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date: September 24, 2004
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FORTUNE roundtable
GEOFF COLVIN: America's media melodrama continues with Disney announcing that by June it will name a new CEO to succeed Michael Eisner when he retires in two years. But the bigger story, a huge one, is the melding of media with telecommunications - TV and telephones. And you may be surprised by the company positioning itself to vanquish the titans.
And the economic mega trend of our time now seems to be rising interest rates. Seems like a fat pitch to hit, but if you've tried, you may have struck out. It just could be that everything you know about rates is wrong.
Janice Revell writes FORTUNE magazine's Money Manager Column. She joins us from New York. Marc Gunther is FORTUNE's resident expert on media and much else.
Marc, in this battle to be the company that will bring you home entertainment, who is winning now?
MARC GUNTHER: It's a big, big multi-billion dollar question. I think right now you'd have to say Comcast is winning.
COLVIN: Comcast?
GUNTHER: They have 21 million subscribers, twice as many as anyone else. They're the cable company. They're the number one broadband company in America. They've got 6 million high speed Internet subscribers, and they are about to make a big push into telephony, which has companies like Verizon and SBC nervous.
COLVIN: Now the big story in cable TV is that cable is getting the daylights beaten out of it by satellite. So why is Comcast doing well?
GUNTHER: Well, that's what the big battle is about. Comcast is in the lead now, but the satellite companies are rapidly grabbing market share away from the cable companies. So Wall Street, at the moment, (is) very negative about cable. Bill Gates bought Comcast stock to help the cable industry, I guess it was about three or four years ago, the stock was $42, it's now in the high $20s. So, Comcast has had a rough patch. What they're hoping is that they can sell this so-called triple play of television, telephony, and Internet, and then hold on to their television customers, fight off the onslaught from (Rupert) Murdoch and EchoStar, by giving them a better version of television than satellite can do, which is video on demand, a much more personalized form of television.
COLVIN: Right. So there are a couple of things going here. One is they want to sell you a package, right? You get cable TV, you get your fast Internet connection, and you get telephone service all from the cable TV company, right? And they sell you that at a flat monthly rate.
GUNTHER: Right. At a high rate as well. They want you to write a check of $125 to $150 for all of that. That's their aim.
COLVIN: And have they got people doing it?
GUNTHER: They certainly do. Some number of their customers are taking everything. They haven't really rolled out telephony in its full-featured version nationally yet, so it's a small number. But the issue, as we just said, is while they're trying to sell everything, Murdoch is coming after the television customers. So they have to fight a defensive battle there.
COLVIN: And the way they're doing it you mentioned is video-on-demand, which we have been hearing about for eons, right? Is it actually going to happen and be a commercial success?
GUNTHER: We have been hearing about it for 10 years, almost ad-nauseaum. And not only is it going to happen, it is happening. They have 8 million customers, which is not an insignificant number, who now have video-on-demand in their homes. And what that means is, access to a library today of about 2,000 programs. Within three to five years, I think the number will be 5,000 to 10,000 programs.
And they are doing all kinds of deals with people like the NFL. They're part of the Sony MGM merger, which just happened about 10 years ago. They're going everything they can. Remember, they went after Disney. In a sense they're putting together the pieces they would have gotten from Disney one at a time: Football, movies, kids programming, and they want this library to be so compelling that you will stay with them and say "No" to Mr. Murdoch.
COLVIN: There's another issue: Dating. What's the story?
GUNTHER: If you live in Philadelphia, Comcast has a very popular program, they've tried it there, and it probably will roll out because it's a hit, called Dating on Demand. Essentially, it's video personals. Single people make videos of themselves. And people who aren't looking for dates apparently find it enormously entertaining. It's like reality television.
COLVIN: This sounds like a ton of fun. There's more to talk about, but Janice, I want to ask you something, because this is an urgent issue. I mean, interest rates are rising, right? They've gotten so low they've got no place to go but up. They went up again just this past week. Now, there are mutual funds that specialize in capitalizing on rising interest rates. Shouldn't we all be piling into those funds?
JANICE REVELL: Well, Jeff, that's the idea that they specialize on capitalizing on rising interest rates, but it doesn't always play out that way. You have to remember, one of the important things to remember, is that trying to bet on movements in interest rates is really no different than trying to time the stock market. It's extremely risky, and investors can get smoked just as easily in the bond market as they can in stock markets. So you've really got to keep that in mind before you jump into any of these funds. I can guarantee you though that the fund industry will be heavily marketing these offerings as rates continue to rise.
COLVIN: Well, okay, so here's the first part of conventional wisdom that turns out not to be true. Interest rates, in the big picture, have been rising, and everyone seems to think they will be rising, but playing the mutual funds that capitalize on it may not work.
The other part of conventional wisdom that seems to be at least questionable is home mortgage rates should be going up. After all, rates are rising, and yet they seem not to be. What's happening there?
REVELL: Right. Well, it's important to remember that long-term fixed rate mortgages, like 15-year mortgages, 30-year mortgages, really don't track movements in short-term interest rates. What they track more closely are movements in the 10-year treasury bond. The yield on the 10-year treasury bond has actually been going down, even since Greenspan has been hiking rates this year. So, therefore, rates and mortgages have been going down. So, we could very well see an environment where mortgages slip even further to, you know, 5.5, even 5 percent.
COLVIN: Well, now, that leads to yet another piece of conventional wisdom that you have debunked, which is, when mortgage rates get this low, the average person thinks, "Man, this is the moment to lock in a fixed rate, 30-year mortgage. It will be the greatest decision of my life."
You say not necessarily.
REVELL: Not necessarily. It's certainly not a disaster if you do that, of course, at these rates. The important thing to look at though when you're buying a home, or when you're refinancing, is the spread between rates charged on 15- and 30-year mortgages and rates charged on adjustable rate mortgages.
The adjustable rate mortgage will, of course, always carry a lower rate, because when you get a fixed rate mortgage you're really buying two products for the bank. You're buying a mortgage, but you're also buying an insurance policy that locks you into that lower rate. But, of course, you're going to pay a big premium for that insurance policy. Right now the spread between a 30-year fixed mortgage and an adjustable rate mortgage that's fixed for 5 years and then fluctuates after that, is about 1.5 percentage points. That may not sound like a lot, but that's huge. That can add up to hundreds of thousands of dollars on a big mortgage.
So -- and historically speaking, that spread is very wide -- so what you really need to do is crunch the numbers. Take a look at how long you're going to be in the home, and really, if you're going to be in your home for 10 years or less, it's almost a no-brainer to get an adjustable rate mortgage at this point in time.
COLVIN: Because -- I saw the analysis you did -- even if that adjustable mortgage goes up by the maximum amount every year, it still won't get so high that over those 10 years you'll spend more.
REVELL: That's right. You can't lose. And the other thing to remember about adjustable rate mortgages is that almost all of them have lifetime caps. And right now the highest any of these products can go is about 10 3/4 percent. So when you think back to the scary days when mortgages were at 17, 18 percent, that's not going to happen to you when you buy one of these products. It can't.
COLVIN: Marc, I want to talk to you about a subject on which you are a genuine expert, which is the Walt Disney Corporation. There's been a lot of drama with Michael Eisner first announcing his retirement two years from now, at the end of September '06. Then, the Disney board saying we are actually going to name his successor by next June, even though he will, that person, whoever it is, will then have to wait 15 months to get the CEO's job. Is this actually going to play out as advertised?
GUNTHER: I don't think it will. I think the board announcement this week was very significant, that they said they would complete the search by June. In effect, what they were saying is, "Michael, you can't dictate the time of your departure. We're the board, we're in charge, we're going to run the schedule, we're going to hire the next CEO."
And when you think about the history of Disney, and the board that used to be there, populated by his school principal where his kids went to school, his lawyer...
COLVIN: It was a notoriously poor board, and was widely criticized.
GUNTHER: By you, and by others.
COLVIN: That's right.
GUNTHER: You really have to say this is a victory -- albeit not a perfect or speedy victory -- for the principles of corporate governance that have gotten so much attention in the last year or two.
COLVIN: If a new CEO is named next June, and has 15 months to go before he supposedly becomes the real CEO, how can that situation sustain itself? Who in the world is going to want to talk to Michael Eisner at that point?
GUNTHER: Well, it can't. And no one is going to come in from the outside and take the CEO job under those circumstances. I think realistically if we see an outsider come in, Michael Eisner will probably have to leave by September '05, rather than '06, which was his timetable. If they go with Bob Eiger, who is Michael Eisner's candidate, and internally, they have an excellent working relationship, you might have a much longer transition. But again, I think this was an assertion on the part of a once weak board that we are now in charge of running the Disney company.
COLVIN: Janice, there was a piece of news this week that was generally overlooked. It had to do with some criticism by an outside monitor of Fannie Mae. Now, most people find Fannie Mae, and similar quasi-government organizations like Sallie Mae, almost incomprehensible. And the criticism, similarly, seemed a little hard to understand, but you say this is actually significant. What's the story?
REVELL: Oh, it's actually a rather huge development because Fannie Mae, as you mentioned, is a quasi-governmental organization, but it is a huge player in the residential mortgage market in the United States. It buys trillions of dollars worth of mortgages from banks and other financial institutions, thereby freeing them up to make more loans to consumers.
And what's been happening is, the regulator has been inspecting Fannie Mae's accounting over the last few months and it's come up with what it says are some pretty significant irregularities -- quite similar if you might recall to what was discovered with Fannie Mae's cousin, Freddie Mac, a few months ago.
This could -- it's a little too early to tell right now -- but this could have some pretty broad ramifications when you consider the enormous impact that Fannie Mae has on the U.S. residential housing market.
COLVIN: Well, and could that in turn have an effect on the bubble in housing prices?
REVELL: Well, that's the nightmare scenario, and for those who believe that we already are in a real estate bubble, then it's not too far fetched. Although it's just way too early to tell right now what's happening. As you mentioned, Fannie Mae is an enormously complex organization, and I think it's going to take a while for this to shake out.
COLVIN: But you've given us a reason to keep an eye on something most of us wouldn't have been keeping an eye on.
REVELL: It's important.
COLVIN: Janice Revell, thank you. Marc Gunther, great to hear from you.
GUNTHER: Thanks, Jeff.
COLVIN: Marc Gunther, thank you very much. Janice Revell, thanks for being with us.
REVELL: Thanks, Jeff.
Mauboussin interview
KAREN GIBBS: It's only week three of the NFL season and already sports fans are scratching some of their fantasy football teams off the list, while elevating others to Super Bowl status. But are short-term results indicative of long-term success?
Michael Mauboussin sees the same psychological traps play in sports, business and investing. This Legg Mason strategist has quite a reputation as a successful, albeit unconventional, investment strategist, author and teacher. Michael, welcome.
MICHAEL MAUBOUSSIN: Thanks, Karen. Great to be here.
GIBBS: Well, what are some of the parallels you see between sports, statistics and investing?
MAUBOUSSIN: Well, I thought your opening segments laid it out perfectly, this idea of process versus outcome. And to state the obvious, we're all very focused on the outcomes, although week three is probably a little early to make the judgment on that, but what we really want to think about is the dimension of time, which is, in a very short period of time you can have really awful process and good outcomes, and a really good process and bad outcomes.
Let me give you an example and then maybe I can tie it back a bit to investing and maybe to sports. A friend of mine tells me this great story. He's in Las Vegas playing black jack, and a guy sitting next to him has got a 17, sitting on a 17, and the dealer says, "Do you want a hit?" The guy says, "Yes." Now, any black jack player knows that's not the right thing to do. Dealer flips over the card and it's a four. So he gets a 21. Right? Great outcome, but a bad process.
Now why is that a bad process? Obviously, if you play that hand 100 times, or a 1,000 times, you're going to lose a lot more than you win. So, we really do have to focus on process, long-term process, in investing and in sports.
There's another link, of course, in the area of psychology between the two.
GIBBS: Is that the behavioral of economics that you hear about now?
MAUBOUSSIN: Yeah. For example, in baseball: You know, the rule of thumb would be find players that can run fast, hit, that are really strong, good-looking athletes. That meant a lot of teams were drafting, you know, 18-year-old kids that had a lot of potential, but hadn't done a lot in terms of skills. Some of these teams came along and realized it wasn't necessarily about what the players looked like, but really the skills that they had, and the statistics revealed that. So they're able to get really good players put together at relatively low costs. They were just like classic value investors.
Same thing applies to the investing world -- lots and lots of rules of thumb. And the classic one is simple things like, price earnings multiplied by the price of stock divided by earnings. And people use those rules of thumb, but really need to go to the next level to understand whether a stock is an attractive value or not.
GIBBS: But EPS, earnings per share, price-earnings ratio, that does mean something, doesn't it?
MAUBOUSSIN: Yeah, earnings mean something, but the way we like to think about it, it's really the expectations built into the stock price. And we typically have kind of a three-step process.
The first thing we think about is the current stock price. And we say, "What sort of expectations are baked into today's price?" And when I say expectations, we do typically go a level deeper than earnings and really focus on cash flows -- the ability of the company to pay cash back to the owners of the business.
The second thing we do is apply financial and strategic tools to understand whether that set of expectations is too high or too low, and then we make our decision. So a metaphor for that would be sort of the high jumper bar. The first step sort of tells you where the bar is set, your financial strategic analysis tells you how high the company can jump. And what we're looking for, obviously, companies that can jump higher than the bar. Those tend to be buys. What we want to avoid is the opposite.
GIBBS: Now, most mutual fund managers are focused on outcome. They're looking at managing their portfolios to either meet or beat their benchmark. Are you saying that they might be missing a bigger picture?
MAUBOUSSIN: Yeah, most definitely. I'll tell you, this is probably going to reveal some of my biases, because I do tend to be longer term oriented. But we did an interesting study last year. We took a look at all mutual funds out there -- now, we put some brackets around data, they had to be $1 billion (in assets), they had to be general equity funds, we wanted to have one manager -- but we ran that screen to see all the funds in America that beat the S&P 500. And there are about 30 or so that made that group.
And we then we said, "All right, are there any interesting characteristics of these funds, and how do they contrast with everybody else?" And sort of four things popped off the page.
The first thing was their portfolio turnover, which is basically how often they buy and sell stocks. The average portfolio turnover in the United States is about 115 to 120 percent, which means that the whole portfolio turns more than once a year. For this group, the average turnover was 30 percent. And interestingly, even the highest turnover was about 20 percent lower than the average. So what that means in practical terms, is that group of investors, our elite group, was taking a very long perspective, whereas the average person takes a short-term perspective.
The second issue was concentration of the portfolios. These portfolio managers tend to have less stocks, or they probably had more conviction, and the average manager has more stocks who tends to mirror the benchmarks a little bit closer, so they minimize their difference versus the benchmark.
The third thing is, this group tends to have an intrinsic value perspective. So they focused on cash flows and not what the, you know, latest momentum shows. And the fourth and final one, which I thought was somewhat controversial, is the vast majority of these funds were not based in New York or Boston. They were based in places like Salt Lake City, Utah, Memphis, Tennessee, and Baltimore, Maryland. So, maybe that's a little bit of a noise factor, getting away from the noise factor that you see in the Northeast financial corridor.
GIBBS: Well, you're now in Baltimore working for Legg Mason, which is well known for its value funds run by Bill Miller. He runs a pretty tight ship. Have you rocked the boat at all since you've been there?
MAUBOUSSIN: No, I don't think I've rocked the boat much at all. But I'll tell you a funny story about Bill. Just shortly after I joined the team, he was out visiting with a client, and the client says, "You've got a new chief investment strategist. Is this guy going to tell you what to do, or tell you what the market's going to do?" Bill said, "No, he's really not that kind of a strategist." So, he has specific things that he wants me to do.
I'm really working on a couple of things. Working with our analysts on our investment process -- it's a really terrific process now, we're going to try to make that even better. And then continuing to spend time on what I call sort of the periphery of investing, ideas that are important that may be coming from different disciplines or different fields that relate back to the world of investing. So, no, I think the boat is still pretty calm.
GIBBS: Well, let's talk about some of the perspective that you bring, particularly to a portfolio that's pretty much established. Can you talk about some of the holdings in the Legg Mason Value Fund?
MAUBOUSSIN: Yeah, one of the areas that we've been working a lot on lately is the idea of networks, and network effects. The network effect, to just be specific, is the value of a good or service increases the more people use that good or service. So here's a simple example. If you're the only person in the world to own a fax machine, it's not very valuable because you can't communicate with anybody. Add a couple more fax machines, the value goes up. Add a whole lot of them and the value goes up a lot more. So that's this basic idea of network effects. The value goes up as more people use it. And there a number of stocks in the portfolio that we think really benefit from network effects that may be the market doesn't fully appreciate.
One example I would cite is Nextel Communications.
And Nextel, you may know, has got a really wonderful "push to talk" technology, where people can really instantaneously communicate with one another. That's a very classic example of powerful network effects. So the stock to us looks like it's got good growth prospects, very strong free cash flows, and with a very strong free cash flow you'll get very good valuation.
Another example along that line is eBay.
eBay has been a stock that's been done very well, and it's very well-known, but we think the network effects there are also very, very pronounced, which will allow them to continue to enjoy good growth for many years in the future with really excellent cash flow characteristics. So that would be another example of a good case where we take these ideas and disciplines and apply them back to the portfolio.
GIBBS: What specifically is better for eBay than Nextel? eBay stock has done very, very well. It's up for the year. Nextel, not doing as well in terms of stock price. And both of them in that "Technology" arena, which, very volatile.
MAUBOUSSIN: Right. Well, I think that Nextel certainly faces more competition than eBay. So there are a lot of players in the wireless communication. And they're also facing some technology upgrades, and there are some question marks about what that will cost them. So, we tend to be optimistic about those outcomes, but there's probably a little bit more uncertainty about Nextel's situation. We feel good it's going to work out, but that probably explains some of that valuation disparity.
GIBBS: Michael, you were able to sit in on the analysts' meeting for Eastman Kodak this week. Can you share with us some of the insights and some of the things that you see going on there?
MAUBOUSSIN: Yeah, and Kodak is an interesting one because most of us, when you hear the name Kodak you almost always think of traditional photography business, and Kodak is going through a very interesting transition from the traditional film business to a digital business. And I think that the headline this week is that, that transition from traditional to digital business is probably at or ahead of the plan they laid out about a year ago.
So, you fast forward five or 10 years down the road, Kodak will be a much more digital business, a much more rapidly growing business, and we think with still pretty good economics. And given today's valuations, there still seems to be a lot of uncertainty and question marks, and what we'd say (are) relatively low expectations about their ability to achieve against that plan.
GIBBS: Well, you were also saying earlier that individual investors need to kind of peel the layers back and look more than just the top line statistics. But when a company such as Eastman Kodak is going through a revolution or something, it's kind of difficult isn't it for individual investors to see what the heck is going on.
MAUBOUSSIN: I think it is very difficult, and, you know, it's like anything, it takes a lot of time. It's different for professionals to do it. You need a lot of time and diligence to go and do that. But that's exactly what the name of the game is. Finding things where the expectations are low, trying to take it to the next level to understand, those changing dynamics. And then eventually, you know, unmaking your bet as to whether that's going to unfold or not.
GIBBS: Given that backdrop for what you just described, what's the next big thing we should be trying to get in on now?
MAUBOUSSIN: Well, I don't know. For me I think the next big, big wave -- and this is maybe not an immediate thing, but five or 10 years -- I think is going to be nanotechnology. And nanotechnology is something that, as a technology is very dispersed, it's in a lot of different domains and fields, and so there's not one big idea.
But that's creeping into materials businesses, health care business, a lot of technology businesses. So my own suspicion is, five or ten years from now, when we talk about what's the next big thing, it will probably be something along the lines of nanotechnology.
GIBBS: Michael Mauboussin, thanks so much for joining us.
MAUBOUSSIN: My pleasure.
Next week: Figuring out how much a home is really worth. And an interview with former Treasury Secretary Robert Rubin.
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