Cramer Rewrites 'What the Heck's Up With Nortel?'

Tough week. All tough weeks are the same, aren't they? They lead you to question every assumption. They make you want to give up on stocks that you've loved and made big money with because maybe, this time, it's over. They tend to take your breath away. You feel your chest heaving and your heart seems to want to wend its way up your throat to your mouth. The pounding and the pointlessness of hitting up the same quote over and over again as if, somehow, it would change things.

Most professionals would sooner be caught dead than admit that they have such feelings. We're supposed to be made of steel, or at least rebar and concrete. But I know the truth and I'm willing to share it because I want you to be a better investor and a better trader. Why do I want that? Why shouldn't I? The trade's been good to me. I want it to be good to you. There are people who helped me along the way, and they did it because they wanted to. There have been all sorts of questions regarding my motives for years now, to which I resign myself. There will be questions about my motives 10 years from now, too. There's a difference, though, and the difference is the thousands of emails I get each week thanking me for writing this column. Somehow that will always make up for the hits I take.

This column left me life open to you. I am obviously long Nortel (NT:NYSE - news - boards) and I am obviously distressed by it. I worry about it and I don't like losing money any more than anybody else. The day after I wrote this column, NT fell another four points. I took all four points personally, as I always do. I had just enough paranoia about how people knew I was out there and long NT and wanted me punished. But I banished those thoughts because if you want to shoot against me, there are certainly easier ways to do so, and more personal ways, than going against a great telecommunications company's stock. So it becomes a test of wills. Will Jeff and Todd and Matt and I break and sell? Will we take something off the table? Will we simply buy more on a scale? Will we buy options to enhance return on the way up? Will we insure on the way down? How will we battle this position? The greatness of the diary format is that you and I will see it unfold next week together.

Nothing beleaguers you like multiple sellers. (We learn of multiple sellers because we have direct lines to every major firm on Wall Street. The traders on those lines will say, "We've got 200,000 Nortel to go." Or, "We have a six-figure seller of NT." When you hear of this merchandise, it's pretty clear what's going to happen to the stock unless they catch buyers bigger than the sellers. They clearly haven't yet.)

Here we were all morning Thursday betting that the networking and telco equipment stocks would have at last bottomed, courtesy of the positive spin put on by Qwest (Q:NYSE - news - boards) about capital spending, and we watch, helplessly, as Nortel gets taken down by seller after seller. (Remember that telco spending is NT's lifeblood. NT makes equipment that helps you build out wireless and fiber-optic systems that get voice and data and Net traffic. That's why when Qwest, a major telco network, says it's going to spend more money, we rejoice that more orders will be coming NT's way. We thought this was bullish for NT. It might be, but there were other forces at work that weren't.)

Most of you don't trade institutionally, (When you run hundreds of millions of dollars, you may be better served by an apparatus that can help you buy and sell stocks more easily than by machines or the Web alone. We trade flow. We try to buy stocks as close as possible to our own prices and sell them at the best prices we can get. To do that we need the street. We need brokers managing our orders. We need a sales trader on the other end of the line that can work us out of a block of stock or put us in a block of stock at advantageous prices. When I speak of advantageous, what I mean is buying stocks pennies cheaper or selling them pennies dearer.

For us, performance is everything, so we need to have these folks helping us. To help us, they have to go over their loudspeaker systems and tell people what kind of merchandise they have. That's why we were recipients of the information that there were large sellers of Nortel. It's true that you could have guessed there were large sellers from the price action, but we were unable to track how those sellers were doing. If the sellers' merchandise was being lapped up, we would buy more NT at that level. But if the sellers were overwhelming the buyers, we would simply set up a strict and disciplined buy down scale. And that's what we've done in NT these last few days.

Of course, the problem with the buy down is that we don't know when the selling is going to end. That can make it so we're getting larger and larger in the stock. However, as we genuinely believe that stocks get cheaper on the way down -- I'm saying that tongue in cheek for you chartists out there -- we don't mind getting bigger, as long as it's at our price. We'll sell a little of the excess stock on the way back up, as we trade around these positions constantly.), so you probably have no idea what the heck I'm talking about, so I'm going to talk you through the harrowing experience of anonymous multiple sellers, so you know how debilitating they can be. First, understand that telco equipment stocks, like oil service stocks, trade on the budgets of giant customers. If you know that Exxon-Mobil (XOM:NYSE - news - boards) and Chevron (CHV:NYSE - news - boards) and BP Amoco (BP:NYSE ADR - news - boards) are going to up their capital spending budgets, you want to own stocks like Schlumberger (SLB:NYSE - news - boards), Halliburton (HAL:NYSE - news - boards) or Baker Hughes (BHI:NYSE - news - boards).

(One of the reasons why I like the drillers on weakness is because I know that the budgets for exploration will get larger and larger as the price of oil stays up. That means the earnings for the drilling sector will be up nicely year over year and that's what these drilling stocks trade off. It's very bullish for them if oil is up big for a sustained period of time.)

Similarly, if you know that the big telecommunications concerns are going to up capital spending, you want to own stocks like Cisco (CSCO:Nasdaq - news - boards), Nortel, Alcatel (ALA:NYSE - news - boards), AFCI (AFCI:Nasdaq - news - boards) or ADC Telecom (ADCT:Nasdaq - news - boards). Or even Lucent (LU:NYSE - news - boards) (although we own puts on that one). (There are a couple of key variables with these stocks. Telco demand is one. Gross domestic product growth is another. And having the right type of equipment is the third. We have been leaning against Lucent because we don't think it has competitive product lines compared with those of NT and Cisco. But we're conscious of the fact that if telco equipment spending is going to be cut back because of problems at AT&T (T:NYSE - news - boards) or WorldCom (WCOM:Nasdaq - news - boards), then none of these stocks is worth owning. Our thesis is that these companies, however, have no choice but to spend just to stay competitive. And I don't think they're doing so poorly that they're going to give up. AT&T and WorldCom, which are at or near 52-week lows, aren't doing well. But they won't do any better by spending no money. That's a sure way to lose the race.)

So, when we saw that Qwest was upping its capital spending budget, we figured it was going to be a good day for all the companies who would get a piece of that spending. (Q wants to be the second-largest phone company. It's very well run. It's going great guns. It's probably one of the most important customers out there. But it is not as important as AT&T or WorldCom. Fortunately, all over the world there are build-outs going on. This is a uniquely worldwide business. We wouldn't be in any of these if the international story weren't always part of the equation, and here it's a big part. NT and Cisco are constantly winning big business overseas.)

That includes Nortel.

When Nortel opened up anemically and then started trading down, we bought a little. Next thing you know, brokers were coming into us, multiple brokers, telling us that they had "six-figure NT to go." Some of them had 50,000 NT to go short. At one time we counted five different firms working simultaneous sell orders. (When you hear that someone is shorting NT in institutional size, the first thing that goes through your head is that there is someone out there who knows something negative. People tend not to short in that size because they're making market or valuation bets. They are betting that something extremely negative is going to happen and that it will knock the stock down long and hard enough to make a profit. I wrote about this extensively during the raid against Goldman Sachs some 50 points ago. Short-sellers were all over that stock, but they helped cause the bottom with their negativity. Remember that when you short, you are setting yourself up to be a buyer somewhere down the line. As an aside, I urge you to read Ben Holmes' excellent column about shorting, the one that contrasts his view with mine.)

That is highly unusual. One or two large sellers is not unusual, especially for a stock as strong as NT, where there are many people with profits. Even three sellers can happen. But five sellers? We think that means one of four things: 1. Imminent downgrade. 2. Loss of a big customer. 3. Giant dilutive acquisition. 4. Massive lockup unleashed. (I should have included 5. A negative upcoming article, which was the case here. The very next day the The Wall Street Journal's Heard on the Street column was devoted to this crushed customer thesis. It was all about how the WorldComs and the AT&T's may be too hobbled to spend. I thought people knew this, but it hurt the stocks again and there was still no sign of any turn when I left the joint Friday night.)

We can't really get our arms around No. 1. It's illegal for analysts to tell us or any client that they're going to downgrade a stock. (This is called front-running, and it's against the law. You can't tip off clients about what you're going to do. I sure wish they could, because we make tons of calls and would get this stuff all of the time. But they can't because it's illegal, and for good reason: The street is predicated on the belief that the playing field should be level. It would be very unlevel if every day you got a call saying, "This is Joe Blow from Merrill and you should get short so and so because I'm going to downgrade it tomorrow." That just doesn't happen, or if it does happen, it's done away from anybody I know, and I know a lot of folks.) All we can do is be sure that the fundamentals are strong and hope that no one downgrades it on "price."

(We fear downgrades. One look at the power of a Jon Joseph proactive downgrade of the semis tells you what happens if analysts get negative. Analysts sometimes do get negative because they can't take the pain of a stock going against them. But most often they use the opportunity to reiterate their buys. We're hoping that some analysts reiterate their buys on Nortel next week.)

There's always the possibility of a proactive downgrade -- someone saying "take profits because the stock has had a big run" -- but those downgrades don't really scare us. And as we'd just heard a presentation by management at a large public forum, we had no fears that something was going to crop up right then and there that could provoke a downgrade. (We hear a lot about how it would be better if analysts were to come out ahead of declines and tell you to sell. They don't do that enough. Believe me, though, if they don't think a stock should be going down, they aren't going to switch to being bears. Analysts aren't supposed to make trading calls as much as they are supposed to make calls on the fundamentals. However, even a squawk about how "I am worried that telco spending could be curtailed" could be dreadful.

Loss of a big customer is always a possibility. Nortel does vendor financing. They did vendor financing of that Logon America I wrote about recently. Maybe one of their clients defaulted. We keep close tabs on that, but it does happen, as we know from Ciena (CIEN:Nasdaq - news - boards) earlier in the week. While this is always a possibility, we couldn't figure out who people were guessing about today, other than Winstar (WCII:Nasdaq - news - boards) because it was down. We felt hedged anyway, because Winstar is a big customer of Lucent and we had the puts on Lucent. Cisco, Nortel and Lucent are always gunning for each other's customers, but Nortel has been winning more than its share, especially in optical.

(These companies are very competitive. They have to do what's necessary to win important orders, including, at times, financing the customer. This is not heretical. Did you ever notice how much money car companies make in car loans? It's a good business and these companies reserve against the problems. I am never that scared about vendor financing, because it's part of the game. These companies have well-paid risk managers who see it as their job to say no to credits that might not pay. It is not, per se, a dangerous thing to do.)

A giant dilutive acquisition can never be ruled out with a high-multiple stock like NT. (Remember, it has a higher price-to-earnings multiple than Cisco.) We saw Juniper (JNPR:Nasdaq - news - boards) run up and we figured it was just a matter of time before we heard that rumor floated and, like clockwork, it came up. I flagged it as seemingly untrue, although we own Juniper. Finally, Nortel has bought so many companies it's entirely possible that some of the owners of NT stock through these acquisitions might have been free to sell. We didn't have any luck checking this out. (As soon as NT started going down and Juniper was up, we got calls from brokers saying, "NT is going down because it's rumored to be talking to Juniper." I know that such talk is silly, but there have been enough occasions where stocks like NT have gone down because they were about to buy someone that it makes sense to postulate that such a trade may be behind the weakness. It's a big pain in the butt when this variable surfaces, because companies don't talk about acquisitions. So this is a fairly easy way to "raid down" a stock without worrying about the consequences. Kurtz's book, The Fortune Tellers, goes on and on about how rumors like this sweep through the street and routinely move stocks when the media picks them up. As soon as Juniper was up four, I figured it was just a matter of time before some source told CNBC that NT might be buying Juniper. It's too plausible not to run with! And if you don't say it, maybe Reuters, or TSC or Bloomberg or CNNFN will.)

So, while we couldn't rule out two, three and four, we were quite confident we wouldn't get one, and we bought stock into the maelstrom. Every time the sellers came back, we bought a little more. I guess you could say that we figured the sellers were wrong. It happens. A lot of selling in the business occurs because you hear about others selling. But you don't know what motivates the sellers or who they are. (Wall Street brokers never give up the names of sellers and don't tell you why they're selling, because they don't know themselves.)

(This kind of buying down on a scale is our stock in trade. Some of you emailed me and said, "Why do you sit there and take that beating?" To which I say, "How do we know when the beating will end?" We have to take advantage of the better prices to buy more of an equity we believe in. Maybe we shouldn't be, but we are, in the end, creatures of the fundamentals more than creatures of the technicals or of valuation. We know that NT is an expensive stock. But our gameplan says the market right now doesn't care much about whether something is expensive. It cares about whether a company is going to beat numbers, raise expectations and do better. Those kinds of stocks go up. They have bouts of profit-taking, but they go up. I can't control the sellers or even know who they are. But I can bet against them. And I did just that.)

We ended up with a big position bought at what looked to be good prices when we went home. (Ouch, that was dead wrong. And costly. We felt awful about NT's pricing action but we approached it as business as usual on Friday and we bought the stock all the way down. It's still not a huge position, but it's big enough that we felt emotionally wounded by its failure to bounce back Friday. We'll look at it again Monday and probably elect to do more buying, but as we bought the stock at $71.75 on Friday, we won't pay more than that and will wait until it trades at $70 to get longer.)

Sounds like we did it with precision, but several times we got off the desk to ask ourselves what all of these sellers could know. Many times we kicked ourselves and cursed that we couldn't get our arms around the reasons for the bailout. Ultimately, we simply called it opportunity, and took it.

We would never do so if we didn't, fundamentally, like the stock. I can't wait to see what happens next. (What happened next is we got off the desk many more times to evaluate whether we were missing something or something was wrong or amiss. We called every analyst and we spoke to the company. We came up with nothing other than what we already knew and is described here. As I told Jeff when he was leaving the office Friday: "Some mutual funds want out of this sector and will give you a millions reasons to sell. Every time we refute them, more sellers come out. They just want out, period." We accept that, but we not only don't want out, we want to continue to buy, on a scale, all the way down because we think NT will come roaring back.)

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James J. Cramer is manager of a hedge fund and co-founder of TheStreet.com. At time of publication, his fund was long AT&T, Alcatel, Cisco, Juniper Networks, Lucent puts, Nortel, Qwest Communications and Schlumberger. His fund often buys and sells securities that are the subject of his columns, both before and after the columns are published, and the positions that his fund takes may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Cramer's writings provide insights into the dynamics of money management and are not a solicitation for transactions. While he cannot provide investment advice or recommendations, he invites you to send comments on his column to James J. Cramer.