some days they leaveyou alone. But every day there’s something going on. An example isour initial purchase of Marvel Entertainment at 14, which we thoughtwas pretty cheap. Ron Perelman [the billionaire owner of Revlon and
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Marvel among other companies] was buying it pretty aggressively atthat price.
Tanous:! thought he sold the company?
Sloate: Well, he sold a chunk in the 17 to 25 range, and he boughtback a big piece of that around 14 3/4 to 15 1/2. That was for taxconsolidation reasons, but I’m sure he would rather pay 10 1/2 than15. I think there’s value there. The company had many problems withits principal businesses - trading cards and comics - and now it’scome down to the $11 area. We looked at the cash flows; we lookedat the underlying values of the company’s divisions, including ToyBiz [Marvel owns 37% of the company]. The baseball season shouldbe better than last year - no strike - which will help their trading cardbusiness. Ron Perelman is a resourceful guy. He’s got his right-handman at Marvel, and it’s my guess that at 10 1/2 bucks it’s probablybottomed. So we increased our position. The market won't believetheir story until the company turnaround is evident. But in the spring,these guys got up at a meeting and gave EBIT [earnings before interestand taxes] and earnings projections by division. Either they want tohang themselves, or they banked those numbers, and they’re prettycertain they'll hit them.
Tanous: They gave estimates by division?
Sloate: I said either those numbers are almost certain or those guysare nuts. Would I buy it today [April 1, 1996]? Probably not. I don’tthink it’ll do anything till July [7996]. The bottom line is, if I sell it,I know I'll see the stock at 15, and that’s almost a 50% move fromits current level.
Tanous:So, why did you say you wouldn’t buy it?
Sloate: Because we already own it. This is one we doubled up on.At this point I’m so worn out with all the problems and the aggrava-tion I’ve had with it, and I’ve been wrong about it before. Most of thebad stuff is in the price; we bought it prematurely. There are a lot ofpositive elements in this company’s turnaround and Perelman is downtwo-and-a-half billion dollars in his stake in the last two and a halfyears. I still think there’s a lot of value there. I realize I spent a lot oftime on this, but I wanted to give you an example of the discipline.
Tanous:Laura, many of the managers I talk to have investing themesor areas that they latch on to that are particularly important to them.How about you?
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Sloate: I can tell you two we don’t do. One, we don’t invest intechnology stocks.
Tanous:Of course, technology is tough for a value investor.
Sloate: Well, a lot of value investors do buy technology. Value in-vestors bought Digital Equipment because the cash flow is this andthe balance sheet is that. But we don’t buy tech stocks because webelieve we know nothing about technology. The creators of technologyhave their own network and you really have to understand it. Wedon’t know who is going to come down the pike tomorrow morningwith a better widget or gizmo, and our stock will be down 30%, andwe'll have no idea what to do. So we don’t buy technology.
Second, we don’t buy foreign stocks because, although we mayunderstand the business, we don’t know the political or currency risks.
Tanous:Any other themes you like or dislike?
Sloate: We like managers. Good management is key. We'll buysome companies with secondary managements and great asset values,but we obviously prefer having a good manager.
Tanous:Let’s talk about that for a second. It’s interesting becauseI talked to another investment manager with almost the opposite ap-proach. It makes sense when you say you like good management, butthis other value manager, Eric Ryback [page 197], who runs theLindner Funds, doesn’t talk to companies at all. He doesn’t even wantto talk to them. I found that strange. He said that they’re now startingto talk to them on the phone under certain circumstances. Problemis, Eric says, all the companies are trying to put a spin on things andgive the answers they think we want to hear. That raises this question:If evaluating management is very important, how do you do that?How do you know who the good ones are?
Sloate: You do and you don’t. Part of it is the track record. Whathave they done? You know that Jack Welch [GE] is a good manager.Look at his record. Larry Bossidy [AlliedSignal] is a good manager.You know by their track records. You know if a management is goodor not by their responsiveness to changing scenery. I’m not sure thatI agree that most of what they tell you is party line.
Yes, the annual report is P.R. for the most part, but you can oftenfind some elements within it that make sense if you’ve read enoughof them. For example, read Coca-Cola’s annual report - by the way,I don’t own Coke. To me the stock is at a bizarre multiple. It mayhave the greatest franchise in the world, but I get acrophobia at 40
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times earnings. If you read the annual, you will find a very disciplinedapproach to growth. You can see how logical it is. This company iswell-run, well-focused. It’s not like reading a report from a companywhere management is talking about shareholder value, but the returnshave been down for the last three years, plus it has four differentunrelated businesses with no synergy.
Here’s an example. We just bought FMC. Let’s see where it’s trading.[Laura’s fingers find the keyboard on her desk and she punches in thesymbol FMC. A squawk box speaks mechanically in response:“F...M...C..closed at 76...” She switches it off.] It closed at 76. Wepaid 74 1/2 last week. I read a lot of stuff. I became interested in itafter I read several Merrill Lynch reports over the last few months.We sent one of our analysts over to a Merrill Lynch Chemical Confer-ence and told him to be sure to see the FMC people. What we dis-covered was that this had been a public LBO [leveraged buyout] byGoldman Sachs in the ’80s. Management did it to avoid a takeover,leveraging the balance sheet in the process. Sixty percent of thecompany is in chemicals, 30% is machinery equipment, of whichabout half is in the underwater platform business. The gold miningbusiness is up for sale. We did some quantitative analysis and theearnings estimate looked like $7 to $8.50 [per share], which soundedvery attractive for a 74 dollar stock.
Tanous:Seven dollars was the estimate per share for what year?
Sloate: Seven for ’96 and $8.50 per share in ’97. Next, we lookedat its peer groups and discovered that if you broke the company upinto the pieces, and the pieces traded at comparable multiples to theirpeer groups, the stock would be worth over $100. We looked at wherethe conglomerates are selling and FMC is selling at 3 or 4 multiplesbelow the bottom of the range. FMCs capital expenditures were over$60 a share and R&D was more than $15 over the last five years.Then we looked at management’s age and they were only 54 - thatwas a negative. And, they own 22% of the company.
Tanous:What’s negative about being 54?
Sloate: Well, management has done a sub-par job and, at 54, theycould conceivably be around for another ten years. Al Costello, CEOof W.R. Grace, is on the FMC board. He knows a lot about companiesbeing broken up and sold, and he understands the chemical business.The long and the short of it is, we thought this was an undiscovered
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value on an asset discount basis. We just didn’t think there was a lotof downside at ten times earnings.
Tanous:That example really speaks to your investment approach.I also noticed that you manage one of the Strong Funds, not surpris-ingly, the Strong Value Fund. How did that come about?
Sloate: That’s new. I’ve known Dick Strong for 28 years. We weretalking last summer and he said, would you run a fund for me? Ithought about it, and said I'd love to. The fund opened on December29, 1995. And the fund is run like all the other accounts. We wereup over 8.5% in the first quarter of 1996. It’s a little baby fund though.The reason we wanted a fund was to get into the 401(k) business andthe variable annuity business. Also, we were turning down a lot ofmoney, since our account minimum is $500,000. We wanted to bewith a large, reputable organization that would handle the distributionand marketing functions. We just want to manage the fund.
Tanous:Laura, I want to give you a chance to revert to your aca-demic background for a second. One of the things I’m doing in thisbook, that I don’t think has been done before, is juxtaposing theopinions of great money managers and great academics. The academicsI interview generally believe that you can’t beat the market consistently.People like you, they say, exist in any distribution, but the identity ofthe outperformers is inherently unpredictable. How do you respondto the thesis that the market is efficient - that everything about thecompany is known and therefore you can’t beat the market? How doyou respond to the contention that future predictability of performancebased on the past performance of the manager is not possible?
Sloate: I’d agree with the second part of that. I think the past givesyou an example of what the future could be. But past results shouldn’tbe over-stressed. Of course, if a manager has a terrible past, it maymean a lack of talent. If they’ve had a past that is totally off the edgeof the curve, you should be careful because that may be luck or maybethey took some very high risk, some rainmaker bet. For example, theymight have had 30% of their portfolio in a stock that got taken overor the manager bought 22 new issues and made money. That’s justgetting lucky.
But there is value in information. A couple of weekends ago,Hilton’s stock was getting murdered. It was down like three points,and my guys say they hadn’t heard anything. I said, they probablyhad a lousy weekend at the baccarat table. So I swear, five minutes
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later C.J. Lawrence comes out on the tape and lowers their estimates.Two minutes later they said it was due to gaming shortfalls. I said tomy traders: “I told you it was the baccarat table! You didn’t believeme!” I know Hilton’s business. They’re in the high roller gamingbusiness. If they have a lousy weekend at baccarat it could cost themthree cents a share. Look, maybe you can’t beat the market if you’replaying the market. We’re not playing the market; We’re playing 60stocks. We should be able to beat the market with 60 stocks.
Tanous: Well said.
Sloate: So the bottom line is, yeah, I agree with the academics. IfI try to play the whole market I can’t beat the whole market. That’swhy size is important. That’s why $50 billion is totally inefficient torun in one portfolio.
Tanous: Yeah, because you have to make big bets, which is whatJeff Vinik did at Magellan.
Sloate: And you have to make too many of them - and be right.But if you’re dealing with 50, 60, or 70 stocks, you should be right.You should be able to be right enough to beat the market.
Tanous:Because you picked the 60 where your information is su-perior and thorough?
Sloate: We have an insight. I call it vision, an insight that’s beyondwhat’s there. A perfect example is Comsat, which I own. It’s probablyselling at a third of its real value.
Tanous:What’s it selling at today?
Sloate: 23 1/2. The company has been misrun. It was the originalU.S. commercial entry in the satellite business. If we did it all overagain today, and satellites were where they were and wireless commu-nication was where it is, we’d have no cable. It’s much cheaper andmuch more efficient to use satellites. Only one fourth of the worldhas telephones. Probably 10% of the world has cable, and the waythe rest are going to get communications is by satellite. This companyis leading the effort to privatize the Intelsat and Inmarsat SatelliteSystems, which is probably worth the value of the company.
Tanous: What do you mean by that?
Sloate: Comsat is the U.S. representative of a 136-country consor-tium that was set up in the 1960s. The consortium owns Intelsat. AndInmarsat has 75-80 country participants. Intelsat and Inmarsat haveannounced initiatives to privatize over the next 18 months to makeeach a commercial, profit-driven corporation. Comsat has several
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other ventures. They have a stated book value of $17. It pays a 3.5%dividend. Analysts think this is an earnings story. But this is an assetredeployment story. Comsat has an entertainment business they’llsell. They own Command Video and two Denver sports teams, theAvalanche [NHL hockey] and the Nuggets [NBA basketball], plus thearena.
Tanous:That sounds dumb.
Sloate: It’s stupid for Comsat to own these other businesses! I toldyou they were dumb. Comsat is an example of poor management.Well, has the dumb management suddenly gotten smart? I don’t know.But I do know that Bruce Crockett [the CEO] has several hundredthousand options at 20.
Tanous:That’s called incentive!
Sloate: And he understands the satellite business. Comsat under-stands the satellite business better than everyone else because they’vebeen at it for 33 years. We have a different vision on this stock versusthe world.
Tanous: You own it, I assume.
Sloate: We’ve owned it for a year. We just doubled up our position.
Tanous:This is fun. As soon as everybody gets this book the firstthing they'll do is look up the price of Comsat! That was brave of you!Laura, you’re young, you’ve got the world ahead of you, what is inyour personal future?
Sloate: Well, I’m going to teach a bit at Columbia next year.
Tanous:In the business school? Are you going to teach value invest-ing?
Sloate: I did a lecture this year and I’ve been invited back to dothat. I’m going to teach a seminar with Bruce Greenwald.
Tanous:Gabelli also mentioned Greenwald. He replaced RogerMurray at Columbia.
Sloate: I’m going to teach the seminar course next spring. Teachingis something I enjoy. I love what I do, so I do it seven days a week.There’s nothing else I'd do right now.
There’s no question that Laura Sloate is a master of her craft. Whatwas it in her background that made her so good? She mentioned focus.She cited it as the quality that distinguished Peter Lynch and WarrenBuffett and led to the downfall of others who may have had it, becamedistracted, and lost it. She is smart, of course, the common character-
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istic of all the successful managers. Discipline, focus, tenacity, andjudgment are all qualities Laura Sloate seems to have in abundance.
Her technique is interesting. You can see from the interview thatshe really latches on to a story once it has captured her attention.And it is a piece-by-piece, detail-by-detail process. Once Laura Sloatehas decided to buy a company, I dare say there is not a single rationalquestion you can ask her about the company that she can’t answer.It is interesting that Laura follows the same value precept that MarioGabelli does: Good value in a company is not enough. If the stockhold-ers are going to make money, you also need a catalyst to shake thingsup and get the value realized.
Another manager, another lesson. Laura Sloate reinforces the rulesfor finding the hidden values in certain stocks, either by analyzingthe sum of the parts, or through a clear vision of what the future mayhold for a company or an industry, a vision which may not yet beapparent to others. For those who want to invest on their own, thesepathways are worth following. For the readers who would like to letLaura invest for them, she runs the Strong Value Fund.
132SCOTT STERLING JOHNSTON
The quest for investment gurus takes us to strange places. In thiscase, Scott Johnston and I got together at a private meeting room inthe United Airlines Red Carpet Club at Washington’s Dulles Airport.I would have preferred to meet him on his home turf, San Francisco.Just try to catch up with this guy, and you'll know why I met him atthe airport in our nation’s capital. He is one of a new breed of man-agers who are constantly on the move. The breed may be new; ScottJohnston is not. He’s been around for a few years and qualifies, al-though just barely, for membership in the AARP. You’d never knowit from his schedule.
Scott Johnston, a former institutional broker turned money manager,founded Sterling Financial Group, a predecessor company, in 1985,after nine years turning around the investment results of two majorbank trust departments. In 1992, the company became Apodaca-Johnston Capital Management Inc., which specializes in small-capit-alization emerging growth stocks - stocks with future earnings growthof a minimum of 35% and with a maximum of $750 million in marketcapitalization.
Successful money managers, as we know, come from a variety ofbackgrounds. Scott’s is particularly unusual. After receiving a degreein zoology at U.C. Berkeley, and an MBA from the University ofSouthern California, he began his career as a consultant. He was anauditor with Arthur Andersen & Co. before becoming an institutionalsalesman with Smith Barney. Securities salesmen don’t usually havethe temperament or patience to do the detailed investigations requiredwhen analyzing potential companies to buy. But Scott says that beinga salesman actually helped him become a successful portfolio manager.
How do we define success? Scott’s five-year annualized performancerecord is 38.2% for the period ended June 30, 1996, and his ten-yearrecord 25.6%. His 20-year record is 27.2%. I'll wait until you catchyour breath. The Wall Street Journalrecognized his accomplishmentsas a money manager as early as 1981, and he was profiled in MoneyMagazine in 1984. Let’s settle in and find out how he does it.
Tanous:How did you first get interested in stocks?
Johnston: I never was so much interested in stock per se; it’s alwaysPETER J. TANOUS
the great story that fires me up. I get excited when I discover somegreat product or unique service, a dynamic management, somethingthat’s got a competitive advantage. It’s almost like you want to bepart of that company. You want it to grow. If you can discover itearly on, and understand what makes it tick, that’s the fun part. I lovethe creative aspect of the investment process. I love the hunt. But, Ialso get bored with a company once I’ve discovered it. | want to goon to another company and find another exciting story. The mainten-ance part is not that interesting to me. I have people who do that forme.
Tanous: You and I have a common investment heritage in that wewere both early alumni of the old Smith Barney.
Johnston: That’s where a lot of this came from.
Tanous:One of the interesting things about you, unlike most of theother managers I talk to, is that you come from the sales side of theStreet. Has that helped or hurt?
Johnston: It’s a major help. But let’s step back.
First, the degree in the sciences is an important foundation. Thescientific method is a way of thinking, a formal approach to investig-ation. It’s the essence of what analysts do. Second, my Arthur Ander-sen background out of graduate school also helped. I spent a year-and-a-half consulting, so I understood systems real well. Then I wentinto the small business division of Arthur Andersen, which auditsonly small companies. Within a one-to-two-month period you audita whole company. During my time, I probably audited thirty differentcompanies in a myriad of businesses. I talked to senior managementsand did the complete audit. That gave me a firm foundation in systemsand in audit. Look at it this way: The entire stock market valuationmechanism revolves around one simple number which is the bottomline of all publicly traded companies - earnings per share. So youdamn well better be able to read a financial statement. Most researchanalysts just look at snapshots when they look at balance sheets andincome statements every quarter. They don’t really understand cashflow and inventory turnover. But if you have actually audited acompany, as I have, you understand these things.
Then I went to Smith Barney, and that experience did a number ofthings. One, working on the sell side gave me an edge. | learned howWall Street research departments worked, how they put together astory, how they put an idea together, how they marketed the idea.
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Wall Street’s research engine is what drives stocks. Think about it.One way or another, 80% maybe 90% of all the ideas we investmentmoney managers purchase come from the brokerage side. That’s be-cause we have outsourced most of that activity to the Street. So, ifyou once worked in the canyons of Wall Street, it gives you one hellof an edge.
Tanous: You had other useful experiences, I believe, in addition tohaving worked for Arthur Andersen and Smith Barney.
Johnston: In 1976, I joined San Diego Trust and Savings Bank aschief of investments, and stayed there until 1981. I worked for OliverJames, who headed up the trust department and was my mentor. Ourinvestment team was one of the earliest clients of the William O’NeilCompany. I met Bill O’Neil in 1976 and his investment principlescontributed to the development of my style of investing. I headed upSecurity Pacific’s investment activities from 1981 to 1985, and I ranabout $5 billion there. My mission was to turn around the laggingperformance results. I took my former right-hand-man, Art Nicholas,with me, and we hit the deck running. Our style quickly produced thereturns the bank was after.
Tanous:One of the things that we are looking for in this book iswhat the academics call “persistence.” I’m not interviewing anymanager who hasn’t been managing money for a long time becauselots of managers have two or three great years. They can, arguably,be called lucky. Lots of mutual funds are on lists of top performersand then you never hear from them again. You’re one of the preciousfew who are there consistently. Follow these numbers with me: Youwere up 21% in 1994, compared to the Russell 2000 index, whichwas off 1.8%. You were up 41% in 1995. Your five year annualizedrecord was 37.5%. Your ten year record is 27.7%. These are amazingnumbers, Scott. What’s the process?
Johnston: The principal thing that makes stocks go, in my opinion,is early discovery. A lot of companies will meet our small-cap growthstyle, but the difference is the great story. We are looking for compan-ies, products, services, that have huge upside potential. You’re afterthe big home run. To do this, you need a company that is so exciting,it will capture the imagination of other investors. You could look atten stocks that have the same damn profile, the same big percentageincreases in earnings, etc., but the ones that will really move earlyon are the ones that have the great story.
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The typical institutional salesperson on the desk is competing withabout two hundred other firms trying to get the buy side’s attention.To be good at it, you’ve got to be able to process a huge amount ofinformation and synthesize the very best names and stories. If you’vedone that for four years, like I did, you get damn good at encapsulat-ing the essence of a story. So when you go over to the buy side, you’regood at recognizing whether a story has all the elements to be awinner.
On the buy side, you’re hearing from 150 brokers. They’re callingyou all the time, and they’re giving you stocks, so you develop a sixthsense to pick out the best story. If you can get into that story beforeanybody else does, you know that other people are going to hear thesame thing and they’re going to say, wow, that’s a great story! Sureit’s a great company, great fundamentals, but, boy, is that ever a greatstory! And that is what drives stocks. Because in my opinion, the oldadage that stocks are sold, they’re not bought, is true.
Tanous:Let’s talk about the “great story” concept. By the time youhear this great story, isn’t it almost certainly all over the Streetalready?
Johnston: Wrong. It may not be all over the Street. There are over10,000 publicly traded stocks in the U.S. Even if the new idea is allover the Street, it takes time for firms to do their homework, especiallythe large banks, advisors, mutual funds and others with huge bureau-cracies. Or their sheer buying power requires weeks to establish ameaningful position, moving the price up in the process.
We are very nimble and responsive to brokers’ calls. About 20%of the ideas we get are off our own screens and database. Most of thenames we are buying are between $100 million and $750 million inmarket capitalization. The median is usually about $300 million. Weare generally initiating our positions at about $150 to $200 million.At that stage, you’ve only got two or three brokers covering them,and sometimes only one. We do most of our business with regionalfirms who are closest to that kind of information. The major firms doan excellent job, but by the time the Smith Barney’s of the world picka stock up, it’s got to have enough trading liquidity to make it worththeir while. By then you’ve probably got a company that’s worth $500million market cap, with five or six firms following it.
Our job is to capture the companies early-on in that huge growthphase, when you've got only two or three regional firms following
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it. Now, if they have a great product, great management, you’ve gota company that could become a Microsoft. You’ve got company aftercompany that have grown to be $1 billion to $5 billion market capcompanies because the product is great and you were able to pickthem up at the $250 million level on the way to $600 million - inthe early phases. And that stock can keep going to $5 billion.
Tanous:How does the discovery process break down? You mentionedyou were looking at screens. You might, presumably, find a companybefore the sell side broker even calls you, right? Then, at other times,the salesman calls you and says, Scott, check this one out: Here’s thestory in two-and-a-half minutes.
Johnston: Right. We do business with 150 brokerage firms. That’sa massive information flow of ideas to our firm. We try not to missa thing.
Tanous:That’s a lot of calls.
Johnston: A lot of calls. Now these people don’t talk to me everyday. Some I might talk to every three months or so. Maybe I talk to30 or 40 regularly. I run screens to look for stocks with the earningsprofiles and the technical profiles. Then I pick up the phone and callthe company and ask “who covers you” fon Wall Street]? Usuallyyou find two or three firms that do. That’s one way.
Also, when you use screens, you might notice that energy stocks,for example, are really beginning to move. And you look at the newhighs every day and you notice, boy, this group is hitting new highs.It might be the medical or the technology stocks. You dig a littledeeper and you might find that this company is a driller and the oildrillers have been strong for the last four or five months, and theyall have big forecasted earnings. So then you ask, okay, who else isin the drilling group? Next, I do a screen of all the stocks in the oilfieldservice machinery and related areas, and then hone in on the oneswith the best profiles. Then, I get on the phone and call brokers. That’smaybe the source of 20% or 25% of the ideas.
The vast majority of ideas, though, comes from regional brokerswho I’ve been doing business with for 10 to 20 years. These peopleknow exactly what my style is, so it’s an efficient call for both of us.I've had relationships with these people for a long time. When themarket is really moving and you’re overwhelmed with information,and you have more calls than you can possibly return, you don’t havethe time to check out a name as thoroughly as you'd like. How do
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you prioritize? You take the call from the guy or gal who has alwaysbeen there for you, who consistently made you money. These prosare so good they could be managing money themselves. They’ve gotthe instincts and judgment, and they know who the best analysts intheir firms are. In my opinion, the better institutional salesman wantsto do business with your three-or-four-man shops, because they wantto talk to decisionmakers. In the largest firms, like Smith Barney,Goldman Sachs, or Morgan Stanley, where they’ve got so muchproduct, the institutional salesman just can’t know all the stories. Yougo to a regional firm, and the institutional salesman knows the storyalmost as well as the analyst. So when he picks up the phone, he ismuch more effective than his counterpart at the larger firm.
Also, the larger firms have younger salesmen who are coming upthe ranks. They act as social secretaries, taking investment bankingdeals or research analysts around. There’s a lot of maintenance-typecoverage, which is not so much idea-driven. So the key here is, whenthe great salesman calls, one who is “Street smart” from years of ex-perience, and says, Johnston, you’ve just got to get into this thing,you get into it. You focus your attention very quickly because thisguy is so good. That’s what happens.
Tanous:Let’s get a summary of your investment criteria, which Ipresume these salesmen you're talking about know by heart.
Johnston: You bet. First of all, we’re basically a bottoms-up,stockpicker manager. We stay fully invested at all times. In terms ofthe academicians, for 20 years I haven’