Air
date: September 12, 2003
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Homeland security investing
GEOFF COLVIN: A dramatic week just passed: the 9/11 remembrances so emotionally draining for many, the President asking for $87 billion to fight terrorism in Afghanistan and Iraq. But are we any safer today than we were? What are the prospects for our personal security and our economic security in a world of spreading terrorism?
Michael Cherkasky supervised the Joint Terrorist Task Force after the World Trade Center bombing in 1993. Today he's CEO of Kroll, a major risk consulting firm that's advising the U.S. military in Iraq. Timothy Quillin is an analyst with Stephens, the investment banking firm, where he covers many of the companies developing cutting-edge technologies for defense and security.
Mike, the President has asked for $87 billion to wage war on terrorism in Afghanistan and Iraq. We've certainly spend many billions over the past two years. Are we safer from terrorism today than we were on September 10, 2001?
MICHAEL CHERKASKY: No, we are not.
COLVIN: How can it be after all of the effort that has gone into it, all that we've been through?
CHERKASKY: You know, I think it's because we reacted in a remedial fashion to what happened, and that was understandable. We put guards in place, we tried to look at what had happened to us and focused on airline security. We rushed to try to close that gap without taking a systematic look at what the real risks were to our country, to our businesses, to our people. And I think we're still in that phase where instead of being thoughtful and having a logical plan and then carrying out those tactics, we still are knee-jerk reacting.
So we've spent a lot of money. There's some areas that we've done some good things in, but overall in the last two years, I think we've caused ourselves to be at greater risk than we ever have been in the last 20, 30 years.
COLVIN: Now it has to be said that it is in your interest to say that we are under-prepared. Your company, Kroll, has benefitted enormously from the fear of terrorism, its stock up over 200 percent in the past two years.
The fact is, we haven't had another attack in these past two years. Is it possible that we're actually doing a pretty good job?
CHERKASKY: No, I don't think so. Listen, you'd hope it would be so, and Kroll, 95 percent of our business is not physical security. So we've done other things right.
But again, you'd hope that we would spend money wisely, you'd hope we'd make the tough political decisions, but we're really not doing those kinds of things. We're still going through -- yesterday I went, flew from California, and I was screened and then re-screened and then re-screened again. So we continue to look at people, all the people who are trying to get on planes in the same way, and that doesn't make any sense.
We have gaps in who comes into this country, what comes in, the freight that comes into this country. As long as we don't understand who's coming into the United States and what's coming into the United States, it's very hard to have any kind of thoughtful security. And finally, the fact that we haven't really included the private sector as part of the solution: 85 percent of our infrastructure is in fact controlled, critical infrastructure, is controlled by the private sector, and they haven't been brought into this process as key players.
I think we're clearly not safer today, and that's very regrettable.
COLVIN: Tim, we've certainly seen a change in tone from Washington. In May the president landed on an aircraft carrier, stood in front of a backdrop that said "Mission Accomplished." This past week, it was something very different.
(Video excerpt)
BUSH: "We've taken unprecedented, effective measures to protect this homeland. Yet, our nation has more to do. We will never be complacent. We will defend our people, and we will win this war."
(End video excerpt)
COLVIN: So it's a shift from we've done the job, to we've still got a lot of work to do. Now, you have spent this past week visiting companies in northern Virginia, D.C., companies that could benefit from increased spending to fight terrorism. But could more money spent in Afghanistan and Iraq actually take money away from homeland security?
TIMOTHY QUILLIN: Right. I think to a certain extent the Bush administration has decided that the best defense is a good offense. And the best way to ensure our security in the long term is to help foster liberal democracy in the Middle East and the way, our starting point, or one of the starting points, is in Iraq. And certainly we can't, we don't have enough money to do it all. We don't have enough money to have perfect security. I'm a little less pessimistic than Michael, in the sense that I do think we are more secure at this point, and I think a lot of that is just knowing what the consequences are of not paying attention to security.
COLVIN: With all the money being spent now on fighting terrorism, what companies do you see that are doing particularly interesting work?
QUILLIN: Well, the certainly the operations in Iraq have been a reinforcement of the Rumsfeldian vision of network-centric warfare. And the companies that provide information technology to leverage people and platforms are in great position to benefit from defense spending for the next several years. Specifically we like SRA International, Titan Corp, Anteon International, and MTC Technologies to play that theme.
COLVIN: Now Mike mentioned the danger of things coming in apparently unregulated, unobserved through our ports as cargo. What's going on there?
QUILLIN: Well, absolutely. We're not completely protected in ports right now, and I see gradual improvement over the next several years. A company we like that makes container screening equipment is OSI Systems, and they have a broad portfolio of products that they can put into ports to help improve screening.
COLVIN: Mike, if the president hired you and said do whatever you want to make America safer from terrorism, what would you do?
CHERKASKY: First, I'd do a risk analysis. I think we have to really understand what the problems are.
But I think clearly we need to have a national identification card. We need it so that the 400 million people who cross our borders every year, we understand who they are, not just the people who are coming in, but actually who they are and some of the background of who they are.
I think we need to have, understand, clearly understand, what kind of freight. We have 20 million containers coming into the United States, and only 2 percent of those are inspected. We need to have inspections of every one of those containers, and that is only going to be done if private industry is in fact designated to certify those kind of inspections.
COLVIN: Well, and in fact we saw this past week that ABC News, with a lot of publicity, brought some depleted uranium through the port of Los Angeles or Long Beach through a cargo container.
CHERKASKY: And it could easily happen. We've been asked to do those kind of things, and we've declined. But I don't think, that is not just a publicity stunt. That is actually an everyday possibility, and we can't allow those kinds of enormous gaps.
I think there is the technology out there. I think there are the processes to make us substantially safer. But what we've chosen to do is kind of like the guy who puts the little card in his car saying no radio. We've allowed ourselves to say, "Well, there's not going to be an attack on airline security," but that hasn't made us more secure in general, because they're just going to go somewhere else. We need to have a system of security. I think there's some things that we can use, some of the companies that were just mentioned.
We have some tremendous technology. Let's use that technology to make, information technology, hard machine technology, to make ourselves safer. We can do it, and we can do it under a reasonable budget. But we just haven't taken those steps because there is a political cost.
COLVIN: Tim, you have some personal knowledge of what we're talking about here. You served in the Army during Desert Storm, as I understand a bomb disposal technician.
QUILLIN: Correct.
COLVIN: It's incredible. Did this help you. Does it help you understand in what you're doing now?
QUILLIN: Well, I joke sometimes that it just helps in figuring out the language of the military and understanding the acronyms that they use, and they certainly throw a lot of acronyms at us.
But I did see the impact of munitions that were not perfectly targeted. And the statistic I've heard recently is it took 30,000 sorties to kill one hard target in Vietnam. It took 10 sorties to kill one hard target in the first Gulf War. We can kill 10 hard targets with one sortie in the most recent Gulf War action.
COLVIN: The technological advances have been incredible. I'm afraid we're about out of time, guys. But Tim, do you have any disclosures you need to make?
QUILLIN: Disclosures are I don't own any of the stocks that we talked about and we are seeking an investment -- we should be seeking an investment banking relationship with all of the companies that we mentioned.
COLVIN: Tim and Mike, thanks so much for your time.
Smart money talks
KAREN GIBBS: So what's one sign of a great investor? It's the ability to keep cool in times of chaos and uncertainty. FORTUNE's David Rynecki has been talking to some of the most successful money managers and he joins us now from New York. David, what are these smart money managers doing? Is there a common theme or denominator?
DAVID RYNECKI: Sure, it's quality and value, two things that most investors really don't understand. When you talk to people like Bill Miller at Legg Mason and Bill Nygren at Oakmark, then they certainly do understand.
GIBBS: Well, let's talk specifics. Bill Miller, what's the key to his success?
RYNECKI: You know, you go back about two years ago, we were writing about this guy as if he was absolutely looney. He was buying Amazon.com at $80 a share. We thought, "What kind of a Legg Mason Value Trust is that?" Certainly didn't trust that.
Well, sure enough, he continued buying it all the way down to $7. He now has an average price of $19 a share. The stock is, I think it's in the $40s. He's doubled his money, he's made about $612 million on paper. That's how he's made his money.
GIBBS: Well, it sounds very easy for him but isn't it kind of risky for individual investors to try to catch a falling knife?
RYNECKI: Absolutely. It takes tremendous confidence and faith in what you're doing. You have to really understand the company and know that it's not going to go out of business.
GIBBS: What else is Bill Miller buying?
RYNECKI: Well, Bill Miller likes two companies that are really out of favor: He likes Tyco and he likes Nextel. Tyco, we're all aware of with the accounting problems. Nextel is a wireless company; it was once $80 a share with an incredibly high value, high P-E ratio. Well, the stock is now well below that, and the P-E is around 7. Well, he's buying this stock.
GIBBS: What's the story with Bill Nygren?
RYNECKI: Bill Nygren, it's interesting. He's similar to Bill Miller, Nygren likes to buy these deep value stocks.
Some of his favorites are Sprint and Nextel, the wireless companies. Interestingly, the two Bills both like some of the phone-oriented companies, sort of telecom companies.
Nygren is also a fan of Washington Mutual, which those of us in New York and probably around the country have seen these little boutique banks opening up on various corners.
GIBBS: So you've got telecoms and you've some of the consumer companies, some of the financials there. What about bonds? We've heard a lot about the bubble. What are smart money saying about bonds?
RYNECKI: We were recently talking to Bob Rodriguez, who runs one of the more successful bond funds of the last decade, consistently beating the Lehman Brothers Aggregate Index, which is the benchmark for bonds.
Surprisingly and shockingly, he's hardly buying anything in bonds. He's very negative on bonds for the first time in many years. His feeling is that we do have a bond bubble, that it is bursting, that rates are going to be going higher. So what he's done is that he's got 31 percent of his money in cash. The money that he doesn't have in cash, the money that's actually in bonds, he has in Treasury inflation-protected securities, also known as TIPS. Those are a way of protecting your wealth.
GIBBS: All right. David Rynecki, thanks for joining us.
Roundtable discussion
GIBBS: Well, those guys David and I just discussed get the headlines, but there are a handful of other extraordinary investment pros that may not have hit your radar -- until now.
Pat Winans is one of them. As CEO of Magna Securities, she sees where big time pension funds and money managers are putting their money long before the rest of us.
Ron Muhlenkamp runs one of the best all around stock funds in the country. His Muhlenkamp Fund is up about 26 percent so far this year. So, Ron, are we in a real bull market or is this is bear market rally?
RON MUHLENKAMP: We're in a bull market, mostly because the economy is coming back. Things got delayed over the last 18 months, all the way from 9/11 through March or April of this year with the Iraqi war. But the economy is coming back and the markets are coming back. So, yes, we're in a long-term bull market.
GIBBS: Pat, do you agree with Ron? Are we in a recovery?
PAT WINANS: We absolutely are. And I think one of the biggest trends that we've been seeing, is we've been seeing pension funds pouring billions of dollars out of the S&P 500 and putting that money into value-cap stocks that are actively managed.
I think I would agree with Ron in that right now is a time to pick stocks. Right now is a time to be proactive. And as we see those managers get more and more money that's pouring out of the S&P 500 index because plan sponsors are looking for more yield, they're looking to beat the benchmark, we see them going into financial stocks, drug stocks, some defense stocks, but again, the commodities, as Ron mentioned. A lot of basic industry stocks where you have people that are now looking to ramp up their production again, they're buying stocks that have paper, copper, steel.
MUHLENKAMP: This is where the operating leverage is as you come, as the economy expands and you come out of a recession, it's in these kinds of companies, and therefore, those kinds of stocks.
GIBBS: So, Ron, do you believe that it is a stock pickers market, as like Pat said?
MUHLENKAMP: Absolutely. One of the other things that happens -- and, see, we think we're back to normal, but it's a normal we haven't seen since 1965: inflation of 1 or 2 percent, interest rates are now fair, they're about inflation +3, stock prices, we think, are fair -- but you also, in nearly every industry, have ample capacity. That means that if you're going to do well, you're going to do well at the expense of your competitors. So you can't just buy discount retailers -- for instance, if Wal-Mart does well, it would do well at the expense of JCPenney and Kmart. You can't just buy autos. In any industry, you'll have to pick the people who are beating their competitors. And i think that's just about a definition of a stock pickers market.
GIBBS: Now, Pat, you earlier mentioned that there is a lot of money flowing into large cap value stocks, and I'll ask both of you this, do you think that that's the place to be right now?
WINANS: Yes, given where we are at this phase of the recovery, that's exactly where you want to be. Two years ago, when we first sort of went into the recession, there was a big play: plan sponsors were looking for small cap, and as you go up sort of the Dow curve of, you know, 9,000 to 9,250 to 9,500, you want to own larger and larger capitalized companies because they're going to be poised for that recovery when it actually does turn around, and I think we're well on our way.
GIBBS: Ron, isn't that against conventional wisdom that always says small caps lead us out of the recovery?
MUHLENKAMP: We look for value any place we can find it. And three years ago it was almost all small cap. Ten years ago it was big cap. Now we're, it's across the board, but we think we've picked individual companies that are beating their industry. If they happen to be big that's fine, if they happen to be small that's fine.
We've never found size to be useful criteria. I know it's popular because it's easy to measure. But we think you go for the good companies and value wherever you can find them.
GIBBS: And value, again, is anything that is lower than the market P-E.
MUHLENKAMP: Well, no. To us a good company is a better than average return on shareholder equity. If you can get a better than average on shareholder equity, and then a P-E below, we want a P-E below the R-L-E.
So we don't want to junk company at any price. We tell the public we're trying to buy Pontiacs and Buicks when they go on sale. Right now there's probably a few Cadillacs on sale. They don't go on sale very often, but we don't want a Yugo at any price. So we don't want a shlock company, we don't care what it's doing. But if you can get a better-than-average company at a below average price, that's a pretty good combination.
GIBBS: So, what are you buying?
MUHLENKAMP: Well, we start again with housing. The other thing that we've noticed is that once in a while, the public shifts their focus a little bit. Across the '90s recession, they came in buying housing and cars, they came out buying financial stuff. In the first half of the '90s, Merrill Lynch's revenues grew faster than Kmart.
This time, they're kind of shifting back towards things relating to housing. We find it fascinating when the economists say, "Well, gee, the economy's been too slow and it's got to pick up." and I say, "Well, they're buying housing." "Oh, but they can't sustain that."
GIBBS: They're trying.
MUHLENKAMP: Well, but they are.
GIBBS: A lot of people thought this was a real estate bubble. You don't buy that.
MUHLENKAMP: No.
GIBBS: Okay.
MUHLENKAMP: It might be in a couple neighborhoods, it might be in the Hamptons or places (like that). Certainly not in the stocks. I mean, (housing) stocks are 7 or 8 times earnings. If they were 30 times earnings, I'd worry about it.
GIBBS: Okay, let me get some names.
MUHLENKAMP: Centex, Lennar, NVR Industries, Meritage.
Early this year we were buying mainly things like Capital One financial -- they're the credit card company. Usually the news gets the worst for credit card companies about 15 to 18 months after the bottom of the recession. We've been told the recession bottomed in november of, I think -- somebody asked me 6 months ago, when the recession bottomed, I said "By the time they tell you it will be too late, don't worry about when they tell you." So those are the kinds of things, and we're looking for things that have leverage as the economy expands as you come out of this recession.
GIBBS: With this housing market, and it's being as hot as it is, not only the financing is interesting, but you're finding opportunity in the things that go into housing.
MUHLENKAMP: Absolutely.
GIBBS: Let's talk about that.
MUHLENKAMP: Try going into a Best Buy and finding a flat panel TV -- they're sold out. Carpets, Mohawk carpet. Furniture, Stanley Furniture. What we hear also from the managers of large department stores, we ask what people are buying, they say anything related to the home. And if you ask your neighbors. I learned a long time ago that if your neighbors tell you one thing and the economists tell you something else, go with the neighbors.
GIBBS: All right, Pat, let's talk about the bond market. Is there any life left in this bond market party?
WINANS: Well, I think interest rates are definitely on the way up. I mean, if you can interpret Fed speak, the indication that we see from people that we talk to is that rates are on the way up. And what we find particularly interesting from a brokerage perspective, because we talk to all types of investors, are municipal bonds. I would say that now is the time that munis are going to be back in play.
GIBBS: Why?
WINANS: They're tax exempt. And in New York, and many other states, they're triple tax exempt. So if you factor in the fact that you don't pay Federal taxes, you don't pay state taxes, you don't pay city taxes on New York City paper, then you'd have an equivalent yield that would be much more attractive than that of a Treasury right now.
GIBBS: But you have a lot of states in dire straits terms of budgets. Doesn't that mean then we're going to flooded with supply?
WINANS: Yeah, debt, debt and more debt. The Treasury has obviously to issue more debt. And municipalities, because they're not taking in the tax receipts and they need to cover these shortfalls, they have to now issue bonds. I mean, probably in the worst case scenario, the state of California has to issue some $17 billion worth of bonds. I saw on the cover of the Connecticut Times just earlier this week, that they (Connecticut) have got to issue $1 billion worth of bonds. So the states and municipalities are hurting.
MUHLENKAMP: Pat, aren't you also going to see a lot of people rechecking their numbers and comparing dividends to both munis and bonds? With the new tax rates, all of a sudden -- in the past, people have never really compared corporate dividends to munis.
WINANS: That's exactly right. And you do have some stocks that are yielding, if you will, if you consider what the dividend is paying in the new tax code, 6 and 7 percent. So now you have these types of dividend-yielding stocks that are also competing...
MUHLENKAMP: Which would be 5 or 6 percent after tax.
WINANS: Exactly. That are now competing with Treasuries.
GIBBS: Now Ron, you're talking about the financials in terms of the credit cards, but don't you have a big bank that would be a big play on the international, the global area?
MUHLENKAMP: You start with Citigroup.
GIBBS: There you go.
MUHLENKAMP: They're a world bank. I was asked several years ago to name a stock for a decade; you know, who knows what a decade's going to do? But I said Citigroup, because there's major parts of the world that are moving toward freer markets and people are going to need banking, and city's in a place to take advantage of that.
GIBBS: Pat, are you seeing any institutional money going international?
WINANS: We've seen a little bit of it where people can get into smaller capitalized international stocks, emerging markets. But I think we've seen probably a bigger trend coming out of some of the developed countries and yet coming back into the U.S. And going back into large-cap domestic stocks.
GIBBS: Thank you very much, Ron Muhlenkamp and Pat Winans. Thank you very much.
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