THE SUPERSTOCK INVESTOR PHẦN 4 pptx

the 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 the stock market closes. If the market turns around and manages to erase its 200-point loss and close higher, the “bearish” items will miracu- lously be interpreted as bullish, as in “Wall Street had second thoughts about President Clinton’s tax cut proposal . . .” and so on. Believe me, once you get used to thinking in terms of super- stock analysis, you will begin to see these stock market commentaries in an entirely different light—that is, if you bother to see them at all. Can you really invest in stocks while you completely ignore the stock market in general? Can you really ignore the stock market prognosticators and other talking heads who can always be count- ed on to have an explanation of what the stock market did on any given 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 than anyone else. All you really need to know is this: When interest rates are rising sharply and the no-risk rate of return begins to exceed the inflation rate by more than 3 or 4 percentage points, it’s time to think about reducing your market exposure. Other than that, nobody knows anything. Which brings me to William Goldman. William Goldman is not a stock market analyst. He is the screen- writer of Butch Cassidy and the Sundance Kid, Marathon Man, and numerous other well-known motion pictures. William Goldman is also the author of a brilliant and entertaining book, Adventures in the Screen Trade, in which he coined a memorable phrase that summed up everything he’d ever learned about the movie business. Here it is: “Nobody knows anything.” What Goldman was saying was that you could take all of the sophisticated market research, all of the experience of studio heads and producers, all of the box office grosses of predecessor films, and all of the marketing savvy of the best distribution people, and throw it all out the window. If all of the widely available information known to everyone in the movie business meant anything, everyone would be making nothing but successful movies—and that sure isn’t hap- pening. Says Goldman: CHAPTER EIGHT If Everybody Knows Everything, Then Nobody Knows Anything 69 Chap 08 7/9/01 8:52 AM Page 69 • If anybody knew anything, B.J. 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 Ark would 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 E.T., even after the studio spent a million dollars developing the film. (E.T. wound up at Universal.) • If anybody knew anything, Paramount Pictures would not have offered The Godfather to 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 role of Michael Corleone to Robert Redford, Warren Beatty, Ryan O’Neal, Dustin Hoffman, and Martin Sheen before they got around to offering it to Al Pacino. Now, if you think about it, you can apply William Goldman’s premise to the stock market, but with a slight variation. In the stock market, when everybody knows everything, nobody knows anything. Overall, the evidence seems to indicate that the stock mar- ket, as a whole, is a pretty good “discounting” mechanism that takes into account everything that is knowable at any given time. The more 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 value. This 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 beaten path and to focus on areas of the market where analytical attention is slim or nonexistent. It also follows that there’s no “edge” to be had in terms of trying to outguess the general market, since virtually every analyst and investor is looking at the same information, which will therefore be pretty well discounted, just as William Goldman’s movie studio executives are all poring over the same current and historical data regarding box office grosses. If all of this “macro” publicly avail- 70 PART ONE The Making of a Superstock Investor Chap 08 7/9/01 8:52 AM Page 70 TEAMFLY Team-Fly ® able information meant anything, everyone would be making the right move all of the time—and they’re not. This strongly suggests that 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 were. The same holds true for large-cap stocks. A 1999 study by Peter Schliemann, 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, while stocks with a market cap of less than $100 million had an average of less than one analyst following the company. This means that some of these 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 more than a few of the small companies with no analytical coverage had lots of cash, no debt, and no need for investment banking services from 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 the competition by the way these stocks react to surprisingly good or bad 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 earnings estimate and downgrades the stock, and your $66 large-cap stock simply opens at $50. That is how the efficient market works with widely followed stocks: Everybody immediately takes the new real- ity into account and the market adjusts its perception of value instan- taneously. Since everybody expected earnings of, say, $0.60 for the quar- ter, everybody knew everything—therefore, they knew nothing. Now that everybody knows earnings came in at, say, $0.50, every- body knows everything once again—but they still know nothing since there is no way to take advantage of that information to avoid the stock price decline. So, 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 knowing. When you’re looking for an edge in an area of the stock market where everyone else is looking, you’ll find that new business becomes old business pretty darn quickly—usually too quickly to be of any CHAPTER EIGHT If Everybody Knows Everything, Then Nobody Knows Anything 71 Chap 08 7/9/01 8:52 AM Page 71 use to an individual investor. By the time you hear any new signif- icant information about the market in general or big-cap stocks, it’s a good bet that it will be old business already, no matter how new it seems to you. Now, compare this instantaneous reaction to new business in the large-cap stocks to the way the market reacted to Laidlaw’s announcement that it would sell 12 percent of ADT Ltd. to Western Resources (see Chapter 9) for $14 a share. Did ADT immediately jump to $20 or $25 a share based on the likelihood that this move would ultimately lead to a takeover bid? No, it did not. The stock moved up gradually, over time, providing numerous excellent entry points for tuned-in investors. But if, say, IBM were to reveal that it had been buying shares of Dell Computer in the open market and that it had accumulated a 12 percent stake without talking it over with Dell’s management, what do you think would happen to Dell’s stock price? Most likely, the Wall Street analytical community would immediately take its best guess as to Dell’s potential takeover value and the stock would rise toward that level almost immediately. This did not happen, as we will learn, with ADT. Nor did it happen with Rexel, Inc., even though the parent company, Rexel S.A., methodically bought shares in the open market, giving off a blatant clue that a takeover bid was on the way. With both of these stocks, investors had plenty of time to accumulate shares prior to the eventual takeover because the stock market was inefficient in pricing their stocks in light of this information. That 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 related to the audience for that information—i.e., whether institutional investors and the analysts who are fighting for their commission business are paying attention will determine how accurately the market reflects new information. You will find, over time, it is important to spend more time researching individual stocks that are off the beaten path and less time thinking about the overall stock market and the popular stocks of the moment. 72 PART ONE The Making of a Superstock Investor Chap 08 7/9/01 8:52 AM Page 72 Two 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 that edge in terms of individual stocks, where it is sometimes possible to notice information and interpret that information in a way that can give you some unique insight into a particular situation. In other words, where individual stocks are concerned, the prize goes to those investors who go the extra mile, who do their home- work better than everybody else. Sometimes this involves digging deeper for information about the company itself. Other times it involves thinking in terms of cause and effect, where a seemingly unrelated news item in the maze of information released on a daily basis 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 bid because Rexel S.A., which bought Rexel, was a subsidiary of Pinault Printemps (see Chapter 9). But how many investors—or professional analysts—would have known that if they had not lived through the Rexel takeover drama? So, lesson number one is: Research individual stocks—and smaller stocks, at that—and don’t try to predict the market or com- pete with every analyst on Wall Street tracking the large-cap stocks. The second lesson is that a lot of valuable public information is available out there that is not reflected in stock prices, especially when you’re dealing with stocks that are not widely followed by the mainstream Wall Street analysts. So, lesson number two: If you really want to get an edge on Wall Street, you should focus your attention on smaller-cap stocks that are not widely followed by analysts and their institutional clients. That is where you are most likely to turn up information and see a connection somewhere that is completely public but that has not been properly reflected in the stock price. This principle explains why stocks like Rexel, ADT, Brylane, and others could easily have been purchased for months on end at bargain prices even though it was becoming increasingly likely to anyone paying attention that a takeover bid was on the way. When you start to focus more of your attention on individual stocks and less attention on the general market, you’ll be better able to train yourself to think in new paradigm terms. You will notice a CHAPTER EIGHT If Everybody Knows Everything, Then Nobody Knows Anything 73 Chap 08 7/9/01 8:52 AM Page 73 subtle change in the way you perceive the news. You’ll think in terms of cause and effect, and see connections between seemingly unre- lated companies and events that others do not notice. The more you think this way, the more likely you will be able to identify potential “superstocks”—and the less interested you’ll become in the daily blather that passes for stock market analysis. 74 PART ONE The Making of a Superstock Investor Chap 08 7/9/01 8:52 AM Page 74 PART TWO Identifying Takeover Targets Chap 09 7/9/01 8:53 AM Page 75 Copyright 2001 The McGraw-Hill Companies, Inc. Click Here for Terms of Use. This page intentionally left blank. CHAPTER NINE Creeping Takeovers Let’s begin this chapter with an actual example of a company that received a takeover bid that was completely predictable to those who were tuned in to the superstock method of analysis. One of the best ways to spot a future takeover target is to focus on companies that are already partially owned by another company that is con- sistently adding to its stake by purchasing additional shares in the open market. Many times these continual open-market purchases are a prelude to eventual takeover bids at much higher prices. To understand why this is so, put yourself in the position of the outside owner. Suppose you own 45 percent of a company whose stock is trading at $10. Suppose this company operates a business that is complementary to yours and has excellent growth prospects. And let’s suppose further that your management team has decided it would be a good idea to acquire this company within the next 2 years. If the eventual plan is to buy the 55 percent of this company you do not already own through a takeover bid or tender offer, you know two things. First, you will have to offer a premium over the stock’s current trading price. And you also know that even though you already own 45 percent of this company, your offer will be sub- ject to what is called a “fairness opinion.” This means that even though 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 price for the shareholders. The Board of Directors will probably enlist the services of a brokerage firm that will dispatch a team of analysts to 77 Chap 09 7/9/01 8:53 AM Page 77 Copyright 2001 The McGraw-Hill Companies, Inc. Click Here for Terms of Use. study the target company, the industry in which it operates, the val- uations of its competitors, and the future growth prospects of the company you want to buy. All of this means that you’ll probably have to pay a hefty premium over the stock’s current $10 trading price—especially if the growth prospects you envision are apparent to the target company’s management and to the financial advisers the target company retains. Given 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 starts adding 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 market prices, gradually increasing the stake. If these purchases are made in a cautious and patient manner, they may not push the stock price up very much. In fact, the stock price may not go up at all since there is always stock available for sale in the normal course of trading. Simply bidding for stock and putting out the word to market makers that a bid is available should a block of stock come up for sale may be all it takes to accumulate an additional, sizable stake in the target company. This approach makes all the sense in the world because if your ultimate goal is to acquire the entire company, and if you know you will have to pay a sizable premium once the formal bid is made, the more stock you can accumulate at low prices, the less the eventual takeover will ultimately cost you. CASE STUDY: HOW REXEL S.A. ACQUIRED REXEL INC. If you think like a potential acquirer and you keep an eye on outside owners who are accumulating additional shares of a company on the open market, you can act right along with them by purchasing shares in the potential target company. How can you do this? Any holder of 5 percent or more of a public company is deemed a “ben- eficial owner” and must report all additional purchases and sales of stock. Once a “beneficial owner” crosses that 5 percent threshold, each additional purchase of stock becomes a matter of public record. Later, you will learn where to find this information so you can buy right along with these outside beneficial owners. But first, let’s look at Rexel Inc. and the “creeping takeover” engineered by its largest shareholder, Rexel S.A. of France. 78 PART TWO Identifying Takeover Targets Chap 09 7/9/01 8:53 AM Page 78 [...]... and other institutional investors do indeed take all new information immediately into account when the information involves the largecap stocks these institutions, and the analysts who serve them, are following with the precision of an electron microscope But when it comes to smaller-cap stocks that are not on the institutional radar screen, you can throw the efficient market theory right out the window... simply not the case The reason is that if the outside beneficial owner continues to purchase large blocks of stock on the open market, it’s a strong indication that there is good value at those price levels If the price declines, the outside beneficial owner tends to go into the open market to purchase more shares, thereby supporting the price Every time an open-market purchase is made by the outside... another company before finally making a bid By the end of the summer in 1996, Rexel S.A had made two additional purchases of Rexel Inc stock: 46 ,000 shares at $131 4 and 175,700 shares at a price as high as $ 141 4 And there was continued scattered buying of stock by Rexel Inc.’s officers and directors In September 1996, Rexel S.A purchased another 162,000 shares of Rexel Inc., at prices between $133 4. .. Creeping Takeovers 85 The reason for this is that, more often than not, the outside beneficial owner owns so much stock that an open-market sale is not only impractical but also makes no business sense Since the objective of the beneficial owner should be to maximize the value of the investment, the proper way to get out of a large position in one company is to either sell the stake to another company that... percent interest in ADT from Laidlaw at $ 14 and held an option to buy another 12 percent And yet, ADT shares were sitting right there, in the $ 14 to $15 range, as though nothing fundamental had changed as a result of these two separate, but related news items ADT became part of the master list of recommended stocks in our Superstock Investor newsletter At the time, some utilities, including telephone... price bumped to $ 14; however, Rexel drifted back to where it had started, meeting support in the $12 area Rexel met strong support at that price And then the “creeping takeover” really got under way In 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 40 00 shares of... accumulates and the longer the stock takes to react, the more time you have to accumulate shares with even greater confidence—which means 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 S.A had Chap 09 7/9/01 8:53 AM Page 83 CHAPTER NINE Creeping Takeovers 83 spent most of the year... to sell its stake—is usually a sign that the target company is about to enter the ranks of the superstocks CASE STUDY: THE TAKEOVER OF ADT An example of this approach is ADT Ltd., a security alarm monitoring company In February 1996 a small news item appeared about ADT Ltd., which at the time was the largest home security alarm company in the United States The news item did not seem to raise any alarm... over the next year, the handful of investors who followed the ADT story would have had numerous opportunities to add to their ADT stake along the way, sometimes at prices below which Western Resources had paid for the stock on the open market As more evidence accumulated that ADT would be acquired, a perfectly efficient stock market should have removed such bargain-purchase opportunities from the equation;... purchased another 79,000 shares of Rexel Inc at $133 4 And yet, amazingly, despite the sizable open-market purchases by Rexel S.A that I had been documenting, month after month, Rexel Inc shares were trading in November 1996 right at $ 14, no higher than they had been trading at the start of 1996 This proved two things: First, no one on Wall Street was paying the slightest attention to the Rexel situation . Since the objec- tive of the beneficial owner should be to maximize the value of the investment, the proper way to get out of a large position in one com- pany is to either sell the stake to another. this way, the more likely you will be able to identify potential “superstocks”—and the less interested you’ll become in the daily blather that passes for stock market analysis. 74 PART ONE The Making. individual stocks that are off the beaten path and less time thinking about the overall stock market and the popular stocks of the moment. 72 PART ONE The Making of a Superstock Investor Chap 08 7/9/01