Wynn Quon

Remember how the word "powerhouse" was used to describe companies like Nortel, Cisco, Intel and JDS Uniphase? You don’t see that word much these days. Nortel is down 93% from its peak, Cisco’s off 81%, Intel’s powered itself to a loss of 65%. And who even talks about JDS? (Well, we will, later in this column...but not for long.)

What happened to all the bulls that were extolling the new economy last year? There’s an eerie silence now. Some contrarians believe that this may be a good sign, because if everyone is bearish, most of the selling is over. But that might be premature because the problem isn’t to do with selling, it’s to do with buying. If I can describe the average tech investor today I would call him "fatigued". The high rollers who used margin have been burned badly. The conservative investors who tried to "bottom fish" earlier this year ("Hey, Nortel looks cheap at $30!) are now glumly waiting for it to come back before investing more. But the danger is that this fatigue can result in even more precipitous declines including single day crashes like the one in 1987, that saw stocks fall 20% in a day. All it could take to spark this off would be a flurry of unexpected bad news that would cause investors to simultaneously throttle way back on their buying. An unexpected bankruptcy, a default, a serious rise in unemployment statistics – any or all of these could be a trigger to a market conflagration. Another thing to keep in mind is that (and I hate to use the phrase), it really is different this time. With the rise of the Internet, bad news travels fast. Reaction (and overreaction) to bad news travels even faster. Chat groups and online trading helped pump the tech bubble up. The same channels will also amplify fear and panic in a crash.

All this means that keeping a level head is more important than ever before. Just as in the tech boom, the profits during a bear market go to the ones who keep their heads while others are losing theirs. In fact there’s a little-known stock market saying that goes "a bear market returns money to its rightful owners". So what investment approach should we take in this uncertain climate? One thing I’ve learned is that the more reluctant you are when you’re buying a stock, the more likely you’re getting a good deal. This goes against our day-to-day experience in buying things. When you see gas on sale at 30 cents a litre, you have no problem joining the lineup. Everyone knows that’s a bargain. But in the stock market it’s strangely different – the more bargains, the fewer buyers show up. This is because most people go by emotions. In a bear market, bad news and fear amplify each other until you can hardly give away stocks in otherwise fine companies. I don’t have anything against gut feelings in other spheres of life, but letting them run your portfolio is a quick way to get "gutted".

The way out of this dilemma is to turn your stock buying decisions into ones that more closely resemble how you buy your gas. When you pay 30 cents at the pump, you get one litre of gas. What are you getting when you pay US$6.00 for a share of Nortel? From the latest numbers, you’ll get US$8 of sales and US$0.60 of cash. Based on this, you now have to decide whether this is cheap or not. The decision isn’t a simple one (Nortel sales are falling) but at least you’re making your moves based on quantitative criteria. The trap many fall into is thinking: "X is selling at $10, it used to be $40, therefore it is cheap". It isn’t cheap if that $10 only buys you 10 cents of revenues.

But you may respond: "Don’t talk to me about valuation, what I really care about is when the heck telecoms are going to turn around." The only answer I have is that, without exception, any investment approach which relies on predicting short-term market or economic movements will eventually let you down, and badly. To succeed in the stock market, you need a long-term approach that embraces uncertainty. The first step is to separate what you think from what you know. Here’s an example. I think that things may get worse in the stock market. I think that we’ll see quite a few false rallies. I think the TSE and the Dow are vulnerable to a 50% decline over the next year or two. I think we’ll see some marquee names in high tech go down in flames. But I don’t know any of this. So I fall back on the scenario planning techniques which we’ve discussed before in this column. Scenario planning is invaluable as a risk assessment tool and more importantly as a way of breaking out of the psychological mindcuffs all investors get into. Here’s how I would handle Nortel. There is a slim chance that Nortel could go under, though I doubt it because we still have a Liberal government. I would decide how much to earmark for investing. (Of course, this is money we can afford to lose, we’re not talking GICs here.) I’d divide it into three parts. The current price is around US$6. I’d invest a third now. If the price falls to US$3, I’d invest the second third. If the price falls to US$1.50, I’d invest the last third. Say I have $3000 to invest. If the worst happens and Nortel falls to US$1.50, I’ll end up picking up 450 shares at that price. Now having said this, I have nothing against someone taking their whole allocation and investing it all at the current US$6. But only as long as it’s done with the right mindset. If you just want to have some stake in Nortel, you’re willing to wait a few years for a possible payback and you don’t monitor your holdings on a day-by-day basis, this would be fine. However, I would argue strongly against you if your rationale is that you "know" that Nortel has hit bottom and that it’s "impossible" for it to fall further. (I was at a dog-and-pony show in the spring where the manager of one of Canada’s leading tech funds got up and actually said that it was "impossible" for Nortel to fall to $20. Gee, and people pay an MER of over 2% for this?) Although the initial result is the same (buying at US$6), the end result is likely to be different. Why you get into a position will determine why you get out. The investor who "knows" Nortel is only going to go up will be flummoxed if it falls instead. The investor who’s steeled himself for a long-term ride is less likely to be frustrated or panicked. By the way, if Nortel actually does hit US$1.50, buying it will be excruciatingly difficult psychologically. Nortel at US$1.50 means either a dramatic bust in the economy or a more localized holocaust in the telecom sector. Most tech portfolios will be burned beyond recognition. The challenge would be to look past our own soot-covered faces and ante up.

Warren Buffett has said that he thinks stock prices will underperform for the next eight years. But is he selling all his holdings and putting his money into his mattress? Absolutely not. He may think it’ll be eight years, but he doesn’t know it. Most importantly, he knows he doesn’t know. That puts him in a whole different league from most investors (with the results to show for it).

Portfolio Update

The biggest disappointment in our portfolio, just as it is for some of our readers, is the implosion of Nortel. Even though we bought it four years ago at a relatively low price, we are down 57%. I’m glad we recommended a partial sell last year when Nortel was in the stratosphere. We will average down at the current price, and again in the future if it hits US$3 and even US$1.50.

Our other picks are still showing robust gains despite a tech market that’s down over 60% during the past year. Analog Devices, one of our picks of the year, remains strong, buoyed by hopes of an early semiconductor turnaround and protected by strong franchises in its DSP and specialized chip lines.

AMD, another pick of the year, had an extraordinarily strong start at the beginning of the year returning 150%. Now that advance has fizzled out because of the weakening PC market. It’s still a good company but the prospect of a forthcoming loss has knocked investors’ hopes down. We’ll hang on to it for now.

The other PC stock is Intel. It’s doing okay but will feel the pressure as it slashes its CPU prices to try to pump life back into the personal computer industry. Unfortunately, it’ll be a little while before we see growing sales. But unlike the Monty Python parrot, the PC industry isn’t dead, it’s just resting. When the economy turns around, both AMD and Intel will have healthy cash flows.

We’re adding two new names to our portfolio: Cisco and Corning. These companies are both giants in their respective fields of Internet routing equipment and fiber optics. Cisco, unlike either Nortel or Lucent is largely debt free and is well placed for a recovery. At its current price, it is selling for five times sales, a reasonable though not overwhelmingly cheap price. However, I’m not worried about the downside for Cisco. The reason is we have Cisco put options that will increase in value if Cisco’s price falls (more on this later).

Corning sells at slightly above one times sales, a bargain at this price. Of course, if you’ve followed our general musings to this point, you know that’s no guarantee of anything. We’ll be buying more if it falls to US$5 and US$2.50. Much has been said about the fibre glut but what’s sometimes forgotten is that this is mostly a North American phenomenon. When things turn up, the rest of the world will need fibre and Corning’s the one who makes it.

Why buy Corning rather than JDS? JDS was built in a short time through acquisitions and now it’s struggling to manage its conglomeration of takeovers while downsizing at the same time. Not easy. I like organic growth rather than growth through acquisitions. If a company buys other companies, I prefer it if they buy smaller companies (this is Cisco’s way) rather than bigger ones. The track record for megamergers and corporate buying sprees is awful. (Speaking of megamergers, I’d stay away from the new HP-Compaq, instead we’ll be putting Dell on our watch list.) Another factor is valuation. JDS is selling for two times sales, twice as much as Corning. Finally, Corning benefits from a diversified product line. In particular, it has a strong lead in LCD displays for PCs. Corning will do well selling these new slimmed down, power-efficient screens.

Fun and games

In 1999, I wanted to protect our portfolio from a fall in what I thought were dangerously overinflated tech stock prices. The first technique we used was the short selling of three Internet stocks: Infospace, Critical Path and Inktomi. (Shortselling basically gives you profits if the target stock falls in price.) It was a flop. Rather than falling, these three stocks shot up in early 2000 from their already huge valuations to even higher levels. We bailed out to protect ourselves, sustaining heavy loss. In retrospect I failed in not having a better defined exit plan. Our previous short selling successes made me believe that I knew that prices would go down (yet another example of the crucial difference between thinking and knowing). Learning from this mistake, we tried another approach. (If you can’t beat ‘em, try using a bigger stick.) We purchased long-term put options on some stocks we believed were grossly overvalued. The great advantage of these vehicles is that the amount of risk capital is limited, unlike in short selling. These put options, in Yahoo, JDS Uniphase and Cisco have paid off remarkably, protecting us from the tech collapse.

We’re going to close the Yahoo! put position now, for a profit of 718%. We’ll keep the JDS Uniphase puts for downside protection in the telecom sector, ie. it helps offset price drops in Nortel. We’ll also keep the Cisco puts but for a different reason. Since we’re initiating a stock position in Cisco, it forms a hedged position. We’re protected on the downside until January 2003. On the other hand we’ve capped the possible profit we can make on the put option at its current 204%.

(Postscript: So what happened to those stocks we sold short? Inktomi shot as high as US$170; it is now US$2. Critical Path whose stock hit US$120 has crashed to US$0.27. Their claim to fame is that they decided to cook their books, reporting millions in false revenue. Infospace touched US$120 and is now toast at US$1.40. If we had been able to hang on to our short positions, we would have made a mint, but that would have been gambling and not investing. The problem with short selling is that as the shorted stock rises, you have to put up more margin. If you don’t have an exit plan then you’re gambling because the margin call could wipe you out.)

Final word

I believe we are heading into an era of great opportunity but the days of easy profits are over. The traditionally dangerous month of October may hold some sharp surprises for us. Stay loose and plan for turbulence!

Wynn Quon, Chief Technology Investment Analyst, wynn_quon@hotmail.com

© Canadian MoneySaver, PO Box 370, Bath, ON K0H 1G0 613-352-7448 - Published October 2001