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Karen Gibbs and Geoff Colvin Karen Gibbs Geoff Colvin Geoff Colvin Karen Gibbs
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Air date: May 28, 2004
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FORTUNE roundtable

GEOFF COLVIN: It's been one of those weeks when the stories behind the news are more interesting and important than what's been in the headlines. Eliot Spitzer sues Richard Grasso over his New York Stock Exchange pay, most of which was in retirement accounts -- but hardly anyone has noticed a far larger pension outrage. The Dow climbs back above 10,000 -- three cheers please -- but how much should you really care? And unlikely as it seems, the elections in India continue to roil world markets -- but in fact that nation represents good news for the U.S. economy.

Joining me for insight into what's really going on are three of my FORTUNE magazine colleagues. Marc Gunther is just back from India, where he saw some strangely familiar TV shows, among other things. Justin Fox is trying to make sense of the stock market -- a brave man. And Janice Revell has been poking into public pensions.

But the biggest food fight on Wall Street is Dick Grasso versus Eliot Spitzer. Spitzer filed a civil lawsuit against Dick Grasso and Ken Langone demanding that Dick Grasso pay back over $100 million of compensation.

What is your take on that, Janice?

JANICE REVELL: Well, my take on it is it is interesting and Spitzer is invoking a very kind of obscure part of the legal code to go after this. Basically he's saying that no one running a non-profit organization should be walking out the door with almost $200 million. And, you know, I think that Grasso and Langone have both kind of come back swinging. They've said they have no intention of settling this. You know, obviously this is clearly a governance issue, but I think if they want to try to take this to a jury, a New York jury, and try to convince people that someone running a non-profit organization is worth that kind of money, they're going to have a hard time.

COLVIN: Justin, should we care? I mean is this, as Dick Grasso actually says, a dispute between him and his board of directors that the rest of us don't need to worry about?

JUSTIN FOX: Well, all that money of his is coming out of somewhere. I assume, I'm not quite clear where. Wall Street is this amazing machine for just taking out little, little bits of our money and somehow putting them together into huge paychecks for people.

COLVIN: Well, it's a good point actually. The money came from the members of the New York Stock Exchange, which are the firms that we all do business with.

FOX: Right. And I don't know what the legal standing is and I don't, but I think this is very useful for us as a society to every generation or so think about how things work and whether people need to make all that money. And it is a special case where this is not some company he started and made great. He did a good job, as far as I can tell, running the stock exchange, but it is this non-profit organization.

COLVIN: He didn't have an entrepreneur's stake, to say the least.

FOX: Right.

COLVIN: You've done some work, Marc, on governance and stuff like that. What's your view?

MARC GUNTHER: I think it's healthy, because I think it's fairly clear that neither, that the board didn't do its duty really to understand fully what they were paying Dick Grasso, and conversely he didn't do his duty to fully explain to them what his pay package was all about. And I have a feeling those practices are more common than we might wish them to be, and this is going to discourage that.

COLVIN: Well, other than Dick Grasso's pension, there are actually some other pensions that we ought to know about and most of us don't know anything about, and you've been looking into them, Janice. They make Grasso's pension look insignificant. What's the story?

Apart from Dick Grasso's pension, the ones that most of us should know about but don't know about are pensions in the public sector, firemen, teachers, librarians, public workers who have pensions that are in fact an incredible story that you have looked into. So, what is the story?

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REVELL: Well, the story is that there is this incredible pension system operating in the public sector for the 16 million state and local workers. As you said, librarians, sanitation workers, teachers, policemen, firemen. And what's happening is that for those folks, retirement benefits are rich and in many cases getting even richer, as at the same time benefits in the private sector are on the decline.

FOX: The tradeoff has always been that you supposedly get paid more in the private sector for a similar job, I mean that's always been the argument that's been given.

REVELL: Right, exactly. Historically, the traditional deal has been you come and work for the government, we're going to give you great benefits, we're going to give you great job security, but you're probably not going to get the opportunity to make as much money as you could in the private sector. And certainly when you look at the compensation studies that have been done, that's true at the executive level, of course, and at the upper management level. But for the vast majority of people who actually work in these jobs -- blue collar jobs and middle, lower middle management jobs -- the notion that they're being paid less than folks in the private sector actually no longer holds true.

COLVIN: Well, what I was amazed to find was that there are cases where people are receiving their pensions, but they haven't left their jobs yet. So they're still getting paid for doing their jobs.

REVELL: Absolutely, and this is the kind of thing of course that is just unheard of in the private sector. But what's happening is that these plans in the public sector are geared up to retire people basically at the age of 50 or 55 with unreduced benefits. Well, with the baby boom coming up, what we have are all kinds of municipalities where 40, 50 percent of the workforce is ready to walk out the door. And people -- you know, the municipalities can't have that happen, so they're saying, "Okay, look, if you stay here, we'll pay you both your salary and your pension at the same time." And usually the pension will get put in an escrow account and get credited in some cases with just outlandish interest rates, you know, 8, 9, 10 percent. I mean you can't go wrong.

COLVIN: Guaranteed annual interest.

REVELL: Guaranteed minimum annual interest. So you're getting people walking out the door with lump sums accumulated under these schemes of three, four, $500,000, $1 million, and then continuing to collect their pension annuities.

COLVIN: And so one result of this has been these incredible deficits, underfunded pensions. The S&P 500 private companies, their pension funds are underfunded by $259 billion, but you found that state and local government pension funds are $366 billion underfunded.

REVELL: Right, and counting. And you know what has caused that is a combination of a cratering stock market and low interest rates, and we've seen that in the private sector. But actually making the situation much worse is the fact that politicians at the state and local level, unlike their counterparts in the private sector, have the ability to basically shove that liability out to the next generation of taxpayers.

COLVIN: Right, but it has to be paid.

REVELL: It has to be paid.

COLVIN: By law it has to be paid.

Justin, you've been away from the magazine for a bit working on a book about the stock market. Now lately the stock market has sort of been without identifiable trend. It was up a little bit when the price of oil went below $40 a barrel the other day, then it was down a bit when the consumer sentiment index wasn't as high as people thought it would be. From your perspective, how should the average individual investor play this environment or look at this environment?

FOX: I mean, in terms of playing it, I think most of us, we just don't know. There's nothing reasonable that can be said about the day-to-day ups and downs of the stock market. I'm writing my book about this idea that came out of academia forty years ago, which is efficient markets and the random walk, the idea that it's just perfectly random, and I don't think -- that's no longer really believed anymore. But at the same time that most of us can make any sense of it or that there is even sense to be made of it -- there's not.

COLVIN: And yet an awful lot of people make their livings talking about this, right?

FOX: Yes.

COLVIN: In our own magazine we have an article about what investors should think about the stock market between now and the Fed meeting on June 29. Your view, I take it, is most individual investors shouldn't worry about it.

FOX: Completely. I mean I just think it's so much noise. So much of it is just noise, and it's so hard. I mean, the stock market is this amazing thing that's looking into the future. All these millions of investors trying to figure out what the future's going to be. Now it's uncertain what the future's going to be, and so most, a lot of the guesses are going to be wrong. But the thought that an individual can consistently outguess that -- some people can. I mean that's the thing that I think has finally, the academics and everybody are finally coming around to that Warren Buffett isn't just lucky. But at the same time, Warren Buffett's not going to tell you what to do between now and the Fed meeting.

COLVIN: Right, and in fact he explicitly says he has no idea and would never attempt to say what you should do on such a short-term basis.

FOX: And then certain investors, like a George Soros, in the past he might say something, but only because he knew that he was about to cause a run on the Federal Reserve or something.

COLVIN: Right, when you're moving $10 billion around, you can make things happen.

FOX: Well, yeah, and I think there is intelligent -- I think there are people with this skill to divine that, "Okay, something big is coming and I'm going to jump on that," and maybe there's something more to that than just luck. But, yeah, in terms of the viewers of this show, what are you going to do between now and the Fed meeting? Sit there.

COLVIN: It's the smartest thing you can do.

GUNTHER: Enjoy your weekend.

FOX: Exactly.

COLVIN: Enjoy your weekend. Good advice for all of us, right?

COLVIN: You've just been to India, just back a few days ago. What's the most popular show on Indian TV?

GUNTHER: Well, at the moment, actually it's a soap opera called Kyunki, which is a multi-generational, very traditional soap opera. Men are men, women are women, the family is respected. But in a certain sense this program is a resistance to the rapid, almost scary changes that are happening in India, having to do with the economy, the role of women, the threats to the family, the threats to the caste system. But the network that runs that star, Rupert Murdoch's company, was built on Who Wants to be a Millionaire?, which I think you were expecting me to say, you thought I was going to say.

COLVIN: That's what I thought was the most, that's right.

GUNTHER: And that has been the most popular program, and that reflects the other side of Indian society: Aspirational, business oriented, change oriented.

COLVIN: IPOs are big in India. You were telling me about this earlier, and I had never imagined it.

GUNTHER: You actually see IPOs advertised on billboards in the streets of Bombay as you ride your taxi, get in by May 25th. So as someone said to me the last day I was there, the fascinating thing about this country is the past, the present, and the future all live side by side, so you have a very traditional, religious, caste-driven society, even among the middle class. You know, the girls are still married off in arranged marriages, and yet you have a dynamic, capitalist, changing society existing side by side.

COLVIN: Well, part of the fear that gripped world markets after the recent elections was that maybe the Communists were going to make inroads in India, but you're describing a society that is so devoted to capitalism and material progress. That sounds very unlikely to me.

GUNTHER: I think that was way overread and I think that was a sentimental move in both the Indian and Asian stock markets.

FOX: And the Communists are capitalists there.

GUNTHER: That was two facts. The Communists are capitalists. In West Bengal, which the Communists have run since 1977, they've hired McKinsey and Price Waterhouse to help them fix the state-owned enterprises.

COLVIN: Imperialist running dogs now are welcome.

GUNTHER: They are. And the other thing is, interestingly I spent a lot of time at MTV. They had a poll last year: Who is the youth idol of the year? And it turned out to be the CEO of Reliance, the biggest company in India, who is kind of the Bill Gates in India, and he beat out Bollywood stars, cricket stars and others, the most admired among people 18 to 25.

COLVIN: One of the industries that you are a genuine expert on is media, and of course India is famous as the home of Bollywood, as you say. And I gather that it is now much more than that. It is attracting the interest of Rupert Murdoch, Viacom, Sony -- the world's giant media conglomerates.

GUNTHER: They think India is a goldmine or the next goldmine, because right now there are, I guess there are 250 million homes in India. Only 90 million have television itself and 45 million have cable, but both of those numbers are doubling every four or five years. So you have, as a cable subscriber in India, it's a great deal. You can get 150 channels for about $2 a month, because everyone is in there trying to get a foothold. There are 10 all news channels in India.

COLVIN: Ten?

GUNTHER: Ten.

COLVIN: Is that because of the many languages?

GUNTHER: Partly because of the languages, partly because everyone wants to be the CNN of India, and partly because I don't think there's ever a slow news day over there.

FOX: I was there last fall, and there are at least two channels that just show cricket all the time, one of them being ESPN. You turn on ESPN, and it's cricket, cricket, cricket.

COLVIN: The cricket channel. Well, it's the national passion, right?

GUNTHER: And it does an all music channel, because everyone wants to get in while the getting's good and get a foothold. But again, it's this consumer society. Advertisers are moving in there, so they want to build their brands. There's just an excitement and dynamism to the consumer economy there.

COLVIN: Marc Gunther, thank you very much. Justin Fox, Janice Revell, thanks.

Emulating Wall Street wizards

KAREN GIBBS: We Americans love our heroes. Baseball fans still worship Babe Ruth. Rock and rollers swear Elvis never died. And for Wall Street stock pros, it's the father of value investing, Benjamin Graham. He literally wrote the book on value investing, The Intelligent Investor, a book many consider second in importance only to the Bible. His name is invoked in current newsletters and marketing materials, even though he's been dead for almost 30 years. Wouldn't it be great if you could use his strategies to pick stocks for your portfolio? Well, now you can. Thanks to a computer program designed by John Reese, founder and president of Validea.com, you too can trade like Ben Graham and other wizards of Wall Street.

Well, John, tell me what can a computer do that a human being can't?

REESE: First of all, the fact that it does take out the emotion is a very big differentiator. That's a very big factor in why it actually outscores. Take myself as an example. Before I started these methodologies, I would say I had less than a 50/50 chance of guessing correctly how a specific event would affect the stock price, either at the time that I heard of it or several days afterwards. Usually the stock price went down. I'd become very fearful and want to sell and get out. If the stock price was going up, I'd be very greedy and want to stay in. It's a very emotional reaction that almost all investors have. By taking that emotion out and looking just at what the stock has actually done, performance dramatically improves.

GIBBS: Let's take a look now at the Ben Graham portfolio, up over 49 percent, and some of the top holdings there are the Hancock Fabrics, again, Atlantic Coast Airlines, Natuzzi, Superior Industries International, and Orthodontic Centers of America.

Now how is it that this portfolio is outperforming the performance of many of the living disciples of Ben Graham?

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REESE: Well, I should add that in the particular methodology that we're looking at, every 28 days we rebalance the portfolio with the very best scoring stocks using that particular guru methodology. So one of the ways that it's actually outscoring is, first of all, we're using current data. We have more data than may have been available to them at that point in time. And we're unemotionally applying that logic. We're not trying to second guess it. We're not claiming that we know better how to do it and evaluating it than the numbers actually give them credit for.

GIBBS: Let's bring in a real world value investor. Eric Miller co-manages the Heartland Advisors Value fund and is a disciple of the Benjamin Graham approach to investing, believing that the best investments are generated by ferreting out undervalued, underowned stocks. His fund has returned over 40 percent this year.

Eric, what do you bring to the table in terms of managing a portfolio that a computer can't do?

MILLER: Well, it's looking at qualitative factors. I mean the computers are great at screening for quantitative. We certainly use computers to do our quantitative screens to sort of get our list of candidates that we want to buy.

But then, especially with the small microcaps, you know, you want to meet management. You want to talk to them. You want to see the passion. Computers can't see the passion in a CEO. And of course, you know, what you have to do, and as John alluded to it, is you have to not let the emotion overweigh a rational approach to investing.

And so it's looking at both the quantitative screening, but then saying, "Okay, these are cheap stocks that we think we can buy below intrinsic worth, but what is the catalyst?" And that's where, you know, hopefully our value added comes in, is recognizing proper catalysts.

GIBBS: John, let me ask you about the management idea, because investors have lost a little bit of confidence in corporate America and now are closely looking at how a company is run, how the managers are managing the business. How does your program take account of that or make up the deficit of that?

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REESE: The key point about that is, the programs actually look at what management has actually accomplished in terms of their profitability, return on equity, growth. It looks for what they've actually proven, not what they're promising to prove. And we judge management quality based upon that.

It won't get all the factors, but basically we've found that Validea in our testing just the quantitative portions of these gurus' strategies result in substantial outperformance.

GIBBS: Well, let's take a look at the guru portfolio (designed to follow a Peter Lynch-style strategy). In fact, it's up an impressive nearly 52 percent since inception, and some of the stocks in that portfolio: Atlantic Coast Airlines, Humana, Oxford Health Plans, WellPoint Health, and Etrade Financial.

Tell me, what screens did they use? What is the common metric used?

REESE: Following the Peter Lynch logic, you can first classify stocks into several different categories, such as fast growth, slow growth, stalwart, and then applies different criteria to each, depending on what they are. It may also apply different criteria depending upon the industry that they're in.

GIBBS: Well, John, Lynch is a great investor, but one of Graham's best students, Warren Buffett, has said that if capitalists had been around at Kitty Hawk, when the Wright Brothers plane first took off, they should have shot it down.

Why are any airlines, even Atlantic Coast, in these two portfolios, Graham and Lynch?

REESE: Because the performance of them generally recently has been coming around or turning around in terms of the criteria that the guru methodologies look for. And they're down at a price where it becomes a very attractive value play on those particular styles, those airlines.

GIBBS: Eric, What do you think?

MILLER: Buffett is right and anybody is right, you don't buy and hold airlines for 10 and 20 years. You're not going to make money in it. But you can still use them as trading vehicles. And I pay probably a little bit less attention necessarily to valuation tools for airlines as opposed to sentiment.

Mesa is certainly a good example. I mean Mesa's stock has gotten hit very hard, down 40 percent this year.

Tyco

Boy, we're not perfect. We're still down in the name. We just started buying it in April, and it's still kept going down, but it looks to be gradually recovering right now.

GIBBS: Why is Mesa more attractive to you than Atlantic Coast?

MILLER: Well, they're very similar. I mean we looked at both. If you looked at the valuation screens, they're very similar. One thing they both have is both have insider buying.

But again, what we thought is the sentiment had proven so negative short term on Mesa because of the fact that the US Air scenario was getting played out in investors' minds. We just thought the stock had been unfairly punished.

GIBBS: Do you have any of those great opportunities that would go against the grain, or in this case, against the Graham strategy of investing?

MILLER: For instance, we own a stock today, one of our larger holdings, it's a biotech company. Pretty hard for a biotech company that today has no earnings and virtually no revenues to pass a Benjamin Graham screen.

The company is OrthoLogic. The symbol is OLGC.

Tyco

And we've actually owned this probably for about five, four or five years now. We believe OrthoLogic is a leader in a very exciting field of orthobiologics, which is sort of the marrying of biotechnology with orthopedics. And its product, which is called Chrysalin, is a synthetic peptide. It's been used in phase 1 and 2 trials to show that you inject it into a fracture site, it's going to heal the fracture about 30 percent quicker than if you didn't use it at all. And so our view is that when this gets FDA approval, which it still has to, and there's always a risk it won't, but when it does, that's a potential billion-dollar market, and they are several years ahead of anybody else.

Perhaps another example is a company that didn't screen out when we first started investing in it real well on our valuation screens, but it was a -- and we still own it very heavily -- a company up in Toronto, Canada called Alliance Atlantis Communications. The symbol is AACB.

Tyco

I think we started investing in this three years ago, they had just started a series with CBS called Crime Scene Investigation, CSI, where they are the 50 percent producer with CBS of that. We had seen, I think it was in its first year out, I actually watched the show, and I don't watch much TV, but I thought, "Hey, this is a pretty interesting show, it actually may catch on." Now we never, frankly, envisioned that the CSI franchise, as it's beginning to be called now, was going to be as prolific as what it's turning out to be.

But I think the intrinsic worth of this business is far more than what the stock is selling for today.

GIBBS: Eric Miller, John Reese, thanks very much for joining us.

In terms of full disclosure, we do need to point out that the SEC has filed action against two now defunct municipal bond funds now managed by others at Heartland Advisors.

Next week

COLVIN: Good market news this week after bad news last week -- it's back-and-forth markets like these that keep investors up at night. That's why the stock picks from FORTUNE magazine's new All-Star Analysts are so intriguing. Next week they'll tell us why they're bucking conventional wisdom and buying homebuilders, gold, and even diet companies right now.

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