Running Money, page 21
“Watch them all squirm,” Fred said with a mock satanic laugh.
“You’re having fun with this?”
“When we head up, I’m always gloomy, worrying if it is all going to roll over. When the market blows up, I get in a good mood. I probably personalize this contrarian stuff a bit too much.”
“Fred, you almost barfed during the Robertson conference just last month. Let me know when the giddy wears off—it’s a great indicator.”
“I think we’ll be OK. Dot-coms won’t be buying much equipment anymore, but the telcos will.”
Fred was right, but only for a while. Telcos did keep buying. The NASDAQ meltdown of March and April 2000 was followed by a buying binge for infrastructure stocks—companies that made network equipment, chips, software, anything related to broadband. WorldCom announced record capital spending (little did anyone realize it was CFO Scott Sullivan classifying every expense as capital spending so he could write it off over years rather than right away).
NASDAQ came back, led by Cisco and networkers. The 80-20 barrier that Netscape helped break created a monster waterfall. Our investment, Alteon, had switches that sat at the same edge of the network as Cisco, and they were booming. Their stock was flying—$100, $120, $140 and rising all summer. Then one day, we woke up to this news release: “Nortel Networks buys Web switch vendor Alteon for $7.8 billion.”
“Wow, it doesn’t get any better than this,” I told Fred.
“What are they paying?” Fred asked.
“$7.8 billion. That’s more than AOL paid for Netscape!” I exclaimed.
“No, how much per share?”
“It’s gotta be $200 plus.”
“Read on,” Fred said.
“Deal to close Q4, blah, blah, blah, $144 per share. Hey, wait a second, that’s about where it closed yesterday. No premium? They’re stealing this company out from under us. What the—”
“It already was trading at a $7.8 billion valuation. Let’s see, they did about $50 million last quarter.”
“That’s only 39 times.”
“Fifty million dollars in sales. That’s 39 times revenue. They did 16 cents per share in earnings last quarter…”
“Blowing away the three cents that the street predicted,” I added.
“I’ll do the math for you, Mr. Electrical Engineer. That’s a P/E, price to earnings ratio, of 225.”
“Are you trying to suggest we should be happy that Nortel is stealing Alteon?”
“Something like that.”
“So much for the efficient market theory!” I sighed.
“Oh, it’s efficient. The inputs are just flaky. Alteon has to make $10 a share in 2005 to justify $144. They might—but now it’s Nortel’s problem.”
“Well, I didn’t get into the hedge fund business to own a Canadian telephone switch company. Nothing personal against our frozen friends to the north, but we don’t have much of a choice here,” I said.
“Nope. Blow it out!”
I spent the month of August at the beach with my family, with a Blackberry pager in one hand and a cell phone in the other, hitting the bid for almost a million shares of Alteon. Some of our shares weren’t registered yet, so we had to tender them and get Nortel shares. Yuck. We didn’t hit Nortel’s peak of $80 something, but our anti-Canadian bias was useful. We blew Nortel shares out at $75, $65, $60, $55 and $50 and then poof—we were done. The cash disappeared at the end of the month to whatever investors were summarily tossed out that month. We sold bits and pieces of everything else, but not enough—all would have been enough. But we had the luck of the Canucks. I have been nice to Canadians ever since.
Fred was right to be nauseous. If everyone knows, it’s over. The clump of water was about to break up on the rocks, the second derivative had played out, enticing investors in with the seduction of faster and faster growth. Metcalfe’s Law was no longer a secret; you could see it in subscriber growth and Internet usage and equipment sales and page views and everything. Fast growth became an input and an assumption to value schlock like MP3.com and plenty of other garbage too. This also meant great companies went up way too far as well.
It all peaked in September 2000. The fourth quarter of 2000 is when the market really gave up the ghost. It was like the crisis of 1998, but with real volume, real selling. We were down 50% in the quarter. Fortunately, we had been returning capital to investors every month, forcing us to sell, and we ended up down only 5% for the year. It’s not a great consolation prize.
Morgan Stanley Tech Conference 2001
SCOTTSDALE, ARIZONA—JANUARY 2001
“Did you listen to Shamazon? It looked like Bezos wanted to strangle Mary Meeker for showing up late.”
“Nick, how come I knew I would run into you here?” I said.
“I’m still waiting for an answer why they classify order fulfillment as a marketing expense.”
“Because it would show they are shipping a $5 bill with every order they fill?” I asked.
“That too. They’re hiding how bad their gross margins are. They’ll survive, but a company with low margins just isn’t worth my time.”
“Do you like anything?”
“Oh, you mean like High Village? Candace Carpenter as CEO of the decade?”
“You must like something.”
“Oh, you mean like the shop until they drop companies? Webscam? Free-toys? Price-slime.con? Bye-Buy.com? They’re all negative gross margin free-tailers.”
“OK, so the dot-com names are crazy. What about B2B, e-commerce stuff?”
“Oh, Amoeba/Ariba, Commerce None? Those are even worse. Or all those Sink-ubators like Internet Capital Group and Divine Interventures—give me a break.”
“Networking maybe?”
“Floundry Networks, no thanks.”
“It’s really over, isn’t it?” I said.
“See those guys over there?” Nick asked.
“You mean those guys with the Ashleigh Banfield glasses? Are those the Janus guys we always used to see?”
“Yup, just a new look. Until six months ago, those guys used to never break a sweat. Money flowed in like water, so they would just buy more of what they owned. Helped their performance numbers. What did they care? Gemstar—Gemscar. It was just their investors’ money—they got paid either way. They rode ’em up and they’re going to ride ’em down.”
“You’re fouler than usual,” I said.
“Doesn’t bother me, I’ll take either side of this thing. I’m just not sure who the next sucker is to come in and buy this garbage. The Asians are broke, and the Europeans don’t buy anything without a dividend, so it’s just the dumb-ass American public pouring into the Januses of the world. I’ll take the other side of that trade every day of the week.”
“You don’t think fundamentals will hold up?”
“Not a chance—it was all funny money. AOL buying TimeWarner is just a farce. Even if business stays good, paying 100 times earnings and 20 times sales means they have to stay great for five or more years. How many tech cycles do you remember that have lasted that long? Any?”
“Nope.”
“The stock of the greatest company in the world is crap if every investor already thinks it is the greatest company in the world.”
Yup, sometimes you gotta wait for the next waterfall.
Global Pitches
Diligently, month by month in 2001, I sold what I needed to meet the forced redemptions at the end of the month. The market was all over the place but mostly down, down, down. The selling was relentless, which made my job tougher. Still, we had a September deadline to get completely out on our five-year anniversary.
We still visited companies—that doesn’t stop. And we still got pitched new ideas from entrepreneurs looking for venture funding. But it was sometime in 2001 that I started noticing a difference to these pitches. They weren’t coming from Stanford MBAs or three guys in Sunnyvale with a brilliant idea.
I got pitched by a group visiting from Bangalore to expand call centers for U.S. companies. Or from another group in Bombay doing contract software development work for hire. A group of Israeli physicists had a new way of creating transistors that could change the entire semiconductor business. There were some software coders in Norway working on applications for cell phones. A group out of Russia had some really cool 3-D technology. Japanese videogame creators. Finnish packet handling. And on and on.
We weren’t set up to do foreign investments, but they all sounded fascinating. Maybe they’d work, maybe not, but something was going on outside of the four walls of Silicon Valley.
Part VII
The Margin Surplus
What Is Wealth?
I suppose this is the point in the story where I walk away and question the meaning of life. Except I can’t seem to walk away, and I’ve never been good at navel gazing. But something bizarre had just taken place and I must have learned something.
I mean that was without a doubt the strangest few years of my life. Boom-bust, boom-bust and then, oh yeah, the big whopper BOOM-BUST. Trillions gained in ’99, kazillions lost again since then. What a way to live. But inside that yo-yo is a lesson somewhere. I kind of realized toward the end that although I’m in the business of running money—we had a billion dollars under management at our peak—I barely had time to think out the most important question: What is wealth?
Wealth is fleeting, I suppose, from the looks of the last year and a half, but there must be some absolutes. Industrialists generated wealth. But what about now—in a postindustrial world? The answer makes a difference in how to put money to work.
Those “families with substantial assets” had wealth, but it wasn’t static. Every generation it shrank unless they chased returns. No rest for the weary. But they don’t like risk. Well, too bad. I think what I learned is that wealth comes not just from taking risk but from constantly taking risks.
The four-door office isn’t a metaphor, it’s reality. You can be a long-term investor, but you constantly have to adjust your sights to the next big thing. We may be in the midst of a long cycle like the British 100-year industrial boom, but that doesn’t mean you can buy and hold and be on the golf course by noon.
What startles me is that those who generate wealth in Silicon Valley run at 100 miles per hour. They don’t own anything of value like a textile mill or an auto factory. They own a process, the ability to constantly update their products and take advantage of that waterfall, some massive price declines and then move on to the next product or process.
The world had changed. The mighty economies of Japan and Korea and Thailand are not taking over. Their output of cars and laptops and VCRs and DVD players and memory chips and computer monitors and sneakers is booming, but something’s wrong. They have giant factories with lots of lower-wage workers who wind wire, screw screws, bolt bolts, wrap plastic and stick in power cords. But that’s not what anyone pays for anymore. Their economies achieve full employment, sure, but these countries are not economic powerhouses. Not anymore.
We were investing in companies with no more than 50–100 workers, most of them highly paid programmers and engineers, whose occupational hazard is coming down off a caffeine buzz and an occasional late night Nerf gun injury. Yet even after the market bubble burst in 2000, these companies would still be worth more than Ssangyong, a company a hundred or a thousand times their size. The stock market values small businesses with high margins over big businesses with low margins. Is that good or bad? Should I even care?
Whenever I try to figure out why this is, I keep thinking back and visualizing Mr. Shim, a walking, talking and sweating metaphor for how to invest. Something like “We think, they sweat.” The spoils go to those with high margins.
You can make intellectual property, but real soon it’s worthless. You don’t really own anything tangible, just the ability to move it along, kick the can down the road, as diplomats like to say.
Ask economists, and somewhere in their babble they will tell you that the role of an economy is to increase the standard of living of its participants. Did the boom-bust, boom-bust yo-yo I just lived through do that? I think so, but with lots of change. America doesn’t make stuff anymore—we design it. The numbers are fishy, but even after the rocky start in the 1990s, I think this new think/sweat thing will create more wealth for more people, not just in the U.S. but around the world, than the Industrial Revolution ever did.
The model I keep focusing on has the U.S. designing chips and someone in Taiwan making them for cheap. That sounds like a plan, but somehow this means we run trade deficits. Just the word deficit sounds so awful—no one likes to be called deficient. What is the right model? Maybe we should just manufacture these chips and everything else in the U.S.? Aren’t all jobs good for the economy and our standard of living?
Industrial Economists
When I was a kid, every morning as I walked out my front door, I subconsciously held my breath and then looked up to see if the fog was in. If not, I would take a deep breath and head off to the school bus. If the sky was overcast with low, overhanging clouds, I held my breath for as long as I could. The first breath was always a nasty one, a sharp, stinging reek that would permeate my sinuses and make me wish I were somewhere else. The town I lived in was in central New Jersey, a highly industrialized stretch connected to the outside world by the Raritan River, Interstate 287 and railroad tracks that crisscrossed the town. It wasn’t as bad as Perth Amboy or Rahway, with their giant Esso oil refineries that still stink up the New Jersey Turnpike and give the state a bad name. Nor was it an armpit like Camden. But it still stank.
Upwind were a combination of Union Carbide, Johns Manville, Sherwin-Williams, Dow Chemical, Hoechst and Johnson & Johnson. No wonder it reeked; I lived in an industrial sewer. These companies became a murderers’ row, mostly killing off their own workers. Our neighbor worked for Johns Manville, until asbestos litigation shuttered the local facilities and the company hightailed it to Denver. Union Carbide killed thousands in Bhopal, India, in 1984, but a similar accident probably could just have easily happened in my hometown.
Not that I had any clue. It actually was a nice place to live—suburbia filled almost entirely with middle-class families: lower, middle and upper middle class. There were jobs for everybody. The lower lived well; they all owned houses in decent neighborhoods. The upper, well, they moved uphill.
But as I look back, I realize that the ’60s and ’70s were not only the peak but the start of the petering out of industrial central New Jersey and industrial America.
Unfortunately, most active Wall Street economists were trained in the 1960s and ’70s. Government statistics back then tracked an industrial economy. I long ago figured out that I couldn’t make a dime listening to industrial economists.
Even if they are fresh PhD in economics grads, class of 2004, they are industrial economists. Intellectual property is a foreign idea to them. So is the stock market. It just doesn’t fit into their thinking. The math is too hard. You can’t model the stock market. So they ignore it or look at it as a casino rather than as an important source and destination of capital. They are stuck in the era of Wilkinson and Watt and Classical Gold Standards. They cloud our thinking.
But investors still listen to them and dissect industrial data. Hmmm. I smell opportunity.
My hometown is now a haven and a heaven for the biotech industry. Up and down Interstate 287 are two-and three-story office parks filled with firms playing around with DNA, creating pharmaceuticals to cure all the illnesses the Industrial Revolution heaped upon us. A mall and a minor league baseball stadium have replaced the Sherwin-Williams factory.
Is there a long-term trade here? Of course, lessons are all over the place if you just turn the world upside down. Perhaps the Dow is more important than GDP.
Will the dollar go down or go up? Do interest rates matter? Are deficits bad or good? Should I even give a shit about economics?
It matters, I suppose, but not to me. I just want to figure out where the big quantum leaps are. Give me a big enough sandbox to play in, and I’ll find the part of it not being used as kitty litter.
Grand Unifying Theory
PALO ALTO, CALIFORNIA—SUMMER 2001
“We are going to send shares to your account and some cash too,” I told Mr. Zed.
“I’d rather you keep going, but you were smart to send money back over the last couple of years. The selling was the right thing to do.”
“It worked out that way.” I still felt guilty telling the guy who put us in business that we were no longer going to work for him, although we did give him back six times his original investment.
“And I understand why you are closing up,” Mr. Zed said.
“You do? Then maybe you can explain it to me.”
“Because it worked. It was supposed to take ten years, and a bull market squeezed it into three. Now, who needs the hassle? You can sit back with a more relaxed pace and think even longer term. You’ll be an even better investor,” Mr. Zed said.
“I suppose.” That was pretty good. I’m not sure that he was right, but maybe that is how I should look at it.
“But now you have to tell me how you are going to think over the next ten years.”
“The only thing I really figured out is that the industrial era is over,” I said.
“OK, I understand that. You have an intellectual property economy. I understand the splitting of intellectual property and manufacturing. That’s fine. But I can’t seem to follow the money trail. What happens to all those dollars that you Americans spend on fine German automobiles or Chinese toys or Japanese laptops? It must show up somewhere.”
