Lappin/Farr discussion
KAREN GIBBS: Standing out in the crowd and going against conventional wisdom may have the guys in the white coats after you, but it can also make you a lot of money. Our guests tonight have nothing to fear from the former and have made lots of the latter.
Joan Lappin is one of the few who called this bull market in the dark days of last October, and her Gramercy New Millennium fund is up nearly 40 percent so far this year. Michael Farr says the rally may take a breather, but we’re still in a bull market period.
Well, good to see you both. Let me start with you, Mike. The big picture, earnings, it’s all about earnings.
MICHAEL FARR: It’s about earnings and it’s about the economy. Earnings are improving. We’re hearing that IT companies are seeing greater end market demand. The economy’s improving. This is a recovery, so I think that certainly we have seen this advance without much of a pause. We should expect a pause, but the trend is up. Don’t fight that trend.
GIBBS: Joan, do you believe that?
JOAN LAPPIN: I do. I agree. And I believe that there, I do believe this. It’s not clear to me that the stock market is just going to go roaring forward, and I’ve said that ever since I suggested that the market had turned on your show last October. I believe we’re in a stock-picker’s environment, and the people with good analytical skills who can pick and choose well are the ones that are thriving now and will thrive.
GIBBS: What about bonds, the argument of stocks versus bonds? Would you put a dime or a dollar in bonds now?
LAPPIN: I wouldn’t put a penny in bonds, and the reason is very simple. This year if you -- we did these statistics last week to just compare, I believe it’s the 10-year (Treasury) notes (that) have provided a 2.2 percent yield for the nine months, compared to 11 or 12 (percent) for the Dow and substantially higher for the S&P, and much higher for the Nasdaq. So if you consider this year, you didn’t actually lose money in bonds; you lost opportunity cost.
Next year you’re not going to be so lucky. If interest rates go higher, and I believe they will, then you will actually lose money in bonds. You won’t just lose the opportunity to have made back some of your nest egg in the stock market like you have this year.
FARR: And most people don’t understand that you can lose significant money. I mean, Joan’s not talking about you can lose 2 or 3 percent. You can lose 15 and 20 percent in a 10-year Treasury after you’ve received the dividend. We saw that in 1991. The 10-year Treasury, over the course of 12 months, you had a negative return of around 17 percent.
GIBBS: So you’re not buying bonds either.
FARR: I’m not buying bonds either. Well, certain clients need that anchor, require that anchor, and for those clients we’re keeping those maturities very short, because we don’t think you should ever speculate for income.
GIBBS: Well, Eastman Kodak has been a household name for years, and some think it’s been one of the most mismanaged companies over the past 5 years. Fuji Film ate their lunch, and they missed the whole digital revolution. To add insult to injury, Kodak plans to slash its dividend.
Joan, you’ve been following this company closely. Give me two reasons to buy Eastman Kodak.
LAPPIN: Well, I don’t know that I can give you two reasons to buy, but I can give you some food for thought on how to look at the Kodak situation.
GIBBS: I’ll bite.
LAPPIN: And the answer is, we should not "dis" Eastman Kodak totally, because they have in fact been leaders in the move to digital photography. Unfortunately, like other companies in the past -- and I would give you IBM as an example; IBM invented PCs and then did nothing to exploit them. Motorola was one of the leaders in developing digital telephony but was making so much money off of analog phones they were slow to move forward -- and it’s the exact same case with Eastman Kodak, where they believe they invented digital photography, and I’m willing to take their word for it. And they were making so much money in the film business that there was a schism inside the company. The film folks didn’t want in any way to see all the money that they were making funneled off into developing digital.
But now it’s clear, everybody’s running to own a digital camera, e-mail pictures of their children, grandchildren, you know, whatever here and there. And there’s no stopping that train. So Kodak, in my opinion, has no choice but to charge forward. And if the only way they’re going to have the cash to do that is to cut their dividend, I don’t know what other options they have. I think they have to cut the dividend, and now the question is execution.
We don’t know if they’re going to be able to execute their plan, but I would say this about their plan. If I were running that company and I were trying to take it in a new direction, brought in a whole bunch of new managers as they have done, what kind of a plan would you put out there? If you’re not an idiot, you would put out a very low-ball plan, and then you can beat the plan. So people are attacking them: "Oh, my heavens, you’re going to spend all this money, and at the end of the day your sales are only going to go up 6 percent." If they don’t spend the money, if they don’t make acquisitions, their sales are going to drop 25 or 30 percent. So I think that’s the way you have to look at Eastman Kodak now.
GIBBS: Mike, do you think, though, that they’re coming late to the party for this digital game, particularly the digital printers? They’re up against some heavy hitters, Hewlett-Packard, Canon, Lexmark, who made their mark in this area. Can Eastman Kodak take some ground away from them?
FARR: Well, you know, I think that what’s been said is exactly right. They were enjoying the cash flow and the earnings from the film business, and they wouldn’t let go. My problem with Kodak right now is, why as a shareholder do I own it? They’ve just seen their debt rating downgraded. They have to make all sorts of acquisitions, and I don’t think they have a well-articulated plan. I think that management, I think Daniel Carp is really, one, I think he’s a good guy. Having talked to him a couple of times, I really do. And I don’t think he has much of a choice other than to rebuild or build something new that doesn’t exist now, because the old model isn’t going to get it done.
Okay, the old film model is not going to get it done. But if you are that, if you’re Mr. Carp and you’ve put this strategy together, I think he needs to sell that strategy. I think he needs to take that strategy to Wall Street analysts, explain to them what he’s doing, and try and garner some support instead of going into these shareholder fight meetings like they had yesterday.
GIBBS: Because the institutional shareholders aren’t buying this plan at all.
FARR: They don’t know what he’s going to do.
LAPPIN: I disagree, because I went to that meeting yesterday. I thought it was quite hilarious. That Provident Capital Company held a meeting, and they’ve whipped up everybody in the press. They were marketing to get a client. They’re hoping that they can agitate enough that half a dozen large shareholders will retain them, and they said so much at the meeting. That was a marketing meeting for Provident. That was not an anti -- I mean as much as they wanted it to be an anti-Kodak meeting, I don’t think that was the feel in the room. I think half the people were there because they were curious. That’s why I was there.
FARR: But Bill Miller from Legg Mason has joined that group, and he tends to be a fairly serious investor. I mean to me, I agree with you about sort of Provident’s motives, but I still wonder what are you going to do? How are you going to do it? Why do I remain a shareholder while you increase debt at a higher cost of debt in order to build a what? You need to reinvent yourself. I think they probably can, I just want to know how.
LAPPIN: I’d like to add one thing. I thought about this the last few days, and I asked, I called them and I said, "You know, if somebody were to think of the top brands in the world, where would you fit in that list? Would you be in the top 20 or whatever?" And the answer I got this morning was there are several surveys that measure different things, brand loyalty, people’s view of your delivering a quality product, and so on and so forth.
They said, they named one particular company, I can’t think of the name now, who had conducted this survey, and their brand was considered the number one global brand in terms of people’s image of quality. Now, I don’t think that a company that still has that fine a reputation should give up, like some of these shareholders are suggesting, and just milk the cash cow, pay out the dividends until there’s nothing left and they become Polaroid.
FARR: I agree with that entirely, I agree with that entirely. I don’t think they have another choice. If you’re CEO of that company, this is what you have to do.
LAPPIN: And besides, if they do that, if they follow that plan, my guess is that within three or four years, the same people that are complaining that they’re cutting the dividend would be suing them for dissipating their assets and doing nothing to save the company.
GIBBS: They can’t win either way.
LAPPIN: Right.
FARR: But I don’t want to own it...
GIBBS: You don’t want to own it.
FARR:...during that process. There are other, I think, good, reasonably valued companies that are growing with a well-articulated strategy that are pursuing it and executing. So I think there are other places to put money.
GIBBS: Such as? Give me some names.
FARR: I like Pfizer. I like General Electric.
GIBBS: Those are the same two that you had at the end of the year, so you still like them.
FARR: And those two, of the list of 10 that I had coming into 2003, haven’t moved very much. They still represent I think good value. Pfizer has continued to execute. They have been brought down with the group. And so I like to put money into stocks that perhaps haven’t moved all that much and still have good earnings and are still executing. And to that list, you know, both of them have dividends in excess of 2 percent, and to that list I’d add Bank of America, 11 or 12 times next year’s earnings, paying a 4 percent dividend. For me there’s money to make there. People that are patient with Kodak are probably going to do fine. I probably just am not as patient.
GIBBS: At the end of the year...
LAPPIN: I want to add Kodak, even with the cut dividend, is paying over 2 percent.
GIBBS: At the end of the year, you happened to like Nextel and Providian. Are you still holding those?
LAPPIN: We are still holding both, and they are still among my preferred stocks. Providian is probably still my single best idea. You know, we started with it at $4. I think when I was last here it was around $10. It’s now about $12.50. My target remains $20. And it’s a turnaround. It’s, we’re two, almost, we’ve completed almost two years of what management stated would be a three-year turnaround. And I think that next year the earnings could double from this year.
The same thing with Nextel. My case at the beginning of the year was a credit upgrade, which has happened. Paying down debt, which has happened. The FCC, the Federal Communications Commission, clearing the 800 band and giving them a lot of contiguous bandwidth so that they can more efficiently operate and build out their system in the future. Add to that, my expectation was this year they would earn between 50 cents and $1.00. They are now leading people to $1.15 (in earinngs). So to go from no earnings in your first year of making money to over $1, I find impressive. And I’ve spoken with them this week, so this is very fresh info, and they’re now saying, if you take our latest quarter, and we don’t have any growth next year, we’re going to earn close to $1.80 to $2. So at that point, what seemed to be maybe a fully valued stock over $20 -- I’m sure it will have a little rest here -- but if they’re really going to earn close to $2 next year, then the stock is still, it’s 10 times that, and that’s too cheap for what seems to be the leader in wireless telephony.
GIBBS: Joan, you’ve also bucked the trend with Motorola. Talk about Motorola and why people should own that.
LAPPIN: Motorola I think is one of the great technology companies in our country. With all the turmoil that has gone on there, no one has ever accused them of not producing outstanding products and the like. I think we, I mentioned them earlier in the Eastman Kodak context, that they invented or held many of the very early and most important digital telephony patents, and then didn’t exploit them. Now they have had to play catch up.
One of the things that I think is important to understand is that they and Nokia are both going to have a problem going forward because now one of the hugest markets for those guys was China and that whole Asia Pacific region. And now you have springing up major manufacturers within China that are going to serve the Chinese market and also in other parts of Asia. So what happens is people look at Nokia as a last cycle, big winner. I have no problem with the company. It’s just that stock is not going to run and make you the kind of money it did. I look at Motorola and say, been down so long, looks like up to me.
GIBBS: How about your feelings on Nokia, Mike
FARR: I like Nokia better than I like Motorola by a good measure. We own Nokia. We used to own Motorola. And one thing, Joan’s explanation is a very thoughtful, on-target explanation for I think a contrarian rebound. But Nokia to me has 39 percent market share versus around 16 percent for Motorola in the hand-held phones. Margins at Nokia are something higher than 12 percent. At the peak a couple of years ago, Motorola was at around 5 percent on their margins. They’re 18 times, Nokia is 18 times next year’s estimates. Motorola is 31 times estimates. By most valuation measures, balance sheet, other things, I think that you own Nokia.
I think that they continue to execute and I like the numbers better. If the market moves against us again, I think that this sort of earnings strength and market share and margin and balance sheet will leave you in better stead. I’m always thinking about the more defensive position there. Motorola is down, too. I mean you probably would argue it’s not going to go a lot lower, but I like Nokia.
GIBBS: But you see more upside in Nokia.
FARR: I prefer Nokia.
LAPPIN: If you went back a decade, though, I think it was Motorola that had the huge market share and Nokia was the, you know, new kid on the block that came in and took it away from them by manufacturing in a much more efficient manner and just doing a lot of things better. But at this point they’re the ones with this very high (market share), more than a third of the market, and they’re the ones that have the most to lose to the Chinese.
GIBBS: Where else do you see some opportunity for investors, Joan?
LAPPIN: Well, I have always, I always have something going in the biotech area, and one of the companies I like there is Cephalon. The stock is actually down a few dollars for this year, and they have a drug called Provigil, which was approved a year or more ago for narcoleptics, people that just can’t stay awake. And just in the last 10 days, Provigil has been given an expanded label so that it can be used by people who work night shifts and so forth. They’ve done studies that the Three Mile Island accident happened because people were exhausted. And you know the circadian rhythms or whatever they call them that want us to be up during the day and sleeping at night are disrupted for night shift workers. And so that’s just one of many new opportunities for them to market, and I think that drug is going to grow to be $1 billion drug.
GIBBS: Would you be in biotechs on that rollercoaster or would you want something a little bit more sound and secure?
FARR: Yes.
GIBBS: Tell me what.
FARR: Well, I actually think that you have to have some representation in your portfolio, if you’re in healthcare, in biotechnology. It is the fastest growing area, you know, productivity gains from the computer and IT side are going to benefit biotech stocks almost more than any other growth industry right now in their ability to do analytics. So I like biotechs. I think that you need to diversify and not overweight in any one particular biotech because many, many, many of them still don’t have earnings. They’re bleeding cash. With really good R&D pipelines, it’s just a matter of which one comes through. So I think it’s a part that needs to be a diversified part of an overall healthcare section in your portfolio.
LAPPIN: I think Mike has made a very good point, and I would point out there are only about somewhere between a dozen and two dozen companies that do earn money, and Cephalon is in that club.
GIBBS: Did you have some financials that you wanted to talk about?
FARR: I like the financial stocks in general right now, and I like AIG, I like Citigroup, I like Wells Fargo and Bank of America. All are selling at fairly low multiples. Most people are worried about what happens when the mortgage refinance market sort of stops. But a lot of these major banks are seeing an increase in investment banking revenues. They have demand deposits and they’ve been growing demand deposits.
Bank of America picked up a million new checking accounts so far this year. As interest rates rise, I think they’re going to get great leverage there and they’re going to be able to replace a lot of that revenue and earnings stream. So I like that sector, also because it hasn’t performed very well. I don’t like to buy the things that are moving very much with new money.
LAPPIN: Well, Citigroup is near its all time high. AIG, however, is way down, so I’d love to hear why you want to own AIG.
FARR: I like to own AIG right now because it is way down and because I think that the earnings power is, continues to be with AIG. I like their market share. I think they’re certainly going through a leadership transition at AIG. But long term I think that there’s value there. The price gains in Citigroup have been terrific, but the valuations are really, they’ve been earnings driven. They’ve been driven by the fundamentals and not by a margin expansion or an expansion in valuation. So I think it’s still reasonably priced.
LAPPIN: But AIG, do you see AIG’s earnings going up now?
FARR: I think AIG’s earnings over the next three to five years are going to increase probably at a rate of around 9 to 10 percent, yeah. So something superior to the broad market.
GIBBS: Michael Farr, Joan Lappin, thank you very much for joining us.
FARR: Thank you.
LAPPIN: Always a pleasure to be here.
FORTUNE roundtable
GEOFF COLVIN: It’s great to hear bullish views on U.S. stocks, but if you look overseas will you feel better or worse? President Bush is just back from Asia, where he faced hot-button issues -- the war on terror, nuclear proliferation, trade -- that could have major effects on companies and the U.S. economy.
Here at home, Wal-Mart’s in the news in a big way, which is almost always significant, and sensational revelations in the trial of Dennis Kozlowski, the livin’ large former CEO of Tyco who was apparently livin’ even larger than we knew.
For insight into it all I’m joined by my two FORTUNE colleagues, senior writers Bill Powell and Jerry Useem, and also the Time magazine deputy bureau chief in Washington, Jay Carney.
Jay, is the world a safer or more dangerous place than it was one week ago?
JAY CARNEY: Well, I think it may be marginally safer for a couple of reasons. One, primarily the Iranians have come to a tentative agreement with three European nations to basically show and tell with their nuclear programs to prove their contention that they are not developing nuclear weapons, as the United States and much of Europe fear. Now that agreement that they’ve reached may not materialize into an actual agreement to the point where the Iranians come clean, and that’s what the Americans are worried about because Tehran was clearly trying to cut this deal with the Europeans as a way of further dividing our European allies from the United States.
COLVIN: Bill Powell, this issue of Iran and its nuclear program has not actually been getting as much attention in the U.S. as sort of daily developments in Iraq. But I gather you think it’s as least as important.
BILL POWELL: Well, certainly in the medium-to-long term, Geoff, it is. If weapons of mass destruction and the proliferation thereof are the signature issue of our time, which I think arguably they are, then you have to look at Iran and North Korea and their evident ambitions to develop nukes as critical issues, both for regional security issues in their own neighborhoods, and also for the possibility of proliferations, that is giving the nukes to bad guys.
COLVIN: Well, you mentioned North Korea, which seems like a huge issue. Now how would you rate the Administration’s handling of it so far?
POWELL: So far I think it’s been good actually. It is not unilateral. They are going out of their way to include the critical players in the region, South Korea, Japan, and China, most importantly. The President on this trip stressed that it was going to try to be a multilateral solution. And I think a lot of the talk that we’ve heard kind of subterraneanly in Washington over the last year about an Aus-Iraq style strike, that is going in and taking out the North Korean suspected nuclear sites. You’re not going to hear that kind of thing much at all. Clearly they’re looking for a diplomatic solution.
COLVIN: Well, exactly. And what we’re talking about in the big picture is the safety and security of the world. Jay, I want to ask you, if you were a money manager looking at all of this and really trying to decide whether you had to rethink your strategy and you looked at this week’s news, how would you analyze it?
CARNEY: Well, I would still look at Iraq as a primary concern when it came to making predictions about the future stability of international markets and the American economy, because Iraq is a war that’s being fought right now. The worries about future conflicts potentially with Iran and North Korea are somewhat more off in the future.
Iraq continues to be a festering problem. As Secretary Rumsfeld at the Defense Department made unwittingly public this week in a private memo that was leaked, he’s as concerned as a lot of Americans are about how that war is going and how the overall global war on terror against al-Qaeda is going. And his assessment was pretty bleak. And the more we see body bags coming home, American soldiers killed in Iraq, the more Americans focus on the fact that this is a long slog, as Rumsfeld put it, that’s going to cost tens of billions of dollars over a number of years, I think the more fear Americans and money managers might feel about this recovery that’s underway in the United States and how long it will last.
COLVIN: Well, we’re going to come back to some of these issues, but I want to get to another thing in the news, Jerry, which is Wal-Mart, the world’s largest company. Almost everything that happens to it is significant for markets and other companies. This week of course the big raid on Wal-Marts all over America because a contractor -- not Wal-Mart itself -- but apparently contractors, were employing illegal aliens.
Other than that, the big supermarket strike in Southern California is really all about Wal-Mart because it’s coming into California, paying workers much less than unionized grocery workers there make. In fact, I believe that the grocery workers in California make an average of just over $19,000 a year. The average Wal-Mart sales clerk gets $14,000 a year. So the big grocery chains -- Albertson’s, Kroger, Safeway -- want their workers to take a pay freeze. They go on strike. What’s the big picture?
JERRY USEEM: Well, you know you’re a powerful company when you’re making other companies’ employees go on strike. The big picture here is that retail, and Wal-Mart especially, is the new battleground in terms of labor and employment issues. It’s hard to judge the seriousness of what happened yesterday with the raids on the offices. But again, 1.4 million employees, it’s almost hard to put that in perspective. It’s bigger than the Army. It’s about four times as big as the next private employer. And it’s the sort of thing where we’ll probably be hearing a lot more about issues between Wal-Mart and their employees.
COLVIN: They seem to be getting pounded a lot in the press just on the public relations front about employment practices, one thing or another, sort of month after month after month. Is it hurting them?
USEEM: I think they are beginning to realize they’re very vulnerable on it. In fact, some research has indicated that people, that corporate reputation, the number one factor going into it is people’s perceptions of how a company treats its employees. And they’ve started running a couple of TV spots featuring happy employees and such. So I think they are taking a more, they’re starting to worry about it.
COLVIN: Let me ask you about another big story this week that you’ve been on, which is the Dennis Kozlowski trial in downtown Manhattan. I gather you’ve been attending. There have been some sensational revelations. How’s it all look to you? How’s it going to turn out?
USEEM: Well, it is high theater. As we found out yesterday, he’s was allegedly having an affair with a former marketing manager who took the stand.
COLVIN: Well, they both seem to have admitted that.
USEEM: Right. But she then alleged that she was living in an apartment that was paid for by Tyco funds. Kozlowski had obviously a very big share the wealth program. He’s accused of being greedy, but he’s an extraordinarily generous guy in a kind of, appears to be kind of three for me, one for you sort of way.
COLVIN: Right. And the allegation is that this was to help keep people quiet of course, to cut them in on the deal.
USEEM: Right. Well, it’s interesting. The defense is essentially yes, we took some of this money, but the board let us. So both sides are airing the maximum amount of dirty laundry. So kind of both sides are prosecuting corporate excess.
COLVIN: Do you get any sense that the jury might turn on him regardless of the legal technical issues just because he was taking so much money out of the company, it was so excessive?
USEEM: Well, I think this little affair with the woman is important, and from a legal standpoint it’s probably very tangential, but the numbers are so complex that you’ve got to very kind of concretely say this is about lying, cheating, and stealing in ways that are easily understandable. I mean I’m spending half the time trying to figure out where they’re headed with such and such question. So we’ll see how it turns out, but they’ve got to somehow find their way out of this morass of numbers and make it clear that’s what it’s about.
COLVIN: That’s what it’s all about. Jay, I want to get back to some political concerns, Washington concerns, and that comes down to the election, not only the effect of the election on the economy, but the effect of the economy on the election. If you had to make a bet on the President’s prospects right now, how would you rate them?
CARNEY: Well, if I had to go to Las Vegas and place money on who would win the election next year, I’d still say the good money would go to Bush. He is the incumbent President. His numbers, while significantly below what they were, are still above 50 percent in the polls, his job approval rating. And no single Democrat has emerged yet in a compelling way as the preeminent challenger to Bush. The Democrats, you know, there are nine candidates and there’s a plausible path to victory for the nomination for at least four of them.
So I think Bush is still in a reasonably strong position, but there are a lot of things that he doesn’t control that will control his fate. The situation in Iraq is a big one. If we are no better off there a year from now than we are now, I think he’s in a world of trouble. And the economy, the recovery is another problem. Even the most optimistic assessment from his administration on job creation over the next year would still leave him with a net job loss in his first term, which is a position no president seeking reelection wants to be in. In fact I’m not sure any president has ever been reelected heading into the cycle with a net job loss on his watch.
COLVIN: If the economy is growing, and the signs are now that it is returning to growth, let’s suppose it’s growing at a respectable, if not rip-roaring, rate of 3 percent or so, the unemployment rate’s coming down, does that pretty much put it in the bag for him?
CARNEY: Well, it all depends on perception. Remember that the first President Bush, by the time the November 1992 election occurred, the recession was over and the economy was growing, but Americans weren’t aware of it because, as we all know here, jobs, job growth is a lagging indicator in an economic recovery and we could have several successive quarters of robust growth but still have a situation where a lot of Americans feel economically insecure.
What the Administration interestingly is counting on is for the markets to be the signal to Americans that the economy has now rebounded. Sixty percent of American voters are investors, and when they see their portfolios growing, their 401(k)s, their retirement funds growing with the market, they’re hoping, they and the Administration, that voters will thank Bush for that and reward him at the polls.
COLVIN: Bill, let me ask you briefly another question about perception. Before the Iraq war, conventional wisdom said the markets hate uncertainty, that’s why the markets were going nowhere. The markets now are booming, but if you look at the news, look at the world, there seems to be at least as much uncertainty as there ever was before. So what’s the explanation?
POWELL: I think the explanation is that Iraq for the moment -- let’s just take Iraq as an example --just basically isn’t affecting the price of equities. You have, even though you have an $87 billion price tag and high budget deficits, you still have long term interest rates at very low levels. Yes, they’re up from where they were a year ago, but you still have extraordinarily low rates. So while there is a lot of talk about the potential impact that Iraq may have and funding the long term reconstruction of Iraq, I don’t think it’s really showing up yet and not in a tangible way to voters.
COLVIN: Got it. Jay Carney, Bill Powell, Jerry Useem, thanks so much.
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