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» Roundtable » Greg Forsythe interview » Mergers

Roundtable

GEOFF COLVIN: Can you find anybody in business today who's actually brilliant? The answer is yes. The latest scandal trial headlines may suggest most business people are crooks or dopes or both, but those stories have obscured some stunning successes -- ingenious companies, products, advertising, and more that reveal who's winning now and who may be winning next.

Todd Lappin is a senior editor at Business 2.0 magazine, which has been tracking the biggest business winners. He joins us from San Francisco. David Kirkpatrick is one of my FORTUNE magazine colleagues, just back from the World Economic Forum in Davos, Switzerland. So Todd, let's start with the big winner. Who do you guys say is the smartest company of the year?

TODD LAPPIN: Well, we think that Toyota is the company that really is the smartest company of the year. And it's been a very difficult time for American automakers. They're having a tough time selling enough cars at a profit to make it worth their while without discounts, but Toyota's doing a great job of that. And the numbers tell the story. Toyota's market capitalization is greater than the American Big Three combined. It's a company that's doing very, very well in a very tough business.

COLVIN: It's an incredible thing. You mentioned this, but it is worth more than General Motors and Ford and DaimlerChrysler all put together. I gather that it won't be long before it surpasses Chrysler as the number three automaker in America, too.

LAPPIN: Well, actually they're on target to soon pass General Motors as the biggest automaker in the world. It's a company that's just doing very, very well, very shrewd, sticks to its knitting and really knows how to get its cars out in a way that again maintains profitability, a very difficult thing to do.

COLVIN: It is difficult. It's an incredible story. Now you also identified something on a very different scale, which was the smartest, coolest, cleverest advertising of the year. What was that all about?

LAPPIN: Well, we thought that the most interesting advertising campaign of the year was the pairing of U2 and Apple on the iPod. It just worked really, really well. U2 of course was a band which everybody was wondering, are they still relevant? By pairing with iPod, they made it immediately clear that they were relevant, and for Apple it worked out very well. U2 is their kind of a band, it's sort of an upstart band with a very strong countercultural message, and the pairing worked really, really well. And you can see that in the sales numbers for both of the products. U2's album went to number one on the charts and the iPod had a fantastic Christmas season.

COLVIN: The iPod has been beyond belief as a phenomenon. And David, as a guy who follows this industry, meaning the technology industry in general, you have a pretty good handle on this. Do you think Steve Jobs, CEO of Apple, is one of the smartest people in business?

DAVID KIRKPATRICK: I just think there's no question he is the smartest person in business. I think he is the iconic businessman of our age really. He's a visionary. He comes out with products that people want. He's a brilliant marketer. He is himself a brilliant product designer, because he gets deeply involved in the details of everything Apple does. He's an unbelievable control freak. I'm not sure I'd want to work for him. But he makes the technology industry amazingly interesting.

COLVIN: And we haven't said a thing about his role at Pixar, which is another mega success.

LAPPIN: I was about to say, that's the one thing that's striking.

KIRKPATRICK: But they don't have failures at Pixar, another interesting fact.

COLVIN: Todd, what were you going to say about Pixar? You're out there with them.

LAPPIN: Yeah, it's just again, Pixar, we always forget that he has a hand in that, but that is an amazing company. I mean they have not had anything even approximating a flop yet. They have the Midas touch when it comes to making animated films, and you can see that in the way that their, what they have been doing is changing the field of animation and all of Hollywood.

COLVIN: For a really unexpected story, I liked what you guys picked as the turnaround of the year. What was it?

LAPPIN: Well, McDonald's was our turnaround of the year, and that was a big surprise. You know, it wasn't all that long ago that we were hearing gloom and doom stories about McDonald's.

COLVIN: Well, there was Fast Food Nation, which really just pounded them, the book, and then there was Super Size Me, the movie, which just further pounded them. This looked like a company that was getting beaten down month after month.

LAPPIN: It's true when basically, the core assumptions that basically you can eat fast food and not really have to worry about it too much are being challenged -- very, very bad publicity. What McDonald's did that was very smart was they regrouped. They focused on their core customer, which it turns out is the mother with kids. They made sure there were menu offerings that would appeal to them, salads and chicken sandwiches, and the idea was to get Mom in the store so then they could make the real money selling Happy Meals to kids, and it's worked out very, very well for them.

COLVIN: It has worked after a long time of really not working very well. You identified the smartest entrepreneur, and there are a lot of people I think who still don't know this guy. They don't know his name, and they don't know his record, which is beyond belief.

LAPPIN: Yeah, Jeffrey Citron of Vonage has really done an amazing thing in building basically a business out of nothing. Vonage is a company that sells voice-over-IP services, which is basically making telephone calls, voice calls over an Internet backbone, and that's turned out to be a great business because the costs are very, very low. And it's the kind of thing that you can really see ripples of it taking place, resonating throughout the telecommunications industry, including in things like the SBC-AT&T merger which we saw. It's very, very disruptive technology, and he's really been a pioneer in making it a reality for consumers.

COLVIN: Well, and David, this is what I want to ask you about, because you follow that industry very, very well, closely, and this merger in which AT&T is going to get bought, the last vestige, the thing that was called AT&T is going to disappear, or at least it's going to be swallowed up inside a bigger company. How historic a development is that?

KIRKPATRICK: Well, it's a hugely historical development. This was the great American corporation. You know, AT&T and General Motors, which is another company not doing quite as well as we used to think it would, and we just heard a little bit about that, those two companies were the companies. Now AT&T is going away, and being bought by one of its former parts -- how ironic -- but AT&T was the company that created the whole telephone system of this country. But I think they're going away after an unprecedented series of stupid business decisions, and in some sense, I hate to say it, but they deserve it.

COLVIN: Well, this is what I wanted to ask you about, because there are people who argue that their demise was fated, that there was nothing they could do about it, that technological advances of the kind that Todd was telling us about were going to doom the long distance business, and it was only a matter of managing the decline. You think they screwed it up.

KIRKPATRICK: Well, I think frankly getting rid of the wireless division was a big mistake. I think, I doubt if it would possibly have been worse for them if they had held on to the cable properties, which they sold.

COLVIN: They sold, that's right.

KIRKPATRICK: I also think, you know, buying NCR, a real big mistake that they undid later, and it was a huge management distraction. Honestly I think Bob Allen and Mike Armstrong both are going to go down in history as sadly not the greatest of leaders.

COLVIN: You have just been in Davos, the World Economic Forum, this huge conclave that occurs every year, attended by heads of state, the biggest CEOs in the world. What was the big theme? There's always a big theme at Davos. What was it this year?

KIRKPATRICK: Well, this year it wasn't hard to discern, although it wasn't what you might think of as exactly a business theme. It was poverty. It was the recognition that global poverty was the biggest problem, even for those who are not poor in the developed countries. And this was set off by big speeches that Schroeder of Germany and Tony Blair of Great Britain gave early on in the forum, each of them making major commitments to working to alleviate poverty, particularly in Africa.

And then it was picked up throughout a number of other sessions in the forum, including some that I moderated on technology, where technology companies are increasingly thinking of ways to get their products into the developing world as a way both to build their own sales and at the same time really help those people.

COLVIN: And this is one of the largest, I think one of the largest ideas in business anywhere right now, which is the idea that there is a lot of money to be made selling products to the 5 billion people around the world who we have always thought didn't have enough money to buy anything. Was there a lot of talk about that?

KIRKPATRICK: Well, there was, and of course we've got to give credit to CK Prahalad who both of us know and who's a great business thinker and has written this extremely influential book that's out now called The Fortune at the Bottom of the Pyramid. He was all over Davos. And the theory is that companies have never seen such a big market as now exists in the poor of the world, that they've been selling the same things over and over to the same half-billion or billion or so of us rich people, and now is the time to think of broadening that to the biggest market that ever existed.

Now the problem is those people don't have money, which is why my technology companies that I follow are especially excited about this, because technology uniquely is the kind of business where the product you give someone can help them improve their productivity so they can pay for it.

COLVIN: In other words, it could enable them to make enough money to buy more.

KIRKPATRICK: Yeah, to become less poor at the same time they can afford to pay HP or AMD or one of the other companies that's working hard on the problem.

COLVIN: But you've got to get them started somehow. And so I gather, are there companies giving away products to sort of jumpstart the process?

KIRKPATRICK: Well, there's certainly a lot of philanthropy around this issue of technology in the developing world and a ton of stuff happening, although we've heard for years about Gramin phone where one cell phone in a village can make all the difference, and people are starting to do the same thing with PCs, so yes. I mean it's a very complex hybrid of philanthropy and profit-oriented activities.

A company like Microsoft, for example, which is just absolutely obsessed with this market, is doing both a lot of stuff with philanthropy and education in the developing world in countries like Gabon and Namibia. And at the same time, repositioning the way they price their operating system and their applications so that they can be affordable for these people and, by the way, keep out that nasty open source stuff that's giving Microsoft a real run for its non-money, or whatever you want to...

COLVIN: Yeah, that's the operating system that is free. Todd, you're there in the center of America's info tech industry. Is it a hot topic?

LAPPIN: Well, it is. The one thing that's becoming clear is that there are opportunities. You know, there's a tendency to think, "Well, how can we possibly compete with Chinese firms or some of these South Korean firms?" But it turns out that both in China and in countries like India there is a demand for value. There is a recognition that you do get what you pay for.

And in some of these developing markets, among those who are willing to buy the technology, they're not necessarily always looking for the cheapest. It has to be affordable, but they are doing a, sort of a, cost comparison where they're willing to pay a little bit more if they have a greater perception of value, greater quality, greater performance, so on and so forth. Those are where the opportunities are for American firms, that's for sure, and the smart ones are starting to move in on that.

COLVIN: Todd, one of the most popular regular features in Business 2.0 magazine is your annual compilation of the 101 dumbest moments in business. It's just out, and they are really dumb. What was the dumbest moment in business of 2004?

LAPPIN: The dumbest moment in business turned out to be the Kryptonite lock company, which is of course a famous maker of bike locks, introduced a product that it turns out...

COLVIN: Right, unbreakable, right? I mean these are the things, unbreakable locks, the best you can get.

LAPPIN: Well, it turns out that you could break this lock, and all you needed to do it was a regular ballpoint pen. You would just stick the pen inside the lock hole and the lock would open, which is bad. But what made it even worse was that there was a demonstration of this just to prove that it worked which somebody made a short video of on the Internet, which then began to circulate. So not only was it just bad, it became a public relations disaster, and the company was forced to recall the locks and reintroduce the product. Not good.

COLVIN: Believe it or not, I think that David has an observation on this.

KIRKPATRICK: Well, with all due respect, it's something I wrote about in FORTUNE very recently in our cover on blogging, because blogs were so salient to that whole chain of events. And having spent a lot of time talking to the company, I don't really think it's fair to call it the dumbest moment in business myself, because in reality they didn't know this, nobody knew it, the thieves figured it out. They couldn't help the fact that the Internet is now a whole new medium for dissemination for this kind of information. So my feeling is they were caught in a vise not of their own making, and their product, which has been the defining product of that industry for decades, has been, you know, assaulted. However, they made a very smart move, I think, which is that they decided to replace any lock of that type, that U-shaped lock, that has ever been sold, going back to the '70s. So I would say that was a very smart move. Luckily, they're owned by Ingersoll-Rand, which is a big company that gives them the deep pockets.

COLVIN: They can afford it. Although, in Todd's defense, I would say that in 30 years of making the product, they might have figured out before now that you could open it with a Bic pen.

KIRKPATRICK: Perhaps. Sorry about that, Todd.

COLVIN: Todd, you're a connoisseur of dumbness. What else were your favorites in the dumbest moments this year?

LAPPIN: There's so many good ones. My favorite all around was, to go back to AT&T, AT&T was fined $400,000 this year by the U.S. government for basically making unauthorized telemarketing calls to customers, which was again that's bad, but what was really bad was that AT&T was also administering a $3.5 million federal government contract to administer the Do-not-call list. So this was the same company that managed the list of people who they weren't supposed to call, which was then fined for unauthorized telemarketing. Again, that's classic dumbness, and I don't think there's any two ways to tell that story.

COLVIN: No, that's hard to beat.

KIRKPATRICK: There is not.

COLVIN: That's classic. It's tough to beat. Anything else that appealed to you in the list?

LAPPIN: There's just so many. I mean the other great story of the year was the chairman of Smith & Wesson who was found to have a history of armed robberies and was forced to step down during his youthful indiscretion phase. Again, it's great to know that you believe in your product and you're willing to use the product, but this is not the kind of thing that is going to make any board of directors happy at all, and he was forced to step down.

COLVIN: He did have to leave, and as you guys said in the magazine, this was a guy who literally stood behind his product, just earlier in his career.

LAPPIN: Exactly.

COLVIN: Well, you can't make this stuff up, as they say. Todd Lappin, David Kirkpatrick, thank you.

KIRKPATRICK: Thanks.

LAPPIN: My pleasure.

Greg Forsythe interview

KAREN GIBBS: There's an old market saying: As January goes, so goes the year. Well, January was pretty ugly for the markets, with the Dow losing almost 3 percent. But February is off to a good start. The Dow gained 140 points for the first four trading days of February, the Nasdaq picked up 20, and the S&P added 16. So you could say the January sell-off offered you a good buying opportunity. But how do you know which stocks to buy? You could follow the herd and buy great companies. Or you could do what the brokerage firm with the best stock picking record over the past three years does…buck the trend and buy strong stocks.

Greg Forsythe, director of Schwab's Equity Model Development team joins us to share his strategy. Well, Greg, what do you do at Charles Schwab that others aren't doing?

GREG FORSYTHE: I think that we take a strikingly different research approach than that of the traditional Wall Street firms.

GIBBS: What is that different research approach?

FORSYTHE: Well, I believe that it starts with a focus on the stock. What we see with a lot of traditional analysts is that they seem to be focusing on the company. Their implicit assumption seems to be that if I find a great company, I'll find a great stock. But we've found that that is not really very effective, because greatness is no secret, so those companies tend to be fairly valued, actually have high and above average multiples, but maybe more importantly, they're set up for disappointment. And when that disappointment comes in, the growth doesn't come in as expected, those great companies turn out to be bad stocks.

So a great stock by contrast, is one that is undervalued. Okay, but if a stock stays undervalued, that doesn't do the investor much good, so there has to be a mechanism by which that undervalued stock comes back to fair value. And we believe that mechanism is to concentrate on the expectations that are embedded in any stock price. So what we're doing is we're looking for companies that have modest expectations and certain financial characteristics that we believe serve as a precursor to performance that exceeds those expectations.

GIBBS: Well, let's take a look at four stocks that you have on your portfolio list. One of the great stocks here is ExxonMobil. You also have MetLife, Electronic Data Systems, or EDS, and Tektronix. Now what makes these great stocks?

FORSYTHE: Well, they do share some common attributes. First of all, notice that none of them are expected to grow 33 percent a year like an eBay, for example. So they all start from modest expectations. But again, what we're looking for is their ability to outperform those expectations. So some of the attributes that they have are strong and rising free cash flow, also improving investor sentiment. And one way we can kind of see that, this surprisingly good performance out of their fundamentals, is that all four of these companies have exceeded analyst expectations in terms of the reported earnings for each of the last four quarters. So that's something we look for as a confirmation that these companies are doing better than what people really are counting on.

GIBBS: Well, with crude oil trading at almost 50 bucks a barrel, ExxonMobil seems like almost a no-brainer. Am I right?

FORSYTHE: Well, you know another common attribute that they share is controversy. I mean really all of these are contrarian choices. If you take Exxon, for example, of course some people think it might be a no-brainer with oil prices going up, but yet they might say hey, you know, I'd like to have a more leveraged play on oil. Of course there's the other side, and that's all those people that think that oil prices are due for a fall and they would not want to hold Exxon or any other energy stock. So all of these have something that's maybe a little bit tainting them in some way or other, and again I think that's what leads to better valuations that we can pick up on.

GIBBS: Well, basic materials are getting some serious investor interest for those that want to get a little bit better performance out of their portfolio. So why does Dow Chemical make your cut while Engelhard Corporation doesn't with gold at $420 an ounce?

FORSYTHE: Well, basically both of these are pretty good commodity chemical type of plays, but then you have to look at the actual performance and what they're showing. Engelhard's earnings are going nowhere. They're basically flat in an environment that we would think would be favorable to that kind of company. By contrast, Dow is turning in excellent earnings performance. So that's where we're really keying in on why we prefer Dow over Engelhard.

GIBBS: Do you have any great companies that are not great stock purchases?

FORSYTHE: Well, I mentioned eBay earlier as maybe an example that most people are familiar with. I mean we all know that that company is great, at least by the definition of it's been a great grower in the past, you know, a leader in its segment, but why we think it's not a great stock, we actually just got a chance to see that. You know they reported their recent earnings, which are really very, very strong, but slightly below those inflated expectations I was talking about, and the stock got absolutely hammered. So these great companies like eBay, that's what makes them tough. They have so much expectation built into their stock price that there's no room for error.

Another company like that is Southwest Airlines, and we all know how the airline industry is struggling, and Southwest seems to be like the one that we can count on surviving. Yet what's interesting is the company is making positive earnings, which is notable, but they're not really going anywhere very fast, yet investors are pricing this company at 30 to 40 times earnings. Using the approach embedded in Schwab Equity Ratings, we wouldn't pay that kind of multiple for any stock, much less an airline.

GIBBS: Greg, I keep hearing you mention expectations, and Wall Street lives on that. It's not what you did last quarter, it's what are you going to do for me next quarter? You seem to say no, don't think about expectations.

FORSYTHE: Well, what we want to do is don't automatically think that high growth is good. Every company has some level of expectations built into the stock price. That kind of serves as your benchmark. And whether those expectations are high, average, or low, what you want to do is look for companies that have the fundamental strength that would lead us to believe that they can outperform those expectations. When expectations are exceeded, those expectations rise, and stock prices tend to rise in concert.

GIBBS: Are you seeing any other trends coming up in your portfolio for 2005?

FORSYTHE: The approach that we use, our Equity Ratings are very evenly distributed across the growth and value spectrum and across the capitalization spectrum. But interestingly, right now we're seeing more large-cap stocks in our A-rated section than we have in years. And while Schwab Equity Ratings aren't really designed to make market-style calls, what that's kind of telling us, though, is from the bottom-up point of view, the large-cap stocks seem to be where the value is. Maybe that's due to the four-year-plus run up of small-caps, but we find that to be an interesting pattern and why I might guide people toward investing in large-caps this year.

GIBBS: Does it mean investors should sell their small-cap stocks?

FORSYTHE: Well, again, my specialty is really trying to figure out which stocks have the real good investment characteristics. So in general at Schwab we have a viewpoint, and we're fairly neutral right now on capitalization, though we may begin shifting more toward large-cap. So, no, don't go out and just sell your small-caps because we were seeing this interesting predominance of large-caps in the A's, but what we would be saying is really, really concentrate on each company's financial characteristics. And if you see any deterioration in the fundamentals, at the valuation levels a lot of these small-caps are selling, again there's not a lot of room for error.

GIBBS: Greg Forsythe, thanks for joining us.

FORSYTHE: Thank you, Karen, for having me.

Mergers

COLVIN: A huge influence on the price of any stock, for better or worse, is a takeover. The merger fever is upon corporate America, and suddenly megadeals are getting announced every few days -- Procter & Gamble to buy Gillette, SBC to buy AT&T, MetLife to buy a big chunk of Travelers, with much more on the way. For investors like you and me that means one thing above all: Watch your wallet. Big deals are usually bad news for the buyers. Not always -- just usually. In the ten biggest takeovers of all time, the stock of the buyer went down after the deal in seven cases. That doesn't mean you should try to play these stocks like a violin after a deal becomes public -- by then it's too late, says Judith Cohen, editor of Mergers & Acquisitions Report:

JUDITH COHEN: When a mega deal is announces it is no longer the average investor who is in the stock; the acquirer's stock and the target stock. It is the hedge fund. It is too difficult for an individual to assess the arbitrage risk; therefore, the average investor should enjoy the ride, if you will. Just enjoy the view and take a step back.

COLVIN: But before that happens you can do your homework: If you own a company that's making noises about looking for targets, proceed with caution -- especially in this deal-mad season.

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