What happens when few growth stocks are growing and few value stocks are cheap?
You get the current strange state of affairs on Wall Street -- a no man's land where just about anything can happen from day to day because so few investors strongly believe in the stocks they own, and even fewer can find a compelling reason to invest in anything new. Many stocks, I'd say, have lost their constituencies.
It's constituencies, after all, that create stability in the market. Think of constituencies as large groups of institutional and mutual fund managers who are dedicated, by charter, to owning a particular type of stock. The biggest categories are growth managers and value managers, who have essentially opposite views about the type of stocks that should succeed. The first group believes that income growth powers stock price growth -- and they're willing to pay high price-to-earnings multiples (P/E) to own fast-growing companies. The second group believes that income growth is nice, but what matters most is the cheapness of a stock price relative to income, as well as cash flow and sales.
When great growth stocks go bust -- e.g., after they announce that sales are slowing down -- they tend to free-fall in price until caught by cheapskate value managers. When value stocks succeed, on the other hand, their owners kiss them farewell and place them gently into the hands of growth managers. This growth/value handoff goes on in the background of the market all the time.
Well, most of the time, anyway. These days, the problem is that the sheer number of busted growth stocks has overwhelmed the number of value managers willing to give them a home. And few value stocks are turning in the roaring success stories that would make them attractive to growth managers. So thousands of securities -- many of them formerly favorite tech stocks like
-- are in limbo. They're homeless creatures with no natural constituency and they will continue to drift down in price until either their growth picks up or their sheer asset value becomes compelling.
Growth managers, for instance, are unlikely to snap up Cisco shares in bulk until its executives clearly say that sales are back on track. Judging from the recent comments of Chief Executive John Chambers, don't expect that kind of talk to come until at least September. In the meantime, the stock's natural constituency seems to be willing to pay a P/E multiple that's equal only to a very modest level of growth expectations. Let's be generous and call that expected growth 18%. Apply a P/E multiple of 18 against the inflated consensus view that Cisco will earn 60 cents per share in its 2001 fiscal year, which ends in July, and you get a price of $10.80. Apply it to the 67 cents it's expected to earn in 2002, and you get $12.06. With the stock recently trading at $13.75, you can see that Cisco bulls have a problem.
So when will value managers step up to the plate to buy a stock like Cisco? Not for a while, since most of these folks tend to be very, very patient. They prey not on weakness, but on
. Cisco would have to fall by more than half again to get these skinflints to pay attention.
So which growth stocks are drawing the attention of value managers? Late last week I talked to two top practitioners -- Clyde McGregor at
and Susan Schottenfeld at
TCW Galileo Funds
-- to find out if
broken growth stocks are building a constituency among value investors.
Few Buys for the Buyers
First let's hear from McGregor, portfolio manager at
, which runs the superb value-oriented Oakmark family of mutual funds out of Chicago. "
has been saying lately that despite the sharp drop in stock prices, there's not much to buy -- and I agree with him," said McGregor. "Value stocks aren't as cheap as they were last year at this time. We're nibbling at the stuff we already own, but we're having trouble finding anything else. We need stocks with bulletproof balance sheets that trade at a 40% to 60% discount to their intrinsic values, and there still just aren't very many to look at."
Oakmark Equity & Income Fund is up 26% in the past year and 13.8% annually for the past three years, a pace that has helped him steadily outperform the broad market. He didn't look so smart in 1998 and 1999 -- a couple of "wilderness" years for value, when growth ruled -- but his style of balancing a portfolio of 55% stocks with 45% government and corporate debt has certainly paid off over time.
One tech stock that has caught McGregor's eye is networking software maker
. This is a company that has had more false starts than a sprinter with a hearing problem. Despite having a lock on the corporate networking software business in the early 1990s, it's lost 64% in value in the past 10 years.
But McGregor is willing to let bygones be bygones. Here's what he likes: Now trading around $5, the company has no debt and $2 per share in cash, $1 in "alleged value" in other companies and $1 per share in the "excess" real estate value (that is, property valued higher than what is carried on the company's books). That $3 or so is McGregor's "margin of safety," the rock-hard value that he believes another company would be willing to pay to acquire Novell's assets.
Novell recently indicated that it plans to enhance its software business by adding additional consulting resources. To that end, it recently announced plans to purchase
Cambridge Technology Partners
, a struggling information technology consulting company. McGregor says he's skeptical of any company's ability to make fundamental transitions in its business plan, but at these prices, he's willing to bet Novell can make this work.
The stock's price-to-sales ratio is 1.46, well below the 7.44 average of the application software industry. (Contrast that with a former highflying networking software maker like
, which despite a 60% decline in share price in the past six months, still sells at a price/sales multiple of 18.) McGregor said he would normally be looking for a double over three to five years, but in this case he is gunning for a triple or better to $15 to $20 by 2004.
Focused on Future Payoffs
Susan Schottenfeld, portfolio manager at
TCW Galileo Value Opportunities Fund, meanwhile, isn't shy about describing her relationship to growth managers. "We buy companies after those guys throw them out," she said. "This is a fantastic time for investors who really excel at research." Business may not be good today for most growth companies, but if her analysts can make a case that a company trading at eight times normalized three-year earnings will grow 15% per year long-term, she'll consider giving it a shot.
First, though, she has some hard and fast rules about stocks that make her short list: They must be trading at the low end of their five-year P/E range, they must have great excess cash flow, they must have a great balance sheet and they must have a low market capitalization relative to sales. In addition -- and this is where the art comes in -- there must be some catalyst on the horizon that will get other investors interested; that could be a new product, a restructuring or new management. (She has leveraged all of her 16 years of experience to put up big numbers in the past year; her fund is up 57.7% in the past 12 months, and almost 6% so far this year, both far above the market.)
Here are two tech stocks that she's buying now:
- Network Associates (NETA) . She thinks strong new management has the potential to propel this bedraggled company into a powerful turnaround story. It's recently been trading near $7, down from $67 two years ago. She says it has no debt, $2 in cash, owns 85% of McAfee.com (MCAF) , has a solid annuity-like business with genuine expectations for 20% growth, gets 80% gross margins and will earn $1 per share this year on normalized earnings (that is, with one-time charges removed).She believes the company can earn $1.50 per share in two years, which would take the stock to around $16 with the current multiple. If it passes that hurdle, she thinks growth managers will slap a 20 P/E on the stock and propel it to $30 by 2004. "That's a great story, right?" she says.
- Maxtor (MXTR) . Schottenfeld believes that the suicidal disk-drive industry, which has price-cut itself into near oblivion, is on the mend. She thinks competitors Seagate Technology and Western Digital (WDC) - Get Western Digital Corporation Report are determined to keep prices up, and if that works out you've got a group that can easily grow 15% per year. She thinks Maxtor, which will become No. 1 in the industry with its purchase of Quantum's (HDD) hard disk business, will earn $1 per share over the next year and has $3.30 per share in cash, net of debt. That gives her a reasonable margin of safety at a recent price near $7 a share. As other investors "start to see the $1," Schottenfeld says the P/E multiple on normalized earnings will lift to 15 to 20 and a share price around $30 is possible in three to five years. "I love this one because everyone hates it," she said.
I've done a screen that captures most of the quantitative rules that Schottenfeld seeks, and it turned up a few other stocks she likes, including passive electronics manufacturers
If the market is ever to bottom, it needs to get more stocks like these into the patient hands of this new constituency -- the Schottenfelds and McGregors of the world. Another month or two like February should do the trick.
As originally published, this story contained an error. Please see
Corrections and Clarifications.
At the time of publication, Jon Markman did not own or control shares in any the equities mentioned in this column.