For the first quarter of 1999, our average account gained +14.00%.
Success at finding underappreciated stocks used to
be the mark of a smart fund manager. But investors
are leaving that old-fashioned approach for dead.”
Front Page N.Y. Times, April 4
Value investing is not about to go the way of the passenger pigeon any time soon, and that this currently seems doubtful to the Timesman quoted above will no doubt soon become the source of mirth for many years to come. In no other realm of business can an item that will not sell at $100 be marked up to $200 and regularly be counted on to fly out the door. Yet it has always been so in the investment world, and the current Internet frenzy is just the latest exemplar. Of course this enthusiasm is threatening not only tried and true concepts, but even the language. For many years we have been on the lookout for “net-nets”, stocks that are selling for less than their working capital minus all debts. It is an investment theme first espoused by Ben Graham in 1932. Imagine our delight in hearing on television an advertisement for the Munder Netnet Fund on CNBC recently; joy, we thought, we’ll grab a prospectus, and find a list of great bargains all in one place. Alas, turns out to be a fund full of Internet stocks, devoted to “dramatically changing the way we do business”. Also puts a dent in the English language.
Nevertheless, part of our pleasing performance in the first quarter comes from sneaking into an Internet play by way of an open accounting window. We bought a sizable position in Qualcomm, the cellular telephone company, because we understood its recent income statement obscured more than it revealed. Qualcomm owns a dominating patent position in one type of cell phone technology. It had been the company’s long-held hope that its system for digital cell phone transmission would naturally be adopted by all the worlds’ manufacturers when the capacity of existing analog systems ran out. Three years ago, when Europe adopted a different system, and Qualcomm’s own system was late with the typical software glitches, things looked dire. The company’s solution was to prove its system was best by building its own handsets, semiconductors chips and base stations for any phone company who could be cajoled to sign up, even at the cost of sizable losses on the hardware. The hope was to make up in future royalties whatever losses were incurred currently. It worked, and worked so well that in the third quarter of last year more cell phone users signed up for digital than analog in the U.S., and over 75% of those digital users opted for Qualcomm technology. The strategy was painful, however, because mass producing electrical hardware in high cost San Diego is no one’s idea of profitable fun.
If the new chief operating officer of Qualcomm could be persuaded that the need for manufacturing was past, then the current losses in hardware could be looked at as an investment, and the stock was selling at about 14 times its royalty earnings, and those earnings appeared to be growing very rapidly. To give you a feel for what “rapidly” means in the prior sentence, estimates are that digital phone sales will grow 5 times in the next four years, and while Qualcomm will not capture all of that, most is enough.
Enter Levy, Harkins & Co., with our long dead value approach. Shortly after that, enter Ericsson, the giant Swedish phone maker on March 25th, with an offer to buy Qualcomm’s money losing division for several hundred million dollars. Giving it away would have been a blessing. Better yet, Ericsson agreed to sponsor Qualcomm’s designs for the next generation of cell phones, which will be far more like tiny personal computers than traditional phone handsets. This means within a year you will be able to get e-mail and Internet access directly off your next cell phone, and it will be near instantaneous. We have been out to San Diego and seen this system work, and while there are always glitches to be anticipated in new technologies, this is not vaporware. We do not mean to get swept up in visions of the future, but if prices for long distance service via cellular have already fallen below fixed phone levels, as the long distance carriers do not have to pay the local Bells exorbitant last mile charges, and if you can get Internet access off a cell phone, why do you need the big, ugly, cable snaking implement sitting next to your elbow right now? Just a thought.
No letter from us would be complete without some update on Echostar. The company has been going from strength to strength. Subscriber additions to its satellite television service have been almost as great in the first quarter as they were in the last quarter of 1998. The business is supposed to be seasonal; the prospect of installing outdoor electrical equipment in February is unappealing in most parts of America. Legislation is also pending in Congress that would give Echostar an enormous advantage over its sole remaining competitor in the all important delivery of local stations as part of its 300 channel satellite package. We will not hazard a guess as to how this issue will break, and you need no guidance from us as to which way we’re rooting.
We continue to be amazed at the number of quality companies with medium-size capitalizations that pay large and increasing dividends, and whose shares go utterly ignored. In a world that is meant to be yield famished, crowds strolling past a buffet table empty handed is odd behavior. If this quarter is anything like the last, we will spend the rest of the year slowly shifting from growth to overlooked yield.
Sincerely,
Edwin A. Levy
Michael J. Harkins