, 1998 wasn't good. The market said, "You can't
fool me, you can't all put up all these apartments and all these hotels and it all
works out fine." In what tends to be a self-fulfilling prophecy, equity money
tends to go only to the highest rate of return, the best projects. So what has
happened this year, in the long run, should be very positive for REITs,
because it sets up a different type of rationalization process in '99. After all,
the highest and best value of REITs in the past two or three months has been
to sell them for the tax losses. Which has not been a great
supply-and-demand situation. So I'm assuming now that when we're talking
about '99, everyone has offset their gains in Dell by selling all their REITs for
the tax losses. Going forward, there will be certain REITs that will do well --
but they're not the new growth paradigm companies. They never were. They
are no longer owned by mutual funds that are not REIT-specific, because
there is no longer momentum there.
Q: Which, for instance?
A: Things that were never mentioned as growth vehicles, like a Weingarten
REIT. High-quality, excellent, total-return companies, where you'll get your
15% a year-half of it, perhaps, as a dividend, so you'll be thrilled to death.
Then, out of the ashes, you'll also see rationalizers emerge, Phoenix-like. In
other words, the people who have money. And the people who have the
assets will discover that the value of those assets is higher in the private
market than the public market will pay. There will be plenty of deal fodder.
Q: So, what are your favorite real-estate holdings? The ones that have
been beaten down the most?
A: Not necessarily. The companies that have been most horribly hit were the
paired-share growth vehicles -- and some may become rationalizers; others,
fodder. The market will decide which. But the problem with investing in those
sorts of situations is that if something doesn't happen, you end up holding a
not-good-quality security. When a whole industry is underpriced, our
preference is to buy the highest-quality stocks. So one of the stocks that we
like is Vornado Realty Trust, which a lot of investors view as overvalued, in
the sense that it has a lower yield and a higher FFO [funds from operations]
multiple than some other REITs.
Q: FFO, we should explain, is the REIT equivalent of EBITDA, earnings
before interest, taxes, depreciation. But why Vornado?
A: Vornado is a company created by a man named Steve Roth, as a vehicle
for him and Mike Fascitelli, who for years was the Goldman Sachs partner in
charge of real estate, to put together some really excellent real-estate assets
and leverage them over time. Since the fascination with REITs as new growth
stocks is over -- and thank heaven, because that was never their job -- you
have to analyze them as asset plays, and that's where Vornado shines. Many
REITs a couple of years ago were selling at huge premiums to their NAVs
[net asset values]. Now some are selling at discounts. Another name that we
still own, and like, Crescent Real Estate Equities, is selling at a significant
discount to its NAV. In Vornado's case, the stock is around 35 and its NAV
is -- call it 32. So it's not quite selling at |
