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FM 7/9/01 8:43 AM Page iTHE SUPERSTOCKINVESTOR
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FM 7/9/01 8:43 AM Page iiiTHE SUPERSTOCKINVESTORProfiting from Wall Street’sBest Undervalued CompaniesCharles M. LaLoggiaCherrie A. MahonMcGraw-HillNew YorkChicagoSan FranciscoLisbonLondonMadridMexico CityMilanNew DelhiSan JuanSeoulSingaporeSydneyToronto
McGraw-Hill abcCopyright '2001 by the McGraw-Hill Companies Inc. All rights reserved. Manufactured in the UnitedStates of America. Except as permitted under the United States Copyright Act of 1976, no part of thispublication may be reproduced or distributed in any form or by any means, or stored in a database orretrieval system, without the prior written permission of the publisher. 0-07-138116-3 The material in this eBook also appears in the print version of this title: 0-07-136083-2All trademarks are trademarks of their respective owners. Rather than put a trademark symbol afterevery occurrence of a trademarked name, we use names in an editorial fashion only, and to the benefitof the trademark owner, with no intention of infringement of the trademark. Where such designationsappear in this book, they have been printed with initial caps. McGraw-Hill eBooks are available at special quantity discounts to use as premiums and sales pro-motions, or for use in corporate training programs. For more information, please contact GeorgeHoare, Special Sales, at george_hoare@ or (212) 904-4069. TERMSOFUSEThis is a copyrighted work and The McGraw-Hill Companies, Inc. ( McGraw-Hill ) and its licensorsreserve all rights in and to the work. Use of this work is subject to these terms. Except as permittedunder the Copyright Act of 1976 and the right to store and retrieve one copy of the work, you may notdecompile, disassemble, reverse engineer, reproduce, modify, create derivative works based upon,transmit, distribute, disseminate, sell, publish or sublicense the work or any part of it withoutMcGraw-Hill s prior consent. You may use the work for your own noncommercial and personal use;any other use of the work is strictly prohibited. Your right to use the work may be terminated if youfail to comply with these terms. THE WORK IS PROVIDED AS IS . McGRAW-HILLAND ITS LICENSORS MAKE NO GUAR-ANTEES OR WARRANTIES AS TO THE ACCURACY, ADEQUACYOR COMPLETENESS OFOR RESULTS TO BE OBTAINED FROM USING THE WORK, INCLUDING ANYINFORMA-TION THATCAN BE ACCESSED THROUGH THE WORK VIAHYPERLINK OR OTHERWISE,AND EXPRESSLYDISCLAIM ANYWARRANTY, EXPRESS OR IMPLIED, INCLUDING BUTNOTLIMITED TO IMPLIED WARRANTIES OF MERCHANTABILITYOR FITNESS FOR APARTICULAR PURPOSE. McGraw-Hill and its licensors do not warrant or guarantee that the func-tions contained in the work will meet your requirements or that its operation will be uninterrupted orerror free. Neither McGraw-Hill nor its licensors shall be liable to you or anyone else for any inac-curacy, error or omission, regardless of cause, in the work or for any damages resulting -Hill has no responsibility for the content of any information accessed through the no circumstances shall McGraw-Hill and/or its licensors be liable for any indirect, incidental,special, punitive, consequential or similar damages that result from the use of or inability to use thework, even if any of them has been advised of the possibility of such damages. This limitation of lia-bility shall apply to any claim or cause whatsoever whether such claim or cause arises in contract, tortor :
FM 7/9/01 8:43 AM Page vCONTENTSACKNOWLEDGMENTSixINTRODUCTION1PART ONETHE MAKING OF ASUPERSTOCK INVESTORChapter OneADefining Moment11Chapter TwoASuperstock Is Born15Chapter Three Stock Selection19Chapter FourInvesting Paradigms: ANew Way of Thinking about Stock Selection25Chapter FiveThe Twilight of Index Investing31Chapter Six Experts: What Do They Know?35Case Study: Sunbeam46Chapter Seven What Is Value?57vCopyright 2001 The McGraw-Hill Companies, Inc. Click Here for Terms of Use.
FM 7/9/01 8:43 AM Page viviCONTENTSChapter Eight If Everybody Knows Everything, Then Nobody KnowsAnything65PART TWOIDENTIFYING TAKEOVER TARGETS Chapter NineCreeping Takeovers77Case Study: How Rexel . Acquired Rexel Study: The Takeover of ADT85Chapter Ten How to Create Your Own “Research Universe” of TakeoverCandidates—The Telltale Signs95Case Study: Spotting Brylane as a Takeover Target106Case Study: Sam Heyman and Dexter Eleven How to Use the Financial Press125Case Study: The Triple Play and Midway Games140Chapter TwelveFamily Feuds149Case Study: Copley Pharmaceuticals149PART THREETAKEOVER CLUESChapter Thirteen“Beneficial Owner” Buying159Case Study: Sumner Redstone and WMS Industries159
FM 7/9/01 8:43 AM Page viiCONTENTSviiChapter FourteenThe “Pure Play” and the Drugstore Industry187Case Study: Fay’s and Genovese190Case Study: Smith Food & Drug Centers201Chapter FifteenUsing Charts205Case Study: Salick Health Care207Case Study: Rohr, SixteenThe Domino Effect215Case Study: Vivra and Ren-Corp. USA215Case Study: Renal Treatment Centers219Chapter SeventeenMerger Mania: Take the Money and Run223Case Study: JCPenney and Rite Aid233Case Study: The Alarming Story of Protection One238Case Study: How Mattel Got Played by The Learning Company247Case Study: Waste Management and Allied Waste Industries251Chapter EighteenLook for Multiple Telltale Signs259Case Study: Sugen, Study: Frontier Study: Water Utilities271APPENDIX: ASUPERSTOCK SHOPPING LIST285RESOURCES295INDEX297
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FM 7/9/01 8:43 AM Page ixACKNOWLEDGMENTSIwould like to thank the person who inspired this book and with-out whom it would not have been written: my friend, my businesspartner, and Director of Research, Cherrie Mahon. This book wasactually born when I met Cherrie in 1998. She was a stockbroker atthe time and was endlessly inquisitive about my newsletter, researchtechniques, and rather unusual approach to stock selection in com-parison to what she was learning at the major “mainstream” bro-kerage firm that employed her. She seemed to recognize that myway of thinking was different from anything she had been exposedto, and her constant search for answers forced me, for the first time,to think about and explain, in detail, the thought processes that wentinto the recommendations in the newsletter. In a way, Cherrie’s inter-rogating and seemingly endless curiosity forced me to turn anapproach that had been based mostly on instinct and experience intoan understandable and, I hope, instructive set of principles andguidelines that can be used by any investor willing to take the timeand effort to learn how to use , I have done a lot of writing over the years, but writ-ing a book is different. If it were not for Cherrie, this book wouldnot have been born—and if it were not for Cherrie, I probably neverwould have had the determination to complete it. Her supportthroughout this process was M. LaLoggiaixCopyright 2001 The McGraw-Hill Companies, Inc. Click Here for Terms of Use.
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Introduction 7/9/01 8:44 AM Page 1IntroductionIf you’d been born in a cave and had lived there your entire life,with no knowledge of radio or television signals, you would prob-ably be skeptical if someone were to tell you the air waves were filledwith conversation, political commentary, advice for the lovelorn, hotstock tips, music, and even pictures. Of course, without a radio ortelevision you would not be aware of the existence of such signals would be all around you, but you’d be oblivious to themwithout the means to pick them , if you are accustomed to a certain way of reading thefinancial news, you can pick up “signals” that a certain stock thatseemingly has nothing much going for it will soon rise dramatical-ly in price. Why? Because something is about to happen which willliterally forcethe stock market to recognize that stock’s true value. Icall such stocks “superstocks,” because they can leap above any kindof market in a single began publishing my stock market newsletter as The CMLInvestment Letter—currently named Superstock Investor—in December1974. Along the way I developed a reputation for being able to spotneglected companies that were about to become stock market stars—not because they suddenly became supergrowth companies or haddeveloped a ground-breaking new technology, but because some-thing was about to happen that would send that stock price to amuch higher level that better reflected that company’s value as abusiness. Usually, that “something”—an outside event, or what Icall a “catalyst”—had the effect of pushing the stock price higher inone sudden jump rather than gradually over time. Seemingly, that1Copyright 2001 The McGraw-Hill Companies, Inc. Click Here for Terms of Use.
Introduction 7/9/01 8:44 AM Page 22INTRODUCTIONoutside event came out of the blue. But in reality that event was thelogical conclusion to a series of events that began with a single clue,or Telltale Sign, that strongly suggested what the ultimate outcomewould book shows you the clues, or Telltale Signs, that can pointyou toward stocks like these. I know these Telltale Signs exist becauseI have been using them for 25 years to pick countless takeover tar-gets. My success in recognizing these signs is a matter of publicrecord, as you will see. During one particularly productive 55-monthperiod through September 2000, a total of 48 of my recommendedstocks received takeover bids (see Table I–1).I want to make one thing perfectly clear at the outset, though:What you will learn in this book is not a “get rich quick” method ofinvesting. There are no sure things in the stock market except this:There are no sure things! I have seen countless systems and approach-es to stock selection and market timing come and go. Many workfor a while—sometimes for quite a while—and then fall into disfa-vor and disrepute because they simply stop working. Nobody knowswhy. Some resurface years later and begin working again, “discov-ered” by a new generation of that is not what this book is all about. This approach is nota “system”—rather, you will learn a new way of thinking and a newway of observing the day-to-day financial news that passes yourway. This new way of thinking is not meant to supplant any otherapproach to investing you may already be using—it is meant to sup-plement it. It can become a way to add to the mix of your investmentportfolio by uncovering interesting and usually off-the-beaten-pathstock ideas that can not only be profitable, but also rewarding on apurely intellectual basis. In addition, you will find that the stocksyou uncover by using this method will usually march to their owndrummer and will not be as affected as most stocks by the short-term emotional winds that buffet the stock effect, this approach will provide you with a sort of “offline”portfolio of stocks that travels along its own path, with each stock inthe portfolio responding to events that are, for the most part, divorcedfrom the events affecting the rest of the stock all of the 48 stocks that received takeover bids duringthat 55-month period ending in September 2000 were on my newslet-ter’s recommended list because, based on the approach described
Introduction 7/9/01 8:44 AM Page 3INTRODUCTION3TableI–1Charles M. LaLoggia’s 48 Takeover Bids in 55 MonthsPercentPercentGainAnnualized Months Held(or Loss)Gain (or Loss)Sep 00 Advest1+19+230Sep 00 AXAFinancial12+70+70Sep 00 Donaldson, Lufkin8+85+127Aug 00 PaineWebber21+119+88Dec 99 Pittway3+41+164Dec 99 Dexter Corp5+36+ 99 E Town Corp11+38+. 99 SJW Corp10+100+120Sep 99 Nichols Research19+10+ 99 United Water Resources9+77+ 99 Copley Pharmaceuticals11+23+ 99 Red Roof Inns9+30+40June 99 Aquarion7+50+ 99 Sugen Inc42+169+ 99 Frontier Corp28+156+54Jan 99 Alarmguard21+21+12Dec 98 Brylane2+52+312Nov 98 Genovese Drug Stores27+219+ 98 Pool Energy Services56+53+ 98 Clearview Cinemas6+75+150Aug 98 American Stores2+25+150Jul 98 Life Technologies2+20+120Jul 98 Grand Casinos7+46+ 98 Union Texas Petroleum8+21+ 98 Giant Food28+36+ 98 Harvey s Casino1+32+384Feb 98 Arbor Drugs17+163+115Dec 97 Showboat25+16+ 97 Holmes Protection10+43+ 97 Renal Treatment28+261+ 97 Rexel Corp23+110+ 97 Rohr27+124+ 97 Riviera Holdings1+0+0Sep 97 WHG Resorts5+100+240Aug 97 Protection One7+105+180Continued
Introduction 7/9/01 8:44 AM Page 44INTRODUCTIONTableI–1Charles M. LaLoggia’s 48 Takeover Bids in 55 Months(continued)PercentPercentGainAnnualized Months Held(or Loss)Gain (or Loss)Jul 97 Rotech Medical36+143+ 97 Logicon40+292+ 97 Smith Food & Drug7+50+ 97 Vivra36+119+ 97 UNC Inc6+100+200Dec 96 ADTCorp9+50+ 96 Roosevelt Financial12+22+22Oct 96 Ornda Healthcare4+16+48July 96 Fay s Drugs7+87+ 96 Bally Corp2+20+120Jun 96 Community Health11+40+ 96 Hemlo Gold12+29+29Feb 96 Loral Corp10+15+18in this book, I considered them takeover candidates. No “magic”insights will be revealed here; instead, this book will describe whatI have observed to be true over 25 years—that a certain event ordevelopment tends to lead to another, which ultimately results inthe birth of a “superstock.” Think of this book, and the approach itdescribes, as a road map. The map will point out guideposts andlandmarks that can lead you toward a takeover target that sudden-ly jumps in price because an event has occurred and the stock mar-ket has no choice but to value it at—or very near—its intrinsic valueas a the same way professional poker players can see certainbehavioral patterns and use them to their advantage, you will learnto spot certain Telltale Signs that may seem meaningless or unim-portant to most investors but will be highly significant and mean-ingful to you. These signs will point you in the direction of poten-tial me repeat that the approach to investing you are about tolearn is not a system. The key to this approach is interpreting the news.
Introduction 7/9/01 8:44 AM Page 5INTRODUCTION5This type of interpretation involves experience and a determinationto delve into areas that most investors have neither the time norinclination to examine. To be honest, it isn’t easy to the past 25 years, I have explained my approach to count-less thousands of subscribers, as well as journalists and the viewersand listeners of many television and radio programs. The approachto interpreting the news has never stopped working, for two rea-sons. First, it is far too complex and involves far too much judg-ment, experience, and willpower for most investors. Second, itinvolves human nature—it describes what companies and their man-agement and major shareholders tend to do during the years,months, or weeks prior to an event that forces the stock price high-er. In other words, it describes the sort of rational decision-makingand human behavior patterns that tend to emerge when someone—either inside or outside the company—believes a stock is severelyundervalued and intends to do something about it. And that type ofbehavior is not likely to change, no matter how many people learnto recognize that extent, the telltale signs discussed in this book willalways be valid. And to the extent that using these techniquesinvolves not only experience but also the inner confidence to believewhat you are seeing—and sticking to your convictions even whenthere is little or no support from Wall Street—well, I just can’t imag-ine this approach becoming so popular that it simply stops often asked about investment books is: Does thesystem—in this case, the interpretive approach—always work?The answer here is a resounding no! There is no sure-fire keyto stock market riches. There have been plenty of times when the“Telltale” Signs you’ll read about here seemed to point directly to afuture superstock, only to turn out in the end to be that bother you?It shouldn’t, because reality should never bother you on anylevel—it should only serve as a means for better understanding theway the world really works. Every mistake along the way—everyroad you take or stock you buy that does not work out as hoped—should be considered a learning experience that will make the nextexperience more likely to can only say that if you follow the clues described here, you’llend up with more winners than losers.
Introduction 7/9/01 8:44 AM Page 66INTRODUCTIONNow, I will describe some really interesting things I have learnedover the years. It’s an approach to investing that has served me well,and if you learn to use it, it will do the same for BULLS, THE BEARS, AND THE HORSESThe recent trend toward microanalyzing the stock market on aminute-by-minute basis has less to do with investing than it doeswith providing a “fix” for stock market addicts. In his classic bookThe Money Game, author George Goodman, writing under the name“Adam Smith,” says that most people are not in the stock market tomake money; they are in it for the excitement. And if you were tocatch a stockbroker in a moment of candor, you would probably dis-cover that many have reached the same conclusion. Alarge part ofthe stock market’s explosive popularity in recent years is that theadvent of financial television and the Internet has turned investinginto a form of entertainment that provides a welcome diversion fromthe predictability of day-to-day completely understand this, of course, having spent 25 years ofmy life transfixed by the stock market. Watching the minute-by-minuteanalysis on financial television and having a real-time quote systemon your desk is part of the appeal of the whole business. Nothingwrong with that, although this book is a way of pointing out that thereis another way to approach the business of picking stocks, one thatallows you the opportunity to get up from in front of your televisionset to get a glass of water and maybe even do a little are many people who will tell you that the stock marketis actually just like horse racing, and if you stop to think about it,they may have a good point. As every horse bettor knows, there isnothing quite like the adrenaline rush one gets when your bet isdown, the bell rings, the starting gate opens, and the track announc-er says, “They’re off!”This, of course, is precisely the feeling a day trader gets at nine-thirty each morning when he or she is tuned in to CNBC. The onlydifference is that the chairman of Time Warner is not standing at thestarting gate ringing the is probably no accident that as the stock market has becomeincreasingly popular and accessible to the masses over the past 15years, the horse-racing industry has gone into a steady decline.
Introduction 7/9/01 8:44 AM Page 7INTRODUCTION7Financial magazines are multiplying like rabbits while the DailyRacing Formhas been sold and resold several times as its circulationeroded year after ’s face it: Wall Street is beating the horse-racing business atits own game. While a horse race can provide periodic bursts ofentertainment and excitement, each race lasts only a minute or twoand is followed by a period of boredom and slowly building antic-ipation until the next race begins. On Wall Street you get nonstop1action for 6⁄2hours 5 days a week, and if you’re a real glutton forpunishment, you can buy a sophisticated quotation system thatallows you to sit around all night watching after-hours trading, andthe opening of the Asian markets and the start of European tradingin the predawn Street never stops. How can horse racing compete withthis?For one thing, they might try out the concept of horse New York State there are Off Track Betting parlors scattered allover the place. What’s the difference between this and brokeragefirm branch offices? There are no horse brokers. The only thing theseOTB parlors lack are salesmen with clients who can be badgeredover the telephone to bet on the horses and generate some com-mission why stop there? To support the sales force—excuse me,the horse brokers—OTB could even hire analysts to write researchreports. If you are a “value” investor who concentrates on funda-mentals, your horse broker could send you a report on the pedigreeand training performances of a good-looking prospect in the sev-enth race at Belmont Park. Or if you are a “momentum” player whoconcentrates on technical analysis with a preference for followingthe “smart money,” you could get a frantic call from your horse bro-ker doing his best James Cramer imitation moments before post timeabout some mysterious movement in the odds that could indicatesomebody knows something.“Who cares why the odds are going down?” he would screaminto the telephone. “This is a momentum horse! Get your moneydown now, before it’s too late!”The similarities are endless. Was the jockey holding his horse thelast time out so the trainer can turn him loose today and cash a bigbet at large odds? Has that corporation been overstating its earn-
Introduction 7/9/01 8:44 AM Page 88INTRODUCTIONings to keep the stock price up so insiders can bail out at high prices?You want to take a shot at big money? Forget options—play the dailydouble—here are our top picks, for speculators, of course. What’sthat? You’re wondering what to do with your pension funds? Why,that calls for a more conservative approach—how about allocating5 percent of your account on the favorite, to show?One reason the stock market fascinates so many of us is thatthere are so many ways to approach it. This frantic moment-to-moment approach, in which the market is treated as though it werea racetrack or a casino, is certainly a valid book is about a different way.
Chap 01 7/9/01 8:44 AM Page 9PART ONEThe Making of aSuperstock InvestorCopyright 2001 The McGraw-Hill Companies, Inc. Click Here for Terms of Use.
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Chap 01 7/9/01 8:44 AM Page 11CHAPTER ONEA Defining MomentLALOGGIA’S DICTIONARYSu-per-stock(soo-per-stok): Astock that has the potential to rise sig-nificantly in price regardless of what the general stock market isdoing. This significant rise in price is due to a specific potential event,or “catalyst,” usually a takeover bid, which, if it occurred, wouldforce the price most stock market investors are obsessed with growth, per-fectly good companies with consistent profits—many of which arecash rich with little or no debt—are passed over, shunned by themajority of investors seeking growth and earnings , a great deal of value can often be found in such stocks. Theproblem is, these neglected and undervalued stocks can remainundervalued for a long period of time, creating “dead” money, whileother stocks provide solid superstocksgenerally sell far below their actual value asa business, but nobody cares because the company’s earnings maybe erratic or even trending lower and the company’s growth poten-tial may be of events, or “catalysts,” can force a stock trading atundervalued levels to move instantly closer to its true value as a busi-ness. The most efficient catalyst is a takeover bid, where a company orindividual—and sometimes even the management of the company—11Copyright 2001 The McGraw-Hill Companies, Inc. Click Here for Terms of Use.
Chap 01 7/9/01 8:44 AM Page 1212PART ONEThe Making of a Superstock Investoroffers to pay a premium over the prevailing price to buy all outstandingshares. Other catalysts include a massive partial stock buyback at apremium. In this scenario, the company offers to acquire a largepercentage of the outstanding stock at above-market prices. Athirdcatalyst is a large onetime cash or stock dividend, where a companydistributes accumulated cash or shares in a wholly owned subsidiaryto its shareholders. Afourth type of catalyst occurs in a spinoff, wherea company tries to establish the inherent value of a subsidiary byselling a small piece to the public in an initial public offering, therebycalling attention to the value of its remaining potential catalysts, as well as others, can suddenly turna previously boring, uninteresting company into a superstock—astock that rises dramatically in price, usually over a one- to two-dayperiod, regardless of what the overall stock market is LIGHTBULB GOES ONThe early 1970s were a difficult time for the . economy and alsofor the stock market. Asharp rise in inflation in 1972–73 resulted insharply higher interest rates, which in turn plunged the economyinto a severe recession. The Dow Jones Industrial Average plum-meted from the 1000 level to its ultimate low near the midst of this economic and financial downturn, manycompanies saw their earnings evaporate and turn into huge cut or reduced dividends on their common and pre-ferred April 1975, as inflation began to ebb and interest rates beganto go down, I noticed an interesting phenomenon. Some of the com-panies that had plunged into the red and had been forced to elimi-nate dividends were moving toward profitability also noticed that some of the preferred stocks that had stoppedpaying dividends were “cumulative,” which meant that all unpaiddividends would accumulate and have to be paid in full before anydividends could be paid on the common such company was LTV Corporation, which had sus-pended the dividend on its $5 Cumulative Preferred stock back to1970. By April 1975, $ of dividends “in arrears” had accumu-lated. LTV’s earnings were turning sharply positive by 1975, and its
Chap 01 7/9/01 8:44 AM Page 13CHAPTER ONEADefining Moment13shareholders, who noted the improvement, had begun to push fordividends on the common issued a statement that it would soon “consider” its dividendpolicy at a special meeting of the Board of Directors. But the only wayLTV could pay a dividend on its common stock would be to first payall of the cumulative preferred dividends in arrears. In other words,anyone who had bought the $5 Cumulative Preferred—then tradingat about $57 a share—stood a reasonable chance of getting a lump-sum payment of $ a share. Also, if the regular $5 preferred divi-dend were reinstated, the stock would probably move , if a certain event took place—the payment of the $ pershare in back dividends—LTV Preferred stock would literally beforcedhigher, no matter what the general stock market this reasoning, I recommended LTV $5 CumulativePreferred. Not long afterward, LTV’s Board of Directors announcedit would pay the $ in back dividends and reinstate the $5 annu-al preferred dividend. The price of LTV Preferred soared when thisnews was this “taste” of what would become superstock investing,I looked for a company in a similar situation—and found it. LikeLTV, Avco Corporation had a cumulative preferred stock (the $ Preferred) trading on the New York Stock LTV, Avco had fallen on hard times and suspended dividendpayments on the preferred, and they were accumulating “in arrears.”And like LTV, Avco’s earnings had taken a major turn for the better,and its common stockholders were pushing for dividends on thecommon shares, which could only be paid if the arrears were paidon the cumulative preferred recommended Avco $ Cumulative Preferred in August11975 at 18⁄2. After Avco paid all of the arrears on the preferred stockand reinstated the annual $ dividend, the stock was selling at$47. This literally forced the stock market to revalue the preferredstock at a higher level since that $ annual dividend would havecreated a yield of almost 18 percent, based on the original price of118⁄2—far too high a yield. To adjust for the fact that the dividendwas once again being paid, the price of the preferred stock wouldhave to rise. In other words, based on this anticipated development—the reinstated dividend—this stock hadto go up.
Chap 01 7/9/01 8:44 AM Page 1414PART ONEThe Making of a Superstock InvestorRemember, though, higher earnings do not necessarily meanthat a stock hasto go up, even if those earnings beat analysts’ expec-tations. Afat, new contract does not mean a stock has to respond tothe news. What we should look for is a development that makes itabsolutely necessary for a stock to rise dramatically in price to reflect thenew reality of the LESSON LEARNEDHere’s what can be learned from these two successful recommen-dations. Sometimes it is possible to anticipate a certain specific eventwhich—if it were to take place—would literally force a stock priceto move higher, no matter what the overall stock market is doing at thetime. There are plenty of situations where a certain event could ele-vate a stock out of the usually unpredictable world of Wall Streetand into another is these events that create the world of “superstocks.”
Chap 02 7/9/01 8:45 AM Page 15CHAPTER TWOA Superstock Is BornOn August 3, 1998, American Stores, a supermarket and drugstore3company, jumped 5⁄4points, or 25 percent. American Stores was thelargest percentage gainer on the New York Stock Exchange that day,a day on which the Dow Jones Industrial Average dropped 96 following day the Dow fell 299 points, and American Stores3once again bucked the trend, rising another 1⁄ that performance, American Stores joined the ranks of thesuperstocks—stocks that have the ability to rise quickly and sub-stantially in price no matter what the general stock market is propelled American Stores into the ranks of the super-stocks? Atakeover bid from Albertsons, a supermarket operatorwhich, like many other supermarket companies, was seeking toexpand by acquiring other companies. When Albertsons made itstakeover bid for American Stores, it offered a big premium overAmerican Stores’ previous closing price. American Stores shares sim-ply had to move sharply higher. It made absolutely no differencewhat the stock market did on that day. An outside “catalyst” waspropelling the price change, and American Stores shareholderswatched their stock soar in price as the general stock market col-lapsed over a 2-day ! There is no sweeter sound for an investor than to wake upto discover that a stock is the subject of a takeover bid at a huge pre-mium over the previous day’s closing price. It’s not uncommon fortakeover bids to drive a stock price higher by 25 percent, 50 percent,15Copyright 2001 The McGraw-Hill Companies, Inc. Click Here for Terms of Use.
Chap 02 7/9/01 8:45 AM Page 1616PART ONEThe Making of a Superstock Investoror even more in a single day—usually in a single trade, right at theopening bell, following the announcement that Company Ais offer-ing to buy Company while, to a casual observer, it may seem that these takeoverbids that create instant profits usually come out of the blue, in factmany takeover bids do not occur as a random bolt, but as a final,predictable event that is the culmination of a series of other are the logical conclusion to a series of interrelated develop-ments that, when properly noticed and analyzed, can clearly pointthe way to many takover bids that seem totally unpredictable to out-side observers who don’t know what to look here’s the best part: Because many takeover bids involveneglected, undervalued, and out-of-favor stocks, you will not nec-essarily be incurring an inordinate level of risk when you pepperyour portfolio with these genuine takeover candidates. The only riskyou’ll be taking is opportunity risk—and even that usually turnsout to be a temporary problem. Aneglected takeover candidate thatjust sits there while the trendier momentum stocks hog the spotlightcan be frustrating to own. But when your takeover candidate shootsup 25 to 50 percent in one day on news of a takeover bid, you willbe paid back in spades for those periods of temporary remember this: While undervalued takeover candidatesthat do not respond to the general market can be frustrating to ownwhen the market is going up, they can be rewarding when theymarch to their own drummer while the rest of the stock market ismarching off a cliff, as many investors learned in this book you will learn how to spot the Telltale Signs of aseemingly sleepy, out-of-favor stock with nothing much apparent-ly going for it that could suddenly turn it into a superstock and chalkup huge gains as a result of a takeover bid. This is not a “get richquick” system, backtested by computer, and guaranteed to makeyou is a book for investors who recognize that successful invest-ing requires research and clear, original thinking. It’s for investorswho understand that brains are often confused with bull markets, andthat in a rising market anyonecan look like a genius. Those with theexperience or insight understand that the true test of investment
Chap 02 7/9/01 8:45 AM Page 17CHAPTER TWOASuperstock Is Born17acumen comes when the general stock market is going against , and only then, are the benefits of shrewd stock selection clear-ly example of a takeover success story in this book was pre-dicted, thoroughly analyzed, and fully documented in my invest-ment newsletter, Superstock Investor. These are actual case studiesthat show how the clues observed along the way clearly pointed tothe ultimate outcome—a profitable takeover Stores, for example, had tipped its hand a few monthsprior to the takeover bid. We had already alerted subscribers to theongoing takeover trends in both the supermarket and drugstoreindustries, and chalked up several winners that became takeover tar-gets in those industries. As you will learn later, one of the strategiesto identify a potential takeover target is to monitor stocks in takeover-lively industries that are acting suspiciously well relative to otherstocks in the industry or relative to the stock market in Stores was added to my Master List of RecommendedStocks for that very reason. During a 4-day period in the spring of1998, while the Dow Jones Industrial Average was plunging 500points, American Stores was moving slowly and steadily higher,completely disregarding the spreading weakness in the overall stockmarket. That performance, combined with the established takeovertrends in both the supermarket and drugstore industries—two busi-nesses operated by American Stores—suggested that American Storeswas acting like a potential American Stores received a takeover bid from Albertsonson August 3, investors enjoyed large profits while the broad stockmarket was declining sharply—precisely the result a superstock issupposed to the time you finish this book, you’ll know how to identifysuch potential superstocks as they tip their hand. And by then you’llhave a framework to help you get started.
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Chap 03 7/9/01 8:46 AM Page 19CHAPTER THREEStock SelectionFor most investors, the traditional method of stock selection goessomething like this: You’re sitting in your office trying to figure out where to go tolunch and the phone rings. It’s your broker.“Hello, Mr. Spinelli?”“Yes?”“Tom Hayden, from Dewey, Pickum & Howe.”“Oh. Hi, Tom.”“Listen, Mr. Spinelli, our research department has come outwith their stock pick of the week.”“I’m thrilled. What is it?”“General Electric. We think it’s a great company at these prices.”“You need a research department to tell me General Electric isa great company?”“Well, no, the thing is, we think they’re going to beat the streetestimates by around a penny a share.”“General Electric has tripled over the past four years. It’s dou-bled over the past year and a half. Nowyou tell me to buy GeneralElectric?”“Well, we—”“What else do you like?”“We like Dell Computer.”“Dell Computer?”“Yes. Our research department thinks it’s a—”“I know, it’s a great company. What else?”19Copyright 2001 The McGraw-Hill Companies, Inc. Click Here for Terms of Use.
Y L F M AChap 03 7/9/01 8:46 AM Page 20 E T 20PART ONEThe Making of a Superstock Investor “Uh . . . IBM?” “Listen Tom, no offense, butI can hear about every one of these stocks a hundred times a day on CNBC. I can give you the entire list by heart. I already own six mutual funds and these stocks are in every one of them. Every one! Why don’t you guys recommend a stock like WMS Industries? That’s a great turnaround story that nobody’s talking about. Plus, the Chairman of Viacom has been buy- ing this stock on the open market and he owns 25 percent of the company. He obviously thinks it’s undervalued. Maybe he’ll make a takeover bid.” “WMS Industries?” “Yeah.”“Uh . . . Let ’s see. Here it is. Well, they have no debt. And theyhave lots of cash.” “Exactly. It’s a great situation.” “Well, no . . . You see, if they have no debt and they have lots of cash, we probably wouldn’t recommend it.” ®“Why not?”Team-Fly “Well, because they probably wouldn’t need to do any invest-ment banking business.”“Any what?”“Investment banking business. See, if they wanted to do a stockor bond offering, we could be their investment banker and then we’drecommend the stock. That’s how it works with smaller companies.”“It does?”“Usually, yes.”By the end of this conversation, you have learned an invalu-able lesson about Wall Street: Much of the time—perhaps most ofthe time—mainstream Wall Street research has less to do with pick-ing stocks than it has to do with generating business. It is no accidentthat less than 1 percent of brokerage firm research reports are sellrecommendations. Brokers do not want to offend potential invest-ment banking clients. And it is also no accident that smaller com-panies with lots of cash and no debt are usually overlooked by thebigger research departments on Wall Street. This is because thesepoor outfits, flush with cash and owing nothing, face the dreadeddouble whammy: Not only are they too small for the big institutionsthat generate the big commissions to bother getting involved with,but they are also not even potential investment banking clients for
Chap 03 7/9/01 8:46 AM Page 21CHAPTER THREEStock Selection21the brokerage firm. So, given a limited universe of stocks to dealwith and limited time, what kinds of stocks do you think the bro-kerage analysts are going to cover and recommend?I once had a conversation with a gentleman who ran a fast-growing health care company whose earnings were growing at 40percent a year. The company had more than enough cash, no debtwhatsoever, and no intention of raising any money. Larger compa-nies in his industry that were loaded with debt and doing secondarystock offerings were selling at 30 to 40 times earnings and were rec-ommended by every major brokerage firm on Wall Street. This poorguy’s stock was trading at 13 times earnings and going nowhere. Icalled him up to see if I was missing something, like perhaps therewas a mass murderer on the Board of Directors.“We can’t get anybody to talk to us,” the president moaned.“Why not?” I asked.“Because we don’t want to do any banking business with thebrokerage firms.”I asked him if he was joking.“No,” he said. “They all say the same thing. Do a little con-vertible bond. Do a little secondary offering. Acquire somebody, letus be the banker on the deal. Then we can follow the company.”That conversation was a real eye-opener. But, it is a familiarrefrain because when I am looking for takeover candidates, the focustends to be on companies with lots of cash and little or no debt. Thesecompanies tend to make more tempting takeover targets. And, theirony is that since these are precisely the sort of companies neglect-ed by Wall Street research departments, these cash-rich, low-debtcompanies tend to lag behind the market due to a lack of analyticalsupport. By lagging and trading far below the values accorded theaverage stock, these financially strong companies tend to trade at ahuge discount below their true values as takeover this means to you as an individual investor is that the WallStreet behemoths have left the playing field wide open for anyonewho wants to be an independent thinker and look for individualstocks that are being left behind and are selling at great values. Theobsession with large-cap stocks and servicing the big institutionalclients has resulted in big research departments becoming little morethan marketing arms of the sales force, something that has alwaysbeen a fact of life on Wall Street but never to the extent that it is today.
Chap 03 7/9/01 8:46 AM Page 2222PART ONEThe Making of a Superstock InvestorImagine some poor junior analyst trying to convince his or herboss to recommend WMS Industries.“Mr. Gerard?”“Yeah.”“I have this report I’d like you to look at.”“It’s a buy recommendation, isn’t it?”“Yes.”“Because we don’t want to offend anybody. That’s bad busi-ness.”“Yes, I know.”Mr. Gerard looks at the report. “WMS Industries, huh? Marketcap is only $500 million. That’s pretty small for us. How much do theywant to raise?”“Excuse me?”“How much money do they want to raise?”“Uh . . . I don’t think they want to raise any money.”“What do you mean they don’t want to raise money? Look here,they have no debt. Don’t they want to borrow some money? Sellsome bonds?”“Well, see, their cash flow is quite strong and they have a lot ofcash, and . . . Sumner Redstone, Chairman of Viacom, has been buy-ing stock on the open market, and—”“Do they want to acquire somebody?”“Not that I know of.”“Well, then, what are you bothering me for? Get out of my office!Come back when you can recommend something that will generateus some revenue.”Eventually the analysts learn how the game is played and theirresearch tilts farther away from the smaller, financially strong com-panies. And as time goes on, all the analysts are looking over theirshoulders as they play the same game, and the focus begins to nar-row to a progressively smaller group of stocks, the same stocks youhear about day in and day out, ad nauseam, on CNBC, CNNfn, andevery other financial program and publication. The buy recommen-dations proliferate, no matter how high the stocks go, because almosteverybody says buy and nobody wants to offend a potential disappointments are overlooked: The silver lining is alwaysfound. Eventually, all this positive commentary and concentratedbuying on a small group of large-cap stocks creates a situation where
Chap 03 7/9/01 8:46 AM Page 23CHAPTER THREEStock Selection23these stocks are so overvalued relative to their small-cap counter-parts that the pendulum must inevitably swing the other ago Doug Flutie electrified the college football world when hethrew a “Hail Mary” touchdown pass with no time left on the clockand Boston College scored an upset win over the mighty MiamiHurricanes. That play, which has been shown thousands of times,capped a stellar collegiate career for Flutie. But after he graduated,Flutie was able to secure only part-time employment in the NationalFootball League and was eventually banished to the CanadianFootball League, where he became not a superstock, but a ’s shortcoming, as far as the NFLwas concerned, was thathe was too small. At 5 feet, 9 inches, Flutie simply could not see overthe heads of onrushing linemen. So how could he find his receivers?The logic seemed sound. If you’re 5 feet, 9 inches, and six mus-cle-bound monsters standing 6 feet, 10 inches and weighing 300pounds apiece are bearing down on you, it stands to reason that youmight have difficulty spotting a wiry little guy 20 yards so the NFLsaid, “Sorry, too short,” and Flutie went on to leadseveral Canadian Football League teams to you follow football at all, you probably know the rest of thestory. Flutie returned to the NFLin 1998 as a backup quarterbackwith the Buffalo Bills, and when the starting quarterback went downwith an injury, Flutie stepped in and almost took the Bills to theSuper did he do it, considering his diminutive stature relative tohis opponents? The key is that Flutie did not try to match the onrush-ing linemen strength for strength or height for height. He refusedto play their game. Instead, he used his agility to simply step aside,avoid the lumbering behemoths, and scramble around until he spot-ted the receivers and completed his book Supermoney, author George Goodman, writing underthe name “Adam Smith,” used the analogy of the small but nimblequarterback to point out that individuals can compete with the giantinstitutional investors by “taking a quick look and stepping into thegaps between them.” If you think of yourself as Doug Flutie, andyou think of the index funds and other huge mutual funds and pen-sion funds as lumbering, muscle-bound opponents, you will beginto see the tremendous advantage individual investors have today.
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Chap 04 7/9/01 8:46 AM Page 25CHAPTER FOURInvesting Paradigms: A New Way of Thinkingabout Stock SelectionAparadigm is a framework or model. As we learn and experience, webegin to establish various paradigms relating to all aspects of ourlives. Eventually, we establish a framework with which we’re com-fortable. We begin to expect that certain ways of thinking or behav-ing will bring certain results, and we reach a certain comfort levelbetween our actions and the reactions they will create. Sometimes theparadigms we establish serve us well for our entire lives. Other times,we become dissatisfied with the results our actions create and itbecomes necessary to create a new it comes to selecting individual stocks, percent ofinvestors and Wall Street analysts are operating using a dog-eared,shop-worn paradigm that is coming apart at the seams. They are alllooking for the same thing: growth stocks with earnings momen-tum that will deliver strong earnings gains indefinitely into the futureand enable these companies to justify their sky-high stock are two problems with this paradigm: First, it’s been in exis-tence for nearly 20 years and it’s getting a bit creaky. In fact, it’s prob-ably on its last legs. The second problem with this paradigm is thatit’s not new; it’s only a new version of other paradigms that havecome and gone over the years. The late 1960s version, for example,was called the “One-Decision Stock Paradigm.” In this version, cer-25Copyright 2001 The McGraw-Hill Companies, Inc. Click Here for Terms of Use.
Chap 04 7/9/01 8:46 AM Page 2626PART ONEThe Making of a Superstock Investortain stocks had earnings that would grow forever, which meant theirstock prices would go up forever. That, in turn, meant that investorswould never have to sell the stocks. Thus, only one decision wasnecessary—to buy paradigm eventually collapsed when it turned out thatsome perpetual growth industries (like bowling) reached their sat-uration points far sooner than analysts expected; other perpetualgrowth industries attracted competitors and price competition, there-by reducing profit margins (like calculators and CB radios); and eco-nomic recessions still surfaced from time to time, which had a ten-dency to affect all industries, turning growth stocks into normal,run-of-the-mill cyclical book offers a new paradigm—a new way of thinking aboutstock selection. Forget about earnings estimates and concentrate onasset values. Ignore the hot momentum stocks everybody is recom-mending and concentrate on industries and stocks that are out of you read The Wall Street Journal, ignore the market commentaryand the earnings digest and instead look for items—especially smallitems—that involve industry consolidation, or takeovers. Listen care-fully to CEO interviews on CNBC or CNNfn and pay particular atten-tion to those who talk about “growth through acquisitions.” Take noteof every large merger announcement you see, and pay particular atten-tion to the reasoning behind that merger. Get a list of the top 10 to 15companies in that industry and zero in on those with little or no debtand high cash and/or working capital relative to their stock prices, onthe theory that a merger trend in motion tends to stay in motion andthat once a large merger has occurred in an industry, more willinevitably follow. Take note of every merger that falls apart, on the the-ory that the buying company will look around for another target. Alsotake note of situations where two companies are trying to acquire thesame target, on the theory that only one of them can win the prize, andthe company that loses out will eventually look around for anothercompany to buy. Subscribe to the Vickers Weekly Insider Reportand makea note of every outside company that is raising its stake in anothercompany through open-market stock purchases. Take notice of everycompany that announces a stock buyback of 5 percent or more, and puta big red circle around those that operate in industries where a greatdeal of takeover activity has occurred. Make note of every company thatenacts a “Shareholder Rights Plan” designed to make a takeover more
Chap 04 7/9/01 8:46 AM Page 27CHAPTER FOURInvesting Paradigms27difficult, based on the theory that the company wouldn’t be botheringwith such a plan unless it felt its stock was undervalued relative to itsassets, and it was vulnerable to a takeover bid at an unrealistically lowprice. Make note of every company in a consolidating industry where10 percent or more of the stock is held by a brokerage firm, a buyoutfirm, or an investment partnership that does not maintain long-terminvestments in the normal course of its business. The theory behindthis is that a sophisticated stockholder will recognize the opportunityto maximize its investment and will act as a “catalyst” for a takeoverbid. Take note of companies that are selling or spinning off noncoreoperations, especially when the parent company or the spinoff oper-ates in an industry where takeovers are occurring, because corporaterestructurings like this are often a prelude to a takeover , subscribe to the Mansfield Chart Service or a similarservice that presents charts organized by industry group. Theseenable you to see at a glance if a particular stock in an industry groupis suspiciously outperforming its peers—often a sign that some sortof takeover development is way of thinking is new paradigm territory for per-cent of investors and analysts. At first it may seem difficult andunusual, but if you have the courage to enter this new paradigm,you will find yourself in a fascinating new world where all sorts ofnew and exciting stock ideas will present themselves. You’ll alsofind that this new paradigm is sparsely populated, which at firstmay be uncomfortable. But eventually, seeing things that others donot see will eventually turn out to be the source of great excitementand satisfaction. You will understand things that others do not under-stand. At times, you’ll feel almost as if you can see the future, andyou will marvel at the inability of others to do the if you think that’s exaggeration, consider this real-lifeexample of old paradigm thinking versus new paradigm December 1998, I presented a front-page story in Superstock Investorentitled “Water Utility Industry Could Be on the Verge of a TakeoverWave.” The article compared the water utility industry to the drug-store industry, which had undergone a rapid wave of takeovers overthe previous 2 or 3 years. It noted that two major water utility merg-ers had recently taken place—the purchase of Consumers Water byPhiladelphia Suburban, and the purchase of National Enterprisesby American Water Works—and that a third smaller takeover of
Chap 04 7/9/01 8:46 AM Page 2828PART ONEThe Making of a Superstock InvestorDominguez Water by California Water Service had just been addition, I noted that I had seen interviews with water util-ity executives outlining clear and logical reasons for future takeoversin this industry. As a result, I presented a list of water utility takeovercandidates, and I began to track this industry on a regular that month, on December 21, 1998, I appeared on CNBCand made the case for investing in water utility takeover candidatesand specifically recommended two water utilities traded on the NewYork Stock Exchange, Aquarion (WTR) and California Water Services(CWT).Just 6 months later, in June 1999, Aquarion received a takeoverbid from Yorkshire Water PLC, a British water company, at a priceof $ per share, a 50 percent premium over my original recom-mended price for Aquarion. And remember, we are talking hereabout a water utility—a safe, stable stock with a dividend yield ofnearly 5 percent. And yet, by focusing in on the developing takeovertrend in the water utility industry, we were able to generate profitsof 50 percent in 6 months!On July 23, 1999, less than 2 months after the Aquarion takeover,CNBC presented an interview with J. James Barr, CEO of AmericanWater Works, the largest publicly owned water utility. I was lookingforward to this interview because I thought I might be able to gleanadditional reasoning and information regarding the takeover trendin the water utility industry. And if I were lucky, maybe I might geta hint of whether American Water Works was still looking to acquirecompanies, and if so, what region of the country they might be look-ing at. In other words, I was looking for clues that might lead me toa takeover interview began on a promising note. Mr. Barr stated thathis goal was to continue to grow the business, and he said that oneof the keys to continued growth would be an ongoing policy ofacquiring other water utility systems. So far, so , what followed was as classic an example of oldparadigm thinking as you could possibly hope not to see. Here werethe questions Barr was asked: are the possibilities of turning saltwater into drink-ing water?
Chap 04 7/9/01 8:46 AM Page 29CHAPTER FOURInvesting about turning glaciers into drinking water? about turning icebergs into drinking water? difficult will it be for you to raise rates? you think there might come a time when governmentcould confiscate your assets in the event of a water shortage? contingency plans have you developed in the eventterrorists attack the nation’s water supply?Terrorists? Glaciers? Icebergs? These ridiculous questions are thetype that make superstock investors all across America groan withdisappointment. Asuperstock investor would have immediatelyfocused on Mr. Barr’s comment on growth through acquisitions andtried to pin him down with questions like these: kind of water utility companies are you looking tobuy? region of the country are you looking at for newgrowth opportunities? big might a potential target be in terms of revenues? might the characteristics of a potential target be?Anything at all to try to get a clue as to where American WaterWorks might strike next in terms of taking over a water utility. That’swhat investors would want to know. Those questions are designedto make you money in the stock market. But those questions werenever asked. (At least we discovered that Mr. Barr isn’t too worriedabout terrorists. That may be comforting to know, but it is not goingto make you any money in the stock market.)That, in a nutshell, is the difference between old paradigm andnew paradigm thinking. If you’re thinking in terms of takeover tar-gets, you always look for clues and you are always on the lookoutfor an opening to receive new information and new insights. But ifyou’re not used to thinking in these terms, you miss golden oppor-tunities, such as those the CNBC interviewers missed, to bring newinformation to the American Water Works interview was just one more exam-ple of how the vast majority of Wall Street analysts and commentatorsthink in old paradigm terms. It illustrated why the new paradigm isso sparsely populated, and how information and evidence that is in
Y L F M AChap 04 7/9/01 8:46 AM Page 30 E T 30PART ONEThe Making of a Superstock Investor plain view for everyone to see can be completely overlooked by the majority of investors and the people from whom they receive advice and information. Just 10 months after this noninterview, American Water Works made a takeover bid for SJW Corp. SJW was on my recommended list as a takeover candidate. Suppose, for the sake of discussion, one of the CNBC interviewers had asked J. James Barr which region of the . American Water Works might be looking at in terms of potential acquisitions. Suppose he had mentioned the western United States. This would have enabled superstock investors to zero in on the hand- ful of publicly traded western water utilities as possible targets— SJW prominently among them. But the question was never why wasn’t the question asked? W ell, certainly not becausethe CNBC interviewers are not good at wh at they do. It is extremelyrare for any CEO to appear on CNBC and not be peppered with pre- cisely the right questions. But in this particular interview CNBC missed the mark, and the reason is that they were talking to a CEO who oper- ®ated in an obscure industry with a limited analytical following. UpTeam-Fly until the takeover wave began to unfold, the water utility industryconsisted of only a handful of public companies that generated verylittle news and even less excitement. For this reason, these stocks werecompletely off the Wall Street radar screen. In fact, even some of thehandful of analysts who actually followed these stocks were behindthe curve in picking up on the takeover potential in this group. So, itis perfectly understandable that this particular interview came off asthough a group of people were struggling to make small talk at a bor-ing cocktail yourself aware of every industry—even an obscureindustry like water utilities—that is beginning to consolidate throughtakeovers requires a new way of thinking about the financial fact that you are reading this book indicates that you are likelyto be receptive to this new way of thinking. In a few minutes I amgoing to take you inside the “superstock paradigm” and show youhow to think and invest within that new before you get to that paradigm you will have to traversea Wall Street landscape that is full of potholes, dead ends, and hotair that can easily throw you off course. So let’s take a brief look atsome more of that landscape.
Chap 05 7/9/01 8:49 AM Page 31CHAPTER FIVEThe Twilight of IndexInvestingAlemming is a member of the rodent family with a powerful herdinstinct. They are noted for moving in packs, but then, many ani-mals are pack animals, so this may not seem so unusual. Lemmings,however, take their herd instinct to a ridiculous extreme: They fol-low each other into the sea, often jumping off cliffs, which results inmass drownings. Although this sort of behavior may strike you asincredibly stupid, the same thing happens on Wall Street virtuallyevery business Wall Street, the herd instinct is a powerful force money managers, once they have been around for awhile, discover there is great comfort in doing pretty much the samething everybody else is doing. Acertain style of investing, once itproves successful, tends to remain in style, year after year, untilinvestors come to believe that this is the way things will be doneforever and that no other style makes sense. Recently, the Wall Streetlemmings have been running full speed toward the cliff of indexinvesting, the fad of the moment that is sort of the bizarro world ofsuperstock all tend to base our view of the future on our most recentexperience. This tendency to extrapolate trends of the recent pastindefinitely into the future is perfectly natural—and on Wall Streetit is extremely 2001 The McGraw-Hill Companies, Inc. Click Here for Terms of Use.
Chap 05 7/9/01 8:49 AM Page 3232PART ONEThe Making of a Superstock InvestorThe history of the stock market is replete with examples of“can’t miss” investing techniques that were successful for a whileand then simply stopped working, victims of an overpopularity thateventually created the seeds of their own the 1960s, for example, small-cap stocks were all the -known large caps were viewed as too boring, too predictable,and having limited growth prospects. Instead, investors wantedyoung companies with small revenue bases that might somedayturn into larger companies that would bring huge stock price increas-es to their happy stockholders. The next Xerox. The next IBM. Thenext this, the next that. The next is always the case on Wall Street, brokerage firms and mutu-al fund companies were more than happy to create the productsinvestors craved, and a slew of small-cap mutual funds were born,all of which were looking for the next IBM and all of which beganchasing smaller-cap stocks. Eventually, the bargains disappeared,victims of too much money chasing the same stocks. How manyIBMs could there have been, after all? The entire small stock sectorcrashed. The pendulum had swung too far toward small caps, andit was time to shift recently, the focus has been on large-cap stocks—the samelarge caps everybody used to shun. If you’ve heard it once, you’veheard it a thousand times: The best way for individual investors tomake consistent profits in the stock market is to buy an “index” fundthat tracks the performance of a broad-based stock market index likethe Standard & Poor’s 500 Index, which, in turn, represents a crosssection of America’s most solid, time-tested ’t try to pick individual ’t try to outsmart the stock ’t go too far off the beaten path trying to find overlookedvalues. All pertinent information is so readily available and so wellanalyzed by the Wall Street geniuses that it is already processed and“discounted” by the market. If you’re an individual investor, don’teven bother trying to find an edge. It can’t be lemmings, stock market commentators and mutual fundmanagers, and investors who listen to their advice, have run head-long toward the large-cap/indexing craze. It sounds so simple, whocan resist it? This mantra has been repeated so often that you might
Chap 05 7/9/01 8:49 AM Page 33CHAPTER FIVEThe Twilight of Index Investing33think that the larger-cap stocks that dominate the major indices haveoutperformed their small-cap counterparts virtually 100 percent ofthe time since the stock market was created. One would think thatearnings momentum has always been the stock market’s holy grailand that value, asset-oriented stocks have always trailed the yet, those assumptions are not true. I’m not going to boreyou with an historical examination of how the stock market favoreddifferent types of stocks at different times, except to say this: Theinfatuation with large-cap stocks has come and gone numerous timesover the long history of Wall Street, and it will dissipate again, justas it has in the past. Trends ebb and flow, investment philosophiescome and go, and every investment mania—that is, the recent obses-sion with indexing and large-cap stocks—contains the seeds of itsown a brief look at the past will prove the point. Figure 5–1,which tracks the relative performance of the S&PLow-Priced StockIndex to the S&PBig-Cap Index back to 1930, shows that smaller-capstocks and larger-cap stocks have taken turns outperforming eachother. Arising line means lower-priced stocks were leading the mar-ket; a falling line means the larger-cap stocks were leading the mar-ket. Good luck trying to glean anything from this chart, except forone thing: things change. For most of the 1960s small-cap stocks wereoutperforming large caps. In the early 1970s large-cap stocks werethe star performers, but from 1976 through 1984, the small caps out-performed the large large caps took over from 1984 until1991, then the small caps had a run from 1991 through 1995, andsince then, the large caps have taken over once can we learn from this? For one thing: Anybody who tellsyou that the undisputed path to investment success is to index yourinvestments to the S&P500, which is dominated by large-cap stocks,has a limited sense of stock market history, has never seen this chart,or is a salesperson for an index fund. For another: No single invest-ment style works best all of the time, and an intelligent lemmingwith a strong survival instinct had better learn that there comes atime when it’s better to stop following the in 1999 the “value gap” between large-cap and small-capstocks was at the highest level in history. What this means is thatprice/earnings ratios accorded the large-cap stocks were at the high-est level ever relative to small-cap stocks.
Chap 05 7/9/01 8:49 AM Page 3434PART ONEThe Making of a Superstock InvestorFigure 5–1Relative Leadership Index19301935194019451950195519601965197019751980198519901995464464414414S&P Low-Priced Stock Index/S&P High-Grade Stock Index370370331331296Rising = Low-Priced Stocks Lead the Market2962642642362362112111881881681681501501341341201201071079696868677Falling = High-Grade Leadership776868This fact, combined with the historical evidence shown in Figure5–1, should at least raise the question: Are we fast approaching thetwilight of large-cap and index investing? Is the pendulum about toswing the other way? And if it is, is superstock investing going to bethe best way to beat the stock market over the next several years?
Chap 06 7/9/01 8:50 AM Page 35CHAPTER SIXExperts: What Do They Know?When you get to a fork in the road, take it. Yogi BerraBy taking the fork in the road marked “superstock investing,” youoften will find that you have little, if any, analytical or “expert” sup-port. This may produce an uncomfortable feeling at chapter is designed to get you over that you begin to think in terms of the “new paradigm” of stockselection, you will have to get used to the idea, when you go off thebeaten path, that you’re not going to have a lot of company. In invest-ment terms, the path in this book is definitely the road less ’s perfectly natural for any investor to feel more comfortablewhen buying a stock that is recommended by a large number of“expert” analysts. And yet, as you will see, the more analysts whoare following a particular stock, the less likely it becomes that youcan come up with any significant insight that hasn’t already beenfactored into the stock price. Not only that, the more analysts whorecommend any given stock, the greater the likelihood that all of thepositive news and potential surrounding this particular company isalready more than reflected in the stock price. This means that theslightest disappointment will result in an immediate and significantdrop in the stock, which could wipe out months or years of profitsin a single 2001 The McGraw-Hill Companies, Inc. Click Here for Terms of Use.
Chap 06 7/9/01 8:50 AM Page 3636PART ONEThe Making of a Superstock InvestorIn Heaven Can Wait,James Mason, an emissary from heaven,reveals a basic truth of life when he tells Warren Beatty that “thelikelihood of a person being right increases in direct proportion to thenumber of people attempting to prove him wrong.” This is anotherway of saying that if you are looking for truth, insight, or really greatstock ideas, don’t be afraid to go down that untrodden path—anddon’t waver simply because most people don’t think the way youthink or can’t see what you you apply the principles described in this book to yourstock selection process, you often will wind up with stocks that forone reason or another have been neglected or are out of favor. Andyet, the Telltale Signs you’ll learn to spot will strongly suggest that,beneath the surface of a sleepy, out-of-favor stock, a metamorpho-sis is starting to take place that has not yet become apparent to themainstream Wall Street establishment, ., the “experts.”By the time you finish this book, you will recognize many ofthese Telltale Signs that metamorphosis is in the making, but thatwill be only half the battle. Even after you’ve spotted a potential win-ner, analyzed the situation correctly, and taken the plunge by buyingthe stock, you will probably have to suffer through a frustrating peri-od during which whatever was blindingly obvious to you is com-pletely overlooked by the experts who influence stock can be pretty lonely and sometimes spooky when you’restrolling down the untrodden superstock help you get through these inevitable periods of frustrationwhen your confidence in your own judgment will be tested, and tohelp you remember that it is perfectly possible for you to be rightwhile the “experts” are wrong, we’ll show you some world-class exam-ples of expert opinion that turned out to be completely off the IS AN “EXPERT,” ANYWAY?One wonderful definition is that an expertis “somebody from outof town,” which is another way of saying that distance lends definition, and probably the best one for our purpos-es, would identify an “expert” as anybody who manages to get quot-ed in a newspaper or magazine or has a publicist with enough cloutto wrangle an interview on television or radio. Considering the explo-
Chap 06 7/9/01 8:50 AM Page 37CHAPTER SIXExperts: What Do They Know?37sion of media outlets in recent years devoted to finance and invest-ing, including the proliferation of financial Web sites, this definitionof an “expert” would have to be considered fully diluted, if you getmy drift.“Experts” have always had a difficult time predicting the future,although this has never stopped any of them from making predic-tions. And it probably will not surprise you to learn that the ranks right up there when it comes to the list of “experts”who have made pronouncements about the future that have turnedout to be spectacularly example, every now and then over the past 30 years wehave been subjected to an “energy scare” and we are told that ener-gy supplies are running out. Every time these energy scares havesurfaced, they turned out to be false alarms. But did you know thatdire predictions of an imminent “energy doomsday scenario” havebeen going on for the last 115 years?Take a look at the list of predictions about energy supplies fromvarious . government agencies given in Table 6–1, and rememberit well the next time some bureaucrat or Wall Street analyst tells youthat oil or gas supplies are running even a genuine, card-carrying expert with a track record ofaccomplishment and insight can be completely out of sync in anygiven situation and therefore way off the mark. Why? For one thing,even genuine experts are out there taking their best educated guess,just like the rest of us. And they can be influenced, like everybodyelse, by the subconscious idea that a trend in force for a long timewill simply continue, indefinitely, into the future. And that means thatmost experts are not very good at identifying major turning pointsin the economy, the stock market, or the individual stock that hasbeen in favor or out of favor for a long rule of thumb that has developed over the years is that when-ever a certain trend in the economy or the stock market manages tomake the cover of a general-interest magazine like Timeor Newsweek,it’s time to consider the possibility that this particular trend has pret-ty much run its course. Aclassic example of this phenomenon is theNewsweekcover, dated December 2, 1974, entitled, “How Bad aSlump?” When this issue of Newsweekhit the stands, the economywas in a severe recession, the stock market had been sliding for twoyears, inflation and oil prices had spiraled out of control, and interest
Chap 06 7/9/01 8:50 AM Page 3838PART ONEThe Making of a Superstock InvestorTable 6–1“Expert” Oil Supply Predictions from the or no chance for oil discovery in California (. Geological Survey).Little or no chance for oil to be discovered in Kansas or Texas ( Survey).1891Little or no chance for oil to be discovered in Kansas or Texas ( Survey).1908Maximum future supply of oil to be discovered in the United States will billion barrels (. Geological Survey). (Note: By 1949, 35 billion barrels had already been discovered, with another 27 billion barrels proven and available.)1914Total future . production of oil will be a maximum of billion barrels(. Bureau of Mines). (Note:By 1976, another 34 billion barrels had beendiscovered, with no end in sight.). oil supplies will last only 13 more years (. Department of theInterior).1947Sufficient oil for . energy consumption can no longer be found in theUnited States (. State Department).1948End of . oil supply almost in sight (Secretary of the Interior).Source: Herman Kahn, The Next 200 Years(William Morrow & Co., New York, 1976).rates were in the stratosphere. So “How Bad a Slump?” seemed a per-fectly legitimate question to ask. What nobody knew at the time wasthat the slump had already ended, the stock market had already hitbottom, and both inflation and interest rates had already recent example of a magazine cover signaling the end ofa financial trend was the December 27, 1999, issue of Timemagazinein which founder Jeff Bezos was named Time’s “Personof the Year.” That issue of Timecoincided with the exact peak ’s stock price, which proceeded to fall from $113 to aslow as $ over the following year. This does not imply that JeffBezos did not deserve the honor—only that Time’s cover story result-ed in large part from a very newsworthy trend (the incredible stockmarket performance of the Internet stocks), which had been in forcefor a long time and which by that time had reached a ridiculousextreme. Time’s cover story signaled the end of the bull market notonly for but for every other Internet stock, all of whichplunged dramatically during 2000, and many of which actually wentcompletely out of business.
Chap 06 7/9/01 8:50 AM Page 39CHAPTER SIXExperts: What Do They Know?39This strategy of betting against magazine covers should not beconfined to economic and investing issues, by the way. Here isanother classic example of expert opinion that was off the mark. Inthe October 17, 1988, issue, Sports Illustratedran a cover story on theinvincible Oakland A’s, who were about to face the Cincinnati Redsin the World Series.“The 1988 A’s,” the story said, “are the best team the AmericanLeague has sent to the World Series since Charlie Finley’s teams ofthe early 1970s. These A’s may be even better.” Having thus beenanointed one of the greatest baseball teams of all time, the A’s wenton to lose four straight World Series games to the Cincinnati “experts” aren’t very good at predicting recessions recessions do not announce their arrival the way JackNicholson announced his arrival in The Shining—by breaking downa door with an axe and scaring Shelly Duval out of her wits as heannounced: “Honey! I’m home!” Rather, recessions tend to arriveon muffled oars, quietly, arousing little or no suspicion until one daythe Commerce Department announces that, “Guess what? We havebeen in a recession for the past 6 months. Have a nice day, and goodluck paying off those loans that you took out to expand your busi-ness at precisely the wrong moment.”Yet another classic example of the “experts’” inability to pre-dict recessions was evident in July 1989, when Fortuneannouncedthere would be “No recession this year or next.” Of course, the reces-sion of 1990 was already in the process of beginning, but none of theexperts Fortunerelied on saw it take a look at thr chronology of headlines in Table 6–2 tosee how much help the “experts” will be in preparing you for the 6–2Chronology of HeadlinesSourceHeadlineFortune, July 17, 1989 No Recession This Year or Next Newsweek, September 1989 Is there Ever Going to Be Another Recession? New York Times, February 1990 Economy s Slide May Have Ended, Greenspan Says Investor s Business Daily, January 1991 It s Official: The . Is in a Recession, But It Won t Last Long, Government Says.
Y L F M AChap 06 7/9/01 8:50 AM Page 40 E T 40PART ONEThe Making of a Superstock Investor You can also use the media to call turning points in both interest rates and oil prices. Here’s a classic. On September 16, 1987, The Wall Street Journal’s front page lead story was headlined: “The Bond Bears: Debt Securities Prices May Slide for Years, Many Analysts Think.” The implication was that interest rates would be rising for years into the future. This front-page story, amazingly enough, coincided with the exact peak in long-term interest rates. When this story appeared, the 30-year Treasury bond was yielding around per- cent (see the arrow on the chart in Figure 6–1). Bond prices then embarked on a relentless 6-year rally, which carried the yield on the 30-year Treasury down below 6 percent by late 1993. In another classic example, Associated Press managed to catchthe exact bottom in crude oil when it ran a story on March 9, 1986,entitled: “No Bottom to Oil.” Again, check the arrow on the chart inFigure 6–1. This story managed to appear at the precise bottom in the ®Figure 6–1Team-Fly Examples of How the Media Can Call Turning Points30-Year Treasury Yield Points/Annum When:%30-Year Constant Maturity Treasury Bond Yields63-Day % Change inPoints/ % of11Crude Oil Is:AnnumTime11BOND PRICES MAY Above FOR YEARSBetween —5 and ——5 and Below— Texas Intermediate Crude Oil7/24/98 = (NY Mercantile Light, Sweet3232303013-Week Perpetual Contract)2828$ Per BOTTOM FOR OIL90907/24/98 = — Oil Prices606063-Day Rate of Change45453030151500—15—15—30—30—45—45MJSDMJSDMJSDMJSDMJSDMJSDMJSDMJSDMJSDMJSDMJSDMJSDMJSDMJ19851986198719881989199019911992199319941995199619971998Source: Ned Davis Research, 2100 Riveredge Parkway, Suite 750, Atlanta, GA30328.
Chap 06 7/9/01 8:50 AM Page 41CHAPTER SIXExperts: What Do They Know?41price of oil, which rose from $12 to $ a barrel within 4 years ofthe story’s did The Wall Street Journalmanage to run a lead story thatwas negative on bonds at precisely the peak in interest rates? Howdid the Associated Press proclaim that there was no bottom in sightfor oil prices at the exact bottom for oil? They did what came natu-rally: They got used to a persistent trend and felt compelled to writeabout that trend for their readers. When The Wall Street JournalandAssociated Press reporters went to their “expert” sources, thesesources had also gotten used to a trend that had been in force, andsimply extrapolated that trend into the future. It’s always easier toexplain what has been happening than to stick your neck out andsuggest that something new is about to transpire, which is why youtend to see the media make a very big deal out of trends and peoplejust as they are about to fizzle rat that I am, I have numerous examples of the media shin-ing the spotlight on the wrong trend or the wrong person at preciselythe wrong time. Here is one more example, a cover story dated October26, 1987. This issue of Fortunehit the newsstands the very week of the1987 stock market crash, and it said: “Why Greenspan Is Still Bullish.”On October 19, 1987, the same week this issue appeared, the Dow JonesIndustrial Average fell 508 points, a 1-day plunge of 18 course, following the monstrous stock market decline, the verysame news magazines that had been touting prosperity and a forever-rising stock market shifted gears and began running cover stories aboutthe coming recession and possible depression. The message of the stockmarket debacle, we were told, was that “hard times” were coming andthat investors and businesspeople should batten down the again. The media went overboard on the meaning of the 1987crash, just as it went overboard on the rally that preceded the consensus of the media and its “experts” following the 1987 crashwas that this could be just the beginning, a harbinger of severe eco-nomic problems for the world financial system. Even Robert Samuelson,Newsweek’s economic columnist and a man about as mainstream asyou can get, ran a column after the crash entitled “The Specter ofDepression,” in which he asked the question: Did the market crashserve as a warning that an economic depression was imminent? Hisanswer, delivered not entirely convincingly: “Probably not.”
Chap 06 7/9/01 8:50 AM Page 4242PART ONEThe Making of a Superstock InvestorAs it turned out, the 1987 stock market crash meant nothing atall. It was not an omen of anything, just a blip on the road to acontinuing bull market and a . economic advance that contin-ued, with only brief interruptions, for more than a you sure wouldn’t have guessed that in October 1987 if youhad listened to the “experts.”In the fall of 2000 the stock market was weakening as it becameapparent that the economy was slowing down dramatically, andpundits were debating whether the slowdown would turn into arecession. On Friday, December 22, The New York Daily Newsran abanner headline on page 5: “EXPERTS: NO RECESSION.” I don’tknow about you, but I did not find this headline EXPERTS CAN BE WRONGSo, what is it with these “experts” anyway? How can so many well-informed people be so wrong so often?Part of the problem may be that the pool of “experts” is years ago, before the proliferation of talk shows and theInternet, you had to be well versed in a particular subject before youwere invited to appear on television or anymore. These days, talk shows have multiplied to suchan extent that the supply of “experts” has increased to meet thedemand. Of course, common sense will tell you there is a limitedsupply of experts on any particular subject, but this doesn’t seem tomatter very much because there is so much babble sprouting up inall forms of media that it’s possible to say almost anything, no mat-ter how outlandish or uninformed, and get away with proliferation of Internet financial sites has also createddemand for more “experts.” Every site needs columnists and “ana-lysts” to expound on the daily developments on the financial of them are excellent writers, and it sure soundslike they knowwhat they’re talking about. But who are they? What are their back-grounds? How much experience do they have? Have any of themever even experienced a bear market or anything other than “momen-tum” and “index” investing?It’s tough to tell if you’re reading truly informed analysis orjust plain nonsense that has been created to provide content.
Chap 06 7/9/01 8:50 AM Page 43CHAPTER SIXExperts: What Do They Know?43This nonsense cuts across ideological boundaries. No matterwhat your personal, political, or business agenda, it is possible toput your own “spin” on almost anything—even historical mattersthat are not really open to debate—and chances are you will not bechallenged. And even if you are challenged, so what?Rush Limbaugh, for example, has blamed the oil shortages andgasoline lines of the 1970s on Jimmy Carter, saying that “those gas lineswere a direct result of foreign oil powers playing tough with us becausethey didn’t fear Jimmy Carter.” But the first—and worst—OPEC oilprice hike took place between 1973 and 1974, during the administra-tion of Richard Nixon. Not only that, but one reason for OPEC’s initialoil price hike was the Nixon policy of wage and price controls, whichcaused OPEC to feel it was not receiving a fair price for its you look, “experts” are spinning facts to promotean agenda. To this day, Democrats still try to deny that the economyperformed well under Ronald North, who lied to Congress and was rewarded with theRepublican nomination for senator from Virginia and then with anationally syndicated talk show, refused to criticize Jerry Falwell forselling videotapes accusing President Clinton of murder, andresponds to a question on Larry King Liveby calling the tapes “allegedtapes,” which apparently means that North could not even bringhimself to acknowledge that such tapes even exist. If he hadacknowl-edged their existence, after all, it would have reflected badly onFalwell, a philosophical and political , it seems, has an agenda. Cigarette company execu-tives testify to Congress, under oath, that they do not believe nicotineis addictive. Even the sports world is not immune. In 1994 umpiresconfiscated the bat of Cleveland Indians slugger Albert Belle afterthe Chicago White Sox accused Belle of using a corked bat. AmericanLeague officials X-rayed the bat, cut it in half, and then announced thatthe bat was illegally corked and suspended Belle for 10 the media confronted Belle’s agent, the agent borroweda page from the . Simpson defense playbook and claimed the inci-dent was “concocted by the Chicago White Sox.”So, given the surging supply of “experts” and the heightened prob-ability that any given expert you may be listening to is promoting anagenda, don’t be terribly concerned if you seem to have uncovered anexciting stock or two that is totally bereft of analytical “sponsorship.”
Chap 06 7/9/01 8:50 AM Page 4444PART ONEThe Making of a Superstock InvestorEven Federal Reserve Chairman Alan Greenspan is a “spinner”with an agenda. In his book The Agenda—an appropriate title for thisdiscussion—author Bob Woodward says that Greenspan managed toconvince then–Treasury Secretary Lloyd Bentsen, early in PresidentClinton’s first term, that the bond market would respond favorably ifthe Federal Reserve were to begin raising interest rates. Bentsen,impressed with Greenspan’s reasoning, performed the spin on Clinton,who bought it hook, line, and sinker. Greenspan, Bentsen, and Clintonthen performed their spin for the financial community, and everyoneinvolved began to believe their own baloney to such an extent thatthey were all genuinely surprised when the bond market and the stockmarket headed lower following the Federal Reserve’s interest rate , one reason why an “expert” may be off the mark is that heor she is selling you a bill of goods, ., promoting an agenda, ratherthan trying to get at the reason experts don’t always hit the mark is that theyare not really tryingto deliver the goods for a different reason, andthat reason is that they’re not always rewarded for telling the truth—especially when the truth is something their superiors do not wantto hear. Sometimes they are even punishedfor telling the his book 1929 Again, author Terry R. Rudd points out that“one of the underlying problems making it virtually impossible forknowledgeable people to tell us the truth is that we can’t accept itwithout reacting unfavorably.”“When the recipient doesn’t receive news in a manner beneficialto the giver, “ Rudd writes, “there is no incentive for the giver to do so.”It is a well-known fact among Wall Street professionals, forexample, that there is little mileage in taking a negative attitudetoward the stock market or the economy. Optimism sells, and if youwant to do business, you are almost always better off taking the rosyview of just about everything on the investment the classic example of this fundamental truth took placeon September 5, 1929, just a few weeks before the Great Stock MarketCrash. Economist Roger Babson, speaking at a major business con-ference, made the following statement: “Sooner or later a crash iscoming, and it may be terrific. Factories will be shut down . . . menwill be thrown out of work . . . the vicious cycle will be in full rever-sal and the recession will be a serious business depression.”Now that is about as accurate as you can get in terms of pre-dicting the stock market and the economy. Babson’s reward was that
Chap 06 7/9/01 8:50 AM Page 45CHAPTER SIXExperts: What Do They Know?45he was ridiculed and criticized as a fearmonger. Rudd says that onemajor brokerage firm actually took out an ad in The Wall Street Journalraking Babson over the coals and stating that “we will not be stam-peded into selling stocks because of the gratuitous forecasts of awell-known statistician.”The stock market actually began declining on the very dayBabson made his historical forecast, and that particular drop becameknown as the “Babson Break.” By late October the crash that Babsonhad predicted was under way, culminating on “Black Tuesday,”October 29, 1929, the worst day in stock market what was Babson’s reward for being so accurate? Some peo-ple had the temerity to criticize Babson for being early in his bearishprediction, and others actually went so far as to blame the stock mar-ket crash and the ensuing depression on Babson’s “fearmongering.”This is a lesson that has been learned and relearned in varyingdegrees over the years by anyone who has had the misfortune of turn-ing prematurely bearish on the stock market or the economy or hav-ing the nerve to issue a “sell” signal on a big-name company with apopular stock and a penchant for doing investment banking , you should not expect much help from the “experts”when it comes to predicting bear markets, recessions, earnings dis-appointments at large, well-known companies that do a lot of invest-ment banking business on Wall Street, or in other areas where theforecast of bad news might be met with, shall we say, a bad of the all-time great examples of an “expert” receiving anicy attitude toward his honest point of view is the Russian economistNikolai D. Kondratieff, who was exiled to a labor facility in Siberiaand died there after he wrote a 1925 treatise in which he suggestedthat capitalism was a perfectly legitimate economic system that wouldalways recover from depressions if left to its own devices. This pointof view was not something the Communists particularly wanted tohear, since Moscow had taken the position that capitalism was aflawed system that contained the seeds of its own so, the father of the “Kondratieff Wave,” which turned outto be one of the more enduring theories of economics, was handeda pickax, or whatever they gave you when they shipped you off toSiberia, and is most likely preserved in ice for future inhabitants tothaw and scratch their heads all experts receive such harsh treatment for trying to reportthe truth as they perceive it. Some of them, like the brokerage firm
Chap 06 7/9/01 8:50 AM Page 4646PART ONEThe Making of a Superstock Investoranalyst who issued a negative report on one of Donald Trump’s com-panies several years ago, merely got meet with a more subtle form of Study: Sunbeam you want to get a feel for how difficult it can be for mainstream WallStreet analysts to say “sell” when they know they will incur thewrath of the company in question, their clients, the brokers whowork for their firms, and possibly even their employers, considerthe brouhaha that greeted PaineWebber analyst Andrew Shore in1997 when he merely downgraded his opinion on Sunbeam buy to stock had taken off like a rocket, rising from $12 toover $50 following the arrival of a reputed corporate savior namedAl Dunlap. Dunlap had a history of cutting costs and streamliningoperations at poorly managed companies, and in fact had just engi-neered a turnaround at Scott Paper, which was then sold to KimberlyClark and resulted in huge profits for Scott Paper Street expected Dunlap to perform the same miracle atSunbeam, an old-line appliance manufacturer whose stock was in thedoldrums due to what Wall Street perceived to be poor managementof a potentially powerful brand name. Al Dunlap arrived, full ofbravado, and proceeded to lay off employees, close down plants,and issue optimistic projections for the future. Wall Street totallybought Dunlap’s performance, and Sunbeam shares took every analyst who followed Sunbeam sang Dunlap’s prais-es and expected a breathtaking turnaround, followed by an eventu-al takeover of Sunbeam—in other words, they expected an exactreplay of the Scott Paper . Shore, however, had his doubts. He was somewhat skepticalof Al Dunlap from the start, wondering how layoffs and plant clos-ings could possibly turn a low-margin business, faced with cutthroatcompetition, into a growth stock phenomenon—but he recommendedthe stock along with everyone else based on the premise that Dunlap’sname and reputation alone would probably take the stock for quite aprofitable ride. The trick, he thought, would be to get out in , in 1997, Andrew Shore began to notice warning signsdeep within the Sunbeam financial statements filed with the SEC. As
Chap 06 7/9/01 8:50 AM Page 47CHAPTER SIXExperts: What Do They Know?47it turned out, these warning signs were harbingers of huge problemslurking beneath the shiny surface of Sunbeam which eventuallypushed the company to the brink of bankruptcy. Shore decided hewould pull his buy rating on Sunbeam; yet, even though he sus-pected a massive deterioration of Sunbeam’s financial situation, hecould only bring himself to change his rating from buy to “neutral.”But even this move, which in retrospect proved to be a timid andincomplete decision, made him a virtual Nostradamus compared tohis first reaction to Mr. Shore’s decision to pull his buy rec-ommendation on Sunbeam came from his research associate, whotold Shore that he risked a negative reaction not only from Al Dunlapand Sunbeam, but also from PaineWebber clients and brokers. “Yourealize what you’re doing here, don’t you?” he asked Shore.“If we’re wrong we’re going to be fired,” Shore replied, “butwe have to do this.” Shore even felt compelled to contact the legalcompliance department at PaineWebber to explain his downgrade ofSunbeam before the downgrade was you stop and think about the fear and soul-searchingthat preceded a mere downgrade from buy to neutral, you have tolaugh out loud. Here was a well-known and established securityanalyst literally shaking in his boots because he was going to down-grade a popular stock to neutral. He was so fearful of being fired—fired!—if he were wrong that he felt compelled to explain his deci-sion in advance to the PaineWebber compliance department, just incase the stock continued to go up and he had to explain himself April 3, 1997, Andrew Shore got on the PaineWebber“squawk box” and reported his downgrade to PaineWebber’s 5000stockbrokers. Within minutes Sunbeam stock dropped $4 a thereafter, when Andrew Shore checked his voice mail, hewas stunned to hear a barrage of “caustic and bitter messages.” “Mostof the callers,” author John A. Byrne says, “wanted Shore fired.”Shore, according to Byrne who documented these events in hisbook Chainsaw, was “horrified by the content” of the messages, whichranged from calling him “stupid and irresponsible” to even worse.“It was a nightmare,” said Shore’s assistant, who bore the bruntof the flak from clients and brokers reacting to Shore’s story had a happy ending for Andrew Shore. Shortly afterthe downgrade, Sunbeam shocked Wall Street with the announce-
Chap 06 7/9/01 8:50 AM Page 4848PART ONEThe Making of a Superstock Investorment that earnings would come in far below expectations. Thosewho had acted on Shore’s advice saved a bundle—and of course,the congratulatory calls began to flow LearnedWhat lessons can we learn from this episode?First, keep in mind that Andrew Shore never told anyone to sellSunbeam. He merely downgraded the stock to “neutral.” Investorswere forced to read between the lines of the recommendation, andthose who did were spared the bulk of the Sunbeam carnage; thestock eventually fell to $, down 99 percent from its Dunlap-maniahigh, as the news from Sunbeam got progressively even that downgrade to neutral caused fear and soul-search-ing for Andrew Shore, which gives you an idea of why so few “sell”recommendations emanate from the mainstream Wall Street researchdepartments. And the venomous reaction from PaineWebber clientsand brokers to the Sunbeam downgrade should also go a long waytoward explaining why the “messenger” is often so reluctant to deliv-er the bad news. When the reaction is criticism and anger, what is theincentive to tell the truth? Experts Are Pressured to Conform toPrevailing Ideology“Asell signal from an analyst is as common as a Barbra Streisand concert.” Arthur Levitt, Chairman of the Securities & Exchange CommissionIt is not just the company, clients, and brokers who exert psycho-logical pressure on analysts to maintain a positive attitude on thepopular stocks they follow, although that would be more thanenough. There is also pressure from other analysts to conform to thebullish point of view. If you are a mainstream Wall Street analystand you have decided to turn bearish on a stock or an industry thatis being recommended by virtually all of your analytical colleagues,you had better have your facts straight and be prepared for somecriticism, veiled and otherwise. Curiously, the inverse is not true: Itis perfectly acceptable for an analyst to turn bullish on an industrywhen everyone else is bearish; trying to be the first to catch the bot-tom, apparently, is within the rules of the analytical game.
Chap 06 7/9/01 8:50 AM Page 49CHAPTER SIXExperts: What Do They Know?49But if an analyst tries to catch the top by turning negative on anindustry or an individual stock everyone else loves, watch out!On November 22, 1999, The Wall Street Journalran a story enti-tled “Bearish Call on Banks Lands Analyst in Doghouse.” The storydescribed the travails of Michael Mayo of Credit Suisse First Boston,and the doghouse to which Mr. Mayo was exiled was owned andoperated by other Wall Street banking analysts who saw only blueskies ahead for the bank stocks. When Mr. Mayo peered into the dis-tance and announced that he saw some storm clouds brewing forthe banking industry he was treated like the Wall Street equivalentof a stinky wet dog trying to shake itself head trader at Sun Trust Funds, said The Wall Street Journal,“angrily grabbed a picture of Mr. Mayo, blew up the photo on thecopier, scribbled ‘Wanted’ over his face, and pinned it to her bul-letin board.” When questioned about this response by The Wall StreetJournal, the trader replied that “my impression [of Mr. Mayo] as ahuman being is that he’s somewhat self-promotional,” as thoughthis were a rare trait among analysts on Wall bank analyst, angered by the sell signal, referred toMayo derisively as “Mayo-naise” in a conference call with clients,according to The Wall Street Journal. Other analysts also questionedMayo’s motives, both publicly and in private. Some of them whis-pered that Mayo was in cahoots with short sellers who were in aposition to profit if bank stocks declined in price. Others said that hewas gunning for publicity in an attempt to earn a high ranking in anupcoming analyst survey by Institutional Investor after Michael Mayo’s negative call on bank stocks turnedout to be accurate, the critics refused to let up on him. Afew monthsafter his cautionary report on the group, Bank One, a Wall Streetdarling, collapsed in price following the surprising news that prob-lems at its credit card unit, First USA, would lead to lower thanexpected earnings. Mayo had put a “sell” on Bank One (ONE) at$ a share; the stock ultimately fell as low as $ following thedisappointing earnings, a 61 percent even that did not keep the critics quiet. Instead of givingMayo his due for his gutsy and accurate call, the bank bulls decid-ed that nitpicking was now called ’s general negative attitude toward the bank stocksstemmed from his belief that the earnings growth being reported by
Y L F M AChap 06 7/9/01 8:50 AM Page 50 E T 50PART ONEThe Making of a Superstock Investor many banks was of “low quality”; in other words, the accountants were becoming increasingly creative in their ongoing effort to give Wall Street the earnings momentum it craved and expected. Anyone who understands financial accounting knows there are about 50 dif- ferent and perfectly acceptable ways to look at almost everything and that your earnings may be up 5 percent, up 10 percent, or even down 10 percent, depending on which way the accountants decide they are going to paint the picture this particular quarter. Eventually, though, the accountants’ bag of tricks gets deplet- ed, and if a company is not growing all that rapidly—or worse, if cre- ative accounting has directed analytical attention away from a fes- tering problem—the piper must be is not an uncommon occurrence with popular stocks thatare under tremendous pressure to meet Wa ll Street expectations, andthe general observation that a particular company or an industry, in general, has begun to resort to accounting gimmicks to meet Wall Street expectations—., that reported earnings are of “low quality,” ®as Mayo stated—is a valid and sufficient reason to turn negative. IfTeam-Fly you smell something rotten, you don’t have to rummage through thegarbage to figure out what it is—you can just walk away from Bank One revealed that problems had been brewing inits credit card operations and that its earnings would be way belowexpectations, that should have been enough to shut Mayo’s critics it wasn’t.“Critics say,” The Wall Street Journalreported with a straightface, “that Mr. Mayo had not pinpointed the credit card problem.”When another bank stock cited by Mayo as having “poor earn-ings quality”—National City Corp.—warned that earnings wouldbe lower than expected, that stock took a nosedive as well. But, TheWall Street Journalpointed out, “Mr. Mayo didn’t specifically have a‘sell’ recommendation on that stock.”The overall tone of The Wall Street Journalstory on Michael Mayowas that he was sort of a self-promotional kind of guy who sort oflucked out by issuing a generally negative call on the bank stocks andturned out to be right for the wrong reasons, and that he was not allthat popular among colleagues and can see that the bar is raised considerably higher when youare bearish than when you are a conforming bull. The Wall StreetJournalcould have run a story about the 99 percent of analysts who
Chap 06 7/9/01 8:50 AM Page 51CHAPTER SIXExperts: What Do They Know?51were incorrectly bullish on Bank One, for example, and interviewedtheirclients, to see how they enjoyed riding that stock down by 61percent. But it didn’t. Instead, The Wall Street Journaldissected Mayo’sbearish (and correct) call with a fine-tooth comb, and created theimpression that while he turned out to be right, he wasn’t really allthat right and that he was a publicity hound to Mayo’s reward for being bearish on the regional bankswas to be fired. On September 29, 2000, he announced that CreditSuisse First Boston had terminated his employment. “It’s hard to doinvestment banking for a client with an analyst who is negative onthat client,” a source told doesn’t work the other way around, by the way. If you’re acheerleader for a stock and it goes up, nobody complains that itdidn’t go up for the reasons you said it would. You’re just a brilliantanalyst who made the right call. But if you’re a bear on the bankstocks because you think that earnings quality is deteriorating andthat some banks have been stretching to make their earnings forecastsand that this cannot go on indefinitely—if you say all that and youturn out to be right—that is still not enough. You have to pinpointexactly what the problem was or your correctly bearish call can be dis-sected, analyzed, and ultimately criticized whole thing would be funny if it were not so important toyou, as an investor, and these cautionary tales involving Mr. Mayoand Sunbeam analyst Andrew Shore are meant to illustrate a truth: Ifyou really want original, independent research and you think you aregoing to get it from Wall Street, you may be in for a big in the 1980s a group of penny stock brokers had just com-pleted a public offering for a company that was trying to develop acure for cancer derived from shark fluids. I ran into the brokers at arestaurant one evening and they were so enthusiastic about this com-pany’s prospects they could barely contain themselves. The stockhad run up from $ a share to $, and there were plans for a sec-ondary offering to finance further research into new drugs once thecompany had proven it could use shark fluids to cure was going swimmingly until the scientist who ranthe company called the president of the brokerage firm with the badnews that the process doesn’t work.“What are you talking about?” the brokerage firm presidentsaid.
Chap 06 7/9/01 8:50 AM Page 5252PART ONEThe Making of a Superstock Investor“We cannot cure cancer with shark fluids,” the scientist said.“Yes, you can,” said the brokerage firm president.“No, we can’t,” said the scientist. “The process doesn’t work.”“Yes, it does,” said the brokerage firm scientist was taken aback at this response. “I wish it didwork,” he said again. “But it doesn’t.”“Hold on,” said the brokerage firm the brokerage firm president returned to the line, the sci-entist found himself in the midst of a conference call with every bro-ker in the office. For the next half hour the brokers browbeat the sci-entist into submission, trying to convince him that he could, indeed,cure cancer through the use of shark scientist tried his best to hold his ground. “It doesn’t work!”he said pleadingly.“It has to work!” screamed one broker. “Your stock is at $,all of my clients own it, and we’re almost ready to do your secondaryoffering!”And so, at the urging of his “constituency,” the scientist agreedto go back to the drawing board to try to find a cure for cancer usingshark fluids, trying to fulfill the fervent hope of a group of pennystock brokers that such a cure could be found so that these brokerscould do a secondary stock offering. Yet, the scientist knew full well,as he continued his research, that the process didn’t scientist admitted, long after the fact, that listening to thoseguys nearly convinced him that he had missed was reminded of this story on December 1, 2000, when TheNew York Timesreported that certain analysts were “skeptical” ofcomputer maker Gateway’s shocking announcement that it was low-ering its revenues and earnings forecasts for the quarter because itssales had unexpectedly plunged 30 percent over the weekend fol-lowing Thanksgiving. Like the shark fluid brokers, these analystsjust could not accept the bad news that Gateway delivered. Insteadof accepting the news and revising their forecasts, some analyststried to convince themselves (and Gateway) that the sales slumpdidn’t mean what Gateway said it meant, which was that businesswas turning rotten. Loaded with Gateway shares in client accountsand stuck like SuperGlue to their overly bullish forecasts, these ana-lysts accused Gateway management of “overreacting,” which onlygoes to show you that whether we’re talking about shark fluids andpenny stock brokers or computers and big-time Wall Street analysts,
Chap 06 7/9/01 8:50 AM Page 53CHAPTER SIXExperts: What Do They Know?53there are few things so constant as human nature. As songwriterPaul Simon reminded us in The Boxer, “a man sees what he wants tosee and disregards the rest.” That is a fundamental truth of WallStreet that every investor should keep firmly in , one thing to keep in mind when you’re listening to the opin-ion of an expert: Who is the expert’s constituency? Or, to put it morebluntly, who pays the expert’s salary? If it isn’t you—and it usuallywill not be you—consider the possible agenda of the expert and/orconstituency and view the expert’s point of view in that experts who are honestly taking their best shot and arenot influenced at all by an agenda or a constituency can get thingsall wrong, as Figure 6–2 ALSO REALLY HELPS IF YOU CAN MAINTAINSOME PERSPECTIVE“To understand what the outside of an aquarium looks like, it is better not to be a fish.” André MalrauxBack in 1974, when I was working as a junior analyst on Wall Street,I used to circulate a weekly tongue-in-cheek stock market report amongmy fellow employees. The newsletter was mostly satire, poking funat some of the idiosyncrasies and absurdities of Wall the fall of 1974 the Dow Jones Industrial Average was tradingbelow 600, trading volume was running at around 6 million shares, andon most days you could have organized a good racketball tourna-ment on the floor of the New York Stock Exchange and not annoyedanybody because nothing much was going on down there were so slow that a major investment magazine ran a coverstory entitled: “This Is Not Just a Bear Market. This Is the Way ThingsAre Going to Be from Now On.” (The experts were wrong, of course.)During lunch, we would sit around and lazily watch the tick-er tape move across the top of our quote machines, that is, when itmoved at all. In those days, the tape moved in fits and starts; a cou-ple of trades would show up, then the tape would just sit there, andnot move for 10 or 20 seconds, and then another solitary trade wouldbe reported. Sometimes the tape would stop for such a prolongedperiod of time that we would tap the side of the computer screen, asif we were tapping the side of a pinball or videogame, trying to getthe tape moving again.
Chap 06 7/9/01 8:50 AM Page 5454PART ONEThe Making of a Superstock InvestorFigure6–2 “Experts” and Their Statements¥It was expert Jimmy the Greek who declared Impossible! when someoneasked him whether Cassius Clay (aka,Muhammad Ali) could last even sixrounds with heavyweight champion Sonny Liston, just a few days before Claywon the title.¥It was expert Thomas Edison who said in 1922 that the radio craze will die outin time. ¥It was expert Harry Warner, President of Warner Bros., who in 1927, laughed atthe idea of using sound in motion pictures, saying, Who the hell wants to hearactors talk? ¥It was expert Emmeline Snively, Director of the Blue Book Modeling Agency,who told Marilyn Monroe in 1944: You d better learn secretarial work, or else getmarried. ¥It was an expert (a United Artists executive) who turned down actor RonaldReagan for the starring role as the President in The Best Manby saying: RonaldReagan doesn t have that presidential look. ¥It was expert Jim Denny, manager of the Grand Ole Opry, who told ElvisPresley on September 25, 1954: You ain t goin nowhere son. You ought to goback to driving a truck. ¥It was expert Ken Olson, President of the Digital Equipment Company, who saidin 1977: There is no reason for any individual to have a computer in their home. ¥It was expert Charles H. Duell, Commissioner of the . Office of Patents, whourged President William McKinley to abolish the Patent Office in 1899, based onthe incredible logic that Everything that can be invented has been invented. ¥It was expert Professor of Economics Irving Fisher of Yale University whodeclared, on October 17, 1929: Stocks have reached what looks like a perma-nently high plateau. ¥It was expert Thomas J. Watson, Chairman of IBM, who declared, in 1943, Ithink there is a world market for about five computers. ¥It was expert Eric Easton, manager of the Rolling Stones, who said of MickJagger in 1963: The singer will have to go. Source: Christopher Cerf and Victor Navasky, The Experts Speak(Pantheon Books, New York, 1984).On some days the trades were so few and far between we wereable to sit around and comment at length on each trade that appearedon the tape before the next one appeared. This got me to thinkingabout the potential for a television program in which a group ofanalysts just sat around and commented on the New York StockExchange ticker tape all day long.
Chap 06 7/9/01 8:50 AM Page 55CHAPTER SIXExperts: What Do They Know?55My friends got a big laugh out of that days later I published my weekly stock market “report”in which I imagined what it would be like if Howard Cosell, FrankGifford, and “Dandy” Don Meredith, the hosts of ABC-TV’s MondayNight Football, were to host a live daily television program directfrom the New York Stock I envisioned it, Howard Cosell and Frank Gifford would besitting in a booth high above the New York Stock Exchange tradingfloor, much as political commentators sit above the floor of a polit-ical convention, watching a huge ticker tape and providing a trade-by-trade commentary on the day’s stock market , Don Meredith, a former Dallas Cowboys’ quarter-back, would serve as the sideline commentator, roaming the floorof the NYSE, elbowing his way through the mass of traders and look-ing for expert analysis and inside a laugh, right? Little did I ’s nothing wrong with minute-by-minute analysis of thefinancial markets and the fact that so much market analysis andcommentary is so short-term-oriented. There are many ways to skinthe proverbial stock market cat, and many approaches to the marketthat can yield profitable , there is no use complaining about it. In the age of theInternet and instant information, when complete access to the floorof the New York Stock Exchange is available, you cannot expect thatall of this will not be put to use. You can question whether it reallymatters what the stock market does on any given day, or during anygiven hour, and you can wonder if much of the short-term com-mentary you hear day in and day out is of much real value. (Youcan wonder, for example, how it is possible for a guest to sit there,on live television, and respond to question after question from view-ers calling on the telephone, asking about a series of random can this “expert” possibly provide a thoughtful, informedresponse on every single question?)You can wonder about all of this, but you can’t fight it, andbesides, there is a market for this type of information. Plenty ofinvestors apparently find it useful or there would not be such a wideaudience for CNBC and stock message boards. Short-term trading,based on instant analysis, is a perfectly acceptable way to approachthe stock market. Just ask any trader.
Chap 06 7/9/01 8:50 AM Page 5656PART ONEThe Making of a Superstock InvestorBut it is not the only way. And the problem is since so much ofthe mainstream media has become fixated on this ultra-short-termapproach to investing, there is a tendency to forget that there are otherapproaches that do not make you feel guilty if you leave your quotemachine or turn off the financial television station for 10 can, if you wish, be made aware of every uptick anddowntick of the market, all day, every day. You can know about everyanalyst upgrade and downgrade and why any stock is moving onany given day. You can know all of the important earnings estimates,down to the last penny; you will also know the “whisper number”; youwill know if the company that has just reported earnings managed tobeat the official estimate, the “whisper number”, or both; and you caneven hang around after the close to see if the lemmings are frantical-ly buying or selling in after-hours trading, based on the burning issueof the moment, which in all probability will be replaced the next dayby another, completely unrelated burning issue of the can put yourself through this madness, if you like. Butthere is another way to deal with the stock market. You can decideto take a step back from the precipice of urgent microanalysis anddeal with the stock market only from a vantage point that providessome vantage point involves looking for stocks that are showingsigns that something significant is changing—for the better—on along-term basis. You can look at neglected stocks that have fallen sofar out of favor that you have to begin to remind yourself that thisis a business, not just a piece of paper for Wall Street to play gameswith, and that if certain Telltale Signs are popping up, there is a goodpossibility that somebody will step in and force the stock market tovalue this neglected stock at its proper value as a this book, you will learn how to spot some of the Telltale Signsthat will enable you to buy these out-of-favor stocks with will show you how to determine when a formerly sleepy, seem-ingly uninteresting stock may be about to emerge as a huge short, we have arrived at a fork in the stock market road—this book will take you on a trip down the road less once you’ve been down this road, you will never look atthe frantic three-ring circus of urgent day-to-day stock market com-mentary and “expert” analysis in quite the same way.
Chap 07 7/9/01 8:51 AM Page 57CHAPTER SEVENWhat Is Value?You’ve heard a lot about “value investing” recently, but what exact-ly does that term mean? Generally, value investing involves buyingstocks that are out of favor and therefore undervalued relative toother stocks. That sounds like a sensible way to invest until you asktwo key questions: is “value?” can’t a stock that is undervalued remain underval-ued, theoretically, indefinitely?It’s all well and good to say that in the long run the stock mar-ket will adjust undervalued stocks to a more reasonable value, butas John Maynard Keynes pointedly reminded us, “In the long run weare all dead.”What we need is an investing approach that not only focuses on“value” but also provides for some sort of catalyst—some outsideevent—that will literally force the stock market to take an under-valued stock and reprice it at a higher, more appropriate ’s start with this premise: Astock is worth what the stockmarket says it is worth on any given day—no more, no less. You canargue that a stock is overvalued or undervalued, but if you want tobuy it or sell it, there is only one value that really matters: the pricethe stock market is placing on that stock right does that price come from?It comes from two places: (1) earnings expectations and (2) thepresent value the market is willing to place on those earnings 2001 The McGraw-Hill Companies, Inc. Click Here for Terms of Use.
Chap 07 7/9/01 8:51 AM Page 5858PART ONEThe Making of a Superstock InvestorThink of a stock as representing a small piece of ownership inan estimated future stream of earnings. Those earnings are unknown,and investors rely on the best guesses of Wall Street analysts to deter-mine what they’ll be. When you buy a share of stock today, you’rebuying a stake in that future earnings course, analyst estimates of that future earnings stream maybe wildly off the mark, which adds another major variable to thequestion of determining value. But let’s assume, charitably, that theanalysts are going to get it right and you know precisely what a com-pany will earn over the next 10 so, you would have only half the equation because thenext question would be: What is that future earnings stream worthtoday? What the market is willing to pay for a given level of earn-ings is the price/earnings ratio. And if you think predicting earningsis difficult, you haven’t seen anything a look at Figure 7–1, which shows the price/earnings ratioof the Standard & Poor’s 500 Index going back to 1925. As you cansee, the stock market at various points along the way has decided thatstocks were worth anywhere from six times earnings (in 1949) to asmuch as 28 times earnings in 1998. And that ratio has gyrated wild-ly along the way, rising and falling sharply, so that a stock earning$2 per share could be worth $40 one year and only $20 the follow-ing year. Same company, same earnings—but a wildly different con-cept of 7–1S&P Price/Earnings Ratio1930193519401945195019551960196519701975198019851990199528282727Average from 1970 to 1998 = from 1950 to 1998 = = (- - -)1515141413131212111110109988Bargains77
Chap 07 7/9/01 8:51 AM Page 59CHAPTER SEVENWhat Is Value?59What causes price/earnings ratios to shift so dramatically?The major determining factor is interest rates. When interestrates rise, price/earnings ratios tend to fall. When interest ratesdecline, price/earnings ratios tend to are two reasons for the profound effect of interest rateson price/earnings ratios. The first has to do with how money man-agers behave. The stock market is one place where a money managercan invest funds, but there are other alternatives, and the relativeattractiveness of those alternatives can affect the amount of moneythat goes into or out of some investors the stock market competes for funds withthe bond market. Stocks carry risk, but long-term bonds carry lessrisk. A20- or 30-year bond can have some awfully wild swings beforethe payoff (maturity) date, but some money managers look at long-term bonds as an alternative to stocks because at least they knowthese bonds will have a certain maturity value at a certain fixed pointin time, at which time their original investment will be intact. Stocks,obviously, carry no such other money managers are deciding whether to commitmore or less capital to the stock market, what they’re really lookingat as an alternative is the “no-risk” alternative— “cash” we mean money market funds or short-term trea-sury securities, where a dollar invested today will be worth a dollartomorrow, unequivocally and with no other potential outcome. Thisis the riskless alternative to the stock market, and the interest rate amoney manager can earn on this riskless alternative is perhaps themajor variable that determines the price/earnings multiple placedon a given level of , for example, you are managing a pension fund for alarge company. Your job is to make sure that when employees retirethey will receive their pension benefits. Your company has set asidea certain amount of money for this purpose and instructed you toinvest it in such a way that when the benefits have to be paid, atsome point in the future, there is enough money to pay them. Ateamof actuarial accountants has prepared a very nice booklet, completewith actuarial tables, that sits on your desk. And what this booklettells you, basically, is that if you can earn 8 percent per year on themoney that’s been left for you to manage, there will be enough moneyto pay the retirees and everyone will be happy.
Y L F M AChap 07 7/9/01 8:51 AM Page 60 E T 60PART ONEThe Making of a Superstock Investor As you sit there and survey the investment scene, you see that long-term . government bonds are yielding 6 percent. That will do you no good because you need to earn 8 percent or the retirees will be calling you up for loans so they can maintain their standard of living 20 years from now. The yield on money market funds, at percent, is even less. To earn the required 8 percent, therefore, you will have to take some risk—and that means you’ll have to invest in the stock market. Although stocks do not come with guaranteed returns, they do offer upside growth potential. And since there’s no other way to get the 8 percent you need, you take the plunge into the market. Across the street there is another money manager in charge of another company pension fund. His job is just like yours, except hiscompany has a lousy union and the pensio n benefits for its retireesare going to be a lot less than yours. According to the actuarial tables, the money manager across the street needs to earn only percent on his investments to fund the retirement plan. ®So, you’re both in the same boat—at least for now. You need toTeam-Fly earn 8 percent and the money manager across the street needs toearn percent, but neither one of you can get what you want inbonds or money market funds, so you’re both buying , let’s suppose interest rates start to rise. The yield on the 30-year government bonds jumps to 7 percent. This is still not goodenough for you because you need 8 percent to fund the pension the money manager across the street now faces an interesting sit-uation. He needs percent to fund his plan; he can get 7 percent . government bonds. In order to do his job, all he has to do is buybonds and go shoot a round of golf. He will also have a lot less he must now ask the question: If I can get the 7 percent I needin government bonds, why should I be taking risks in stocks? That isa very good question, and the answer will likely be that this moneymanager will begin moving at least a portion of the funds he hasinvested out of stocks and into bonds. And if the interest on “cash”investments, like money funds and short-term treasury bills, alsoreaches 7 percent, he will likely move a lot more money out of other words, as interest rates on less risky investments rise,a certain amount of money will leave the stock market to lock in thatreturn. At 7 percent, a certain number of investors will determine
Chap 07 7/9/01 8:51 AM Page 61CHAPTER SEVENWhat Is Value?61that they do not need to take the risk the stock market entails. At 8percent, a new round of money managers will make the same deci-sion. Each uptick in interest rates will suck money out of the marketbecause the lesser-risk return meets some investor’s goal, which isone reason why rising interest rates almost always put downwardpressure on the stock profound effect of interest rate movements on stock pricesis the major reason Wall Street is so obsessed with Alan Greenspanand the Federal Reserve, even to the point where CNBC analyzesthe size of Greenspan’s briefcase as a potential clue as to whetherthe Federal Reserve is about to shift its interest rate is another reason why rising interest rates usually meanlower stock prices. It’s a bit more complicated but its worth know-ing, and it explains a big part of the mystery of the wildly gyratingprice/earnings ratios touched on concept is called “discounted present value,” and what itboils down to is this: If you know what a company will earn over thenext 10 years, what is that future earnings stream worth today?Again, what the market is willing to pay today for those future earn-ings is the price/earnings ’s use this example:Suppose Totter’s Rollerblades Inc. (TRI) is estimated to earn agrand total of $50 per share over the next 10 years. This means ifyou buy one share of TRI today, you are buying a piece of that futureearnings stream. What is that future earnings stream worth rightnow? Put another way, what amount would you have to invest todayto have $50 ten years from now?Answer: It depends on the level of interest rates. The higherthe level of interest rates, the less you must invest today to get that$50 ten years from now. In other words, when interest rates are high,the present valueof that $50 will be less than it would be when inter-est rates are lower. High interest rates will result in the present valueof that $50 ten years from now being lower, while low interest rateswill result in present value being example, if you want to have $50 ten years from now andinterest rates are 10 percent, you only have to invest around $19today. But if interest rates are at 5 percent, you will have to invest $31today to get that $50 ten years from now.
Chap 07 7/9/01 8:51 AM Page 6262PART ONEThe Making of a Superstock InvestorThink about that for a moment. Ten percent interest rates makethe present value of $50 ten years from now worth $19. Five percentrates make the present value $31. In other words, given the earn-ings projections for Totter’s Rollerblades Inc., the present value ofthose earnings can be worth anywhere from $19 to $31, dependingon the level of interest rates. And if you think of a stock price interms of present value, you can see how interest rates can have aprofound effect on what Wall street will be willing to pay today fora projected future earnings stream. Same company, same earningsprojections—the only difference is what those earnings are worthright now in any given interest rate , in simplified terms, is how most stocks trade. For the mostpart they’re at the mercy of earnings forecasts that are constantlychanging and may or may not be on the mark, and they’re at themercy of interest rate movements that cause professional moneymanagers to move into and out of stocks in general and that willalter the value of your investments as rates fluctuate, even if earn-ings estimates are all of this, how can anyone define “value”?Let me tell you one thinking of value, think of this: What would a companybe worth to another company as a business? Every company has acertain value, which can be fairly well-defined, when viewed in thislight. But this is a far different concept of value than the one underwhich Wall Street actual value of a stock—as a business—is only fleetinglyrelated, if it is related at all, to the gyrations of the stock , depending on shifting earnings forecasts or interest rate fluc-tuations, stocks can move all over the place, like a ship passing anoth-er ship on a foggy night, without even knowing it’s only time this concept of value matters is when someoneis willing to step up to the plate to pay that value. In other words,when a takeover bid takes concept of a “value” situation, therefore, is: stocks that are sell-ing at clearance-sale prices, significantly below their value as a business,where there is a reasonable possibility that someone will step up and offerto pay that value, thereby forcing the stock market to reflect that value inthe stock price.
Chap 07 7/9/01 8:51 AM Page 63CHAPTER SEVENWhat Is Value?63When this happens, a normal, run-of-the-mill stock that is at themercy of all of the variables discussed here becomes a superstock. Itimmediately rises to its true value level—as a business— and it is nolonger subject to the whims of the stock market and all of the unpre-dictable variables that determine where most stocks may think that choosing stocks that are likely to becometakeover targets is an impossible task. The reason why you maythink this way is that you’ve probably heard this refrain over andover again from Wall Street commentators who are obsessed withearnings forecasts and stock market projections and who have noexperience when it comes to selecting logical takeover picking takeover targets is notan impossible an individual investor, you can uncover neglected and underval-ued stocks that are not only selling at a discount to their value as a busi-ness, but that also have a reasonable possibility of being forced higher by atakeover the time you finish this book, you will look at the stock mar-ket and at stock selection in an entirely different way. You will becomeaware of news items and the availability of certain types of infor-mation that most investors are completely unaware will be on the lookout for superstocks.
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Chap 08 7/9/01 8:52 AM Page 65CHAPTER EIGHTIf Everybody KnowsEverything, Then NobodyKnows AnythingBy now you might be thinking: This is a book about the stock mar-ket, yet the stock market itself will not be a factor in any of the super-stock takeover situations we discussed. Every one of these super-stocks generated a profit for reasons totally unrelated to the trend ofthe general stock is precisely the point. When you’re dealing with super-stocks, pegging your stock selections to specific events or “catalysts”related to a particular company that are likely to force the stock pricehigher, for the most part you’re removing the behavior of the gen-eral stock market from the you begin to think in terms of the new paradigm, you’llfind yourself zeroing in on news items that relate to the stocks you’reholding or to other stocks that could become potential ’ll find yourself paying attention to “micro” news items ratherthan “macro” news items. You’ll become less interested in grandiosegeneralizations concerning the big picture and more interested in spe-cific news items that will impact individual stocks you’re example, you’ll find yourself paying more attention to CEOinterviews (“We believe the consolidation in our industry will con-tinue and we intend to be one of the major players by making addi-tional acquisitions”), merger announcements (“We will continue to65Copyright 2001 The McGraw-Hill Companies, Inc. Click Here for Terms of Use.
Chap 08 7/9/01 8:52 AM Page 6666PART ONEThe Making of a Superstock Investorlook for opportunities to grow our defense electronics segment”),or “shareholder rights plans” (“Although we know of no specificplans to acquire our company, this shareholder rights plan will ensurethat our shareholders will receive fair value in the event of a bid”).You will find yourself taking note of stock buybacks (“Webelieve our stock is undervalued”) in consolidating industries. Youwill be paying close attention to 13-D filings that indicate an out-side beneficial owner has increased his or her stake in a your ears will perk up when you hear that a company plans tospin off one of its subsidiaries to “enhance shareholder value,”espe-cially if the parent company or the subsidiary operates in an industry wheretakeovers are will even notice when an outside beneficial owner receivesa hostile takeover bid, because one way the beneficial owner canensure protection from such a bid would be to turn around and makean acquisition itself—and therefore, what company would be a morelogical takeover candidate than a company that is already partiallyowned by the outside beneficial owner?On the other hand, you’ll pay less attention to durable goodsorders, the consumer price index, the trade deficit, and whether AlanGreenspan might have gotten up on the wrong side of the bed thismorning before he presided over the Federal Reserve’s Open MarketCommittee meeting. You would be more interested in the fact thatWMS Industries has announced that it will spin off its three PuertoRico hotel/casinos as a separately trading company because you willhave noted a takeover wave in the hotel/casino industry (see Chapter13). Therefore, while the TV talking heads are wringing their handsover what Greenspan may or may not do, you’ll be more interested inthe possibility that the WMS spinoff might become a takeover targetonce the hotel/casinos are trading separately as a “pure play.” (It did.)You will also begin to realize that if Rexel . plans to make atakeover bid for Rexel Inc. (see Chapter 9), it will make the bidwhether or not housing starts were up last month, and it won’t mat-ter to Rexel . if Apple Computer missed its earnings estimates bya penny. And you will know that Rexel . is not going to scratch itstakeover plans because some market strategist who has been bullishbefore now believes we may be headed for a 10 percent correction.
Chap 08 7/9/01 8:52 AM Page 67CHAPTER EIGHTIf Everybody Knows Everything, Then Nobody Knows Anything67The superstocks you’ll be tracking will be marching to theirown drummers, and you’ll pay less attention to what “the market”is doing and more attention to the stream of information and scat-tered clues and evidence that directly impact the themes, trends, andspecific superstocks you’re you’re like me, you won’t miss the market “analysis” at fact, you may find it’s a relief to get it out of your hair because somuch of it is meaningless sheer quantity of financial commentary being offered todayon television, radio, the print media, and the Internet requires con-stant explanation and interpretation of every stock market gyration,no matter how unexplainable it may be. As a result, financial com-mentators, stockbrokers, and analysts are expected to have an answerfor investors understand that much of what passes as marketanalysis is nothing more than gibberish, but they tolerate it becauseeven stock market gibberish tends to be a lot more interesting thanmost other topics of some of you this may be difficult to accept, especially if youare an avid follower of television financial reporting or if you have oneof those stockbrokers who seems to have an answer for everything.“How’s the market?” you ask.“Down 80 points,” he says.“Eighty points? Why is it down 80 points?”“Profit-taking.”Now, you may not be the smartest investor who ever lived, butyou’re smart enough to know that since the market has declined in17 of the past 20 sessions, it is definitely not profit-taking that’s push-ing the market lower today. Your broker knows that, too, but has totell you something because he or she is supposed to know what’sgoing on. Consequently, the broker will have an answer for any ques-tion you can possibly come up does the broker do this?On any given day there are probably 5 or 10 potentially bullishnews items and 5 or 10 potentially bearish news items on the DowJones news wire. Depending on which way the market has gone thatday, one or more of these innocent items will be plucked from the
Chap 08 7/9/01 8:52 AM Page 6868PART ONEThe Making of a Superstock Investortape, like some Miss America from the crowd in Atlantic City, andthis news item will be used to explain what the market did that us say that, at ten-twenty in the morning, the Dow JonesIndustrial Average is down 200 points. There are four major items ofinterest on the news wire: (1) the President has announced that hewill seek a tax cut, (2) Iraq and Iran are at it again, and an Iraqi fight-er plane has been shot down, (3) the bond market is higher, and (4)durable goods orders jumped percent last month. Item 2 is mean-ingless but could be trotted out to explain a falling market, if neces-sary. Item 3 is bullish. And items 1 and 4 can be either bullish orbearish, depending on how you want to look at broker can use any one of these news items to put a “spin”on why the Dow Jones is down 200 stockbroker is sitting at his phone rings. It’s you.“How’s the market?” you ask.“It’s down 200 points,” your broker says.“Two hundred points? How come?”“Well, the market has been depressed by a couple of news itemsthis morning. First, the President says he wants a tax cut, and that’sbearish because the Fed may decide to raise interest rates to counter-act the potential inflationary effect of a tax cut. Also, Iran and Iraq arefighting, and an Iraqi plane was shot down. And durable goods orderswere up more than expected, which could be inflationary also.”“Oh.”On the other hand, the market might be up 200 points. Withthe very same items on the tape, the conversation would then gosomething like this:“How’s the market?”“Up 200 points.”“Up 200 points? How come?”“Well, the President says he wants a tax cut, and that’s bullishfor the economy and for corporate earnings. Also, durable goodsorders were up percent, another sign of economic strength. Also,the bond market is higher this morning.”“Oh.”Since that sort of instant analysis is only a game to pass the time,the tough questions rarely, if ever, get asked, such as: If the market isdown 200 points because the Fed might raise interest rates in light of
Chap 08 7/9/01 8:52 AM Page 69CHAPTER EIGHTIf Everybody Knows Everything, Then Nobody Knows Anything69the President’s tax cut proposal, how come the bond market is up? Or,what do Iran and Iraq have to do with the stock market?Nevertheless, this ritual is repeated over and over again until thestock market closes. If the market turns around and manages to eraseits 200-point loss and close higher, the “bearish” items will miracu-lously be interpreted as bullish, as in “Wall Street had second thoughtsabout President Clinton’s tax cut proposal . . .” and so me, once you get used to thinking in terms of super-stock analysis, you will begin to see these stock market commentariesin an entirely different light—that is, if you bother to see them at you really invest in stocks while you completely ignorethe stock market in general? Can you really ignore the stock marketprognosticators and other talking heads who can always be count-ed on to have an explanation of what the stock market did on anygiven day, even if in truth there is no explanation?Yes. Because when it comes to the trend of the general market,it’s doubtful that any one person can have much more insight thananyone else. All you really need to know is this: When interest ratesare rising sharply and the no-risk rate of return begins to exceed theinflation rate by more than 3 or 4 percentage points, it’s time to thinkabout reducing your market than that, nobody knows brings me to William Goldman is not a stock market analyst. He is the screen-writer of Butch Cassidy and the Sundance Kid, Marathon Man, andnumerous other well-known motion pictures. William Goldman isalso the author of a brilliant and entertaining book, Adventures in theScreen Trade, in which he coined a memorable phrase that summedup everything he’d ever learned about the movie it is: “Nobody knows anything.”What Goldman was saying was that you could take all of thesophisticated market research, all of the experience of studio headsand producers, all of the box office grosses of predecessor films, andall of the marketing savvy of the best distribution people, and throwit all out the window. If all of the widely available information knownto everyone in the movie business meant anything, everyone wouldbe making nothing but successful movies—and that sure isn’t hap-pening. Says Goldman:
Y L F M AChap 08 7/9/01 8:52 AM Page 70 E T 70PART ONEThe Making of a Superstock Investor •If anybody knew anything, . Thomas’s advisers would not have been so upset after the first sneak preview of Butch Cassidy and the Sundance Kid. After hearing Thomas’s new song, “Raindrops Keep Falling on My Head,” in the context of Butch Cassidy, they were convinced that Thomas had made a potentially fatal career move. •If anybody knew anything, Raiders of the Lost Arkwould not have been turned down by every studio in town before Paramount decided to make the film. •If anybody knew anything, Columbia Pictures would not have told Steven Spielberg that it decided not to make ., even after the studio spent a million dollars developing the film. ( up at Universal.) •If anybody knew anything, Paramount Pictures would not have offered The Godfatherto 12 directors (all of whom turned it down) before they got around to offering it to Francis Ford Coppola, and they would not have offered the®Team-Fly role of Michael Corleone to Robert Redford, Warren Beatty,Ryan O’Neal, Dustin Hoffman, and Martin Sheen beforethey got around to offering it to Al , if you think about it, you can apply William Goldman’spremise to the stock market, but with a slight the stock market, when everybody knows everything, nobody , the evidence seems to indicate that the stock mar-ket, as a whole, is a pretty good “discounting” mechanism that takesinto account everything that is knowable at any given time. Themore analytical attention that is focused on the market or on a sec-tor of the market or on any given stock, the more “efficient” the mar-ket becomes at determining a fair being the case, I would argue that the only way for an indi-vidual investor to get an “edge” on Wall Street is to go off the beatenpath and to focus on areas of the market where analytical attention isslim or nonexistent. It also follows that there’s no “edge” to be had interms of trying to outguess the general market, since virtually everyanalyst and investor is looking at the same information, which willtherefore be pretty well discounted, just as William Goldman’s moviestudio executives are all poring over the same current and historicaldata regarding box office grosses. If all of this “macro” publicly avail-
Chap 08 7/9/01 8:52 AM Page 71CHAPTER EIGHTIf Everybody Knows Everything, Then Nobody Knows Anything71able information meant anything, everyone would be making theright move all of the time—and they’re not. This strongly suggeststhat the way to hit a home run is to take a left turn when the lem-mings are turning right—to take the road less traveled, as it same holds true for large-cap stocks. A1999 study by PeterSchliemann, a money manager formerly with David L. Babson &Co., revealed that stocks with a market capitalization of more than$4 billion had an average of 17 analysts following the company, whilestocks with a market cap of less than $100 million had an average ofless than one analyst following the company. This means that some ofthese companies with a market cap under $100 million had no analytical cov-erage at all.(I don’t know for sure, but I’d be willing to bet that morethan a few of the small companies with no analytical coverage hadlots of cash, no debt, and no need for investment banking servicesfrom Wall Street. See Chapter 3.)In terms of large-cap stocks, you can see how efficient the mar-ket is and how difficult it is for any investor to get an edge on thecompetition by the way these stocks react to surprisingly good orbad information. When a widely followed stock trading at $66 miss-es its earnings estimate, there is no chance for anyone to sell at any-where near $66. Every analyst in town lowers his or her earningsestimate and downgrades the stock, and your $66 large-cap stocksimply opens at $50. That is how the efficient market works withwidely followed stocks: Everybody immediately takes the new real-ity into account and the market adjusts its perception of value everybody expected earnings of, say, $ for the quar-ter, everybody knew everything—therefore, they knew that everybody knows earnings came in at, say, $, every-body knows everything once again—but they still know nothingsince there is no way to take advantage of that information to avoidthe stock price , when it comes to analyzing the general market or the widely fol-lowed big-cap stocks, nobody on Wall Street really knows anything at all—or maybe we should say that nobody really knows anything more than any-body else—or anything really worth you’re looking for an edge in an area of the stock marketwhere everyone else is looking, you’ll find that new business becomesold business pretty darn quickly—usually too quickly to be of any
Chap 08 7/9/01 8:52 AM Page 7272PART ONEThe Making of a Superstock Investoruse to an individual investor. By the time you hear any new signif-icant information about the market in general or big-cap stocks, it’sa good bet that it will be old business already, no matter how new itseems to , compare this instantaneous reaction to new business in thelarge-cap stocks to the way the market reacted to Laidlaw’sannouncement that it would sell 12 percent of ADT Ltd. to WesternResources (see Chapter 9) for $14 a share. Did ADT immediatelyjump to $20 or $25 a share based on the likelihood that this movewould ultimately lead to a takeover bid? No, it did not. The stockmoved up gradually, over time, providing numerous excellent entrypoints for tuned-in if, say, IBM were to reveal that it had been buying shares ofDell Computer in the open market and that it had accumulated a 12percent stake without talking it over with Dell’s management, whatdo you think would happen to Dell’s stock price? Most likely, theWall Street analytical community would immediately take its bestguess as to Dell’s potential takeover value and the stock would risetoward that level almost did not happen, as we will learn, with ADT. Nor did ithappen with Rexel, Inc., even though the parent company, ., methodically bought shares in the open market, giving off ablatant clue that a takeover bid was on the way. With both of thesestocks, investors had plenty of time to accumulate shares prior tothe eventual takeover because the stock market was inefficient in pricingtheir stocks in light of this is the difference between how the market processes infor-mation involving widely followed large-cap stocks and less well-followed small-cap stocks. In fact, you can safely say that the mar-ket’s efficiency in processing significant information is directly relatedto the audience for that information—., whether institutionalinvestors and the analysts who are fighting for their commissionbusiness are paying attention will determine how accurately themarket reflects new will find, over time, it is important to spend more timeresearching individual stocks that are off the beaten path and lesstime thinking about the overall stock market and the popular stocksof the moment.
Chap 08 7/9/01 8:52 AM Page 73CHAPTER EIGHTIf Everybody Knows Everything, Then Nobody Knows Anything73Two very important points can be made now: First, if you real-ly want to have an edge in the stock market, you can only gain thatedge in terms of individual stocks, where it is sometimes possible tonotice information and interpret that information in a way that cangive you some unique insight into a particular other words, where individual stocks are concerned, the prizegoes to those investors who go the extra mile, who do their home-work better than everybody else. Sometimes this involves diggingdeeper for information about the company itself. Other times itinvolves thinking in terms of cause and effect, where a seeminglyunrelated news item in the maze of information released on a dailybasis has a connection to a stock you are following. For example,when Brylane’s outside shareholder, Pinault Printemps, began rais-ing its stake in Brylane, I saw a connection to the Rexel takeover bidbecause Rexel ., which bought Rexel, was a subsidiary of PinaultPrintemps (see Chapter 9). But how many investors—or professionalanalysts—would have known that if they had not lived through theRexel takeover drama?So, lesson number one is: Research individual stocks—andsmaller stocks, at that—and don’t try to predict the market or com-pete with every analyst on Wall Street tracking the large-cap second lesson is that a lot of valuable public information isavailable out there that is notreflected in stock prices, especiallywhen you’re dealing with stocks that are not widely followed by themainstream Wall Street , lesson number two: If you reallywant to get an edge on WallStreet, you should focus your attention on smaller-cap stocks thatare not widely followed by analysts and their institutional is where you are most likely to turn up information and see aconnection somewhere that is completely public but that has notbeen properly reflected in the stock principle explains why stocks like Rexel, ADT, Brylane,and others could easily have been purchased for months on end atbargain prices even though it was becoming increasingly likely toanyone paying attention that a takeover bid was on the you start to focus more of your attention on individualstocks and less attention on the general market, you’ll be better ableto train yourself to think in new paradigm terms. You will notice a
Chap 08 7/9/01 8:52 AM Page 7474PART ONEThe Making of a Superstock Investorsubtle change in the way you perceive the news. You’ll think in termsof cause and effect, and see connections between seemingly unre-lated companies and events that others do not more you think this way, the more likely you will be ableto identify potential “superstocks”—and the less interested you’llbecome in the daily blather that passes for stock market analysis.
Chap 09 7/9/01 8:53 AM Page 75PART TWOIdentifying TakeoverTargetsCopyright 2001 The McGraw-Hill Companies, Inc. Click Here for Terms of Use.
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Chap 09 7/9/01 8:53 AM Page 77CHAPTER NINECreeping TakeoversLet’s begin this chapter with an actual example of a company thatreceived a takeover bid that was completely predictable to thosewho were tuned in to the superstock method of analysis. One of thebest ways to spot a future takeover target is to focus on companiesthat are already partially owned by another company that is con-sistently adding to its stake by purchasing additional shares in theopen market. Many times these continual open-market purchasesare a prelude to eventual takeover bids at much higher understand why this is so, put yourself in the position of theoutside owner. Suppose you own 45 percent of a company whosestock is trading at $10. Suppose this company operates a business thatis complementary to yours and has excellent growth prospects. Andlet’s suppose further that your management team has decided it wouldbe a good idea to acquire this company within the next 2 the eventual plan is to buy the 55 percent of this companyyou do not already own through a takeover bid or tender offer, youknow two things. First, you will have to offer a premium over thestock’s current trading price. And you also know that even thoughyou already own 45 percent of this company, your offer will be sub-ject to what is called a “fairness opinion.” This means that eventhough you are, by far, the largest shareholder of the target compa-ny, the Board of Directors of the target company will have to seek out-side advice as to whether your takeover bid represents a fair pricefor the shareholders. The Board of Directors will probably enlist theservices of a brokerage firm that will dispatch a team of analysts to77Copyright 2001 The McGraw-Hill Companies, Inc. Click Here for Terms of Use.
Chap 09 7/9/01 8:53 AM Page 7878PART TWOIdentifying Takeover Targetsstudy the target company, the industry in which it operates, the val-uations of its competitors, and the future growth prospects of thecompany you want to buy. All of this means that you’ll probablyhave to pay a hefty premium over the stock’s current $10 tradingprice—especially if the growth prospects you envision are apparentto the target company’s management and to the financial advisers thetarget company all of this, what would you do?What many outside owners do is embark on what is called a“creeping takeover.” In a creeping takeover, the outside owner startsadding to his or her stake in the potential target company by purchas-ing shares on the open market. Week after week, month after month,the outside owner accumulates additional shares at prevailing marketprices, gradually increasing the stake. If these purchases are made in acautious and patient manner, they may not push the stock price upvery much. In fact, the stock price may not go up at all since there isalways stock available for sale in the normal course of trading. Simplybidding for stock and putting out the word to market makers that abid is available should a block of stock come up for sale may be all ittakes to accumulate an additional, sizable stake in the target approach makes all the sense in the world because if yourultimate goal is to acquire the entire company, and if you know youwill have to pay a sizable premium once the formal bid is made, themore stock you can accumulate at low prices, the less the eventualtakeover will ultimately cost STUDY: HOW REXEL . ACQUIRED REXEL you think like a potential acquirer and you keep an eye on outsideowners who are accumulating additional shares of a company onthe open market, you can act right along with them by purchasingshares in the potential target company. How can you do this? Anyholder of 5 percent or more of a public company is deemed a “ben-eficial owner” and must report all additional purchases and sales ofstock. Once a “beneficial owner” crosses that 5 percent threshold,each additional purchase of stock becomes a matter of public , you will learn where to find this information so you can buyright along with these outside beneficial owners. But first, let’s lookat Rexel Inc. and the “creeping takeover” engineered by its largestshareholder, Rexel . of France.
Chap 09 7/9/01 8:53 AM Page 79CHAPTER NINECreeping Takeovers791We recommended Rexel Inc. in October 1995 at $10⁄4for threereasons: Rexel . had recently raised its stake in Rexel from to45 percent through additional open-market stock purchases, Rexelhad turned itself into a pure playelectrical supply distributor by sell-ing off noncore operations, and Rexel had announced that it wouldbuy back 10 percent of its own stock. As you will soon see, these areall “Telltale Signs” of a potential takeover you will see throughout this book, we will spend some timepresenting original recommendations and ongoing analysis of thesetakeover targets, for one important reason: We’re not discussing“theoretical examples” or how you “might have done this” or “mighthave done that.” We’re concerned with actual recommendations and theactual takeovers that followed, and you need to see that the original rea-soning that went into these recommendations was directly related to theultimate purpose of this book is to train you to thinklike a takeover detective, to spot the telltale clues that often precedea profitable takeover bid. The precise reasoning that went into eachrecommendation is significant because it describes the thoughtprocess you should use to ferret out takeover candidates that willlater emerge as was what could be called “sneaky strong,” moving up grad-ually, meeting good buying support on pullbacks, and generallyembarking on a gentle uptrend, month after month, no matter what thegeneral stock market was other words, Rexel was beginning to act like a superstock—marching to its own drummer, oblivious to the manic/depressivegyrations of the overall stock market. A“creeping takeover” drama wasunfolding: Such situations, for all their potential, tend to be a lot less riskythan the average stock. This, as you would guess, goes against everythingyou’ve ever learned about risk and reward, which is that if you wanta big reward, you have to take a bigger than usual when it comes to a “creeping takeover,” this is simply notthe case. The reason is that if the outside beneficial owner continuesto purchase large blocks of stock on the open market, it’s a strongindication that there is good valueat those price levels. If the pricedeclines, the outside beneficial owner tends to go into the open mar-ket to purchase more shares, thereby supporting the price. Everytime an open-market purchase is made by the outside beneficialowner—and especially if these purchases take place at successivelyhigher price levels—it becomes logical that when the price dips too
Y L F M AChap 09 7/9/01 8:53 AM Page 80 E T 80PART TWOIdentifying Takeover Targets far below that level, it is viewed as a bargain, not only by the outside beneficial owner but also by the handful of stock market partici- pants who focus on situations like this. The result is often strong support on pullbacks, no matter what the stock market is doing. So, even if there is no takeover—and sometimes, even if the overall stock market is exceedingly weak—situations like this tend to hold up very well, thereby creating less risk. Tell that to the next know-it-all stock market pundit who tells you that investing in takeover candidates is “too risky for the aver- age investor.” Following aBusiness Weekstory on Rexel, the price bumped to $14; however, Rexel drifted back to where it had started, meetingsupport in the $12 area. Rexel met str ong support at that price. Andthen the “creeping takeover” really got un der the stock market, you can tell where the value is by who is doing the buying. That notion is seen clearly in the fact that a Rexel vice president had gone into the open market to purchase 4000 shares 3®of Rexel at a price of $11⁄8. This created what I call a “triple play” situ-Team-Fly ation, usually the most powerful of all signs that a stock is going high-er. Atriple play occurs when an outside beneficial owner, the company itself,and also its corporate officials (insiders) are all buying stock on the open mar-ket. This is just about as good as it gets in terms of identifying a severelyundervalued stock that is going to go significantly higher. While 4000 sharesis not exactly a monstrous transaction, it was just one more clue thatRexel was heading a lot February 1996 there was another major purchase of Rexelshares—Rexel . bought another 150,000 Rexel shares at prices1between $12 and $12⁄ was clear by March 1996 that Rexel . had begun to “creep.”The French company had once again gone into the open market to3buy 59,100 additional Rexel shares, at a price of $12⁄4. The continu-ing purchases of Rexel . suggested that Rexel could become atakeover target at any Much for the “Efficient Market” TheoryAt this point the Rexel story becomes a bit more interesting for a dif-ferent reason. The information age has arrived in full force, and it’s safeto say that there’s virtually no piece of information on any public
Chap 09 7/9/01 8:53 AM Page 81CHAPTER NINECreeping Takeovers81company that is not readily available to anyone who is interested inlooking for problem is, fewer and fewer analysts are looking for themost significant information—but that leaves the playing field wideopen for the rest of , you learned that Wall Street research is increasinglygeared toward servicing those who generate the largest commissions—mutual funds, pension funds, hedge funds, and other large-scaleinvestors who require big-cap stocks with lots of liquidity. Smaller-cap stocks and micro-cap stocks—and also stocks in out-of-favor indus-tries that are too boring to interest the momentum players—are sim-ply not followed as closely as their better known theory of the “efficient stock market” is that all pertinentinformation is so widely available that anything you and I know hasalready been discounted. But the reality is this: When lesser knownstocks become increasingly neglected by the Wall Street analyticalcommunity, it becomes increasingly common to see information that10 years ago would have moved a stock sharply higher have liter-ally no effect at all. The fact that Rexel ., for example, had uppedits open-market purchase price for Rexel from the $9 area to the $123to $12⁄4area should have sent a strong signal that Rexel was a great3value at a $12 to $12⁄4price. If Rexel ., which one must assume hada pretty good handle on the value of Rexel, was buying stock at pro-gressively higher levels, then it would seem logical that investorsshould follow Rexel .’s lead. And certainly if Rexel shares trad-3ed below the $12⁄4area that Rexel . had been willing to pay, thatwould make Rexel a very good value. Right?Not necessarily. Again, remember that we’re dealing here witha neglected stock that was virtually not followed at all by mainstreamWall Street research. What seems a logical way of looking at this sit-uation—namely, that Rexel would have been a logical buy anywhere3below $12⁄4—simply did not register with the vast majority of WallStreet analysts and the investors who received their advice from leads to an important point: You would be amazed at howmuch time you have to accumulate genuine takeover candidates thatare undergoing a “creeping takeover” before Wall Street catches onto what’s happening. And you would also be amazed at how often youcan buy these “creeping takeover” candidates at a significantly lowerprice than the outside beneficial owner has been paying!
Chap 09 7/9/01 8:53 AM Page 8282PART TWOIdentifying Takeover TargetsIn the case of Rexel, Wall Street greeted Rexel .’s continuing3purchases up to the $12⁄4area with a collective yawn, and Rexelshares drifted back below $12 midyear Rexel . had made two additional purchases of13Rexel Inc stock: 21,000 shares and 275,600 shares, both at $11⁄2to $11⁄ many investors, takeover bids may seem unpredictable and tocome “out of the blue.” But in other instances takeover bids are theculmination of a series of events that can point you in the right direc-tion if you watch the evidence accumulate and you exercise buys by Rexel ., while not proof that a takeover was immi-nent, provide a case study in how a parent company methodicallyraises its stake in another company before finally making a the end of the summer in 1996, Rexel . had made two1additional purchases of Rexel Inc. stock: 46,000 shares at $13⁄4and1175,700 shares at a price as high as $14⁄4. And there was continuedscattered buying of stock by Rexel Inc.’s officers and September 1996, Rexel . purchased another 162,000 shares37of Rexel Inc., at prices between $13⁄4and $13⁄8, an indication thatRexel . was accomplishing a takeover by attrition through itscontinuing open-market November 7, 1996, I reported to my subscribers that . had purchased another 79,000 shares of Rexel Inc. at $13⁄4. Andyet, amazingly, despite the sizable open-market purchases by . that I had been documenting, month after month, Rexel were trading in November 1996 right at $14, no higher thanthey had been trading at the start of proved two things: First, no one on Wall Street was pay-ing the slightest attention to the Rexel situation. And, second, as I’vesaid before and I’ll say again, if you’re going to invest in off-the-beaten-path stocks with genuine takeover potential, you’re going toneed patience and the courage of your convictions. It can be a mad-dening experience to have so much accumulated evidence of a prob-able takeover bid staring you right in the face only to see a stockmove sideways or even lower due to Wall Street’s yet, the flip side of that coin is: The more evidence thataccumulates and the longer the stock takes to react, the more time youhave to accumulate shares with even greater confidence—whichmeans the ultimate payoff, when it comes, will be even sweeter!By the end of 1996, Rexel was still trading near $14 a share,right where it began the year, despite the fact that Rexel . had
Chap 09 7/9/01 8:53 AM Page 83CHAPTER NINECreeping Takeovers83spent most of the year adding significantly to its Rexel stake . . . and7despite the fact that Rexel . had just paid as high as $14⁄8for an addi-tional 167,000 the first week of January 1997, Rexel Inc. finally broke out toa new high. (See Figure 9–1.)Then, in February 1997, I reported to my subscribers that . purchased another 43,500 shares of Rexel Inc., paying as much7as $15⁄16, a new high for Rexel .’s open-market March 1997, Rexel Inc. stock suddenly pierced the $20 levelon very large volume. Prior to that, Rexel . had purchased anoth-3er small block of 8000 shares, paying a new high of $16⁄ Last ChanceAt this point you’re probably thinking: How could Wall Street havemissed this obvious takeover candidate for so long? Why did it takeover a year for Rexel Inc. to really respond to the growing takeoverpotential? And why would Wall Street provide an opportunity forinvestors to buy Rexel shares at prices significantly below what . paid for the stock at so many different points and for suchFigure 9–1Rexel Inc. (RXL), 1995–1997Source:Courtesy of Mansfield Chart Service, Jersey City, NJ.
Chap 09 7/9/01 8:53 AM Page 8484PART TWOIdentifying Takeover Targetsextended periods of time along the way? There is an old saying thatthere are no free lunches on Wall Street, but in this case Wall Streetprovided a 12-course then Wall Street provided dessert!Shortly after it was announced that Rexel . had just pur-1chased another 184,000 shares of Rexel, paying as high as $20⁄16, Rexelshares dipped down to the $16 to $17 area and stayed there for sev-eral months. In other words, the perfectly efficient stock market,which sees all, knows all, and discounts everything, provided one lastextended opportunity for investors to buy Rexel shares for signifi-cantly less than Rexel . had just April 1997, Rexel . went into the open market and bought7a small block of 10,000 Rexel shares at $16⁄8. The purchase made per-1fect sense; Rexel had just paid as high as $20⁄16for 184,000 shares, sowhy not buy more at lower prices? By June 1997, Rexel stock hadspent nearly four months trading listlessly between $16 and $18,despite the fact that Rexel . had paid over $20 for the stock justmonths earlier. All told, Rexel . had purchased a grand total of1,734,900 shares of Rexel over the past two Time!Finally, in September 1997, Rexel . announced a takeover bid forRexel. The offer was initially at $ per share, then ultimatelyraised to $ per share. That takeover price represented a premi-1um of 119 percent over our original recommended price of $10⁄4injust two years. The moral of the story is that even when you clearly spot theTelltale Signs that an event is about to occur that will drive up theprice of an undervalued stock, you also may have to be very OTHER SIDE OF TAKEOVERS: SELLING BY ABENEFICIAL OWNERThis next case study illustrates another method of spotting takeovertargets, which is the mirror image of the approach used with addition to monitoring stocks that are being bought by outsidebeneficial owners, you should also take a close look at stocks where anoutside beneficial owner has indicated a desire to sell.
Chap 09 7/9/01 8:53 AM Page 85CHAPTER NINECreeping Takeovers85The reason for this is that, more often than not, the outside ben-eficial owner owns so much stock that an open-market sale is notonly impractical but also makes no business sense. Since the objec-tive of the beneficial owner should be to maximize the value of theinvestment, the proper way to get out of a large position in one com-pany is to either sell the stake to another company that may want tobuy the target company or perhaps urge the target company to putitself up for sale as a way of maximizing value for all the vast majority of cases where a block of stock owned byan outside beneficial owner is sold to a third party, the third partywill be thinking in terms of an eventual , what seems to be a negative to “old paradigm”thinkers—that a large outside beneficial owner shareholder wants tosell its stake—is usually a sign that the target company is about toenter the ranks of the STUDY: THE TAKEOVER OF ADTAn example of this approach is ADT Ltd., a security alarm moni-toring February 1996 a small news item appeared about ADT Ltd.,which at the time was the largest home security alarm company inthe United States. The news item did not seem to raise any alarmbells on Wall Street. It seemed that Laidlaw Inc., a Canadian companythat owned approximately 24 percent of ADT, had agreed to sell halfof its ADT stake to a Kansas-based utility company, WesternResources, for $14 per share, roughly the price at which ADT shareswere trading on the New York Stock Exchange. As part of the deal,Laidlaw had also granted Western Resources an option to buy theother 12 percent of ADT owned by Laidlaw by May 15, additional interesting part of the new item: ADT was active-ly attempting to sell its automobile auction business, which account-ed for about 27 percent of its revenues. As you learned earlier, com-panies that sell or spin off “noncore” operations are often preparingto sell themselves as a pure play to a larger company. So the fact thata block of ADT shares had been sold to a third party, combined withthe fact that ADT was setting itself up as a pure play, added up to thisconclusion: ADT was about to be “in play” as a genuine takeovercandidate.
Chap 09 7/9/01 8:53 AM Page 8686PART TWOIdentifying Takeover TargetsMy first response to this news item was to do a little researchon Western Resources. Why would a midwestern utility want to buya 24 percent interest in a security alarm company?The answer was intriguing. Wester Resources, formerly KansasPower & Light, was seeking to diversify into the nonutility fact, recent press releases from Western Resources indicated thatthe company had publicly stated it was thinking of expanding into thehome security alarm business through Resources had already told Wall Street that it was seek-ing to buy security alarm companies. Following this public state-ment, Western purchased a 12 percent interest in ADT from Laidlawat $14 and held an option to buy another 12 percent. And yet, ADTshares were sitting right there, in the $14 to $15 range, as thoughnothing fundamental had changed as a result of these two separate,but related news became part of the master list of recommended stocks inour Superstock Investor the time, some utilities, including telephone companies,viewed home security companies as a cost-efficient “add-on” ser-vice. Due to these supposed economies of scale in a utility acquisitionof a home security company, it seemed logical for Western Resourcesto eventually exercise its option to buy Laidlaw’s remaining 12 per-cent of ADT and then to make a bid for the rest of the same reasoning suggested that two smaller companies,Protection One (ALRM), then trading near $11, and Holmes Pro-tection (HLMS), then trading below the $8 area, were also potentialtakeover analysis of the security alarm industry provided a detailedroad map for investors for an upcoming takeover wave in the secu-rity alarm mid-March Western Resources had exercised its option topurchase the additional 12 percent of ADT owned by Laidlaw at$ per share. It was not expected that Western Resources wouldbuy the additional 12 percent of ADT so soon, but since the optionexercise price related to ADT’s market price, Western Resources mayhave acted as quickly as it did because they thought ADT shareswould move May 1996 a rather curious development took place: ADT’smanagement team had exchanged their low-priced ADT stock
Chap 09 7/9/01 8:53 AM Page 87CHAPTER NINECreeping Takeovers87options (with an exercise price of $9 per share) for a larger numberof higher-priced options (exercisable at $15 per share).In effect, ADT management exchanged a guaranteed profit fora chance to make more money, but only if ADT rose significantlyabove $ did they do it? To me, there was only one possible conclu-sion: ADT management expected the company to be acquired at a pricemuch higher than $15. And yet despite this growing evidence thatADT was about to be acquired at a price much higher than $15, youwould have had no problem buying ADT shares in the $16 to $17 my ADT update, subscribers were once again3reminded that Protection One (then trading at $7⁄4) could also getcaught up in a takeover wave involving security alarm March 16, 1996, CNBC’s Dan Dorfman reported on the rec-ommendation of ADT as a takeover candidate. At the time, ADTshares had drifted back toward the $16 area again, demonstratingonce again that it is surprising how many chances you will receive to buyunderfollowed stocks at bargain prices even when takeover storm cloudsare obviously gathering a May 3 report an item was included about a hostile takeoverbid that Western Resources had just made for Kansas City Power &Light. It was reported that Western’s bid for Kansas City Power & Lightwas unsolicitated and that it disrupted a friendly merger agreement thathad already been negotiated between KCP&Land another Resources had entered into an aggressive acquisitionmode. One of the tricks to picking genuine takeover candidates is tolook for companies that are already partly owned by other companiesand have demonstrated they are in an acquisition mode. WesternResources’ unsolicited bid for Kansas City Power & Light was a clearsignal that Western was looking to grow through observation demonstrates another strategy of pickingtakeover targets: It pays to know the track record of the outside as our experience with Rexel . and Rexel Inc. led usto the takeover of Brylane (see Chapter 10), this hostile bid by WesternResources for Kansas City Power & Light was a strong clue thatWestern Resources was in high-gear acquisition mode, and thatshould it want to buy ADT, would not easily take no for an , ADT announced a 5 million share buyback, anotherTelltale Sign that ADT was seriously worried about a takeover bid at
Chap 09 7/9/01 8:53 AM Page 8888PART TWOIdentifying Takeover Targetsan unreasonably low price. Remember the Telltale Sign: When a com-pany whose stock is being bought by a third-party “beneficial owner”announces a stock buyback, it is usually a strong signal that (1) thecompany is worried about a takeover, and (2) the company believesits stock is severely undervalued and the potential acquirer willattempt a “low-ball” bid that might be above the current market pricebut still below the true value of the company as a Western Resources and Kansas City Power & Light ranamazingly hostile advertisements about one another in The WallStreet Journal, again indicating Western Resources was in an aggres-sive acquisition mode. This type of aggressive action made an even-tual bid for ADT all the more likely. By this time ADT had crossed the $18 level and was trading at1$18⁄8, up 20 percent in less than three months since the news thatWestern Resources had bought 12 percent of ADT from ! Republic Industries Makes aTakeover Bid for ADT1On July 1, 1996, ADT became a superstock, jumping 5⁄2points in one11day, to $24⁄2, on news that ADT had received a takeover bid. That 5⁄2-point one-day gain amounted to a 29 percent gain on the day and a63 percent gain from the original recommended price of $15 just 4months the takeover bid for ADT did not come from WesternResources. Instead, it came from Republic Industries, a company runby Wayne Huizenga, who had previously built both Waste Manage-ment and Blockbuster Entertainment into major growth Industries had determined that it too wanted to be a leaderin the home security business. The takeover bid for ADT was valuedat $26, a 73 percent gain over the original recommended Resources was strangely silent over the RepublicIndustries bid from ADT. And the strangest twist in this story wasyet to Followers Get Another Chance to Buy at Bargain PricesDuring the discussion of the Rexel Inc. takeover, you learned howmany opportunities a patient, informed investor can get to buy a
Chap 09 7/9/01 8:53 AM Page 89CHAPTER NINECreeping Takeovers89genuine takeover candidate at bargain prices, even as additional evi-dence of an imminent takeover bid accumulates to enormous pro-portions. The reason for this apparent defect in the “efficient market” the-ory is that information is only properly discounted when the Wall Streetpowerhouses are paying funds, pension funds, andother institutional investors do indeed take all new informationimmediately into account when the information involves the large-cap stocks these institutions, and the analysts who serve them, arefollowing with the precision of an electron when it comes to smaller-cap stocks that are not on the insti-tutional radar screen, you can throw the efficient market theory rightout the July 26, 1996, Western Resources owned 24 percent of ADTand there was a $26 takeover bid on the table from RepublicIndustries. That $26 bid involved Republic Industries stock, how-ever, which had been weak since the takeover bid was a result, on July 26, 1996, an investor following the ADT3story could have bought ADT for—would you believe it?—$17⁄ reason for this price disparity was that Republic shares hadbegun to slide. As a result, ADT shares fell along with Republic, sincethe agreement was that Republic would exchange .928 of its sharesfor each ADT share. Also contributing to weakness in ADT was a gen-eral question over whether this deal could ever take place. Why?Because neither ADT nor Republic thought it important to check with WesternResources, which owned 24 percent of heard it correctly. Republic Industries and ADT had enteredinto a takeover agreement without bothering to seek the blessing ofWestern Resources, owner of 24 percent of ADT. In response to theRepublic–ADT agreement, Western said only that it was “exploringits alternatives.”The intent of that statement was probably an indication thatWestern Resources had intended to ultimately buy the rest of ADT,and its management was angry about not being consulted about thedeal. Also, it was highly unlikely that Western Resources wouldaccept shares of Republic Industries for its stake in ADT, becauseRepublic shares carried with them a substantial “personality pre-mium,” based on the popularity of Wayne this point, most Wall Street commentators were saying itwould be impossible for Western Resources to mount a competing bidfor ADT. Was it impossible? Not necessarily, but another possibility
Y L F M AChap 09 7/9/01 8:53 AM Page 90 E T 90PART TWOIdentifying Takeover Targets was that Western Resources would find another buyer for ADT who was willing to pay cash or stock with a more stable or reasonable value than Republic Industries. Athird possibility was for Western Resources to force Republic to substantially increase its offer in light of the decline in Republic shares. All three of these scenarios should have resulted in a sharp rise in ADT shares from their trading level of $17 to $18—a price level lower than where ADT traded prior to the Republic bid! Yet another possibility was for Western to simply oppose the merger but do nothing but vote against it—possible but unlikely considering Western’s aggressive personality. Finally, the Republic Industries–ADT agreement carried with it an unusual arrangement that seemed to indicate that both Republicand ADT wer e actually expectinga higher bid: ADT granted Republica warrant to purchase 15 million ADT shar es at $20 if the agreementwas terminated for any reason. This, by the way, is another reason why Western Resources was understandably miffed. In effect, it meant that anybody making a competing bid for ADT at any price ®over $20 had to buy 15 million additional shares and hand RepublicTeam-Fly Industries an instant profit. Why would ADT and Republic agree tosuch a warrant unless they both felt that a competing bid fromWestern Resources or someone else was possible?Now, a reasonably perceptive superstock observor would haveto say that the Republic bid for ADT appeared to be only the open-ing salvo in a bitter war for control of ADT. Based on what you’veobserved of Western Resources to this point, you would probablyhave agreed it was highly unlikely that Western would simply handADT over to Republic Industries and simply abandon its plans tobecome a security alarm powerhouse without at least putting upsome semblance of a you would expect that a “perfectly efficient stock market”would have processed all of this public information and decidedthat ADT should be selling perhaps in the low to mid $20 range,especially in light of the fact that Republic had already offered $26in stock to acquire the of the drop in its own stock price by early October 1996,Republic Industries had withdrawn its bid for ADT, and ADT shareshad dropped back to $18, following a brief run up toward the $22area. This provided yet another opportunity for savvy investors to buyADT stock at a significant discount to the $ price Western Resources
Chap 09 7/9/01 8:53 AM Page 91CHAPTER NINECreeping Takeovers91had paid for part of its million share purchase just a couple of withdrew its bid even though Western had notuttered one public comment on the Republic–ADT takeover , Western really didn’t have to say anything to ’s purchase of an additional million shares of ADTin August, after the Republic bid was announced, was Western’sway of saying: “Get lost.”Sure enough, just 1 month later, Western Resources purchasedanother million shares of ADT in the open market, this time pay-1ing between $18⁄4and $19. ADT shares once again rose above $20, but3just barely, trading around $20⁄, those of you who are thinking, “Aha! Acreepingtakeover!” can go to the head of the class. By saying nothing andcontinuing to accumulate ADT shares well below $20, WesternResources was creating a situation in which the final price it wouldpay for ADT would be lower. The more shares Western purchasedbefore making a formal bid, the less it would ultimately have to payfor the entire company. To anyone trained to think like a takeoverdetective—in other words, trained to think in superstock paradigmterms—it was perfectly obvious what Western Resources was up toas it continued to buy ADT shares on the open market while sayingnothing about the Republic bid or its own , after buying another 209,500 ADT shares at the end of3October at $19⁄4, Western Resources made its move: Western offered$ per share for ADT, making the offer in a hostile manner (sur-prise!) directly to ADT shareholders and completely bypassing ADTmanagement. In addition, Western called for a special ADT stock-holders meeting to replace the ADT Board of Directors. This movewas just what you would have expected from Western Resources inlight of the company’s hostile takeover bid for Kansas City Power &Light and also in light of the arrogant and cavalier manner in whichADT had disregarded Western’s interests when it accepted theRepublic takeover bid from Western Resources, in other words, shouldhave come as no surprise to any new paradigm thinker who hadbeen following this situation. Western’s anger, by the way, was evi-dent in the fact that its $ takeover bid was significantly lessthan Republic’s previous $26 bid. In fact, Western’s bid was so stingythat we advised subscribers to hold ADT based on the possibility
Chap 09 7/9/01 8:53 AM Page 9292PART TWOIdentifying Takeover Targetsthat Western Resources would raise its bid or that the situation wouldturn so hostile that ADT would find a competing once again, subscribers were reminded that two othersmaller security alarm companies, Protection One and HolmesProtection, could also get caught up in the takeover frenzy in thisindustry (see Chapter 17).Tyco International Bids $28 for ADTOn March 17, 1997, the ADT soap opera came to an end. On thatday, Tyco International, a diversified company seeking to expandits security alarm operations, offered to buy ADT for $28 in $28 takeover bid represented an 86 percent premium overthe original recommended price of $15 just 1 year earlier, a recom-mendation that was touched off by a seemingly innocuous newsitem about Laidlaw selling a portion of its ADT stake to a midwest-ern utility company, Western Resources. Although the vast majori-ty of investors and Wall Street analysts completely missed the sig-nificance of that news item, new paradigm thinkers would haveimmediately recognized it and realized that ADT was “in play” asa potential takeover target. And although ADT rose 86 percent overthe next year, the handful of investors who followed the ADT storywould have had numerous opportunities to add to their ADT stakealong the way, sometimes at prices below which Western Resourceshad paid for the stock on the open market. As more evidence accu-mulated that ADT would be acquired, a perfectly efficient stock mar-ket should have removed such bargain-purchase opportunities fromthe equation; instead the opposite occurred. As it became more obvi-ous that ADT would be bought by someone, the stock market offeredadditional lower-priced entry points for those who were becomingincreasingly convinced that a takeover would occur. ADT eventual-ly rose to $33 as Tyco stock moved you look at Figure 9–2, you’ll see a picture of a stock that hadbursts of strength when new developments occurred and then peri-ods of weakness when the takeover saga cooled off for a while. WallStreet has become obsessed with short-term performance, and tradersseem more interested in short-term swings and buying stocks withmomentum than they are in positioning themselves for a solid prof-it over time. As a result, what you will find in these ongoing, drawn-
Chap 09 7/9/01 8:53 AM Page 93CHAPTER NINECreeping Takeovers93Figure 9–2ADT, 1995–1997Source:Courtesy of Mansfield Chart Service, Jersey City, takeover situations is that when several weeks or months go bywithout a new development, interest in these takeover candidatesseems to wane. Much like a child with too many toys will quickly loseinterest in one toy and move on to the next, for Wall Street there’salways a new story, always another stock moving. The “hot” money,obsessed with short-term performance, can quickly lose interest ina takeover situation that temporarily runs out of steam. When the“hot” money sells to move into something temporarily more excit-ing, it creates buying opportunities in the genuine takeover candi-dates for those with the insight, foresight, and patience to take advan-tage of these it’s not just the 120 percent you could have made in ADT ifyou’d bought the stock at $15 in March 1996 and tendered to TycoInternational at $33 a year later that is significant, but also the factthat if you were thinking like a “takeover detective,” you would
Chap 09 7/9/01 8:53 AM Page 9494PART TWOIdentifying Takeover Targetshave become increasingly confident along the way that ADT wouldbe bought, and you could have added to your position with confi-dence at several junctures prior to the final takeover bid. Even if youhad paid higher prices than your original $15 purchase price, youwould have been doing so based on much more evidence of a prob-able bid at much higher , of course, the best part of the ADT story was that ADTturned out to be a superstock. It would not have mattered what thestock market was doing between March 1996 and March 1997,because ADT was on its way tofinding its proper value as a of being tossed about by the whims of the market, respond-ing to analysts’ estimates and interest rate movements, ADT wasbeing analyzed as a businessby three potential acquirers. And even-tually that bid by Tyco forced the stock market to place a realisticvalue on ADT as a other words, ADT would have gone from $15 to $33 even ifthe stock market had gone sideways or down during that period oftime, and that is the reason for spending so much time and effortlooking for superstocks.
Chap 10 7/9/01 8:55 AM Page 95CHAPTER TENHow to Create Your Own“Research Universe” ofTakeover Candidates—The Telltale SignsTwo roads diverged in a wood, and I—I tookthe road less traveled, and that has made all the FrostNow that you have seen how Rexel and ADT became takeover tar-gets, you can probably see the difference between “superstock” analy-sis and the usual sort of analysis practiced by most investors and ana-lysts. Tracking these two stories from start to finish was sort of likewatching a financial soap opera or miniseries, where the plot unfoldsexcruciatingly slowly over a period of weeks or months. While youmight be able to say the same thing about other stocks, the key dif-ference when you’re dealing with potential superstocks such as theseis that each plot development along the way points inexorably toward a cli-max or conclusion to the story, ., a takeover bid that forced the stock mar-ket to value Rexel’s and ADT’s stock according to their values as businessesregardless of what the general stock market was doing at the how do you find a stock like Rexel or ADT in the first place?To answer that question I am going to point you down the roadless traveled toward an entirely new direction in terms of thoughtprocess and 2001 The McGraw-Hill Companies, Inc. Click Here for Terms of Use.
Chap 10 7/9/01 8:55 AM Page 9696PART TWOIdentifying Takeover TargetsFirst, forget about the trendy “momentum” stocks everybodyknows and loves. If you want to own some of them, fine—but we’regoing to explore different territory because we are on the lookoutfor stocks and information that the mainstream Wall Street analystsare overlooking. I have all the respect in the world for Michael Dell,Bill Gates, Scott McNealy, Jack Welch, and all the rest of the well-known and widely followed business geniuses you can hear andread about every day of the week—but they live on a highly traf-ficked and overly developed road, and we’re headed for a far morebarren piece of terrain. These guys and the stocks they’re involvedwith are so widely followed, so idolized and analyzed, that there isabsolutely nothing you and I can discover that hasn’t already beennoted, rehashed a thousand times, and factored into their stock , I am going to suggest that you become a definition of browseis to look, wander, or meander throughsomething or somewhere in a casual and unfocused manner. Whenyou are browsing, you do not always have a specific goal in mind;you do not always know precisely what you are looking for. You aresimply passing through in an unhurried way, noticing whatever itis that happens to cross your is a very different mindset than setting out to find a spe-cific piece of Internet is a wonderful tool. It provides a bottomless pit offacts and figures, virtually anything you’re looking for. But what ifyou don’t know exactly what you’re looking for?To me, the Internet, which condenses and categorizes infor-mation, has eroded the art of browsing, which opens up the playingfield for independent-minded investors to notice out-of-the-way bitsof information that can lead to great stock ideas and a treasure troveof potential takeover targets. Once you have encountered an inter-esting idea through browsing, the Internet becomes a valuable toolto gather additional information. But if you’re looking for originalideas that have been overlooked by the crowd and that may not evenhave crossed your own mind yet, the best way to find them is the old-fashioned way—by reading certain publications cover to cover, espe-cially noticing the smaller, out-of-the-way items that would escapethe attention of 99 percent of your fellow investors. And thendigdeeper using the Internet.
Chap 10 7/9/01 8:55 AM Page 97CHAPTER TENCreate Your Own “Research Universe” of Takeover Candidates97Reading every single item in The Wall Street Journal, for exam-ple—especially the smaller items that may be only a few sentenceslong—can often lead you to make a mental connection to somethingelse you have seen or read along the way. Browsing through a chartbook with no particular stock in mind can often lead you to noticea potential superstock chart pattern belonging to a stock you havenever even heard of (more on that later).Of course, if you’re going to browse for antiques, you won’tmake much progress if you walk into a pet store. If you want tobecome a browser, browse the following publications on a regularbasis because in them you’ll encounter information that can leadyou to superstock takeover ’s Business DailyThe Mansfield Chart ServiceThe New York TimesThe Vickers Weekly Insider ReportThe Wall Street JournalCreate Your Own “Research Universe”Your goal as you begin your new career as a “superstock browser”will be to create your own “research universe.” Every Wall Streetanalyst has a “research universe” that consists of a group of stocksthe analyst follows on a regular basis. Most of the time, these stocksare organized by industry group. Achemical stock analyst, for exam-ple, will follow a universe of chemical companies and select one orseveral as his or her top a superstock browser, your goal will be to create your ownresearch universe, a list of potential “superstock” takeover candi-dates that possess one or more of the characteristics addressed inthis chapter. You’ll be looking for some of the Telltale Signs that sug-gest that a sleepy, out-of-favor, and out-of-the-way stock might beabout to emerge as a takeover advantage you will have over the average Wall Street ana-lyst is that your “research universe” will not be confined to a cer-tain industry group. Instead, once you learn to spot specific charac-teristics of potential takeover targets, you’ll find yourself following
Chap 10 7/9/01 8:55 AM Page 9898PART TWOIdentifying Takeover Targetsa diverse group of stocks that span a wide variety of industry once you’ve constructed your “research universe,” you shouldlook at it as a potential shopping list of investment example, if you are a conservative investor, you may findthat a water or natural gas utility or a supermarket company appearson your list of takeover candidates. Or, if you happen to believe thatenergy prices are headed higher, you may notice that an oil and gasexploration company is on your shopping list. Or, if you believeenergy prices are headed lower, you might note that a trucking com-pany or an airline, or some other company which could benefit fromlower energy costs, is on the other words, once you get the hang of browsing for takeovercandidates, you will be able to find stocks that fit almost any invest-ment goal or philosophy. But these stocks will have the added attrac-tion of being genuine takeover possibilities, which means they’llhave the potential of rising suddenly and substantially in price, nomatter what the stock market is here’s the best part: This “icing on the cake” comes free ofcharge. If you do your homework properly and focus on stocks not widelyfollowed, and therefore undervalued by Wall Street, you will be able to buystocks that carry this highly charged takeover potential with no takeover pre-mium built into the stock other words, to the outside worldthese stocks will look like boring, mild-mannered Clark Kents—butin reality, each will have the potential of slipping into a phone boothat a moment’s notice and emerging as a YOU’LL BE LOOKING FORI suggest that you read, copy, and post the following list of TelltaleSigns that a neglected stock has the potential to become a superstocktakeover candidate. You should study this list until it becomes sec-ond nature to you because these are the things you’ll be looking foras a superstock Telltale outside company or individual (“beneficial owner”)accumulates more than 5 percent of a company’s stock
Chap 10 7/9/01 8:55 AM Page 99CHAPTER TENCreate Your Own “Research Universe” of Takeover Candidates99and then files a Form 13-D with the Securities andExchange that already has one outside “beneficial”owner attracts a second or even a third outside investorwho accumulates a position of 5 percent of outside beneficial owner, in its Form 13-D filing, saysthat it is seeking ways to “enhance shareholder value,”“maximize shareholder value,” or speak to managementor other shareholders about “exploring strategic alterna-tives”—all code phrases for potentially putting a compa-ny up for sale to get the stock price outside “beneficial” owner pays substantially morethan the current market price of the stock in a privatetransaction with the company to establish an initial posi-tion or increase its stake, or agrees to provide services orsomething else of value to a company in exchange for anoption to purchase shares where the option’s exerciseprice is substantially higher than the current market priceof the stock. This is often a strong indication that all par-ties involved see substantially higher values ahead for thecompany and its outside beneficial owner adds to its stake in a compa-ny through additional open market purchases of its outside beneficial owner expresses an interest in sell-ing its stake in a companyand says it will review strategicalternatives—often a code phrase for a desire to have thetarget company acquired by a third party to maximize thevalue of the beneficial owner’s between an outside beneficial owner and thecompany in which it owns a stake breaks out into theopen—often a signal that a battle for control of the companywill take place or that the outside beneficial owner will finda third party to buy its stake as a prelude to a takeover in which an outside beneficial owner holds astake or is accumulating additional shares and/or whichoperates in an industry where takeovers are proliferatingannounces a stock buyback program.
Y L F M AChap 10 7/9/01 8:55 AM Page 100 E T 100PART TWOIdentifying Takeover Targets in which an outside beneficial owner holds a stake or is adding to its stake is the subject of insider buy- ing by its own officers and/or directors. with an outside beneficial owner and/or operates in an industry where takeovers are proliferating announces a “shareholder rights plan” designed to make a hostile takeover more difficult. in a consolidating industry sells or spins off “noncore” assets or operations, thereby turning itself into a “pure play” (see Chapter 14), which is often a signal that the company is preparing to sell itself to a larger company within its core industry. in a consolidating industry takes a large “restructuring” charge, in effect putting past mistakes behind it and clearing the decks for future positive earn- ings reports. Such action can be important to a potential acquirer and is often a sign that a company is preparing®Team-Fly to sell in a consolidating industry announces arestructuring charge that causes the stock to declinesharply and becomes the subject of significant insiderbuying and/or announces a stock buyback. This is usual-ly a sign that the stock market is taking a shortsighted, fartoo negative view of what may actually be an early cluethat a takeover is on the in a consolidating industry is partially ownedby a “financially oriented” company or investor, such as abrokerage firm or buyout firm, that has a tendency to buyand sell assets and that would be ready, willing, and ableto craft a profitable “exit strategy” for itself by engineer-ing a takeover of the company in question, should theopportunity present founder of a company who owns a major block ofstock (10 percent or more) passes away. This type of situa-tion often leads to a desire by the estate to eventuallymaximize the value of the stock—in other words, a desireto have the company acquired.
Chap 10 7/9/01 8:55 AM Page 101CHAPTER TENCreate Your Own “Research Universe” of Takeover or more bidders try to acquire a company in a cer-tain industry, resulting in a bidding war. Since only one ofthese bidders can be a winner of the target company,there is a good chance that the losing bidder will lookelsewhere for another acquisition target within the indus-try. In a case like this, you should browse through othercompanies within the industry looking for one or more ofthe Telltale Signs on the -to-medium-size company in a consolidatingindustry achieves a breakout from a “superstock breakoutpattern”; ., the stock penetrates a well-defined resis-tance level at least 12 months in duration following aseries of progressively rising bottoms or support levels,which indicates that buyers are willing to pay increasing-ly higher prices to establish a position. This pattern cre-ates the appearance of a “rising triangle” on the chart. Thebest superstock breakout patterns occur when volatility decreas-es markedly in the weeks or days prior to the that owns a piece of another company is itselfacquired. Many times it can pay dividends to look into asituation where a stake in one company is “inherited”through a takeover of another company. Many times, ifCompany Aacquires Company B, which, in turn, owns astake in Company C, you will find that Company C be-comes a takeover target in one of two ways: (1) CompanyAmay eventually bid for the rest of Company C if this fitsits overall business/acquisition strategy or (2) Company Amay sell off the inherited stake in Company C to a thirdparty, which then bids for the rest of Company C. Atake-over of a company whose stock is “inherited” throughanother takeover becomes even more likely when there isalready a business relationship between Company AandCompany illustrative purposes, let’s look at an actual example ofTelltale Sign number 18. In June 1999, Weyerhauser, the largest lum-ber producer in the United States, purchased Canadian timber com-pany MacMillan Bloedel Ltd. As part of that takeover, Weyerhauser
Chap 10 7/9/01 8:55 AM Page 102102PART TWOIdentifying Takeover Targets“inherited” a 49 percent stake in Trus Joist, a Boise, Idaho, manufac-turer of lumber products, which was partially owned by other 51 percent of Trus Joist was owned by TJ International, apublicly traded company listed on was some speculation at the time of the Weyerhauserpurchase of MacMillan Bloedel as to what would happen to TrusJoist. Most observers seemed to believe that TJ International wouldbuy out the 49 percent of Trus Joist that had been inherited byWeyerhauser. Others seemed to feel that Weyerhauser might makea takeover bid for TJ International as a way to buy the remaining 51percent of Trus first TJ International stock rocketed from the low $20s to as7high as $33⁄8, based on the second scenario: a potential takeover bidfrom Weyerhauser. But TJ shares then fell back sharply, falling as3low as $21⁄8, based on the emerging consensus that TJ would prob-ably buy out the 49 percent Trus Joist stake from observer who noted that Weyerhauser was themajor distributor for Trus Joist’s products and supplied most of theraw materials for Trus Joist could have concluded that it was high-ly likely that Weyerhauser, which was already in acquisition mode, wouldwant to own the rest of Trus Joist rather than sell its 49 percent to November 23, 1999, just 5 months after it bought MacMillanBloedel, Weyerhauser agreed to buy TJ International for $42 per3share. TJ International jumped $9⁄8(or 22 percent) in one day as aresult of the bid, which was nearly 100 percent premium to TJ’s stockprice just 4 months THINGS TO LOOK FORIn addition to these telltale signs that a formerly sleepy and over-looked stock is about to become a superstock takeover candidate,you should also pay close attention to any and all merger announce-ments each and every day, making note of which industries are expe-riencing consolidation and what the reasoning behind that consoli-dation may be. You should also read and listen to any interviews ofCEOs of companies that are making acquisitions for clues aboutwhat their future acquisition plans may be. You will be amazed athow much information you can obtain and how many tantalizing
Chap 10 7/9/01 8:55 AM Page 103CHAPTER TENCreate Your Own “Research Universe” of Takeover Candidates103clues are available by simply listening carefully to companies that areactively acquiring other THE VICKERS WEEKLY INSIDER REPORTTOFIND AND TRACK “BENEFICIAL OWNERS”Browsing through the Vickers Weekly Insider Report on a regular basisis a great way to find companies that are already partially ownedby outside beneficial owners who are also increasing their stakes bycontinuing to buy stock on the open market. This type of browsingis what led to discovering Rexel and its outside beneficial owner,Rexel ., a browsing coup that led to a 119 percent Vickers Weekly Insider Reportis available by mail and alsoonline. Published by Argus Research, the report is a summary ofbuy and sell transactions by corporate “insiders” (officers and direc-tors) and also outside “beneficial owners” of 10 percent or more ofa company’s stock (see Figure 10–1).Of particular interest is the “beneficial owner” an outside investor accumulates 5 percent or more of a com-pany’s shares, he or she must file a Form 13-D with the Securities andExchange Commission. That form will indicate the date and pricespaid for the stock and also, in general terms, the purpose of theinvestment. Some 13-Ds clearly state that the stock has been boughtfor “investment purposes only,” while other 13-D filings leave openthe possibility that the outside beneficial owner may seek to influ-ence management in some way, including possibly urging the restruc-turing or sale of the company as a means of “maximizing” or“enhancing” shareholder the Vickers Weekly Insider Reportlook for outside beneficialowners that are accumulating additional shares on the open an outside beneficial owner who already owns a stake in acompany goes into the open market to buy additional stock it tells youtwo things. First, at the very least, it indicates that the outside bene-ficial owner still sees value at a certain price level and is willing to buymore stock at that price. Second, additional open market buying canalso be an early clue that the outside beneficial owner intends to even-tually take over the entire company and is trying to accumulate asmany shares as possible at a bargain price before offering a premiumto buy the remainder of the shares owned by the public.
Chap 10 7/9/01 8:55 AM Page 104104PART TWOIdentifying Takeover TargetsFigure 10–1Sample of Vickers Weekly Insider ReportSimply sitting in a comfortable spot with a highlighter and a penand browsing through the entire Vickers Reporteach week, high-lighting those beneficial owner (B/O) transactions that seem inter-esting and making notations relating to names you have seen before
Chap 10 7/9/01 8:55 AM Page 105CHAPTER TENCreate Your Own “Research Universe” of Takeover Candidates105(or never seen before), will often lead to new and profitable ideasyou would not have otherwise one thing, you’ll notice familiar names popping up in dif-ferent places. You may find, for example, that an outside beneficialowner you have been tracking in one company also owns a piece ofanother company in a related industry. Or you may find that an out-side beneficial owner is buying shares of one company while sellingshares of another. You also may find that an outside beneficial ownerowns pieces of several different companies, or that companies arepopping up for the first time, which can take your search in an entire-ly new and different direction, as we shall soon are other ways to get information on the activities of ben-eficial owners other than waiting around for the Vickers Weekly InsiderReport to show up in your mailbox. You can go to the Internet, clickon or any of a number of other sites, and get a list of13-D filings every day. And once you have developed an interest ina certain stock, you can zero in on all of the relevant SEC filings anddevelop a wealth of information on your potential target there are connections that would not show up in a normal13-D filing or through a search of 13-D’s example, one key reason to use the Vickers Weekly InsiderReportis that it focuses on “Form 4” filings, which are required to befiled not only by outside shareholders who own 10 percent or moreof a company, but also by corporate officers and directors. By group-ing all Form 4 filings together, you can get a clearer, more encom-passing picture of all the buying and selling activities of “in theknow” stockholders than you would get simply by focusing on 13-D filings by may notice, for example, heavy insider buying by officersand directors in a company where an outside beneficial owner isalso accumulating shares—a powerfully bullish signal that a stockis undervalued and that some bullish factor that has not yet beentaken into account by the market is lurking beneath the surface. Onthe other hand, you may also notice heavy insider selling in a stockthat is being purchased by an outside beneficial owner, which wouldraise the question: If a takeover is possible, why would the officersand directors of this company be selling so heavily? In a case likethis, you might pass on this particular stock.
Chap 10 7/9/01 8:55 AM Page 106106PART TWOIdentifying Takeover TargetsYou may also notice heavy insider buying by officers and direc-tors in a stock that operates in a takeover lively industry, or you maynotice heavy insider buying in several stocks in the same industry,which raises the possibility that something bullish is going on in thatparticular industry that has not yet been perceived by the you may notice heavy insider buying and/or outside ben-eficial owner buying in a stock where you have previously noticeda potential “superstock breakout pattern” (more on that later).The point is, by taking the time to browse through this wealthof information and familiarizing yourself with it on a regular basisyou will soon find yourself recognizing the names of individualsand companies you have never encountered before. After a while,you’ll be making connections between seemingly unrelated bits ofinformation, getting a feel for how some of these outside beneficialowners operate, and you will notice patterns and clues that youcould not possibly have noticed in any other way other than takingthe time to me give you a real-life example that illustrates the useful-ness of this STUDY: SPOTTING BRYLANE AS A TAKEOVERTARGETIn 1997, Vickersreported a purchase of 429,400 shares of a companycalled Brylane Inc., by an outside beneficial owner, Pinault Printemps-Redoute . The Vickers data indicated that Pinault-Printemps hadpurchased these Brylane shares between June 3 and June 30, 1998, at3prices ranging from $45⁄4to $51. Brylane was added to the potential“research universe” of stocks to look into and monitor on a weeks later, the following transaction appeared:1BLACKROCK INVTS-1,756JULY29 988 20SABATH, KAREN H. SEC7BORG WARNERD-400 XJULY30 9848 16100 XDRUMMOND, JERE A. DIR13BRYLANE INCB-128,300 XJULY 1-28 9840 4-45 48,568,617PINAULT-PRNTMPS RDT SA B/O117BUCKLE INCS-20,200JUNE 5-28 9854 16-55 8N/ANELSON, DENNIS H. PRAnd a few weeks after that, these transactions appeared:31BRUSH . 5-10 9816 18-17 210,000ROBERTSON, WILLIAM R. DIR7BRUSH . 3-04 9815 8-1617,200HARNETT, GORDON D. CB
Chap 10 7/9/01 8:55 AM Page 107CHAPTER TENCreate Your Own “Research Universe” of Takeover Candidates107BRYLANE INCB-25, 98258,808,017KRAMER HARTMUT3BRYLANE INCB-8, 9826 46,000JOHNSON, WILLIAM C DIR3BRYLANE INCB-2, 9824 46,000STARRETT, PETER M DIR53BRYLANE INCB-214,400 -19 9824 8-38 48,783,017 XPINAULT PRNTMPS RDT SA B/O15BUCKEYE PARTNERSB-5,-26 9826 16-2740,000BUCKEYE MGMT CO. PARTHere was a situation where an outside beneficial owner, Pinault-Printemps, was buying huge chunks of a stock that was apparentlydropping like a rock. The initial purchases of 429,400 shares in Junetook place at prices as high as $51. By July, Pinault-Printemps was1buying Brylane shares as low as $40⁄4. By mid-August, Pinault was5in the open market buying additional Brylane shares as low as $24⁄8—less than half the price they paid just 2 months earlier!In addition, once Brylane fell to the mid-$20s, several Brylaneinsiders began to buy shares as well, including two directors, WilliamC. Johnson and Peter M. Starrett, who purchased 6000 shares and332000 shares, respectively, at $26⁄4and $24⁄ continuing large purchases by Pinault-Printemps, com-bined with the apparently large decline in Brylane’s stock price andthe emergence of insider buying, compelled me to literally dropeverything and find out just what Brylane and its outside beneficialowner, Pinault-Printemps, were all about. In other words, experienceindicated that Telltale Signs were flashing and that this was a situationworth looking into—right of Brylane revealed that this stock had plunged from over$60 down to the $14 area in less than 7 months!What was particularlyastonishing about this price performance was not that Brylane shareshad fallen so far so fast—after all, individual stocks are collapsingevery day on Wall Street, and it’s not all that unusual. What wasunusual was that an outside beneficial owner had purchased suchmassive amounts of Brylane stock at very high prices and had beenso wrong so tracking the activities of outside beneficial owners, we areoperating on the theory that these major shareholders know valuewhen they see it. We assume they are intimately familiar with theoperations of a company, they regularly speak with management,and they are therefore well-aware of how things are going and whatthe company’s prospects though, when you see an outside beneficial owner step-ping into the open market to buy big blocks of stock, you assume he
Chap 10 7/9/01 8:55 AM Page 108108PART TWOIdentifying Takeover Targetsor she has reached an informed conclusion—., in light of all theyknow about the company and its prospects, there is compelling valuein the stock at this level, and the beneficial owner is willing to investadditional funds to back up their you add insider buying into the mix—., when you seeofficers and directors buying shares along with the outside benefi-cial owner at a certain price level—you have a double-barreled voteof confidence that a stock has reached a compelling price point interms of its value as a , Pinault-Printemps watched Brylane fall from $61to $51 and decided that at $51, the stock was a great value. Pinault-Printemps also apparently thought Brylane was a great value at $45,5$38, and $24⁄ Brylane directors also thought the stock was a great value33at $24⁄4and $26⁄, in a breathtakingly short period of time, Brylane hadplunged all the way to the $14 to $15 , again, here is what was so intriguing about Brylane: Howcould all of these sophisticated investors be so monumentally wrongin such a short period of time? And, if Pinault-Printemps thought5Brylane was a good value all the way down from $51 to $24⁄8, whywouldn’t it consider buying the rest of the company now that thestock had fallen to $14?For all of these reasons—and to answer all of these questions,which emerged as a result of browsing through the Vickers WeeklyInsider Report—we researched Brylane and its outside beneficialowner, Pinault-Printemps. The result of this research can be bestsummarized by an old adage on Wall Street that you should nevertry to catch a falling piano. It’s always dangerous to try to predict abottom in a stock that has been falling precipitously. What you wantto look for is an easing of the selling pressure, a leveling out of thestock price, and ideally, the formation of a sideways trading range,or base pattern, which indicates that buyers are finally stepping inand that the supply/demand situation is coming back into why would you try to catch this falling piano? Because Brylanewas percent owned by a French company, ., the parent company of Rexel ’s right—Pinault-Printemps turned out to be the parent compa-ny of Rexel . of France, the very same outside beneficial owner that
Chap 10 7/9/01 8:55 AM Page 109CHAPTER TENCreate Your Own “Research Universe” of Takeover Candidates109methodically purchased additional shares of Rexel Inc. on the open marketprior to making a takeover bid for the entire company!And Brylane, it turned out, was a very well-known company:a major catalog retailer that published, among others, catalogs forSears, Lane Bryant (thus the name of the company), Lerner, andChadwick’s. Thirteen months after Brylane’s February 1997 publicoffering, Pinault-Printemps purchased a percent stake in Brylanefor $51 per after Pinault-Printemps went into the open market tobuy additional shares in June and July 1998, Brylane had plunged inreaction to two separate news developments. First, on August 19, 1998,13Brylane dropped 11⁄2points to $24⁄4on news that sales of the compa-ny’s Lerner catalog were disappointing and below expectations. Thisnews led to several earnings estimate cuts by the small group of ana-lysts who followed Brylane, and the institutional investors who fol-lowed these analysts obviously dumped Brylane shares, en after Brylane stock plunged 11⁄2points in one day, the com-pany announced a $40 million stock development wasespecially intriguing because when an outside beneficial owner, com-pany insiders, and the company itself are all buying shares on theopen market, it is one of the strongest possible clues that a stock isselling in a great long-term value area and the stock market is over-reacting to a short-term problem, creating a compelling buyingopportunity value for investors who have the vision and the forti-tude to look beyond the hysteria of the moment. (See “EighteenTelltale Signs,” numbers 8 and 9 earlier in this chapter.)But even though Pinault-Printemps, several Brylane insiders,and Brylane itself all apparently believed that the stock was a greatvalue in the mid-to-high $20s, Brylane shares were blasted againonSeptember 24 and 25, 1998, following another analyst downgradeand earnings estimate second price plunge took the stock down to the $14 to $ into Brylane revealed that Pinault-Printemps hadagreed to a “standstill agreement,” which limited Pinault to own-ing a maximum of percent of Brylane for three years, endingApril 3, , a “standstill agreement” might be viewed as animpediment to a takeover. However, that’s not always the case.
Y L F M AChap 10 7/9/01 8:55 AM Page 110 E T 110PART TWOIdentifying Takeover Targets Further research into Pinault-Printemps revealed this company to be Europe’s third-largest mail order company. Pinault was a company that generated $ billion per year in revenues. So, paying $300 million or so for the rest of Brylane, which operated a mail order business that obviously fit right into Pinault’s business mix, did not seem like a very big deal—especially in view of the fact that Pinault had paid $51 for its original stake, over three times what Brylane was trading for in October 1998. As a superstock investor, you could have taken a gradual and patient approach with Brylane. Tax-loss selling could have hurt the stock as year-end approached since it is, indeed, tough to catch a “falling piano.” But all of Wall Street loved Brylane at $61. Now, close to $15, Brylane looked like a very interesting special situationif you were willing to be patient and take a one-to-two year invest-ment horizon. In November there was another insider buyer in Brylane, this 15time at a price of $15⁄16. In December, Brylane had once again issued ®an earnings warning and the stock had retreated to the $10 to $11 -Fly At these low prices it would be a safe guess that Pinault-Printemps,the French company that owned that percent stake, should atleast be thinking about a potential takeover weeks later, Brylane soared from $11 to $23, following thenews that Pinault-Printemps had made a takeover bid for the company!Anyone who had bought Brylane at $14 to $15 chalked up a gainof as much as 50 percent in less than 3 months. Any investor who hadpurchased shares of Brylane following the final plunge to the $10 to$11 area would have made a 100% (or more) profit in just 2 or 3 weeks!This phenomenally successful recommendation came about forone reason and one reason only: I took the time to browse throughthe Vickers Weekly Insider Reportand noticed a couple of names thatwere completely new to me. Through continued browsing, thesenames popped up again, which led to further investigation of thesecompanies. This investigation, in turn, led to the discovery thatPinault-Printemps was the parent company of Rexel . of France,a company that had already taken over one of my previous of experience and research, together with thefact that Brylane itself and Brylane insiders were buying stock onthe open market right along with Pinault-Printemps—two of the
Chap 10 7/9/01 8:55 AM Page 111CHAPTER TENCreate Your Own “Research Universe” of Takeover Candidates111Telltale Signs I always watch for—created a logical and compellingsuperstock takeover how you use the Vickers Weekly Insider STUDY: SAM HEYMAN AND DEXTER observers of thoroughbred horse racing can usually tellhalfway through a horse race, with a high degree of accuracy, whichhorses are likely to be in contention at the finish and which will can usually determine which horses are looking “strong”and which are on the verge of tiring as the race is in progress, andthey often use these observations to accentuate certain horses as theycall the race. How do they do this? They know the characteristics,through long experience, of horses that are running as fast as theycan in the early stages of the race and of horses that are beingrestrained and have not yet been asked to run at top speed. Once arace is under way and the horses have settled into stride, veteranrace watchers can usually tell which horses will be around at thefinish and which will be also-rans. They do this by watching thehorses’ strides, how high the jockeys are riding in the saddle, whetherthe reins are loose or taut, the position of the jockeys’ hands, andother clues that can only be observed by someone who has seen allof this thousands of times before and learned to recognize some ofthe Telltale Signs to help determine the is an invaluable asset when you are browsing forsuperstock takeover candidates. The more you browse, the moreyou’ll notice, and the more you notice, the more you’ll be able tomake certain connections that other investors will be unable to the identical set of circumstances, you’ll see something thatothers do not see and you will be able to see a high probability of acertain outcome, and that’s where you gain your edge. Each expe-rience—even those that do not turn out profitably—will lay thegroundwork for future experiences. Eventually, you’ll find yourselfextrapolating a certain set of circumstances all the way to their log-ical—and profitable— Dorfman, one of the most respected financial reporters onWall Street and the former author ofThe Wall Street Journal’s “Heardon the Street” column, was writing a column for whenhe called me on November 1, 1999. His request was straightforward
Chap 10 7/9/01 8:55 AM Page 112112PART TWOIdentifying Takeover Targetsenough: He asked me to list my top three takeover candidates in thecoming 12 months. I offered the following three stocks. E’town Corp.,a New Jersey water utility, Dexter Corp., a specialty chemicals com-pany, and California Water Service, another water utility. Amazingly, within 6 weeks two of those three takeover candi-dates received takeover bids. E’town jumped 10 points in one day fol-lowing a bid from Thames Water PLC of Britain. (For more on theE’town takeover and the reasoning that went into it, see Chapter 18.)The other company to receive a takeover bid was Dexter Corp. proved to be another strong example of the ben-efits of browsing. While looking through the weekly list of 13-D fil-ings in Barron’s, I noticed that International Specialty Products (ISP)had purchased 365,200 shares of Dexter at prices ranging from $ $ per share, giving ISPa total of 1,996,900 shares, or per-cent of Dexter’s outstanding , if not most, of the 13-D filings reported in Barron’s andelsewhere each week involve money managers, and they are of nointerest because these are passive investors who are not likely to cre-ate a takeover browsing through these filings each week, it helps to lookfor 13-D filers who are either corporations—., real businesses whomay want to acquire another business—or individuals who for onereason or another seem to have the ability, the inclination, or both,to mount a takeover tool is to look for names you do not recognize. Forinstance, when an individual or a company that does not normallyacquire a 5 percent interest in another company suddenly files a 13-D, it is often an indication that they are a serious player—., theyare thinking in terms of a takeover, or, at the very least, they will usetheir ownership leverage to prod a company to maximize the valueof the stock in some September 1999, International Specialty Products was not afamiliar name. Dexter was, however, because of a company calledLife Technologies, which was 53 percent owned by Dexter. Life Tech-nologies was recommended on May 29, 1998, because the “life sci-ences” industry, where LTEK operated, had seen a wave of really sparked the LTEK recommendation as a takeover target,however, was a simple statement found in a series of Dexter pressreleases. Press releases are yet another useful tool that can help you
Chap 10 7/9/01 8:55 AM Page 113CHAPTER TENCreate Your Own “Research Universe” of Takeover Candidates113get a feel for a company and its thinking in terms of either acquiringcompanies or selling itself to someone else. In one of Dexter’s releases,the company said that it was actively seeking acquisition , this may seem like a ridiculously simple conclusion, andin reality it is. The amazing thing is how few observers managed toreach it. Here was Dexter, a slow-growth chemicals company thatowned 53 percent of fast-growing Life Technologies, a company ina popular industry where a series of takeovers had already takenplace. Dexter needed something to juice up its growth rate; it alreadyowned 53 percent of LTEK and had just stated that it was looking toacquire a seemed pretty logical that LTEK might be on Dexter’s radarscreen as a takeover target, and that Dexter might bid for the 47 per-cent of LTEK it did not already , LTEK jumped 8 points in one day on news that Dexter hadoffered $37 per share to acquire the remainder of LTEK. That bidwas viewed as too low, and it prompted howls of outrage from LTEK1shareholders. Dexter eventually raised its bid to $39⁄8. Part of beinga superstock investor is knowing when to sell, and that was the rec-ommendation made for this stock at this point in had been a year since the LTEK takeover, and now somebodyhad filed a 13-D on Dexter and was raising its revealed that International Specialty Products was con-trolled by a man named Samuel Heyman. This piqued my interestbecause I had already recommended a Sam Heyman takeover targetway back in 1982. The horse race now seemed half over: The outcomewas apparent. On Wall Street, just like in horse racing, the past per-formances can tell you a immediately knew that a hostile takeover bid for Dexter wasvirtually inevitable because history had shown that Samuel Heymanhad a burning desire to win every battle he decided to 1982, long before the term “hostile takeover” became a famil-iar part of the Wall Street lexicon, Samuel Heyman was a shareholderin a company called GAF Corp. At some point Heyman reached theconclusion that GAF’s assets were worth far more than its stock priceand that GAF’s management was not running the company in amanner that was making optimal use of those other words, to put it bluntly, Samuel Heyman thought thatGAF’s management was doing a lousy job and that he could do
Chap 10 7/9/01 8:55 AM Page 114114PART TWOIdentifying Takeover Targetsbetter. Heyman announced that he intended to wage a proxy fightto replace GAF’s management and that he would then embark on aprogram to maximize GAF’s value for its , this would not be what you would call a startling devel-opment. News that a dissident shareholder is urging managementto maximize value and is threatening to wage a proxy fight is socommonplace that it would barely raise an eyebrow. But in 1982,Samuel Heyman was a man ahead of his time. He nominated a newslate of directors, headed by himself, and announced that he intend-ed to take over Street reacted to Sam Heyman as if Rodney Dangerfieldhad announced he intended to run for President. It was as thoughan interloper had decided to get involved in a process where onlymembers of an exclusive club were allowed to operate, and Heyman’sbattle with GAF was viewed with a combination of amusement anda decided lack of respect in the investment , meanwhile, was not amused, and its management reactedangrily to Sam Heyman’s audacity. GAF questioned Heyman’s credi-bility and management abilities and generally scoffed at the idea thatHeyman and his inexperienced group of outsiders could unseat GAF’swell-entrenched management. Eventually, the scoffing stopped andturned to outright hostility, involving a series of increasingly hostilestatements and newspaper advertisements in which the two contestantsinsulted each other and tried to win the support of GAF won the proxy fight, ousted GAF management,restructured the company, liquidated some assets, and completely fol-lowed through on everything he said he would do. Along the way,he accumulated a percent stake in Union Carbide—an especial-ly audacious move, since Union Carbide was many times larger thanGAF—and actually threatened to take Union over! GAF made a hugeprofit on its Union Carbide stock. GAF had soared to $67 a share, a1gain of 375 percent in 2⁄2years. Heyman ultimately took GAF privatein 1989, then sold 20 percent of International Specialty Products, aGAF subsidiary, to the public in , 14 years later, here was Samuel Heyman accumulating astake in Dexter Corp. on the open market through his new public com-pany, International Specialty Products. On the surface, Dexter seemedan unlikely candidate for an outside beneficial owner to take a majorstake: The oldest company listed on the New York Stock Exchange, it
Chap 10 7/9/01 8:55 AM Page 115CHAPTER TENCreate Your Own “Research Universe” of Takeover Candidates115was a specialty chemicals company operating in an industry whererising raw material costs and shrinking margins, combined with slow-ing revenue growth, had put a severe crimp in its earnings was one of the major reasons Dexter had made the takeover bidfor the 47 percent of Life Technologies it did not own—Dexter hopedthat LTEK’s high-growth business would inject some badly neededexcitement into a stock that was being neglected by Wall was more to the Dexter situation than met the eye, especiallyto someone looking at this situation in terms of a potential superstocktakeover , the very circumstances causing profit marginsto shrink among all chemicals companies had already set off atakeover wave in that industry, as chemicals companies looked forcombinations to achieve economies of scale. This has been seen overand over again in recent years: When an industry reaches maturityor when it faces a set of circumstances that makes it appear thatgrowth opportunities will be limited, the larger companies in theindustry look to mergers and cost-cutting as a way to grow earn-ings. In such situations, the smaller and mid-size companies tend tobecome takeover targets, and suddenly a sleepy company with stag-nant or declining earnings, one that is totally ignored by Wall Street,becomes a superstock because it’s a takeover companies will never be on the recommended lists ofmomentum players, because they have no momentum, either in theearnings or their stock price. They will never show up on a sophis-ticated “screen” that directs investors’ attention to the strongest stockwith the most rapid earnings growth. And they will rarely be rec-ommended by mutual fund managers who talk about their mostbrilliant ideas on television, because what is there to talk about whena company’s revenues are flat and its earnings are declining?And yet, the fact is that some of the most compelling values onWall Street can be found in sectors where the fundamentals appearto be most unappealing—provided you can see the potential of some sortof “catalyst” that would force the stock market to recognize the inherentvalue in these had a catalyst, and his name was Samuel Heyman. Herewe had a company operating in a consolidating industry where anoutside beneficial owner—Heyman—was accumulating shares onthe open market. Even better, the outside beneficial owner had a his-tory of acquiring companies.
Chap 10 7/9/01 8:55 AM Page 116116PART TWOIdentifying Takeover TargetsBut there was even a more interesting twist to the Dexter–SamHeyman story that convinced me, absolutely and without a doubt, thatHeyman and International Specialty Products would soon be making ahostile takeover bid for Dexter turned out that a group led by Sam Heyman and InternationalSpecialty Products had been major stockholders of Life Technologiesa year earlier, when Dexter angered LTEK’s shareholders by makinga takeover bid that was perceived to be too controversy over Dexter’s bid still lingered. Actually, I hadstopped following Life Technologies after Dexter’s takeover bid. CherrieMahon went back and pieced together the chain of events that had cul-minated in Sam Heyman’s steady accumulation of Dexter shares onthe open market. I discovered that, following Dexter’s offer for LTEK,two directors of Life Technologies resigned because they believed thatDexter’s bid was too low. Remember, Dexter already owned 53 per-cent of LTEK, which put it firmly in the driver’s seat. Life Technologiesformed a special committee to evaluate the Dexter bid; they retainedGoldman Sachs, which estimated that LTEK was worth as much as $601per share, compared to Dexter’s upwardly revised bid of $39⁄8. Dexter,1meanwhile, had retained Merrill Lynch, which said that Dexter’s $39⁄8offer was fair and reasonable. The discrepancy between Goldman’sestimate of LTEK’s value and Merrill Lynch’s value estimate proves thatvalue, like beauty, is in the eye of the again, it may prove something else. Dexter, armed witha “fairness” opinion from Merrill Lynch, and having proved thatcomparison shopping can save you money on Wall Street, proceed-1ed with its $39⁄8per share tender offer for Life Technologies. Theoffer attracted another 18 percent of LTEK’s shares, giving Dexter atotal of 71 percent of the , the rest of LTEK’s shareholders refused to tendertheir shares, a highly unusual situation when the controlling share-holder is issuing a take-it-or-leave-it offer. Dexter allowed the tenderoffer to expire, issued a statement that it was disappointed that someof LTEK’s shareholders refused to take advantage of its takeoverbid, and said that it was content to own 71 percent of LifeTechnologies. Shortly afterward, Life Technologies, which had pre-viously traded on the NASDAQ market, was exiled to the OTC“Bulletin Board” because there were not enough public sharehold-ers left to qualify for NASDAQ listing.
Chap 10 7/9/01 8:55 AM Page 117CHAPTER TENCreate Your Own “Research Universe” of Takeover Candidates117And who were these handful of LTEK shareholders who refused to selltheir stock to Dexter at what they considered to be an unfairly low price?You guessed it—a group led by Samuel Heyman and Inter-national Specialty ’s right. Sam Heyman, the man who challenged GAF andtook over that company back in the early 1980s because he believedhe was being treated unfairly as a GAF shareholder, simply sat onhis hands and refused to respond to Dexter’s takeover bid for LifeTechnologies. Not only that, Heyman and ISPactually went into theopen market to purchase additional Life Technologies shares just asthe Dexter tender offer was expiring—and they paid more for LTEKstock than the value of Dexter’s bid, which amounted to one morethumb of the nose at Dexter and a clear signal that Heyman was notgoing to take this lying December 1998, the same month that Dexter’s bidexpired, International Specialty Products went into the open marketand bought 1,471,320 LTEK shares, paying as high as $ per investors associated with Sam Heyman and ISPalso went intothe open market during December 1998 and bought LTEK shares. Asa result, when the Dexter offer expired, Sam Heyman and his groupowned a total of 86 percent of LTEK’s remaining public “float.”To someone who did not know Sam Heyman’s history, the factthat Heyman and ISPwere now buying Dexter shares on the openmarket may have had little or no meaning. In fact, there was noshortage of analysts who dismissed Heyman’s purchases of Dexteras nothing more than a ploy to get a higher price for his LifeTechnologies shares. They felt that Heyman had gotten himself intoa box with his LTEK stake and was now seeking to bully Dexter intobailing him out with a higher bid. Others believed Heyman wouldnever make a bid for Dexter because ISPwas so highly leveragedthat it would not be able to obtain the financing for an Sam Heyman did not operate that way. Heyman was notlooking for Dexter to “bail him out” and would not have started thisfight without the ability to finish it. Heyman would ultimately makea hostile takeover bid for Dexter, with the intention of taking over thecompany, selling off various Dexter assets for their fair value—includ-ing Dexter’s stake in Life Technologies—and restructuring Dexterso its true asset value, estimated by analysts to be as much as $55 pershare or more, could be realized by its shareholders. Another clue that
Chap 10 7/9/01 8:55 AM Page 118118PART TWOIdentifying Takeover TargetsSam Heyman was serious was that ISPhad been selling off its “non-core” operations. The conclusions reached from all of this were that Sam Heymanwas trying to put Dexter “in play,” and either ISPor a group head-ed by ISP, or possibly a third party, would soon be making a takeoverbid for Dexter. Heyman’s intent toward Dexter would be what WallStreet would call hostile, and ISPwould attempt to gain control ofDexter, sell off various Dexter operations that it did not want, retainsome of Dexter’s specialty chemicals operations that fit the ISPbusi-ness profile, and possibly sell off the LTEK stake to another bidderwilling to pay a more reasonable (and much higher) Heyman went into the open market to purchase additionalDexter shares, raising his stake to percent of the company, andhe filed a notification that he intended to raise his stake to at least responded by lowering the threshold of its “sharehold-er rights” plan from 20 percent to 11 percent. Under the terms of theplan, a “poison pill” would kick in if any outside person or grouppassed the 11 percent ownership threshold without Dexter’s per-mission. The poison pill would touch off a ridiculously complexseries of financial shenanigans that only an investment banker withfar too much time on his hands could have dreamed up. But the out-come would be this: The poison pill would make a hostile takeoverprohibitively expensive and virtually , Dexter shares were drifting slowly but surely downtoward that $30 to $33 support area that I advised subscribers towatch was yet another example of Wall Street’s remarkable abil-ity to overlook the obvious in spending its time obsessing over ahandful of high-profile “momentum” stocks while ignoring virtuallyeverything else. 9On Friday, December 11, 1999, Dexter closed at $32⁄16. On thattrading day, Dexter was just another basic industry “value” stock withuninspiring revenue and earnings growth, of little or no interest totrendy “momentum” investors seeking to beat the stock Monday, December 14, 1999, Dexter was the best-performing5stock on the New York Stock Exchange, soaring 8⁄8points, or per-cent in a single day. In other words, Dexter had become a ?
Chap 10 7/9/01 8:55 AM Page 119CHAPTER TENCreate Your Own “Research Universe” of Takeover Candidates119Because Sam Heyman’s International Specialty Productsannounced a hostile $45 per share takeover bid for Dexter—atakeover bid that seemed to come out of the blue for most marketwatchers but that certainly came as no surprise to anyone who wastuned in to the events that led up to the it certainly came as no surprise to anyone who knew any-thing about Sam probably think this is the end of the Dexter story. In fact, themost lucrative part of the story was yet to come!Following Sam Heyman’s $45 bid for Dexter, Dexter stock spent thenext 4 months trading within a range of $34 and $ Wall Streetanalytical community, you see, still did not take Sam Heyman the jump in Dexter’s stock price to $41⁄16, which wasstill nearly 4 points below the value of Sam Heyman’s takeover bid,Dexter’s stock began to erode again because analysts openly ques-tioned: (1) whether Heyman was seriously trying to buy Dexter, and(2) whether Heyman and ISPhad access to the financing to actual-ly do the took Dexter nearly two weeks to respond to Heyman’stakeover bid. Finally, in a letter that literally dripped with sarcasmand insults, Dexter’s Chairman and CEO, K. Grahame Walker, reject-ed Heyman’s offer, calling it “inadequate.”But Walker did not stop there. First, to buttress his case thatHeyman was not really serious about buying Dexter, Walker quot-ed a Merrill Lynch analyst who questioned Heyman’s true motiva-tion—as though a securities analyst had any insight into whatHeyman’s actual intentions then laid into Heyman for “opportunistically interven-ing” to frustrate Dexter’s objective of acquiring Life Technologies. Heaccused Heyman of “inviting himself” to a meeting with Dextermanagement and “disregarding the interests and welfare” of Dexter’sstockholders; an ironic charge when one considers how this situationultimately turned concluded his letter by suggesting to Heyman that “wefervently hope (and strongly recommend) that you return your man-agerial focus to your own companies, leaving the stewardship ofDexter . . . where it belongs.”
Y L F M AChap 10 7/9/01 8:55 AM Page 120 E T 120PART TWOIdentifying Takeover Targets In January 2000 we offered the following analysis of the situation: The stock market is reacting to this takeover bid with caution. As this1 is written Dexter is trading around $38⁄4, quite a discount from the $45 takeover price. This discount reflects apparent skepticism thatMr. Heyman and his group will be able to raise the financing for thisbid. I completely disagree with this skepticism . . . The insulting tone of Dexter’s letter to Heyman is only likely to take this battle to another level, and my view is that Dexter will ultimately be bought by ISP or a third party more to Dexter’s liking and that the ultimate takeover price will be at least $50/$55 a share. At this point Dexter and its genius investment bankers hadmade two miscalculations: First, by lowe ring the threshold of its“poison pill” to pointedly single out Heym an and prevent him fromincreasing his stake in Dexter, they had thrown down the gauntlet to the wrong guy, virtually guaranteeing a hostile bid. Then, by send- ing such a condescending letter in response to Heyman’s $45 takeover ®bid, they had very likely ticked him off again. Based on everythingTeam-Fly I knew about Heyman, it was very clear to me that this sort of arro-gant response—which was precisely the sort of response Heymanreceived from GAF back in the 1980s—would only serve to makeHeyman more determined to win this on January 20, Dexter made its other blunder by offeringto buy the remaining publicly traded shares of Life Technologies at$49 a share—a price $10 higher than it had previously paid the restof LTEK’s shareholders. Since Heyman and his group controlled vir-tually all of the remaining public float in Life Technologies, and sinceLTEK was trading around $44 when Dexter announced this $49 offer,the overwhelming interpretation on Wall Street was that Dexter wastrying to get Heyman to drop his bid by offering him a premiumprice on his LTEK is a perfect example of how a superstock investor whounderstood the history and motivations of Sam Heyman—and whostopped to think about how Heyman could benefit most from thissituation—could look at precisely the same set of circumstances aseveryone else on Wall Street and come to a diametrically opposed—and absolutely correct—conclusion. If Heyman accepted the Dexteroffer for his LTEK shares, the value of Heyman’s Dexter stock wouldundoubtedly drop further once the takeover threat evaporated.
Chap 10 7/9/01 8:55 AM Page 121CHAPTER TENCreate Your Own “Research Universe” of Takeover Candidates121And there was another, more compelling reason for Sam Heymanto reject the Dexter bid: From a public relations point of view, andpossibly from a legal and ethical point of view, the Dexter offer had atainted feel to it from the very beginning because to some veteranstock market observers the Dexter bid for Heyman’s Life Technologiesshares smelled an awful lot like “greenmail,” a term used to describeone of the most outlandish and fundamentally unfair practices thatemerged during the heyday of the so-called corporate raiders of themid-1980s. In those days, investors like T. Boone Pickens, the Bassbrothers, Saul Steinberg, and Rupert Murdoch would accumulate astake in a public company and then announce a hostile takeover target company would then essentially bribe the raider togo away by offering the raider—but not the public shareholders—apremium price for his or her shares, in exchange for a promise todrop the takeover bid and refrain from buying any more shares inthe target company for a specified period of time. Once the news ofa “greenmail” deal was announced, the stock of the target company—which had risen on word of the takeover bid—would plunge, leav-ing the public shareholders holding the bag. The raider, meanwhile,would pocket a huge profit and move on to the next was so fundamentally obnoxious and unfair that in1987 it was effectively outlawed when Congress decreed that therewould be a 100 percent tax on any profits achieved in this put an end to Dexter’s offer were actually a form of greenmail, and ifHeyman took the bait and dropped his bid for Dexter, that would bebad news for Dexter shareholders. But by knowing Heyman’s his-tory, remembering that he had more at stake in Dexter than in LTEK,and realizing that to Heyman this was not only a matter of princi-ple but also a financial question to be decided in a rational manner,a superstock investor would have come to the clear conclusion thatthe smart move was for Heyman to reject Dexter’s bid. Not onlycould Heyman make more money by plowing ahead with his bid forDexter, he would also avoid the negative firestorm of publicity andcriticism that would have inevitably been directed toward him hadhe chosen to accept the offer from January 27, 2000, Sam Heyman sent a letter to Dexter CEOGrahame Walker rejecting the $49 per share offer for Life Tech-nologies. In the letter, Heyman made it clear that he found the Life
Chap 10 7/9/01 8:55 AM Page 122122PART TWOIdentifying Takeover TargetsTechnologies offer inappropriate under the circumstances—which isprecisely the response one would have expected from a man likeHeyman in a situation like this.“It is apparent from the timing of Dexter’s offer for our LifeTechnologies shares coming on the heels of ISP’s $45 per share offerfor Dexter . . . that Dexter is seeking to divert ISPfrom a course ofaction designed to maximize shareholder values for all Dexter share-holders,” Heyman wrote. “In this connection, we believe thatDexter’s attempt to deter us by providing benefits to ISPnot avail-able to other shareholders is simply inappropriate.”Heyman also called the Dexter bid for Life Technologies in 1998“an attempted squeeze-out of LTEK’s minority shareholders,” whichonce and for all made Heyman’s motivation in this situation crystalclear: He was paying Dexter back, in spades, for what he perceivedas Dexter’s mistreatment of ISPin the Life Technologies tender the letter, Heyman also informed Dexter that ISPwouldlaunch a hostile proxy fight in which it would nominate a slate ofdirectors to Dexter’s board. He also told Dexter that Chase Securitieshad agreed to provide the funds for the acquisition, and he noted thatISP’s stake in Dexter amounted to “more than five times that held byDexter’s entire board,” a pointed reference to the question of whichslate of directors had the most incentive to act in the best interests ofthe concluded with this zinger:Grahame, I just do not think it would be productive at this time torespond to your mischaracterizations and attempts to impugn ourmotives—which by the way I do not appreciate. All the best, Samuel J. HeymanHeyman’s rejection of the Dexter bid for Life Technologiesresulted in a jump in Dexter shares back to the $38 to $39 area—a nicebounce, to be sure, but still far lower than the $45 takeover you get to the point at which a takeover bid has turnedinto a public mudslinging contest you can be certain of two things:(1) Neither side is going to capitulate and be perceived as the loserwithout putting up one heck of a fight, and (2) the target company willdo everything in its power to find another potential suitor to sell itselfto in order to avoid being bought by the hostile bidder. The rule ofthumb is simply this: The more venomous the dialogue in a hostile takeover
Chap 10 7/9/01 8:55 AM Page 123CHAPTER TENCreate Your Own “Research Universe” of Takeover Candidates123situation, the more likely that the target company will wind up being acquired,usually by a third if the target company started out by mak-ing statements that it was determined to remain independent, onceit becomes obvious that the hostile bidder is not going to be deterred,the target company is usually left with only one alternative: findanother bidder more to its liking willing to pay a higher price thanthe hostile once again that things change, on February 28, 2000,Dexter announced that it would open up its books and records toother third parties and that it had hired Lehman Brothers Holdingsto “explore a possible merger, sale or restructuring, or the spinoff orsale of a business unit.”9Dexter’s shares jumped $4⁄16, or 12 percent to $42—still wellbelow Sam Heyman’s lowball $45 takeover March 2000 I noted that Dexter stock could have been pur-chased at extremely low prices even in the face of mounting evi-dence that this company would be taken over by now, following Dexter’s announcement that it will entertainpotential takeover bids from other buyers, Dexter shares are tradingbelow ISP’s $45 per share lowball bid . . . lower than they should beunder the circumstances. By the time this soap opera plays itself out,I think Dexter shareholders will receive $55 a share or more for theirstock, and that one of three things will happen: (1) Mr. Heyman andISPwill raise their $45 offer significantly, (2) another bidder willemerge for Dexter with a substantially higher offer, or (3) Dexter willdecide to liquidate the company and pay out cash and/or stock toshareholders on a tax-free basis, thereby passing through the truevalue of Life Technologies and Dexter’s other assets to the March 23, 2000, ISPraised its takeover bid to $50 “based on ourevaluation to date” of Dexter’s books, and said it might raise the offereven further if its continuing evaluation warranted such a price continuing hostility between Dexter and ISPmade it quiteobvious that Dexter would move heaven and earth to avoid beingpurchased by Sam Heyman’s group. Dexter shares jumped to a high1of $56⁄4, then fell back to the low 50s again as the general stock mar-1ket slumped. At their highs of $56⁄4, Dexter shares were already up53 percent from my original recommended price—and the final actin this superstock drama was yet to unfold.
Chap 10 7/9/01 8:55 AM Page 124124PART TWOIdentifying Takeover TargetsFinally, on September 14, 2000, Dexter shareholders approvedthe sale of Dexter to Invitrogen. Under the terms of the takeover,Dexter shareholders were offered $ per Dexter opportunity came about from a 13-D filing in Barron’sinvolving Dexter. It came about because my business partner, CherrieMahon, sent me a research folder where I spotted the name of SamuelHeyman. This became the road map that clearly pointed to a takeoverbid from Samuel Heyman and ISP. This is a far different feeling thanholding on to declining stock with nothing more than a vague hopethat someday it will reverse course and go back up.
Chap 11 7/9/01 8:56 AM Page 125CHAPTER ELEVENHow to Use the Financial PressThere is a growing tendency for the media to downsize, categorize,analyze, and trivialize the news—a sorry trend that panders to thedesire of an American public, suffering from information overload,to have the news prefiltered, explained, and generally the media operates in this manner, almost everythingbecomes either black or white, and the various shades in betweentend to disappear. Not only that, when the media begins to think interms of giving us what we want, rather than simply acting as a con-duit for information, it is only a matter of time until our sources ofinformation become nothing more than a reflection of the consensusof majority opinion—a circular, reinforcing mechanism that virtual-ly guarantees that original thinkers will have an increasingly diffi-cult time accessing the sort of information that leads to unique financial media is becoming increasingly infected with thisinformation virus because it has learned that many investors—espe-cially those who have only recently become enamored with the stockmarket—would prefer to believe their research “homework” can beeasily done for them and the process of making money on Wall Streetis really not all that any journalist or stock market adviser who choosesto oversimplify the stock picking process will find a receptive audi-ence for this approach. After all, what could be easier than buyingthe high-profile “momentum” stocks you hear about day in and day125Copyright 2001 The McGraw-Hill Companies, Inc. Click Here for Terms of Use.
Chap 11 7/9/01 8:56 AM Page 126126PART TWOIdentifying Takeover Targetsout, based on the premise that today’s market leaders will be tomor-row’s market leaders as well? Besides, there is comfort in buyingthe stocks everybody else is buying and every analyst on Wall Streetis already recommending, even when they go down. Group com-miseration is always more comforting that suffering fact that Wall Street and the financial press has learned thatit pays to play to your audience is one reason why Fund Manager Awill appear on television and tell you his three favorite stocks areDell Computer, General Electric, and Microsoft, followed by FundManager B, who will inform you that her three favorite stocks areGeneral Electric, Intel, and Dell Computer. Then Fund Manager C,after exhaustive research, has decided that his three favorite stocksare Intel, General Motors, and Coca-Cola, although he may be chal-lenged by Fund Manager D, who will argue that her three favoritestocks are Coca-Cola, Dell Computer, and it comes to reporting and analyzing the news, financialtelevision reporters understand that there are a lot more viewerswho own Time Warner and Warner Lambert than some obscurewater utility that has just received a takeover bid. Therefore, theywill spend 10 minutes dissecting the latest rumor involving the pos-sibility that Time Warner might buy NBC or some nuance of a 30-dayold takeover battle involving Warner Lambert and Pfizer, while com-pletely neglecting the stunning and ongoing takeover wave in thewater utility industry that has been pushing sleepy, conservativewater stocks up by between 50 and 100 percent all year—an amaz-ing story, especially in terms of risk and reward—which was badlyunderreported throughout 1999 in large part because it would playto a small audience, and who needs that?The only way to counteract this tendency of the financial mediato narrow its focus to the widely held stocks and to oversimplifythings by playing to an audience that seems to prefer things thatway is to become a serious browser. But to do that, you cannot relyon just one financial news source because chances are you will notget all of the information you need in just one of the best sources to browse are Investor’s Business Daily,The Wall Street Journal, and The New York TimesBusiness Day section. Investor’s Business Daily (IBD), published by William O’Neil andCompany in Los Angeles, is a pioneer of financial journalism. In
Chap 11 7/9/01 8:56 AM Page 127CHAPTER ELEVENHow to Use the Financial Press127many important ways IBD is a unique and highly useful, sophisti-cated publication that has made giant inroads into areas where TheWall Street Journalhas stubbornly refused to tread, especially tech-nical, momentum, relative strength, and chart analysis. If you are looking to identify current market leaders or emerg-ing market leaders, stocks with unusual and possibly telltale vol-ume “spikes,” stocks that are about to break out on the charts orstocks that are performing well versus the general market, there isno substitute in the daily financial press for when it comes to actually reporting the financial news, IBDis sort of the USATodayof financial journalism. Everything is report-ed in sound bites. What’s worse, IBD has become a prime exampleof the “Big Brother” approach to financial journalism that is makingit increasingly difficult to find the sort of original ideas that we’relooking for as superstock browsers. Because of this, if you’re goingto be looking for off-the-beaten-path stock ideas, you will not be ableto rely solely on IBD for all the information you I said, IBD has taken it upon itself to become your “BigBrother” information filter, directing its readers toward the popu-lar, high-profile, relative strength “momentum” stocks, and steer-ing them firmly away—like a parent with an all-knowing guidinghand—from the lower-priced, thinly traded stocks that might getyou in trouble. IBD’s attitude is that the big winners come from acertain “gene pool” involving certain industries and stocks with cer-tain characteristics, and it does not want you wasting your timethinking about losers with low stock prices, low trading volume,and limited upside an incredibly bold move that stands as possibly the ultimateexample of Big Brother financial journalism, on October 19, 1998,IBD proudly announced that it was taking its stock tables “to thenext level”—IBD did not specify in what direction—by exiling low-priced, low-volume stocks to the financial netherworld. In a frontpage story written by IBD chairman and founder William O’Neil,IBD announced that these lower-priced and less active NYSE andNASDAQ stocks would be relegated to their own section in the backof the newspaper, away from the main stock tables, presumablywhere they might contaminate portfolios and impair the perfor-mance of unwary investors.
Chap 11 7/9/01 8:56 AM Page 128128PART TWOIdentifying Takeover TargetsWhen I first read this story, I thought of Michael Caine and SteveMartin in Dirty Rotten Scoundrels, and a scene in which Steve Martinpretends to be Michael Caine’s mentally unbalanced younger broth-er who must be housed in a basement dungeonlike bedroom underlock and key, away from the normal daily activities of the householdso that the staff and guests would not be offended or ’s Business Daily, these “Dirty Rotten Stocks,” whichare lower-priced and not very actively traded, are a danger to yourportfolio and financial well-being, so IBD has taken it upon itself tomake it just a bit more difficult for you to find them—sort of the waydrugstores put the girlie magazines on the top shelf, making it hard-er for impressionable and naive adolescents to get their grubby lit-tle hands on William O’Neil explained in his articles to IBD readers, “Withmore than 500 initial public offerings added a year, the tables getlonger and get harder to scan for future big winners.”Good Heavens! Too much information!Therefore: “To save you time, we will separate lower-pricedand less active NYSE and NASDAQ stocks from the main tables show NYSE and NASDAQ stocks priced at $7 or belowor trading less than an average of 10,000 shares a day.”Later in the article, Mr. O’Neil gets around to explaining the realreason for IBD’s decision to banish lower-priced and less-popularstocks to the financial dungeon. “Studies have shown that most stockspriced below $7 or trading less than 10,000 shares a day have lowerquality, less institutional ownership, or weaker recent usually carry greater risk or offer less long-term potential.”There are several problems with this logic that superstockinvestors should be aware of. For one thing, the term “lower quali-ty” is an awfully subjective term. For example, throughout 1999, thehigh-yielding, conservative water utility stocks were undergoing atakeover wave that made this group one of the top performers ofthe year. Several of them, as I noted before, rose between 50 and 100percent, or more, following takeover bids , and most of the rest of thewater utility stocks rose sharply in response to this takeover yet, if you had looked for water utility stocks likeConnecticut Water Service (CTWS) in the main NASDAQ stock list-ings carried in IBD, you wouldn’t have found it, because its tradingvolume fell below the respectability line, which makes this stock
Chap 11 7/9/01 8:56 AM Page 129CHAPTER ELEVENHow to Use the Financial Press129riskier and gives it less long-term potential, according to IBD. Norwould you have found a water utility like Middlesex Water (MSEX),another genuine takeover possibility, until the stock jumped over 50percent and began to trade big volume following a series of waterutility takeovers. Once Middlesex went up in price and became moreactive, it “graduated” to IBD’s more respectable neighborhood. Butwhen Middlesex was neglected and a much better value, it was stilllisted in the dungeon take a stock like Pittway (PRYA), a large and well-knownmanufacturer of alarms and other components used by manufac-turers of security and fire alarm systems. Pittway had just sold itspublishing business, turning itself into a “pure play” company oper-ating in an industry where takeovers were taking place (see Chapter14). For this reason Pittway was on my recommended list. The stocktraded at a respectable $31 a share. Yet, in November 1999, for the“crime” of having average daily trading volume of less than 10,000shares, Pittway had been exiled to the IBD “Dirty Rotten Stocks”list. Barely a month later, Pittway soared 16 points in one day to $45(+55 percent) following a takeover bid from Honeywell (see Figure11–1). Also in November 1999 the IBD dungeon list was pepperedwith numerous low-priced energy stocks. Their only “crime” wasthat they were trading below $7, not because they were low-quali-ty companies but only because energy was out of favor at themoment. But most of these stocks did well in 2000 when oil and gasstocks returned to favor. Anumber of low-priced health care stockswere also on the list just before this group returned to favor in IBD’s eyes, all of these stocks were of lesser quality than, say, (STMP), which was trading at $ in November 1999and had a market cap of $ billion with zero revenues. STMPwasright there on the “respectable” mainstream list, even though it wason the verge of making a stunningly swift trip down to $ a share,a decline of 97 percent. (PCLN) was on the “respect-able” list, too, before it dropped from $150 to $, along with count-less other Internet stocks with out-of-this-world valuations that ulti-mately crashed. Of course, you can prove anything with 20/20hindsight, but that is not my point. My point is this: If you are goingto use the methods of analysis outlined in this book you cannotrestrict yourself to publications that skew their reporting towardstocks and industries which are trendy at the moment, because much
Y L F M AChap 11 7/9/01 8:56 AM Page 130 E T 130PART TWOIdentifying Takeover Targets Figure 11–1 Sample of Investor’s Business Daily’sSection “Where the Big Money’s Flowing” ®Team-Fly Source: Investor s Business Daily, December 21, the information you will need to implement this approach willnot be easily accessible to you, and some of it may not be availableat since when does “less institutional ownership” translateinto the financial version of The Scarlet Letter? To a genuine super-stock sleuth, that is the whole point. Adearth of institutional own-ership is precisely the sort of characteristic in a neglected stock withlittle or no mainstream sponsorship that we look for. It is precisely thatcurrent lack of sponsorship that will translate into a sharply risingstock price later on, when the mutual funds and the mainstream WallStreet analysts finally catch on.
Chap 11 7/9/01 8:56 AM Page 131CHAPTER ELEVENHow to Use the Financial Press131The crime of “weaker recent performance” is also enough toget a stock sent to the IBD doghouse, which is more of the sameshort-term, lemminglike thinking we are trying to avoid believes that it is just encouraging you to think and act in amanner that is best for your long-range investment performancebecause everybody knows that the big-name, high-capitalization stocks,with high trading volume and extensive institutional sponsorship, arethe best way to outperform the stock market. The trouble is, it has notalways been that way (as we have already seen in Chapter 5), and if youare stubborn enough to believe that there is more than one way to skinthe proverbial stock market cat, you will need something more thanInvestor’s Business Dailyto get all of the information you problem with Investor’s Business Dailyis that, in itsongoing drive to categorize everything, the newspaper often allowssignificant news items to fall through the cracks. In contrast, IBD’s“To the Point” section, which appears on page 2 of the newspaper,is an excellent summary of the significant news stories of the previ-ous day. This section usually is a great source of merger and dealnews and it often points to new and interesting directions in theongoing search for takeover IBD could not leave well enough alone, apparently, andsomeone decided that it would be better to make this section moreefficient by categorizing all of the news items under such headingsas “Computers & Tech,” “Telecom,” “Internet,” “Medical,” and othersuch groupings—in other words, making certain that its readerswere seeing the news in a well-organized fashion in the most pop-ular and trendy industry groups of the problem with this approach is that when a very interestingitem pops up that does not fit in with the trendier industry groupsIBD is using on any particular day, it’s not available. In November1999, for example, E’town Corp., a NYSE-listed, New Jersey-basedwater utility, which we discussed earlier, agreed to be acquired byBritain’s Thames Water PLC. E’town soared over $10 a share on thisnews to just over $62, a 22 percent gain in one day. But the more sig-nificant part of this story was not E’town’s stock price jump. Rather,it was that the takeover bid for E’town was part of a continuing andastonishingly rapid trend toward takeovers of . water utilities,many of which were being acquired by foreign companies eager toestablish a major presence in the . water industry.
Chap 11 7/9/01 8:56 AM Page 132132PART TWOIdentifying Takeover TargetsThe takeover bid for E’town represented the fourth takeover in lessthan a year from a list of nine water utilities that I had recommendedto my subscribers, and it would not be an exaggeration to say that therapid takeover wave in sleepy, conservative water utility stocks at pre-miums of 50 to 100 percent, or more, of their recent trading prices—toonce again repeat this notable phenomenon—was probably the singlemost interesting takeover story of 1999, especially considering the excel-lent risk/reward ratio involved in these conservative, high-yieldingstocks and also in light of the limited universe of public water utilitystocks to begin with. To those who were tuned into this trend, for mostof 1999 it was literally like shooting fish in a preceding the takeover wave in the water utilitystocks, five of the nine stocks I recommended in my water utility“Water World” portfolio were listed in IBD’s second-class stock list-ings, presumably too risky and/or uninteresting for the averageinvestor to bother the time E’town received its takeover bid, the water utilitytakeover trend was in full force. Yet, the E’town takeover did notmanage to make it into the news section of Investor’s Business it did not fit the cookie-cutter mold of categories that IBD usedto present its news items on that particular day, or E’town’s marketcapitalization or industry group was too small and/or uninterestingto present to IBD’s readers, who were constantly being schooled inthe high-profile follow-the-leader momentum school of investing.(IBD has since abandoned its news “categorization” approach.)Compare this total lack of analysis in IBD to the way The WallStreet Journalreported the E’town story: The Journalpresented a com-plete background report not only on the E’town takeover, but alsoon its larger implications. Anyone reading this story who wasschooled in the superstock approach to reading the financial newswould immediately recognize the water utility industry to be a fer-tile hunting ground for takeover candidates, if they hadn’t alreadynoticed it months the efforts of Investor’s Business Dailyto portray itself asan alternative to the The Wall Street Journal, there is really no com-parison between the two—especially if you are on the lookout foroverlooked special situations and the background information thatwill allow you to read between the lines and make connectionsbetween seemingly unrelated news items that other observers arenot perceiving.
Chap 11 7/9/01 8:56 AM Page 133CHAPTER ELEVENHow to Use the Financial Press133The moral of all of this is that you should not depend on a sin-gle source for all of your business/financial you want to be certain of seeing as many news items as pos-sible that contain the sort of superstock Telltale Signs you will belooking for, you should browse through the page 2 “To the Point” sec-tion of Investor’s Business Dailyevery day, paying special attention tothe smaller, seemingly unimportant items. You should also scan thefront page of IBD, particularly the “IBD’s Top 10” section, whichcontains IBD’s version of the 10 most important business stories ofthe previous that will not be enough, and if you want to cover all thebases, you should also browse the “Company News” column in TheNew York TimesBusiness Day section. “Company News” generallyruns the entire length of a page on the left-hand side, and the columnfocuses on deals and transactions, such as mergers, spinoffs, assetsales, and other news items that would generally be of interest toyou as a superstock browsing through certain sections of certain publications likeInvestor’s Business Dailyand The New York Times, you will assure your-self of encountering important information. Some will be new to youand cause you to move in a new, analytical direction, and some willremind you of something you have seen before that you haven’t hadthe time to investigate or may have seemed an isolated event—untilanother seemingly isolated event or piece of information places theprevious item in a new and more meaningful Wall Street Journalis the financial “newspaper of record,” andit will be a rare occasion when a story of financial significance failsto rate a mention in The Journal. However, when it comes to the infor-mation we superstock investors are looking for, it may help to lookin the more out-of-the-way sections of The Journalto find it. Of course,the high-profile takeovers, spinoffs, asset sales, and so on, will oftenbe discussed on the front page of The Journalin the “Business &Finance” section of the “What’s News” column, which runs the entirelength of page one. The more intriguing information, which can point the way tosuperstock takeover targets long before they attract the attention ofmost investors, can be found inside The Journal, often at the bottomof the page, in a one- or two-paragraph “must read” section ofThe Wall Street Journalfor super-stock sleuths is the “Corporate Focus” column, which appears in Section
Chap 11 7/9/01 8:56 AM Page 134134PART TWOIdentifying Takeover TargetsB of that newspaper. This column often deals with mergers and acqui-sitions news, providing background and insights involving deals inthe news. You will often find interviews with CEOs in which they talkabout why they have decided to acquire a certain company, what sortsof acquisitions they may still be looking for, and whether they believetheir industry will continue to consolidate. You will also find this sortof material from time to time in The Journal’s “Industry Focus” column,which also appears in the B Section. You never know where you will find interesting and useful infor-mation. It often won’t be on the front page of The Journalbecause themore obscure the information, the more useful it will be to you sinceit’s less likely that the Wall Street “discounting” mechanism will havefactored the information into the prices of the stocks involved. (TheE’town takeover, for example, did not make the front page.)For example, our old friend, Pinault-Printemps-Redoute—acquirer of both Rexel Inc. and Brylane—made the news again inOctober 1999 by buying out the percent of French office supplycompany Guilbert . that PPR did not already could have learned two things from this story, whichappeared in the international section of The Wall Street Journal. First,PPR was still out there acquiring companies in which PPR alreadyowned a stake, so this article served as a reminder to keep an eye onPinault-Printemps—especially if PPR were to go into the open mar-ket to buy shares of another company in the future. But you would also have learned something else by browsingthrough this story: that PPR is the largest shareholder of Gucci GroupNV, the Italian company (NYSE: GUC) that designs and marketsluggage, handbags, shoes, watches, and other luxury PPR has a history of acquiring companies it already ownsa piece of, and since this article indicated that PPR was still makingacquisitions of partially owned companies, you would have notedPPR’s partial ownership of Gucci, if you did not already know it,and added Gucci to your “research universe” for further the other examples presented here, you would havenoted that Burns International Services terminated discussions witha potential acquirer, which you would have viewed as a signal thatBurns would be interested in selling itself at the right price. The factthat a company has entered into discussions for its sale tells youthat the company is receptive to the right buyer offering the right
Chap 11 7/9/01 8:56 AM Page 135CHAPTER ELEVENHow to Use the Financial Press135terms; the fact that Burns did not come to terms with a potentialbuyer was too bad for Burns shareholders over the short run, butwould have been an interesting thing to note and remember in thelonger run, especially since a number of security firms had beentaken over in you might have added Burns International Services to yourresearch universe, keeping an eye on the stock and watching forpotential Telltale Signs that a takeover of this company might be onthe horizon. And you would not have been shocked when in August2000, Burns stock soared 62 percent in one day following a takeoverbid from Sweden’s Securitas should have noticed that Abbott Labs (NYSE: ABT) hadenacted a “shareholder rights plan” designed to make a hostiletakeover more difficult at a time when takeovers of pharmaceuticalcompanies were proliferating. And although Abbott Labs stated, ascompanies always do, that it had not received any takeover over-tures and that it knew of no potential suitors lurking in the wings,you would also know that companies implement shareholder rightsplans for one reason and one reason only: They believe their stockis undervalued relative to its true value as a business, and they feelvulnerable to the possibility that an unwanted suitor might make abid at a premium to the current market price, which would still rep-resent a substantial discount to the company’s true would also have noticed that an outside shareholder of Dun& Bradstreet (NYSE: DNB) was trying to organize other sharehold-ers in an attempt to prod DNB management to sell the you would have noticed that Mead Corp. (NYSE:MEA),a company that operates in the consolidating forest products indus-try, had announced a 10 million share buyback, often a sign that acompany believes its stock is undervalued relative to its true worthas a business. These items, and many others like them, are the sort of thingsyou will be looking for and noticing as you train yourself to think likea superstock sleuth. The more you browse the financial pages, themore you will see and the more connections you’ll make to otheritems you have seen, until slowly but surely pieces of a previouslyunnoticed puzzle will begin to come together in your mind and a pic-ture will be formed—a picture that only you and others who thinkas you do will be able to see.
Chap 11 7/9/01 8:56 AM Page 136136PART TWOIdentifying Takeover TargetsOTHER PLACES TO FIND “TELLTALE SIGNS” OFFUTURE SUPERSTOCK TAKEOVER CANDIDATESI’ve noted some of the shortcomings of Investor’s Business Daily. But,IBD is a unique and innovative publication that provides a greatdeal of information you will not find in any other daily or weeklyfinancial , let’s look at some things that IBD does extremely well thatcan be useful to you as a superstock are three sections of IBD, in addition to the general newssummaries, that are often helpful in the ongoing search for superstocktakeover ProfilesInvestor’s Business Dailyregularly carries either a profile of a com-pany or an industry that can provide a wealth of information. Theseprofiles are helpful tools in the search for companies and/or indus-tries where consolidation (takeovers) is taking place. Very often youwill find that IBD is profiling a company that has been on the acqui-sition trail itself or that operates in an industry where takeovers aretaking place. Since we already know that IBD is partial to the larger,higher-profile companies, you will usually find that the companiesprofiled in this section are larger companies that have been buyingother companies rather than potential takeover targets. But that’sfine, because by reading the profiles of companies like this, you canoften get a feel for the reasoning behind the takeover trend in a cer-tain industry. Not only that: When IBD profiles a company that hasbeen acquiring other companies, you will often find a detailed expla-nation of the reasoning behind these takeovers, and on occasion theCEO of an acquiring company will offer a set of clues as to wherethat company might be looking for future takeover extremely useful aspect of the industry profiles sec-tion is a listing of companies that operate within the industry beingprofiled. Headlined “Who’s Who in the Group,” this list of compa-nies provides an excellent starting point for superstock sleuths whomay be seeking takeover candidates within that particular industry. This list of industry participants is also useful because IBD willoften note various takeover transactions that have recently takenplace within the industry. For example, on August 16, 1999, IBD’s
Chap 11 7/9/01 8:56 AM Page 137CHAPTER ELEVENHow to Use the Financial Press137industry profile was entitled: “Paper Products: Tighter Supplies,Consolidation Fuel Upswing in Long-Suffering Industry.” The storytalked about the recent trend toward takeovers in the industry andcontained a table of 25 companies operating within the paper andpaper products industry, including three notations on takeover trans-actions involving Kimberly Clark, Boise Cascade, and Pope & Talbot. When I encounter a story like this in IBD, my tendency is tofocus on the mid-size and smaller companies in the industry, basedon two premises. First, if a consolidation trend is taking place andthe larger companies in an industry are getting bigger and morecost-efficient, the mid-size to smaller companies in that industry arelikely to be more receptive to being acquired. Second, the smallercompanies in any given industry are less likely to be overfollowedand overanalyzed by Wall Street, which increases the probabilitythat there will be bargains among them relative to their course,Investor’s Business Daily, which focuses on relativestrength, earnings momentum, and other characteristics of stocksthat are already currently in vogue and in the forefront of the mar-ket, cannot simply list the industry participants from top to bottomin terms of size, based on revenues or market capitalization. Instead,IBD lists the companies from top or bottom in terms of stock per-formance and/or earnings growth. The stocks, says IBD, are “ranked(not ‘listed,’ mind you, but ‘ranked’—this is Big Brother we are talk-ing about, remember) by a combination of their earnings per shareand Relative Strength rankings.”So you will have to do a little reshuffling of the list if you wantto focus on the smaller companies in the that’s a small price to pay for a very useful presentation, andI have uncovered quite a few takeover targets by reading IBD’s indus-try profiles section on a regular basis.“Where the Big Money’s Flowing”Another useful section of Investor’s Business Dailyto look at on a reg-ular basis, which can contain clues that may direct you to futuresuperstock takeovers, is “Where the Big Money’s Flowing” (seeFigure 11–1). This table, which precedes the listings for the NYSE,American Stock Exchange, and NASDAQ listings, is designed to
Chap 11 7/9/01 8:56 AM Page 138138PART TWOIdentifying Takeover Targetshighlight stocks with significant increases in trading volume, bothon the upside and a superstock investor, you should read this section, focusingon stocks moving higher with significant volume increases, in searchof familiar names. When you see a stock that is part of your “researchuniverse” suddenly pop up on IBD’s list of upside volume alerts fora fundamental news-related reason, pay close attention. The basicpremise is that there is always somebody who knows more than youdo, and very often that person will take advantage of that knowledgeby buying the a stock has already exhibited one or more of the Telltale Signsof a potential superstock and suddenly begins showing up on IBD’slist of stocks with unusually high upside volume, this is often a signthat one of the Telltale Signs you have already noted is about to trans-late into a takeover bid or some other positive corporate developmentthat will boost the stock price. Characteristically, IBD tends to “filter” this information for youthat only stocks trading at $18 or higher ($16 or higher on NASDAQ)1and moving at least ⁄2point will be included in the table. (For theAmerican Stock Exchange, a stock must be trading $12 or higher and1move at least ⁄4point.) In addition, a stock must trade at least 60,000shares to pop up on IBD’s NYSE volume-alert table, and the stock’sEarnings Per Share and Relative Strength Ratings—both assigned byIBD—must exceed a certain number. To top it off, the earnings estimatefor a particular stock for the following year must be at least 17 percenthigher than the current year. The entire section, in other words, isdesigned to keep you focused on the strongest, trendiest stocks. Whatall of this means is that you will not necessarily see a previously under-performing “value” stock with stagnant earnings pop up on this vol-ume-alert section—even if the stock begins acting out of , these volume-alert tables are a valuable tool and youshould browse them on a regular basis for familiar names that youhave already noticed for other reasons. IBD deserves a lot of creditfor this innovative way of calling to your attention stocks that areshowing unusual volume and : IBD’s “Stocks in the News”Another area where Investor’s Business Dailyis head and shouldersabove The Wall Street Journalis in its presentation of stock charts.
Chap 11 7/9/01 8:56 AM Page 139CHAPTER ELEVENHow to Use the Financial Press139IBD correctly recognizes that technical analysis—including chartanalysis—is a valuable tool that can be used to your , the whole premise of technical analysis is that there willalways be somebody—usually many somebodies—with more infor-mation than you have, and this information will usually be put to useeither buying or selling the stock premise of technical analysis is that while you may notknow what the “insiders” know, you know what they do by ana-lyzing charts, volume, and other technical tools designed to spotsigns for stock accumulation (buying) or distribution (selling).You will learn more about chart analysis, including how to spotthe Telltale Signs of a “superstock breakout,” later in this book. Butfor now, you should know that if you are going to become a seriousbrowser, one of the places you should be browsing is the “Stocks inthe News” sections of Investor’s Business Daily. IBD has a “Stocks in the News” chart section for the NYSE,AMEX, and NASDAQ markets. It presents a series of stock chartsthat carry certain characteristics, including stocks that have justreached new price highs or have recently reached new highs, or stocksthat have had an extraordinarily large increase in volume. Thesecharts are designed to call your attention to stocks that are showingsigns of becoming market leaders, and as with “Where the BigMoney’s Flowing,” IBD provides valuable information in “Stocks inthe News.”And here’s another reason to pay particular attention to IBD’sstock charts: IBD tries to focus on stocks that are just emerging froma consolidation or basing formation, which, as you will soon see, is oneof the key characteristics of a superstock chart breakout. Any stockthat is up 15 percent or more from where IBD considers its breakoutlevel to be is omitted from the charts that are presented. What you areleft with is a group of stocks that are acting well relative to the market, show-ing signs of unusual volume, and are at—or not very far above—key break-out levels on the charts—a valuable combination of characteristics, for our pur-poses, which you can only find in Investor’s Business Daily. Again, just as in the IBD volume-alert tables, what you will be watch-ing for are stocks you have already noticed for other reasons which sud-denly exhibit the sort of characteristics that qualify them to be presented inthe IBD chart fact that a stock that has already caughtyour attention as a result of one of the Telltale Signs is now flashingone or more of the technical signals that it may be about to emerge
Y L F M AChap 11 7/9/01 8:56 AM Page 140 E T 140PART TWOIdentifying Takeover Targets as a market leader is often a tipoff that some good news, such as a takeover, is about to break. This can often be the final catalyst that prods you to take the plunge and buy the stock in question. E’town Corp., as an example, popped up in IBD’s NYSE “Stocks in the News” section just several weeks prior to its takeover bid from Thames Water PLC. So did SJW Corp. (SJW) in the months preced- ing the announcement that it might put itself up for sale. If you had been a superstock browser at the time, both of these water utilities would already have been very high on your radar screen. Barron’sFinancial Weekly One other financial publication you should browse on a regular basisis Barron’s. You will often find interviews w ith industry analysts whodiscuss industries where consolidation is taking place. Barron’s very often asks these analysts to zero in on some potential takeover tar- gets. You should use these interviews in the same way we are using ®most of the rest of the information discussed here: Look for familiarTeam-Fly names that have managed to achieve a spot on your “research uni-verse” for other reasons. Often, you will find background informa-tion that is new and reinforces a point of view you have held forsome time but for a different important section is Barron’slisting of selected Form13-D filings, which usually appears in the early pages of Barron’s“Market Week” section. Many, if not most, of the 13-D filings Barron’spresents involve mutual funds or pension funds or other institutionalinvestors that are not really a threat to take over a company and whichmay not even be interested in an “activist” role to urge a company tomaximize value. But a new name will occasionally pop up, or you maysee a transaction involving a familiar name that you may have over-looked for some reason. Browsing through this one-page section inBarron’seach week will prove worthwhile on many STUDY: THE TRIPLE PLAY AND MIDWAY GAMESOne of the strongest clues that the stock market is severely under-valuing a stock is a combination of outside beneficial owner buyingand insider buying on the part of a company’s officers or directors.
Chap 11 7/9/01 8:56 AM Page 141CHAPTER ELEVENHow to Use the Financial Press141The reason is that any major outside shareholder with a stake of 10percent or more would probably be aware of information or devel-opments that would give the beneficial owner a better idea of a com-pany’s true value than most outsiders. And it goes without sayingthat a company’s own management would know better than anyonewhat the underlying fundamentals of a company look like and whatits future prospects might you see a situation where the outside beneficial owner anda company’s officers and directors are consistently buying stock onthe open market, this is the “double play”—a bullish signal thatshould not be ignored. When you also have the company itself buy-ing back stock, this is the rare “triple play”—one of the closest thingsyou will get to “a sure thing” on Wall example of a “triple play,” which turned out to be very prof-itable for those who noticed it, was the dramatic turnaround inMidway Games (MWY) that took place in 1999. Midway Games beganits corporate life in late 1996 as a spinoff from WMS Industries. Aman-ufacturer of arcade and home video games, Midway was perceived byWall Street to have excellent growth prospects, and for most of 1997and into early 1998 the stock traded between $20 and $27 a in 1996, however, analysts began to see signs of an earn-ings slowdown. Midway’s business model was to introduce newgames into the coin-operated arcade market, where the games devel-oped consumer awareness, and then to release the games into thehome video market. But a delay in introducing certain company-developed games and a shortage of third-party titles available for sell-ing into the home video market created a series of worse-than-expect-ed earnings reports in 1998. Midway’s stock collapsed as Wall Streetanalysts began pulling their buy recommendations. As you can see in Figure 11–2, Wall Street does not show anymercy when a “growth” stock stops growing. Midway shares plum-5meted from near $25 in the spring of 1998 to a low of $7⁄8by early1999. Virtually all the analysts who had been strongly recommend-ing Midway throughout 1997 and into early 1998 stopped recom-mending the stock as the company reported one earnings disap-pointment after another. By the time Midway shares had plunged intothe $7 to $8 range, the company’s support among the mainstreamWall Street analysts had evaporated. Aformer Wall Street darling inthe high $20s, Midway was totally unloved at $8 by January 1999.
Chap 11 7/9/01 8:56 AM Page 142142PART TWOIdentifying Takeover TargetsFigure 11–2Midway Games (MWY), 1997–1999Source:Courtesy of Mansfield Chart Service, Jersey City, , not exactly totally. Because as one Wall Street analyst afteranother threw Midway overboard, and the institutional investorswho follow their advice dumped Midway shares, two people whoknew this company better than anyone else were buying huge blocksof Midway stock on the open market: Sumner Redstone, chairmanof Viacom, and Midway’s own chairman and CEO, Neil of Midway’s conference calls with Wall Street analystsfrom 1998 to 1999 were real eye-openers for me. In particular, I couldsense the frustration in the voice of Midway chairman Neil Nicastroas he attempted to explain that Midway’s earnings setbacks weretemporary and that the analysts who followed the company shouldbe looking beyond the current shortage of product to a much strongerproduct lineup that would lead to a strong earnings analysts did not want to hear it. They wanted to know whatwould happen in the next quarter, which Nicastro had already
Chap 11 7/9/01 8:56 AM Page 143CHAPTER ELEVENHow to Use the Financial Press143explained would also be weak because the backlog of product thecompany had been developing would not appear for another 6 to 9months. Midway was operating on a June fiscal year, and by late1998 and early 1999 it was already apparent that the fiscal year endedJune 1999 would not be a good one for the company. From the con-ference calls, it was obvious that Midway had pretty much conced-ed that fiscal year 1999 was going to be a big disappointment and thatthere was nothing much to be done about it. It also seemed thatMidway was getting all of the bad news out and was stockpilingsome new products to make as positive an impact as possible whenfiscal 2000 began on July 1, the analysts insisted on talking about what was happen-ing now and what had gone wrong in the latest quarter, and who wasto blame for Nicastro and the Wall Street analysts who followed Mid-way Games were not communicating at all because they were talk-ing about two different things. Nicastro was talking about business,while the analysts were talking abut the short-term momentum (or lackthereof) of a number that appears in The Wall Street Journalevery day:Midway’s stock price. Meanwhile, something very interesting was appearing in VickersWeekly Insider Report, which clearly suggested that Midway share-holders would soon be experiencing better first clue that Wall Street might have been overreacting toMidway’s short-term speed bump appeared in the June 10, 1998,issue of Vickers Weekly Insider Report. Midway shares had alreadyplunged from over $25 to below $15 when four Midway insiderswent into the open market to purchase a total of 115,500 shares at17prices ranging from $13⁄4to $13⁄ purchase that really stood outwas a 100,000-share buy on the part of Midway chairman Nicastro1at $13⁄4, on May 21, insider purchases, combined with an announcement that Midwayitself would buy back 1 million shares of its own stock, strongly suggestedthat Midway’s stock price decline was far out of proportion to the short-term earnings problems the company was a compa-ny announces a stock buyback, it can be misleading. Though theBoard of Directors has “authorized” a buyback “up to 1 millionshares,” it does not necessarily mean the company will actually buythe shares. In most cases the authorization will say that the timing
Chap 11 7/9/01 8:56 AM Page 144144PART TWOIdentifying Takeover Targetsand/or implementation of the buyback will “depend on the stockprice or market conditions,” which gives the company wide latitudein deciding when to buy stock or even whether it will buy stock at all. Immediately following the 1987 stock market crash, a wide rangeof companies announced authorization for stock buybacks that nevertook place. In many cases, these announcements were made to cre-ate the appearance of support for the stock or to get the messageacross that the companies themselves believed their stocks wereundervalued. When the market bounced back and it was laterrevealed that many of the announced buybacks never occurred, manycompanies said it was because their stock prices had recovered sharplyfrom the prices which the buybacks authorized. This was a plausibleexplanation, of course, but the large number of buybacks announcedin 1987 created a lingering skepticism among investors and analystsover the meaning of company “authorizations” to buy back , when a company stock buyback is coupled with thenews that officers and directors are going into the open market to buysignificant amounts of stock with their own money, this a far moremeaningful set of circumstances. It’s easy for the CEO of a compa-ny to use company money to support the stock price, especially if theCEO owns a large number of shares personally, even if the CEO har-bors a suspicion that the stock market’s negative view on his stockmight actually be accurate. But when company officials are in themarket buying shares with their own personal funds at the sametime the company itself is buying back stock, the company buybackannouncement should be taken far more seriously, and it has beenmy experience that this is usually an accurate indication of an under-valued , by the summer of 1998 there was evidence of two-thirds ofa “triple play” in Midway Games: The company itself and several ofits insiders were buying stocks in the $13 area in the face of disap-pointing earnings. And yet, Midway stock was destined to fall sig-nificantly below that level, providing an amazingly lucrative buyingopportunity for superstock browsers who were on the lookout for therare “triple play!” Afew weeks later, Midway insiders purchased77500 shares at $13⁄16, another bullish mid-1998, Midway had dropped below $10, and the Sep-tember 16, 1998, issue of Vickers Weekly Insider Reportnoted moreinsider buying. Once again Midway chairman Neil Nicastro had
Chap 11 7/9/01 8:56 AM Page 145CHAPTER ELEVENHow to Use the Financial Press145purchased a large block of stock, this time buying 20,000 shares on37August 31, 1998, at $9⁄4to $9⁄8. Also, on August 31, Midway’s VP7Byron Cook purchased 5000 shares at $10⁄ was in September that the last piece of the“triple play” mate-rialized: Sumner Redstone and his holding company, NationalAmusements, went into the open market and began adding to theirstake in Midway by purchasing large blocks of stock. Redstone1bought 107,800 shares at $10⁄2. Then, during the second half of1October, Redstone bought a huge block of 573,200 shares at $9⁄4to5$12⁄8. So now, Midway itself, several Midway insiders, and an out-side beneficial owner were all buying Midway shares on the openmarket, following a stock price decline touched off by what Midwaywas openly calling a short-term earnings the open market buying did not stop there: Nicastro pur-chased another 25,000 shares, bringing his total purchases to 169,000shares. And in late November, Sumner Redstone bought another 140,000shares, followed by an additional purchase in early December of 119,800shares. This brought Redstone’s total purchases since September 1998 to940,800 shares, a nearly $10 million commitment to Midway stock, which isquite a vote of confidence, even for a man of Sumner Redstone’s ’s important to take a step back at this point and examine thethought process that went into my strong recommendation ofMidway as the stock fell below $10 late in , the only reason I was following this stock was because 24percent was owned by Sumner Redstone, an astute businessmanwho has made a career out of acquiring other companies. ThatMidway was partially owned by an outside beneficial owner wasthe catalyst that caused me to focus on it. Then, the fact that Midwayhad an outside beneficial owner andthere was heavy insider buyingin the stock were the reasons to not bail out along with everyoneelse on Wall Street. Instead, I became moreaggressive with the stockas it fell, because these purchases by Redstone, Midway insiders,and Midway itself had provided a road map, or a benchmark ofvalue, which can be totally lacking in other stocks that have to carrysome of the Telltale Signs of a potential is a classic case of Wall Street focusing on momentum,while Redstone, Midway chairman Nicastro, and other insiders—as well as the company itself—were focusing on Midway’s longer-term value as a business. The “value” assigned to Midway by the
Chap 11 7/9/01 8:56 AM Page 146146PART TWOIdentifying Takeover TargetsWall Street momentum crowd and the analysts who pander to them,compared to the “value” assigned to Midway by Redstone and itsown management team, were as different as night and day, provid-ing that value, like beauty, is in the eye of the continue with the clues that made Midway a superstock, inJanuary 1999, Midway chairman Nicastro bought an additional303,950 shares at $8 and Sumner Redstone bought another 80,0001shares between $8⁄2and $10. In February, however, Midway shares5took another plunge, falling to the $7⁄8to $8 a Midway conference call reported in March 1999, Nicastroindicated that earnings and revenues for the next two quarters wouldbe lower than expected. But Nicastro and other Midway spoke-persons attempted to call analysts’ attention to what they believedwould happen in the second half of 1999, which would be the first6 months of Midway’s fiscal year 2000. In particular, Nicastro triedto direct the analysts’ attention to a strong product lineup as theChristmas 1999 selling season approached, and as I listened I knewexactly what Nicastro was trying to say: If you’re smart, you willforget about the next two quarters and focus on the last two quar-ters of calendar 1999, because they are going to be a company has growing earnings, Wall Street will rec-ommend the stock at almost any price. But when earnings are slip-ping or stagnant, it seems that Wall Street is not interested at any creates a large gap between a stock price and the true long-termvalue of a business, an environment that creates takeover bids atlarge premiums. In order to participate in this profit potential, how-ever, you must be able to think like a Wall Street insider. In otherwords, you must be able to buy a stock nobody else is interested inat the moment, and you must be prepared to take a longer-term viewof perhaps 12 to 18 months. If you can do these things, neglectedstocks flashing Telltale Signs should interest May 1999 my business partner and research associate, CherrieMahon, conducted a most remarkably informative interview withNeil Nicastro in which he explained, in detail and in a refreshinglystraightforward manner, why he had been buying so much Midwaystock on the open market. That type of interview can serve as a blue-print in illustrating the difference between how a corporate execu-tive views his or her company and how Wall Street analysts viewthat very same company.
Chap 11 7/9/01 8:56 AM Page 147CHAPTER ELEVENHow to Use the Financial Press147The $64,000 question, or in this case, the $5 million question,was why had Nicastro spent roughly that amount of his own moneypurchasing 461,450 shares of Midway stock over the preceding 12months? The Midway chairman said: “I believe that at some point themarket will value our business much differently than it values it today. Ijust don’t think Wall Street is properly anticipating the opportunity for asubstantial earnings rebound. That is the great opportunity I see, and thatis why I bought the stock.”You may have noticed that Neil Nicastro used the phrase “valueour business.” Too often, Wall Street treats a stock as nothing morethan a piece of paper. Terry Rudd, author of the book 1929 Again,makes reference to stocks being treated by Wall Street as nothingmore than pieces of playground equipment, with so-called profes-sional investors rushing around from one piece of equipment toanother as they quickly became bored with one and frantically lookedfor something else to amuse themselves. That is about as good adescription of “momentum investing” as I have ever seen. The prob-lem with this approach is that it does not take into account that thesepieces of paper we call “stocks” represent shares in a business, andbusiness is not always a one-way street. Even a true “momentum”business, a true “growth” company, can hit an occasional potholeor speed bump. To a company’s management, this is just how busi-ness can be sometimes; to Wall Street, it is interpreted as the end ofthe world, and the stock involved is treated as though it were infect-ed with some exotic virus to be ditched immediately lest it contam-inate the year-end portfolio statement institutional investors sendto their Cherrie Mahon asked Neil Nicastro, “Why are you buy-ing so much stock?” Nicastro said, in effect, because Midway’s prof-its were going to go back up and Wall Street would be nuts to placesuch a low valuation on this Nicastro’s comments and the outlook for Midway stock,analysts were not focusing on what was ahead. They were moreinterested in their rearview mirrors. They were turning their backson Midway just when they should have been issuing buy recom-mendations in anticipation of an earnings rebound. The story of Midway Games not only provides an example of therare “triple play,” in which an outside beneficial owner, companyinsiders, and the company itself are all buying stock at the same time.
Chap 11 7/9/01 8:56 AM Page 148148PART TWOIdentifying Takeover TargetsIt also shows a rare behind-the-scenes glimpse at how company insid-ers beat the professional WallStreet analysts and investors at theirown game by simply taking a step back to take a longer-term pointof view. In fact, “longer-term” in this case only meant 6 to 12 months—but to the Wall Street “momentum” crowd, that is an eternity. And thatis where the buying opportunities arise for those who are willing totake a step back and use a little ultimate outcome of this little drama: Midway’s earningsrebounded strongly in the second half of 1999, just as Neil Nicastrosaid they would. The rebound resulted from a surge of new productreleased into the home video market, just as Nicastro said it transpired just as he suggested in early 1999—in thatsame conference call that led to a rash of analyst sell recommenda-tions virtually at the bottom of Midway’s stock November 1999, Midway had reached $24⁄8as earningssoared to record levels, and the same Wall Street analysts who hadbeen issuing sell recommendations at the bottom reinstated theirbuy recommendations—at triple the price from Midway’s lows inJanuary or February the next time you see a “triple play” think of the MidwayGames story. No matter how dismal the news may seem on the sur-face, if an outside beneficial owner, company insiders, and the com-pany itself are all buying stock on the open market, it’s almost alwaysa signal that you have a potential superstock on your hands and thatthe news is about to get better. Alotbetter.
Chap 12 7/9/01 8:56 AM Page 149CHAPTER TWELVEFamily FeudsHere’s another lesson to be learned from the ADT-Western Re-sources takeover saga we examined in Chapter 9: When animositydevelops between a company and its major outside shareholder, the eventualresult is often a takeover the case of ADT–Western Resources, thediscord that developed between these two companies made itextremely unlikely that Western Resources would simply sit silent-ly on the sidelines as a passive outside two more like-ly scenarios: ADT would either attempt to sell itself to a third party(which it did) or Western Resources would attempt to buy ADT andremove its directors and top management (which it tried to do).Therefore, a useful rule of thumb is that you should pay close atten-tion when disagreements arise between a company and an outside “bene-ficial owner,” especially when these disagreements break out into a the following case study as another STUDY: COPLEY PHARMACEUTICALS On July 27, 1998, two directors of Copley Pharmaceuticals (CPLY), ageneric drug manufacturer, resigned. They did not go quietly. One ofthe directors, Agnes Varis, publicly blasted Hoechst AG, a hugeGerman chemical and pharmaceuticals company that owned 51 per-cent of Copley. According to Varis, Hoechst had disrupted Copley’soperations by continuously changing its mind about what it wantedto do with its Copley stake. Hoechst, said Ms. Varis, “was demoralizing149Copyright 2001 The McGraw-Hill Companies, Inc. Click Here for Terms of Use.
Y L F M AChap 12 7/9/01 8:56 AM Page 150 E T 150PART TWOIdentifying Takeover Targets management and depressing shareholder value.” She complained that Hoechst “forced Copley to hire investment bankers and spend millions of dollars in fees and time of key Copley personnel who could have been developing new products and expanding Copley’s busi- ness.” She claimed that after forcing Copley to go through the process of hiring an investment banker, Hoechst decided it did not want to sell its stake after all. In a parting shot Varis added: “I’ll serve Copley’s shareholders better from outside the company. You can’t do anything inside.” Agnes Varis’s stinging public criticism of Hoechst AG was high- ly unusual. From time to time you will see private disagreements between officers or directors of a company and a major sharehold-er. Usually, these disagreements come in th e form of structured let-ters, written by attorneys, that are “leaked ,” filed with the SEC as a13-D amendment, or simply released to the press. In most cases thesedisagreements arise between mutual fund companies or pension funds that hold sizable stakes in a company and that, for one reason ®or another, are unhappy about the direction the company has -Fly Investment companies in particular have been taking a moreactive role in recent years to get corporate managements to takeactions that will increase the stock price. It’s not unusual for an insti-tutional investor to take a stake in a company, sit with it for a while,and then fire off a letter to management suggesting the companytake steps to “enhance shareholder value” or “maximize shareholdervalue.” Sometimes, the institutional investor will release the letter tothe press, perhaps do a round of television interviews, and feignoutrage over the manner in which the company has been managedor reality, in most cases the institutional investor is trying tolight a fire under a losing position—., trying to bail out of a mis-take by bullying the management into taking short-term actions thatcould boost the stock a while these public relations tactics seemed to work, butin recent years corporate management has learned that the best wayto deal with institutional saber rattling is to simply ignore like mutual funds or pension funds are, for the mostpart, not equipped to get down into the trenches and force the man-agement of a company to put itself up for sale to maximize value. Aninstitutional that owns, say, 5 to 10 percent of a company would be
Chap 12 7/9/01 8:56 AM Page 151CHAPTER TWELVEFamily Feuds151more likely to send up a few threatening flares, see what happens,and then quietly liquidate its position on any runup in the stock asa result of the , don’t take it too seriously when a mutual fund or a pensionfund sends a letter to a company criticizing management anddemanding that steps be taken to “enhance shareholder value.” Anymanagement that has been paying attention to recent trends shouldrespond with a polite letter thanking the institution for its thoughts,and then go back to running the business. This sort of publicity gam-bit usually won’t lead to a takeover situation at Copley Pharmaceuticals, as you will see, wasquite different. The background of the Copley Pharmaceuticals-Hoechst AG situation following Agnes Varis’s public blasting ofHoechst indicated that the bitterness between Copley and its largestshareholder would probably lead to one of two outcomes: Hoechstwould bid for the 49 percent of Copley it did not already own andthrow out Copley management, or Copley would find a third partyto buy the Hoechst stake and then acquire the rest of the company,which would effectively result in Copley throwing out its 51 per-cent Pharmaceuticals had gone public in October 1992 at$ per share, adjusted for a subsequent 3-for-2 split. Copley stockwent straight up, and in the fall of 1993 Hoechst AG arrived on thescene, offering to pay $55 per share for a 51 percent stake in Copley,proving that even a gigantic international pharmaceuticals compa-ny can act like a lemming under the right circumstances. It turnedout that Hoechst had made its move right at the peak, and Copleyshares began a long, downhill slide that took the stock down to the$5 to $6 area by early drop in Copley’s stock price was helped along by the recallof one of its products due to contamination problems, and by shrink-ing profit margins and brutal price competition in the generic drugbusiness. On the way down, Agnes Varis purchased additionalCopley shares in the low $30s, proving that even corporate insiderscan misjudge a company’s prospects and the future direction of itsstock September 1996, Hoechst publicly stated that Copley did notfit its “core” business strategy, and forced Copley to hire an invest-ment banker to look into the possible sale of the company. This move,
Chap 12 7/9/01 8:56 AM Page 152152PART TWOIdentifying Takeover Targetsaccording to Varis, severely disrupted Copley, its management, andits employees. Nothing came of these efforts, and Copley shares lan-guished in the $5 to $6 area until Varis left the company and issuedher public criticism of August 1998 we noted that a “standstill agreement,” whichprevented Hoechst from buying additional Copley shares, wouldexpire in October is a standstill agreement?Sometimes, when one company buys a sizable stake in anoth-er company, the purchase is subject to certain conditions. One of theconditions may be a limitation on any future purchases of stock fora specified period of time. Generally, these agreements will say thatCompany Acannot increase its stake in Company B beyond a certainpercentage without expressed permission from Company B. That’sa standstill a big chunk of one company is owned by another,you should check the terms of the standstill agreement to see whatthe terms are and, most important, when the standstill agreementexpires. You can find this information in a company’s 10-K report,which is the annual report filed with the SEC. When the relation-ship between a company and an outside beneficial owner is turn-ing testy and the standstill agreement is set to expire soon, it indicatesthat a takeover situation may be about to a result of this research, Copley was recommended in thenewsletter as an “additional idea.” In September 1998, Copley Pharmaceuticals was added to thesuperstock recommended list. The stock price for Copley at the time3was $8⁄4. The news that Hoechst AG had decided to undergo a cor-porate restructuring was significant. In a situation like this, where ageneral corporate “housecleaning,” such as Hoechst was about toundergo, would take place, a decision was likely to be made aboutHoechst’s 51 percent stake in Copley. Now, all of the pieces were in place for a takeover drama relationship, even personal relationships, start out withhigh hopes. But when the relationship sours and both parties beginto get on each other’s nerves, it is only a matter of time before a sep-aration has to take place.
Chap 12 7/9/01 8:56 AM Page 153CHAPTER TWELVEFamily Feuds153When the relationship is personal, it may be a relatively easymatter to dissolve it. But in the corporate world things get a bit morecomplicated. The next time you see a story inThe Wall Street Journalsimilar to this one, where a corporate insider resigns in a huff andcriticizes management, the Board of Directors, or a major sharehold-er, and starts to talk about enhancing shareholder value or doingwhat’s best for the shareholders, you have encountered a Telltale Signof new paradigm thinking. In situations like this the usual outcomeis that someone, somewhere, will make a bid for the company inquestion because that is usually the only way to settle disputes wheretwo parties that are inextricably linked no longer see seemed clear to me that Hoechst or some third party wouldhave to make a bid for Copley. Unfortunately—or perhaps fortu-nately, depending on how you look at it—it wasn’t clear to anybodyelse. Copley shares sank as low as $6 by October 1998, providingnew paradigm thinkers, who were focused on the takeover possi-bilities by recognizing one of the Telltale Signs, an ideal opportuni-ty to buy more Copley shares at what would turn out to be bargain-basement prices. Late in 1998, I appeared on CNBC and predictedthat Copley would become a takeover target. The stock ran up briefly,then sagged back and traded listlessly in the $8 to $10 December 1998, with Copley trading at $8⁄16, there wererumors that Hoechst AG was about to merge with France’s Rhone-Poulenc SA. The rumors, if true, would create the world’s second-largest pharmaceuticals company. Remember, Hoechst had an-nounced a planned “restructuring,” and in fact Hoechst had alreadysold several of its noncore operations, including its paints is how we analyzed this rumor of a potential Hoechst–Rhone-Poulenc linkup in terms of Copley:As Hoechst is reinventing itself and moving to focus on pharmaceu-ticals while divesting itself of unwanted operations, Copley Pharm-aceuticals could become an issue to deal with. I would not be sur-prised to see Hoechst either bid for the rest of Copley and assimilatethe company completely, or sell its 51 percent stake in Copley to athird party who might bid for the rest of the company. Given Copley’sbook value of $ per share, any time this stock drops down to the$6 to $7 area I would rate it as a strong buy. I think Copley has a goodrisk/reward ratio anywhere in the $6 to $9 range.
Chap 12 7/9/01 8:56 AM Page 154154PART TWOIdentifying Takeover Targets11In February 1999, with Copley trading at $9⁄16, Hoechst hadbeen selling off some of its smaller, noncore operations and we indi-cated that “the idea that Hoechst may simply sell its Copley stake tosomeone else has actually gained the upper hand over the past fewweeks, as Hoechst has been selling off one small operation afteranother. Copley could be part of this trend.”And then we added: “The difficult matter in analyzing Copleyis determining what this company might be worth. If you find thathard to believe, remember that Hoechst paid $55 per share for itsoriginal Copley stake!”As things turned out, that last statement was significant. It’s usually a lot easier to figure out that a takeover bid is com-ing than it is to determine the price at which the takeover bid will takeplace. In most cases, you will see a takeover bid take place at a pre-mium—sometimes a significant premium—to a stock’s 52-week nearly all cases, a takeover bid will a carry a premium to a stock’saverage trading price over the past 30 or 60 days. Only in rare cases,where word of a takeover bid has leaked and a stock has had a dra-matic price advance, will you see a takeover bid at virtually no pre-mium to the previous day’s closing price. And once in a blue moon,when word of a takeover has leaked so badly that the target com-pany’s stock has really soared, you will witness what is called a take-under—a situation where the takeover price is actuallylowerthanthe previous day’s closing price because advance word of the dealwas so widespread that speculators got carried away and simplybid the price of the target company too the case of Copley Pharmaceuticals, we had a buy limit of1$11⁄2on our recommendation. However, based on some apparentimprovement in Copley’s earnings, and influenced by the fact thatHoechst had paid an incredible $55 per share for its original stake,it seemed that raising the buy limit on Copley to $13 would be asound that point, Copley was trading near $10⁄4. By April 1999,3Copley had crossed $11⁄4. For the next several months, Copley trad-31ed quietly between $8⁄4and $10⁄2. Then in June 1999, a news item15was the clincher. Copley was trading at $9⁄16when Hoechstannounced that it would spin off its Copley stake as part of CelaneseAG, a Hoechst operation containing most of Hoechst’s chemical and
Chap 12 7/9/01 8:56 AM Page 155CHAPTER TWELVEFamily Feuds155industrial businesses. This was a curious move, since Copley didnot fit the Celanese business model at all. This spinoff made it crys-tal clear that Hoechst would be willing to part with Copley at theright price. This move, which angered Copley shareholders, made iteven more likely that some of Copley’s other major shareholderswould try to take Copley private or sell it to a third the next 2 months Copley traded quietly between roughly11$8⁄2and $10⁄2. Then, on August 10, 1999, Copley jumped 21 percentin one day, following news that Teva Pharmaceuticals of Israel hadagreed to buy Copley for $11 per share in cash. As part of the deal,Hoechst AG also agreed to sell its 51 percent stake in Copley to Tevafor $11 per share. 3Anyone who had bought Copley at $8⁄4would have made aprofit of 25 percent, based on this $11 takeover bid, in 10 who had followed the growing body of evidence that atakeover bid for Copley was brewing and had taken advantage ofdips in Copley’s stock price to the $6 to $7 level would have donemuch better in percentage terms. And, to be perfectly fair and honest about this, anyone whopaid $10 to $11 for Copley would have just about broken even as aresult of the takeover repeat, the toughest part of uncovering takeover targets is notfinding the targets themselves. The toughest part, especially whenwe are dealing with smaller companies, is trying to determine whatthe ultimate value of the takeover bid might be. When a certain industry is consolidating and a number oftakeovers have already taken place, it is often possible to establisha benchmark value that will give you a general idea of what a com-pany would be worth in a takeover situation. In other industries,however, pegging a value is more the end, Copley proved solidly profitable, although less prof-itable than the most important lesson to be learned from the CopleyPharmaceuticals saga is that the original analysis, based on theorig-inal evidence, proved to be accurate. The next time you see a public disagreement erupt between acompany and its largest shareholder—especially if that sharehold-er is another corporation, and not an investment company—you
Chap 12 7/9/01 8:56 AM Page 156156PART TWOIdentifying Takeover Targetsshould think in terms of a potential takeover bid. The next time yousee a public disagreement between a director and a company’s man-agement—especially if the director resigns and makes statementsabout protecting shareholder interests or enhancing shareholdervalue—you should think in terms of a potential takeover bid. In the world of the stock market, a family feud is often the firstsign that a company is going to wind up being acquired.
Chap 13 7/9/01 8:58 AM Page 157PART THREETakeover CluesCopyright 2001 The McGraw-Hill Companies, Inc. Click Here for Terms of Use.
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Chap 13 7/9/01 8:58 AM Page 159CHAPTER THIRTEEN“Beneficial Owner” BuyingCASE STUDY: SUMNER REDSTONE AND WMS INDUSTRIESKnowing how to read a stock chart can be a valuable tool in select-ing potential superstocks. Astock that is breaking out above a well-defined multiyear resistance level is usually telling you something,., that something bullish is going on. Here’s how chart analysisled to a recommendation of WMS Industries. In spring 1989, the chart in Figure 13–1 caught my indicated that WMS Industries manufactured pinball andvideo games and owned two hotel/casinos in Puerto Rico. Here wasa stock with a terrific long-term chart that was acting like it wasabout to attempt a superstock chart April 1989, WMS was trading at $7⁄8, and the chart indicat-ed a very well-defined resistance area near $8, which had turnedback several rally attempts since 1986. The chart also shows a seriesof rising bottoms in WMS in late 1988 and early 1989, which indicatedthat buying pressure was coming in at progressively higher can often be a signal that a stock is about to make a seriousattempt at a major breakout—a superstock breakout browsing through a chart book looking for this sort of super-stock breakout pattern, an investor might well have noticed WMSand decided to do some further research into this 2001 The McGraw-Hill Companies, Inc. Click Here for Terms of Use.
Y L F M AChap 13 7/9/01 8:58 AM Page 160 E T 160PART THREETakeover Clues Figure 13–1 WMS Industries (WMS), 1987–1989 ®Team-Fly Source:Courtesy of Mansfield Chart Service, Jersey City, first thing I noticed about WMS Industries once I began toresearch the company was that WMS had an outside beneficialowner: Sumner Redstone, chairman of Viacom, Inc. and NationalAmusements. Viacom was a well-known media company; NationalAmusements was a major owner of motion picture theaters. TheWMS financials revealed that Redstone had recently been purchas-ing WMS shares in the open market, buying a total 157,500 shares in5early 1989 at prices ranging from $5⁄8to $ was a potentially powerful combination: a little-followed stock witha potentially explosive superstock chart pattern, combined with open marketbuying by an outside beneficial owner. All that was needed to confirm this1explosive combination was a breakout above the $8 to $8⁄4area, themultiyear resistance level that had contained WMS since 1986.
Chap 13 7/9/01 8:58 AM Page 161CHAPTER THIRTEEN“Beneficial Owner” Buying161When a well-defined multiyear resistance area in a stock is beingpenetrated, it usually means something has changed significantly forthe better. Sometimes it’s the overall market environment, but some-times the bullish development is specific to the company itself. In thecase of WMS Industries, a specifically bullish development wasalready brewing deep within the company that was not apparent tooutside observers. But the WMS chart was calling attention to the sit-uation—in effect telling anyone who knew what to look for that some-thing interesting was going on. The consistent buying of WMS sharesby Sumner Redstone, a well-known and sophisticated entrepreneur,was also a suggestion that something bullish was the time, WMS Industries was in the early stages of devel-oping a new gaming device, a so-called video lottery terminal thatwould sell like hotcakes as state governments legalized video gam-bling in order to generate desperately needed revenues. WMS wasalso thinking about “spinning off” its hotel/casino as a WMS received its first official order for its video lotteryterminals 30 months later, this $7 stock was trading at $42 and hadearned the honor of being the best-performing stock on the NewYork Stock Exchange for 1991! But the road from $7 to $42 was a tortuous one. As is the casewith most superstocks, the WMS saga was dotted with twists andturns that provided a number of bargain-priced buying opportuni-ties but also tested the willpower of those who were attuned to thesuperstock manner of stock late April 1989 the stock broke out above its multiyear resis-tance level. This breakout resulted in a focus on two things: the openmarket purchases of WMS stock by Sumner Redstone, and an appar-ent earnings turnaround that was taking place at WMS. This earn-ings turnaround was probably going to be more explosive than WallStreet realized. That would explain why WMS had broken out of asuperstock chart pattern and why Sumner Redstone was buyingmore stock on the open market. But there was a lot more potentiallurking beneath the surface of the WMS situation than the researchinitially indicated. What was the realreason WMS would turn out tobe such a huge winner?Undoubtedly, many people were becoming aware of the explo-sive potential for video lottery terminals and of WMS’s desire to
Chap 13 7/9/01 8:58 AM Page 162162PART THREETakeover Cluesmaximize the value of its hotel/casino operations. When a compa-ny is thinking of getting into a new business, it’s hard to keep itunder wraps. And WMS was a leading manufacturer and distribu-tor of pinball and video games—with the trade names “Williams,”“Midway,” and “Bally”—that could be found in restaurants and tav-erns throughout America. Now, a brand new industry was emerg-ing—video lotteries and video poker—that would enable patronsin these taverns and restaurants to gamble on state-sanctionedmachines. What do you do when you want to branch into a newbusiness? You talk to suppliers, talk to your customers, and begin tosound out state officials about becoming licensed in various juris-dictions. Even in the early stages, long before the new business isactually launched, many individuals in all walks of life will get windof what is going superstock chart pattern and the major breakout came aboutas a result of buying pressure in the stock. Who was doing the buy-ing? Agood guess would have been that a growing number of peo-ple close to WMS and/or its business were beginning to get wind ofthe potential for the video lottery business. (In addition, by this timeWMS was already looking into how to “maximize the value” of itsPuerto Rico hotel/casinos, which were carried on WMS Industries’books at far below their actual values.)These are the sort of “under the surface” developments thatcreate bullish chart patterns and major breakouts. Sometimes thereasons for the major breakouts are apparent—and sometimes theyare apparent only in retrospect. Either way, if you know what to lookfor, a knowledge of chart analysis can often point you toward a sit-uation you would never otherwise have noticed—which is precise-ly what happened in tracking WMS April 28, 1989, I noted the major breakout in WMS: “Thisstock seems to have a lot going for it: Asolid story, an apparent earn-ings turnaround; a great long-term chart, and steady accumulationon the open market by a potential acquirer.”By mid-May, WMS had moved up to $11. By this time, anychartist on the lookout for potential superstock breakouts wouldhave had a hard time missing the significance of the WMS chart pat-tern. Here was a classic multiyear resistance level breakout that hadtaken place on a clear volume “spike.” Again, the chartist may nothave known whyWMS shares were being bought with such urgency,
Chap 13 7/9/01 8:58 AM Page 163CHAPTER THIRTEEN“Beneficial Owner” Buying163but the chart was clearly suggesting that something very bullish wasgoing the first week of June, WMS had rocketed to $15, a gain of96 percent in two months. The stock had performed just as the WMSpotential superstock chart pattern indicated it might: Following thebreakout above the well-defined multiyear resistance area, WMSpowered higher on sharply rising trading volume. By June, SumnerRedstone had once again purchased WMS shares in the open mar-15ket, this time buying 101,100 shares at prices between $8⁄4and $11⁄’s stake in WMS had now increased to percent, and hewas not deterred by the rising price of WMS stock at all. Once again, the sharp advance in stock price was attributed tothe substantial earnings recovery taking place at the company, whichwas certainly accurate. But, it was far from the entire mid-August 1989, WMS had fallen back below $12 per and earnings continued to rise sharply due to rapid growthin the company’s pinball and video arcade games. On September 1,1989, our recommendation was that “since Sumner Redstone paid as5much as $11⁄8for WMS stock, this should serve as somewhat of abenchmark for us—., whenever WMS falls below $12, the stockis in an excellent buying range because Mr. Redstone, who probablyknows this company as well as anyone, bought stock at that level.”By late 1989 the stock was getting wobbly as signs of a poten-tial recession rattled Wall Street. Although the major averages werehanging in there, smaller stocks and the advance/decline line weresinking relentlessly. In October, a sharp sinking spell took the Dowdown a quick 11 percent, but smaller stocks suffered much , WMS had announced some disappointing company said it would report a loss at the quarter due to aplanned shutdown of its manufacturing line, for “retooling.” Thebullish significance of that announcement would not become appar-ent until much later. The stock market, which was in no mood toforgive any disappointment involving a small-cap stock, was relent-less in punishing WMS. The stock plunged as low as $ to classic chart analysis, that $8 level should haverepresented a major support level because a well-defined resistancearea, once penetrated to the upside, should serve as support on theway down. And for a while $8 did serve as support. WMS bouncedback to $11 by late October as the market steadied. Then another
Chap 13 7/9/01 8:58 AM Page 164164PART THREETakeover Cluesdisaster struck: this time, a natural disaster. Hurricane Hugo dam-aged some of the WMS hotel/casino properties in Puerto Rico. Thecombination of Hugo and the assembly line shutdown caused WMSto report a loss of $ per share for the quarter, and the stockslumped back toward the $8 support area again. 1990: Convictions about WMS Are Put to the TestWhat happened during 1990 to WMS stock was a classic example ofhow superstock investing differs from almost any other method ofstock selection. Acombination of recession, Iraq’s invasion of Kuwait,a crumbling market for small-cap stocks, and a sharply eroding stockprice for WMS would have made it difficult, if not impossible, tohang in there, except for one thing: Sumner Redstone, the outsidebeneficial owner. 5Redstone had paid up to $11⁄8for WMS shares on the open mar-ket. As WMS declined in price, it was reasonable to assume that if asophisticated investor like Redstone had paid that much for WMSshares, we should hold tight and even buy more as the share pricefell further into the single digits in the midst of increasingly demor-alized stock those open market purchases by Redstone there would havebeen no benchmark of value with which to work. But since we did have thatbenchmark—and since we were betting on Redstone or on something Redstoneknew about WMS as a potential catalyst to get the stock price higher—weadded to our stake in WMS during nearly all of 1990 at single digit was not easy to watch WMS decline as far as it did in 1990,but there was a specific reason for hanging in there and to buy moreshares at lower prices. That reason was the presence of SumnerRedstone. WMS had something extra going for it that most otherstocks did not—and that, as it turned out, made all the late December 1990, WMS Industries’ stock had fallen to7$3⁄8. But two new Telltale Signs emerged during that year to indicateit was still a potential two catalysts were the announcement that WMS would seekto spin off its Puerto Rico hotel/casinos to “enhance shareholdervalue,” and WMS would write off its investment in a company calledDivi Hotels, even though the investment still had apparent value.
Chap 13 7/9/01 8:58 AM Page 165CHAPTER THIRTEEN“Beneficial Owner” Buying165These two Telltale Sign announcements, along with the percent ownership of Sumner Redstone and the fact that Redstone5had paid as high as $11⁄8for WMS stock, was a sign that WMS hadsignificant unrecognized values lurking beneath its low stock decision to write off the investment of Divi Hotels was an exam-ple of what is calledkitchen sinkaccounting—a term used when acompany writes off any and all potential losing investments or expens-es in a single year to set the stage for a cleaner, more explosive earn-ings rebound the following a superstock detective, these telltale signs clearly suggestedthat something very bullish was lurking beneath the surface atWMS—some development, or some value that the stock market hadnot yet recognized. Yet WMS shares plunged throughout the fully appreciate the environment in which WMS shares werefalling, it might be instructive to briefly revisit the stock market andeconomic environment of that turbulent year. WMS was not simplydropping on its own. It was victimized by a horrible market forsmaller-cap stocks, rising interest rates, a declining overall stockmarket, a severe recession, a virtual collapse of the Japanese stockmarket, and the virtual collapse of most . bank stocks, whichwere suffering from a rash of bad an environment such as this, it is not easy to disregard the gen-eral stock market and focus on specific events or potential “catalysts”that will affect the special situation stocks in your portfolio. Nor is it dif-ficult to understand how a low-priced, analytically neglected stock likeWMS could suffer dramatically, especially since the company was tak-ing write-offs and had just reported a large loss. Even in the best oftimes, a company with little or no analytical support would have haddifficulty bolstering its stock price while it reported nonrecurringcharges, even though revenues and operating earnings remained ontrack. But these were not the best of times—in fact, they were the worstof times for small stocks, and WMS spent all of 1990 eroding in or later, it will happen to you. Chances are it has alreadyhappened. You buy a stock with high expectations for what youbelieve are sound reasons. But the stock starts to decline, and you arefaced with a difficult decision: Do you hang in there and possibly buymore at lower prices? Or do you cut your losses and move on?There are no clear-cut answers. “Cutting your losses” is easiersaid than done. Nobody has perfect timing; you may have bought
Chap 13 7/9/01 8:58 AM Page 166166PART THREETakeover Cluesprecisely the right stock for precisely the right reasons, and yourscenario for why this stock will double in price may be perfectlyvalid. But who is to say the stock cannot decline 10 to 20 percent, oreven more, before your scenario plays itself out precisely as youexpected? Perhaps the stock has declined because the overall mar-ket has been weak: Does that make your original analysis invalid?Perhaps some mutual fund is getting out of a position, and the stockis dropping: Does that make you wrong and the mutual fund right?That’s why you should understand why you bought the stock inthe first place. If you know why, and if the reasons for your purchaseremain valid, you should hold it and even buy more on the if you don’t really know why you bought a stock—if you boughtit for some vague reason (an analyst recommended it on television,it’s a “good company,” it’s a growth stock, etc.)—then you’re goingto have a difficult time deciding what to do when the stock startsmoving in the wrong investing, while it is by no means perfect, at leastgives you a guidepost. In the case of WMS Industries, the stock took1a sickening plunge from $10 to as low as $3⁄4between July andDecember 1990. It was not pleasant: But I knew whyI had recom-mended the stock in the first place, and did not see anything thatcaused me to doubt my original reiterate, here are the reasons I stuck with WMS: Redstone, an outside beneficial owner with a stel-lar track record, owned percent of WMS and had5recently bought stock for as much as $11⁄8. With WMStrading in the $4 to $5 range, there was a good possibilityhe would either step in and buy more stock or even offerto buy the entire had raised the possibility of spinning off its PuertoRico hotel/casinos as a separate company to enhanceshareholder value. The term “enhance shareholder value”is a keyphrase and a telltale sign for superstock means that the management of a company sees hiddenvalue within its corporate structure that the stock marketis not taking into account, and management is looking forways to force the stock market to reflect this earnings disruption at WMS had taken place for a spe-cific reason—a shutdown of the manufacturing facility for
Chap 13 7/9/01 8:58 AM Page 167CHAPTER THIRTEEN“Beneficial Owner” Buying167retooling. Yet the stock market—due to a lack of analystcoverage of WMS —was overacting to the temporary WMS write-off of its investment Divi Hotels, eventhough the investment still had value, was similar to manysituations in the past where a company that is expecting adramatic earnings turnaround takes every possible write-off to “clear the decks” for better news around the cor-ner—another Telltale is no way around this. If you want to make the right deci-sion when a stock starts moving against you, youhaveto know exact-ly whyyou bought the stock in the first place. One of the benefits ofsuperstock investing is that you should always buy a stock for a spe-cific reason—you should be looking at a specific “clue” or potential“catalyst” that tells you to buy this stock. Then, if the stock movesthe wrong way, you should ask yourself: Is the reasoning still valid?If the outside beneficial owner starts to reduce his or her stake inyour stock, for example, the original reasoning is no longer valid. Ifa company says it is looking into ways to enhance value and thenannounces that the plan has been scrapped, the original reasoningis no longer if the original premise remains sound, you should hang inthere—and if you can, you should buy more to take advantage of thelower December 31, 1990, WMS closed at $3⁄4. Despite whatseemed to be a logical analysis, the stock had now declined 57 per-5cent from my original recommended price of $7⁄8. I did not use a stop loss on the way down and did not recom-mend a “sell” of WMS for year-end tax loss. In other words, I did notfollow any of the simplistic “rules” for intelligent it’s a good thing too, because in 1991 WMS Industries turnedout to be the best-performing stock on the entire New York Stock February 8, 1991, WMS had broken out of a nice base in the11$3⁄2to $4⁄2area. The stock moved up quickly, trading above $ rebounded nicely, following the onetime charges and theretooling, which really was not much of a surprise since WMSIndustries’ basic business was continuing to again, the lack of analytical coverage had caused the mar-ket to overreact to the temporary earnings setback. Without analystsexplaining the situation to a force of retail brokers, who in turn can
Chap 13 7/9/01 8:58 AM Page 168168PART THREETakeover Cluesreassure investors that a charge or write-off is temporary, a neglect-ed small-cap stock can overreact in a major way, all out of propor-tion to the earnings setback. This is precisely what happened to WMS1late in 1990 on its way from $10 to $3⁄ again, Sumner Redstone had paid over $10 for large blocksof stock and there was WMS’s desire to enhance shareholder value—one of the key code phrases for superstock investors—spinning offits hotel/casinos operations as a separate into this plan led to some interesting informationabout appraisals of the value of the WMS hotel/casino Condado Plaza was worth between $105 and $110 million, whichmeant that the 80 percent owned by WMS was worth about $84 mil-lion (about $10/share). Yet WMS carried its 80 percent ownershipof the Condado Plaza on its books at a value of $37 million (about$ The other property, the El San Juan, was appraised at$100 million. WMS owned 50 percent of the El San Juan, or $50 mil-lion (about $6/share). However, this asset was also carried on theWMS books at only $37 million ($ In a situation like this it’s important to focus on the differencebetween “book value” and true “asset value,” especially when you’redealing with real estate. Agreat deal of unrecognized value on theWMS balance sheet could be recognized by the market if this spin-off did take place. Here was a classic example of how inefficient the stock marketcan be when you are dealing with lesser-followed small-cap or micro-cap stocks. In order to understand why, you have to understand theterm book valueand how misleading this figure can be in certain cir-cumstances. When a company carries an asset on its balance sheet, that assetmust be assigned a certain value, which is called “book value.”Usually, the asset is initially valued at its historical cost, which mayor may not reflect the actual value several years down the the case of a piece of machinery, for example , the value of thatmachinery will decline over time as the machine’s useful life growsshorter. Eventually, the machine will wear out and become virtuallyworthless. As a result, the accountants came up with the concept ofdepreciation, whereby a company is allowed to deduct a certain por-tion of that asset’s cost each year from its earnings. The depreciation“expense” is not really a cash expense; it is just a bookkeeping entry
Chap 13 7/9/01 8:58 AM Page 169CHAPTER THIRTEEN“Beneficial Owner” Buying169that allows the company to reduce its tax bill somewhat and alsoreduces the carrying value, or “book value,” of the asset each example, a $1 million piece of machinery with a 10-yearuseful life would be carried on the books at its $1 million cost forthe first year. In the second year the company would take a $100,000depreciation charge (one-tenth of the machine’s cost), that is deduct-ed from earnings. If the company earned $2 million that year, itwould only report $ million after the $100,00 depreciation“expense.” The “expense” did not involve a cash outlay, but savedperhaps $40,000 in taxes because it reduced reported earnings. That$40,000 saving is supposed to allow the company to accumulate cashto replace the machine when its useful life wears out in 10 is the purpose of the depreciation other effect of that $100,000 depreciation “expense” is toreduce the carrying value, or “book value,” of the machine on the com-pany’s balance sheet. At the end of the first year that $1 million machinewill be carried on the books at its newly depreciated value of $900, book value of that machine will decline each year by $100,000 untilthe machine wears out and a new one must be course, if the company has a really good mechanic or if themachine is particularly well-constructed it may last 15 years, or pos-sibly 20 years. In that case the machine will actually be worth morethan its carrying value, and therefore the “book value” of the com-pany will understate the actual value of its can also work the other way. If a company buys a piece ofland for $1 million, based on a bet that this land will soon be direct-ly in the path of a brand new highway, but then the HighwayDepartment decides to build the highway someplace else, the landmay not be worth $1 million anymore. But the company may keepthe land on the books at its historical cost. Or a company may pur-chase inventory and find that it cannot be sold at anywhere nearcost. Or a company might buy drilling rights on a piece of propertyand spend a number of fruitless years trying to find oil. In cases likethis, the “book value” may overstate the actual value of the the other hand, let’s say you buy some oil and it turns outyour geologist had an eagle eye. You hit pay dirt, the oil and gas startflowing from the wells, and you are rolling in clover. The propertiesare still carried on your books at historical cost, but that was beforeyou found oil. Now these properties are worth many multiples of
Y L F M AChap 13 7/9/01 8:58 AM Page 170 E T 170PART THREETakeover Clues what you paid—but their true worth is not reflected in your compa- ny’s “book value.” Book Value and Kirby Industries The term “book value” can be very misleading. In 1974, in the midst of a crushing bear market, a small oil and gas company called Kirby Industries announced that it would sell off its assets and pay out cash to its shareholders. This type of self-liquidation is fairly com- mon today; it usually occurs when a company believes its assets are worth far more than its stock price and when the stockholders would be better served by selling the assets and paying the proceeds direct- ly to the 1974, however, the concept of vo luntary liquidation wasnovel—so novel, in fact, that nobody seemed to know how to analyze the situation. I was still a junior analyst at Merrill Lynch when Kirby announced it would liquidate itself, and the only reason I noticed the ®announcement was that I had a friend who owned a substantial num-Team-Fly ber of Kirby shares. I called him and asked him what the announce-ment meant.“The assets of this company,” he told me, “are worth way morethan the stock is selling for. They have properties with proven oiland gas reserves that are worth far more than book value. They haveother properties that are adjacent to major discoveries where theyhaven’t even started drilling yet, but they know the oil and gas arethere. They even have a small auto insurance company in PuertoRico that’s worth way more than its book value. They think sellingthe company off piece by piece will create a better value for the stock-holders.”This was intriguing. The idea of selling assets and paying outcash to stockholders seemed a very efficient way to force the stockmarket to reflect the true value of your company. I called KirbyIndustries and asked them to send all of their financials. I talked toa Kirby spokesperson and tried to get a feel for the reasoning behindthe liquidation oil and gas analysts were hopelessly confused. They hadnever come across a voluntary liquidation and they did not knownow to handle it. Besides, Kirby was not on their radar screen; the
Chap 13 7/9/01 8:58 AM Page 171CHAPTER THIRTEEN“Beneficial Owner” Buying171company was too small. Their advice was to stay away from the sit-uation because it appeared “too risky.”Too risky? What is risky about a management knowing that thevalue of its assets is substantially higher than the stock price andsetting out to deliver that value to stockholders? Actually, the term“too risky” means: “It doesn’t fit the paradigm in which I am usedto operating.” Everybody is used to a certain way of doing things,both personally and professionally. When a situation arises thatbreaks the mold, the initial reaction is tonot deal with it. Ignore it does not exist. Just go on doing what you’re used to doingwhile an opportunity sits there, outside the box, waiting to be expe-rienced and profited the case of Kirby Industries, a voluntary liquidation was out-side the familiar paradigms of most securities analysts. So, insteadof “thinking outside the box,” the oil and gas analysts just didn’tthink about Kirby at all. They ignored it because it did not fit theirpreferred and preconceived manner of stock market did not know what to do about KirbyIndustries because the analysts who followed oil and gas stocks didnot know what to do about it. Kirby had announced in November1974 that it would self-liquidate; the stock, which had previously1traded at $15⁄8, did not trade for several days as the specialist (mar-ket maker) on the floor of the American Stock Exchange tried to fig-ure out where to open the stock in light of this new and confusinginformation. When Kirby finally opened, the price was $28—up nearly $13or 86 percent in a single trade!This opening price was very interesting because the stock hadopened almost precisely at its book value figure of $! In otherwords, what the stock market seemed to be saying was that, whenKirby finished selling its assets, it would be worth what the balancesheet said it was worth. But this seemed far too simplistic based onwhat I knew about “book value” and “historical cost” in relation tooil and gas research on Kirby Industries indicated the stock marketwas overlooking a huge opportunity. I became so convinced thatWall Street was missing the boat on Kirby Industries that I resignedfrom Merrill Lynch to start my own stock market advisory letter—and decided to make Kirby Industries my very first recommendation!
Chap 13 7/9/01 8:58 AM Page 172172PART THREETakeover CluesAnd how did my December 1974 recommendation of KirbyIndustries at $24 turn out? By the time the dust settled, Kirby shareholders had receiveda series of cash and stock distributions with a combined value ofover $450 per share!The experience with Kirby Industries brought to mind WMSIndustries and its plan to unlock the value of its Puerto Ricohotel/casinos. Because the hotel/casinos had been depreciated onWMS’s books, they were therefore undoubtedly worth more than“book value.” There was a high possibility, then, that these proper-ties were worth more than the stock market was giving WMS cred-it for. Not only that, for WMS to even consider a plan to unlock thevalue of these properties could mean only one thing: WMS man-agement believed they were worth more than the stock price wasreflecting and were looking for ways to force the stock market toreflect that there was the Sumner Redstone factor. Here was an astutebusinessman who had proven time and time again that he had an eyefor value. Redstone had made a career out of seeing what othersfailed to see, making a bet on his vision and proving to be had paid far in excess of WMS’s current market price for stock,and he must have seen something that the market was it have been the value of the hotel/casinos? Or somethingelse that was not on Wall Street’s radar screen? Looking at the WMS situation through the eyes of its manage-ment and outside investor Sumner Redstone, it seemed clear thatsomething valuable was lurking beneath the surface of this neglect-ed, low-priced stock. My experience with the way Wall Street canoverlook situations like this for extended periods of time explainedthe weakness in WMS early February 1991, however, WMS had doubled in price1from its 1990 close of $3⁄4. One reason for this was that earnings pershare were rising again. As already noted, the earnings problemsWMS experienced in the second half of 1990 had been the result ofunusual charges that had nothing to do with the company’s basicbusiness, but since there was no analytical support to interpret thisinformation for investors, the stock had reacted badly to lower earn-ings that had not truly reflected what was going on at the company.
Chap 13 7/9/01 8:58 AM Page 173CHAPTER THIRTEEN“Beneficial Owner” Buying173Now, the true earnings power of WMS was becoming apparent onceagain, and the stock was moving March 1991, WMS was trading between $6 and $7, andSumner Redstone had just filed another report with the SEC, indi-cating additional purchases of WMS shares on the open market at31prices between $3⁄8and $6⁄8. This was a major reinforcement to hangin there and continue to follow Redstone’s lead by buying more ofWMS at these low levels. Again, this is the difference between pan-icking out of a stock that is declining (because you have no “roadmap” to guide you) and adding to your stake in a declining you bought the stock in the first place—in this case,because we were following a sophisticated outside beneficialowner—tells you what to do if the stock starts going against , by adding to his stake in WMS at these lower prices, hadjust updated the road map. WMS was still a the same time, there were also some interesting “technical”or chart patterns in WMS. Take a look at this chart in Figure 13–21and you will see that WMS, on the way up from its low at $3⁄4, wasactually sketching out a series of very short-term superstock chartpatterns: a series of well-defined resistance levels, combined withrising support levels, followed by a breakout, and then a new short-term superstock consolidating was the importance of this? Demand was coming in atprogressively higher levels, chewing through supply, and thedemand for WMS shares, wherever it was coming from, was per-fectly willing to keep buying at progressively higher price April 1991 it became apparent where at least part of this demandfor WMS had been coming from: Sumner Redstone reported that hehad been buying more WMS shares in the open May 1991, Redstone purchased an additional 193,100 WMS7shares at prices between $8⁄8and $11. This was extremely importantnews because it demonstrated his willingness to buy more WMSshares even as the stock rose to new short-term highs. This couldonly mean that he knew or suspected something very bullish wasbrewing beneath the surface at WMS that was not yet reflected in itsstock , think about what this would mean to you, as an you had been a WMS shareholder at the time. You bought1stock at $8 and watched it slump to a low of $3⁄4. “Old paradigm”
Chap 13 7/9/01 8:58 AM Page 174174PART THREETakeover CluesFigure 13–2WMS Industries (WMS), 1989–1991Source:Courtesy of Mansfield Chart Service, Jersey City, would have been discouraged and confused—but as asuperstock investor, you would not because you’d be following tworoad maps: Sumner Redstone’s continuing purchases of WMS, andthe WMS plan to unlock the value of its hotel/casino old paradigm thinkers who get into a losing situation like thismight think of throwing in the towel, a superstock investor wouldbe thinking in precisely the opposite terms. You’d be looking at theslump in WMS stock price as an opportunity to add to your stake, so thatif your original analysis was correct, your ultimate profit would beeven this confident attitude to the plight of someone whobuys a stock for some vague reason—let’s say because it is a “growth”stock. You buy the stock and it starts to decline. What do you do? Youhang in there because you have been told it is a “growth” soon the stock is down 25 percent. Now what do you do?
Chap 13 7/9/01 8:58 AM Page 175CHAPTER THIRTEEN“Beneficial Owner” Buying175Cutting Your LossesDo you follow the simplistic “cut your losses” routine, or do youbuy more? Well, it’s hard to say because you really don’t have a han-dle on why you bought the stock in the first place. Even if it’s a“growth stock,” what is it worth? Are interest rates rising? If they are,your growth stock might be growing nicely but the stock price isgoing to be worth progressively less as interest rates rise because itsprice/earnings ratio will decline, as we have already learned. Thenone day the company announces that its earnings are still growingall right, but they will be growing at a rate that is somewhat lessthan Wall Street expected. This “new business,” which is immediatelytaken into account by the market, results in your “growth stock”opening another 25 percent lower in a single trade, which meansyou should have followed the “cut your losses rule.”On the other hand, maybe you did follow the “cut your losses”rule and sold your growth stock after it had declined 25 percent. Noharm there, right? You live to fight another day. Except that thegrowth stock you just sold bottoms out and doubles after you soldit, and it turns out that what you have done is dump your shares atthe bottom of a perfectly normal short-term correction within thecontext of a major uptrend. Now you feel really should you? How could you have possibly known what todo? You were operating without a road map, without guidelines—without a guiding principle, if you want to put it in those this feeling of being lost in the Wall Street wildernessto the feeling you would have had as an investor in WMS. You knewthe company had assets on the books that were worth far in excess ofbook value. You knewthat WMS management was aware of this andthat they were looking for ways to force the stock market to reflectthis value. You knewthat Sumner Redstone, a busy man who is run-ning Viacom and has better things to do than speculate in low-pricedstocks had somehow found the time to accumulate WMS shares on theopen market and was still buying, even as WMS shares were in the dol-drums. He must be doing this for a reason, so if you followed his leadin the first place by buying WMS shares, you should also follow hislead by hanging in there and buying more after the stock has mind-set is the major difference between superstock invest-ing and any other approach to the stock market. It won’t always lead
Chap 13 7/9/01 8:58 AM Page 176176PART THREETakeover Cluesto profitable investments—but it will lead to peace of mind, a coher-ent strategy, and the ability to make decisions for rational there is a lot to be said for June 1991, I received a letter from a subscriber who askedwhether WMS might eventually become a manufacturer of videolottery lottery terminals? Some research revealed that video lot-tery terminals were actually video poker games, sanctioned andsponsored by state governments, that were popping up in restau-rants and taverns in the handful of states that had legalized this kindof gaming. Asmall item in Replay Magazine, a magazine devoted topinball and video game manufacturing, reported a rumor thatWilliams Electronics, a WMS subsidiary, had been secretly design-ing its own video lottery terminals for some time and that WMS wasabout to enter the market for these research indicated that a number of states were seri-ously considering legalizing video poker, which meant that this waspotentially a brand new growth industry. And there was another burgeoning market for video pokermachines: Native American casinos. These casinos were popping upin various regions of the country, and every new casino required hun-dreds, if not thousands, of slot machines and video gaming a long time Wall Street had looked at manufacturers of casinogaming devices as a stagnant, slow-growth industry because theyviewed gambling as an industry confined to Las Vegas and AtlanticCity. With the number of casinos relatively fixed, where would themajor growth in demand for gaming machines come from? Suddenly,there was an answer to this question: The growth in demand wouldcome from state-run video lottery/poker terminals and the prolifer-ation of Native American casinos across the further research led to the stock price performance ofInternational Game Technology (NYSE:IGT), the industry leaderfor casino games. IGT had vaulted from below $10 in October 1990to nearly $50 a share by June 1991, a gain of 400 percent—all becauseof the growing excitement over video lottery terminals and the poten-tial new source of demand for casino-style machines from state gov-ernments and Native American WMS Industries enter the market for video lottery ter-minals? If so, the effect on its stock price could be huge.
Chap 13 7/9/01 8:58 AM Page 177CHAPTER THIRTEEN“Beneficial Owner” Buying177WMS was not commenting. But Dow Jones News Service hadtalked to a distributor of WMS’s pinball/video games, which as Isaid were ubiquitous in restaurants and taverns all over the distributor confirmed to Dow Jones that WMS had told him it wouldsoon be unveiling a video lottery terminal—possibly within the next 60 to90 days. This report suggested WMS would have advantages over acompetitor like International Game Technology. While IGT had beenselling its gaming machines to casinos for decades, WMS had beenselling its pinball and video arcade games to bars and restaurants forequally as long. And the potential demand for state-run video lotteryterminals would put WMS at a distinct advantage should it enterthis market. Why? Because the WMS sales force (distributors) werealready placing WMS products in these establishments. It was, andstill is, literally impossible to walk into any establishment with apinball and video game and not see one of WMS’s products—Williams, Bally, and Midway. Now, if WMS were about to unveil avideo lottery terminal—which in manufacturing terms was not allthat different from what WMS was already producing—the rela-tionships of WMS distributors with bar and restaurant owners acrossthe country could mean that WMS would be in the drivers’ seat ver-sus IGT when it came to placing these stock market had taken the WMS announcement duringthe past summer that it would temporarily close its manufacturingfacilities to retool as a major negative. But did this retooling havesomething to do with the fact that WMS was planning to add videolottery terminals to its product line?1By June 1991, WMS had already advanced from $3⁄4to $12 sinceyear-end 1990. Sumner Redstone had added significantly to his stakealong the way, and other buyers were bidding for WMS stock at pro-gressively higher levels, something the chart had indicated monthsearlier as WMS chewed through successively higher resistance lev-els with the greatest of retrospect, it’s easy to see why WMS was performing so well,and this strong price performance is a good lesson in what drivesstock prices. Even though WMS had made no official statement, theword about manufacturing video lottery terminals was already leak-ing out, most notably in the Dow Jones report. How could it not?WMS had to retool it’s manufacturing facilities, it had to conductmarket research, it had to bring in teams of designers, and it had to
Chap 13 7/9/01 8:58 AM Page 178178PART THREETakeover Cluesprepare its distributors around the country for the introduction of thisnew product. The increasing awareness of WMS’s upcoming entryinto this exciting new growth industry was undoubtedly one of themajor factors in the bullish patterns being created on the company’sstock price. The increasing demand for WMS shares, the easy pen-etration of resistance levels, and the willingness of informed buyersto bid for stock at progressively higher prices were Telltale Signs ofsomething bullish brewing at is another example of how charts can help point youtoward potential stock market winners. It’s not that charts can pre-dict the future, but that when informed investors who know morethan you do are buying or selling, they are in effect leaving “foot-prints” on the chart. By recognizing the signs of informed and con-fident demand, you can pretty much know what the smart moneyis doing—even if you do not know what the smart money the end of June, WMS confirmed that it would enter themarket for video lottery terminals. Of all the portents that WMS was going to turn into a huge win-ner, to me the most significant was the performance of InternationalGame Technology, whose stock soared between late 1990 and mid-1991. Here is a rule of thumb that works nearly 100 percent of thetime: When the stock of an industry leader takes off to the upside, virtual-ly every other stock in that industry will eventually move up in its wake. Thereason for this tendency makes perfect sense. Whatever bullish devel-opments are inducing investors to buy the industry leader shouldalso apply to other companies doing business in that , there will be no “lag time” at all, and all of the stocks inthe industry group will move together. Other times there will be a brieflag—days or a week or two at the most—before the other stocks inthe industry group start to move up in sympathy with the recent years the lag time has grown longer, a phenomenonthat has to do with the increased institutionalization of the stockmarket and the narrowing of analytical coverage discussed institutional investors are focused mainly on liquid, large-capstocks, they will pour their money into the biggest companies if theysee something that leads them to believe they should be weighted ina certain industry group. The mid-size companies will usually fol-low along quickly if the industry leaders are breaking out to newhighs. But, the smaller companies with no analytical coverage and
Chap 13 7/9/01 8:58 AM Page 179CHAPTER THIRTEEN“Beneficial Owner” Buying179no institutional interest will often sit there for weeks on end, notparticipating at all in the general strength of other stocks in theirindustry group. Eventually, the realization that other stocks in the industry aremaking new highs will filter down to even the smallest stocks in thegroup—but the lag time having grown significantly longer, presentsan opportunity to individual investors who are willing to go off thebeaten path to look for stocks that are being neglected. What final-ly causes investors to focus on the small-cap and microcap stocks,which have not yet moved along with their larger counterparts, usu-ally involves individual newsletter analysts, small-cap or microcapfunds that are looking for bargains, and individuals—just like you—who are willing to put two and two together and come up withfour—a simple enough task, it would seem, that is beyond the capa-bility of many institutional money managers and brokerage firmanalysts who are forced to operate in a completely different para-digm than the rest of guiding principle here is that what is superbullish for theindustry leader is probably going to be superbullish for everybodyelse in the industry. It was a good reason to remain ultrabullish onWMS, even though its stock had already tripled from its year-end1990 low. Here was International Game Technology, soaring from$9 to $50 based mainly on the implications of an emerging new mar-ket for video lottery terminals. And here was WMS, which wasalready experiencing a major earnings turnaround even withoutvideo lottery terminals (VLTs), completely neglected by the WallStreet analytical community. In mid-1991 not one brokerage firm ana-lyst followed WMS Industries. It was no wonder that WMS was not par-ticipating in the excitement over VLTs. In fact, WMS stock respond-ed to the announcement of the company’s entrance into the VLTmarket by dropping from $13 to $10, providing yet another buyingopportunity for those who were keeping their eye on the , in late July 1991, a brokerage firm analyst noticed WMSand published a report recommending it as a a look at the chart in Figure 13–3 and you will see the powerof a brokerage firm analysis. WMS immediately jumped to a newhigh of $15 as a result of this report, and the stock had taken on anew and powerful ally—brokerage firm sponsorship. This was thefinal ingredient necessary for WMS to follow in the footsteps of
Y L F M AChap 13 7/9/01 8:58 AM Page 180 E T 180PART THREETakeover Clues Figure 13–3 WMS Industries (WMS), 1990–1992 ®Team-Fly Source:Courtesy of Mansfield Chart Service, Jersey City, Game Technology. WMS was now on the radar screenof Wall Street analysts and institutional investors who monitoredtheir recommendations. The report made it more likely that any bull-ish development for the VLT market would have a positive impact onWMS. In August 1991 our recommendation was: In the final analysis what will drive WMS stock higher will be theperception that state legislatures which face mounting budget deficitswill see the legalization of VLTs as a politically painless way to gen-erate desperately needed revenues...each time another state decidesto legalize VLTs we think the handful of stocks involved in VLTs willget a was unveiling its first video lottery terminal on September12, 1991. In an interview with a confident WMS president NeilNicastro, he said he believed WMS would do very well competing
Chap 13 7/9/01 8:58 AM Page 181CHAPTER THIRTEEN“Beneficial Owner” Buying181with International Game Technologies and others in terms of placingits machines into any state that legalized VLTs. Nicastro confirmed thatWMS had strong distributor relationships in both Louisiana andOregon, the two states that had already legalized VLTs, and that thesame people who were placing WMS pinball and video games inbars and restaurants would also be representing WMS’s new told me that “Williams Electronics is the strongest name in thecoin operated amusement game business, and our distributors knowthat we will be able to satisfy demand quickly and with a reliableproduct.” Nicastro also confirmed that “if this business develops aswe hope it will, and if we can be an effective competitor, the additionalVLT revenues will mean a dramatic spike in income for WMS.”Meanwhile, back on the chart, WMS was sketching out thatfamiliar superstock chart pattern once again. Ashort-term resistance1area near $15 to $15⁄2was being attacked over and over again bybuyers, with demand coming in at progressively higher levels—astrong signal that WMS stock would be moving higher. By late September 1991, WMS had broken out above its resistance3area at $15 to $15⁄8to a clear new high in the $18 to $19 area. In thesuperstock concept, a stock like WMS Industries should do very wellregardless of what the overall economy and the stock market weredoing. Our recommendation suggested “concentrating on stockswhich will not depend entirely on an economic recovery to do stocks would include takeover candidates and companies whichmay be involved in an industry which could actually benefitfrom asluggish economy. An example would be WMS Industries, whichreached another new high and which is up an astonishing 85 percentsince late June!”In October–November 1991 the news started coming fast andfurious. WMS reported that revenues and earnings were risingsharply; a judge in Oregon threw out a lawsuit designed to block theintroduction of video lottery terminals in that state, which was viewedas a strong signal that anti-VLT forces in other states would have a dif-ficult time as well. Other state governments, strapped for cash, wereannouncing that they too would consider video lottery terminals asa new source of badly needed revenues. Landenburg Thalmann, theonly brokerage firm willing to stick out its neck in recommendingWMS, offered the view that a burgeoning market for WMS’s pinballgames could be developing in Eastern Europe, where communism
Chap 13 7/9/01 8:58 AM Page 182182PART THREETakeover Clueswas giving way to democracy, and also in South America, where pin-ball games were catching on with young on Wall Street does the demand for an item increase asthe price rises. As WMS stock price moved higher, analytical cover-age increased and the WMS story suddenly became interesting toinstitutional investors and the analysts who provide the researchthat influences their investment decisions. Proving that to some peo-ple there is nothing that makes as much investment sense as a risingstock, suddenly there were lots of reasons to love WMS of the Telltale Signs that had suddenly turned WMS into a WallStreet darling had been in plain sight for months. But now WMSwas moving in a more “respectable” price range and the stock hadmorphed into a “momentum” Street research departments jumped onboard, mainlybecause WMS had moved into the price range that would interesttheir institutional clients. I had been speaking on a regular basis to one analyst who cov-ered the “leisure” industry, which included gaming stocks. He hadloved WMS all along and had actually provided some guidance to mealong the way based on his view that video lottery terminals wouldsoon be proliferating. But when I asked him why he wouldn’t officiallyrecommend WMS, he told me it was “not an institutional sort ofstock,” whatever that , one day I heard that my friend had officially recom-mended WMS. I called him to find out what thrilling new piece ofinformation he had uncovered that had finally tipped the scales.“Now that it’s a $20 stock, I can get our institutional clients inter-ested,” the analyst said.“Excuse me?”“Look,” he said, “these guys aren’t going to buy a $7 stock withno research coverage that nobody’s ever heard of. It’s too risky. If itgoes down you’ll get all sorts of heat, and who needs that? Now thatWMS is a $20 stock and it’s moving, and it’s a relative strengthleader—see, I can sell that story. They’ll listen to me at this price stock is more recommendable at these levels.”“Are you telling me,” I said, “that even though you knew thesame things about WMS at $7 or $10 that you know now that youdidn’t recommend the stock simply because it was too cheap?”“Yes.”
Chap 13 7/9/01 8:58 AM Page 183CHAPTER THIRTEEN“Beneficial Owner” Buying183“And now that WMS is more expensive you are willing to stickyour neck out because you won’t get criticized as much as if it doesn’twork out?”The analyst sighed. “I know it sounds ridiculous,” he said. “Butyes, that is what I’m telling you.”Do you think things have changed since then?On November 19, 1998, a mutual fund portfolio managerappeared on CNBC. In response to a viewer question, the fund man-ager launched into an informed and enthusiastic analysis of what youwould call a “value stock,” which carried a rich dividend yield, soldat a low price/earnings ratio, and seemed like an undiscovered gem.“Would you buy the stock here?” the host asked. “Well,” the portfolio manager said, “I would if I didn’t have somuch short-term performance pressure on me. It would be a greatstock to buy and tuck away. But, you know, I can’t do that . . . it’stough.”The portfolio manager’s voice trailed away and the host went onto the next question. But his comments spoke volumes about the “lem-ming” instinct of mainstream portfolio management and the analystswho provide their research. More often than not there is safety in num-bers. It is better to be wrong betting on a stock that everybody elseowns than to go off the beaten path and take a chance on losing moneyon something that nobody has ever heard of. Thus, the trendy momen-tum stocks are overbought and overpriced, and the neglected gemsare unloved and underpriced—until something happens to pluck themout of obscurity and thrust them into the limelight. This portfolio man-ager had made a sound and bullish case for an undervalued stock thathe would havelovedto buy and “tuck away” in his fund’s portfolio, buthe didn’t have the nerve to do it because short-term performance pres-sure made it necessary for him to stick with the stocks his peers werebuying, just so he could keep up with the December 31, 1991, WMS Industries closed at $27⁄8,up 669 per-1cent from its 1990 closing price of $3⁄4. That performance made WMS thebest-performing stock on the New York Stock Exchange for the time WMS received its first order for video lottery ter-minals from the Oregon Lottery Commission in January 1992, WMShad soared to $41 a share—an incredible gain of 1161 percent fromits closing level at year-end 1990!What is the lesson to be learned from the WMS story?
Chap 13 7/9/01 8:58 AM Page 184184PART THREETakeover CluesActually, there are Industries had three of the Telltale Signs for identifyingfuture superstocks: (1) a potential superstock chart pattern, with awell-defined long-term resistance level being penetrated; (2) an out-side beneficial owner (Sumner Redstone) who was buying stock onthe open market and who had demonstrated the ability in the pastto identify winning investments ahead of the crowd; and (3) man-agement that seemed convinced there was an unrecognized under-lying value within the company and appeared determined to takesteps to “unlock” that were the three elements that made WMS attractive andprovided the willpower to hang on even though WMS performedpoorly at first. Before the evidence emerged and it became apparentwhat all the excitement was about, the Telltale Signs of a potentialsuperstock were apparent. In retrospect, it seems WMS’s bullishchart pattern was created by persistent buying among those whowere becoming aware of the company’s impending entry into thevideo lottery terminal industry. It’s possible that Sumner Redstone’sbuying was related to this insight as well—or perhaps SumnerRedstone was buying because he knew that the WMS hotel/casinoswere worth far more than WMS’s stock price was knows?The point is this: The signs were there, even if the informationthat created those Telltale Signs did not emerge until Industries is a textbook example of how a superstockchart pattern, together with outside beneficial owner buying, canlead you to a huge winner—even if you don’t know whythat stockis going to be a winner!Postscript to the WMS Story:Eventually, WMS Industries got around to spinning off itshotel/casino properties. In early 1997, WMS created a new compa-ny, WHG Resorts, which was spun off from WMS and began trad-ing on the NYSE in the $5 to $6 range (adjusted for a 2-for-1 split inWMS stock). Within 6 months WHG Resorts received a takeover bidthat valued WHG at more than $20 per takeover bid for WHG Resorts valued the company ataround $130 million. Based on the fact that WMS Industries hadaround million shares outstanding when the company first
Chap 13 7/9/01 8:58 AM Page 185CHAPTER THIRTEEN“Beneficial Owner” Buying185announced that it was seeking to “unlock the value” of its hotel/casi-nos, WMS’s hotels/casino properties turned out to be worth nearly$13 per share on the presplit WMS share. No wonder WMS management was looking for ways to unlockthe value of these is why you should always take a close look at “spinoffs”as potential superstock candidates.
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Chap 14 7/9/01 8:58 AM Page 187CHAPTER FOURTEENThe “Pure Play” and theDrugstore IndustryThere is always a disposition in people’s minds to think that existing conditions will be permanent. While the market is down and dull, it is hard to make people believe that this is the prelude to a period of activity andadvance. When prices are up and the country is prosperous, it is always said thatwhile preceding booms have not lasted, there are circumstances connected withthis which make it unlike its predecessors andgive assurance of H. Dow, JournalistJune 8, 1901, The Wall Street JournalThings Ameche, ActorThings ChangeCharles Dow, founder of Dow Jones & Company, and Don Ameche,a great actor, were both saying pretty much the same thing when theyuttered these words, only Don Ameche put it more succinctly. In thestock market, as in life, you should never extrapolate current circum-stances too far into the future because—well, because things Wall Street the tendency to assume that current conditionswill remain in force indefinitely, if not forever, is a common form ofmass delusion that must be experienced the hard way by every gen-eration of investors that comes down the pike. What these investorsdo not understand about Wall Street is that trends come and go, fads187Copyright 2001 The McGraw-Hill Companies, Inc. Click Here for Terms of Use.
Chap 14 7/9/01 8:58 AM Page 188188PART THREETakeover Cluesappear and disappear, and the pendulum swings from one extremeto the other, over and over and again, inevitably and without fail. Andas difficult as it is to believe that the pendulum can ever swing theother way when you’re riding the final, glorious upward arc—italways reverses course, and you had better learn to either get off orturn around and prepare yourself for the return trip because ridinga pendulum backwards is no fun, financially or this chapter you will learn about “pure plays” and spinoffsand how they can lead you to superstocks and superstock first let’s go back to the 1960s, when “conglomerates” were allthe rage and Wall Street was discovering the meaning of the latestbuzzword—a fad called “synergy.”The technical definition of synergyis “the joint action of agents,such as drugs, that when taken together increase each other’s effec-tiveness.” Two people, for example, can create synergy. Or two mus-cles. Or, in the case of Wall Street, two businesses. Or three, or maybefive, or the 1960s, the concept of “synergy” took hold as the key ofconquering business cycles and creating stocks that could continueto go up, in good markets and bad, in recessions and in boom idea was to create multi-industry companies through acquisitionsso that when one industry was in the doldrums, the slack would betaken up by another. If the synergist were clever and calculatingenough, the resulting company—called a “conglomerate”—wouldreport ever-rising earnings through any and all economic cycles. Ifthe homebuilding division was going bad, for example, this wouldbe offset by a very good year in the rocket fuel business, the bowl-ing alleys, the funeral homes—or whatever else you owned thatmight be doing well while something else was performing was the theory, at least, and for a while conglomerates wereall the rage, until the inflationary recession spirals of the 1970s hitand all of the businesses went bad at the same time. To make mattersworse, it became apparent that it was a lot harder than it looked tooversee a company with 27 different divisions, all operating in total-ly unrelated industries, not to mention how difficult it was for WallStreet analysts to cover these companies in any coherent synergy and the conglomerate craze slowly petered out—proving once again that Charles Dow and Don Ameche knew whatthey were talking about. (Of course, some “synergies” are too powerful
Chap 14 7/9/01 8:58 AM Page 189CHAPTER FOURTEENThe “Pure Play” and the Drugstore Industry189and obvious to be denied. In an obviously well-thought-out strategy,Netherlands-based Unilever PLC announced two takeovers on thesame day in April 2000. First, Unilever said it would buy ice creammaker Ben & Jerry’s Homemade, whose products include the notori-ously calorie-laden “Chubby Hubby” brand for $326 million. Also onthat day, Unilever announced the $ billion acquisition of diet prod-ucts company Slim Fast Foods, thus putting Unilever in the businessof both causing and curing obesity—a synergistic win-win situationif ever there was one.)Interestingly, however, there are some vestiges around of thetrend toward synergy even today—and when these vestiges beginto jettison operations that do not fit their core businesses—in otherwords, when a company decides it wants to be more of a “pure play”in a well-defined industry—it can lead you to potential recent years a growing number of companies have decidedthat they—and their stockholders—would be better off as “pureplays”—., companies that operate in a single, well-defined indus-try. The major reason is because Wall Street analysts are industryspecialists, and since analytical coverage is the key to a widely heldand fairly priced stock, many companies have come to the conclu-sion that an easily understood corporate identity is crucial for astrong stock price. For example, a mutual fund looking for exposurein the auto parts industry would be more likely to buy shares in acompany with 100 percent of its revenues coming from auto partsthan it would a company with, say, 60 percent of its revenues com-ing from auto parts and the other 40 percent from radio order to become a pure play, a company needs to removenoncore businesses from the mix. There are two ways to do this: sellthe businesses outright, or spin them off to shareholders as a sepa-rate a pure spinoff, 100 percent of the stock of the noncore businessis distributed to shareholders of the parent company, and the spinoffstarts a new life as an independent, publicly traded company. Thereare a number of theoretical benefits to spinoffs, including the proba-bility that the management of the new company will be better able tomanage the spinoff’s business once it is separated from the theoretical advantage to owning shares in a spinoff isthat the value of a fast-growing subsidiary hidden within a larger cor-porate structure may have been overlooked by Wall Street. By sep-
Y L F M AChap 14 7/9/01 8:58 AM Page 190 E T 190PART THREETakeover Clues arating the fast-growing subsidiary and turning it into a separately trading company, the growth rate that had been previously obscured will become more apparent, which could lead to a higher price/earn- ings multiple for the spinoff’s stock. Athird possibility is that by spinning off a company in an indus- try where there is a lot of takeover activity, the spinoff could become a takeover target. This is what happened to WHG Resorts, the hotel/casino spinoff of WMS Industries which, following its sepa- ration from the parent company in 1997, more than doubled in price within 6 months. Most Wall Street analysts recommend investing in spinoffs for all of these reasons, but there is a different way to look at a superstock investor , you should look at every announced spin-off and ask yourself : Which company oper ates in an industry wherethere is a great deal of takeover activity, the parent company or the company being spun off? The answer to that question may surprise you. In fact, in many ®cases you would be better off buying the parent company—espe-Team-Fly cially if that company operates in a takeover-lively industry. Thereason is because a number of instances have occurred over the yearswhere a company in a takeover-lively industry decides to sell or spinoff noncore businesses as the initial step in ultimately putting itselfup for of thumb, therefore: Whenever you see an announcementinvolving a spinoff, analyze the parent company. Check to see if there hasbeen any recent takeover activity in the parent company’s the answer is yes, and if the parent company is a mid-size orsmaller company within that consolidating industry, you should seri-ously consider the possibility that the parent company is turning itselfinto a pure play as a prelude to selling itself to the highest STUDY: FAY’S AND GENOVESEIn fall 1995, I noticed an interview with the chairman of Rite Aid, adrugstore company that had just made a takeover bid for Revco, oneof its largest competitors. That merger, which would have created thenation’s largest drugstore company, was never consummated becauseof regulatory opposition. But in commenting on the reasoning for
Chap 14 7/9/01 8:58 AM Page 191CHAPTER FOURTEENThe “Pure Play” and the Drugstore Industry191Rite Aid’s bid for Revco, Rite Aid’s chairman, Martin Grass, com-pared the fragmented drugstore industry to the banking industry,which was then undergoing a frantic wave of consolidation. Thedrugstore industry, said the Rite Aid executive, was very similar tothe banking industry in that significant cost savings through econ-omies of scale were possible by combining companies. He went onto predict that the same reasoning being applied to the wave of bankmergers could be applied to the drugstore industry, and that thiswas the driving rationale behind his company’s bid for the Rite Aid–Revco merger never took place, this inter-view was the “road map” for finding superstock takeover candidates. As a starting point, I compiled a list of the 15 publicly tradeddrugstore companies and ranked them from top to bottom, basedon the value of their outstanding stock, or market capitalization: Aid (see Chapter 17) Corp. (which owned CVS Drugs, which waseventually spun off and acquired) Health (which owned Medicine Shoppes) Stores (which owned Osco and Sav-On Drugs) (which owned Thrift Drugs) (see Chapter 17) Drug ’ Drug StoresIf you eliminated JCPenney, which was far too large to beacquired and was more likely to be an acquirer itself, 14 drugstorecompanies were on this list. Amazingly, in less than 2 years, 9 of these14 companies were taken over! And it all started because of an inter-view with the chairman of Rite Aid, who described the reasoning
Chap 14 7/9/01 8:58 AM Page 192192PART THREETakeover Cluesbehind his bid for Revco—which only goes to prove that Yogi Berraknew what he was talking about when he said: “You can observe alot just by watching.” Or, in this case, takeover wave in the drugstore industry ran its coursebreathtakingly quickly. One by one the mid-size and smaller drug-store chains were acquired by their larger competitors. Along theway, this takeover wave served as a case study on how to spot var-ious telltale signs of impending superstock first successful drugstore takeover candidate recommen-dation was Fay’s Inc., and it was recommended for one reason—thissmall drugstore company was selling off noncore assets, makingitself a “pure play” drugstore company. By December 1995, Fay’shad just sold its Wheel’s Discount Auto Supply stores for $37 millionin cash and announced that its Paper Cutter retail stores would alsobe put up for sale. These announcements, combined with the viewthat a takeover trend was about to engulf the drugstore industry,made Fay’s an obvious takeover candidate. Fay’s was readying itselffor sale by getting rid of “noncore” operations, a move that wouldmake it more attractive to a larger drugstore company seeking acqui-3sitions. At the time, Fay’s was trading at $6⁄ January 1996 another small drugstore company was addedto my list of takeover recommendations. Genovese, the nineteenthlargest drugstore company—with 113 stores in the New York City/Long Island area—had also recently become a pure play by sellingoff its nondrugstore quoted Rite Aid chairman Martin Grass on the rationale ofpotential drugstore industry mergers being “very analogous towhat’s going on in the banking industry. We’re able to absorb stores,eliminate tremendous overhead, and take costs off the system.”Our view was that the managements of Fay’s and Genovese, bydeciding to become pure drugstore companies through the sale ofnoncore businesses, already saw the handwriting on the wall andwere preparing themselves to be acquired. In March 1996, I reported another Telltale Sign appeared, indi-cating that Fay’s management might be preparing to sell the com-pany:“As I previously reported, Fay’s has been selling off its nondrugstoreretail operations. Now, Fay’s has announced the elimination of 90administrative jobs, which would save $3 million per year, or about
Chap 14 7/9/01 8:58 AM Page 193CHAPTER FOURTEENThe “Pure Play” and the Drugstore Industry193$ per share. These are the moves you should expect to see from a compa-ny that might be readying itself for sale in a rapidly consolidating ’s stock continued to languish at $7⁄4. As part of its cost-cut-ting move, Fay’s had taken a “restructuring” charge, and the stock1market reacted by pushing Fay’s shares briefly down to the $6⁄ was another situation where a complete lack of analytical coverageresulted in the stock market putting the wrong interpretation on this in noticing the Telltale Signs of an impending superstocktakeover target—., any company selling off noncore assets andcutting costs in an industry where a takeover trend was in force—was practically hanging a “For Sale” sign on the front door. But whenFay’s took its restructuring charge—which would yield future ben-efits to cash flow and earnings—all the stock market saw was a lossfor the quarter. There was no room for nuance: Alow-priced stockwith no analytical following had reported a loss, and down wentthe stock. But to the trained eye of a superstock analyst, the verynews that was sending Fay’s shares lower was another clue thatFay’s would soon become a takeover April 1996 the Rite Aid–Revco merger agreement fell apartwhen the Federal Trade Commission decided that the resulting com-bination would be anticompetitive and would dominate the drug-store industry in a way that would be detrimental to , the FTC left the door open for other drugstore industrymergers, which would be smaller in scale. By May 1996, Fay’s stockwas moving higher—ever since the Rite Aid–Revco deal was July 1996, Fay’s had finally sold its Paper Cutter office sup-ply stores for $14 million, which meant it was now a pure concentrating on the “pure play” concept and the factthat Fay’s was operating in an industry which was about to experi-ence a takeover wave would by this time have seen crystal-clear sig-nals that Fay’s was a genuine takeover candidate. And yet, despitethe fact that Fay’s had finally sold off its last nondrugstore operationand taken a “clear the decks” restructuring charge—and despite thefact that the Federal Trade Commission had pretty much publiclystated that it would encourage smaller drugstore mergers—despite5all of this, Fay’s shares were trading at $7⁄8, only slightly higher than3the original recommended price of $6⁄4six months earlier.
Chap 14 7/9/01 8:59 AM Page 194194PART THREETakeover CluesSuddenly, just 8 days later, on July 11, 1996, Fay’s announcedthat it had received a takeover bid from JCPenney, which owned theThrift Drug Store chain. The stock market reacted as though it was7shocked—shocked—at the news. Fay’s shares jumped to $10⁄8onthis news. Fay’s did not specify a takeover price, saying only that ithad received a proposal from JCPenney and that it would have nofurther comment until a deal was consummated or the talks July 1996, discussing the Fay’s takeover proposal, I againraised the possibility that Genovese Drug Stores could become atakeover target for precisely the same reason that Fay’s had. Genovesehad sold off its nursing home division in the previous year, a movesimilar to Fay’s selling off its nondrugstore operations in 1995–1996prior to selling itself to , the Genovese chain of drugstores was located almost pre-cisely in the middle of the geographic areas that would be servedby Penney’s Thrift Drugs chain and a newly acquired Fay’s chain. Atthat time, Genovese Drug Stores was trading near $8, adjusted fortwo subsequent 10 percent stock two weeks Fay’s announced that it had agreed to beacquired by JCPenney for $ per share—an 85 percent gain from3the recommended price of $6⁄4in just 7 months, and all because Fay’shad tipped its hand by selling off its noncore operations and becoming apure play in an industry where a takeover wave was under Fay’s recommendation had turned out to be on target, sowe next turned our attention to Genovese, a very similar addition to operating in the same general area of the country asFay’s and, like Fay’s, recently becoming a pure play by selling offnoncore assets—in its case, a nursing home division—Genovese hadsomething else going for it: a potential superstock chart pattern. Thechart showed a well-defined, multiyear resistance area at $11 to $12—precisely the sort of major, long-term resistance level that if brokento the upside, can create a superstock. This chart pattern, togetherwith the fact that Genovese was becoming a pure play in a consoli-dating industry, were strong clues that Genovese Drug Stores wasprobably on its way to superstock showed that 43 percent of Genovese’s stock wasowned by the family who founded the company. Now, you mightlogically think that would be a roadblock to a takeover. But in fact,
Chap 14 7/9/01 8:59 AM Page 195CHAPTER FOURTEENThe “Pure Play” and the Drugstore Industry195the opposite is true. Around a third of Fay’s outstanding stock wasowned by the founding family, yet Fay’s decided to sell itself toJCPenney. Why? Because when you have a large block of stock in a smallcompany in a consolidating industry controlled by the founders of the com-pany, you will very often find that these stockholders recognize the propermoment to “cash out” and become part of a larger at it from this point of view: You start a small company,build it up over the years, compete and prosper, and wind up witha large chunk of a small, profitable company. Suddenly, you findthat the industry you operate in is consolidating rapidly, and youbegin to realize that it will soon be dominated by a handful of giantcompanies that will be consolidating operations, cutting costs, andsqueezing the profit margins of its smaller do you do? Do you stubbornly hold on to your indepen-dence and take the risk that your company’s profits will be squeezedby increasingly large competitors, leaving you on the outside look-ing in when the takeover wave finally runs its course? Or do yourecognize the handwriting on the wall and take this opportunity tocash out at a huge premium to your stock’s recent market price?In such situations, there are tax ramifications to consider and wereported in Superstock Investor: When a public company is so heavily owned by a founding family,tax considerations come into play. Take a look at the JCPenney–Fay’sdeal: this buyout was structured as atax-free transactionunder whichFay’s shareholders receive $ worth of JCPenney stock. For thePanasci family, which founded Fay’s, they were sitting with a $7 stockwith the realization that the company they founded was worth almosttwice that amount. Acash buyout would result in a huge tax liability;but in this tax-free swap with JCPenney, they receive a huge premiumfor their shares, they have no tax liability unless and until they selltheir JCPenney shares, and they have received a far more liquid secu-rity to boot. The Genovese family is in virtually the same , here is another superstock clue to keep in mind: When atakeover trend engulfs a certain industry, take a close look at small-er companies in that industry in which the founding family stillowns a large stake. More often than you might think, these majorstockholders recognize the optimal moment to cash out—and youwill find that many of these family-controlled companies will become
Chap 14 7/9/01 8:59 AM Page 196196PART THREETakeover Clueswilling takeover targets rather than run the risk of being left by thewayside as minor players in an industry dominated by a handful ofgiant July 2, 1997, a news item appeared on the Dow JonesNewswire that reported that two Genovese family members hadagreed to act in concert in terms of their stock to SEC regulations, when two or more stockholderswho own 5 percent or more of a public company agree to act in con-cert, they must notify the SEC that they are acting together. Thisagreement by Leonard Genovese, chairman and CEO of GenoveseDrug Stores, and his sister Frances Genovese Wangberg, a directorof Genovese, was characterized in the press as an “anti-takeover” our view was that the press had it all wrong, and it wasmisleading to characterize this as an “anti-takeover pact.” TheGenovese family members had made an agreement that requiredmutual consent before either of these two Genovese stockholderscould sell. You could look at this agreement this way: these twomajority Genovese shareholders—who control percent ofGenovese stock—recognized that they owned a very attractive prop-erty in an environment of rapid consolidation in the drugstore indus-try and had discussed how they would deal with any potentialtakeover bid that might take place in the a rule of thumb: Whenever you see any indication that twoor more large stockholders of a company have made any sort of pactto act in concert, to require mutual approval, or in any way haveindicated that they have discussed how they will sell their shares, youshould take this as an indication that these stockholders are at leastconsidering the possibility that the company will be sold at somepoint in the the case of Genovese Drug Stores, this pact between the twolargest shareholders of the company indicated—in no uncertainterms—that they were discussing what they would do in the eventof a takeover November 1998, Genovese agreed to be acquired for $30 pershare by none other than JCPenney—precisely the company target-ed as the logical buyer. That $30 takeover price represented a 229percent gain from my original recommended price, adjusted for stockdividends, of $
Chap 14 7/9/01 8:59 AM Page 197CHAPTER FOURTEENThe “Pure Play” and the Drugstore Industry197So, Genovese Drug Stores went from $9 to $30 in just over 2years and the company received a takeover bid from JCPenney, justas predicted. Except that it wasn’t quite that easy to hang in there withGenovese over that 2-year period, and therein lies another lesson interms of what it takes to stick to your guns during periods in whichthe stock market completely ignores what might be blindingly obvi-ous to a superstock it comes to stocks that are not widely followed by ana-lysts, or sometimes not followed by anyanalyst, news items andindustry trends that seem to have clearly bullish implications for asmaller, off-the-beaten-path company have no effect on the see news, you make the connection, you buy the stock, and—nothing happens. The stock just sits there, or even moves lower, asif nothing significant has occurred. During periods like this (as withthe WMS situation discussed in the previous chapter) there is noalternative to keeping your eye on the “road map”—., remem-beringwhyyou bought the stock, making certain that the initial rea-soning remains in force, and, if you have the means, buying more ata lower price so that your ultimate profit will be greater once WallStreet catches on to what you have already a look at the chart of Genovese Drug Stores (Figure 14–1).Within seven weeks of this chart being published, Genovese soaredto $30 a share on the JCPenney takeover bid yet, between April andAugust 1998, as the ultimate takeover bid was fast approaching,1Genovese stock plunged from $25⁄2to $15! Genovese had also had a sinking spell a year earlier, after thecompany announced a “strategic restructuring” in which it cut costsand closed underperforming stores—precisely the sort of movesFay’s implemented prior to its takeover, and exactly what you wouldexpect from a company preparing to sell itself. It was a classic TelltaleSign. And yet, the stock market did not react to this restructuringannouncement positively and as a harbinger of a potential , Genovese was September 1996 a subscriber informed me that while myGenovese takeover recommendation obviously made sense, I wasobviously wrong. Why? Because if Genovese were truly a takeovercandidate in light of the Fay’s acquisition the stock should be doingbetter—and it wasn’ was my response:
Chap 14 7/9/01 8:59 AM Page 198198PART THREETakeover CluesFigure 14–1Genovese Drug Stores (GDXA), 1996–1998Source:Courtesy of Mansfield Chart Service, Jersey City, is a fact of life on Wall Street: Unless a widely followed estab-lishment analyst with a connection to a strong retail sales force (.,lots of stockbrokers) is delivering a certain story, that story—no mat-ter how logical—will not be fully reflected in the stock price. This isa major problem with small-cap and microcap stocks, and I can’t tellyou how many times I have heard this refrain from a frustrated CEOof a small company who cannot understand why Wall Street does notproperly value his or her company. When I first recommended Rehabcare Group, I asked an officerof the company why his stock was trading at a measily 11 times earn-ings while most specialty health care stocks were trading at 25 timesearnings or more. The answer, of course, was that other than a cou-ple of regional brokerage firms, no major analyst was following thecompany. Rehabcare was politely informed that research coveragemight be forthcoming if Rehabcare were to do a stock or bond offer-ing; ., generate fees as an investment banking client.
Chap 14 7/9/01 8:59 AM Page 199CHAPTER FOURTEENThe “Pure Play” and the Drugstore Industry199It used to bother me when I saw something that seemed obvi-ously bullish to me which was not reflected in the stock price, becauseI felt I must be missing something. But not anymore. Today, with giantmutual funds and other institutional investors calling the shots onWall Street, most research is directed toward servicing these mam-moth clients. Since most of these large funds cannot traffic in small andmicrocap stocks, there is no mileage for most research departments infollowing the smaller companies—therefore, some terrific stories Fay’s was selling off its nondrugstore operations, closingunprofitable stores, taking write-offs, and reducing expenses, thesewere the classic moves of a company that might be preparing itself forsale—especially in view of the fact that the drugstore industry wasrapidly consolidating. But Fay’s stock did nothing for a long time,despite the fact that it was trading far below its takeover value, untilthe company finally announced that it was talking to JCPenney abouta possible back to Genovese Drug Stores, after a smattering ofdrugstore takeovers over the past year and a half, the drugstoretakeover bell was rung earlier this year when Rite Aid announcedthat it would acquire Revco, a merger that would create the largestdrugstore company in the United States. In an interview shortly afterannouncing the agreement, Rite Aid’s chairman carefully spelled outthe reasoning behind the agreement, noting that competition andeconomies of scale would create a powerful incentive for drugstorecompanies to merge. He compared the coming drugstore merger waveto what was already happening in the banking industry, and said thatcosts and overhead could be dramatically reduced through the Rite Aid–Revco merger was not consummatedbecause the Federal Trade Commission believed it was too big a merg-er, the handwriting was on the wall. Even the FTC said it would lookfavorably on smaller drugstore mergers because they would theoret-ically reduce health care costs by reducing overall costs. Therefore, itseemed reasonable to assume that some of the smaller drugstore com-panies could become buyout targets, and Fay’s turned out to be amajor winner for us. In my last letter, I noted that there were a number of drugstorecompanies who are believed to be shopping for acquisitions. Rite Aid hasto be on the list, since they tried to acquire Revco. JCPenney is probablyalso on the list, since the takeover of Fay’s indicates that JCPenney islooking to build its Thrift Drug unit into a major player. Arecent TuckerAnthony research report on Arbor Drugs suggests that Arbor has the cash
Y L F M AChap 14 7/9/01 8:59 AM Page 200 E T 200PART THREETakeover Clues and the infrastructure to handle an acquisition. Melville Corp. will soon be spinning off its CVS Drug Store chain as a separate company, and analysts believe CVS will attempt to get bigger through acquisitions. Other potential buyers include Walgreens, Eckerd, and Longs. Also, in another interesting development, the chairman of Revco recently told Dow Jones that he expects drugstore industry consoli-dation to continue. Now that the Rite Aid–Revco merger is off, Revco’s chairman told Dow Jones that Revco now plans to be an aggressive buyer itself of smaller drugstore chains. So, we have a very large list of potential buyers out there, and it seems obvious that some of the smaller drugstore companies will be receiving takeover bids. Other than Genovese Drug Stores, who are some of the other candidates?If you want to look further afield, consider Big B, a 383-storechain. After the Fay’s takeover, Big B’s executive vice president said that Big B has “no interest in entertaining acquisition offers” and that the company is trying to expand on its own. That could mean that Big B is also on the list of possible buyers of smaller chains, but ana- lysts still consider Big B to be a potential target itself.®Team-Fly This lengthy quote illustrates what is meant by the term “roadmap.” Here was the analysis, from beginning to end. Any investorwho read this analysis had two choices: It either made sense or itdidn’t. If it made sense, the logical move was to buy Genovese andsome of the smaller drugstore chains. If it did not make sense, the log-ical move was to take a pass on the whole stock languished for 2 years after this report beforetripling on the JCPenney takeover bid. And it is not as though theGenovese story did not receive any public attention. During 1996,BusinessWeek’s “Inside Wall Street” column had two articles on theprospects of a buyout of Genovese Drug Stores by JCPenney andthe takeover of Fay’s. Here was the complete story on GenoveseDrug Stores—the road map, if you will—in an international maga-zine read by millions of people, brought to you by an analyst whohad just predicted the takeover of Fay’s in the very same publica-tion—and yet, Genovese stock continued to languish for 2 years,right up until the takeover bid forced the stock to once again proves that you can be 100 percent correct and thestock market can be 100 percent wrong when it comes to analyzingthe prospects of small-cap and microcap stock with no analytical
Chap 14 7/9/01 8:59 AM Page 201CHAPTER FOURTEENThe “Pure Play” and the Drugstore Industry201coverage. If you are going to operate in this sector of the stock mar-ket, you will have to learn to trust your instincts, learn to maintain thecourage of your convictions, and believe that in this sector of the mar-ket there is no such thing as an “efficient stock market,” which meansyou’ll be able to see things that the Wall Street pros are I’ve noted more than once, though it is worth repeating: It’sdifficult to sit with a stock doing nothing or drifting lower—especiallywhen you see evidence that this stock should be selling at a sub-stantially higher price. But when this happens, you have to stick toyour guns—as long as the original “road map” is is no other way to do weeks later Big B—the drugstore company that had publiclystated that it would remain independent—accepted a takeover bid fromnone other than Revco, the company that had publicly stated that it wouldstart shopping for smaller drugstore B was still controlled by the founding Bruno family, a sign tolook around for another small drugstore company with a large blockof stock owned by the founding family. If the founders of Fay’s and BigB were willing to sell the companies they had built, the same reason-ing should apply to other small drugstore companies with large blocksof stock still owned by their founders. Genovese was definitely in thiscategory, which only served to flesh out the Genovese road map. Abrokerage firm report had mentioned Arbor Drugs, a Michigan-baseddrugstore chain, as a potential buyer of other companies. But based onArbor’s small size and on the fact that the founding family controlled a largestake in this company, Arbor Drugs was likely to be acquired September 1996, following the Big B takeover, Arbor Drugs3was added to my recommended list at $8⁄4. And in February 1998,Arbor Drugs accepted a $23 per share takeover bid from CVS. CASE STUDY: SMITH FOOD & DRUG CENTERSIn November 1996, browsing through a list of 13-D “beneficialowner” filings in Barron’srevealed that Transamerica Corp., the giantinsurance company, was accumulating shares of Smith Food & DrugCenters (SFD) on the open market. Research indicated that SFD wasa potential superstock takeover candidate.
Chap 14 7/9/01 8:59 AM Page 202202PART THREETakeover CluesSFD operated in two industries where takeover activity wasrampant: supermarkets and drugstores. The company operated 147food and drug centers mostly in the southwestern United , SFD had just closed down its 34-store California oper-ations, which resulted in a large restructuring charge. Does thatsound familiar? Here was a company that looked like it might begetting its house in order in preparation for selling itself. At the sametime, SFD was buying back large chunks of its own stock on the openmarket—another Telltale Sign, and a strong signal that a companybelieves its stock is initially drew my attention to SFD was the open marketbuying by Transamerica, which had recently raised its stake to of the company, paying as high as $ for SFD shares. Butfurther research revealed something far more interesting. About 14percent of SFD was owned by the investment/buyout firm of YucaipaCos., which had already been involved in several supermarket owned a controlling interest in supermarket giant FredMeyer Inc. and also owned stakes in publicly traded Dominick’sFoods, a Chicago-based supermarket chain, and Ralph’s, a privatesupermarket company. Clearly, Yucaipa was the sort of sophisticat-ed outside investor who would have the ability to “cash out” of itsstake in SFD at the right time and the right price if it chose to do SFD was operating in two takeover-lively industries, YucaipaCos. would certainly be aware of the fact that SFD might be sold ata very rich price should the company be put up for at SFD’s long-term chart was also encouraging: SFD hadbeen locked in a fairly well-defined price range with an upper resis-tance level of $30 for nearly 2 years. Now, with takeover activitypicking up in both the supermarket and drugstore industries, SFDlooked like it was about to finally break out above that $30 resis-tance area. In other words, SFD’s chart had the look of a pendingsuperstock breakout. This fact, combined with the open market buy-ing by Transamerica, the 14 percent ownership of Yucaipa Cos., andthe recent restructuring and elimination of unprofitable operations,all indicated that SFD was a takeover candidate. In November 1996, SFD was added to my recommended list at1$29⁄2. Less than 6 months later, in May 1997, SFD soared to $49 pershare, following a takeover bid from none other than Fred MeyerInc., which was controlled by Yucaipa Cos.
Chap 14 7/9/01 8:59 AM Page 203CHAPTER FOURTEENThe “Pure Play” and the Drugstore Industry203Ultimately, Dominick’s Foods—the other publicly traded super-market company, which was partially owned by Yucaipa Cos.—alsoreceived a takeover bid. Remember, I began browsing through those13-D filings in Barron’s, which resulted in a single piece of informa-tion involving Transamerica’s purchases, and that touched off someresearch. That research yielded additional clues, which eventually ledto information about Yucaipa Cos. That’s an example of why it pays to LEARNEDLesson number one is this: If you believe a takeover wave is aboutto strike a particular industry, and if you’re on the lookout for poten-tial takeover targets, you should concentrate on smaller to mid-sizedcompanies because they will be the most vulnerable to stands to reason because the economies of scale being achievedthrough takeovers will tend to make it more difficult for smallercompanies to compete—and this is one reason why these small com-panies may decide to link up with a larger second lesson is to look for companies in a takeover-livelyindustry that appear to be transforming themselves into “pure plays.”Fay’s was a perfect example of this approach; so was Genovese DrugStores. You should pay particular attention to companies that are sell-ing off noncore assets, since this is often a sign that a company ispreparing to sell third lesson is that any company that operates in a takeover-lively industry and is taking restructuring charges or implementingcost-cutting measures or closing down marginal or unprofitableoperations is also a candidate for putting a “For Sale” sign on thedoor. Think of restructuring, cost-cutting, and other measures in thesame way you would think of a property owner doing some cos-metic work on a home or building that is about to go on the fourth lesson, all things being equal, is that you shouldtake special note of companies in which a large block of stock (say,10 percent or more) is held by a single shareholder—especially an out-side shareholder who would recognize when the time is right tomaximize the value of an investment. Try to put yourself in the placeof the large shareholder—try to think as that shareholder wouldthink. If that shareholder, even if he or she is a founder of the com-pany, has been sitting with a stagnant stock for a long period of time
Chap 14 7/9/01 8:59 AM Page 204204PART THREETakeover Cluesand suddenly finds that a takeover wave is sweeping the industryand large premiums are being paid for buyout candidates, there willbe a strong temptation for that large shareholder to “seize themoment” by cashing , look for superstock chart patterns. Pay particular atten-tion to smaller companies that are bumping up against well-defined,multiyear resistance levels. Any stock that is about to break out abovea resistance level that has contained the price for 1 year or more istrying to tell you that circumstances have changed for the you see a chart pattern like this, combined with one or moreof these other characteristics in a stock whose industry is undergo-ing consolidation through takeovers, chances are you have a livesuperstock candidate on your in mind that it may be one isolated observation that leadsyou into a treasure trove of superstocks. In the case of the drugstoreindustry, the single catalyst was noticing comments of the Rite Aidchairman when he explained why he was making a bid for considering his reasoning, the conclusion was that more drug-store takeovers were likely. That observation led to Fay’s, a pureplay in the making, which led to Genovese Drug Stores—and so observation will lead you to the next; one clue will leadyou to another. As long as you know what characteristics to lookfor, you will find that this sort of new paradigm thinking will opennew doors and lead you down paths where you will encounter yourshare of superstocks and takeover candidates.
Chap 15 7/9/01 9:00 AM Page 205CHAPTER FIFTEENUsing Charts The market feels what cannot be observed. It is continually alerting us to those things which are not readily . FrostThe benefits of stock charts is that they can often lead you into ter-ritory you did not suspect. If you recognize the sort of chart patternsthat often precede significant moves in stocks, and if you spend sometime browsing through chart books, you will find your attentiondrawn to companies you did not even know existed—often withhighly profitable late A. J. Frost, a veteran stock market analyst, had it exact-ly right when he said that the collective wisdom of the market isusually ahead of the curve. The reason for this is that whenever newinformation emerges, it is axiomatic that someone, somewhere, willget around to acting on that information by buying or selling an industry is in the doldrums and harbingers of a new, positivetrend begin to emerge, someone will be the first to get wind of , as the information becomes more widely disseminated, a light-bulb will go on in somebody’s head and a bullish bet will be placedon this trend through the purchase of stock that will benefit fromthis trend. Long before the analysts get wind of the change for thebetter—and certainly long before individual investors become awareof it—the stocks that will benefit will be bid higher, and Telltale Signswill emerge to be noticed and interpreted by investors who are205Copyright 2001 The McGraw-Hill Companies, Inc. Click Here for Terms of Use.
Chap 15 7/9/01 9:00 AM Page 206206PART THREETakeover Cluesfamiliar with chart analysis. This is the most important thing charts cando for you:They can draw your attention to a great stock that youwould otherwise never have chapter will describe to you the specific chart pattern calleda “superstock breakout” pattern. This chart pattern involves a stockthat is breaking out to the upside above a very well-defined, multiyearresistance level. Resistance levelis a price level that has contained atleast three previous attempts to move higher over a period of at least1 year. Each time a stock attacks the resistance level, sellers step inand offer stock for sale, causing the stock to retreat. The stock fallsback, regroups, and moves up toward the resistance level again. Sellingreappears, overwhelms demand, and the stock falls back more often a stock attacks this resistance level and fails topenetrate it, the more significant it becomes when the resistance levelis finally penetrated. Once this breakout occurs, it is a sign thatdemand has overwhelmed supply and the stock should be able tomove significantly significance of a breakout from a “superstock breakout”pattern is that it usually means something has changed significant-ly for the better. For some reason, demand has increased to the pointat which it is finally able to penetrate the supply of stock for sale atthe resistance level. Either the sellers have backed off or have beenexhausted, or the buyers are so certain that something bullish is tak-ing place that they are undaunted by the fact that they’re buyingstock at levels that have contained every previous rally way, a breakout above a multiyear resistance level is usu-ally a sign that a stock is going to move significantly best way to introduce you to this type of chart pattern is tostart with an actual late 1993 and early 1994 there was an emerging trend towardhealth care takeovers. In January 1994 we wrote that “if there is oneclear trend developing in the takeover area right now, it is this:Hospital companies are looking to get bigger by acquiring smallerhospital companies, and they are also looking to broaden their healthcare services by ‘vertically integrating,’ or acquiring companies thatprovide other types of health care.”
Chap 15 7/9/01 9:00 AM Page 207CHAPTER FIFTEENUsing Charts207CASE STUDY: SALICK HEALTH CAREBrowsing through charts of every small hospital and “specialty healthcare” company in search of the “superstock breakout” pattern justdescribed, a stock called Salick Health Care (SHCI) popped up. Itschart pattern had that of a potentially powerful superstock breakoutpattern (Figure 15–1). Based on its chart pattern, Salick Health Care was exactly thesort of specialty health care company that could get caught up in thetrend toward health care takeovers. Aclose look at this chart illustratesthe classic superstock breakout formation: In early 1992 Salick movedup to the $17 area, then fell back to around $9. From there Salicklaunched another attack on the $17 resistance area, getting as high1as $16⁄4in January 1993. Sellers won that battle once again, and Salickdropped back down to the $10 area. By summer 1993, Salick wasFigure 15–1Salick Health Care (SHCI), 1992–1994Source:Courtesy of Mansfield Chart Service, Jersey City, NJ.
Chap 15 7/9/01 9:00 AM Page 208208PART THREETakeover Cluesattacking that $17 resistance area again, and once again the stockretreated—but this time the buyers stepped in just below the $14 early 1994 the stock was in the process of making its fifth attemptat a breakout in the multiyear resistance area near $ strong suspicion was that eventually Salick would be ableto break through the resistance level. Why? Because something fun-damental had of “specialty health care” compa-nies were picking up steam, and a company like Salick, which pro-vided cancer treatment and kidney dialysis services, was in the rightplace at the right time. This chart was indicating that buyers “in theknow”—., buyers who either knew or strongly suspected thatSalick would ultimately become a takeover target as part of thisongoing trend, were stepping up to the plate and bidding moreaggressively for the you have this sort of chart pattern in a stock that is part of anindustry group where takeovers are proliferating, there is a very strong prob-ability that you have an emerging superstock takeover target on your 1994 progressed and a number of specialty health caretakeovers took place, it seemed apparent that Salick Health Care wasprecisely the sort of company that could attract a takeover bid. Yet,after breaking out above the key resistance area near $17, Salickreversed course and fell back to the $14 area once again. In AprilSalick had strong support in the $14 to $16 area on any decline. Itwas not expected that Salick would drop back below the breakoutarea—but it did, providing one last buying opportunity to those whobelieved in the message of the chart and also in the premise that spe-cialty health care companies like Salick had an excellent chance ofbecoming takeover is no problem so vexing, to an investor, as a stock thatseems to have everything going for it that suddenly turns againstyou. It would be neat to be able to invest according to a set of rulesthat would enable you to limit your losses. The cold reality is that nosuch rules exist, and anyone who purports to provide you with themis selling you a bill of goods. No matter how careful you are, no mat-ter how accurate your original analysis, no matter how talented achart analyst you may be, there will always be times when you are100 percent correct and you have just purchased a stock that willmake you a lot of money. But before that scenario plays itself out, you
Chap 15 7/9/01 9:00 AM Page 209CHAPTER FIFTEENUsing Charts209may have to endure a 20 percent, 30 percent, or even a 50 percentdecline in the stock you insist on limiting your losses to 10 percent, you will be“stopped out” of ultimate winners. Even limiting your losses to 20percent is dangerous because when you are dealing with relativelythinly traded small-cap stocks, you can experience a 20 percent movefor no reason other than general market weakness or perhaps thefact that a single investor is selling a position. In other words, theweakness may have nothing to do with the company and the premiseon which you have made the is no easy answer to this problem. The bottom line is this:If a stock starts going against you, you should know two , is the original premise on which you based your decision to buystill intact? And second, where is the support level on the chart—., where can this stock reasonably be expected to meet buying sup-port so you can add to your position at an intelligent level? And ifyour original premise was correct, you will ultimately increase yourprofits down the the case of Salick Health Care, the logical support zone was$14 to $16. In July 1994, Salick Health rose sharply from its supportzone near $14 on news that the company had signed an agreementto provide cancer treatment services to a large Health MaintenanceOrganization in August 1994, Salick Health was once again threatening tobreak out above that long-term resistance area, and in Septemberthe stock finally did break out, in a major ultimate outcome of this recommendation: In December1994, Salick Health Care soared to $35 per share on news that Britishpharmaceutical giant Zeneca Group had offered to acquire Salick at$ per share. That takeover bid resulted in a gain of 118 percentin less than a year for those who purchased Salick at the original rec-ommended price of $ how did I manage to unearth a little-known company likeSalick Health Care as a takeover target? Was I an expert in the healthcare industry? Did I have spreadsheets and computer analysis of thelatest trends in specialty health care? Was I some sort of expert on can-cer treatment or kidney dialysis? The answer to all of these ques-tions, obviously, is no. This stock had a potential superstock break-
Y L F M AChap 15 7/9/01 9:00 AM Page 210 E T 210PART THREETakeover Clues out pattern that was instantly recognizable because it had worked a hundred times before. By determining that there were likely to be takeovers in the specialty health care stocks, I searched for a super- stock breakout pattern and found it. That’s how I did it—and that’s how you can do it too. CASE STUDY: ROHR , INC. Investors are like children on a playground. They rotate from one ride to another: from slides and swings to teeter totters. Every piece of market “equipment” gets its use. Terry R. Rudd 1929 Again Every dog has its day, and any momentum player can tell you whichdog is having its day in the sun at any given time. But the trick, at least in terms of superstock investing, is to fig- ®ure out which lucky dog will be -Fly The “superstock breakout” chart pattern signifies that some-thing has changed in the fortunes or prospects of a company. This pat-tern involves a well-defined resistance level that has stopped everyprice advance for at least the past year, and preferably longer. Finally,when a stock is able to break through this long-term resistance level,a sustained and significant price advance becomes highly likely. The fact that a formerly formidable resistance level has beenbroken to the upside usually signifies that something has changedfor the better; ., a paradigm shift is taking Salick Health Care finally broke out above its long-term1resistance area near $17 to $17⁄4, that breakout was a clue that thisstock was responding to a new and very positive development, adevelopment that was able to push Salick Health Care above a wallof selling (resistance) that had contained every rally attempt over aperiod of 2 years. In the case of Salick, that positive developmentwas this: Atakeover wave was unfolding among specialty healthcare stocks, just like Salick, and the stock market was taking thisnew reality into account. Prior to this takeover wave, Salick had beena little-known health care company whose stock had been locked ina wide trading range between $9 and $17 for nearly 3 years.
Chap 15 7/9/01 9:00 AM Page 211CHAPTER FIFTEENUsing Charts211Sellers were quite content to sell Salick every time the stockapproached the $17 area, and buyers were very confident in buyingSalick each time the stock fell toward the $9 to $10 area. The stock wastrading on its earnings, growth prospects, the outlook for its industry,and the general stock market environment, just like every other the emerging takeover wave in the specialty health care stockschanged the paradigm for Salick. That takeover wave transformedSalick from an obscure cancer treatment/kidney dialysis provider intoa potential takeover target. And when Salick became a potentialtakeover target, its stock price was removed from the straightjacket ofanalyst coverage and earnings estimates and placed into a new para-digm: the superstock paradigm. In this paradigm, the question was nolonger what Salick might earn in the next quarter. The question was:What would Salick Health Care be worth as a business to a potentialbuyer? And based on this new paradigm, Salick’s supply/demandequation breakout above the $17 to $17⁄4resistance area was a clearsignal that Salick was being perceived in a different light by WallStreet. Here is another example of how a superstock chart breakout—and nothing but a superstock breakout—led me to the takeover bidfor Rohr, Inc. In June 1995 an emerging takeover trend was taking place inthe defense/aerospace industry. Scanning through the charts in theMansfield Chart Service, which are arranged by industry groups,indicated that multiyear breakout pattern. Rohr, Inc., a company thatmanufactured and supplied parts used by most of the major aircraftmanufacturers, had a chart pattern that showed a classic superstockbreakout pattern. The charts (Figures 15–2 and 15–3) showed a well-defined, multiyear resistance area near $13 and a clear breakout abovethat level. That long-term resistance area first manifested itself in late1992 and early 1993, and again in 1994 and early 1995. Beginning inlate 1993, Rohr also showed a series of rising bottoms, indicating thatbuying was coming in at progressively higher levels. For the pastfew years Rohr had been a stock market “dog,” trying on five sepa-rate occasions to break out above the $11 to $13 area and failing everytime. But the stock had finally managed to break out, strongly sug-gesting that this was a dog about to have its day.
Chap 15 7/9/01 9:00 AM Page 212212PART THREETakeover CluesFigure 15–2Rohr Inc. (RHR), 1991–1993Source:Courtesy of Mansfield Chart Service, Jersey City, was added to my recommended list. Much like an elec-trocardiogram can tell an experienced physician what is going oninside a patient’s chest, there are certain chart patterns that can tellan experienced chart analyst that there is something important goingon beneath the surface of an apparently uninteresting a few weeks after the initial recommendation, an outsidebeneficial owner—an investor named Paul Newton of NorthCarolina—had accumulated a percent stake in Rohr. Within a year of the original recommendation, based on its super-3stock breakout pattern, Rohr had soared from $13 to $23⁄4. Then some-thing interesting happened: Rohr reported an unexpected quarterlyloss, the result of restructuring charges. This was one of the Telltale Signsof a developing takeover situation in a company that operates in a con-solidating industry that decides to write off its past mistakes, “clearingthe decks,” so to speak, for future positive earnings reports. If you are
Chap 15 7/9/01 9:00 AM Page 213CHAPTER FIFTEENUsing Charts213Figure 15–3Rohr Inc. (RHR), 1993–1995Source:Courtesy of Mansfield Chart Service, Jersey City, a company that you perceive to be a takeover candidate, andyou want top dollar for your shareholders, one strategy to make yourcompany more appealing is to get the disappointments that may belurking beneath the surface out of the way and safely behind Fay’s, Genovese Drug Stores, and others demonstrated, thestock market usually takes news of an unexpected restructuringcharge at a sparsely followed company as a negative—but the mar-ket’s initial reaction is often completely shares dropped from around $22 to as low as $16 on thisnews, then bounced back to the $18 to $19 area. Within a few weeksRohr insiders had gone into the open market to purchase shares onthis price decline, another Telltale a rule of thumb: When corporate officers and directors pur-chase shares in their own company on the open market immediately
Chap 15 7/9/01 9:00 AM Page 214214PART THREETakeover Cluesfollowing a negative surprise that seems like a one-time, nonrecur-ring item, it is usually a sign that the stock market has overreacted ina negative way and that the news from there on will be the case of Rohr, this combination of restructuring charge andthe insider buying that took place on the dip in the stock price weretwo excellent omens that the original “road map” remained shares eventually fell as low as $14 following the restruc-turing write-offs and the quarterly loss. Just several months later,though, Rohr roared back to $21 following a better-than-expectedearnings report—which is precisely what you would have expectedin light of the insider buying following the previous earnings insider buying provided a road map to Rohr’s value—in otherwords, the insider buying provided the confidence to hang in thereand not give up the ship simply because Wall Street was taking apanicky short-term view of the ultimate outcome of this recommendation, which all beganwith a superstock chart breakout: In September 1997, Rohr soared to $33a share following word that the company had received a takeover bid.
Chap 16 7/9/01 9:18 AM Page 215CHAPTER SIXTEENThe Domino Effect Back in the 1960s, when the United States was gradually immers-ing itself into the morass that became the Vietnam War, there was alot of talk about the “Domino Effect.” This was a geopolitical theo-ry under which a Communist takeover of one country in SoutheastAsia would eventually lead to other countries in that region fallingunder Communist domination, one by one, like a series of Domino Effect may or may not be valid in geopoliticalterms, but it can work on Wall Street. And one way to uncover futuresuperstocks is to pay close attention to industries where mergeractivity is picking up, especially among the smaller players in Domino Effect works best in industries dominated by threeor four large players, followed by perhaps 5 to 10 smaller companiesthat are dwarfed in size by the industry leaders. The drugstore indus-try (see Chapter 14) was an excellent example of the Domino Effectin STUDY: VIVRA AND REN-CORP. USAAnother example was the kidney dialysis industry, an industry thatled to three superstock takeovers over a period of 2 years. And onceagain, it all started with a superstock breakout pattern. By now you will probably see familiar signs in the chart of Vivra(Figure 16–1). Here is that superstock breakout pattern again: a well-215Copyright 2001 The McGraw-Hill Companies, Inc. Click Here for Terms of Use.
Chap 16 7/9/01 9:18 AM Page 216216PART THREETakeover CluesFigure 16–1Vivra (V), 1992–1994Source:Courtesy of Mansfield Chart Service, Jersey City, , multiyear resistance level with a recent series of rising bot-toms, indicating that buying pressure is coming in at progressivelyhigher levels. In Vivra’s case, the key price level was around $24–$ a kidney dialysis company, Vivra fell into the general category of spe-cialty health care—an area where takeover activity was very was added to my list of recommended stocks at $ months after that initial recommendation, it was trading at$36. Vivra had completed its superstock breakout and forged relent-lessly higher. By this time Salick Health Care—which also operatedsome kidney dialysis facilities, you will recall—had received itstakeover bid. The Salick bid, combined with the bullish performanceof Vivra following the superstock breakout, led me to review thechart patterns of every other small kidney dialysis company. Thisresearch led to Ren-Corp. USA.
Chap 16 7/9/01 9:18 AM Page 217CHAPTER SIXTEENThe Domino Effect217Ren-Corp. had a “baby superstock” breakout pattern. The major1breakout took place when the stock moved above $14⁄2. Had I focusedearlier on the kidney dialysis industry in particular, I might havecaught Ren-Corp. sooner. But I was a bit late. Still, Ren-Corp.’s chart1did show a long-term breakout crossing $14⁄2and another potential3short-term breakout crossing $16⁄ Ren-Corp. had something else going for it: an outside bene-ficial owner. By this time you’re probably beginning to understand how youfeel when you find a small, analyst-starved company in a consoli-dating industry with a superstock breakout pattern and an outsidebeneficial owner. Your heart beats a bit faster and you absolutelyknow that you have uncovered a genuine superstock candidate!Fifty-four percent of Ren-Corp. it turned out was owned by GambroAB of April 1995, Vivra, a larger dialysis company, had seen it stocksoar from $26 to $36 during the past five months, but Ren-Corp. hadnot followed suit. We reported that the reason might have been “dueto underexposure in the financial community . . . but if Vivra con-tinues to be one of the best-performing stocks on the NYSE, they’llget around to Ren-Corp. eventually.”This is another example of a phenomenon discussed earlier:The lag time between a major movement in the stock price of anindustry leader and other, smaller stocks in that industry has grownlonger as the stock market has become more institutionalized. Doyou remember Pavlov’s dogs? Ivan Petrovich Pavlov was a Russianpsychologist who conducted a series of experiments that studiedthe relationship between stimuli and rewards. Pavlov demonstrat-ed that dogs could be trained in terms of conditioned reflexes, andthat they would respond to certain external stimuli by behaving ina certain the old days (say, prior to the advent of the Index Fund)when an industry leader like Vivra took off to the upside and becameone of the top relative strength stocks on the NYSE, the investmentcommunity, like Pavlov’s dogs, were conditioned to react by mark-ing up the stock prices of every other company operating in thatindustry, no matter how small, with very little lag days, if you think of Pavlov’s dogs on Valium, it will giveyou an idea of how Wall Street reacts to the same stimuli. It’s almost
Chap 16 7/9/01 9:18 AM Page 218218PART THREETakeover Cluesas though the connecting mechanism is inoperative. The reason is thatthe markets are so dominated by large, lumbering institutional behe-moths that can only deal in large, liquid securities. Therefore, you donot get the same instant reactions you used to get in the smaller-capstocks. This is all to the good for our purposes because it means indi-vidual investors who can see these connections can uncover all sortsof interesting opportunities and also have the time to act on what theyhave what did Ren-Corp. USAdo next? It dropped from $16 to$12, that’s what it did. Despite the fact that specialty health carestocks were being taken over left and right, despite the fact that 54percent of Ren-Corp. USAwas owned by a Swedish health care com-pany—despite all of this, Ren-Corp. dropped 25 percent almostimmediately after we recommended continued to recommend Ren-Corp. because the “road map”was intact. Not only was it intact—it had been enhanced. As Ren-Corp. was dropping 25 percent, a news development involving Vivrasent a clear signal that more takeovers were coming in the kidneydialysis buyout group had proposed a merger between Vivraand National Medical Care, a unit of W. R. Grace, which Grace wasabout to spin off as a separate company. Grace said it was not interestedin such a merger, but this proposal is one of those early clues to lookfor when trying to peg an industry where a takeover wave is about tostrike. It’s not just the deals that get done; it’s also the proposals or trial bal-loons that do not get done that can lead you to future superstocks.(Remember,the frantic takeover wave in the drugstore industry was foreshadowedby the Rite Aid–Revco merger that was never consummated.)Here we had an announcement that a major leveraged buyoutfirm wanted to merge the two largest dialysis companies. The ideawas rebuffed, but the fuse had been lit. Under these circumstances,“Pavlov’s dogs” should have started buying shares in all of the small-er dialysis companies, based on the prospects of a takeover wave inthis industry. But as we have seen, Pavlov’s dogs were now zonedout on Valium, and from the way they missed this signal on the dial-ysis companies, they might have been out drinking or munchinghash addition to the rumors swirling around Vivra, Dow JonesService had reported on June 14 that National Medical, in a defensive
Chap 16 7/9/01 9:18 AM Page 219CHAPTER SIXTEENThe Domino Effect219move, would seek to buy Ren-Corp. USA. In response, Gambro AB,the Swedish company that owned 54 percent of Ren-Corp., issued adenial that it was seeking to sell its stake in , takeover clouds were rolling in on the , Pavlov’s dogs had apparently passed July 3, 1995, issue of BusinessWeekran a story by AmyDunkin entitled “Plugging Into Merger Mania Without Burning YourFingers.” In that story, I recommended Ren-Corp. USAas a Friday, July 14, 1995, just 2 weeks later, Ren-Corp. USA17soared from $4⁄8to $19⁄8, or 26 percent in 1 day, following a takeoverbid from—what a surprise!—Gambro AB of Sweden!Ren-Corp., a formerly sleepy and virtually unfollowed dialysiscompany, had soared from $12 to nearly $20 in a period of 6 weeks—in other words, it had turned into a reiterate how this successful superstock takeover came tomy attention in the first place: I had noticed a potential superstockbreakout pattern in Vivra, another dialysis company, and that led tofurther research into this industry. Eventually, that research led to asmaller company that was already partially owned by an outsidebeneficial that is how charts can help lead you to exciting new super-stock STUDY: RENAL TREATMENT CENTERS What do you do when you suspect that you are about to witness the“Domino Effect” in a particular industry, where one company afteranother becomes the target of a takeover bid and a new batch ofsuperstocks are in gestation?The answer: You immediately look around for additional poten-tial “superstock breakout” patterns. Renal Treatment Centers wasanother company I had never heard of, but by now I'm sure all youneed to do is glance at the chart (Figure 16–2) to understand why Irecommended this stock. There it was: Awell-defined long-term resistance area near $25to $26 in a little followed company in a rapidly consolidating indus-try. Aseries of rising bottoms, indicating rising demand.
Y L F M AChap 16 7/9/01 9:18 AM Page 220 E T 220PART THREETakeover Clues Figure 16–2 Renal Treatment Centers (RXTC), 1993–1995 Source:Courtesy of Mansfield Chart Service, Jersey City, NJ.®Team-Fly In July 1995, we recommended Renal Treatment Centers at $23. The chart in Figure 16–2 emphasizes the significance of a long-term perspective. If the investor had only reviewed the 6-monthperiod from January 1995 to July 1995, which simply shows that1Renal Treatment Centers had recently dropped back from $26⁄4toaround $23—an amazing thing, when you think about it, in light ofthe fact that Ren-Corp. USAhad just received a takeover bid, and thatRenal Treatment Centers and Ren-Corp. were nearly identical in sizein terms of revenues. It’s surprising that this short-term chart ofRenal Treatment Centers looked as uninspiring as it did. Again, inthe old days when Wall Street’s “connecting mechanism” was work-ing properly, a takeover bid for Ren-Corp. would have resulted instrong money flows into a nearly identical company like RenalTreatment Centers. Today, the cause-and-effect process has a muchlonger lag time, and sometimes the process breaks down complete-ly. This can produce extreme frustration when you see somethingothers don’t—but it can also give you time to accumulate more stock,and at lower prices, before the payoff arrives.
Chap 16 7/9/01 9:18 AM Page 221CHAPTER SIXTEENThe Domino Effect221Even though the short-term view of Renal Treatment Centerslooked like nothing special was going on, the longer-term view clear-ly showed that this stock was sketching out a potential superstockbreakout pattern—you can see the advantage that a longer-term per-spective can give May 1997, Vivra soared to $35 following a takeover bid. Thestock had split 3-for-2, so the original recommended price of $24was adjusted down to $ November 1997, Renal Treatment Centers, which had split 2-for-1 since our recommendation, received a $ per share takeoverbid. Take a look at the chart of Renal Treatment Centers in Figure16–3 and you will see that the original superstock breakout patternin mid-1995 that prompted the initial recommendation at a split-1adjusted $11⁄2looks like just a distant memory on this long-termFigure 16–3Renal Treatment Centers (RXTC), 1995–1997Source:Courtesy of Mansfield Chart Service, Jersey City, NJ.
Chap 16 7/9/01 9:18 AM Page 222222PART THREETakeover Clueschart. Again, the importance of having just the right perspective can-not be recommended three kidney dialysis companies between1994 and 1997, all of which were taken over and all of which gener-ated huge profits for my did it happen?It happened by recognizing a potential superstock breakoutpattern in Vivra, which led to focusing on the dialysis industry. Aleveraged buyout fund had proposed a merger of Vivra and NationalMedical Care, and even though that merger never took place, it wasa harbinger of merger activity within this industry. And it happeneddue to anticipation of the “Domino Effect” in this industry: I wenton the lookout for other potential candidates with superstock break-out patterns (Renal Treatment Centers) and/or outside beneficialowners (Ren-Corp. USA).In other words, it happened by using several of the toolsdescribed in this book—in particular, with a chart pattern that direct-ed my attention to this industry in the first place.
Chap 17 7/9/01 9:02 AM Page 223CHAPTER SEVENTEENMerger Mania: Take theMoney and RunMy son, my son, if you knew with what little wisdom the world is causes the “Domino Effect”? What are the forces that canunleash a takeover wave that literally causes an entire industry toimplode, where most of the smaller to mid-size companies are gob-bled up by their larger competitors, transforming an industry froma fragmented hotbed of competition to one controlled by a handfulof giants?They are the same forces that have always driven the financialmarkets, and always will: fear and one or two large takeovers in any given industry takeplace, the fear factor kicks in among other companies within thatindustry. After a couple of strategic acquisitions occur—sometimesit only takes one—other players within the industry become fear-ful. Fearful of what? Well, they may be fearful that their competi-tors, through acquisitions, will achieve economies of scale or greatermarket share, and that they will become more efficient, competitive,and powerful. Or they may be fearful that their competitors havefigured out a strategic approach that they themselves have notthought of yet. Even if they cannot figure out what the heck the rea-soning may be behind any given acquisition, they may be fearful223Copyright 2001 The McGraw-Hill Companies, Inc. Click Here for Terms of Use.
Chap 17 7/9/01 9:02 AM Page 224224PART THREETakeover Cluesthat once they dofigure out the rationale, there may not be any attrac-tive acquisition candidates left to be purchased at a reasonable , then they become fearful that if they do not play “followthe leader” by acting nowand buying somebody, they will be left outof the parade when the reasoning becomes apparent to everyone,or they’ll be forced to pay too much even if they do identify atakeover candidate. And sometimes it is simply the fear of beingacquired itselfthat leads a company to take over another company, asan act of self-defense, the reasoning being that if you make yourselfbigger, you’re less likely to become a target and more likely to beone of the survivors once the consolidation trend runs its can guess what you are thinking: How can astute businessexecutives making momentous decisions regarding multibillion dol-lar mergers act on nothing more than emotional reactions to what acompetitor is doing? These decisions, you’re thinking, must be madein a sober, intelligent, and businesslike manner by serious peoplewho have sound, logical, and well-thought-out reasons for offeringto acquire another , sometimes that is exactly how these decisions come sometimes in the 1980s, the chief executive officer of a company oper-ating in an industry where takeovers were proliferating made a com-ment that I will never forget. I had called him to ask if his companyhad been approached about a possible takeover; I considered thecompany to be a potential takeover target and I was thinking ofadding the stock to my recommended CEO told me that “we are actually more likely to be an acquir-er of other companies; in light of what is going on in our industry, wefeel we should be making acquisitions, although, frankly, we are notentirely convinced of the rationale behind those acquisitions. . . . ” Hisvoice trailed off, and then he added: “That was off the record, by theway. Don’t quote me on that, okay?”I never did quote that CEO, and his company actually woundup being acquired before it was able to buy someone else. But hiscomment stuck because he was saying: Everybody else is takingover companies, and if we want to keep up with them and remainindependent and not become a target, I suppose we will have to buysomebody, but we’re not at all sure why we’re doing this and whetherthese details make any business sense. But what the hell.
Chap 17 7/9/01 9:02 AM Page 225CHAPTER SEVENTEENMerger Mania: Take the Money and Run225In 1993, Merck & Co., the giant pharmaceutical company, decid-ed it would be a good strategic move to acquire a pharmacy benefitsmanager (PBM). PBMs were obscure businesses at the time. Basically,they acted as agents for employers and their job was to process pre-scription claims, make deals with drug suppliers, and generally con-trol the costs and manage the health care process for those who didn’twant to bother with it. Merck’s bright idea was to buy one of thesePBMs and to use it to direct business toward Merck knew at the time whether this would turn out to be afantastic idea or an absurd idea—but after Merck made its move,other pharmaceutical companies simply had to own a PBM, and PBMstock prices took off because they were perceived to be takeover tar-gets. Shortly after Merck bought its PBM, SmithKline Beecham fol-lowed suit, buying Diversified Pharmaceutical Services for $ bil-lion. “Over the past year,” SmithKline declared in announcing thetakeover, “we have conducted an exhaustive analysis . . . and con-cluded that the unique alliance announced today positions us to win.”Less than 5 years later, SmithKline would unload its $ billion“unique alliance” for $700 million. But of course, nobody knew thisat the , Eli Lilly & Co. was watching its competitors scram-ble to get into the pharmacy benefits business. At the time of theMerck acquisition, Eli Lilly had not yet even dreamed of buying aPBM. In fact, in a burst of candor, Eli Lilly’s chief financial officersaid at the time,”We looked at Merck’s move and said, ‘What thehell is a pharmacy benefits manager?’”In other words, it was not as though Eli Lilly’s strategic thinkershad been sitting around for months, studying their computers andtheir spreadsheets and musing over the wisdom of strategic diver-sification through the purchase of a PBM, only to finally feel impelledto make its move following Merck’s entry into that truth was that Lilly was not even thinking along those lines,and the PBM business was not even on the Lilly radar that did not stop Eli Lilly from paying $4 billion, or 130times earnings, for PCS Health Systems on July 11, on the heels of Merck and SmithKline, Eli Lilly & Co. hadsnagged its very own pharmacy benefits manager. Once these twocompetitors had made their moves, Lilly decided it simply had to getinto the PBM business. And so it did.
Chap 17 7/9/01 9:02 AM Page 226226PART THREETakeover Clues“We believe,” said Lilly, “it’s the jewel of those that are outthere, and we believe we acquired that jewel at a very attractiveprice.”Barely 4 years later, Lilly wound up selling its $4 billion “jewel”to Rite Aid for $ billion.“Our experience,” said Lilly as it exited the PBM business, “hasbeen that certain businesses can benefit from new ownership arrange-ments.”In November 1999, Rite Aid announced that it would attemptto sell PCS Health Systems for a price in the neighborhood of $ bil-lion, which was $200 million less than it paid for the company a were no February 25, 2000, a Rite Aid spokesperson told that the company had “multiple bidders” for PCS HealthSystems. “We need to sell it because we need to pay debt,” said thespokesperson. Rite Aid, you will recall, had gone on an acquisitionspree during the drugstore takeover mania. The company’s overlyambitious expansion strategy combined with accounting irregulari-1ties had pummeled its stock, which had plunged from a high of $51⁄81in January 1999 to as low as $4⁄2, a decline of 91 percent—one of theall-time great examples of a respected, predictable company in a sta-ble industry self-destructing by turning into a serial on February 25, 2000, The Wall Street Journalreported thatrival drugstore company CVS was interested in buying PCS HealthSystems from Rite Aid for between $800 million and $1 billion—aprice that would have been 33 to 46 percent less than Rite Aid hadpaid a year denied that it was interested in buying PCS , on April 11, 2000, Rite Aid announced that it was unableto sell PCS Health Systems at a reasonable price. “While we will con-tinue to explore opportunities to sell PCS at some point,” said RiteAid’s new CEO, Bob Miller, he conceded that the price Rite Aid couldget for PCS at the current time was “very depressed.”Rite Aid also announced that it had reached an agreement torestructure a portion of its massive debt load, much of it relating toits purchase of PCS Health Systems. As part of the agreement, agreed to convert $200 million of debt into Rite Aid commonstock valued at $ per share.
Chap 17 7/9/01 9:02 AM Page 227CHAPTER SEVENTEENMerger Mania: Take the Money and Run227PCS Health Systems would be part of the collateral to secure thisnew debt restructuring, said Rite saga of PCS Health Systems by this point was beginning toresemble a WallStreet version of “Old Maid”—only this time Rite Aidwas finding no takers. And it was all touched off by Merck’s decisionback in 1993 to diversify into the pharmacy benefits business, whichled Merck’s rivals to follow suit in a lemminglike stampede thateventually took Rite Aid to the brink of disaster and lopped 91 per-cent off its stock stories will help you understand one of the major reasonswhy the “Domino Effect” occurs: Corporate managers can act likelemmings, just like anyone else. Sometimes a merger wave in anindustry is touched off for logical and perceptive reasons, and every-body else in the industry can be jolted into awareness by the bril-liance of the initial takeover transaction, which forces them to getinto the act before it is too late. And sometimes everything turns outjust times, however, the mad rush to imitate and consolidateis based on less perceptive reasoning—such as the fear that one ofyour competitors has figured out something you haven’t eventhought of yet, which means you had better do the same thing, fast,and you can figure it all out , that is how “fear” can touch off the “Domino Effect.”Then there is the “greed” will probably not surprise you to learn that corporate CEOscan have large egos, and it will also not come as much of a shockthat some takeovers take place simply because the number two ornumber three company in an industry had just become the largestcompany through an acquisition, and therefore the former industryleader decides that it too will have to take somebody over just toregain its status as the top dog. Or it may simply be a case of an exec-utive with a personal whim to get into a certain September 1989, Sony, the Japanese electronics and enter-tainment giant, purchased Columbia Pictures for $ billion plus$ billion in assumed debt. The deal stunned both Hollywood andWall Street, which felt that Sony had staggeringly overpaid for themotion picture studio, a transaction that represented the highestprice a Japanese company had ever paid for an American , in fact, had paid $27 a share for Columbia— times the value
Chap 17 7/9/01 9:02 AM Page 228228PART THREETakeover Cluesof Columbia’s stock after the shares were spun off from their formerowner, Coca-Cola company, just 2 years the deal was announced, most observers believed theprice to be preposterous. Vanity Fairmagazine called the acquisition“a comic epic.” Forbes magazine called it an example of “unprece-dented naiveté.” Asource on Columbia’s side of the negotiations told authorsNancy Griffin and Kim Masters, who chronicled Sony’s Hollywoodmisadventure in Hit & Run,that the price Sony paid for Columbia“had no relationship to the worth of the entity.”But that was only the beginning. Sony also paid $200 million forGuber-Peters Entertainment, a production company that had lost$ million on revenues of $ million in its most recent fiscalyear because it wanted the expertise and management services ofits owners, producers Peter Guber and Jon their guidance, Sony/Columbia proceeded to embarkon a spending and production spree that culminated in a November1994 write-off of $ billion—a gargantuan loss even by the stan-dards of Hollywood, which knows a thing or two about losing themoney of years afterward, Hollywood insiders, Wall Street analysts,and others who witnessed Sony’s colossal miscalculation, have won-dered: How could a respected, well-run and experienced companylike Sony have made such an error in business judgment?Finally, in 2000, we got the answer. In a book entitled Sony: ThePrivate Life, author John Nathan described how the ultimate deci-sion to buy Columbia Pictures came about. According to Nathan,who was granted access and cooperation by Sony in the writing ofhis book, Sony’s CEO Norio Ohga—who had been the leading pro-ponent of the Columbia takeover—told a meeting of Sony execu-tives in August 1989 that he had a change of heart. Sony’s founderand chairman, the revered Akio Morita, responded that he, too, washaving second thoughts about the wisdom of buying to the minutes of that board meeting, the decisionwas made to withdraw the takeover bid. The minutes read: “PerChairman, Columbia acquisition abandoned.”But later that evening the Sony executives changed their deci-sion and agreed to go ahead with the takeover of Columbia.
Chap 17 7/9/01 9:02 AM Page 229CHAPTER SEVENTEENMerger Mania: Take the Money and Run229Why?While Sony executives were having a dinner break, some of theboard members overheard Sony’s chairman Morita say, softly, “It’sreally too bad. I’ve always dreamed of owning a Hollywood studio.”When the board meeting resumed, Sony’s CEO—apparently indeference to the emotional desire of his beloved and respected chair-man, who had already concurred with the cancellation of the deal—told theexecutives that he had reconsidered the situation during dinner, andnow believed that Sony should buy Columbia Pictures after all—assuming, of course, the Sony chairman Morita concurred with hischange of heart. Which, of course, he that is how Sony blundered into the Godzilla of all , power, industry leadership, status—even childhooddreams—these are all potential driving forces for corporate takeovers,probably more so than many corporate executives would care September 1995 the New York Daily Newsran a tiny item thatquoted Michael Dornemann, CEO of Bertelsmann AG, the largestmedia company in Germany and the third-largest media companyin the world. The brief quote, which was attributed to the Germanweekly news magazine Der Spiegel, was highly critical of the recentwave of megamergers in the media and entertainment businesses.“From a businessman’s point of view,” Dornemann told Der Spiegel,“I can only say the Americans are crazy to pay such prices.”In the interview, Dornemann said that prices being paid . media properties were, in the immortal words of Crazy Eddie,insane. He said that the megamergers being crafted were not beingengineered for sound business reasons, but because of the huge egosof the media moguls involved and the desire of Wall Street invest-ment bankers to generate feels.“The big media companies are in a kind of race to see who willhave the biggest operation,” he said, “and the prices are simplyhyped up. This sort of thing will never pay off. I predict that manyof these mergers will not last.“The desire for size and power can be a dangerous secondarymotive” for many mergers, Dornemann went on to say. He said thatWall Street investment bankers had learned to use the egos of CEOs
Y L F M AChap 17 7/9/01 9:02 AM Page 230 E T 230PART THREETakeover Clues to their advantage, prodding them to do deals by playing on a CEO’s desire to be the biggest or to simply keep up with a rival. “Do not be fooled,” he said. “WallStreet has big interest in having big deals like this. The investment bankers earn good money on such takeovers, and for that reason they make sure that the necessary euphoria exists.” That last comment can be taken as as implication that Wall Street’s euphoric reaction to certain megamergers, even so-called mergers of equals where no premiums are involved, can be more contrived than real, and that it only serves to encourage the next round of megamergers. Dornemann also scoffed at the idea that “synergy” (see Chapter 14) can justify sky-high buyout prices—., that producers of pro-gramming must absolutely own a network or other distribution out-lets, and that cross-promotion among va rious media propertieswould enhance the value of the entire enterprise. “History has shown,” he told Der Spiegel, “that a lot can be justified on the basis of synergy, with very little ultimately achieved.” ®Which brings us to the investment -Fly Of all of the forces that can touch off a Domino Effect–typetakeover wave in any given industry, the WallStreet investmentbanking community’s insatiable desire for fees must top the list. Assoon as any new industry is hit with a significant takeover, invest-ment bankers all over the country start burning the midnight oil inan attempt to play matchmaker, trying to find the perfect target forthe perfect buyer. Once they find a potential match, they barrage thepotential buyer with unsolicited advice, trying to convince the man-agement of the potential buyer that they must make this or thatacquisition, before somebody else does and they are left on the out-side of the consolidation window, looking of the deals these investments bankers pitch to potentialclients will turn out to be winners, and some will turn out to be dis-astrous mistakes, and it is not always easy to determine at the timewhich will be to you, as a superstock takeover sleuth the ultimate out-come of these takeovers is irrelevant: All you will care about is thatyou own shares in the target company and that someone is offeringto pay you a premium for those the years, a curious “spin” on the takeover scene has devel-oped among mainstream Wall Street analysts and institutional money
Chap 17 7/9/01 9:02 AM Page 231CHAPTER SEVENTEENMerger Mania: Take the Money and Run231managers: They claim investors are better off owning shares in theacquiring companies rather than the target have always suspected that much of Wall Street’s support andenthusiasm for the acquiring companies was designed to (1) createbuy recommendations for institutions that were more inclined tobuy higher-priced, liquid high-capitalization stocks anyway, and (2)keep the stock prices of the acquiring companies going higher sothey could continue to use their stock to acquire more companies, andso their rising stock prices would serve as examples and induce-ments for other companies to do the same, thereby keeping thetakeover assembly line humming and keeping those huge invest-ment banking fees rolling December 1999 a study by the accounting and consultingfirm KPMG confirmed that after studying the 700 largest cross-bor-der mergers between 1996 and 1998, 83 percent of these deals failedto produce any benefits to shareholders. “Even more alarming,” saidKPMG, “over half actually destroyed value.”The shareholders KPMG was talking about, of course, were theshareholders of the acquiring company—the “gobbler” that was sup-posedly going to manage the assets of the target company better,achieving economies of scale and other miracle efficiencies thatwould enhance value for their shareholders. KPMG was also talkingabout the shareholders of companies involved in so-called mergersof equals, where two huge companies simply combine operations,with no premiums being paid to anybody. Based on this, the stockprices of both companies often rise sharply at first, as though some-thing new is about to be created. Remember: “synergy,” as in twoplus two equals KPMG demonstrated, however, was that much of the bal-lyhoo surrounding many of these deals was just a lot of hot air—not a scarce commodity on Wall Street, certainly, but surprising per-haps in this light since so many institutional money managers havebought into the 1960s retread concept of “synergy” hook, line, andsinker. (On the other hand, when you consider that many of today’smoney managers were not even born in the 1960s, perhaps not so sur-prising.)The lesson is this: The way to make money investing in takeovers isto own shares in a company that becomes a takeover target of another com-pany willing to pay a premium for the target company’s stock.
Chap 17 7/9/01 9:02 AM Page 232232PART THREETakeover CluesThe big pharmaceutical companies that acted like lemmingsand scooped up the pharmacy benefits managers were losers as aresult of this strategy, and so were their shareholders. The winnerswere those investors prescient (or lucky) enough to own shares in thePBMs, which soared in price as a result of the takeover examples of “synergistic” losers: •Quaker Oats was a loser when it bought Snapple for $ in November 1994, and so were its shareholders:1Quaker Oats unloaded Snapple for $300 million 2⁄2yearslater. The big winners were the Snapple shareholders, whotook the money from Quaker Oats and moved on. •Novell shareholders were losers following that company’spurchase of WordPerfect for $ billion in stock in March1994. Less than 2 years later Novell unloaded WordPerfectfor $124 million, but the original WordPerfect stockholderswho took the money and ran made out just fine.•Albertsons stockholders saw the value of their stock plungewhen it proved far more difficult than expected to integrateitself with American ’s the best thing to do when one of your stocks is the sub-ject of a takeover bid and the acquiring company is offering youshares of its own stock and the opportunity to participate in somegrand vision of the future as the combined companies create evergreater value in the years to come?The following rule of thumb has served investors well over theyears: If you buy a stock because you believe it is a takeover candi-date, and you are fortunate enough to receive that takeover bid, takethe money and run. Leave the “synergies” and the “economies of scale”and all of the future growth prospects to the Wall Street analysts andinstitutions who invest on this basis—they may turn out to be rightor wrong, but most of the time that will notbe the reason you boughtthe target company in the first place, and you should not stick aroundto find on to see what can go wrong after the takeover occursand the happy bloom of marriage has faded into the reality of every-day business. These are cautionary tales of why it may not pay to buyinto the grand strategic vision that often accompanies the press
Chap 17 7/9/01 9:02 AM Page 233CHAPTER SEVENTEENMerger Mania: Take the Money and Run233release announcing a takeover bid, and why you are usually betteroff taking the profit from the takeover and walking STUDY: JCPENNEY AND RITE AIDJCPenney was one of the major acquirers of drugstore companiesduring one of the greatest examples of the Domino Effect that WallStreet has ever seen. Penney acquired two of my drugstore takeovercandidates: Fay’s Inc. in July 1996 and Genovese Drug Stores inDecember 1998. In each case, these target companies chalked up biggains for my subscribers, who were then faced with a choice: Shouldthey simply take their profits and move on, or should they acceptshares in JCPenney as a long-term play on the benefits of consoli-dation in the drugstore industry?At the time it seemed to make sense to go along for the ride, hop-ing that JCPenney would continue to be a growth stock as it wrungnew profits out of its growing collection of drugstores and usedthose stores to complement its department store , when drugstore consolidation was sweeping Wall Street,it seemed to make all the sense in the world to everyone involved,and there was little reason to doubt that the strategy of combiningsmaller chains would reap major “guru” of this line of thinking was Martin L. Grass, chairmanand CEO of Rite Aid, who never missed an opportunity to explain tothe media and to Wall Street the reasoning behind drugstore , it was an interview with Mr. Grass and his vision of drug-store consolidation that led to my recommendation of several smalldrugstore stocks as takeover candidates in the first place.“Drugstore consolidation is going to continue,” Grass told TheWallStreet Journalon September 12, 1996, “because the economiesare overwhelming. The smaller chains can’t survive as independentcompanies. The independent operators are doomed.”Shortly before his own company was acquired by JCPenney, adistrict manager of the Eckerd drugstore chain waxed enthusiasticabout the new avenues of marketing that would be available to chainswith larger data banks of customers: “Say a brand new medicinecomes out that is just far superior to anything that is on the market,”he said. “We could be able to look at our customer base and see who
Chap 17 7/9/01 9:02 AM Page 234234PART THREETakeover Cluesmight be better served by this new medication. We would informthose people, ‘Hey, there’s a new change on the horizon. Ask yourphysician about it.’” Larger customer bases would provide the drug-store consolidators more information on medical histories and there-fore create new and innovative marketing possibilities. “If one storeserves a large number of diabetics,”The Journalsaid in 1996, “thechain can establish special services at the location.” In January 1997,The Journalran another story on the logic behind drugstore consoli-dation, explaining that “mergers provide big chains with strong mar-ket share, and thus clout, in negotiating more beneficial prescriptionprices with managed care companies. Acquisitions can also bringattractive lists of prescription customers to whom other products canbe marketed. They also permit buyers to slash operating costs in thechains they pick up, thereby increasing their own efficiency.”Awarning signal—and a prescient one, at that—was also sound-ed in The WallStreet Journal’s January 2, 1997, story on the mergermania in the drugstore industry. The mergers, it was noted, “do notaddress a range of endemic problems for drugstores, from their gen-eral laziness about marketing to their typically lackluster serviceand staff.”So, here was the choice faced by Fay’s and Genovese stock-holders when JCPenney offered to exchange Penney shares for thesecompanies: Should I sell and take the profit? Or should I takeJCPenney stock and become a part of Penney’s growth strategy in thedrugstore industry?There were two ways to look at it. If you owned both Fay’s andGenovese because you wanted a long-term investment in the drug-store industry, and you had been pleasantly surprised by takeoverbids, perhaps you would have decided to accept JCPenney shares andhold for the long term so your portfolio would continue to be exposedto the drugstore industry. That would have been a sensible point ofview, although it probably would have made more sense to own a“pure play” drugstore company rather than a company weigheddown by slower-growing department the other hand, if you had purchased Fay’s and GenoveseDrug Stores strictly because you believed they were superstocktakeover candidates—and if you turned out to be correct—whywould you want to exchange these stocks for shares in JCPenney?The original premise had proven correct, both companies became
Chap 17 7/9/01 9:02 AM Page 235CHAPTER SEVENTEENMerger Mania: Take the Money and Run235takeover targets and substantial profits had been made. Why take aleap of faith and become a long-term investor in JCPenney?The outcome of this story can be seen on a JCPenney stock pricechart: Penney shares performed miserably, falling from a high near$70 in early 1998 to below $20 by year-end 1999. Along the wayJCPenney cut its dividend nearly in February 24, 2000, JCPenney announced that it would close289 of the Eckerd drugstores it had acquired, along with 45 depart-ment stores, resulting in $325 million in mid-April, JCPenney shares were trading under $13—down81 percent from their high in early 1998. In September 2000, JCPenneycut its dividend again. It also announced that it would close 270Eckerd drugstores and that it would report a quarterly loss due inlarge part to its underperforming drugstore operations. By that timeits stock had fallen to $9. Meanwhile, as we have just seen, Rite Aid, the drugstore addictthat had led the way toward the industry’s consolidation, had becomea basket case and investors were beginning to wonder whether theentire premise of the takeover wave that had engulfed the industrywas flawed. (Keep in mind that you would not have needed to evenponder this question had you simply taken the profits on your drug-store takeover targets and used it to buy a cottage on the lake, whereyou could have sat and pondered something more pleasant.)Rite Aid’s problems, you see, were not confined to PCS Aid discovered that cost-cutting and”efficiencies” some-times impacted customer service—often with disastrous of drugstore chains acquired by larger companies beganto notice a distinct reduction in the quality of service, and manybegan to shop elsewhere. (Some of the big banks discovered thesame thing following acquisition sprees in the mid-1990s: Sharplyreducing customer service at acquired banks was a quick way to cutcosts and improve profit margins, but poor service and customerdissatisfaction eventually took their toll and many of these acquisi-tions turned out badly.)Rite Aid also discovered that it is not always the easiest thing tointegrate drugstore chains from various sectors of the country into aseamless and efficient operation because it can be difficult to com-bine operations that bring different business philosophies, different
Chap 17 7/9/01 9:02 AM Page 236236PART THREETakeover Cluesoperating heritages, and a distinctly different mix of people alongwith particular, Rite Aid ran into trouble with its acquisition ofThrifty-Payless, a 1000-store chain it bought in 1996 for $ billionin Rite Aid stock. Thrifty-Payless was the largest drugstore chain onthe West Coast, and its merchandising mix was far different fromanything Rite Aid was used to operating. In addition, the Thrifty-Payless chain required extensive remodeling. Rite Aid respondedby changing the stores’ merchandising offerings, sharply reducingadvertising, and generally trying to turn Thrifty-Payless into whatRite Aid wanted—which was Rite Aid only problem with this was that Thrifty-Payless customersshopped at Thrifty-Payless because they likedThrifty-Payless andits unique mix of merchandise and style, which had grown to reflectthe communities in which the company operated. The result: As RiteAid changed the stores, sales began to the chart in Figure 17–1 illustrates, Rite Aid stockholders—including those who owned the drugstore companies Rite Aidacquired and took Rite Aid shares in return—suffered through anightmare in 1999, the year in which grand strategy of growththrough acquisition so eloquently (and often) expressed by Rite Aidchairman Martin E. Grass began to unravel. Throughout 1999, RiteAid issued one earnings warning after another, including one infa-mous announcement that rescinded an earnings forecast that hadjust been made by its own chairman. Rite Aid told Wall Street thatit “should not rely on forward-looking profitability and cash flowinformation” the company had just recently given to analysts at anOctober 11, 1999, meeting. Shortly thereafter, Grass resigned, and sodid Rite Aid’s year-end 1999, the Motley Fool summed up the sorry sagaof Rite Aid this way: “The root of the company’s problems stemsfrom an aggressive acquisition play that has failed miserably, leav-ing Rite Aid mired in debt.”Meanwhile, JCPenney’s stock price continued to feel the falloutof the Rite Aid debacle. Penney, after all, had been one of the biggestdrugstore “gobblers”—and Wall Street, which had cheered on thedrugstore merger wave while it was happening, now began to recoilfrom the entire premise.
Chap 17 7/9/01 9:02 AM Page 237CHAPTER SEVENTEENMerger Mania: Take the Money and Run237Figure 17–1Rite Aid (RAD), 1998–2000Source:Courtesy of Mansfield Chart Service, Jersey City, a result, a Fay’s stockholder who took JCPenney stock in the fallof 1996 would have seen the value of that stock fall from the $45 to $50area to below $20 by the end of 1999, a decline of up to 60 percent duringone of the greatest bull markets in history, which would have wiped out thebulk of the takeover premium Fay’s stockholders received in the first place!And a Genovese Drug Stores stockholder who took JCPenneystock in early 1999 would have seen an equally vicious decline, whichwould have wiped out the bulk of the takeover premium offered toGenovese stockholders in a breathtakingly short period of , those who simply sold their Fay’s and Genoveseshares following the takeover bids received full value for their stock andwere in a position of being able to deploy the proceeds somewhereelse, in some other takeover candidate somewhere down the line.
Chap 17 7/9/01 9:02 AM Page 238238PART THREETakeover CluesCASE STUDY: THE ALARMING STORY OFPROTECTION ONEHere’s another horror story that illustrates a grand acquisition/diver-sification strategy gone awry. Between 1996 and 1998, the security alarm business experi-enced the Domino Effect as a series of companies—including ADT,Holmes Protection, Alarmguard, and others—were acquired in rapid-fire order. All of these were on my takeover list (see Introduction),and all were taken over one after the takeover targets was Protection One (NYSE: POI),which was acquired by Western Resources in July 1997. ProtectionOne was recommended as a takeover candidate in January 1997 at1a price of $9⁄2. In July 1997, Western Resources, a midwestern utili-ty, offered to buy 80 percent of Protection One by making a specialone-time $7 per share cash payment to Protection One shareholdersand then combining Western Resources’ own home security opera-tions with those of Protection One, creating a much larger companythat could benefit from—you guessed it!—economies of the time, I had just had a pleasant experience with WesternResources, which led me into a successful takeover recommenda-tion of ADT Ltd (see Chapter 9). Western was run by David Wittig,who had been lured from his investment banking duties at SalomonBrothers to lead Western Resources into a brave new world of diver-sification following the deregulation of the utility industry. One ofWittig’s first moves was an audacious 1996 hostile takeover bid forKansas City Power & Light. What made this bid audacious, otherthan the fact that hostile takeovers in the genteel utility industrywere rare, was that Kansas City Power & Light had already agreedto be acquired by a neighboring utility, Utilicorp United. Anastyfight ensued, with charges and countercharges flying all over theplace among the three combatants. But in 1997, Western Resourcesand Kansas City Power & Light reached a friendly merger agree-ment. That deal unraveled 11 months later, in December 1997, whenthe stock price of Western Resources got too strong, rising from thelow $30s to the low $ a result of Western’s rising stock price, Western’s invest-ment bankers decided that Kansas City Power & Light stockholderswere getting too good a deal—so the terms were revised.
Chap 17 7/9/01 9:02 AM Page 239CHAPTER SEVENTEENMerger Mania: Take the Money and Run239In light of what was about to happen, this proved to be the ulti-mate Resources had been trading around $30 a share when42-year-old David Wittig arrived as its CEO in 1995, charged withtransforming Western Resources from a sleepy utility into a lean,mean acquisition Western Resources bought and sold a huge stake in homesecurity company ADT in 1996, turning an $864 million profit whenADT was ultimately acquired by Tyco International, Wittig decidedthat Western Resources’ major push into the home security industrywould be accomplished through the acquisition of Protection had previously purchased the home security business ofWestinghouse Electric, and Wittig now sought to combine thoseoperations with Protection One and then use the new company as avehicle to further expand into that business. The move made strategic sense to almost everybody. Here wasa utility company that ran lines into a home and provided a servicefor which it was paid on a monthly basis, like clockwork. As Westernand Wittig saw it, the home security business was little different: Aninitial marketing push and the onetime expense of installing an alarmsystem would then yield to a steady stream of “monthly recurring rev-enues,” and it would all have to be supported by the sort of infra-structure that a utility company like Western Resources already hadin place. So, the theory went, Western could cross-market its utilityservices to its home security customers, and vice versa. In interviews,Wittig was talking about further diversifying Western Resources alongthe same lines into areas such as telecommunications or cable so, when Protection One soared from the original recom-1mended price of $9⁄2in January 1997 to $21 in July of that year, fol-lowing the Western Resources takeover bid, shareholders faced achoice: Should they simply take the profit and move on? Or shouldthey stick around for the $7 per share cash payment and then holdthe ex-dividend shares of Protection One for the long haul, bettingthat Western Resources, as POI’s new majority shareholder, couldsuccessfully implement its growth strategy?The Western Resources strategy seemed like a good one, butwith more than 100 percent profit in only 7 months in a stock that hadcorrectly been predicted as a takeover target, the decision was totake the profit and get out of Dodge.
Y L F M AChap 17 7/9/01 9:02 AM Page 240 E T 240PART THREETakeover Clues I told my subscribers: “Since I am focusing mainly on takeover candidates, I am going to bid farewell to Protection One. If you were prescient enough to own Protection One, I would suggest a switch to either Holmes Protection or Alarmguard,” two other security alarm takeover candidates. This turned out to be the correct move. Both Holmes Protection and Alarmguard ultimately received takeover bids and the Domino Effect continued to sweep through the security alarm business. Western Resources, pleased with the reception that its growth strategy had received on WallStreet, promoted David Wittig to chair- man and CEO in May 1998. Western’s stock price had jumped from7 $30 when Wittig arrived in 1995 to a high of $48⁄8in March 1998— not bad for a conservative utility company in the midst of meta-morphosis. In October 1998, Western Resources kept the dominoes falling in the alarm industry when its now 85 percent-owned Protection One unit agreed to acquire Lifeline Systems, a company that provided alarm- ®paging services to elderly people through a nationwide network ofTeam-Fly hospitals. Lifeline customers wore paging pendants around their necks,which could be activated if they needed medical assistance. Asignalwould then be sent to a Lifeline Systems control center, which wouldthen alert the nearest hospital to the emergency David Wittig, this was a natural offshoot of the home secu-rity alarm expansion program that Western Resources had been pur-suing through Protection One. In announcing the deal, he also toldThe WallStreet Journalthat Western was on the lookout for still moreacquisitions outside the electric utility industry, possibly includingbottled water companies, which struck me as a dangerous mix withan electric WallStreet Journalnoted that utility companies had tried oncebefore to diversify and “had failed at it in the 1980s, when they boughtcompanies such as savings & loans, a drugstore chain, and even aninsurance company.” But The Journalreported that unlike the past,Mr. Wittig said that “Western is investing in businesses that are sim-ilar in terms of the relationships we’re having with the customers.”The Journalalso noted that Protection One had nearly tripledits customer base since being acquired by Western, and that it hadspent about $1 billion on acquisitions, buying 20 security companies inthe . and also overseas in the year since it was bought by Western.
Chap 17 7/9/01 9:02 AM Page 241CHAPTER SEVENTEENMerger Mania: Take the Money and Run241Meanwhile, Protection One stockholders were beginning tohear alarm bells of their own. Following the $7 per share cash pay-ment, the stock fell from its “ex-dividend” high near $14 throughout1998. By year-end, the steady price erosion had taken Protection Onedown to the $8 area. Early in 1999, Protection One shares plungedrapidly, falling as low as $5, before stabilizing in the , WallStreet sensed a mid-1999, the festering problems finally came to the sur-face: Protection One announced that its cash flow had turned nega-tive, that it was suffering from a growing rate of customer attrition,that its accounting practices had come under the scrutiny of theSecurities & Exchange Commission, that the company would lose$ million in the third quarter, and that it had failed to meet theterms of its banking lending agreements. Then, Protection One ter-minated its previously announced acquisition of Lifeline Systems. Finally, in October 1999, Western Resources acknowledged that ithad erred in its belief that Protection One would become a vehicle forgrowth in the security alarm business. “Western Resources has expe-rienced some short-term financial challenges with regard to itsProtection One investment,” the company said in a press release, whichhad to be in the running for “Understatement of the Year.” Westernadded that “while the security alarm business generates strong cashflow, it has not generated net income.” Therefore, said Western, it wasnow “considering alternatives” for its 85 percent-owned security alarmbusiness, which had by this time declined to under $2 a share—a sick-ening 85 percent decline from its $14 peak in less than 2 years in themidst of one of the greatest bull markets of all Western Resources was “considering alternatives,” whatalternatives were available to loyal shareholders of Protection Onewho had decided to hold their shares following the takeover and goalong as minority shareholders for the growth ride envisioned byDavid Wittig and Western Resources?The sad truth was that there wereno alternatives anymore, otherthan taking a tax loss and chalking it up to experience. Like an oppor-tunity that comes along and is then gone forever, the alternative wasavailable only for a brief time when Protection One rose to its ulti-mate high following the takeover bid. Those Protection One share-holders who seized the alternative had sold their shares on the openmarket and walked away.
Chap 17 7/9/01 9:02 AM Page 242242PART THREETakeover CluesMeanwhile, in the ultimate irony, by December 1999, Westernchairman and CEO David Wittig was hosting investor and analystdinner meetings in New York City trying to drum up support forhis badly sagging stock price. Western had plunged 46 percent in1999 to around $18, and at that low price Western’s merger withKansas City Power & Light—which had been held in regulatory pur-gatory for nearly 3 years—was now in 2 years earlier the deal had almost fallen apart becauseWestern’s stock price had risen too quickly based on Wall Street’sperception of David Wittig as an astute deal maker. The terms hadbeen negotiated downward in deference to Western shareholders,who owned an increasingly popular stock and did not want to givetoo much of it away to Kansas City Power & Light , the opposite was taking place: Because of the Protection Onedisaster, Western’s stock price had slumped so far that the deal wasin danger of coming apart once January 3, 2000, Kansas City Power & Light announced thatit had terminated its merger pact with Western Resources. After near-ly 3 years of negotiating, regulatory red tape, and untold millions inlegal fees, the Western Resources–KCP&Lmerger was undone, inlarge part, by the Protection One fiasco—a takeover that turned outvery badly for the acquiring company and its , as the 1990s drew to a close it was becoming increas-ingly apparent that it is a lot easier to take a company over than it isto run it in a manner that creates any long-term value for the “gobbler.”But of all the ironic developments that took place during thedisastrous diversification adventure of Western Resources, the finalplot twist topped them all: On March 29, 2000, 4 years after WesternResources made its first move to diversify out of the utility industryby purchasing its initial stake in ADT Ltd., and less than 3 years afteracquiring Protection One, Western Resources announced that it hadcome to the conclusion that it would be better off as—drum roll,please—a pure play!Proving once again that there is virtually nothing new under thesun, and that every innovative new concept eventually runs its courseand recycles itself, Western Resources admitted that its investorswould be better off if the company concentrated on a single busi-ness and that its grand strategy to become a 1960s style “conglom-erate” had been a failure.
Chap 17 7/9/01 9:02 AM Page 243CHAPTER SEVENTEENMerger Mania: Take the Money and Run243In a press release, Western Resources chairman and CEO DavidWittig announced that the company would split itself into two com-panies: an electric utility company named Westar Energy, and anoth-er company to be named later, which would consist of everything thecompany had acquired over the past few years, in an attempt todiversify itself and get its stock price higher.“We believe,” said Mr. Wittig, “that a pure play electric utilitycompany will unlock the valueassociated with our electric assets byproviding shareholders an investment opportunity exclusively inour electric utility operations.”The press release stated that Westar Energy, the new “pure play”utility company, would consist of two electric utilities, Kansas Power& Light and Kansas Gas & Electric, which provide electric service to628,000 customers in Kansas. The nonelectric utility company, whichwas yet to be named, would consist of Western’s 85 percent owner-ship in Protection One, its 100 percent interest in Protection OneEurope, a 45 percent interest in NYSE-listed natural gas transmis-sion company named Oneok (more about this later), and a 40 per-cent interest in a direct market company called, ironically, ParadigmDirect the time Western Resources decided to change paradigms bygoing back to the strategy of being a “pure play” (which is what thecompany was in the first place) rather than a collection of unrelatedbusinesses, Western’s stock price was scraping along near its lowsunder $15, down from a peak of nearly $40 in early 1998 when theinitial giddiness over its new relationship with Protection One wasstill masking the festering problems that would soon come to thesurface and cause Western’s stock price to press release from Western Resources, meanwhile, was agold mine of clues, information, and Telltale Signs for superstocksleuths. For one thing, as we have learned, when a troubled companystarts taking steps to return to its roots by jettisoning noncore operationsand turning itself into a pure play, its often a sign that the ultimate planis to sell the company. This is especially true when the company oper-ates in an industry that is already trending toward the case of Western Resources, it was a company that hadbeen doing perfectly well as a pure play Kansas-based utility. HadWestern just sat there and done nothing but make its utility operations
Chap 17 7/9/01 9:02 AM Page 244244PART THREETakeover Cluesmore efficient and profitable, there is a very good possibility that thetakeover wave, which struck the utility industry during the late 1990s,would have engulfed Western Resources, much to the delight of Western did not want to become a “gobblee”; in fact, thecompany aspired to be a “gobbler,” and it wound up undoing itselfand its shareholders by removing itself from its position of beingdirectly in the path of the regional electric utility takeover wave anddiversifying into a business—security alarms—that turned out to bea disaster for everyone except the shareholders of Protection Onewho decided to take the money and , having come full circle, Western Resources issued a pressrelease that contained three code phrases, or Telltale Signs, that wouldimmediately pique the interest of a superstock sleuth: pure play, corebusiness, and unlock the value. These three phrases would have imme-diately aroused the takeover antenna of any investor browsing thefinancial news who was familiar with the way of thinking you havelearned about here. Western was about to create a new company that consisted sole-ly of two Kansas-based electric utilities—about as pure a play as youcan get. Not only that, having produced and directed the utility indus-try version of Titanic, one would have to assume that Western’s man-agement would be in no position to fend off a takeover attempt of thisnew pure play electric utility should some other utility company makean offer for this company once it was separated from the rest ofWestern’s operations. In fact, the press release issued by WesternResources chairman and CEO David Wittig implicitly stated that pres-sure from shareholders to create an electric utility pure play was one of thedriving forces behind the decision to split the company in two , the logical assumption would be this: It’s very possible thatseparating the electric utility assets was the first step in having theseassets acquired, and even if that were notthe primary purpose of cre-ating the utility pure play, Western’s management, having lost mostof its credibility with its shareholders, would certainly seem to be inno position to reject a reasonable takeover bid for the newly separateutility company should one ultimately other words: Westar Energy, once it began trading separately,would have to be viewed as a potential superstock takeover candidate—and
Chap 17 7/9/01 9:02 AM Page 245CHAPTER SEVENTEENMerger Mania: Take the Money and Run245this stock should have been added to your universe of potential superstocksto keep a close eye the other side of the equation was the company that wouldown Western’s nonelectric utility assets—temporarily nameless butcertainly not without interest to a superstock sleuth, because one of itsmajor assets would be a 45 percent interest in Oneok (OKE), a NYSE-listed natural gas transmission -trained superstock sleuth—which would be you, by thistime—would immediately ask: What is Oneok? How did WesternResources wind up with this 45 percent stake? Is it possible that thisnewly independent company without a name might try to buy therest of Oneok or eventually sell its stake to a third party? Or mightOneok try to buy back that 45 percent stake in some way?To answer questions like these, the best strategy is to go to the10-K Report (the annual report filed with the Securities & ExchangeCommission) of the company whose stock is owned by the outsidebeneficial owner. The 10-K Report is available by going to the Website . It might take you a while, but if you browsethrough the 10-K, which is considerably more lengthy and detailedthan the annual reports published for public consumption, you willeventually find a description of how this outside beneficial ownercame to acquire its stock. In the case of Oneok, by checking out the company’s most recent10-K, you would have learned that this company provided naturalgas transmission and distribution services to million customersin Kansas and Oklahoma—right in Western Resources’neck of the you would also have learned that, in 1998, Oneok acquired thenatural gas distribution assets of Western Resources in exchange forOneok stock—and that is how Western Resources wound up with its45 percent stake in Oneok. In other words, when Western’s diversi-fication-minded management decided to branch out from the utili-ty business, one of its early moves was to sell its natural gas trans-mission business to reading the history of this transaction in the Oneok 10-K,you would also have learned that there was a “standstill agreement”between Oneok and Western Resources that prevented Western fromincreasing its ownership above 45 percent. And you would also havelearned that Oneok’s stated corporate strategy was to “acquire
Chap 17 7/9/01 9:02 AM Page 246246PART THREETakeover Cluesadditional distribution and transmission facilities and other assets,”and in fact Oneok had recently announced the $ million pur-chase of the natural gas processing plants plus the Kansas andOklahoma transmission systems of a company called Dynergy(DYN). The 10-K revealed that Oneok had agreed to buy SouthwestGas, a natural gas utility serving customers in Arizona, Nevada, andCalifornia, in 1999, but that Oneok had recently cancelled the merg-er checking out the insider trading data on Western Resourcesand Oneok, you would have learned that Western Resources hadbeen regularly selling off small chunks of its Oneok stake late in sleuth trained to look for situations like this wouldsee several possibilities, but no clear picture as yet to the ultimate out-come of this situation. But let’s put it to you this way:This situationwould appear to be pregnant with possibilities—and both the WesternResources companies and Oneok should have been immediately placed onthe superstock sleuth’s list of stocks to monitor just in case future TelltaleSigns were to fact that Western Resources had been selling off someOneok stock, combined with the fact that Oneok appeared to be acompany determined to acquire other companies—a “gobbler,” inother words—would seem to make it unlikely that the new WesternResources spinoff would seek to buy the rest of Oneok. This wouldbe especially true in light of the “standstill agreement.”But that would not prevent Western from selling its stake to athird party, which would then bid for Oneok. Or perhaps Oneokmight turn around and acquire the new Western spinoff to get that45 percent stake back. Or perhaps some third party would acquirethe Western spinoff to get a stake in Oneok as a prelude to a hostiletakeover knows?The point is this: There were possibilities here, a situation to bemonitored just in case one or more additional Telltale Signs were toemerge that might point you toward a clear and logical opinion asto what happened the best part is, had you been a Protection One shareholderwho took the money and ran, you would have had the capital totake a position in one of these stocks if and when further cluesemerged which made it seem logical to do so.
Chap 17 7/9/01 9:02 AM Page 247CHAPTER SEVENTEENMerger Mania: Take the Money and Run247On the other side of the equation, those Protection One share-holders who hung on to their shares after the Western Resourcestakeover by buying into the growth/diversification strategy wouldhave been reduced to wishing and hoping while watching theirinvestments shrink dramatically in other aspect of this situation to remember is this: You willfind, as you utilize the thought processes and strategies outlined foryou here, that familiar names will reappear over time, drawing yourattention to out-of-the-way news items you may not have noticed hadyou not been involved with a certain situation at a prior time. Overtime, in other words, accumulated experience will become a valuableally and will in turn lead you to further interesting—and hopefullyprofitable— STUDY: HOW MATTEL GOT PLAYED BY THELEARNING COMPANYIn December 1998, Mattel announced that it would acquire TheLearning Company for $ billion in Mattel stock. The LearningCompany was a seller of educational software and entertainmentprogramming, including Sesame Street and Reader Rabbit. The pro-posed acquisition of The Learning Company was viewed as anattempt by Mattel to transform itself from a traditional toy manu-facturer into what the company called “a global children’s productscompany.” In announcing the acquisition, Mattel called The LearningCompany “an excellent strategic fit” and said it would immediate-ly add to Mattel’s observers were not so sure. Among them was HerbGreenberg, columnist for , who wrote at the time thatThe Learning Company had attracted an unusually large and sophis-ticated legion of detractors. These skeptics, said Greenberg, had forsome time been questioning The Learning Company’s “aggressiveaccounting.” They also believed that The Learning Company was hav-ing difficulty moving products, that its distribution channel was cloggedwith inventory, and that the company was headed for openly questioned Mattel’s judgment in paying $ for The Learning Company when the deal was announced. Asit turned out, these were the very issues that would shortly returnto haunt Mattel and its stockholders.
Chap 17 7/9/01 9:02 AM Page 248248PART THREETakeover CluesOn October 4, 1999—just 5 months after the transaction wascompleted—Mattel unleashed a bombshell, disclosing that TheLearning Company would lose between $50 and $100 million in thethird quarter of 1999 compared to an expected profit. The problemsthat were surfacing were some of the very issues openly discussedby Herb Greenberg and The Learning Company skeptics beforeMattel even arrived on the scene. Yet Mattel went ahead with theacquisition and was apparently blindsided by the problems it shares, which had peaked near $30 earlier in 1999,7plunged 5 points to $11⁄8following the announcement, wiping outover $2 billion in shareholder value in a single only winners in the Mattel takeover of The LearningCompany were those Learning Company shareholders who tookthe money and ran following Mattel’s takeover bid. Those who optedto accept Mattel stock and hold on for the fruits of the synergisticmelding of these two companies wound up with huge , as in the case of Western Resources–Protection One,the Mattel–Learning Company fiasco also had an ironic ending inwhich several Telltale Signs a widely publicized acquisition turns out badly, the mediagenerally has a field day, and there seems to be a certain satisfactionin seeing high-paid corporate movers and shakers knocked down afew pegs when they must face the music and admit they have justlost hundreds of millions or even billions of their stockholders’money on an ill-advised acquisition. This can be especially gallingwhen, as in the case of Mattel, the acquisition turns sour in a breath-takingly short period of as we have just seen in the case of Western Resources andProtection One, the unraveling of an acquisition strategy can pro-vide more than a means for journalists to rake the “gobbler” over thecoals; sometimes the final chapter of an acquisition that has gonebad can turn out to be the opening chapter of a superstock key, as usual, is to watch for the Telltale the case of Mattel, soon after its stock collapsed on the newsof The Learning Company’s losses, a group of Mattel insiders beganbuying large chunks of stock on the open market. This is a variationof one of the Telltale Signs, which is that when a company announces
Chap 17 7/9/01 9:02 AM Page 249CHAPTER SEVENTEENMerger Mania: Take the Money and Run249a big “restructuring” charge or some sort of corporate reorganiza-tion—or some other piece of bad news that takes WallStreet by sur-prise—you should keep an eye out for insider buying, which canoften be a clue that the problem will be short-lived and that WallStreet is taking an inordinately short-term point of after The Learning Company debacle, a massive waveof insider buying began, with several Mattel insiders buying a totalof 464,000 shares between October 25 and November 24, 1999, at1prices between $13 and $14⁄, Mattel shares continued to fall below $10, eventhough these insiders—which included Mattel director JohnVogelstein, the powerful vice chairman of the investment firmWarburg-Pincus—had paid much higher prices for the stock theypurchased on the open an interview following The Learning Company news,Vogelstein categorically rejected comparisons to Mattel’s troubles inthe late 1980s, telling a questioner, “This company is not broken. Ithas a core businessthat is vital and well-run.”“Core business?” By now that term should be music to your was a sophisticated, well-connected Mattel insider whocertainly should have had the ability to force the stock market toplace a higher value on Mattel shares, which would better reflect itsvalue as a business. He was buying stock on the open market andtalking about Mattel’s “core business.”When you get a situation like this, where a well-known com-pany with a valuable franchise makes a major misstep, you veryoften wind up with a takeover candidate because there are usually“bottom fishing” turnaround investors lurking around waiting, basedon the premise that they can come in, take the company over, andrestore it to its former , by February 15 the American Federation of State, County andMunicipal Employees Pension Fund announced on Valentine’s Day that itwanted to have a heart-to-heart talk with Mattel’s Board of Directors aboutseveral matters, including the possibility of dismantling Mattel’s takeoverdefenses. The pension fund owned around percent of Mattel’s was another Telltale Sign: An outside beneficial owner was get-ting restless and urging the Board of Directors to take steps and tomake Mattel more takeover-friendly.
Y L F M AChap 17 7/9/01 9:02 AM Page 250 E T 250PART THREETakeover Clues Nobody cared, and Mattel stock continued to languish below $10. In March 2000, John Vogelstein had purchased another 100,000 9Mattel shares on the open market, this time at a price of $10⁄16. In April 2000, two more insiders had purchased an additional 56,750 shares at prices ranging from $ to $ per share. Also, in April 2000, Mattel had decided to bite the bullet by selling The Learning Company. The Wall Street Journalhad reported on the morning of April 3 that Mattel would soon announce that The Learning Company was for sale, and estimated that company, for which Mattel had issued $ billion worth of its own stock just a year earlier, would probably fetch between $500 million and $1 billion—which has to rank as one of the most striking examples of how rapidly an acquisition can go badin the annals of American business. Later that day, Mattel confirmed tha t it had retained CreditSuisse First Boston to sell The Learning Company, but Mattel went out of its way to make it clear that it did not intend to sell any of its “core brands.” ®In other words, Mattel had decided to revert to being a pure play toyTeam-Fly company. One would think that Mattel shares might have sagged on thenews that the company would soon lose as much as $3 billion in oneyear on its acquisition of The Learning Company—but instead Mattelshares jumped 30 percent on this news. Why? Because the TelltaleSigns were accumulating, and some investors apparently were begin-ning to get the feeling that The Learning Company disaster wouldultimately be the catalyst that could turn Mattel into a takeover September 29, 2000, Mattel announced that it would virtu-ally give away The Learning Company by “selling” it to a privatecompany in return for a share in any future profits. In reporting thistransaction, the Associated Press called Mattel’s acquisition of TheLearning Company “one of the worst deals in recent corporate his-tory.” This was almost certainly true—unless you were a shareholderof The Learning Company who took the money and Mattel–Learning Company saga is important for three rea-sons: First, it illustrates why it’s almost always better to “take themoney and run” when a stock you own receives a takeover , it shows how accumulated experience with various com-panies and individuals can lead you to anticipate future develop-
Chap 17 7/9/01 9:02 AM Page 251CHAPTER SEVENTEENMerger Mania: Take the Money and Run251ments, which you might perceive in a different light than almosteveryone else because of your awareness of Telltale Signs. And third,it illustrates how the seeds of a future superstock can be planted inthe midst of a barrage of bad news and ridicule from the financialpress, whose incessant harping on what has gone wrong creates thevery stock market bargains that can bring you profits in the longrun—if you’re willing to think “outside the box” when it seems likenobody else around you list of takeover blunders that occurred in the mid-to-late 1990scould be a book in itself. In 1999 alone, of the 10 worst-performingstocks in the Standard &Poor’s 500, at least seven could be traceddirectly to acquisitions that turned out badly or, at the very least,did not deliver the benefits Wall Street expected: JCPenney, WasteManagement, Allied Waste Industries, HealthSouth, McKessonHBOC, Rite Aid, and Service Corp. of these companies were gobblers that suffered a bad caseof indigestion when their grand plans for synergy, economies ofscale, or whatever it was that motivated them to make these acqui-sitions turned out to be off the an investor searching for potential superstock takeover tar-gets, you should not underestimate the lemminglike mania that attimes can overpower corporate executives. The more you under-stand the impulsive manner in which decisions like this can be made,the less surprised you are apt to be at the speed and scope at whicha takeover wave can engulf an entire industry, turning a highly com-petitive industry landscape into a barren wasteland consisting of ahandful of behemoths with stomach this: Do not assume that the takeovers that takeplace in the midst of a lemminglike mania will make any long-termsense, or that these takeovers occurred based on a rational decision-making process. The waste management industry is an example. CASE STUDY: WASTE MANAGEMENT AND ALLIEDWASTE INDUSTRIES As a group, the waste management stocks were trashed in 1999,tumbling nearly 60 percent. They were led on the way down by thetwo industry giants, Waste Management and Allied Waste Industries,
Chap 17 7/9/01 9:02 AM Page 252252PART THREETakeover Cluesboth of which spent most of 1998 leading the way toward consoli-dating the garbage industry. The fact that both of these companiesturned up on the list of the 10 worst-performing stocks in the S&P500 one year later tells you all you need to know about howthatstrategy turned trend toward garbage company takeovers was initiated inJuly 1998 when USAWaste bought Waste Management in a $19 billiontakeover. The new industry giant kept the Waste Management name,and then one month later announced the acquisition of anothergarbage company, Eastern Environmental Services, for $ it so far? Two megamergers, back-to-back, started the domi-noes falling in the waste management industry. Suddenly, littlegarbage companies were being acquired left and right, and everyinvestment banker on Wall Street was looking for a garbage pick-up. In October 1998, Allied Waste announced the takeover ofAmerican Disposal Services for $ billion, which everybody onWall Street agreed was a sound move because of the obvious“economies of scale,” and you know the rest by now. On October21, 1998, just a couple of months before these stocks would enter therecord books as one of the worst-performing groups of 1999, Investor’sBusiness Dailyreported that “analysts continue to see the waste man-agement companies as a safe haven that can be counted on to gen-erate double-digit earnings growth.” On March 8, 1999, Allied Waste struck again when it agreed to buyBrowning-Ferris Industries for $ billion, another megamerger thatcreated ripples of excitement in Wall Street investment banking cir-cles but apparently created little else of value, since Allied Waste sharesfell sharply on the news and have never been as high , all of this frantic takeover activity was touched offby the USAWaste–Waste Management–Eastern EnvironmentalServices triple merger, which served as the role model for garbageindustry consolidation and established both the rationale as well asthe valuations that would be used in future is, the premise turned out to be a bit December 30, 1999, Waste Management filed a lawsuit alleg-ing that it had been defrauded into overpaying for Eastern Environ-mental Services. The lawsuit came about as a result of a Special AuditCommittee established by Waste Management’s Board of Directors,who were trying to figure out why chaos had ensued at Waste
Chap 17 7/9/01 9:02 AM Page 253CHAPTER SEVENTEENMerger Mania: Take the Money and Run253Management almost immediately after the three companies werecombined.“The lawsuit,” said The WallStreet Journal, “arose out of asprawling effort by Waste Management’s Board of Directors to deter-mine how the company’s $19 billion merger with USAWaste Serviceswent wrong, and how the company’s management lost control ofits operations and accounting systems in the months after the July1998 merger.” In a follow-up story on February 29, The Journalreport-ed that Waste Management executives were still assuring companydirectors as late as mid-June 1999 that the acquisition was going welland that it appeared the company would meet its earnings forecastfor the second first hint of trouble—and it was quite a hint—came on July6, 1999, when Waste Management shares dropped from $53 to $25 ina single day, following word that the company’s third-quarter rev-enues and earnings would be far less than expected. The companyannounced massive management changes. The new group soon dis-covered massive disarray in such areas as receivables, billing, andinventory—almost all a result of the chaos surrounding the compa-ny’s inability to integrate its help sort out its problems, Waste Management enlisted theservices of Roderick M. Hills, former chairman of the Securities &Exchange Commission, who wound up as chairman of the AuditCommittee. “The big story here,” Mr. Hills concluded, “is that theymade terrible acquisitions and didn’t know how to run the mergedcompany.”The most telling comment of all from The WallStreet Journalwas: “And the pioneers of the practice proved not much better atfiguring out when to run for cover than the average investor.” Thiswas a reference to the fact that insiders of the acquiring companyeither continued to buy stock or failed to sell prior to the ultimateunraveling of these highly touted thereafter, Allied Waste—the other serial garbage acquir-er—announced it would miss its earnings estimates for the fourthquarter of 1999 and also for the year 2000 due to “costs associatedwith the Browning–Ferris acquisition.”Stewart Scharf, an analyst at Standard &Poor’s, commentedthat “companies need to ensure what they are acquiring is a good fit.”
Chap 17 7/9/01 9:02 AM Page 254254PART THREETakeover CluesAnother analyst, Jaimi Goodfriend, told CBS Marketwatch,“Over the course of the last couple of years, these companies havemade massive amounts of acquisitions in order to try to stimulate thetop line revenues growth. In doing so, it’s sort of been more of a ‘buynow, integrate later’ strategy. They would buy a lot of companiesand acquire all of this new revenue—but in doing that, they neglect-ed the systems integration.”When you throw in the additional allegations of fraud thatWaste Management says caused it to overpay for Eastern Environ-mental Services, you can see that the deals that paved the way forgarbage industry consolidation in 1998–99 turned out to be basedon a foundation that was about as solid as a landfill. Which explainswhy the “safe” waste management stocks dropped over 60 percentin , keep in mind that any Eastern Environmental share-holder who accepted $ worth of Waste Management stock inDecember 1998 and held it until year-end 1999 wound up seeing thevalue of that investment decline by around 60 percent, which onceagain illustrates the danger of believing that the acquiring compa-ny in a takeover transaction necessarily knows what it is purpose of this chapter was to illustrate, in no uncertain terms,that “brilliant” corporate executives often make dumb acquisitionsfor poorly thought-out reasons, and that they are advised and encour-aged to do so by “brilliant” investment bankers who are just outthere taking their best guess like the rest of us, at best—and who, atworst, are motivated in part by the desire to generate investmentbanking fees, which cannot be generated unless transactions likethese take , “analysts” who are compensated in large part basedon their ability to bring investment banking business to their firms,and whose bonuses depend in large part on investment banking feesearned by their firms in general, disseminate voluminous researchreports that may say a “buy,” “strong buy,” “accumulate,” “outper-form,” or “neutral”—but only say “sell” percent of the should keep these cautionary tales in mind the next timeyou turn on CNBC and discover that one of your stocks has receiveda takeover bid, and the CEOs of both companies are sitting theretrying to convince you to become a long-term stockholder of the
Chap 17 7/9/01 9:02 AM Page 255CHAPTER SEVENTEENMerger Mania: Take the Money and Run255combined entity based on their visions of the future and the “analy-sis” of some investment banker that the deal makes all the sense inthe world and that it will turn out just next time you are in a situation like that, do what chocolatebaron Milton Hershey did: Sell your ticket on Titanicto someonewho is frantically bidding for a chance to go on the Synergy Cruise,and use the techniques I have outlined for you in this book to findanother possible takeover target. In the summer and fall of 2000 the Domino Effect was in fullforce as banks and insurance companies paid all-time record pricesin their rush to acquire securities brokerage firms. PaineWebber;Donaldson, Lufkin; Advest; Daine-Raushcer; . Morgan; and oth-ers were all acquired at valuations that would have been consideredpie-in-the-sky 2 or 3 years ago. These brokerage firms were boughtdespite the fact that there seemed to be growing evidence of (1) aweakening tech sector, which would probably reduce the number ofIPOs in the foreseeable future; (2) cutthroat commission competitionfrom online brokerage firms; (3) growing worries that brokerage firmsthat have provided bridge financing to private companies might windup with burgeoning bad debts; and (4) weakening earnings from“Old-Economy” companies, which could be an early warning of aneconomic downturn and possibly a bear of that mattered to the “gobblers,” however. Buying abrokerage was the “in” thing to do, and independent stockbrokersstarted disappearing like puddles on a sunny afternoon.(One notable exception to the lemming syndrome was France’sAXAGroup, a multinational insurance company that decided totake advantage of the mad rush to buy stockbrokers by sellingitsstake in Donaldson, Lufkin to Credit Suisse First Boston.)All of which should reinforce the following concepts: “Domino Effect,” or the “Lemming Effect,” or whatevername you want to attach to this phenomenon of a takeover frenzyrunning rampant through a certain industry, is as powerful as it isbecause sometimes corporate executives can get emotionally carriedaway and make silly and impulsive shopping decisions, just the waywe do when we have a credit card burning a hole in our pocket andtoo much time on our hands at the mall. This is one major reason whyso many takeovers in a certain industry can occur in such a hurry, andwhy the prices paid for companies can often exceed the estimates of
Chap 17 7/9/01 9:02 AM Page 256256PART THREETakeover Cluessober Wall Street analysts and sometimes even the wildest dreams ofthe controlling shareholders of the target companies other words, if you smell a Domino Effect in the making, don’tbe afraid to buy any logical takeover candidates you uncover, anddo not be surprised if you receive more for your shares than youexpected if a takeover bid does you dobuy a stock because you are betting on a DominoEffect takeover wave, and you’re fortunate enough to wind up with atakeover target, you should take the money and run rather than acceptstock in the acquiring company and stick around to see if the businessgeniuses who offered to buy your company turn out to be the mutual funds and the institutional money managerswho absolutely must own the big-cap stocks take the risk that the“gobblers” will be right. Because very often, in fact, more than youmight expect, they won’ same holds true for the high-publicity “mergers ofequals” like AOL–Time Warner/Daimler–Chrysler, or any futurecombination of two huge companies that results in no premiumbeing paid to any shareholder of either company. More often than not,these deals take place because (a) neither company can figure outhow to grow its business in a significant way, therefore they decideto combine operations and attempt to create cost efficiencies thatwill lead to higher earnings, or (b) both companies are fearful ofbeing acquired, so they decide to merge with each other to protectthemselves. In either instance, there is no money to be made forshareholders of either company, so you should ignore such deals. Ifyou own stock in either company involved in a “merger of equals,”sell it and move on. Despite the fact that you read about thesemegadeals ad infinitum, and you will hear chatter among televisionanalysts day in and day out involving the nuances of these dealsand the exciting plans and “synergies” that will result, the basic ruleof thumb is that there is no money to be made for you, as an indi-vidual investor. Therefore, ignore them, and ignore the WallStreetspin machine as it attempts to lure you and others into these dealsbased on some pie-in-the-sky projection of what will happen yearsinto the give us the premium for our takeover target, thank youvery much, and we will be on our way to browse for the next poten-tial target.
Chap 17 7/9/01 9:02 AM Page 257CHAPTER SEVENTEENMerger Mania: Take the Money and Run257By the end of 1999, the WallStreet shell game involving merg-ers of equals had worn thin with investors. Instead of bidding upthe stock prices of companies that simply exchanged pieces of paperwith each other without offering a takeover premium to anybody,based on the premise that two plus two equals five, companies thatproposed mergers of equals began to find that their stock pricesdeclined on the Christmas Day 1999 the Associated Press ran a story en-titled “Drug Deals Stumble as Shares Fall,” which discussed the factthat the Monsanto–Pharmacia & Upjohn merger of equals as wellas the Warner-Lambert–American Home Products merger hadreceived a collective thumbs-down from Wall Street in the form offalling stock prices for all four companies.“The Warner-Lambert and Monsanto transaction raises funda-mental questions regarding the viability of mergers of equals,” saidTom Warnock of Credit Suisse First Boston. “Given the market reac-tion to both of these deals, Boards of Directors will be more circum-spect before pursuing such a partner.”The Associated Press concluded that “investors want a merg-er to offer them a premium for their shares in the target company.”No can’t have a true takeover if everybody wants to be thegobbler, and with nothing but gobblers, you have no , any merger without a true “gobblee” is not a takeoverthat should interest you.
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Chap 18 7/9/01 9:02 AM Page 259CHAPTER EIGHTEENLook for MultipleTelltale SignsIhave owned a lot of race horses in my life and I’ve met some verysmart horse bettors. One bettor I know had an uncanny knack for pick-ing horses that would win races at 8-to-1 or 10-to-1—not outrageouslong shots by any means, just decent horses with ability that were per-fectly capable of winning and had been overlooked by the asked him how he managed to come up with so many winnersat such generous odds.“It took me a long time to learn this,” he said, “but I finallylearned to trust my instincts.“I see a lot of races,” he said. “I notice things, and after a whileI learned that if I see certain things, a certain result usually it took me a long time to learn to trust in what I have observed,because when I see something and then I look up and a horse is 10-to-1, I used to think, ‘Well, I must be missing something, otherwisethe horse would be 2-to-1 or 3-to-1.’ And then the horse wins, and Irealize that I am just more experienced than the other bettors. I haveseen more than they have seen, and I pay attention to what hasworked in the past. I can see meaning in a piece of information thatthey think is irrelevant, if they notice it at all. And after a while I justgained confidence in my own judgment, and now it doesn’t botherme at all to put my money on a 10-to-1 shot if I see something I knowis meaningful and which suggests that the horse has the best shot towin. I just don’t care about the odds anymore. Why should I? The259Copyright 2001 The McGraw-Hill Companies, Inc. Click Here for Terms of Use.
Y L F M AChap 18 7/9/01 9:02 AM Page 260 E T 260PART THREETakeover Clues odds only reflect what everybody else thinks, and I am more inter- ested in what I think. I’ve learned to trust my own judgment.” Once you become accustomed to reading the financial news in terms of the list of Telltale Signs, you will begin to understand what my friend the horse bettor was talking about. You’ll begin to notice small items which, to most readers of the financial news, are insignif- icant—but they will be of great significance to you. You will be see- ing them in a totally different light than virtually everyone else because you’ll be operating in a different paradigm. Eventually you will encounter situations where more than one Telltale Sign is present. These can sometimes be the most profitable situations of all because there will be no one outstanding or terriblyunusual development that would attract t he attention of the finan-cial community, thereby leading them to s uspect that a superstocktakeover is brewing. However, when taken together, a combination of several apparently unrelated developments—all of which are on the list of Telltale Signs—can clearly point you in the direction of a ®winning stock. Team-Fly The trick is: When you dosee these multiple Telltale Signs pop-ping up, you will have to trust your instincts, even though you’llhave virtually no support from the “experts” everybody else seemsto look to for analysis. You may have to endure a long period of frus-tration as the clues pile up and nobody else is paying attention. Butif you can do this—if you can recognize the sign and have the courageto stick to your guns as long as the evidence is on your side—you canoften run rings around the Wall Street are several examples of how I zeroed in on takeover can-didates that were overlooked by Wall Street simply by noticing mul-tiple Telltale STUDY: SUGEN, December 21,1995, Sugen Inc. (SUGN) was recommended as a1takeover candidate at $11⁄2. Sugen was a development stage biotechcompany working mainly on innovative anticancer therapies. Therewas really nothing to separate Sugen from a hundred other biotechcompanies with big ambitions, except for this: Britain’s Zeneca Ltd.,a large pharmaceutical company, had purchased 281,875 Sugen shareson September 29, 1995, at $12 per share. Some further research
Chap 18 7/9/01 9:02 AM Page 261CHAPTER EIGHTEENLook for Multiple Telltale Signs261revealed that Zeneca had already held a stake in Sugen, and thatthis new purchase had increased Zeneca’s interest in the companyto around 20 of the reason I took special note of the Zeneca purchasewas that Zeneca had made a takeover bid for one of my recom-mended stocks, Salick Health Care, earlier in 1995 (see Chapter 15).Zeneca was in an acquisition mode, and the fact it was increasing itsstake in Sugen was a Telltale into Sugen a bit further revealed that Amgen, anoth-er large biotech company, also owned a percent stake in was not terribly unusual because many development-stagebiotech companies attract investments from larger pharmaceuticalcompanies hoping to own a stake in a small company that makes abig discovery. And although Amgen’s stake fell below the 5 percentthreshold that makes an outside company an “official” beneficialowner, the fact of the matter was that Sugen had attracted not onebut two major outside investors, each of which was perfectly capa-ble of buying Sugen at some point in the finally led to my recommendation of Sugen, however,was the news on December 6, 1995, that Asta Medica, a Germanpharmaceutical company, had purchased 495,000 Sugen shares. Thispurchase was made as part of an agreement that gave Asta Medicathe right to jointly develop, manufacture, and market Sugen’s anti-cancer drugs in Europe, and it gave Asta Medica a roughly 5 percentstake in development gave Sugen a total of threeoutside beneficialowners, each of which was a legitimate candidate to someday takeover that wasn’t all: The final Telltale Sign in a series of TelltaleSigns was the fact that Asta Medica had purchased those 495,000Sugen shares at an above-market price of $ per share—whichwas two times the prevailing market price of Sugen’s stock at thetime of the shares had briefly spiked up to the $14 area from around1$10⁄2when the news broke of Asta Medica’s above-market purchase,but the stock quickly dropped back to the $11 area, providing an entrypoint and proving, once again, that when you are dealing with under-followed stocks, the market can be remarkably accommodating inproviding tuned-in investors with one excellent buying opportunity
Chap 18 7/9/01 9:02 AM Page 262262PART THREETakeover Cluesafter another, even in the face of a news development that makes ithighly likely that something very bullish is 1 year later, Sugen had gained exactly one-eighth of apoint from the recommended price. So far, I did not look like a I had enough experience with the Telltale Signs to know that theodds were on my side, and I continued to recommend December 1996, 1 year after the initial recommendation,Zeneca purchased another 509,000 Sugen shares at $12, raising itsstake to percent of the company. I also noted that Allergan(AGN), another large drug company, had purchased 191,000 sharesof Sugen at the same above-market price of $ that Germany’sAsta Medica had paid a year new Telltale Signs now gave Sugen a total of fourout-side “beneficial owners,” two of which had paid nearly twice thevalue of Sugen’s current stock price for their stock. And every oneof these four companies was a large pharmaceutical company per-fectly capable of making a takeover bid for Sugen should they havedesired. These multiple Telltale Signs strongly suggested that Sugen’sresearch was promising and that these outside shareholders sus-pected that a marketable drug would be created as a result of thisresearch. These multiple signs also strongly suggested that Sugenhad the potential to become a superstock takeover January 1997, another Telltale Sign appeared: Sugen’s stockprice was starting to sketch out a potential “superstock breakout” pat-tern, a pattern that often signals a significant accumulation of thestock taking place in anticipation of some sort of major bullish devel-opment on the the end of 1996 a Sugen director bought nearly 22,0001shares at $12⁄8on the open market—flashing yet another Telltale Sign,which was the strongly bullish combination of insider buying and multipleoutside beneficial owner buying. Sugen was piling up Telltale Signs allover the place—but the stock was still stuck in neutral. Still, the signs kept coming on: On November 13, 1997, Zenecapurchased another 456,000 Sugen shares, paying $16 a share. OnJanuary 16, 1998, another Sugen director bought 20,000 shares of53stock on the open market at $12⁄8to $12⁄ May 8, 1998, we reported that Sugen was in later-stage tri-als for several antiangiogenesis agents designed to kill cancer reason for this story was that on May 3, 1998, The New York Times
Chap 18 7/9/01 9:02 AM Page 263CHAPTER EIGHTEENLook for Multiple Telltale Signs263had run a front page story about antiangiogenesis, a process that lit-erally starved tumors by cutting off their blood supply. The Timeshad focused on a company called Entremed (ENMD), whose stocksoared from $12 to $85 following the had noted that Sugen was also in the forefront of antian-giogenesis research, yet Wall Street had not yet focused on this fact,even though Entremed stock had gone through the roof following TheNew York wasn't really necessary, though, to focus on Sugen’s leader-ship in developing antiangiogenesis drugs because Zeneca, AstaMedica, Amgen, and Allergan—the four outside beneficial owners—had taken stakes in Sugen. And when they all moved into Sugen bypurchasing stock, that was the clue to follow their lead. This is the logic and the advantage of following outside “ben-eficial owners” when they take positions in a company—you maynot know what they know, but you can know what they do—and some-times that is all you really need to June 2, 1998, Sugen’s CEO appeared for an interview onCNBC. He talked about Sugen’s innovative anticancer therapies,adding that he expected Sugen to be profitable within 2 to 3 is especially important to watch CEO interviews when theyinvolve companies you are following for one reason or another. Thereare two reasons for this. First, if you have the right interviewer whoasks the right questions in the right way, you would be surprised atwhat you can learn not only from a CEO’s answer, but also from theCEO’s body language. You can learn to “read” these interviews,looking for subtle clues that might help in your search for super-stock takeover example, there have been a number of occasions on whichthe CEO of a company that has been an active acquirer of other com-panies has given just enough information about his company’s futureacquisition plans that you could actually narrow the list of potentialtargets down to two or three companies. There have also been occa-sions on which a CEO has given a not-so-convincing answer abouthis company remaining independent, or has chosen to answer aquestion about whether his company is a takeover candidate byusing his words so carefully that you just know he cannot deny thepossibility outright, because there is something going on. (Later inthis chapter, in fact, you will learn about an interview with the CEO
Chap 18 7/9/01 9:02 AM Page 264264PART THREETakeover Cluesof Frontier Corp. which led to a recommendation that Frontier wouldbecome a takeover target.)In the case of the interview with Sugen’s CEO, what struck memost of all was the fact that he was highly confident, yet not goingout of his way to convince anybody that Sugen was going to makeanybody rich overnight. It was more the quiet confidence of some-one who knew that he had “the goods,” as they say at the racetrackwhen somebody has a really good horse. He was, in other words, act-ing like the cat that swallowed the canary—and my confidence inSugen went up a notch after watching his performance on the time of the interview with Sugen’s CEO, the companywas trading around $16, compared to the original recommended1price of $11⁄2, 30 months earlier. This was an okay but not great per-formance up to that point. But by September 1998, Sugen’s shares3plunged all the way from $17⁄4to $10. Despite the fact that there wasfar more evidence in September 1998 than in December 1995 thatSugen was a potential superstock takeover candidate, the stock wastrading at a lower price than I had first recommended discouraging, wouldn’t you say?Well, yes. So what do you think I did?I stuck my neck out even further because I had the evidence toback up my opinion and I was willing to reaffirm my recommen-dation based on what I believed I knew, regardless of what the stockmarket seemed to December 1998 two Sugen directors had purchased a totalof 21,000 shares on the open market a few weeks earlier at $10 to3$10⁄4. Not that we needed it, but Sugen had just flashed another ina seemingly endless series of Telltale April 1999, Sugen was featured on a CBS 60 Minutessegmentwhich discussed the promising potential of the company’s anticancerdrugs. During a period of four trading days prior to the 60 Minutes3segment, Sugen shares soared from $14 to $23⁄4! Following the pro-gram, the stock promptly fell back to the $15 it turned out, that was the final buying opportunity in Sugenfor those who had been following the avalanche of clues along the June 16,1999, Sugen jumped 7 points in one day, a gain of31 percent in a single trading session, following an announcementthat Pharmacia & Upjohn had agreed to buy Sugen at $31 per share.
Chap 18 7/9/01 9:02 AM Page 265CHAPTER EIGHTEENLook for Multiple Telltale Signs265That takeover price represented a 72 percent premium over Sugen’strading price at the time of my final front-page recommendation justtwo weeks earlier. It also represented a more than 200 percent pre-mium over Sugen’s trading price as recently as September 1998, just9 months earlier, when Sugen had briefly dropped below the origi-nal recommended came as no surprise that Sugen finally received a takeoverbid. The only surprise was the identity of the buyer: Pharmacia &Upjohn had emerged out of nowhere to become the acquirer Telltale Signs had been everywhere, from multiple beneficialowners raising their stakes to these same beneficial owners payingabove-market prices for stock. When Sugen insiders began buyingstock in conjunction with outside beneficial owner buying, this wasanother Telltale Sign—and remember, Sugen had sketched out a“superstock breakout” pattern along the way, which is usually a signof major accumulation in anticipation of some major bullish of these Telltale Signs foreshadowed the takeover bid forSugen. None of them, viewed in isolation, would have been enoughto get any mainstream Wall Street analyst interested in Sugen. Buttaken together and viewed from the perspective of experience, theyprovided a clear and comforting “road map” to recommend Sugendespite the frustration of seeing all of the obvious signs and havingthe stock market completely ignore were literally hundreds of biotech companies floatingaround, and there still are. But not many of them got acquired. Sugendid—and the Telltale Signs were there to foreshadow the takeoverbid for those who knew what to look as you can see, it was a long road between the first TelltaleSign to the final takeover bid. Asuperstock investor would not onlyneed to know what to look for, he or she would also have needed con-fidence as well as patience and the resilience to weather one false1start after another. It took about 3⁄2years from the original recom-mendation of Sugen for that takeover bid from Pharmacia & Upjohnto create a 169 percent profit. And remember, if you were extremelyconfident (and how could you not have been with all of the TelltaleSigns?)—you could have bought Sugen in the $10 to $11 area inSeptember 1998 and wound up with a nearly 200 percent profit in just9 months.
Chap 18 7/9/01 9:02 AM Page 266266PART THREETakeover CluesNo index fund could have matched that , superstock investing requires a little more mainte-nance and a lot of patience. In the end you have to look at it thisway: If you believe something to be true based on experience, andif you have the courage to make a decision based on that knowl-edge, the longer it takes for the stock market to recognize what youalready see, the more of an opportunity you will have to accumulateshares at bargain prices—especially if the price of the stock contin-ues to languish even as the multiple evidence continues to accumu-late, making you even more certain of your original premise. And that is really the only way to look at it. Do not be frustrat-ed when others fail to see what is obvious to you. Instead, look at itas an opportunity—and be thankful that you have developed aninsight that others simply do not STUDY: FRONTIER December 1996 a developing takeover trend was taking place inthe telecommunications industry. Ironically, the very news item thatled to the recommendation of Frontier Corp. as a takeover candi-date was viewed by Wall Street as a huge negative when it wasannounced: Frontier stock plunged 6 points in one day followingword that its earnings would come in below expectations, due inpart to a “restructuring” , it seemed, was biting the bullet in certain areas, takingwrite-offs and redirecting the company toward more profitable andpromising “core”operations. By this time, that sort of news wouldprobably prick up your ears and you would look at this announcementas a signal to look into the company as a potential takeover target,especially since Frontier was operating in a consolidating Street did not see it that way, however, and Frontier sharesplunged from $27 to $21 in a single day, when we added the stockto the Master List of Recommended Stocks on December 20, was the nation’s fifth largest long distance company. As1recently as mid-1996 the stock had been trading at $33⁄2. And yet,even though a takeover trend had already developed in the tele-phone industry (Bell Atlantic had just announced a deal to mergewith Nynex), and even though the sort of “restructuring” moves
Chap 18 7/9/01 9:02 AM Page 267CHAPTER EIGHTEENLook for Multiple Telltale Signs267that Frontier had announced were one of the Telltale Signs of a com-pany preparing to sell itself, WallStreet took completely the oppo-site view of Frontier and knocked the stock down to the $21 area,providing a great entry there was more to the recommendation: In a mid-DecemberCNBC interview with Frontier’s chairman, CNBC reporter DavidFaber conducted a terrific “new paradigm” interview. Instead of ask-ing all sorts of generic questions about the industry, Faber zeroed inon the developing takeover trend in the telecom industry and askedif Frontier had received any takeover inquiries as a result of its recent-ly falling stock price. Frontier’s chairman replied, “We are not in anyactive merger discussions at this time.”David Faber did not move on,as most interviewers would have; he sensed that the answer wascarefully phrased, and he pressed Frontier’s chairman with a fol-low-up question: Are you saying you have not been approachedabout a takeover? Frontier’s chairman replied: “I am saying we arenot in active discussions at this time.”What David Faber had done in this interview was elicit valu-able information for any superstock sleuth who was paying closeattention: He asked the correct question, received an answer thatbegged a follow-up question, and he had asked the logical follow-upquestion. The clear impression from this interchange between DavidFaber and Frontier’s chairman was that Frontier had been ap-proached about a takeover but that there were no talks going onright now. This impression, combined with Frontier’s restructuringmoves and the fact that Frontier’s industry was seeing a number oftakeovers, led me to recommend Frontier as a takeover June 1997, Frontier’s stock had dropped again, this time tothe $16 to $18 area. Earnings continued to come in at disappointinglevels—but again, the bulk of the earnings disappointments weredue to the fact that Frontier was repositioning itself, jettisoning non-performing operations, taking the appropriate write-downs, andinvesting large amounts in a new infrastructure that would allowthe company to expand its Internet capabilities as well as enhanceits long distance infrastructure. Everything Frontier was doing wouldmake it more attractive as a takeover June 1997 the takeover trend in the telecom industry was con-tinuing, with a proposed merger of AT&T and SBC Communications.
Chap 18 7/9/01 9:02 AM Page 268268PART THREETakeover CluesThey say that beauty is in the eye of the beholder. On Wall Streetyou can say the same thing about “bad”news. Each time Frontierannounced another restructuring-related write-off, Wall Street dumpedFrontier stock—yet each of these announcements was a thing of beautybecause they were Telltale Signs that this company was setting itself up tobe October 1997 it was apparent that the takeover wave in thetelecom industry was accelerating. Among the deals, Worldcom hadjust bid for MCI Corp., Excel Communications had agreed to acquireTelco Communications, a combination of long distance carriers; andLCI agreed to buy USLD Communications, another merger of longdistance companies. Clearly, Frontier was a restructuring companyin a consolidating October 31,1997, another Telltale Sign emerged: the “multi-ple bidders” signal. Three bidders emerged to buy long distance tele-com company MCI Communications: British Telecom, WorldCom,and GTE. The multiple bidders concept is a strong signal that thetakeover wave in that industry will continue in full force. Usually, the“multiple bidder” Telltale Sign involves two companies trying to takeover a company. In this case there were threemultiple bidders—a raredevelopment that indicated the takeover wave among telecom com-panies in general, and long distance companies in particular, was stillin its early stages. In November 1997 Frontier’s newly installed CEO, Joseph Clay-ton, was interviewed. Again, it was remarkable what could be learnedsimply from paying attention to what was said and the manner inwhich Clayton said it. In a remarkably straightforward response tothe right question, he said that Frontier “could be acquired” but thathe believed the company would be able to deliver more value to its share-holders by first turning the company around. He predicted that therestructuring Frontier was currently implementing would improveFrontier’s results by the end of the first quarter of 1998. In otherwords, the CEO of Frontier confirmed the suspicion that all of therestructuring moves and write-offs that were causing the lemmings to dumpFrontier stock were, in reality, Telltale Signs that Frontier was about tobecome a takeover target! This was an excellent illustration of the dif-ference between “new paradigm” and “old paradigm” thinking: Thesame piece of information can lead to diametrically opposed con-
Chap 18 7/9/01 9:02 AM Page 269CHAPTER EIGHTEENLook for Multiple Telltale Signs269clusions about the future depending on what you know, what youhave experienced, and how the information is a year later, in October 1998, Frontier stock was tradingin the high $20s. We reported in Superstock Investor: Frontier’s new CEO Clayton has been selling off noncore and under-performing operations, which is often a telltale cluethat a company isputting itself in better shape for a potential sale in the not-too-distantfuture. Given the rapid consolidation in the telecommunications indus-try and the evolution of this business into a small group of multina-tional behemoths, a takeover bid for Frontier seems quite light of what was about to happen, those comments were about asclose to the mark as you can get in this February 1999 a spokesperson for Frontier Corp. deliveredanother Telltale Sign by uttering the words “restructuring options”and “increase shareholder value,” which are two key phrases to lookfor when you are looking for companies that believe their stock isundervalued and that intend to do something to rectify the situa-1tion. At the time, Frontier was trading at $35⁄ interview with Frontier’s CFO Rolla Huff, in which made these statements, did not appear in the national fact, the interview appeared in a Rochester, New York, businesspublication—another example of how browsing through out-of-the-way publications can sometimes lead you to a perfectly exquisitegem of information that can lead to big stock market profits. In theinterview, Huff said that Frontier was frustrated by the relativelylow valuation being accorded its stock, and he said that “the com-pany is evaluating a number of options, including spinoffs, initialpublic offerings, and mergers.” In particular, Huff pointed to Frontier’s data and Internet business,which was hidden beneath the company’s image as a long distance tele-phone company, as being worth far more than the stock market was givingFrontier credit March 1999 we reported that Frontier was attempting tobreak out of a superstock breakout pattern: “The entire price rangebetween roughly $34 and $37 is the upper end of a trading rangetrading back to 1996. Each time Frontier threatened to break outabove this range the stock was blindsided by an earnings setback. But1the recent move up to $39⁄4, combined with the willingness of Frontier
Y L F M AChap 18 7/9/01 9:02 AM Page 270 E T 270PART THREETakeover Clues management to make the bold forecast mentioned earlier, strongly implies that this break-in process is the real thing.” It had been 27 months since the original recommendation of Frontier Corp. The original recommendation had been based on a Telltale Sign of a company in a consolidating industry announcing restructuring moves designed to rid itself of underperforming oper- ations and make it more of a “pure play.” This was followed by anoth- er Telltale Sign: multiple bidders for MCICorp., which strongly implied that more takeovers of long distance companies would take place. This was followed by Frontier officials using buzzwords like “increase shareholder value” and “restructuring options,” which are often code phrases used by managements who believe their stock is badly undervalued and who are searching for a catalyst to force thestock market to push the stock higher. And finally, Frontier had bro-ken out of a “superstock” trading range by crossing the $34 to $37 area. By March 1999, Frontier received a $62 takeover bid from Global Crossing. Frontier was originally recommended in December 1996 ®at $21, when it was viewed as a hopelessly troubled company withTeam-Fly erratic earnings and very little going for it. The momentum playershated it, and the Wall Street lemmings sold it. The purpose in telling you about the Sugen and Frontiertakeovers is to illustrate how seemingly insignificant news items canaccumulate, one after another, to form a giant flashing arrow point-ing directly to a superstock takeover. In the case of Frontier, whatwas especially ironic was that some of the Telltale Signs that led toFrontier in the first place with increasing confidence were preciselythe news developments that caused the Wall Street lemmings todump Frontier stock!All of which proves one thing:Wall Street is a lot like horse racing, and also a lot like life, in thatexperience makes a huge difference. Like my friend who was able topick those 8-to-1 shots at the track, if you give two people the iden-tical information or circumstances, you will sometimes find that oneof them is able to see something that the other simply cannot is a huge advantage, and by becoming a “new paradigm”thinker, you can create this advantage for yourself when it comes topicking superstock takeover candidates.
Chap 18 7/9/01 9:02 AM Page 271CHAPTER EIGHTEENLook for Multiple Telltale Signs271CASE STUDY: WATER UTILITIESOnce you get used to the idea of reading the financial news in termsof the Telltale Signs, certain news items that don’t register at all withmost investors will literally jump out at you as a guidepost and pre-cursor to future takeover developments in a particular industry, or fora certain company within that industry. Often you will find that it’snot just one news item but an accumulation of small items, or clues,that when taken together begin to form a clear picture of what liesahead. Like the straw that broke the camel’s back, it was not the strawthat finally touched off the event—rather, it was the accumulation ofstraws, one after another, that did the camel in. Similarly, there willbe times when you notice one item, then another, and then another,and based on an accumulation of evidence you’ll finally decide thata certain industry or a certain stock deserves your close Wednesday, October 14, 1998, an item appeared on page B-26 of The Wall Street Journal. The very fact that it appeared on pageB-26 tells you how high up on the list of major financial news devel-opments this story stood on that particular day. But by this time youwill understand everythingin the financial news comes to you in a pre-filtered manner. After all, somebody, somewhere, has to decide whichnews developments are at the top of the list in terms of significanceand general interest, and which will be buried somewhere insidethe newspaper—or possibly not even reported at headline on this particular story was, “American WaterAgrees to Acquire Utility for Stock,” and the gist of the report wasthat American Water Works (AWK), a water utility, had agreed tobuy privately held National Enterprises Inc., another water utility,in a transaction valued at $ are three probable reasons why this story did not receivevery much attention. First, National Enterprises was a privately heldcompany, and therefore the takeover bid did not involve a big jumpin anybody’s stock price. Second, the value of the transaction was notexactly an eye-opener in an era of multibillion-dollar mergers. Andthird, these were water utility companies, for heaven’s sake—andhow exciting is that?But anyone who took the time to read this story would havefound several Telltale Signs that suggested a potentially profitable
Chap 18 7/9/01 9:02 AM Page 272272PART THREETakeover Cluestakeover wave was about to unfold in the previously sleepy waterutility industry. The story, written by Allanna Sullivan, pointed outthat this takeover was part of a recently developing trend towardconsolidation in the water utility industry, and that a number of pri-vate water companies had already been bought by publicly heldwater story mentioned that smaller water companies were beinghurt by increasingly stringent environmental laws, which hadincreased operating costs, and that these smaller utilities were decid-ing to sell out to larger, better-financed water utility companies. Thestory also pointed out that American Water Works had purchased aHawaiian water utility just several months earlier, and it quoted anAmerican Water Works spokesperson as saying that other potentialacquisitions were being might have been easy to miss this story if not for an excellentreport that appeared in the Investor’s Business Daily“Companies inthe News” section just a month before. The IBD “Companies in theNews” section is an excellent “browsing” place and it can often pro-vide invaluable information for superstock browsers, not onlybecause it provides in-depth discussion of the thinking that goesinto various corporate maneuvers (such as takeovers), but alsobecause its “Industry Group Focus” table, which usually accompa-nies its reports, gives you a top-to-bottom look at the various pub-licly traded companies that comprise the industry being discussed. This particular “Companies in the News” item dealt withPhiladelphia Suburban Corp. (PSC), a large water utility that hadjust grown larger by announcing that it would acquire Maine-basedConsumers Water Co. (CONW). That merger, said the IBD report,would move Philadelphia Suburban from its present ranking as thethird largest water company (behind American Water Works andUnited Water Resources) into the number two position. The IBDreport described the reasoning behind this takeover, alluding to theburden of rising regulatory costs being borne by smaller water util-ities, and also made reference to the economies of scale that could beachieved by merging water IBD story quoted Philadelphia Suburban’s CEO as follows:“Since this is such a highly fragmented industry, the acquisitiongives us a head start in the consolidation phase.” He added that he
Chap 18 7/9/01 9:02 AM Page 273CHAPTER EIGHTEENLook for Multiple Telltale Signs273expected the combined Philadelphia Suburban–Consumers Waterto “take advantage of what we think will be great opportunities forbuying up smaller companies in the future.”This IBD story was reminiscent of the dominolike takeoverwave that had recently engulfed the drugstore industry (see Chapters14 and 17), and so the water utility industry became a possible can-didate for the Domino after reading the report on Philadelphia Suburban andnoting that the list of publicly traded water utility stock in the accom-panying table was rather small, it seemed that the water industrymight be about to undergo the same sort of consolidation wave thathad recently struck the drugstore combination of these—one in IBD and the other in The WallStreet Journal—two items appearing less than a month apart, is whatfinally led me to take a long, hard look at the water utility list of publicly traded water utility stocks was similar to thedrugstore industry just prior to the “dominolike” takeover wave thatshrunk the number of public drugstore companies down to a hand-ful. There were a total of 15 public water utility companies, and aftersome research focusing on the region of the country where they oper-ated and a comparison to the larger takeover-minded industry lead-ers, it became obvious that this industry could evolve into a handfulof large regional companies—just as the drugstore industry , when the stock price values of the public water util-ities were compared to the takeover values being placed on water util-ities that had recently been acquired, it became startlingly obviousthat the smaller publicly traded water utility stocks, which were themost obvious takeover candidates, were trading at values far belowtheir potential takeover these water stocks had an added attraction: Because theywere utilities, they carried high dividend yields, generally between4 and 5 percent, which were a juicy bonus in an environment ofultralow interest , several of the water utilities on the list were alreadypartially owned by an outside “beneficial owner,” which was oneof the Telltale Signs to always look for—the fact that two of theseoutside beneficial owners were acquisition-minded European com-panies was also a major plus.
Chap 18 7/9/01 9:02 AM Page 274274PART THREETakeover CluesIn December 1998, I presented a front-page report in SuperstockInvestorentitled “Water Utility Industry Could Be on the Verge of aTakeover Wave.” The report compared the state of the water utilityindustry to the drugstore industry back in 1996, just prior to the bar-rage of takeovers that reduced that formerly fragmented industryto a handful of regional December 1998 nine water utilities (and one water servicesstock) were recommended (Table 18–1), and we suggested a crosssection of these stocks, thinking of the portfolio as a sort of “mutu-al fund” of water utility takeover candidates. We noted that two ofthe water utilities in the portfolio were already partially owned byoutside beneficial owners: percent of United Water Resourceswas owned by a French company, Lyonnaise des Eaux; and per-cent of California Water was owned by SJW Corp., a neighboringCalifornia water beauty of this situation was that these water stocks wereutilities. And if ever there were an example of how a takeover trendcould turn previously unexciting stocks into “superstocks,” thiswould be it. Historically, utility stocks tend to be viewed as low-growth income vehicles whose dividend yields are the most impor-tant part of their investment profile. As the stock market soared inthe mid-to-late 1990s, dividend yields began to wane in importanceas investors increasingly sought growth and capital gains. Some util-ity companies, in fact, actually reduced or eliminated their dividendsand sought to become growth companies by diversifying away fromtheir core business. (For more on thatstrategy, take a look at whathappened to Western Resources in Chapter 17.) So, the concept of buying a stock for its dividend yield hadbecome a hopelessly out-of-favor investment strategy, which is oneof the major reasons why the water utilities, which were not diver-sifying like the electric and gas utilities, were completely unloved andvirtually unfollowed among the traditional Wall Street concept of buying these stocks as potential takeover candi-dateshad not yet emerged as a strategy at the time of the originalrecommendation and in the months that followed, which meant thatthe water utilities simply moved inversely with interest rates, muchas traditional utility stocks had always done. When interest ratesrose, the water stocks fell, so their dividend yields would rise along
Chap 18 7/9/01 9:02 AM Page 275CHAPTER EIGHTEENLook for Multiple Telltale Signs275Table 18–1Water Utility Stocks as of 12/98 (original recommended prices)1United Water Resources (UWR)$20 167California Water (CWT)$26 81E town Corp. (ETW)$45 83Aquarion (WTR) (adjusted for 3-for-2 split)$24 41American States Water$28 2SJW Corp. (SJW)$601Connecticut Water (CTWS)$27 21Middlesex Water (MSEX)$24 2Southwest Water (SWWC) (adjusted for two 53-for-2 splits)$6 8with interest rates in general. When interest rates fell, the water util-ity stocks bounced up a bit, so their dividend yields would , as a superstock sleuth who was focusing on the takeoveraspects of these stocks, it seemed the water stocks would soon bemarching to the beat of a very different drummer. Based on experi-ence in picking takeover candidates and noticing characteristics ofindustries and stocks that were about to become takeover targets,these stocks appeared in an entirely different light. Each time thewater utility stocks fell back in response to rising interest rates, itbecame yet another opportunity to buy more, because their divi-dend yields would soon become completely irrelevant. And, thesestocks would soon be valued on the basis of their takeover was also an easy matter to calculate what each of these waterstocks would be worth in a takeover situation because the water util-ity takeovers that had occurred up to that point had been trendinghigher from a valuation of times book value to the area of the book value. So it was a fairly simple matter to determine thatmost of the water utility stocks had the potential to rise 50 percent ormore in the event of a takeover—an incredible risk/reward situationsince we were talking about water utilities, for heaven’s often in the stock market are you offered the chance tomake 50 percent on your money with minimal downside risk? Thatwas the appeal of the water utility stocks—and yet, for severalmonths these stocks could have easily been purchased at or belowthe original recommended prices.
Chap 18 7/9/01 9:02 AM Page 276276PART THREETakeover CluesIn February 1999, in an off-the-record conversation I had withan executive at one of the water utilities on the takeover list, theexecutive asked to remain anonymous but gave me permission to usehis comments. He told me that my analysis was “right on target,” andlisted a number of logical reasons why smaller publicly traded waterutilities would opt to be acquired by larger companies. The list of rea-sons sounded quite familiar to a seasoned takeover sleuth, and, infact, read like a list of reasons to expect another lemminglike, DominoEffect takeover wave to strike this the competitors become larger, they will achieve a com-petitive advantage as their cost of capital is lower. Becausethe water utility industry is capital-intensive, this is amajor issue to smaller water utility industry is particularly suited toeconomies of scale resulting from combining companies,which include elimination of general office operations,billing operations, lab expenses, and the day-to-dayexpenses of running a business such as engineering costs,purchasing, accounting, insurance, and so increasing costs of complying with environmentalrequirements, especially in the eastern United States, coulddrive smaller water companies to merge with larger conversation with a well-positioned water utility executive,even though it was off-the-record, was an excellent example of some-thing I learned over the years, which is that you would be amazed atwhat an officer, director, or spokesperson for a publicly traded companymight tell you if you just took the time to ask. Not inside informationabout revenues or earnings, but rather, background informationregarding business strategy, industry conditions, opinions aboutcompetitors and what they may be up to, and even the relative val-uations of stock prices compared to potential takeover , it is a natural inclination for a person to want to talkabout what he or she knows best. Whenever you ask a person to discussa topic that is near and dear to that person’s heart, or one that per-son spends most of his or her time dealing with on a daily basis, youwill find that you are requesting information that the giver is natu-rally inclined to impart to you.
Chap 18 7/9/01 9:02 AM Page 277CHAPTER EIGHTEENLook for Multiple Telltale Signs277The same holds true in the world of business, but there are vari-ations on this theme. Some officers and directors of publicly tradedcompanies are ultracautious and will answer questions from a stock-holder (or a newsletter writer) only in a thinly veiled prescriptedway. This is generally the case with larger companies or very pop-ular stocks that are attracting a great deal of analyst and investorattention. You will find that the more popular a stock has become,the less information you are likely to elicit from that company’sinvestor relations spokesperson. Many times you will get the feelingthat this person receives hundreds of inquiries per day and proba-bly wishes that talking to shareholders and analysts were no longerpart of his or her job you will also find that, as you begin dealing with companieswhose stocks are unloved and out of favor—as will be the case muchof the time if you put these principles and thought processes to workfor you—you are very likely to elicit interesting and valuable infor-mation simply by picking up the phone and calling the company. Oftenyou’ll find that these companies have attracted so little investor inter-est that they do not even have a full-time investor relations person,and you will wind up speaking to the company treasurer, a vice pres-ident, or some other officer who doubles as the investor cases like this, you will often discover that these people areperfectly willing and even anxious to discuss and explain their busi-ness and industry to an outsider, especially a stockholder who seemsgenuinely interested. It often seemed that some of these people werejust sitting there dyingfor someone to call and express an interest intheir company. And, when they finally heard an interested and recep-tive voice on the other end of the phone, they were more than will-ing to tell that person almost anything they might want to may seem like an exaggeration, but it is not. You should tryit was the distinct impression I received in a conversationwith the water utility executive in January 1999. Here was a guy whowas an officer of a water utility that had operated in an industry thatis about as predictable as you can get in the world of business. Peopleneed water, all the time, every day. You provide it. When your costsgo up a little, you apply for a rate increase. You pay out a certain per-centage of earnings as dividends, people who are seeking incomebuy your stock, and that’s that—what more is there to say?
Chap 18 7/9/01 9:02 AM Page 278278PART THREETakeover CluesSuddenly, the landscape changed. Several water utilities hadbeen purchased by larger companies and consolidation was in the stocks perked up a bit as a handful of investors who appearedto be paying attention began to suspect that these formerly sleepystocks might become takeover targets. The industry itself was abuzzwith questions: Who might be the next target? What might thesecompanies be worth as takeover targets? Some of these companiesalso owned large tracts of real estate—could these parcels inject avaluable “wild card” into potential valuations?Suddenly, the water utility business was getting very interest-ing—but virtually nobody on Wall Street was paying attention. Thiswater utility executive had a lot to say and was more than willing todiscuss the industry and the “new paradigm” that was emergingfor all of its players. In fact, he was so pleased that someone outsidethe industry had noticed what was going on that he actually calledme back later to add some thoughts that he had failed to mention. What arethe odds that an executive at General Electric would call you backjust to talk a little more?The executive deflected the question about whether his waterutility might wind up as a takeover target, as well he should have.(Sometimes that question is not deflected, however, so it never hurtsto ask.) But his comments about the reasons behind the recent waterutility takeovers and his view that these rationales made sense andwould continue to make sense provided more confidence in the sce-nario I had already the juiciest nugget of information obtained from thisconversation involved the potential valuations of future water util-ity takeovers. In such a conversation with an executive of a compa-ny, it is important to ask the most pertinent questions first, eventhough they are usually unlikely to be answered directly. But don’tgive up if you don’t get the direct answers you are hoping for. Andalways greet whatever response you receive in an understanding,good-natured way. If you don’t get what you were after, try to keepthe conversation going in terms of more general industry questionsthat relate in some way to what you are trying to an executive will give you a “Yes”for an answerwhen asked if his company has received a takeover bid. More often,the question must be couched in different terms, such as: “If youreceived a takeover bid would you reject it out of hand, or would you
Chap 18 7/9/01 9:02 AM Page 279CHAPTER EIGHTEENLook for Multiple Telltale Signs279consider what is in the best interest of shareholders?” Or, if a com-pany already has an outside “beneficial owner,” the question mightgo like this: “Have you ever discussed the possibility of beingacquired by XYZ?” Or: “Is it possible they might want to buy therest of the shares they don’t own?” Or: “Would it make any sense forthem to eventually want to buy you outright?” Or: “Are there anyunderstandings or agreements that would prevent XYZ from acquir-ing the rest of your company?”The point is that there are a number of different ways to askthe same question without directly asking if a company is likely tobecome a takeover target, and if you phrase the question carefully,you leave the executive enough “wiggle room” to respond to you ina manner that you may gain the information you are looking for ina roundabout way—or possibly even other information that you hadnot even considered asking the case of the water utility executive, in addition to learn-ing all of the excellent reasons why water companies would contin-ue to be acquired, two additional things were revealed by just keep-ing the conversation going: First, water utilities located in the easternUnited States might be under a bit more pressure to sell out to a larg-er company; and second, it would be fair to assume that most of thewater utilities on the list would be worth between and timesbook value if they were to be acquired—with the potential valua-tion moving up toward the upper end of that range as time went onand fewer acquisition candidates were interview led me to focus on the valuation question, com-paring the stock prices of the recommended water utility stocks totheir potential takeover values. What I was looking for was thebiggest “gap” between a company’s stock price and its possible buy-out value—in other words, the most undervalued water utilities inthe group. Three water utilities appeared to be particularly under-valued: E’town Corp., SJW Corp, and American States Water. SJWCorp. also owned an percent stake in California Water, whichcould give SJW an added attraction as a takeover 10 months two of these three water companies hadreceived takeover May 1999, using a technique that has often pointed direct-ly toward a takeover target, I made note of stocks that were per-forming noticeably better than other stocks in their industry group.
Y L F M AChap 18 7/9/01 9:02 AM Page 280 E T 280PART THREETakeover Clues The two stocks in question were both water utilities: Aquarion (WTR), a Connecticut-based water company, and E’town (ETW), a New Jersey water company. Generally, stocks within a well-defined industry group will tend to move in the same general direction; not every day, certainly, but over time. When you have a situation where a certain stock in an industry is moving up consistently, while its peers are doing nothing or even declining, it can often be a sign that something very bullish is brewing. Both Aquarion and E’town were examples of this principle. Also, Aquarion had large real estate holdings, which could add to its takeover appeal—something I learned from the water company exec- utive a few months earlier. And, both of these water utilities operat-ed in the eastern United States, wher e I’d discovered that water com-panies might be under more pressure to sel l themselves, due to morestringent environmental regulations and higher compliance costs. You can see that a combination of various factors—lessons learned, comments heard—led to focusing directly on both Aquarion ®and E’-Fly On June 1, 1999, Aquarion announced that it had agreed to be acquiredby Yorkshire Water PLC, Britain’s largest utility, for $ per , a Connecticut water company, was one of the water util-ities that owned large tracts of real estate. That $ takeover price represented a premium of nearly 70percent above Aquarion’s trading price as recently as March 1999, andit represented a 50 percent gain above the initial recommended pricein December 1998. Once again the stock market had obliginglyallowed tuned-in superstock investors to buy a stock at a bargainprice even after, in the case of Aquarion, it became obvious that waterutilities were about to become takeover targets, as demonstrated bythe fact that Aquarion slipped significantly below the original rec-ommended price even in the face of gathering evidence that atakeover trend in this group was already under way and would verylikely continue. I cannot overemphasize this point: You will be astonishedat how often the stock market disregards Telltale Signs that are perfectly obvi-ous to you, and how long genuine superstock takeover candidates willremain on the bargain counter right up until the takeover was a boring, high-yielding water utility—and yet super-stock analytical techniques led directly to the takeover of Aquarion. Theconcept of risk vs. reward—in which an investor considers not only
Chap 18 7/9/01 9:02 AM Page 281CHAPTER EIGHTEENLook for Multiple Telltale Signs281the potential profit but also the potential risk—was a lost art for a timein the late 1990s, and making 50 percent in a stock was not especiallyimpressive in some circles. But to those investors who had been aroundlong enough to understand that risk is usually commensurate withreward, the idea that one could make 50 percent in 6 months on awater utility stock should have been a wake-up call that there weretremendous opportunities to be found in other water utility message, however, did not sink in. The other water stocksin the portfolio bumped up briefly on the Aquarion takeover, butsoon settled back to levels that stillleft huge gaps between their stockprice levels and their potential takeover values. Was this frustrat-ing? No. This just meant that the opportunity for profit was hang-ing around longer—all the better for investors. Even the fact thatAquarion had been acquired at times book value—which con-firmed the takeover value range I had been using—was not enoughto bring the water utility stocks significantly closer to their takeovervalues. As a result of that times book value figure, in June 1999the potential takeover values of the water utility stocks in the port-folio were estimated. And once again, E’town, SJW Corp., andAmerican States Water were the three water utilities that seemed tobe selling at the biggest discount to their potential buyout August 24, United Water Resources announced that it hadagreed to be acquired by Suez Lyonnaise des Eaux, a French com-pany, for $ per share. That takeover price represented a 77 per-cent premium over the original recommended price for United StatesWater just 9 months earlier. The takeover bid for United WaterResources certainly came as no surprise—especially since SuezLyonnaise was already an outside “beneficial owner” of United Waterwith a 32 percent stake in that company. As any seasoned super-stock takeover sleuth might have expected, the accelerating trendtoward water company takeovers had resulted in a “me too” typetakeover bid in which an outside owner who already owned a largestake in United Water decided to join in the takeover parade by bid-ding for the rest of the company. It was not a coincidence that aEuropean water company that owned a stake in United Water woulddecide to buy the rest of the company just weeks after Aquarion hadbeen taken over by Yorkshire Water, a British company. The “lem-ming” effect, or the Domino Effect, or whatever label you might
Chap 18 7/9/01 9:02 AM Page 282282PART THREETakeover Clueswant to put on this tendency of corporate decision makers to play fol-low the leader, was alive and well, and it was playing out perfectlyin the water utilities industry, to the delight of those handful ofinvestors who had recognized the signs early and had the foresightand confidence to buy these stocks when nobody else wanted virtually all of 1999 an investor could easily have purchasedUnited Water Resources in the $19 to $22 range, receiving a heftyyield to boot, and wound up with a superstock takeover target val-ued at over $35. All that you, as an investor, would have needed wasa familiarity with a thought process, a way of looking at the finan-cial news, that would have made it crystal clear that water utilitytakeovers would be taking place. From there it would have been aneasy matter to zero in on a company already partially owned by anoutside “beneficial owner.” United Water, in fact, traded in that $19to $22 range right up until the last week of July 1999, just prior to thetakeover bid, despite mounting evidence that water utilities werebecoming takeover targets. This was another clear example of howthe stock market overlooks values in sleepy, out-of-favor industriesto such an extent that individual investors can beat the Wall Streetexperts at their own game simply by being willing to go off the beat-en path in search of stock market “inefficiencies.”On October 29, SJW Corp. announced that it had accepted a$128 takeover bid from American Water Works—the very same com-pany whose CEO had managed to get through an entire interview on CNBCwithout being asked a single question about water industry consolidation(see Chapter 4). That $128 takeover price represented a 113 percentpremium over the original recommended price for SJW of $60 just11 months than 1 month later, on November 22, 1999, E’town that it would be acquired by Britain’s Thames Water PLCfor $68 per share, a premium of percent above the original rec-ommended price 12 months before. E’town jumped over $10 pershare in a single day on this had been less than a year since we recommended the waterutility portfolio, and already four of the nine stocks on the list hadreceived takeover bids, at premiums ranging from percent to 113percent above the original recommended prices. Moreover, in eachcase these takeover targets could have been purchased at prices sig-nificantly belowthe original recommended price, even as the evidence
Chap 18 7/9/01 9:02 AM Page 283CHAPTER EIGHTEENLook for Multiple Telltale Signs283mounted that water company takeovers were coming, resulting ingreater percentage gains. An article in The Wall Street Journalthe day after the bid forE’town was announced clearly spelled out the reasons for thetakeover wave in the water stocks. It all seemed so obvious—but itwould have been just as obvious one year earlier if you’d been usingmany of the techniques discussed in this book about spotting thisdeveloping trend. The difficult part, you see, is not always seeingthe handwriting on the wall. Sometimes the difficult part is believ-ing what you see and having the courage to act on what you believe,even though the stock market is paying no attention to this evidencewhatsoever. You have to “know what you know,” in other words, andyou have to have the confidence to act accordingly even if it seemsthat you are out of step with everyone else around you.
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Appx A 7/9/01 9:03 AM Page 285APPENDIXA Superstock Shopping ListAs you have seen, an important part of my approach has been tomake special note of companies that are partially owned by outside“beneficial owner” investors. I am particularly interested when one ofthese partially owned companies exhibits one or more additionalTelltale Signs—especially when the outside beneficial owner had boththe ability and the desire to maximize the value of its help you start your own “research universe,” we have com-piled a sampling of companies that are partially owned by eitheranother company or a private investor or what Iwould call a “finan-cial” investor, such as a brokerage firm or buyout firm which wouldpresumably know how to take advantage of any opportunity to max-imize the value of its stock. By listing these firms as outside benefi-cial owners, our assumption is that should the opportunity presentitself, these “financial” outside owners would be ready, willing, andable to cash out of their investments at a nice have also elected to include several stocks in which a sig-nificant ownership stake is held by a family trust, in some instancesinvolving descendants of the founding family. As in the case of out-side “financially oriented” owners, companies that are partiallyowned by a family trust are also candidates for “value maximization”when the timing is list was compiled from the most recent data available at thetime this book was published—but as we have learned, things285Copyright 2001 The McGraw-Hill Companies, Inc. Click Here for Terms of Use.
Appx A 7/9/01 9:03 AM Page 286286APPENDIXchange. I’d suggest, therefore, that before you make any investmentdecisions based on the following information, you should make cer-tain that there have been no material changes in the data we’ve pro-vided are two ways to determine the very latest ownershipstakes of these “beneficial owners”: You can either call the compa-ny directly or you can go to on the you access , simply enter the trading symbol ofthe company and click on “view filings.” You will then see a list ofthe company’s Securities & Exchange Commission filings. The bestfiling to check would be the most recent Proxy Statement, listed onthe site as “Form DEF-14A–Definitive Proxy Statement.” Within thatfiling you will find a section listing all of the company’s major share-holders, including “beneficial owners” with more than a 5 percentstake. You should also make note of any recent Form 13 filings,including not only 13-D’s but also Form 13-G’s, which are filed byinvestment advisers. These filings may indicate that an outside ownerhad either increased or decreased its position, or that a new outsideowner has you scan this list you will see that these partially ownedcompanies span a multitude of industry groups. You will find stockson this list that will fit almost any conceivable investment criteria, andI would urge you to study this list and become familiar with it fortwo , all things being equal, if you are looking to invest a por-tion of your investment funds in a certain industry, why not includea stock or two within that industry that is already partially ownedby an outside beneficial owner? You will pay nothing extra for theprivilege, and you just may wake up some morning to find that theoutside beneficial owner has come up with a way to maximize thevalue of its investment, which would also maximize the value second reason you should become familiar with the com-panies on this list is that as you scan the financial news in search ofthe Telltale Signs, you will eventually find some of these companiespopping up on your radar screen. Remember, any of the Telltale Signscombined with an outside beneficial owner is a potential signal thatyou may have a superstock takeover candidate on your hands.
Appx A 7/9/01 9:03 AM Page 287ASUPERSTOCK SHOPPING LIST287I want to make it clear that this is nota recommended list of stocks,and you should not view this list in that way. Rather, it is a starting pointfor further research if you have the inclination to use the tools that havebeen described to you and apply them to these companies that are alreadypartially goal in writing this book was to describe a personal per-spective on the financial news that I have developed over the past26 years. In a way, I have tried to provide you with a new set of lens-es that will enable you to filter out significant elements of the finan-cial news that most investors, including most “professionals,” tendto overlook. As I said at the outset, I make no claim that this is anysort of “foolproof system,” and I readily acknowledge that it takesa lot of effort. But I am confident that if you learn to recognize theTelltale Signs and if you take the time to study and remember theactual case studies of successful takeover recommendations I haverelated to you here, you will soon find yourself zeroing in on seem-ingly innocuous news items that will have little or no meaning tomost investors but will have a great deal of meaning to you. Youwill view these news items in a totally different light—and if youtake the time to delve further into these situations as they presentthemselves, you will soon be wending your way toward findingyour own superstock takeover targets.
Appx A 7/9/01 9:03 AM Page 288288APPENDIXShopping List of Potential SuperstocksInformation as of 10/17/00CompanySymbolPartial Owners21st Century Insurance Group TWAmerican International Group (%)Abercrombie & Fitch ANF . Morgan Co. (%) ABM Industries ABM Rosenberg Family Trust (21%) AcmatACMTQueenswayFinancialCanada(%) Actrade Financial ACRTNTS Corporation (%) ACTV, Inc. IATV Liberty Media (%) Advanced Magnetics AVM BVF Partners (%)/Eiken Chemical, Ltd. Japan(%) Advanced Tissue Sciences ATIS Smith & Nephew, Inc. England(%) Aegon Insurance Group AEG Vereniging NV Netherlands(%) AEPIndustries AEPI Borden, Inc. (%) Allied Waste Industries AW Apollo Advisers . (%)/Blackstone Mgt. LLC (%) Ambac Financial ABK . Morgan (%) AMC Entertainment AEN Fairmac Realty Group (%)/Syufy Century Corp.(%)/ Durwood Family Heirs (%) American Classic Voyages AMCV Sam Zell Group (36%) American Express AXPBerkshire Hathaway Warren Buffett(%) American Locker Group ALGI Estate of Harold Ruttenberg (%) Ann Taylor ANN Morgan Stanley (%) ARI Network Services ARIS Briggs & Stratton (%)/Witech (%)/Vulcan Ventures (%) Aristotle Corporation ARTLGeneve Corporation (%) Astoria Financial ASFC . Morgan (%) Atchison Casting Corporation FDYEdmundson International, Inc. (%) Autozone AZO ESL, Ltd. (%) Bancwest Corporation BWE Banque National de Paris(45%) Barnes & Noble BKS Forstman-Leff Associates (%) Barrick Gold ABX Trizec Hahn Canada(8%) Battle Mountain Gold BMG Noranda Inc. Canada(%) Beringer Wine BERW Texas Pacific Group (%) Berlitz International BTZ Soichiro Fukutake/Benesse Corporation Japan(%) Biosphere Medical BSMD Sepracor, Inc. (58%) Continues
Appx A 7/9/01 9:03 AM Page 289ASUPERSTOCK SHOPPING LIST289Shopping List of Potential SuperstocksInformation as of 10/17/00 (continued)CompanySymbolPartial OwnersBlockbuster, Inc. BBI Viacom, Inc. (%) California Water CWTSJW Corporation Being acquired by American Water Works(%) Campbell Soup CPB Dorrance Family Heirs (%) Catalina Marketing POS General Electric (%) CDI Corporation CDI Garrison Family Trust (%) Centex Construction Products CXPCentex Corporation (%) Cerus Corporation CERS Baxter Healthcare (%) Chart House Enterprises CHTSamstock, LLC (%) Chiron CHIR Novartis (44%) Churchill Downs, Inc. CHDN Duchossois Industries (%) CITGroupCITDai-IchiBankJapan(%) Clorox CLX Henkel K GaAGermany(%) CNAFinancial CNALoews Corporation (%) Coca-ColaKOBerkshireHathawayWarren Buffett(%) Coca-Cola Bottling COKE Coca-Cola Company (31%) Coca-Cola Enterprises CCE Coca-Cola Company (%) Cognizant Technology CTSH IMS Health (61%) Congoleum Corporation CGM American Biltrite (%) Conmed Corporation CNMD Bristol Myers Squibb (%) Continental Airlines CALNWACorporation (%) Cooper Industries CBE . Morgan (%) Coventry Health Care CVTYPrincipal Life Insurance Co. (%)/Warburg, Pincus Ventures (%) CPC of America CPCF CTM Group, Inc. (%) Curtiss-Wright CW Unitrin (43%) Darden Restaurants DRI Prudential Insurance (%)/American Express (%) Dave & Busters DAB LJH Corporation (%)/ Mandarin, Inc. United Kingdom(%) Dawson Geophysical DWSN Pebbleton Corporation (%) Detroit Diesel DDC Daimler Chrysler (21%) Devon Energy DVN Santa Fe Synder Corporation (%) Diamond Offshore DO Loews Corporation (%) Donnelly Corporation DON Johnson Controls, Inc. (%) Continues
Y L F M AAppx A 7/9/01 9:03 AM Page 290 E T 290APPENDIX Shopping List of Potential Superst ocksInformation as of 10/17/00 (continued) CompanySymbolPartial Owners Dreyers Grand Ice Cream DRYR Nestle (%)/General Electric (%) DSTSystems DSTKansas City Southern Industries (%) Dynergy DYN Chevron (%) E*Trade Group EGRPSoftbank Holdings (%) Ecolab ECLHenkel K GaAGermany(%) Electric Lightwave ELIX Citizens Communications (%) Entrust Technologies ENTU Nortel Networks (%) Euronet Services EEFTDSTSystems (%) Excite @ Home ATHM AT&T(%)/Comcast (%)/ Cox Communications (%)/ Cablevision Systems (%) Family Dollar Stores FDO Bank of America (%) Federal Realty FRTMorgan Stanley Dean Witter (%) Fiberstars, Inc. FBSTAdvanced Lighting Technologies (33%) ®Fifth Third Bancorp FITB Cincinnati Financial Corporation (%)Team-Fly Fleet Boston Financial FBF Kohlberg Kravis Roberts (%) Footstar, Inc. FTS ESLPartners (%) Franklin Electronics Publishers FEPBermuda Trust Company (%) Freeport McMoran Copper FCX Rio Tinto Indonesia, Ltd. (37%) Friendly Ice Cream FRN Prestley Blake (%) Galey & Lord GNLCiticorp Venture Capital (%) Galileo International GLC UALCorporation (17%)/Swiss Air (%) Garden Fresh Restaurant Corporation LTUS D3 Family Fund . David Nierenberg(%) General Binding GBND Lane Industries (%) Gillette G Berkshire Hathaway (%)/Kohlberg Kravis Roberts (%) Golden State Bancorp GSB Mafco Holdings Ronald Perelman(32%)Great Atlantic & Pacific GAPTengelmann Group Germany(54%) Great Lakes Chemical GLK Berkshire Hathaway Warren Buffett(%) GTS Duratek DRTK The Carlyle Group (%) Guitar Center GTRC Chase Capital Partners (%) Hagler Bailey, Inc. HBIX Cap Gemini . (%) Halifax Energy HX Research Industries (%) Hanover Compressor HC GKH Investments (39%) Continues
Appx A 7/9/01 9:03 AM Page 291ASUPERSTOCK SHOPPING LIST291Shopping List of Potential SuperstocksInformation as of 10/17/00 (continued)CompanySymbolPartial OwnersHarleysville Group HGIC Harleysville Mutual Insurance (%) Hearst Argyle TV HTV Hearst Broadcasting (63%) Heska Corporation HSKANovartis (11%)/Ralston Purina (%)Hispanic Broadcasting HSPClear Channel Communications (26%)Houston Exploration THX Keyspan (%) Human Genome Sciences HGSI Bass Group (%)/Merrill Lynch (%) ICN Pharmaceuticals ICN Special Situation Partners (%) IDEC Pharmaceuticals IDPH Genentech (%)/Citicorp (%) IDEX IEX Kohlberg Kravis Roberts (%) IIC Industries IICR Kenyon Phillips, (%) Immunex IMNX American Home Products (%) Impco Technologies IMCO BERU Aktiengesellschaft Germany(%) Insurance Management Solutions INMG Bankers Insurance Group (%)International Home Foods IHF Hicks, Muse (%) International Multifoods IMCArcher Daniels Midland (%) Interstate Bakeries IBC Ralston Purina (%) (%) Isis Pharmaceuticals ISIPNovarits Switzerland(%) Kemet Corporation KEM Citicorp (%) Keystone Consolidated KES Contran Corporation (%) Kohl s Corporation KSS AXAFrance(%)/Prudential Insurance (%) Laboratory Corporation of America LH Roche Holdings (%) Ladish Company LDSH Grace Brothers (%) Lafarge Corporation LAF Lafarge . France(%) Legg Mason LM AXAFinancial (%) Liberty Financial LLiberty Mutual (%) Lifeway Foods LWAYDanone Foods (Dannon) France (20%) Ligand Pharmaceuticals LGND ELAN International Services (%)Lilly (ELI) & Co. LLYLilly Foundation (%) Lincoln National LNC Dai-Ichi Mutual Life Insurance (7%) Continues
Appx A 7/9/01 9:03 AM Page 292292APPENDIXShopping List of Potential SuperstocksInformation as of 10/17/00 (continued)CompanySymbolPartial OwnersLinens N Things LIN Marsh & McLennan (%)/American Express (%) Litton Industries LITUnitrin (%) Lone Star Technologies LSS Alpine Capital (%)/Keystone, Inc. (%) Loral Space & Communications LOR Lockheed (%) Magnum Hunter Resources MHR Oneok, Inc. (38%) Mascotech MSX Masco Corporation (%) McMoran Exploration MMR Alpine Capital (%) Mediquist MEDQ Koninklijke Philips Electronics NV Netherlands(%) Meemic Holdings MEMH Professionals Group, Inc. (82%) Midway Games MWYSumner Redstone National Amusements(25%) Millennium Pharmaceuticals MLNM Bayer AG Switzerland(11%) Mylan Labs MYLAmerican Express (%) Neiman Marcus NMGAHarcourt General (%) Neurogen NRGN Pfizer (%) Nextel Communications NXTLMotorola (%) Noland Company NOLD Edmundson International (%) OMI Corporation OMM Mega TankersNorway(11%) Oneida Corporation OCQ National Rural Electric Co-Op (%) Oneok, Western Resources (45%) Overseas Shipholding OSG Archer Daniels Midland (%) Owens-Illinois OI Kohlberg Kravis Roberts (%) Panamsat Corporation SPOTGeneral Motors Hughes(%) Payless ShoeSource, Inc. PSS ESLPartners (%) People s Bank PBCTPeople s Mutual Holdings (%) Petrocorp PEX Kaiser-Francis Oil Company (%) PetsmartPETMCarrefourSAFrance(%) Philadelphia Suburban PSC Vivendi France(18%) Phillips Van Heusen PVH Vaneton International Hong Kong(18%)/Mellon Financial (%) Picturetel Corporation PCTLIntel (%) Primedia PRM Kohlberg Kravis Roberts (72%) Prodigy Communications PRGYSBC Communications (%) Continues
Appx A 7/9/01 9:03 AM Page 293ASUPERSTOCK SHOPPING LIST293Shopping List of Potential SuperstocksInformation as of 10/17/00 (continued)CompanySymbolPartial OwnersProtective Life Corporation PLAmsouth Bancorp (%) RCN Corporation RCNC Level 3 Telecom Holdings (%)/Vulcan Ventures (%) Redhook Ale Brewery HOOK Anheuser-Busch (25%) Regis Corporation RGIS Curtis Squire (%) Ribozyme Pharmaceuticals RZYM Elan Int l Ireland(%)/Chiron Corp (%) Rosetta Inpharmatics RSTAVulcan Ventures (%) Royal Caribbean Cruises RCLA. Wilhelmensen . (25%)/Pritzker Family (28%) Russell Corporation RMLMerrill Lynch (%) Safeway SWYKohlberg Kravis Roberts (10%) Samsonite SAMC Artemis America France(%) Scitex Corporation SCIX Merrill Lynch (%) Scripps (.) . Scripps Trust (%) Seacor Smit CKH Geocapital Corporation (%) Smart & Final SMF Groupe Casino France(%) Sodexho-Marriott Services SDH Sodexho Alliance . France(48%)/TransAmerica Investments (12%) Sport Supply Group GYM Emerson Radio (%) Sterling Sugars SSUG . Patout & Sons, Inc. (62%) Stolt Offshore SCSWF Stolt Nielson . Luxemburg(%) Sunrise Assisted Living Centers SNRZ Morgan Stanley (%) Supergen, Inc. SUPG Abbott Labs (49%) Swiss Army Brands SABI Victorinox Switzerland(%)/Brae Group (%) Talbots, Jusco, Inc. (%) Targeted Genetics TGEN Immunex (%)/Elan Int l Ireland (%)Tiffany & Co. TIF Jennison Associates LLC (%) Timberland TBLSwartz Family Trust (%) Titanium Metals TIE Tremont Corporation (%) Transatlantic Holdings TRH American International Group (60%) Tremont Corporation TRE Valhi, Inc. (%) Triton Energy OILHicks, Muse (%) True North Communications TNO Publicis . France(%) . Cellular USM Telephone & Data Systems (%) Ultramar Diamond Shamrock UDS Total Finance/TOTALFrance(%) Continues
Appx A 7/9/01 9:03 AM Page 294294APPENDIXShopping List of Potential SuperstocksInformation as of 10/17/00 (continued)CompanySymbolPartial OwnersUnionBanCal UB Bank ofTokyo—Mitsubishi (%) United Park City Mining UPK Loeb Investors (%)/Farley Group (%) UNOVAUNAUnitrin (%) USG Corporation USG Knauf International (%) . Corporation VFC Barbey Trust (%) Valhi, Contran Corporation (%) Venator Group Z Greenway Partners LP(%)/AXAFrance(%) Vicorp Restaurants VRES SE Asset Management (19%)/Quaker Capital (12%) Washington Post Company WPO Berkshire Hathaway Warren Buffett(%) Westfield America WEAWestfield America Trust (%) Westwood One WON Viacom, Inc. (%) White Mountains Insurance WTM Berkshire Hathaway Warren Buffett(%) Whitman Corporation WH PepsiCo, Inc. (%) WMS Industries WMS Sumner RedstoneNational Amusements(25%) Worldtex, Inc. WTX Lockheed Martin Investment Management (%)/EGS Partners (%) Yonkers Financial YFCB Gould Investors LP(%) Note:This data has been obtained from sources believed to be reliable, but its accuracy cannot beguaranteed. This data is subject to change at any time and may have changed already subse-quent to this compilation. Readers are advised to independently verify this data and conduct theirown research.
Resources 7/9/01 9:03 AM Page 295RESOURCESBarron’s, published by Dow Jones & Company, Inc., New , published by The McGraw-Hill Companies, New , John, Chainsaw(New York: HarperCollins, 1999).Cerf, Christopher, and Victor Navasky, The Experts Speak(New York:Pantheon Books, 1984)., a product of EDGAR Online, Inc., is the market leader inEDGAR data , William, Adventures in the Screen Trade(New York: Warner Books,1989).Griffin, Nancy, and Kim Masters, Hit & Run(New York: Simon & Schuster,1996).Investor’s Business Daily, published by William O’Neil & Co., Los Angeles,, , a product of JAG Notes, is a financial , Herman, The Next 200 Years (New York: William Morrow & Co.,1976).Kiplinger’s, published by The Kiplinger Washington Editors, Inc., Wash-ington, Mansfield Chart Service, published by . Mansfield & , John, Sony: The Private Life(Boston: Houghton Mifflin, 2000).The New York Times, published by The New York Times , Terry R., 1929 Again(Lewiston Idaho: Bell Curve Research Founda-tion, 1986).Smith, Adam, The Money Game(New York: Random House, 1967).Smith, Adam, Supermoney(New York: Random House, 1972).295Copyright 2001 The McGraw-Hill Companies, Inc. Click Here for Terms of Use.
Resources 7/9/01 9:03 AM Page 296296RESOURCESSuperstock Investor, published by Superstocks, Inc., Rochester, New Weekly Insiders Report, published by Argus Research, Baltimore, Wall Street Journal, published by Dow Jones & Co., New , Bob, The Agenda(New York: Pocket Books, 1995).Yahoo! Finance, a product of Yahoo! Inc.
Index 7/9/01 9:04 AM Page 297INDEXABreakout, 206Brokerage firm research reports, 20, 21Abbott Labs (ABT), 135Browsing, 96–106, 126Accounting gimmicks, 50Brylane Inc., 106–111ADT Ltd., 85–94Burns International Services, 134, 135Adventures in the Screen TradeByrne, John A., 47(Goldman), 69Agenda, The(Woodward), 44CAllied Waste Industries, 251–254Ameche, Don, 187Case studies:American Stores, 15–17ADT Ltd., 85–94American Water Works, 27–30, 282Brylane Inc., 106–111Aquarion (WTR), 28Copley Pharmaceuticals, 149–155Arbor Drugs, 201Dexter Corp., 111–124Asset values, 26Fay’s/Genovese, 190–201Avco Corporation, 13Frontier Corp., 266–270JCPenney/Rite Aid, 233–237BMattel/The Learning Company,Babson, Roger, 44, 45247–250Babson Break, 45Midway Games, 140–148Bank One (ONE), 49, 50Protection One, 238–247BarrRenal Treatment Centers, 219–222, J. James, 28, 29BarronRexel Inc., 78–84’s, 140“Bearish Call on Banks Lands AnalystRohr, Inc., 210–214Salick Health Care, 207–210in Doghouse,” 49Belle, Albert, 43Smith Food & Drug Centers, 201–202Beneficial owner transactions, 103–105,Sugen, Inc., 260–265285, 286Sunbeam Corp., 46–48Bentsen, Lloyd, 43Vivra/Ren-Corp. USA, 215–219Berra, Yogi, 35Waste Management/Allied Waste,Big B, 201251–254“Bond Bears: Debt Securities PricesWMS Industries, 159–185May Slide for Years, Many AnalystsCatalysts, 11, 12Think, The,” 40Cautionary tabs (merger mania),Bonds, 59233–254Book value, 170Chainsaw(Byrne), 47297Copyright 2001 The McGraw-Hill Companies, Inc. Click Here for Terms of Use.
Index 7/9/01 9:04 AM Page 298298INDEXChange, 187, 188FCharts, 138, 139, 159, 205–214Faber, David, 267Clayton, Joseph, 268Fairness opinion, 77Clinton, Bill, 44Family feuds, 149–156Conglomerate craze, 188Family trust, 285Connecticut Water Service (CTWS), 128Fay’s Inc., 192–195Copley Pharmaceuticals, 149–155Federal Reserve, 61Corporate-shareholder disagreements,Financial press, 125–148149–156Barron’s, 140Cosell, Howard, 54case study (Midway Games), 140–148Creeping takeovers, 77–94Investor’s Business Daily, 126–132,136–140D(See also Investor’s Business Daily)Dexter Corp., 111–124magazine covers/articles, 37–42Dirty Rotten Scoundrels, 128New York Times, The, 133Discounted present value, 61Vickers Weekly Insider Report, 103–105Domino effect, 215–222, 227, 255Wall Street Journal, The, 133Dorfman, Dan, 111Flutie, Doug, 23Dornemann, Michael, 229, 230Form 4 filings, 105Double play, 141Form 13 filings, 103, 140, 286Dow, Charles H., 187Form 13-D filings, 103, 140Drugstore industry, 187–, 286case study (Fay’s/Genovese), Frontier Corp., 266–270190–201Frost, A. J., 205case study (Smith Food & DrugFrost, Robert, 95Centers), 201–202GDun & Bradstreet (DNB), 135Dunlap, Al, 46, 47Gateway, 52–53Genovese Drug Stores, 192, 194–201EGifford, Frank, 54E’town Corp., 131, 132, 140, 282Goldman, William, 69, 70Efficient market, 80, 81Goodfriend, Jaimi, 254Eli Lilly, 225, 226Goodman, George, 6, 23Examples (seeCase studies)Grass, Martin, 191, 192, 233, 236Excitement, 6, 7Greenberg, Herb, 247Experts, 35–36Greenmail, 121agenda, 43, 44Greenspan, Alan, 44, 61conforming to prevailing ideology,Griffin, Nancy, 22848–53Hdefined, 36famous bloopers, 54HealthSouth, 251magazine covers/articles, 37–42Heaven Can Wait, 36shortage of, 42Herd instinct, 31truth telling, 44–48Heyman, Samuel, 113–124
Index 7/9/01 9:04 AM Page 299INDEX299Hills, Roderick M., 253Major shareholders, 286Hit & Run(Griffin/Masters), 228(See also Beneficial owner transac-Horse racing, 6, 7tions)Horror stories (merger mania), 233–254Malraux, André, 53Huff, Rolla, 269Mansfield Chart Service, 27, 97, 211Masters, Kim, 228IMattel, 247–250IBD (see Investor’s Business Daily)Mayo, Michael, 49–51Illustrations (seeCase studies)McKesson HBOC, 251Index investing, 31–34Mead Corp. (MEA), 135Interest rates, 59–62, 69Media (see Financial press)Interpreting the news, 4, 5Merck, 225Investing paradigms, 25–30Meredith, Don, 54Investor’s Business Daily, 97, 126–132Merger mania, 223–257dirty rotten stocks, 127–130blunders, 231, 232, 251“Industry Profile,” 136, 137case studies:problems, 127–132JCPenney/Rite Aid, 233–237“Stocks in the News,” 138–140Mattel/The Learning Company,“To the Point,” 130, 132247–250“Where the Big Money’s Flowing,”Protection One, 238–247130, 137, 138Waste Management/Allied Waste,251–254JCEO egos, 227–229investment banking’s desire for fees,JCPenney, 233–237, 251230Klemming effect, 225–227, 251merger of equals, 256, 257Keynes, John Maynard, 57take the money and run, 232, 256Kidney dialysis industry, 215–222Merger of equals, 256, 257Kirby Industries, 170–172Middlesex Water (MSEX), 129Kondratieff, Nikolai D., 45Midway Games (MWY), 140–148LMoney Game, The(Goodman), 6Morita, Akio, 228, 229LaLoggia, Charles M., 3, 4, 303Mudslinging contest, 122Large-cap stocks, 32, 33, 71, 72Learning Company, The, 247–250NLemming, 31Lemming effect, 225–227, 251, 255Nathan, John, 228Limbaugh, Rush, 43National City Corp., 50List of potential superstocks, 288–294Negative surprise, 213, 214Long-term bonds, 59New paradigm vs. old paradigm LTV Corporation, 12, 13thinking, 27–30New York Times, The, 97, 133MNicastro, Neil, 142–148, 180, 181Magazine covers/articles, 37–421929 Again(Rudd), 44Mahon, Cherrie, 124, 146, 147, 3031987 stock market crash, 42
Y L F M AIndex 7/9/01 9:04 AM Page 300 E T 300INDEX “No Bottom to Oil,” 40S No-risk rate of return, 69S&Pprice/earnings ratio, 58 Nobody knows anything, 70Salick Health Care (SHCI), 207–211North, Oliver , 43Samuelson, Robert, 41 Scharf, Stewart, 253OSchliemann, Peter, 71 O’Neil, William, 127, 128Service Corp. International, 251 Old paradigm vs. new paradigm Shining, The, 39 thinking, 27–30Shopping list of potential superstocks,One-decision stock paradigm, 25, 26 288–294Oneok (OKE), 245, 246Shore, Andrew, 46–48 Oxenstierna, 223SJW Corp., 282 Small-cap stocks, 32P Smith Food & Drug Centers, Paradigm, 25 201–202PCS Health Systems, 225–227SmithKline Beecham, 225 Pharmacy benefits manager (PBM), 225Sony, 227–229 Pinault-Printemps-Redoute, 134Sony: The Private Life(Nathan), 228 Pittway, 129“Specter of Depression, The”Potential takeovers (Telltale Signs), (Samuelson), 41®98–101Spin-offs, 188–190Team-Fly Price/earnings ratios, 58, 59Stock charts, 138, 139, 159, 205–214Protection One, 238–247Stock market crash of 1987, 42Public mudslinging contest, 122Stock selection, 19–23Pure plays, 188, 189Sugen, Inc., 260–265Sullivan, Allanna, 272RSunbeam Corp., 46–48Redstone, SumnerSupermoney(Goodman), 23, 145, 159–166, 168,Superstock, 11172–174, 177, 184Relative leadership index, 34Superstock breakout pattern, 206Ren-Corp. USA, 216Superstock Investor, 1, 17, 303–219Renal Treatment Centers, 219Superstock shopping list, 285–294–222Research departments, 20, 21Synergy, 188, 189Research universe, 97, 98TResistance level, 206Resources, 295, 296Takeover indicators (Telltale Signs),(See alsoFinancial press)98–101Rexel Inc., 78–84Takeover-lively industry, 203Riskless alternative to the stock market,Talk shows, 4259Technical analysis, 139Rite Aid, 233–237, 251Telltale Signs, 98–101Rite Aid–Revco merger, 190–19310-K Report, 245Rohr, Inc., 210–214The Learning Company, 247–250Rudd, Terry R., 44, 147, 21013-D filings, 103, 140
Index 7/9/01 9:04 AM Page 301INDEX301“This Is Not Just a Bear Market. This IsWthe Way Things Are Going to BeWall Street Journal, The, 97, 132–134from Now On,” 53Wall Street research, 20, 21TJ International, 102Warnock, Tom, 257Triple play, 141, 148Waste Management, 251–254Trus Joist, 102Water utilities, 271“Water Utility Industrial Could Be onUthe Verge of a Takeover Wave”United Water Resources, 281, 282(LaLoggia), 27Western Resources, 86–92, 238–246VWeyerhauser, 101, 102Value, 62“Why Greenspan Is Still Bullish,” 41Value investing, 57Wittig, David, 238–244Vickers Weekly Insider Report, 26, 97,WMS Industries, 159–185103–105Woodward, Bob, 44Vignettes (see Case studies)YVivra, 215–222Yucaipa Cos., 202, 203
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About the Author 7/9/01 9:04 AM Page 303ABOUT THE AUTHORSCharles M. LaLoggiais the editor and publisher of Superstock Investor,a monthly stock market newsletter he has published since 1974. Hehas also written numerous newspaper columns and magazine articleson investing. Charles LaLoggia’s stock market views and stock rec-ommendations have been reported in virtually every major financialpublication in the world, including BusinessWeek, The Wall Street Journal,Barron’s, The New York Times, Kiplinger’s Personal Finance, Money, Fortune,Newsweek, and many others. He has appeared on numerous televisionand radio programs, including Wall Street Week With Louis Rukeyser,The Nightly Business Reporton PBS, and CNBC. During his 26-yearcareer as a stock market analyst, Charles LaLoggia has developed areputation for being able to identify future takeover targets in theirearly stages, before they become widely recognized. In 1999, financialcolumnist Dan Dorfman called Charles LaLoggia “unquestionably oneof the country’s hottest—if not the hottest—takeover picker.” In aDecember 2000 article entitled “Riding the Buyout Wave,” Fortunemagazine said that Charles LaLoggia’s Superstock Investornewsletter“has a solid record for predicting buyouts.”Cherrie A. Mahonis copublisher and director of research of theSuperstock Investornewsletter. Prior to that she was a stockbroker at amajor Wall Street information regarding the monthly Superstock Investornewsletter is available by e-mailing ssinvestor@ or calling1-800-450-0551 or writing to Superstock Investor, . Box 30547,Rochester, New York 2001 The McGraw-Hill Companies, Inc. Click Here for Terms of Use.
