Practical Models for Sifting Through Stock Ideas

In 1999, many managers held rigidly to "value" models and had a terrible year. The problem was that most technology companies got screened out by traditional value models. With tech sector gains averaging 79.6% last year, the only way for value managers to stay in the game was to abandon their value discipline (tough to explain to their investment committees) or watch their assets flow out the door.

My firm follows a plain-vanilla growth model -- primarily, investments have to meet certain quantitative standards, have so many years of positive earnings and have certain growth characteristics relative to the S&P 500 index.

Some 90% of the companies in our portfolios meet these criteria. Sometimes, however, we see investment opportunities that don't meet these screens but offer the potential for outsize returns. These riskier investments are the fuel that boosts our returns over the S&P 500. Fortunately, we have a number of "qualitative" models we can use to sift through these opportunities:

Innovators/Adopters/Laggards Model

This model is straight out of any marketing textbook. The theory is that potential customers learn about, try and adopt or reject new products, processes or concepts at different rates. Innovators want to try everything; adopters try something only if they can leverage off someone else's experience; and laggards participate only if it's clear that the cost of not participating is higher.

As investors, we try to predict which new product or concept will expand beyond the innovators and how quickly.

Successful Product

The above chart illustrates the sales growth of a successful product from introduction to maturation. DVD players are an example. A couple of years ago, only hard-core audiophiles had even heard of this product. This past Christmas, however, sales jumped as video rental stores added DVD movie titles. Over the next several years, look for more households to acquire DVD players as the discs replace video cassettes as the preferred medium for viewing movies (especially in combination with HDTV). Eventually, even the laggards will have to get DVD players, just as they had to get CD players when music stores stopped selling vinyl records.

Unsuccessful Product

This chart illustrates sales growth of a product that failed to catch on. DAT players are a good example of this scenario. Although they share many characteristics of DVD players, DAT players didn't offer consumers a substantial listening advantage over conventional tape or CDs and sales never caught on.

At the dawn of the Internet era (1994), it was not clear which path Internet use would take. Was it the next network TV or the next CB radio? In 1995, when www.companyname.com became ubiquitous in corporate advertising, it became clear that the adopters had taken over from the innovators.

In contrast, a few years ago the cigar sector was a hot investment. Somehow, we just couldn't see cigars becoming a universal consumer product, and fad products are notoriously difficult to invest in. In fact, cigar sales have followed the growth pattern pictured in the second chart. A review of the stock price history of, say, 800 JR Cigar (JRJR - commentary - Cramer's Take) shows that the people who made the most money off this opportunity were the insiders who sold out at the initial public offering.

Smoke to Ashes 800 JR Cigar, and the cigar fad, appear to have burned out.

Source: BigCharts

When Highways Are Being Built, Buy Cement Companies Model

In the late 1950s, President Eisenhower conceived the Interstate Highway System, one of the greatest civil engineering projects of all time. Prescient investors capitalized on the project by investing in cement companies, heavy machinery manufacturers and, later, in land near exits and at major intersections.

When the Internet was first described as the "information superhighway," we immediately began researching companies that would provide the infrastructure. So, we put money into Sun Microsystems (SUNW - commentary - Cramer's Take), which provided servers, Cisco (CSCO - commentary - Cramer's Take), which designed routers, and EMC (EMC - commentary - Cramer's Take), which manufactured mass-storage devices.

At the time (1996), we regarded these investments as low-risk compared with taking stakes in America Online (AOL - commentary - Cramer's Take) or Amazon.com (AMZN - commentary - Cramer's Take) because these companies already had real products, real sales and real earnings. If the Internet had turned out to be a flop, the downside would have been limited.

The Enabling Model

Another low-risk approach is to consider companies that are "enabled" by a new technology. In the dawn of the Industrial Era, British coal mining companies were enabled by the introduction of the steam powered water pump, which allowed deep seam mining because it was possible to keep the shafts drained. The semi-conductor had an equally transforming effect on manufacturing and on white-collar work in the 1970s and '80s.

By 1997, it was clear that the Internet was an enormous enabling force. The pure Internet plays still looked dicey but plenty of companies were taking advantage of the new medium, like Dell (DELL - commentary - Cramer's Take), which pushed its build-to-order model right onto the desks of its customers, and FedEx (FDX - commentary - Cramer's Take), which achieved enormous savings by putting its package tracking on the Web.

The simplest method of determining which companies are in fact using new technology effectively is to look for success stories in trade publications and, to a lesser extent, in magazines such as Forbes. A corollary to the enabling model is the "denial" model -- you should be wary of companies that publicly decry a new technology. Merrill Lynch (MER - commentary - Cramer's Take), for example, was very outspoken against the Internet two years ago in its defense of traditional phone-based broker relationships. After Charles Schwab (SCH - commentary - Cramer's Take) and other e-brokers started taking away its best customers, Merrill was forced last spring into an embarrassing about-face. The two-year return in Merrill Lynch stock was 40.8%; for Charles Schwab, 190.8%.

The Salmon Swimming Upstream Model

Standing at the mouth of the Bogachiel River in Washington you'll see thousands of salmon heading upstream. Some will survive to the spawning grounds, but which ones? Go a few dams upstream, and you can then start making picks from the 10 salmon left per 1,000 that entered the mouth of the river.

With the introduction of every new technology, hundreds, even thousands of new companies will spring up to take advantage. The mortality of these companies is horrific. There were at one time in the early 1900s nearly 2000 car manufacturers in the U.S. Now there are two: Ford (F - commentary - Cramer's Take) and General Motors (GM - commentary - Cramer's Take); three, if you count DaimlerChrysler (DCX - commentary - Cramer's Take).

If an investor had put equal dollar amounts in these 2000 car manufacturers in 1920, he or she would have just about broken even by 1950. If in 1950, the same investor put equal dollar amounts in the 10 car companies that remained, he or she would have done very well by 1970, even though only four companies remained.

So what about Internet stocks? There are about 500 pure-play companies in this sector, 90% of which won't exist in five years. The odds favor those companies that have the biggest mindshare (i.e. have established the highest level of brand awareness), the biggest market share in their subsector (portals, online retailing, etc.) and enough currency (high market cap, cash in the bank) to throw their weight around.

Last April we bought a basket of these stocks for our clients, including Amazon.com, AOL, Broadcom (BRCM - commentary - Cramer's Take), CMGI (CMGI - commentary - Cramer's Take), DoubleClick (DCLK - commentary - Cramer's Take), eBay (EBAY - commentary - Cramer's Take), Macromedia (MACR - commentary - Cramer's Take), RealNetworks (RNWK - commentary - Cramer's Take) and Yahoo! (YHOO - commentary - Cramer's Take). We're patient with the volatility (the group fell 50% between April and August 1999) and continue to add positions.

The End-Game Model

In chess, the "end game" is the stage in which the player with the advantage in pieces and position bears down on the opponent. The weaker opponent at that point cannot hope to win, only to drag out the game perhaps to a draw, more likely a loss. In investing, the end game occurs when a sector matures.

For example, in the mid-1980s, the market for desktop software applications was wide open, with Lotus, IBM (IBM - commentary - Cramer's Take), Ashton-Tate, Borland, Corel (CORL - commentary - Cramer's Take) and WordPerfect all competing vigorously with products based on the DOS operating system. Microsoft (MSFT - commentary - Cramer's Take) was barely in the applications game at that point. However, with the migration to Windows-based applications and the introduction of suite-based products, Microsoft gained enough market share to pull ahead of the competition once and for all.

The end game is pretty challenging to figure out. As an investor, you have to keep track of which companies are gaining market share at whose expense, which companies have carved out a defensible strategic niche (e.g., Microsoft in desktop operating systems) and which companies are vulnerable. Strategic alliances and mergers take place -- which companies gained, which ones chose badly?

Recently, AOL and Time-Warner (TWX - commentary - Cramer's Take) announced a merger. What does this merger mean? A triumph of new media over old media? Recognition by AOL that its current 22 million customers may represent saturation of its market? Or just another chapter in the history of Time-Warner executives enriching themselves at someone else's expense? We've read every piece of analysis we can find on this merger, and we're still forming an opinion.

In another recent merger, Charles Schwab is buying U.S. Trust (UTC - commentary - Cramer's Take) at a handsome premium. If Web-based stock trading is the wave of the future, why would the leading e-broker buy a company known more for tea service than execution service? U.S. Trust may be old-fashioned, but its profit margin at 23.8% is much more attractive than Schwab's 14.9% (and falling) profit margin. Schwab may well have looked into a profitless future of $7.95 commissions and decided to differentiate itself from recent upstarts. Look for similar mergers between new-economy and old-economy companies in the months to come.

Last, we see Amazon.com making substantial investments in Drugstore.com (DSCM - commentary - Cramer's Take), Audible (ADBL - commentary - Cramer's Take), Homegrocer.com, Pets.com (IPET - commentary - Cramer's Take) and Della.com.

Although Amazon.com is a long way from making money, it has that critical level of mindshare that enabled the company to sell $1.25 billion of high-yield securities for the last three quarters. Amazon.com's targets are not so fortunate. Audible.com, for example, has $42 million in cash on hand, $36 million from its recent initial public offering. That's not a lot of money in an era when 30 seconds of Super Bowl advertising costs $2 million. To survive, Audible has to partner with a presence like Amazon.com, which can promote Audible without spending cash.

Especially this year, which we predict will be a shakeout year for many Internet companies, investors have to scrutinize the balance sheets and cash flow statements of their investments and limit their investments to those with the deepest pockets.

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David Edwards is a portfolio manager and president of Heron Capital Management, a New York management firm. At the time of publication, his firm was long Sun Microsystems, Cisco, EMC, America Online, Amazon.com, Dell, FedEx, Intuit, Ford, General Motors, DaimlerChrysler, IBM, Apple Computer, Broadcom, CMGI, DoubleClick, eBay, Macromedia, RealNetworks, Yahoo! and Microsoft, though positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Edwards appreciates your feedback at [e-mail].