Jim McCall isn't backing down.
The manager of
Merrill Lynch Focus Twenty and other
big-cap growth funds is sticking with his networking favorites like
, despite the sector's recent tumble. You might remember McCall from
, where he made his name running funds like
PBHG Large Cap Growth and
PBHG Large Cap Twenty. With tech stocks about as even keeled as
Captain Queeg in the
, we thought it might be a good time to ask Jim what he makes of the market these days and where he's going to make his shareholders money.
Fund: Merrill Lynch Focus Twenty Managed Fund Since: March 3, 2000 (inception). Formerly managed PBHG Large Cap Twenty and PBHG Large Cap Growth
3-Month Performance/Rank vs. Peers: 11.9%/Top 1%
Assets: $1.6 billion
Load/Expenses: 5.25%/1.25% (Class A shares)
Top Holdings:Network Appliance Juniper Networks Ciena
Source: Merrill Lynch. Performance thorough Nov. 2. Holdings through Oct. 30
1. What do you make of the market these days? Where do you think we're headed going into 2001?
The big issue right now is psychology. It has been extremely negative, especially in the aggressive growth part of the market, which is where we invest.
That's quite the inverse from this time last year.
That's exactly right. And I've had the feeling for several days now that these stocks are overdone on the down side, but clearly they can get more overdone.
There seems to be a lack of a catalyst right now, and people are fixated on a few data points that have some negative repercussions. In the absence of any positive data points, it's just a rush to the exits.
What could that catalyst be? The elections?
Well, that's the great question. I think a lot of things have people very nervous, and the election is certainly one of them. Not so much the uncertainty of it, but just the fact that it's looming out there and we don't know what the result is. The key thing is to get it over with, not necessarily who wins.
Maybe once we get that behind us, I don't know that that will be a catalyst, but maybe it will.
As you indicated, catalysts are hard to discern before they exert their influence, but it's really hard to identify a positive catalyst at this point. I thought last week when we got the
results that that would be a positive catalyst for the whole aggressive growth part of the market, and it was for about an hour. And it's been due south ever since.
All we're trying to do is make sure that the companies we invest
in have fundamentals
that are still very strong. We believe they are, and we just have to fight this negative psychology battle. It's not a good answer to your question, but I'm not sure there is one.
2. It's a very unpredictable, awkward time. Let's focus on the fundamentals. Based on earnings growth and other fundamentals, what sectors and what companies are you liking the most these days, and what's giving you that confidence?
We still like the optical space. Clearly, that part of the market's getting just creamed here, but again, we think it's just an overdone kind of a situation. We're still of the opinion that carriers need to continue to spend money on next-generation optical systems or their revenues are going to go to zero. I don't think they're going to allow that to happen.
I think they'll find the funding sources necessary to keep their revenues growing because they have shareholders, too, and they need to keep their shareholders happy, and the only way to do that is to keep their businesses growing.
If they're going to grow their business, they have to invest. The bottom line is, if you want to get revenue to grow, you have to offer services that are in demand. Clearly that's what the new optical systems are providing. At the end of the day, they're going to have to continue to invest in these systems.
We think the companies in the optical space that are the key suppliers are going to continue to deliver on the bottom line. And whether the stock prices react to that remains to be seen, but ultimately they will. You just have to be patient.
What are some companies that jump out to you in the optical space as being the strongest managementwise, and the strongest in terms of fundamental business strength?
Ciena is one of our largest positions. We think they are extremely well-positioned in this new, next-generation optical-systems market. They have three products out there now. They have a diverse customer base; their technology is cutting-edge; they seem to have all cylinders firing right now.
Does anybody else come to mind in that category, or are they far out in front of other folks?
There's different ways to look at that market. We also like the communications integrated-circuit companies like
Applied Micro Circuits
. They're essentially the munitions suppliers to the whole sector; their customer bases are diverse as well.
AMCC's under a lot of pressure because one of their largest customers is
, and everybody's worried about Nortel's business going to hell in a handbasket, so that's somewhat problematic. Nonetheless, we think it's way overblown -- certainly Nortel's an important customer for them, but they have several other large customers as well that seem to be taking up the slack.
We also like
. They're the optical-component supplier that's a generation ahead of the competition with their new products, although that's a smaller company at this point.
One thing that comes up when folks are taking shots at the optical sector these days is valuation. Many people think these stocks got to be too rich. Another component to the sector that's starting to come up is vendor financing, the idea of some networkers loaning money to their customers to buy the equipment from them -- which could, potentially, cause a problem down the road. There's a risk involved in loaning anyone money.
That's one of the big worries right now that's driving these stocks lower. But I think you have to look at the companies you own: How heavily are they participating in that, in the vendor-financing scheme?
Clearly that's a problem for
. It seems to be somewhat of a problem for Nortel, at least perceptionwise, although it seems to me that they're reasonably conservative in that regard and their customers are fairly well-capitalized to begin with, so I'm not sure there's a risk that their customers ultimately will not be able to pay for the equipment.
Clearly, if you're a customer and your equipment supplier is offering such a program, you certainly want to take advantage of it. Because it preserves your capital and spreads some of the risk around.
If the vendor doing the financing is not being particularly selective, then that's a risk. But I think the people at Nortel and Lucent are smart enough to not get too out of control with that. Ciena, on the other hand, I don't believe they do financing at all. So it's not a risk for them; yet the way the stock's acting, you would think they're about to file Chapter 11.
So it's an issue, certainly, and it's probably getting overblown. It certainly is under the microscope and probably getting more attention than it deserves, nonetheless when the psychology is as negative as it is, these things tend to get magnified.
3. Is there a cyclicality to the networking business regarding capital spending that some people didn't see? Where people take a vacation in the third quarter because spending will sometimes drop, then return in the fourth quarter?
I think the issue that people are more focused on is these new carriers, the ones that have yet to achieve profitability and that aren't that well-capitalized and need to raise capital in order to meet the business plans by some point in 2001. The concern is, if the financial environment does not improve as far as people being willing to lend to them, then come the middle of 2001, when they're about to run out of cash, that there's nobody that's going to step up and lend them money. Then they're out of business.
So I think that's a bigger issue than whether or not people are going to step up as they normally do in the fourth quarter, which I think they will.
4. What areas of the market are you avoiding these days?
Our approach is we want to buy the fastest-growing companies we can find and we want them to be secular growth dynamics as opposed to cyclical. We tend to stay away from the more economically sensitive names. We don't have any financials in our portfolios; we don't have any energy. I'm not so sure energy's a great place to be right now, simply because the price of oil is so darned high, and you want to buy energy stocks when the price of oil is low.
My sense is, we're in an economy that is very definitely slowing down and that the real question is, hard landing vs. soft landing. I happen to think soft landing is the likely scenario here. But any time the economy is slowing down, the first thing that happens is, companies that have exposure to markets that involve commodities, those markets just hit a wall. Then it's up to other parts of the economy to keep the economy growing while these commodity-oriented markets are flat to down.
So any market where there's a commodity slant to the end product, I want to stay away from those kinds of names. So we've basically stayed away from -- even in the technology space -- more commodity-oriented semiconductor companies. We
have stayed away from the PC manufacturers, and we've also gotten out of all of the semiconductor capital-equipment companies because that's the most cyclical part of the technology space. If the economy is indeed slowing down, then those companies -- I just don't see any catalyst at all there, and I would think estimates will be coming down there.
5. Two networking companies that are in a lot of investors' portfolios and fund holdings are Cisco (CSCO) - Get Report and Lucent. What do you see for those two companies? Can Lucent get back on its feet, and can Cisco compete with smaller, maybe more nimble competitors?
Lucent obviously has a lot to prove. They've disappointed three quarters in a row now. It's going to be very difficult for them to regain credibility. I think they took the first step last week by ousting Rich McGinn. I think that was a necessary step.
It's going to be hard because they've lost a lot of market share. I understand that the defections in terms of personnel are just unbelievable, and I don't know how you attract or retain people in that type of environment. So I think they've got a real challenge ahead of them. Even at this $20 stock level, I wouldn't encourage anybody to step up here. I'd rather miss the first 20% on the way back up, rather than risk coming in here and watching the stock go to $6.
As far as Cisco's concerned, it's very interesting today. You know, people used to talk Cisco up because it was facing this huge opportunity in the carrier space in a huge market where they hadn't been before. But now with the acquisitions and new products starting to penetrate, an analyst just made a call saying you should own Cisco because the bulk of their business is still in the corporate-enterprise space,
that they have not that much exposure to the carrier market. So we've kind of come full circle on Cisco.
Clearly, the strength in Cisco is the fact that they own their end customers. And when that's the case, you don't need to have the latest technology or the best price; if you have the customer relationship, you can continue to move product, and I think that's a huge advantage that they have right now. And that probably will sustain them, at least for a few more quarters. I can't see much further out than that.
Do you folks own the stock?
6. One issue a lot of people have been talking about is tax-loss selling. Coming off of last year, a lot of funds had just massive gains. A lot of people blamed a lot of the selling we've seen on institutions making investment decisions for tax reasons separate from investment criteria. Is that your thought? Is that what you think contributed to some of the down momentum?
Definitely. If you're a technology-fund manager, you're probably down in the year to date. The last thing that you want to do when you file your annual report with your shareholders is to tell them that, "Yes, we've lost 10% of your money and, oh, by the way, you've got a significant tax bill on top of that." So fund managers tend to do whatever they need to do coming into that end-of-the-year period to not have to send out that report.
I think there's a lot of selling of these tech stocks. Of course, they're selling where they have losses, so that's just compounding the natural order of things, I guess.
Now we're in the fortunate situation that we launched on March 3, which was right about at the peak of the
market, and so the stocks that we bought back in March all got crushed in the spring. And as we made changes to the portfolio, we were realizing substantial losses. So as we came toward the end of the year, and we checked to see where we stood, we discovered that we still had a significant net realized loss, so we had no issues as far as trying to offset any gains.
7. Another issue that has received a great deal of attention this year is the battle between the so-called Old Tech and New Tech. The Old Tech would be companies like Microsoft (MSFT) - Get Report and Intel (INTC) - Get Report or Dell (DELL) - Get Report that rely on the maturing PC market for a significant portion of their growth. New Tech includes companies in a lot of the networking space that are more dependent upon the growth of the Internet and the buildout of the Internet and the updating of the world's communications networks. Is this an overblown concept, or is there really a transformation happening? If so, who are some of the New Tech bellwethers?
The first company that comes to mind is
. Here's the first company to consistently be able to take market share from such a dominant competitor as Cisco. That clearly reflects the fact that they have a better product in the core routing space. Other names that might be emerging would be companies like
, clearly JDS Uniphase and probably names like PMC-Sierra.
And with JDS you're going to get SDL (SDLI) , too.
Right, actually SDL's the one that we own. We don't own JDS, but they move in tandem.
As a growth manager, do you set any time horizon or valuation parameters when you put money into a stock?
None of our decision criteria involve valuation. Our view is that valuation is really something that is determined by the market overall. It's really a psychological thing; it just reflects the psychology of the investor in the aggregate at any given point in time.
It's impossible to predict which way the psyche is going to go on that. Clearly, something can be overvalued and become greatly overvalued before it becomes undervalued.
If you make your investment choices based on somebody telling you that a stock is overvalued, you need to run away from that person as quickly as you can, in my view. We think the focus should be on the business characteristics of the companies and the markets that they're in and their competitive stance within those markets, and that's going to determine whether or not that company's growth rates are going to be accelerating or decelerating.
Our view is that if the growth rates are accelerating, it doesn't matter what the valuation is, those are the companies that you want to own, because the stock prices will react to the acceleration and the growth, not to the perception of the valuation.
In terms of time horizons, we get into a company with the expectation that we're going to own it for a multiyear period. The caveat on that being, of course, that the fundamental characteristics do nothing but get better over that time period. If they deteriorate, then it's immediately a candidate for sale.
8. That leads to the next question that every investor wants to know. Before a company comes out and says its results are not going to be what it thought they were going to be, what are some of the signals that you use as sell criteria? What are the flags that come up that people might not necessarily pay attention to or read correctly?
That's a great question. You have to be really in tune with the sector that that company's participating in and how the competition is faring. Clearly, if a competitor, whether it's a superior competitor or an inferior competitor, is having problems in a space, you need to track down why that is happening.
Is it because there's something wrong with the sector overall from a macro point of view, or is it just that a new competitor with a better technology has entered the space, or is it
that the company you own is clearly dominating and just crushing the competition?
You really have to keep a close eye on what's going on all around the company you own. And if you get the sense that there's something wrong, the probability is that there is something wrong, and you have to make a judgment without complete information, because if you wait until you have 100% confidence in your information, it's usually too late.
You have to make a judgment, and you're not going to be right every time. But if you're paying close attention, you'll be right more times than you're wrong, and that's what you get paid for.
In terms of a real-world example of that, what about the Lucent warning? A lot of their competitors fell with them, and a lot of people at the same time were saying, "This is a Lucent problem, this is not a networking problem."
I don't know. I'm still in the camp that says it's a Lucent-specific problem. Clearly they overpromised new products that they couldn't deliver. Whereas Nortel, on the other hand, does have the products out there that the market wants, and the problems with Nortel don't seem to be the same that we got from Lucent. So that would be a great analogy if it could be drawn, but I would have trouble drawing that analogy.
9. If you had to pick three stocks to buy today and hold for three years, what would they be?
I would buy Extreme Networks, I would buy Juniper Networks and I would buy
BEA Systems, that's something we haven't really talked about. What makes you bullish there?
Well, they have the leading product for enabling companies to become functional on the Web in terms of integrating back office and front office systems with Web applications software tools. Their only real competition is
WebSphere division, and that's not really great competition. The stock's been getting creamed over the last few days because they've had a reseller relationship with
for their product. Recently, Hewlett Packard announced the acquisition of
, which is a low-end application server/software company.
They don't really compete with BEA, but the perception in the market seems to be that the Hewlett-Packard-BEA relationship is going to go away now because of this Bluestone acquisition. Even if it did go away, it's not that big a deal; it's like $100 million over multiple years. I don't think it's going away, but even if it did, it's not that significant, and yet the stock is acting like it's the end of the world, so I just think it's badly overdone here.
10. Last question: What is the most recent stock added to your personal portfolio and the last stock added to your fund's portfolio?
I haven't added a new name to my personal account in a long time. I don't usually do that.
For most managers, that's impossible because you're not allowed to be in the same name on the same day with anything.
Yes, I just buy the fund. I don't think I'd want it any other way. I mean, if I have to worry about my own personal portfolio and also worry about the fund, I'm going to die at a young age. I don't want that to happen.
The last new name added to the fund ... I guess I'm hesitant because we're still building a position with one of the names, so how about the latest name that's now a full position?
That would be