Air date: October 8, 2004
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Olstein interview
KAREN GIBBS: Many investors are sitting on the sidelines and most money managers are hoarding cash. But Bob Olstein, veteran manager of the Olstein Financial Alert Fund, is fully invested for the first time in nearly a decade.
Well, what do you see that nobody else sees? I mean the market's pretty much dead in the water and going forward a lot of people think this economy is slowing.
OLSTEIN: It is slowing, but slowing, it's growing slower as opposed to turning down. Business confidence eroded, they're worried about the price of oil, they're worried about the election. But when you look at it, the S&P earnings are going to be above $70 next year, and what's wrong with 2 or 3 percent growth? There's nothing wrong with that.
And so once people change their expectations about the growth rates -- 10 and 15 percent growth rates, they're fantasies, you know. But people think you can't play the market unless there's 10 or 15 percent growth rates, and we're finding a lot of companies with free cash flow, 8 and 10 percent yields and going to grow at 2 percent and under a temporary reign of pessimism. But that's when you get good prices -- during pessimistic times.
GIBBS: So people need to kind of readjust their expectations for market growth, maybe down to 2 percent.
OLSTEIN: Yeah, I think a 2 and 3 percent grower is going to be a great grower. The days of booming growth are gone, and everybody has always fantasized companies that grow 10 percent for 10 years. You can put on probably two hands the amount of companies in my career that have ever maintained that type of growth rate. So you've got to change your expectations, and during periods in which the glass is half empty, as it is right now, is when you find value.
So we're not bullish or bearish on the market, because I think the market's maybe 3 or 4 percent undervalued here -- not a lot, but we're finding that people are overreacting to a bad quarter or to a slowdown in growth rates, and we're finding values now. And as soon as they start to go up, we sell.
GIBBS: Okay, so now you're looking at the market and you see some specific values. What is the key to the values that you see in the stock market?
OLSTEIN: We're looking for companies that have 8 percent free cash flow yields...
GIBBS: Which means?
OLSTEIN: That means basically that free cash flow divided by their market capitalization would return 8 percent or 7 percent a year if you owned 100 percent of the company.
And we're looking for companies that are under a temporary bout of pessimism because they missed a quarter (or) they've had a temporary problem, like Interpublic has -- which we're going to discuss, okay -- and we feel that if we can make 50 percent over a 2-year period, why we buy the pessimism, and pessimism creates good prices, and that's the most important thing when you purchase companies. You have to pay the right price. So we're looking for companies in the 7 to 10 percent free cash flow yields that can get their earnings back to where they were a year or two ago. And we're not worried about short-term performance.
GIBBS: Explain the concept of free cash flow to me.
OLSTEIN: Free cash flow is the money that's left that an owner can take out of a business after capital expenditures, and of course that's earnings minus capital expenditures, or plus depreciation, minus capital expenditures, and what they need to support receivables and inventory is also subtracted. In essence, if I own that company, what could I put in my pocket and not affect the growth of my business?
GIBBS: Interpublic is one of the companies, Interpublic Group is one of the companies that fits this criteria. It's an advertising group mostly.
OLSTEIN: Yes.
GIBBS: If the economy slows down and businesses pull back, one of the first things they do is cut back on advertising. How would that affect Interpublic holdings?
OLSTEIN: Well, first of all, people are going to have to advertise if they want to grow. You're saying the economy slows down. That's a lot different than the economy turning down.
Here's a company that went pretty far asunder from their basic business a couple of years ago. They went into speed racing. They had accounting problems. Earnings dropped into the 40-cents-per-share range. Here's a company not operating at peak margins. If they get back to their 12 percent margins -- that is a low margin for that industry -- here's a company that can produce 80 or 90 cents a share in free cash flow, we believe advertising can grow 1 to 2 percent a year sporadically. It's not going to be straight up. And if they do that, we think the company's worth $17 a share, and we're basing that off U.S. Treasury yields, and we're buying the stock at $11. So we think that's a pretty decent risk/reward.
Now, here's key: if you buy bad news and we're wrong -- and the place that you're normally wrong is that you predict free cash flow and it never really occurs or it doesn't occur as high -- if you buy the bad news, you limit risk in long-term performance, or you limit how much you lose. Long-term performance is not determined by how much you win. It determines the level of the mistakes you make.
GIBBS: Pier 1 is another company that you're looking at and that you really like. Pier 1, in the retail sector...
OLSTEIN: We're not looking at it. We've made a commitment to the fund and we bought it.
They missed same store sales. Everybody who has a three-day horizon blew the stock out from $25 all the way down to $16, $17. The company has already, they missed the little fashion trend in the furniture industry. This is an excellent company with no debt. They have cash. Here's a company that's capable of producing $1.50 a share of free cash flow, selling at $17. We think the company can grow with the gross national product. Here's a company we think that if we wait a couple of years we can get that up to $25 a share. We don't think that's a bad return anymore from $17.
GIBBS: Not bad. Now this is one I can understand and relate to, Del Monte. We've got to eat no matter what.
OLSTEIN: Well, Del Monte made some acquisitions from Heinz. They have StarKist Tuna now, they have Del Monte Foods. Here's a company that's going to be cutting their capital expenditures way back as they get these plants up to snuff. And here's a company that can produce $1 a share in free cash flow. The stock sells for $10.50 a share. It's very undervalued. Their earnings have been flat for three years. Everybody's down on it. We like pessimism. It produces the right price. We value this company at $15 a share. If we go from $10 to $15 in two years, that's more than adequate to give my fund a return. We're not looking, if we can do 10 percent a year in the equity market now, we'd be more than ecstatic, okay? And that's much lower than the returns we've done over the last 10 years.
GIBBS: And if I don't eat it, I'm going to store it, and Tupperware is probably the most storable household name you know. Tell me about Tupperware.
OLSTEIN: Tupperware made a critical mistake. They went away from their party system. They started marketing their goods through Target stores, and what it did is it cannibalized their party format. And what happened is they lost a lot of representatives. Their earnings went down to 40, 50 cents a share. Here's a company that said we pull the plug, we're out of the retail. They pulled the plug from Target. They're building up their representatives again. There's a nice 4.5 percent dividend yield while we wait. We think this company is capable of earning $1.50 a share two to three years down the line. They're building up their party system again. We see early signs of it starting to turn around. We think the stock is worth somewhere between $22 and $24 a share, and we like buying a stock at $16, $17 that's worth $22 to $24 with a 4.5 percent dividend yield.
GIBBS: And finally let's talk about Hasbro. We're coming up to the all important Christmas shopping season. Hasbro have anything new out, or what are you seeing there?
OLSTEIN: It's just a change in strategy. Here's a company that used to go out and sign expensive licensing agreements, and it always got them into trouble. The company is back to a monopoly, G.I. Joe, their basic business. Their earnings power now is $1.40 a share, and really if you look at free cash flow, it's about $1.60 to $170 a share. Here's a company that has higher depreciation than they're making in capital expenditures, which is a non-cash expense. We figure that Hasbro is now worth somewhere in the $24 to $25 a share price. It grows maybe 1 to 2 percent a year, the toy industry, with some cyclical growth, but again, people do not understand that we think Hasbro's growth is going to be more regular now that they're out of these expensive licensing deals and back to basics. They've paid down their debt. They'll be out of debt soon. And we think it's an undervalued toy company.
GIBBS: You're an incredibly disciplined money manager. Do you always sell your stocks when they reach the target price?
OLSTEIN: Well, we don't have target price, we have values. I resent the word target price only because too many analysts use that word. We value companies.
Now we have a prenuptial agreement with every stock in our portfolio. The hardest thing to do is sell, because usually you have to sell when everybody else, and you have to buy when everybody else is telling you don't buy, you have to sell when everybody is telling you don't sell and the good news is finally coming out. But you must be disciplined. You know, I was asked the question the other day at a seminar, they said it sounds like your discipline is so easy, how come everybody doesn't do it? And I say it's easy to pontificate on. It's very difficult to practice. I say I must stick to my discipline, but then I go home and throw up.
GIBBS: Well, we're going to watch this very closely. Bob, you made a real name for yourself in uncovering some of the fraud and accounting gimmicks going on in corporate America. How is the sleuthing business now in the Sarbanes-Oxley era going?
OLSTEIN: Well, it's not as good as it once was. I mean we uncovered, as you know, Boston Chicken, Lucent. We saw a lot of the financial tricks going on in Enron. You're not finding a lot of that now, and as I said, that's really characteristic also in a bear market or right after a bear market, because valuations are not extended and people don't have to manufacture earnings to justify valuations. But that being said, you still have to sleuth, because generally accepted accounting principles requires assumptions, and people who make unrealistic assumptions, or companies, I should say, who make unrealistic assumptions about their earnings, okay, or about what gives rise to their earnings, you have to adjust the earnings before you go out and predict future cash flow. So the sleuthing business will never end. It's just not going to get some notoriety for awhile as all of the religion has been adopted at the bottom of this bear market or the most recent bear market.
GIBBS: Bob Olstein, always a pleasure. Thanks for joining us.
Merck and Vioxx
GEOFF COLVIN: A blockbuster drug became history last week when Merck, the giant pharmaceutical company, withdrew Vioxx from the market, saying the arthritis pain medicine can increase the risk of heart attacks in long-term users.
Major lawsuits followed immediately. In fact, plaintiffs' lawyers started advertising for clients, potential clients who had used Vioxx. This ad appeared in The Washington Post. Now the stock has cratered, and millions of investors have to decide whether Merck -- one of the most widely held stocks in America -- is still worth owning, or whether it has fallen so far that it's actually worth buying. Wall $treet Week with FORTUNE contributor Michael Farr has some answers I'm glad to say.
Michael, Merck stock fell 27 percent in one day on this news. It has lost $30 billion or so of value in the past week, almost all of it in that one day. Was the market overreacting?
MICHAEL FARR: No. I think the market was reacting probably pretty well, acting in a reasonable way, something that the market doesn't often do. If Vioxx was 20 percent of Merck's earnings...
COLVIN: Which it was.
FARR: Which it was, and that 20 percent got pulled away, then the stock price should have dropped 20 percent.
COLVIN: Well, the lawsuits are of course the great danger in something like this, because if you're talking about people's lives and the drug was being used by millions of people, there could be potentially huge liability for them here, right? Is there any way for investors to get a handle on that?
FARR: If you take a look at previous pharmaceutical settlements, we've seen settlements for fen-phen and other problem drugs in a range between $200,000 and $500,000 per incident. If you consider a pool, extrapolating on the Kaiser Permanente study of a potential of around 27,000 victims of this particular trouble and this particular drug, then you're looking at a range of liability for Merck of between $5 (billion) and $10 billion. The stock dropped 3 percent, on Thursday. That was about a $6.6 billion market cap drop. So I think you can make the argument that it is priced in, and a very bad case is probably priced in for Merck right now, which means shares are probably reasonably priced.
One thing to keep in mind is that the world's best logic can lead you perfectly to the absolutely wrong conclusion. We're doing the math and we're making a guess, and this is my best guess for our investors. I hope I'm right.
COLVIN: Sounds like you're making an argument for buying it.
FARR: I'm not, and I'm not for a couple of reasons. They've got two other drugs coming off patent in the next couple of years that are a significant part of their revenues. They don't forecast any earnings growth for the next two years. So Merck management has to pull a rabbit out of a hat somewhere in here. And if you want to own a pharmaceutical, there's no reason to buy trouble. Let's find one that's reasonably priced that doesn't have these issues.
COLVIN: Which would be?
FARR: Which would be, well, there are two choices, and one of them will make you nervous. It's Pfizer.
COLVIN: Right, because it has another drug in the same class as Vioxx, which is Celebrex.
FARR: Celebrex, which is another COX-2 inhibitor drug. It has not shown the problems, has not shown trouble, has not shown incidents. They haven't had troubled studies on Celebrex. But shareholders of Merck would tell you, you don't want to be owning those shares when they find out that there is a problem.
So, what do you do? I think you take a look at Johnson & Johnson.
It's 17 times earnings. It's growing those earnings at around 12 percent. It's very predictable. It has a nice dividend. Johnson & Johnson is different from these companies, too, in that 35 percent of their revenues come from their medical device, the earnings come from the medical device companies. Medical device companies are valued at around 25 times earnings. So with Johnson & Johnson valued about equal to an average S&P 500 company, growing earnings faster and paying a dividend, it seems to be a pretty good place to be.
COLVIN: A better package. So your bottom line it sounds like is if you own Merck now, you'd hold on to it, yes?
FARR: I'm going to hold on to it, yes. I'm going to take my 5 percent dividend.
COLVIN: And if you want to put new money into the pharmaceutical sector, put it into J&J.
FARR: That's what I think, and I think that you'll probably do pretty well doing that.
COLVIN: Thanks for having a clear point of view with us, Michael. We appreciate it.
FARR: Thank you.
Radio frequency ID tags
GEOFF COLVIN: Pharmaceuticals are biotechnology that goes into your body, but now imagine a type of information technology that can go into your body as well as into virtually everything, and I mean everything, you own. That technology, called RFID, tech jargon for radio ID tags, is about to change our lives and the way every company does business. These tiny chips, some as small as a grain of salt, carry extensive information and with the proper device can be read remotely, invisibly, silently.
(holding up shipping label) This label for a pallet, a big pallet of goods. From the outside it looks conventional, but look at the back. Peel off the backing and there is the radio tag. Actually, most of what you see there is the antenna, only the black dot in the center is the actual tag.
And unlike today's barcodes, they don't just identify a type of product, they identify each unique item they're attached to, whether it's a car or a shirt or a head of lettuce. Earlier this year a nightclub in Barcelona started implanting RFID chips in their VIP customers so they can be instantly identified for special treatment. More significant for investors, these minuscule tags will soon change the way giant companies operate -- as my FORTUNE magazine colleague David Kirkpatrick explains.
DAVID KIRKPATRICK: The holy grail in RFID is for a company to get to a situation where when you take a product off the shelf at a retailer, that generates a signal that goes to the warehouse so the retailer can replenish that shelf, or maybe the back room and then the warehouse, but it ideally goes all the way to the manufacturer's computers so they know they need to make more of that device or product and get it to the retailer so it can go back on the shelf to replace the one you took. It's really aiming at a wholesale redesign of the process by which things get from being made to being purchased.
We're at a very early phase of this entire technology. In reality where we are today is that you have a number of very powerful retailers, led by Wal-Mart, and a few other players, like the Department of Defense, that have said, effectively demanded, of all of their suppliers that they will comply and have their pallets, which are the big bunches of boxes that they ship to the retailer or their boxes of products that they ship to the retailer, compliant with RFID.
Wal-Mart, which is by far the world's largest retailer and world's largest company, has set a date of January 1st for its top 100 suppliers to be delivering it RFID compliant merchandise. Because all the biggest manufacturers of consumer products in the world sell to Wal-Mart, basically their demand has meant that the entire consumer products industry has started moving in the direction of this technology.
We've never had a company with the power of Wal-Mart before. That's the big difference. Wal-Mart is so big and so many people sell to them, that when they say something, they effectively have the power of governments that you have to comply, because you have to sell to them because otherwise your business might go away. People are selling a substantial percentage of their product to Wal-Mart, so they can't risk losing that customer. I mean Wal-Mart's power is so great that even China is likely to comply with these EPCglobal standards because Wal-Mart wants them to.
One of the big problem is today that the retailers are demanding they want compliance by a certain date, Wal-Mart, Target, Albertson's, and a number of, Best Buy, a number of other big retailers have said you've got to be shipping this stuff with this RFID identification. But for the suppliers, they're saying to themselves, "Well, what's in it for me?" Adding RFID is pure cost to them.
The cost of RFID tags with actual devices that are affixed to a box have historically been in the dollars range. But at the moment they're down to 25 cents or so. It's generally thought that this is really going to take off when they hit the 5-to-10 cent range, and probably eventually they'll go lower than that.
For investors, one thing you can watch is how rapidly the retailers succeed in getting their suppliers to comply with this, because Wal-Mart's going to make more money when this happens, Albertson's is going to make more money when this happens. You also could look at the big systems integration companies like IBM, EDS, Accenture. They're the ones who could make a lot of money helping people make this transition, because this is a big transition. And then finally there's some companies that are building the technology for this.
One public company is Symbol Technologies. They just bought a small player that has RFID technology. And then there's non-public small private companies like OAT Systems that have very important technology that will eventually go public, and at that point they'll be good investments potentially as well.
For 30 years we've had the UPC, the universal product code, or as most people think of it, the barcode. Now we're moving to EPC, the electronic product code.
That's really all we're talking about when we talk about RFID, moving from the barcode to a more sophisticated way of identifying information about a product or a bunch of products moving around a company. So really in the end probably consumers won't even know the difference when this is fully deployed, except if they're lucky, products will be cheaper and the companies they invest in will be more profitable.
COLVIN: These radio tags also bring a potential danger: When everything you wear or use, everything in your house, carries a speck-sized radio ID tag that can be read remotely, silently, and invisibly by anyone within 30 feet, what becomes of your privacy? For better or worse, we're about to find out.
Next week: Investing based on an aging population
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