Market roundtable
KAREN GIBBS: At the risk of mangling an overused cliché, these are the times that try investors' souls. Gasoline is soaring over $2 a gallon in many parts of the country. Inflation is now unquestionably on the rise. And the pictures coming out of Iraq get more disturbing by the day.
But -- and there's always a but -- by most measures, the economy is in pretty good shape. Corporate earnings are on the rise, and the "Help wanted" signs are even showing up again. Yet anxiety seems to be the only real emotion guiding the markets.
Steve Romick's FPA Crescent Portfolio is one of those unique funds that can boldly invest wherever he wants, and for now, he wants out of the market. However, Wall $treet Week with FORTUNE contributor Michael Farr says this uncertainty can create opportunities.
Steve, these are difficult times for investors to know what to do and where to put their money. Where are you finding value?
STEVE ROMICK: Today in the market we are finding value, and one place is cash. It's only one part of the portfolio. We're still, it's not that we want out of the market, we are looking at investments today that currently represent, stocks that represent 50 percent of the portfolio, and we have some high yield and distressed debt investments in the portfolio as well, although at a low, or the lowest we've been in the last 11 years in that sector. We're sitting with about 35 percent net cash in the portfolio because today the opportunities are not as plentiful as they've been in the past.
GIBBS: Why do you think that the opportunities are not as plentiful? What's behind that?
ROMICK: We're very disciplined investors. We look at each company one by one and determine whether or not the risk/reward of that particular investment provides us with an opportunity, a chance to get a reasonable amount of upside, a good amount of upside with only a small amount of downside. And in today's environment, it's not that the stock market is so ridiculously expensive, it's that the investments that we're finding don't offer us the opportunities to make a lot of money with a reasonable amount of risk.
GIBBS: So you put them in cash. You've got a lot, you say 35 percent. That kind of makes you one of the most expensive money market funds, if you were to be judged as a money market fund.
ROMICK: Oh, absolutely. As a money market fund, you wouldn't want to invest with us. For that matter, if you think the stock market's going from here to the moon, you know, we're a bad investment for somebody. But I think that people who do invest with us have succeeded over the last 11 years. We've been the number one performing balance fund over that time, and we've beaten the stock market, almost all the indices, I think up to this point in time with far less risk than the market. In fact we've had less than 60 percent in stocks on average in that time frame. And we've had better than market, stock market rates of return.
GIBBS: Michael, what are you telling your clients that may want to have a cash position but don't want to stuff it in the mattress?
MICHAEL FARR: Well, if you want to have a cash position because you need money to be defensive, then I think short-term instruments, and in particular short-term CDs, certificates of deposit, are showing a bit better yields for the individual investor. And rather than make some sort of long-term bet, even though 5-year CDs will pay you a much better yield, I would suggest that you keep your money short somewhere between 6 and 24 months, and you can put together a ladder. You buy different maturities, so that your short maturities, when they come due you reinvest them out on the longer end, and as rates go up you should be able to increase the yield of your portfolio and keep your cash.
GIBBS: Steve, you like the small and mid-cap stocks when you do see some value. Why?
ROMICK: It's easier, they're easier for me to understand. I mean most large companies have multiple divisions, and small and medium size companies have fewer divisions. So for the simple-minded people like me, it's beneficial to go out and look at companies that do one thing. So if I have a portfolio of 30 stocks, I might have a portfolio of 30 businesses. As a large-cap manager, if you have a portfolio of 30 stocks, you might have 90 businesses that you need to analyze. So it's easier for me and it's a less efficient market for me to look to excel.
GIBBS: Having a very nimble cash position of 35 percent means that you can take advantage of things when you do see opportunities, and I know that you've done something in the energy sector. We've seen crude oil top $41 per barrel, it does appear that it's kind of late for someone to be getting in on the energy sector. How do you play that, Steve?
ROMICK: Well, the energy sector is very broad. very easily. Today, we are largely exposed to natural gas, and natural gas services most specifically. Natural gas is very different from oil, because oil can be imported from all over the world very easily. Natural gas cannot be. It can be imported, just not easily. And so as a result, natural gas is supply constrained and affords an opportunity for these companies over the next few years, if not longer, to have above average rates of return. So that is really where we largely have our investment. It includes such companies as Ensco International, which is a large offshore jack-up rig company in the Gulf of Mexico.
GIBBS: Do you have some other energy companies?
ROMICK: We do. We have a few others as well. One of them is National Oilwell, which is an equipment manufacturer.
They make a large portion of the rigs -- I mean, the draw pumps and mud works that go into these rigs. And it's a very interesting business because the rigs in general, I mean 20 years ago we were sitting with 5,000 rigs in this country, land rigs all over pumping up gas. And today we're sitting with 1,200 and change, almost 80 percent decline. So if you think about it, you know, there were, tremendous supply, just if you look at that historic number. And there might be gas out there, but we as a nation tend not to like rigs in certain places. I mean, if you're going to Yellowstone National Park this summer with your family, you're not going to see a land rig next to Old Faithful.
GIBBS: Steve, you have a unique take on the retail sector. Wal-Mart and Target came out this week with really better-than-expected first quarter earnings, but Wal-Mart warned, saying that these gas prices may either raise retailers cost or certainly crimp consumer spending. Does that affect your outlook of the retail sector?
ROMICK: In terms of our take on retail, we tend to buy dominant companies, just not quite as dominant as Wal-Mart, which is in a class unto itself.
We own companies like Michaels Stores, which is the largest arts and crafts retailer in this country.
They have 800 stores and change, and they dominate the crafts industry. There's not another competitor who's close. We've owned this company since 1996, and our average cost net at the time when we first bought it, it was down $5 and change, and it's $46 today, clearly gone up a lot. We've sold stock along the way and we've bought it back because it's tended to trade somewhat volatile at different points in time.
Another example would be Big Lots, which is a deep discounter, close-out merchandise, which is a company that, we tend to buy companies that are in a turnaround phase.
In the case of Big Lots, which has a national chain of discount stores, they sell close, they sell products like old Rubbermaid -- not old, but close-out Rubbermaid. They change the color from taupe to teal, the taupe, you know, garbage cans end up in Big Lots, and they sell that stuff at deep discounts. It's a great thing for consumers who are looking to save money. Nevertheless, Big Lots has been a turnaround for some time. Hasn't happened yet. We're betting that the management will be able to do it, but it still is up to management to prove it.
FARR: One of the things you look for is earnings growth, I read. How about earnings growth for Michaels and for Big Lots?
ROMICK: Well, the first thing we look for, we're value investors, you know, strict, deep value investors, but we insist on buying companies that are growing. We do at times inadvertently buy companies that aren't growing, but that's, you know, my partner's mistake.(chuckles)
FARR: Right. Good to have partners at those times, yeah.
ROMICK: It's great to have partners, and I've certainly had my share of mistakes in this process. However, when looking at companies like Michaels, Michaels has grown their earnings in the high teens over the last five years. We expect growth at least in the mid-teens for the next five years.
GIBBS: Michael, what do you think is the overriding concern for investors now? They're almost paralyzed here. On one side, you see very good corporate earnings; on the other side, you see the fear of rising interest rates.
FARR: Investors seem to be embracing the bad news. They seem to be discounting the good news, and there's a lot of uncertainty. Investors hate uncertainty. There's uncertainty about the election, about oil prices, about inflation, what the Federal Reserve is going to do, what's going to happen in Iraq. And just when we think we can calm down for another few minutes, something else crops up that begins to worry us again.
GIBBS: And with this sideways action, what do you think are the main factors fueling this kind of churning action in the stock market?
ROMICK: I mean I'm not smart enough for that, honestly. I just know what makes a cheap company, you know, what makes a good business and what makes it a good investment. I don't keep track of, I'm not one of those people that really is that concerned about quarter-to-quarter earnings. I've owned stocks for a few years before they've worked out. They might double or triple in year four or five. It's not unusual. We're not that concerned about the near-term gyrations.
My expectation is that for the next five to 10 years stock market returns should fall in the 4 to 8 percent range. Again, admittedly a wide range, but that's still a better place than cash, so why cash? Because today at this moment I'm just not finding those ideas, and (what I do is ) different from what Michael does; Michael invests in large-cap companies, and if he decides to change his mind about a company, he can get that liquidity pretty darn easily. If we own 5 to 10 percent of a company, we can't just decide to go and say, "Okay, we're done with you over here, you know, company X to go put it in company Y." We have to, you know, keep that in mind as we go through our investment portfolio.
GIBBS: When you talked about the liquidity or lack of in the small and mid-cap sectors, how do you then determine when you're going to sell at the best opportunity?
ROMICK: We don't get in at the bottom and we don't get out at the top. We tend to sell out as it's on its way up. At times we get lucky and we look really smart was we bought at the bottom and we sold at the top. In the case of Ensco, when we first bought it the bottom back in '99 was $10 and we sold it at $40 within, I think, it was like 18 months. Our partner Rikard Ekstrand was a point person for us on that, and it was a brilliant trade, bought at the bottom and sold at the top. It doesn't happen that often.
FARR: He sounds a lot like Warren Buffett, doesn't he?
GIBBS: He does.
FARR: I mean, we buy simple companies that we understand, we're going to look for the valuation, we're prepared to hold them for a long time, we're not worried about the market fluctuations, we're worried about those fundamentals.
GIBBS: And holding cash like Warren Buffett.
FARR: I like it. Yes.
GIBBS: Well, Michael Farr, Steven Romick, thank you very much for joining us.
ROMICK: Thank you.
FARR: Thank you, Karen.
Medicare drug benefits
GEOFF COLVIN: This is Topic A for America's seniors right now. It is the new Medicare drug discount card, part of the largest expansion of Medicare since the program was created in the '60s. But so far bafflement may outweigh benefits. Some 70 cards are available -- how do you choose? Do you have to use the Internet? How much will you really save? And by the way -- as an investor, which stocks should you get into or out of in response to all this?
Paul Gulden manages the Pax World Growth Fund and has studied which stocks will win and lose from this giant new program. He joins us from New York. Jordan Goodman is one of America's top personal finance experts, an author, speaker, broadcaster who can clear up some of the confusion about these cards.
Jordan, Medicare is running these ads on television touting the benefits of this program.
(Video clip begins)
COMMERCIAL VOICEOVER: Good news for those with Medicare. You can get savings on prescriptions, and now millions of lower income people may qualify for an additional $600 credit only with a Medicare-approved discount card. Call 1-800-Medicare now for more information on how to save, because you either have the power to save -- or you don't.
(Video clip ends)
COLVIN: But, in fact, I think most people are massively confused by it. So let's start at the beginning. Who should participate?
JORDAN GOODMAN: Well, the people who participate, first of all you have to be getting Medicare, and you have to not be getting discounts from some other place. So if you have an employer retiree benefit plan, for example, that's already got a discount card, this is not for you.
COLVIN: You can't do this.
GOODMAN: That's right. So you've got to basically be without any kind of drug coverage right now, which is still millions of Americans.
COLVIN: How do you get started, and do you have to do it on the Internet?
GOODMAN: No, you don't have to do it on the Internet. You can call the 800 Medicare number and wait in line along with the hundreds of thousands of other people who have called the same number, or you can get on to the Web site, which is Medicare.gov, and see all the different plans. As you say, there's over 70 of them out there, so there's a lot that you can choose from. Or you can go to, typically, the health care organization you're already dealing with. If you've got an HMO, they're probably offering one. Your local drug store may be offering one. Lots of different players are offering them.
COLVIN: There are lots and lots of them, but you were mentioning to me earlier there are scams going on. What's the story?
GOODMAN: Absolutely, yes. Well, the scams, there are people going door-to-door to seniors saying "I've got a Medicare-approved card and it's going to save you lots of money on drugs," and in fact they don't have such a thing. They're basically trying to get people's personal information to fill out the form and then they steal their identity and this usual identity theft kind of thing. So you've got to be careful about that.
COLVIN: So is the idea if somebody comes to your door for this, don't talk to them?
GOODMAN: Don't let them in, no, not a good idea. You go to legitimate sources like your existing health insurance company or HMO or drug store.
COLVIN: How much of a discount do you get?
GOODMAN: Well, you first of all have to pay up to $30. There are some free cards, but $30 is what the fee is going to be.
COLVIN: $30 per...
GOODMAN: Per year.
COLVIN: Per year.
GOODMAN: And if you sign up now, it actually goes into effect June 1. It's going to last through the end of this year, and then you have to renew next year, and then the whole program disappears January 1, 2006, because that's when the real Medicare drug bill goes into effect and you won't need this anymore. So it's $30. But savings are going to vary depending on which drug you have and whether it's brand name or generic. The average brand name savings is going to be about 17 percent, but it varies widely amongst different drugs, and generics is going to be even more, about 40 percent savings on generics. So that's an average, but each card is going to be offering different prices on different drugs at different drug stores.
COLVIN: Paul Gulden, when anything this big comes along, somebody wins and somebody loses. Among stocks, among big companies, who wins and loses?
PAUL GULDEN: Well, I think actually what's happening here is simply an extension of what's been happening in the medical field all along. In other words, the major pharma companies have been coming under more and more pressure. They clearly are going to produce more volume as a result of this. But we're getting closer and closer -- even though the bill says this won't happen -- we're getting closer and closer to price controls over the major pharmaceutical companies and what they come out with.
COLVIN: And so the big pharmaceutical companies have not done well in response to this development. At this point, are they trading sort of based on the poll results that predict the Presidential election?
GULDEN: I think politics has a lot to do with it, but I think the growth rates are obviously slowing down. I mean they've got their own problems in addition to, let's say, this problem. Of course one is expiring patents, the other is the pipeline hasn't been that full.
But more than anything else, I think this whole area, particularly the public, the publicity about what's going on in Canada, should we reimport drugs, again it's more and more the fact that we're getting closer to price controls on major pharmaceutical products. It's still more expensive to buy major drugs in the U.S. than any other country in the world.
COLVIN: So who wins? Which companies win from all this?
GULDEN: I think the distributors win. A good example would be the pharmacy benefit management companies. They're the only ones -- they're major companies -- they're the only ones around that have the ability to distribute, the ability to do the mail order.
COLVIN: So more volume is good for them, right?
GULDEN: Yes, definitely yes.
COLVIN: Who do you like?
GULDEN: Well, Express Scripts is a good example. We own it in our fund. We also own Caremark. Those are two of the top quality names.
COLVIN: Jordan, you're not so sure about pharmacy benefit managers benefiting. What's your view?
GOODMAN: I don't think it's going to be that big a deal for them. I mean they've already been gaining share to some extent anyway, but it's not as though there's going to be a huge increase in volume with these things. The real winners, I think, actually are the generic companies.
Teva Pharmaceutical is an Israeli company traded on the New York Stock Exchange, Barr Labs, Mylan Labs. There you're going to see a really big increase, and they benefit from exactly what he was saying before, is that a lot of big drugs are coming off patent. They've already got the wind behind them.
COLVIN: Paul, you're big on generic drug makers also. Am I right?
GULDEN: Yes. I was about to say that my second category would have been the generics. There's no question. I mean there are incentives all over the place, particularly in this bill, to switch to generic drugs. Eon Labs is one of the largest holdings we have in the growth fund.
COLVIN: What about long-term care contractors, Paul? You've mentioned them, but I think a lot of people are not quite sure what they are.
GULDEN: Well, I have mentioned them in the past. I wouldn't say that necessarily they are necessarily the major beneficiary here, but some of the other offshoot companies are. For instance, the companies that deal with outcomes analysis, which is sort of a word that's thrown around. It's better medical care, as an example. There's a company called American Healthways which we do own in the fund which I think is quite interesting.
They effectively take over disease management programs for the HMOs and the hospitals for sustaining diseases, if you will. Diabetes would be a good example. A very difficult program to administer, and they are experts in doing so.
COLVIN: Paul, one other sector we haven't talked about is drug stores. There seems to be a drug store on just about every street corner in America. What's going to happen to them?
GULDEN: Well, actually they should do reasonably well. I think that this new Medicare drug plan will be good for them, because they have signed up, they're participants. As a matter of fact, generally the drug stores and the PBMs, or the pharmacy benefit management companies, have been hostile towards one another. Express Scripts just signed up with a major drug store chain to process theirs.
GOODMAN: Although the Mom & Pop pharmacies have actually been complaining about this. The CVSes and the Walgreens of the world are going to do better, but the Mom & Pops, who have already been under pressure, have already put out some statements saying they think this is a bad idea and they're going to lose even more and they're already getting squeezed. So you might have fewer Mom & Pops because of this.
COLVIN: Paul, I'm interested in your views about the big pharmaceutical companies, which we mentioned a little earlier, simply because these have been some of the best investments in America for the past 50 years. And I get the feeling that something large really has changed, but what is it?
GULDEN: Well, what's really changed more than anything else is public opinion. As you know, every time we go more and more towards the public saying it's "my right," rather than "my privilege," and it's a political football, and you start to get more and more government intervention -- then a little bit of the profit margin also comes out. So I think that you'll see the profit margins in the major pharmas start to deteriorate even further. As I said, pricing, it's more expensive in the U.S. than any other place to buy drugs. So we also have a situation in terms of the marketplace where you, the multiples start to shrink because you'll pay less and less for that type of earnings.
GOODMAN: But there is a reason why the prices are highest here, is that we're the only ones funding research and development.
COLVIN: The research that develops the new drugs.
GOODMAN: And so you can say it's wonderful to have these drugs at Canadian prices, as French and British and other lower prices, you know, government-mandated price controls, but where is the money going to come from to do research and development? And that's the big problem. The United States is funding the world's research really.
GULDEN: I agree with that entirely, but the other side of the coin, and unfortunately the reality, is if you say to a senior citizen, "Would you like to pay $50 for this or $25?" they're going to say $25.
COLVIN: We're going to have to leave it there, guys, but Jordan Goodman, Paul Gulden, this is obviously going to be a complex issue for a long time to come. Thank you for your help.
GOODMAN: Thank you very much, Geoff.
GULDEN: Thank you.
Jets and stock performance
COLVIN: Every investor wants an edge in deciding which stocks to buy or sell, but the latest tip-off is one you probably never suspected: how the CEO goes on vacation. If he gets there in the luxury of the company jet -- watch out. New York University researcher David Yermack has just completed a large-scale study with striking results.
DAVID YERMACK: If you had bought a portfolio of firms that permit CEOs to fly for personal reasons on the company plane, you would underperform the market by about 4 percent per year. And you just never see results that enormous when you do research to try and explain why companies earn the returns that they do.
COLVIN: He's right -- 4 percent a year is a huge difference. Since you're probably wondering, the jet-friendliest CEO in Yermack's study was Sandy Weill of Citigroup. He's no longer CEO. Among those still holding that title, the top five personal fliers were:
| CEO | Company |
| Nicholas Chabraja | General Dynamics |
| Jeff Immelt | General Electric |
| David Goode | Norfolk Southern |
| Robert Walter | Cardinal Health |
| George David | United Technologies |
Of course not every company on that list will underperform, but among the 237 companies in the study, the tendency was clear. Yermack found some fascinating trends in the flying habits of CEOs. For example, the best educated CEOs fly the least for personal reasons, while the least educated fly the most -- at least in general.
YERMACK: Lawyer CEOs, along with CEOs who never went to college, are the ones who really stand out as heavy personal users of aircraft.
COLVIN: You figure it out; maybe lawyer CEOs just negotiate better employment contracts. As for where all those CEOs are going on their personal time, Yermack uncovered some evidence on that, too -- and it won't surprise you in the least.
YERMACK: It turns out that golf seems to have a pretty big impact on this.
COLVIN: A major factor is whether a CEO belongs to out-of-state country clubs, and especially whether he's a member of the Master of all golf clubs.
YERMACK: If you belong to Augusta National, you tend to fly a little bit more than other CEOs for personal reasons.
COLVIN: To me, Yermack's most remarkable finding is that the stocks of these companies are actually beating the market -- until the CEO begins personal use of the jet. Then the stock plunges and never does get back up to average.
If that pattern reminds you of what happens to an adolescent male's grades after he gets his first used Chevy -- and if you consider that virtually all the CEOs in the study were men, and that a new Gulfstream V corporate jet costs $50 million -- you can't help thinking of that old saying: The only difference between men and boys -- is the price of their toys.
GIBBS: I wonder if they store their golf clubs on those planes rather than hauling them back and forth.
Well, that's it for this week. Next week, we're going to see if some of those extreme image makeovers being attempted on Wall Street are paying dividends yet.
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