Whether you're a Net stock fan or a Net stock phobe, you should see what Paul Meeks has to say.
He runs the $646.7 million
Merrill Lynch Internet Strategies fund and the $3.7 billion
Merrill Lynch Global Technology fund, in addition to clones of each portfolio for foreign investors. Unlike most talking heads, he's not chock full of mixed messages, he's a straight shooter who's not afraid to tell you where he's putting his investors' money and exactly who he thinks the next Net bellwethers will be. In a market obsessed with the simplistic mantra that "there will be big winners and big losers," he'll also tell you which companies will end up in either camp.
It's understandable if Net stocks and Net funds are scaring the hell out of you right now, but what other slices of the market might make you more money over the next 20 years?
1. OK, first off, let's just get it out of the way. What's your take on this election mess and the smackdown it's caused on the market these days? While we're discussing it, is either candidate really better or worse for tech stocks in general and Internet-related stocks more specifically?
Well, I guess it's all intertwined. I think the only impact this whole issue in the delay of naming the president is that it brings uncertainty to the market. And markets hate uncertainty and bull markets -- including technology, Internet stocks, particularly -- hate uncertainty.
When it comes to the individual candidate who wins, my sense is that each candidate is so interested in courting the technology vote out of Silicon Valley -- either before the election or while president because he is so interested in having their support -- that they're both going to do and say all the right things by the technology sector.
The bottom line: I don't think either one is going to push an agenda on technology that is radically different from the other. I think there might be a slight bias toward
George W. Bush
, just because Bush and the Republican Party might be deemed to be slightly more business favoring, but think about what happened during the election. Each guy spent a lot of time in Silicon Valley. It was obviously very important to each candidate.
2. A lot of discussion about the Internet is that it has reached "second stage," moving away from pure play Net companies toward infrastructure stocks. There are a lot of business-to-customer (B2C) shops out there that haven't found a way to monetize their business. But there are people who are monetizing this unmonetized traffic -- the networkers, the software shops behind the scenes. What's your take on that idea, and do you buy into it? With that in mind, where are you putting your money to work in the Internet sector these days?
That's a great question. I'll try to answer it and tell you how we're set up. We use, on a day-to-day basis, the
Dow Jones Composite Internet Index
as our stock specific benchmark. We get paid to beat other Internet funds, but unfortunately I can't pull up any of my competitors' fund holdings with any accuracy on a day-to-day basis.
So in the meantime, you've got to beat a stock specific index and you hope that if you beat the stock specific index, then by default, you beat most funds.
So I'm going to tell you our bets vs. the Dow Jones Composite Internet Index. In B2C, and we define B2C as having three flavors: finance, retail and new media, which are mostly the portal companies. But in B2C in its entirety, the index has a 35.7% weighting. We have 16.3%.
Who are your favorites there?
In the B2C space, as you can see by our weightings, we don't like much. I'll tell you what we own.
We own in finance our B2C finance category, Homestore and Intuit -- we like 'em both. And the only B2C retail name we own is
. And then in new media, which is mostly the portals, we have
. Now, even though we own those, Getty Images is not even in our benchmark at all, so just having a bet there or owning shares is a bet, but we are underweighted vs. this Dow Jones Internet Index, even though we have sizable absolute weightings in AOL and Yahoo! and we have an overweight in InfoSpace.com.
In the B2B (business-to-business) space, we have 30.8% in the index vs. our 19.5%, so we're also underweighted here. We divide the world into B2B advertising and marketing companies and then B2B, which is essentially the exchanges, so you could say B2B exchanges, the service companies and solutions providers.
in the advertising and marketing section; that's the only thing we've got. In the exchange vendors, we have
. However, they're both below the weight in the index.
In the what we call communications services under the B2B heading we own
and that's not in our index. We own
The Web hoster?
Yes. Exodus Communications. It's 3% of our fund, but it's a little bit less in the index. We own
at about the same weight as the index, we own a tidbit in
, the wireless vendor. That's it in services. And what we call services and solutions we own some
, the handheld device company. Also, we actually have a fund where we're allowed to do a very small amount in privates. We own a private holding in a company called
, which is a wireless vendor out of Atlanta.
If you're underweight for two other parts of the Internet -- B2C and B2B -- you have to be overweight in the third -- Internet infrastructure -- because there's only three in our opinion. Internet infrastructure comes in three flavors: hardware companies, components and software.
And in the index, total infrastructure is 36.3% and we're 54.2%.
This is where we are. And I'll give you a couple of the names in hardware:
In the components, they're mostly semis, companies that have their chips going into these networks:
on the optical component side,
(also going to be part of JDS Uniphase),
. We did the
IPO from a few days ago and
Then we have, in the last part of infrastructure, which is kind of the Web software companies,
, which is a pretty big 4.2% of the portfolio and
. And that's the dot fund.
3. In the Net area, what kind of parameters do you set for holding periods, and how do you make sense of a stock's valuation?
Well, first of all, we spend probably about 20% of our time doing the top-down thinking, which is: How much do we want to have vs. this Dow Jones Composite Internet Index in B2C, B2B and Internet infrastructures? Top-down stuff for us doesn't mean figuring out what the price of oil is doing or what
Greenspan's doing, or inflation or the euro; it's just these three broad segments of the Internet. Do we want to be overweighted, neutral-weighted or underweighted?
Then the next step is, say we decided in infrastructure we want to be overweighted. Within our hardware, components and software camps, we're trying to find leaders. That's a qualitative judgment that we make one of three ways, either from leadership in market share in what you do; leadership in technology, so over time if you have pretty good technology and pretty good distribution in marketing you do get to the No. 1 market share position; or a leadership in business model, which may have nothing to do with the first two.
Then we actually pick the stocks -- take a look at the peer group of where we want to be overweighted, who are the leaders. Usually you can find a leader that meets all three of those legs of the stool, and you have to do some quantification. And what we do is we try to set a tier price target. We want to have a stock that we think can move at least 50% over two years, and with better stocks in technology, because we do this same kind of method with all of our funds, we look at the price-to-earnings, the price to sales -- obviously, you can't make heads or tails of most of those benchmarks. We typically use some kind of discounted cash flow analysis for the dot-commers that show up in our portfolio -- which is actually kind of light, as you saw.
But the other companies like the hardware, the software, the solutions providers are the companies that usually end up in the heavily weighted, kind of the majority of the portfolio in infrastructure. Most of those are companies, like Cisco, for which you could easily make the case that they're No. 1 in Internet infrastructure but you can value them based on a traditional method because they've been around a long time.
Then if the stock gets too close to your price target, if we can't make a case for greater earnings power or cash flow generation, whatever the case may be at that point, we sell it. That could happen in two weeks. If we're lucky, you pick a good one, and if you pick a bad one, in our core funds we usually have a come to Jesus meeting if the stock drops 25% from below what we bought it; we just might throw in the towel, even if we can't get any new information.
In the Internet funds, a 25% downward drop before it hopefully goes up again is commonplace. So we can't blow everything out automatically.
4. The market's mantra over the past few years has been this simplification -- some would say oversimplification -- of people saying just buy the winners. That sounds great, but it's really not an easy thing to do. What are some of the criteria that jump out to you?
When a company has No. 1 market share and they're increasing their lead from No. 1 to No. 2, that distance is actually widening instead of shrinking as you would think, in a kind of situation where you typically regress to the mean.
I do believe that in technology -- and this isn't just for the Internet but for every company -- that the strong get stronger. That over time, No. 1, you say, "Oh, geez, Cisco's gotta have some market share taken away by Juniper." Those things happen from time to time. But I do think, for the most part, the strong get stronger.
So, starting with No. 1 market share, in a market that is not in secular decline or maturing but is still a pretty fast growth market, then even if somebody takes some share, there's still room for everybody and I'd say that's the Cisco/Juniper philosophy. These guys usually build on their gains, instead of lessen their gains.
And part of that, from a pragmatist's standpoint, is that people at companies that buy technology for a living, they're not going to get fired for buying a Cisco product, and somebody else seems like a risk. That's part of how that momentum builds, right?
Yes. So the strong get stronger, particularly in the Internet world where you go another step. Like in core technology you may not get fired for buying Cisco, but you may not be too worried about buying No. 2 because that company's going to be around. But in the Internet world, with these business models where there is a high risk of bankruptcy to some of the second-tier providers, then you really want to go with the leaders because you could get fired if you have no after-market support because that vendor actually went bankrupt.
You know, you actually see that in the Internet space vs. the core tech space. You could have a loser, who's the loser for a while, but is not in financial jeopardy of going bankrupt.
I think business model is important. You've got to have a superior business model that shows me no more than 18 months away from not just cash flow generation but earnings power. I mean, like anybody else in this space, a year or so ago we did participate in a lot of IPOs because it was easy money. But now, I don't know if I'm going to even go to an IPO, even when the investment bankers open the IPO window, to a roadshow, when I don't know that in advance. I've just been burned.
So you've got No. 1 market share, a superior business model and also, as I said before, a superior technology, which is obviously very important for the infrastructure guys, not necessarily important for somebody like a content provider, right, because nobody cares about the technology behind it.
And you want to be in the markets you feel good about qualitatively, the fast-growth markets that have kind of a reasonable time line to profitability, where you really can say that company adds value vs. that company is just like everybody else existing out there. We got a lot of those Internet companies, which claimed that they would add value, and you saw very quickly that they didn't.
5. In the very recent past we've seen Pets.com (IPET) , Streamline.com (SLNE) , we've seen some of these more tenuous folks, the hangers-on kind of stop hanging on. Do you think we're going to see a lot more of that over the next year?
Oh, I think you're in the midst of massive consolidation in the Internet space and I honestly believe that 80% of the companies that existed are going to go to zero. Now, when they go to zero, they may go to zero with a bankruptcy route, or else they might, if they're lucky, get taken out by one of the strong-get-stronger players.
Now the 20% that remains -- that's why I'm actually still bullish on the Internet over time. The Internet is still a theme that's reshaping the world; nobody disputes that. After we get through the consolidation period, the massive shakeout, what are we, in the sixth inning, or something like that? Probably further along than you might think.
The ones that remain are going to be fantastic investments, in my opinion. Because think about it: Not only will they get bigger and stronger and then all of the scale benefits that we discussed before from the biggest fish, but also some of these companies have been hit by pricing pressure, by the weaker guys that were trying to be on a massive land grab and not care about profitability. So they brought a lot of pressure to the industry, which was bad for everybody's margins.
Once those guys go away, the guys that remain are not only bigger and get the advantages of scale, but there's less pricing pressure on what they do, so they might even get an enhancement in their margins. So that's going to be great, but I can't give anybody near-term encouragement as to when this is all going to end, but I do think it's past the middle point, not to the seventh inning stretch, but I think maybe we're in the sixth, though we could have this continue for probably another year or so.
6. When we talk about this 20% -- the folks that are going to be around, the pure play winners -- I want to throw out some names as bellwethers, and if you could talk about those individually and then note if we're missing some. Three names that jump to my mind are AOL, Yahoo! and Amazon (AMZN) - Get Amazon.com Inc. Report. I don't know if you would add eBay or take away Amazon. What do you think?
AOL, I agree. I think they're going to be a multimedia powerhouse with
and I do think the deal gets done. Yahoo! we also own, we're a little bit light the benchmark. I do think Yahoo! is going to be a survivor. However, with 40% of their revenue in advertising, and both the online and the offline advertising spending either declining or growing at a lesser rate, I do think in the next couple of quarters, I wouldn't say they're in jeopardy -- I think they lowered the bar enough on their last conference call -- but I don't think it's a fabulous investment for someone who's looking for a short-term bounce in Internet stocks. I do think AOL, when they merge with Time Warner, could have that short-term bounce. eBay we prefer over Amazon.
Is that a business model decision?
Yes. Because think about it -- eBay has none of the inventory, none of these football-stadium-size distribution centers. It's pure Internet leverage, as Internet leverage should be, getting a cut of every transaction. And I do think that the auction market fits the bill of a market that is big and expanding and has a lot of potential as they go into other products.
Whereas Amazon, I do think there's a chance, I think Amazon is a story where it's going to be boom or bust. I think if they succeed, they will be the next
and years from now you'll say, "Geez, I could have gotten Amazon at this ridiculously cheap price."
However, I also think that their insistence on essentially ignoring Wall Street's advice to get closer to profitability and just Jeff Bezos' attitude of, "'I'm going to do my own thing and don't worry, I'll take care of you in the long run," -- each and every quarter, they announce another quarter in which they burn more cash and they can't give you any closer deadline to profitability -- I think it's a bit worrisome.
The way I look at Amazon is, we don't own it now. We haven't owned it since '99, and when Amazon turns around and gets closer to profitability it'll be so obvious that even if you miss the stock coming up 20 points from the bottom, if you buy it then when all the evidence is staring you in the face, you're still going to have a home run investment. So the way I look at it is, let's not try to play hero. When it happens, we'll miss a little move off the bottom, but it'll still be a multibagger for us.
It just doesn't pay to be a hero now because I think there's a 50% chance, as I said, that they're the boom Wal-Mart, and there's a 50% chance that they're bust zero. Not a good risk-reward scenario, even at this price.
I think I was reading an interview with Jim Clark, the fellow who founded Netscape and Healtheon and Silicon Graphics (SGI) -- and he was saying Wal-Mart and Amazon should get together. Do you ever see that happening?
That particular merchant?
Yes, Wal-Mart is perennially in search of a Web site, Amazon in search of profits.
I don't think so because Wal-Mart has been quietly and without a lot of fanfare increasing their own Web presence. I think they did something with a venture capital outfit on the West Coast.
They have so much offline clout, they probably wouldn't need Amazon. And then when you get the other side of the equation, Jeff Bezos has such a tremendous ego and he owns so much of the stock that he can do his own thing, and Amazon has such online clout that they probably don't think they need Wal-Mart.
So unless one side was to totally capitulate, which I could never see, I don't think they would do it. Unless we get in a situation where Amazon starts to become a bust scenario as I was describing, 50-50 it goes either way. If it happens that it starts to be very, very clear that it's going to be a bust, maybe they're so financially weakened they get absorbed by a Wal-Mart or something. Not a hostile takeover, but hey, you know what? This thing has failed, I'm going to sell it to you at a bargain basement price.
Now, we just talked about some bellwethers that are in the marketplace of ideas, people associate them with the word bellwether. Is there anybody that you would add to that list maybe down the road?
I think a couple of other dot-commer stocks should be in the group. I think there's short-term risk in Exodus Communications. But, you know, with this
purchase they're going to be an absolute Goliath, the 800-pound Gorilla in Web hosting. I think Web hosting is one of the markets I was describing before which is big and fast-growing and has a lot of potential. I think that needs to be on the long-term list.
I think Inktomi has a chance for that kind of status, but I'm more confident in Exodus long term. How about another company that clearly meets leadership that had an awesome, awesome quarter? TMP Worldwide.
I want to swing back to them a little bit because we've all been talking about this dipping ad revenue and instantly everybody thinks Yahoo! and what are they going to do with it and they guide the industry? Who's upstream from that problem that's maybe going to get hurt by it worse than the obvious folks? What about TMP? How do they weather that storm?
TMP, sure, they could get bit but first of all,
and all their Internet properties I think are only 20% of total revenues. The nice thing about them is they're kind of a pseudo-Internet company, they're actually generating a lot of nice cash flow and earnings. It's been a tremendous sustaining power for the valuation, but in the meantime the Internet business continues to do very, very well. And think about it: You have a chance of risk in ad revenues which is small for them because of the obvious -- you see what's happened to Yahoo! and
and everybody else -- but on the other hand, they're more than offset by a very powerful theme that we have in our society, which is 3.9% unemployment in the States.
Now these guys with monster.com: This is the Web site to go to, and so in an environment where, particularly when it comes to technology employees, there's negative employment, that means we can't possibly even fill all the positions we want to in the technology sector. These guys would be a beneficiary of that, I think that more than overpowers the advertising revenue, which I think for them is pretty small. And think about a company that has real world cash flow and earnings to offset the Internet build. In the meantime, their Internet business is growing beyond anybody's expectations. And I think they even mentioned in their last conference call, which was just a few days ago, that monster.com itself is profitable.
That's a big step.
Yes, I think that's a company where people don't realize that they have a monster in the market share with monster.com. It pulled away and it gets stronger and stronger. And of course they don't get a lot of press -- there's not too many Wall Street analysts covering this stock -- so I think it's an opportunity.
And you take a look at the chart, the stock has actually held up very well for a dot-com. It actually was going closer to its high more recently than its low. And one of the reasons is here's a company that, in 2001 is probably going to earn $1.39. That's some serious profits, because this year, they're on a December year, this year they're going to earn about 91 cents.
7. Right. Now, what's your take on the so-called Old Tech companies such as Microsoft, (MSFT) - Get Microsoft Corporation Report, Dell (DELL) - Get Dell Technologies Inc. Class C Report and Intel (INTC) - Get Intel Corporation Report that are somewhat dependent on maturing PC sales? They're trying to get into new areas. What do you think of Microsoft.net, the company's big Net push?
I do believe that there is a transition from Old World tech to New World tech.
For example, how we've held very little PC stocks throughout the year, it's helped us a bit, the only one we had was Dell and when we got their preannouncement many, many weeks ago, actually, when did we sell it?
We sold it the day that Intel preannounced. Because we knew everything PC was going to get hit, so we weren't around for their actual earnings. So, yes, the guys, kind of like the old horsemen, you know, let's talk about 'em, Dell, Cisco, Intel, Microsoft, probably led the charge for the better part of a decade.
Because all of those companies are tied at the hip to the PC, it doesn't really matter what market share they have any more because they already have all the market share they can get, right? Windows and Intel microprocessors control 90% of the pie.
Right, and everybody's got a PC at home and a PC at the office.
So they're not going to take any more market share because they already have the market share. They were totally dependent on further increases in the size of the pie, which is the PC market. And I think everybody would tell you that, yes, sooner or later we might get some signs that Christmas is going to be better for PCs than we originally thought, but this is a market that is used to growing at 20% to 25% per year.
PC business worldwide is probably going to settle into low teens growth rate. It's not going to go negative, but do you want to own a lot of Dell,
, the tech leaders of the Old World under that kind of scenario? I don't think so. So there used to be so much stuff in tech that was pulled by the PC, including a lot of software companies and other kind of commodities, semiconductor vendors like
, for example.
Now, we want to be in Web-enabled, new era technology leaders. So we've got some of these optical holdings in semiconductors; we're still there. But we're with the communications guys, not the PC-oriented guys. In software we're still there, but we have zero Microsoft but a lot of webMethods. Those are the kind of decisions we've made so far.
Our portfolio has gone from Old World tech to New World tech, which gave us pretty good relative performance until
lowered the boom on some of these expensive stocks a few weeks ago. And actually, overnight, we dropped in the rankings, but I still think these new era tech stocks are the ones to be in.
Yes. I think there's a changing of the guard, driven by the Internet.
8. You mentioned Christmas. What do you see in terms of this Christmas for online retailers? I know you said online retail is not an area you're overweight, not an area you're really rabid about.
I think there's actually going to be a lot of sales, more than last year, so it makes you confident in the Internet.
I think that's all legit that there's going to be more B2C and B2B done than you would have ever thought, and that's why I think the Internet's worth investing in, in that 20% of companies. But I think people are so despondent about Internet companies, particularly about some of these B2C profitless prosperity models that even though they have their upticks around the Christmas season...
Remember last year? These upticks made for a great fall for some of these stocks, fall of 1999. This year, I don't know, even if they deliver them, unless they show concrete signs to greater profitability, I don't know if people are really going to be that interested in the sales figures, maybe permanently on some of these names. So I think it's all going to happen, I just don't think people are going to care.
What's your take on DoubleClick?
Don't like it. They have a leadership position, but I just don't see a near-term rebound based on their market place. We've been in this stock, we might get back in it, but we've been out of it for some time.
I also think that management gets pretty arrogant. They've been battling the government for a while. They do not have a great reputation, whereas I have greater admiration for Yahoo!'s management team.
9. If you had to buy three stocks today that you'd hold for five years, which would they be?
Does it have to be dot-commers?
No, let's open it up. Any three tech names.
OK. Let me take a look here.
at 78 -- I pretty much like the contract manufacturing theme -- I would go with
10. What's the last new name added to the Net Strategies Fund? And what's the latest new name to your personal portfolio?
For the fund: Getty Images. Kind of small-cap, but we like it. In my personal account? I don't usually invest in stocks, I only own two and I've had them for a couple years, two contract manufacturers, Flextronics and
Those are the biggies, right?
Yes. But I'd say 90% of my net worth is in Merrill Lynch Global Technology and Merrill Lynch Internet Strategies at about a 2/3 weight to Global Technology to about a 1/3 weight to Internet Strategies.