"Nowhere does history indulge in repitition so often or so uniformly as in Wall Street. When you read contemporary accounts of booms or panics, the one thing that strikes you most forcibly is how little either stock speculation or stock speculators today differ from yesterday. The game does not change and neither does human nature."
-Edwin Lefevre, Reminiscences of a Stock Operator (1923)

Wow! What a ride it has been for the financial markets during the first quarter of 2000. The NASDAQ ricocheted between euphoria and fear, rallying its way past 5,000 for the first time and then getting hammered on three different occasions with corrections of 10% or more. The Dow, on the other hand, trailed the NASDAQ by 17.1 percentage points. The so-called Old Economy stocks were tested after disappointing results were announced by Proctor & Gamble, shocking most on Wall Street. However, many of these Old Economy stocks have come back to life after several quarters of neglect as investors have started to believe that inflationary threats seem under control and Alan Greenspan's string of rate hikes could come to an end over the next several months. In addition, recent fear and panic resulting from the NASDAQ's unprecedented volatility during the start of the second quarter has resulted in large sums of money exiting many stocks formerly exhibiting extremely high valuations; those funds are now running to the perceived safety of the Old Economy. On the surface, small-cap stocks appeared to have taken the lead this year as evidenced by the performance of the Russell 2000 Index which appreciated 7.1% through March 31, versus a gain of a mere 2.3% for the S&P 500. So, small-caps have been the place to be…or have they? After a closer look, one can see that the small-cap sector reflects what has been going on in the market as a whole. As has been the case with the S&P 500 for the past several years, a handful of large companies (primarily tech and biotech companies) has been leading the charge of the Russell 2000, while the majority of small-cap companies, especially those deemed "value stocks," have continued to languish or have produced negative results for the year.

One primary divergence in the Russell 2000 and other market indices has been between growth versus value. Year-to-date through March 31, 2000, the Russell 2000 Growth Index returned an impressive 7.4%. (In fact, during the first seven weeks of the year, it outperformed the S&P 500 by an unbelievable 2,250 basis points!) On the other hand, the Russell 2000 Value Index returned a mere 2.4%. The unusually volatile market activity at the beginning of the current quarter, with its attendant closing of the stock performance gap between the Old Economy and the more speculative elements of the New Economy, underscores how truly irrational the market had become. Given this disparity in performance during the first quarter and the subsequent reversal at the start of the second quarter, we think it would be useful to discuss some of the finer points of value versus growth and explain how both KING and your portfolios fit into this interesting market dichotomy.

The "Safety" Of Group Thinking

Throughout the years, KING has embraced a philosophy which gives us the flexibility to purchase stocks with varying market capitalizations. In the past we have owned large-caps, mid-caps, and small-caps, and the mix for our clients always depends on where we believe the most opportunity is present and what is consistent with our clients' objectives and risk parameters. Currently we are seeing many opportunities in all three market-cap segments, but perhaps one of the more striking anomalies in today's market is illustrated by the divergences present in the Russell 2000 Index, a benchmark for small-cap stocks. As mentioned, just a handful of stocks-16, in fact-accounted for the entire move in the Russell 2000 during the first quarter. In terms of capitalization, these stocks were hardly small, with market cap values ranging from $5 billion to $14 billion. In addition, seven of the 16 were losing money, while the P/E multiples of six others ranged from 139.9x to 533.8x. Only three had more "realistic" multiples (ranging from 29.1x to 44.9x). With the exception of one telecommunications concern, all of these stocks were either biotech or technology companies. Outside this handful of stellar performers, most stocks either declined or posted very slight gains. In fact, since the start of 1999, approximately 6,000 stocks traded on U.S. exchanges or the NASDAQ had actually declined 53.5% from their highs through the end of the first quarter.

Further exacerbating this divergence in performance is the fact that in the market environment of the past several quarters aggressive money chased hot stocks as never before. In most cases, little regard has been given to "minor" issues such as valuation or fundamentals. Investors of all types felt the need to participate. They frequently abandon their disciplines and, in some cases, their common sense, to follow the crowd. The end results often are devastating. Take MicroStrategy, one of the big movers responsible for driving the Russell 2000 Index substantially higher (at least through March 17th). MicroStrategy, which went public with a great idea in June 1998, was a high-flying software company with a market cap in excess of $25 billion at its peak. The Company's stock had actually languished below $20 per share following its IPO in 1998, but exploded when the company was repositioned to take advantage of the Internet. MicroStrategy was a typical story stock with a great concept which attracted significant attention from Wall Street and tremendous amounts of capital from investors. The only downside to this story was the neglectful attitude paid to how the company recognized and recorded its revenues and earnings. On March 20th, the company announced reported revenues and earnings for the past two years would be significantly reduced after it received comments from the SEC and other accounting policy makers. Shares of MicroStrategy plummeted 62% after the announcement, slicing $11 billion off its market value. Its shares at quarter-end traded at $87 per share, down from a high of $333 achieved on March 10, 2000. The "in-crowd" which purchased MicroStrategy in a feeding frenzy turned up with macro losses.

Dot-Com Collapse

Another phenomenon occurring with greater frequency is the implosion of many smaller Internet companies. In the dot-com world, many second- and third-tier companies which recently were the beneficiaries of hot IPOs and skyrocketing share prices now are running into financial difficulties. Theglobe.com, a company whose record sevenfold increase on the day of its IPO became an symbol of dot-com mania, is now running out of money. After its first day of trading in 1998, the company had a market value of $1.3 billion. With a recent market cap of $180 million, management faces the unthinkable scenario of exhausting its cash by late summer. And with shares changing hands at the close of March at just over $9 per share, down from a high of $48 1/2, a secondary offering is unlikely. Even more nausea was provided by MotherNature.com, an online health products company whose shares have plummeted from $13 to $3 5/32 after its December 1999 IPO. Then there is eToys, a well-known toy retailer, which went public at $20 in 1999 and watched its share price skyrocket to over $80. Due to increasing competition in the toy arena, shares recently traded for under $9 per share. eToys has only enough cash to last eleven months. Finally, Peapod, an Internet supermarket, has burned through all its cash. It recently announced that a potential injection of $120 million in funding was withdrawn after news broke that the company's CEO was resigning for health reasons. The CEO is not the only one who is ill. Its shareholders turned green upon learning that the company is considering putting itself up for sale, but has warned it might not be able to continue operations while it is considering alternatives. After going public in 1997 at $16 per share, the stock closed the quarter at $2 11/16.

For most of these companies, raising capital, once a sure thing for almost all aspiring dot-coms, is now a serious problem. Secondary offerings for many are certainly out of the question at these depressed levels. The ability to raise debt is also very limited. With a lack of assets, these companies can frequently only borrow money on terms which are not favorable and at very high interest rates (frequently in excess of 20%). It is also worth noting that, while large-cap Internet companies do not face the same capital-raising hurdles as their smaller-cap brethren, some also are starting to run low on cash. One of the best known Internet plays, Amazon.com, may have only ten months worth of cash left in the till.

The message is clear. Money-losing Internet companies with sinking shares are limited in their ability to raise the capital needed to survive, even if they have a viable business model, which many do not. The alternatives for raising capital are few as many of these companies have a short track record, few assets, and little promise of turning a profit in the near-term. We are witnessing a bubble bursting, which will give rise to the following refrain: Out of dough, out of time, out of business.

Value, the New Economy, and Market Inefficiencies

It is clear that devastating land mines exist in today's financial battlefield. Unfortunately, many investors and investment managers alike frequently have been caught up in the manias of today's market. They are afraid of being left behind if they do not participate on days when the major averages have large swings to the upside (even if the moves are being driven by a handful of overpriced stocks), or if they do not own a stock mirroring the latest fad, or if they are left out of the latest hot IPO. But the cost to participate for fear of being left behind often is very expensive as evidenced by the examples cited above. Again we get back to the old adage, patience pays, and sticking to a disciplined and successful investment philosophy ultimately pays off over the long-run.

David Dreman, a well-known money manager and investment author, recently conducted a study of 1,500 stocks traded in the U.S. from 1983 through 1998. He charted five major fundamentals-earnings, cash flow, sales, profit margins, and return on equity-against three important ratios: price/book, price/earnings, and price/cash flow. He then compared the most expensive stocks, based on these valuations, with their stock performance over that time frame, and did the same comparison for the lower priced stocks. The result of the study was that no consistent link existed between fundamentals and short-term stock price movements. The market is not always efficient over shorter periods of time. This is the result of investors not correctly valuing the prospects of companies. Those with perceived good fundamentals often are overvalued significantly. At the other extreme, those stocks exhibiting weaker operating performance tend to be undervalued to an extreme by investors.

So how does an investor succeed in today's market without incurring significant risk and chasing the high-fliers? At the other valuation extreme, there are true value stocks, companies trading at a low price/earnings, price/book, or price/sales ratio. While most of these companies clearly do not have the same levels of operational risk or business risk that many high-flying, technology-related companies have, they have demonstrated that they do possess market risk. Despite extremely low valuations-for example, small cap value stocks are trading at 30-year lows relative to large-cap stocks based on P/E, price/book, and P/E to growth rate ratios-pure value stocks have not been the place to be over the last several years. In fact, many companies are essentially being given away at today's extremely low valuations. Few "investors" care. And during the first quarter of 2000, the disparity in returns became even more profound.

One recurring problem is that investment managers and investors frequently fall into so-called value traps. They cannot justify selling many of these stocks because they are "too cheap," but frequently there are no near-term catalysts to get the stocks moving. In some cases, these companies are experiencing slow (or no) revenue/earnings growth due to strategies which have gone awry. Regardless of the rationale, their value is not being unlocked or seen in the world of the New Economy. The end result is clear: holding on to these stocks has resulted in underperformance.

This trend is clearly illustrated when looking at recent money flows into various categories within the mutual fund universe. In 1999, the aggressive growth and growth categories combined attracted $131.4 billion in net inflows versus a net outflow of $14.4 billion in value funds. In fact, value funds, as a group, experienced net redemptions every month during 1999. At the start of 2000, this trend accelerated. In January alone, aggressive growth and growth funds brought in a total of $29 billion (an astounding 22% of the total inflow for 1999), while value funds experienced their greatest one-month outflow over the last thirteen months, losing more than $4.8 billion in assets. On a positive note, it is possible that the first quarter of 2000 witnessed the zenith of this outflow from the value category into the growth category, as many value stocks have begun to show signs of stabilizing while the NASDAQ has sustained severe wounds in recent weeks. The hemorrhaging of value funds might finally be coming to an end.

Another by-product of the underperformance in the value category is that many managers abandoned their buy discipline and have been chasing the hot stocks, deviating from their stated philosophy in many cases. According to Morningstar, only ten out of 44 mutual funds (22.7%) in the small-cap value universe have maintained an 85% exposure to small value stocks over the last three years. In fact, Morningstar's top five performing small-cap value funds had an average exposure to small-cap value stocks of only 26% as of the end of January 2000.

So why has value underperformed for so long and by so much? One primary reason is that the economy and today's business landscape has changed. It is no longer driven by manufacturing and smokestack industries, but by rapid-fire innovations in technology and services. There is no question that things are different. In today's New Economy, the big winners are not the lumbering corporate giants of the world, but companies that can change with the times and make their cost structure more efficient, properly utilizing and benefiting from major technological innovations. In order to prosper in this type of environment, an investment manager must come to grips with the New Economy's growth engines, a concept some traditional value managers have yet to embrace.

There is no question that over the last decade the world has undergone some very real technological breakthroughs which have changed the economic and business landscape forever. The recent technology/Internet mania is indicative of this fact. The history of manias is that they often are based on revolutionary developments (such as the Worldwide Web changing the way we communicate and the speed at which data can be sent around the world) which profoundly impact society. However, when investors get too caught up in these developments and lose sight of valuations and fundamentals, they tend to push shares to excessive valuations and price levels. Historically, when these manias balloon to extremes, the bubble eventually bursts, resulting in massive wealth destruction. On the other hand, investors who have eschewed these trends and developments in recent years, such as strict low P/E and low price/book value managers, have been left in the dust with performance records which leave much to be desired.

Value with a Growth Overlay

The obvious question raised is how KING and its clients have been able to prosper over time in the "anti-value" environment of the last several quarters, without straying from its discipline and resisting the temptation to buy the riskier high-fliers which have propelled performance for the major averages. One way we have been able to generate solid long-term returns (as opposed to quarterly sprints and fallbacks) and enhance the performance of our clients' accounts has been to stick to our investment philosophy and buy discipline, and yet realize that the world is a dynamic place. As a result, we find it is important to remain flexible in order to respond to real structural changes in the financial markets and in the economy. We are a value manager in the sense that embedded in the value philosophy is the belief that a company's stock price does not always reflect its true worth as a business. A value manager strives to buy a stock when it is significantly underpriced, in the belief that eventually other investors or third parties will recognize the stock is a bargain and will bid its price higher. However, unlike many traditional value managers, we do not shun growth. The price or multiple we pay for a stock is very important and a variable to which we are very sensitive; this is a crucial element to our process. We do not limit ourselves to purchase only stocks from a universe which has traditionally been branded as "value."

In past editions of The Decision Maker we have written on the topic of private-market value, which is very important to our investment philosophy and distinguishes us from many other money managers. However, it is the private-market value principle combined with purchasing stocks at a discount to their projected earnings or EBITDA growth rates which also makes us significantly different from most traditional value managers. It is this flexibility which has helped us as a value manager to succeed, adapt, and thrive in the New Economy.

As described, this approach enables us to be more flexible and take advantage of changes and real opportunities as they present themselves. For example, if an industry is undergoing significant growth, it usually is difficult to find a stock within the industry which is trading at a low valuation on an absolute basis unless there are financial problems, a poor business model, subpar products, or some other major problem at that specific company. Let's say a technological breakthrough occurs benefiting a particular industry and, as a result, companies within that industry are projected to grow their earnings at 30% to 35% annually over the next five years. A stock which we would consider buying would be one trading at 15x to 20x earnings, significantly less than its growth rate; however, this is a multiple other value managers might consider too rich. In many cases, traditional value managers may not be able to take advantage of today's growth opportunities if they are looking for a security trading at 10x earnings or less, or 1.0x book value or less. This frequently eliminates opportunities for their clients in industries which are growing and are attractive. However, if one looks at the companies within that industry which are trading at lower valuations on a relative basis or versus their own projected growth rate, some big winners can be found. Again, growth is a desirable characteristic. We are just sensitive to the price we are willing to pay.

Opportunities are present in today's market which allow investors to benefit from some of the revolutionary events taking place, without paying exorbitant prices. It is prudent to limit your risk by being conscientious of the price or multiple you are paying for the growth you desire. Examples can be found throughout the market in different capitalization stocks: large-cap, mid-cap, and small-cap. In the past we have commented on how we have benefited from changes in technology through our holdings in wireless telecommunications stocks, companies which, for the most part, were fairly inexpensive on a cash flow basis just a year or so ago. Although many of these stocks have seen their share prices raise substantially over the last year, the potential for mobile communications and mobile data is still huge. In some ways, it is like 1995 revisited with regard to the development of the Internet on the wired side. People fundamentally want to be untethered and, once they find a suitable wireless product, they tend to increase their usage of that product. In addition, declining prices lead to both increased individual usage as well as a greater appeal to a broader group of users. In the U.S., penetration of wireless products is 30.8%, an improvement of 4.8% versus last year. While the increase is healthy, it pales in comparison to the results seen around the world in 1999: the U.K. added 21.9% users; Italy, 17.5%; Korea, 19.9%; and Hong Kong picked up 11.3%. These are hefty growth rates and it is likely that wireless growth will remain robust. In fact, in the U.S., the crossing of the 30% penetration level is significant as it signifies that wireless has reached a level of social acceptance and growth in penetration that should actually accelerate from this point. Some predict that wireless penetration should increase to 48% by the end of 2001 and be as high as 80% by 2006!

Cable stocks are another area where our clients have benefited from the New Economy. Cable companies have benefited from the acceptance and use of the Internet as they essentially provide the inroads for this technology to enter into our homes. The value of cable recently was validated with the announcement of the America Online/Time Warner merger. In addition to highlighting the value inherent in cable companies, the merger should facilitate the affiliation between AOL and other cable operators which should, in turn, accelerate the rollout and adoption of cable broadband high-speed Internet service. Substantial growth still should come from this area, and consolidation opportunities should also present themselves.

A third example is in the potential growth of the biotech industry. It is expected that biotech companies will be able during the upcoming year to decipher the way human genes are constructed. Biotech researchers believe that once the gene map is decoded, drugs can be developed to treat many now untreatable diseases. This excitement has led to the biotech and genomics craze we have witnessed this past quarter. This evolving event is very significant and should result in explosive growth over the next several years in the healthcare industry. Although we do not own any of these biotech companies directly (many having cratered or crashed recently), we do own companies which should benefit from these developments. For example, Beckman Coulter, owned in most of our mid- and small-cap accounts, is a laboratory-equipment provider which stands to benefit significantly from this event. Trading at a low-teens multiple of projected 2000 earnings, Beckman is the largest supplier of the equipment used in DNA analysis to the biotech industry.

While we see much opportunity in today's market, rest assured that we will not get caught up in frenzies and abandon our investment philosophy and buy discipline to pursue richly priced stocks. And we will not get swept away in the recurring mania and speculation which impacts several areas of the market from time to time in order to chase returns. The current mania, which is already showing significant cracks, eventually will dwindle. Manias are no excuse for an investment manager to drift from a successful process based on a fundamentally sound but adaptive approach. Our emphasis will remain on private-market value and growth at a reasonable price. Today's market, despite its recent violent correction, still focuses on growth. And like most investors, we view earnings growth as an important attribute. However, unlike many investors, we are highly selective about the price we pay for it. In the current environment, just as in many other volatile periods of the past, we believe our process will amply reward clients over the long-term.

Patience is a virtue often forgotten in today's fast moving markets. However, patience does amply reward investors over longer time horizons. The value inherent in many undervalued stocks once again will emerge, rewarding investors. However, it is likely this will occur on a sustained basis only after the current speculative fever is truly broken. Already the spring meltdown is revealing some major cracks in the edifice of the "buy at any cost" mantra. Yesterday's illusory profits of overhyped and highly speculative stocks are quickly evaporating in the heat of economic reality.

Leah R. Friday, CFA
Vice President

Roger E. King, CFA
Editor and Contributing Writer