TEAMFLY

Team-Flyreg

THE SUPERSTOCKINVESTOR

FM 7901 843 AM Page i

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THE SUPERSTOCKINVESTORProfiting from Wall StreetrsquosBest Undervalued Companies

Charles M LaLoggiaCherrie A Mahon

McGraw-HillNew York Chicago San Francisco

Lisbon London Madrid Mexico CityMilan New Delhi San Juan Seoul

Singapore Sydney Toronto

FM 7901 843 AM Page iii

Copyright copy 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 0-07-136083-2

All 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_hoaremcgraw-hillcom or (212) 904-4069

TERMS OF USEThis is a copyrighted work and The McGraw-Hill Companies Inc (ldquoMcGraw-Hillrdquo) 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 upontransmit distribute disseminate sell publish or sublicense the work or any part of it withoutMcGraw-Hillrsquos prior consent You may use the work for your own noncommercial and personal useany 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 ldquoAS ISrdquo McGRAW-HILL AND ITS LICENSORS MAKE NO GUAR-ANTEES OR WARRANTIES AS TO THE ACCURACY ADEQUACY OR COMPLETENESS OFOR RESULTS TO BE OBTAINED FROM USING THE WORK INCLUDING ANY INFORMA-TION THAT CAN BE ACCESSED THROUGH THE WORK VIA HYPERLINK OR OTHERWISEAND EXPRESSLY DISCLAIM ANY WARRANTY EXPRESS OR IMPLIED INCLUDING BUTNOT LIMITED TO IMPLIED WARRANTIES OF MERCHANTABILITY OR 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 therefromMcGraw-Hill has no responsibility for the content of any information accessed through the workUnder no circumstances shall McGraw-Hill andor its licensors be liable for any indirect incidentalspecial 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 otherwise

DOI 1010360071381163

abcMcGraw-Hill

C O N T E N T S

ACKNOWLEDGMENTS ix

INTRODUCTION 1

PART ONE

THE MAKING OF A SUPERSTOCK INVESTOR

Chapter One

A Defining Moment 11

Chapter Two

A Superstock Is Born 15

Chapter Three

Stock Selection 19

Chapter Four

Investing Paradigms A New Way of Thinking about Stock Selection 25

Chapter Five

The Twilight of Index Investing 31

Chapter Six

Experts What Do They Know 35

Case Study Sunbeam 46

Chapter Seven

What Is Value 57 v

FM 7901 843 AM Page v

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

Chapter Eight

If Everybody Knows Everything Then Nobody KnowsAnything 65

PART TWO

IDENTIFYING TAKEOVER TARGETS

Chapter Nine

Creeping Takeovers 77

Case Study How Rexel SA Acquired Rexel Inc 78Case Study The Takeover of ADT 85

Chapter Ten

How to Create Your Own ldquoResearch Universerdquo of TakeoverCandidatesmdashThe Telltale Signs 95

Case Study Spotting Brylane as a Takeover Target 106Case Study Sam Heyman and Dexter Corp 111

Chapter Eleven

How to Use the Financial Press 125

Case Study The Triple Play and Midway Games 140

Chapter Twelve

Family Feuds 149

Case Study Copley Pharmaceuticals 149

PART THREE

TAKEOVER CLUES

Chapter Thirteen

ldquoBeneficial Ownerrdquo Buying 159

Case Study Sumner Redstone and WMS Industries 159

vi CONTENTS

FM 7901 843 AM Page vi

Chapter Fourteen

The ldquoPure Playrdquo and the Drugstore Industry 187

Case Study Fayrsquos and Genovese 190Case Study Smith Food amp Drug Centers 201

Chapter Fifteen

Using Charts 205

Case Study Salick Health Care 207Case Study Rohr Inc 210

Chapter Sixteen

The Domino Effect 215

Case Study Vivra and Ren-Corp USA 215Case Study Renal Treatment Centers 219

Chapter Seventeen

Merger Mania Take the Money and Run 223

Case Study JCPenney and Rite Aid 233Case Study The Alarming Story of Protection One 238Case Study How Mattel Got Played by The Learning Company 247Case Study Waste Management and Allied Waste Industries 251

Chapter Eighteen

Look for Multiple Telltale Signs 259

Case Study Sugen Inc 260Case Study Frontier Corp 266Case Study Water Utilities 271

APPENDIX A SUPERSTOCK SHOPPING LIST 285

RESOURCES 295

INDEX 297

CONTENTS vii

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A C K N O W L E D G M E N T S

I would 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 ldquomainstreamrdquo 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 timeto think about and explain in detail the thought processes that wentinto the recommendations in the newsletter In a way Cherriersquos 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 them

Obviously 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 bornmdashand if it were not for Cherrie I probably neverwould have had the determination to complete it Her supportthroughout this process was invaluable

Charles M LaLoggia

ix

FM 7901 843 AM Page ix

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

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TEAMFLY

Team-Flyreg

Introduction

If yoursquod been born in a cave and had lived there your entire lifewith 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 signalsThe signals would be all around you but yoursquod be oblivious to themwithout the means to pick them up

Similarly if you are accustomed to a certain way of reading thefinancial news you can pick up ldquosignalsrdquo 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 force the stock market to recognize that stockrsquos true value Icall such stocks ldquosuperstocksrdquo because they can leap above any kindof market in a single bound

I began publishing my stock market newsletter as The CMLInvestment Lettermdashcurrently named Superstock Investormdashin December1974 Along the way I developed a reputation for being able to spotneglected companies that were about to become stock market starsmdashnot 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 companyrsquos value as abusiness Usually that ldquosomethingrdquomdashan outside event or what Icall a ldquocatalystrdquomdashhad the effect of pushing the stock price higher inone sudden jump rather than gradually over time Seemingly that

1

Introduction 7901 844 AM Page 1

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

outside event came out of the blue But in reality that event was thelogical conclusion to a series of events that began with a single clueor Telltale Sign that strongly suggested what the ultimate outcomewould be

This 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 Indash1)

I want to make one thing perfectly clear at the outset thoughWhat you will learn in this book is not a ldquoget rich quickrdquo method ofinvesting There are no sure things in the stock market except thisThere are no sure things I have seen countless systems and approach-es to stock selection and market timing come and go Many workfor a whilemdashsometimes for quite a whilemdashand then fall into disfa-vor and disrepute because they simply stop working Nobody knowswhy Some resurface years later and begin working again ldquodiscov-eredrdquo by a new generation of investors

But that is not what this book is all about This approach is nota ldquosystemrdquomdashrather 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 usingmdashit 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 market

In effect this approach will provide you with a sort of ldquoofflinerdquoportfolio 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 market

Almost all of the 48 stocks that received takeover bids duringthat 55-month period ending in September 2000 were on my newslet-terrsquos recommended list because based on the approach described

2 INTRODUCTION

Introduction 7901 844 AM Page 2

INTRODUCTION 3

T a b l e Indash1

Charles M LaLoggiarsquos 48 Takeover Bids in 55 Months

Percent PercentGain Annualized

Months Held (or Loss) Gain (or Loss)

Sep rsquo00 Advest 1 +19 +230

Sep rsquo00 AXA Financial 12 +70 +70

Sep rsquo00 Donaldson Lufkin 8 +85 +127

Aug rsquo00 PaineWebber 21 +119 +88

Dec rsquo99 Pittway 3 +41 +164

Dec rsquo99 Dexter Corp 5 +36 +864

Nov rsquo99 ErsquoTown Corp 11 +38 +414

Oct rsquo99 SJW Corp 10 +100 +120

Sep rsquo99 Nichols Research 19 +10 +63

Aug rsquo99 United Water Resources 9 +77 +1026

Aug rsquo99 Copley Pharmaceuticals 11 +23 +251

July rsquo99 Red Roof Inns 9 +30 +40

June rsquo99 Aquarion 7 +50 +857

June rsquo99 Sugen Inc 42 +169 +482

Mar rsquo99 Frontier Corp 28 +156 +54

Jan rsquo99 Alarmguard 21 +21 +12

Dec rsquo98 Brylane 2 +52 +312

Nov rsquo98 Genovese Drug Stores 27 +219 +973

Nov rsquo98 Pool Energy Services 56 +53 +113

Aug rsquo98 Clearview Cinemas 6 +75 +150

Aug rsquo98 American Stores 2 +25 +150

Jul rsquo98 Life Technologies 2 +20 +120

Jul rsquo98 Grand Casinos 7 +46 +788

May rsquo98 Union Texas Petroleum 8 +21 +315

May rsquo98 Giant Food 28 +36 +154

Feb rsquo98 Harveyrsquos Casino 1 +32 +384

Feb rsquo98 Arbor Drugs 17 +163 +115

Dec rsquo97 Showboat 25 +16 +77

Nov rsquo97 Holmes Protection 10 +43 +516

Nov rsquo97 Renal Treatment 28 +261 +1118

Sep rsquo97 Rexel Corp 23 +110 +574

Sep rsquo97 Rohr 27 +124 +551

Sep rsquo97 Riviera Holdings 1 +0 +0

Sep rsquo97 WHG Resorts 5 +100 +240

Aug rsquo97 Protection One 7 +105 +180

Continued

Introduction 7901 844 AM Page 3

in this book I considered them takeover candidates No ldquomagicrdquoinsights will be revealed here instead this book will describe whatI have observed to be true over 25 yearsmdashthat a certain event ordevelopment tends to lead to another which ultimately results inthe birth of a ldquosuperstockrdquo 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 atmdashor very nearmdashits intrinsic valueas a business

In 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 superstocks

Let me repeat that the approach to investing you are about tolearn is not a system The key to this approach is interpreting the news

4 INTRODUCTION

T a b l e Indash1

Charles M LaLoggiarsquos 48 Takeover Bids in 55 Months(continued)

Percent PercentGain Annualized

Months Held (or Loss) Gain (or Loss)

Jul rsquo97 Rotech Medical 36 +143 +476

May rsquo97 Logicon 40 +292 +876

May rsquo97 Smith Food amp Drug 7 +50 +857

May rsquo97 Vivra 36 +119 +396

Feb rsquo97 UNC Inc 6 +100 +200

Dec rsquo96 ADT Corp 9 +50 +666

Dec rsquo96 Roosevelt Financial 12 +22 +22

Oct rsquo96 Ornda Healthcare 4 +16 +48

July rsquo96 Fayrsquos Drugs 7 +87 +1491

July rsquo96 Bally Corp 2 +20 +120

Jun rsquo96 Community Health 11 +40 +436

Apr rsquo96 Hemlo Gold 12 +29 +29

Feb rsquo96 Loral Corp 10 +15 +18

Introduction 7901 844 AM Page 4

This 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 isnrsquot easy to implement

Over 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 naturemdashit describes what companies and their man-agement and major shareholders tend to do during the yearsmonths 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 someonemdasheither inside or outside the companymdashbelieves 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 it

To 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 seeingmdashand sticking to your convictions even whenthere is little or no support from Wall Streetmdashwell I just canrsquot imag-ine this approach becoming so popular that it simply stops working

A question often asked about investment books is Does thesystemmdashin this case the interpretive approachmdashalways work

The answer here is a resounding no There is no sure-fire keyto stock market riches There have been plenty of times when theldquoTelltalerdquo Signs yoursquoll read about here seemed to point directly to afuture superstock only to turn out in the end to be unprofitable

Does that bother youIt shouldnrsquot because reality should never bother you on any

levelmdashit should only serve as a means for better understanding theway the world really works Every mistake along the waymdasheveryroad you take or stock you buy that does not work out as hopedmdashshould be considered a learning experience that will make the nextexperience more likely to succeed

I can only say that if you follow the clues described here yoursquollend up with more winners than losers

INTRODUCTION 5

Introduction 7901 844 AM Page 5

Now I will describe some really interesting things I have learnedover the years Itrsquos an approach to investing that has served me welland if you learn to use it it will do the same for you

THE BULLS THE BEARS AND THE HORSES

The recent trend toward microanalyzing the stock market on aminute-by-minute basis has less to do with investing than it doeswith providing a ldquofixrdquo for stock market addicts In his classic bookThe Money Game author George Goodman writing under the nameldquoAdam Smithrdquo 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 A large part ofthe stock marketrsquos 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 life

I 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 gardening

There are many people who will tell you that the stock marketis actually just like horse racing and if you stop to think about itthey 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 ldquoTheyrsquore offrdquo

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 bell

It 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

6 INTRODUCTION

Introduction 7901 844 AM Page 6

Financial magazines are multiplying like rabbits while the DailyRacing Form has been sold and resold several times as its circulationeroded year after year

Letrsquos 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 nonstopaction for 61frasl2 hours 5 days a week and if yoursquore 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 hours

Wall Street never stops How can horse racing compete withthis

For one thing they might try out the concept of horse brokersIn New York State there are Off Track Betting parlors scattered allover the place Whatrsquos 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 business

And why stop there To support the sales forcemdashexcuse methe horse brokersmdashOTB could even hire analysts to write researchreports If you are a ldquovaluerdquo 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 ldquomomentumrdquo player whoconcentrates on technical analysis with a preference for followingthe ldquosmart moneyrdquo 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

ldquoWho cares why the odds are going downrdquo he would screaminto the telephone ldquoThis is a momentum horse Get your moneydown now before itrsquos too laterdquo

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

Introduction 7901 844 AM Page 7

ings to keep the stock price up so insiders can bail out at high pricesYou want to take a shot at big money Forget optionsmdashplay the dailydoublemdashhere are our top picks for speculators of course Whatrsquosthat Yoursquore wondering what to do with your pension funds Whythat calls for a more conservative approachmdashhow 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 way

This book is about a different way

8 INTRODUCTION

Introduction 7901 844 AM Page 8

P A R T O N E

The Making of aSuperstock Investor

Chap 01 7901 844 AM Page 9

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

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TEAMFLY

Team-Flyreg

C H A P T E R O N E

A Defining Moment

LALOGGIArsquoS DICTIONARY

Su-per-stock (soo-per-stok) A stock 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 eventor ldquocatalystrdquo usually a takeover bid which if it occurred wouldforce the price higher

Since most stock market investors are obsessed with growth per-fectly good companies with consistent profitsmdashmany of which arecash rich with little or no debtmdashare passed over shunned by themajority of investors seeking growth and earnings momentum

Yet 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 ldquodeadrdquo money whileother stocks provide solid gains

These superstocks generally sell far below their actual value asa business but nobody cares because the companyrsquos earnings maybe erratic or even trending lower and the companyrsquos growth poten-tial may be unexciting

A number of events or ldquocatalystsrdquo 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 orindividualmdashand sometimes even the management of the companymdash

11

Chap 01 7901 844 AM Page 11

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

offers 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 A thirdcatalyst is a large onetime cash or stock dividend where a companydistributes accumulated cash or shares in a wholly owned subsidiaryto its shareholders A fourth 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 ownership

These potential catalysts as well as others can suddenly turna previously boring uninteresting company into a superstockmdashastock that rises dramatically in price usually over a one- to two-dayperiod regardless of what the overall stock market is doing

A LIGHTBULB GOES ON

The early 1970s were a difficult time for the US economy and alsofor the stock market A sharp rise in inflation in 1972ndash73 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 570

In the midst of this economic and financial downturn manycompanies saw their earnings evaporate and turn into huge lossesCompanies cut or reduced dividends on their common and pre-ferred stocks

By 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 again

I also noticed that some of the preferred stocks that had stoppedpaying dividends were ldquocumulativerdquo which meant that all unpaiddividends would accumulate and have to be paid in full before anydividends could be paid on the common stock

One such company was LTV Corporation which had sus-pended the dividend on its $5 Cumulative Preferred stock back to1970 By April 1975 $2250 of dividends ldquoin arrearsrdquo had accumu-lated LTVrsquos earnings were turning sharply positive by 1975 and its

12 PART ONE The Making of a Superstock Investor

Chap 01 7901 844 AM Page 12

shareholders who noted the improvement had begun to push fordividends on the common stock

LTV issued a statement that it would soon ldquoconsiderrdquo 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 wordsanyone who had bought the $5 Cumulative Preferredmdashthen tradingat about $57 a sharemdashstood a reasonable chance of getting a lump-sum payment of $2250 a share Also if the regular $5 preferred divi-dend were reinstated the stock would probably move higher

So if a certain event took placemdashthe payment of the $2250 pershare in back dividendsmdashLTV Preferred stock would literally beforced higher no matter what the general stock market did

Using this reasoning I recommended LTV $5 CumulativePreferred Not long afterward LTVrsquos Board of Directors announcedit would pay the $2250 in back dividends and reinstate the $5 annu-al preferred dividend The price of LTV Preferred soared when thisnews was announced

With this ldquotasterdquo of what would become superstock investingI looked for a company in a similar situationmdashand found it LikeLTV Avco Corporation had a cumulative preferred stock (the $320Cumulative Preferred) trading on the New York Stock ExchangeLike LTV Avco had fallen on hard times and suspended dividendpayments on the preferred and they were accumulating ldquoin arrearsrdquoAnd like LTV Avcorsquos earnings had taken a major turn for the betterand its common stockholders were pushing for dividends on thecommon shares which could only be paid if the arrears were paidon the cumulative preferred stock

I recommended Avco $320 Cumulative Preferred in August1975 at 181frasl2 After Avco paid all of the arrears on the preferred stockand reinstated the annual $320 dividend the stock was selling at$47 This literally forced the stock market to revalue the preferredstock at a higher level since that $320 annual dividend would havecreated a yield of almost 18 percent based on the original price of181frasl2mdashfar 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 developmentmdashthe reinstated dividendmdashthis stock had to go up

CHAPTER ONE A Defining Moment 13

Chap 01 7901 844 AM Page 13

Remember though higher earnings do not necessarily meanthat a stock has to go up even if those earnings beat analystsrsquo expec-tations A fat 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 situation

THE LESSON LEARNED

Herersquos what can be learned from these two successful recommen-dations Sometimes it is possible to anticipate a certain specific eventwhichmdashif it were to take placemdashwould 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 world

It is these events that create the world of ldquosuperstocksrdquo

14 PART ONE The Making of a Superstock Investor

Chap 01 7901 844 AM Page 14

C H A P T E R T W O

A Superstock Is Born

On August 3 1998 American Stores a supermarket and drugstorecompany jumped 53frasl4 points or 25 percent American Stores was thelargest percentage gainer on the New York Stock Exchange that daya day on which the Dow Jones Industrial Average dropped 96 pointsThe following day the Dow fell 299 points and American Storesonce again bucked the trend rising another 13frasl16

With that performance American Stores joined the ranks of thesuperstocksmdashstocks that have the ability to rise quickly and sub-stantially in price no matter what the general stock market is doing

What propelled American Stores into the ranks of the super-stocks A takeover 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 Storesrsquo 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 ldquocatalystrdquo waspropelling the price change and American Stores shareholderswatched their stock soar in price as the general stock market col-lapsed over a 2-day period

Takeover 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 dayrsquos closing price Itrsquos not uncommon fortakeover bids to drive a stock price higher by 25 percent 50 percent

15

Chap 02 7901 845 AM Page 15

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

or even more in a single daymdashusually in a single trade right at theopening bell following the announcement that Company A is offer-ing to buy Company B

And 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 finalpredictable event that is the culmination of a series of other eventsThey 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 donrsquot know what to look for

And herersquos 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 riskyoursquoll be taking is opportunity riskmdashand even that usually turnsout to be a temporary problem A neglected 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 underperfor-mance

And 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 2000

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 ldquoget richquickrdquo system backtested by computer and guaranteed to makeyou rich

This is a book for investors who recognize that successful invest-ing requires research and clear original thinking Itrsquos for investorswho understand that brains are often confused with bull markets andthat in a rising market anyone can look like a genius Those with theexperience or insight understand that the true test of investment

16 PART ONE The Making of a Superstock Investor

Chap 02 7901 845 AM Page 16

acumen comes when the general stock market is going against youThen and only then are the benefits of shrewd stock selection clear-ly apparent

Every 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 outcomemdasha profitable takeover bid

American 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 general

American 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 highercompletely disregarding the spreading weakness in the overall stockmarket That performance combined with the established takeovertrends in both the supermarket and drugstore industriesmdashtwo busi-nesses operated by American Storesmdashsuggested that American Storeswas acting like a potential superstock

When American Stores received a takeover bid from Albertsonson August 3 investors enjoyed large profits while the broad stockmarket was declining sharplymdashprecisely the result a superstock issupposed to deliver

By the time you finish this book yoursquoll know how to identifysuch potential superstocks as they tip their hand And by then yoursquollhave a framework to help you get started

CHAPTER TWO A Superstock Is Born 17

Chap 02 7901 845 AM Page 17

This page intentionally left blank

C H A P T E R T H R E E

Stock Selection

For most investors the traditional method of stock selection goessomething like this

Yoursquore sitting in your office trying to figure out where to go tolunch and the phone rings Itrsquos your broker

ldquoHello Mr SpinellirdquoldquoYesrdquoldquoTom Hayden from Dewey Pickum amp HowerdquoldquoOh Hi TomrdquoldquoListen Mr Spinelli our research department has come out

with their stock pick of the weekrdquoldquoIrsquom thrilled What is itrdquoldquoGeneral Electric We think itrsquos a great company at these pricesrdquoldquoYou need a research department to tell me General Electric is

a great companyrdquoldquoWell no the thing is we think theyrsquore going to beat the street

estimates by around a penny a sharerdquoldquoGeneral Electric has tripled over the past four years Itrsquos dou-

bled over the past year and a half Now you tell me to buy GeneralElectricrdquo

ldquoWell wemdashrdquoldquoWhat else do you likerdquoldquoWe like Dell ComputerrdquoldquoDell ComputerrdquoldquoYes Our research department thinks itrsquos amdashrdquoldquoI know itrsquos a great company What elserdquo

19

Chap 03 7901 846 AM Page 19

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

ldquoUh IBMrdquoldquoListen Tom no offense but I can hear about every one of these

stocks a hundred times a day on CNBC I can give you the entire listby heart I already own six mutual funds and these stocks are inevery one of them Every one Why donrsquot you guys recommend astock like WMS Industries Thatrsquos a great turnaround story thatnobodyrsquos talking about Plus the Chairman of Viacom has been buy-ing this stock on the open market and he owns 25 percent of thecompany He obviously thinks itrsquos undervalued Maybe hersquoll makea takeover bidrdquo

ldquoWMS IndustriesrdquoldquoYeahrdquoldquoUh Letrsquos see Here it is Well they have no debt And they

have lots of cashrdquoldquoExactly Itrsquos a great situationrdquoldquoWell no You see if they have no debt and they have lots

of cash we probably wouldnrsquot recommend itrdquoldquoWhy notrdquoldquoWell because they probably wouldnrsquot need to do any invest-

ment banking businessrdquoldquoAny whatrdquoldquoInvestment banking business See if they wanted to do a stock

or bond offering we could be their investment banker and then wersquodrecommend the stock Thatrsquos how it works with smaller companiesrdquo

ldquoIt doesrdquoldquoUsually yesrdquoBy the end of this conversation you have learned an invalu-

able lesson about Wall Street Much of the timemdashperhaps most ofthe timemdashmainstream 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 withbut they are also not even potential investment banking clients for

20 PART ONE The Making of a Superstock Investor

Chap 03 7901 846 AM Page 20

TEAMFLY

Team-Flyreg

the 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 poorguyrsquos 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

ldquoWe canrsquot get anybody to talk to usrdquo the president moanedldquoWhy notrdquo I askedldquoBecause we donrsquot want to do any banking business with the

brokerage firmsrdquoI asked him if he was jokingldquoNordquo he said ldquoThey 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 companyrdquo

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 targets

What 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

CHAPTER THREE Stock Selection 21

Chap 03 7901 846 AM Page 21

Imagine some poor junior analyst trying to convince his or herboss to recommend WMS Industries

ldquoMr GerardrdquoldquoYeahrdquoldquoI have this report Irsquod like you to look atrdquoldquoItrsquos a buy recommendation isnrsquot itrdquoldquoYesrdquoldquoBecause we donrsquot want to offend anybody Thatrsquos bad busi-

nessrdquoldquoYes I knowrdquoMr Gerard looks at the report ldquoWMS Industries huh Market

cap is only $500 million Thatrsquos pretty small for us How much do theywant to raiserdquo

ldquoExcuse merdquoldquoHow much money do they want to raiserdquoldquoUh I donrsquot think they want to raise any moneyrdquoldquoWhat do you mean they donrsquot want to raise money Look here

they have no debt Donrsquot they want to borrow some money Sellsome bondsrdquo

ldquoWell 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 andmdashrdquo

ldquoDo they want to acquire somebodyrdquoldquoNot that I know ofrdquoldquoWell then what are you bothering me for Get out of my office

Come back when you can recommend something that will generateus some revenuerdquo

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 clientEarnings 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

22 PART ONE The Making of a Superstock Investor

Chap 03 7901 846 AM Page 22

these stocks are so overvalued relative to their small-cap counter-parts that the pendulum must inevitably swing the other way

Years ago Doug Flutie electrified the college football world when hethrew a ldquoHail Maryrdquo 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 timescapped a stellar collegiate career for Flutie But after he graduatedFlutie 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 superstar

Flutiersquos shortcoming as far as the NFL was 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 yoursquore 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 downfieldAnd so the NFL said ldquoSorry too shortrdquo and Flutie went on to leadseveral Canadian Football League teams to championships

If you follow football at all you probably know the rest of thestory Flutie returned to the NFL in 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 Bowl

How 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 asideavoid the lumbering behemoths and scramble around until he spot-ted the receivers and completed passes

In his book Supermoney author George Goodman writing underthe name ldquoAdam Smithrdquo used the analogy of the small but nimblequarterback to point out that individuals can compete with the giantinstitutional investors by ldquotaking a quick look and stepping into thegaps between themrdquo 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

CHAPTER THREE Stock Selection 23

Chap 03 7901 846 AM Page 23

This page intentionally left blank

C H A P T E R F O U R

Investing Paradigms A New Way of Thinkingabout Stock Selection

A paradigm 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 wersquore 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 timeswe become dissatisfied with the results our actions create and itbecomes necessary to create a new paradigm

When it comes to selecting individual stocks 999 percent ofinvestors and Wall Street analysts are operating using a dog-earedshop-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 pricesThere are two problems with this paradigm First itrsquos been in exis-tence for nearly 20 years and itrsquos getting a bit creaky In fact itrsquos prob-ably on its last legs The second problem with this paradigm is thatitrsquos not new itrsquos only a new version of other paradigms that havecome and gone over the years The late 1960s version for examplewas called the ldquoOne-Decision Stock Paradigmrdquo In this version cer-

25

Chap 04 7901 846 AM Page 25

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

tain 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 wasnecessarymdashto buy them

That 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 normalrun-of-the-mill cyclical stocks

This book offers a new paradigmmdasha 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 favorWhen you read The Wall Street Journal ignore the market commentaryand the earnings digest and instead look for itemsmdashespecially smallitemsmdashthat 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 ldquogrowth through acquisitionsrdquo 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 andor 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 Report and 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 ldquoShareholder Rights Planrdquo designed to make a takeover more

26 PART ONE The Making of a Superstock Investor

Chap 04 7901 846 AM Page 26

difficult based on the theory that the company wouldnrsquot 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 ldquocatalystrdquo 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 bid

Finally 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 peersmdashoften a sign that some sortof takeover development is brewing

This way of thinking is new paradigm territory for 999 per-cent of investors and analysts At first it may seem difficult andunusual but if you have the courage to enter this new paradigmyou will find yourself in a fascinating new world where all sorts ofnew and exciting stock ideas will present themselves Yoursquoll 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 yoursquoll feel almost as if you can see the future andyou will marvel at the inability of others to do the same

And if you think thatrsquos exaggeration consider this real-lifeexample of old paradigm thinking versus new paradigm thinkingIn December 1998 I presented a front-page story in Superstock Investorentitled ldquoWater Utility Industry Could Be on the Verge of a TakeoverWaverdquo 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 placemdashthe purchase of Consumers Water byPhiladelphia Suburban and the purchase of National Enterprisesby American Water Worksmdashand that a third smaller takeover of

CHAPTER FOUR Investing Paradigms 27

Chap 04 7901 846 AM Page 27

Dominguez Water by California Water Service had just been an-nounced

In 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 basis

Later 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 $3705 per share a 50 percent premium over my original recom-mended price for Aquarion And remember we are talking hereabout a water utilitymdasha 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 takeoverCNBC 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 target

The 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 good

Unfortunately what followed was as classic an example of oldparadigm thinking as you could possibly hope not to see Here werethe questions Barr was asked

1 What are the possibilities of turning saltwater into drink-ing water

28 PART ONE The Making of a Superstock Investor

Chap 04 7901 846 AM Page 28

2 What about turning glaciers into drinking water3 What about turning icebergs into drinking water4 How difficult will it be for you to raise rates5 Do you think there might come a time when government

could confiscate your assets in the event of a water shortage6 What contingency plans have you developed in the event

terrorists attack the nationrsquos water supply

Terrorists Glaciers Icebergs These ridiculous questions are thetype that make superstock investors all across America groan withdisappointment A superstock investor would have immediatelyfocused on Mr Barrrsquos comment on growth through acquisitions andtried to pin him down with questions like these

1 What kind of water utility companies are you looking tobuy

2 What region of the country are you looking at for newgrowth opportunities

3 How big might a potential target be in terms of revenues4 What 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 Thatrsquoswhat 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 isnrsquot 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 yoursquore 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 ifyoursquore not used to thinking in these terms you miss golden oppor-tunities such as those the CNBC interviewers missed to bring newinformation to the surface

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

CHAPTER FOUR Investing Paradigms 29

Chap 04 7901 846 AM Page 29

plain view for everyone to see can be completely overlooked by themajority of investors and the people from whom they receive adviceand information

Just 10 months after this noninterview American Water Worksmade a takeover bid for SJW Corp SJW was on my recommended listas a takeover candidate Suppose for the sake of discussion one ofthe CNBC interviewers had asked J James Barr which region of theUS American Water Works might be looking at in terms of potentialacquisitions Suppose he had mentioned the western United StatesThis would have enabled superstock investors to zero in on the hand-ful of publicly traded western water utilities as possible targetsmdashSJW prominently among them But the question was never asked

And why wasnrsquot the question asked Well certainly not becausethe CNBC interviewers are not good at what 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 missedthe mark and the reason is that they were talking to a CEO who oper-ated in an obscure industry with a limited analytical following Upuntil 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 party

Making yourself aware of every industrymdasheven an obscureindustry like water utilitiesmdashthat is beginning to consolidate throughtakeovers requires a new way of thinking about the financial newsThe 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 ldquosuperstock paradigmrdquo and show youhow to think and invest within that new framework

But 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 letrsquos take a brief look atsome more of that landscape

30 PART ONE The Making of a Superstock Investor

Chap 04 7901 846 AM Page 30

TEAMFLY

Team-Flyreg

C H A P T E R F I V E

The Twilight of IndexInvesting

A lemming 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 Lemmingshowever 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 day

On Wall Street the herd instinct is a powerful force indeedProfessional money managers once they have been around for awhile discover there is great comfort in doing pretty much the samething everybody else is doing A certain 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 investing

We 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 naturalmdashand on Wall Streetit is extremely dangerous

31

Chap 05 7901 849 AM Page 31

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

The history of the stock market is replete with examples ofldquocanrsquot missrdquo investing techniques that were successful for a whileand then simply stopped working victims of an overpopularity thateventually created the seeds of their own destruction

In the 1960s for example small-cap stocks were all the rageWell-known large caps were viewed as too boring too predictableand 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 lemming

As 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 bornall of which were looking for the next IBM and all of which beganchasing smaller-cap stocks Eventually the bargains disappearedvictims 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 gears

More recently the focus has been on large-cap stocksmdashthe samelarge caps everybody used to shun If yoursquove heard it once yoursquoveheard it a thousand times The best way for individual investors tomake consistent profits in the stock market is to buy an ldquoindexrdquo fundthat tracks the performance of a broad-based stock market index likethe Standard amp Poorrsquos 500 Index which in turn represents a crosssection of Americarsquos most solid time-tested companies

Donrsquot try to pick individual stocksDonrsquot try to outsmart the stock marketDonrsquot go too far off the beaten path trying to find overlooked

values All pertinent information is so readily available and so wellanalyzed by the Wall Street geniuses that it is already processed andldquodiscountedrdquo by the market If yoursquore an individual investor donrsquoteven bother trying to find an edge It canrsquot be done

BaloneyLike lemmings stock market commentators and mutual fund

managers and investors who listen to their advice have run head-long toward the large-capindexing craze It sounds so simple whocan resist it This mantra has been repeated so often that you might

32 PART ONE The Making of a Superstock Investor

Chap 05 7901 849 AM Page 32

think 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 marketrsquos holy grailand that value asset-oriented stocks have always trailed the field

And yet those assumptions are not true Irsquom 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 maniamdashthat is the recent obses-sion with indexing and large-cap stocksmdashcontains the seeds of itsown destruction

Just a brief look at the past will prove the point Figure 5ndash1which tracks the relative performance of the SampP Low-Priced StockIndex to the SampP Big-Cap Index back to 1930 shows that smaller-capstocks and larger-cap stocks have taken turns outperforming eachother A rising 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 capsThe 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 again

What can we learn from this For one thing Anybody who tellsyou that the undisputed path to investment success is to index yourinvestments to the SampP 500 which is dominated by large-cap stockshas a limited sense of stock market history has never seen this chartor 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 itrsquos better to stop following the crowd

Early in 1999 the ldquovalue gaprdquo between large-cap and small-capstocks was at the highest level in history What this means is thatpriceearnings ratios accorded the large-cap stocks were at the high-est level ever relative to small-cap stocks

CHAPTER FIVE The Twilight of Index Investing 33

Chap 05 7901 849 AM Page 33

This fact combined with the historical evidence shown in Figure5ndash1 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

34 PART ONE The Making of a Superstock Investor

464

414

370

331

296

264

236

211

188

168

150

134

120

107

96

86

77

68

464

414

370

331

296

264

236

211

188

168

150

134

120

107

96

86

77

68Falling = High-Grade Leadership

Rising = Low-Priced Stocks Lead the Market

SampP Low-Priced Stock IndexSampP High-Grade Stock Index

1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995

F i g u r e 5ndash1

Relative Leadership Index

Chap 05 7901 849 AM Page 34

C H A P T E R S I X

Experts What Do They Know

When you get to a fork in the road take it Yogi Berra

By taking the fork in the road marked ldquosuperstock investingrdquo youoften will find that you have little if any analytical or ldquoexpertrdquo sup-port This may produce an uncomfortable feeling at first

This chapter is designed to get you over that feelingOnce you begin to think in terms of the ldquonew paradigmrdquo of stock

selection you will have to get used to the idea when you go off thebeaten path that yoursquore not going to have a lot of company In invest-ment terms the path in this book is definitely the road less traveled

Itrsquos perfectly natural for any investor to feel more comfortablewhen buying a stock that is recommended by a large number ofldquoexpertrdquo 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 hasnrsquot 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 day

35

Chap 06 7901 850 AM Page 35

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

In Heaven Can Wait James Mason an emissary from heavenreveals a basic truth of life when he tells Warren Beatty that ldquothelikelihood of a person being right increases in direct proportion to thenumber of people attempting to prove him wrongrdquo This is anotherway of saying that if you are looking for truth insight or really greatstock ideas donrsquot be afraid to go down that untrodden pathmdashanddonrsquot waver simply because most people donrsquot think the way youthink or canrsquot see what you see

When 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 yoursquoll learn to spot will strongly suggest thatbeneath 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 ie the ldquoexpertsrdquo

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 yoursquove 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 prices

It can be pretty lonely and sometimes spooky when yoursquorestrolling down the untrodden superstock path

To 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 ldquoexpertsrdquo are wrong wersquoll show you some world-class exam-ples of expert opinion that turned out to be completely off the mark

WHAT IS AN ldquoEXPERTrdquo ANYWAY

One wonderful definition is that an expert is ldquosomebody from outof townrdquo which is another way of saying that distance lends enchant-ment

Another definition and probably the best one for our purpos-es would identify an ldquoexpertrdquo 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-

36 PART ONE The Making of a Superstock Investor

Chap 06 7901 850 AM Page 36

sion of media outlets in recent years devoted to finance and invest-ing including the proliferation of financial Web sites this definitionof an ldquoexpertrdquo would have to be considered fully diluted if you getmy drift

ldquoExpertsrdquo have always had a difficult time predicting the futurealthough this has never stopped any of them from making predic-tions And it probably will not surprise you to learn that the USgovernment ranks right up there when it comes to the list of ldquoexpertsrdquowho have made pronouncements about the future that have turnedout to be spectacularly wrong

For example every now and then over the past 30 years wehave been subjected to an ldquoenergy scarerdquo 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 ldquoenergy doomsday scenariordquo havebeen going on for the last 115 years

Take a look at the list of predictions about energy supplies fromvarious US government agencies given in Table 6ndash1 and rememberit well the next time some bureaucrat or Wall Street analyst tells youthat oil or gas supplies are running out

But 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 thingeven genuine experts are out there taking their best educated guessjust 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 time

One 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 Time or Newsweekitrsquos time to consider the possibility that this particular trend has pret-ty much run its course A classic example of this phenomenon is theNewsweek cover dated December 2 1974 entitled ldquoHow Bad aSlumprdquo When this issue of Newsweek hit 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

CHAPTER SIX Experts What Do They Know 37

Chap 06 7901 850 AM Page 37

rates were in the stratosphere So ldquoHow Bad a Slumprdquo 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 peaked

A more recent example of a magazine cover signaling the end ofa financial trend was the December 27 1999 issue of Time magazinein which Amazoncom founder Jeff Bezos was named Timersquos ldquoPersonof the Yearrdquo That issue of Time coincided with the exact peak ofAmazoncomrsquos stock price which proceeded to fall from $113 to aslow as $1938 over the following year This does not imply that JeffBezos did not deserve the honormdashonly that Timersquos 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 Timersquos cover story signaled the end of the bull market notonly for Amazoncom but for every other Internet stock all of whichplunged dramatically during 2000 and many of which actually wentcompletely out of business

38 PART ONE The Making of a Superstock Investor

T a b l e 6ndash1

ldquoExpertrdquo Oil Supply Predictions from the USGovernment

Year Prediction

1885 Little or no chance for oil discovery in California (US Geological Survey)Little or no chance for oil to be discovered in Kansas or Texas (USGeological Survey)

1891 Little or no chance for oil to be discovered in Kansas or Texas (USGeological Survey)

1908 Maximum future supply of oil to be discovered in the United States will be225 billion barrels (US Geological Survey) (Note By 1949 35 billion barrels had already been discovered with another 27 billion barrels proven and available)

1914 Total future US production of oil will be a maximum of 57 billion barrels(US Bureau of Mines) (Note By 1976 another 34 billion barrels had beendiscovered with no end in sight)

1939 US oil supplies will last only 13 more years (US Department of theInterior)

1947 Sufficient oil for US energy consumption can no longer be found in theUnited States (US State Department)

1948 End of US oil supply almost in sight (Secretary of the Interior)

Source Herman Kahn The Next 200 Years (William Morrow amp Co New York 1976)

Chap 06 7901 850 AM Page 38

This 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 Illustrated ran a cover story on theinvincible Oakland Arsquos who were about to face the Cincinnati Redsin the World Series

ldquoThe 1988 Arsquosrdquo the story said ldquoare the best team the AmericanLeague has sent to the World Series since Charlie Finleyrsquos teams ofthe early 1970s These Arsquos may be even betterrdquo Having thus beenanointed one of the greatest baseball teams of all time the Arsquos wenton to lose four straight World Series games to the Cincinnati Reds

The ldquoexpertsrdquo arenrsquot very good at predicting recessions eitherEconomic recessions do not announce their arrival the way Jack

Nicholson announced his arrival in The Shiningmdashby breaking downa door with an axe and scaring Shelly Duval out of her wits as heannounced ldquoHoney Irsquom homerdquo Rather recessions tend to arriveon muffled oars quietly arousing little or no suspicion until one daythe Commerce Department announces that ldquoGuess 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 momentrdquo

Yet another classic example of the ldquoexpertsrsquordquo inability to pre-dict recessions was evident in July 1989 when Fortune announcedthere would be ldquoNo recession this year or nextrdquo Of course the reces-sion of 1990 was already in the process of beginning but none of theexperts Fortune relied on saw it coming

Just take a look at thr chronology of headlines in Table 6ndash2 tosee how much help the ldquoexpertsrdquo will be in preparing you for the nextrecession

CHAPTER SIX Experts What Do They Know 39

T a b l e 6ndash2

Chronology of Headlines

Source Headline

Fortune July 17 1989 ldquoNo Recession This Year or Nextrdquo

Newsweek September 1989 ldquoIs there Ever Going to Be Another Recessionrdquo

New York Times February 1990 ldquoEconomyrsquos Slide May Have Ended Greenspan Saysrdquo

Investorrsquos Business Daily January 1991 ldquoItrsquos Official The US Is in a Recession But It Wonrsquot Last Long Government Saysrdquo

Chap 06 7901 850 AM Page 39

You can also use the media to call turning points in both interestrates and oil prices Herersquos a classic On September 16 1987 The WallStreet Journalrsquos front page lead story was headlined ldquoThe Bond BearsDebt Securities Prices May Slide for Years Many Analysts Thinkrdquo

The implication was that interest rates would be rising for yearsinto the future This front-page story amazingly enough coincidedwith the exact peak in long-term interest rates When this storyappeared the 30-year Treasury bond was yielding around 1025 per-cent (see the arrow on the chart in Figure 6ndash1)

Bond prices then embarked on a relentless 6-year rally whichcarried the yield on the 30-year Treasury down below 6 percent bylate 1993

In another classic example Associated Press managed to catchthe exact bottom in crude oil when it ran a story on March 9 1986entitled ldquoNo Bottom to Oilrdquo Again check the arrow on the chart inFigure 6ndash1 This story managed to appear at the precise bottom in the

40 PART ONE The Making of a Superstock Investor

11

10

9

8

7

6

9075604530150

ndash15ndash30ndash45

36343230282624222018161412

11

10

9

8

7

6

907560453015

0ndash15ndash30ndash45

36343230282624222018161412

30-Year Constant Maturity Treasury Bond Yields

BOND PRICES MAY SLIDE FOR YEARS

NO BOTTOM FOR OIL

30-Year Treasury Yield PointsAnnum When

63-Day Change in Points ofCrude Oil Is Annum Time

Above 118 25 135Between ndash5 and 118 ndash43 546ndash5 and Below ndash75 319

West Texas Intermediate Crude Oil(NY Mercantile Light Sweet13-Week Perpetual Contract)

$ Per Barrel

72498 = 1455

72498 = ndash89

2144 2227

1800

3650

1735

2332

1807

2263

1885

2114

1434

1971

1694

1971

1657

2478

1916

1429

Crude Oil Prices63-Day Rate of Change

M1985

J S D M1986

J S D M1987

J S D M1988

J S D M1989

J S D M1990

J S D M1991

J S D M1992

J S D M1993

J S D M1994

J S D M1995

J S D M1996

J S D M1997

J S D M1998

J

F i g u r e 6ndash1

Examples of How the Media Can Call Turning Points

Source Ned Davis Research 2100 Riveredge Parkway Suite 750 Atlanta GA 30328

Chap 06 7901 850 AM Page 40

TEAMFLY

Team-Flyreg

price of oil which rose from $12 to $3650 a barrel within 4 years ofthe storyrsquos appearance

How did The Wall Street Journal manage 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 Journal andAssociated Press reporters went to their ldquoexpertrdquo sources thesesources had also gotten used to a trend that had been in force andsimply extrapolated that trend into the future Itrsquos 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 out

Pack 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 Fortune hit the newsstands the very week of the1987 stock market crash and it said ldquoWhy Greenspan Is Still BullishrdquoOn October 19 1987 the same week this issue appeared the Dow JonesIndustrial Average fell 508 points a 1-day plunge of 18 percent

Of 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 ldquohard timesrdquo were coming andthat investors and businesspeople should batten down the hatchesWrong again The media went overboard on the meaning of the 1987crash just as it went overboard on the rally that preceded the debacleThe consensus of the media and its ldquoexpertsrdquo 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 SamuelsonNewsweekrsquos economic columnist and a man about as mainstream asyou can get ran a column after the crash entitled ldquoThe Specter ofDepressionrdquo in which he asked the question Did the market crashserve as a warning that an economic depression was imminent Hisanswer delivered not entirely convincingly ldquoProbably notrdquo

CHAPTER SIX Experts What Do They Know 41

Chap 06 7901 850 AM Page 41

As 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 US economic advance that contin-ued with only brief interruptions for more than a decade

But you sure wouldnrsquot have guessed that in October 1987 if youhad listened to the ldquoexpertsrdquo

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 News ran abanner headline on page 5 ldquoEXPERTS NO RECESSIONrdquo I donrsquotknow about you but I did not find this headline reassuring

WHY EXPERTS CAN BE WRONG

So what is it with these ldquoexpertsrdquo anyway How can so many well-informed people be so wrong so often

Part of the problem may be that the pool of ldquoexpertsrdquo is gettingdiluted

A few 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 radio

Not anymore These days talk shows have multiplied to suchan extent that the supply of ldquoexpertsrdquo has increased to meet thedemand Of course common sense will tell you there is a limitedsupply of experts on any particular subject but this doesnrsquot seem tomatter very much because there is so much babble sprouting up inall forms of media that itrsquos possible to say almost anything no mat-ter how outlandish or uninformed and get away with it

The proliferation of Internet financial sites has also createddemand for more ldquoexpertsrdquo Every site needs columnists and ldquoana-lystsrdquo to expound on the daily developments on the financial sceneMost of them are excellent writers and it sure sounds like they knowwhat theyrsquore 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 ldquomomen-tumrdquo and ldquoindexrdquo investing

Itrsquos tough to tell if yoursquore reading truly informed analysis orjust plain nonsense that has been created to provide content

42 PART ONE The Making of a Superstock Investor

Chap 06 7901 850 AM Page 42

This nonsense cuts across ideological boundaries No matterwhat your personal political or business agenda it is possible toput your own ldquospinrdquo on almost anythingmdasheven historical mattersthat are not really open to debatemdashand 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 ldquothose gas lineswere a direct result of foreign oil powers playing tough with us becausethey didnrsquot fear Jimmy Carterrdquo But the firstmdashand worstmdashOPEC oilprice hike took place between 1973 and 1974 during the administra-tion of Richard Nixon Not only that but one reason for OPECrsquos 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 oil

Everywhere you look ldquoexpertsrdquo are spinning facts to promotean agenda To this day Democrats still try to deny that the economyperformed well under Ronald Reagan

Oliver 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 Live by calling the tapes ldquoallegedtapesrdquo which apparently means that North could not even bringhimself to acknowledge that such tapes even exist If he had acknowl-edged their existence after all it would have reflected badly onFalwell a philosophical and political ally

Everybody 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 days

When the media confronted Bellersquos agent the agent borroweda page from the OJ Simpson defense playbook and claimed the inci-dent was ldquoconcocted by the Chicago White Soxrdquo

So given the surging supply of ldquoexpertsrdquo and the heightened prob-ability that any given expert you may be listening to is promoting anagenda donrsquot be terribly concerned if you seem to have uncovered anexciting stock or two that is totally bereft of analytical ldquosponsorshiprdquo

CHAPTER SIX Experts What Do They Know 43

Chap 06 7901 850 AM Page 43

Even Federal Reserve Chairman Alan Greenspan is a ldquospinnerrdquowith an agenda In his book The Agendamdashan appropriate title for thisdiscussionmdashauthor Bob Woodward says that Greenspan managed toconvince thenndashTreasury Secretary Lloyd Bentsen early in PresidentClintonrsquos first term that the bond market would respond favorably ifthe Federal Reserve were to begin raising interest rates Bentsenimpressed with Greenspanrsquos reasoning performed the spin on Clintonwho 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 Reserversquos interest rate hike

So one reason why an ldquoexpertrdquo may be off the mark is that heor she is selling you a bill of goods ie promoting an agenda ratherthan trying to get at the truth

Another reason experts donrsquot always hit the mark is that theyare not really trying to deliver the goods for a different reason andthat reason is that theyrsquore not always rewarded for telling the truthmdashespecially when the truth is something their superiors do not wantto hear Sometimes they are even punished for telling the truth

In his book 1929 Again author Terry R Rudd points out thatldquoone of the underlying problems making it virtually impossible forknowledgeable people to tell us the truth is that we canrsquot accept itwithout reacting unfavorablyrdquo

ldquoWhen the recipient doesnrsquot receive news in a manner beneficialto the giver ldquo Rudd writes ldquothere is no incentive for the giver to do sordquo

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 scene

Perhaps 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 ldquoSooner 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 depressionrdquo

Now that is about as accurate as you can get in terms of pre-dicting the stock market and the economy Babsonrsquos reward was that

44 PART ONE The Making of a Superstock Investor

Chap 06 7901 850 AM Page 44

he 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 ldquowe will not be stam-peded into selling stocks because of the gratuitous forecasts of awell-known statisticianrdquo

The stock market actually began declining on the very dayBabson made his historical forecast and that particular drop becameknown as the ldquoBabson Breakrdquo By late October the crash that Babsonhad predicted was under way culminating on ldquoBlack TuesdayrdquoOctober 29 1929 the worst day in stock market history

And what was Babsonrsquos 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 Babsonrsquos ldquofearmongeringrdquo

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 ldquosellrdquo signal on a big-name company with apopular stock and a penchant for doing investment banking business

Therefore you should not expect much help from the ldquoexpertsrdquowhen 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 attitude

One of the all-time great examples of an ldquoexpertrdquo 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 destruction

And so the father of the ldquoKondratieff Waverdquo 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 at

Not all experts receive such harsh treatment for trying to reportthe truth as they perceive it Some of them like the brokerage firm

CHAPTER SIX Experts What Do They Know 45

Chap 06 7901 850 AM Page 45

analyst who issued a negative report on one of Donald Trumprsquos com-panies several years ago merely got fired

Others meet with a more subtle form of resistance

Case Study Sunbeam Corp

If you want to get a feel for how difficult it can be for mainstream WallStreet analysts to say ldquosellrdquo 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 Corpfrom buy to hold

Sunbeam 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 shareholders

Wall 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 plantsand issue optimistic projections for the future Wall Street totallybought Dunlaprsquos performance and Sunbeam shares took offVirtually every analyst who followed Sunbeam sang Dunlaprsquos prais-es and expected a breathtaking turnaround followed by an eventu-al takeover of Sunbeammdashin other words they expected an exactreplay of the Scott Paper scenario

Mr 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 phenomenonmdashbut he recommendedthe stock along with everyone else based on the premise that Dunlaprsquosname and reputation alone would probably take the stock for quite aprofitable ride The trick he thought would be to get out in time

Finally in 1997 Andrew Shore began to notice warning signsdeep within the Sunbeam financial statements filed with the SEC As

46 PART ONE The Making of a Superstock Investor

Chap 06 7901 850 AM Page 46

it 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 Sunbeamrsquos financial situation hecould only bring himself to change his rating from buy to ldquoneutralrdquoBut even this move which in retrospect proved to be a timid andincomplete decision made him a virtual Nostradamus compared tohis colleagues

The first reaction to Mr Shorersquos 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 ldquoYourealize what yoursquore doing here donrsquot yourdquo he asked Shore

ldquoIf wersquore wrong wersquore going to be firedrdquo Shore replied ldquobutwe have to do thisrdquo Shore even felt compelled to contact the legalcompliance department at PaineWebber to explain his downgrade ofSunbeam before the downgrade was issued

When 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 firedmdashfiredmdashif 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 later

On April 3 1997 Andrew Shore got on the PaineWebberldquosquawk boxrdquo and reported his downgrade to PaineWebberrsquos 5000stockbrokers Within minutes Sunbeam stock dropped $4 a shareShortly thereafter when Andrew Shore checked his voice mail hewas stunned to hear a barrage of ldquocaustic and bitter messagesrdquo ldquoMostof the callersrdquo author John A Byrne says ldquowanted Shore firedrdquo

Shore according to Byrne who documented these events in hisbook Chainsaw was ldquohorrified by the contentrdquo of the messages whichranged from calling him ldquostupid and irresponsiblerdquo to even worse

ldquoIt was a nightmarerdquo said Shorersquos assistant who bore the bruntof the flak from clients and brokers reacting to Shorersquos downgrade

The story had a happy ending for Andrew Shore Shortly afterthe downgrade Sunbeam shocked Wall Street with the announce-

CHAPTER SIX Experts What Do They Know 47

Chap 06 7901 850 AM Page 47

ment that earnings would come in far below expectations Thosewho had acted on Shorersquos advice saved a bundlemdashand of coursethe congratulatory calls began to flow in

Lessons 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 ldquoneutralrdquo 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 $025 down 99 percent from its Dunlap-maniahigh as the news from Sunbeam got progressively worse

But even that downgrade to neutral caused fear and soul-search-ing for Andrew Shore which gives you an idea of why so few ldquosellrdquorecommendations 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 ldquomessengerrdquo 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

ldquoA sell signal from an analyst is as common as a Barbra Streisand concertrdquo Arthur Levitt Chairman of the Securities amp Exchange Commission

It 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 colleaguesyou 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

48 PART ONE The Making of a Superstock Investor

Chap 06 7901 850 AM Page 48

But 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 Journal ran a story enti-tled ldquoBearish Call on Banks Lands Analyst in Doghouserdquo The storydescribed the travails of Michael Mayo of Credit Suisse First Bostonand 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 dry

The head trader at Sun Trust Funds said The Wall Street Journalldquoangrily grabbed a picture of Mr Mayo blew up the photo on thecopier scribbled lsquoWantedrsquo over his face and pinned it to her bul-letin boardrdquo When questioned about this response by The Wall StreetJournal the trader replied that ldquomy impression [of Mr Mayo] as ahuman being is that hersquos somewhat self-promotionalrdquo as thoughthis were a rare trait among analysts on Wall Street

Another bank analyst angered by the sell signal referred toMayo derisively as ldquoMayo-naiserdquo in a conference call with clientsaccording to The Wall Street Journal Other analysts also questionedMayorsquos 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 Magazine

Even after Michael Mayorsquos negative call on bank stocks turnedout to be accurate the critics refused to let up on him A few 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 ldquosellrdquo on Bank One (ONE) at$5981 a share the stock ultimately fell as low as $2319 following thedisappointing earnings a 61 percent decline

But 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 for

Mayorsquos general negative attitude toward the bank stocksstemmed from his belief that the earnings growth being reported by

CHAPTER SIX Experts What Do They Know 49

Chap 06 7901 850 AM Page 49

many banks was of ldquolow qualityrdquo in other words the accountantswere becoming increasingly creative in their ongoing effort to giveWall Street the earnings momentum it craved and expected Anyonewho understands financial accounting knows there are about 50 dif-ferent and perfectly acceptable ways to look at almost everythingand that your earnings may be up 5 percent up 10 percent or evendown 10 percent depending on which way the accountants decidethey are going to paint the picture this particular quarter

Eventually though the accountantsrsquo bag of tricks gets deplet-ed and if a company is not growing all that rapidlymdashor worse if cre-ative accounting has directed analytical attention away from a fes-tering problemmdashthe piper must be paid

This is not an uncommon occurrence with popular stocks thatare under tremendous pressure to meet Wall Street expectations andthe general observation that a particular company or an industry ingeneral has begun to resort to accounting gimmicks to meet WallStreet expectationsmdashie that reported earnings are of ldquolow qualityrdquoas Mayo statedmdashis a valid and sufficient reason to turn negative Ifyou smell something rotten you donrsquot have to rummage through thegarbage to figure out what it ismdashyou can just walk away from it

When 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 Mayorsquos critics up

But it wasnrsquotldquoCritics sayrdquo The Wall Street Journal reported with a straight

face ldquothat Mr Mayo had not pinpointed the credit card problemrdquoWhen another bank stock cited by Mayo as having ldquopoor earn-

ings qualityrdquomdashNational City Corpmdashwarned that earnings wouldbe lower than expected that stock took a nosedive as well But TheWall Street Journal pointed out ldquoMr Mayo didnrsquot specifically have alsquosellrsquo recommendation on that stockrdquo

The overall tone of The Wall Street Journal story 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 clients

You can see that the bar is raised considerably higher when youare bearish than when you are a conforming bull The Wall StreetJournal could have run a story about the 99 percent of analysts who

50 PART ONE The Making of a Superstock Investor

Chap 06 7901 850 AM Page 50

TEAMFLY

Team-Flyreg

were incorrectly bullish on Bank One for example and interviewedtheir clients to see how they enjoyed riding that stock down by 61percent But it didnrsquot Instead The Wall Street Journal dissected Mayorsquosbearish (and correct) call with a fine-tooth comb and created theimpression that while he turned out to be right he wasnrsquot really allthat right and that he was a publicity hound to boot

Michael Mayorsquos 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 ldquoItrsquos hard to doinvestment banking for a client with an analyst who is negative onthat clientrdquo a source told Reuters

It doesnrsquot work the other way around by the way If yoursquore acheerleader for a stock and it goes up nobody complains that itdidnrsquot go up for the reasons you said it would Yoursquore just a brilliantanalyst who made the right call But if yoursquore 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 indefinitelymdashif you say all that and youturn out to be rightmdashthat 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 anyway

The 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 disappointment

Back 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-panyrsquos prospects they could barely contain themselves The stockhad run up from $010 a share to $130 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 cancer

Everything was going swimmingly until the scientist who ranthe company called the president of the brokerage firm with the badnews that the process doesnrsquot work

ldquoWhat are you talking aboutrdquo the brokerage firm presidentsaid

CHAPTER SIX Experts What Do They Know 51

Chap 06 7901 850 AM Page 51

ldquoWe cannot cure cancer with shark fluidsrdquo the scientist saidldquoYes you canrdquo said the brokerage firm presidentldquoNo we canrsquotrdquo said the scientist ldquoThe process doesnrsquot workrdquoldquoYes it doesrdquo said the brokerage firm presidentThe scientist was taken aback at this response ldquoI wish it did

workrdquo he said again ldquoBut it doesnrsquotrdquoldquoHold onrdquo said the brokerage firm presidentWhen 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 indeedcure cancer through the use of shark fluids

The scientist tried his best to hold his ground ldquoIt doesnrsquot workrdquohe said pleadingly

ldquoIt has to workrdquo screamed one broker ldquoYour stock is at $130all of my clients own it and wersquore almost ready to do your secondaryofferingrdquo

And so at the urging of his ldquoconstituencyrdquo 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 wellas he continued his research that the process didnrsquot work

The scientist admitted long after the fact that listening to thoseguys nearly convinced him that he had missed something

I was reminded of this story on December 1 2000 when TheNew York Times reported that certain analysts were ldquoskepticalrdquo ofcomputer maker Gatewayrsquos 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 slumpdidnrsquot 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 ldquooverreactingrdquo which onlygoes to show you that whether wersquore talking about shark fluids andpenny stock brokers or computers and big-time Wall Street analysts

52 PART ONE The Making of a Superstock Investor

Chap 06 7901 850 AM Page 52

there are few things so constant as human nature As songwriterPaul Simon reminded us in The Boxer ldquoa man sees what he wants tosee and disregards the restrdquo That is a fundamental truth of WallStreet that every investor should keep firmly in mind

So one thing to keep in mind when yoursquore listening to the opin-ion of an expert Who is the expertrsquos constituency Or to put it morebluntly who pays the expertrsquos salary If it isnrsquot youmdashand it usuallywill not be youmdashconsider the possible agenda of the expert andorconstituency and view the expertrsquos point of view in that light

Even 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 6ndash2 shows

IT ALSO REALLY HELPS IF YOU CAN MAINTAINSOME PERSPECTIVE

ldquoTo understand what the outside of an aquarium looks like it is better not to be a fishrdquo Andreacute Malraux

Back in 1974 when I was working as a junior analyst on Wall StreetI 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 Street

In 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 anywayThings were so slow that a major investment magazine ran a coverstory entitled ldquoThis Is Not Just a Bear Market This Is the Way ThingsAre Going to Be from Now Onrdquo (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

CHAPTER SIX Experts What Do They Know 53

Chap 06 7901 850 AM Page 53

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

54 PART ONE The Making of a Superstock Investor

F i g u r e 6ndash2

ldquoExpertsrdquo and Their Statements

bull It was ldquoexpertrdquo Jimmy the Greek who declared ldquoImpossiblerdquo 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

bull It was ldquoexpertrdquo Thomas Edison who said in 1922 that ldquothe radio craze will die outin timerdquo

bull It was ldquoexpertrdquo Harry Warner President of Warner Bros who in 1927 laughed atthe idea of using sound in motion pictures saying ldquoWho the hell wants to hearactors talkrdquo

bull It was ldquoexpertrdquo Emmeline Snively Director of the Blue Book Modeling Agencywho told Marilyn Monroe in 1944 ldquoYoursquod better learn secretarial work or else getmarriedrdquo

bull It was an ldquoexpertrdquo (a United Artists executive) who turned down actor RonaldReagan for the starring role as the President in The Best Man by saying ldquoRonaldReagan doesnrsquot have that presidential lookrdquo

bull It was ldquoexpertrdquo Jim Denny manager of the Grand Ole Opry who told ElvisPresley on September 25 1954 ldquoYou ainrsquot goinrsquo nowhere son You ought to goback to driving a truckrdquo

bull It was ldquoexpertrdquo Ken Olson President of the Digital Equipment Company who saidin 1977 ldquoThere is no reason for any individual to have a computer in their homerdquo

bull It was ldquoexpertrdquo Charles H Duell Commissioner of the US Office of Patents whourged President William McKinley to abolish the Patent Office in 1899 based onthe incredible logic that ldquoEverything that can be invented has been inventedrdquo

bull It was ldquoexpertrdquo Professor of Economics Irving Fisher of Yale University whodeclared on October 17 1929 ldquoStocks have reached what looks like a perma-nently high plateaurdquo

bull It was ldquoexpertrdquo Thomas J Watson Chairman of IBM who declared in 1943 ldquoIthink there is a world market for about five computersrdquo

bull It was ldquoexpertrdquo Eric Easton manager of the Rolling Stones who said of MickJagger in 1963 ldquoThe singer will have to gordquo

Source Christopher Cerf and Victor Navasky The Experts Speak (Pantheon Books New York 1984)

Chap 06 7901 850 AM Page 54

My friends got a big laugh out of that oneA few days later I published my weekly stock market ldquoreportrdquo

in which I imagined what it would be like if Howard Cosell FrankGifford and ldquoDandyrdquo Don Meredith the hosts of ABC-TVrsquos MondayNight Football were to host a live daily television program directfrom the New York Stock Exchange

As 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 dayrsquos stock market action

Meanwhile Don Meredith a former Dallas Cowboysrsquo 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 scoops

What a laugh right Little did I knowTherersquos nothing wrong with minute-by-minute analysis of the

financial 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 results

And 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 thereon live television and respond to question after question from view-ers calling on the telephone asking about a series of random stocksHow can this ldquoexpertrdquo possibly provide a thoughtful informedresponse on every single question)

You can wonder about all of this but you canrsquot 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 tradingbased on instant analysis is a perfectly acceptable way to approachthe stock market Just ask any trader

CHAPTER SIX Experts What Do They Know 55

Chap 06 7901 850 AM Page 55

But 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 minutes

You 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 estimatesdown to the last penny you will also know the ldquowhisper numberrdquo youwill know if the company that has just reported earnings managed tobeat the official estimate the ldquowhisper numberrdquo 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 moment

You 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 perspective

This vantage point involves looking for stocks that are showingsigns that something significant is changingmdashfor the bettermdashon 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 business

In this book you will learn how to spot some of the Telltale Signsthat will enable you to buy these out-of-favor stocks with confidenceWe will show you how to determine when a formerly sleepy seem-ingly uninteresting stock may be about to emerge as a huge winner

In short we have arrived at a fork in the stock market roadmdashthis book will take you on a trip down the road less traveled

And once yoursquove been down this road you will never look atthe frantic three-ring circus of urgent day-to-day stock market com-mentary and ldquoexpertrdquo analysis in quite the same way

56 PART ONE The Making of a Superstock Investor

Chap 06 7901 850 AM Page 56

C H A P T E R S E V E N

What Is Value

Yoursquove heard a lot about ldquovalue investingrdquo 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

1 What is ldquovaluerdquo2 Why canrsquot a stock that is undervalued remain underval-

ued theoretically indefinitely

Itrsquos 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 ldquoIn the long run weare all deadrdquo

What we need is an investing approach that not only focuses onldquovaluerdquo but also provides for some sort of catalystmdashsome outsideeventmdashthat will literally force the stock market to take an under-valued stock and reprice it at a higher more appropriate value

Letrsquos start with this premise A stock is worth what the stockmarket says it is worth on any given daymdashno 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 now

Where does that price come fromIt comes from two places (1) earnings expectations and (2) the

present value the market is willing to place on those earnings expectations

57

Chap 07 7901 851 AM Page 57

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

Think of a stock as representing a small piece of ownership inan estimated future stream of earnings Those earnings are unknownand investors rely on the best guesses of Wall Street analysts to deter-mine what theyrsquoll be When you buy a share of stock today yoursquorebuying a stake in that future earnings stream

Of course analyst estimates of that future earnings stream maybe wildly off the mark which adds another major variable to thequestion of determining value But letrsquos assume charitably that theanalysts are going to get it right and you know precisely what a com-pany will earn over the next 10 years

Even 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 priceearnings ratio And if you think predicting earningsis difficult you havenrsquot seen anything yet

Take a look at Figure 7ndash1 which shows the priceearnings ratioof the Standard amp Poorrsquos 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 earningsmdashbut a wildly different con-cept of value

58 PART ONE The Making of a Superstock Investor

Bargains

Expensive

Average from 1970 to 1998 = 1465Average from 1950 to 1998 = 1478

63098 = 2625

1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 199528272625242322212019181716151413121110987

28272625242322212019181716151413121110987

Norm (- - -)

F i g u r e 7ndash1

SampP PriceEarnings Ratio

Chap 07 7901 851 AM Page 58

What causes priceearnings ratios to shift so dramaticallyThe major determining factor is interest rates When interest

rates rise priceearnings ratios tend to fall When interest ratesdecline priceearnings ratios tend to rise

There are two reasons for the profound effect of interest rateson priceearnings 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 stocks

For some investors the stock market competes for funds withthe bond market Stocks carry risk but long-term bonds carry lessrisk A 20- 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 Stocksobviously carry no such guarantee

When other money managers are deciding whether to commitmore or less capital to the stock market what theyrsquore really lookingat as an alternative is the ldquono-riskrdquo alternativemdashcash

By ldquocashrdquo 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 priceearnings multiple placedon a given level of earnings

Suppose 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 A teamof 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 thatrsquos been left for you to manage there will be enough moneyto pay the retirees and everyone will be happy

CHAPTER SEVEN What Is Value 59

Chap 07 7901 851 AM Page 59

As you sit there and survey the investment scene you see thatlong-term US government bonds are yielding 6 percent That willdo you no good because you need to earn 8 percent or the retireeswill be calling you up for loans so they can maintain their standardof living 20 years from now The yield on money market funds at 475percent is even less

To earn the required 8 percent therefore you will have to takesome riskmdashand that means yoursquoll have to invest in the stock marketAlthough stocks do not come with guaranteed returns they do offerupside growth potential And since therersquos no other way to get the8 percent you need you take the plunge into the market

Across the street there is another money manager in charge ofanother company pension fund His job is just like yours except hiscompany has a lousy union and the pension benefits for its retireesare going to be a lot less than yours According to the actuarial tablesthe money manager across the street needs to earn only 65 percenton his investments to fund the retirement plan

So yoursquore both in the same boatmdashat least for now You need toearn 8 percent and the money manager across the street needs toearn 65 percent but neither one of you can get what you want inbonds or money market funds so yoursquore both buying stocks

Now letrsquos 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 planBut the money manager across the street now faces an interesting sit-uation He needs 65 percent to fund his plan he can get 7 percent inUS 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 stressAnd 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 ldquocashrdquoinvestments like money funds and short-term treasury bills alsoreaches 7 percent he will likely move a lot more money out of stocks

In other words as interest rates on less risky investments risea certain amount of money will leave the stock market to lock in thatreturn At 7 percent a certain number of investors will determine

60 PART ONE The Making of a Superstock Investor

Chap 07 7901 851 AM Page 60

TEAMFLY

Team-Flyreg

that 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 investorrsquos goal which isone reason why rising interest rates almost always put downwardpressure on the stock market

The 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 Greenspanrsquos briefcase as a potential clue as to whetherthe Federal Reserve is about to shift its interest rate policy

There is another reason why rising interest rates usually meanlower stock prices Itrsquos a bit more complicated but its worth know-ing and it explains a big part of the mystery of the wildly gyratingpriceearnings ratios touched on earlier

This concept is called ldquodiscounted present valuerdquo 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 todayAgain what the market is willing to pay today for those future earn-ings is the priceearnings ratio

Letrsquos use this exampleSuppose Totterrsquos Rollerblades Inc (TRI) is estimated to earn a

grand 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 highthe present value of 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 higher

For 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

CHAPTER SEVEN What Is Value 61

Chap 07 7901 851 AM Page 61

Think 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 Totterrsquos 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 earningsprojectionsmdashthe only difference is what those earnings are worthright now in any given interest rate environment

That in simplified terms is how most stocks trade For the mostpart theyrsquore at the mercy of earnings forecasts that are constantlychanging and may or may not be on the mark and theyrsquore 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 accurate

Given all of this how can anyone define ldquovaluerdquoLet me tell you one wayWhen thinking of value think of this What would a company

be 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 operates

The actual value of a stockmdashas a businessmdashis only fleetinglyrelated if it is related at all to the gyrations of the stock marketAgain 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 itrsquos there

The only time this concept of value matters is when someoneis willing to step up to the plate to pay that value In other wordswhen a takeover bid takes place

My concept of a ldquovaluerdquo situation therefore is stocks that are sell-ing at clearance-sale prices significantly below their value as a businesswhere 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

62 PART ONE The Making of a Superstock Investor

Chap 07 7901 851 AM Page 62

When 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 levelmdashas a businessmdash and it is nolonger subject to the whims of the stock market and all of the unpre-dictable variables that determine where most stocks trade

You may think that choosing stocks that are likely to becometakeover targets is an impossible task The reason why you maythink this way is that yoursquove 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 candidates

But picking takeover targets is not an impossible taskAs 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 bid

By 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 of

You will be on the lookout for superstocks

CHAPTER SEVEN What Is Value 63

Chap 07 7901 851 AM Page 63

This page intentionally left blank

C H A P T E R E I G H T

If Everybody KnowsEverything Then NobodyKnows Anything

By 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 market

Which is precisely the point When yoursquore dealing with super-stocks pegging your stock selections to specific events or ldquocatalystsrdquorelated to a particular company that are likely to force the stock pricehigher for the most part yoursquore removing the behavior of the gen-eral stock market from the equation

When you begin to think in terms of the new paradigm yoursquollfind yourself zeroing in on news items that relate to the stocks yoursquoreholding or to other stocks that could become potential superstocksYoursquoll find yourself paying attention to ldquomicrordquo news items ratherthan ldquomacrordquo news items Yoursquoll become less interested in grandiosegeneralizations concerning the big picture and more interested in spe-cific news items that will impact individual stocks yoursquore following

For example yoursquoll find yourself paying more attention to CEOinterviews (ldquoWe believe the consolidation in our industry will con-tinue and we intend to be one of the major players by making addi-tional acquisitionsrdquo) merger announcements (ldquoWe will continue to

65

Chap 08 7901 852 AM Page 65

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

look for opportunities to grow our defense electronics segmentrdquo)or ldquoshareholder rights plansrdquo (ldquoAlthough 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 bidrdquo)

You will find yourself taking note of stock buybacks (ldquoWebelieve our stock is undervaluedrdquo) 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 companyAnd your ears will perk up when you hear that a company plans tospin off one of its subsidiaries to ldquoenhance shareholder valuerdquo espe-cially if the parent company or the subsidiary operates in an industry wheretakeovers are proliferating

You 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 itselfmdashand 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 yoursquoll 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 Reserversquos Open MarketCommittee meeting You would be more interested in the fact thatWMS Industries has announced that it will spin off its three PuertoRico hotelcasinos as a separately trading company because you willhave noted a takeover wave in the hotelcasino industry (see Chapter13) Therefore while the TV talking heads are wringing their handsover what Greenspan may or may not do yoursquoll be more interested inthe possibility that the WMS spinoff might become a takeover targetonce the hotelcasinos are trading separately as a ldquopure playrdquo (It did)

You will also begin to realize that if Rexel SA 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 wonrsquot mat-ter to Rexel SA if Apple Computer missed its earnings estimates bya penny And you will know that Rexel SA 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

66 PART ONE The Making of a Superstock Investor

Chap 08 7901 852 AM Page 66

The superstocks yoursquoll be tracking will be marching to theirown drummers and yoursquoll pay less attention to what ldquothe marketrdquois doing and more attention to the stream of information and scat-tered clues and evidence that directly impact the themes trends andspecific superstocks yoursquore tracking

If yoursquore like me you wonrsquot miss the market ldquoanalysisrdquo at allIn fact you may find itrsquos a relief to get it out of your hair because somuch of it is meaningless anyway

The 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 gyrationno matter how unexplainable it may be As a result financial com-mentators stockbrokers and analysts are expected to have an answerfor everything

Most 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 conversation

For 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

ldquoHowrsquos the marketrdquo you askldquoDown 80 pointsrdquo he saysldquoEighty points Why is it down 80 pointsrdquoldquoProfit-takingrdquoNow you may not be the smartest investor who ever lived but

yoursquore smart enough to know that since the market has declined in17 of the past 20 sessions it is definitely not profit-taking thatrsquos push-ing the market lower today Your broker knows that too but has totell you something because he or she is supposed to know whatrsquosgoing on Consequently the broker will have an answer for any ques-tion you can possibly come up with

How does the broker do thisOn any given day there are probably 5 or 10 potentially bullish

news 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

CHAPTER EIGHT If Everybody Knows Everything Then Nobody Knows Anything 67

Chap 08 7901 852 AM Page 67

tape like some Miss America from the crowd in Atlantic City andthis news item will be used to explain what the market did that day

Let 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 52 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 it

Your broker can use any one of these news items to put a ldquospinrdquoon why the Dow Jones is down 200 points

Your stockbroker is sitting at his deskThe phone rings Itrsquos youldquoHowrsquos the marketrdquo you askldquoItrsquos down 200 pointsrdquo your broker saysldquoTwo hundred points How comerdquoldquoWell the market has been depressed by a couple of news items

this morning First the President says he wants a tax cut and thatrsquosbearish 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 alsordquo

ldquoOhrdquoOn the other hand the market might be up 200 points With

the very same items on the tape the conversation would then gosomething like this

ldquoHowrsquos the marketrdquoldquoUp 200 pointsrdquoldquoUp 200 points How comerdquoldquoWell the President says he wants a tax cut and thatrsquos bullish

for the economy and for corporate earnings Also durable goodsorders were up 52 percent another sign of economic strength Alsothe bond market is higher this morningrdquo

ldquoOhrdquoSince 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

68 PART ONE The Making of a Superstock Investor

Chap 08 7901 852 AM Page 68

the Presidentrsquos tax cut proposal how come the bond market is up Orwhat 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 ldquobearishrdquo items will miracu-lously be interpreted as bullish as in ldquoWall Street had second thoughtsabout President Clintonrsquos tax cut proposal rdquo 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 commentariesin an entirely different lightmdashthat is if you bother to see them at all

Can 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 marketitrsquos 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 itrsquos time to thinkabout reducing your market exposure

Other than that nobody knows anythingWhich brings me to William GoldmanWilliam 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 hersquod ever learned about the movie business

Here it is ldquoNobody knows anythingrdquoWhat Goldman was saying was that you could take all of the

sophisticated 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 moviesmdashand that sure isnrsquot hap-pening

Says Goldman

CHAPTER EIGHT If Everybody Knows Everything Then Nobody Knows Anything 69

Chap 08 7901 852 AM Page 69

bull If anybody knew anything BJ Thomasrsquos advisers wouldnot have been so upset after the first sneak preview ofButch Cassidy and the Sundance Kid After hearing Thomasrsquosnew song ldquoRaindrops Keep Falling on My Headrdquo in thecontext of Butch Cassidy they were convinced that Thomashad made a potentially fatal career move

bull If anybody knew anything Raiders of the Lost Ark would nothave been turned down by every studio in town beforeParamount decided to make the film

bull If anybody knew anything Columbia Pictures would nothave told Steven Spielberg that it decided not to make ETeven after the studio spent a million dollars developing thefilm (ET wound up at Universal)

bull If anybody knew anything Paramount Pictures would nothave offered The Godfather to 12 directors (all of whomturned it down) before they got around to offering it toFrancis Ford Coppola and they would not have offered therole of Michael Corleone to Robert Redford Warren BeattyRyan OrsquoNeal Dustin Hoffman and Martin Sheen beforethey got around to offering it to Al Pacino

Now if you think about it you can apply William Goldmanrsquospremise to the stock market but with a slight variation

In the stock market when everybody knows everything nobody knowsanything Overall the evidence seems to indicate that the stock mar-ket as a whole is a pretty good ldquodiscountingrdquo 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 ldquoefficientrdquo 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 ldquoedgerdquo 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 therersquos no ldquoedgerdquo 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 Goldmanrsquos moviestudio executives are all poring over the same current and historicaldata regarding box office grosses If all of this ldquomacrordquo publicly avail-

70 PART ONE The Making of a Superstock Investor

Chap 08 7901 852 AM Page 70

TEAMFLY

Team-Flyreg

able information meant anything everyone would be making theright move all of the timemdashand theyrsquore not This strongly suggeststhat the way to hit a home run is to take a left turn when the lem-mings are turning rightmdashto take the road less traveled as it were

The same holds true for large-cap stocks A 1999 study by PeterSchliemann a money manager formerly with David L Babson ampCo 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 donrsquot know for sure but Irsquod 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 instan-taneously

Since everybody expected earnings of say $060 for the quar-ter everybody knew everythingmdashtherefore they knew nothingNow that everybody knows earnings came in at say $050 every-body knows everything once againmdashbut they still know nothingsince there is no way to take advantage of that information to avoidthe 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 allmdashor maybe we should say that nobody really knows anything more than any-body elsemdashor anything really worth knowing

When yoursquore looking for an edge in an area of the stock marketwhere everyone else is looking yoursquoll find that new business becomesold business pretty darn quicklymdashusually too quickly to be of any

CHAPTER EIGHT If Everybody Knows Everything Then Nobody Knows Anything 71

Chap 08 7901 852 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 itrsquosa good bet that it will be old business already no matter how new itseems to you

Now compare this instantaneous reaction to new business in thelarge-cap stocks to the way the market reacted to Laidlawrsquosannouncement 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 investors

But 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 Dellrsquos management whatdo you think would happen to Dellrsquos stock price Most likely theWall Street analytical community would immediately take its bestguess as to Dellrsquos potential takeover value and the stock would risetoward that level almost immediately

This did not happen as we will learn with ADT Nor did ithappen with Rexel Inc even though the parent company RexelSA 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 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-ketrsquos efficiency in processing significant information is directly relatedto the audience for that informationmdashie whether institutionalinvestors and the analysts who are fighting for their commissionbusiness are paying attention will determine how accurately themarket reflects new information

You 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

72 PART ONE The Making of a Superstock Investor

Chap 08 7901 852 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 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 situation

In 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 examplewhen Brylanersquos outside shareholder Pinault Printemps began rais-ing its stake in Brylane I saw a connection to the Rexel takeover bidbecause Rexel SA which bought Rexel was a subsidiary of PinaultPrintemps (see Chapter 9) But how many investorsmdashor professionalanalystsmdashwould have known that if they had not lived through theRexel takeover drama

So lesson number one is Research individual stocksmdashandsmaller stocks at thatmdashand donrsquot 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 isavailable out there that is not reflected in stock prices especiallywhen yoursquore dealing with stocks that are not widely followed by themainstream Wall Street analysts

So lesson number two If you really want to get an edge on WallStreet you should focus your attention on smaller-cap stocks thatare not widely followed by analysts and their institutional clientsThat 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 price

This principle explains why stocks like Rexel ADT Brylaneand 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 way

When you start to focus more of your attention on individualstocks and less attention on the general market yoursquoll be better ableto 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 7901 852 AM Page 73

subtle change in the way you perceive the news Yoursquoll think in termsof 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 ableto identify potential ldquosuperstocksrdquomdashand the less interested yoursquollbecome in the daily blather that passes for stock market analysis

74 PART ONE The Making of a Superstock Investor

Chap 08 7901 852 AM Page 74

P A R T T W O

Identifying TakeoverTargets

Chap 09 7901 853 AM Page 75

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

This page intentionally left blank

C H A P T E R N I N E

Creeping Takeovers

Letrsquos 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 prices

To 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 Andletrsquos suppose further that your management team has decided it wouldbe a good idea to acquire this company within the next 2 years

If 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 thestockrsquos 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 ldquofairness opinionrdquo 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 to

77

Chap 09 7901 853 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 thecompany you want to buy All of this means that yoursquoll probablyhave to pay a hefty premium over the stockrsquos current $10 tradingpricemdashespecially if the growth prospects you envision are apparentto the target companyrsquos management and to the financial advisers thetarget company retains

Given all of this what would you doWhat many outside owners do is embark on what is called a

ldquocreeping takeoverrdquo 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 monththe 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 company

This 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 you

CASE STUDY HOW REXEL SA ACQUIRED REXEL INC

If 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 ldquoben-eficial ownerrdquo and must report all additional purchases and sales ofstock Once a ldquobeneficial ownerrdquo crosses that 5 percent thresholdeach additional purchase of stock becomes a matter of public recordLater you will learn where to find this information so you can buyright along with these outside beneficial owners But first letrsquos lookat Rexel Inc and the ldquocreeping takeoverrdquo engineered by its largestshareholder Rexel SA of France

78 PART TWO Identifying Takeover Targets

Chap 09 7901 853 AM Page 78

We recommended Rexel Inc in October 1995 at $101frasl4 for threereasons Rexel SA had recently raised its stake in Rexel from 435 to45 percent through additional open-market stock purchases Rexelhad turned itself into a pure play electrical 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 ldquoTelltale Signsrdquo of a potential takeover target

As you will see throughout this book we will spend some timepresenting original recommendations and ongoing analysis of thesetakeover targets for one important reason Wersquore not discussingldquotheoretical examplesrdquo or how you ldquomight have done thisrdquo or ldquomighthave done thatrdquo Wersquore 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 outcome The 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 superstocks

Rexel was what could be called ldquosneaky strongrdquo 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 doing

In other words Rexel was beginning to act like a superstockmdashmarching to its own drummer oblivious to the manicdepressivegyrations of the overall stock market A ldquocreeping takeoverrdquo 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 everythingyoursquove ever learned about risk and reward which is that if you wanta big reward you have to take a bigger than usual risk

But when it comes to a ldquocreeping takeoverrdquo this is simply notthe case The reason is that if the outside beneficial owner continuesto purchase large blocks of stock on the open market itrsquos a strongindication that there is good value at 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 beneficialownermdashand especially if these purchases take place at successivelyhigher price levelsmdashit becomes logical that when the price dips too

CHAPTER NINE Creeping Takeovers 79

Chap 09 7901 853 AM Page 79

far below that level it is viewed as a bargain not only by the outsidebeneficial owner but also by the handful of stock market partici-pants who focus on situations like this The result is often strongsupport on pullbacks no matter what the stock market is doing Soeven if there is no takeovermdashand sometimes even if the overall stockmarket is exceedingly weakmdashsituations like this tend to hold upvery well thereby creating less risk

Tell that to the next know-it-all stock market pundit who tellsyou that investing in takeover candidates is ldquotoo risky for the aver-age investorrdquo

Following a Business Week story on Rexel the price bumped to$14 however Rexel drifted back to where it had started meetingsupport in the $12 area Rexel met strong support at that price Andthen the ldquocreeping takeoverrdquo really got under way

In the stock market you can tell where the value is by who isdoing the buying That notion is seen clearly in the fact that a Rexelvice president had gone into the open market to purchase 4000 sharesof Rexel at a price of $113frasl8 This created what I call a ldquotriple playrdquo situ-ation usually the most powerful of all signs that a stock is going high-er A triple play occurs when an outside beneficial owner the company itselfand 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 higher

In February 1996 there was another major purchase of RexelsharesmdashRexel SA bought another 150000 Rexel shares at pricesbetween $12 and $121frasl2

It was clear by March 1996 that Rexel SA had begun to ldquocreeprdquoThe French company had once again gone into the open market tobuy 59100 additional Rexel shares at a price of $123frasl4 The continu-ing purchases of Rexel SA suggested that Rexel could become atakeover target at any time

So Much for the ldquoEfficient Marketrdquo Theory

At this point the Rexel story becomes a bit more interesting for a dif-ferent reason The information age has arrived in full force and itrsquos safeto say that therersquos virtually no piece of information on any public

80 PART TWO Identifying Takeover Targets

Chap 09 7901 853 AM Page 80

TEAMFLY

Team-Flyreg

company that is not readily available to anyone who is interested inlooking for it

The problem is fewer and fewer analysts are looking for themost significant informationmdashbut that leaves the playing field wideopen for the rest of us

Previously you learned that Wall Street research is increasinglygeared toward servicing those who generate the largest commissionsmdashmutual funds pension funds hedge funds and other large-scaleinvestors who require big-cap stocks with lots of liquidity Smaller-cap stocks and micro-cap stocksmdashand also stocks in out-of-favor indus-tries that are too boring to interest the momentum playersmdashare sim-ply not followed as closely as their better known counterparts

The theory of the ldquoefficient stock marketrdquo 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 SA for example had uppedits open-market purchase price for Rexel from the $9 area to the $12to $123frasl4 area should have sent a strong signal that Rexel was a greatvalue at a $12 to $123frasl4 price If Rexel SA 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 SArsquos lead And certainly if Rexel shares trad-ed below the $123frasl4 area that Rexel SA had been willing to pay thatwould make Rexel a very good value Right

Not necessarily Again remember that wersquore 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-uationmdashnamely that Rexel would have been a logical buy anywherebelow $123frasl4mdashsimply did not register with the vast majority of WallStreet analysts and the investors who received their advice from them

Which leads to an important point You would be amazed at howmuch time you have to accumulate genuine takeover candidates thatare undergoing a ldquocreeping takeoverrdquo before Wall Street catches onto whatrsquos happening And you would also be amazed at how often youcan buy these ldquocreeping takeoverrdquo candidates at a significantly lowerprice than the outside beneficial owner has been paying

CHAPTER NINE Creeping Takeovers 81

Chap 09 7901 853 AM Page 81

In the case of Rexel Wall Street greeted Rexel SArsquos continuingpurchases up to the $123frasl4 area with a collective yawn and Rexelshares drifted back below $12 again

By midyear Rexel SA had made two additional purchases ofRexel Inc stock 21000 shares and 275600 shares both at $111frasl2 to $113frasl4To many investors takeover bids may seem unpredictable and tocome ldquoout of the bluerdquo 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 patienceSuch buys by Rexel SA 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 bid

By the end of the summer in 1996 Rexel SA had made twoadditional purchases of Rexel Inc stock 46000 shares at $131frasl4 and175700 shares at a price as high as $141frasl4 And there was continuedscattered buying of stock by Rexel Incrsquos officers and directors

In September 1996 Rexel SA purchased another 162000 sharesof Rexel Inc at prices between $133frasl4 and $137frasl8 an indication thatRexel SA was accomplishing a takeover by attrition through itscontinuing open-market purchases

On November 7 1996 I reported to my subscribers that RexelSA had purchased another 79000 shares of Rexel Inc at $133frasl4 Andyet amazingly despite the sizable open-market purchases by RexelSA that I had been documenting month after month Rexel Incshares were trading in November 1996 right at $14 no higher thanthey had been trading at the start of 1996

This proved two things First no one on Wall Street was pay-ing the slightest attention to the Rexel situation And second as Irsquovesaid before and Irsquoll say again if yoursquore going to invest in off-the-beaten-path stocks with genuine takeover potential yoursquore 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 Streetrsquos disinterest

And 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 confidencemdashwhichmeans the ultimate payoff when it comes will be even sweeter

By the end of 1996 Rexel was still trading near $14 a shareright where it began the year despite the fact that Rexel SA had

82 PART TWO Identifying Takeover Targets

Chap 09 7901 853 AM Page 82

spent most of the year adding significantly to its Rexel stake anddespite the fact that Rexel SA had just paid as high as $147frasl8 for an addi-tional 167000 shares

In the first week of January 1997 Rexel Inc finally broke out toa new high (See Figure 9ndash1)

Then in February 1997 I reported to my subscribers that RexelSA purchased another 43500 shares of Rexel Inc paying as muchas $157frasl16 a new high for Rexel SArsquos open-market purchases

In March 1997 Rexel Inc stock suddenly pierced the $20 levelon very large volume Prior to that Rexel SA had purchased anoth-er small block of 8000 shares paying a new high of $163frasl4

One Last Chance

At this point yoursquore 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 RexelSA paid for the stock at so many different points and for such

CHAPTER NINE Creeping Takeovers 83

F i g u r e 9ndash1

Rexel Inc (RXL) 1995ndash1997

Source Courtesy of Mansfield Chart Service Jersey City NJ

Chap 09 7901 853 AM Page 83

extended 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 meal

And then Wall Street provided dessertShortly after it was announced that Rexel SA had just pur-

chased another 184000 shares of Rexel paying as high as $201frasl16 Rexelshares dipped down to the $16 to $17 area and stayed there for sev-eral months In other words the perfectly efficient stock marketwhich sees all knows all and discounts everything provided one lastextended opportunity for investors to buy Rexel shares for signifi-cantly less than Rexel SA had just paid

In April 1997 Rexel SA went into the open market and boughta small block of 10000 Rexel shares at $167frasl8 The purchase made per-fect sense Rexel had just paid as high as $201frasl16 for 184000 shares sowhy not buy more at lower prices By June 1997 Rexel stock hadspent nearly four months trading listlessly between $16 and $18despite the fact that Rexel SA had paid over $20 for the stock justmonths earlier All told Rexel SA had purchased a grand total of1734900 shares of Rexel over the past two years

Takeover Time

Finally in September 1997 Rexel SA announced a takeover bid forRexel The offer was initially at $1950 per share then ultimatelyraised to $2250 per share That takeover price represented a premi-um of 119 percent over our original recommended price of $101frasl4 injust 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 patient

THE OTHER SIDE OF TAKEOVERS SELLING BY ABENEFICIAL OWNER

This next case study illustrates another method of spotting takeovertargets which is the mirror image of the approach used with RexelIn 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

84 PART TWO Identifying Takeover Targets

Chap 09 7901 853 AM Page 84

The 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 stockholders

In 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 takeover

Therefore what seems to be a negative to ldquoold paradigmrdquothinkersmdashthat a large outside beneficial owner shareholder wants tosell its stakemdashis usually a sign that the target company is about toenter the ranks of the superstocks

CASE STUDY THE TAKEOVER OF ADT

An example of this approach is ADT Ltd a security alarm moni-toring company

In February 1996 a small news item appeared about ADT Ltdwhich 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 dealLaidlaw had also granted Western Resources an option to buy theother 12 percent of ADT owned by Laidlaw by May 15 1997

One 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 ldquononcorerdquo 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 ldquoin playrdquo as a genuine takeovercandidate

CHAPTER NINE Creeping Takeovers 85

Chap 09 7901 853 AM Page 85

My 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 amp Light was seeking to diversify into the nonutility businessIn fact recent press releases from Western Resources indicated thatthe company had publicly stated it was thinking of expanding into thehome security alarm business through acquisitions

Western 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 separatebut related news items

ADT became part of the master list of recommended stocks inour Superstock Investor newsletter

At the time some utilities including telephone companiesviewed home security companies as a cost-efficient ldquoadd-onrdquo 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 Laidlawrsquos remaining 12 per-cent of ADT and then to make a bid for the rest of the company

The same reasoning suggested that two smaller companiesProtection One (ALRM) then trading near $11 and Holmes Pro-tection (HLMS) then trading below the $8 area were also potentialtakeover targets

This analysis of the security alarm industry provided a detailedroad map for investors for an upcoming takeover wave in the secu-rity alarm industry

By mid-March Western Resources had exercised its option topurchase the additional 12 percent of ADT owned by Laidlaw at$1480 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 ADTrsquos market price Western Resources mayhave acted as quickly as it did because they thought ADT shareswould move higher

In May 1996 a rather curious development took place ADTrsquosmanagement team had exchanged their low-priced ADT stock

86 PART TWO Identifying Takeover Targets

Chap 09 7901 853 AM Page 86

options (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 $15

Why 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 range

Following my ADT update subscribers were once againreminded that Protection One (then trading at $73frasl4) could also getcaught up in a takeover wave involving security alarm companies

On March 16 1996 CNBCrsquos 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 overhead

In a May 3 report an item was included about a hostile takeoverbid that Western Resources had just made for Kansas City Power ampLight It was reported that Westernrsquos bid for Kansas City Power amp Lightwas unsolicitated and that it disrupted a friendly merger agreement thathad already been negotiated between KCPampL and another company

Western 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 WesternResourcesrsquo unsolicited bid for Kansas City Power amp Light was a clearsignal that Western was looking to grow through takeovers

This observation demonstrates another strategy of pickingtakeover targets It pays to know the track record of the outside beneficialowners Just as our experience with Rexel SA and Rexel Inc led usto the takeover of Brylane (see Chapter 10) this hostile bid by WesternResources for Kansas City Power amp 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 answer

Next ADT announced a 5 million share buyback anotherTelltale Sign that ADT was seriously worried about a takeover bid at

CHAPTER NINE Creeping Takeovers 87

Chap 09 7901 853 AM Page 87

an unreasonably low price Remember the Telltale Sign When a com-pany whose stock is being bought by a third-party ldquobeneficial ownerrdquoannounces 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 ldquolow-ballrdquo bid that might be above the current market pricebut still below the true value of the company as a business

Both Western Resources and Kansas City Power amp 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 at$181frasl8 up 20 percent in less than three months since the news thatWestern Resources had bought 12 percent of ADT from Laidlaw

Surprise Republic Industries Makes aTakeover Bid for ADT

On July 1 1996 ADT became a superstock jumping 51frasl2 points in oneday to $241frasl2 on news that ADT had received a takeover bid That 51frasl2-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 earlier

But 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 companiesRepublic 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 price

Western Resources was strangely silent over the RepublicIndustries bid from ADT And the strangest twist in this story wasyet to come

ADT Followers Get Another Chance to Buy at Bargain Prices

During the discussion of the Rexel Inc takeover you learned howmany opportunities a patient informed investor can get to buy a

88 PART TWO Identifying Takeover Targets

Chap 09 7901 853 AM Page 88

genuine 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 ldquoefficient marketrdquo the-ory is that information is only properly discounted when the Wall Streetpowerhouses are paying attention Mutual 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 microscope

But 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 window

By 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 announced

As a result on July 26 1996 an investor following the ADTstory could have bought ADT formdashwould you believe itmdash$173frasl4

The 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 WhyBecause neither ADT nor Republic thought it important to check with WesternResources which owned 24 percent of ADT

You 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 theRepublicndashADT agreement Western said only that it was ldquoexploringits alternativesrdquo

The intent of that statement was probably an indication thatWestern Resources had intended to ultimately buy the rest of ADTand 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 ldquopersonality pre-miumrdquo based on the popularity of Wayne Huizenga

At 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

CHAPTER NINE Creeping Takeovers 89

Chap 09 7901 853 AM Page 89

was that Western Resources would find another buyer for ADT whowas willing to pay cash or stock with a more stable or reasonablevalue than Republic Industries A third possibility was for WesternResources to force Republic to substantially increase its offer in lightof the decline in Republic shares All three of these scenarios shouldhave resulted in a sharp rise in ADT shares from their trading levelof $17 to $18mdasha price level lower than where ADT traded prior tothe Republic bid Yet another possibility was for Western to simplyoppose the merger but do nothing but vote against itmdashpossible butunlikely considering Westernrsquos aggressive personality

Finally the Republic IndustriesndashADT agreement carried with itan unusual arrangement that seemed to indicate that both Republicand ADT were actually expecting a higher bid ADT granted Republica warrant to purchase 15 million ADT shares at $20 if the agreementwas terminated for any reason This by the way is another reasonwhy Western Resources was understandably miffed In effect itmeant that anybody making a competing bid for ADT at any priceover $20 had to buy 15 million additional shares and hand RepublicIndustries 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 yoursquoveobserved 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 fight

And you would expect that a ldquoperfectly efficient stock marketrdquowould have processed all of this public information and decidedthat ADT should be selling perhaps in the low to mid $20 rangeespecially in light of the fact that Republic had already offered $26in stock to acquire the company

Because of the drop in its own stock price by early October 1996Republic 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 $1975 price Western Resources

90 PART TWO Identifying Takeover Targets

Chap 09 7901 853 AM Page 90

TEAMFLY

Team-Flyreg

had paid for part of its 13 million share purchase just a couple of monthsearlier Republic withdrew its bid even though Western had notuttered one public comment on the RepublicndashADT takeover dealBut Western really didnrsquot have to say anything to Republic

Westernrsquos purchase of an additional 13 million shares of ADTin August after the Republic bid was announced was Westernrsquosway of saying ldquoGet lostrdquo

Sure enough just 1 month later Western Resources purchasedanother 13 million shares of ADT in the open market this time pay-ing between $181frasl4 and $19 ADT shares once again rose above $20 butjust barely trading around $203frasl4

Now those of you who are thinking ldquoAha A creepingtakeoverrdquo 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 takeoverdetectivemdashin other words trained to think in superstock paradigmtermsmdashit 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 intentions

Finally after buying another 209500 ADT shares at the end ofOctober at $193frasl4 Western Resources made its move Western offered$2250 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 companyrsquos hostile takeover bid for Kansas City Power ampLight and also in light of the arrogant and cavalier manner in whichADT had disregarded Westernrsquos interests when it accepted theRepublic takeover bid

A hostile bid from Western Resources in other words shouldhave come as no surprise to any new paradigm thinker who hadbeen following this situation Westernrsquos anger by the way was evi-dent in the fact that its $2250 takeover bid was significantly lessthan Republicrsquos previous $26 bid In fact Westernrsquos bid was so stingythat we advised subscribers to hold ADT based on the possibility

CHAPTER NINE Creeping Takeovers 91

Chap 09 7901 853 AM Page 91

that Western Resources would raise its bid or that the situation wouldturn so hostile that ADT would find a competing bidder

And 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 ADT

On 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 stock

That $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 ldquoin playrdquo 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 higher

If you look at Figure 9ndash2 yoursquoll 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-

92 PART TWO Identifying Takeover Targets

Chap 09 7901 853 AM Page 92

out 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 therersquosalways a new story always another stock moving The ldquohotrdquo moneyobsessed with short-term performance can quickly lose interest ina takeover situation that temporarily runs out of steam When theldquohotrdquo 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 opportunities

So itrsquos not just the 120 percent you could have made in ADT ifyoursquod 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 ldquotakeover detectiverdquo you would

CHAPTER NINE Creeping Takeovers 93

F i g u r e 9ndash2

ADT 1995ndash1997

Source Courtesy of Mansfield Chart Service Jersey City NJ

Chap 09 7901 853 AM Page 93

have 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 prices

And 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 1997because ADT was on its way to finding its proper value as a businessInstead of being tossed about by the whims of the market respond-ing to analystsrsquo estimates and interest rate movements ADT wasbeing analyzed as a business by three potential acquirers And even-tually that bid by Tyco forced the stock market to place a realisticvalue on ADT as a business

In 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

94 PART TWO Identifying Takeover Targets

Chap 09 7901 853 AM Page 94

C H A P T E R T E N

How to Create Your OwnldquoResearch Universerdquo ofTakeover CandidatesmdashThe Telltale Signs

Two roads diverged in a wood and ImdashI tookthe road less traveled and that has made all the difference

Robert Frost

Now that you have seen how Rexel and ADT became takeover tar-gets you can probably see the difference between ldquosuperstockrdquo 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 yoursquore 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 ie a takeover bid that forced the stock mar-ket to value Rexelrsquos and ADTrsquos stock according to their values as businessesregardless of what the general stock market was doing at the time

So how do you find a stock like Rexel or ADT in the first placeTo answer that question I am going to point you down the road

less traveled toward an entirely new direction in terms of thoughtprocess and analysis

95

Chap 10 7901 855 AM Page 95

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

First forget about the trendy ldquomomentumrdquo stocks everybodyknows and loves If you want to own some of them finemdashbut wersquoregoing 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 DellBill 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 weekmdashbut they live on a highly traf-ficked and overly developed road and wersquore headed for a far morebarren piece of terrain These guys and the stocks theyrsquore involvedwith are so widely followed so idolized and analyzed that there isabsolutely nothing you and I can discover that hasnrsquot already beennoted rehashed a thousand times and factored into their stock prices

Instead I am going to suggest that you become a browserThe definition of browse is to look wander or meander through

something or somewhere in a casual and unfocused manner Whenyou are browsing you do not always have a specific goal in mindyou 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 path

This is a very different mindset than setting out to find a spe-cific piece of information

The Internet is a wonderful tool It provides a bottomless pit offacts and figures virtually anything yoursquore looking for But what ifyou donrsquot know exactly what yoursquore 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 yoursquore 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 waymdashby 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 then digdeeper using the Internet

96 PART TWO Identifying Takeover Targets

Chap 10 7901 855 AM Page 96

Reading every single item in The Wall Street Journal for exam-plemdashespecially the smaller items that may be only a few sentenceslongmdashcan 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 yoursquore going to browse for antiques you wonrsquotmake 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 yoursquoll encounter information that can leadyou to superstock takeover candidates

Investorrsquos Business DailyThe Mansfield Chart ServiceThe New York TimesThe Vickers Weekly Insider ReportThe Wall Street Journal

Create Your Own ldquoResearch Universerdquo

Your goal as you begin your new career as a ldquosuperstock browserrdquowill be to create your own ldquoresearch universerdquo Every Wall Streetanalyst has a ldquoresearch universerdquo that consists of a group of stocksthe analyst follows on a regular basis Most of the time these stocksare organized by industry group A chemical stock analyst for exam-ple will follow a universe of chemical companies and select one orseveral as his or her top pick

As a superstock browser your goal will be to create your ownresearch universe a list of potential ldquosuperstockrdquo takeover candi-dates that possess one or more of the characteristics addressed inthis chapter Yoursquoll 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 target

One advantage you will have over the average Wall Street ana-lyst is that your ldquoresearch universerdquo will not be confined to a cer-tain industry group Instead once you learn to spot specific charac-teristics of potential takeover targets yoursquoll find yourself following

CHAPTER TEN Create Your Own ldquoResearch Universerdquo of Takeover Candidates 97

Chap 10 7901 855 AM Page 97

a diverse group of stocks that span a wide variety of industry groupsAnd once yoursquove constructed your ldquoresearch universerdquo you shouldlook at it as a potential shopping list of investment possibilities

For 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 list

In 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 theyrsquollhave the potential of rising suddenly and substantially in price nomatter what the stock market is doing

And herersquos the best part This ldquoicing on the cakerdquo 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 price In other words to the outside worldthese stocks will look like boring mild-mannered Clark Kentsmdashbutin reality each will have the potential of slipping into a phone boothat a momentrsquos notice and emerging as a superstock

WHAT YOUrsquoLL BE LOOKING FOR

I 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 yoursquoll be looking foras a superstock browser

Eighteen Telltale Signs

1 An outside company or individual (ldquobeneficial ownerrdquo)accumulates more than 5 percent of a companyrsquos stock

98 PART TWO Identifying Takeover Targets

Chap 10 7901 855 AM Page 98

and then files a Form 13-D with the Securities andExchange Commission

2 A company that already has one outside ldquobeneficialrdquoowner attracts a second or even a third outside investorwho accumulates a position of 5 percent of more

3 An outside beneficial owner in its Form 13-D filing saysthat it is seeking ways to ldquoenhance shareholder valuerdquoldquomaximize shareholder valuerdquo or speak to managementor other shareholders about ldquoexploring strategic alterna-tivesrdquomdashall code phrases for potentially putting a compa-ny up for sale to get the stock price higher

4 An outside ldquobeneficialrdquo 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 optionrsquos 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 stock

5 An outside beneficial owner adds to its stake in a compa-ny through additional open market purchases of its stock

6 An outside beneficial owner expresses an interest in sell-ing its stake in a company and says it will review strategicalternativesmdashoften a code phrase for a desire to have thetarget company acquired by a third party to maximize thevalue of the beneficial ownerrsquos investment

7 A dispute between an outside beneficial owner and thecompany in which it owns a stake breaks out into theopenmdashoften 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 bid

8 A company in which an outside beneficial owner holds astake or is accumulating additional shares andor whichoperates in an industry where takeovers are proliferatingannounces a stock buyback program

CHAPTER TEN Create Your Own ldquoResearch Universerdquo of Takeover Candidates 99

Chap 10 7901 855 AM Page 99

9 A company in which an outside beneficial owner holds astake or is adding to its stake is the subject of insider buy-ing by its own officers andor directors

10 A company with an outside beneficial owner andoroperates in an industry where takeovers are proliferatingannounces a ldquoshareholder rights planrdquo designed to makea hostile takeover more difficult

11 A company in a consolidating industry sells or spins offldquononcorerdquo assets or operations thereby turning itself intoa ldquopure playrdquo (see Chapter 14) which is often a signalthat the company is preparing to sell itself to a largercompany within its core industry

12 A company in a consolidating industry takes a largeldquorestructuringrdquo charge in effect putting past mistakesbehind it and clearing the decks for future positive earn-ings reports Such action can be important to a potentialacquirer and is often a sign that a company is preparingto sell itself

13 A company in a consolidating industry announces arestructuring charge that causes the stock to declinesharply and becomes the subject of significant insiderbuying andor 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 horizon

14 A company in a consolidating industry is partially ownedby a ldquofinancially orientedrdquo 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 ldquoexit strategyrdquo for itself by engineer-ing a takeover of the company in question should theopportunity present itself

15 The 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 stockmdashin other words a desireto have the company acquired

100 PART TWO Identifying Takeover Targets

Chap 10 7901 855 AM Page 100

TEAMFLY

Team-Flyreg

16 Two 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 companythere 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 list

17 A small-to-medium-size company in a consolidatingindustry achieves a breakout from a ldquosuperstock breakoutpatternrdquo ie the stock penetrates a well-defined resis-tance level at least 12 months in duration following aseries of progressively rising bottoms or support levelswhich indicates that buyers are willing to pay increasing-ly higher prices to establish a position This pattern cre-ates the appearance of a ldquorising trianglerdquo on the chart Thebest superstock breakout patterns occur when volatility decreas-es markedly in the weeks or days prior to the breakout

18 A company 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 ldquoinheritedrdquothrough a takeover of another company Many times ifCompany A acquires 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) CompanyA may eventually bid for the rest of Company C if this fitsits overall businessacquisition 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 A take-over of a company whose stock is ldquoinheritedrdquo throughanother takeover becomes even more likely when there isalready a business relationship between Company A andCompany C

For illustrative purposes letrsquos 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

CHAPTER TEN Create Your Own ldquoResearch Universerdquo of Takeover Candidates 101

Chap 10 7901 855 AM Page 101

ldquoinheritedrdquo a 49 percent stake in Trus Joist a Boise Idaho manufac-turer of lumber products which was partially owned by MacMillanThe other 51 percent of Trus Joist was owned by TJ International apublicly traded company listed on NASDAQ

There 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 Joist

At first TJ International stock rocketed from the low $20s to ashigh as $337frasl8 based on the second scenario a potential takeover bidfrom Weyerhauser But TJ shares then fell back sharply falling aslow as $213frasl8 based on the emerging consensus that TJ would prob-ably buy out the 49 percent Trus Joist stake from Weyerhauser

A superstock observer who noted that Weyerhauser was themajor distributor for Trus Joistrsquos 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 TJInternational

On November 23 1999 just 5 months after it bought MacMillanBloedel Weyerhauser agreed to buy TJ International for $42 pershare TJ International jumped $93frasl8 (or 22 percent) in one day as aresult of the bid which was nearly 100 percent premium to TJrsquos stockprice just 4 months before

OTHER THINGS TO LOOK FOR

In addition to these telltale signs that a formerly sleepy and over-looked stock is about to become a superstock takeover candidateyou 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

102 PART TWO Identifying Takeover Targets

Chap 10 7901 855 AM Page 102

clues are available by simply listening carefully to companies that areactively acquiring other companies

USING THE VICKERS WEEKLY INSIDER REPORT TOFIND AND TRACK ldquoBENEFICIAL OWNERSrdquo

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 ownerRexel SA a browsing coup that led to a 119 percent profit

The Vickers Weekly Insider Report is available by mail and alsoonline Published by Argus Research the report is a summary ofbuy and sell transactions by corporate ldquoinsidersrdquo (officers and direc-tors) and also outside ldquobeneficial ownersrdquo of 10 percent or more ofa companyrsquos stock (see Figure 10ndash1)

Of particular interest is the ldquobeneficial ownerrdquo transactionsWhen an outside investor accumulates 5 percent or more of a com-panyrsquos 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 ldquoinvestment purposes onlyrdquo 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 ldquomaximizingrdquo orldquoenhancingrdquo shareholder value

In the Vickers Weekly Insider Report look for outside beneficialowners that are accumulating additional shares on the open marketWhen 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

CHAPTER TEN Create Your Own ldquoResearch Universerdquo of Takeover Candidates 103

Chap 10 7901 855 AM Page 103

Simply sitting in a comfortable spot with a highlighter and a penand browsing through the entire Vickers Report each week high-lighting those beneficial owner (BO) transactions that seem inter-esting and making notations relating to names you have seen before

104 PART TWO Identifying Takeover Targets

F i g u r e 10ndash1

Sample of Vickers Weekly Insider Report

Chap 10 7901 855 AM Page 104

(or never seen before) will often lead to new and profitable ideasyou would not have otherwise encountered

For one thing yoursquoll 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 see

There 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 freeedgarcom 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 company

But there are connections that would not show up in a normal13-D filing or through a search of 13-Drsquos only

For example one key reason to use the Vickers Weekly InsiderReport is that it focuses on ldquoForm 4rdquo 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 ldquoin theknowrdquo stockholders than you would get simply by focusing on 13-D filings by outsiders

You may notice for example heavy insider buying by officersand directors in a company where an outside beneficial owner isalso accumulating sharesmdasha 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

CHAPTER TEN Create Your Own ldquoResearch Universerdquo of Takeover Candidates 105

Chap 10 7901 855 AM Page 105

You 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 industrywhich raises the possibility that something bullish is going on in thatparticular industry that has not yet been perceived by the market

Or you may notice heavy insider buying andor outside ben-eficial owner buying in a stock where you have previously noticeda potential ldquosuperstock breakout patternrdquo (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 whileyoursquoll 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 browse

Let me give you a real-life example that illustrates the useful-ness of this tool

CASE STUDY SPOTTING BRYLANE AS A TAKEOVERTARGET

In 1997 Vickers reported a purchase of 429400 shares of a companycalled Brylane Inc by an outside beneficial owner Pinault Printemps-Redoute SA The Vickers data indicated that Pinault-Printemps hadpurchased these Brylane shares between June 3 and June 30 1998 atprices ranging from $453frasl4 to $51 Brylane was added to the potentialldquoresearch universerdquo of stocks to look into and monitor on a regularbasis

A few weeks later the following transaction appeared

BLACKROCK INVT S-1756 JULY29 rsquo98 81frasl2 0 SABATH KAREN H SEC

BORG WARNER D-400 X JULY30 rsquo98 487frasl16 100 X DRUMMOND JERE A DIR

BRYLANE INC B-128300 X JULY 1-28 rsquo98 401frasl4-453frasl4 8568617 PINAULT-PRNTMPS RDT SA BO

BUCKLE INC S-20200 JUNE 5-28 rsquo98 5411frasl16-557frasl8 NA NELSON DENNIS H PR

And a few weeks after that these transactions appeared

BRUSH WELLMAN B-5000 AUG 5-10 rsquo98 163frasl18-171frasl2 10000 ROBERTSON WILLIAM R DIR

BRUSH WELLMAN B-8700 Aug 3-04 rsquo98 157frasl8-16 17200 HARNETT GORDON D CB

106 PART TWO Identifying Takeover Targets

Chap 10 7901 855 AM Page 106

BRYLANE INC B-25000 AUG21 rsquo98 25 8808017 KRAMER HARTMUT

BRYLANE INC B-8000 AUG25 rsquo98 263frasl4 6000 JOHNSON WILLIAM C DIR

BRYLANE INC B-2000 AUG21 rsquo98 243frasl4 6000 STARRETT PETER M DIR

BRYLANE INC B-214400 X AUG13-19 rsquo98 245frasl8-383frasl4 8783017 X PINAULT PRNTMPS RDT SA BO

BUCKEYE PARTNERS B-5000 AUG25-26 rsquo98 2615frasl16-27 40000 BUCKEYE MGMT CO PART

Here 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 429400 shares in Junetook place at prices as high as $51 By July Pinault-Printemps wasbuying Brylane shares as low as $401frasl4 By mid-August Pinault wasin the open market buying additional Brylane shares as low as $245frasl8mdashless 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 and2000 shares respectively at $263frasl4 and $243frasl4

The continuing large purchases by Pinault-Printemps com-bined with the apparently large decline in Brylanersquos 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 intomdashright now

A chart 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 fastmdashafter all individual stocks are collapsingevery day on Wall Street and itrsquos 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 quickly

By 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 managementand they are therefore well-aware of how things are going and whatthe companyrsquos prospects are

Usually though when you see an outside beneficial owner step-ping into the open market to buy big blocks of stock you assume he

CHAPTER TEN Create Your Own ldquoResearch Universerdquo of Takeover Candidates 107

Chap 10 7901 855 AM Page 107

or she has reached an informed conclusionmdashie 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 opinion

When you add insider buying into the mixmdashie when you seeofficers and directors buying shares along with the outside benefi-cial owner at a certain price levelmdashyou have a double-barreled voteof confidence that a stock has reached a compelling price point interms of its value as a business

Apparently 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$38 and $245frasl8

Two Brylane directors also thought the stock was a great valueat $243frasl4 and $263frasl4

Yet in a breathtakingly short period of time Brylane hadplunged all the way to the $14 to $15 area

So 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 thoughtBrylane was a good value all the way down from $51 to $245frasl8 whywouldnrsquot it consider buying the rest of the company now that thestock had fallen to $14

For all of these reasonsmdashand to answer all of these questionswhich emerged as a result of browsing through the Vickers WeeklyInsider Reportmdashwe 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 Itrsquos 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 rangeor base pattern which indicates that buyers are finally stepping inand that the supplydemand situation is coming back into balance

So why would you try to catch this falling piano Because Brylanewas 4753 percent owned by a French company Pinault-Printemps-RedouteSA the parent company of Rexel SA

Thatrsquos rightmdashPinault-Printemps turned out to be the parent compa-ny of Rexel SA of France the very same outside beneficial owner that

108 PART TWO Identifying Takeover Targets

Chap 10 7901 855 AM Page 108

methodically 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 companya major catalog retailer that published among others catalogs forSears Lane Bryant (thus the name of the company) Lerner andChadwickrsquos Thirteen months after Brylanersquos February 1997 publicoffering Pinault-Printemps purchased a 437 percent stake in Brylanefor $51 per share

Shortly 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 1998Brylane dropped 111frasl2 points to $243frasl4 on news that sales of the compa-nyrsquos 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 masse

Shortly after Brylane stock plunged 111frasl2 points in one day the com-pany announced a $40 million stock buyback This 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 ldquoEighteenTelltale Signsrdquo numbers 8 and 9 earlier in this chapter)

But even though Pinault-Printemps several Brylane insidersand Brylane itself all apparently believed that the stock was a greatvalue in the mid-to-high $20s Brylane shares were blasted again onSeptember 24 and 25 1998 following another analyst downgradeand earnings estimate reduction

This second price plunge took the stock down to the $14 to $15area

Research into Brylane revealed that Pinault-Printemps hadagreed to a ldquostandstill agreementrdquo which limited Pinault to own-ing a maximum of 475 percent of Brylane for three years endingApril 3 2001

Normally a ldquostandstill agreementrdquo might be viewed as animpediment to a takeover However thatrsquos not always the case

CHAPTER TEN Create Your Own ldquoResearch Universerdquo of Takeover Candidates 109

Chap 10 7901 855 AM Page 109

Further research into Pinault-Printemps revealed this company tobe Europersquos third-largest mail order company Pinault was a companythat generated $145 billion per year in revenues So paying $300million or so for the rest of Brylane which operated a mail orderbusiness that obviously fit right into Pinaultrsquos business mix did notseem like a very big dealmdashespecially in view of the fact that Pinaulthad paid $51 for its original stake over three times what Brylanewas trading for in October 1998

As a superstock investor you could have taken a gradual andpatient approach with Brylane Tax-loss selling could have hurt thestock as year-end approached since it is indeed tough to catch aldquofalling pianordquo But all of Wall Street loved Brylane at $61 Nowclose 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 thistime at a price of $1515frasl16 In December Brylane had once again issuedan earnings warning and the stock had retreated to the $10 to $11 areaAt these low prices it would be a safe guess that Pinault-Printempsthe French company that owned that 475 percent stake should atleast be thinking about a potential takeover bid

Several 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 Report and 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 SA of Francea company that had already taken over one of my previous takeoverrecommendations

A combination of experience and research together with thefact that Brylane itself and Brylane insiders were buying stock onthe open market right along with Pinault-Printempsmdashtwo of the

110 PART TWO Identifying Takeover Targets

Chap 10 7901 855 AM Page 110

TEAMFLY

Team-Flyreg

Telltale Signs I always watch formdashcreated a logical and compellingsuperstock takeover candidate

That is how you use the Vickers Weekly Insider Report

CASE STUDY SAM HEYMAN AND DEXTER CORP

Experienced 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 notAnnouncers can usually determine which horses are looking ldquostrongrdquoand 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 characteristicsthrough 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 thehorsesrsquo strides how high the jockeys are riding in the saddle whetherthe reins are loose or taut the position of the jockeysrsquo 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 outcome

Experience is an invaluable asset when you are browsing forsuperstock takeover candidates The more you browse the moreyoursquoll notice and the more you notice the more yoursquoll be able tomake certain connections that other investors will be unable to makeGiven the identical set of circumstances yoursquoll see something thatothers do not see and you will be able to see a high probability of acertain outcome and thatrsquos where you gain your edge Each expe-riencemdasheven those that do not turn out profitablymdashwill lay thegroundwork for future experiences Eventually yoursquoll find yourselfextrapolating a certain set of circumstances all the way to their log-icalmdashand profitablemdashconclusion

Dan Dorfman one of the most respected financial reporters onWall Street and the former author of The Wall Street Journalrsquos ldquoHeardon the Streetrdquo column was writing a column for Jagnotescom whenhe called me on November 1 1999 His request was straightforward

CHAPTER TEN Create Your Own ldquoResearch Universerdquo of Takeover Candidates 111

Chap 10 7901 855 AM Page 111

enough He asked me to list my top three takeover candidates in thecoming 12 months I offered the following three stocks Ersquotown Corpa 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 Ersquotown jumped 10 points in one day fol-lowing a bid from Thames Water PLC of Britain (For more on theErsquotown takeover and the reasoning that went into it see Chapter 18)

The other company to receive a takeover bid was Dexter CorpDexter 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 Barronrsquos I noticed that International Specialty Products (ISP)had purchased 365200 shares of Dexter at prices ranging from $3625to $3863 per share giving ISP a total of 1996900 shares or 867 per-cent of Dexterrsquos outstanding shares

Many if not most of the 13-D filings reported in Barronrsquos 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 threat

In browsing through these filings each week it helps to lookfor 13-D filers who are either corporationsmdashie real businesses whomay want to acquire another businessmdashor individuals who for onereason or another seem to have the ability the inclination or bothto mount a takeover bid

Another 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 playermdashie 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 way

In 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 ldquolife sci-encesrdquo industry where LTEK operated had seen a wave of takeoversWhat really sparked the LTEK recommendation as a takeover targethowever was a simple statement found in a series of Dexter pressreleases Press releases are yet another useful tool that can help you

112 PART TWO Identifying Takeover Targets

Chap 10 7901 855 AM Page 112

get a feel for a company and its thinking in terms of either acquiringcompanies or selling itself to someone else In one of Dexterrsquos releasesthe company said that it was actively seeking acquisition candidates

Now 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 company

It seemed pretty logical that LTEK might be on Dexterrsquos radarscreen as a takeover target and that Dexter might bid for the 47 per-cent of LTEK it did not already own

Soon 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 LTEKshareholders Dexter eventually raised its bid to $391frasl8 Part of beinga superstock investor is knowing when to sell and that was the rec-ommendation made for this stock at this point in time

It had been a year since the LTEK takeover and now somebodyhad filed a 13-D on Dexter and was raising its stake

Research 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 lot

I 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 wage

In 1982 long before the term ldquohostile takeoverrdquo 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 GAFrsquos assets were worth far more than its stock priceand that GAFrsquos management was not running the company in amanner that was making optimal use of those assets

In other words to put it bluntly Samuel Heyman thought thatGAFrsquos management was doing a lousy job and that he could do

CHAPTER TEN Create Your Own ldquoResearch Universerdquo of Takeover Candidates 113

Chap 10 7901 855 AM Page 113

better Heyman announced that he intended to wage a proxy fightto replace GAFrsquos management and that he would then embark on aprogram to maximize GAFrsquos value for its shareholders

Today 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 1982Samuel 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 GAF

Wall 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 Heymanrsquosbattle with GAF was viewed with a combination of amusement anda decided lack of respect in the investment community

GAF meanwhile was not amused and its management reactedangrily to Sam Heymanrsquos audacity GAF questioned Heymanrsquos credi-bility and management abilities and generally scoffed at the idea thatHeyman and his inexperienced group of outsiders could unseat GAFrsquoswell-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 stockholders

Heyman won the proxy fight ousted GAF managementrestructured the company liquidated some assets and completely fol-lowed through on everything he said he would do Along the wayhe accumulated a 99 percent stake in Union Carbidemdashan especial-ly audacious move since Union Carbide was many times larger thanGAFmdashand actually threatened to take Union over GAF made a hugeprofit on its Union Carbide stock GAF had soared to $67 a share again of 375 percent in 21frasl2 years Heyman ultimately took GAF privatein 1989 then sold 20 percent of International Specialty Products aGAF subsidiary to the public in 1991

Now 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

114 PART TWO Identifying Takeover Targets

Chap 10 7901 855 AM Page 114

was 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 growthThis was one of the major reasons Dexter had made the takeover bidfor the 47 percent of Life Technologies it did not ownmdashDexter hopedthat LTEKrsquos high-growth business would inject some badly neededexcitement into a stock that was being neglected by Wall Street

There was more to the Dexter situation than met the eye especiallyto someone looking at this situation in terms of a potential superstocktakeover target First 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 Streetbecomes a superstock because itrsquos a takeover target

These 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 ldquoscreenrdquo that directs investorsrsquo 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 companyrsquos 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 unappealingmdashprovided you can see the potential of some sortof ldquocatalystrdquo that would force the stock market to recognize the inherentvalue in these situations

Dexter had a catalyst and his name was Samuel Heyman Herewe had a company operating in a consolidating industry where anoutside beneficial ownermdashHeymanmdashwas accumulating shares onthe open market Even better the outside beneficial owner had a his-tory of acquiring companies

CHAPTER TEN Create Your Own ldquoResearch Universerdquo of Takeover Candidates 115

Chap 10 7901 855 AM Page 115

But there was even a more interesting twist to the DexterndashSamHeyman story that convinced me absolutely and without a doubt thatHeyman and International Specialty Products would soon be making ahostile takeover bid for Dexter Corp

It turned out that a group led by Sam Heyman and InternationalSpecialty Products had been major stockholders of Life Technologiesa year earlier when Dexter angered LTEKrsquos shareholders by makinga takeover bid that was perceived to be too low

The controversy over Dexterrsquos bid still lingered Actually I hadstopped following Life Technologies after Dexterrsquos takeover bid CherrieMahon went back and pieced together the chain of events that had cul-minated in Sam Heymanrsquos steady accumulation of Dexter shares onthe open market I discovered that following Dexterrsquos offer for LTEKtwo directors of Life Technologies resigned because they believed thatDexterrsquos bid was too low Remember Dexter already owned 53 per-cent of LTEK which put it firmly in the driverrsquos seat Life Technologiesformed a special committee to evaluate the Dexter bid they retainedGoldman Sachs which estimated that LTEK was worth as much as $60per share compared to Dexterrsquos upwardly revised bid of $391frasl8 Dextermeanwhile had retained Merrill Lynch which said that Dexterrsquos $391frasl8offer was fair and reasonable The discrepancy between Goldmanrsquosestimate of LTEKrsquos value and Merrill Lynchrsquos value estimate proves thatvalue like beauty is in the eye of the beholder

Then again it may prove something else Dexter armed witha ldquofairnessrdquo opinion from Merrill Lynch and having proved thatcomparison shopping can save you money on Wall Street proceed-ed with its $391frasl8 per share tender offer for Life Technologies Theoffer attracted another 18 percent of LTEKrsquos shares giving Dexter atotal of 71 percent of the company

Meanwhile the rest of LTEKrsquos 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 LTEKrsquos 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 OTCldquoBulletin Boardrdquo because there were not enough public sharehold-ers left to qualify for NASDAQ listing

116 PART TWO Identifying Takeover Targets

Chap 10 7901 855 AM Page 116

And 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 itmdasha group led by Samuel Heyman and Inter-national Specialty Products

Thatrsquos 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 Dexterrsquos takeover bid for LifeTechnologies Not only that Heyman and ISP actually went into theopen market to purchase additional Life Technologies shares just asthe Dexter tender offer was expiringmdashand they paid more for LTEKstock than the value of Dexterrsquos bid which amounted to one morethumb of the nose at Dexter and a clear signal that Heyman was notgoing to take this lying down

During December 1998 the same month that Dexterrsquos bidexpired International Specialty Products went into the open marketand bought 1471320 LTEK shares paying as high as $3928 per shareOther investors associated with Sam Heyman and ISP also 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 LTEKrsquos remaining public ldquofloatrdquo

To someone who did not know Sam Heymanrsquos history the factthat Heyman and ISP were now buying Dexter shares on the openmarket may have had little or no meaning In fact there was noshortage of analysts who dismissed Heymanrsquos 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 ISP was so highly leveragedthat it would not be able to obtain the financing for an offer

But Sam Heyman did not operate that way Heyman was notlooking for Dexter to ldquobail him outrdquo 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 valuemdashinclud-ing Dexterrsquos stake in Life Technologiesmdashand 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

CHAPTER TEN Create Your Own ldquoResearch Universerdquo of Takeover Candidates 117

Chap 10 7901 855 AM Page 117

Sam Heyman was serious was that ISP had been selling off its ldquonon-corerdquo operations

The conclusions reached from all of this were that Sam Heymanwas trying to put Dexter ldquoin playrdquo and either ISP or a group head-ed by ISP or possibly a third party would soon be making a takeoverbid for Dexter Heymanrsquos intent toward Dexter would be what WallStreet would call hostile and ISP would attempt to gain control ofDexter sell off various Dexter operations that it did not want retainsome of Dexterrsquos specialty chemicals operations that fit the ISP busi-ness profile and possibly sell off the LTEK stake to another bidderwilling to pay a more reasonable (and much higher) price

Sam Heyman went into the open market to purchase additionalDexter shares raising his stake to 998 percent of the company andhe filed a notification that he intended to raise his stake to at least 15percent

Dexter responded by lowering the threshold of its ldquosharehold-er rightsrdquo plan from 20 percent to 11 percent Under the terms of theplan a ldquopoison pillrdquo would kick in if any outside person or grouppassed the 11 percent ownership threshold without Dexterrsquos 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 impossible

Meanwhile Dexter shares were drifting slowly but surely downtoward that $30 to $33 support area that I advised subscribers towatch for

This was yet another example of Wall Streetrsquos remarkable abil-ity to overlook the obvious in spending its time obsessing over ahandful of high-profile ldquomomentumrdquo stocks while ignoring virtuallyeverything else

On Friday December 11 1999 Dexter closed at $329frasl16 On thattrading day Dexter was just another basic industry ldquovaluerdquo stock withuninspiring revenue and earnings growth of little or no interest totrendy ldquomomentumrdquo investors seeking to beat the stock market

On Monday December 14 1999 Dexter was the best-performingstock on the New York Stock Exchange soaring 85frasl8 points or 265 per-cent in a single day In other words Dexter had become a superstock

Why

118 PART TWO Identifying Takeover Targets

Chap 10 7901 855 AM Page 118

Because Sam Heymanrsquos International Specialty Productsannounced a hostile $45 per share takeover bid for Dextermdashatakeover 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 bid

And it certainly came as no surprise to anyone who knew any-thing about Sam Heyman

You probably think this is the end of the Dexter story In fact themost lucrative part of the story was yet to come

Following Sam Heymanrsquos $45 bid for Dexter Dexter stock spent thenext 4 months trading within a range of $34 and $40 The Wall Streetanalytical community you see still did not take Sam Heyman seri-ously

Following the jump in Dexterrsquos stock price to $413frasl16 which wasstill nearly 4 points below the value of Sam Heymanrsquos takeover bidDexterrsquos stock began to erode again because analysts openly ques-tioned (1) whether Heyman was seriously trying to buy Dexter and(2) whether Heyman and ISP had access to the financing to actual-ly do the deal

It took Dexter nearly two weeks to respond to Heymanrsquostakeover bid Finally in a letter that literally dripped with sarcasmand insults Dexterrsquos Chairman and CEO K Grahame Walker reject-ed Heymanrsquos offer calling it ldquoinadequaterdquo

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 Heymanrsquos true motiva-tionmdashas though a securities analyst had any insight into whatHeymanrsquos actual intentions were

Walker then laid into Heyman for ldquoopportunistically interven-ingrdquo to frustrate Dexterrsquos objective of acquiring Life Technologies Heaccused Heyman of ldquoinviting himselfrdquo to a meeting with Dextermanagement and ldquodisregarding the interests and welfarerdquo of Dexterrsquosstockholders an ironic charge when one considers how this situationultimately turned out

Walker concluded his letter by suggesting to Heyman that ldquowefervently hope (and strongly recommend) that you return your man-agerial focus to your own companies leaving the stewardship ofDexter where it belongsrdquo

CHAPTER TEN Create Your Own ldquoResearch Universerdquo of Takeover Candidates 119

Chap 10 7901 855 AM Page 119

In January 2000 we offered the following analysis of the situation

The stock market is reacting to this takeover bid with caution As thisis written Dexter is trading around $381frasl4 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 ofDexterrsquos letter to Heyman is only likely to take this battle to another leveland my view is that Dexter will ultimately be bought by ISP or a third partymore to Dexterrsquos 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 lowering the threshold of itsldquopoison pillrdquo to pointedly single out Heyman and prevent him fromincreasing his stake in Dexter they had thrown down the gauntletto the wrong guy virtually guaranteeing a hostile bid Then by send-ing such a condescending letter in response to Heymanrsquos $45 takeoverbid they had very likely ticked him off again Based on everythingI knew about Heyman it was very clear to me that this sort of arro-gant responsemdashwhich was precisely the sort of response Heymanreceived from GAF back in the 1980smdashwould only serve to makeHeyman more determined to win this fight

Then on January 20 Dexter made its other blunder by offeringto buy the remaining publicly traded shares of Life Technologies at$49 a sharemdasha price $10 higher than it had previously paid the restof LTEKrsquos 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 offerthe overwhelming interpretation on Wall Street was that Dexter wastrying to get Heyman to drop his bid by offering him a premiumprice on his LTEK shares

Here is a perfect example of how a superstock investor whounderstood the history and motivations of Sam Heymanmdashand whostopped to think about how Heyman could benefit most from thissituationmdashcould look at precisely the same set of circumstances aseveryone else on Wall Street and come to a diametrically opposedmdashand absolutely correctmdashconclusion If Heyman accepted the Dexteroffer for his LTEK shares the value of Heymanrsquos Dexter stock wouldundoubtedly drop further once the takeover threat evaporated

120 PART TWO Identifying Takeover Targets

Chap 10 7901 855 AM Page 120

TEAMFLY

Team-Flyreg

And 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 Heymanrsquos Life Technologiesshares smelled an awful lot like ldquogreenmailrdquo 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 bid

The target company would then essentially bribe the raider togo away by offering the raidermdashbut not the public shareholdersmdashapremium 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 ldquogreenmailrdquo deal was announced the stock of the target companymdashwhich had risen on word of the takeover bidmdashwould plunge leav-ing the public shareholders holding the bag The raider meanwhilewould pocket a huge profit and move on to the next victim

Greenmail 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 mannerThis put an end to greenmail

If Dexterrsquos 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 Heymanrsquos his-tory remembering that he had more at stake in Dexter than in LTEKand realizing that to Heyman this was not only a matter of princi-ple but also a financial question to be decided in a rational mannera superstock investor would have come to the clear conclusion thatthe smart move was for Heyman to reject Dexterrsquos 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 Dexter

On 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

CHAPTER TEN Create Your Own ldquoResearch Universerdquo of Takeover Candidates 121

Chap 10 7901 855 AM Page 121

Technologies offer inappropriate under the circumstancesmdashwhich isprecisely the response one would have expected from a man likeHeyman in a situation like this

ldquoIt is apparent from the timing of Dexterrsquos offer for our LifeTechnologies shares coming on the heels of ISPrsquos $45 per share offerfor Dexter that Dexter is seeking to divert ISP from a course ofaction designed to maximize shareholder values for all Dexter share-holdersrdquo Heyman wrote ldquoIn this connection we believe thatDexterrsquos attempt to deter us by providing benefits to ISP not avail-able to other shareholders is simply inappropriaterdquo

Heyman also called the Dexter bid for Life Technologies in 1998ldquoan attempted squeeze-out of LTEKrsquos minority shareholdersrdquo whichonce and for all made Heymanrsquos motivation in this situation crystalclear He was paying Dexter back in spades for what he perceivedas Dexterrsquos mistreatment of ISP in the Life Technologies tender offer

In the letter Heyman also informed Dexter that ISP wouldlaunch a hostile proxy fight in which it would nominate a slate ofdirectors to Dexterrsquos board He also told Dexter that Chase Securitieshad agreed to provide the funds for the acquisition and he noted thatISPrsquos stake in Dexter amounted to ldquomore than five times that held byDexterrsquos entire boardrdquo a pointed reference to the question of whichslate of directors had the most incentive to act in the best interests ofthe shareholders

Heyman 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 ourmotivesmdashwhich by the way I do not appreciate

All the best Samuel J Heyman

Heymanrsquos rejection of the Dexter bid for Life Technologiesresulted in a jump in Dexter shares back to the $38 to $39 areamdasha nicebounce to be sure but still far lower than the $45 takeover bid

When 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

122 PART TWO Identifying Takeover Targets

Chap 10 7901 855 AM Page 122

situation the more likely that the target company will wind up being acquiredusually by a third party Even 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 deterredthe target company is usually left with only one alternative findanother bidder more to its liking willing to pay a higher price thanthe hostile suitor

Proving once again that things change on February 28 2000Dexter announced that it would open up its books and records toother third parties and that it had hired Lehman Brothers Holdingsto ldquoexplore a possible merger sale or restructuring or the spinoff orsale of a business unitrdquo

Dexterrsquos shares jumped $49frasl16 or 12 percent to $42mdashstill wellbelow Sam Heymanrsquos lowball $45 takeover bid

In 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 somebody

Even now following Dexterrsquos announcement that it will entertainpotential takeover bids from other buyers Dexter shares are tradingbelow ISPrsquos $45 per share lowball bid lower than they should beunder the circumstances By the time this soap opera plays itself outI think Dexter shareholders will receive $55 a share or more for theirstock and that one of three things will happen (1) Mr Heyman andISP will 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 andor stock toshareholders on a tax-free basis thereby passing through the truevalue of Life Technologies and Dexterrsquos other assets to the stock-holders

On March 23 2000 ISP raised its takeover bid to $50 ldquobased on ourevaluation to daterdquo of Dexterrsquos books and said it might raise the offereven further if its continuing evaluation warranted such a price increase

The continuing hostility between Dexter and ISP made it quiteobvious that Dexter would move heaven and earth to avoid beingpurchased by Sam Heymanrsquos group Dexter shares jumped to a highof $561frasl4 then fell back to the low 50s again as the general stock mar-ket slumped At their highs of $561frasl4 Dexter shares were already up53 percent from my original recommended pricemdashand the final actin this superstock drama was yet to unfold

CHAPTER TEN Create Your Own ldquoResearch Universerdquo of Takeover Candidates 123

Chap 10 7901 855 AM Page 123

Finally on September 14 2000 Dexter shareholders approvedthe sale of Dexter to Invitrogen Under the terms of the takeoverDexter shareholders were offered $6250 per share

The Dexter opportunity came about from a 13-D filing in Barronrsquosinvolving 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

124 PART TWO Identifying Takeover Targets

Chap 10 7901 855 AM Page 124

C H A P T E R E L E V E N

How to Use the Financial Press

There is a growing tendency for the media to downsize categorizeanalyze and trivialize the newsmdasha sorry trend that panders to thedesire of an American public suffering from information overloadto have the news prefiltered explained and generally oversimplified

When 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 opinionmdasha 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 ideas

The financial media is becoming increasingly infected with thisinformation virus because it has learned that many investorsmdashespe-cially those who have only recently become enamored with the stockmarketmdashwould prefer to believe their research ldquohomeworkrdquo can beeasily done for them and the process of making money on Wall Streetis really not all that difficult

Certainly 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 ldquomomentumrdquo stocks you hear about day in and day

125

Chap 11 7901 856 AM Page 125

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

out based on the premise that todayrsquos market leaders will be tomor-rowrsquos 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 alone

The 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 Cafter 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 IBM

When 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 yearmdashan amaz-ing story especially in terms of risk and rewardmdashwhich 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 place

Some of the best sources to browse are Investorrsquos Business DailyThe Wall Street Journal and The New York Times Business Day section

Investorrsquos Business Daily (IBD) published by William OrsquoNeil andCompany in Los Angeles is a pioneer of financial journalism In

126 PART TWO Identifying Takeover Targets

Chap 11 7901 856 AM Page 126

many important ways IBD is a unique and highly useful sophisti-cated publication that has made giant inroads into areas where TheWall Street Journal has 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 ldquospikesrdquo 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 IBD

But when it comes to actually reporting the financial news IBDis sort of the USA Today of financial journalism Everything is report-ed in sound bites Whatrsquos worse IBD has become a prime exampleof the ldquoBig Brotherrdquo approach to financial journalism that is makingit increasingly difficult to find the sort of original ideas that wersquorelooking for as superstock browsers Because of this if yoursquore goingto be looking for off-the-beaten-path stock ideas you will not be ableto rely solely on IBD for all the information you need

As I said IBD has taken it upon itself to become your ldquoBigBrotherrdquo information filter directing its readers toward the popu-lar high-profile relative strength ldquomomentumrdquo stocks and steer-ing them firmly awaymdashlike a parent with an all-knowing guidinghandmdashfrom the lower-priced thinly traded stocks that might getyou in trouble IBDrsquos attitude is that the big winners come from acertain ldquogene poolrdquo 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 volumeand limited upside potential

In an incredibly bold move that stands as possibly the ultimateexample of Big Brother financial journalism on October 19 1998IBD proudly announced that it was taking its stock tables ldquoto thenext levelrdquomdashIBD did not specify in what directionmdashby exiling low-priced low-volume stocks to the financial netherworld In a frontpage story written by IBD chairman and founder William OrsquoNeilIBD 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

CHAPTER ELEVEN How to Use the Financial Press 127

Chap 11 7901 856 AM Page 127

When 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 Cainersquos 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 endangered

To Investorrsquos Business Daily these ldquoDirty Rotten Stocksrdquo 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 themmdashsort 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 them

As William OrsquoNeil explained in his articles to IBD readers ldquoWithmore than 500 initial public offerings added a year the tables getlonger and get harder to scan for future big winnersrdquo

Good Heavens Too much informationTherefore ldquoTo save you time we will separate lower-priced

and less active NYSE and NASDAQ stocks from the main tablesThese tables show NYSE and NASDAQ stocks priced at $7 or belowor trading less than an average of 10000 shares a dayrdquo

Later in the article Mr OrsquoNeil gets around to explaining the realreason for IBDrsquos decision to banish lower-priced and less-popularstocks to the financial dungeon ldquoStudies have shown that most stockspriced below $7 or trading less than 10000 shares a day have lowerquality less institutional ownership or weaker recent performanceThey usually carry greater risk or offer less long-term potentialrdquo

There are several problems with this logic that superstockinvestors should be aware of For one thing the term ldquolower quali-tyrdquo 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 trend

And yet if you had looked for water utility stocks likeConnecticut Water Service (CTWS) in the main NASDAQ stock list-ings carried in IBD you wouldnrsquot have found it because its tradingvolume fell below the respectability line which makes this stock

128 PART TWO Identifying Takeover Targets

Chap 11 7901 856 AM Page 128

riskier 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 ldquograduatedrdquo to IBDrsquos more respectable neighborhood Butwhen Middlesex was neglected and a much better value it was stilllisted in the dungeon section

Or 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 ldquopure playrdquo 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 theldquocrimerdquo of having average daily trading volume of less than 10000shares Pittway had been exiled to the IBD ldquoDirty Rotten Stocksrdquolist Barely a month later Pittway soared 16 points in one day to $45(+55 percent) following a takeover bid from Honeywell (see Figure11ndash1) Also in November 1999 the IBD dungeon list was pepperedwith numerous low-priced energy stocks Their only ldquocrimerdquo 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 A number of low-priced health care stockswere also on the list just before this group returned to favor in 2000In IBDrsquos eyes all of these stocks were of lesser quality than sayStampscom (STMP) which was trading at $9850 in November 1999and had a market cap of $35 billion with zero revenues STMP wasright there on the ldquorespectablerdquo mainstream list even though it wason the verge of making a stunningly swift trip down to $250 a sharea decline of 97 percent Pricelinecom (PCLN) was on the ldquorespect-ablerdquo list too before it dropped from $150 to $119 along with count-less other Internet stocks with out-of-this-world valuations that ulti-mately crashed Of course you can prove anything with 2020hindsight 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

CHAPTER ELEVEN How to Use the Financial Press 129

Chap 11 7901 856 AM Page 129

of the information you will need to implement this approach willnot be easily accessible to you and some of it may not be availableat all

And since when does ldquoless institutional ownershiprdquo translateinto the financial version of The Scarlet Letter To a genuine super-stock sleuth that is the whole point A dearth 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

130 PART TWO Identifying Takeover Targets

F i g u r e 11ndash1

Sample of Investorrsquos Business Dailyrsquos Section ldquoWherethe Big Moneyrsquos Flowingrdquo

Source Investorrsquos Business Daily December 21 1999

Chap 11 7901 856 AM Page 130

TEAMFLY

Team-Flyreg

The crime of ldquoweaker recent performancerdquo 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 here

IBD 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 stockswith 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 thanInvestorrsquos Business Daily to get all of the information you need

Another problem with Investorrsquos Business Daily is that in itsongoing drive to categorize everything the newspaper often allowssignificant news items to fall through the cracks In contrast IBDrsquosldquoTo the Pointrdquo section which appears on page 2 of the newspaperis 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 candidates

But 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 ldquoComputers amp Techrdquo ldquoTelecomrdquo ldquoInternetrdquo ldquoMedicalrdquo and othersuch groupingsmdashin 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 moment

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 itrsquos not available In November1999 for example Ersquotown Corp a NYSE-listed New Jersey-basedwater utility which we discussed earlier agreed to be acquired byBritainrsquos Thames Water PLC Ersquotown 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 Ersquotownrsquos stock price jump Ratherit was that the takeover bid for Ersquotown was part of a continuing andastonishingly rapid trend toward takeovers of US water utilitiesmany of which were being acquired by foreign companies eager toestablish a major presence in the US water industry

CHAPTER ELEVEN How to Use the Financial Press 131

Chap 11 7901 856 AM Page 131

The takeover bid for Ersquotown 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 pricesmdashtoonce again repeat this notable phenomenonmdashwas probably the singlemost interesting takeover story of 1999 especially considering the excel-lent riskreward 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 barrel

Immediately preceding the takeover wave in the water utilitystocks five of the nine stocks I recommended in my water utilityldquoWater Worldrdquo portfolio were listed in IBDrsquos second-class stock list-ings presumably too risky andor uninteresting for the averageinvestor to bother with

By the time Ersquotown received its takeover bid the water utilitytakeover trend was in full force Yet the Ersquotown takeover did notmanage to make it into the news section of Investorrsquos Business DailyEither it did not fit the cookie-cutter mold of categories that IBD usedto present its news items on that particular day or Ersquotownrsquos marketcapitalization or industry group was too small andor uninterestingto present to IBDrsquos readers who were constantly being schooled inthe high-profile follow-the-leader momentum school of investing(IBD has since abandoned its news ldquocategorizationrdquo approach)

Compare this total lack of analysis in IBD to the way The WallStreet Journal reported the Ersquotown story The Journal presented a com-plete background report not only on the Ersquotown 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 hadnrsquot alreadynoticed it months before

Despite the efforts of Investorrsquos Business Daily to portray itself asan alternative to the The Wall Street Journal there is really no com-parison between the twomdashespecially 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

132 PART TWO Identifying Takeover Targets

Chap 11 7901 856 AM Page 132

The moral of all of this is that you should not depend on a sin-gle source for all of your businessfinancial information

If 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 ldquoTo the Pointrdquo sec-tion of Investorrsquos Business Daily every day paying special attention tothe smaller seemingly unimportant items You should also scan thefront page of IBD particularly the ldquoIBDrsquos Top 10rdquo section whichcontains IBDrsquos version of the 10 most important business stories ofthe previous day

But that will not be enough and if you want to cover all thebases you should also browse the ldquoCompany Newsrdquo column in TheNew York Times Business Day section ldquoCompany Newsrdquo 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 sleuth

By browsing through certain sections of certain publications likeInvestorrsquos Business Daily and 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 havenrsquot hadthe time to investigate or may have seemed an isolated eventmdashuntilanother seemingly isolated event or piece of information places theprevious item in a new and more meaningful context

The Wall Street Journal is the financial ldquonewspaper of recordrdquo 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 Journal to find it Of coursethe high-profile takeovers spinoffs asset sales and so on will oftenbe discussed on the front page of The Journal in the ldquoBusiness ampFinancerdquo section of the ldquoWhatrsquos Newsrdquo 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 story

Another ldquomust readrdquo section of The Wall Street Journal for super-stock sleuths is the ldquoCorporate Focusrdquo column which appears in Section

CHAPTER ELEVEN How to Use the Financial Press 133

Chap 11 7901 856 AM Page 133

B 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 Journalrsquos ldquoIndustry Focusrdquo columnwhich also appears in the B Section

You never know where you will find interesting and useful infor-mation It often wonrsquot be on the front page of The Journal because themore obscure the information the more useful it will be to you sinceitrsquos less likely that the Wall Street ldquodiscountingrdquo mechanism will havefactored the information into the prices of the stocks involved (TheErsquotown takeover for example did not make the front page)

For example our old friend Pinault-Printemps-Redoutemdashacquirer of both Rexel Inc and Brylanemdashmade the news again inOctober 1999 by buying out the 428 percent of French office supplycompany Guilbert SA that PPR did not already own

You could have learned two things from this story whichappeared in the international section of The Wall Street Journal FirstPPR was still out there acquiring companies in which PPR alreadyowned a stake so this article served as a reminder to keep an eye onPinault-Printempsmdashespecially 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 items

Since 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 notedPPRrsquos partial ownership of Gucci if you did not already know itand added Gucci to your ldquoresearch universerdquo for further study

Among 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

134 PART TWO Identifying Takeover Targets

Chap 11 7901 856 AM Page 134

terms 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 1999

So 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 Swedenrsquos Securitas AB

You should have noticed that Abbott Labs (NYSE ABT) hadenacted a ldquoshareholder rights planrdquo 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 wingsyou 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 companyrsquos true worth

You would also have noticed that an outside shareholder of Dunamp Bradstreet (NYSE DNB) was trying to organize other sharehold-ers in an attempt to prod DNB management to sell the company

And 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 yoursquoll 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 formedmdasha picture that only you and others who thinkas you do will be able to see

CHAPTER ELEVEN How to Use the Financial Press 135

Chap 11 7901 856 AM Page 135

OTHER PLACES TO FIND ldquoTELLTALE SIGNSrdquo OFFUTURE SUPERSTOCK TAKEOVER CANDIDATES

Irsquove noted some of the shortcomings of Investorrsquos Business Daily ButIBD is a unique and innovative publication that provides a greatdeal of information you will not find in any other daily or weeklyfinancial publication

So letrsquos look at some things that IBD does extremely well thatcan be useful to you as a superstock sleuth

There are three sections of IBD in addition to the general newssummaries that are often helpful in the ongoing search for superstocktakeover candidates

Industry Profiles

Investorrsquos Business Daily regularly 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 andor 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 largerhigher-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 thatrsquosfine 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 targets

Another extremely useful aspect of the industry profiles sec-tion is a listing of companies that operate within the industry beingprofiled Headlined ldquoWhorsquos Who in the Grouprdquo 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 IBDrsquos

136 PART TWO Identifying Takeover Targets

Chap 11 7901 856 AM Page 136

industry profile was entitled ldquoPaper Products Tighter SuppliesConsolidation Fuel Upswing in Long-Suffering Industryrdquo 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 amp 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 takeoverpotential

Of course Investorrsquos 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 InsteadIBD lists the companies from top or bottom in terms of stock per-formance andor earnings growth The stocks says IBD are ldquoranked(not lsquolistedrsquo mind you but lsquorankedrsquomdashthis is Big Brother we are talk-ing about remember) by a combination of their earnings per shareand Relative Strength rankingsrdquo

So you will have to do a little reshuffling of the list if you wantto focus on the smaller companies in the group

But thatrsquos a small price to pay for a very useful presentation andI have uncovered quite a few takeover targets by reading IBDrsquos indus-try profiles section on a regular basis

ldquoWhere the Big Moneyrsquos Flowingrdquo

Another useful section of Investorrsquos Business Daily to look at on a reg-ular basis which can contain clues that may direct you to futuresuperstock takeovers is ldquoWhere the Big Moneyrsquos Flowingrdquo (seeFigure 11ndash1) This table which precedes the listings for the NYSEAmerican Stock Exchange and NASDAQ listings is designed to

CHAPTER ELEVEN How to Use the Financial Press 137

Chap 11 7901 856 AM Page 137

highlight stocks with significant increases in trading volume bothon the upside and downside

As 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 ldquoresearchuniverserdquo suddenly pop up on IBDrsquos 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 stock

If a stock has already exhibited one or more of the Telltale Signsof a potential superstock and suddenly begins showing up on IBDrsquoslist 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 ldquofilterrdquo this information for youthat only stocks trading at $18 or higher ($16 or higher on NASDAQ)and moving at least 1frasl2 point will be included in the table (For theAmerican Stock Exchange a stock must be trading $12 or higher andmove at least 1frasl4 point) In addition a stock must trade at least 60000shares to pop up on IBDrsquos NYSE volume-alert table and the stockrsquosEarnings Per Share and Relative Strength Ratingsmdashboth assigned byIBDmdashmust 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 ldquovaluerdquo stock with stagnant earnings pop up on this vol-ume-alert sectionmdasheven if the stock begins acting out of character

Still 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 activity

Charts IBDrsquos ldquoStocks in the Newsrdquo

Another area where Investorrsquos Business Daily is head and shouldersabove The Wall Street Journal is in its presentation of stock charts

138 PART TWO Identifying Takeover Targets

Chap 11 7901 856 AM Page 138

IBD correctly recognizes that technical analysismdashincluding chartanalysismdashis a valuable tool that can be used to your advantageAgain the whole premise of technical analysis is that there willalways be somebodymdashusually many somebodiesmdashwith more infor-mation than you have and this information will usually be put to useeither buying or selling the stock involved

The premise of technical analysis is that while you may notknow what the ldquoinsidersrdquo 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 ldquosuperstock breakoutrdquo 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 ldquoStocks inthe Newsrdquo sections of Investorrsquos Business Daily

IBD has a ldquoStocks in the Newsrdquo chart section for the NYSEAMEX 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 ldquoWhere the BigMoneyrsquos Flowingrdquo IBD provides valuable information in ldquoStocks inthe Newsrdquo

And herersquos another reason to pay particular attention to IBDrsquosstock 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 atmdashor not very far abovemdashkey break-out levels on the chartsmdasha valuable combination of characteristics for our pur-poses which you can only find in Investorrsquos 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 sections The 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

CHAPTER ELEVEN How to Use the Financial Press 139

Chap 11 7901 856 AM Page 139

as a market leader is often a tipoff that some good news such as atakeover is about to break This can often be the final catalyst thatprods you to take the plunge and buy the stock in question

Ersquotown Corp as an example popped up in IBDrsquos NYSE ldquoStocksin the Newsrdquo section just several weeks prior to its takeover bid fromThames Water PLC So did SJW Corp (SJW) in the months preced-ing the announcement that it might put itself up for sale If you hadbeen a superstock browser at the time both of these water utilitieswould already have been very high on your radar screen

Barronrsquos Financial Weekly

One other financial publication you should browse on a regular basisis Barronrsquos You will often find interviews with industry analysts whodiscuss industries where consolidation is taking place Barronrsquos veryoften asks these analysts to zero in on some potential takeover tar-gets You should use these interviews in the same way we are usingmost of the rest of the information discussed here Look for familiarnames that have managed to achieve a spot on your ldquoresearch uni-verserdquo 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 reason

Another important section is Barronrsquos listing of selected Form13-D filings which usually appears in the early pages of BarronrsquosldquoMarket Weekrdquo section Many if not most of the 13-D filings Barronrsquospresents 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 ldquoactivistrdquo 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 inBarronrsquos each week will prove worthwhile on many occasions

CASE STUDY THE TRIPLE PLAY AND MIDWAY GAMES

One 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 companyrsquos officers or directors

140 PART TWO Identifying Takeover Targets

Chap 11 7901 856 AM Page 140

TEAMFLY

Team-Flyreg

The 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-panyrsquos true value than most outsiders And it goes without sayingthat a companyrsquos own management would know better than anyonewhat the underlying fundamentals of a company look like and whatits future prospects might be

When you see a situation where the outside beneficial owner anda companyrsquos officers and directors are consistently buying stock onthe open market this is the ldquodouble playrdquomdasha bullish signal thatshould not be ignored When you also have the company itself buy-ing back stock this is the rare ldquotriple playrdquomdashone of the closest thingsyou will get to ldquoa sure thingrdquo on Wall Street

An example of a ldquotriple playrdquo 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 A man-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 share

Early in 1996 however analysts began to see signs of an earn-ings slowdown Midwayrsquos 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 Midwayrsquos stock collapsed as Wall Streetanalysts began pulling their buy recommendations

As you can see in Figure 11ndash2 Wall Street does not show anymercy when a ldquogrowthrdquo stock stops growing Midway shares plum-meted from near $25 in the spring of 1998 to a low of $75frasl8 by 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 companyrsquos support among the mainstreamWall Street analysts had evaporated A former Wall Street darling inthe high $20s Midway was totally unloved at $8 by January 1999

CHAPTER ELEVEN How to Use the Financial Press 141

Chap 11 7901 856 AM Page 141

Well 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 Midwayrsquos own chairman and CEO Neil Nicastro

Several of Midwayrsquos 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 Midwayrsquos 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 rebound

The analysts did not want to hear it They wanted to know whatwould happen in the next quarter which Nicastro had already

142 PART TWO Identifying Takeover Targets

F i g u r e 11ndash2

Midway Games (MWY) 1997ndash1999

Source Courtesy of Mansfield Chart Service Jersey City NJ

Chap 11 7901 856 AM Page 142

explained 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 1999

But 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 it

Neil 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 businesswhile the analysts were talking abut the short-term momentum (or lackthereof) of a number that appears in The Wall Street Journal every dayMidwayrsquos stock price

Meanwhile something very interesting was appearing in VickersWeekly Insider Report which clearly suggested that Midway share-holders would soon be experiencing better times

The first clue that Wall Street might have been overreacting toMidwayrsquos short-term speed bump appeared in the June 10 1998issue 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 115500 shares atprices ranging from $131frasl4 to $137frasl16 The purchase that really stood outwas a 100000-share buy on the part of Midway chairman Nicastroat $131frasl4 on May 21 1998

These insider purchases combined with an announcement that Midwayitself would buy back 1 million shares of its own stock strongly suggestedthat Midwayrsquos stock price decline was far out of proportion to the short-term earnings problems the company was experiencing When a compa-ny announces a stock buyback it can be misleading Though theBoard of Directors has ldquoauthorizedrdquo a buyback ldquoup to 1 millionsharesrdquo it does not necessarily mean the company will actually buythe shares In most cases the authorization will say that the timing

CHAPTER ELEVEN How to Use the Financial Press 143

Chap 11 7901 856 AM Page 143

andor implementation of the buyback will ldquodepend on the stockprice or market conditionsrdquo 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 ldquoauthorizationsrdquo to buy back shares

However 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 Itrsquos 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 marketrsquos 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 stock

So by the summer of 1998 there was evidence of two-thirds ofa ldquotriple playrdquo 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 ldquotriple playrdquo A few weeks later Midway insiders purchased7500 shares at $137frasl16 another bullish omen

By mid-1998 Midway had dropped below $10 and the Sep-tember 16 1998 issue of Vickers Weekly Insider Report noted moreinsider buying Once again Midway chairman Neil Nicastro had

144 PART TWO Identifying Takeover Targets

Chap 11 7901 856 AM Page 144

purchased a large block of stock this time buying 20000 shares onAugust 31 1998 at $93frasl4 to $97frasl8 Also on August 31 Midwayrsquos VPByron Cook purchased 5000 shares at $107frasl8

It was in September that the last piece of theldquotriple playrdquo 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 Redstonebought 107800 shares at $101frasl2 Then during the second half ofOctober Redstone bought a huge block of 573200 shares at $91frasl4 to$125frasl8 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 setback

And the open market buying did not stop there Nicastro pur-chased another 25000 shares bringing his total purchases to 169000shares And in late November Sumner Redstone bought another 140000shares followed by an additional purchase in early December of 119800shares This brought Redstonersquos total purchases since September 1998 to940800 shares a nearly $10 million commitment to Midway stock which isquite a vote of confidence even for a man of Sumner Redstonersquos means

Itrsquos 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 1998

First 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 and there was heavy insider buyingin the stock were the reasons to not bail out along with everyoneelse on Wall Street Instead I became more aggressive with the stockas it fell because these purchases by Redstone Midway insidersand 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 superstock

Here is a classic case of Wall Street focusing on momentumwhile Redstone Midway chairman Nicastro and other insidersmdashas well as the company itselfmdashwere focusing on Midwayrsquos longer-term value as a business The ldquovaluerdquo assigned to Midway by the

CHAPTER ELEVEN How to Use the Financial Press 145

Chap 11 7901 856 AM Page 145

Wall Street momentum crowd and the analysts who pander to themcompared to the ldquovaluerdquo 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 beholder

To continue with the clues that made Midway a superstock inJanuary 1999 Midway chairman Nicastro bought an additional303950 shares at $8 and Sumner Redstone bought another 80000shares between $81frasl2 and $10 In February however Midway sharestook another plunge falling to the $75frasl8 to $8 range

In 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 analystsrsquo attention to what they believedwould happen in the second half of 1999 which would be the first6 months of Midwayrsquos fiscal year 2000 In particular Nicastro triedto direct the analystsrsquo 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 yoursquore 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 blockbusters

When 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 priceThis 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 you

In 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

146 PART TWO Identifying Takeover Targets

Chap 11 7901 856 AM Page 146

The $64000 question or in this case the $5 million questionwas why had Nicastro spent roughly that amount of his own moneypurchasing 461450 shares of Midway stock over the preceding 12months The Midway chairman said ldquoI believe that at some point themarket will value our business much differently than it values it today Ijust donrsquot 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 stockrdquo

You may have noticed that Neil Nicastro used the phrase ldquovalueour businessrdquo Too often Wall Street treats a stock as nothing morethan a piece of paper Terry Rudd author of the book 1929 Againmakes 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 ldquomomentum investingrdquo 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 ldquostocksrdquo represent shares in a business andbusiness is not always a one-way street Even a true ldquomomentumrdquobusiness a true ldquogrowthrdquo company can hit an occasional potholeor speed bump To a companyrsquos 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 clients

When Cherrie Mahon asked Neil Nicastro ldquoWhy are you buy-ing so much stockrdquo Nicastro said in effect because Midwayrsquos prof-its were going to go back up and Wall Street would be nuts to placesuch a low valuation on this company

Despite Nicastrorsquos comments and the outlook for Midway stockanalysts 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 ldquotriple playrdquo in which an outside beneficial owner companyinsiders and the company itself are all buying stock at the same time

CHAPTER ELEVEN How to Use the Financial Press 147

Chap 11 7901 856 AM Page 147

It also shows a rare behind-the-scenes glimpse at how company insid-ers beat the professional Wall Street analysts and investors at theirown game by simply taking a step back to take a longer-term pointof view In fact ldquolonger-termrdquo in this case only meant 6 to 12 monthsmdashbut to the Wall Street ldquomomentumrdquo 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 perspective

The ultimate outcome of this little drama Midwayrsquos 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 wouldEverything transpired just as he suggested in early 1999mdashin thatsame conference call that led to a rash of analyst sell recommenda-tions virtually at the bottom of Midwayrsquos stock slump

By November 1999 Midway had reached $247frasl8 as earningssoared to record levels and the same Wall Street analysts who hadbeen issuing sell recommendations at the bottom reinstated theirbuy recommendationsmdashat triple the price from Midwayrsquos lows inJanuary or February 1999

So the next time you see a ldquotriple playrdquo 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 itrsquos almost alwaysa signal that you have a potential superstock on your hands and thatthe news is about to get better A lot better

148 PART TWO Identifying Takeover Targets

Chap 11 7901 856 AM Page 148

C H A P T E R T W E L V E

Family Feuds

Herersquos 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 bid In the case of ADTndashWestern 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 investorThe 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 ldquobene-ficial ownerrdquo especially when these disagreements break out into a publicsquabble

Consider the following case study as another example

CASE 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 Copleyrsquosoperations by continuously changing its mind about what it wantedto do with its Copley stake Hoechst said Ms Varis ldquowas demoralizing

149

Chap 12 7901 856 AM Page 149

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

management and depressing shareholder valuerdquo She complainedthat Hoechst ldquoforced Copley to hire investment bankers and spendmillions of dollars in fees and time of key Copley personnel who couldhave been developing new products and expanding Copleyrsquos busi-nessrdquo She claimed that after forcing Copley to go through the processof hiring an investment banker Hoechst decided it did not want to sellits stake after all

In a parting shot Varis added ldquoIrsquoll serve Copleyrsquos shareholdersbetter from outside the company You canrsquot do anything insiderdquo

Agnes Varisrsquos stinging public criticism of Hoechst AG was high-ly unusual From time to time you will see private disagreementsbetween officers or directors of a company and a major sharehold-er Usually these disagreements come in the form of structured let-ters written by attorneys that are ldquoleakedrdquo filed with the SEC as a13-D amendment or simply released to the press In most cases thesedisagreements arise between mutual fund companies or pensionfunds that hold sizable stakes in a company and that for one reasonor another are unhappy about the direction the company has taken

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 Itrsquos not unusual for an insti-tutional investor to take a stake in a company sit with it for a whileand then fire off a letter to management suggesting the companytake steps to ldquoenhance shareholder valuerdquo or ldquomaximize shareholdervaluerdquo 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 mismanaged

In reality in most cases the institutional investor is trying tolight a fire under a losing positionmdashie trying to bail out of a mis-take by bullying the management into taking short-term actions thatcould boost the stock price

For 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 itInstitutions 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

150 PART TWO Identifying Takeover Targets

Chap 12 7901 856 AM Page 150

TEAMFLY

Team-Flyreg

more likely to send up a few threatening flares see what happensand then quietly liquidate its position on any runup in the stock asa result of the brouhaha

So donrsquot 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 ldquoenhance shareholder valuerdquo Anymanagement that has been paying attention to recent trends shouldrespond with a polite letter thanking the institution for its thoughtsand then go back to running the business This sort of publicity gam-bit usually wonrsquot lead to a takeover bid

The situation at Copley Pharmaceuticals as you will see wasquite different The background of the Copley Pharmaceuticals-Hoechst AG situation following Agnes Varisrsquos 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 companywhich would effectively result in Copley throwing out its 51 per-cent shareholder

Copley Pharmaceuticals had gone public in October 1992 at$1267 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 Copleyproving 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 1997

The drop in Copleyrsquos 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 companyrsquos prospects and the future direction of itsstock price

In September 1996 Hoechst publicly stated that Copley did notfit its ldquocorerdquo business strategy and forced Copley to hire an invest-ment banker to look into the possible sale of the company This move

CHAPTER TWELVE Family Feuds 151

Chap 12 7901 856 AM Page 151

according 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 Hoechst

In August 1998 we noted that a ldquostandstill agreementrdquo whichprevented Hoechst from buying additional Copley shares wouldexpire in October 1998

What is a standstill agreementSometimes 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 A cannot increase its stake in Company B beyond a certainpercentage without expressed permission from Company B Thatrsquosa standstill agreement

Whenever a big chunk of one company is owned by anotheryou 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 companyrsquos 10-K reportwhich 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 unfold

As a result of this research Copley was recommended in thenewsletter as an ldquoadditional ideardquo

In September 1998 Copley Pharmaceuticals was added to thesuperstock recommended list The stock price for Copley at the timewas $83frasl4 The news that Hoechst AG had decided to undergo a cor-porate restructuring was significant In a situation like this where ageneral corporate ldquohousecleaningrdquo such as Hoechst was about toundergo would take place a decision was likely to be made aboutHoechstrsquos 51 percent stake in Copley

Now all of the pieces were in place for a takeover drama tounfold

Every relationship even personal relationships start out withhigh hopes But when the relationship sours and both parties beginto get on each otherrsquos nerves it is only a matter of time before a sep-aration has to take place

152 PART TWO Identifying Takeover Targets

Chap 12 7901 856 AM Page 152

When 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 in The 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 doingwhatrsquos 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 eye-to-eye

It seemed clear to me that Hoechst or some third party wouldhave to make a bid for Copley Unfortunatelymdashor perhaps fortu-nately depending on how you look at itmdashit wasnrsquot 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 brieflythen sagged back and traded listlessly in the $8 to $10 range

In December 1998 with Copley trading at $87frasl16 there wererumors that Hoechst AG was about to merge with Francersquos Rhone-Poulenc SA The rumors if true would create the worldrsquos second-largest pharmaceuticals company Remember Hoechst had an-nounced a planned ldquorestructuringrdquo and in fact Hoechst had alreadysold several of its noncore operations including its paints business

Here is how we analyzed this rumor of a potential HoechstndashRhone-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 Copleyrsquosbook value of $530 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 goodriskreward ratio anywhere in the $6 to $9 range

CHAPTER TWELVE Family Feuds 153

Chap 12 7901 856 AM Page 153

In February 1999 with Copley trading at $911frasl16 Hoechst hadbeen selling off some of its smaller noncore operations and we indi-cated that ldquothe 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 trendrdquo

And then we added ldquoThe 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 stakerdquo

As things turned out that last statement was significant Itrsquos 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-miummdashsometimes a significant premiummdashto a stockrsquos 52-week highIn nearly all cases a takeover bid will a carry a premium to a stockrsquosaverage trading price over the past 30 or 60 days Only in rare caseswhere 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 dayrsquos closing price And once in a blue moonwhen word of a takeover has leaked so badly that the target com-panyrsquos stock has really soared you will witness what is called a take-undermdasha situation where the takeover price is actually lower thanthe previous dayrsquos closing price because advance word of the dealwas so widespread that speculators got carried away and simplybid the price of the target company too high

In the case of Copley Pharmaceuticals we had a buy limit of$111frasl2 on our recommendation However based on some apparentimprovement in Copleyrsquos earnings and influenced by the fact thatHoechst had paid an incredible $55 per share for its original stakeit seemed that raising the buy limit on Copley to $13 would be asound move

At that point Copley was trading near $101frasl4 By April 1999Copley had crossed $113frasl4 For the next several months Copley trad-ed quietly between $83frasl4 and $101frasl2 Then in June 1999 a news itemwas the clincher Copley was trading at $915frasl16 when Hoechstannounced that it would spin off its Copley stake as part of CelaneseAG a Hoechst operation containing most of Hoechstrsquos chemical and

154 PART TWO Identifying Takeover Targets

Chap 12 7901 856 AM Page 154

industrial 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 Copleyrsquos other major shareholderswould try to take Copley private or sell it to a third party

For the next 2 months Copley traded quietly between roughly$81frasl2 and $101frasl2 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 dealHoechst AG also agreed to sell its 51 percent stake in Copley to Tevafor $11 per share

Anyone who had bought Copley at $83frasl4 would have made aprofit of 25 percent based on this $11 takeover bid in 10 monthsAnyone who had followed the growing body of evidence that atakeover bid for Copley was brewing and had taken advantage ofdips in Copleyrsquos 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 bid

To 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 industrieshowever pegging a value is more difficult

In the end Copley proved solidly profitable although less prof-itable than anticipated

But the most important lesson to be learned from the CopleyPharmaceuticals saga is that the original analysis based on the orig-inal evidence proved to be accurate

The next time you see a public disagreement erupt between acompany and its largest shareholdermdashespecially if that sharehold-er is another corporation and not an investment companymdashyou

CHAPTER TWELVE Family Feuds 155

Chap 12 7901 856 AM Page 155

should think in terms of a potential takeover bid The next time yousee a public disagreement between a director and a companyrsquos man-agementmdashespecially if the director resigns and makes statementsabout protecting shareholder interests or enhancing shareholdervaluemdashyou 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

156 PART TWO Identifying Takeover Targets

Chap 12 7901 856 AM Page 156

P A R T T H R E E

Takeover Clues

Chap 13 7901 858 AM Page 157

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

This page intentionally left blank

C H A P T E R T H I R T E E N

ldquoBeneficial Ownerrdquo Buying

CASE STUDY SUMNER REDSTONE AND WMS INDUSTRIES

Knowing how to read a stock chart can be a valuable tool in select-ing potential superstocks A stock that is breaking out above a well-defined multiyear resistance level is usually telling you somethingie that something bullish is going on Herersquos how chart analysisled to a recommendation of WMS Industries

In spring 1989 the chart in Figure 13ndash1 caught my attentionResearch indicated that WMS Industries manufactured pinball andvideo games and owned two hotelcasinos in Puerto Rico Here wasa stock with a terrific long-term chart that was acting like it wasabout to attempt a superstock chart breakout

In April 1989 WMS was trading at $75frasl8 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 levelsThis can often be a signal that a stock is about to make a seriousattempt at a major breakoutmdasha superstock breakout pattern

By 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 company

159

Chap 13 7901 858 AM Page 159

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

The 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 157500 shares inearly 1989 at prices ranging from $55frasl8 to $8

This 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 thisexplosive combination was a breakout above the $8 to $81frasl4 area themultiyear resistance level that had contained WMS since 1986

160 PART THREE Takeover Clues

F i g u r e 13ndash1

WMS Industries (WMS) 1987ndash1989

Source Courtesy of Mansfield Chart Service Jersey City NJ

Chap 13 7901 858 AM Page 160

TEAMFLY

Team-Flyreg

When a well-defined multiyear resistance area in a stock is beingpenetrated it usually means something has changed significantly forthe better Sometimes itrsquos 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-uationmdashin 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 entrepreneurwas also a suggestion that something bullish was brewing

At 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 ldquospinning offrdquo its hotelcasino as a separatecompany

When 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 analysis

In 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 real reason 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 WMSrsquos desire to

CHAPTER THIRTEEN ldquoBeneficial Ownerrdquo Buying 161

Chap 13 7901 858 AM Page 161

maximize the value of its hotelcasino operations When a compa-ny is thinking of getting into a new business itrsquos hard to keep itunder wraps And WMS was a leading manufacturer and distribu-tor of pinball and video gamesmdashwith the trade names ldquoWilliamsrdquoldquoMidwayrdquo and ldquoBallyrdquomdashthat could be found in restaurants and tav-erns throughout America Now a brand new industry was emerg-ingmdashvideo lotteries and video pokermdashthat 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 on

The superstock chart pattern and the major breakout came aboutas a result of buying pressure in the stock Who was doing the buy-ing A good guess would have been that a growing number of peo-ple close to WMS andor 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 ldquomaximize the valuerdquo of itsPuerto Rico hotelcasinos which were carried on WMS Industriesrsquobooks at far below their actual values)

These are the sort of ldquounder the surfacerdquo developments thatcreate bullish chart patterns and major breakouts Sometimes thereasons for the major breakouts are apparentmdashand 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 noticedmdashwhich is precise-ly what happened in tracking WMS Industries

On April 28 1989 I noted the major breakout in WMS ldquoThisstock seems to have a lot going for it A solid story an apparent earn-ings turnaround a great long-term chart and steady accumulationon the open market by a potential acquirerrdquo

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 ldquospikerdquo Again the chartist may nothave known why WMS shares were being bought with such urgency

162 PART THREE Takeover Clues

Chap 13 7901 858 AM Page 162

but the chart was clearly suggesting that something very bullish wasgoing on

By 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-ket this time buying 101100 shares at prices between $81frasl4 and $115frasl8Redstonersquos stake in WMS had now increased to 288 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 story

By mid-August 1989 WMS had fallen back below $12 per shareRevenues and earnings continued to rise sharply due to rapid growthin the companyrsquos pinball and video arcade games On September 11989 our recommendation was that ldquosince Sumner Redstone paid asmuch as $115frasl8 for WMS stock this should serve as somewhat of abenchmark for usmdashie 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 levelrdquo

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 advancedecline line weresinking relentlessly In October a sharp sinking spell took the Dowdown a quick 11 percent but smaller stocks suffered much more

Meanwhile WMS had announced some disappointing newsThe company said it would report a loss at the quarter due to aplanned shutdown of its manufacturing line for ldquoretoolingrdquo 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 $8

According 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

CHAPTER THIRTEEN ldquoBeneficial Ownerrdquo Buying 163

Chap 13 7901 858 AM Page 163

disaster struck this time a natural disaster Hurricane Hugo dam-aged some of the WMS hotelcasino properties in Puerto Rico Thecombination of Hugo and the assembly line shutdown caused WMSto report a loss of $076 per share for the quarter and the stockslumped back toward the $8 support area again

1990 Convictions about WMS Are Put to the Test

What happened during 1990 to WMS stock was a classic example ofhow superstock investing differs from almost any other method ofstock selection A combination of recession Iraqrsquos invasion of Kuwaita 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

Redstone had paid up to $115frasl8 for 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 market

Without those open market purchases by Redstone there would havebeen no benchmark of value with which to work But since we did have thatbenchmarkmdashand since we were betting on Redstone or on something Redstoneknew about WMS as a potential catalyst to get the stock price highermdashweadded to our stake in WMS during nearly all of 1990 at single digit prices

It was not easy to watch WMS decline as far as it did in 1990but 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 notmdashand that as it turned out made all the difference

By late December 1990 WMS Industriesrsquo stock had fallen to$37frasl8 But two new Telltale Signs emerged during that year to indicateit was still a potential superstock

The two catalysts were the announcement that WMS would seekto spin off its Puerto Rico hotelcasinos to ldquoenhance shareholdervaluerdquo and WMS would write off its investment in a company calledDivi Hotels even though the investment still had apparent value

164 PART THREE Takeover Clues

Chap 13 7901 858 AM Page 164

These two Telltale Sign announcements along with the continuing288 percent ownership of Sumner Redstone and the fact that Redstonehad paid as high as $115frasl8 for WMS stock was a sign that WMS hadsignificant unrecognized values lurking beneath its low stock priceThe decision to write off the investment of Divi Hotels was an exam-ple of what is called kitchen sink accountingmdasha 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 year

As a superstock detective these telltale signs clearly suggestedthat something very bullish was lurking beneath the surface atWMSmdashsome development or some value that the stock market hadnot yet recognized Yet WMS shares plunged throughout the year

To 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 US bank stocks whichwere suffering from a rash of bad loans

In an environment such as this it is not easy to disregard the gen-eral stock market and focus on specific events or potential ldquocatalystsrdquothat 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 timesmdashin fact they were the worstof times for small stocks and WMS spent all of 1990 eroding in price

Sooner 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 ldquoCutting your lossesrdquo is easiersaid than done Nobody has perfect timing you may have bought

CHAPTER THIRTEEN ldquoBeneficial Ownerrdquo Buying 165

Chap 13 7901 858 AM Page 165

precisely 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 invalidPerhaps some mutual fund is getting out of a position and the stockis dropping Does that make you wrong and the mutual fund right

Thatrsquos 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 declineBut if you donrsquot really know why you bought a stockmdashif you boughtit for some vague reason (an analyst recommended it on televisionitrsquos a ldquogood companyrdquo itrsquos a growth stock etc)mdashthen yoursquore goingto have a difficult time deciding what to do when the stock startsmoving in the wrong direction

Superstock investing while it is by no means perfect at leastgives you a guidepost In the case of WMS Industries the stock tooka sickening plunge from $10 to as low as $31frasl4 between July andDecember 1990 It was not pleasant But I knew why I had recom-mended the stock in the first place and did not see anything thatcaused me to doubt my original premise

To reiterate here are the reasons I stuck with WMS 1 Sumner Redstone an outside beneficial owner with a stel-

lar track record owned 288 percent of WMS and hadrecently bought stock for as much as $115frasl8 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 company

2 WMS had raised the possibility of spinning off its PuertoRico hotelcasinos as a separate company to enhanceshareholder value The term ldquoenhance shareholder valuerdquois a key phrase and a telltale sign for superstock investorsIt 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 value

3 The earnings disruption at WMS had taken place for a spe-cific reasonmdasha shutdown of the manufacturing facility for

166 PART THREE Takeover Clues

Chap 13 7901 858 AM Page 166

retooling Yet the stock marketmdashdue to a lack of analystcoverage of WMS mdashwas overacting to the temporary loss

4 The 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 ldquoclear the decksrdquo for better news around the cor-nermdashanother Telltale Sign

There is no way around this If you want to make the right deci-sion when a stock starts moving against you you have to know exact-ly why you 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 reasonmdashyou should be looking at a specific ldquocluerdquo or potentialldquocatalystrdquo that tells you to buy this stock Then if the stock movesthe wrong way you should ask yourself Is the reasoning still validIf 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 valid

But if the original premise remains sound you should hang intheremdashand if you can you should buy more to take advantage of thelower price

On December 31 1990 WMS closed at $31frasl4 Despite whatseemed to be a logical analysis the stock had now declined 57 per-cent from my original recommended price of $75frasl8

I did not use a stop loss on the way down and did not recom-mend a ldquosellrdquo of WMS for year-end tax loss In other words I did notfollow any of the simplistic ldquorulesrdquo for intelligent investing

And itrsquos a good thing too because in 1991 WMS Industries turnedout to be the best-performing stock on the entire New York Stock Exchange

On February 8 1991 WMS had broken out of a nice base in the$31frasl2 to $41frasl2 area The stock moved up quickly trading above $6Earnings rebounded nicely following the onetime charges and theretooling which really was not much of a surprise since WMSIndustriesrsquo basic business was continuing to grow

But 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

CHAPTER THIRTEEN ldquoBeneficial Ownerrdquo Buying 167

Chap 13 7901 858 AM Page 167

reassure 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 WMSlate in 1990 on its way from $10 to $31frasl4

Once again Sumner Redstone had paid over $10 for large blocksof stock and there was WMSrsquos desire to enhance shareholder valuemdashone of the key code phrases for superstock investorsmdashspinning offits hotelcasinos operations as a separate company

Research into this plan led to some interesting informationabout appraisals of the value of the WMS hotelcasino propertiesThe Condado Plaza was worth between $105 and $110 million whichmeant that the 80 percent owned by WMS was worth about $84 mil-lion (about $10share) Yet WMS carried its 80 percent ownershipof the Condado Plaza on its books at a value of $37 million (about$435share) 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 $6share) However this asset was also carried on theWMS books at only $37 million ($435share)

In a situation like this itrsquos important to focus on the differencebetween ldquobook valuerdquo and true ldquoasset valuerdquo especially when yoursquoredealing with real estate A great 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 value and 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 ldquobook valuerdquoUsually the asset is initially valued at its historical cost which mayor may not reflect the actual value several years down the road

In the case of a piece of machinery for example the value of thatmachinery will decline over time as the machinersquos 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 assetrsquos cost each year from its earnings The depreciationldquoexpenserdquo is not really a cash expense it is just a bookkeeping entry

168 PART THREE Takeover Clues

Chap 13 7901 858 AM Page 168

that allows the company to reduce its tax bill somewhat and alsoreduces the carrying value or ldquobook valuerdquo of the asset each year

For 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 $100000depreciation charge (one-tenth of the machinersquos cost) that is deduct-ed from earnings If the company earned $2 million that year itwould only report $19 million after the $10000 depreciationldquoexpenserdquo The ldquoexpenserdquo did not involve a cash outlay but savedperhaps $40000 in taxes because it reduced reported earnings That$40000 saving is supposed to allow the company to accumulate cashto replace the machine when its useful life wears out in 10 yearsThat is the purpose of the depreciation allowance

The other effect of that $100000 depreciation ldquoexpenserdquo is toreduce the carrying value or ldquobook valuerdquo of the machine on the com-panyrsquos balance sheet At the end of the first year that $1 million machinewill be carried on the books at its newly depreciated value of $900000The book value of that machine will decline each year by $100000 untilthe machine wears out and a new one must be purchased

Of 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 ldquobook valuerdquo of the com-pany will understate the actual value of its assets

It 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 ldquobook valuerdquo may overstate the actual value of the asset

On the other hand letrsquos 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

CHAPTER THIRTEEN ldquoBeneficial Ownerrdquo Buying 169

Chap 13 7901 858 AM Page 169

what you paidmdashbut their true worth is not reflected in your compa-nyrsquos ldquobook valuerdquo

Book Value and Kirby Industries

The term ldquobook valuerdquo can be very misleading In 1974 in the midstof a crushing bear market a small oil and gas company called KirbyIndustries announced that it would sell off its assets and pay outcash to its shareholders This type of self-liquidation is fairly com-mon today it usually occurs when a company believes its assets areworth far more than its stock price and when the stockholders wouldbe better served by selling the assets and paying the proceeds direct-ly to the stockholders

In 1974 however the concept of voluntary liquidation wasnovelmdashso novel in fact that nobody seemed to know how to analyzethe situation I was still a junior analyst at Merrill Lynch when Kirbyannounced it would liquidate itself and the only reason I noticed theannouncement was that I had a friend who owned a substantial num-ber of Kirby shares I called him and asked him what the announce-ment meant

ldquoThe assets of this companyrdquo he told me ldquoare 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 theyhavenrsquot even started drilling yet but they know the oil and gas arethere They even have a small auto insurance company in PuertoRico thatrsquos worth way more than its book value They think sellingthe company off piece by piece will create a better value for the stock-holdersrdquo

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 plan

The 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

170 PART THREE Takeover Clues

Chap 13 7901 858 AM Page 170

TEAMFLY

Team-Flyreg

company was too small Their advice was to stay away from the sit-uation because it appeared ldquotoo riskyrdquo

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 termldquotoo riskyrdquo means ldquoIt doesnrsquot fit the paradigm in which I am usedto operatingrdquo Everybody is used to a certain way of doing thingsboth personally and professionally When a situation arises thatbreaks the mold the initial reaction is to not deal with it Ignore itPretend it does not exist Just go on doing what yoursquore used to doingwhile an opportunity sits there outside the box waiting to be expe-rienced and profited from

In the case of Kirby Industries a voluntary liquidation was out-side the familiar paradigms of most securities analysts So insteadof ldquothinking outside the boxrdquo the oil and gas analysts just didnrsquotthink about Kirby at all They ignored it because it did not fit theirpreferred and preconceived manner of thinking

The 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 previouslytraded at $151frasl8 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 $28mdashup 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 $2828 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 ldquobook valuerdquo and ldquohistorical costrdquo in relation tooil and gas properties

More 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 lettermdashand decided to make Kirby Industries my very first recommendation

CHAPTER THIRTEEN ldquoBeneficial Ownerrdquo Buying 171

Chap 13 7901 858 AM Page 171

And 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 Ricohotelcasinos Because the hotelcasinos had been depreciated onWMSrsquos books they were therefore undoubtedly worth more thanldquobook valuerdquo 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 value

Then 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 correctHe had paid far in excess of WMSrsquos current market price for stockand he must have seen something that the market was missingCould it have been the value of the hotelcasinos Or somethingelse that was not on Wall Streetrsquos 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 stock

By early February 1991 however WMS had doubled in pricefrom its 1990 close of $31frasl4 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 companyrsquos 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

172 PART THREE Takeover Clues

Chap 13 7901 858 AM Page 172

Now the true earnings power of WMS was becoming apparent onceagain and the stock was moving higher

By 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 atprices between $33frasl8 and $61frasl8 This was a major reinforcement to hangin there and continue to follow Redstonersquos 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 ldquoroadmaprdquo to guide you) and adding to your stake in a declining stockKnowing why you bought the stock in the first placemdashin this casebecause we were following a sophisticated outside beneficialownermdashtells you what to do if the stock starts going against youRedstone by adding to his stake in WMS at these lower prices hadjust updated the road map WMS was still a buy

At the same time there were also some interesting ldquotechnicalrdquoor chart patterns in WMS Take a look at this chart in Figure 13ndash2and you will see that WMS on the way up from its low at $31frasl4 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 pattern

What 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 pointsBy 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 market

In May 1991 Redstone purchased an additional 193100 WMSshares at prices between $87frasl8 and $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 price

Now think about what this would mean to you as an investorSuppose you had been a WMS shareholder at the time You boughtstock at $8 and watched it slump to a low of $31frasl4 ldquoOld paradigmrdquo

CHAPTER THIRTEEN ldquoBeneficial Ownerrdquo Buying 173

Chap 13 7901 858 AM Page 173

investors would have been discouraged and confusedmdashbut as asuperstock investor you would not because yoursquod be following tworoad maps Sumner Redstonersquos continuing purchases of WMS andthe WMS plan to unlock the value of its hotelcasino propertiesWhile 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 Yoursquod 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 greater

Compare this confident attitude to the plight of someone whobuys a stock for some vague reasonmdashletrsquos say because it is a ldquogrowthrdquostock You buy the stock and it starts to decline What do you do Youhang in there because you have been told it is a ldquogrowthrdquo stockPretty soon the stock is down 25 percent Now what do you do

174 PART THREE Takeover Clues

F i g u r e 13ndash2

WMS Industries (WMS) 1989ndash1991

Source Courtesy of Mansfield Chart Service Jersey City NJ

Chap 13 7901 858 AM Page 174

Cutting Your Losses

Do you follow the simplistic ldquocut your lossesrdquo routine or do youbuy more Well itrsquos hard to say because you really donrsquot have a han-dle on why you bought the stock in the first place Even if itrsquos aldquogrowth stockrdquo what is it worth Are interest rates rising If they areyour growth stock might be growing nicely but the stock price isgoing to be worth progressively less as interest rates rise because itspriceearnings 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 ldquonew businessrdquo which is immediatelytaken into account by the market results in your ldquogrowth stockrdquoopening another 25 percent lower in a single trade which meansyou should have followed the ldquocut your losses rulerdquo

On the other hand maybe you did follow the ldquocut your lossesrdquorule 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 stupid

But should you How could you have possibly known what todo You were operating without a road map without guidelinesmdashwithout a guiding principle if you want to put it in those terms

Compare 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 knew that WMS management was aware of this andthat they were looking for ways to force the stock market to reflectthis value You knew that 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 dropped

This mind-set is the major difference between superstock invest-ing and any other approach to the stock market It wonrsquot always lead

CHAPTER THIRTEEN ldquoBeneficial Ownerrdquo Buying 175

Chap 13 7901 858 AM Page 175

to profitable investmentsmdashbut it will lead to peace of mind a coher-ent strategy and the ability to make decisions for rational reasonsAnd there is a lot to be said for that

In June 1991 I received a letter from a subscriber who askedwhether WMS might eventually become a manufacturer of videolottery terminals

Video 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 A small 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 machines

Further 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 devicesFor 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 Suddenlythere was an answer to this question The growth in demand wouldcome from state-run video lotterypoker terminals and the prolifer-ation of Native American casinos across the country

Some 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 percentmdashall 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 casinos

Would WMS Industries enter the market for video lottery ter-minals If so the effect on its stock price could be huge

176 PART THREE Takeover Clues

Chap 13 7901 858 AM Page 176

WMS was not commenting But Dow Jones News Service hadtalked to a distributor of WMSrsquos pinballvideo games which as Isaid were ubiquitous in restaurants and taverns all over the countryThe distributor confirmed to Dow Jones that WMS had told him it wouldsoon be unveiling a video lottery terminalmdashpossibly 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 WMSrsquos productsmdashWilliams Bally and Midway Now if WMS were about to unveil avideo lottery terminalmdashwhich in manufacturing terms was not allthat different from what WMS was already producingmdashthe rela-tionships of WMS distributors with bar and restaurant owners acrossthe country could mean that WMS would be in the driversrsquo seat ver-sus IGT when it came to placing these machines

The 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

By June 1991 WMS had already advanced from $31frasl4 to $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 ease

In retrospect itrsquos easy to see why WMS was performing so welland 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 notWMS had to retool itrsquos manufacturing facilities it had to conductmarket research it had to bring in teams of designers and it had to

CHAPTER THIRTEEN ldquoBeneficial Ownerrdquo Buying 177

Chap 13 7901 858 AM Page 177

prepare its distributors around the country for the introduction of thisnew product The increasing awareness of WMSrsquos upcoming entryinto this exciting new growth industry was undoubtedly one of themajor factors in the bullish patterns being created on the companyrsquosstock 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 WMS

This is another example of how charts can help point youtoward potential stock market winners Itrsquos 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 ldquofoot-printsrdquo on the chart By recognizing the signs of informed and con-fident demand you can pretty much know what the smart moneyis doingmdasheven if you do not know what the smart money knows

By 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 industrySometimes there will be no ldquolag timerdquo at all and all of the stocks inthe industry group will move together Other times there will be a brieflagmdashdays or a week or two at the mostmdashbefore the other stocks inthe industry group start to move up in sympathy with the leader

In 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 earlierSince 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

178 PART THREE Takeover Clues

Chap 13 7901 858 AM Page 178

no 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 thegroupmdashbut 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 stockswhich 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 individualsmdashjust like youmdashwho are willing to put two and two together and come up withfourmdasha 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 us

The 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 companyrsquos entrance into the VLTmarket by dropping from $13 to $10 providing yet another buyingopportunity for those who were keeping their eye on the ball

Finally in late July 1991 a brokerage firm analyst noticed WMSand published a report recommending it as a buy

Take a look at the chart in Figure 13ndash3 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 allymdashbrokerage firm sponsorship This was thefinal ingredient necessary for WMS to follow in the footsteps of

CHAPTER THIRTEEN ldquoBeneficial Ownerrdquo Buying 179

Chap 13 7901 858 AM Page 179

International 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 revenueseach time another state decidesto legalize VLTs we think the handful of stocks involved in VLTs willget a boost

WMS 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

180 PART THREE Takeover Clues

F i g u r e 13ndash3

WMS Industries (WMS) 1990ndash1992

Source Courtesy of Mansfield Chart Service Jersey City NJ

Chap 13 7901 858 AM Page 180

TEAMFLY

Team-Flyreg

with 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 WMSrsquos new VLTHe told me that ldquoWilliams 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 reliableproductrdquo Nicastro also confirmed that ldquoif 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 WMSrdquo

Meanwhile back on the chart WMS was sketching out thatfamiliar superstock chart pattern once again A short-term resistancearea near $15 to $151frasl2 was being attacked over and over again bybuyers with demand coming in at progressively higher levelsmdashastrong signal that WMS stock would be moving higher

By late September 1991 WMS had broken out above its resistancearea at $15 to $153frasl8 to 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 ldquoconcentrating on stockswhich will not depend entirely on an economic recovery to do wellSuch stocks would include takeover candidates and companies whichmay be involved in an industry which could actually benefit from asluggish economy An example would be WMS Industries whichreached another new high and which is up an astonishing 85 percentsince late Junerdquo

In OctoberndashNovember 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 WMSrsquos pinballgames could be developing in Eastern Europe where communism

CHAPTER THIRTEEN ldquoBeneficial Ownerrdquo Buying 181

Chap 13 7901 858 AM Page 181

was giving way to democracy and also in South America where pin-ball games were catching on with young people

Only 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 IndustriesAll 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 ldquorespectablerdquo price range and the stock hadmorphed into a ldquomomentumrdquo stock

Wall 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 ldquoleisurerdquo 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 wouldnrsquot officiallyrecommend WMS he told me it was ldquonot an institutional sort ofstockrdquo whatever that meant

Finally 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

ldquoNow that itrsquos a $20 stock I can get our institutional clients inter-estedrdquo the analyst said

ldquoExcuse merdquoldquoLookrdquo he said ldquothese guys arenrsquot going to buy a $7 stock with

no research coverage that nobodyrsquos ever heard of Itrsquos too risky If itgoes down yoursquoll get all sorts of heat and who needs that Now thatWMS is a $20 stock and itrsquos moving and itrsquos a relative strengthleadermdashsee I can sell that story Theyrsquoll listen to me at this price levelThe stock is more recommendable at these levelsrdquo

ldquoAre you telling merdquo I said ldquothat even though you knew thesame things about WMS at $7 or $10 that you know now that youdidnrsquot recommend the stock simply because it was too cheaprdquo

ldquoYesrdquo

182 PART THREE Takeover Clues

Chap 13 7901 858 AM Page 182

ldquoAnd now that WMS is more expensive you are willing to stickyour neck out because you wonrsquot get criticized as much as if it doesnrsquotwork outrdquo

The analyst sighed ldquoI know it sounds ridiculousrdquo he said ldquoButyes that is what Irsquom telling yourdquo

Do you think things have changed since thenOn November 19 1998 a mutual fund portfolio manager

appeared on CNBC In response to a viewer question the fund man-ager launched into an informed and enthusiastic analysis of what youwould call a ldquovalue stockrdquo which carried a rich dividend yield soldat a low priceearnings ratio and seemed like an undiscovered gem

ldquoWould you buy the stock hererdquo the host asked ldquoWellrdquo the portfolio manager said ldquoI would if I didnrsquot have so

much short-term performance pressure on me It would be a greatstock to buy and tuck away But you know I canrsquot do that itrsquostoughrdquo

The portfolio managerrsquos voice trailed away and the host went onto the next question But his comments spoke volumes about the ldquolem-mingrdquo 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 underpricedmdashuntil 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 have loved to buy and ldquotuck awayrdquo in his fundrsquos portfolio buthe didnrsquot 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 lemmings

On December 31 1991 WMS Industries closed at $277frasl8 up 669 per-cent from its 1990 closing price of $31frasl4 That performance made WMS thebest-performing stock on the New York Stock Exchange for 1991

By 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 sharemdashan incredible gain of 1161 percent fromits closing level at year-end 1990

What is the lesson to be learned from the WMS story

CHAPTER THIRTEEN ldquoBeneficial Ownerrdquo Buying 183

Chap 13 7901 858 AM Page 183

Actually there are severalWMS Industries had three of the Telltale Signs for identifying

future 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 ldquounlockrdquo that value

These 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 WMSrsquos bullishchart pattern was created by persistent buying among those whowere becoming aware of the companyrsquos impending entry into thevideo lottery terminal industry Itrsquos possible that Sumner Redstonersquosbuying was related to this insight as wellmdashor perhaps SumnerRedstone was buying because he knew that the WMS hotelcasinoswere worth far more than WMSrsquos stock price was reflecting

Who knowsThe point is this The signs were there even if the information

that created those Telltale Signs did not emerge until laterWMS Industries is a textbook example of how a superstock

chart pattern together with outside beneficial owner buying canlead you to a huge winnermdasheven if you donrsquot know why that stockis going to be a winner

Postscript to the WMS StoryEventually WMS Industries got around to spinning off its

hotelcasino 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 share

The takeover bid for WHG Resorts valued the company ataround $130 million Based on the fact that WMS Industries hadaround 104 million shares outstanding when the company first

184 PART THREE Takeover Clues

Chap 13 7901 858 AM Page 184

announced that it was seeking to ldquounlock the valuerdquo of its hotelcasi-nos WMSrsquos hotelscasino 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 properties

Which is why you should always take a close look at ldquospinoffsrdquoas potential superstock candidates

CHAPTER THIRTEEN ldquoBeneficial Ownerrdquo Buying 185

Chap 13 7901 858 AM Page 185

This page intentionally left blank

C H A P T E R F O U R T E E N

The ldquoPure Playrdquo and theDrugstore Industry

There is always a disposition in peoplersquos 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 with

this which make it unlike its predecessors andgive assurance of permanency

Charles H Dow JournalistJune 8 1901 The Wall Street Journal

Things changeDon Ameche Actor

Things Change

Charles Dow founder of Dow Jones amp Company and Don Amechea 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 becausemdashwell because things change

On 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 fads

187

Chap 14 7901 858 AM Page 187

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

appear 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 yoursquore riding the final glorious upward arcmdashitalways 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 otherwise

In this chapter you will learn about ldquopure playsrdquo and spinoffsand how they can lead you to superstocks and superstock takeoversBut first letrsquos go back to the 1960s when ldquoconglomeratesrdquo were allthe rage and Wall Street was discovering the meaning of the latestbuzzwordmdasha fad called ldquosynergyrdquo

The technical definition of synergy is ldquothe joint action of agentssuch as drugs that when taken together increase each otherrsquos effec-tivenessrdquo 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 ten

In the 1960s the concept of ldquosynergyrdquo 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 timesThe 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 companymdashcalled a ldquoconglomeraterdquomdashwouldreport 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 homesmdashor whatever else you owned thatmight be doing well while something else was performing poorly

That 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 manner

So synergy and the conglomerate craze slowly petered outmdashproving once again that Charles Dow and Don Ameche knew whatthey were talking about (Of course some ldquosynergiesrdquo are too powerful

188 PART THREE Takeover Clues

Chap 14 7901 858 AM Page 188

and obvious to be denied In an obviously well-thought-out strategyNetherlands-based Unilever PLC announced two takeovers on thesame day in April 2000 First Unilever said it would buy ice creammaker Ben amp Jerryrsquos Homemade whose products include the notori-ously calorie-laden ldquoChubby Hubbyrdquo brand for $326 million Also onthat day Unilever announced the $23 billion acquisition of diet prod-ucts company Slim Fast Foods thus putting Unilever in the businessof both causing and curing obesitymdasha synergistic win-win situationif ever there was one)

Interestingly however there are some vestiges around of thetrend toward synergy even todaymdashand when these vestiges beginto jettison operations that do not fit their core businessesmdashin otherwords when a company decides it wants to be more of a ldquopure playrdquoin a well-defined industrymdashit can lead you to potential superstocks

In recent years a growing number of companies have decidedthat theymdashand their stockholdersmdashwould be better off as ldquopureplaysrdquomdashie 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 stations

In 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 company

In 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 spinoffrsquos business once it is separated from the parent

Another 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-

CHAPTER FOURTEEN The ldquoPure Playrdquo and the Drugstore Industry 189

Chap 14 7901 858 AM Page 189

arating the fast-growing subsidiary and turning it into a separatelytrading company the growth rate that had been previously obscuredwill become more apparent which could lead to a higher priceearn-ings multiple for the spinoffrsquos stock

A third possibility is that by spinning off a company in an indus-try where there is a lot of takeover activity the spinoff could becomea takeover target This is what happened to WHG Resorts thehotelcasino spinoff of WMS Industries which following its sepa-ration from the parent company in 1997 more than doubled in pricewithin 6 months

Most Wall Street analysts recommend investing in spinoffs forall of these reasons but there is a different way to look at spinoffsAs a superstock investor you should look at every announced spin-off and ask yourself Which company operates in an industry wherethere is a great deal of takeover activity the parent company or thecompany being spun off

The answer to that question may surprise you In fact in manycases you would be better off buying the parent companymdashespe-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 sale

A rule 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 companyrsquos industry

If 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 bidder

CASE STUDY FAYrsquoS AND GENOVESE

In 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 thenationrsquos largest drugstore company was never consummated becauseof regulatory opposition But in commenting on the reasoning for

190 PART THREE Takeover Clues

Chap 14 7901 858 AM Page 190

TEAMFLY

Team-Flyreg

Rite Aidrsquos bid for Revco Rite Aidrsquos chairman Martin Grass com-pared the fragmented drugstore industry to the banking industrywhich 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 companyrsquos bid for Revco

Although the Rite AidndashRevco merger never took place this inter-view was the ldquoroad maprdquo 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

1 Rite Aid (see Chapter 17)2 Revco3 Walgreens4 Eckerd5 Melville Corp (which owned CVS Drugs which was

eventually spun off and acquired)6 Cardinal Health (which owned Medicine Shoppes)7 Thrifty-Payless8 American Stores (which owned Osco and Sav-On Drugs)9 JCPenney (which owned Thrift Drugs) (see Chapter 17)

10 Longs Drug Stores11 Big B12 Fayrsquos13 Drug Emporium14 Arbor Drugs15 Genovese Drug Stores

If 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

CHAPTER FOURTEEN The ldquoPure Playrdquo and the Drugstore Industry 191

Chap 14 7901 858 AM Page 191

behind his bid for Revcomdashwhich only goes to prove that Yogi Berraknew what he was talking about when he said ldquoYou can observe alot just by watchingrdquo Or in this case browsing

The 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 takeovers

My first successful drugstore takeover candidate recommen-dation was Fayrsquos Inc and it was recommended for one reasonmdashthissmall drugstore company was selling off noncore assets makingitself a ldquopure playrdquo drugstore company By December 1995 Fayrsquoshad just sold its Wheelrsquos 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 industrymade Fayrsquos an obvious takeover candidate Fayrsquos was readying itselffor sale by getting rid of ldquononcorerdquo operations a move that wouldmake it more attractive to a larger drugstore company seeking acqui-sitions At the time Fayrsquos was trading at $63frasl4

In January 1996 another small drugstore company was addedto my list of takeover recommendations Genovese the nineteenthlargest drugstore companymdashwith 113 stores in the New York CityLong Island areamdashhad also recently become a pure play by sellingoff its nondrugstore operations

I quoted Rite Aid chairman Martin Grass on the rationale ofpotential drugstore industry mergers being ldquovery analogous towhatrsquos going on in the banking industry Wersquore able to absorb storeseliminate tremendous overhead and take costs off the systemrdquo

Our view was that the managements of Fayrsquos 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 Fayrsquos management might be preparing to sell the com-pany

ldquoAs I previously reported Fayrsquos has been selling off its nondrugstoreretail operations Now Fayrsquos has announced the elimination of 90administrative jobs which would save $3 million per year or about

192 PART THREE Takeover Clues

Chap 14 7901 858 AM Page 192

$014 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 industry

Fayrsquos stock continued to languish at $73frasl4 As part of its cost-cut-ting move Fayrsquos had taken a ldquorestructuringrdquo charge and the stockmarket reacted by pushing Fayrsquos shares briefly down to the $61frasl2 areaHere was another situation where a complete lack of analytical coverageresulted in the stock market putting the wrong interpretation on this newsExperience in noticing the Telltale Signs of an impending superstocktakeover targetmdashie any company selling off noncore assets andcutting costs in an industry where a takeover trend was in forcemdashwas practically hanging a ldquoFor Salerdquo sign on the front door But whenFayrsquos took its restructuring chargemdashwhich would yield future ben-efits to cash flow and earningsmdashall the stock market saw was a lossfor the quarter There was no room for nuance A low-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 Fayrsquos shares lower was another clue thatFayrsquos would soon become a takeover target

In April 1996 the Rite AidndashRevco 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 consumersHowever the FTC left the door open for other drugstore industrymergers which would be smaller in scale By May 1996 Fayrsquos stockwas moving highermdashever since the Rite AidndashRevco deal was ter-minated

By July 1996 Fayrsquos had finally sold its Paper Cutter office sup-ply stores for $14 million which meant it was now a pure drugstorecompany

Anyone concentrating on the ldquopure playrdquo concept and the factthat Fayrsquos 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 Fayrsquos was a genuine takeover candidate And yet despitethe fact that Fayrsquos had finally sold off its last nondrugstore operationand taken a ldquoclear the decksrdquo restructuring chargemdashand despite thefact that the Federal Trade Commission had pretty much publiclystated that it would encourage smaller drugstore mergersmdashdespiteall of this Fayrsquos shares were trading at $75frasl8 only slightly higher thanthe original recommended price of $63frasl4 six months earlier

CHAPTER FOURTEEN The ldquoPure Playrdquo and the Drugstore Industry 193

Chap 14 7901 858 AM Page 193

Suddenly just 8 days later on July 11 1996 Fayrsquos announcedthat it had received a takeover bid from JCPenney which owned theThrift Drug Store chain The stock market reacted as though it wasshockedmdashshockedmdashat the news Fayrsquos shares jumped to $107frasl8 onthis news Fayrsquos 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 ended

In July 1996 discussing the Fayrsquos takeover proposal I againraised the possibility that Genovese Drug Stores could become atakeover target for precisely the same reason that Fayrsquos had Genovesehad sold off its nursing home division in the previous year a movesimilar to Fayrsquos selling off its nondrugstore operations in 1995ndash1996prior to selling itself to JCPenney

Also the Genovese chain of drugstores was located almost pre-cisely in the middle of the geographic areas that would be servedby Penneyrsquos Thrift Drugs chain and a newly acquired Fayrsquos chain Atthat time Genovese Drug Stores was trading near $8 adjusted fortwo subsequent 10 percent stock dividends

Within two weeks Fayrsquos announced that it had agreed to beacquired by JCPenney for $1275 per sharemdashan 85 percent gain fromthe recommended price of $63frasl4 in just 7 months and all because Fayrsquoshad tipped its hand by selling off its noncore operations and becoming apure play in an industry where a takeover wave was under way

The Fayrsquos recommendation had turned out to be on target sowe next turned our attention to Genovese a very similar companyIn addition to operating in the same general area of the country asFayrsquos and like Fayrsquos recently becoming a pure play by selling offnoncore assetsmdashin its case a nursing home divisionmdashGenovese hadsomething else going for it a potential superstock chart pattern Thechart showed a well-defined multiyear resistance area at $11 to $12mdashprecisely 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 status

Research showed that 43 percent of Genovesersquos stock wasowned by the family who founded the company Now you mightlogically think that would be a roadblock to a takeover But in fact

194 PART THREE Takeover Clues

Chap 14 7901 859 AM Page 194

the opposite is true Around a third of Fayrsquos outstanding stock wasowned by the founding family yet Fayrsquos 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 ldquocash outrdquo and become part of a larger company

Look at it from this point of view You start a small companybuild 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 competitors

What do you do Do you stubbornly hold on to your indepen-dence and take the risk that your companyrsquos 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 stockrsquos 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 familytax considerations come into play Take a look at the JCPenneyndashFayrsquosdeal this buyout was structured as a tax-free transaction under whichFayrsquos shareholders receive $1275 worth of JCPenney stock For thePanasci family which founded Fayrsquos they were sitting with a $7 stockwith the realization that the company they founded was worth almosttwice that amount A cash buyout would result in a huge tax liabilitybut 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 position

So 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 outmdashand youwill find that many of these family-controlled companies will become

CHAPTER FOURTEEN The ldquoPure Playrdquo and the Drugstore Industry 195

Chap 14 7901 859 AM Page 195

willing takeover targets rather than run the risk of being left by thewayside as minor players in an industry dominated by a handful ofgiant competitors

On 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 holdings

According 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 ldquoanti-takeoverrdquoagreement

But our view was that the press had it all wrong and it wasmisleading to characterize this as an ldquoanti-takeover pactrdquo 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 shareholdersmdashwho control 574 percent ofGenovese stockmdashrecognized 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 future

As 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 future

In the case of Genovese Drug Stores this pact between the twolargest shareholders of the company indicatedmdashin no uncertaintermsmdashthat they were discussing what they would do in the eventof a takeover bid

In November 1998 Genovese agreed to be acquired for $30 pershare by none other than JCPenneymdashprecisely 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 $911share

196 PART THREE Takeover Clues

Chap 14 7901 859 AM Page 196

So 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 wasnrsquot 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 investor

When it comes to stocks that are not widely followed by ana-lysts or sometimes not followed by any analyst news items andindustry trends that seem to have clearly bullish implications for asmaller off-the-beaten-path company have no effect on the stockYou see news you make the connection you buy the stock andmdashnothing 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 ldquoroad maprdquomdashie remem-bering why you 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 deduced

Take a look at the chart of Genovese Drug Stores (Figure 14ndash1)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 approachingGenovese stock plunged from $251frasl2 to $15

Genovese had also had a sinking spell a year earlier after thecompany announced a ldquostrategic restructuringrdquo in which it cut costsand closed underperforming storesmdashprecisely the sort of movesFayrsquos 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 takeoverInstead Genovese was punished

In 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 Fayrsquos acquisition the stock should be doingbettermdashand it wasnrsquot

Here was my response

CHAPTER FOURTEEN The ldquoPure Playrdquo and the Drugstore Industry 197

Chap 14 7901 859 AM Page 197

This is a fact of life on Wall Street Unless a widely followed estab-lishment analyst with a connection to a strong retail sales force (ielots of stockbrokers) is delivering a certain story that storymdashno mat-ter how logicalmdashwill not be fully reflected in the stock price This isa major problem with small-cap and microcap stocks and I canrsquot 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 ie generate fees as an investment banking client

198 PART THREE Takeover Clues

F i g u r e 14ndash1

Genovese Drug Stores (GDXA) 1996ndash1998

Source Courtesy of Mansfield Chart Service Jersey City NJ

Chap 14 7901 859 AM Page 198

It 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 companiesmdashtherefore some terrific stories gounreported

When Fayrsquos 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 forsalemdashespecially in view of the fact that the drugstore industry wasrapidly consolidating But Fayrsquos stock did nothing for a long timedespite the fact that it was trading far below its takeover value untilthe company finally announced that it was talking to JCPenney abouta possible buyout

Getting 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 Aidrsquos 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 mergers

Although the Rite AidndashRevco 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 Fayrsquos 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 Fayrsquos indicates that JCPenney islooking to build its Thrift Drug unit into a major player A recent TuckerAnthony research report on Arbor Drugs suggests that Arbor has the cash

CHAPTER FOURTEEN The ldquoPure Playrdquo and the Drugstore Industry 199

Chap 14 7901 859 AM Page 199

and the infrastructure to handle an acquisition Melville Corp will soonbe spinning off its CVS Drug Store chain as a separate company and analystsbelieve CVS will attempt to get bigger through acquisitions Other potentialbuyers include Walgreens Eckerd and Longs

Also in another interesting development the chairman of Revcorecently told Dow Jones that he expects drugstore industry consoli-dation to continue Now that the Rite AidndashRevco merger is off Revcorsquoschairman told Dow Jones that Revco now plans to be an aggressive buyer itselfof smaller drugstore chains

So we have a very large list of potential buyers out there andit seems obvious that some of the smaller drugstore companies willbe receiving takeover bids Other than Genovese Drug Stores whoare some of the other candidates

If you want to look further afield consider Big B a 383-storechain After the Fayrsquos takeover Big Brsquos executive vice president saidthat Big B has ldquono interest in entertaining acquisition offersrdquo and thatthe company is trying to expand on its own That could mean thatBig 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

This lengthy quote illustrates what is meant by the term ldquoroadmaprdquo Here was the analysis from beginning to end Any investorwho read this analysis had two choices It either made sense or itdidnrsquot 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 idea

Genovese 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 1996BusinessWeekrsquos ldquoInside Wall Streetrdquo column had two articles on theprospects of a buyout of Genovese Drug Stores by JCPenney andthe takeover of Fayrsquos Here was the complete story on GenoveseDrug Storesmdashthe road map if you willmdashin an international maga-zine read by millions of people brought to you by an analyst whohad just predicted the takeover of Fayrsquos in the very same publica-tionmdashand yet Genovese stock continued to languish for 2 yearsright up until the takeover bid forced the stock to triple

It 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

200 PART THREE Takeover Clues

Chap 14 7901 859 AM Page 200

TEAMFLY

Team-Flyreg

coverage 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 ldquoefficient stock marketrdquo which meansyoursquoll be able to see things that the Wall Street pros are completelyoverlooking

As Irsquove noted more than once though it is worth repeating Itrsquosdifficult to sit with a stock doing nothing or drifting lowermdashespeciallywhen you see evidence that this stock should be selling at a sub-stantially higher price But when this happens you have to stick toyour gunsmdashas long as the original ldquoroad maprdquo is intact

There is no other way to do itA few weeks later Big Bmdashthe drugstore company that had publicly

stated that it would remain independentmdashaccepted a takeover bid fromnone other than Revco the company that had publicly stated that it wouldstart shopping for smaller drugstore companies

Big 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 Fayrsquos 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 onArborrsquos small size and on the fact that the founding family controlled a largestake in this company Arbor Drugs was likely to be acquired itself

In September 1996 following the Big B takeover Arbor Drugswas added to my recommended list at $83frasl4 And in February 1998Arbor Drugs accepted a $23 per share takeover bid from CVS

CASE STUDY SMITH FOOD amp DRUG CENTERS

In November 1996 browsing through a list of 13-D ldquobeneficialownerrdquo filings in Barronrsquos revealed that Transamerica Corp the giantinsurance company was accumulating shares of Smith Food amp DrugCenters (SFD) on the open market Research indicated that SFD wasa potential superstock takeover candidate

CHAPTER FOURTEEN The ldquoPure Playrdquo and the Drugstore Industry 201

Chap 14 7901 859 AM Page 201

SFD operated in two industries where takeover activity wasrampant supermarkets and drugstores The company operated 147food and drug centers mostly in the southwestern United StatesInterestingly 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 openmarketmdashanother Telltale Sign and a strong signal that a companybelieves its stock is undervalued

What initially drew my attention to SFD was the open marketbuying by Transamerica which had recently raised its stake to 1642percent of the company paying as high as $2825 for SFD shares Butfurther research revealed something far more interesting About 14percent of SFD was owned by the investmentbuyout firm of YucaipaCos which had already been involved in several supermarket dealsYucaipa owned a controlling interest in supermarket giant FredMeyer Inc and also owned stakes in publicly traded DominickrsquosFoods a Chicago-based supermarket chain and Ralphrsquos a privatesupermarket company Clearly Yucaipa was the sort of sophisticat-ed outside investor who would have the ability to ldquocash outrdquo of itsstake in SFD at the right time and the right price if it chose to do soSince 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 sale

A look at SFDrsquos 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 SFDrsquos 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 operationsall indicated that SFD was a takeover candidate

In November 1996 SFD was added to my recommended list at$291frasl2

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

202 PART THREE Takeover Clues

Chap 14 7901 859 AM Page 202

Ultimately Dominickrsquos Foodsmdashthe other publicly traded super-market company which was partially owned by Yucaipa Cosmdashalsoreceived a takeover bid Remember I began browsing through those13-D filings in Barronrsquos which resulted in a single piece of informa-tion involving Transamericarsquos purchases and that touched off someresearch That research yielded additional clues which eventually ledto information about Yucaipa Cos

Thatrsquos an example of why it pays to browse

LESSONS LEARNED

Lesson number one is this If you believe a takeover wave is aboutto strike a particular industry and if yoursquore on the lookout for poten-tial takeover targets you should concentrate on smaller to mid-sizedcompanies because they will be the most vulnerable to takeoversThis stands to reason because the economies of scale being achievedthrough takeovers will tend to make it more difficult for smallercompanies to competemdashand this is one reason why these small com-panies may decide to link up with a larger company

The second lesson is to look for companies in a takeover-livelyindustry that appear to be transforming themselves into ldquopure playsrdquoFayrsquos 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 itself

The 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 ldquoFor Salerdquo 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 market

The fourth lesson all things being equal is that you shouldtake special note of companies in which a large block of stock (say10 percent or more) is held by a single shareholdermdashespecially 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 shareholdermdashtry 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

CHAPTER FOURTEEN The ldquoPure Playrdquo and the Drugstore Industry 203

Chap 14 7901 859 AM Page 203

and 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 ldquoseize themomentrdquo by cashing out

Finally look for superstock chart patterns Pay particular atten-tion to smaller companies that are bumping up against well-definedmultiyear 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 betterWhen 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 hands

Keep 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 RevcoAfter considering his reasoning the conclusion was that more drug-store takeovers were likely That observation led to Fayrsquos a pureplay in the making which led to Genovese Drug Storesmdashand so on

One 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

204 PART THREE Takeover Clues

Chap 14 7901 859 AM Page 204

C H A P T E R F I F T E E N

Using Charts

The market feels what cannot be observed It is continually alerting us to those things which are not readily foreseeable

AJ Frost

The 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 existedmdashoften withhighly profitable results

The 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 stocksIf an industry is in the doldrums and harbingers of a new positivetrend begin to emerge someone will be the first to get wind of itAnd as the information becomes more widely disseminated a light-bulb will go on in somebodyrsquos 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 thebettermdashand certainly long before individual investors become awareof itmdashthe stocks that will benefit will be bid higher and Telltale Signswill emerge to be noticed and interpreted by investors who are

205

Chap 15 7901 900 AM Page 205

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

familiar 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 noticed

This chapter will describe to you the specific chart pattern calleda ldquosuperstock breakoutrdquo pattern This chart pattern involves a stockthat is breaking out to the upside above a very well-defined multiyearresistance level Resistance level is 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 again

The 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 higher

The significance of a breakout from a ldquosuperstock breakoutrdquopattern 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 theyrsquore buyingstock at levels that have contained every previous rally attempt

Either way a breakout above a multiyear resistance level is usu-ally a sign that a stock is going to move significantly higher

The best way to introduce you to this type of chart pattern is tostart with an actual example

In late 1993 and early 1994 there was an emerging trend towardhealth care takeovers In January 1994 we wrote that ldquoif there is oneclear trend developing in the takeover area right now it is thisHospital companies are looking to get bigger by acquiring smallerhospital companies and they are also looking to broaden their healthcare services by lsquovertically integratingrsquo or acquiring companies thatprovide other types of health carerdquo

206 PART THREE Takeover Clues

Chap 15 7901 900 AM Page 206

CASE STUDY SALICK HEALTH CARE

Browsing through charts of every small hospital and ldquospecialty healthcarerdquo company in search of the ldquosuperstock breakoutrdquo pattern justdescribed a stock called Salick Health Care (SHCI) popped up Itschart pattern had that of a potentially powerful superstock breakoutpattern (Figure 15ndash1)

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 A close 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 highas $161frasl4 in January 1993 Sellers won that battle once again and Salickdropped back down to the $10 area By summer 1993 Salick was

CHAPTER FIFTEEN Using Charts 207

F i g u r e 15ndash1

Salick Health Care (SHCI) 1992ndash1994

Source Courtesy of Mansfield Chart Service Jersey City NJ

Chap 15 7901 900 AM Page 207

attacking that $17 resistance area again and once again the stockretreatedmdashbut this time the buyers stepped in just below the $14 areaIn early 1994 the stock was in the process of making its fifth attemptat a breakout in the multiyear resistance area near $17

The strong suspicion was that eventually Salick would be ableto break through the resistance level Why Because something fun-damental had changed Takeovers of ldquospecialty health carerdquo 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 ldquoin theknowrdquomdashie 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 stock

When 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 hands

As 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 Yetafter 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 breakoutareamdashbut 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 targets

There 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

208 PART THREE Takeover Clues

Chap 15 7901 900 AM Page 208

may have to endure a 20 percent 30 percent or even a 50 percentdecline in the stock price

If you insist on limiting your losses to 10 percent you will beldquostopped outrdquo 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 investment

There is no easy answer to this problem The bottom line is thisIf a stock starts going against you you should know two thingsFirst is the original premise on which you based your decision to buystill intact And second where is the support level on the chartmdashie 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 line

In 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 Miami

By 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 way

The 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$3735 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 $16

And 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-

CHAPTER FIFTEEN Using Charts 209

Chap 15 7901 900 AM Page 209

out pattern that was instantly recognizable because it had worked ahundred times before By determining that there were likely to betakeovers in the specialty health care stocks I searched for a super-stock breakout pattern and found it

Thatrsquos how I did itmdashand thatrsquos 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 ldquoequipmentrdquo gets its useTerry 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 next

The ldquosuperstock breakoutrdquo 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 Finallywhen a stock is able to break through this long-term resistance levela 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 ie a paradigm shift is taking place

When Salick Health Care finally broke out above its long-termresistance area near $17 to $171frasl4 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 A takeover 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

210 PART THREE Takeover Clues

Chap 15 7901 900 AM Page 210

TEAMFLY

Team-Flyreg

Sellers 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 industryand the general stock market environment just like every other stock

But the emerging takeover wave in the specialty health care stockschanged the paradigm for Salick That takeover wave transformedSalick from an obscure cancer treatmentkidney 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 wasWhat would Salick Health Care be worth as a business to a potentialbuyer And based on this new paradigm Salickrsquos supplydemandequation shifted

That breakout above the $17 to $171frasl4 resistance area was a clearsignal that Salick was being perceived in a different light by WallStreet

Here is another example of how a superstock chart breakoutmdashand nothing but a superstock breakoutmdashled me to the takeover bidfor Rohr Inc

In June 1995 an emerging takeover trend was taking place inthe defenseaerospace industry Scanning through the charts in theMansfield Chart Service which are arranged by industry groupsindicated 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 15ndash2 and 15ndash3) 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 ldquodogrdquo 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

CHAPTER FIFTEEN Using Charts 211

Chap 15 7901 900 AM Page 211

Rohr was added to my recommended list Much like an elec-trocardiogram can tell an experienced physician what is going oninside a patientrsquos 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 stock

Just a few weeks after the initial recommendation an outsidebeneficial ownermdashan investor named Paul Newton of NorthCarolinamdashhad accumulated a 52 percent stake in Rohr

Within a year of the original recommendation based on its super-stock breakout pattern Rohr had soared from $13 to $233frasl4 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 ldquoclearingthe decksrdquo so to speak for future positive earnings reports If you are

212 PART THREE Takeover Clues

F i g u r e 15ndash2

Rohr Inc (RHR) 1991ndash1993

Source Courtesy of Mansfield Chart Service Jersey City NJ

Chap 15 7901 900 AM Page 212

running 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 you

As Fayrsquos Genovese Drug Stores and others demonstrated thestock market usually takes news of an unexpected restructuringcharge at a sparsely followed company as a negativemdashbut the mar-ketrsquos initial reaction is often completely mistaken

Rohr 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 Sign

As a rule of thumb When corporate officers and directors pur-chase shares in their own company on the open market immediately

CHAPTER FIFTEEN Using Charts 213

F i g u r e 15ndash3

Rohr Inc (RHR) 1993ndash1995

Source Courtesy of Mansfield Chart Service Jersey City NJ

Chap 15 7901 900 AM Page 213

following 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 considerablybetter

In 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 ldquoroad maprdquo remained intact

Rohr shares eventually fell as low as $14 following the restruc-turing write-offs and the quarterly loss Just several months laterthough Rohr roared back to $21 following a better-than-expectedearnings reportmdashwhich is precisely what you would have expectedin light of the insider buying following the previous earnings reportThat insider buying provided a road map to Rohrrsquos valuemdashin 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 situation

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

214 PART THREE Takeover Clues

Chap 15 7901 900 AM Page 214

C H A P T E R S I X T E E N

The 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 ldquoDomino Effectrdquo 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 fallingdominoes

The 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 theindustry

The 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 action

CASE STUDY VIVRA AND REN-CORP USA

Another 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 16ndash1) Here is that superstock breakout pattern again a well-

215

Chap 16 7901 918 AM Page 215

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

defined multiyear resistance level with a recent series of rising bot-toms indicating that buying pressure is coming in at progressivelyhigher levels In Vivrarsquos case the key price level was around $24ndash$26As a kidney dialysis company Vivra fell into the general category of spe-cialty health caremdashan area where takeover activity was very lively

Vivra was added to my list of recommended stocks at $24Fourteen 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 Caremdashwhich also operatedsome kidney dialysis facilities you will recallmdashhad 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

216 PART THREE Takeover Clues

F i g u r e 16ndash1

Vivra (V) 1992ndash1994

Source Courtesy of Mansfield Chart Service Jersey City NJ

Chap 16 7901 918 AM Page 216

Ren-Corp had a ldquobaby superstockrdquo breakout pattern The majorbreakout took place when the stock moved above $141frasl2 Had I focusedearlier on the kidney dialysis industry in particular I might havecaught Ren-Corp sooner But I was a bit late Still Ren-Corprsquos chartdid show a long-term breakout crossing $141frasl2 and another potentialshort-term breakout crossing $163frasl8

But Ren-Corp had something else going for it an outside bene-ficial owner

By this time yoursquore 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 candidateFifty-four percent of Ren-Corp it turned out was owned by GambroAB of Sweden

By 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 ldquodueto underexposure in the financial community but if Vivra con-tinues to be one of the best-performing stocks on the NYSE theyrsquollget around to Ren-Corp eventuallyrdquo

This is another example of a phenomenon discussed earlierThe 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 Pavlovrsquos 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 way

In 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 Pavlovrsquos 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 time

These days if you think of Pavlovrsquos dogs on Valium it will giveyou an idea of how Wall Street reacts to the same stimuli Itrsquos almost

CHAPTER SIXTEEN The Domino Effect 217

Chap 16 7901 918 AM Page 217

as 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 discovered

And what did Ren-Corp USA do next It dropped from $16 to$12 thatrsquos 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 USA was owned by a Swedish health care com-panymdashdespite all of this Ren-Corp dropped 25 percent almostimmediately after we recommended it

We continued to recommend Ren-Corp because the ldquoroad maprdquowas intact Not only was it intactmdashit 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 industry

Aleveraged 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 Itrsquos not just the deals that get done itrsquos also the proposals or trial bal-loons that do not get done that can lead you to future superstocks (Rememberthe frantic takeover wave in the drugstore industry was foreshadowedby the Rite AidndashRevco 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 circumstancesldquoPavlovrsquos dogsrdquo 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 Pavlovrsquos 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 brownies

In addition to the rumors swirling around Vivra Dow JonesService had reported on June 14 that National Medical in a defensive

218 PART THREE Takeover Clues

Chap 16 7901 918 AM Page 218

move would seek to buy Ren-Corp USA In response Gambro ABthe Swedish company that owned 54 percent of Ren-Corp issued adenial that it was seeking to sell its stake in Ren-Corp

Obviously takeover clouds were rolling in on the dialysisindustry

Meanwhile Pavlovrsquos dogs had apparently passed outThe July 3 1995 issue of BusinessWeek ran a story by Amy

Dunkin entitled ldquoPlugging Into Merger Mania Without Burning YourFingersrdquo In that story I recommended Ren-Corp USA as a takeovercandidate

On Friday July 14 1995 just 2 weeks later Ren-Corp USAsoared from $41frasl8 to $197frasl8 or 26 percent in 1 day following a takeoverbid frommdashwhat a surprisemdashGambro AB of Sweden

Ren-Corp a formerly sleepy and virtually unfollowed dialysiscompany had soared from $12 to nearly $20 in a period of 6 weeksmdashin other words it had turned into a superstock

To 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 owner

And that is how charts can help lead you to exciting new super-stock ideas

CASE STUDY RENAL TREATMENT CENTERS

What do you do when you suspect that you are about to witness theldquoDomino Effectrdquo 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 ldquosuperstock breakoutrdquo patterns Renal Treatment Centers wasanother company I had never heard of but by now Im sure all youneed to do is glance at the chart (Figure 16ndash2) to understand why Irecommended this stock

There it was A well-defined long-term resistance area near $25to $26 in a little followed company in a rapidly consolidating indus-try A series of rising bottoms indicating rising demand

CHAPTER SIXTEEN The Domino Effect 219

Chap 16 7901 918 AM Page 219

In July 1995 we recommended Renal Treatment Centers at $23 The chart in Figure 16ndash2 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 thatRenal Treatment Centers had recently dropped back from $261frasl4 toaround $23mdashan amazing thing when you think about it in light ofthe fact that Ren-Corp USA had just received a takeover bid and thatRenal Treatment Centers and Ren-Corp were nearly identical in sizein terms of revenues Itrsquos surprising that this short-term chart ofRenal Treatment Centers looked as uninspiring as it did Again inthe old days when Wall Streetrsquos ldquoconnecting mechanismrdquo 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 donrsquotmdashbut it can also give you time to accumulate more stockand at lower prices before the payoff arrives

220 PART THREE Takeover Clues

F i g u r e 16ndash2

Renal Treatment Centers (RXTC) 1993ndash1995

Source Courtesy of Mansfield Chart Service Jersey City NJ

Chap 16 7901 918 AM Page 220

TEAMFLY

Team-Flyreg

Even 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 patternmdashyou can see the advantage that a longer-term per-spective can give you

In 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 $16

In November 1997 Renal Treatment Centers which had split 2-for-1 since our recommendation received a $4155 per share takeoverbid Take a look at the chart of Renal Treatment Centers in Figure16ndash3 and you will see that the original superstock breakout patternin mid-1995 that prompted the initial recommendation at a split-adjusted $111frasl2 looks like just a distant memory on this long-term

CHAPTER SIXTEEN The Domino Effect 221

F i g u r e 16ndash3

Renal Treatment Centers (RXTC) 1995ndash1997

Source Courtesy of Mansfield Chart Service Jersey City NJ

Chap 16 7901 918 AM Page 221

chart Again the importance of having just the right perspective can-not be overestimated

We recommended three kidney dialysis companies between1994 and 1997 all of which were taken over and all of which gener-ated huge profits for my subscribers

How did it happenIt happened by recognizing a potential superstock breakout

pattern 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 ldquoDomino Effectrdquo in this industry I wenton the lookout for other potential candidates with superstock break-out patterns (Renal Treatment Centers) andor outside beneficialowners (Ren-Corp USA)

In other words it happened by using several of the toolsdescribed in this bookmdashin particular with a chart pattern that direct-ed my attention to this industry in the first place

222 PART THREE Takeover Clues

Chap 16 7901 918 AM Page 222

C H A P T E R S E V E N T E E N

Merger Mania Take theMoney and Run

My son my son if you knew with what little wisdom the world is ruled

Oxenstierna

What causes the ldquoDomino Effectrdquo 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 greed

When 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 occurmdashsometimesit only takes onemdashother 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 competitiveand 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 fearful

223

Chap 17 7901 902 AM Page 223

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

that once they do figure out the rationale there may not be any attrac-tive acquisition candidates left to be purchased at a reasonable price

And then they become fearful that if they do not play ldquofollowthe leaderrdquo by acting now and buying somebody they will be left outof the parade when the reasoning becomes apparent to everyoneor theyrsquoll be forced to pay too much even if they do identify atakeover candidate And sometimes it is simply the fear of beingacquired itself that leads a company to take over another company asan act of self-defense the reasoning being that if you make yourselfbigger yoursquore less likely to become a target and more likely to beone of the survivors once the consolidation trend runs its course

I 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 yoursquore 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 company

Well sometimes that is exactly how these decisions come aboutAnd sometimes notBack 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 list

The CEO told me that ldquowe 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 rdquo Hisvoice trailed off and then he added ldquoThat was off the record by theway Donrsquot quote me on that okayrdquo

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 wersquore not at all sure why wersquore doing this and whetherthese details make any business sense But what the hell

224 PART THREE Takeover Clues

Chap 17 7901 902 AM Page 224

In 1993 Merck amp 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 Basicallythey 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 didnrsquotwant to bother with it Merckrsquos bright idea was to buy one of thesePBMs and to use it to direct business toward Merck products

Nobody knew at the time whether this would turn out to be afantastic idea or an absurd ideamdashbut after Merck made its moveother 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 $23 bil-lion ldquoOver the past yearrdquo SmithKline declared in announcing thetakeover ldquowe have conducted an exhaustive analysis and con-cluded that the unique alliance announced today positions us to winrdquo

Less than 5 years later SmithKline would unload its $23 billionldquounique alliancerdquo for $700 million But of course nobody knew thisat the time

Meanwhile Eli Lilly amp 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 Lillyrsquos chief financial officersaid at the timerdquoWe looked at Merckrsquos move and said lsquoWhat thehell is a pharmacy benefits managerrsquordquo

In other words it was not as though Eli Lillyrsquos 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 Merckrsquos entry into that business

The truth was that Lilly was not even thinking along those linesand the PBM business was not even on the Lilly radar screen

But that did not stop Eli Lilly from paying $4 billion or 130times earnings for PCS Health Systems on July 11 1994

Hot on the heels of Merck and SmithKline Eli Lilly amp 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

CHAPTER SEVENTEEN Merger Mania Take the Money and Run 225

Chap 17 7901 902 AM Page 225

ldquoWe believerdquo said Lilly ldquoitrsquos the jewel of those that are outthere and we believe we acquired that jewel at a very attractivepricerdquo

Barely 4 years later Lilly wound up selling its $4 billion ldquojewelrdquoto Rite Aid for $15 billion

ldquoOur experiencerdquo said Lilly as it exited the PBM business ldquohasbeen that certain businesses can benefit from new ownership arrange-mentsrdquo

In November 1999 Rite Aid announced that it would attemptto sell PCS Health Systems for a price in the neighborhood of $13 bil-lion which was $200 million less than it paid for the company a yearearlier

There were no takersOn February 25 2000 a Rite Aid spokesperson told TheStreet

com that the company had ldquomultiple biddersrdquo for PCS HealthSystems ldquoWe need to sell it because we need to pay debtrdquo said thespokesperson Rite Aid you will recall had gone on an acquisitionspree during the drugstore takeover mania The companyrsquos overlyambitious expansion strategy combined with accounting irregulari-ties had pummeled its stock which had plunged from a high of $511frasl8in January 1999 to as low as $41frasl2 a decline of 91 percentmdashone of theall-time great examples of a respected predictable company in a sta-ble industry self-destructing by turning into a serial acquirer

Also on February 25 2000 The Wall Street Journal reported thatrival drugstore company CVS was interested in buying PCS HealthSystems from Rite Aid for between $800 million and $1 billionmdashaprice that would have been 33 to 46 percent less than Rite Aid hadpaid a year earlier

CVS denied that it was interested in buying PCS HealthFinally on April 11 2000 Rite Aid announced that it was unable

to sell PCS Health Systems at a reasonable price ldquoWhile we will con-tinue to explore opportunities to sell PCS at some pointrdquo said RiteAidrsquos new CEO Bob Miller he conceded that the price Rite Aid couldget for PCS at the current time was ldquovery depressedrdquo

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 JPMorgan agreed to convert $200 million of debt into Rite Aid commonstock valued at $550 per share

226 PART THREE Takeover Clues

Chap 17 7901 902 AM Page 226

PCS Health Systems would be part of the collateral to secure thisnew debt restructuring said Rite Aid

The saga of PCS Health Systems by this point was beginning toresemble a Wall Street version of ldquoOld Maidrdquomdashonly this time Rite Aidwas finding no takers And it was all touched off by Merckrsquos decisionback in 1993 to diversify into the pharmacy benefits business whichled Merckrsquos 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 price

These stories will help you understand one of the major reasonswhy the ldquoDomino Effectrdquo 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 dandy

Other times however the mad rush to imitate and consolidateis based on less perceptive reasoningmdashsuch as the fear that one ofyour competitors has figured out something you havenrsquot eventhought of yet which means you had better do the same thing fastand you can figure it all out later

So that is how ldquofearrdquo can touch off the ldquoDomino EffectrdquoThen there is the ldquogreedrdquo factorIt will probably not surprise you to learn that corporate CEOs

can 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 business

In September 1989 Sony the Japanese electronics and enter-tainment giant purchased Columbia Pictures for $34 billion plus$16 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 businessSony in fact had paid $27 a share for Columbiamdash36 times the value

CHAPTER SEVENTEEN Merger Mania Take the Money and Run 227

Chap 17 7901 902 AM Page 227

of Columbiarsquos stock after the shares were spun off from their formerowner Coca-Cola company just 2 years before

When the deal was announced most observers believed theprice to be preposterous Vanity Fair magazine called the acquisitionldquoa comic epicrdquo Forbes magazine called it an example of ldquounprece-dented naiveteacuterdquo

A source on Columbiarsquos side of the negotiations told authorsNancy Griffin and Kim Masters who chronicled Sonyrsquos Hollywoodmisadventure in Hit amp Run that the price Sony paid for Columbialdquohad no relationship to the worth of the entityrdquo

But that was only the beginning Sony also paid $200 million forGuber-Peters Entertainment a production company that had lost$192 million on revenues of $237 million in its most recent fiscalyear because it wanted the expertise and management services ofits owners producers Peter Guber and Jon Peters

Under their guidance SonyColumbia proceeded to embarkon a spending and production spree that culminated in a November1994 write-off of $32 billionmdasha gargantuan loss even by the stan-dards of Hollywood which knows a thing or two about losing themoney of outsiders

For years afterward Hollywood insiders Wall Street analystsand others who witnessed Sonyrsquos 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 Nathanwho was granted access and cooperation by Sony in the writing ofhis book Sonyrsquos CEO Norio Ohgamdashwho had been the leading pro-ponent of the Columbia takeovermdashtold a meeting of Sony execu-tives in August 1989 that he had a change of heart Sonyrsquos founderand chairman the revered Akio Morita responded that he too washaving second thoughts about the wisdom of buying Columbia

According to the minutes of that board meeting the decisionwas made to withdraw the takeover bid The minutes read ldquoPerChairman Columbia acquisition abandonedrdquo

But later that evening the Sony executives changed their deci-sion and agreed to go ahead with the takeover of Columbia

228 PART THREE Takeover Clues

Chap 17 7901 902 AM Page 228

WhyWhile Sony executives were having a dinner break some of the

board members overheard Sonyrsquos chairman Morita say softly ldquoItrsquosreally too bad Irsquove always dreamed of owning a Hollywood studiordquo

When the board meeting resumed Sonyrsquos CEOmdashapparently indeference to the emotional desire of his beloved and respected chair-man who had already concurred with the cancellation of the dealmdashtold theexecutives that he had reconsidered the situation during dinner andnow believed that Sony should buy Columbia Pictures after allmdashassuming of course the Sony chairman Morita concurred with hischange of heart Which of course he did

And that is how Sony blundered into the Godzilla of all write-offs

Size power industry leadership statusmdasheven childhooddreamsmdashthese are all potential driving forces for corporate takeoversprobably more so than many corporate executives would care toadmit

In September 1995 the New York Daily News ran 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 businessesldquoFrom a businessmanrsquos point of viewrdquo Dornemann told Der SpiegelldquoI can only say the Americans are crazy to pay such pricesrdquo

In the interview Dornemann said that prices being paid forUS media properties were in the immortal words of Crazy Eddieinsane 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

ldquoThe big media companies are in a kind of race to see who willhave the biggest operationrdquo he said ldquoand the prices are simplyhyped up This sort of thing will never pay off I predict that manyof these mergers will not last

ldquoThe desire for size and power can be a dangerous secondarymotiverdquo for many mergers Dornemann went on to say He said thatWall Street investment bankers had learned to use the egos of CEOs

CHAPTER SEVENTEEN Merger Mania Take the Money and Run 229

Chap 17 7901 902 AM Page 229

to their advantage prodding them to do deals by playing on a CEOrsquosdesire to be the biggest or to simply keep up with a rival ldquoDo not befooledrdquo he said ldquoWall Street has big interest in having big deals likethis The investment bankers earn good money on such takeoversand for that reason they make sure that the necessary euphoria existsrdquoThat last comment can be taken as as implication that Wall Streetrsquoseuphoric reaction to certain megamergers even so-called mergersof equals where no premiums are involved can be more contrivedthan real and that it only serves to encourage the next round ofmegamergers

Dornemann also scoffed at the idea that ldquosynergyrdquo (see Chapter14) can justify sky-high buyout pricesmdashie that producers of pro-gramming must absolutely own a network or other distribution out-lets and that cross-promotion among various media propertieswould enhance the value of the entire enterprise ldquoHistory hasshownrdquo he told Der Spiegel ldquothat a lot can be justified on the basisof synergy with very little ultimately achievedrdquo

Which brings us to the investment bankersOf all of the forces that can touch off a Domino Effectndashtype

takeover wave in any given industry the Wall Street investmentbanking communityrsquos 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 in

Some 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 which

But 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 shares

Over the years a curious ldquospinrdquo on the takeover scene has devel-oped among mainstream Wall Street analysts and institutional money

230 PART THREE Takeover Clues

Chap 17 7901 902 AM Page 230

TEAMFLY

Team-Flyreg

managers They claim investors are better off owning shares in theacquiring companies rather than the target companies

I have always suspected that much of Wall Streetrsquos 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 in

In 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 ldquoEven more alarmingrdquo saidKPMG ldquoover half actually destroyed valuerdquo

The shareholders KPMG was talking about of course were theshareholders of the acquiring companymdashthe ldquogobblerrdquo that was sup-posedly going to manage the assets of the target company betterachieving 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 operationswith 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 ldquosynergyrdquo as in twoplus two equals five

What KPMG demonstrated however was that much of the bal-lyhoo surrounding many of these deals was just a lot of hot airmdashnot 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 ldquosynergyrdquo hook line andsinker (On the other hand when you consider that many of todayrsquosmoney 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 companyrsquos stock

CHAPTER SEVENTEEN Merger Mania Take the Money and Run 231

Chap 17 7901 902 AM Page 231

The 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 bids

Some examples of ldquosynergisticrdquo losers

bull Quaker Oats was a loser when it bought Snapple for $17billion in November 1994 and so were its shareholdersQuaker Oats unloaded Snapple for $300 million 21frasl2 yearslater The big winners were the Snapple shareholders whotook the money from Quaker Oats and moved on

bull Novell shareholders were losers following that companyrsquospurchase of WordPerfect for $14 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

bull Albertsons stockholders saw the value of their stock plungewhen it proved far more difficult than expected to integrateitself with American Stores

Whatrsquos 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 ldquosynergiesrdquo and the ldquoeconomies of scalerdquoand all of the future growth prospects to the Wall Street analysts andinstitutions who invest on this basismdashthey may turn out to be rightor wrong but most of the time that will not be the reason you boughtthe target company in the first place and you should not stick aroundto find out

Read 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

232 PART THREE Takeover Clues

Chap 17 7901 902 AM Page 232

release announcing a takeover bid and why you are usually betteroff taking the profit from the takeover and walking away

CASE STUDY JCPENNEY AND RITE AID

JCPenney 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 Fayrsquos 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 operationsRemember when drugstore consolidation was sweeping Wall Streetit seemed to make all the sense in the world to everyone involvedand there was little reason to doubt that the strategy of combiningsmaller chains would reap major benefits

The ldquogururdquo 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 takeoversIndeed 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

ldquoDrugstore consolidation is going to continuerdquo Grass told TheWall Street Journal on September 12 1996 ldquobecause the economiesare overwhelming The smaller chains canrsquot survive as independentcompanies The independent operators are doomedrdquo

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 ldquoSay a brand new medicinecomes out that is just far superior to anything that is on the marketrdquohe said ldquoWe could be able to look at our customer base and see who

CHAPTER SEVENTEEN Merger Mania Take the Money and Run 233

Chap 17 7901 902 AM Page 233

might be better served by this new medication We would informthose people lsquoHey therersquos a new change on the horizon Ask yourphysician about itrsquordquo Larger customer bases would provide the drug-store consolidators more information on medical histories and there-fore create new and innovative marketing possibilities ldquoIf one storeserves a large number of diabeticsrdquo The Journal said in 1996 ldquothechain can establish special services at the locationrdquo In January 1997The Journal ran another story on the logic behind drugstore consoli-dation explaining that ldquomergers 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 efficiencyrdquo

A warning signalmdashand a prescient one at thatmdashwas also sound-ed in The Wall Street Journalrsquos January 2 1997 story on the mergermania in the drugstore industry The mergers it was noted ldquodo notaddress a range of endemic problems for drugstores from their gen-eral laziness about marketing to their typically lackluster serviceand staffrdquo

So here was the choice faced by Fayrsquos 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 Penneyrsquos growth strategy in thedrugstore industry

There were two ways to look at it If you owned both Fayrsquos 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 aldquopure playrdquo drugstore company rather than a company weigheddown by slower-growing department stores

On the other hand if you had purchased Fayrsquos and GenoveseDrug Stores strictly because you believed they were superstocktakeover candidatesmdashand if you turned out to be correctmdashwhywould you want to exchange these stocks for shares in JCPenneyThe original premise had proven correct both companies became

234 PART THREE Takeover Clues

Chap 17 7901 902 AM Page 234

takeover 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 half

On 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 charges

By mid-April JCPenney shares were trading under $13mdashdown81 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 industryrsquos 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 Aidrsquos problems you see were not confined to PCS HealthSystems

Rite Aid discovered that cost-cutting andrdquoefficienciesrdquo some-times impacted customer servicemdashoften with disastrous resultsCustomers 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

CHAPTER SEVENTEEN Merger Mania Take the Money and Run 235

Chap 17 7901 902 AM Page 235

operating heritages and a distinctly different mix of people alongwith them

In particular Rite Aid ran into trouble with its acquisition ofThrifty-Payless a 1000-store chain it bought in 1996 for $14 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 storesrsquo merchandising offerings sharply reducingadvertising and generally trying to turn Thrifty-Payless into whatRite Aid wantedmdashwhich was Rite Aid stores

The only problem with this was that Thrifty-Payless customersshopped at Thrifty-Payless because they liked Thrifty-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 decline

As the chart in Figure 17ndash1 illustrates Rite Aid stockholdersmdashincluding those who owned the drugstore companies Rite Aidacquired and took Rite Aid shares in returnmdashsuffered 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 ldquoshould not rely on forward-looking profitability and cash flowinformationrdquo the company had just recently given to analysts at anOctober 11 1999 meeting Shortly thereafter Grass resigned and sodid Rite Aidrsquos accountants

At year-end 1999 the Motley Fool summed up the sorry sagaof Rite Aid this way ldquoThe root of the companyrsquos problems stemsfrom an aggressive acquisition play that has failed miserably leav-ing Rite Aid mired in debtrdquo

Meanwhile JCPenneyrsquos stock price continued to feel the falloutof the Rite Aid debacle Penney after all had been one of the biggestdrugstore ldquogobblersrdquomdashand Wall Street which had cheered on thedrugstore merger wave while it was happening now began to recoilfrom the entire premise

236 PART THREE Takeover Clues

Chap 17 7901 902 AM Page 236

As a result a Fayrsquos 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 Fayrsquos 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 time

Meanwhile those who simply sold their Fayrsquos 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

CHAPTER SEVENTEEN Merger Mania Take the Money and Run 237

F i g u r e 17ndash1

Rite Aid (RAD) 1998ndash2000

Source Courtesy of Mansfield Chart Service Jersey City NJ

Chap 17 7901 902 AM Page 237

CASE STUDY THE ALARMING STORY OFPROTECTION ONE

Herersquos another horror story that illustrates a grand acquisitiondiver-sification strategy gone awry

Between 1996 and 1998 the security alarm business experi-enced the Domino Effect as a series of companiesmdashincluding ADTHolmes Protection Alarmguard and othersmdashwere acquired in rapid-fire order All of these were on my takeover list (see Introduction)and all were taken over one after another

Among 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 ata price of $91frasl2 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 Resourcesrsquo own home security opera-tions with those of Protection One creating a much larger companythat could benefit frommdashyou guessed itmdasheconomies of scale

At 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 Wittigwho 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 ofWittigrsquos first moves was an audacious 1996 hostile takeover bid forKansas City Power amp Light What made this bid audacious otherthan the fact that hostile takeovers in the genteel utility industrywere rare was that Kansas City Power amp Light had already agreedto be acquired by a neighboring utility Utilicorp United A nastyfight ensued with charges and countercharges flying all over theplace among the three combatants But in 1997 Western Resourcesand Kansas City Power amp 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 $40s

As a result of Westernrsquos rising stock price Westernrsquos invest-ment bankers decided that Kansas City Power amp Light stockholderswere getting too good a dealmdashso the terms were revised

238 PART THREE Takeover Clues

Chap 17 7901 902 AM Page 238

In light of what was about to happen this proved to be the ulti-mate irony

Western 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 leanmean acquisition machine

After 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 Resourcesrsquo major push into the home security industrywould be accomplished through the acquisition of Protection OneWestern 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 ldquomonthly recurring rev-enuesrdquo 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 interviewsWittig was talking about further diversifying Western Resources alongthe same lines into areas such as telecommunications or cable TV

And so when Protection One soared from the original recom-mended price of $91frasl2 in 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 POIrsquos 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

CHAPTER SEVENTEEN Merger Mania Take the Money and Run 239

Chap 17 7901 902 AM Page 239

I told my subscribers ldquoSince I am focusing mainly on takeovercandidates I am going to bid farewell to Protection One If you wereprescient enough to own Protection One I would suggest a switchto either Holmes Protection or Alarmguardrdquo two other securityalarm takeover candidates

This turned out to be the correct move Both Holmes Protectionand Alarmguard ultimately received takeover bids and the DominoEffect continued to sweep through the security alarm business

Western Resources pleased with the reception that its growthstrategy had received on Wall Street promoted David Wittig to chair-man and CEO in May 1998 Westernrsquos stock price had jumped from$30 when Wittig arrived in 1995 to a high of $487frasl8 in March 1998mdashnot bad for a conservative utility company in the midst of meta-morphosis

In October 1998 Western Resources kept the dominoes falling inthe alarm industry when its now 85 percent-owned Protection Oneunit agreed to acquire Lifeline Systems a company that provided alarm-paging services to elderly people through a nationwide network ofhospitals Lifeline customers wore paging pendants around their neckswhich could be activated if they needed medical assistance A signalwould then be sent to a Lifeline Systems control center which wouldthen alert the nearest hospital to the emergency situation

To 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 Wall Street Journal that 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 company

The Wall Street Journal noted that utility companies had tried oncebefore to diversify and ldquohad failed at it in the 1980s when they boughtcompanies such as savings amp loans a drugstore chain and even aninsurance companyrdquo But The Journal reported that unlike the pastMr Wittig said that ldquoWestern is investing in businesses that are sim-ilar in terms of the relationships wersquore having with the customersrdquo

The Journal also 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 US and also overseas in the year since it was bought by Western

240 PART THREE Takeover Clues

Chap 17 7901 902 AM Page 240

TEAMFLY

Team-Flyreg

Meanwhile Protection One stockholders were beginning tohear alarm bells of their own Following the $7 per share cash pay-ment the stock fell from its ldquoex-dividendrdquo 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 spring

Obviously Wall Street sensed a problemBy 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 attritionthat its accounting practices had come under the scrutiny of theSecurities amp Exchange Commission that the company would lose$169 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 ldquoWestern Resources has expe-rienced some short-term financial challenges with regard to itsProtection One investmentrdquo the company said in a press release whichhad to be in the running for ldquoUnderstatement of the Yearrdquo Westernadded that ldquowhile the security alarm business generates strong cashflow it has not generated net incomerdquo Therefore said Western it wasnow ldquoconsidering alternativesrdquo for its 85 percent-owned security alarmbusiness which had by this time declined to under $2 a sharemdasha 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 time

While Western Resources was ldquoconsidering alternativesrdquo 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 were no 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

CHAPTER SEVENTEEN Merger Mania Take the Money and Run 241

Chap 17 7901 902 AM Page 241

Meanwhile 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 Westernrsquos merger withKansas City Power amp Lightmdashwhich had been held in regulatory pur-gatory for nearly 3 yearsmdashwas now in jeopardy

Just 2 years earlier the deal had almost fallen apart becauseWesternrsquos stock price had risen too quickly based on Wall Streetrsquosperception of David Wittig as an astute deal maker The terms hadbeen negotiated downward in deference to Western shareholderswho owned an increasingly popular stock and did not want to givetoo much of it away to Kansas City Power amp Light stockholdersNow the opposite was taking place Because of the Protection Onedisaster Westernrsquos stock price had slumped so far that the deal wasin danger of coming apart once again

On January 3 2000 Kansas City Power amp 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 ResourcesndashKCPampL merger was undone inlarge part by the Protection One fiascomdasha takeover that turned outvery badly for the acquiring company and its shareholders

Indeed 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 ldquogobblerrdquo

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 asmdashdrum rollpleasemdasha 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 ldquoconglom-eraterdquo had been a failure

242 PART THREE Takeover Clues

Chap 17 7901 902 AM Page 242

In 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

ldquoWe believerdquo said Mr Wittig ldquothat a pure play electric utilitycompany will unlock the value associated with our electric assets byproviding shareholders an investment opportunity exclusively inour electric utility operationsrdquo

The press release stated that Westar Energy the new ldquopure playrdquoutility company would consist of two electric utilities Kansas Poweramp Light and Kansas Gas amp Electric which provide electric service to628000 customers in Kansas The nonelectric utility company whichwas yet to be named would consist of Westernrsquos 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 LLC

By the time Western Resources decided to change paradigms bygoing back to the strategy of being a ldquopure playrdquo (which is what thecompany was in the first place) rather than a collection of unrelatedbusinesses Westernrsquos 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 Westernrsquos stock price to unravel

This 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 consolidation

In 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

CHAPTER SEVENTEEN Merger Mania Take the Money and Run 243

Chap 17 7901 902 AM Page 243

more efficient and profitable there is a very good possibility that thetakeover wave which struck the utility industry during the late 1990swould have engulfed Western Resources much to the delight of itsshareholders

But Western did not want to become a ldquogobbleerdquo in fact thecompany aspired to be a ldquogobblerrdquo 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 businessmdashsecurity alarmsmdashthat turned out to bea disaster for everyone except the shareholders of Protection Onewho decided to take the money and run

Now 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 utilitiesmdashabout 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 Westernrsquos 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 ofWesternrsquos 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 parts

So the logical assumption would be this Itrsquos very possible thatseparating the electric utility assets was the first step in having theseassets acquired and even if that were not the primary purpose of cre-ating the utility pure play Westernrsquos 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 emerge

In other words Westar Energy once it began trading separatelywould have to be viewed as a potential superstock takeover candidatemdashand

244 PART THREE Takeover Clues

Chap 17 7901 902 AM Page 244

this stock should have been added to your universe of potential superstocksto keep a close eye on

On the other side of the equation was the company that wouldown Westernrsquos nonelectric utility assetsmdashtemporarily 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 company

A well-trained superstock sleuthmdashwhich would be you by thistimemdashwould 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 amp ExchangeCommission) of the company whose stock is owned by the outsidebeneficial owner The 10-K Report is available by going to the Website wwwfreeedgarcom 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 companyrsquos most recent10-K you would have learned that this company provided naturalgas transmission and distribution services to 14 million customersin Kansas and Oklahomamdashright in Western Resourcesrsquo neck of the woodsAnd you would also have learned that in 1998 Oneok acquired thenatural gas distribution assets of Western Resources in exchange forOneok stockmdashand that is how Western Resources wound up with its45 percent stake in Oneok In other words when Westernrsquos 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 Oneok

In reading the history of this transaction in the Oneok 10-Kyou would also have learned that there was a ldquostandstill agreementrdquobetween Oneok and Western Resources that prevented Western fromincreasing its ownership above 45 percent And you would also havelearned that Oneokrsquos stated corporate strategy was to ldquoacquire

CHAPTER SEVENTEEN Merger Mania Take the Money and Run 245

Chap 17 7901 902 AM Page 245

additional distribution and transmission facilities and other assetsrdquoand in fact Oneok had recently announced the $3077 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 agreement

By 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 1999

A superstock 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 letrsquos put it to you this way This situationwould appear to be pregnant with possibilitiesmdashand both the WesternResources companies and Oneok should have been immediately placed onthe superstock sleuthrsquos list of stocks to monitor just in case future TelltaleSigns were to emerge

The fact that Western Resources had been selling off someOneok stock combined with the fact that Oneok appeared to be acompany determined to acquire other companiesmdasha ldquogobblerrdquo inother wordsmdashwould 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 ldquostandstill agreementrdquo

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 bid

Who knowsThe point is this There were possibilities here a situation to be

monitored just in case one or more additional Telltale Signs were toemerge that might point you toward a clear and logical opinion asto what happened next

And 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

246 PART THREE Takeover Clues

Chap 17 7901 902 AM Page 246

On 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 growthdiversification strategy wouldhave been reduced to wishing and hoping while watching theirinvestments shrink dramatically in value

The 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 interestingmdashand hopefullyprofitablemdashsituations

CASE STUDY HOW MATTEL GOT PLAYED BY THELEARNING COMPANY

In December 1998 Mattel announced that it would acquire TheLearning Company for $36 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 ldquoa global childrenrsquos productscompanyrdquo In announcing the acquisition Mattel called The LearningCompany ldquoan excellent strategic fitrdquo and said it would immediate-ly add to Mattelrsquos earnings

Some observers were not so sure Among them was HerbGreenberg columnist for TheStreetcom 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 Companyrsquos ldquoaggressiveaccountingrdquo 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 trouble

Greenberg openly questioned Mattelrsquos judgment in paying $36billion 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

CHAPTER SEVENTEEN Merger Mania Take the Money and Run 247

Chap 17 7901 902 AM Page 247

On October 4 1999mdashjust 5 months after the transaction wascompletedmdashMattel 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 hadinherited

Mattel shares which had peaked near $30 earlier in 1999plunged 5 points to $117frasl8 following the announcement wiping outover $2 billion in shareholder value in a single day

The only winners in the Mattel takeover of The LearningCompany were those Learning Company shareholders who tookthe money and ran following Mattelrsquos 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 losses

However as in the case of Western ResourcesndashProtection Onethe MattelndashLearning Company fiasco also had an ironic ending inwhich several Telltale Signs emerged

When 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 stockholdersrsquomoney 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 time

But 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 ldquogobblerrdquo over thecoals sometimes the final chapter of an acquisition that has gonebad can turn out to be the opening chapter of a superstock story

The key as usual is to watch for the Telltale SignsIn the case of Mattel soon after its stock collapsed on the news

of The Learning Companyrsquos 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

248 PART THREE Takeover Clues

Chap 17 7901 902 AM Page 248

a big ldquorestructuringrdquo charge or some sort of corporate reorganiza-tionmdashor some other piece of bad news that takes Wall Street by sur-prisemdashyou 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 view

Shortly after The Learning Company debacle a massive waveof insider buying began with several Mattel insiders buying a totalof 464000 shares between October 25 and November 24 1999 atprices between $13 and $141frasl2

Nevertheless Mattel shares continued to fall below $10 eventhough these insidersmdashwhich included Mattel director JohnVogelstein the powerful vice chairman of the investment firmWarburg-Pincusmdashhad paid much higher prices for the stock theypurchased on the open market

In an interview following The Learning Company newsVogelstein categorically rejected comparisons to Mattelrsquos troubles inthe late 1980s telling a questioner ldquoThis company is not broken Ithas a core business that is vital and well-runrdquo

ldquoCore businessrdquo By now that term should be music to your earsHere was a sophisticated well-connected Mattel insider who

certainly 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 Mattelrsquos ldquocore businessrdquo

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 usuallyldquobottom fishingrdquo turnaround investors lurking around waiting basedon the premise that they can come in take the company over andrestore it to its former luster

Also by February 15 the American Federation of State County andMunicipal Employees Pension Fund announced on Valentinersquos Day that itwanted to have a heart-to-heart talk with Mattelrsquos Board of Directors aboutseveral matters including the possibility of dismantling Mattelrsquos takeoverdefenses The pension fund owned around 37 percent of Mattelrsquos stockHere 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

CHAPTER SEVENTEEN Merger Mania Take the Money and Run 249

Chap 17 7901 902 AM Page 249

Nobody cared and Mattel stock continued to languish below $10In March 2000 John Vogelstein had purchased another 100000

Mattel shares on the open market this time at a price of $109frasl16In April 2000 two more insiders had purchased an additional

56750 shares at prices ranging from $969 to $1112 per share Alsoin April 2000 Mattel had decided to bite the bullet by selling The LearningCompany The Wall Street Journal had reported on the morning of April3 that Mattel would soon announce that The Learning Company wasfor sale and estimated that company for which Mattel had issued$35 billion worth of its own stock just a year earlier would probablyfetch between $500 million and $1 billionmdashwhich has to rank as oneof the most striking examples of how rapidly an acquisition can go badin the annals of American business

Later that day Mattel confirmed that it had retained CreditSuisse First Boston to sell The Learning Company but Mattel wentout of its way to make it clear that it did not intend to sell any of itsldquocore brandsrdquo

In other words Mattel had decided to revert to being a pure play toycompany

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 Companymdashbut 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 tar-get

On September 29 2000 Mattel announced that it would virtu-ally give away The Learning Company by ldquosellingrdquo it to a privatecompany in return for a share in any future profits In reporting thistransaction the Associated Press called Mattelrsquos acquisition of TheLearning Company ldquoone of the worst deals in recent corporate his-toryrdquo This was almost certainly truemdashunless you were a shareholderof The Learning Company who took the money and ran

The MattelndashLearning Company saga is important for three rea-sons First it illustrates why itrsquos almost always better to ldquotake themoney and runrdquo when a stock you own receives a takeover bidSecond it shows how accumulated experience with various com-panies and individuals can lead you to anticipate future develop-

250 PART THREE Takeover Clues

Chap 17 7901 902 AM Page 250

TEAMFLY

Team-Flyreg

ments which you might perceive in a different light than almosteveryone else because of your awareness of Telltale Signs And thirdit 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 longrunmdashif yoursquore willing to think ldquooutside the boxrdquo when it seems likenobody else around you can

The 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 amp Poorrsquos 500 at least seven could be traceddirectly to acquisitions that turned out badly or at the very leastdid not deliver the benefits Wall Street expected JCPenney WasteManagement Allied Waste Industries HealthSouth McKessonHBOC Rite Aid and Service Corp International

All 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 mark

As 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 madethe 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 pains

Remember 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 1999tumbling nearly 60 percent They were led on the way down by thetwo industry giants Waste Management and Allied Waste Industries

CHAPTER SEVENTEEN Merger Mania Take the Money and Run 251

Chap 17 7901 902 AM Page 251

both 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 SampP500 one year later tells you all you need to know about how thatstrategy turned out

The trend toward garbage company takeovers was initiated inJuly 1998 when USA Waste bought Waste Management in a $19 billiontakeover The new industry giant kept the Waste Management nameand then one month later announced the acquisition of anothergarbage company Eastern Environmental Services for $15 billion

Got 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 $11 billion which everybody onWall Street agreed was a sound move because of the obviousldquoeconomies of scalerdquo 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 InvestorrsquosBusiness Daily reported that ldquoanalysts continue to see the waste man-agement companies as a safe haven that can be counted on to gen-erate double-digit earnings growthrdquo

On March 8 1999 Allied Waste struck again when it agreed to buyBrowning-Ferris Industries for $73 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 since

Remember all of this frantic takeover activity was touched offby the USA WastendashWaste ManagementndashEastern 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 deals

Trouble is the premise turned out to be a bit shakyOn 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 Managementrsquos Board of Directorswho were trying to figure out why chaos had ensued at Waste

252 PART THREE Takeover Clues

Chap 17 7901 902 AM Page 252

Management almost immediately after the three companies werecombined

ldquoThe lawsuitrdquo said The Wall Street Journal ldquoarose out of asprawling effort by Waste Managementrsquos Board of Directors to deter-mine how the companyrsquos $19 billion merger with USA Waste Serviceswent wrong and how the companyrsquos management lost control ofits operations and accounting systems in the months after the July1998 mergerrdquo In a follow-up story on February 29 The Journal report-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 quarter

The first hint of troublemdashand it was quite a hintmdashcame on July6 1999 when Waste Management shares dropped from $53 to $25 ina single day following word that the companyrsquos 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 andinventorymdashalmost all a result of the chaos surrounding the compa-nyrsquos inability to integrate its acquisition

To help sort out its problems Waste Management enlisted theservices of Roderick M Hills former chairman of the Securities ampExchange Commission who wound up as chairman of the AuditCommittee ldquoThe big story hererdquo Mr Hills concluded ldquois that theymade terrible acquisitions and didnrsquot know how to run the mergedcompanyrdquo

The most telling comment of all from The Wall Street Journalwas ldquoAnd the pioneers of the practice proved not much better atfiguring out when to run for cover than the average investorrdquo 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 mergers

Shortly thereafter Allied Wastemdashthe other serial garbage acquir-ermdashannounced it would miss its earnings estimates for the fourthquarter of 1999 and also for the year 2000 due to ldquocosts associatedwith the BrowningndashFerris acquisitionrdquo

Stewart Scharf an analyst at Standard amp Poorrsquos commentedthat ldquocompanies need to ensure what they are acquiring is a good fitrdquo

CHAPTER SEVENTEEN Merger Mania Take the Money and Run 253

Chap 17 7901 902 AM Page 253

Another analyst Jaimi Goodfriend told CBS MarketwatchldquoOver 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 itrsquos sort of been more of a lsquobuynow integrate laterrsquo strategy They would buy a lot of companiesand acquire all of this new revenuemdashbut in doing that they neglect-ed the systems integrationrdquo

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 1998ndash99 turned out to be basedon a foundation that was about as solid as a landfill Which explainswhy the ldquosaferdquo waste management stocks dropped over 60 percentin 1999

Meanwhile keep in mind that any Eastern Environmental share-holder who accepted $2987 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 doing

The purpose of this chapter was to illustrate in no uncertain termsthat ldquobrilliantrdquo corporate executives often make dumb acquisitionsfor poorly thought-out reasons and that they are advised and encour-aged to do so by ldquobrilliantrdquo investment bankers who are just outthere taking their best guess like the rest of us at bestmdashand who atworst are motivated in part by the desire to generate investmentbanking fees which cannot be generated unless transactions likethese take place

Meanwhile ldquoanalystsrdquo who are compensated in large part basedon their ability to bring investment banking business to their firmsand whose bonuses depend in large part on investment banking feesearned by their firms in general disseminate voluminous researchreports that may say a ldquobuyrdquo ldquostrong buyrdquo ldquoaccumulaterdquo ldquooutper-formrdquo or ldquoneutralrdquomdashbut only say ldquosellrdquo 09 percent of the time

You 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

254 PART THREE Takeover Clues

Chap 17 7901 902 AM Page 254

combined entity based on their visions of the future and the ldquoanaly-sisrdquo of some investment banker that the deal makes all the sense inthe world and that it will turn out just peachy

The next time you are in a situation like that do what chocolatebaron Milton Hershey did Sell your ticket on Titanic to someonewho is frantically bidding for a chance to go on the Synergy Cruiseand 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 PaineWebberDonaldson Lufkin Advest Daine-Raushcer JP 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 fromldquoOld-Economyrdquo companies which could be an early warning of aneconomic downturn and possibly a bear market

None of that mattered to the ldquogobblersrdquo however Buying abrokerage was the ldquoinrdquo thing to do and independent stockbrokersstarted disappearing like puddles on a sunny afternoon

(One notable exception to the lemming syndrome was FrancersquosAXA Group a multinational insurance company that decided totake advantage of the mad rush to buy stockbrokers by selling itsstake in Donaldson Lufkin to Credit Suisse First Boston)

All of which should reinforce the following concepts1 The ldquoDomino Effectrdquo or the ldquoLemming Effectrdquo or whatever

name 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

CHAPTER SEVENTEEN Merger Mania Take the Money and Run 255

Chap 17 7901 902 AM Page 255

sober Wall Street analysts and sometimes even the wildest dreams ofthe controlling shareholders of the target companies themselves

In other words if you smell a Domino Effect in the making donrsquotbe 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 emerge

2 If you do buy a stock because you are betting on a DominoEffect takeover wave and yoursquore 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 right

Let the mutual funds and the institutional money managerswho absolutely must own the big-cap stocks take the risk that theldquogobblersrdquo will be right Because very often in fact more than youmight expect they wonrsquot

3 The same holds true for the high-publicity ldquomergers ofequalsrdquo like AOLndashTime WarnerDaimlerndashChrysler or any futurecombination of two huge companies that results in no premiumbeing paid to any shareholder of either company More often than notthese 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 ldquomerger of equalsrdquosell 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 ldquosynergiesrdquo 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 Wall Streetspin 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 future

Just 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

256 PART THREE Takeover Clues

Chap 17 7901 902 AM Page 256

By the end of 1999 the Wall Street 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 anybodybased on the premise that two plus two equals five companies thatproposed mergers of equals began to find that their stock pricesdeclined on the news

On Christmas Day 1999 the Associated Press ran a story en-titled ldquoDrug Deals Stumble as Shares Fallrdquo which discussed the factthat the MonsantondashPharmacia amp Upjohn merger of equals as wellas the Warner-LambertndashAmerican Home Products merger hadreceived a collective thumbs-down from Wall Street in the form offalling stock prices for all four companies

ldquoThe Warner-Lambert and Monsanto transaction raises funda-mental questions regarding the viability of mergers of equalsrdquo saidTom Warnock of Credit Suisse First Boston ldquoGiven the market reac-tion to both of these deals Boards of Directors will be more circum-spect before pursuing such a partnerrdquo

The Associated Press concluded that ldquoinvestors want a merg-er to offer them a premium for their shares in the target companyrdquo

No kiddingYou canrsquot have a true takeover if everybody wants to be the

gobbler and with nothing but gobblers you have no superstockTherefore any merger without a true ldquogobbleerdquo is not a takeoverthat should interest you

CHAPTER SEVENTEEN Merger Mania Take the Money and Run 257

Chap 17 7901 902 AM Page 257

This page intentionally left blank

C H A P T E R E I G H T E E N

Look for MultipleTelltale Signs

I have owned a lot of race horses in my life and Irsquove 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-1mdashnot outrageouslong shots by any means just decent horses with ability that were per-fectly capable of winning and had been overlooked by the crowd

I asked him how he managed to come up with so many winnersat such generous odds

ldquoIt took me a long time to learn thisrdquo he said ldquobut I finallylearned to trust my instincts

ldquoI see a lot of racesrdquo he said ldquoI notice things and after a whileI learned that if I see certain things a certain result usually followsBut it took me a long time to learn to trust in what I have observedbecause when I see something and then I look up and a horse is 10-to-1 I used to think lsquoWell I must be missing something otherwisethe horse would be 2-to-1 or 3-to-1rsquo 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 doesnrsquot 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 donrsquot care about the odds anymore Why should I The

259

Chap 18 7901 902 AM Page 259

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

odds only reflect what everybody else thinks and I am more inter-ested in what I think Irsquove learned to trust my own judgmentrdquo

Once you become accustomed to reading the financial news interms of the list of Telltale Signs you will begin to understand whatmy friend the horse bettor was talking about Yoursquoll begin to noticesmall items which to most readers of the financial news are insignif-icantmdashbut they will be of great significance to you You will be see-ing them in a totally different light than virtually everyone elsebecause yoursquoll be operating in a different paradigm

Eventually you will encounter situations where more than oneTelltale Sign is present These can sometimes be the most profitablesituations of all because there will be no one outstanding or terriblyunusual development that would attract the attention of the finan-cial community thereby leading them to suspect that a superstocktakeover is brewing However when taken together a combinationof several apparently unrelated developmentsmdashall of which are onthe list of Telltale Signsmdashcan clearly point you in the direction of awinning stock

The trick is When you do see these multiple Telltale Signs pop-ping up you will have to trust your instincts even though yoursquollhave virtually no support from the ldquoexpertsrdquo 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 thismdashif you can recognize the sign and have the courageto stick to your guns as long as the evidence is on your sidemdashyou canoften run rings around the Wall Street professionals

Here are several examples of how I zeroed in on takeover can-didates that were overlooked by Wall Street simply by noticing mul-tiple Telltale Signs

CASE STUDY SUGEN INC

On December 211995 Sugen Inc (SUGN) was recommended as atakeover candidate at $111frasl2 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 Britainrsquos Zeneca Ltda large pharmaceutical company had purchased 281875 Sugen shareson September 29 1995 at $12 per share Some further research

260 PART THREE Takeover Clues

Chap 18 7901 902 AM Page 260

TEAMFLY

Team-Flyreg

revealed that Zeneca had already held a stake in Sugen and thatthis new purchase had increased Zenecarsquos interest in the companyto around 20 percent

Part 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 Sign

Looking into Sugen a bit further revealed that Amgen anoth-er large biotech company also owned a 35 percent stake in SugenThis 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 Amgenrsquos stake fell below the 5 percentthreshold that makes an outside company an ldquoofficialrdquo 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 future

What finally led to my recommendation of Sugen howeverwas the news on December 6 1995 that Asta Medica a Germanpharmaceutical company had purchased 495000 Sugen shares Thispurchase was made as part of an agreement that gave Asta Medicathe right to jointly develop manufacture and market Sugenrsquos anti-cancer drugs in Europe and it gave Asta Medica a roughly 5 percentstake in Sugen

This development gave Sugen a total of three outside beneficialowners each of which was a legitimate candidate to someday takeover Sugen

And that wasnrsquot all The final Telltale Sign in a series of TelltaleSigns was the fact that Asta Medica had purchased those 495000Sugen shares at an above-market price of $2088 per sharemdashwhichwas two times the prevailing market price of Sugenrsquos stock at thetime of the purchase

Sugen shares had briefly spiked up to the $14 area from around$101frasl2 when the news broke of Asta Medicarsquos above-market purchasebut 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

CHAPTER EIGHTEEN Look for Multiple Telltale Signs 261

Chap 18 7901 902 AM Page 261

after another even in the face of a news development that makes ithighly likely that something very bullish is brewing

Nearly 1 year later Sugen had gained exactly one-eighth of apoint from the recommended price So far I did not look like a geniusBut I had enough experience with the Telltale Signs to know that theodds were on my side and I continued to recommend Sugen

In December 1996 1 year after the initial recommendationZeneca purchased another 509000 Sugen shares at $12 raising itsstake to 249 percent of the company I also noted that Allergan(AGN) another large drug company had purchased 191000 sharesof Sugen at the same above-market price of $2088 that GermanyrsquosAsta Medica had paid a year earlier

These new Telltale Signs now gave Sugen a total of four out-side ldquobeneficial ownersrdquo two of which had paid nearly twice thevalue of Sugenrsquos 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 Sugenrsquosresearch 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 target

By January 1997 another Telltale Sign appeared Sugenrsquos stockprice was starting to sketch out a potential ldquosuperstock breakoutrdquo 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 horizon

Toward the end of 1996 a Sugen director bought nearly 22000shares at $121frasl8 on the open marketmdashflashing yet another Telltale Signwhich was the strongly bullish combination of insider buying and multipleoutside beneficial owner buying Sugen was piling up Telltale Signs allover the placemdashbut the stock was still stuck in neutral

Still the signs kept coming on On November 13 1997 Zenecapurchased another 456000 Sugen shares paying $16 a share OnJanuary 16 1998 another Sugen director bought 20000 shares ofstock on the open market at $125frasl8 to $123frasl4

On May 8 1998 we reported that Sugen was in later-stage tri-als for several antiangiogenesis agents designed to kill cancer tumorsThe reason for this story was that on May 3 1998 The New York Times

262 PART THREE Takeover Clues

Chap 18 7901 902 AM Page 262

had 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 story

We had noted that Sugen was also in the forefront of antian-giogenesis research yet Wall Street had not yet focused on this facteven though Entremed stock had gone through the roof following TheNew York Times story

It wasnt really necessary though to focus on Sugenrsquos leader-ship in developing antiangiogenesis drugs because Zeneca AstaMedica Amgen and Allerganmdashthe four outside beneficial ownersmdashhad 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 ldquoben-eficial ownersrdquo when they take positions in a companymdashyou maynot know what they know but you can know what they domdashand some-times that is all you really need to know

On June 2 1998 Sugenrsquos CEO appeared for an interview onCNBC He talked about Sugenrsquos innovative anticancer therapiesadding that he expected Sugen to be profitable within 2 to 3 years

It 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 CEOrsquos answer but also from theCEOrsquos body language You can learn to ldquoreadrdquo these interviewslooking for subtle clues that might help in your search for super-stock takeover candidates

For 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 companyrsquos 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

CHAPTER EIGHTEEN Look for Multiple Telltale Signs 263

Chap 18 7901 902 AM Page 263

of Frontier Corp which led to a recommendation that Frontier wouldbecome a takeover target)

In the case of the interview with Sugenrsquos 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 ldquothe goodsrdquo 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 canarymdashand my confidence inSugen went up a notch after watching his performance on CNBC

At the time of the interview with Sugenrsquos CEO the companywas trading around $16 compared to the original recommendedprice of $111frasl2 30 months earlier This was an okay but not great per-formance up to that point But by September 1998 Sugenrsquos sharesplunged all the way from $173frasl4 to $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 it

Pretty discouraging wouldnrsquot you sayWell yes So what do you think I didI stuck my neck out even further because I had the evidence to

back 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 think

By December 1998 two Sugen directors had purchased a totalof 21000 shares on the open market a few weeks earlier at $10 to$103frasl4 Not that we needed it but Sugen had just flashed another ina seemingly endless series of Telltale Signs

In April 1999 Sugen was featured on a CBS 60 Minutes segmentwhich discussed the promising potential of the companyrsquos anticancerdrugs During a period of four trading days prior to the 60 Minutessegment Sugen shares soared from $14 to $233frasl4 Following the pro-gram the stock promptly fell back to the $15 area

As it turned out that was the final buying opportunity in Sugenfor those who had been following the avalanche of clues along the way

On June 161999 Sugen jumped 7 points in one day a gain of31 percent in a single trading session following an announcementthat Pharmacia amp Upjohn had agreed to buy Sugen at $31 per share

264 PART THREE Takeover Clues

Chap 18 7901 902 AM Page 264

That takeover price represented a 72 percent premium over Sugenrsquostrading price at the time of my final front-page recommendation justtwo weeks earlier It also represented a more than 200 percent pre-mium over Sugenrsquos trading price as recently as September 1998 just9 months earlier when Sugen had briefly dropped below the origi-nal recommended price

It came as no surprise that Sugen finally received a takeoverbid The only surprise was the identity of the buyer Pharmacia ampUpjohn had emerged out of nowhere to become the acquirer ofSugen

The 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 Signmdashand remember Sugen had sketched out aldquosuperstock breakoutrdquo pattern along the way which is usually a signof major accumulation in anticipation of some major bullish event

All 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 ldquoroad maprdquo to recommend Sugendespite the frustration of seeing all of the obvious signs and havingthe stock market completely ignore them

There were literally hundreds of biotech companies floatingaround and there still are But not many of them got acquired Sugendidmdashand the Telltale Signs were there to foreshadow the takeoverbid for those who knew what to look for

And as you can see it was a long road between the first TelltaleSign to the final takeover bid A superstock 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 falsestart after another It took about 31frasl2 years from the original recom-mendation of Sugen for that takeover bid from Pharmacia amp Upjohnto create a 169 percent profit And remember if you were extremelyconfident (and how could you not have been with all of the TelltaleSigns)mdashyou could have bought Sugen in the $10 to $11 area inSeptember 1998 and wound up with a nearly 200 percent profit in just9 months

CHAPTER EIGHTEEN Look for Multiple Telltale Signs 265

Chap 18 7901 902 AM Page 265

No index fund could have matched that returnGranted 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 pricesmdashespecially 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 opportunitymdashand be thankful that you have developed aninsight that others simply do not have

CASE STUDY FRONTIER CORP

In 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 ldquorestructuringrdquo charge

Frontier it seemed was biting the bullet in certain areas takingwrite-offs and redirecting the company toward more profitable andpromising ldquocorerdquooperations 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 targetespecially since Frontier was operating in a consolidating industry

Wall 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 1996

Frontier was the nationrsquos fifth largest long distance company Asrecently as mid-1996 the stock had been trading at $331frasl2 And yeteven 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 ldquorestructuringrdquo moves

266 PART THREE Takeover Clues

Chap 18 7901 902 AM Page 266

that Frontier had announced were one of the Telltale Signs of a com-pany preparing to sell itself Wall Street took completely the oppo-site view of Frontier and knocked the stock down to the $21 areaproviding a great entry point

And there was more to the recommendation In a mid-DecemberCNBC interview with Frontierrsquos chairman CNBC reporter DavidFaber conducted a terrific ldquonew paradigmrdquo 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 Frontierrsquos chairman replied ldquoWe are not in anyactive merger discussions at this timerdquo David Faber did not move onas most interviewers would have he sensed that the answer wascarefully phrased and he pressed Frontierrsquos chairman with a fol-low-up question Are you saying you have not been approachedabout a takeover Frontierrsquos chairman replied ldquoI am saying we arenot in active discussions at this timerdquo

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 Frontierrsquos chairman was that Frontier had been ap-proached about a takeover but that there were no talks going onright now This impression combined with Frontierrsquos restructuringmoves and the fact that Frontierrsquos industry was seeing a number oftakeovers led me to recommend Frontier as a takeover candidate

By June 1997 Frontierrsquos stock had dropped again this time tothe $16 to $18 area Earnings continued to come in at disappointinglevelsmdashbut 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 candidate

In June 1997 the takeover trend in the telecom industry was con-tinuing with a proposed merger of ATampT and SBC Communications

CHAPTER EIGHTEEN Look for Multiple Telltale Signs 267

Chap 18 7901 902 AM Page 267

They say that beauty is in the eye of the beholder On Wall Streetyou can say the same thing about ldquobadrdquonews Each time Frontierannounced another restructuring-related write-off Wall Street dumpedFrontier stockmdashyet each of these announcements was a thing of beautybecause they were Telltale Signs that this company was setting itself up tobe acquired

By 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 industry

On October 311997 another Telltale Sign emerged the ldquomulti-ple biddersrdquo signal Three bidders emerged to buy long distance tele-com company MCI Communications British Telecom WorldComand GTE The multiple bidders concept is a strong signal that thetakeover wave in that industry will continue in full force Usually theldquomultiple bidderrdquo Telltale Sign involves two companies trying to takeover a company In this case there were three multiple biddersmdasha 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 Frontierrsquos 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 ldquocould be acquiredrdquo 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 improveFrontierrsquos 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 ldquonew paradigmrdquo and ldquoold paradigmrdquo thinking Thesame piece of information can lead to diametrically opposed con-

268 PART THREE Takeover Clues

Chap 18 7901 902 AM Page 268

clusions about the future depending on what you know what youhave experienced and how the information is interpreted

Nearly a year later in October 1998 Frontier stock was tradingin the high $20s We reported in Superstock Investor

Frontierrsquos new CEO Clayton has been selling off noncore and under-performing operations which is often a telltale clue that 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 possible

In light of what was about to happen those comments were about asclose to the mark as you can get in this business

In February 1999 a spokesperson for Frontier Corp deliveredanother Telltale Sign by uttering the words ldquorestructuring optionsrdquoand ldquoincrease shareholder valuerdquo 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-tion At the time Frontier was trading at $351frasl2

The interview with Frontierrsquos CFO Rolla Huff in which MrHuff made these statements did not appear in the national mediaIn fact the interview appeared in a Rochester New York businesspublicationmdashanother 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 ldquothe com-pany is evaluating a number of options including spinoffs initialpublic offerings and mergersrdquo

In particular Huff pointed to Frontierrsquos data and Internet businesswhich was hidden beneath the companyrsquos image as a long distance tele-phone company as being worth far more than the stock market was givingFrontier credit for

In March 1999 we reported that Frontier was attempting tobreak out of a superstock breakout pattern ldquoThe 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 Butthe recent move up to $391frasl4 combined with the willingness of Frontier

CHAPTER EIGHTEEN Look for Multiple Telltale Signs 269

Chap 18 7901 902 AM Page 269

management to make the bold forecast mentioned earlier stronglyimplies that this break-in process is the real thingrdquo

It had been 27 months since the original recommendation ofFrontier Corp The original recommendation had been based on aTelltale Sign of a company in a consolidating industry announcingrestructuring moves designed to rid itself of underperforming oper-ations and make it more of a ldquopure playrdquo This was followed by anoth-er Telltale Sign multiple bidders for MCI Corp which stronglyimplied that more takeovers of long distance companies would takeplace This was followed by Frontier officials using buzzwords likeldquoincrease shareholder valuerdquo and ldquorestructuring optionsrdquo which areoften code phrases used by managements who believe their stock isbadly 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 ldquosuperstockrdquo trading range by crossing the $34 to $37 area

By March 1999 Frontier received a $62 takeover bid from GlobalCrossing Frontier was originally recommended in December 1996at $21 when it was viewed as a hopelessly troubled company witherratic 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 thingWall Street is a lot like horse racing and also a lot like life in that

experience 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 see

That is a huge advantage and by becoming a ldquonew paradigmrdquothinker you can create this advantage for yourself when it comes topicking superstock takeover candidates

270 PART THREE Takeover Clues

Chap 18 7901 902 AM Page 270

TEAMFLY

Team-Flyreg

CASE STUDY WATER UTILITIES

Once you get used to the idea of reading the financial news in termsof the Telltale Signs certain news items that donrsquot 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 itrsquosnot just one news item but an accumulation of small items or cluesthat when taken together begin to form a clear picture of what liesahead Like the straw that broke the camelrsquos back it was not the strawthat finally touched off the eventmdashrather 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 anotherand based on an accumulation of evidence yoursquoll finally decide thata certain industry or a certain stock deserves your close attention

On 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 everything in 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 newspapermdashor possibly not even reported at all

The headline on this particular story was ldquoAmerican WaterAgrees to Acquire Utility for Stockrdquo and the gist of the report wasthat American Water Works (AWK) a water utility had agreed tobuy privately held National Enterprises Inc another water utilityin a transaction valued at $4852 million

There 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 anybodyrsquos 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 heavenrsquos sakemdashandhow exciting is that

But anyone who took the time to read this story would havefound several Telltale Signs that suggested a potentially profitable

CHAPTER EIGHTEEN Look for Multiple Telltale Signs 271

Chap 18 7901 902 AM Page 271

takeover 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 companies

The 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 considered

It might have been easy to miss this story if not for an excellentreport that appeared in the Investorrsquos Business Daily ldquoCompanies inthe Newsrdquo section just a month before The IBD ldquoCompanies in theNewsrdquo section is an excellent ldquobrowsingrdquo 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 ldquoIndustry Group Focusrdquo 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 ldquoCompanies in the Newsrdquo 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 reportwould 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 utilities

The IBD story quoted Philadelphia Suburbanrsquos CEO as followsldquoSince this is such a highly fragmented industry the acquisitiongives us a head start in the consolidation phaserdquo He added that he

272 PART THREE Takeover Clues

Chap 18 7901 902 AM Page 272

expected the combined Philadelphia SuburbanndashConsumers Waterto ldquotake advantage of what we think will be great opportunities forbuying up smaller companies in the futurerdquo

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 Effect

And 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 industry

The combination of thesemdashone in IBD and the other in The WallStreet Journalmdashtwo items appearing less than a month apart is whatfinally led me to take a long hard look at the water utility industry

The list of publicly traded water utility stocks was similar to thedrugstore industry just prior to the ldquodominolikerdquo 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 companiesmdashjust as the drugstore industry had

Moreover 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 values

And 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 rates

Finally several of the water utilities on the list were alreadypartially owned by an outside ldquobeneficial ownerrdquo which was oneof the Telltale Signs to always look formdashthe fact that two of theseoutside beneficial owners were acquisition-minded European com-panies was also a major plus

CHAPTER EIGHTEEN Look for Multiple Telltale Signs 273

Chap 18 7901 902 AM Page 273

In December 1998 I presented a front-page report in SuperstockInvestor entitled ldquoWater Utility Industry Could Be on the Verge of aTakeover Waverdquo 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 giants

In December 1998 nine water utilities (and one water servicesstock) were recommended (Table 18ndash1) and we suggested a crosssection of these stocks thinking of the portfolio as a sort of ldquomutu-al fundrdquo of water utility takeover candidates We noted that two ofthe water utilities in the portfolio were already partially owned byoutside beneficial owners 291 percent of United Water Resourceswas owned by a French company Lyonnaise des Eaux and 87 per-cent of California Water was owned by SJW Corp a neighboringCalifornia water utility

The 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 ldquosuperstocksrdquo 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 that strategy 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 investmentfirms

The concept of buying these stocks as potential takeover candi-dates had 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

274 PART THREE Takeover Clues

Chap 18 7901 902 AM Page 274

with interest rates in general When interest rates fell the water util-ity stocks bounced up a bit so their dividend yields would fall

But 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 targetsthese 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 values

It 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 25 times book value to the area of 29times 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 takeovermdashan incredible riskreward situationsince we were talking about water utilities for heavenrsquos sake

How 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 stocksmdashand yet for severalmonths these stocks could have easily been purchased at or belowthe original recommended prices

CHAPTER EIGHTEEN Look for Multiple Telltale Signs 275

T a b l e 18ndash1

Water Utility Stocks as of 1298 (original recommended prices)

United Water Resources (UWR) $201frasl16

California Water (CWT) $267frasl8

Ersquotown Corp (ETW) $451frasl8

Aquarion (WTR) (adjusted for 3-for-2 split) $243frasl4

American States Water $281frasl2

SJW Corp (SJW) $60

Connecticut Water (CTWS) $271frasl2

Middlesex Water (MSEX) $241frasl2

Southwest Water (SWWC) (adjusted for two 3-for-2 splits) $65frasl8

Chap 18 7901 902 AM Page 275

In 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 ldquoright on targetrdquo 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 industry

1 As 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 companies

2 The water utility industry is particularly suited toeconomies of scale resulting from combining companieswhich include elimination of general office operationsbilling operations lab expenses and the day-to-dayexpenses of running a business such as engineering costspurchasing accounting insurance and so forth

3 The increasing costs of complying with environmentalrequirements especially in the eastern United States coulddrive smaller water companies to merge with larger com-panies

This conversation with a well-positioned water utility executiveeven 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 value

Remember 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 personrsquos 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

276 PART THREE Takeover Clues

Chap 18 7901 902 AM Page 276

The 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 becomethe less information you are likely to elicit from that companyrsquosinvestor 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 description

But you will also find that as you begin dealing with companieswhose stocks are unloved and out of favormdashas will be the case muchof the time if you put these principles and thought processes to workfor youmdashyou are very likely to elicit interesting and valuable infor-mation simply by picking up the phone and calling the company Oftenyoursquoll find that these companies have attracted so little investor inter-est that they do not even have a full-time investor relations personand you will wind up speaking to the company treasurer a vice pres-ident or some other officer who doubles as the investor contact

In 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 dying for 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 know

This may seem like an exaggeration but it is not You should tryit sometime

This 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 thatrsquos thatmdashwhat more is there to say

CHAPTER EIGHTEEN Look for Multiple Telltale Signs 277

Chap 18 7901 902 AM Page 277

Suddenly the landscape changed Several water utilities hadbeen purchased by larger companies and consolidation was in the airThe 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 estatemdashcould these parcels inject avaluable ldquowild cardrdquo into potential valuations

Suddenly the water utility business was getting very interest-ingmdashbut 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 ldquonew paradigmrdquo 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 painted

Perhaps 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 donrsquotgive up if you donrsquot get the direct answers you are hoping for Andalways greet whatever response you receive in an understandinggood-natured way If you donrsquot 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 determine

Sometimes an executive will give you a ldquoYesrdquo for an answerwhen asked if his company has received a takeover bid More oftenthe question must be couched in different terms such as ldquoIf youreceived a takeover bid would you reject it out of hand or would you

278 PART THREE Takeover Clues

Chap 18 7901 902 AM Page 278

consider what is in the best interest of shareholdersrdquo Or if a com-pany already has an outside ldquobeneficial ownerrdquo the question mightgo like this ldquoHave you ever discussed the possibility of beingacquired by XYZrdquo Or ldquoIs it possible they might want to buy therest of the shares they donrsquot ownrdquo Or ldquoWould it make any sense forthem to eventually want to buy you outrightrdquo Or ldquoAre there anyunderstandings or agreements that would prevent XYZ from acquir-ing the rest of your companyrdquo

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 carefullyyou leave the executive enough ldquowiggle roomrdquo to respond to you ina manner that you may gain the information you are looking for ina roundabout waymdashor possibly even other information that you hadnot even considered asking about

In 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 25 and 29 timesbook value if they were to be acquiredmdashwith the potential valua-tion moving up toward the upper end of that range as time went onand fewer acquisition candidates were available

This 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 ldquogaprdquo between a companyrsquos stock price and its possible buy-out valuemdashin other words the most undervalued water utilities inthe group Three water utilities appeared to be particularly under-valued Ersquotown Corp SJW Corp and American States Water SJWCorp also owned an 87 percent stake in California Water whichcould give SJW an added attraction as a takeover candidate

Within 10 months two of these three water companies hadreceived takeover bids

By 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

CHAPTER EIGHTEEN Look for Multiple Telltale Signs 279

Chap 18 7901 902 AM Page 279

The two stocks in question were both water utilities Aquarion(WTR) a Connecticut-based water company and Ersquotown (ETW) aNew Jersey water company Generally stocks within a well-definedindustry group will tend to move in the same general direction notevery day certainly but over time When you have a situation wherea certain stock in an industry is moving up consistently while itspeers are doing nothing or even declining it can often be a sign thatsomething very bullish is brewing

Both Aquarion and Ersquotown were examples of this principle AlsoAquarion had large real estate holdings which could add to itstakeover appealmdashsomething 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 where Irsquod discovered that water com-panies might be under more pressure to sell themselves due to morestringent environmental regulations and higher compliance costs

You can see that a combination of various factorsmdashlessonslearned comments heardmdashled to focusing directly on both Aquarionand Ersquotown

On June 1 1999 Aquarion announced that it had agreed to be acquiredby Yorkshire Water PLC Britainrsquos largest utility for $3705 per shareAquarion a Connecticut water company was one of the water util-ities that owned large tracts of real estate

That $3705 takeover price represented a premium of nearly 70percent above Aquarionrsquos 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 occurs

This was a boring high-yielding water utilitymdashand yet super-stock analytical techniques led directly to the takeover of Aquarion Theconcept of risk vs rewardmdashin which an investor considers not only

280 PART THREE Takeover Clues

Chap 18 7901 902 AM Page 280

TEAMFLY

Team-Flyreg

the potential profit but also the potential riskmdashwas 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 takeovercandidates

That 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 still left 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 longermdashall the better for investors Even the fact thatAquarion had been acquired at 27 times book valuemdashwhich con-firmed the takeover value range I had been usingmdashwas not enoughto bring the water utility stocks significantly closer to their takeovervalues As a result of that 27 times book value figure in June 1999the potential takeover values of the water utility stocks in the port-folio were estimated And once again Ersquotown SJW Corp andAmerican States Water were the three water utilities that seemed tobe selling at the biggest discount to their potential buyout prices

On August 24 United Water Resources announced that it hadagreed to be acquired by Suez Lyonnaise des Eaux a French com-pany for $3548 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 surprisemdashespecially since SuezLyonnaise was already an outside ldquobeneficial ownerrdquo 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 ldquome toordquo 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 ldquolem-mingrdquo effect or the Domino Effect or whatever label you might

CHAPTER EIGHTEEN Look for Multiple Telltale Signs 281

Chap 18 7901 902 AM Page 281

want 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 them

For 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 ldquobeneficial ownerrdquo 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 ldquoinefficienciesrdquo

On October 29 SJW Corp announced that it had accepted a$128 takeover bid from American Water Worksmdashthe 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 before

Less than 1 month later on November 22 1999 Ersquotown Corpannounced that it would be acquired by Britainrsquos Thames Water PLCfor $68 per share a premium of 506 percent above the original rec-ommended price 12 months before Ersquotown jumped over $10 pershare in a single day on this news

It 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 506 percent to 113percent above the original recommended prices Moreover in eachcase these takeover targets could have been purchased at prices sig-nificantly below the original recommended price even as the evidence

282 PART THREE Takeover Clues

Chap 18 7901 902 AM Page 282

mounted that water company takeovers were coming resulting ingreater percentage gains

An article in The Wall Street Journal the day after the bid forErsquotown was announced clearly spelled out the reasons for thetakeover wave in the water stocks It all seemed so obviousmdashbut itwould have been just as obvious one year earlier if yoursquod 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 believeeven though the stock market is paying no attention to this evidencewhatsoever You have to ldquoknow what you knowrdquo 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

CHAPTER EIGHTEEN Look for Multiple Telltale Signs 283

Chap 18 7901 902 AM Page 283

This page intentionally left blank

A P P E N D I X

A Superstock Shopping List

As you have seen an important part of my approach has been tomake special note of companies that are partially owned by outsideldquobeneficial ownerrdquo investors I am particularly interested when one ofthese partially owned companies exhibits one or more additionalTelltale Signsmdashespecially when the outside beneficial owner had boththe ability and the desire to maximize the value of its investment

To help you start your own ldquoresearch universerdquo we have com-piled a sampling of companies that are partially owned by eitheranother company or a private investor or what I would call a ldquofinan-cialrdquo 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 ldquofinancialrdquo outside owners would be ready willing andable to cash out of their investments at a nice premium

We 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 ldquofinancially orientedrdquo owners companies that are partiallyowned by a family trust are also candidates for ldquovalue maximizationrdquowhen the timing is right

This list was compiled from the most recent data available at thetime this book was publishedmdashbut as we have learned things

285

Appx A 7901 903 AM Page 285

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

change Irsquod 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 wersquove pro-vided here

There are two ways to determine the very latest ownershipstakes of these ldquobeneficial ownersrdquo You can either call the compa-ny directly or you can go to wwwfreeedgarcom on the InternetOnce you access freeedgarcom simply enter the trading symbol ofthe company and click on ldquoview filingsrdquo You will then see a list ofthe companyrsquos Securities amp Exchange Commission filings The bestfiling to check would be the most recent Proxy Statement listed onthe site as ldquoForm DEF-14AndashDefinitive Proxy Statementrdquo Within thatfiling you will find a section listing all of the companyrsquos major share-holders including ldquobeneficial ownersrdquo with more than a 5 percentstake You should also make note of any recent Form 13 filingsincluding not only 13-Drsquos but also Form 13-Grsquos 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 surfaced

As 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 reasons

First 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 ofyour investment

The 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

286 APPENDIX

Appx A 7901 903 AM Page 286

I want to make it clear that this is not a recommended list of stocksand 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 owned

Our 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 ldquoprofessionalsrdquo tendto overlook As I said at the outset I make no claim that this is anysort of ldquofoolproof systemrdquo 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 lightmdashand 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

A SUPERSTOCK SHOPPING LIST 287

Appx A 7901 903 AM Page 287

Shopping List of Potential SuperstocksInformation as of 101700

Company Symbol Partial Owners

21st Century Insurance Group TW American International Group (621)

Abercrombie amp Fitch ANF JP Morgan Co (77)

ABM Industries ABM Rosenberg Family Trust (21)

Acmat ACMT Queensway Financial Canada (198)

Actrade Financial ACRT NTS Corporation (292)

ACTV Inc IATV Liberty Media (238)

Advanced Magnetics AVM BVF Partners (136)Eiken Chemical Ltd Japan (56)

Advanced Tissue Sciences ATIS Smith amp Nephew Inc England (795)

Aegon Insurance Group AEG Vereniging NV Netherlands (344)

AEP Industries AEPI Borden Inc (324)

Allied Waste Industries AW Apollo Advisers LP (172)Blackstone Mgt LLC (119)

Ambac Financial ABK JP Morgan (104)

AMC Entertainment AEN Fairmac Realty Group (113)Syufy Century Corp(72) Durwood Family Heirs (58)

American Classic Voyages AMCV Sam Zell Group (36)

American Express AXP Berkshire Hathaway Warren Buffett(114)

American Locker Group ALGI Estate of Harold Ruttenberg (225)

Ann Taylor ANN Morgan Stanley (54)

ARI Network Services ARIS Briggs amp Stratton (136)Witech (213)Vulcan Ventures (87)

Aristotle Corporation ARTL Geneve Corporation (508)

Astoria Financial ASFC JP Morgan (99)

Atchison Casting Corporation FDY Edmundson International Inc (118)

Autozone AZO ESL Ltd (162)

Bancwest Corporation BWE Banque National de Paris (45)

Barnes amp Noble BKS Forstman-Leff Associates (157)

Barrick Gold ABX Trizec Hahn Canada (8)

Battle Mountain Gold BMG Noranda Inc Canada (284)

Beringer Wine BERW Texas Pacific Group (517)

Berlitz International BTZ Soichiro FukutakeBenesse Corporation Japan (616)

Biosphere Medical BSMD Sepracor Inc (58)

288 APPENDIX

Continues

Appx A 7901 903 AM Page 288

Shopping List of Potential SuperstocksInformation as of 101700 (continued)

Company Symbol Partial Owners

Blockbuster Inc BBI Viacom Inc (823)

California Water CWT SJW Corporation Being acquired by American Water Works (85)

Campbell Soup CPB Dorrance Family Heirs (388)

Catalina Marketing POS General Electric (76)

CDI Corporation CDI Garrison Family Trust (292)

Centex Construction Products CXP Centex Corporation (615)

Cerus Corporation CERS Baxter Healthcare (162)

Chart House Enterprises CHT Samstock LLC (271)

Chiron CHIR Novartis (44)

Churchill Downs Inc CHDN Duchossois Industries (242)

CIT Group CIT Dai-Ichi Bank Japan (268)

Clorox CLX Henkel K GaA Germany (265)

CNAFinancial CNA Loews Corporation (868)

Coca-Cola KO Berkshire Hathaway Warren Buffett (81)

Coca-Cola Bottling COKE Coca-Cola Company (31)

Coca-Cola Enterprises CCE Coca-Cola Company (403)

Cognizant Technology CTSH IMS Health (61)

Congoleum Corporation CGM American Biltrite (683)

Conmed Corporation CNMD Bristol Myers Squibb (613)

Continental Airlines CAL NWA Corporation (846)

Cooper Industries CBE JP Morgan (71)

Coventry Health Care CVTY Principal Life Insurance Co (255)Warburg Pincus Ventures (306)

CPC of America CPCF CTM Group Inc (395)

Curtiss-Wright CW Unitrin (43)

Darden Restaurants DRI Prudential Insurance (136)American Express (93)

Dave amp Busters DAB LJH Corporation (113) Mandarin Inc United Kingdom (106)

Dawson Geophysical DWSN Pebbleton Corporation (181)

Detroit Diesel DDC Daimler Chrysler (21)

Devon Energy DVN Santa Fe Synder Corporation (166)

Diamond Offshore DO Loews Corporation (517)

Donnelly Corporation DON Johnson Controls Inc (151)

A SUPERSTOCK SHOPPING LIST 289

Continues

Appx A 7901 903 AM Page 289

Shopping List of Potential SuperstocksInformation as of 101700 (continued)

Company Symbol Partial Owners

Dreyers Grand Ice Cream DRYR Nestle (218)General Electric (188)

DST Systems DST Kansas City Southern Industries (323)

Dynergy DYN Chevron (289)

ETrade Group EGRP Softbank Holdings (261)

Ecolab ECL Henkel K GaA Germany (136)

Electric Lightwave ELIX Citizens Communications (102)

Entrust Technologies ENTU Nortel Networks (318)

Euronet Services EEFT DST Systems (117)

Excite Home ATHM ATampT (238)Comcast (46)Cox Communications (73)Cablevision Systems (52)

Family Dollar Stores FDO Bank of America (82)

Federal Realty FRT Morgan Stanley Dean Witter (149)

Fiberstars Inc FBST Advanced Lighting Technologies (33)

Fifth Third Bancorp FITB Cincinnati Financial Corporation (156)

Fleet Boston Financial FBF Kohlberg Kravis Roberts (55)

Footstar Inc FTS ESL Partners (221)

Franklin Electronics Publishers FEP Bermuda Trust Company (216)

Freeport McMoran Copper FCX Rio Tinto Indonesia Ltd (37)

Friendly Ice Cream FRN Prestley Blake (114)

Galey amp Lord GNL Citicorp Venture Capital (472)

Galileo International GLC UAL Corporation (17)Swiss Air (67)

Garden Fresh Restaurant Corporation LTUS D3 Family Fund

LP David Nierenberg (143)

General Binding GBND Lane Industries (628)

Gillette G Berkshire Hathaway (91)Kohlberg Kravis Roberts (49)

Golden State Bancorp GSB Mafco Holdings Ronald Perelman (32)

Great Atlantic amp Pacific GAP Tengelmann Group Germany (54)

Great Lakes Chemical GLK Berkshire Hathaway Warren Buffett(139)

GTS Duratek DRTK The Carlyle Group (231)

Guitar Center GTRC Chase Capital Partners (232)

Hagler Bailey Inc HBIX Cap Gemini SA (144)

Halifax Energy HX Research Industries (349)

Hanover Compressor HC GKH Investments (39)

290 APPENDIX

Continues

Appx A 7901 903 AM Page 290

TEAMFLY

Team-Flyreg

Shopping List of Potential SuperstocksInformation as of 101700 (continued)

Company Symbol Partial Owners

Harleysville Group HGIC Harleysville Mutual Insurance (566)

Hearst Argyle TV HTV Hearst Broadcasting (63)

Heska Corporation HSKA Novartis (11)Ralston Purina (67)

Hispanic Broadcasting HSP Clear Channel Communications (26)

Houston Exploration THX Keyspan (703)

Human Genome Sciences HGSI Bass Group (153)Merrill Lynch (66)

ICN Pharmaceuticals ICN Special Situation Partners (85)

IDEC Pharmaceuticals IDPH Genentech (67)Citicorp (77)

IDEX IEX Kohlberg Kravis Roberts (287)

IIC Industries IICR Kenyon Phillips Ltd England (778)

Immunex IMNX American Home Products (553)

Impco Technologies IMCO BERU Aktiengesellschaft Germany(121)

Insurance Management Solutions INMG Bankers Insurance Group (627)

International Home Foods IHF Hicks Muse (426)

International Multifoods IMC Archer Daniels Midland (86)

Interstate Bakeries IBC Ralston Purina (295)

Intrusioncom INTZ Science Applications InternationalCorporation (156)

Isis Pharmaceuticals ISIP Novarits Switzerland (72)

Kemet Corporation KEM Citicorp (76)

Keystone Consolidated KES Contran Corporation (408)

Kohlrsquos Corporation KSS AXA France (149)Prudential Insurance (54)

Laboratory Corporation of America LH Roche Holdings (462)

Ladish Company LDSH Grace Brothers (284)

Lafarge Corporation LAF Lafarge SA France (522)

Legg Mason LM AXA Financial (167)

Liberty Financial L Liberty Mutual (714)

Lifeway Foods LWAY Danone Foods (Dannon) France (20)

Ligand Pharmaceuticals LGND ELAN International Services (193)

Lilly (ELI) amp Co LLY Lilly Foundation (154)

Lincoln National LNC Dai-Ichi Mutual Life Insurance (7)

A SUPERSTOCK SHOPPING LIST 291

Continues

Appx A 7901 903 AM Page 291

Shopping List of Potential SuperstocksInformation as of 101700 (continued)

Company Symbol Partial Owners

Linens rsquoN Things LIN Marsh amp McLennan (122)American Express (53)

Litton Industries LIT Unitrin (278)

Lone Star Technologies LSS Alpine Capital (382)Keystone Inc (97)

Loral Space amp Communications LOR Lockheed (155)

Magnum Hunter Resources MHR Oneok Inc (38)

Mascotech MSX Masco Corporation (175)

McMoran Exploration MMR Alpine Capital (277)

Mediquist MEDQ Koninklijke Philips Electronics NV Netherlands (685)

Meemic Holdings MEMH Professionals Group Inc (82)

Midway Games MWY Sumner Redstone National Amusements (25)

Millennium Pharmaceuticals MLNM Bayer AG Switzerland (11)

Mylan Labs MYL American Express (105)

Neiman Marcus NMGA Harcourt General (181)

Neurogen NRGN Pfizer (184)

Nextel Communications NXTL Motorola (131)

Noland Company NOLD Edmundson International (164)

OMI Corporation OMM Mega Tankers Norway (11)

Oneida Corporation OCQ National Rural Electric Co-Op (86)

Oneok Inc OKE Western Resources (45)

Overseas Shipholding OSG Archer Daniels Midland (168)

Owens-Illinois OI Kohlberg Kravis Roberts (245)

Panamsat Corporation SPOT General Motors Hughes (808)

Payless ShoeSource Inc PSS ESL Partners (143)

Peoplersquos Bank PBCT Peoplersquos Mutual Holdings (597)

Petrocorp PEX Kaiser-Francis Oil Company (498)

Petsmart PETM Carrefour SA France (117)

Philadelphia Suburban PSC Vivendi France (18)

Phillips Van Heusen PVH Vaneton International Hong Kong

(18)Mellon Financial (51)

Picturetel Corporation PCTL Intel (99)

Primedia PRM Kohlberg Kravis Roberts (72)

Prodigy Communications PRGY SBC Communications (419)

292 APPENDIX

Continues

Appx A 7901 903 AM Page 292

Shopping List of Potential SuperstocksInformation as of 101700 (continued)

Company Symbol Partial Owners

Protective Life Corporation PL Amsouth Bancorp (96)

RCN Corporation RCNC Level 3 Telecom Holdings (328)Vulcan Ventures (279)

Redhook Ale Brewery HOOK Anheuser-Busch (25)

Regis Corporation RGIS Curtis Squire (157)

Ribozyme Pharmaceuticals RZYM Elan Intrsquol Ireland (159)Chiron Corp (86)

Rosetta Inpharmatics RSTA Vulcan Ventures (127)

Royal Caribbean Cruises RCL A Wilhelmensen AS (25)Pritzker Family (28)

Russell Corporation RML Merrill Lynch (81)

Safeway SWY Kohlberg Kravis Roberts (10)

Samsonite SAMC Artemis America France (302)

Scitex Corporation SCIX Merrill Lynch (607)

Scripps (EW) SSP EW Scripps Trust (493)

Seacor Smit CKH Geocapital Corporation (86)

Smart amp Final SMF Groupe Casino France (602)

Sodexho-Marriott Services SDH Sodexho Alliance SA France (48)TransAmerica Investments (12)

Sport Supply Group GYM Emerson Radio (232)

Sterling Sugars SSUG MA Patout amp Sons Inc (62)

Stolt Offshore SCSWF Stolt Nielson SA Luxemburg (449)

Sunrise Assisted Living Centers SNRZ Morgan Stanley (108)

Supergen Inc SUPG Abbott Labs (49)

Swiss Army Brands SABI Victorinox Switzerland (402)Brae Group (238)

Talbots Inc TLB Jusco Inc (613)

Targeted Genetics TGEN Immunex (72)Elan Intrsquol Ireland (59)

Tiffany amp Co TIF Jennison Associates LLC (104)

Timberland TBL Swartz Family Trust (369)

Titanium Metals TIE Tremont Corporation (391)

Transatlantic Holdings TRH American International Group (60)

Tremont Corporation TRE Valhi Inc (789)

Triton Energy OIL Hicks Muse (389)

True North Communications TNO Publicis SA France (94)

US Cellular USM Telephone amp Data Systems (431)

Ultramar Diamond Shamrock UDS Total FinanceTOTAL France (804)

A SUPERSTOCK SHOPPING LIST 293

Continues

Appx A 7901 903 AM Page 293

Shopping List of Potential SuperstocksInformation as of 101700 (continued)

Company Symbol Partial Owners

UnionBanCal UB Bank of TokyondashMitsubishi (646)

United Park City Mining UPK Loeb Investors (661)Farley Group (126)

UNOVA UNA Unitrin (227)

USG Corporation USG Knauf International (999)

VF Corporation VFC Barbey Trust (199)

Valhi Inc VHI Contran Corporation (789)

Venator Group Z Greenway Partners LP (144)AXA France (104)

Vicorp Restaurants VRES SE Asset Management (19)Quaker Capital (12)

Washington Post Company WPO Berkshire Hathaway Warren Buffett(183)

Westfield America WEA Westfield America Trust (647)

Westwood One WON Viacom Inc (173)

White Mountains Insurance WTM Berkshire Hathaway Warren Buffett(199)

Whitman Corporation WH PepsiCo Inc (396)

WMS Industries WMS Sumner Redstone National Amusements (25)

Worldtex Inc WTX Lockheed Martin Investment Management (215)EGS Partners (342)

Yonkers Financial YFCB Gould Investors LP (162)

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

294 APPENDIX

Appx A 7901 903 AM Page 294

R E S O U R C E S

Barronrsquos published by Dow Jones amp Company Inc New York

BusinessWeek published by The McGraw-Hill Companies New York

Byrne John Chainsaw (New York HarperCollins 1999)

Cerf Christopher and Victor Navasky The Experts Speak (New YorkPantheon Books 1984)

FreeEDGARcom a product of EDGAR Online Inc is the market leader inEDGAR data retrieval

Goldman William Adventures in the Screen Trade (New York Warner Books1989)

Griffin Nancy and Kim Masters Hit amp Run (New York Simon amp Schuster1996)

Investorrsquos Business Daily published by William OrsquoNeil amp Co Los AngelesCalifornia

JagNotescom JAGfncom a product of JAG Notes is a financial network

Kahn Herman The Next 200 Years (New York William Morrow amp Co1976)

Kiplingerrsquos published by The Kiplinger Washington Editors Inc Wash-ington DC

The Mansfield Chart Service published by PW Mansfield amp Co

Nathan John Sony The Private Life (Boston Houghton Mifflin 2000)

The New York Times published by The New York Times Co

Rudd 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)

295

Resources 7901 903 AM Page 295

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

Superstock Investor published by Superstocks Inc Rochester New York

Vickers Weekly Insiders Report published by Argus Research BaltimoreMaryland

The Wall Street Journal published by Dow Jones amp Co New York

Woodward Bob The Agenda (New York Pocket Books 1995)

Yahoo Finance a product of Yahoo Inc

296 RESOURCES

Resources 7901 903 AM Page 296

A

Abbott Labs (ABT) 135Accounting gimmicks 50ADT Ltd 85ndash94Adventures in the Screen Trade

(Goldman) 69Agenda The (Woodward) 44Allied Waste Industries 251ndash254Ameche Don 187American Stores 15ndash17American Water Works 27ndash30 282Aquarion (WTR) 28Arbor Drugs 201Asset values 26Avco Corporation 13

B

Babson Roger 44 45Babson Break 45Bank One (ONE) 49 50Barr J James 28 29Barronrsquos 140ldquoBearish Call on Banks Lands Analyst

in Doghouserdquo 49Belle Albert 43Beneficial owner transactions 103ndash105

285 286Bentsen Lloyd 43Berra Yogi 35Big B 201ldquoBond Bears Debt Securities Prices

May Slide for Years Many AnalystsThink Therdquo 40

Bonds 59Book value 170

Breakout 206Brokerage firm research reports 20 21Browsing 96ndash106 126Brylane Inc 106ndash111Burns International Services 134 135Byrne John A 47

C

Case studiesADT Ltd 85ndash94Brylane Inc 106ndash111Copley Pharmaceuticals 149ndash155Dexter Corp 111ndash124FayrsquosGenovese 190ndash201Frontier Corp 266ndash270JCPenneyRite Aid 233ndash237MattelThe Learning Company

247ndash250Midway Games 140ndash148Protection One 238ndash247Renal Treatment Centers 219ndash222Rexel Inc 78ndash84Rohr Inc 210ndash214Salick Health Care 207ndash210Smith Food amp Drug Centers 201ndash202Sugen Inc 260ndash265Sunbeam Corp 46ndash48VivraRen-Corp USA 215ndash219Waste ManagementAllied Waste

251ndash254WMS Industries 159ndash185

Catalysts 11 12Cautionary tabs (merger mania)

233ndash254Chainsaw (Byrne) 47

297

I N D E X

Index 7901 904 AM Page 297

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

Change 187 188Charts 138 139 159 205ndash214Clayton Joseph 268Clinton Bill 44Conglomerate craze 188Connecticut Water Service (CTWS) 128Copley Pharmaceuticals 149ndash155Corporate-shareholder disagreements

149ndash156Cosell Howard 54Creeping takeovers 77ndash94

D

Dexter Corp 111ndash124Dirty Rotten Scoundrels 128Discounted present value 61Domino effect 215ndash222 227 255Dorfman Dan 111Dornemann Michael 229 230Double play 141Dow Charles H 187Drugstore industry 187ndash204

case study (FayrsquosGenovese) 190ndash201

case study (Smith Food amp DrugCenters) 201ndash202

Dun amp Bradstreet (DNB) 135Dunlap Al 46 47

E

Ersquotown Corp 131 132 140 282Efficient market 80 81Eli Lilly 225 226Examples (see Case studies)Excitement 6 7Experts 35ndash36

agenda 43 44conforming to prevailing ideology

48ndash53defined 36famous bloopers 54magazine coversarticles 37ndash42shortage of 42truth telling 44ndash48

F

Faber David 267Fairness opinion 77Family feuds 149ndash156Family trust 285Fayrsquos Inc 192ndash195Federal Reserve 61Financial press 125ndash148

Barronrsquos 140case study (Midway Games) 140ndash148Investorrsquos Business Daily 126ndash132

136ndash140(See also Investorrsquos Business Daily)

magazine coversarticles 37ndash42New York Times The 133Vickers Weekly Insider Report 103ndash105Wall Street Journal The 133

Flutie Doug 23Form 4 filings 105Form 13 filings 103 140 286Form 13-D filings 103 140Freeedgarcom 286Frontier Corp 266ndash270Frost A J 205Frost Robert 95

G

Gateway 52ndash53Genovese Drug Stores 192 194ndash201Gifford Frank 54Goldman William 69 70Goodfriend Jaimi 254Goodman George 6 23Grass Martin 191 192 233 236Greenberg Herb 247Greenmail 121Greenspan Alan 44 61Griffin Nancy 228

H

HealthSouth 251Heaven Can Wait 36Herd instinct 31Heyman Samuel 113ndash124

298 INDEX

Index 7901 904 AM Page 298

Hills Roderick M 253Hit amp Run (GriffinMasters) 228Horse racing 6 7Horror stories (merger mania) 233ndash254Huff Rolla 269

I

IBD (see Investorrsquos Business Daily)Illustrations (see Case studies)Index investing 31ndash34Interest rates 59ndash62 69Interpreting the news 4 5Investing paradigms 25ndash30Investorrsquos Business Daily 97 126ndash132

dirty rotten stocks 127ndash130ldquoIndustry Profilerdquo 136 137problems 127ndash132ldquoStocks in the Newsrdquo 138ndash140ldquoTo the Pointrdquo 130 132ldquoWhere the Big Moneyrsquos Flowingrdquo

130 137 138

J

JCPenney 233ndash237 251

K

Keynes John Maynard 57Kidney dialysis industry 215ndash222Kirby Industries 170ndash172Kondratieff Nikolai D 45

L

LaLoggia Charles M 3 4 303Large-cap stocks 32 33 71 72Learning Company The 247ndash250Lemming 31Lemming effect 225ndash227 251 255Limbaugh Rush 43List of potential superstocks 288ndash294Long-term bonds 59LTV Corporation 12 13

M

Magazine coversarticles 37ndash42Mahon Cherrie 124 146 147 303

Major shareholders 286(See also Beneficial owner transac-

tions)Malraux Andreacute 53Mansfield Chart Service 27 97 211Masters Kim 228Mattel 247ndash250Mayo Michael 49ndash51McKesson HBOC 251Mead Corp (MEA) 135Media (see Financial press)Merck 225Meredith Don 54Merger mania 223ndash257

blunders 231 232 251case studies

JCPenneyRite Aid 233ndash237MattelThe Learning Company

247ndash250Protection One 238ndash247Waste ManagementAllied Waste

251ndash254CEO egos 227ndash229investment bankingrsquos desire for fees

230lemming effect 225ndash227 251merger of equals 256 257take the money and run 232 256

Merger of equals 256 257Middlesex Water (MSEX) 129Midway Games (MWY) 140ndash148Money Game The (Goodman) 6Morita Akio 228 229Mudslinging contest 122

N

Nathan John 228National City Corp 50Negative surprise 213 214New paradigm vs old paradigm

thinking 27ndash30New York Times The 97 133Nicastro Neil 142ndash148 180 1811929 Again (Rudd) 441987 stock market crash 42

INDEX 299

Index 7901 904 AM Page 299

ldquoNo Bottom to Oilrdquo 40No-risk rate of return 69Nobody knows anything 70North Oliver 43

O

OrsquoNeil William 127 128Old paradigm vs new paradigm

thinking 27ndash30One-decision stock paradigm 25 26Oneok (OKE) 245 246Oxenstierna 223

P

Paradigm 25PCS Health Systems 225ndash227Pharmacy benefits manager (PBM) 225Pinault-Printemps-Redoute 134Pittway 129Potential takeovers (Telltale Signs)

98ndash101Priceearnings ratios 58 59Protection One 238ndash247Public mudslinging contest 122Pure plays 188 189

R

Redstone Sumner 145 159ndash166 168172ndash174 177 184

Relative leadership index 34Ren-Corp USA 216ndash219Renal Treatment Centers 219ndash222Research departments 20 21Research universe 97 98Resistance level 206Resources 295 296

(See also Financial press)Rexel Inc 78ndash84Riskless alternative to the stock market

59Rite Aid 233ndash237 251Rite AidndashRevco merger 190ndash193Rohr Inc 210ndash214Rudd Terry R 44 147 210

S

SampP priceearnings ratio 58Salick Health Care (SHCI) 207ndash211Samuelson Robert 41Scharf Stewart 253Schliemann Peter 71Service Corp International 251Shining The 39Shopping list of potential superstocks

288ndash294Shore Andrew 46ndash48SJW Corp 282Small-cap stocks 32Smith Food amp Drug Centers

201ndash202SmithKline Beecham 225Sony 227ndash229Sony The Private Life (Nathan) 228ldquoSpecter of Depression Therdquo

(Samuelson) 41Spin-offs 188ndash190Stock charts 138 139 159 205ndash214Stock market crash of 1987 42Stock selection 19ndash23Sugen Inc 260ndash265Sullivan Allanna 272Sunbeam Corp 46ndash48Supermoney (Goodman) 23Superstock 11Superstock breakout pattern 206Superstock Investor 1 17 303Superstock shopping list 285ndash294Synergy 188 189

T

Takeover indicators (Telltale Signs)98ndash101

Takeover-lively industry 203Talk shows 42Technical analysis 139Telltale Signs 98ndash10110-K Report 245The Learning Company 247ndash25013-D filings 103 140

300 INDEX

Index 7901 904 AM Page 300

TEAMFLY

Team-Flyreg

ldquoThis Is Not Just a Bear Market This Isthe Way Things Are Going to Befrom Now Onrdquo 53

TJ International 102Triple play 141 148Trus Joist 102

U

United Water Resources 281 282

V

Value 62Value investing 57Vickers Weekly Insider Report 26 97

103ndash105Vignettes (see Case studies)Vivra 215ndash222

W

Wall Street Journal The 97 132ndash134Wall Street research 20 21Warnock Tom 257Waste Management 251ndash254Water utilities 271ldquoWater Utility Industrial Could Be on

the Verge of a Takeover Waverdquo(LaLoggia) 27

Western Resources 86ndash92 238ndash246Weyerhauser 101 102ldquoWhy Greenspan Is Still Bullishrdquo 41Wittig David 238ndash244WMS Industries 159ndash185Woodward Bob 44

Y

Yucaipa Cos 202 203

INDEX 301

Index 7901 904 AM Page 301

This page intentionally left blank

A B O U T T H E A U T H O R S

Charles M LaLoggia is the editor and publisher of Superstock Investora monthly stock market newsletter he has published since 1974 Hehas also written numerous newspaper columns and magazine articleson investing Charles LaLoggiarsquos stock market views and stock rec-ommendations have been reported in virtually every major financialpublication in the world including BusinessWeek The Wall Street JournalBarronrsquos The New York Times Kiplingerrsquos Personal Finance Money FortuneNewsweek and many others He has appeared on numerous televisionand radio programs including Wall Street Week With Louis RukeyserThe Nightly Business Report on 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 ldquounquestionably oneof the countryrsquos hottestmdashif not the hottestmdashtakeover pickerrdquo In aDecember 2000 article entitled ldquoRiding the Buyout Waverdquo Fortunemagazine said that Charles LaLoggiarsquos Superstock Investor newsletterldquohas a solid record for predicting buyoutsrdquo

Cherrie A Mahon is copublisher and director of research of theSuperstock Investor newsletter Prior to that she was a stockbroker at amajor Wall Street firm

Further information regarding the monthly Superstock Investornewsletter is available by e-mailing ssinvestoraolcom or calling1-800-450-0551 or writing to Superstock Investor PO Box 30547Rochester New York 14603

About the Author 7901 904 AM Page 303

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

This page intentionally left blank

THE SUPERSTOCKINVESTORProfiting from Wall StreetrsquosBest Undervalued Companies

Charles M LaLoggiaCherrie A Mahon

McGraw-HillNew York Chicago San Francisco

Lisbon London Madrid Mexico CityMilan New Delhi San Juan Seoul

Singapore Sydney Toronto

FM 7901 843 AM Page iii

Copyright copy 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 0-07-136083-2

All 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_hoaremcgraw-hillcom or (212) 904-4069

TERMS OF USEThis is a copyrighted work and The McGraw-Hill Companies Inc (ldquoMcGraw-Hillrdquo) 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 upontransmit distribute disseminate sell publish or sublicense the work or any part of it withoutMcGraw-Hillrsquos prior consent You may use the work for your own noncommercial and personal useany 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 ldquoAS ISrdquo McGRAW-HILL AND ITS LICENSORS MAKE NO GUAR-ANTEES OR WARRANTIES AS TO THE ACCURACY ADEQUACY OR COMPLETENESS OFOR RESULTS TO BE OBTAINED FROM USING THE WORK INCLUDING ANY INFORMA-TION THAT CAN BE ACCESSED THROUGH THE WORK VIA HYPERLINK OR OTHERWISEAND EXPRESSLY DISCLAIM ANY WARRANTY EXPRESS OR IMPLIED INCLUDING BUTNOT LIMITED TO IMPLIED WARRANTIES OF MERCHANTABILITY OR 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 therefromMcGraw-Hill has no responsibility for the content of any information accessed through the workUnder no circumstances shall McGraw-Hill andor its licensors be liable for any indirect incidentalspecial 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 otherwise

DOI 1010360071381163

abcMcGraw-Hill

C O N T E N T S

ACKNOWLEDGMENTS ix

INTRODUCTION 1

PART ONE

THE MAKING OF A SUPERSTOCK INVESTOR

Chapter One

A Defining Moment 11

Chapter Two

A Superstock Is Born 15

Chapter Three

Stock Selection 19

Chapter Four

Investing Paradigms A New Way of Thinking about Stock Selection 25

Chapter Five

The Twilight of Index Investing 31

Chapter Six

Experts What Do They Know 35

Case Study Sunbeam 46

Chapter Seven

What Is Value 57 v

FM 7901 843 AM Page v

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

Chapter Eight

If Everybody Knows Everything Then Nobody KnowsAnything 65

PART TWO

IDENTIFYING TAKEOVER TARGETS

Chapter Nine

Creeping Takeovers 77

Case Study How Rexel SA Acquired Rexel Inc 78Case Study The Takeover of ADT 85

Chapter Ten

How to Create Your Own ldquoResearch Universerdquo of TakeoverCandidatesmdashThe Telltale Signs 95

Case Study Spotting Brylane as a Takeover Target 106Case Study Sam Heyman and Dexter Corp 111

Chapter Eleven

How to Use the Financial Press 125

Case Study The Triple Play and Midway Games 140

Chapter Twelve

Family Feuds 149

Case Study Copley Pharmaceuticals 149

PART THREE

TAKEOVER CLUES

Chapter Thirteen

ldquoBeneficial Ownerrdquo Buying 159

Case Study Sumner Redstone and WMS Industries 159

vi CONTENTS

FM 7901 843 AM Page vi

Chapter Fourteen

The ldquoPure Playrdquo and the Drugstore Industry 187

Case Study Fayrsquos and Genovese 190Case Study Smith Food amp Drug Centers 201

Chapter Fifteen

Using Charts 205

Case Study Salick Health Care 207Case Study Rohr Inc 210

Chapter Sixteen

The Domino Effect 215

Case Study Vivra and Ren-Corp USA 215Case Study Renal Treatment Centers 219

Chapter Seventeen

Merger Mania Take the Money and Run 223

Case Study JCPenney and Rite Aid 233Case Study The Alarming Story of Protection One 238Case Study How Mattel Got Played by The Learning Company 247Case Study Waste Management and Allied Waste Industries 251

Chapter Eighteen

Look for Multiple Telltale Signs 259

Case Study Sugen Inc 260Case Study Frontier Corp 266Case Study Water Utilities 271

APPENDIX A SUPERSTOCK SHOPPING LIST 285

RESOURCES 295

INDEX 297

CONTENTS vii

FM 7901 843 AM Page vii

This page intentionally left blank

A C K N O W L E D G M E N T S

I would 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 ldquomainstreamrdquo 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 timeto think about and explain in detail the thought processes that wentinto the recommendations in the newsletter In a way Cherriersquos 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 them

Obviously 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 bornmdashand if it were not for Cherrie I probably neverwould have had the determination to complete it Her supportthroughout this process was invaluable

Charles M LaLoggia

ix

FM 7901 843 AM Page ix

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

This page intentionally left blank

TEAMFLY

Team-Flyreg

Introduction

If yoursquod been born in a cave and had lived there your entire lifewith 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 signalsThe signals would be all around you but yoursquod be oblivious to themwithout the means to pick them up

Similarly if you are accustomed to a certain way of reading thefinancial news you can pick up ldquosignalsrdquo 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 force the stock market to recognize that stockrsquos true value Icall such stocks ldquosuperstocksrdquo because they can leap above any kindof market in a single bound

I began publishing my stock market newsletter as The CMLInvestment Lettermdashcurrently named Superstock Investormdashin December1974 Along the way I developed a reputation for being able to spotneglected companies that were about to become stock market starsmdashnot 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 companyrsquos value as abusiness Usually that ldquosomethingrdquomdashan outside event or what Icall a ldquocatalystrdquomdashhad the effect of pushing the stock price higher inone sudden jump rather than gradually over time Seemingly that

1

Introduction 7901 844 AM Page 1

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

outside event came out of the blue But in reality that event was thelogical conclusion to a series of events that began with a single clueor Telltale Sign that strongly suggested what the ultimate outcomewould be

This 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 Indash1)

I want to make one thing perfectly clear at the outset thoughWhat you will learn in this book is not a ldquoget rich quickrdquo method ofinvesting There are no sure things in the stock market except thisThere are no sure things I have seen countless systems and approach-es to stock selection and market timing come and go Many workfor a whilemdashsometimes for quite a whilemdashand then fall into disfa-vor and disrepute because they simply stop working Nobody knowswhy Some resurface years later and begin working again ldquodiscov-eredrdquo by a new generation of investors

But that is not what this book is all about This approach is nota ldquosystemrdquomdashrather 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 usingmdashit 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 market

In effect this approach will provide you with a sort of ldquoofflinerdquoportfolio 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 market

Almost all of the 48 stocks that received takeover bids duringthat 55-month period ending in September 2000 were on my newslet-terrsquos recommended list because based on the approach described

2 INTRODUCTION

Introduction 7901 844 AM Page 2

INTRODUCTION 3

T a b l e Indash1

Charles M LaLoggiarsquos 48 Takeover Bids in 55 Months

Percent PercentGain Annualized

Months Held (or Loss) Gain (or Loss)

Sep rsquo00 Advest 1 +19 +230

Sep rsquo00 AXA Financial 12 +70 +70

Sep rsquo00 Donaldson Lufkin 8 +85 +127

Aug rsquo00 PaineWebber 21 +119 +88

Dec rsquo99 Pittway 3 +41 +164

Dec rsquo99 Dexter Corp 5 +36 +864

Nov rsquo99 ErsquoTown Corp 11 +38 +414

Oct rsquo99 SJW Corp 10 +100 +120

Sep rsquo99 Nichols Research 19 +10 +63

Aug rsquo99 United Water Resources 9 +77 +1026

Aug rsquo99 Copley Pharmaceuticals 11 +23 +251

July rsquo99 Red Roof Inns 9 +30 +40

June rsquo99 Aquarion 7 +50 +857

June rsquo99 Sugen Inc 42 +169 +482

Mar rsquo99 Frontier Corp 28 +156 +54

Jan rsquo99 Alarmguard 21 +21 +12

Dec rsquo98 Brylane 2 +52 +312

Nov rsquo98 Genovese Drug Stores 27 +219 +973

Nov rsquo98 Pool Energy Services 56 +53 +113

Aug rsquo98 Clearview Cinemas 6 +75 +150

Aug rsquo98 American Stores 2 +25 +150

Jul rsquo98 Life Technologies 2 +20 +120

Jul rsquo98 Grand Casinos 7 +46 +788

May rsquo98 Union Texas Petroleum 8 +21 +315

May rsquo98 Giant Food 28 +36 +154

Feb rsquo98 Harveyrsquos Casino 1 +32 +384

Feb rsquo98 Arbor Drugs 17 +163 +115

Dec rsquo97 Showboat 25 +16 +77

Nov rsquo97 Holmes Protection 10 +43 +516

Nov rsquo97 Renal Treatment 28 +261 +1118

Sep rsquo97 Rexel Corp 23 +110 +574

Sep rsquo97 Rohr 27 +124 +551

Sep rsquo97 Riviera Holdings 1 +0 +0

Sep rsquo97 WHG Resorts 5 +100 +240

Aug rsquo97 Protection One 7 +105 +180

Continued

Introduction 7901 844 AM Page 3

in this book I considered them takeover candidates No ldquomagicrdquoinsights will be revealed here instead this book will describe whatI have observed to be true over 25 yearsmdashthat a certain event ordevelopment tends to lead to another which ultimately results inthe birth of a ldquosuperstockrdquo 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 atmdashor very nearmdashits intrinsic valueas a business

In 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 superstocks

Let me repeat that the approach to investing you are about tolearn is not a system The key to this approach is interpreting the news

4 INTRODUCTION

T a b l e Indash1

Charles M LaLoggiarsquos 48 Takeover Bids in 55 Months(continued)

Percent PercentGain Annualized

Months Held (or Loss) Gain (or Loss)

Jul rsquo97 Rotech Medical 36 +143 +476

May rsquo97 Logicon 40 +292 +876

May rsquo97 Smith Food amp Drug 7 +50 +857

May rsquo97 Vivra 36 +119 +396

Feb rsquo97 UNC Inc 6 +100 +200

Dec rsquo96 ADT Corp 9 +50 +666

Dec rsquo96 Roosevelt Financial 12 +22 +22

Oct rsquo96 Ornda Healthcare 4 +16 +48

July rsquo96 Fayrsquos Drugs 7 +87 +1491

July rsquo96 Bally Corp 2 +20 +120

Jun rsquo96 Community Health 11 +40 +436

Apr rsquo96 Hemlo Gold 12 +29 +29

Feb rsquo96 Loral Corp 10 +15 +18

Introduction 7901 844 AM Page 4

This 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 isnrsquot easy to implement

Over 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 naturemdashit describes what companies and their man-agement and major shareholders tend to do during the yearsmonths 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 someonemdasheither inside or outside the companymdashbelieves 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 it

To 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 seeingmdashand sticking to your convictions even whenthere is little or no support from Wall Streetmdashwell I just canrsquot imag-ine this approach becoming so popular that it simply stops working

A question often asked about investment books is Does thesystemmdashin this case the interpretive approachmdashalways work

The answer here is a resounding no There is no sure-fire keyto stock market riches There have been plenty of times when theldquoTelltalerdquo Signs yoursquoll read about here seemed to point directly to afuture superstock only to turn out in the end to be unprofitable

Does that bother youIt shouldnrsquot because reality should never bother you on any

levelmdashit should only serve as a means for better understanding theway the world really works Every mistake along the waymdasheveryroad you take or stock you buy that does not work out as hopedmdashshould be considered a learning experience that will make the nextexperience more likely to succeed

I can only say that if you follow the clues described here yoursquollend up with more winners than losers

INTRODUCTION 5

Introduction 7901 844 AM Page 5

Now I will describe some really interesting things I have learnedover the years Itrsquos an approach to investing that has served me welland if you learn to use it it will do the same for you

THE BULLS THE BEARS AND THE HORSES

The recent trend toward microanalyzing the stock market on aminute-by-minute basis has less to do with investing than it doeswith providing a ldquofixrdquo for stock market addicts In his classic bookThe Money Game author George Goodman writing under the nameldquoAdam Smithrdquo 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 A large part ofthe stock marketrsquos 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 life

I 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 gardening

There are many people who will tell you that the stock marketis actually just like horse racing and if you stop to think about itthey 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 ldquoTheyrsquore offrdquo

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 bell

It 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

6 INTRODUCTION

Introduction 7901 844 AM Page 6

Financial magazines are multiplying like rabbits while the DailyRacing Form has been sold and resold several times as its circulationeroded year after year

Letrsquos 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 nonstopaction for 61frasl2 hours 5 days a week and if yoursquore 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 hours

Wall Street never stops How can horse racing compete withthis

For one thing they might try out the concept of horse brokersIn New York State there are Off Track Betting parlors scattered allover the place Whatrsquos 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 business

And why stop there To support the sales forcemdashexcuse methe horse brokersmdashOTB could even hire analysts to write researchreports If you are a ldquovaluerdquo 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 ldquomomentumrdquo player whoconcentrates on technical analysis with a preference for followingthe ldquosmart moneyrdquo 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

ldquoWho cares why the odds are going downrdquo he would screaminto the telephone ldquoThis is a momentum horse Get your moneydown now before itrsquos too laterdquo

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

Introduction 7901 844 AM Page 7

ings to keep the stock price up so insiders can bail out at high pricesYou want to take a shot at big money Forget optionsmdashplay the dailydoublemdashhere are our top picks for speculators of course Whatrsquosthat Yoursquore wondering what to do with your pension funds Whythat calls for a more conservative approachmdashhow 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 way

This book is about a different way

8 INTRODUCTION

Introduction 7901 844 AM Page 8

P A R T O N E

The Making of aSuperstock Investor

Chap 01 7901 844 AM Page 9

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

This page intentionally left blank

TEAMFLY

Team-Flyreg

C H A P T E R O N E

A Defining Moment

LALOGGIArsquoS DICTIONARY

Su-per-stock (soo-per-stok) A stock 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 eventor ldquocatalystrdquo usually a takeover bid which if it occurred wouldforce the price higher

Since most stock market investors are obsessed with growth per-fectly good companies with consistent profitsmdashmany of which arecash rich with little or no debtmdashare passed over shunned by themajority of investors seeking growth and earnings momentum

Yet 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 ldquodeadrdquo money whileother stocks provide solid gains

These superstocks generally sell far below their actual value asa business but nobody cares because the companyrsquos earnings maybe erratic or even trending lower and the companyrsquos growth poten-tial may be unexciting

A number of events or ldquocatalystsrdquo 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 orindividualmdashand sometimes even the management of the companymdash

11

Chap 01 7901 844 AM Page 11

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

offers 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 A thirdcatalyst is a large onetime cash or stock dividend where a companydistributes accumulated cash or shares in a wholly owned subsidiaryto its shareholders A fourth 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 ownership

These potential catalysts as well as others can suddenly turna previously boring uninteresting company into a superstockmdashastock that rises dramatically in price usually over a one- to two-dayperiod regardless of what the overall stock market is doing

A LIGHTBULB GOES ON

The early 1970s were a difficult time for the US economy and alsofor the stock market A sharp rise in inflation in 1972ndash73 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 570

In the midst of this economic and financial downturn manycompanies saw their earnings evaporate and turn into huge lossesCompanies cut or reduced dividends on their common and pre-ferred stocks

By 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 again

I also noticed that some of the preferred stocks that had stoppedpaying dividends were ldquocumulativerdquo which meant that all unpaiddividends would accumulate and have to be paid in full before anydividends could be paid on the common stock

One such company was LTV Corporation which had sus-pended the dividend on its $5 Cumulative Preferred stock back to1970 By April 1975 $2250 of dividends ldquoin arrearsrdquo had accumu-lated LTVrsquos earnings were turning sharply positive by 1975 and its

12 PART ONE The Making of a Superstock Investor

Chap 01 7901 844 AM Page 12

shareholders who noted the improvement had begun to push fordividends on the common stock

LTV issued a statement that it would soon ldquoconsiderrdquo 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 wordsanyone who had bought the $5 Cumulative Preferredmdashthen tradingat about $57 a sharemdashstood a reasonable chance of getting a lump-sum payment of $2250 a share Also if the regular $5 preferred divi-dend were reinstated the stock would probably move higher

So if a certain event took placemdashthe payment of the $2250 pershare in back dividendsmdashLTV Preferred stock would literally beforced higher no matter what the general stock market did

Using this reasoning I recommended LTV $5 CumulativePreferred Not long afterward LTVrsquos Board of Directors announcedit would pay the $2250 in back dividends and reinstate the $5 annu-al preferred dividend The price of LTV Preferred soared when thisnews was announced

With this ldquotasterdquo of what would become superstock investingI looked for a company in a similar situationmdashand found it LikeLTV Avco Corporation had a cumulative preferred stock (the $320Cumulative Preferred) trading on the New York Stock ExchangeLike LTV Avco had fallen on hard times and suspended dividendpayments on the preferred and they were accumulating ldquoin arrearsrdquoAnd like LTV Avcorsquos earnings had taken a major turn for the betterand its common stockholders were pushing for dividends on thecommon shares which could only be paid if the arrears were paidon the cumulative preferred stock

I recommended Avco $320 Cumulative Preferred in August1975 at 181frasl2 After Avco paid all of the arrears on the preferred stockand reinstated the annual $320 dividend the stock was selling at$47 This literally forced the stock market to revalue the preferredstock at a higher level since that $320 annual dividend would havecreated a yield of almost 18 percent based on the original price of181frasl2mdashfar 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 developmentmdashthe reinstated dividendmdashthis stock had to go up

CHAPTER ONE A Defining Moment 13

Chap 01 7901 844 AM Page 13

Remember though higher earnings do not necessarily meanthat a stock has to go up even if those earnings beat analystsrsquo expec-tations A fat 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 situation

THE LESSON LEARNED

Herersquos what can be learned from these two successful recommen-dations Sometimes it is possible to anticipate a certain specific eventwhichmdashif it were to take placemdashwould 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 world

It is these events that create the world of ldquosuperstocksrdquo

14 PART ONE The Making of a Superstock Investor

Chap 01 7901 844 AM Page 14

C H A P T E R T W O

A Superstock Is Born

On August 3 1998 American Stores a supermarket and drugstorecompany jumped 53frasl4 points or 25 percent American Stores was thelargest percentage gainer on the New York Stock Exchange that daya day on which the Dow Jones Industrial Average dropped 96 pointsThe following day the Dow fell 299 points and American Storesonce again bucked the trend rising another 13frasl16

With that performance American Stores joined the ranks of thesuperstocksmdashstocks that have the ability to rise quickly and sub-stantially in price no matter what the general stock market is doing

What propelled American Stores into the ranks of the super-stocks A takeover 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 Storesrsquo 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 ldquocatalystrdquo waspropelling the price change and American Stores shareholderswatched their stock soar in price as the general stock market col-lapsed over a 2-day period

Takeover 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 dayrsquos closing price Itrsquos not uncommon fortakeover bids to drive a stock price higher by 25 percent 50 percent

15

Chap 02 7901 845 AM Page 15

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

or even more in a single daymdashusually in a single trade right at theopening bell following the announcement that Company A is offer-ing to buy Company B

And 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 finalpredictable event that is the culmination of a series of other eventsThey 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 donrsquot know what to look for

And herersquos 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 riskyoursquoll be taking is opportunity riskmdashand even that usually turnsout to be a temporary problem A neglected 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 underperfor-mance

And 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 2000

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 ldquoget richquickrdquo system backtested by computer and guaranteed to makeyou rich

This is a book for investors who recognize that successful invest-ing requires research and clear original thinking Itrsquos for investorswho understand that brains are often confused with bull markets andthat in a rising market anyone can look like a genius Those with theexperience or insight understand that the true test of investment

16 PART ONE The Making of a Superstock Investor

Chap 02 7901 845 AM Page 16

acumen comes when the general stock market is going against youThen and only then are the benefits of shrewd stock selection clear-ly apparent

Every 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 outcomemdasha profitable takeover bid

American 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 general

American 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 highercompletely disregarding the spreading weakness in the overall stockmarket That performance combined with the established takeovertrends in both the supermarket and drugstore industriesmdashtwo busi-nesses operated by American Storesmdashsuggested that American Storeswas acting like a potential superstock

When American Stores received a takeover bid from Albertsonson August 3 investors enjoyed large profits while the broad stockmarket was declining sharplymdashprecisely the result a superstock issupposed to deliver

By the time you finish this book yoursquoll know how to identifysuch potential superstocks as they tip their hand And by then yoursquollhave a framework to help you get started

CHAPTER TWO A Superstock Is Born 17

Chap 02 7901 845 AM Page 17

This page intentionally left blank

C H A P T E R T H R E E

Stock Selection

For most investors the traditional method of stock selection goessomething like this

Yoursquore sitting in your office trying to figure out where to go tolunch and the phone rings Itrsquos your broker

ldquoHello Mr SpinellirdquoldquoYesrdquoldquoTom Hayden from Dewey Pickum amp HowerdquoldquoOh Hi TomrdquoldquoListen Mr Spinelli our research department has come out

with their stock pick of the weekrdquoldquoIrsquom thrilled What is itrdquoldquoGeneral Electric We think itrsquos a great company at these pricesrdquoldquoYou need a research department to tell me General Electric is

a great companyrdquoldquoWell no the thing is we think theyrsquore going to beat the street

estimates by around a penny a sharerdquoldquoGeneral Electric has tripled over the past four years Itrsquos dou-

bled over the past year and a half Now you tell me to buy GeneralElectricrdquo

ldquoWell wemdashrdquoldquoWhat else do you likerdquoldquoWe like Dell ComputerrdquoldquoDell ComputerrdquoldquoYes Our research department thinks itrsquos amdashrdquoldquoI know itrsquos a great company What elserdquo

19

Chap 03 7901 846 AM Page 19

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

ldquoUh IBMrdquoldquoListen Tom no offense but I can hear about every one of these

stocks a hundred times a day on CNBC I can give you the entire listby heart I already own six mutual funds and these stocks are inevery one of them Every one Why donrsquot you guys recommend astock like WMS Industries Thatrsquos a great turnaround story thatnobodyrsquos talking about Plus the Chairman of Viacom has been buy-ing this stock on the open market and he owns 25 percent of thecompany He obviously thinks itrsquos undervalued Maybe hersquoll makea takeover bidrdquo

ldquoWMS IndustriesrdquoldquoYeahrdquoldquoUh Letrsquos see Here it is Well they have no debt And they

have lots of cashrdquoldquoExactly Itrsquos a great situationrdquoldquoWell no You see if they have no debt and they have lots

of cash we probably wouldnrsquot recommend itrdquoldquoWhy notrdquoldquoWell because they probably wouldnrsquot need to do any invest-

ment banking businessrdquoldquoAny whatrdquoldquoInvestment banking business See if they wanted to do a stock

or bond offering we could be their investment banker and then wersquodrecommend the stock Thatrsquos how it works with smaller companiesrdquo

ldquoIt doesrdquoldquoUsually yesrdquoBy the end of this conversation you have learned an invalu-

able lesson about Wall Street Much of the timemdashperhaps most ofthe timemdashmainstream 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 withbut they are also not even potential investment banking clients for

20 PART ONE The Making of a Superstock Investor

Chap 03 7901 846 AM Page 20

TEAMFLY

Team-Flyreg

the 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 poorguyrsquos 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

ldquoWe canrsquot get anybody to talk to usrdquo the president moanedldquoWhy notrdquo I askedldquoBecause we donrsquot want to do any banking business with the

brokerage firmsrdquoI asked him if he was jokingldquoNordquo he said ldquoThey 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 companyrdquo

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 targets

What 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

CHAPTER THREE Stock Selection 21

Chap 03 7901 846 AM Page 21

Imagine some poor junior analyst trying to convince his or herboss to recommend WMS Industries

ldquoMr GerardrdquoldquoYeahrdquoldquoI have this report Irsquod like you to look atrdquoldquoItrsquos a buy recommendation isnrsquot itrdquoldquoYesrdquoldquoBecause we donrsquot want to offend anybody Thatrsquos bad busi-

nessrdquoldquoYes I knowrdquoMr Gerard looks at the report ldquoWMS Industries huh Market

cap is only $500 million Thatrsquos pretty small for us How much do theywant to raiserdquo

ldquoExcuse merdquoldquoHow much money do they want to raiserdquoldquoUh I donrsquot think they want to raise any moneyrdquoldquoWhat do you mean they donrsquot want to raise money Look here

they have no debt Donrsquot they want to borrow some money Sellsome bondsrdquo

ldquoWell 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 andmdashrdquo

ldquoDo they want to acquire somebodyrdquoldquoNot that I know ofrdquoldquoWell then what are you bothering me for Get out of my office

Come back when you can recommend something that will generateus some revenuerdquo

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 clientEarnings 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

22 PART ONE The Making of a Superstock Investor

Chap 03 7901 846 AM Page 22

these stocks are so overvalued relative to their small-cap counter-parts that the pendulum must inevitably swing the other way

Years ago Doug Flutie electrified the college football world when hethrew a ldquoHail Maryrdquo 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 timescapped a stellar collegiate career for Flutie But after he graduatedFlutie 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 superstar

Flutiersquos shortcoming as far as the NFL was 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 yoursquore 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 downfieldAnd so the NFL said ldquoSorry too shortrdquo and Flutie went on to leadseveral Canadian Football League teams to championships

If you follow football at all you probably know the rest of thestory Flutie returned to the NFL in 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 Bowl

How 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 asideavoid the lumbering behemoths and scramble around until he spot-ted the receivers and completed passes

In his book Supermoney author George Goodman writing underthe name ldquoAdam Smithrdquo used the analogy of the small but nimblequarterback to point out that individuals can compete with the giantinstitutional investors by ldquotaking a quick look and stepping into thegaps between themrdquo 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

CHAPTER THREE Stock Selection 23

Chap 03 7901 846 AM Page 23

This page intentionally left blank

C H A P T E R F O U R

Investing Paradigms A New Way of Thinkingabout Stock Selection

A paradigm 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 wersquore 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 timeswe become dissatisfied with the results our actions create and itbecomes necessary to create a new paradigm

When it comes to selecting individual stocks 999 percent ofinvestors and Wall Street analysts are operating using a dog-earedshop-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 pricesThere are two problems with this paradigm First itrsquos been in exis-tence for nearly 20 years and itrsquos getting a bit creaky In fact itrsquos prob-ably on its last legs The second problem with this paradigm is thatitrsquos not new itrsquos only a new version of other paradigms that havecome and gone over the years The late 1960s version for examplewas called the ldquoOne-Decision Stock Paradigmrdquo In this version cer-

25

Chap 04 7901 846 AM Page 25

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

tain 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 wasnecessarymdashto buy them

That 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 normalrun-of-the-mill cyclical stocks

This book offers a new paradigmmdasha 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 favorWhen you read The Wall Street Journal ignore the market commentaryand the earnings digest and instead look for itemsmdashespecially smallitemsmdashthat 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 ldquogrowth through acquisitionsrdquo 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 andor 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 Report and 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 ldquoShareholder Rights Planrdquo designed to make a takeover more

26 PART ONE The Making of a Superstock Investor

Chap 04 7901 846 AM Page 26

difficult based on the theory that the company wouldnrsquot 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 ldquocatalystrdquo 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 bid

Finally 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 peersmdashoften a sign that some sortof takeover development is brewing

This way of thinking is new paradigm territory for 999 per-cent of investors and analysts At first it may seem difficult andunusual but if you have the courage to enter this new paradigmyou will find yourself in a fascinating new world where all sorts ofnew and exciting stock ideas will present themselves Yoursquoll 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 yoursquoll feel almost as if you can see the future andyou will marvel at the inability of others to do the same

And if you think thatrsquos exaggeration consider this real-lifeexample of old paradigm thinking versus new paradigm thinkingIn December 1998 I presented a front-page story in Superstock Investorentitled ldquoWater Utility Industry Could Be on the Verge of a TakeoverWaverdquo 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 placemdashthe purchase of Consumers Water byPhiladelphia Suburban and the purchase of National Enterprisesby American Water Worksmdashand that a third smaller takeover of

CHAPTER FOUR Investing Paradigms 27

Chap 04 7901 846 AM Page 27

Dominguez Water by California Water Service had just been an-nounced

In 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 basis

Later 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 $3705 per share a 50 percent premium over my original recom-mended price for Aquarion And remember we are talking hereabout a water utilitymdasha 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 takeoverCNBC 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 target

The 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 good

Unfortunately what followed was as classic an example of oldparadigm thinking as you could possibly hope not to see Here werethe questions Barr was asked

1 What are the possibilities of turning saltwater into drink-ing water

28 PART ONE The Making of a Superstock Investor

Chap 04 7901 846 AM Page 28

2 What about turning glaciers into drinking water3 What about turning icebergs into drinking water4 How difficult will it be for you to raise rates5 Do you think there might come a time when government

could confiscate your assets in the event of a water shortage6 What contingency plans have you developed in the event

terrorists attack the nationrsquos water supply

Terrorists Glaciers Icebergs These ridiculous questions are thetype that make superstock investors all across America groan withdisappointment A superstock investor would have immediatelyfocused on Mr Barrrsquos comment on growth through acquisitions andtried to pin him down with questions like these

1 What kind of water utility companies are you looking tobuy

2 What region of the country are you looking at for newgrowth opportunities

3 How big might a potential target be in terms of revenues4 What 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 Thatrsquoswhat 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 isnrsquot 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 yoursquore 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 ifyoursquore not used to thinking in these terms you miss golden oppor-tunities such as those the CNBC interviewers missed to bring newinformation to the surface

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

CHAPTER FOUR Investing Paradigms 29

Chap 04 7901 846 AM Page 29

plain view for everyone to see can be completely overlooked by themajority of investors and the people from whom they receive adviceand information

Just 10 months after this noninterview American Water Worksmade a takeover bid for SJW Corp SJW was on my recommended listas a takeover candidate Suppose for the sake of discussion one ofthe CNBC interviewers had asked J James Barr which region of theUS American Water Works might be looking at in terms of potentialacquisitions Suppose he had mentioned the western United StatesThis would have enabled superstock investors to zero in on the hand-ful of publicly traded western water utilities as possible targetsmdashSJW prominently among them But the question was never asked

And why wasnrsquot the question asked Well certainly not becausethe CNBC interviewers are not good at what 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 missedthe mark and the reason is that they were talking to a CEO who oper-ated in an obscure industry with a limited analytical following Upuntil 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 party

Making yourself aware of every industrymdasheven an obscureindustry like water utilitiesmdashthat is beginning to consolidate throughtakeovers requires a new way of thinking about the financial newsThe 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 ldquosuperstock paradigmrdquo and show youhow to think and invest within that new framework

But 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 letrsquos take a brief look atsome more of that landscape

30 PART ONE The Making of a Superstock Investor

Chap 04 7901 846 AM Page 30

TEAMFLY

Team-Flyreg

C H A P T E R F I V E

The Twilight of IndexInvesting

A lemming 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 Lemmingshowever 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 day

On Wall Street the herd instinct is a powerful force indeedProfessional money managers once they have been around for awhile discover there is great comfort in doing pretty much the samething everybody else is doing A certain 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 investing

We 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 naturalmdashand on Wall Streetit is extremely dangerous

31

Chap 05 7901 849 AM Page 31

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

The history of the stock market is replete with examples ofldquocanrsquot missrdquo investing techniques that were successful for a whileand then simply stopped working victims of an overpopularity thateventually created the seeds of their own destruction

In the 1960s for example small-cap stocks were all the rageWell-known large caps were viewed as too boring too predictableand 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 lemming

As 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 bornall of which were looking for the next IBM and all of which beganchasing smaller-cap stocks Eventually the bargains disappearedvictims 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 gears

More recently the focus has been on large-cap stocksmdashthe samelarge caps everybody used to shun If yoursquove heard it once yoursquoveheard it a thousand times The best way for individual investors tomake consistent profits in the stock market is to buy an ldquoindexrdquo fundthat tracks the performance of a broad-based stock market index likethe Standard amp Poorrsquos 500 Index which in turn represents a crosssection of Americarsquos most solid time-tested companies

Donrsquot try to pick individual stocksDonrsquot try to outsmart the stock marketDonrsquot go too far off the beaten path trying to find overlooked

values All pertinent information is so readily available and so wellanalyzed by the Wall Street geniuses that it is already processed andldquodiscountedrdquo by the market If yoursquore an individual investor donrsquoteven bother trying to find an edge It canrsquot be done

BaloneyLike lemmings stock market commentators and mutual fund

managers and investors who listen to their advice have run head-long toward the large-capindexing craze It sounds so simple whocan resist it This mantra has been repeated so often that you might

32 PART ONE The Making of a Superstock Investor

Chap 05 7901 849 AM Page 32

think 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 marketrsquos holy grailand that value asset-oriented stocks have always trailed the field

And yet those assumptions are not true Irsquom 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 maniamdashthat is the recent obses-sion with indexing and large-cap stocksmdashcontains the seeds of itsown destruction

Just a brief look at the past will prove the point Figure 5ndash1which tracks the relative performance of the SampP Low-Priced StockIndex to the SampP Big-Cap Index back to 1930 shows that smaller-capstocks and larger-cap stocks have taken turns outperforming eachother A rising 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 capsThe 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 again

What can we learn from this For one thing Anybody who tellsyou that the undisputed path to investment success is to index yourinvestments to the SampP 500 which is dominated by large-cap stockshas a limited sense of stock market history has never seen this chartor 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 itrsquos better to stop following the crowd

Early in 1999 the ldquovalue gaprdquo between large-cap and small-capstocks was at the highest level in history What this means is thatpriceearnings ratios accorded the large-cap stocks were at the high-est level ever relative to small-cap stocks

CHAPTER FIVE The Twilight of Index Investing 33

Chap 05 7901 849 AM Page 33

This fact combined with the historical evidence shown in Figure5ndash1 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

34 PART ONE The Making of a Superstock Investor

464

414

370

331

296

264

236

211

188

168

150

134

120

107

96

86

77

68

464

414

370

331

296

264

236

211

188

168

150

134

120

107

96

86

77

68Falling = High-Grade Leadership

Rising = Low-Priced Stocks Lead the Market

SampP Low-Priced Stock IndexSampP High-Grade Stock Index

1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995

F i g u r e 5ndash1

Relative Leadership Index

Chap 05 7901 849 AM Page 34

C H A P T E R S I X

Experts What Do They Know

When you get to a fork in the road take it Yogi Berra

By taking the fork in the road marked ldquosuperstock investingrdquo youoften will find that you have little if any analytical or ldquoexpertrdquo sup-port This may produce an uncomfortable feeling at first

This chapter is designed to get you over that feelingOnce you begin to think in terms of the ldquonew paradigmrdquo of stock

selection you will have to get used to the idea when you go off thebeaten path that yoursquore not going to have a lot of company In invest-ment terms the path in this book is definitely the road less traveled

Itrsquos perfectly natural for any investor to feel more comfortablewhen buying a stock that is recommended by a large number ofldquoexpertrdquo 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 hasnrsquot 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 day

35

Chap 06 7901 850 AM Page 35

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

In Heaven Can Wait James Mason an emissary from heavenreveals a basic truth of life when he tells Warren Beatty that ldquothelikelihood of a person being right increases in direct proportion to thenumber of people attempting to prove him wrongrdquo This is anotherway of saying that if you are looking for truth insight or really greatstock ideas donrsquot be afraid to go down that untrodden pathmdashanddonrsquot waver simply because most people donrsquot think the way youthink or canrsquot see what you see

When 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 yoursquoll learn to spot will strongly suggest thatbeneath 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 ie the ldquoexpertsrdquo

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 yoursquove 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 prices

It can be pretty lonely and sometimes spooky when yoursquorestrolling down the untrodden superstock path

To 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 ldquoexpertsrdquo are wrong wersquoll show you some world-class exam-ples of expert opinion that turned out to be completely off the mark

WHAT IS AN ldquoEXPERTrdquo ANYWAY

One wonderful definition is that an expert is ldquosomebody from outof townrdquo which is another way of saying that distance lends enchant-ment

Another definition and probably the best one for our purpos-es would identify an ldquoexpertrdquo 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-

36 PART ONE The Making of a Superstock Investor

Chap 06 7901 850 AM Page 36

sion of media outlets in recent years devoted to finance and invest-ing including the proliferation of financial Web sites this definitionof an ldquoexpertrdquo would have to be considered fully diluted if you getmy drift

ldquoExpertsrdquo have always had a difficult time predicting the futurealthough this has never stopped any of them from making predic-tions And it probably will not surprise you to learn that the USgovernment ranks right up there when it comes to the list of ldquoexpertsrdquowho have made pronouncements about the future that have turnedout to be spectacularly wrong

For example every now and then over the past 30 years wehave been subjected to an ldquoenergy scarerdquo 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 ldquoenergy doomsday scenariordquo havebeen going on for the last 115 years

Take a look at the list of predictions about energy supplies fromvarious US government agencies given in Table 6ndash1 and rememberit well the next time some bureaucrat or Wall Street analyst tells youthat oil or gas supplies are running out

But 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 thingeven genuine experts are out there taking their best educated guessjust 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 time

One 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 Time or Newsweekitrsquos time to consider the possibility that this particular trend has pret-ty much run its course A classic example of this phenomenon is theNewsweek cover dated December 2 1974 entitled ldquoHow Bad aSlumprdquo When this issue of Newsweek hit 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

CHAPTER SIX Experts What Do They Know 37

Chap 06 7901 850 AM Page 37

rates were in the stratosphere So ldquoHow Bad a Slumprdquo 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 peaked

A more recent example of a magazine cover signaling the end ofa financial trend was the December 27 1999 issue of Time magazinein which Amazoncom founder Jeff Bezos was named Timersquos ldquoPersonof the Yearrdquo That issue of Time coincided with the exact peak ofAmazoncomrsquos stock price which proceeded to fall from $113 to aslow as $1938 over the following year This does not imply that JeffBezos did not deserve the honormdashonly that Timersquos 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 Timersquos cover story signaled the end of the bull market notonly for Amazoncom but for every other Internet stock all of whichplunged dramatically during 2000 and many of which actually wentcompletely out of business

38 PART ONE The Making of a Superstock Investor

T a b l e 6ndash1

ldquoExpertrdquo Oil Supply Predictions from the USGovernment

Year Prediction

1885 Little or no chance for oil discovery in California (US Geological Survey)Little or no chance for oil to be discovered in Kansas or Texas (USGeological Survey)

1891 Little or no chance for oil to be discovered in Kansas or Texas (USGeological Survey)

1908 Maximum future supply of oil to be discovered in the United States will be225 billion barrels (US Geological Survey) (Note By 1949 35 billion barrels had already been discovered with another 27 billion barrels proven and available)

1914 Total future US production of oil will be a maximum of 57 billion barrels(US Bureau of Mines) (Note By 1976 another 34 billion barrels had beendiscovered with no end in sight)

1939 US oil supplies will last only 13 more years (US Department of theInterior)

1947 Sufficient oil for US energy consumption can no longer be found in theUnited States (US State Department)

1948 End of US oil supply almost in sight (Secretary of the Interior)

Source Herman Kahn The Next 200 Years (William Morrow amp Co New York 1976)

Chap 06 7901 850 AM Page 38

This 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 Illustrated ran a cover story on theinvincible Oakland Arsquos who were about to face the Cincinnati Redsin the World Series

ldquoThe 1988 Arsquosrdquo the story said ldquoare the best team the AmericanLeague has sent to the World Series since Charlie Finleyrsquos teams ofthe early 1970s These Arsquos may be even betterrdquo Having thus beenanointed one of the greatest baseball teams of all time the Arsquos wenton to lose four straight World Series games to the Cincinnati Reds

The ldquoexpertsrdquo arenrsquot very good at predicting recessions eitherEconomic recessions do not announce their arrival the way Jack

Nicholson announced his arrival in The Shiningmdashby breaking downa door with an axe and scaring Shelly Duval out of her wits as heannounced ldquoHoney Irsquom homerdquo Rather recessions tend to arriveon muffled oars quietly arousing little or no suspicion until one daythe Commerce Department announces that ldquoGuess 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 momentrdquo

Yet another classic example of the ldquoexpertsrsquordquo inability to pre-dict recessions was evident in July 1989 when Fortune announcedthere would be ldquoNo recession this year or nextrdquo Of course the reces-sion of 1990 was already in the process of beginning but none of theexperts Fortune relied on saw it coming

Just take a look at thr chronology of headlines in Table 6ndash2 tosee how much help the ldquoexpertsrdquo will be in preparing you for the nextrecession

CHAPTER SIX Experts What Do They Know 39

T a b l e 6ndash2

Chronology of Headlines

Source Headline

Fortune July 17 1989 ldquoNo Recession This Year or Nextrdquo

Newsweek September 1989 ldquoIs there Ever Going to Be Another Recessionrdquo

New York Times February 1990 ldquoEconomyrsquos Slide May Have Ended Greenspan Saysrdquo

Investorrsquos Business Daily January 1991 ldquoItrsquos Official The US Is in a Recession But It Wonrsquot Last Long Government Saysrdquo

Chap 06 7901 850 AM Page 39

You can also use the media to call turning points in both interestrates and oil prices Herersquos a classic On September 16 1987 The WallStreet Journalrsquos front page lead story was headlined ldquoThe Bond BearsDebt Securities Prices May Slide for Years Many Analysts Thinkrdquo

The implication was that interest rates would be rising for yearsinto the future This front-page story amazingly enough coincidedwith the exact peak in long-term interest rates When this storyappeared the 30-year Treasury bond was yielding around 1025 per-cent (see the arrow on the chart in Figure 6ndash1)

Bond prices then embarked on a relentless 6-year rally whichcarried the yield on the 30-year Treasury down below 6 percent bylate 1993

In another classic example Associated Press managed to catchthe exact bottom in crude oil when it ran a story on March 9 1986entitled ldquoNo Bottom to Oilrdquo Again check the arrow on the chart inFigure 6ndash1 This story managed to appear at the precise bottom in the

40 PART ONE The Making of a Superstock Investor

11

10

9

8

7

6

9075604530150

ndash15ndash30ndash45

36343230282624222018161412

11

10

9

8

7

6

907560453015

0ndash15ndash30ndash45

36343230282624222018161412

30-Year Constant Maturity Treasury Bond Yields

BOND PRICES MAY SLIDE FOR YEARS

NO BOTTOM FOR OIL

30-Year Treasury Yield PointsAnnum When

63-Day Change in Points ofCrude Oil Is Annum Time

Above 118 25 135Between ndash5 and 118 ndash43 546ndash5 and Below ndash75 319

West Texas Intermediate Crude Oil(NY Mercantile Light Sweet13-Week Perpetual Contract)

$ Per Barrel

72498 = 1455

72498 = ndash89

2144 2227

1800

3650

1735

2332

1807

2263

1885

2114

1434

1971

1694

1971

1657

2478

1916

1429

Crude Oil Prices63-Day Rate of Change

M1985

J S D M1986

J S D M1987

J S D M1988

J S D M1989

J S D M1990

J S D M1991

J S D M1992

J S D M1993

J S D M1994

J S D M1995

J S D M1996

J S D M1997

J S D M1998

J

F i g u r e 6ndash1

Examples of How the Media Can Call Turning Points

Source Ned Davis Research 2100 Riveredge Parkway Suite 750 Atlanta GA 30328

Chap 06 7901 850 AM Page 40

TEAMFLY

Team-Flyreg

price of oil which rose from $12 to $3650 a barrel within 4 years ofthe storyrsquos appearance

How did The Wall Street Journal manage 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 Journal andAssociated Press reporters went to their ldquoexpertrdquo sources thesesources had also gotten used to a trend that had been in force andsimply extrapolated that trend into the future Itrsquos 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 out

Pack 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 Fortune hit the newsstands the very week of the1987 stock market crash and it said ldquoWhy Greenspan Is Still BullishrdquoOn October 19 1987 the same week this issue appeared the Dow JonesIndustrial Average fell 508 points a 1-day plunge of 18 percent

Of 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 ldquohard timesrdquo were coming andthat investors and businesspeople should batten down the hatchesWrong again The media went overboard on the meaning of the 1987crash just as it went overboard on the rally that preceded the debacleThe consensus of the media and its ldquoexpertsrdquo 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 SamuelsonNewsweekrsquos economic columnist and a man about as mainstream asyou can get ran a column after the crash entitled ldquoThe Specter ofDepressionrdquo in which he asked the question Did the market crashserve as a warning that an economic depression was imminent Hisanswer delivered not entirely convincingly ldquoProbably notrdquo

CHAPTER SIX Experts What Do They Know 41

Chap 06 7901 850 AM Page 41

As 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 US economic advance that contin-ued with only brief interruptions for more than a decade

But you sure wouldnrsquot have guessed that in October 1987 if youhad listened to the ldquoexpertsrdquo

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 News ran abanner headline on page 5 ldquoEXPERTS NO RECESSIONrdquo I donrsquotknow about you but I did not find this headline reassuring

WHY EXPERTS CAN BE WRONG

So what is it with these ldquoexpertsrdquo anyway How can so many well-informed people be so wrong so often

Part of the problem may be that the pool of ldquoexpertsrdquo is gettingdiluted

A few 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 radio

Not anymore These days talk shows have multiplied to suchan extent that the supply of ldquoexpertsrdquo has increased to meet thedemand Of course common sense will tell you there is a limitedsupply of experts on any particular subject but this doesnrsquot seem tomatter very much because there is so much babble sprouting up inall forms of media that itrsquos possible to say almost anything no mat-ter how outlandish or uninformed and get away with it

The proliferation of Internet financial sites has also createddemand for more ldquoexpertsrdquo Every site needs columnists and ldquoana-lystsrdquo to expound on the daily developments on the financial sceneMost of them are excellent writers and it sure sounds like they knowwhat theyrsquore 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 ldquomomen-tumrdquo and ldquoindexrdquo investing

Itrsquos tough to tell if yoursquore reading truly informed analysis orjust plain nonsense that has been created to provide content

42 PART ONE The Making of a Superstock Investor

Chap 06 7901 850 AM Page 42

This nonsense cuts across ideological boundaries No matterwhat your personal political or business agenda it is possible toput your own ldquospinrdquo on almost anythingmdasheven historical mattersthat are not really open to debatemdashand 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 ldquothose gas lineswere a direct result of foreign oil powers playing tough with us becausethey didnrsquot fear Jimmy Carterrdquo But the firstmdashand worstmdashOPEC oilprice hike took place between 1973 and 1974 during the administra-tion of Richard Nixon Not only that but one reason for OPECrsquos 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 oil

Everywhere you look ldquoexpertsrdquo are spinning facts to promotean agenda To this day Democrats still try to deny that the economyperformed well under Ronald Reagan

Oliver 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 Live by calling the tapes ldquoallegedtapesrdquo which apparently means that North could not even bringhimself to acknowledge that such tapes even exist If he had acknowl-edged their existence after all it would have reflected badly onFalwell a philosophical and political ally

Everybody 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 days

When the media confronted Bellersquos agent the agent borroweda page from the OJ Simpson defense playbook and claimed the inci-dent was ldquoconcocted by the Chicago White Soxrdquo

So given the surging supply of ldquoexpertsrdquo and the heightened prob-ability that any given expert you may be listening to is promoting anagenda donrsquot be terribly concerned if you seem to have uncovered anexciting stock or two that is totally bereft of analytical ldquosponsorshiprdquo

CHAPTER SIX Experts What Do They Know 43

Chap 06 7901 850 AM Page 43

Even Federal Reserve Chairman Alan Greenspan is a ldquospinnerrdquowith an agenda In his book The Agendamdashan appropriate title for thisdiscussionmdashauthor Bob Woodward says that Greenspan managed toconvince thenndashTreasury Secretary Lloyd Bentsen early in PresidentClintonrsquos first term that the bond market would respond favorably ifthe Federal Reserve were to begin raising interest rates Bentsenimpressed with Greenspanrsquos reasoning performed the spin on Clintonwho 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 Reserversquos interest rate hike

So one reason why an ldquoexpertrdquo may be off the mark is that heor she is selling you a bill of goods ie promoting an agenda ratherthan trying to get at the truth

Another reason experts donrsquot always hit the mark is that theyare not really trying to deliver the goods for a different reason andthat reason is that theyrsquore not always rewarded for telling the truthmdashespecially when the truth is something their superiors do not wantto hear Sometimes they are even punished for telling the truth

In his book 1929 Again author Terry R Rudd points out thatldquoone of the underlying problems making it virtually impossible forknowledgeable people to tell us the truth is that we canrsquot accept itwithout reacting unfavorablyrdquo

ldquoWhen the recipient doesnrsquot receive news in a manner beneficialto the giver ldquo Rudd writes ldquothere is no incentive for the giver to do sordquo

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 scene

Perhaps 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 ldquoSooner 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 depressionrdquo

Now that is about as accurate as you can get in terms of pre-dicting the stock market and the economy Babsonrsquos reward was that

44 PART ONE The Making of a Superstock Investor

Chap 06 7901 850 AM Page 44

he 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 ldquowe will not be stam-peded into selling stocks because of the gratuitous forecasts of awell-known statisticianrdquo

The stock market actually began declining on the very dayBabson made his historical forecast and that particular drop becameknown as the ldquoBabson Breakrdquo By late October the crash that Babsonhad predicted was under way culminating on ldquoBlack TuesdayrdquoOctober 29 1929 the worst day in stock market history

And what was Babsonrsquos 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 Babsonrsquos ldquofearmongeringrdquo

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 ldquosellrdquo signal on a big-name company with apopular stock and a penchant for doing investment banking business

Therefore you should not expect much help from the ldquoexpertsrdquowhen 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 attitude

One of the all-time great examples of an ldquoexpertrdquo 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 destruction

And so the father of the ldquoKondratieff Waverdquo 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 at

Not all experts receive such harsh treatment for trying to reportthe truth as they perceive it Some of them like the brokerage firm

CHAPTER SIX Experts What Do They Know 45

Chap 06 7901 850 AM Page 45

analyst who issued a negative report on one of Donald Trumprsquos com-panies several years ago merely got fired

Others meet with a more subtle form of resistance

Case Study Sunbeam Corp

If you want to get a feel for how difficult it can be for mainstream WallStreet analysts to say ldquosellrdquo 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 Corpfrom buy to hold

Sunbeam 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 shareholders

Wall 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 plantsand issue optimistic projections for the future Wall Street totallybought Dunlaprsquos performance and Sunbeam shares took offVirtually every analyst who followed Sunbeam sang Dunlaprsquos prais-es and expected a breathtaking turnaround followed by an eventu-al takeover of Sunbeammdashin other words they expected an exactreplay of the Scott Paper scenario

Mr 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 phenomenonmdashbut he recommendedthe stock along with everyone else based on the premise that Dunlaprsquosname and reputation alone would probably take the stock for quite aprofitable ride The trick he thought would be to get out in time

Finally in 1997 Andrew Shore began to notice warning signsdeep within the Sunbeam financial statements filed with the SEC As

46 PART ONE The Making of a Superstock Investor

Chap 06 7901 850 AM Page 46

it 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 Sunbeamrsquos financial situation hecould only bring himself to change his rating from buy to ldquoneutralrdquoBut even this move which in retrospect proved to be a timid andincomplete decision made him a virtual Nostradamus compared tohis colleagues

The first reaction to Mr Shorersquos 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 ldquoYourealize what yoursquore doing here donrsquot yourdquo he asked Shore

ldquoIf wersquore wrong wersquore going to be firedrdquo Shore replied ldquobutwe have to do thisrdquo Shore even felt compelled to contact the legalcompliance department at PaineWebber to explain his downgrade ofSunbeam before the downgrade was issued

When 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 firedmdashfiredmdashif 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 later

On April 3 1997 Andrew Shore got on the PaineWebberldquosquawk boxrdquo and reported his downgrade to PaineWebberrsquos 5000stockbrokers Within minutes Sunbeam stock dropped $4 a shareShortly thereafter when Andrew Shore checked his voice mail hewas stunned to hear a barrage of ldquocaustic and bitter messagesrdquo ldquoMostof the callersrdquo author John A Byrne says ldquowanted Shore firedrdquo

Shore according to Byrne who documented these events in hisbook Chainsaw was ldquohorrified by the contentrdquo of the messages whichranged from calling him ldquostupid and irresponsiblerdquo to even worse

ldquoIt was a nightmarerdquo said Shorersquos assistant who bore the bruntof the flak from clients and brokers reacting to Shorersquos downgrade

The story had a happy ending for Andrew Shore Shortly afterthe downgrade Sunbeam shocked Wall Street with the announce-

CHAPTER SIX Experts What Do They Know 47

Chap 06 7901 850 AM Page 47

ment that earnings would come in far below expectations Thosewho had acted on Shorersquos advice saved a bundlemdashand of coursethe congratulatory calls began to flow in

Lessons 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 ldquoneutralrdquo 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 $025 down 99 percent from its Dunlap-maniahigh as the news from Sunbeam got progressively worse

But even that downgrade to neutral caused fear and soul-search-ing for Andrew Shore which gives you an idea of why so few ldquosellrdquorecommendations 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 ldquomessengerrdquo 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

ldquoA sell signal from an analyst is as common as a Barbra Streisand concertrdquo Arthur Levitt Chairman of the Securities amp Exchange Commission

It 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 colleaguesyou 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

48 PART ONE The Making of a Superstock Investor

Chap 06 7901 850 AM Page 48

But 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 Journal ran a story enti-tled ldquoBearish Call on Banks Lands Analyst in Doghouserdquo The storydescribed the travails of Michael Mayo of Credit Suisse First Bostonand 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 dry

The head trader at Sun Trust Funds said The Wall Street Journalldquoangrily grabbed a picture of Mr Mayo blew up the photo on thecopier scribbled lsquoWantedrsquo over his face and pinned it to her bul-letin boardrdquo When questioned about this response by The Wall StreetJournal the trader replied that ldquomy impression [of Mr Mayo] as ahuman being is that hersquos somewhat self-promotionalrdquo as thoughthis were a rare trait among analysts on Wall Street

Another bank analyst angered by the sell signal referred toMayo derisively as ldquoMayo-naiserdquo in a conference call with clientsaccording to The Wall Street Journal Other analysts also questionedMayorsquos 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 Magazine

Even after Michael Mayorsquos negative call on bank stocks turnedout to be accurate the critics refused to let up on him A few 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 ldquosellrdquo on Bank One (ONE) at$5981 a share the stock ultimately fell as low as $2319 following thedisappointing earnings a 61 percent decline

But 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 for

Mayorsquos general negative attitude toward the bank stocksstemmed from his belief that the earnings growth being reported by

CHAPTER SIX Experts What Do They Know 49

Chap 06 7901 850 AM Page 49

many banks was of ldquolow qualityrdquo in other words the accountantswere becoming increasingly creative in their ongoing effort to giveWall Street the earnings momentum it craved and expected Anyonewho understands financial accounting knows there are about 50 dif-ferent and perfectly acceptable ways to look at almost everythingand that your earnings may be up 5 percent up 10 percent or evendown 10 percent depending on which way the accountants decidethey are going to paint the picture this particular quarter

Eventually though the accountantsrsquo bag of tricks gets deplet-ed and if a company is not growing all that rapidlymdashor worse if cre-ative accounting has directed analytical attention away from a fes-tering problemmdashthe piper must be paid

This is not an uncommon occurrence with popular stocks thatare under tremendous pressure to meet Wall Street expectations andthe general observation that a particular company or an industry ingeneral has begun to resort to accounting gimmicks to meet WallStreet expectationsmdashie that reported earnings are of ldquolow qualityrdquoas Mayo statedmdashis a valid and sufficient reason to turn negative Ifyou smell something rotten you donrsquot have to rummage through thegarbage to figure out what it ismdashyou can just walk away from it

When 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 Mayorsquos critics up

But it wasnrsquotldquoCritics sayrdquo The Wall Street Journal reported with a straight

face ldquothat Mr Mayo had not pinpointed the credit card problemrdquoWhen another bank stock cited by Mayo as having ldquopoor earn-

ings qualityrdquomdashNational City Corpmdashwarned that earnings wouldbe lower than expected that stock took a nosedive as well But TheWall Street Journal pointed out ldquoMr Mayo didnrsquot specifically have alsquosellrsquo recommendation on that stockrdquo

The overall tone of The Wall Street Journal story 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 clients

You can see that the bar is raised considerably higher when youare bearish than when you are a conforming bull The Wall StreetJournal could have run a story about the 99 percent of analysts who

50 PART ONE The Making of a Superstock Investor

Chap 06 7901 850 AM Page 50

TEAMFLY

Team-Flyreg

were incorrectly bullish on Bank One for example and interviewedtheir clients to see how they enjoyed riding that stock down by 61percent But it didnrsquot Instead The Wall Street Journal dissected Mayorsquosbearish (and correct) call with a fine-tooth comb and created theimpression that while he turned out to be right he wasnrsquot really allthat right and that he was a publicity hound to boot

Michael Mayorsquos 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 ldquoItrsquos hard to doinvestment banking for a client with an analyst who is negative onthat clientrdquo a source told Reuters

It doesnrsquot work the other way around by the way If yoursquore acheerleader for a stock and it goes up nobody complains that itdidnrsquot go up for the reasons you said it would Yoursquore just a brilliantanalyst who made the right call But if yoursquore 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 indefinitelymdashif you say all that and youturn out to be rightmdashthat 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 anyway

The 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 disappointment

Back 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-panyrsquos prospects they could barely contain themselves The stockhad run up from $010 a share to $130 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 cancer

Everything was going swimmingly until the scientist who ranthe company called the president of the brokerage firm with the badnews that the process doesnrsquot work

ldquoWhat are you talking aboutrdquo the brokerage firm presidentsaid

CHAPTER SIX Experts What Do They Know 51

Chap 06 7901 850 AM Page 51

ldquoWe cannot cure cancer with shark fluidsrdquo the scientist saidldquoYes you canrdquo said the brokerage firm presidentldquoNo we canrsquotrdquo said the scientist ldquoThe process doesnrsquot workrdquoldquoYes it doesrdquo said the brokerage firm presidentThe scientist was taken aback at this response ldquoI wish it did

workrdquo he said again ldquoBut it doesnrsquotrdquoldquoHold onrdquo said the brokerage firm presidentWhen 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 indeedcure cancer through the use of shark fluids

The scientist tried his best to hold his ground ldquoIt doesnrsquot workrdquohe said pleadingly

ldquoIt has to workrdquo screamed one broker ldquoYour stock is at $130all of my clients own it and wersquore almost ready to do your secondaryofferingrdquo

And so at the urging of his ldquoconstituencyrdquo 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 wellas he continued his research that the process didnrsquot work

The scientist admitted long after the fact that listening to thoseguys nearly convinced him that he had missed something

I was reminded of this story on December 1 2000 when TheNew York Times reported that certain analysts were ldquoskepticalrdquo ofcomputer maker Gatewayrsquos 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 slumpdidnrsquot 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 ldquooverreactingrdquo which onlygoes to show you that whether wersquore talking about shark fluids andpenny stock brokers or computers and big-time Wall Street analysts

52 PART ONE The Making of a Superstock Investor

Chap 06 7901 850 AM Page 52

there are few things so constant as human nature As songwriterPaul Simon reminded us in The Boxer ldquoa man sees what he wants tosee and disregards the restrdquo That is a fundamental truth of WallStreet that every investor should keep firmly in mind

So one thing to keep in mind when yoursquore listening to the opin-ion of an expert Who is the expertrsquos constituency Or to put it morebluntly who pays the expertrsquos salary If it isnrsquot youmdashand it usuallywill not be youmdashconsider the possible agenda of the expert andorconstituency and view the expertrsquos point of view in that light

Even 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 6ndash2 shows

IT ALSO REALLY HELPS IF YOU CAN MAINTAINSOME PERSPECTIVE

ldquoTo understand what the outside of an aquarium looks like it is better not to be a fishrdquo Andreacute Malraux

Back in 1974 when I was working as a junior analyst on Wall StreetI 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 Street

In 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 anywayThings were so slow that a major investment magazine ran a coverstory entitled ldquoThis Is Not Just a Bear Market This Is the Way ThingsAre Going to Be from Now Onrdquo (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

CHAPTER SIX Experts What Do They Know 53

Chap 06 7901 850 AM Page 53

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

54 PART ONE The Making of a Superstock Investor

F i g u r e 6ndash2

ldquoExpertsrdquo and Their Statements

bull It was ldquoexpertrdquo Jimmy the Greek who declared ldquoImpossiblerdquo 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

bull It was ldquoexpertrdquo Thomas Edison who said in 1922 that ldquothe radio craze will die outin timerdquo

bull It was ldquoexpertrdquo Harry Warner President of Warner Bros who in 1927 laughed atthe idea of using sound in motion pictures saying ldquoWho the hell wants to hearactors talkrdquo

bull It was ldquoexpertrdquo Emmeline Snively Director of the Blue Book Modeling Agencywho told Marilyn Monroe in 1944 ldquoYoursquod better learn secretarial work or else getmarriedrdquo

bull It was an ldquoexpertrdquo (a United Artists executive) who turned down actor RonaldReagan for the starring role as the President in The Best Man by saying ldquoRonaldReagan doesnrsquot have that presidential lookrdquo

bull It was ldquoexpertrdquo Jim Denny manager of the Grand Ole Opry who told ElvisPresley on September 25 1954 ldquoYou ainrsquot goinrsquo nowhere son You ought to goback to driving a truckrdquo

bull It was ldquoexpertrdquo Ken Olson President of the Digital Equipment Company who saidin 1977 ldquoThere is no reason for any individual to have a computer in their homerdquo

bull It was ldquoexpertrdquo Charles H Duell Commissioner of the US Office of Patents whourged President William McKinley to abolish the Patent Office in 1899 based onthe incredible logic that ldquoEverything that can be invented has been inventedrdquo

bull It was ldquoexpertrdquo Professor of Economics Irving Fisher of Yale University whodeclared on October 17 1929 ldquoStocks have reached what looks like a perma-nently high plateaurdquo

bull It was ldquoexpertrdquo Thomas J Watson Chairman of IBM who declared in 1943 ldquoIthink there is a world market for about five computersrdquo

bull It was ldquoexpertrdquo Eric Easton manager of the Rolling Stones who said of MickJagger in 1963 ldquoThe singer will have to gordquo

Source Christopher Cerf and Victor Navasky The Experts Speak (Pantheon Books New York 1984)

Chap 06 7901 850 AM Page 54

My friends got a big laugh out of that oneA few days later I published my weekly stock market ldquoreportrdquo

in which I imagined what it would be like if Howard Cosell FrankGifford and ldquoDandyrdquo Don Meredith the hosts of ABC-TVrsquos MondayNight Football were to host a live daily television program directfrom the New York Stock Exchange

As 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 dayrsquos stock market action

Meanwhile Don Meredith a former Dallas Cowboysrsquo 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 scoops

What a laugh right Little did I knowTherersquos nothing wrong with minute-by-minute analysis of the

financial 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 results

And 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 thereon live television and respond to question after question from view-ers calling on the telephone asking about a series of random stocksHow can this ldquoexpertrdquo possibly provide a thoughtful informedresponse on every single question)

You can wonder about all of this but you canrsquot 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 tradingbased on instant analysis is a perfectly acceptable way to approachthe stock market Just ask any trader

CHAPTER SIX Experts What Do They Know 55

Chap 06 7901 850 AM Page 55

But 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 minutes

You 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 estimatesdown to the last penny you will also know the ldquowhisper numberrdquo youwill know if the company that has just reported earnings managed tobeat the official estimate the ldquowhisper numberrdquo 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 moment

You 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 perspective

This vantage point involves looking for stocks that are showingsigns that something significant is changingmdashfor the bettermdashon 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 business

In this book you will learn how to spot some of the Telltale Signsthat will enable you to buy these out-of-favor stocks with confidenceWe will show you how to determine when a formerly sleepy seem-ingly uninteresting stock may be about to emerge as a huge winner

In short we have arrived at a fork in the stock market roadmdashthis book will take you on a trip down the road less traveled

And once yoursquove been down this road you will never look atthe frantic three-ring circus of urgent day-to-day stock market com-mentary and ldquoexpertrdquo analysis in quite the same way

56 PART ONE The Making of a Superstock Investor

Chap 06 7901 850 AM Page 56

C H A P T E R S E V E N

What Is Value

Yoursquove heard a lot about ldquovalue investingrdquo 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

1 What is ldquovaluerdquo2 Why canrsquot a stock that is undervalued remain underval-

ued theoretically indefinitely

Itrsquos 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 ldquoIn the long run weare all deadrdquo

What we need is an investing approach that not only focuses onldquovaluerdquo but also provides for some sort of catalystmdashsome outsideeventmdashthat will literally force the stock market to take an under-valued stock and reprice it at a higher more appropriate value

Letrsquos start with this premise A stock is worth what the stockmarket says it is worth on any given daymdashno 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 now

Where does that price come fromIt comes from two places (1) earnings expectations and (2) the

present value the market is willing to place on those earnings expectations

57

Chap 07 7901 851 AM Page 57

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

Think of a stock as representing a small piece of ownership inan estimated future stream of earnings Those earnings are unknownand investors rely on the best guesses of Wall Street analysts to deter-mine what theyrsquoll be When you buy a share of stock today yoursquorebuying a stake in that future earnings stream

Of course analyst estimates of that future earnings stream maybe wildly off the mark which adds another major variable to thequestion of determining value But letrsquos assume charitably that theanalysts are going to get it right and you know precisely what a com-pany will earn over the next 10 years

Even 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 priceearnings ratio And if you think predicting earningsis difficult you havenrsquot seen anything yet

Take a look at Figure 7ndash1 which shows the priceearnings ratioof the Standard amp Poorrsquos 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 earningsmdashbut a wildly different con-cept of value

58 PART ONE The Making of a Superstock Investor

Bargains

Expensive

Average from 1970 to 1998 = 1465Average from 1950 to 1998 = 1478

63098 = 2625

1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 199528272625242322212019181716151413121110987

28272625242322212019181716151413121110987

Norm (- - -)

F i g u r e 7ndash1

SampP PriceEarnings Ratio

Chap 07 7901 851 AM Page 58

What causes priceearnings ratios to shift so dramaticallyThe major determining factor is interest rates When interest

rates rise priceearnings ratios tend to fall When interest ratesdecline priceearnings ratios tend to rise

There are two reasons for the profound effect of interest rateson priceearnings 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 stocks

For some investors the stock market competes for funds withthe bond market Stocks carry risk but long-term bonds carry lessrisk A 20- 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 Stocksobviously carry no such guarantee

When other money managers are deciding whether to commitmore or less capital to the stock market what theyrsquore really lookingat as an alternative is the ldquono-riskrdquo alternativemdashcash

By ldquocashrdquo 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 priceearnings multiple placedon a given level of earnings

Suppose 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 A teamof 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 thatrsquos been left for you to manage there will be enough moneyto pay the retirees and everyone will be happy

CHAPTER SEVEN What Is Value 59

Chap 07 7901 851 AM Page 59

As you sit there and survey the investment scene you see thatlong-term US government bonds are yielding 6 percent That willdo you no good because you need to earn 8 percent or the retireeswill be calling you up for loans so they can maintain their standardof living 20 years from now The yield on money market funds at 475percent is even less

To earn the required 8 percent therefore you will have to takesome riskmdashand that means yoursquoll have to invest in the stock marketAlthough stocks do not come with guaranteed returns they do offerupside growth potential And since therersquos no other way to get the8 percent you need you take the plunge into the market

Across the street there is another money manager in charge ofanother company pension fund His job is just like yours except hiscompany has a lousy union and the pension benefits for its retireesare going to be a lot less than yours According to the actuarial tablesthe money manager across the street needs to earn only 65 percenton his investments to fund the retirement plan

So yoursquore both in the same boatmdashat least for now You need toearn 8 percent and the money manager across the street needs toearn 65 percent but neither one of you can get what you want inbonds or money market funds so yoursquore both buying stocks

Now letrsquos 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 planBut the money manager across the street now faces an interesting sit-uation He needs 65 percent to fund his plan he can get 7 percent inUS 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 stressAnd 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 ldquocashrdquoinvestments like money funds and short-term treasury bills alsoreaches 7 percent he will likely move a lot more money out of stocks

In other words as interest rates on less risky investments risea certain amount of money will leave the stock market to lock in thatreturn At 7 percent a certain number of investors will determine

60 PART ONE The Making of a Superstock Investor

Chap 07 7901 851 AM Page 60

TEAMFLY

Team-Flyreg

that 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 investorrsquos goal which isone reason why rising interest rates almost always put downwardpressure on the stock market

The 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 Greenspanrsquos briefcase as a potential clue as to whetherthe Federal Reserve is about to shift its interest rate policy

There is another reason why rising interest rates usually meanlower stock prices Itrsquos a bit more complicated but its worth know-ing and it explains a big part of the mystery of the wildly gyratingpriceearnings ratios touched on earlier

This concept is called ldquodiscounted present valuerdquo 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 todayAgain what the market is willing to pay today for those future earn-ings is the priceearnings ratio

Letrsquos use this exampleSuppose Totterrsquos Rollerblades Inc (TRI) is estimated to earn a

grand 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 highthe present value of 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 higher

For 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

CHAPTER SEVEN What Is Value 61

Chap 07 7901 851 AM Page 61

Think 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 Totterrsquos 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 earningsprojectionsmdashthe only difference is what those earnings are worthright now in any given interest rate environment

That in simplified terms is how most stocks trade For the mostpart theyrsquore at the mercy of earnings forecasts that are constantlychanging and may or may not be on the mark and theyrsquore 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 accurate

Given all of this how can anyone define ldquovaluerdquoLet me tell you one wayWhen thinking of value think of this What would a company

be 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 operates

The actual value of a stockmdashas a businessmdashis only fleetinglyrelated if it is related at all to the gyrations of the stock marketAgain 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 itrsquos there

The only time this concept of value matters is when someoneis willing to step up to the plate to pay that value In other wordswhen a takeover bid takes place

My concept of a ldquovaluerdquo situation therefore is stocks that are sell-ing at clearance-sale prices significantly below their value as a businesswhere 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

62 PART ONE The Making of a Superstock Investor

Chap 07 7901 851 AM Page 62

When 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 levelmdashas a businessmdash and it is nolonger subject to the whims of the stock market and all of the unpre-dictable variables that determine where most stocks trade

You may think that choosing stocks that are likely to becometakeover targets is an impossible task The reason why you maythink this way is that yoursquove 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 candidates

But picking takeover targets is not an impossible taskAs 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 bid

By 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 of

You will be on the lookout for superstocks

CHAPTER SEVEN What Is Value 63

Chap 07 7901 851 AM Page 63

This page intentionally left blank

C H A P T E R E I G H T

If Everybody KnowsEverything Then NobodyKnows Anything

By 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 market

Which is precisely the point When yoursquore dealing with super-stocks pegging your stock selections to specific events or ldquocatalystsrdquorelated to a particular company that are likely to force the stock pricehigher for the most part yoursquore removing the behavior of the gen-eral stock market from the equation

When you begin to think in terms of the new paradigm yoursquollfind yourself zeroing in on news items that relate to the stocks yoursquoreholding or to other stocks that could become potential superstocksYoursquoll find yourself paying attention to ldquomicrordquo news items ratherthan ldquomacrordquo news items Yoursquoll become less interested in grandiosegeneralizations concerning the big picture and more interested in spe-cific news items that will impact individual stocks yoursquore following

For example yoursquoll find yourself paying more attention to CEOinterviews (ldquoWe believe the consolidation in our industry will con-tinue and we intend to be one of the major players by making addi-tional acquisitionsrdquo) merger announcements (ldquoWe will continue to

65

Chap 08 7901 852 AM Page 65

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

look for opportunities to grow our defense electronics segmentrdquo)or ldquoshareholder rights plansrdquo (ldquoAlthough 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 bidrdquo)

You will find yourself taking note of stock buybacks (ldquoWebelieve our stock is undervaluedrdquo) 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 companyAnd your ears will perk up when you hear that a company plans tospin off one of its subsidiaries to ldquoenhance shareholder valuerdquo espe-cially if the parent company or the subsidiary operates in an industry wheretakeovers are proliferating

You 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 itselfmdashand 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 yoursquoll 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 Reserversquos Open MarketCommittee meeting You would be more interested in the fact thatWMS Industries has announced that it will spin off its three PuertoRico hotelcasinos as a separately trading company because you willhave noted a takeover wave in the hotelcasino industry (see Chapter13) Therefore while the TV talking heads are wringing their handsover what Greenspan may or may not do yoursquoll be more interested inthe possibility that the WMS spinoff might become a takeover targetonce the hotelcasinos are trading separately as a ldquopure playrdquo (It did)

You will also begin to realize that if Rexel SA 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 wonrsquot mat-ter to Rexel SA if Apple Computer missed its earnings estimates bya penny And you will know that Rexel SA 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

66 PART ONE The Making of a Superstock Investor

Chap 08 7901 852 AM Page 66

The superstocks yoursquoll be tracking will be marching to theirown drummers and yoursquoll pay less attention to what ldquothe marketrdquois doing and more attention to the stream of information and scat-tered clues and evidence that directly impact the themes trends andspecific superstocks yoursquore tracking

If yoursquore like me you wonrsquot miss the market ldquoanalysisrdquo at allIn fact you may find itrsquos a relief to get it out of your hair because somuch of it is meaningless anyway

The 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 gyrationno matter how unexplainable it may be As a result financial com-mentators stockbrokers and analysts are expected to have an answerfor everything

Most 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 conversation

For 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

ldquoHowrsquos the marketrdquo you askldquoDown 80 pointsrdquo he saysldquoEighty points Why is it down 80 pointsrdquoldquoProfit-takingrdquoNow you may not be the smartest investor who ever lived but

yoursquore smart enough to know that since the market has declined in17 of the past 20 sessions it is definitely not profit-taking thatrsquos push-ing the market lower today Your broker knows that too but has totell you something because he or she is supposed to know whatrsquosgoing on Consequently the broker will have an answer for any ques-tion you can possibly come up with

How does the broker do thisOn any given day there are probably 5 or 10 potentially bullish

news 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

CHAPTER EIGHT If Everybody Knows Everything Then Nobody Knows Anything 67

Chap 08 7901 852 AM Page 67

tape like some Miss America from the crowd in Atlantic City andthis news item will be used to explain what the market did that day

Let 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 52 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 it

Your broker can use any one of these news items to put a ldquospinrdquoon why the Dow Jones is down 200 points

Your stockbroker is sitting at his deskThe phone rings Itrsquos youldquoHowrsquos the marketrdquo you askldquoItrsquos down 200 pointsrdquo your broker saysldquoTwo hundred points How comerdquoldquoWell the market has been depressed by a couple of news items

this morning First the President says he wants a tax cut and thatrsquosbearish 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 alsordquo

ldquoOhrdquoOn the other hand the market might be up 200 points With

the very same items on the tape the conversation would then gosomething like this

ldquoHowrsquos the marketrdquoldquoUp 200 pointsrdquoldquoUp 200 points How comerdquoldquoWell the President says he wants a tax cut and thatrsquos bullish

for the economy and for corporate earnings Also durable goodsorders were up 52 percent another sign of economic strength Alsothe bond market is higher this morningrdquo

ldquoOhrdquoSince 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

68 PART ONE The Making of a Superstock Investor

Chap 08 7901 852 AM Page 68

the Presidentrsquos tax cut proposal how come the bond market is up Orwhat 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 ldquobearishrdquo items will miracu-lously be interpreted as bullish as in ldquoWall Street had second thoughtsabout President Clintonrsquos tax cut proposal rdquo 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 commentariesin an entirely different lightmdashthat is if you bother to see them at all

Can 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 marketitrsquos 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 itrsquos time to thinkabout reducing your market exposure

Other than that nobody knows anythingWhich brings me to William GoldmanWilliam 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 hersquod ever learned about the movie business

Here it is ldquoNobody knows anythingrdquoWhat Goldman was saying was that you could take all of the

sophisticated 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 moviesmdashand that sure isnrsquot hap-pening

Says Goldman

CHAPTER EIGHT If Everybody Knows Everything Then Nobody Knows Anything 69

Chap 08 7901 852 AM Page 69

bull If anybody knew anything BJ Thomasrsquos advisers wouldnot have been so upset after the first sneak preview ofButch Cassidy and the Sundance Kid After hearing Thomasrsquosnew song ldquoRaindrops Keep Falling on My Headrdquo in thecontext of Butch Cassidy they were convinced that Thomashad made a potentially fatal career move

bull If anybody knew anything Raiders of the Lost Ark would nothave been turned down by every studio in town beforeParamount decided to make the film

bull If anybody knew anything Columbia Pictures would nothave told Steven Spielberg that it decided not to make ETeven after the studio spent a million dollars developing thefilm (ET wound up at Universal)

bull If anybody knew anything Paramount Pictures would nothave offered The Godfather to 12 directors (all of whomturned it down) before they got around to offering it toFrancis Ford Coppola and they would not have offered therole of Michael Corleone to Robert Redford Warren BeattyRyan OrsquoNeal Dustin Hoffman and Martin Sheen beforethey got around to offering it to Al Pacino

Now if you think about it you can apply William Goldmanrsquospremise to the stock market but with a slight variation

In the stock market when everybody knows everything nobody knowsanything Overall the evidence seems to indicate that the stock mar-ket as a whole is a pretty good ldquodiscountingrdquo 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 ldquoefficientrdquo 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 ldquoedgerdquo 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 therersquos no ldquoedgerdquo 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 Goldmanrsquos moviestudio executives are all poring over the same current and historicaldata regarding box office grosses If all of this ldquomacrordquo publicly avail-

70 PART ONE The Making of a Superstock Investor

Chap 08 7901 852 AM Page 70

TEAMFLY

Team-Flyreg

able information meant anything everyone would be making theright move all of the timemdashand theyrsquore not This strongly suggeststhat the way to hit a home run is to take a left turn when the lem-mings are turning rightmdashto take the road less traveled as it were

The same holds true for large-cap stocks A 1999 study by PeterSchliemann a money manager formerly with David L Babson ampCo 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 donrsquot know for sure but Irsquod 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 instan-taneously

Since everybody expected earnings of say $060 for the quar-ter everybody knew everythingmdashtherefore they knew nothingNow that everybody knows earnings came in at say $050 every-body knows everything once againmdashbut they still know nothingsince there is no way to take advantage of that information to avoidthe 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 allmdashor maybe we should say that nobody really knows anything more than any-body elsemdashor anything really worth knowing

When yoursquore looking for an edge in an area of the stock marketwhere everyone else is looking yoursquoll find that new business becomesold business pretty darn quicklymdashusually too quickly to be of any

CHAPTER EIGHT If Everybody Knows Everything Then Nobody Knows Anything 71

Chap 08 7901 852 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 itrsquosa good bet that it will be old business already no matter how new itseems to you

Now compare this instantaneous reaction to new business in thelarge-cap stocks to the way the market reacted to Laidlawrsquosannouncement 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 investors

But 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 Dellrsquos management whatdo you think would happen to Dellrsquos stock price Most likely theWall Street analytical community would immediately take its bestguess as to Dellrsquos potential takeover value and the stock would risetoward that level almost immediately

This did not happen as we will learn with ADT Nor did ithappen with Rexel Inc even though the parent company RexelSA 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 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-ketrsquos efficiency in processing significant information is directly relatedto the audience for that informationmdashie whether institutionalinvestors and the analysts who are fighting for their commissionbusiness are paying attention will determine how accurately themarket reflects new information

You 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

72 PART ONE The Making of a Superstock Investor

Chap 08 7901 852 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 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 situation

In 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 examplewhen Brylanersquos outside shareholder Pinault Printemps began rais-ing its stake in Brylane I saw a connection to the Rexel takeover bidbecause Rexel SA which bought Rexel was a subsidiary of PinaultPrintemps (see Chapter 9) But how many investorsmdashor professionalanalystsmdashwould have known that if they had not lived through theRexel takeover drama

So lesson number one is Research individual stocksmdashandsmaller stocks at thatmdashand donrsquot 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 isavailable out there that is not reflected in stock prices especiallywhen yoursquore dealing with stocks that are not widely followed by themainstream Wall Street analysts

So lesson number two If you really want to get an edge on WallStreet you should focus your attention on smaller-cap stocks thatare not widely followed by analysts and their institutional clientsThat 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 price

This principle explains why stocks like Rexel ADT Brylaneand 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 way

When you start to focus more of your attention on individualstocks and less attention on the general market yoursquoll be better ableto 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 7901 852 AM Page 73

subtle change in the way you perceive the news Yoursquoll think in termsof 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 ableto identify potential ldquosuperstocksrdquomdashand the less interested yoursquollbecome in the daily blather that passes for stock market analysis

74 PART ONE The Making of a Superstock Investor

Chap 08 7901 852 AM Page 74

P A R T T W O

Identifying TakeoverTargets

Chap 09 7901 853 AM Page 75

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

This page intentionally left blank

C H A P T E R N I N E

Creeping Takeovers

Letrsquos 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 prices

To 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 Andletrsquos suppose further that your management team has decided it wouldbe a good idea to acquire this company within the next 2 years

If 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 thestockrsquos 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 ldquofairness opinionrdquo 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 to

77

Chap 09 7901 853 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 thecompany you want to buy All of this means that yoursquoll probablyhave to pay a hefty premium over the stockrsquos current $10 tradingpricemdashespecially if the growth prospects you envision are apparentto the target companyrsquos management and to the financial advisers thetarget company retains

Given all of this what would you doWhat many outside owners do is embark on what is called a

ldquocreeping takeoverrdquo 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 monththe 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 company

This 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 you

CASE STUDY HOW REXEL SA ACQUIRED REXEL INC

If 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 ldquoben-eficial ownerrdquo and must report all additional purchases and sales ofstock Once a ldquobeneficial ownerrdquo crosses that 5 percent thresholdeach additional purchase of stock becomes a matter of public recordLater you will learn where to find this information so you can buyright along with these outside beneficial owners But first letrsquos lookat Rexel Inc and the ldquocreeping takeoverrdquo engineered by its largestshareholder Rexel SA of France

78 PART TWO Identifying Takeover Targets

Chap 09 7901 853 AM Page 78

We recommended Rexel Inc in October 1995 at $101frasl4 for threereasons Rexel SA had recently raised its stake in Rexel from 435 to45 percent through additional open-market stock purchases Rexelhad turned itself into a pure play electrical 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 ldquoTelltale Signsrdquo of a potential takeover target

As you will see throughout this book we will spend some timepresenting original recommendations and ongoing analysis of thesetakeover targets for one important reason Wersquore not discussingldquotheoretical examplesrdquo or how you ldquomight have done thisrdquo or ldquomighthave done thatrdquo Wersquore 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 outcome The 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 superstocks

Rexel was what could be called ldquosneaky strongrdquo 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 doing

In other words Rexel was beginning to act like a superstockmdashmarching to its own drummer oblivious to the manicdepressivegyrations of the overall stock market A ldquocreeping takeoverrdquo 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 everythingyoursquove ever learned about risk and reward which is that if you wanta big reward you have to take a bigger than usual risk

But when it comes to a ldquocreeping takeoverrdquo this is simply notthe case The reason is that if the outside beneficial owner continuesto purchase large blocks of stock on the open market itrsquos a strongindication that there is good value at 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 beneficialownermdashand especially if these purchases take place at successivelyhigher price levelsmdashit becomes logical that when the price dips too

CHAPTER NINE Creeping Takeovers 79

Chap 09 7901 853 AM Page 79

far below that level it is viewed as a bargain not only by the outsidebeneficial owner but also by the handful of stock market partici-pants who focus on situations like this The result is often strongsupport on pullbacks no matter what the stock market is doing Soeven if there is no takeovermdashand sometimes even if the overall stockmarket is exceedingly weakmdashsituations like this tend to hold upvery well thereby creating less risk

Tell that to the next know-it-all stock market pundit who tellsyou that investing in takeover candidates is ldquotoo risky for the aver-age investorrdquo

Following a Business Week story on Rexel the price bumped to$14 however Rexel drifted back to where it had started meetingsupport in the $12 area Rexel met strong support at that price Andthen the ldquocreeping takeoverrdquo really got under way

In the stock market you can tell where the value is by who isdoing the buying That notion is seen clearly in the fact that a Rexelvice president had gone into the open market to purchase 4000 sharesof Rexel at a price of $113frasl8 This created what I call a ldquotriple playrdquo situ-ation usually the most powerful of all signs that a stock is going high-er A triple play occurs when an outside beneficial owner the company itselfand 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 higher

In February 1996 there was another major purchase of RexelsharesmdashRexel SA bought another 150000 Rexel shares at pricesbetween $12 and $121frasl2

It was clear by March 1996 that Rexel SA had begun to ldquocreeprdquoThe French company had once again gone into the open market tobuy 59100 additional Rexel shares at a price of $123frasl4 The continu-ing purchases of Rexel SA suggested that Rexel could become atakeover target at any time

So Much for the ldquoEfficient Marketrdquo Theory

At this point the Rexel story becomes a bit more interesting for a dif-ferent reason The information age has arrived in full force and itrsquos safeto say that therersquos virtually no piece of information on any public

80 PART TWO Identifying Takeover Targets

Chap 09 7901 853 AM Page 80

TEAMFLY

Team-Flyreg

company that is not readily available to anyone who is interested inlooking for it

The problem is fewer and fewer analysts are looking for themost significant informationmdashbut that leaves the playing field wideopen for the rest of us

Previously you learned that Wall Street research is increasinglygeared toward servicing those who generate the largest commissionsmdashmutual funds pension funds hedge funds and other large-scaleinvestors who require big-cap stocks with lots of liquidity Smaller-cap stocks and micro-cap stocksmdashand also stocks in out-of-favor indus-tries that are too boring to interest the momentum playersmdashare sim-ply not followed as closely as their better known counterparts

The theory of the ldquoefficient stock marketrdquo 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 SA for example had uppedits open-market purchase price for Rexel from the $9 area to the $12to $123frasl4 area should have sent a strong signal that Rexel was a greatvalue at a $12 to $123frasl4 price If Rexel SA 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 SArsquos lead And certainly if Rexel shares trad-ed below the $123frasl4 area that Rexel SA had been willing to pay thatwould make Rexel a very good value Right

Not necessarily Again remember that wersquore 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-uationmdashnamely that Rexel would have been a logical buy anywherebelow $123frasl4mdashsimply did not register with the vast majority of WallStreet analysts and the investors who received their advice from them

Which leads to an important point You would be amazed at howmuch time you have to accumulate genuine takeover candidates thatare undergoing a ldquocreeping takeoverrdquo before Wall Street catches onto whatrsquos happening And you would also be amazed at how often youcan buy these ldquocreeping takeoverrdquo candidates at a significantly lowerprice than the outside beneficial owner has been paying

CHAPTER NINE Creeping Takeovers 81

Chap 09 7901 853 AM Page 81

In the case of Rexel Wall Street greeted Rexel SArsquos continuingpurchases up to the $123frasl4 area with a collective yawn and Rexelshares drifted back below $12 again

By midyear Rexel SA had made two additional purchases ofRexel Inc stock 21000 shares and 275600 shares both at $111frasl2 to $113frasl4To many investors takeover bids may seem unpredictable and tocome ldquoout of the bluerdquo 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 patienceSuch buys by Rexel SA 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 bid

By the end of the summer in 1996 Rexel SA had made twoadditional purchases of Rexel Inc stock 46000 shares at $131frasl4 and175700 shares at a price as high as $141frasl4 And there was continuedscattered buying of stock by Rexel Incrsquos officers and directors

In September 1996 Rexel SA purchased another 162000 sharesof Rexel Inc at prices between $133frasl4 and $137frasl8 an indication thatRexel SA was accomplishing a takeover by attrition through itscontinuing open-market purchases

On November 7 1996 I reported to my subscribers that RexelSA had purchased another 79000 shares of Rexel Inc at $133frasl4 Andyet amazingly despite the sizable open-market purchases by RexelSA that I had been documenting month after month Rexel Incshares were trading in November 1996 right at $14 no higher thanthey had been trading at the start of 1996

This proved two things First no one on Wall Street was pay-ing the slightest attention to the Rexel situation And second as Irsquovesaid before and Irsquoll say again if yoursquore going to invest in off-the-beaten-path stocks with genuine takeover potential yoursquore 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 Streetrsquos disinterest

And 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 confidencemdashwhichmeans the ultimate payoff when it comes will be even sweeter

By the end of 1996 Rexel was still trading near $14 a shareright where it began the year despite the fact that Rexel SA had

82 PART TWO Identifying Takeover Targets

Chap 09 7901 853 AM Page 82

spent most of the year adding significantly to its Rexel stake anddespite the fact that Rexel SA had just paid as high as $147frasl8 for an addi-tional 167000 shares

In the first week of January 1997 Rexel Inc finally broke out toa new high (See Figure 9ndash1)

Then in February 1997 I reported to my subscribers that RexelSA purchased another 43500 shares of Rexel Inc paying as muchas $157frasl16 a new high for Rexel SArsquos open-market purchases

In March 1997 Rexel Inc stock suddenly pierced the $20 levelon very large volume Prior to that Rexel SA had purchased anoth-er small block of 8000 shares paying a new high of $163frasl4

One Last Chance

At this point yoursquore 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 RexelSA paid for the stock at so many different points and for such

CHAPTER NINE Creeping Takeovers 83

F i g u r e 9ndash1

Rexel Inc (RXL) 1995ndash1997

Source Courtesy of Mansfield Chart Service Jersey City NJ

Chap 09 7901 853 AM Page 83

extended 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 meal

And then Wall Street provided dessertShortly after it was announced that Rexel SA had just pur-

chased another 184000 shares of Rexel paying as high as $201frasl16 Rexelshares dipped down to the $16 to $17 area and stayed there for sev-eral months In other words the perfectly efficient stock marketwhich sees all knows all and discounts everything provided one lastextended opportunity for investors to buy Rexel shares for signifi-cantly less than Rexel SA had just paid

In April 1997 Rexel SA went into the open market and boughta small block of 10000 Rexel shares at $167frasl8 The purchase made per-fect sense Rexel had just paid as high as $201frasl16 for 184000 shares sowhy not buy more at lower prices By June 1997 Rexel stock hadspent nearly four months trading listlessly between $16 and $18despite the fact that Rexel SA had paid over $20 for the stock justmonths earlier All told Rexel SA had purchased a grand total of1734900 shares of Rexel over the past two years

Takeover Time

Finally in September 1997 Rexel SA announced a takeover bid forRexel The offer was initially at $1950 per share then ultimatelyraised to $2250 per share That takeover price represented a premi-um of 119 percent over our original recommended price of $101frasl4 injust 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 patient

THE OTHER SIDE OF TAKEOVERS SELLING BY ABENEFICIAL OWNER

This next case study illustrates another method of spotting takeovertargets which is the mirror image of the approach used with RexelIn 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

84 PART TWO Identifying Takeover Targets

Chap 09 7901 853 AM Page 84

The 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 stockholders

In 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 takeover

Therefore what seems to be a negative to ldquoold paradigmrdquothinkersmdashthat a large outside beneficial owner shareholder wants tosell its stakemdashis usually a sign that the target company is about toenter the ranks of the superstocks

CASE STUDY THE TAKEOVER OF ADT

An example of this approach is ADT Ltd a security alarm moni-toring company

In February 1996 a small news item appeared about ADT Ltdwhich 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 dealLaidlaw had also granted Western Resources an option to buy theother 12 percent of ADT owned by Laidlaw by May 15 1997

One 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 ldquononcorerdquo 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 ldquoin playrdquo as a genuine takeovercandidate

CHAPTER NINE Creeping Takeovers 85

Chap 09 7901 853 AM Page 85

My 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 amp Light was seeking to diversify into the nonutility businessIn fact recent press releases from Western Resources indicated thatthe company had publicly stated it was thinking of expanding into thehome security alarm business through acquisitions

Western 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 separatebut related news items

ADT became part of the master list of recommended stocks inour Superstock Investor newsletter

At the time some utilities including telephone companiesviewed home security companies as a cost-efficient ldquoadd-onrdquo 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 Laidlawrsquos remaining 12 per-cent of ADT and then to make a bid for the rest of the company

The same reasoning suggested that two smaller companiesProtection One (ALRM) then trading near $11 and Holmes Pro-tection (HLMS) then trading below the $8 area were also potentialtakeover targets

This analysis of the security alarm industry provided a detailedroad map for investors for an upcoming takeover wave in the secu-rity alarm industry

By mid-March Western Resources had exercised its option topurchase the additional 12 percent of ADT owned by Laidlaw at$1480 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 ADTrsquos market price Western Resources mayhave acted as quickly as it did because they thought ADT shareswould move higher

In May 1996 a rather curious development took place ADTrsquosmanagement team had exchanged their low-priced ADT stock

86 PART TWO Identifying Takeover Targets

Chap 09 7901 853 AM Page 86

options (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 $15

Why 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 range

Following my ADT update subscribers were once againreminded that Protection One (then trading at $73frasl4) could also getcaught up in a takeover wave involving security alarm companies

On March 16 1996 CNBCrsquos 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 overhead

In a May 3 report an item was included about a hostile takeoverbid that Western Resources had just made for Kansas City Power ampLight It was reported that Westernrsquos bid for Kansas City Power amp Lightwas unsolicitated and that it disrupted a friendly merger agreement thathad already been negotiated between KCPampL and another company

Western 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 WesternResourcesrsquo unsolicited bid for Kansas City Power amp Light was a clearsignal that Western was looking to grow through takeovers

This observation demonstrates another strategy of pickingtakeover targets It pays to know the track record of the outside beneficialowners Just as our experience with Rexel SA and Rexel Inc led usto the takeover of Brylane (see Chapter 10) this hostile bid by WesternResources for Kansas City Power amp 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 answer

Next ADT announced a 5 million share buyback anotherTelltale Sign that ADT was seriously worried about a takeover bid at

CHAPTER NINE Creeping Takeovers 87

Chap 09 7901 853 AM Page 87

an unreasonably low price Remember the Telltale Sign When a com-pany whose stock is being bought by a third-party ldquobeneficial ownerrdquoannounces 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 ldquolow-ballrdquo bid that might be above the current market pricebut still below the true value of the company as a business

Both Western Resources and Kansas City Power amp 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 at$181frasl8 up 20 percent in less than three months since the news thatWestern Resources had bought 12 percent of ADT from Laidlaw

Surprise Republic Industries Makes aTakeover Bid for ADT

On July 1 1996 ADT became a superstock jumping 51frasl2 points in oneday to $241frasl2 on news that ADT had received a takeover bid That 51frasl2-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 earlier

But 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 companiesRepublic 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 price

Western Resources was strangely silent over the RepublicIndustries bid from ADT And the strangest twist in this story wasyet to come

ADT Followers Get Another Chance to Buy at Bargain Prices

During the discussion of the Rexel Inc takeover you learned howmany opportunities a patient informed investor can get to buy a

88 PART TWO Identifying Takeover Targets

Chap 09 7901 853 AM Page 88

genuine 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 ldquoefficient marketrdquo the-ory is that information is only properly discounted when the Wall Streetpowerhouses are paying attention Mutual 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 microscope

But 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 window

By 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 announced

As a result on July 26 1996 an investor following the ADTstory could have bought ADT formdashwould you believe itmdash$173frasl4

The 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 WhyBecause neither ADT nor Republic thought it important to check with WesternResources which owned 24 percent of ADT

You 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 theRepublicndashADT agreement Western said only that it was ldquoexploringits alternativesrdquo

The intent of that statement was probably an indication thatWestern Resources had intended to ultimately buy the rest of ADTand 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 ldquopersonality pre-miumrdquo based on the popularity of Wayne Huizenga

At 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

CHAPTER NINE Creeping Takeovers 89

Chap 09 7901 853 AM Page 89

was that Western Resources would find another buyer for ADT whowas willing to pay cash or stock with a more stable or reasonablevalue than Republic Industries A third possibility was for WesternResources to force Republic to substantially increase its offer in lightof the decline in Republic shares All three of these scenarios shouldhave resulted in a sharp rise in ADT shares from their trading levelof $17 to $18mdasha price level lower than where ADT traded prior tothe Republic bid Yet another possibility was for Western to simplyoppose the merger but do nothing but vote against itmdashpossible butunlikely considering Westernrsquos aggressive personality

Finally the Republic IndustriesndashADT agreement carried with itan unusual arrangement that seemed to indicate that both Republicand ADT were actually expecting a higher bid ADT granted Republica warrant to purchase 15 million ADT shares at $20 if the agreementwas terminated for any reason This by the way is another reasonwhy Western Resources was understandably miffed In effect itmeant that anybody making a competing bid for ADT at any priceover $20 had to buy 15 million additional shares and hand RepublicIndustries 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 yoursquoveobserved 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 fight

And you would expect that a ldquoperfectly efficient stock marketrdquowould have processed all of this public information and decidedthat ADT should be selling perhaps in the low to mid $20 rangeespecially in light of the fact that Republic had already offered $26in stock to acquire the company

Because of the drop in its own stock price by early October 1996Republic 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 $1975 price Western Resources

90 PART TWO Identifying Takeover Targets

Chap 09 7901 853 AM Page 90

TEAMFLY

Team-Flyreg

had paid for part of its 13 million share purchase just a couple of monthsearlier Republic withdrew its bid even though Western had notuttered one public comment on the RepublicndashADT takeover dealBut Western really didnrsquot have to say anything to Republic

Westernrsquos purchase of an additional 13 million shares of ADTin August after the Republic bid was announced was Westernrsquosway of saying ldquoGet lostrdquo

Sure enough just 1 month later Western Resources purchasedanother 13 million shares of ADT in the open market this time pay-ing between $181frasl4 and $19 ADT shares once again rose above $20 butjust barely trading around $203frasl4

Now those of you who are thinking ldquoAha A creepingtakeoverrdquo 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 takeoverdetectivemdashin other words trained to think in superstock paradigmtermsmdashit 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 intentions

Finally after buying another 209500 ADT shares at the end ofOctober at $193frasl4 Western Resources made its move Western offered$2250 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 companyrsquos hostile takeover bid for Kansas City Power ampLight and also in light of the arrogant and cavalier manner in whichADT had disregarded Westernrsquos interests when it accepted theRepublic takeover bid

A hostile bid from Western Resources in other words shouldhave come as no surprise to any new paradigm thinker who hadbeen following this situation Westernrsquos anger by the way was evi-dent in the fact that its $2250 takeover bid was significantly lessthan Republicrsquos previous $26 bid In fact Westernrsquos bid was so stingythat we advised subscribers to hold ADT based on the possibility

CHAPTER NINE Creeping Takeovers 91

Chap 09 7901 853 AM Page 91

that Western Resources would raise its bid or that the situation wouldturn so hostile that ADT would find a competing bidder

And 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 ADT

On 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 stock

That $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 ldquoin playrdquo 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 higher

If you look at Figure 9ndash2 yoursquoll 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-

92 PART TWO Identifying Takeover Targets

Chap 09 7901 853 AM Page 92

out 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 therersquosalways a new story always another stock moving The ldquohotrdquo moneyobsessed with short-term performance can quickly lose interest ina takeover situation that temporarily runs out of steam When theldquohotrdquo 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 opportunities

So itrsquos not just the 120 percent you could have made in ADT ifyoursquod 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 ldquotakeover detectiverdquo you would

CHAPTER NINE Creeping Takeovers 93

F i g u r e 9ndash2

ADT 1995ndash1997

Source Courtesy of Mansfield Chart Service Jersey City NJ

Chap 09 7901 853 AM Page 93

have 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 prices

And 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 1997because ADT was on its way to finding its proper value as a businessInstead of being tossed about by the whims of the market respond-ing to analystsrsquo estimates and interest rate movements ADT wasbeing analyzed as a business by three potential acquirers And even-tually that bid by Tyco forced the stock market to place a realisticvalue on ADT as a business

In 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

94 PART TWO Identifying Takeover Targets

Chap 09 7901 853 AM Page 94

C H A P T E R T E N

How to Create Your OwnldquoResearch Universerdquo ofTakeover CandidatesmdashThe Telltale Signs

Two roads diverged in a wood and ImdashI tookthe road less traveled and that has made all the difference

Robert Frost

Now that you have seen how Rexel and ADT became takeover tar-gets you can probably see the difference between ldquosuperstockrdquo 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 yoursquore 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 ie a takeover bid that forced the stock mar-ket to value Rexelrsquos and ADTrsquos stock according to their values as businessesregardless of what the general stock market was doing at the time

So how do you find a stock like Rexel or ADT in the first placeTo answer that question I am going to point you down the road

less traveled toward an entirely new direction in terms of thoughtprocess and analysis

95

Chap 10 7901 855 AM Page 95

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

First forget about the trendy ldquomomentumrdquo stocks everybodyknows and loves If you want to own some of them finemdashbut wersquoregoing 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 DellBill 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 weekmdashbut they live on a highly traf-ficked and overly developed road and wersquore headed for a far morebarren piece of terrain These guys and the stocks theyrsquore involvedwith are so widely followed so idolized and analyzed that there isabsolutely nothing you and I can discover that hasnrsquot already beennoted rehashed a thousand times and factored into their stock prices

Instead I am going to suggest that you become a browserThe definition of browse is to look wander or meander through

something or somewhere in a casual and unfocused manner Whenyou are browsing you do not always have a specific goal in mindyou 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 path

This is a very different mindset than setting out to find a spe-cific piece of information

The Internet is a wonderful tool It provides a bottomless pit offacts and figures virtually anything yoursquore looking for But what ifyou donrsquot know exactly what yoursquore 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 yoursquore 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 waymdashby 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 then digdeeper using the Internet

96 PART TWO Identifying Takeover Targets

Chap 10 7901 855 AM Page 96

Reading every single item in The Wall Street Journal for exam-plemdashespecially the smaller items that may be only a few sentenceslongmdashcan 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 yoursquore going to browse for antiques you wonrsquotmake 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 yoursquoll encounter information that can leadyou to superstock takeover candidates

Investorrsquos Business DailyThe Mansfield Chart ServiceThe New York TimesThe Vickers Weekly Insider ReportThe Wall Street Journal

Create Your Own ldquoResearch Universerdquo

Your goal as you begin your new career as a ldquosuperstock browserrdquowill be to create your own ldquoresearch universerdquo Every Wall Streetanalyst has a ldquoresearch universerdquo that consists of a group of stocksthe analyst follows on a regular basis Most of the time these stocksare organized by industry group A chemical stock analyst for exam-ple will follow a universe of chemical companies and select one orseveral as his or her top pick

As a superstock browser your goal will be to create your ownresearch universe a list of potential ldquosuperstockrdquo takeover candi-dates that possess one or more of the characteristics addressed inthis chapter Yoursquoll 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 target

One advantage you will have over the average Wall Street ana-lyst is that your ldquoresearch universerdquo will not be confined to a cer-tain industry group Instead once you learn to spot specific charac-teristics of potential takeover targets yoursquoll find yourself following

CHAPTER TEN Create Your Own ldquoResearch Universerdquo of Takeover Candidates 97

Chap 10 7901 855 AM Page 97

a diverse group of stocks that span a wide variety of industry groupsAnd once yoursquove constructed your ldquoresearch universerdquo you shouldlook at it as a potential shopping list of investment possibilities

For 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 list

In 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 theyrsquollhave the potential of rising suddenly and substantially in price nomatter what the stock market is doing

And herersquos the best part This ldquoicing on the cakerdquo 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 price In other words to the outside worldthese stocks will look like boring mild-mannered Clark Kentsmdashbutin reality each will have the potential of slipping into a phone boothat a momentrsquos notice and emerging as a superstock

WHAT YOUrsquoLL BE LOOKING FOR

I 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 yoursquoll be looking foras a superstock browser

Eighteen Telltale Signs

1 An outside company or individual (ldquobeneficial ownerrdquo)accumulates more than 5 percent of a companyrsquos stock

98 PART TWO Identifying Takeover Targets

Chap 10 7901 855 AM Page 98

and then files a Form 13-D with the Securities andExchange Commission

2 A company that already has one outside ldquobeneficialrdquoowner attracts a second or even a third outside investorwho accumulates a position of 5 percent of more

3 An outside beneficial owner in its Form 13-D filing saysthat it is seeking ways to ldquoenhance shareholder valuerdquoldquomaximize shareholder valuerdquo or speak to managementor other shareholders about ldquoexploring strategic alterna-tivesrdquomdashall code phrases for potentially putting a compa-ny up for sale to get the stock price higher

4 An outside ldquobeneficialrdquo 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 optionrsquos 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 stock

5 An outside beneficial owner adds to its stake in a compa-ny through additional open market purchases of its stock

6 An outside beneficial owner expresses an interest in sell-ing its stake in a company and says it will review strategicalternativesmdashoften a code phrase for a desire to have thetarget company acquired by a third party to maximize thevalue of the beneficial ownerrsquos investment

7 A dispute between an outside beneficial owner and thecompany in which it owns a stake breaks out into theopenmdashoften 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 bid

8 A company in which an outside beneficial owner holds astake or is accumulating additional shares andor whichoperates in an industry where takeovers are proliferatingannounces a stock buyback program

CHAPTER TEN Create Your Own ldquoResearch Universerdquo of Takeover Candidates 99

Chap 10 7901 855 AM Page 99

9 A company in which an outside beneficial owner holds astake or is adding to its stake is the subject of insider buy-ing by its own officers andor directors

10 A company with an outside beneficial owner andoroperates in an industry where takeovers are proliferatingannounces a ldquoshareholder rights planrdquo designed to makea hostile takeover more difficult

11 A company in a consolidating industry sells or spins offldquononcorerdquo assets or operations thereby turning itself intoa ldquopure playrdquo (see Chapter 14) which is often a signalthat the company is preparing to sell itself to a largercompany within its core industry

12 A company in a consolidating industry takes a largeldquorestructuringrdquo charge in effect putting past mistakesbehind it and clearing the decks for future positive earn-ings reports Such action can be important to a potentialacquirer and is often a sign that a company is preparingto sell itself

13 A company in a consolidating industry announces arestructuring charge that causes the stock to declinesharply and becomes the subject of significant insiderbuying andor 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 horizon

14 A company in a consolidating industry is partially ownedby a ldquofinancially orientedrdquo 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 ldquoexit strategyrdquo for itself by engineer-ing a takeover of the company in question should theopportunity present itself

15 The 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 stockmdashin other words a desireto have the company acquired

100 PART TWO Identifying Takeover Targets

Chap 10 7901 855 AM Page 100

TEAMFLY

Team-Flyreg

16 Two 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 companythere 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 list

17 A small-to-medium-size company in a consolidatingindustry achieves a breakout from a ldquosuperstock breakoutpatternrdquo ie the stock penetrates a well-defined resis-tance level at least 12 months in duration following aseries of progressively rising bottoms or support levelswhich indicates that buyers are willing to pay increasing-ly higher prices to establish a position This pattern cre-ates the appearance of a ldquorising trianglerdquo on the chart Thebest superstock breakout patterns occur when volatility decreas-es markedly in the weeks or days prior to the breakout

18 A company 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 ldquoinheritedrdquothrough a takeover of another company Many times ifCompany A acquires 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) CompanyA may eventually bid for the rest of Company C if this fitsits overall businessacquisition 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 A take-over of a company whose stock is ldquoinheritedrdquo throughanother takeover becomes even more likely when there isalready a business relationship between Company A andCompany C

For illustrative purposes letrsquos 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

CHAPTER TEN Create Your Own ldquoResearch Universerdquo of Takeover Candidates 101

Chap 10 7901 855 AM Page 101

ldquoinheritedrdquo a 49 percent stake in Trus Joist a Boise Idaho manufac-turer of lumber products which was partially owned by MacMillanThe other 51 percent of Trus Joist was owned by TJ International apublicly traded company listed on NASDAQ

There 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 Joist

At first TJ International stock rocketed from the low $20s to ashigh as $337frasl8 based on the second scenario a potential takeover bidfrom Weyerhauser But TJ shares then fell back sharply falling aslow as $213frasl8 based on the emerging consensus that TJ would prob-ably buy out the 49 percent Trus Joist stake from Weyerhauser

A superstock observer who noted that Weyerhauser was themajor distributor for Trus Joistrsquos 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 TJInternational

On November 23 1999 just 5 months after it bought MacMillanBloedel Weyerhauser agreed to buy TJ International for $42 pershare TJ International jumped $93frasl8 (or 22 percent) in one day as aresult of the bid which was nearly 100 percent premium to TJrsquos stockprice just 4 months before

OTHER THINGS TO LOOK FOR

In addition to these telltale signs that a formerly sleepy and over-looked stock is about to become a superstock takeover candidateyou 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

102 PART TWO Identifying Takeover Targets

Chap 10 7901 855 AM Page 102

clues are available by simply listening carefully to companies that areactively acquiring other companies

USING THE VICKERS WEEKLY INSIDER REPORT TOFIND AND TRACK ldquoBENEFICIAL OWNERSrdquo

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 ownerRexel SA a browsing coup that led to a 119 percent profit

The Vickers Weekly Insider Report is available by mail and alsoonline Published by Argus Research the report is a summary ofbuy and sell transactions by corporate ldquoinsidersrdquo (officers and direc-tors) and also outside ldquobeneficial ownersrdquo of 10 percent or more ofa companyrsquos stock (see Figure 10ndash1)

Of particular interest is the ldquobeneficial ownerrdquo transactionsWhen an outside investor accumulates 5 percent or more of a com-panyrsquos 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 ldquoinvestment purposes onlyrdquo 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 ldquomaximizingrdquo orldquoenhancingrdquo shareholder value

In the Vickers Weekly Insider Report look for outside beneficialowners that are accumulating additional shares on the open marketWhen 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

CHAPTER TEN Create Your Own ldquoResearch Universerdquo of Takeover Candidates 103

Chap 10 7901 855 AM Page 103

Simply sitting in a comfortable spot with a highlighter and a penand browsing through the entire Vickers Report each week high-lighting those beneficial owner (BO) transactions that seem inter-esting and making notations relating to names you have seen before

104 PART TWO Identifying Takeover Targets

F i g u r e 10ndash1

Sample of Vickers Weekly Insider Report

Chap 10 7901 855 AM Page 104

(or never seen before) will often lead to new and profitable ideasyou would not have otherwise encountered

For one thing yoursquoll 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 see

There 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 freeedgarcom 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 company

But there are connections that would not show up in a normal13-D filing or through a search of 13-Drsquos only

For example one key reason to use the Vickers Weekly InsiderReport is that it focuses on ldquoForm 4rdquo 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 ldquoin theknowrdquo stockholders than you would get simply by focusing on 13-D filings by outsiders

You may notice for example heavy insider buying by officersand directors in a company where an outside beneficial owner isalso accumulating sharesmdasha 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

CHAPTER TEN Create Your Own ldquoResearch Universerdquo of Takeover Candidates 105

Chap 10 7901 855 AM Page 105

You 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 industrywhich raises the possibility that something bullish is going on in thatparticular industry that has not yet been perceived by the market

Or you may notice heavy insider buying andor outside ben-eficial owner buying in a stock where you have previously noticeda potential ldquosuperstock breakout patternrdquo (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 whileyoursquoll 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 browse

Let me give you a real-life example that illustrates the useful-ness of this tool

CASE STUDY SPOTTING BRYLANE AS A TAKEOVERTARGET

In 1997 Vickers reported a purchase of 429400 shares of a companycalled Brylane Inc by an outside beneficial owner Pinault Printemps-Redoute SA The Vickers data indicated that Pinault-Printemps hadpurchased these Brylane shares between June 3 and June 30 1998 atprices ranging from $453frasl4 to $51 Brylane was added to the potentialldquoresearch universerdquo of stocks to look into and monitor on a regularbasis

A few weeks later the following transaction appeared

BLACKROCK INVT S-1756 JULY29 rsquo98 81frasl2 0 SABATH KAREN H SEC

BORG WARNER D-400 X JULY30 rsquo98 487frasl16 100 X DRUMMOND JERE A DIR

BRYLANE INC B-128300 X JULY 1-28 rsquo98 401frasl4-453frasl4 8568617 PINAULT-PRNTMPS RDT SA BO

BUCKLE INC S-20200 JUNE 5-28 rsquo98 5411frasl16-557frasl8 NA NELSON DENNIS H PR

And a few weeks after that these transactions appeared

BRUSH WELLMAN B-5000 AUG 5-10 rsquo98 163frasl18-171frasl2 10000 ROBERTSON WILLIAM R DIR

BRUSH WELLMAN B-8700 Aug 3-04 rsquo98 157frasl8-16 17200 HARNETT GORDON D CB

106 PART TWO Identifying Takeover Targets

Chap 10 7901 855 AM Page 106

BRYLANE INC B-25000 AUG21 rsquo98 25 8808017 KRAMER HARTMUT

BRYLANE INC B-8000 AUG25 rsquo98 263frasl4 6000 JOHNSON WILLIAM C DIR

BRYLANE INC B-2000 AUG21 rsquo98 243frasl4 6000 STARRETT PETER M DIR

BRYLANE INC B-214400 X AUG13-19 rsquo98 245frasl8-383frasl4 8783017 X PINAULT PRNTMPS RDT SA BO

BUCKEYE PARTNERS B-5000 AUG25-26 rsquo98 2615frasl16-27 40000 BUCKEYE MGMT CO PART

Here 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 429400 shares in Junetook place at prices as high as $51 By July Pinault-Printemps wasbuying Brylane shares as low as $401frasl4 By mid-August Pinault wasin the open market buying additional Brylane shares as low as $245frasl8mdashless 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 and2000 shares respectively at $263frasl4 and $243frasl4

The continuing large purchases by Pinault-Printemps com-bined with the apparently large decline in Brylanersquos 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 intomdashright now

A chart 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 fastmdashafter all individual stocks are collapsingevery day on Wall Street and itrsquos 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 quickly

By 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 managementand they are therefore well-aware of how things are going and whatthe companyrsquos prospects are

Usually though when you see an outside beneficial owner step-ping into the open market to buy big blocks of stock you assume he

CHAPTER TEN Create Your Own ldquoResearch Universerdquo of Takeover Candidates 107

Chap 10 7901 855 AM Page 107

or she has reached an informed conclusionmdashie 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 opinion

When you add insider buying into the mixmdashie when you seeofficers and directors buying shares along with the outside benefi-cial owner at a certain price levelmdashyou have a double-barreled voteof confidence that a stock has reached a compelling price point interms of its value as a business

Apparently 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$38 and $245frasl8

Two Brylane directors also thought the stock was a great valueat $243frasl4 and $263frasl4

Yet in a breathtakingly short period of time Brylane hadplunged all the way to the $14 to $15 area

So 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 thoughtBrylane was a good value all the way down from $51 to $245frasl8 whywouldnrsquot it consider buying the rest of the company now that thestock had fallen to $14

For all of these reasonsmdashand to answer all of these questionswhich emerged as a result of browsing through the Vickers WeeklyInsider Reportmdashwe 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 Itrsquos 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 rangeor base pattern which indicates that buyers are finally stepping inand that the supplydemand situation is coming back into balance

So why would you try to catch this falling piano Because Brylanewas 4753 percent owned by a French company Pinault-Printemps-RedouteSA the parent company of Rexel SA

Thatrsquos rightmdashPinault-Printemps turned out to be the parent compa-ny of Rexel SA of France the very same outside beneficial owner that

108 PART TWO Identifying Takeover Targets

Chap 10 7901 855 AM Page 108

methodically 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 companya major catalog retailer that published among others catalogs forSears Lane Bryant (thus the name of the company) Lerner andChadwickrsquos Thirteen months after Brylanersquos February 1997 publicoffering Pinault-Printemps purchased a 437 percent stake in Brylanefor $51 per share

Shortly 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 1998Brylane dropped 111frasl2 points to $243frasl4 on news that sales of the compa-nyrsquos 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 masse

Shortly after Brylane stock plunged 111frasl2 points in one day the com-pany announced a $40 million stock buyback This 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 ldquoEighteenTelltale Signsrdquo numbers 8 and 9 earlier in this chapter)

But even though Pinault-Printemps several Brylane insidersand Brylane itself all apparently believed that the stock was a greatvalue in the mid-to-high $20s Brylane shares were blasted again onSeptember 24 and 25 1998 following another analyst downgradeand earnings estimate reduction

This second price plunge took the stock down to the $14 to $15area

Research into Brylane revealed that Pinault-Printemps hadagreed to a ldquostandstill agreementrdquo which limited Pinault to own-ing a maximum of 475 percent of Brylane for three years endingApril 3 2001

Normally a ldquostandstill agreementrdquo might be viewed as animpediment to a takeover However thatrsquos not always the case

CHAPTER TEN Create Your Own ldquoResearch Universerdquo of Takeover Candidates 109

Chap 10 7901 855 AM Page 109

Further research into Pinault-Printemps revealed this company tobe Europersquos third-largest mail order company Pinault was a companythat generated $145 billion per year in revenues So paying $300million or so for the rest of Brylane which operated a mail orderbusiness that obviously fit right into Pinaultrsquos business mix did notseem like a very big dealmdashespecially in view of the fact that Pinaulthad paid $51 for its original stake over three times what Brylanewas trading for in October 1998

As a superstock investor you could have taken a gradual andpatient approach with Brylane Tax-loss selling could have hurt thestock as year-end approached since it is indeed tough to catch aldquofalling pianordquo But all of Wall Street loved Brylane at $61 Nowclose 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 thistime at a price of $1515frasl16 In December Brylane had once again issuedan earnings warning and the stock had retreated to the $10 to $11 areaAt these low prices it would be a safe guess that Pinault-Printempsthe French company that owned that 475 percent stake should atleast be thinking about a potential takeover bid

Several 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 Report and 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 SA of Francea company that had already taken over one of my previous takeoverrecommendations

A combination of experience and research together with thefact that Brylane itself and Brylane insiders were buying stock onthe open market right along with Pinault-Printempsmdashtwo of the

110 PART TWO Identifying Takeover Targets

Chap 10 7901 855 AM Page 110

TEAMFLY

Team-Flyreg

Telltale Signs I always watch formdashcreated a logical and compellingsuperstock takeover candidate

That is how you use the Vickers Weekly Insider Report

CASE STUDY SAM HEYMAN AND DEXTER CORP

Experienced 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 notAnnouncers can usually determine which horses are looking ldquostrongrdquoand 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 characteristicsthrough 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 thehorsesrsquo strides how high the jockeys are riding in the saddle whetherthe reins are loose or taut the position of the jockeysrsquo 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 outcome

Experience is an invaluable asset when you are browsing forsuperstock takeover candidates The more you browse the moreyoursquoll notice and the more you notice the more yoursquoll be able tomake certain connections that other investors will be unable to makeGiven the identical set of circumstances yoursquoll see something thatothers do not see and you will be able to see a high probability of acertain outcome and thatrsquos where you gain your edge Each expe-riencemdasheven those that do not turn out profitablymdashwill lay thegroundwork for future experiences Eventually yoursquoll find yourselfextrapolating a certain set of circumstances all the way to their log-icalmdashand profitablemdashconclusion

Dan Dorfman one of the most respected financial reporters onWall Street and the former author of The Wall Street Journalrsquos ldquoHeardon the Streetrdquo column was writing a column for Jagnotescom whenhe called me on November 1 1999 His request was straightforward

CHAPTER TEN Create Your Own ldquoResearch Universerdquo of Takeover Candidates 111

Chap 10 7901 855 AM Page 111

enough He asked me to list my top three takeover candidates in thecoming 12 months I offered the following three stocks Ersquotown Corpa 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 Ersquotown jumped 10 points in one day fol-lowing a bid from Thames Water PLC of Britain (For more on theErsquotown takeover and the reasoning that went into it see Chapter 18)

The other company to receive a takeover bid was Dexter CorpDexter 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 Barronrsquos I noticed that International Specialty Products (ISP)had purchased 365200 shares of Dexter at prices ranging from $3625to $3863 per share giving ISP a total of 1996900 shares or 867 per-cent of Dexterrsquos outstanding shares

Many if not most of the 13-D filings reported in Barronrsquos 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 threat

In browsing through these filings each week it helps to lookfor 13-D filers who are either corporationsmdashie real businesses whomay want to acquire another businessmdashor individuals who for onereason or another seem to have the ability the inclination or bothto mount a takeover bid

Another 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 playermdashie 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 way

In 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 ldquolife sci-encesrdquo industry where LTEK operated had seen a wave of takeoversWhat really sparked the LTEK recommendation as a takeover targethowever was a simple statement found in a series of Dexter pressreleases Press releases are yet another useful tool that can help you

112 PART TWO Identifying Takeover Targets

Chap 10 7901 855 AM Page 112

get a feel for a company and its thinking in terms of either acquiringcompanies or selling itself to someone else In one of Dexterrsquos releasesthe company said that it was actively seeking acquisition candidates

Now 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 company

It seemed pretty logical that LTEK might be on Dexterrsquos radarscreen as a takeover target and that Dexter might bid for the 47 per-cent of LTEK it did not already own

Soon 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 LTEKshareholders Dexter eventually raised its bid to $391frasl8 Part of beinga superstock investor is knowing when to sell and that was the rec-ommendation made for this stock at this point in time

It had been a year since the LTEK takeover and now somebodyhad filed a 13-D on Dexter and was raising its stake

Research 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 lot

I 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 wage

In 1982 long before the term ldquohostile takeoverrdquo 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 GAFrsquos assets were worth far more than its stock priceand that GAFrsquos management was not running the company in amanner that was making optimal use of those assets

In other words to put it bluntly Samuel Heyman thought thatGAFrsquos management was doing a lousy job and that he could do

CHAPTER TEN Create Your Own ldquoResearch Universerdquo of Takeover Candidates 113

Chap 10 7901 855 AM Page 113

better Heyman announced that he intended to wage a proxy fightto replace GAFrsquos management and that he would then embark on aprogram to maximize GAFrsquos value for its shareholders

Today 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 1982Samuel 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 GAF

Wall 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 Heymanrsquosbattle with GAF was viewed with a combination of amusement anda decided lack of respect in the investment community

GAF meanwhile was not amused and its management reactedangrily to Sam Heymanrsquos audacity GAF questioned Heymanrsquos credi-bility and management abilities and generally scoffed at the idea thatHeyman and his inexperienced group of outsiders could unseat GAFrsquoswell-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 stockholders

Heyman won the proxy fight ousted GAF managementrestructured the company liquidated some assets and completely fol-lowed through on everything he said he would do Along the wayhe accumulated a 99 percent stake in Union Carbidemdashan especial-ly audacious move since Union Carbide was many times larger thanGAFmdashand actually threatened to take Union over GAF made a hugeprofit on its Union Carbide stock GAF had soared to $67 a share again of 375 percent in 21frasl2 years Heyman ultimately took GAF privatein 1989 then sold 20 percent of International Specialty Products aGAF subsidiary to the public in 1991

Now 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

114 PART TWO Identifying Takeover Targets

Chap 10 7901 855 AM Page 114

was 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 growthThis was one of the major reasons Dexter had made the takeover bidfor the 47 percent of Life Technologies it did not ownmdashDexter hopedthat LTEKrsquos high-growth business would inject some badly neededexcitement into a stock that was being neglected by Wall Street

There was more to the Dexter situation than met the eye especiallyto someone looking at this situation in terms of a potential superstocktakeover target First 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 Streetbecomes a superstock because itrsquos a takeover target

These 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 ldquoscreenrdquo that directs investorsrsquo 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 companyrsquos 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 unappealingmdashprovided you can see the potential of some sortof ldquocatalystrdquo that would force the stock market to recognize the inherentvalue in these situations

Dexter had a catalyst and his name was Samuel Heyman Herewe had a company operating in a consolidating industry where anoutside beneficial ownermdashHeymanmdashwas accumulating shares onthe open market Even better the outside beneficial owner had a his-tory of acquiring companies

CHAPTER TEN Create Your Own ldquoResearch Universerdquo of Takeover Candidates 115

Chap 10 7901 855 AM Page 115

But there was even a more interesting twist to the DexterndashSamHeyman story that convinced me absolutely and without a doubt thatHeyman and International Specialty Products would soon be making ahostile takeover bid for Dexter Corp

It turned out that a group led by Sam Heyman and InternationalSpecialty Products had been major stockholders of Life Technologiesa year earlier when Dexter angered LTEKrsquos shareholders by makinga takeover bid that was perceived to be too low

The controversy over Dexterrsquos bid still lingered Actually I hadstopped following Life Technologies after Dexterrsquos takeover bid CherrieMahon went back and pieced together the chain of events that had cul-minated in Sam Heymanrsquos steady accumulation of Dexter shares onthe open market I discovered that following Dexterrsquos offer for LTEKtwo directors of Life Technologies resigned because they believed thatDexterrsquos bid was too low Remember Dexter already owned 53 per-cent of LTEK which put it firmly in the driverrsquos seat Life Technologiesformed a special committee to evaluate the Dexter bid they retainedGoldman Sachs which estimated that LTEK was worth as much as $60per share compared to Dexterrsquos upwardly revised bid of $391frasl8 Dextermeanwhile had retained Merrill Lynch which said that Dexterrsquos $391frasl8offer was fair and reasonable The discrepancy between Goldmanrsquosestimate of LTEKrsquos value and Merrill Lynchrsquos value estimate proves thatvalue like beauty is in the eye of the beholder

Then again it may prove something else Dexter armed witha ldquofairnessrdquo opinion from Merrill Lynch and having proved thatcomparison shopping can save you money on Wall Street proceed-ed with its $391frasl8 per share tender offer for Life Technologies Theoffer attracted another 18 percent of LTEKrsquos shares giving Dexter atotal of 71 percent of the company

Meanwhile the rest of LTEKrsquos 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 LTEKrsquos 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 OTCldquoBulletin Boardrdquo because there were not enough public sharehold-ers left to qualify for NASDAQ listing

116 PART TWO Identifying Takeover Targets

Chap 10 7901 855 AM Page 116

And 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 itmdasha group led by Samuel Heyman and Inter-national Specialty Products

Thatrsquos 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 Dexterrsquos takeover bid for LifeTechnologies Not only that Heyman and ISP actually went into theopen market to purchase additional Life Technologies shares just asthe Dexter tender offer was expiringmdashand they paid more for LTEKstock than the value of Dexterrsquos bid which amounted to one morethumb of the nose at Dexter and a clear signal that Heyman was notgoing to take this lying down

During December 1998 the same month that Dexterrsquos bidexpired International Specialty Products went into the open marketand bought 1471320 LTEK shares paying as high as $3928 per shareOther investors associated with Sam Heyman and ISP also 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 LTEKrsquos remaining public ldquofloatrdquo

To someone who did not know Sam Heymanrsquos history the factthat Heyman and ISP were now buying Dexter shares on the openmarket may have had little or no meaning In fact there was noshortage of analysts who dismissed Heymanrsquos 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 ISP was so highly leveragedthat it would not be able to obtain the financing for an offer

But Sam Heyman did not operate that way Heyman was notlooking for Dexter to ldquobail him outrdquo 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 valuemdashinclud-ing Dexterrsquos stake in Life Technologiesmdashand 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

CHAPTER TEN Create Your Own ldquoResearch Universerdquo of Takeover Candidates 117

Chap 10 7901 855 AM Page 117

Sam Heyman was serious was that ISP had been selling off its ldquonon-corerdquo operations

The conclusions reached from all of this were that Sam Heymanwas trying to put Dexter ldquoin playrdquo and either ISP or a group head-ed by ISP or possibly a third party would soon be making a takeoverbid for Dexter Heymanrsquos intent toward Dexter would be what WallStreet would call hostile and ISP would attempt to gain control ofDexter sell off various Dexter operations that it did not want retainsome of Dexterrsquos specialty chemicals operations that fit the ISP busi-ness profile and possibly sell off the LTEK stake to another bidderwilling to pay a more reasonable (and much higher) price

Sam Heyman went into the open market to purchase additionalDexter shares raising his stake to 998 percent of the company andhe filed a notification that he intended to raise his stake to at least 15percent

Dexter responded by lowering the threshold of its ldquosharehold-er rightsrdquo plan from 20 percent to 11 percent Under the terms of theplan a ldquopoison pillrdquo would kick in if any outside person or grouppassed the 11 percent ownership threshold without Dexterrsquos 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 impossible

Meanwhile Dexter shares were drifting slowly but surely downtoward that $30 to $33 support area that I advised subscribers towatch for

This was yet another example of Wall Streetrsquos remarkable abil-ity to overlook the obvious in spending its time obsessing over ahandful of high-profile ldquomomentumrdquo stocks while ignoring virtuallyeverything else

On Friday December 11 1999 Dexter closed at $329frasl16 On thattrading day Dexter was just another basic industry ldquovaluerdquo stock withuninspiring revenue and earnings growth of little or no interest totrendy ldquomomentumrdquo investors seeking to beat the stock market

On Monday December 14 1999 Dexter was the best-performingstock on the New York Stock Exchange soaring 85frasl8 points or 265 per-cent in a single day In other words Dexter had become a superstock

Why

118 PART TWO Identifying Takeover Targets

Chap 10 7901 855 AM Page 118

Because Sam Heymanrsquos International Specialty Productsannounced a hostile $45 per share takeover bid for Dextermdashatakeover 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 bid

And it certainly came as no surprise to anyone who knew any-thing about Sam Heyman

You probably think this is the end of the Dexter story In fact themost lucrative part of the story was yet to come

Following Sam Heymanrsquos $45 bid for Dexter Dexter stock spent thenext 4 months trading within a range of $34 and $40 The Wall Streetanalytical community you see still did not take Sam Heyman seri-ously

Following the jump in Dexterrsquos stock price to $413frasl16 which wasstill nearly 4 points below the value of Sam Heymanrsquos takeover bidDexterrsquos stock began to erode again because analysts openly ques-tioned (1) whether Heyman was seriously trying to buy Dexter and(2) whether Heyman and ISP had access to the financing to actual-ly do the deal

It took Dexter nearly two weeks to respond to Heymanrsquostakeover bid Finally in a letter that literally dripped with sarcasmand insults Dexterrsquos Chairman and CEO K Grahame Walker reject-ed Heymanrsquos offer calling it ldquoinadequaterdquo

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 Heymanrsquos true motiva-tionmdashas though a securities analyst had any insight into whatHeymanrsquos actual intentions were

Walker then laid into Heyman for ldquoopportunistically interven-ingrdquo to frustrate Dexterrsquos objective of acquiring Life Technologies Heaccused Heyman of ldquoinviting himselfrdquo to a meeting with Dextermanagement and ldquodisregarding the interests and welfarerdquo of Dexterrsquosstockholders an ironic charge when one considers how this situationultimately turned out

Walker concluded his letter by suggesting to Heyman that ldquowefervently hope (and strongly recommend) that you return your man-agerial focus to your own companies leaving the stewardship ofDexter where it belongsrdquo

CHAPTER TEN Create Your Own ldquoResearch Universerdquo of Takeover Candidates 119

Chap 10 7901 855 AM Page 119

In January 2000 we offered the following analysis of the situation

The stock market is reacting to this takeover bid with caution As thisis written Dexter is trading around $381frasl4 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 ofDexterrsquos letter to Heyman is only likely to take this battle to another leveland my view is that Dexter will ultimately be bought by ISP or a third partymore to Dexterrsquos 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 lowering the threshold of itsldquopoison pillrdquo to pointedly single out Heyman and prevent him fromincreasing his stake in Dexter they had thrown down the gauntletto the wrong guy virtually guaranteeing a hostile bid Then by send-ing such a condescending letter in response to Heymanrsquos $45 takeoverbid they had very likely ticked him off again Based on everythingI knew about Heyman it was very clear to me that this sort of arro-gant responsemdashwhich was precisely the sort of response Heymanreceived from GAF back in the 1980smdashwould only serve to makeHeyman more determined to win this fight

Then on January 20 Dexter made its other blunder by offeringto buy the remaining publicly traded shares of Life Technologies at$49 a sharemdasha price $10 higher than it had previously paid the restof LTEKrsquos 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 offerthe overwhelming interpretation on Wall Street was that Dexter wastrying to get Heyman to drop his bid by offering him a premiumprice on his LTEK shares

Here is a perfect example of how a superstock investor whounderstood the history and motivations of Sam Heymanmdashand whostopped to think about how Heyman could benefit most from thissituationmdashcould look at precisely the same set of circumstances aseveryone else on Wall Street and come to a diametrically opposedmdashand absolutely correctmdashconclusion If Heyman accepted the Dexteroffer for his LTEK shares the value of Heymanrsquos Dexter stock wouldundoubtedly drop further once the takeover threat evaporated

120 PART TWO Identifying Takeover Targets

Chap 10 7901 855 AM Page 120

TEAMFLY

Team-Flyreg

And 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 Heymanrsquos Life Technologiesshares smelled an awful lot like ldquogreenmailrdquo 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 bid

The target company would then essentially bribe the raider togo away by offering the raidermdashbut not the public shareholdersmdashapremium 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 ldquogreenmailrdquo deal was announced the stock of the target companymdashwhich had risen on word of the takeover bidmdashwould plunge leav-ing the public shareholders holding the bag The raider meanwhilewould pocket a huge profit and move on to the next victim

Greenmail 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 mannerThis put an end to greenmail

If Dexterrsquos 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 Heymanrsquos his-tory remembering that he had more at stake in Dexter than in LTEKand realizing that to Heyman this was not only a matter of princi-ple but also a financial question to be decided in a rational mannera superstock investor would have come to the clear conclusion thatthe smart move was for Heyman to reject Dexterrsquos 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 Dexter

On 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

CHAPTER TEN Create Your Own ldquoResearch Universerdquo of Takeover Candidates 121

Chap 10 7901 855 AM Page 121

Technologies offer inappropriate under the circumstancesmdashwhich isprecisely the response one would have expected from a man likeHeyman in a situation like this

ldquoIt is apparent from the timing of Dexterrsquos offer for our LifeTechnologies shares coming on the heels of ISPrsquos $45 per share offerfor Dexter that Dexter is seeking to divert ISP from a course ofaction designed to maximize shareholder values for all Dexter share-holdersrdquo Heyman wrote ldquoIn this connection we believe thatDexterrsquos attempt to deter us by providing benefits to ISP not avail-able to other shareholders is simply inappropriaterdquo

Heyman also called the Dexter bid for Life Technologies in 1998ldquoan attempted squeeze-out of LTEKrsquos minority shareholdersrdquo whichonce and for all made Heymanrsquos motivation in this situation crystalclear He was paying Dexter back in spades for what he perceivedas Dexterrsquos mistreatment of ISP in the Life Technologies tender offer

In the letter Heyman also informed Dexter that ISP wouldlaunch a hostile proxy fight in which it would nominate a slate ofdirectors to Dexterrsquos board He also told Dexter that Chase Securitieshad agreed to provide the funds for the acquisition and he noted thatISPrsquos stake in Dexter amounted to ldquomore than five times that held byDexterrsquos entire boardrdquo a pointed reference to the question of whichslate of directors had the most incentive to act in the best interests ofthe shareholders

Heyman 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 ourmotivesmdashwhich by the way I do not appreciate

All the best Samuel J Heyman

Heymanrsquos rejection of the Dexter bid for Life Technologiesresulted in a jump in Dexter shares back to the $38 to $39 areamdasha nicebounce to be sure but still far lower than the $45 takeover bid

When 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

122 PART TWO Identifying Takeover Targets

Chap 10 7901 855 AM Page 122

situation the more likely that the target company will wind up being acquiredusually by a third party Even 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 deterredthe target company is usually left with only one alternative findanother bidder more to its liking willing to pay a higher price thanthe hostile suitor

Proving once again that things change on February 28 2000Dexter announced that it would open up its books and records toother third parties and that it had hired Lehman Brothers Holdingsto ldquoexplore a possible merger sale or restructuring or the spinoff orsale of a business unitrdquo

Dexterrsquos shares jumped $49frasl16 or 12 percent to $42mdashstill wellbelow Sam Heymanrsquos lowball $45 takeover bid

In 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 somebody

Even now following Dexterrsquos announcement that it will entertainpotential takeover bids from other buyers Dexter shares are tradingbelow ISPrsquos $45 per share lowball bid lower than they should beunder the circumstances By the time this soap opera plays itself outI think Dexter shareholders will receive $55 a share or more for theirstock and that one of three things will happen (1) Mr Heyman andISP will 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 andor stock toshareholders on a tax-free basis thereby passing through the truevalue of Life Technologies and Dexterrsquos other assets to the stock-holders

On March 23 2000 ISP raised its takeover bid to $50 ldquobased on ourevaluation to daterdquo of Dexterrsquos books and said it might raise the offereven further if its continuing evaluation warranted such a price increase

The continuing hostility between Dexter and ISP made it quiteobvious that Dexter would move heaven and earth to avoid beingpurchased by Sam Heymanrsquos group Dexter shares jumped to a highof $561frasl4 then fell back to the low 50s again as the general stock mar-ket slumped At their highs of $561frasl4 Dexter shares were already up53 percent from my original recommended pricemdashand the final actin this superstock drama was yet to unfold

CHAPTER TEN Create Your Own ldquoResearch Universerdquo of Takeover Candidates 123

Chap 10 7901 855 AM Page 123

Finally on September 14 2000 Dexter shareholders approvedthe sale of Dexter to Invitrogen Under the terms of the takeoverDexter shareholders were offered $6250 per share

The Dexter opportunity came about from a 13-D filing in Barronrsquosinvolving 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

124 PART TWO Identifying Takeover Targets

Chap 10 7901 855 AM Page 124

C H A P T E R E L E V E N

How to Use the Financial Press

There is a growing tendency for the media to downsize categorizeanalyze and trivialize the newsmdasha sorry trend that panders to thedesire of an American public suffering from information overloadto have the news prefiltered explained and generally oversimplified

When 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 opinionmdasha 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 ideas

The financial media is becoming increasingly infected with thisinformation virus because it has learned that many investorsmdashespe-cially those who have only recently become enamored with the stockmarketmdashwould prefer to believe their research ldquohomeworkrdquo can beeasily done for them and the process of making money on Wall Streetis really not all that difficult

Certainly 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 ldquomomentumrdquo stocks you hear about day in and day

125

Chap 11 7901 856 AM Page 125

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

out based on the premise that todayrsquos market leaders will be tomor-rowrsquos 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 alone

The 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 Cafter 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 IBM

When 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 yearmdashan amaz-ing story especially in terms of risk and rewardmdashwhich 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 place

Some of the best sources to browse are Investorrsquos Business DailyThe Wall Street Journal and The New York Times Business Day section

Investorrsquos Business Daily (IBD) published by William OrsquoNeil andCompany in Los Angeles is a pioneer of financial journalism In

126 PART TWO Identifying Takeover Targets

Chap 11 7901 856 AM Page 126

many important ways IBD is a unique and highly useful sophisti-cated publication that has made giant inroads into areas where TheWall Street Journal has 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 ldquospikesrdquo 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 IBD

But when it comes to actually reporting the financial news IBDis sort of the USA Today of financial journalism Everything is report-ed in sound bites Whatrsquos worse IBD has become a prime exampleof the ldquoBig Brotherrdquo approach to financial journalism that is makingit increasingly difficult to find the sort of original ideas that wersquorelooking for as superstock browsers Because of this if yoursquore goingto be looking for off-the-beaten-path stock ideas you will not be ableto rely solely on IBD for all the information you need

As I said IBD has taken it upon itself to become your ldquoBigBrotherrdquo information filter directing its readers toward the popu-lar high-profile relative strength ldquomomentumrdquo stocks and steer-ing them firmly awaymdashlike a parent with an all-knowing guidinghandmdashfrom the lower-priced thinly traded stocks that might getyou in trouble IBDrsquos attitude is that the big winners come from acertain ldquogene poolrdquo 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 volumeand limited upside potential

In an incredibly bold move that stands as possibly the ultimateexample of Big Brother financial journalism on October 19 1998IBD proudly announced that it was taking its stock tables ldquoto thenext levelrdquomdashIBD did not specify in what directionmdashby exiling low-priced low-volume stocks to the financial netherworld In a frontpage story written by IBD chairman and founder William OrsquoNeilIBD 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

CHAPTER ELEVEN How to Use the Financial Press 127

Chap 11 7901 856 AM Page 127

When 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 Cainersquos 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 endangered

To Investorrsquos Business Daily these ldquoDirty Rotten Stocksrdquo 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 themmdashsort 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 them

As William OrsquoNeil explained in his articles to IBD readers ldquoWithmore than 500 initial public offerings added a year the tables getlonger and get harder to scan for future big winnersrdquo

Good Heavens Too much informationTherefore ldquoTo save you time we will separate lower-priced

and less active NYSE and NASDAQ stocks from the main tablesThese tables show NYSE and NASDAQ stocks priced at $7 or belowor trading less than an average of 10000 shares a dayrdquo

Later in the article Mr OrsquoNeil gets around to explaining the realreason for IBDrsquos decision to banish lower-priced and less-popularstocks to the financial dungeon ldquoStudies have shown that most stockspriced below $7 or trading less than 10000 shares a day have lowerquality less institutional ownership or weaker recent performanceThey usually carry greater risk or offer less long-term potentialrdquo

There are several problems with this logic that superstockinvestors should be aware of For one thing the term ldquolower quali-tyrdquo 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 trend

And yet if you had looked for water utility stocks likeConnecticut Water Service (CTWS) in the main NASDAQ stock list-ings carried in IBD you wouldnrsquot have found it because its tradingvolume fell below the respectability line which makes this stock

128 PART TWO Identifying Takeover Targets

Chap 11 7901 856 AM Page 128

riskier 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 ldquograduatedrdquo to IBDrsquos more respectable neighborhood Butwhen Middlesex was neglected and a much better value it was stilllisted in the dungeon section

Or 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 ldquopure playrdquo 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 theldquocrimerdquo of having average daily trading volume of less than 10000shares Pittway had been exiled to the IBD ldquoDirty Rotten Stocksrdquolist Barely a month later Pittway soared 16 points in one day to $45(+55 percent) following a takeover bid from Honeywell (see Figure11ndash1) Also in November 1999 the IBD dungeon list was pepperedwith numerous low-priced energy stocks Their only ldquocrimerdquo 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 A number of low-priced health care stockswere also on the list just before this group returned to favor in 2000In IBDrsquos eyes all of these stocks were of lesser quality than sayStampscom (STMP) which was trading at $9850 in November 1999and had a market cap of $35 billion with zero revenues STMP wasright there on the ldquorespectablerdquo mainstream list even though it wason the verge of making a stunningly swift trip down to $250 a sharea decline of 97 percent Pricelinecom (PCLN) was on the ldquorespect-ablerdquo list too before it dropped from $150 to $119 along with count-less other Internet stocks with out-of-this-world valuations that ulti-mately crashed Of course you can prove anything with 2020hindsight 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

CHAPTER ELEVEN How to Use the Financial Press 129

Chap 11 7901 856 AM Page 129

of the information you will need to implement this approach willnot be easily accessible to you and some of it may not be availableat all

And since when does ldquoless institutional ownershiprdquo translateinto the financial version of The Scarlet Letter To a genuine super-stock sleuth that is the whole point A dearth 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

130 PART TWO Identifying Takeover Targets

F i g u r e 11ndash1

Sample of Investorrsquos Business Dailyrsquos Section ldquoWherethe Big Moneyrsquos Flowingrdquo

Source Investorrsquos Business Daily December 21 1999

Chap 11 7901 856 AM Page 130

TEAMFLY

Team-Flyreg

The crime of ldquoweaker recent performancerdquo 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 here

IBD 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 stockswith 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 thanInvestorrsquos Business Daily to get all of the information you need

Another problem with Investorrsquos Business Daily is that in itsongoing drive to categorize everything the newspaper often allowssignificant news items to fall through the cracks In contrast IBDrsquosldquoTo the Pointrdquo section which appears on page 2 of the newspaperis 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 candidates

But 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 ldquoComputers amp Techrdquo ldquoTelecomrdquo ldquoInternetrdquo ldquoMedicalrdquo and othersuch groupingsmdashin 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 moment

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 itrsquos not available In November1999 for example Ersquotown Corp a NYSE-listed New Jersey-basedwater utility which we discussed earlier agreed to be acquired byBritainrsquos Thames Water PLC Ersquotown 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 Ersquotownrsquos stock price jump Ratherit was that the takeover bid for Ersquotown was part of a continuing andastonishingly rapid trend toward takeovers of US water utilitiesmany of which were being acquired by foreign companies eager toestablish a major presence in the US water industry

CHAPTER ELEVEN How to Use the Financial Press 131

Chap 11 7901 856 AM Page 131

The takeover bid for Ersquotown 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 pricesmdashtoonce again repeat this notable phenomenonmdashwas probably the singlemost interesting takeover story of 1999 especially considering the excel-lent riskreward 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 barrel

Immediately preceding the takeover wave in the water utilitystocks five of the nine stocks I recommended in my water utilityldquoWater Worldrdquo portfolio were listed in IBDrsquos second-class stock list-ings presumably too risky andor uninteresting for the averageinvestor to bother with

By the time Ersquotown received its takeover bid the water utilitytakeover trend was in full force Yet the Ersquotown takeover did notmanage to make it into the news section of Investorrsquos Business DailyEither it did not fit the cookie-cutter mold of categories that IBD usedto present its news items on that particular day or Ersquotownrsquos marketcapitalization or industry group was too small andor uninterestingto present to IBDrsquos readers who were constantly being schooled inthe high-profile follow-the-leader momentum school of investing(IBD has since abandoned its news ldquocategorizationrdquo approach)

Compare this total lack of analysis in IBD to the way The WallStreet Journal reported the Ersquotown story The Journal presented a com-plete background report not only on the Ersquotown 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 hadnrsquot alreadynoticed it months before

Despite the efforts of Investorrsquos Business Daily to portray itself asan alternative to the The Wall Street Journal there is really no com-parison between the twomdashespecially 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

132 PART TWO Identifying Takeover Targets

Chap 11 7901 856 AM Page 132

The moral of all of this is that you should not depend on a sin-gle source for all of your businessfinancial information

If 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 ldquoTo the Pointrdquo sec-tion of Investorrsquos Business Daily every day paying special attention tothe smaller seemingly unimportant items You should also scan thefront page of IBD particularly the ldquoIBDrsquos Top 10rdquo section whichcontains IBDrsquos version of the 10 most important business stories ofthe previous day

But that will not be enough and if you want to cover all thebases you should also browse the ldquoCompany Newsrdquo column in TheNew York Times Business Day section ldquoCompany Newsrdquo 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 sleuth

By browsing through certain sections of certain publications likeInvestorrsquos Business Daily and 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 havenrsquot hadthe time to investigate or may have seemed an isolated eventmdashuntilanother seemingly isolated event or piece of information places theprevious item in a new and more meaningful context

The Wall Street Journal is the financial ldquonewspaper of recordrdquo 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 Journal to find it Of coursethe high-profile takeovers spinoffs asset sales and so on will oftenbe discussed on the front page of The Journal in the ldquoBusiness ampFinancerdquo section of the ldquoWhatrsquos Newsrdquo 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 story

Another ldquomust readrdquo section of The Wall Street Journal for super-stock sleuths is the ldquoCorporate Focusrdquo column which appears in Section

CHAPTER ELEVEN How to Use the Financial Press 133

Chap 11 7901 856 AM Page 133

B 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 Journalrsquos ldquoIndustry Focusrdquo columnwhich also appears in the B Section

You never know where you will find interesting and useful infor-mation It often wonrsquot be on the front page of The Journal because themore obscure the information the more useful it will be to you sinceitrsquos less likely that the Wall Street ldquodiscountingrdquo mechanism will havefactored the information into the prices of the stocks involved (TheErsquotown takeover for example did not make the front page)

For example our old friend Pinault-Printemps-Redoutemdashacquirer of both Rexel Inc and Brylanemdashmade the news again inOctober 1999 by buying out the 428 percent of French office supplycompany Guilbert SA that PPR did not already own

You could have learned two things from this story whichappeared in the international section of The Wall Street Journal FirstPPR was still out there acquiring companies in which PPR alreadyowned a stake so this article served as a reminder to keep an eye onPinault-Printempsmdashespecially 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 items

Since 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 notedPPRrsquos partial ownership of Gucci if you did not already know itand added Gucci to your ldquoresearch universerdquo for further study

Among 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

134 PART TWO Identifying Takeover Targets

Chap 11 7901 856 AM Page 134

terms 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 1999

So 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 Swedenrsquos Securitas AB

You should have noticed that Abbott Labs (NYSE ABT) hadenacted a ldquoshareholder rights planrdquo 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 wingsyou 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 companyrsquos true worth

You would also have noticed that an outside shareholder of Dunamp Bradstreet (NYSE DNB) was trying to organize other sharehold-ers in an attempt to prod DNB management to sell the company

And 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 yoursquoll 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 formedmdasha picture that only you and others who thinkas you do will be able to see

CHAPTER ELEVEN How to Use the Financial Press 135

Chap 11 7901 856 AM Page 135

OTHER PLACES TO FIND ldquoTELLTALE SIGNSrdquo OFFUTURE SUPERSTOCK TAKEOVER CANDIDATES

Irsquove noted some of the shortcomings of Investorrsquos Business Daily ButIBD is a unique and innovative publication that provides a greatdeal of information you will not find in any other daily or weeklyfinancial publication

So letrsquos look at some things that IBD does extremely well thatcan be useful to you as a superstock sleuth

There are three sections of IBD in addition to the general newssummaries that are often helpful in the ongoing search for superstocktakeover candidates

Industry Profiles

Investorrsquos Business Daily regularly 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 andor 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 largerhigher-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 thatrsquosfine 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 targets

Another extremely useful aspect of the industry profiles sec-tion is a listing of companies that operate within the industry beingprofiled Headlined ldquoWhorsquos Who in the Grouprdquo 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 IBDrsquos

136 PART TWO Identifying Takeover Targets

Chap 11 7901 856 AM Page 136

industry profile was entitled ldquoPaper Products Tighter SuppliesConsolidation Fuel Upswing in Long-Suffering Industryrdquo 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 amp 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 takeoverpotential

Of course Investorrsquos 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 InsteadIBD lists the companies from top or bottom in terms of stock per-formance andor earnings growth The stocks says IBD are ldquoranked(not lsquolistedrsquo mind you but lsquorankedrsquomdashthis is Big Brother we are talk-ing about remember) by a combination of their earnings per shareand Relative Strength rankingsrdquo

So you will have to do a little reshuffling of the list if you wantto focus on the smaller companies in the group

But thatrsquos a small price to pay for a very useful presentation andI have uncovered quite a few takeover targets by reading IBDrsquos indus-try profiles section on a regular basis

ldquoWhere the Big Moneyrsquos Flowingrdquo

Another useful section of Investorrsquos Business Daily to look at on a reg-ular basis which can contain clues that may direct you to futuresuperstock takeovers is ldquoWhere the Big Moneyrsquos Flowingrdquo (seeFigure 11ndash1) This table which precedes the listings for the NYSEAmerican Stock Exchange and NASDAQ listings is designed to

CHAPTER ELEVEN How to Use the Financial Press 137

Chap 11 7901 856 AM Page 137

highlight stocks with significant increases in trading volume bothon the upside and downside

As 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 ldquoresearchuniverserdquo suddenly pop up on IBDrsquos 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 stock

If a stock has already exhibited one or more of the Telltale Signsof a potential superstock and suddenly begins showing up on IBDrsquoslist 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 ldquofilterrdquo this information for youthat only stocks trading at $18 or higher ($16 or higher on NASDAQ)and moving at least 1frasl2 point will be included in the table (For theAmerican Stock Exchange a stock must be trading $12 or higher andmove at least 1frasl4 point) In addition a stock must trade at least 60000shares to pop up on IBDrsquos NYSE volume-alert table and the stockrsquosEarnings Per Share and Relative Strength Ratingsmdashboth assigned byIBDmdashmust 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 ldquovaluerdquo stock with stagnant earnings pop up on this vol-ume-alert sectionmdasheven if the stock begins acting out of character

Still 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 activity

Charts IBDrsquos ldquoStocks in the Newsrdquo

Another area where Investorrsquos Business Daily is head and shouldersabove The Wall Street Journal is in its presentation of stock charts

138 PART TWO Identifying Takeover Targets

Chap 11 7901 856 AM Page 138

IBD correctly recognizes that technical analysismdashincluding chartanalysismdashis a valuable tool that can be used to your advantageAgain the whole premise of technical analysis is that there willalways be somebodymdashusually many somebodiesmdashwith more infor-mation than you have and this information will usually be put to useeither buying or selling the stock involved

The premise of technical analysis is that while you may notknow what the ldquoinsidersrdquo 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 ldquosuperstock breakoutrdquo 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 ldquoStocks inthe Newsrdquo sections of Investorrsquos Business Daily

IBD has a ldquoStocks in the Newsrdquo chart section for the NYSEAMEX 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 ldquoWhere the BigMoneyrsquos Flowingrdquo IBD provides valuable information in ldquoStocks inthe Newsrdquo

And herersquos another reason to pay particular attention to IBDrsquosstock 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 atmdashor not very far abovemdashkey break-out levels on the chartsmdasha valuable combination of characteristics for our pur-poses which you can only find in Investorrsquos 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 sections The 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

CHAPTER ELEVEN How to Use the Financial Press 139

Chap 11 7901 856 AM Page 139

as a market leader is often a tipoff that some good news such as atakeover is about to break This can often be the final catalyst thatprods you to take the plunge and buy the stock in question

Ersquotown Corp as an example popped up in IBDrsquos NYSE ldquoStocksin the Newsrdquo section just several weeks prior to its takeover bid fromThames Water PLC So did SJW Corp (SJW) in the months preced-ing the announcement that it might put itself up for sale If you hadbeen a superstock browser at the time both of these water utilitieswould already have been very high on your radar screen

Barronrsquos Financial Weekly

One other financial publication you should browse on a regular basisis Barronrsquos You will often find interviews with industry analysts whodiscuss industries where consolidation is taking place Barronrsquos veryoften asks these analysts to zero in on some potential takeover tar-gets You should use these interviews in the same way we are usingmost of the rest of the information discussed here Look for familiarnames that have managed to achieve a spot on your ldquoresearch uni-verserdquo 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 reason

Another important section is Barronrsquos listing of selected Form13-D filings which usually appears in the early pages of BarronrsquosldquoMarket Weekrdquo section Many if not most of the 13-D filings Barronrsquospresents 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 ldquoactivistrdquo 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 inBarronrsquos each week will prove worthwhile on many occasions

CASE STUDY THE TRIPLE PLAY AND MIDWAY GAMES

One 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 companyrsquos officers or directors

140 PART TWO Identifying Takeover Targets

Chap 11 7901 856 AM Page 140

TEAMFLY

Team-Flyreg

The 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-panyrsquos true value than most outsiders And it goes without sayingthat a companyrsquos own management would know better than anyonewhat the underlying fundamentals of a company look like and whatits future prospects might be

When you see a situation where the outside beneficial owner anda companyrsquos officers and directors are consistently buying stock onthe open market this is the ldquodouble playrdquomdasha bullish signal thatshould not be ignored When you also have the company itself buy-ing back stock this is the rare ldquotriple playrdquomdashone of the closest thingsyou will get to ldquoa sure thingrdquo on Wall Street

An example of a ldquotriple playrdquo 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 A man-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 share

Early in 1996 however analysts began to see signs of an earn-ings slowdown Midwayrsquos 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 Midwayrsquos stock collapsed as Wall Streetanalysts began pulling their buy recommendations

As you can see in Figure 11ndash2 Wall Street does not show anymercy when a ldquogrowthrdquo stock stops growing Midway shares plum-meted from near $25 in the spring of 1998 to a low of $75frasl8 by 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 companyrsquos support among the mainstreamWall Street analysts had evaporated A former Wall Street darling inthe high $20s Midway was totally unloved at $8 by January 1999

CHAPTER ELEVEN How to Use the Financial Press 141

Chap 11 7901 856 AM Page 141

Well 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 Midwayrsquos own chairman and CEO Neil Nicastro

Several of Midwayrsquos 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 Midwayrsquos 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 rebound

The analysts did not want to hear it They wanted to know whatwould happen in the next quarter which Nicastro had already

142 PART TWO Identifying Takeover Targets

F i g u r e 11ndash2

Midway Games (MWY) 1997ndash1999

Source Courtesy of Mansfield Chart Service Jersey City NJ

Chap 11 7901 856 AM Page 142

explained 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 1999

But 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 it

Neil 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 businesswhile the analysts were talking abut the short-term momentum (or lackthereof) of a number that appears in The Wall Street Journal every dayMidwayrsquos stock price

Meanwhile something very interesting was appearing in VickersWeekly Insider Report which clearly suggested that Midway share-holders would soon be experiencing better times

The first clue that Wall Street might have been overreacting toMidwayrsquos short-term speed bump appeared in the June 10 1998issue 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 115500 shares atprices ranging from $131frasl4 to $137frasl16 The purchase that really stood outwas a 100000-share buy on the part of Midway chairman Nicastroat $131frasl4 on May 21 1998

These insider purchases combined with an announcement that Midwayitself would buy back 1 million shares of its own stock strongly suggestedthat Midwayrsquos stock price decline was far out of proportion to the short-term earnings problems the company was experiencing When a compa-ny announces a stock buyback it can be misleading Though theBoard of Directors has ldquoauthorizedrdquo a buyback ldquoup to 1 millionsharesrdquo it does not necessarily mean the company will actually buythe shares In most cases the authorization will say that the timing

CHAPTER ELEVEN How to Use the Financial Press 143

Chap 11 7901 856 AM Page 143

andor implementation of the buyback will ldquodepend on the stockprice or market conditionsrdquo 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 ldquoauthorizationsrdquo to buy back shares

However 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 Itrsquos 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 marketrsquos 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 stock

So by the summer of 1998 there was evidence of two-thirds ofa ldquotriple playrdquo 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 ldquotriple playrdquo A few weeks later Midway insiders purchased7500 shares at $137frasl16 another bullish omen

By mid-1998 Midway had dropped below $10 and the Sep-tember 16 1998 issue of Vickers Weekly Insider Report noted moreinsider buying Once again Midway chairman Neil Nicastro had

144 PART TWO Identifying Takeover Targets

Chap 11 7901 856 AM Page 144

purchased a large block of stock this time buying 20000 shares onAugust 31 1998 at $93frasl4 to $97frasl8 Also on August 31 Midwayrsquos VPByron Cook purchased 5000 shares at $107frasl8

It was in September that the last piece of theldquotriple playrdquo 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 Redstonebought 107800 shares at $101frasl2 Then during the second half ofOctober Redstone bought a huge block of 573200 shares at $91frasl4 to$125frasl8 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 setback

And the open market buying did not stop there Nicastro pur-chased another 25000 shares bringing his total purchases to 169000shares And in late November Sumner Redstone bought another 140000shares followed by an additional purchase in early December of 119800shares This brought Redstonersquos total purchases since September 1998 to940800 shares a nearly $10 million commitment to Midway stock which isquite a vote of confidence even for a man of Sumner Redstonersquos means

Itrsquos 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 1998

First 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 and there was heavy insider buyingin the stock were the reasons to not bail out along with everyoneelse on Wall Street Instead I became more aggressive with the stockas it fell because these purchases by Redstone Midway insidersand 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 superstock

Here is a classic case of Wall Street focusing on momentumwhile Redstone Midway chairman Nicastro and other insidersmdashas well as the company itselfmdashwere focusing on Midwayrsquos longer-term value as a business The ldquovaluerdquo assigned to Midway by the

CHAPTER ELEVEN How to Use the Financial Press 145

Chap 11 7901 856 AM Page 145

Wall Street momentum crowd and the analysts who pander to themcompared to the ldquovaluerdquo 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 beholder

To continue with the clues that made Midway a superstock inJanuary 1999 Midway chairman Nicastro bought an additional303950 shares at $8 and Sumner Redstone bought another 80000shares between $81frasl2 and $10 In February however Midway sharestook another plunge falling to the $75frasl8 to $8 range

In 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 analystsrsquo attention to what they believedwould happen in the second half of 1999 which would be the first6 months of Midwayrsquos fiscal year 2000 In particular Nicastro triedto direct the analystsrsquo 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 yoursquore 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 blockbusters

When 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 priceThis 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 you

In 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

146 PART TWO Identifying Takeover Targets

Chap 11 7901 856 AM Page 146

The $64000 question or in this case the $5 million questionwas why had Nicastro spent roughly that amount of his own moneypurchasing 461450 shares of Midway stock over the preceding 12months The Midway chairman said ldquoI believe that at some point themarket will value our business much differently than it values it today Ijust donrsquot 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 stockrdquo

You may have noticed that Neil Nicastro used the phrase ldquovalueour businessrdquo Too often Wall Street treats a stock as nothing morethan a piece of paper Terry Rudd author of the book 1929 Againmakes 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 ldquomomentum investingrdquo 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 ldquostocksrdquo represent shares in a business andbusiness is not always a one-way street Even a true ldquomomentumrdquobusiness a true ldquogrowthrdquo company can hit an occasional potholeor speed bump To a companyrsquos 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 clients

When Cherrie Mahon asked Neil Nicastro ldquoWhy are you buy-ing so much stockrdquo Nicastro said in effect because Midwayrsquos prof-its were going to go back up and Wall Street would be nuts to placesuch a low valuation on this company

Despite Nicastrorsquos comments and the outlook for Midway stockanalysts 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 ldquotriple playrdquo in which an outside beneficial owner companyinsiders and the company itself are all buying stock at the same time

CHAPTER ELEVEN How to Use the Financial Press 147

Chap 11 7901 856 AM Page 147

It also shows a rare behind-the-scenes glimpse at how company insid-ers beat the professional Wall Street analysts and investors at theirown game by simply taking a step back to take a longer-term pointof view In fact ldquolonger-termrdquo in this case only meant 6 to 12 monthsmdashbut to the Wall Street ldquomomentumrdquo 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 perspective

The ultimate outcome of this little drama Midwayrsquos 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 wouldEverything transpired just as he suggested in early 1999mdashin thatsame conference call that led to a rash of analyst sell recommenda-tions virtually at the bottom of Midwayrsquos stock slump

By November 1999 Midway had reached $247frasl8 as earningssoared to record levels and the same Wall Street analysts who hadbeen issuing sell recommendations at the bottom reinstated theirbuy recommendationsmdashat triple the price from Midwayrsquos lows inJanuary or February 1999

So the next time you see a ldquotriple playrdquo 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 itrsquos almost alwaysa signal that you have a potential superstock on your hands and thatthe news is about to get better A lot better

148 PART TWO Identifying Takeover Targets

Chap 11 7901 856 AM Page 148

C H A P T E R T W E L V E

Family Feuds

Herersquos 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 bid In the case of ADTndashWestern 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 investorThe 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 ldquobene-ficial ownerrdquo especially when these disagreements break out into a publicsquabble

Consider the following case study as another example

CASE 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 Copleyrsquosoperations by continuously changing its mind about what it wantedto do with its Copley stake Hoechst said Ms Varis ldquowas demoralizing

149

Chap 12 7901 856 AM Page 149

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

management and depressing shareholder valuerdquo She complainedthat Hoechst ldquoforced Copley to hire investment bankers and spendmillions of dollars in fees and time of key Copley personnel who couldhave been developing new products and expanding Copleyrsquos busi-nessrdquo She claimed that after forcing Copley to go through the processof hiring an investment banker Hoechst decided it did not want to sellits stake after all

In a parting shot Varis added ldquoIrsquoll serve Copleyrsquos shareholdersbetter from outside the company You canrsquot do anything insiderdquo

Agnes Varisrsquos stinging public criticism of Hoechst AG was high-ly unusual From time to time you will see private disagreementsbetween officers or directors of a company and a major sharehold-er Usually these disagreements come in the form of structured let-ters written by attorneys that are ldquoleakedrdquo filed with the SEC as a13-D amendment or simply released to the press In most cases thesedisagreements arise between mutual fund companies or pensionfunds that hold sizable stakes in a company and that for one reasonor another are unhappy about the direction the company has taken

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 Itrsquos not unusual for an insti-tutional investor to take a stake in a company sit with it for a whileand then fire off a letter to management suggesting the companytake steps to ldquoenhance shareholder valuerdquo or ldquomaximize shareholdervaluerdquo 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 mismanaged

In reality in most cases the institutional investor is trying tolight a fire under a losing positionmdashie trying to bail out of a mis-take by bullying the management into taking short-term actions thatcould boost the stock price

For 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 itInstitutions 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

150 PART TWO Identifying Takeover Targets

Chap 12 7901 856 AM Page 150

TEAMFLY

Team-Flyreg

more likely to send up a few threatening flares see what happensand then quietly liquidate its position on any runup in the stock asa result of the brouhaha

So donrsquot 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 ldquoenhance shareholder valuerdquo Anymanagement that has been paying attention to recent trends shouldrespond with a polite letter thanking the institution for its thoughtsand then go back to running the business This sort of publicity gam-bit usually wonrsquot lead to a takeover bid

The situation at Copley Pharmaceuticals as you will see wasquite different The background of the Copley Pharmaceuticals-Hoechst AG situation following Agnes Varisrsquos 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 companywhich would effectively result in Copley throwing out its 51 per-cent shareholder

Copley Pharmaceuticals had gone public in October 1992 at$1267 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 Copleyproving 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 1997

The drop in Copleyrsquos 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 companyrsquos prospects and the future direction of itsstock price

In September 1996 Hoechst publicly stated that Copley did notfit its ldquocorerdquo business strategy and forced Copley to hire an invest-ment banker to look into the possible sale of the company This move

CHAPTER TWELVE Family Feuds 151

Chap 12 7901 856 AM Page 151

according 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 Hoechst

In August 1998 we noted that a ldquostandstill agreementrdquo whichprevented Hoechst from buying additional Copley shares wouldexpire in October 1998

What is a standstill agreementSometimes 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 A cannot increase its stake in Company B beyond a certainpercentage without expressed permission from Company B Thatrsquosa standstill agreement

Whenever a big chunk of one company is owned by anotheryou 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 companyrsquos 10-K reportwhich 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 unfold

As a result of this research Copley was recommended in thenewsletter as an ldquoadditional ideardquo

In September 1998 Copley Pharmaceuticals was added to thesuperstock recommended list The stock price for Copley at the timewas $83frasl4 The news that Hoechst AG had decided to undergo a cor-porate restructuring was significant In a situation like this where ageneral corporate ldquohousecleaningrdquo such as Hoechst was about toundergo would take place a decision was likely to be made aboutHoechstrsquos 51 percent stake in Copley

Now all of the pieces were in place for a takeover drama tounfold

Every relationship even personal relationships start out withhigh hopes But when the relationship sours and both parties beginto get on each otherrsquos nerves it is only a matter of time before a sep-aration has to take place

152 PART TWO Identifying Takeover Targets

Chap 12 7901 856 AM Page 152

When 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 in The 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 doingwhatrsquos 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 eye-to-eye

It seemed clear to me that Hoechst or some third party wouldhave to make a bid for Copley Unfortunatelymdashor perhaps fortu-nately depending on how you look at itmdashit wasnrsquot 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 brieflythen sagged back and traded listlessly in the $8 to $10 range

In December 1998 with Copley trading at $87frasl16 there wererumors that Hoechst AG was about to merge with Francersquos Rhone-Poulenc SA The rumors if true would create the worldrsquos second-largest pharmaceuticals company Remember Hoechst had an-nounced a planned ldquorestructuringrdquo and in fact Hoechst had alreadysold several of its noncore operations including its paints business

Here is how we analyzed this rumor of a potential HoechstndashRhone-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 Copleyrsquosbook value of $530 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 goodriskreward ratio anywhere in the $6 to $9 range

CHAPTER TWELVE Family Feuds 153

Chap 12 7901 856 AM Page 153

In February 1999 with Copley trading at $911frasl16 Hoechst hadbeen selling off some of its smaller noncore operations and we indi-cated that ldquothe 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 trendrdquo

And then we added ldquoThe 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 stakerdquo

As things turned out that last statement was significant Itrsquos 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-miummdashsometimes a significant premiummdashto a stockrsquos 52-week highIn nearly all cases a takeover bid will a carry a premium to a stockrsquosaverage trading price over the past 30 or 60 days Only in rare caseswhere 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 dayrsquos closing price And once in a blue moonwhen word of a takeover has leaked so badly that the target com-panyrsquos stock has really soared you will witness what is called a take-undermdasha situation where the takeover price is actually lower thanthe previous dayrsquos closing price because advance word of the dealwas so widespread that speculators got carried away and simplybid the price of the target company too high

In the case of Copley Pharmaceuticals we had a buy limit of$111frasl2 on our recommendation However based on some apparentimprovement in Copleyrsquos earnings and influenced by the fact thatHoechst had paid an incredible $55 per share for its original stakeit seemed that raising the buy limit on Copley to $13 would be asound move

At that point Copley was trading near $101frasl4 By April 1999Copley had crossed $113frasl4 For the next several months Copley trad-ed quietly between $83frasl4 and $101frasl2 Then in June 1999 a news itemwas the clincher Copley was trading at $915frasl16 when Hoechstannounced that it would spin off its Copley stake as part of CelaneseAG a Hoechst operation containing most of Hoechstrsquos chemical and

154 PART TWO Identifying Takeover Targets

Chap 12 7901 856 AM Page 154

industrial 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 Copleyrsquos other major shareholderswould try to take Copley private or sell it to a third party

For the next 2 months Copley traded quietly between roughly$81frasl2 and $101frasl2 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 dealHoechst AG also agreed to sell its 51 percent stake in Copley to Tevafor $11 per share

Anyone who had bought Copley at $83frasl4 would have made aprofit of 25 percent based on this $11 takeover bid in 10 monthsAnyone who had followed the growing body of evidence that atakeover bid for Copley was brewing and had taken advantage ofdips in Copleyrsquos 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 bid

To 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 industrieshowever pegging a value is more difficult

In the end Copley proved solidly profitable although less prof-itable than anticipated

But the most important lesson to be learned from the CopleyPharmaceuticals saga is that the original analysis based on the orig-inal evidence proved to be accurate

The next time you see a public disagreement erupt between acompany and its largest shareholdermdashespecially if that sharehold-er is another corporation and not an investment companymdashyou

CHAPTER TWELVE Family Feuds 155

Chap 12 7901 856 AM Page 155

should think in terms of a potential takeover bid The next time yousee a public disagreement between a director and a companyrsquos man-agementmdashespecially if the director resigns and makes statementsabout protecting shareholder interests or enhancing shareholdervaluemdashyou 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

156 PART TWO Identifying Takeover Targets

Chap 12 7901 856 AM Page 156

P A R T T H R E E

Takeover Clues

Chap 13 7901 858 AM Page 157

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

This page intentionally left blank

C H A P T E R T H I R T E E N

ldquoBeneficial Ownerrdquo Buying

CASE STUDY SUMNER REDSTONE AND WMS INDUSTRIES

Knowing how to read a stock chart can be a valuable tool in select-ing potential superstocks A stock that is breaking out above a well-defined multiyear resistance level is usually telling you somethingie that something bullish is going on Herersquos how chart analysisled to a recommendation of WMS Industries

In spring 1989 the chart in Figure 13ndash1 caught my attentionResearch indicated that WMS Industries manufactured pinball andvideo games and owned two hotelcasinos in Puerto Rico Here wasa stock with a terrific long-term chart that was acting like it wasabout to attempt a superstock chart breakout

In April 1989 WMS was trading at $75frasl8 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 levelsThis can often be a signal that a stock is about to make a seriousattempt at a major breakoutmdasha superstock breakout pattern

By 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 company

159

Chap 13 7901 858 AM Page 159

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

The 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 157500 shares inearly 1989 at prices ranging from $55frasl8 to $8

This 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 thisexplosive combination was a breakout above the $8 to $81frasl4 area themultiyear resistance level that had contained WMS since 1986

160 PART THREE Takeover Clues

F i g u r e 13ndash1

WMS Industries (WMS) 1987ndash1989

Source Courtesy of Mansfield Chart Service Jersey City NJ

Chap 13 7901 858 AM Page 160

TEAMFLY

Team-Flyreg

When a well-defined multiyear resistance area in a stock is beingpenetrated it usually means something has changed significantly forthe better Sometimes itrsquos 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-uationmdashin 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 entrepreneurwas also a suggestion that something bullish was brewing

At 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 ldquospinning offrdquo its hotelcasino as a separatecompany

When 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 analysis

In 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 real reason 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 WMSrsquos desire to

CHAPTER THIRTEEN ldquoBeneficial Ownerrdquo Buying 161

Chap 13 7901 858 AM Page 161

maximize the value of its hotelcasino operations When a compa-ny is thinking of getting into a new business itrsquos hard to keep itunder wraps And WMS was a leading manufacturer and distribu-tor of pinball and video gamesmdashwith the trade names ldquoWilliamsrdquoldquoMidwayrdquo and ldquoBallyrdquomdashthat could be found in restaurants and tav-erns throughout America Now a brand new industry was emerg-ingmdashvideo lotteries and video pokermdashthat 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 on

The superstock chart pattern and the major breakout came aboutas a result of buying pressure in the stock Who was doing the buy-ing A good guess would have been that a growing number of peo-ple close to WMS andor 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 ldquomaximize the valuerdquo of itsPuerto Rico hotelcasinos which were carried on WMS Industriesrsquobooks at far below their actual values)

These are the sort of ldquounder the surfacerdquo developments thatcreate bullish chart patterns and major breakouts Sometimes thereasons for the major breakouts are apparentmdashand 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 noticedmdashwhich is precise-ly what happened in tracking WMS Industries

On April 28 1989 I noted the major breakout in WMS ldquoThisstock seems to have a lot going for it A solid story an apparent earn-ings turnaround a great long-term chart and steady accumulationon the open market by a potential acquirerrdquo

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 ldquospikerdquo Again the chartist may nothave known why WMS shares were being bought with such urgency

162 PART THREE Takeover Clues

Chap 13 7901 858 AM Page 162

but the chart was clearly suggesting that something very bullish wasgoing on

By 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-ket this time buying 101100 shares at prices between $81frasl4 and $115frasl8Redstonersquos stake in WMS had now increased to 288 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 story

By mid-August 1989 WMS had fallen back below $12 per shareRevenues and earnings continued to rise sharply due to rapid growthin the companyrsquos pinball and video arcade games On September 11989 our recommendation was that ldquosince Sumner Redstone paid asmuch as $115frasl8 for WMS stock this should serve as somewhat of abenchmark for usmdashie 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 levelrdquo

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 advancedecline line weresinking relentlessly In October a sharp sinking spell took the Dowdown a quick 11 percent but smaller stocks suffered much more

Meanwhile WMS had announced some disappointing newsThe company said it would report a loss at the quarter due to aplanned shutdown of its manufacturing line for ldquoretoolingrdquo 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 $8

According 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

CHAPTER THIRTEEN ldquoBeneficial Ownerrdquo Buying 163

Chap 13 7901 858 AM Page 163

disaster struck this time a natural disaster Hurricane Hugo dam-aged some of the WMS hotelcasino properties in Puerto Rico Thecombination of Hugo and the assembly line shutdown caused WMSto report a loss of $076 per share for the quarter and the stockslumped back toward the $8 support area again

1990 Convictions about WMS Are Put to the Test

What happened during 1990 to WMS stock was a classic example ofhow superstock investing differs from almost any other method ofstock selection A combination of recession Iraqrsquos invasion of Kuwaita 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

Redstone had paid up to $115frasl8 for 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 market

Without those open market purchases by Redstone there would havebeen no benchmark of value with which to work But since we did have thatbenchmarkmdashand since we were betting on Redstone or on something Redstoneknew about WMS as a potential catalyst to get the stock price highermdashweadded to our stake in WMS during nearly all of 1990 at single digit prices

It was not easy to watch WMS decline as far as it did in 1990but 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 notmdashand that as it turned out made all the difference

By late December 1990 WMS Industriesrsquo stock had fallen to$37frasl8 But two new Telltale Signs emerged during that year to indicateit was still a potential superstock

The two catalysts were the announcement that WMS would seekto spin off its Puerto Rico hotelcasinos to ldquoenhance shareholdervaluerdquo and WMS would write off its investment in a company calledDivi Hotels even though the investment still had apparent value

164 PART THREE Takeover Clues

Chap 13 7901 858 AM Page 164

These two Telltale Sign announcements along with the continuing288 percent ownership of Sumner Redstone and the fact that Redstonehad paid as high as $115frasl8 for WMS stock was a sign that WMS hadsignificant unrecognized values lurking beneath its low stock priceThe decision to write off the investment of Divi Hotels was an exam-ple of what is called kitchen sink accountingmdasha 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 year

As a superstock detective these telltale signs clearly suggestedthat something very bullish was lurking beneath the surface atWMSmdashsome development or some value that the stock market hadnot yet recognized Yet WMS shares plunged throughout the year

To 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 US bank stocks whichwere suffering from a rash of bad loans

In an environment such as this it is not easy to disregard the gen-eral stock market and focus on specific events or potential ldquocatalystsrdquothat 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 timesmdashin fact they were the worstof times for small stocks and WMS spent all of 1990 eroding in price

Sooner 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 ldquoCutting your lossesrdquo is easiersaid than done Nobody has perfect timing you may have bought

CHAPTER THIRTEEN ldquoBeneficial Ownerrdquo Buying 165

Chap 13 7901 858 AM Page 165

precisely 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 invalidPerhaps some mutual fund is getting out of a position and the stockis dropping Does that make you wrong and the mutual fund right

Thatrsquos 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 declineBut if you donrsquot really know why you bought a stockmdashif you boughtit for some vague reason (an analyst recommended it on televisionitrsquos a ldquogood companyrdquo itrsquos a growth stock etc)mdashthen yoursquore goingto have a difficult time deciding what to do when the stock startsmoving in the wrong direction

Superstock investing while it is by no means perfect at leastgives you a guidepost In the case of WMS Industries the stock tooka sickening plunge from $10 to as low as $31frasl4 between July andDecember 1990 It was not pleasant But I knew why I had recom-mended the stock in the first place and did not see anything thatcaused me to doubt my original premise

To reiterate here are the reasons I stuck with WMS 1 Sumner Redstone an outside beneficial owner with a stel-

lar track record owned 288 percent of WMS and hadrecently bought stock for as much as $115frasl8 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 company

2 WMS had raised the possibility of spinning off its PuertoRico hotelcasinos as a separate company to enhanceshareholder value The term ldquoenhance shareholder valuerdquois a key phrase and a telltale sign for superstock investorsIt 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 value

3 The earnings disruption at WMS had taken place for a spe-cific reasonmdasha shutdown of the manufacturing facility for

166 PART THREE Takeover Clues

Chap 13 7901 858 AM Page 166

retooling Yet the stock marketmdashdue to a lack of analystcoverage of WMS mdashwas overacting to the temporary loss

4 The 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 ldquoclear the decksrdquo for better news around the cor-nermdashanother Telltale Sign

There is no way around this If you want to make the right deci-sion when a stock starts moving against you you have to know exact-ly why you 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 reasonmdashyou should be looking at a specific ldquocluerdquo or potentialldquocatalystrdquo that tells you to buy this stock Then if the stock movesthe wrong way you should ask yourself Is the reasoning still validIf 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 valid

But if the original premise remains sound you should hang intheremdashand if you can you should buy more to take advantage of thelower price

On December 31 1990 WMS closed at $31frasl4 Despite whatseemed to be a logical analysis the stock had now declined 57 per-cent from my original recommended price of $75frasl8

I did not use a stop loss on the way down and did not recom-mend a ldquosellrdquo of WMS for year-end tax loss In other words I did notfollow any of the simplistic ldquorulesrdquo for intelligent investing

And itrsquos a good thing too because in 1991 WMS Industries turnedout to be the best-performing stock on the entire New York Stock Exchange

On February 8 1991 WMS had broken out of a nice base in the$31frasl2 to $41frasl2 area The stock moved up quickly trading above $6Earnings rebounded nicely following the onetime charges and theretooling which really was not much of a surprise since WMSIndustriesrsquo basic business was continuing to grow

But 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

CHAPTER THIRTEEN ldquoBeneficial Ownerrdquo Buying 167

Chap 13 7901 858 AM Page 167

reassure 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 WMSlate in 1990 on its way from $10 to $31frasl4

Once again Sumner Redstone had paid over $10 for large blocksof stock and there was WMSrsquos desire to enhance shareholder valuemdashone of the key code phrases for superstock investorsmdashspinning offits hotelcasinos operations as a separate company

Research into this plan led to some interesting informationabout appraisals of the value of the WMS hotelcasino propertiesThe Condado Plaza was worth between $105 and $110 million whichmeant that the 80 percent owned by WMS was worth about $84 mil-lion (about $10share) Yet WMS carried its 80 percent ownershipof the Condado Plaza on its books at a value of $37 million (about$435share) 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 $6share) However this asset was also carried on theWMS books at only $37 million ($435share)

In a situation like this itrsquos important to focus on the differencebetween ldquobook valuerdquo and true ldquoasset valuerdquo especially when yoursquoredealing with real estate A great 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 value and 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 ldquobook valuerdquoUsually the asset is initially valued at its historical cost which mayor may not reflect the actual value several years down the road

In the case of a piece of machinery for example the value of thatmachinery will decline over time as the machinersquos 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 assetrsquos cost each year from its earnings The depreciationldquoexpenserdquo is not really a cash expense it is just a bookkeeping entry

168 PART THREE Takeover Clues

Chap 13 7901 858 AM Page 168

that allows the company to reduce its tax bill somewhat and alsoreduces the carrying value or ldquobook valuerdquo of the asset each year

For 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 $100000depreciation charge (one-tenth of the machinersquos cost) that is deduct-ed from earnings If the company earned $2 million that year itwould only report $19 million after the $10000 depreciationldquoexpenserdquo The ldquoexpenserdquo did not involve a cash outlay but savedperhaps $40000 in taxes because it reduced reported earnings That$40000 saving is supposed to allow the company to accumulate cashto replace the machine when its useful life wears out in 10 yearsThat is the purpose of the depreciation allowance

The other effect of that $100000 depreciation ldquoexpenserdquo is toreduce the carrying value or ldquobook valuerdquo of the machine on the com-panyrsquos balance sheet At the end of the first year that $1 million machinewill be carried on the books at its newly depreciated value of $900000The book value of that machine will decline each year by $100000 untilthe machine wears out and a new one must be purchased

Of 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 ldquobook valuerdquo of the com-pany will understate the actual value of its assets

It 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 ldquobook valuerdquo may overstate the actual value of the asset

On the other hand letrsquos 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

CHAPTER THIRTEEN ldquoBeneficial Ownerrdquo Buying 169

Chap 13 7901 858 AM Page 169

what you paidmdashbut their true worth is not reflected in your compa-nyrsquos ldquobook valuerdquo

Book Value and Kirby Industries

The term ldquobook valuerdquo can be very misleading In 1974 in the midstof a crushing bear market a small oil and gas company called KirbyIndustries announced that it would sell off its assets and pay outcash to its shareholders This type of self-liquidation is fairly com-mon today it usually occurs when a company believes its assets areworth far more than its stock price and when the stockholders wouldbe better served by selling the assets and paying the proceeds direct-ly to the stockholders

In 1974 however the concept of voluntary liquidation wasnovelmdashso novel in fact that nobody seemed to know how to analyzethe situation I was still a junior analyst at Merrill Lynch when Kirbyannounced it would liquidate itself and the only reason I noticed theannouncement was that I had a friend who owned a substantial num-ber of Kirby shares I called him and asked him what the announce-ment meant

ldquoThe assets of this companyrdquo he told me ldquoare 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 theyhavenrsquot even started drilling yet but they know the oil and gas arethere They even have a small auto insurance company in PuertoRico thatrsquos worth way more than its book value They think sellingthe company off piece by piece will create a better value for the stock-holdersrdquo

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 plan

The 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

170 PART THREE Takeover Clues

Chap 13 7901 858 AM Page 170

TEAMFLY

Team-Flyreg

company was too small Their advice was to stay away from the sit-uation because it appeared ldquotoo riskyrdquo

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 termldquotoo riskyrdquo means ldquoIt doesnrsquot fit the paradigm in which I am usedto operatingrdquo Everybody is used to a certain way of doing thingsboth personally and professionally When a situation arises thatbreaks the mold the initial reaction is to not deal with it Ignore itPretend it does not exist Just go on doing what yoursquore used to doingwhile an opportunity sits there outside the box waiting to be expe-rienced and profited from

In the case of Kirby Industries a voluntary liquidation was out-side the familiar paradigms of most securities analysts So insteadof ldquothinking outside the boxrdquo the oil and gas analysts just didnrsquotthink about Kirby at all They ignored it because it did not fit theirpreferred and preconceived manner of thinking

The 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 previouslytraded at $151frasl8 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 $28mdashup 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 $2828 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 ldquobook valuerdquo and ldquohistorical costrdquo in relation tooil and gas properties

More 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 lettermdashand decided to make Kirby Industries my very first recommendation

CHAPTER THIRTEEN ldquoBeneficial Ownerrdquo Buying 171

Chap 13 7901 858 AM Page 171

And 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 Ricohotelcasinos Because the hotelcasinos had been depreciated onWMSrsquos books they were therefore undoubtedly worth more thanldquobook valuerdquo 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 value

Then 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 correctHe had paid far in excess of WMSrsquos current market price for stockand he must have seen something that the market was missingCould it have been the value of the hotelcasinos Or somethingelse that was not on Wall Streetrsquos 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 stock

By early February 1991 however WMS had doubled in pricefrom its 1990 close of $31frasl4 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 companyrsquos 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

172 PART THREE Takeover Clues

Chap 13 7901 858 AM Page 172

Now the true earnings power of WMS was becoming apparent onceagain and the stock was moving higher

By 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 atprices between $33frasl8 and $61frasl8 This was a major reinforcement to hangin there and continue to follow Redstonersquos 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 ldquoroadmaprdquo to guide you) and adding to your stake in a declining stockKnowing why you bought the stock in the first placemdashin this casebecause we were following a sophisticated outside beneficialownermdashtells you what to do if the stock starts going against youRedstone by adding to his stake in WMS at these lower prices hadjust updated the road map WMS was still a buy

At the same time there were also some interesting ldquotechnicalrdquoor chart patterns in WMS Take a look at this chart in Figure 13ndash2and you will see that WMS on the way up from its low at $31frasl4 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 pattern

What 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 pointsBy 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 market

In May 1991 Redstone purchased an additional 193100 WMSshares at prices between $87frasl8 and $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 price

Now think about what this would mean to you as an investorSuppose you had been a WMS shareholder at the time You boughtstock at $8 and watched it slump to a low of $31frasl4 ldquoOld paradigmrdquo

CHAPTER THIRTEEN ldquoBeneficial Ownerrdquo Buying 173

Chap 13 7901 858 AM Page 173

investors would have been discouraged and confusedmdashbut as asuperstock investor you would not because yoursquod be following tworoad maps Sumner Redstonersquos continuing purchases of WMS andthe WMS plan to unlock the value of its hotelcasino propertiesWhile 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 Yoursquod 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 greater

Compare this confident attitude to the plight of someone whobuys a stock for some vague reasonmdashletrsquos say because it is a ldquogrowthrdquostock You buy the stock and it starts to decline What do you do Youhang in there because you have been told it is a ldquogrowthrdquo stockPretty soon the stock is down 25 percent Now what do you do

174 PART THREE Takeover Clues

F i g u r e 13ndash2

WMS Industries (WMS) 1989ndash1991

Source Courtesy of Mansfield Chart Service Jersey City NJ

Chap 13 7901 858 AM Page 174

Cutting Your Losses

Do you follow the simplistic ldquocut your lossesrdquo routine or do youbuy more Well itrsquos hard to say because you really donrsquot have a han-dle on why you bought the stock in the first place Even if itrsquos aldquogrowth stockrdquo what is it worth Are interest rates rising If they areyour growth stock might be growing nicely but the stock price isgoing to be worth progressively less as interest rates rise because itspriceearnings 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 ldquonew businessrdquo which is immediatelytaken into account by the market results in your ldquogrowth stockrdquoopening another 25 percent lower in a single trade which meansyou should have followed the ldquocut your losses rulerdquo

On the other hand maybe you did follow the ldquocut your lossesrdquorule 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 stupid

But should you How could you have possibly known what todo You were operating without a road map without guidelinesmdashwithout a guiding principle if you want to put it in those terms

Compare 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 knew that WMS management was aware of this andthat they were looking for ways to force the stock market to reflectthis value You knew that 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 dropped

This mind-set is the major difference between superstock invest-ing and any other approach to the stock market It wonrsquot always lead

CHAPTER THIRTEEN ldquoBeneficial Ownerrdquo Buying 175

Chap 13 7901 858 AM Page 175

to profitable investmentsmdashbut it will lead to peace of mind a coher-ent strategy and the ability to make decisions for rational reasonsAnd there is a lot to be said for that

In June 1991 I received a letter from a subscriber who askedwhether WMS might eventually become a manufacturer of videolottery terminals

Video 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 A small 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 machines

Further 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 devicesFor 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 Suddenlythere was an answer to this question The growth in demand wouldcome from state-run video lotterypoker terminals and the prolifer-ation of Native American casinos across the country

Some 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 percentmdashall 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 casinos

Would WMS Industries enter the market for video lottery ter-minals If so the effect on its stock price could be huge

176 PART THREE Takeover Clues

Chap 13 7901 858 AM Page 176

WMS was not commenting But Dow Jones News Service hadtalked to a distributor of WMSrsquos pinballvideo games which as Isaid were ubiquitous in restaurants and taverns all over the countryThe distributor confirmed to Dow Jones that WMS had told him it wouldsoon be unveiling a video lottery terminalmdashpossibly 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 WMSrsquos productsmdashWilliams Bally and Midway Now if WMS were about to unveil avideo lottery terminalmdashwhich in manufacturing terms was not allthat different from what WMS was already producingmdashthe rela-tionships of WMS distributors with bar and restaurant owners acrossthe country could mean that WMS would be in the driversrsquo seat ver-sus IGT when it came to placing these machines

The 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

By June 1991 WMS had already advanced from $31frasl4 to $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 ease

In retrospect itrsquos easy to see why WMS was performing so welland 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 notWMS had to retool itrsquos manufacturing facilities it had to conductmarket research it had to bring in teams of designers and it had to

CHAPTER THIRTEEN ldquoBeneficial Ownerrdquo Buying 177

Chap 13 7901 858 AM Page 177

prepare its distributors around the country for the introduction of thisnew product The increasing awareness of WMSrsquos upcoming entryinto this exciting new growth industry was undoubtedly one of themajor factors in the bullish patterns being created on the companyrsquosstock 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 WMS

This is another example of how charts can help point youtoward potential stock market winners Itrsquos 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 ldquofoot-printsrdquo on the chart By recognizing the signs of informed and con-fident demand you can pretty much know what the smart moneyis doingmdasheven if you do not know what the smart money knows

By 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 industrySometimes there will be no ldquolag timerdquo at all and all of the stocks inthe industry group will move together Other times there will be a brieflagmdashdays or a week or two at the mostmdashbefore the other stocks inthe industry group start to move up in sympathy with the leader

In 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 earlierSince 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

178 PART THREE Takeover Clues

Chap 13 7901 858 AM Page 178

no 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 thegroupmdashbut 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 stockswhich 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 individualsmdashjust like youmdashwho are willing to put two and two together and come up withfourmdasha 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 us

The 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 companyrsquos entrance into the VLTmarket by dropping from $13 to $10 providing yet another buyingopportunity for those who were keeping their eye on the ball

Finally in late July 1991 a brokerage firm analyst noticed WMSand published a report recommending it as a buy

Take a look at the chart in Figure 13ndash3 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 allymdashbrokerage firm sponsorship This was thefinal ingredient necessary for WMS to follow in the footsteps of

CHAPTER THIRTEEN ldquoBeneficial Ownerrdquo Buying 179

Chap 13 7901 858 AM Page 179

International 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 revenueseach time another state decidesto legalize VLTs we think the handful of stocks involved in VLTs willget a boost

WMS 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

180 PART THREE Takeover Clues

F i g u r e 13ndash3

WMS Industries (WMS) 1990ndash1992

Source Courtesy of Mansfield Chart Service Jersey City NJ

Chap 13 7901 858 AM Page 180

TEAMFLY

Team-Flyreg

with 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 WMSrsquos new VLTHe told me that ldquoWilliams 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 reliableproductrdquo Nicastro also confirmed that ldquoif 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 WMSrdquo

Meanwhile back on the chart WMS was sketching out thatfamiliar superstock chart pattern once again A short-term resistancearea near $15 to $151frasl2 was being attacked over and over again bybuyers with demand coming in at progressively higher levelsmdashastrong signal that WMS stock would be moving higher

By late September 1991 WMS had broken out above its resistancearea at $15 to $153frasl8 to 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 ldquoconcentrating on stockswhich will not depend entirely on an economic recovery to do wellSuch stocks would include takeover candidates and companies whichmay be involved in an industry which could actually benefit from asluggish economy An example would be WMS Industries whichreached another new high and which is up an astonishing 85 percentsince late Junerdquo

In OctoberndashNovember 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 WMSrsquos pinballgames could be developing in Eastern Europe where communism

CHAPTER THIRTEEN ldquoBeneficial Ownerrdquo Buying 181

Chap 13 7901 858 AM Page 181

was giving way to democracy and also in South America where pin-ball games were catching on with young people

Only 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 IndustriesAll 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 ldquorespectablerdquo price range and the stock hadmorphed into a ldquomomentumrdquo stock

Wall 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 ldquoleisurerdquo 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 wouldnrsquot officiallyrecommend WMS he told me it was ldquonot an institutional sort ofstockrdquo whatever that meant

Finally 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

ldquoNow that itrsquos a $20 stock I can get our institutional clients inter-estedrdquo the analyst said

ldquoExcuse merdquoldquoLookrdquo he said ldquothese guys arenrsquot going to buy a $7 stock with

no research coverage that nobodyrsquos ever heard of Itrsquos too risky If itgoes down yoursquoll get all sorts of heat and who needs that Now thatWMS is a $20 stock and itrsquos moving and itrsquos a relative strengthleadermdashsee I can sell that story Theyrsquoll listen to me at this price levelThe stock is more recommendable at these levelsrdquo

ldquoAre you telling merdquo I said ldquothat even though you knew thesame things about WMS at $7 or $10 that you know now that youdidnrsquot recommend the stock simply because it was too cheaprdquo

ldquoYesrdquo

182 PART THREE Takeover Clues

Chap 13 7901 858 AM Page 182

ldquoAnd now that WMS is more expensive you are willing to stickyour neck out because you wonrsquot get criticized as much as if it doesnrsquotwork outrdquo

The analyst sighed ldquoI know it sounds ridiculousrdquo he said ldquoButyes that is what Irsquom telling yourdquo

Do you think things have changed since thenOn November 19 1998 a mutual fund portfolio manager

appeared on CNBC In response to a viewer question the fund man-ager launched into an informed and enthusiastic analysis of what youwould call a ldquovalue stockrdquo which carried a rich dividend yield soldat a low priceearnings ratio and seemed like an undiscovered gem

ldquoWould you buy the stock hererdquo the host asked ldquoWellrdquo the portfolio manager said ldquoI would if I didnrsquot have so

much short-term performance pressure on me It would be a greatstock to buy and tuck away But you know I canrsquot do that itrsquostoughrdquo

The portfolio managerrsquos voice trailed away and the host went onto the next question But his comments spoke volumes about the ldquolem-mingrdquo 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 underpricedmdashuntil 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 have loved to buy and ldquotuck awayrdquo in his fundrsquos portfolio buthe didnrsquot 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 lemmings

On December 31 1991 WMS Industries closed at $277frasl8 up 669 per-cent from its 1990 closing price of $31frasl4 That performance made WMS thebest-performing stock on the New York Stock Exchange for 1991

By 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 sharemdashan incredible gain of 1161 percent fromits closing level at year-end 1990

What is the lesson to be learned from the WMS story

CHAPTER THIRTEEN ldquoBeneficial Ownerrdquo Buying 183

Chap 13 7901 858 AM Page 183

Actually there are severalWMS Industries had three of the Telltale Signs for identifying

future 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 ldquounlockrdquo that value

These 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 WMSrsquos bullishchart pattern was created by persistent buying among those whowere becoming aware of the companyrsquos impending entry into thevideo lottery terminal industry Itrsquos possible that Sumner Redstonersquosbuying was related to this insight as wellmdashor perhaps SumnerRedstone was buying because he knew that the WMS hotelcasinoswere worth far more than WMSrsquos stock price was reflecting

Who knowsThe point is this The signs were there even if the information

that created those Telltale Signs did not emerge until laterWMS Industries is a textbook example of how a superstock

chart pattern together with outside beneficial owner buying canlead you to a huge winnermdasheven if you donrsquot know why that stockis going to be a winner

Postscript to the WMS StoryEventually WMS Industries got around to spinning off its

hotelcasino 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 share

The takeover bid for WHG Resorts valued the company ataround $130 million Based on the fact that WMS Industries hadaround 104 million shares outstanding when the company first

184 PART THREE Takeover Clues

Chap 13 7901 858 AM Page 184

announced that it was seeking to ldquounlock the valuerdquo of its hotelcasi-nos WMSrsquos hotelscasino 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 properties

Which is why you should always take a close look at ldquospinoffsrdquoas potential superstock candidates

CHAPTER THIRTEEN ldquoBeneficial Ownerrdquo Buying 185

Chap 13 7901 858 AM Page 185

This page intentionally left blank

C H A P T E R F O U R T E E N

The ldquoPure Playrdquo and theDrugstore Industry

There is always a disposition in peoplersquos 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 with

this which make it unlike its predecessors andgive assurance of permanency

Charles H Dow JournalistJune 8 1901 The Wall Street Journal

Things changeDon Ameche Actor

Things Change

Charles Dow founder of Dow Jones amp Company and Don Amechea 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 becausemdashwell because things change

On 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 fads

187

Chap 14 7901 858 AM Page 187

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

appear 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 yoursquore riding the final glorious upward arcmdashitalways 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 otherwise

In this chapter you will learn about ldquopure playsrdquo and spinoffsand how they can lead you to superstocks and superstock takeoversBut first letrsquos go back to the 1960s when ldquoconglomeratesrdquo were allthe rage and Wall Street was discovering the meaning of the latestbuzzwordmdasha fad called ldquosynergyrdquo

The technical definition of synergy is ldquothe joint action of agentssuch as drugs that when taken together increase each otherrsquos effec-tivenessrdquo 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 ten

In the 1960s the concept of ldquosynergyrdquo 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 timesThe 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 companymdashcalled a ldquoconglomeraterdquomdashwouldreport 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 homesmdashor whatever else you owned thatmight be doing well while something else was performing poorly

That 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 manner

So synergy and the conglomerate craze slowly petered outmdashproving once again that Charles Dow and Don Ameche knew whatthey were talking about (Of course some ldquosynergiesrdquo are too powerful

188 PART THREE Takeover Clues

Chap 14 7901 858 AM Page 188

and obvious to be denied In an obviously well-thought-out strategyNetherlands-based Unilever PLC announced two takeovers on thesame day in April 2000 First Unilever said it would buy ice creammaker Ben amp Jerryrsquos Homemade whose products include the notori-ously calorie-laden ldquoChubby Hubbyrdquo brand for $326 million Also onthat day Unilever announced the $23 billion acquisition of diet prod-ucts company Slim Fast Foods thus putting Unilever in the businessof both causing and curing obesitymdasha synergistic win-win situationif ever there was one)

Interestingly however there are some vestiges around of thetrend toward synergy even todaymdashand when these vestiges beginto jettison operations that do not fit their core businessesmdashin otherwords when a company decides it wants to be more of a ldquopure playrdquoin a well-defined industrymdashit can lead you to potential superstocks

In recent years a growing number of companies have decidedthat theymdashand their stockholdersmdashwould be better off as ldquopureplaysrdquomdashie 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 stations

In 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 company

In 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 spinoffrsquos business once it is separated from the parent

Another 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-

CHAPTER FOURTEEN The ldquoPure Playrdquo and the Drugstore Industry 189

Chap 14 7901 858 AM Page 189

arating the fast-growing subsidiary and turning it into a separatelytrading company the growth rate that had been previously obscuredwill become more apparent which could lead to a higher priceearn-ings multiple for the spinoffrsquos stock

A third possibility is that by spinning off a company in an indus-try where there is a lot of takeover activity the spinoff could becomea takeover target This is what happened to WHG Resorts thehotelcasino spinoff of WMS Industries which following its sepa-ration from the parent company in 1997 more than doubled in pricewithin 6 months

Most Wall Street analysts recommend investing in spinoffs forall of these reasons but there is a different way to look at spinoffsAs a superstock investor you should look at every announced spin-off and ask yourself Which company operates in an industry wherethere is a great deal of takeover activity the parent company or thecompany being spun off

The answer to that question may surprise you In fact in manycases you would be better off buying the parent companymdashespe-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 sale

A rule 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 companyrsquos industry

If 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 bidder

CASE STUDY FAYrsquoS AND GENOVESE

In 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 thenationrsquos largest drugstore company was never consummated becauseof regulatory opposition But in commenting on the reasoning for

190 PART THREE Takeover Clues

Chap 14 7901 858 AM Page 190

TEAMFLY

Team-Flyreg

Rite Aidrsquos bid for Revco Rite Aidrsquos chairman Martin Grass com-pared the fragmented drugstore industry to the banking industrywhich 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 companyrsquos bid for Revco

Although the Rite AidndashRevco merger never took place this inter-view was the ldquoroad maprdquo 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

1 Rite Aid (see Chapter 17)2 Revco3 Walgreens4 Eckerd5 Melville Corp (which owned CVS Drugs which was

eventually spun off and acquired)6 Cardinal Health (which owned Medicine Shoppes)7 Thrifty-Payless8 American Stores (which owned Osco and Sav-On Drugs)9 JCPenney (which owned Thrift Drugs) (see Chapter 17)

10 Longs Drug Stores11 Big B12 Fayrsquos13 Drug Emporium14 Arbor Drugs15 Genovese Drug Stores

If 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

CHAPTER FOURTEEN The ldquoPure Playrdquo and the Drugstore Industry 191

Chap 14 7901 858 AM Page 191

behind his bid for Revcomdashwhich only goes to prove that Yogi Berraknew what he was talking about when he said ldquoYou can observe alot just by watchingrdquo Or in this case browsing

The 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 takeovers

My first successful drugstore takeover candidate recommen-dation was Fayrsquos Inc and it was recommended for one reasonmdashthissmall drugstore company was selling off noncore assets makingitself a ldquopure playrdquo drugstore company By December 1995 Fayrsquoshad just sold its Wheelrsquos 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 industrymade Fayrsquos an obvious takeover candidate Fayrsquos was readying itselffor sale by getting rid of ldquononcorerdquo operations a move that wouldmake it more attractive to a larger drugstore company seeking acqui-sitions At the time Fayrsquos was trading at $63frasl4

In January 1996 another small drugstore company was addedto my list of takeover recommendations Genovese the nineteenthlargest drugstore companymdashwith 113 stores in the New York CityLong Island areamdashhad also recently become a pure play by sellingoff its nondrugstore operations

I quoted Rite Aid chairman Martin Grass on the rationale ofpotential drugstore industry mergers being ldquovery analogous towhatrsquos going on in the banking industry Wersquore able to absorb storeseliminate tremendous overhead and take costs off the systemrdquo

Our view was that the managements of Fayrsquos 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 Fayrsquos management might be preparing to sell the com-pany

ldquoAs I previously reported Fayrsquos has been selling off its nondrugstoreretail operations Now Fayrsquos has announced the elimination of 90administrative jobs which would save $3 million per year or about

192 PART THREE Takeover Clues

Chap 14 7901 858 AM Page 192

$014 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 industry

Fayrsquos stock continued to languish at $73frasl4 As part of its cost-cut-ting move Fayrsquos had taken a ldquorestructuringrdquo charge and the stockmarket reacted by pushing Fayrsquos shares briefly down to the $61frasl2 areaHere was another situation where a complete lack of analytical coverageresulted in the stock market putting the wrong interpretation on this newsExperience in noticing the Telltale Signs of an impending superstocktakeover targetmdashie any company selling off noncore assets andcutting costs in an industry where a takeover trend was in forcemdashwas practically hanging a ldquoFor Salerdquo sign on the front door But whenFayrsquos took its restructuring chargemdashwhich would yield future ben-efits to cash flow and earningsmdashall the stock market saw was a lossfor the quarter There was no room for nuance A low-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 Fayrsquos shares lower was another clue thatFayrsquos would soon become a takeover target

In April 1996 the Rite AidndashRevco 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 consumersHowever the FTC left the door open for other drugstore industrymergers which would be smaller in scale By May 1996 Fayrsquos stockwas moving highermdashever since the Rite AidndashRevco deal was ter-minated

By July 1996 Fayrsquos had finally sold its Paper Cutter office sup-ply stores for $14 million which meant it was now a pure drugstorecompany

Anyone concentrating on the ldquopure playrdquo concept and the factthat Fayrsquos 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 Fayrsquos was a genuine takeover candidate And yet despitethe fact that Fayrsquos had finally sold off its last nondrugstore operationand taken a ldquoclear the decksrdquo restructuring chargemdashand despite thefact that the Federal Trade Commission had pretty much publiclystated that it would encourage smaller drugstore mergersmdashdespiteall of this Fayrsquos shares were trading at $75frasl8 only slightly higher thanthe original recommended price of $63frasl4 six months earlier

CHAPTER FOURTEEN The ldquoPure Playrdquo and the Drugstore Industry 193

Chap 14 7901 858 AM Page 193

Suddenly just 8 days later on July 11 1996 Fayrsquos announcedthat it had received a takeover bid from JCPenney which owned theThrift Drug Store chain The stock market reacted as though it wasshockedmdashshockedmdashat the news Fayrsquos shares jumped to $107frasl8 onthis news Fayrsquos 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 ended

In July 1996 discussing the Fayrsquos takeover proposal I againraised the possibility that Genovese Drug Stores could become atakeover target for precisely the same reason that Fayrsquos had Genovesehad sold off its nursing home division in the previous year a movesimilar to Fayrsquos selling off its nondrugstore operations in 1995ndash1996prior to selling itself to JCPenney

Also the Genovese chain of drugstores was located almost pre-cisely in the middle of the geographic areas that would be servedby Penneyrsquos Thrift Drugs chain and a newly acquired Fayrsquos chain Atthat time Genovese Drug Stores was trading near $8 adjusted fortwo subsequent 10 percent stock dividends

Within two weeks Fayrsquos announced that it had agreed to beacquired by JCPenney for $1275 per sharemdashan 85 percent gain fromthe recommended price of $63frasl4 in just 7 months and all because Fayrsquoshad tipped its hand by selling off its noncore operations and becoming apure play in an industry where a takeover wave was under way

The Fayrsquos recommendation had turned out to be on target sowe next turned our attention to Genovese a very similar companyIn addition to operating in the same general area of the country asFayrsquos and like Fayrsquos recently becoming a pure play by selling offnoncore assetsmdashin its case a nursing home divisionmdashGenovese hadsomething else going for it a potential superstock chart pattern Thechart showed a well-defined multiyear resistance area at $11 to $12mdashprecisely 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 status

Research showed that 43 percent of Genovesersquos stock wasowned by the family who founded the company Now you mightlogically think that would be a roadblock to a takeover But in fact

194 PART THREE Takeover Clues

Chap 14 7901 859 AM Page 194

the opposite is true Around a third of Fayrsquos outstanding stock wasowned by the founding family yet Fayrsquos 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 ldquocash outrdquo and become part of a larger company

Look at it from this point of view You start a small companybuild 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 competitors

What do you do Do you stubbornly hold on to your indepen-dence and take the risk that your companyrsquos 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 stockrsquos 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 familytax considerations come into play Take a look at the JCPenneyndashFayrsquosdeal this buyout was structured as a tax-free transaction under whichFayrsquos shareholders receive $1275 worth of JCPenney stock For thePanasci family which founded Fayrsquos they were sitting with a $7 stockwith the realization that the company they founded was worth almosttwice that amount A cash buyout would result in a huge tax liabilitybut 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 position

So 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 outmdashand youwill find that many of these family-controlled companies will become

CHAPTER FOURTEEN The ldquoPure Playrdquo and the Drugstore Industry 195

Chap 14 7901 859 AM Page 195

willing takeover targets rather than run the risk of being left by thewayside as minor players in an industry dominated by a handful ofgiant competitors

On 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 holdings

According 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 ldquoanti-takeoverrdquoagreement

But our view was that the press had it all wrong and it wasmisleading to characterize this as an ldquoanti-takeover pactrdquo 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 shareholdersmdashwho control 574 percent ofGenovese stockmdashrecognized 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 future

As 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 future

In the case of Genovese Drug Stores this pact between the twolargest shareholders of the company indicatedmdashin no uncertaintermsmdashthat they were discussing what they would do in the eventof a takeover bid

In November 1998 Genovese agreed to be acquired for $30 pershare by none other than JCPenneymdashprecisely 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 $911share

196 PART THREE Takeover Clues

Chap 14 7901 859 AM Page 196

So 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 wasnrsquot 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 investor

When it comes to stocks that are not widely followed by ana-lysts or sometimes not followed by any analyst news items andindustry trends that seem to have clearly bullish implications for asmaller off-the-beaten-path company have no effect on the stockYou see news you make the connection you buy the stock andmdashnothing 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 ldquoroad maprdquomdashie remem-bering why you 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 deduced

Take a look at the chart of Genovese Drug Stores (Figure 14ndash1)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 approachingGenovese stock plunged from $251frasl2 to $15

Genovese had also had a sinking spell a year earlier after thecompany announced a ldquostrategic restructuringrdquo in which it cut costsand closed underperforming storesmdashprecisely the sort of movesFayrsquos 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 takeoverInstead Genovese was punished

In 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 Fayrsquos acquisition the stock should be doingbettermdashand it wasnrsquot

Here was my response

CHAPTER FOURTEEN The ldquoPure Playrdquo and the Drugstore Industry 197

Chap 14 7901 859 AM Page 197

This is a fact of life on Wall Street Unless a widely followed estab-lishment analyst with a connection to a strong retail sales force (ielots of stockbrokers) is delivering a certain story that storymdashno mat-ter how logicalmdashwill not be fully reflected in the stock price This isa major problem with small-cap and microcap stocks and I canrsquot 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 ie generate fees as an investment banking client

198 PART THREE Takeover Clues

F i g u r e 14ndash1

Genovese Drug Stores (GDXA) 1996ndash1998

Source Courtesy of Mansfield Chart Service Jersey City NJ

Chap 14 7901 859 AM Page 198

It 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 companiesmdashtherefore some terrific stories gounreported

When Fayrsquos 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 forsalemdashespecially in view of the fact that the drugstore industry wasrapidly consolidating But Fayrsquos stock did nothing for a long timedespite the fact that it was trading far below its takeover value untilthe company finally announced that it was talking to JCPenney abouta possible buyout

Getting 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 Aidrsquos 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 mergers

Although the Rite AidndashRevco 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 Fayrsquos 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 Fayrsquos indicates that JCPenney islooking to build its Thrift Drug unit into a major player A recent TuckerAnthony research report on Arbor Drugs suggests that Arbor has the cash

CHAPTER FOURTEEN The ldquoPure Playrdquo and the Drugstore Industry 199

Chap 14 7901 859 AM Page 199

and the infrastructure to handle an acquisition Melville Corp will soonbe spinning off its CVS Drug Store chain as a separate company and analystsbelieve CVS will attempt to get bigger through acquisitions Other potentialbuyers include Walgreens Eckerd and Longs

Also in another interesting development the chairman of Revcorecently told Dow Jones that he expects drugstore industry consoli-dation to continue Now that the Rite AidndashRevco merger is off Revcorsquoschairman told Dow Jones that Revco now plans to be an aggressive buyer itselfof smaller drugstore chains

So we have a very large list of potential buyers out there andit seems obvious that some of the smaller drugstore companies willbe receiving takeover bids Other than Genovese Drug Stores whoare some of the other candidates

If you want to look further afield consider Big B a 383-storechain After the Fayrsquos takeover Big Brsquos executive vice president saidthat Big B has ldquono interest in entertaining acquisition offersrdquo and thatthe company is trying to expand on its own That could mean thatBig 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

This lengthy quote illustrates what is meant by the term ldquoroadmaprdquo Here was the analysis from beginning to end Any investorwho read this analysis had two choices It either made sense or itdidnrsquot 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 idea

Genovese 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 1996BusinessWeekrsquos ldquoInside Wall Streetrdquo column had two articles on theprospects of a buyout of Genovese Drug Stores by JCPenney andthe takeover of Fayrsquos Here was the complete story on GenoveseDrug Storesmdashthe road map if you willmdashin an international maga-zine read by millions of people brought to you by an analyst whohad just predicted the takeover of Fayrsquos in the very same publica-tionmdashand yet Genovese stock continued to languish for 2 yearsright up until the takeover bid forced the stock to triple

It 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

200 PART THREE Takeover Clues

Chap 14 7901 859 AM Page 200

TEAMFLY

Team-Flyreg

coverage 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 ldquoefficient stock marketrdquo which meansyoursquoll be able to see things that the Wall Street pros are completelyoverlooking

As Irsquove noted more than once though it is worth repeating Itrsquosdifficult to sit with a stock doing nothing or drifting lowermdashespeciallywhen you see evidence that this stock should be selling at a sub-stantially higher price But when this happens you have to stick toyour gunsmdashas long as the original ldquoroad maprdquo is intact

There is no other way to do itA few weeks later Big Bmdashthe drugstore company that had publicly

stated that it would remain independentmdashaccepted a takeover bid fromnone other than Revco the company that had publicly stated that it wouldstart shopping for smaller drugstore companies

Big 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 Fayrsquos 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 onArborrsquos small size and on the fact that the founding family controlled a largestake in this company Arbor Drugs was likely to be acquired itself

In September 1996 following the Big B takeover Arbor Drugswas added to my recommended list at $83frasl4 And in February 1998Arbor Drugs accepted a $23 per share takeover bid from CVS

CASE STUDY SMITH FOOD amp DRUG CENTERS

In November 1996 browsing through a list of 13-D ldquobeneficialownerrdquo filings in Barronrsquos revealed that Transamerica Corp the giantinsurance company was accumulating shares of Smith Food amp DrugCenters (SFD) on the open market Research indicated that SFD wasa potential superstock takeover candidate

CHAPTER FOURTEEN The ldquoPure Playrdquo and the Drugstore Industry 201

Chap 14 7901 859 AM Page 201

SFD operated in two industries where takeover activity wasrampant supermarkets and drugstores The company operated 147food and drug centers mostly in the southwestern United StatesInterestingly 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 openmarketmdashanother Telltale Sign and a strong signal that a companybelieves its stock is undervalued

What initially drew my attention to SFD was the open marketbuying by Transamerica which had recently raised its stake to 1642percent of the company paying as high as $2825 for SFD shares Butfurther research revealed something far more interesting About 14percent of SFD was owned by the investmentbuyout firm of YucaipaCos which had already been involved in several supermarket dealsYucaipa owned a controlling interest in supermarket giant FredMeyer Inc and also owned stakes in publicly traded DominickrsquosFoods a Chicago-based supermarket chain and Ralphrsquos a privatesupermarket company Clearly Yucaipa was the sort of sophisticat-ed outside investor who would have the ability to ldquocash outrdquo of itsstake in SFD at the right time and the right price if it chose to do soSince 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 sale

A look at SFDrsquos 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 SFDrsquos 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 operationsall indicated that SFD was a takeover candidate

In November 1996 SFD was added to my recommended list at$291frasl2

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

202 PART THREE Takeover Clues

Chap 14 7901 859 AM Page 202

Ultimately Dominickrsquos Foodsmdashthe other publicly traded super-market company which was partially owned by Yucaipa Cosmdashalsoreceived a takeover bid Remember I began browsing through those13-D filings in Barronrsquos which resulted in a single piece of informa-tion involving Transamericarsquos purchases and that touched off someresearch That research yielded additional clues which eventually ledto information about Yucaipa Cos

Thatrsquos an example of why it pays to browse

LESSONS LEARNED

Lesson number one is this If you believe a takeover wave is aboutto strike a particular industry and if yoursquore on the lookout for poten-tial takeover targets you should concentrate on smaller to mid-sizedcompanies because they will be the most vulnerable to takeoversThis stands to reason because the economies of scale being achievedthrough takeovers will tend to make it more difficult for smallercompanies to competemdashand this is one reason why these small com-panies may decide to link up with a larger company

The second lesson is to look for companies in a takeover-livelyindustry that appear to be transforming themselves into ldquopure playsrdquoFayrsquos 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 itself

The 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 ldquoFor Salerdquo 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 market

The fourth lesson all things being equal is that you shouldtake special note of companies in which a large block of stock (say10 percent or more) is held by a single shareholdermdashespecially 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 shareholdermdashtry 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

CHAPTER FOURTEEN The ldquoPure Playrdquo and the Drugstore Industry 203

Chap 14 7901 859 AM Page 203

and 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 ldquoseize themomentrdquo by cashing out

Finally look for superstock chart patterns Pay particular atten-tion to smaller companies that are bumping up against well-definedmultiyear 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 betterWhen 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 hands

Keep 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 RevcoAfter considering his reasoning the conclusion was that more drug-store takeovers were likely That observation led to Fayrsquos a pureplay in the making which led to Genovese Drug Storesmdashand so on

One 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

204 PART THREE Takeover Clues

Chap 14 7901 859 AM Page 204

C H A P T E R F I F T E E N

Using Charts

The market feels what cannot be observed It is continually alerting us to those things which are not readily foreseeable

AJ Frost

The 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 existedmdashoften withhighly profitable results

The 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 stocksIf an industry is in the doldrums and harbingers of a new positivetrend begin to emerge someone will be the first to get wind of itAnd as the information becomes more widely disseminated a light-bulb will go on in somebodyrsquos 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 thebettermdashand certainly long before individual investors become awareof itmdashthe stocks that will benefit will be bid higher and Telltale Signswill emerge to be noticed and interpreted by investors who are

205

Chap 15 7901 900 AM Page 205

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

familiar 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 noticed

This chapter will describe to you the specific chart pattern calleda ldquosuperstock breakoutrdquo pattern This chart pattern involves a stockthat is breaking out to the upside above a very well-defined multiyearresistance level Resistance level is 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 again

The 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 higher

The significance of a breakout from a ldquosuperstock breakoutrdquopattern 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 theyrsquore buyingstock at levels that have contained every previous rally attempt

Either way a breakout above a multiyear resistance level is usu-ally a sign that a stock is going to move significantly higher

The best way to introduce you to this type of chart pattern is tostart with an actual example

In late 1993 and early 1994 there was an emerging trend towardhealth care takeovers In January 1994 we wrote that ldquoif there is oneclear trend developing in the takeover area right now it is thisHospital companies are looking to get bigger by acquiring smallerhospital companies and they are also looking to broaden their healthcare services by lsquovertically integratingrsquo or acquiring companies thatprovide other types of health carerdquo

206 PART THREE Takeover Clues

Chap 15 7901 900 AM Page 206

CASE STUDY SALICK HEALTH CARE

Browsing through charts of every small hospital and ldquospecialty healthcarerdquo company in search of the ldquosuperstock breakoutrdquo pattern justdescribed a stock called Salick Health Care (SHCI) popped up Itschart pattern had that of a potentially powerful superstock breakoutpattern (Figure 15ndash1)

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 A close 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 highas $161frasl4 in January 1993 Sellers won that battle once again and Salickdropped back down to the $10 area By summer 1993 Salick was

CHAPTER FIFTEEN Using Charts 207

F i g u r e 15ndash1

Salick Health Care (SHCI) 1992ndash1994

Source Courtesy of Mansfield Chart Service Jersey City NJ

Chap 15 7901 900 AM Page 207

attacking that $17 resistance area again and once again the stockretreatedmdashbut this time the buyers stepped in just below the $14 areaIn early 1994 the stock was in the process of making its fifth attemptat a breakout in the multiyear resistance area near $17

The strong suspicion was that eventually Salick would be ableto break through the resistance level Why Because something fun-damental had changed Takeovers of ldquospecialty health carerdquo 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 ldquoin theknowrdquomdashie 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 stock

When 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 hands

As 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 Yetafter 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 breakoutareamdashbut 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 targets

There 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

208 PART THREE Takeover Clues

Chap 15 7901 900 AM Page 208

may have to endure a 20 percent 30 percent or even a 50 percentdecline in the stock price

If you insist on limiting your losses to 10 percent you will beldquostopped outrdquo 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 investment

There is no easy answer to this problem The bottom line is thisIf a stock starts going against you you should know two thingsFirst is the original premise on which you based your decision to buystill intact And second where is the support level on the chartmdashie 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 line

In 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 Miami

By 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 way

The 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$3735 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 $16

And 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-

CHAPTER FIFTEEN Using Charts 209

Chap 15 7901 900 AM Page 209

out pattern that was instantly recognizable because it had worked ahundred times before By determining that there were likely to betakeovers in the specialty health care stocks I searched for a super-stock breakout pattern and found it

Thatrsquos how I did itmdashand thatrsquos 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 ldquoequipmentrdquo gets its useTerry 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 next

The ldquosuperstock breakoutrdquo 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 Finallywhen a stock is able to break through this long-term resistance levela 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 ie a paradigm shift is taking place

When Salick Health Care finally broke out above its long-termresistance area near $17 to $171frasl4 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 A takeover 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

210 PART THREE Takeover Clues

Chap 15 7901 900 AM Page 210

TEAMFLY

Team-Flyreg

Sellers 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 industryand the general stock market environment just like every other stock

But the emerging takeover wave in the specialty health care stockschanged the paradigm for Salick That takeover wave transformedSalick from an obscure cancer treatmentkidney 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 wasWhat would Salick Health Care be worth as a business to a potentialbuyer And based on this new paradigm Salickrsquos supplydemandequation shifted

That breakout above the $17 to $171frasl4 resistance area was a clearsignal that Salick was being perceived in a different light by WallStreet

Here is another example of how a superstock chart breakoutmdashand nothing but a superstock breakoutmdashled me to the takeover bidfor Rohr Inc

In June 1995 an emerging takeover trend was taking place inthe defenseaerospace industry Scanning through the charts in theMansfield Chart Service which are arranged by industry groupsindicated 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 15ndash2 and 15ndash3) 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 ldquodogrdquo 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

CHAPTER FIFTEEN Using Charts 211

Chap 15 7901 900 AM Page 211

Rohr was added to my recommended list Much like an elec-trocardiogram can tell an experienced physician what is going oninside a patientrsquos 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 stock

Just a few weeks after the initial recommendation an outsidebeneficial ownermdashan investor named Paul Newton of NorthCarolinamdashhad accumulated a 52 percent stake in Rohr

Within a year of the original recommendation based on its super-stock breakout pattern Rohr had soared from $13 to $233frasl4 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 ldquoclearingthe decksrdquo so to speak for future positive earnings reports If you are

212 PART THREE Takeover Clues

F i g u r e 15ndash2

Rohr Inc (RHR) 1991ndash1993

Source Courtesy of Mansfield Chart Service Jersey City NJ

Chap 15 7901 900 AM Page 212

running 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 you

As Fayrsquos Genovese Drug Stores and others demonstrated thestock market usually takes news of an unexpected restructuringcharge at a sparsely followed company as a negativemdashbut the mar-ketrsquos initial reaction is often completely mistaken

Rohr 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 Sign

As a rule of thumb When corporate officers and directors pur-chase shares in their own company on the open market immediately

CHAPTER FIFTEEN Using Charts 213

F i g u r e 15ndash3

Rohr Inc (RHR) 1993ndash1995

Source Courtesy of Mansfield Chart Service Jersey City NJ

Chap 15 7901 900 AM Page 213

following 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 considerablybetter

In 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 ldquoroad maprdquo remained intact

Rohr shares eventually fell as low as $14 following the restruc-turing write-offs and the quarterly loss Just several months laterthough Rohr roared back to $21 following a better-than-expectedearnings reportmdashwhich is precisely what you would have expectedin light of the insider buying following the previous earnings reportThat insider buying provided a road map to Rohrrsquos valuemdashin 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 situation

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

214 PART THREE Takeover Clues

Chap 15 7901 900 AM Page 214

C H A P T E R S I X T E E N

The 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 ldquoDomino Effectrdquo 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 fallingdominoes

The 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 theindustry

The 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 action

CASE STUDY VIVRA AND REN-CORP USA

Another 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 16ndash1) Here is that superstock breakout pattern again a well-

215

Chap 16 7901 918 AM Page 215

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

defined multiyear resistance level with a recent series of rising bot-toms indicating that buying pressure is coming in at progressivelyhigher levels In Vivrarsquos case the key price level was around $24ndash$26As a kidney dialysis company Vivra fell into the general category of spe-cialty health caremdashan area where takeover activity was very lively

Vivra was added to my list of recommended stocks at $24Fourteen 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 Caremdashwhich also operatedsome kidney dialysis facilities you will recallmdashhad 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

216 PART THREE Takeover Clues

F i g u r e 16ndash1

Vivra (V) 1992ndash1994

Source Courtesy of Mansfield Chart Service Jersey City NJ

Chap 16 7901 918 AM Page 216

Ren-Corp had a ldquobaby superstockrdquo breakout pattern The majorbreakout took place when the stock moved above $141frasl2 Had I focusedearlier on the kidney dialysis industry in particular I might havecaught Ren-Corp sooner But I was a bit late Still Ren-Corprsquos chartdid show a long-term breakout crossing $141frasl2 and another potentialshort-term breakout crossing $163frasl8

But Ren-Corp had something else going for it an outside bene-ficial owner

By this time yoursquore 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 candidateFifty-four percent of Ren-Corp it turned out was owned by GambroAB of Sweden

By 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 ldquodueto underexposure in the financial community but if Vivra con-tinues to be one of the best-performing stocks on the NYSE theyrsquollget around to Ren-Corp eventuallyrdquo

This is another example of a phenomenon discussed earlierThe 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 Pavlovrsquos 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 way

In 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 Pavlovrsquos 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 time

These days if you think of Pavlovrsquos dogs on Valium it will giveyou an idea of how Wall Street reacts to the same stimuli Itrsquos almost

CHAPTER SIXTEEN The Domino Effect 217

Chap 16 7901 918 AM Page 217

as 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 discovered

And what did Ren-Corp USA do next It dropped from $16 to$12 thatrsquos 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 USA was owned by a Swedish health care com-panymdashdespite all of this Ren-Corp dropped 25 percent almostimmediately after we recommended it

We continued to recommend Ren-Corp because the ldquoroad maprdquowas intact Not only was it intactmdashit 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 industry

Aleveraged 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 Itrsquos not just the deals that get done itrsquos also the proposals or trial bal-loons that do not get done that can lead you to future superstocks (Rememberthe frantic takeover wave in the drugstore industry was foreshadowedby the Rite AidndashRevco 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 circumstancesldquoPavlovrsquos dogsrdquo 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 Pavlovrsquos 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 brownies

In addition to the rumors swirling around Vivra Dow JonesService had reported on June 14 that National Medical in a defensive

218 PART THREE Takeover Clues

Chap 16 7901 918 AM Page 218

move would seek to buy Ren-Corp USA In response Gambro ABthe Swedish company that owned 54 percent of Ren-Corp issued adenial that it was seeking to sell its stake in Ren-Corp

Obviously takeover clouds were rolling in on the dialysisindustry

Meanwhile Pavlovrsquos dogs had apparently passed outThe July 3 1995 issue of BusinessWeek ran a story by Amy

Dunkin entitled ldquoPlugging Into Merger Mania Without Burning YourFingersrdquo In that story I recommended Ren-Corp USA as a takeovercandidate

On Friday July 14 1995 just 2 weeks later Ren-Corp USAsoared from $41frasl8 to $197frasl8 or 26 percent in 1 day following a takeoverbid frommdashwhat a surprisemdashGambro AB of Sweden

Ren-Corp a formerly sleepy and virtually unfollowed dialysiscompany had soared from $12 to nearly $20 in a period of 6 weeksmdashin other words it had turned into a superstock

To 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 owner

And that is how charts can help lead you to exciting new super-stock ideas

CASE STUDY RENAL TREATMENT CENTERS

What do you do when you suspect that you are about to witness theldquoDomino Effectrdquo 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 ldquosuperstock breakoutrdquo patterns Renal Treatment Centers wasanother company I had never heard of but by now Im sure all youneed to do is glance at the chart (Figure 16ndash2) to understand why Irecommended this stock

There it was A well-defined long-term resistance area near $25to $26 in a little followed company in a rapidly consolidating indus-try A series of rising bottoms indicating rising demand

CHAPTER SIXTEEN The Domino Effect 219

Chap 16 7901 918 AM Page 219

In July 1995 we recommended Renal Treatment Centers at $23 The chart in Figure 16ndash2 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 thatRenal Treatment Centers had recently dropped back from $261frasl4 toaround $23mdashan amazing thing when you think about it in light ofthe fact that Ren-Corp USA had just received a takeover bid and thatRenal Treatment Centers and Ren-Corp were nearly identical in sizein terms of revenues Itrsquos surprising that this short-term chart ofRenal Treatment Centers looked as uninspiring as it did Again inthe old days when Wall Streetrsquos ldquoconnecting mechanismrdquo 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 donrsquotmdashbut it can also give you time to accumulate more stockand at lower prices before the payoff arrives

220 PART THREE Takeover Clues

F i g u r e 16ndash2

Renal Treatment Centers (RXTC) 1993ndash1995

Source Courtesy of Mansfield Chart Service Jersey City NJ

Chap 16 7901 918 AM Page 220

TEAMFLY

Team-Flyreg

Even 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 patternmdashyou can see the advantage that a longer-term per-spective can give you

In 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 $16

In November 1997 Renal Treatment Centers which had split 2-for-1 since our recommendation received a $4155 per share takeoverbid Take a look at the chart of Renal Treatment Centers in Figure16ndash3 and you will see that the original superstock breakout patternin mid-1995 that prompted the initial recommendation at a split-adjusted $111frasl2 looks like just a distant memory on this long-term

CHAPTER SIXTEEN The Domino Effect 221

F i g u r e 16ndash3

Renal Treatment Centers (RXTC) 1995ndash1997

Source Courtesy of Mansfield Chart Service Jersey City NJ

Chap 16 7901 918 AM Page 221

chart Again the importance of having just the right perspective can-not be overestimated

We recommended three kidney dialysis companies between1994 and 1997 all of which were taken over and all of which gener-ated huge profits for my subscribers

How did it happenIt happened by recognizing a potential superstock breakout

pattern 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 ldquoDomino Effectrdquo in this industry I wenton the lookout for other potential candidates with superstock break-out patterns (Renal Treatment Centers) andor outside beneficialowners (Ren-Corp USA)

In other words it happened by using several of the toolsdescribed in this bookmdashin particular with a chart pattern that direct-ed my attention to this industry in the first place

222 PART THREE Takeover Clues

Chap 16 7901 918 AM Page 222

C H A P T E R S E V E N T E E N

Merger Mania Take theMoney and Run

My son my son if you knew with what little wisdom the world is ruled

Oxenstierna

What causes the ldquoDomino Effectrdquo 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 greed

When 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 occurmdashsometimesit only takes onemdashother 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 competitiveand 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 fearful

223

Chap 17 7901 902 AM Page 223

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

that once they do figure out the rationale there may not be any attrac-tive acquisition candidates left to be purchased at a reasonable price

And then they become fearful that if they do not play ldquofollowthe leaderrdquo by acting now and buying somebody they will be left outof the parade when the reasoning becomes apparent to everyoneor theyrsquoll be forced to pay too much even if they do identify atakeover candidate And sometimes it is simply the fear of beingacquired itself that leads a company to take over another company asan act of self-defense the reasoning being that if you make yourselfbigger yoursquore less likely to become a target and more likely to beone of the survivors once the consolidation trend runs its course

I 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 yoursquore 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 company

Well sometimes that is exactly how these decisions come aboutAnd sometimes notBack 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 list

The CEO told me that ldquowe 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 rdquo Hisvoice trailed off and then he added ldquoThat was off the record by theway Donrsquot quote me on that okayrdquo

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 wersquore not at all sure why wersquore doing this and whetherthese details make any business sense But what the hell

224 PART THREE Takeover Clues

Chap 17 7901 902 AM Page 224

In 1993 Merck amp 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 Basicallythey 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 didnrsquotwant to bother with it Merckrsquos bright idea was to buy one of thesePBMs and to use it to direct business toward Merck products

Nobody knew at the time whether this would turn out to be afantastic idea or an absurd ideamdashbut after Merck made its moveother 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 $23 bil-lion ldquoOver the past yearrdquo SmithKline declared in announcing thetakeover ldquowe have conducted an exhaustive analysis and con-cluded that the unique alliance announced today positions us to winrdquo

Less than 5 years later SmithKline would unload its $23 billionldquounique alliancerdquo for $700 million But of course nobody knew thisat the time

Meanwhile Eli Lilly amp 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 Lillyrsquos chief financial officersaid at the timerdquoWe looked at Merckrsquos move and said lsquoWhat thehell is a pharmacy benefits managerrsquordquo

In other words it was not as though Eli Lillyrsquos 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 Merckrsquos entry into that business

The truth was that Lilly was not even thinking along those linesand the PBM business was not even on the Lilly radar screen

But that did not stop Eli Lilly from paying $4 billion or 130times earnings for PCS Health Systems on July 11 1994

Hot on the heels of Merck and SmithKline Eli Lilly amp 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

CHAPTER SEVENTEEN Merger Mania Take the Money and Run 225

Chap 17 7901 902 AM Page 225

ldquoWe believerdquo said Lilly ldquoitrsquos the jewel of those that are outthere and we believe we acquired that jewel at a very attractivepricerdquo

Barely 4 years later Lilly wound up selling its $4 billion ldquojewelrdquoto Rite Aid for $15 billion

ldquoOur experiencerdquo said Lilly as it exited the PBM business ldquohasbeen that certain businesses can benefit from new ownership arrange-mentsrdquo

In November 1999 Rite Aid announced that it would attemptto sell PCS Health Systems for a price in the neighborhood of $13 bil-lion which was $200 million less than it paid for the company a yearearlier

There were no takersOn February 25 2000 a Rite Aid spokesperson told TheStreet

com that the company had ldquomultiple biddersrdquo for PCS HealthSystems ldquoWe need to sell it because we need to pay debtrdquo said thespokesperson Rite Aid you will recall had gone on an acquisitionspree during the drugstore takeover mania The companyrsquos overlyambitious expansion strategy combined with accounting irregulari-ties had pummeled its stock which had plunged from a high of $511frasl8in January 1999 to as low as $41frasl2 a decline of 91 percentmdashone of theall-time great examples of a respected predictable company in a sta-ble industry self-destructing by turning into a serial acquirer

Also on February 25 2000 The Wall Street Journal reported thatrival drugstore company CVS was interested in buying PCS HealthSystems from Rite Aid for between $800 million and $1 billionmdashaprice that would have been 33 to 46 percent less than Rite Aid hadpaid a year earlier

CVS denied that it was interested in buying PCS HealthFinally on April 11 2000 Rite Aid announced that it was unable

to sell PCS Health Systems at a reasonable price ldquoWhile we will con-tinue to explore opportunities to sell PCS at some pointrdquo said RiteAidrsquos new CEO Bob Miller he conceded that the price Rite Aid couldget for PCS at the current time was ldquovery depressedrdquo

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 JPMorgan agreed to convert $200 million of debt into Rite Aid commonstock valued at $550 per share

226 PART THREE Takeover Clues

Chap 17 7901 902 AM Page 226

PCS Health Systems would be part of the collateral to secure thisnew debt restructuring said Rite Aid

The saga of PCS Health Systems by this point was beginning toresemble a Wall Street version of ldquoOld Maidrdquomdashonly this time Rite Aidwas finding no takers And it was all touched off by Merckrsquos decisionback in 1993 to diversify into the pharmacy benefits business whichled Merckrsquos 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 price

These stories will help you understand one of the major reasonswhy the ldquoDomino Effectrdquo 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 dandy

Other times however the mad rush to imitate and consolidateis based on less perceptive reasoningmdashsuch as the fear that one ofyour competitors has figured out something you havenrsquot eventhought of yet which means you had better do the same thing fastand you can figure it all out later

So that is how ldquofearrdquo can touch off the ldquoDomino EffectrdquoThen there is the ldquogreedrdquo factorIt will probably not surprise you to learn that corporate CEOs

can 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 business

In September 1989 Sony the Japanese electronics and enter-tainment giant purchased Columbia Pictures for $34 billion plus$16 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 businessSony in fact had paid $27 a share for Columbiamdash36 times the value

CHAPTER SEVENTEEN Merger Mania Take the Money and Run 227

Chap 17 7901 902 AM Page 227

of Columbiarsquos stock after the shares were spun off from their formerowner Coca-Cola company just 2 years before

When the deal was announced most observers believed theprice to be preposterous Vanity Fair magazine called the acquisitionldquoa comic epicrdquo Forbes magazine called it an example of ldquounprece-dented naiveteacuterdquo

A source on Columbiarsquos side of the negotiations told authorsNancy Griffin and Kim Masters who chronicled Sonyrsquos Hollywoodmisadventure in Hit amp Run that the price Sony paid for Columbialdquohad no relationship to the worth of the entityrdquo

But that was only the beginning Sony also paid $200 million forGuber-Peters Entertainment a production company that had lost$192 million on revenues of $237 million in its most recent fiscalyear because it wanted the expertise and management services ofits owners producers Peter Guber and Jon Peters

Under their guidance SonyColumbia proceeded to embarkon a spending and production spree that culminated in a November1994 write-off of $32 billionmdasha gargantuan loss even by the stan-dards of Hollywood which knows a thing or two about losing themoney of outsiders

For years afterward Hollywood insiders Wall Street analystsand others who witnessed Sonyrsquos 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 Nathanwho was granted access and cooperation by Sony in the writing ofhis book Sonyrsquos CEO Norio Ohgamdashwho had been the leading pro-ponent of the Columbia takeovermdashtold a meeting of Sony execu-tives in August 1989 that he had a change of heart Sonyrsquos founderand chairman the revered Akio Morita responded that he too washaving second thoughts about the wisdom of buying Columbia

According to the minutes of that board meeting the decisionwas made to withdraw the takeover bid The minutes read ldquoPerChairman Columbia acquisition abandonedrdquo

But later that evening the Sony executives changed their deci-sion and agreed to go ahead with the takeover of Columbia

228 PART THREE Takeover Clues

Chap 17 7901 902 AM Page 228

WhyWhile Sony executives were having a dinner break some of the

board members overheard Sonyrsquos chairman Morita say softly ldquoItrsquosreally too bad Irsquove always dreamed of owning a Hollywood studiordquo

When the board meeting resumed Sonyrsquos CEOmdashapparently indeference to the emotional desire of his beloved and respected chair-man who had already concurred with the cancellation of the dealmdashtold theexecutives that he had reconsidered the situation during dinner andnow believed that Sony should buy Columbia Pictures after allmdashassuming of course the Sony chairman Morita concurred with hischange of heart Which of course he did

And that is how Sony blundered into the Godzilla of all write-offs

Size power industry leadership statusmdasheven childhooddreamsmdashthese are all potential driving forces for corporate takeoversprobably more so than many corporate executives would care toadmit

In September 1995 the New York Daily News ran 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 businessesldquoFrom a businessmanrsquos point of viewrdquo Dornemann told Der SpiegelldquoI can only say the Americans are crazy to pay such pricesrdquo

In the interview Dornemann said that prices being paid forUS media properties were in the immortal words of Crazy Eddieinsane 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

ldquoThe big media companies are in a kind of race to see who willhave the biggest operationrdquo he said ldquoand the prices are simplyhyped up This sort of thing will never pay off I predict that manyof these mergers will not last

ldquoThe desire for size and power can be a dangerous secondarymotiverdquo for many mergers Dornemann went on to say He said thatWall Street investment bankers had learned to use the egos of CEOs

CHAPTER SEVENTEEN Merger Mania Take the Money and Run 229

Chap 17 7901 902 AM Page 229

to their advantage prodding them to do deals by playing on a CEOrsquosdesire to be the biggest or to simply keep up with a rival ldquoDo not befooledrdquo he said ldquoWall Street has big interest in having big deals likethis The investment bankers earn good money on such takeoversand for that reason they make sure that the necessary euphoria existsrdquoThat last comment can be taken as as implication that Wall Streetrsquoseuphoric reaction to certain megamergers even so-called mergersof equals where no premiums are involved can be more contrivedthan real and that it only serves to encourage the next round ofmegamergers

Dornemann also scoffed at the idea that ldquosynergyrdquo (see Chapter14) can justify sky-high buyout pricesmdashie that producers of pro-gramming must absolutely own a network or other distribution out-lets and that cross-promotion among various media propertieswould enhance the value of the entire enterprise ldquoHistory hasshownrdquo he told Der Spiegel ldquothat a lot can be justified on the basisof synergy with very little ultimately achievedrdquo

Which brings us to the investment bankersOf all of the forces that can touch off a Domino Effectndashtype

takeover wave in any given industry the Wall Street investmentbanking communityrsquos 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 in

Some 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 which

But 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 shares

Over the years a curious ldquospinrdquo on the takeover scene has devel-oped among mainstream Wall Street analysts and institutional money

230 PART THREE Takeover Clues

Chap 17 7901 902 AM Page 230

TEAMFLY

Team-Flyreg

managers They claim investors are better off owning shares in theacquiring companies rather than the target companies

I have always suspected that much of Wall Streetrsquos 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 in

In 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 ldquoEven more alarmingrdquo saidKPMG ldquoover half actually destroyed valuerdquo

The shareholders KPMG was talking about of course were theshareholders of the acquiring companymdashthe ldquogobblerrdquo that was sup-posedly going to manage the assets of the target company betterachieving 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 operationswith 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 ldquosynergyrdquo as in twoplus two equals five

What KPMG demonstrated however was that much of the bal-lyhoo surrounding many of these deals was just a lot of hot airmdashnot 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 ldquosynergyrdquo hook line andsinker (On the other hand when you consider that many of todayrsquosmoney 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 companyrsquos stock

CHAPTER SEVENTEEN Merger Mania Take the Money and Run 231

Chap 17 7901 902 AM Page 231

The 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 bids

Some examples of ldquosynergisticrdquo losers

bull Quaker Oats was a loser when it bought Snapple for $17billion in November 1994 and so were its shareholdersQuaker Oats unloaded Snapple for $300 million 21frasl2 yearslater The big winners were the Snapple shareholders whotook the money from Quaker Oats and moved on

bull Novell shareholders were losers following that companyrsquospurchase of WordPerfect for $14 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

bull Albertsons stockholders saw the value of their stock plungewhen it proved far more difficult than expected to integrateitself with American Stores

Whatrsquos 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 ldquosynergiesrdquo and the ldquoeconomies of scalerdquoand all of the future growth prospects to the Wall Street analysts andinstitutions who invest on this basismdashthey may turn out to be rightor wrong but most of the time that will not be the reason you boughtthe target company in the first place and you should not stick aroundto find out

Read 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

232 PART THREE Takeover Clues

Chap 17 7901 902 AM Page 232

release announcing a takeover bid and why you are usually betteroff taking the profit from the takeover and walking away

CASE STUDY JCPENNEY AND RITE AID

JCPenney 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 Fayrsquos 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 operationsRemember when drugstore consolidation was sweeping Wall Streetit seemed to make all the sense in the world to everyone involvedand there was little reason to doubt that the strategy of combiningsmaller chains would reap major benefits

The ldquogururdquo 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 takeoversIndeed 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

ldquoDrugstore consolidation is going to continuerdquo Grass told TheWall Street Journal on September 12 1996 ldquobecause the economiesare overwhelming The smaller chains canrsquot survive as independentcompanies The independent operators are doomedrdquo

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 ldquoSay a brand new medicinecomes out that is just far superior to anything that is on the marketrdquohe said ldquoWe could be able to look at our customer base and see who

CHAPTER SEVENTEEN Merger Mania Take the Money and Run 233

Chap 17 7901 902 AM Page 233

might be better served by this new medication We would informthose people lsquoHey therersquos a new change on the horizon Ask yourphysician about itrsquordquo Larger customer bases would provide the drug-store consolidators more information on medical histories and there-fore create new and innovative marketing possibilities ldquoIf one storeserves a large number of diabeticsrdquo The Journal said in 1996 ldquothechain can establish special services at the locationrdquo In January 1997The Journal ran another story on the logic behind drugstore consoli-dation explaining that ldquomergers 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 efficiencyrdquo

A warning signalmdashand a prescient one at thatmdashwas also sound-ed in The Wall Street Journalrsquos January 2 1997 story on the mergermania in the drugstore industry The mergers it was noted ldquodo notaddress a range of endemic problems for drugstores from their gen-eral laziness about marketing to their typically lackluster serviceand staffrdquo

So here was the choice faced by Fayrsquos 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 Penneyrsquos growth strategy in thedrugstore industry

There were two ways to look at it If you owned both Fayrsquos 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 aldquopure playrdquo drugstore company rather than a company weigheddown by slower-growing department stores

On the other hand if you had purchased Fayrsquos and GenoveseDrug Stores strictly because you believed they were superstocktakeover candidatesmdashand if you turned out to be correctmdashwhywould you want to exchange these stocks for shares in JCPenneyThe original premise had proven correct both companies became

234 PART THREE Takeover Clues

Chap 17 7901 902 AM Page 234

takeover 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 half

On 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 charges

By mid-April JCPenney shares were trading under $13mdashdown81 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 industryrsquos 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 Aidrsquos problems you see were not confined to PCS HealthSystems

Rite Aid discovered that cost-cutting andrdquoefficienciesrdquo some-times impacted customer servicemdashoften with disastrous resultsCustomers 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

CHAPTER SEVENTEEN Merger Mania Take the Money and Run 235

Chap 17 7901 902 AM Page 235

operating heritages and a distinctly different mix of people alongwith them

In particular Rite Aid ran into trouble with its acquisition ofThrifty-Payless a 1000-store chain it bought in 1996 for $14 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 storesrsquo merchandising offerings sharply reducingadvertising and generally trying to turn Thrifty-Payless into whatRite Aid wantedmdashwhich was Rite Aid stores

The only problem with this was that Thrifty-Payless customersshopped at Thrifty-Payless because they liked Thrifty-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 decline

As the chart in Figure 17ndash1 illustrates Rite Aid stockholdersmdashincluding those who owned the drugstore companies Rite Aidacquired and took Rite Aid shares in returnmdashsuffered 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 ldquoshould not rely on forward-looking profitability and cash flowinformationrdquo the company had just recently given to analysts at anOctober 11 1999 meeting Shortly thereafter Grass resigned and sodid Rite Aidrsquos accountants

At year-end 1999 the Motley Fool summed up the sorry sagaof Rite Aid this way ldquoThe root of the companyrsquos problems stemsfrom an aggressive acquisition play that has failed miserably leav-ing Rite Aid mired in debtrdquo

Meanwhile JCPenneyrsquos stock price continued to feel the falloutof the Rite Aid debacle Penney after all had been one of the biggestdrugstore ldquogobblersrdquomdashand Wall Street which had cheered on thedrugstore merger wave while it was happening now began to recoilfrom the entire premise

236 PART THREE Takeover Clues

Chap 17 7901 902 AM Page 236

As a result a Fayrsquos 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 Fayrsquos 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 time

Meanwhile those who simply sold their Fayrsquos 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

CHAPTER SEVENTEEN Merger Mania Take the Money and Run 237

F i g u r e 17ndash1

Rite Aid (RAD) 1998ndash2000

Source Courtesy of Mansfield Chart Service Jersey City NJ

Chap 17 7901 902 AM Page 237

CASE STUDY THE ALARMING STORY OFPROTECTION ONE

Herersquos another horror story that illustrates a grand acquisitiondiver-sification strategy gone awry

Between 1996 and 1998 the security alarm business experi-enced the Domino Effect as a series of companiesmdashincluding ADTHolmes Protection Alarmguard and othersmdashwere acquired in rapid-fire order All of these were on my takeover list (see Introduction)and all were taken over one after another

Among 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 ata price of $91frasl2 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 Resourcesrsquo own home security opera-tions with those of Protection One creating a much larger companythat could benefit frommdashyou guessed itmdasheconomies of scale

At 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 Wittigwho 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 ofWittigrsquos first moves was an audacious 1996 hostile takeover bid forKansas City Power amp Light What made this bid audacious otherthan the fact that hostile takeovers in the genteel utility industrywere rare was that Kansas City Power amp Light had already agreedto be acquired by a neighboring utility Utilicorp United A nastyfight ensued with charges and countercharges flying all over theplace among the three combatants But in 1997 Western Resourcesand Kansas City Power amp 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 $40s

As a result of Westernrsquos rising stock price Westernrsquos invest-ment bankers decided that Kansas City Power amp Light stockholderswere getting too good a dealmdashso the terms were revised

238 PART THREE Takeover Clues

Chap 17 7901 902 AM Page 238

In light of what was about to happen this proved to be the ulti-mate irony

Western 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 leanmean acquisition machine

After 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 Resourcesrsquo major push into the home security industrywould be accomplished through the acquisition of Protection OneWestern 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 ldquomonthly recurring rev-enuesrdquo 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 interviewsWittig was talking about further diversifying Western Resources alongthe same lines into areas such as telecommunications or cable TV

And so when Protection One soared from the original recom-mended price of $91frasl2 in 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 POIrsquos 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

CHAPTER SEVENTEEN Merger Mania Take the Money and Run 239

Chap 17 7901 902 AM Page 239

I told my subscribers ldquoSince I am focusing mainly on takeovercandidates I am going to bid farewell to Protection One If you wereprescient enough to own Protection One I would suggest a switchto either Holmes Protection or Alarmguardrdquo two other securityalarm takeover candidates

This turned out to be the correct move Both Holmes Protectionand Alarmguard ultimately received takeover bids and the DominoEffect continued to sweep through the security alarm business

Western Resources pleased with the reception that its growthstrategy had received on Wall Street promoted David Wittig to chair-man and CEO in May 1998 Westernrsquos stock price had jumped from$30 when Wittig arrived in 1995 to a high of $487frasl8 in March 1998mdashnot bad for a conservative utility company in the midst of meta-morphosis

In October 1998 Western Resources kept the dominoes falling inthe alarm industry when its now 85 percent-owned Protection Oneunit agreed to acquire Lifeline Systems a company that provided alarm-paging services to elderly people through a nationwide network ofhospitals Lifeline customers wore paging pendants around their neckswhich could be activated if they needed medical assistance A signalwould then be sent to a Lifeline Systems control center which wouldthen alert the nearest hospital to the emergency situation

To 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 Wall Street Journal that 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 company

The Wall Street Journal noted that utility companies had tried oncebefore to diversify and ldquohad failed at it in the 1980s when they boughtcompanies such as savings amp loans a drugstore chain and even aninsurance companyrdquo But The Journal reported that unlike the pastMr Wittig said that ldquoWestern is investing in businesses that are sim-ilar in terms of the relationships wersquore having with the customersrdquo

The Journal also 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 US and also overseas in the year since it was bought by Western

240 PART THREE Takeover Clues

Chap 17 7901 902 AM Page 240

TEAMFLY

Team-Flyreg

Meanwhile Protection One stockholders were beginning tohear alarm bells of their own Following the $7 per share cash pay-ment the stock fell from its ldquoex-dividendrdquo 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 spring

Obviously Wall Street sensed a problemBy 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 attritionthat its accounting practices had come under the scrutiny of theSecurities amp Exchange Commission that the company would lose$169 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 ldquoWestern Resources has expe-rienced some short-term financial challenges with regard to itsProtection One investmentrdquo the company said in a press release whichhad to be in the running for ldquoUnderstatement of the Yearrdquo Westernadded that ldquowhile the security alarm business generates strong cashflow it has not generated net incomerdquo Therefore said Western it wasnow ldquoconsidering alternativesrdquo for its 85 percent-owned security alarmbusiness which had by this time declined to under $2 a sharemdasha 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 time

While Western Resources was ldquoconsidering alternativesrdquo 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 were no 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

CHAPTER SEVENTEEN Merger Mania Take the Money and Run 241

Chap 17 7901 902 AM Page 241

Meanwhile 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 Westernrsquos merger withKansas City Power amp Lightmdashwhich had been held in regulatory pur-gatory for nearly 3 yearsmdashwas now in jeopardy

Just 2 years earlier the deal had almost fallen apart becauseWesternrsquos stock price had risen too quickly based on Wall Streetrsquosperception of David Wittig as an astute deal maker The terms hadbeen negotiated downward in deference to Western shareholderswho owned an increasingly popular stock and did not want to givetoo much of it away to Kansas City Power amp Light stockholdersNow the opposite was taking place Because of the Protection Onedisaster Westernrsquos stock price had slumped so far that the deal wasin danger of coming apart once again

On January 3 2000 Kansas City Power amp 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 ResourcesndashKCPampL merger was undone inlarge part by the Protection One fiascomdasha takeover that turned outvery badly for the acquiring company and its shareholders

Indeed 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 ldquogobblerrdquo

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 asmdashdrum rollpleasemdasha 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 ldquoconglom-eraterdquo had been a failure

242 PART THREE Takeover Clues

Chap 17 7901 902 AM Page 242

In 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

ldquoWe believerdquo said Mr Wittig ldquothat a pure play electric utilitycompany will unlock the value associated with our electric assets byproviding shareholders an investment opportunity exclusively inour electric utility operationsrdquo

The press release stated that Westar Energy the new ldquopure playrdquoutility company would consist of two electric utilities Kansas Poweramp Light and Kansas Gas amp Electric which provide electric service to628000 customers in Kansas The nonelectric utility company whichwas yet to be named would consist of Westernrsquos 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 LLC

By the time Western Resources decided to change paradigms bygoing back to the strategy of being a ldquopure playrdquo (which is what thecompany was in the first place) rather than a collection of unrelatedbusinesses Westernrsquos 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 Westernrsquos stock price to unravel

This 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 consolidation

In 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

CHAPTER SEVENTEEN Merger Mania Take the Money and Run 243

Chap 17 7901 902 AM Page 243

more efficient and profitable there is a very good possibility that thetakeover wave which struck the utility industry during the late 1990swould have engulfed Western Resources much to the delight of itsshareholders

But Western did not want to become a ldquogobbleerdquo in fact thecompany aspired to be a ldquogobblerrdquo 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 businessmdashsecurity alarmsmdashthat turned out to bea disaster for everyone except the shareholders of Protection Onewho decided to take the money and run

Now 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 utilitiesmdashabout 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 Westernrsquos 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 ofWesternrsquos 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 parts

So the logical assumption would be this Itrsquos very possible thatseparating the electric utility assets was the first step in having theseassets acquired and even if that were not the primary purpose of cre-ating the utility pure play Westernrsquos 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 emerge

In other words Westar Energy once it began trading separatelywould have to be viewed as a potential superstock takeover candidatemdashand

244 PART THREE Takeover Clues

Chap 17 7901 902 AM Page 244

this stock should have been added to your universe of potential superstocksto keep a close eye on

On the other side of the equation was the company that wouldown Westernrsquos nonelectric utility assetsmdashtemporarily 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 company

A well-trained superstock sleuthmdashwhich would be you by thistimemdashwould 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 amp ExchangeCommission) of the company whose stock is owned by the outsidebeneficial owner The 10-K Report is available by going to the Website wwwfreeedgarcom 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 companyrsquos most recent10-K you would have learned that this company provided naturalgas transmission and distribution services to 14 million customersin Kansas and Oklahomamdashright in Western Resourcesrsquo neck of the woodsAnd you would also have learned that in 1998 Oneok acquired thenatural gas distribution assets of Western Resources in exchange forOneok stockmdashand that is how Western Resources wound up with its45 percent stake in Oneok In other words when Westernrsquos 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 Oneok

In reading the history of this transaction in the Oneok 10-Kyou would also have learned that there was a ldquostandstill agreementrdquobetween Oneok and Western Resources that prevented Western fromincreasing its ownership above 45 percent And you would also havelearned that Oneokrsquos stated corporate strategy was to ldquoacquire

CHAPTER SEVENTEEN Merger Mania Take the Money and Run 245

Chap 17 7901 902 AM Page 245

additional distribution and transmission facilities and other assetsrdquoand in fact Oneok had recently announced the $3077 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 agreement

By 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 1999

A superstock 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 letrsquos put it to you this way This situationwould appear to be pregnant with possibilitiesmdashand both the WesternResources companies and Oneok should have been immediately placed onthe superstock sleuthrsquos list of stocks to monitor just in case future TelltaleSigns were to emerge

The fact that Western Resources had been selling off someOneok stock combined with the fact that Oneok appeared to be acompany determined to acquire other companiesmdasha ldquogobblerrdquo inother wordsmdashwould 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 ldquostandstill agreementrdquo

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 bid

Who knowsThe point is this There were possibilities here a situation to be

monitored just in case one or more additional Telltale Signs were toemerge that might point you toward a clear and logical opinion asto what happened next

And 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

246 PART THREE Takeover Clues

Chap 17 7901 902 AM Page 246

On 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 growthdiversification strategy wouldhave been reduced to wishing and hoping while watching theirinvestments shrink dramatically in value

The 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 interestingmdashand hopefullyprofitablemdashsituations

CASE STUDY HOW MATTEL GOT PLAYED BY THELEARNING COMPANY

In December 1998 Mattel announced that it would acquire TheLearning Company for $36 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 ldquoa global childrenrsquos productscompanyrdquo In announcing the acquisition Mattel called The LearningCompany ldquoan excellent strategic fitrdquo and said it would immediate-ly add to Mattelrsquos earnings

Some observers were not so sure Among them was HerbGreenberg columnist for TheStreetcom 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 Companyrsquos ldquoaggressiveaccountingrdquo 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 trouble

Greenberg openly questioned Mattelrsquos judgment in paying $36billion 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

CHAPTER SEVENTEEN Merger Mania Take the Money and Run 247

Chap 17 7901 902 AM Page 247

On October 4 1999mdashjust 5 months after the transaction wascompletedmdashMattel 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 hadinherited

Mattel shares which had peaked near $30 earlier in 1999plunged 5 points to $117frasl8 following the announcement wiping outover $2 billion in shareholder value in a single day

The only winners in the Mattel takeover of The LearningCompany were those Learning Company shareholders who tookthe money and ran following Mattelrsquos 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 losses

However as in the case of Western ResourcesndashProtection Onethe MattelndashLearning Company fiasco also had an ironic ending inwhich several Telltale Signs emerged

When 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 stockholdersrsquomoney 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 time

But 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 ldquogobblerrdquo over thecoals sometimes the final chapter of an acquisition that has gonebad can turn out to be the opening chapter of a superstock story

The key as usual is to watch for the Telltale SignsIn the case of Mattel soon after its stock collapsed on the news

of The Learning Companyrsquos 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

248 PART THREE Takeover Clues

Chap 17 7901 902 AM Page 248

a big ldquorestructuringrdquo charge or some sort of corporate reorganiza-tionmdashor some other piece of bad news that takes Wall Street by sur-prisemdashyou 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 view

Shortly after The Learning Company debacle a massive waveof insider buying began with several Mattel insiders buying a totalof 464000 shares between October 25 and November 24 1999 atprices between $13 and $141frasl2

Nevertheless Mattel shares continued to fall below $10 eventhough these insidersmdashwhich included Mattel director JohnVogelstein the powerful vice chairman of the investment firmWarburg-Pincusmdashhad paid much higher prices for the stock theypurchased on the open market

In an interview following The Learning Company newsVogelstein categorically rejected comparisons to Mattelrsquos troubles inthe late 1980s telling a questioner ldquoThis company is not broken Ithas a core business that is vital and well-runrdquo

ldquoCore businessrdquo By now that term should be music to your earsHere was a sophisticated well-connected Mattel insider who

certainly 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 Mattelrsquos ldquocore businessrdquo

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 usuallyldquobottom fishingrdquo turnaround investors lurking around waiting basedon the premise that they can come in take the company over andrestore it to its former luster

Also by February 15 the American Federation of State County andMunicipal Employees Pension Fund announced on Valentinersquos Day that itwanted to have a heart-to-heart talk with Mattelrsquos Board of Directors aboutseveral matters including the possibility of dismantling Mattelrsquos takeoverdefenses The pension fund owned around 37 percent of Mattelrsquos stockHere 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

CHAPTER SEVENTEEN Merger Mania Take the Money and Run 249

Chap 17 7901 902 AM Page 249

Nobody cared and Mattel stock continued to languish below $10In March 2000 John Vogelstein had purchased another 100000

Mattel shares on the open market this time at a price of $109frasl16In April 2000 two more insiders had purchased an additional

56750 shares at prices ranging from $969 to $1112 per share Alsoin April 2000 Mattel had decided to bite the bullet by selling The LearningCompany The Wall Street Journal had reported on the morning of April3 that Mattel would soon announce that The Learning Company wasfor sale and estimated that company for which Mattel had issued$35 billion worth of its own stock just a year earlier would probablyfetch between $500 million and $1 billionmdashwhich has to rank as oneof the most striking examples of how rapidly an acquisition can go badin the annals of American business

Later that day Mattel confirmed that it had retained CreditSuisse First Boston to sell The Learning Company but Mattel wentout of its way to make it clear that it did not intend to sell any of itsldquocore brandsrdquo

In other words Mattel had decided to revert to being a pure play toycompany

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 Companymdashbut 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 tar-get

On September 29 2000 Mattel announced that it would virtu-ally give away The Learning Company by ldquosellingrdquo it to a privatecompany in return for a share in any future profits In reporting thistransaction the Associated Press called Mattelrsquos acquisition of TheLearning Company ldquoone of the worst deals in recent corporate his-toryrdquo This was almost certainly truemdashunless you were a shareholderof The Learning Company who took the money and ran

The MattelndashLearning Company saga is important for three rea-sons First it illustrates why itrsquos almost always better to ldquotake themoney and runrdquo when a stock you own receives a takeover bidSecond it shows how accumulated experience with various com-panies and individuals can lead you to anticipate future develop-

250 PART THREE Takeover Clues

Chap 17 7901 902 AM Page 250

TEAMFLY

Team-Flyreg

ments which you might perceive in a different light than almosteveryone else because of your awareness of Telltale Signs And thirdit 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 longrunmdashif yoursquore willing to think ldquooutside the boxrdquo when it seems likenobody else around you can

The 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 amp Poorrsquos 500 at least seven could be traceddirectly to acquisitions that turned out badly or at the very leastdid not deliver the benefits Wall Street expected JCPenney WasteManagement Allied Waste Industries HealthSouth McKessonHBOC Rite Aid and Service Corp International

All 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 mark

As 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 madethe 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 pains

Remember 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 1999tumbling nearly 60 percent They were led on the way down by thetwo industry giants Waste Management and Allied Waste Industries

CHAPTER SEVENTEEN Merger Mania Take the Money and Run 251

Chap 17 7901 902 AM Page 251

both 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 SampP500 one year later tells you all you need to know about how thatstrategy turned out

The trend toward garbage company takeovers was initiated inJuly 1998 when USA Waste bought Waste Management in a $19 billiontakeover The new industry giant kept the Waste Management nameand then one month later announced the acquisition of anothergarbage company Eastern Environmental Services for $15 billion

Got 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 $11 billion which everybody onWall Street agreed was a sound move because of the obviousldquoeconomies of scalerdquo 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 InvestorrsquosBusiness Daily reported that ldquoanalysts continue to see the waste man-agement companies as a safe haven that can be counted on to gen-erate double-digit earnings growthrdquo

On March 8 1999 Allied Waste struck again when it agreed to buyBrowning-Ferris Industries for $73 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 since

Remember all of this frantic takeover activity was touched offby the USA WastendashWaste ManagementndashEastern 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 deals

Trouble is the premise turned out to be a bit shakyOn 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 Managementrsquos Board of Directorswho were trying to figure out why chaos had ensued at Waste

252 PART THREE Takeover Clues

Chap 17 7901 902 AM Page 252

Management almost immediately after the three companies werecombined

ldquoThe lawsuitrdquo said The Wall Street Journal ldquoarose out of asprawling effort by Waste Managementrsquos Board of Directors to deter-mine how the companyrsquos $19 billion merger with USA Waste Serviceswent wrong and how the companyrsquos management lost control ofits operations and accounting systems in the months after the July1998 mergerrdquo In a follow-up story on February 29 The Journal report-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 quarter

The first hint of troublemdashand it was quite a hintmdashcame on July6 1999 when Waste Management shares dropped from $53 to $25 ina single day following word that the companyrsquos 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 andinventorymdashalmost all a result of the chaos surrounding the compa-nyrsquos inability to integrate its acquisition

To help sort out its problems Waste Management enlisted theservices of Roderick M Hills former chairman of the Securities ampExchange Commission who wound up as chairman of the AuditCommittee ldquoThe big story hererdquo Mr Hills concluded ldquois that theymade terrible acquisitions and didnrsquot know how to run the mergedcompanyrdquo

The most telling comment of all from The Wall Street Journalwas ldquoAnd the pioneers of the practice proved not much better atfiguring out when to run for cover than the average investorrdquo 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 mergers

Shortly thereafter Allied Wastemdashthe other serial garbage acquir-ermdashannounced it would miss its earnings estimates for the fourthquarter of 1999 and also for the year 2000 due to ldquocosts associatedwith the BrowningndashFerris acquisitionrdquo

Stewart Scharf an analyst at Standard amp Poorrsquos commentedthat ldquocompanies need to ensure what they are acquiring is a good fitrdquo

CHAPTER SEVENTEEN Merger Mania Take the Money and Run 253

Chap 17 7901 902 AM Page 253

Another analyst Jaimi Goodfriend told CBS MarketwatchldquoOver 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 itrsquos sort of been more of a lsquobuynow integrate laterrsquo strategy They would buy a lot of companiesand acquire all of this new revenuemdashbut in doing that they neglect-ed the systems integrationrdquo

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 1998ndash99 turned out to be basedon a foundation that was about as solid as a landfill Which explainswhy the ldquosaferdquo waste management stocks dropped over 60 percentin 1999

Meanwhile keep in mind that any Eastern Environmental share-holder who accepted $2987 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 doing

The purpose of this chapter was to illustrate in no uncertain termsthat ldquobrilliantrdquo corporate executives often make dumb acquisitionsfor poorly thought-out reasons and that they are advised and encour-aged to do so by ldquobrilliantrdquo investment bankers who are just outthere taking their best guess like the rest of us at bestmdashand who atworst are motivated in part by the desire to generate investmentbanking fees which cannot be generated unless transactions likethese take place

Meanwhile ldquoanalystsrdquo who are compensated in large part basedon their ability to bring investment banking business to their firmsand whose bonuses depend in large part on investment banking feesearned by their firms in general disseminate voluminous researchreports that may say a ldquobuyrdquo ldquostrong buyrdquo ldquoaccumulaterdquo ldquooutper-formrdquo or ldquoneutralrdquomdashbut only say ldquosellrdquo 09 percent of the time

You 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

254 PART THREE Takeover Clues

Chap 17 7901 902 AM Page 254

combined entity based on their visions of the future and the ldquoanaly-sisrdquo of some investment banker that the deal makes all the sense inthe world and that it will turn out just peachy

The next time you are in a situation like that do what chocolatebaron Milton Hershey did Sell your ticket on Titanic to someonewho is frantically bidding for a chance to go on the Synergy Cruiseand 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 PaineWebberDonaldson Lufkin Advest Daine-Raushcer JP 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 fromldquoOld-Economyrdquo companies which could be an early warning of aneconomic downturn and possibly a bear market

None of that mattered to the ldquogobblersrdquo however Buying abrokerage was the ldquoinrdquo thing to do and independent stockbrokersstarted disappearing like puddles on a sunny afternoon

(One notable exception to the lemming syndrome was FrancersquosAXA Group a multinational insurance company that decided totake advantage of the mad rush to buy stockbrokers by selling itsstake in Donaldson Lufkin to Credit Suisse First Boston)

All of which should reinforce the following concepts1 The ldquoDomino Effectrdquo or the ldquoLemming Effectrdquo or whatever

name 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

CHAPTER SEVENTEEN Merger Mania Take the Money and Run 255

Chap 17 7901 902 AM Page 255

sober Wall Street analysts and sometimes even the wildest dreams ofthe controlling shareholders of the target companies themselves

In other words if you smell a Domino Effect in the making donrsquotbe 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 emerge

2 If you do buy a stock because you are betting on a DominoEffect takeover wave and yoursquore 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 right

Let the mutual funds and the institutional money managerswho absolutely must own the big-cap stocks take the risk that theldquogobblersrdquo will be right Because very often in fact more than youmight expect they wonrsquot

3 The same holds true for the high-publicity ldquomergers ofequalsrdquo like AOLndashTime WarnerDaimlerndashChrysler or any futurecombination of two huge companies that results in no premiumbeing paid to any shareholder of either company More often than notthese 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 ldquomerger of equalsrdquosell 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 ldquosynergiesrdquo 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 Wall Streetspin 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 future

Just 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

256 PART THREE Takeover Clues

Chap 17 7901 902 AM Page 256

By the end of 1999 the Wall Street 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 anybodybased on the premise that two plus two equals five companies thatproposed mergers of equals began to find that their stock pricesdeclined on the news

On Christmas Day 1999 the Associated Press ran a story en-titled ldquoDrug Deals Stumble as Shares Fallrdquo which discussed the factthat the MonsantondashPharmacia amp Upjohn merger of equals as wellas the Warner-LambertndashAmerican Home Products merger hadreceived a collective thumbs-down from Wall Street in the form offalling stock prices for all four companies

ldquoThe Warner-Lambert and Monsanto transaction raises funda-mental questions regarding the viability of mergers of equalsrdquo saidTom Warnock of Credit Suisse First Boston ldquoGiven the market reac-tion to both of these deals Boards of Directors will be more circum-spect before pursuing such a partnerrdquo

The Associated Press concluded that ldquoinvestors want a merg-er to offer them a premium for their shares in the target companyrdquo

No kiddingYou canrsquot have a true takeover if everybody wants to be the

gobbler and with nothing but gobblers you have no superstockTherefore any merger without a true ldquogobbleerdquo is not a takeoverthat should interest you

CHAPTER SEVENTEEN Merger Mania Take the Money and Run 257

Chap 17 7901 902 AM Page 257

This page intentionally left blank

C H A P T E R E I G H T E E N

Look for MultipleTelltale Signs

I have owned a lot of race horses in my life and Irsquove 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-1mdashnot outrageouslong shots by any means just decent horses with ability that were per-fectly capable of winning and had been overlooked by the crowd

I asked him how he managed to come up with so many winnersat such generous odds

ldquoIt took me a long time to learn thisrdquo he said ldquobut I finallylearned to trust my instincts

ldquoI see a lot of racesrdquo he said ldquoI notice things and after a whileI learned that if I see certain things a certain result usually followsBut it took me a long time to learn to trust in what I have observedbecause when I see something and then I look up and a horse is 10-to-1 I used to think lsquoWell I must be missing something otherwisethe horse would be 2-to-1 or 3-to-1rsquo 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 doesnrsquot 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 donrsquot care about the odds anymore Why should I The

259

Chap 18 7901 902 AM Page 259

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

odds only reflect what everybody else thinks and I am more inter-ested in what I think Irsquove learned to trust my own judgmentrdquo

Once you become accustomed to reading the financial news interms of the list of Telltale Signs you will begin to understand whatmy friend the horse bettor was talking about Yoursquoll begin to noticesmall items which to most readers of the financial news are insignif-icantmdashbut they will be of great significance to you You will be see-ing them in a totally different light than virtually everyone elsebecause yoursquoll be operating in a different paradigm

Eventually you will encounter situations where more than oneTelltale Sign is present These can sometimes be the most profitablesituations of all because there will be no one outstanding or terriblyunusual development that would attract the attention of the finan-cial community thereby leading them to suspect that a superstocktakeover is brewing However when taken together a combinationof several apparently unrelated developmentsmdashall of which are onthe list of Telltale Signsmdashcan clearly point you in the direction of awinning stock

The trick is When you do see these multiple Telltale Signs pop-ping up you will have to trust your instincts even though yoursquollhave virtually no support from the ldquoexpertsrdquo 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 thismdashif you can recognize the sign and have the courageto stick to your guns as long as the evidence is on your sidemdashyou canoften run rings around the Wall Street professionals

Here are several examples of how I zeroed in on takeover can-didates that were overlooked by Wall Street simply by noticing mul-tiple Telltale Signs

CASE STUDY SUGEN INC

On December 211995 Sugen Inc (SUGN) was recommended as atakeover candidate at $111frasl2 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 Britainrsquos Zeneca Ltda large pharmaceutical company had purchased 281875 Sugen shareson September 29 1995 at $12 per share Some further research

260 PART THREE Takeover Clues

Chap 18 7901 902 AM Page 260

TEAMFLY

Team-Flyreg

revealed that Zeneca had already held a stake in Sugen and thatthis new purchase had increased Zenecarsquos interest in the companyto around 20 percent

Part 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 Sign

Looking into Sugen a bit further revealed that Amgen anoth-er large biotech company also owned a 35 percent stake in SugenThis 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 Amgenrsquos stake fell below the 5 percentthreshold that makes an outside company an ldquoofficialrdquo 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 future

What finally led to my recommendation of Sugen howeverwas the news on December 6 1995 that Asta Medica a Germanpharmaceutical company had purchased 495000 Sugen shares Thispurchase was made as part of an agreement that gave Asta Medicathe right to jointly develop manufacture and market Sugenrsquos anti-cancer drugs in Europe and it gave Asta Medica a roughly 5 percentstake in Sugen

This development gave Sugen a total of three outside beneficialowners each of which was a legitimate candidate to someday takeover Sugen

And that wasnrsquot all The final Telltale Sign in a series of TelltaleSigns was the fact that Asta Medica had purchased those 495000Sugen shares at an above-market price of $2088 per sharemdashwhichwas two times the prevailing market price of Sugenrsquos stock at thetime of the purchase

Sugen shares had briefly spiked up to the $14 area from around$101frasl2 when the news broke of Asta Medicarsquos above-market purchasebut 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

CHAPTER EIGHTEEN Look for Multiple Telltale Signs 261

Chap 18 7901 902 AM Page 261

after another even in the face of a news development that makes ithighly likely that something very bullish is brewing

Nearly 1 year later Sugen had gained exactly one-eighth of apoint from the recommended price So far I did not look like a geniusBut I had enough experience with the Telltale Signs to know that theodds were on my side and I continued to recommend Sugen

In December 1996 1 year after the initial recommendationZeneca purchased another 509000 Sugen shares at $12 raising itsstake to 249 percent of the company I also noted that Allergan(AGN) another large drug company had purchased 191000 sharesof Sugen at the same above-market price of $2088 that GermanyrsquosAsta Medica had paid a year earlier

These new Telltale Signs now gave Sugen a total of four out-side ldquobeneficial ownersrdquo two of which had paid nearly twice thevalue of Sugenrsquos 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 Sugenrsquosresearch 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 target

By January 1997 another Telltale Sign appeared Sugenrsquos stockprice was starting to sketch out a potential ldquosuperstock breakoutrdquo 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 horizon

Toward the end of 1996 a Sugen director bought nearly 22000shares at $121frasl8 on the open marketmdashflashing yet another Telltale Signwhich was the strongly bullish combination of insider buying and multipleoutside beneficial owner buying Sugen was piling up Telltale Signs allover the placemdashbut the stock was still stuck in neutral

Still the signs kept coming on On November 13 1997 Zenecapurchased another 456000 Sugen shares paying $16 a share OnJanuary 16 1998 another Sugen director bought 20000 shares ofstock on the open market at $125frasl8 to $123frasl4

On May 8 1998 we reported that Sugen was in later-stage tri-als for several antiangiogenesis agents designed to kill cancer tumorsThe reason for this story was that on May 3 1998 The New York Times

262 PART THREE Takeover Clues

Chap 18 7901 902 AM Page 262

had 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 story

We had noted that Sugen was also in the forefront of antian-giogenesis research yet Wall Street had not yet focused on this facteven though Entremed stock had gone through the roof following TheNew York Times story

It wasnt really necessary though to focus on Sugenrsquos leader-ship in developing antiangiogenesis drugs because Zeneca AstaMedica Amgen and Allerganmdashthe four outside beneficial ownersmdashhad 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 ldquoben-eficial ownersrdquo when they take positions in a companymdashyou maynot know what they know but you can know what they domdashand some-times that is all you really need to know

On June 2 1998 Sugenrsquos CEO appeared for an interview onCNBC He talked about Sugenrsquos innovative anticancer therapiesadding that he expected Sugen to be profitable within 2 to 3 years

It 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 CEOrsquos answer but also from theCEOrsquos body language You can learn to ldquoreadrdquo these interviewslooking for subtle clues that might help in your search for super-stock takeover candidates

For 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 companyrsquos 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

CHAPTER EIGHTEEN Look for Multiple Telltale Signs 263

Chap 18 7901 902 AM Page 263

of Frontier Corp which led to a recommendation that Frontier wouldbecome a takeover target)

In the case of the interview with Sugenrsquos 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 ldquothe goodsrdquo 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 canarymdashand my confidence inSugen went up a notch after watching his performance on CNBC

At the time of the interview with Sugenrsquos CEO the companywas trading around $16 compared to the original recommendedprice of $111frasl2 30 months earlier This was an okay but not great per-formance up to that point But by September 1998 Sugenrsquos sharesplunged all the way from $173frasl4 to $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 it

Pretty discouraging wouldnrsquot you sayWell yes So what do you think I didI stuck my neck out even further because I had the evidence to

back 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 think

By December 1998 two Sugen directors had purchased a totalof 21000 shares on the open market a few weeks earlier at $10 to$103frasl4 Not that we needed it but Sugen had just flashed another ina seemingly endless series of Telltale Signs

In April 1999 Sugen was featured on a CBS 60 Minutes segmentwhich discussed the promising potential of the companyrsquos anticancerdrugs During a period of four trading days prior to the 60 Minutessegment Sugen shares soared from $14 to $233frasl4 Following the pro-gram the stock promptly fell back to the $15 area

As it turned out that was the final buying opportunity in Sugenfor those who had been following the avalanche of clues along the way

On June 161999 Sugen jumped 7 points in one day a gain of31 percent in a single trading session following an announcementthat Pharmacia amp Upjohn had agreed to buy Sugen at $31 per share

264 PART THREE Takeover Clues

Chap 18 7901 902 AM Page 264

That takeover price represented a 72 percent premium over Sugenrsquostrading price at the time of my final front-page recommendation justtwo weeks earlier It also represented a more than 200 percent pre-mium over Sugenrsquos trading price as recently as September 1998 just9 months earlier when Sugen had briefly dropped below the origi-nal recommended price

It came as no surprise that Sugen finally received a takeoverbid The only surprise was the identity of the buyer Pharmacia ampUpjohn had emerged out of nowhere to become the acquirer ofSugen

The 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 Signmdashand remember Sugen had sketched out aldquosuperstock breakoutrdquo pattern along the way which is usually a signof major accumulation in anticipation of some major bullish event

All 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 ldquoroad maprdquo to recommend Sugendespite the frustration of seeing all of the obvious signs and havingthe stock market completely ignore them

There were literally hundreds of biotech companies floatingaround and there still are But not many of them got acquired Sugendidmdashand the Telltale Signs were there to foreshadow the takeoverbid for those who knew what to look for

And as you can see it was a long road between the first TelltaleSign to the final takeover bid A superstock 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 falsestart after another It took about 31frasl2 years from the original recom-mendation of Sugen for that takeover bid from Pharmacia amp Upjohnto create a 169 percent profit And remember if you were extremelyconfident (and how could you not have been with all of the TelltaleSigns)mdashyou could have bought Sugen in the $10 to $11 area inSeptember 1998 and wound up with a nearly 200 percent profit in just9 months

CHAPTER EIGHTEEN Look for Multiple Telltale Signs 265

Chap 18 7901 902 AM Page 265

No index fund could have matched that returnGranted 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 pricesmdashespecially 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 opportunitymdashand be thankful that you have developed aninsight that others simply do not have

CASE STUDY FRONTIER CORP

In 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 ldquorestructuringrdquo charge

Frontier it seemed was biting the bullet in certain areas takingwrite-offs and redirecting the company toward more profitable andpromising ldquocorerdquooperations 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 targetespecially since Frontier was operating in a consolidating industry

Wall 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 1996

Frontier was the nationrsquos fifth largest long distance company Asrecently as mid-1996 the stock had been trading at $331frasl2 And yeteven 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 ldquorestructuringrdquo moves

266 PART THREE Takeover Clues

Chap 18 7901 902 AM Page 266

that Frontier had announced were one of the Telltale Signs of a com-pany preparing to sell itself Wall Street took completely the oppo-site view of Frontier and knocked the stock down to the $21 areaproviding a great entry point

And there was more to the recommendation In a mid-DecemberCNBC interview with Frontierrsquos chairman CNBC reporter DavidFaber conducted a terrific ldquonew paradigmrdquo 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 Frontierrsquos chairman replied ldquoWe are not in anyactive merger discussions at this timerdquo David Faber did not move onas most interviewers would have he sensed that the answer wascarefully phrased and he pressed Frontierrsquos chairman with a fol-low-up question Are you saying you have not been approachedabout a takeover Frontierrsquos chairman replied ldquoI am saying we arenot in active discussions at this timerdquo

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 Frontierrsquos chairman was that Frontier had been ap-proached about a takeover but that there were no talks going onright now This impression combined with Frontierrsquos restructuringmoves and the fact that Frontierrsquos industry was seeing a number oftakeovers led me to recommend Frontier as a takeover candidate

By June 1997 Frontierrsquos stock had dropped again this time tothe $16 to $18 area Earnings continued to come in at disappointinglevelsmdashbut 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 candidate

In June 1997 the takeover trend in the telecom industry was con-tinuing with a proposed merger of ATampT and SBC Communications

CHAPTER EIGHTEEN Look for Multiple Telltale Signs 267

Chap 18 7901 902 AM Page 267

They say that beauty is in the eye of the beholder On Wall Streetyou can say the same thing about ldquobadrdquonews Each time Frontierannounced another restructuring-related write-off Wall Street dumpedFrontier stockmdashyet each of these announcements was a thing of beautybecause they were Telltale Signs that this company was setting itself up tobe acquired

By 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 industry

On October 311997 another Telltale Sign emerged the ldquomulti-ple biddersrdquo signal Three bidders emerged to buy long distance tele-com company MCI Communications British Telecom WorldComand GTE The multiple bidders concept is a strong signal that thetakeover wave in that industry will continue in full force Usually theldquomultiple bidderrdquo Telltale Sign involves two companies trying to takeover a company In this case there were three multiple biddersmdasha 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 Frontierrsquos 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 ldquocould be acquiredrdquo 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 improveFrontierrsquos 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 ldquonew paradigmrdquo and ldquoold paradigmrdquo thinking Thesame piece of information can lead to diametrically opposed con-

268 PART THREE Takeover Clues

Chap 18 7901 902 AM Page 268

clusions about the future depending on what you know what youhave experienced and how the information is interpreted

Nearly a year later in October 1998 Frontier stock was tradingin the high $20s We reported in Superstock Investor

Frontierrsquos new CEO Clayton has been selling off noncore and under-performing operations which is often a telltale clue that 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 possible

In light of what was about to happen those comments were about asclose to the mark as you can get in this business

In February 1999 a spokesperson for Frontier Corp deliveredanother Telltale Sign by uttering the words ldquorestructuring optionsrdquoand ldquoincrease shareholder valuerdquo 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-tion At the time Frontier was trading at $351frasl2

The interview with Frontierrsquos CFO Rolla Huff in which MrHuff made these statements did not appear in the national mediaIn fact the interview appeared in a Rochester New York businesspublicationmdashanother 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 ldquothe com-pany is evaluating a number of options including spinoffs initialpublic offerings and mergersrdquo

In particular Huff pointed to Frontierrsquos data and Internet businesswhich was hidden beneath the companyrsquos image as a long distance tele-phone company as being worth far more than the stock market was givingFrontier credit for

In March 1999 we reported that Frontier was attempting tobreak out of a superstock breakout pattern ldquoThe 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 Butthe recent move up to $391frasl4 combined with the willingness of Frontier

CHAPTER EIGHTEEN Look for Multiple Telltale Signs 269

Chap 18 7901 902 AM Page 269

management to make the bold forecast mentioned earlier stronglyimplies that this break-in process is the real thingrdquo

It had been 27 months since the original recommendation ofFrontier Corp The original recommendation had been based on aTelltale Sign of a company in a consolidating industry announcingrestructuring moves designed to rid itself of underperforming oper-ations and make it more of a ldquopure playrdquo This was followed by anoth-er Telltale Sign multiple bidders for MCI Corp which stronglyimplied that more takeovers of long distance companies would takeplace This was followed by Frontier officials using buzzwords likeldquoincrease shareholder valuerdquo and ldquorestructuring optionsrdquo which areoften code phrases used by managements who believe their stock isbadly 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 ldquosuperstockrdquo trading range by crossing the $34 to $37 area

By March 1999 Frontier received a $62 takeover bid from GlobalCrossing Frontier was originally recommended in December 1996at $21 when it was viewed as a hopelessly troubled company witherratic 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 thingWall Street is a lot like horse racing and also a lot like life in that

experience 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 see

That is a huge advantage and by becoming a ldquonew paradigmrdquothinker you can create this advantage for yourself when it comes topicking superstock takeover candidates

270 PART THREE Takeover Clues

Chap 18 7901 902 AM Page 270

TEAMFLY

Team-Flyreg

CASE STUDY WATER UTILITIES

Once you get used to the idea of reading the financial news in termsof the Telltale Signs certain news items that donrsquot 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 itrsquosnot just one news item but an accumulation of small items or cluesthat when taken together begin to form a clear picture of what liesahead Like the straw that broke the camelrsquos back it was not the strawthat finally touched off the eventmdashrather 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 anotherand based on an accumulation of evidence yoursquoll finally decide thata certain industry or a certain stock deserves your close attention

On 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 everything in 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 newspapermdashor possibly not even reported at all

The headline on this particular story was ldquoAmerican WaterAgrees to Acquire Utility for Stockrdquo and the gist of the report wasthat American Water Works (AWK) a water utility had agreed tobuy privately held National Enterprises Inc another water utilityin a transaction valued at $4852 million

There 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 anybodyrsquos 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 heavenrsquos sakemdashandhow exciting is that

But anyone who took the time to read this story would havefound several Telltale Signs that suggested a potentially profitable

CHAPTER EIGHTEEN Look for Multiple Telltale Signs 271

Chap 18 7901 902 AM Page 271

takeover 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 companies

The 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 considered

It might have been easy to miss this story if not for an excellentreport that appeared in the Investorrsquos Business Daily ldquoCompanies inthe Newsrdquo section just a month before The IBD ldquoCompanies in theNewsrdquo section is an excellent ldquobrowsingrdquo 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 ldquoIndustry Group Focusrdquo 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 ldquoCompanies in the Newsrdquo 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 reportwould 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 utilities

The IBD story quoted Philadelphia Suburbanrsquos CEO as followsldquoSince this is such a highly fragmented industry the acquisitiongives us a head start in the consolidation phaserdquo He added that he

272 PART THREE Takeover Clues

Chap 18 7901 902 AM Page 272

expected the combined Philadelphia SuburbanndashConsumers Waterto ldquotake advantage of what we think will be great opportunities forbuying up smaller companies in the futurerdquo

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 Effect

And 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 industry

The combination of thesemdashone in IBD and the other in The WallStreet Journalmdashtwo items appearing less than a month apart is whatfinally led me to take a long hard look at the water utility industry

The list of publicly traded water utility stocks was similar to thedrugstore industry just prior to the ldquodominolikerdquo 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 companiesmdashjust as the drugstore industry had

Moreover 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 values

And 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 rates

Finally several of the water utilities on the list were alreadypartially owned by an outside ldquobeneficial ownerrdquo which was oneof the Telltale Signs to always look formdashthe fact that two of theseoutside beneficial owners were acquisition-minded European com-panies was also a major plus

CHAPTER EIGHTEEN Look for Multiple Telltale Signs 273

Chap 18 7901 902 AM Page 273

In December 1998 I presented a front-page report in SuperstockInvestor entitled ldquoWater Utility Industry Could Be on the Verge of aTakeover Waverdquo 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 giants

In December 1998 nine water utilities (and one water servicesstock) were recommended (Table 18ndash1) and we suggested a crosssection of these stocks thinking of the portfolio as a sort of ldquomutu-al fundrdquo of water utility takeover candidates We noted that two ofthe water utilities in the portfolio were already partially owned byoutside beneficial owners 291 percent of United Water Resourceswas owned by a French company Lyonnaise des Eaux and 87 per-cent of California Water was owned by SJW Corp a neighboringCalifornia water utility

The 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 ldquosuperstocksrdquo 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 that strategy 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 investmentfirms

The concept of buying these stocks as potential takeover candi-dates had 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

274 PART THREE Takeover Clues

Chap 18 7901 902 AM Page 274

with interest rates in general When interest rates fell the water util-ity stocks bounced up a bit so their dividend yields would fall

But 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 targetsthese 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 values

It 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 25 times book value to the area of 29times 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 takeovermdashan incredible riskreward situationsince we were talking about water utilities for heavenrsquos sake

How 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 stocksmdashand yet for severalmonths these stocks could have easily been purchased at or belowthe original recommended prices

CHAPTER EIGHTEEN Look for Multiple Telltale Signs 275

T a b l e 18ndash1

Water Utility Stocks as of 1298 (original recommended prices)

United Water Resources (UWR) $201frasl16

California Water (CWT) $267frasl8

Ersquotown Corp (ETW) $451frasl8

Aquarion (WTR) (adjusted for 3-for-2 split) $243frasl4

American States Water $281frasl2

SJW Corp (SJW) $60

Connecticut Water (CTWS) $271frasl2

Middlesex Water (MSEX) $241frasl2

Southwest Water (SWWC) (adjusted for two 3-for-2 splits) $65frasl8

Chap 18 7901 902 AM Page 275

In 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 ldquoright on targetrdquo 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 industry

1 As 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 companies

2 The water utility industry is particularly suited toeconomies of scale resulting from combining companieswhich include elimination of general office operationsbilling operations lab expenses and the day-to-dayexpenses of running a business such as engineering costspurchasing accounting insurance and so forth

3 The increasing costs of complying with environmentalrequirements especially in the eastern United States coulddrive smaller water companies to merge with larger com-panies

This conversation with a well-positioned water utility executiveeven 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 value

Remember 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 personrsquos 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

276 PART THREE Takeover Clues

Chap 18 7901 902 AM Page 276

The 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 becomethe less information you are likely to elicit from that companyrsquosinvestor 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 description

But you will also find that as you begin dealing with companieswhose stocks are unloved and out of favormdashas will be the case muchof the time if you put these principles and thought processes to workfor youmdashyou are very likely to elicit interesting and valuable infor-mation simply by picking up the phone and calling the company Oftenyoursquoll find that these companies have attracted so little investor inter-est that they do not even have a full-time investor relations personand you will wind up speaking to the company treasurer a vice pres-ident or some other officer who doubles as the investor contact

In 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 dying for 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 know

This may seem like an exaggeration but it is not You should tryit sometime

This 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 thatrsquos thatmdashwhat more is there to say

CHAPTER EIGHTEEN Look for Multiple Telltale Signs 277

Chap 18 7901 902 AM Page 277

Suddenly the landscape changed Several water utilities hadbeen purchased by larger companies and consolidation was in the airThe 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 estatemdashcould these parcels inject avaluable ldquowild cardrdquo into potential valuations

Suddenly the water utility business was getting very interest-ingmdashbut 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 ldquonew paradigmrdquo 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 painted

Perhaps 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 donrsquotgive up if you donrsquot get the direct answers you are hoping for Andalways greet whatever response you receive in an understandinggood-natured way If you donrsquot 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 determine

Sometimes an executive will give you a ldquoYesrdquo for an answerwhen asked if his company has received a takeover bid More oftenthe question must be couched in different terms such as ldquoIf youreceived a takeover bid would you reject it out of hand or would you

278 PART THREE Takeover Clues

Chap 18 7901 902 AM Page 278

consider what is in the best interest of shareholdersrdquo Or if a com-pany already has an outside ldquobeneficial ownerrdquo the question mightgo like this ldquoHave you ever discussed the possibility of beingacquired by XYZrdquo Or ldquoIs it possible they might want to buy therest of the shares they donrsquot ownrdquo Or ldquoWould it make any sense forthem to eventually want to buy you outrightrdquo Or ldquoAre there anyunderstandings or agreements that would prevent XYZ from acquir-ing the rest of your companyrdquo

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 carefullyyou leave the executive enough ldquowiggle roomrdquo to respond to you ina manner that you may gain the information you are looking for ina roundabout waymdashor possibly even other information that you hadnot even considered asking about

In 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 25 and 29 timesbook value if they were to be acquiredmdashwith the potential valua-tion moving up toward the upper end of that range as time went onand fewer acquisition candidates were available

This 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 ldquogaprdquo between a companyrsquos stock price and its possible buy-out valuemdashin other words the most undervalued water utilities inthe group Three water utilities appeared to be particularly under-valued Ersquotown Corp SJW Corp and American States Water SJWCorp also owned an 87 percent stake in California Water whichcould give SJW an added attraction as a takeover candidate

Within 10 months two of these three water companies hadreceived takeover bids

By 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

CHAPTER EIGHTEEN Look for Multiple Telltale Signs 279

Chap 18 7901 902 AM Page 279

The two stocks in question were both water utilities Aquarion(WTR) a Connecticut-based water company and Ersquotown (ETW) aNew Jersey water company Generally stocks within a well-definedindustry group will tend to move in the same general direction notevery day certainly but over time When you have a situation wherea certain stock in an industry is moving up consistently while itspeers are doing nothing or even declining it can often be a sign thatsomething very bullish is brewing

Both Aquarion and Ersquotown were examples of this principle AlsoAquarion had large real estate holdings which could add to itstakeover appealmdashsomething 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 where Irsquod discovered that water com-panies might be under more pressure to sell themselves due to morestringent environmental regulations and higher compliance costs

You can see that a combination of various factorsmdashlessonslearned comments heardmdashled to focusing directly on both Aquarionand Ersquotown

On June 1 1999 Aquarion announced that it had agreed to be acquiredby Yorkshire Water PLC Britainrsquos largest utility for $3705 per shareAquarion a Connecticut water company was one of the water util-ities that owned large tracts of real estate

That $3705 takeover price represented a premium of nearly 70percent above Aquarionrsquos 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 occurs

This was a boring high-yielding water utilitymdashand yet super-stock analytical techniques led directly to the takeover of Aquarion Theconcept of risk vs rewardmdashin which an investor considers not only

280 PART THREE Takeover Clues

Chap 18 7901 902 AM Page 280

TEAMFLY

Team-Flyreg

the potential profit but also the potential riskmdashwas 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 takeovercandidates

That 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 still left 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 longermdashall the better for investors Even the fact thatAquarion had been acquired at 27 times book valuemdashwhich con-firmed the takeover value range I had been usingmdashwas not enoughto bring the water utility stocks significantly closer to their takeovervalues As a result of that 27 times book value figure in June 1999the potential takeover values of the water utility stocks in the port-folio were estimated And once again Ersquotown SJW Corp andAmerican States Water were the three water utilities that seemed tobe selling at the biggest discount to their potential buyout prices

On August 24 United Water Resources announced that it hadagreed to be acquired by Suez Lyonnaise des Eaux a French com-pany for $3548 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 surprisemdashespecially since SuezLyonnaise was already an outside ldquobeneficial ownerrdquo 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 ldquome toordquo 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 ldquolem-mingrdquo effect or the Domino Effect or whatever label you might

CHAPTER EIGHTEEN Look for Multiple Telltale Signs 281

Chap 18 7901 902 AM Page 281

want 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 them

For 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 ldquobeneficial ownerrdquo 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 ldquoinefficienciesrdquo

On October 29 SJW Corp announced that it had accepted a$128 takeover bid from American Water Worksmdashthe 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 before

Less than 1 month later on November 22 1999 Ersquotown Corpannounced that it would be acquired by Britainrsquos Thames Water PLCfor $68 per share a premium of 506 percent above the original rec-ommended price 12 months before Ersquotown jumped over $10 pershare in a single day on this news

It 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 506 percent to 113percent above the original recommended prices Moreover in eachcase these takeover targets could have been purchased at prices sig-nificantly below the original recommended price even as the evidence

282 PART THREE Takeover Clues

Chap 18 7901 902 AM Page 282

mounted that water company takeovers were coming resulting ingreater percentage gains

An article in The Wall Street Journal the day after the bid forErsquotown was announced clearly spelled out the reasons for thetakeover wave in the water stocks It all seemed so obviousmdashbut itwould have been just as obvious one year earlier if yoursquod 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 believeeven though the stock market is paying no attention to this evidencewhatsoever You have to ldquoknow what you knowrdquo 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

CHAPTER EIGHTEEN Look for Multiple Telltale Signs 283

Chap 18 7901 902 AM Page 283

This page intentionally left blank

A P P E N D I X

A Superstock Shopping List

As you have seen an important part of my approach has been tomake special note of companies that are partially owned by outsideldquobeneficial ownerrdquo investors I am particularly interested when one ofthese partially owned companies exhibits one or more additionalTelltale Signsmdashespecially when the outside beneficial owner had boththe ability and the desire to maximize the value of its investment

To help you start your own ldquoresearch universerdquo we have com-piled a sampling of companies that are partially owned by eitheranother company or a private investor or what I would call a ldquofinan-cialrdquo 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 ldquofinancialrdquo outside owners would be ready willing andable to cash out of their investments at a nice premium

We 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 ldquofinancially orientedrdquo owners companies that are partiallyowned by a family trust are also candidates for ldquovalue maximizationrdquowhen the timing is right

This list was compiled from the most recent data available at thetime this book was publishedmdashbut as we have learned things

285

Appx A 7901 903 AM Page 285

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

change Irsquod 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 wersquove pro-vided here

There are two ways to determine the very latest ownershipstakes of these ldquobeneficial ownersrdquo You can either call the compa-ny directly or you can go to wwwfreeedgarcom on the InternetOnce you access freeedgarcom simply enter the trading symbol ofthe company and click on ldquoview filingsrdquo You will then see a list ofthe companyrsquos Securities amp Exchange Commission filings The bestfiling to check would be the most recent Proxy Statement listed onthe site as ldquoForm DEF-14AndashDefinitive Proxy Statementrdquo Within thatfiling you will find a section listing all of the companyrsquos major share-holders including ldquobeneficial ownersrdquo with more than a 5 percentstake You should also make note of any recent Form 13 filingsincluding not only 13-Drsquos but also Form 13-Grsquos 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 surfaced

As 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 reasons

First 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 ofyour investment

The 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

286 APPENDIX

Appx A 7901 903 AM Page 286

I want to make it clear that this is not a recommended list of stocksand 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 owned

Our 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 ldquoprofessionalsrdquo tendto overlook As I said at the outset I make no claim that this is anysort of ldquofoolproof systemrdquo 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 lightmdashand 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

A SUPERSTOCK SHOPPING LIST 287

Appx A 7901 903 AM Page 287

Shopping List of Potential SuperstocksInformation as of 101700

Company Symbol Partial Owners

21st Century Insurance Group TW American International Group (621)

Abercrombie amp Fitch ANF JP Morgan Co (77)

ABM Industries ABM Rosenberg Family Trust (21)

Acmat ACMT Queensway Financial Canada (198)

Actrade Financial ACRT NTS Corporation (292)

ACTV Inc IATV Liberty Media (238)

Advanced Magnetics AVM BVF Partners (136)Eiken Chemical Ltd Japan (56)

Advanced Tissue Sciences ATIS Smith amp Nephew Inc England (795)

Aegon Insurance Group AEG Vereniging NV Netherlands (344)

AEP Industries AEPI Borden Inc (324)

Allied Waste Industries AW Apollo Advisers LP (172)Blackstone Mgt LLC (119)

Ambac Financial ABK JP Morgan (104)

AMC Entertainment AEN Fairmac Realty Group (113)Syufy Century Corp(72) Durwood Family Heirs (58)

American Classic Voyages AMCV Sam Zell Group (36)

American Express AXP Berkshire Hathaway Warren Buffett(114)

American Locker Group ALGI Estate of Harold Ruttenberg (225)

Ann Taylor ANN Morgan Stanley (54)

ARI Network Services ARIS Briggs amp Stratton (136)Witech (213)Vulcan Ventures (87)

Aristotle Corporation ARTL Geneve Corporation (508)

Astoria Financial ASFC JP Morgan (99)

Atchison Casting Corporation FDY Edmundson International Inc (118)

Autozone AZO ESL Ltd (162)

Bancwest Corporation BWE Banque National de Paris (45)

Barnes amp Noble BKS Forstman-Leff Associates (157)

Barrick Gold ABX Trizec Hahn Canada (8)

Battle Mountain Gold BMG Noranda Inc Canada (284)

Beringer Wine BERW Texas Pacific Group (517)

Berlitz International BTZ Soichiro FukutakeBenesse Corporation Japan (616)

Biosphere Medical BSMD Sepracor Inc (58)

288 APPENDIX

Continues

Appx A 7901 903 AM Page 288

Shopping List of Potential SuperstocksInformation as of 101700 (continued)

Company Symbol Partial Owners

Blockbuster Inc BBI Viacom Inc (823)

California Water CWT SJW Corporation Being acquired by American Water Works (85)

Campbell Soup CPB Dorrance Family Heirs (388)

Catalina Marketing POS General Electric (76)

CDI Corporation CDI Garrison Family Trust (292)

Centex Construction Products CXP Centex Corporation (615)

Cerus Corporation CERS Baxter Healthcare (162)

Chart House Enterprises CHT Samstock LLC (271)

Chiron CHIR Novartis (44)

Churchill Downs Inc CHDN Duchossois Industries (242)

CIT Group CIT Dai-Ichi Bank Japan (268)

Clorox CLX Henkel K GaA Germany (265)

CNAFinancial CNA Loews Corporation (868)

Coca-Cola KO Berkshire Hathaway Warren Buffett (81)

Coca-Cola Bottling COKE Coca-Cola Company (31)

Coca-Cola Enterprises CCE Coca-Cola Company (403)

Cognizant Technology CTSH IMS Health (61)

Congoleum Corporation CGM American Biltrite (683)

Conmed Corporation CNMD Bristol Myers Squibb (613)

Continental Airlines CAL NWA Corporation (846)

Cooper Industries CBE JP Morgan (71)

Coventry Health Care CVTY Principal Life Insurance Co (255)Warburg Pincus Ventures (306)

CPC of America CPCF CTM Group Inc (395)

Curtiss-Wright CW Unitrin (43)

Darden Restaurants DRI Prudential Insurance (136)American Express (93)

Dave amp Busters DAB LJH Corporation (113) Mandarin Inc United Kingdom (106)

Dawson Geophysical DWSN Pebbleton Corporation (181)

Detroit Diesel DDC Daimler Chrysler (21)

Devon Energy DVN Santa Fe Synder Corporation (166)

Diamond Offshore DO Loews Corporation (517)

Donnelly Corporation DON Johnson Controls Inc (151)

A SUPERSTOCK SHOPPING LIST 289

Continues

Appx A 7901 903 AM Page 289

Shopping List of Potential SuperstocksInformation as of 101700 (continued)

Company Symbol Partial Owners

Dreyers Grand Ice Cream DRYR Nestle (218)General Electric (188)

DST Systems DST Kansas City Southern Industries (323)

Dynergy DYN Chevron (289)

ETrade Group EGRP Softbank Holdings (261)

Ecolab ECL Henkel K GaA Germany (136)

Electric Lightwave ELIX Citizens Communications (102)

Entrust Technologies ENTU Nortel Networks (318)

Euronet Services EEFT DST Systems (117)

Excite Home ATHM ATampT (238)Comcast (46)Cox Communications (73)Cablevision Systems (52)

Family Dollar Stores FDO Bank of America (82)

Federal Realty FRT Morgan Stanley Dean Witter (149)

Fiberstars Inc FBST Advanced Lighting Technologies (33)

Fifth Third Bancorp FITB Cincinnati Financial Corporation (156)

Fleet Boston Financial FBF Kohlberg Kravis Roberts (55)

Footstar Inc FTS ESL Partners (221)

Franklin Electronics Publishers FEP Bermuda Trust Company (216)

Freeport McMoran Copper FCX Rio Tinto Indonesia Ltd (37)

Friendly Ice Cream FRN Prestley Blake (114)

Galey amp Lord GNL Citicorp Venture Capital (472)

Galileo International GLC UAL Corporation (17)Swiss Air (67)

Garden Fresh Restaurant Corporation LTUS D3 Family Fund

LP David Nierenberg (143)

General Binding GBND Lane Industries (628)

Gillette G Berkshire Hathaway (91)Kohlberg Kravis Roberts (49)

Golden State Bancorp GSB Mafco Holdings Ronald Perelman (32)

Great Atlantic amp Pacific GAP Tengelmann Group Germany (54)

Great Lakes Chemical GLK Berkshire Hathaway Warren Buffett(139)

GTS Duratek DRTK The Carlyle Group (231)

Guitar Center GTRC Chase Capital Partners (232)

Hagler Bailey Inc HBIX Cap Gemini SA (144)

Halifax Energy HX Research Industries (349)

Hanover Compressor HC GKH Investments (39)

290 APPENDIX

Continues

Appx A 7901 903 AM Page 290

TEAMFLY

Team-Flyreg

Shopping List of Potential SuperstocksInformation as of 101700 (continued)

Company Symbol Partial Owners

Harleysville Group HGIC Harleysville Mutual Insurance (566)

Hearst Argyle TV HTV Hearst Broadcasting (63)

Heska Corporation HSKA Novartis (11)Ralston Purina (67)

Hispanic Broadcasting HSP Clear Channel Communications (26)

Houston Exploration THX Keyspan (703)

Human Genome Sciences HGSI Bass Group (153)Merrill Lynch (66)

ICN Pharmaceuticals ICN Special Situation Partners (85)

IDEC Pharmaceuticals IDPH Genentech (67)Citicorp (77)

IDEX IEX Kohlberg Kravis Roberts (287)

IIC Industries IICR Kenyon Phillips Ltd England (778)

Immunex IMNX American Home Products (553)

Impco Technologies IMCO BERU Aktiengesellschaft Germany(121)

Insurance Management Solutions INMG Bankers Insurance Group (627)

International Home Foods IHF Hicks Muse (426)

International Multifoods IMC Archer Daniels Midland (86)

Interstate Bakeries IBC Ralston Purina (295)

Intrusioncom INTZ Science Applications InternationalCorporation (156)

Isis Pharmaceuticals ISIP Novarits Switzerland (72)

Kemet Corporation KEM Citicorp (76)

Keystone Consolidated KES Contran Corporation (408)

Kohlrsquos Corporation KSS AXA France (149)Prudential Insurance (54)

Laboratory Corporation of America LH Roche Holdings (462)

Ladish Company LDSH Grace Brothers (284)

Lafarge Corporation LAF Lafarge SA France (522)

Legg Mason LM AXA Financial (167)

Liberty Financial L Liberty Mutual (714)

Lifeway Foods LWAY Danone Foods (Dannon) France (20)

Ligand Pharmaceuticals LGND ELAN International Services (193)

Lilly (ELI) amp Co LLY Lilly Foundation (154)

Lincoln National LNC Dai-Ichi Mutual Life Insurance (7)

A SUPERSTOCK SHOPPING LIST 291

Continues

Appx A 7901 903 AM Page 291

Shopping List of Potential SuperstocksInformation as of 101700 (continued)

Company Symbol Partial Owners

Linens rsquoN Things LIN Marsh amp McLennan (122)American Express (53)

Litton Industries LIT Unitrin (278)

Lone Star Technologies LSS Alpine Capital (382)Keystone Inc (97)

Loral Space amp Communications LOR Lockheed (155)

Magnum Hunter Resources MHR Oneok Inc (38)

Mascotech MSX Masco Corporation (175)

McMoran Exploration MMR Alpine Capital (277)

Mediquist MEDQ Koninklijke Philips Electronics NV Netherlands (685)

Meemic Holdings MEMH Professionals Group Inc (82)

Midway Games MWY Sumner Redstone National Amusements (25)

Millennium Pharmaceuticals MLNM Bayer AG Switzerland (11)

Mylan Labs MYL American Express (105)

Neiman Marcus NMGA Harcourt General (181)

Neurogen NRGN Pfizer (184)

Nextel Communications NXTL Motorola (131)

Noland Company NOLD Edmundson International (164)

OMI Corporation OMM Mega Tankers Norway (11)

Oneida Corporation OCQ National Rural Electric Co-Op (86)

Oneok Inc OKE Western Resources (45)

Overseas Shipholding OSG Archer Daniels Midland (168)

Owens-Illinois OI Kohlberg Kravis Roberts (245)

Panamsat Corporation SPOT General Motors Hughes (808)

Payless ShoeSource Inc PSS ESL Partners (143)

Peoplersquos Bank PBCT Peoplersquos Mutual Holdings (597)

Petrocorp PEX Kaiser-Francis Oil Company (498)

Petsmart PETM Carrefour SA France (117)

Philadelphia Suburban PSC Vivendi France (18)

Phillips Van Heusen PVH Vaneton International Hong Kong

(18)Mellon Financial (51)

Picturetel Corporation PCTL Intel (99)

Primedia PRM Kohlberg Kravis Roberts (72)

Prodigy Communications PRGY SBC Communications (419)

292 APPENDIX

Continues

Appx A 7901 903 AM Page 292

Shopping List of Potential SuperstocksInformation as of 101700 (continued)

Company Symbol Partial Owners

Protective Life Corporation PL Amsouth Bancorp (96)

RCN Corporation RCNC Level 3 Telecom Holdings (328)Vulcan Ventures (279)

Redhook Ale Brewery HOOK Anheuser-Busch (25)

Regis Corporation RGIS Curtis Squire (157)

Ribozyme Pharmaceuticals RZYM Elan Intrsquol Ireland (159)Chiron Corp (86)

Rosetta Inpharmatics RSTA Vulcan Ventures (127)

Royal Caribbean Cruises RCL A Wilhelmensen AS (25)Pritzker Family (28)

Russell Corporation RML Merrill Lynch (81)

Safeway SWY Kohlberg Kravis Roberts (10)

Samsonite SAMC Artemis America France (302)

Scitex Corporation SCIX Merrill Lynch (607)

Scripps (EW) SSP EW Scripps Trust (493)

Seacor Smit CKH Geocapital Corporation (86)

Smart amp Final SMF Groupe Casino France (602)

Sodexho-Marriott Services SDH Sodexho Alliance SA France (48)TransAmerica Investments (12)

Sport Supply Group GYM Emerson Radio (232)

Sterling Sugars SSUG MA Patout amp Sons Inc (62)

Stolt Offshore SCSWF Stolt Nielson SA Luxemburg (449)

Sunrise Assisted Living Centers SNRZ Morgan Stanley (108)

Supergen Inc SUPG Abbott Labs (49)

Swiss Army Brands SABI Victorinox Switzerland (402)Brae Group (238)

Talbots Inc TLB Jusco Inc (613)

Targeted Genetics TGEN Immunex (72)Elan Intrsquol Ireland (59)

Tiffany amp Co TIF Jennison Associates LLC (104)

Timberland TBL Swartz Family Trust (369)

Titanium Metals TIE Tremont Corporation (391)

Transatlantic Holdings TRH American International Group (60)

Tremont Corporation TRE Valhi Inc (789)

Triton Energy OIL Hicks Muse (389)

True North Communications TNO Publicis SA France (94)

US Cellular USM Telephone amp Data Systems (431)

Ultramar Diamond Shamrock UDS Total FinanceTOTAL France (804)

A SUPERSTOCK SHOPPING LIST 293

Continues

Appx A 7901 903 AM Page 293

Shopping List of Potential SuperstocksInformation as of 101700 (continued)

Company Symbol Partial Owners

UnionBanCal UB Bank of TokyondashMitsubishi (646)

United Park City Mining UPK Loeb Investors (661)Farley Group (126)

UNOVA UNA Unitrin (227)

USG Corporation USG Knauf International (999)

VF Corporation VFC Barbey Trust (199)

Valhi Inc VHI Contran Corporation (789)

Venator Group Z Greenway Partners LP (144)AXA France (104)

Vicorp Restaurants VRES SE Asset Management (19)Quaker Capital (12)

Washington Post Company WPO Berkshire Hathaway Warren Buffett(183)

Westfield America WEA Westfield America Trust (647)

Westwood One WON Viacom Inc (173)

White Mountains Insurance WTM Berkshire Hathaway Warren Buffett(199)

Whitman Corporation WH PepsiCo Inc (396)

WMS Industries WMS Sumner Redstone National Amusements (25)

Worldtex Inc WTX Lockheed Martin Investment Management (215)EGS Partners (342)

Yonkers Financial YFCB Gould Investors LP (162)

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

294 APPENDIX

Appx A 7901 903 AM Page 294

R E S O U R C E S

Barronrsquos published by Dow Jones amp Company Inc New York

BusinessWeek published by The McGraw-Hill Companies New York

Byrne John Chainsaw (New York HarperCollins 1999)

Cerf Christopher and Victor Navasky The Experts Speak (New YorkPantheon Books 1984)

FreeEDGARcom a product of EDGAR Online Inc is the market leader inEDGAR data retrieval

Goldman William Adventures in the Screen Trade (New York Warner Books1989)

Griffin Nancy and Kim Masters Hit amp Run (New York Simon amp Schuster1996)

Investorrsquos Business Daily published by William OrsquoNeil amp Co Los AngelesCalifornia

JagNotescom JAGfncom a product of JAG Notes is a financial network

Kahn Herman The Next 200 Years (New York William Morrow amp Co1976)

Kiplingerrsquos published by The Kiplinger Washington Editors Inc Wash-ington DC

The Mansfield Chart Service published by PW Mansfield amp Co

Nathan John Sony The Private Life (Boston Houghton Mifflin 2000)

The New York Times published by The New York Times Co

Rudd 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)

295

Resources 7901 903 AM Page 295

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

Superstock Investor published by Superstocks Inc Rochester New York

Vickers Weekly Insiders Report published by Argus Research BaltimoreMaryland

The Wall Street Journal published by Dow Jones amp Co New York

Woodward Bob The Agenda (New York Pocket Books 1995)

Yahoo Finance a product of Yahoo Inc

296 RESOURCES

Resources 7901 903 AM Page 296

A

Abbott Labs (ABT) 135Accounting gimmicks 50ADT Ltd 85ndash94Adventures in the Screen Trade

(Goldman) 69Agenda The (Woodward) 44Allied Waste Industries 251ndash254Ameche Don 187American Stores 15ndash17American Water Works 27ndash30 282Aquarion (WTR) 28Arbor Drugs 201Asset values 26Avco Corporation 13

B

Babson Roger 44 45Babson Break 45Bank One (ONE) 49 50Barr J James 28 29Barronrsquos 140ldquoBearish Call on Banks Lands Analyst

in Doghouserdquo 49Belle Albert 43Beneficial owner transactions 103ndash105

285 286Bentsen Lloyd 43Berra Yogi 35Big B 201ldquoBond Bears Debt Securities Prices

May Slide for Years Many AnalystsThink Therdquo 40

Bonds 59Book value 170

Breakout 206Brokerage firm research reports 20 21Browsing 96ndash106 126Brylane Inc 106ndash111Burns International Services 134 135Byrne John A 47

C

Case studiesADT Ltd 85ndash94Brylane Inc 106ndash111Copley Pharmaceuticals 149ndash155Dexter Corp 111ndash124FayrsquosGenovese 190ndash201Frontier Corp 266ndash270JCPenneyRite Aid 233ndash237MattelThe Learning Company

247ndash250Midway Games 140ndash148Protection One 238ndash247Renal Treatment Centers 219ndash222Rexel Inc 78ndash84Rohr Inc 210ndash214Salick Health Care 207ndash210Smith Food amp Drug Centers 201ndash202Sugen Inc 260ndash265Sunbeam Corp 46ndash48VivraRen-Corp USA 215ndash219Waste ManagementAllied Waste

251ndash254WMS Industries 159ndash185

Catalysts 11 12Cautionary tabs (merger mania)

233ndash254Chainsaw (Byrne) 47

297

I N D E X

Index 7901 904 AM Page 297

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

Change 187 188Charts 138 139 159 205ndash214Clayton Joseph 268Clinton Bill 44Conglomerate craze 188Connecticut Water Service (CTWS) 128Copley Pharmaceuticals 149ndash155Corporate-shareholder disagreements

149ndash156Cosell Howard 54Creeping takeovers 77ndash94

D

Dexter Corp 111ndash124Dirty Rotten Scoundrels 128Discounted present value 61Domino effect 215ndash222 227 255Dorfman Dan 111Dornemann Michael 229 230Double play 141Dow Charles H 187Drugstore industry 187ndash204

case study (FayrsquosGenovese) 190ndash201

case study (Smith Food amp DrugCenters) 201ndash202

Dun amp Bradstreet (DNB) 135Dunlap Al 46 47

E

Ersquotown Corp 131 132 140 282Efficient market 80 81Eli Lilly 225 226Examples (see Case studies)Excitement 6 7Experts 35ndash36

agenda 43 44conforming to prevailing ideology

48ndash53defined 36famous bloopers 54magazine coversarticles 37ndash42shortage of 42truth telling 44ndash48

F

Faber David 267Fairness opinion 77Family feuds 149ndash156Family trust 285Fayrsquos Inc 192ndash195Federal Reserve 61Financial press 125ndash148

Barronrsquos 140case study (Midway Games) 140ndash148Investorrsquos Business Daily 126ndash132

136ndash140(See also Investorrsquos Business Daily)

magazine coversarticles 37ndash42New York Times The 133Vickers Weekly Insider Report 103ndash105Wall Street Journal The 133

Flutie Doug 23Form 4 filings 105Form 13 filings 103 140 286Form 13-D filings 103 140Freeedgarcom 286Frontier Corp 266ndash270Frost A J 205Frost Robert 95

G

Gateway 52ndash53Genovese Drug Stores 192 194ndash201Gifford Frank 54Goldman William 69 70Goodfriend Jaimi 254Goodman George 6 23Grass Martin 191 192 233 236Greenberg Herb 247Greenmail 121Greenspan Alan 44 61Griffin Nancy 228

H

HealthSouth 251Heaven Can Wait 36Herd instinct 31Heyman Samuel 113ndash124

298 INDEX

Index 7901 904 AM Page 298

Hills Roderick M 253Hit amp Run (GriffinMasters) 228Horse racing 6 7Horror stories (merger mania) 233ndash254Huff Rolla 269

I

IBD (see Investorrsquos Business Daily)Illustrations (see Case studies)Index investing 31ndash34Interest rates 59ndash62 69Interpreting the news 4 5Investing paradigms 25ndash30Investorrsquos Business Daily 97 126ndash132

dirty rotten stocks 127ndash130ldquoIndustry Profilerdquo 136 137problems 127ndash132ldquoStocks in the Newsrdquo 138ndash140ldquoTo the Pointrdquo 130 132ldquoWhere the Big Moneyrsquos Flowingrdquo

130 137 138

J

JCPenney 233ndash237 251

K

Keynes John Maynard 57Kidney dialysis industry 215ndash222Kirby Industries 170ndash172Kondratieff Nikolai D 45

L

LaLoggia Charles M 3 4 303Large-cap stocks 32 33 71 72Learning Company The 247ndash250Lemming 31Lemming effect 225ndash227 251 255Limbaugh Rush 43List of potential superstocks 288ndash294Long-term bonds 59LTV Corporation 12 13

M

Magazine coversarticles 37ndash42Mahon Cherrie 124 146 147 303

Major shareholders 286(See also Beneficial owner transac-

tions)Malraux Andreacute 53Mansfield Chart Service 27 97 211Masters Kim 228Mattel 247ndash250Mayo Michael 49ndash51McKesson HBOC 251Mead Corp (MEA) 135Media (see Financial press)Merck 225Meredith Don 54Merger mania 223ndash257

blunders 231 232 251case studies

JCPenneyRite Aid 233ndash237MattelThe Learning Company

247ndash250Protection One 238ndash247Waste ManagementAllied Waste

251ndash254CEO egos 227ndash229investment bankingrsquos desire for fees

230lemming effect 225ndash227 251merger of equals 256 257take the money and run 232 256

Merger of equals 256 257Middlesex Water (MSEX) 129Midway Games (MWY) 140ndash148Money Game The (Goodman) 6Morita Akio 228 229Mudslinging contest 122

N

Nathan John 228National City Corp 50Negative surprise 213 214New paradigm vs old paradigm

thinking 27ndash30New York Times The 97 133Nicastro Neil 142ndash148 180 1811929 Again (Rudd) 441987 stock market crash 42

INDEX 299

Index 7901 904 AM Page 299

ldquoNo Bottom to Oilrdquo 40No-risk rate of return 69Nobody knows anything 70North Oliver 43

O

OrsquoNeil William 127 128Old paradigm vs new paradigm

thinking 27ndash30One-decision stock paradigm 25 26Oneok (OKE) 245 246Oxenstierna 223

P

Paradigm 25PCS Health Systems 225ndash227Pharmacy benefits manager (PBM) 225Pinault-Printemps-Redoute 134Pittway 129Potential takeovers (Telltale Signs)

98ndash101Priceearnings ratios 58 59Protection One 238ndash247Public mudslinging contest 122Pure plays 188 189

R

Redstone Sumner 145 159ndash166 168172ndash174 177 184

Relative leadership index 34Ren-Corp USA 216ndash219Renal Treatment Centers 219ndash222Research departments 20 21Research universe 97 98Resistance level 206Resources 295 296

(See also Financial press)Rexel Inc 78ndash84Riskless alternative to the stock market

59Rite Aid 233ndash237 251Rite AidndashRevco merger 190ndash193Rohr Inc 210ndash214Rudd Terry R 44 147 210

S

SampP priceearnings ratio 58Salick Health Care (SHCI) 207ndash211Samuelson Robert 41Scharf Stewart 253Schliemann Peter 71Service Corp International 251Shining The 39Shopping list of potential superstocks

288ndash294Shore Andrew 46ndash48SJW Corp 282Small-cap stocks 32Smith Food amp Drug Centers

201ndash202SmithKline Beecham 225Sony 227ndash229Sony The Private Life (Nathan) 228ldquoSpecter of Depression Therdquo

(Samuelson) 41Spin-offs 188ndash190Stock charts 138 139 159 205ndash214Stock market crash of 1987 42Stock selection 19ndash23Sugen Inc 260ndash265Sullivan Allanna 272Sunbeam Corp 46ndash48Supermoney (Goodman) 23Superstock 11Superstock breakout pattern 206Superstock Investor 1 17 303Superstock shopping list 285ndash294Synergy 188 189

T

Takeover indicators (Telltale Signs)98ndash101

Takeover-lively industry 203Talk shows 42Technical analysis 139Telltale Signs 98ndash10110-K Report 245The Learning Company 247ndash25013-D filings 103 140

300 INDEX

Index 7901 904 AM Page 300

TEAMFLY

Team-Flyreg

ldquoThis Is Not Just a Bear Market This Isthe Way Things Are Going to Befrom Now Onrdquo 53

TJ International 102Triple play 141 148Trus Joist 102

U

United Water Resources 281 282

V

Value 62Value investing 57Vickers Weekly Insider Report 26 97

103ndash105Vignettes (see Case studies)Vivra 215ndash222

W

Wall Street Journal The 97 132ndash134Wall Street research 20 21Warnock Tom 257Waste Management 251ndash254Water utilities 271ldquoWater Utility Industrial Could Be on

the Verge of a Takeover Waverdquo(LaLoggia) 27

Western Resources 86ndash92 238ndash246Weyerhauser 101 102ldquoWhy Greenspan Is Still Bullishrdquo 41Wittig David 238ndash244WMS Industries 159ndash185Woodward Bob 44

Y

Yucaipa Cos 202 203

INDEX 301

Index 7901 904 AM Page 301

This page intentionally left blank

A B O U T T H E A U T H O R S

Charles M LaLoggia is the editor and publisher of Superstock Investora monthly stock market newsletter he has published since 1974 Hehas also written numerous newspaper columns and magazine articleson investing Charles LaLoggiarsquos stock market views and stock rec-ommendations have been reported in virtually every major financialpublication in the world including BusinessWeek The Wall Street JournalBarronrsquos The New York Times Kiplingerrsquos Personal Finance Money FortuneNewsweek and many others He has appeared on numerous televisionand radio programs including Wall Street Week With Louis RukeyserThe Nightly Business Report on 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 ldquounquestionably oneof the countryrsquos hottestmdashif not the hottestmdashtakeover pickerrdquo In aDecember 2000 article entitled ldquoRiding the Buyout Waverdquo Fortunemagazine said that Charles LaLoggiarsquos Superstock Investor newsletterldquohas a solid record for predicting buyoutsrdquo

Cherrie A Mahon is copublisher and director of research of theSuperstock Investor newsletter Prior to that she was a stockbroker at amajor Wall Street firm

Further information regarding the monthly Superstock Investornewsletter is available by e-mailing ssinvestoraolcom or calling1-800-450-0551 or writing to Superstock Investor PO Box 30547Rochester New York 14603

About the Author 7901 904 AM Page 303

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

THE SUPERSTOCKINVESTORProfiting from Wall StreetrsquosBest Undervalued Companies

Charles M LaLoggiaCherrie A Mahon

McGraw-HillNew York Chicago San Francisco

Lisbon London Madrid Mexico CityMilan New Delhi San Juan Seoul

Singapore Sydney Toronto

FM 7901 843 AM Page iii

Copyright copy 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 0-07-136083-2

All 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_hoaremcgraw-hillcom or (212) 904-4069

TERMS OF USEThis is a copyrighted work and The McGraw-Hill Companies Inc (ldquoMcGraw-Hillrdquo) 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 upontransmit distribute disseminate sell publish or sublicense the work or any part of it withoutMcGraw-Hillrsquos prior consent You may use the work for your own noncommercial and personal useany 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 ldquoAS ISrdquo McGRAW-HILL AND ITS LICENSORS MAKE NO GUAR-ANTEES OR WARRANTIES AS TO THE ACCURACY ADEQUACY OR COMPLETENESS OFOR RESULTS TO BE OBTAINED FROM USING THE WORK INCLUDING ANY INFORMA-TION THAT CAN BE ACCESSED THROUGH THE WORK VIA HYPERLINK OR OTHERWISEAND EXPRESSLY DISCLAIM ANY WARRANTY EXPRESS OR IMPLIED INCLUDING BUTNOT LIMITED TO IMPLIED WARRANTIES OF MERCHANTABILITY OR 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 therefromMcGraw-Hill has no responsibility for the content of any information accessed through the workUnder no circumstances shall McGraw-Hill andor its licensors be liable for any indirect incidentalspecial 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 otherwise

DOI 1010360071381163

abcMcGraw-Hill

C O N T E N T S

ACKNOWLEDGMENTS ix

INTRODUCTION 1

PART ONE

THE MAKING OF A SUPERSTOCK INVESTOR

Chapter One

A Defining Moment 11

Chapter Two

A Superstock Is Born 15

Chapter Three

Stock Selection 19

Chapter Four

Investing Paradigms A New Way of Thinking about Stock Selection 25

Chapter Five

The Twilight of Index Investing 31

Chapter Six

Experts What Do They Know 35

Case Study Sunbeam 46

Chapter Seven

What Is Value 57 v

FM 7901 843 AM Page v

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

Chapter Eight

If Everybody Knows Everything Then Nobody KnowsAnything 65

PART TWO

IDENTIFYING TAKEOVER TARGETS

Chapter Nine

Creeping Takeovers 77

Case Study How Rexel SA Acquired Rexel Inc 78Case Study The Takeover of ADT 85

Chapter Ten

How to Create Your Own ldquoResearch Universerdquo of TakeoverCandidatesmdashThe Telltale Signs 95

Case Study Spotting Brylane as a Takeover Target 106Case Study Sam Heyman and Dexter Corp 111

Chapter Eleven

How to Use the Financial Press 125

Case Study The Triple Play and Midway Games 140

Chapter Twelve

Family Feuds 149

Case Study Copley Pharmaceuticals 149

PART THREE

TAKEOVER CLUES

Chapter Thirteen

ldquoBeneficial Ownerrdquo Buying 159

Case Study Sumner Redstone and WMS Industries 159

vi CONTENTS

FM 7901 843 AM Page vi

Chapter Fourteen

The ldquoPure Playrdquo and the Drugstore Industry 187

Case Study Fayrsquos and Genovese 190Case Study Smith Food amp Drug Centers 201

Chapter Fifteen

Using Charts 205

Case Study Salick Health Care 207Case Study Rohr Inc 210

Chapter Sixteen

The Domino Effect 215

Case Study Vivra and Ren-Corp USA 215Case Study Renal Treatment Centers 219

Chapter Seventeen

Merger Mania Take the Money and Run 223

Case Study JCPenney and Rite Aid 233Case Study The Alarming Story of Protection One 238Case Study How Mattel Got Played by The Learning Company 247Case Study Waste Management and Allied Waste Industries 251

Chapter Eighteen

Look for Multiple Telltale Signs 259

Case Study Sugen Inc 260Case Study Frontier Corp 266Case Study Water Utilities 271

APPENDIX A SUPERSTOCK SHOPPING LIST 285

RESOURCES 295

INDEX 297

CONTENTS vii

FM 7901 843 AM Page vii

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A C K N O W L E D G M E N T S

I would 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 ldquomainstreamrdquo 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 timeto think about and explain in detail the thought processes that wentinto the recommendations in the newsletter In a way Cherriersquos 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 them

Obviously 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 bornmdashand if it were not for Cherrie I probably neverwould have had the determination to complete it Her supportthroughout this process was invaluable

Charles M LaLoggia

ix

FM 7901 843 AM Page ix

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

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TEAMFLY

Team-Flyreg

Introduction

If yoursquod been born in a cave and had lived there your entire lifewith 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 signalsThe signals would be all around you but yoursquod be oblivious to themwithout the means to pick them up

Similarly if you are accustomed to a certain way of reading thefinancial news you can pick up ldquosignalsrdquo 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 force the stock market to recognize that stockrsquos true value Icall such stocks ldquosuperstocksrdquo because they can leap above any kindof market in a single bound

I began publishing my stock market newsletter as The CMLInvestment Lettermdashcurrently named Superstock Investormdashin December1974 Along the way I developed a reputation for being able to spotneglected companies that were about to become stock market starsmdashnot 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 companyrsquos value as abusiness Usually that ldquosomethingrdquomdashan outside event or what Icall a ldquocatalystrdquomdashhad the effect of pushing the stock price higher inone sudden jump rather than gradually over time Seemingly that

1

Introduction 7901 844 AM Page 1

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

outside event came out of the blue But in reality that event was thelogical conclusion to a series of events that began with a single clueor Telltale Sign that strongly suggested what the ultimate outcomewould be

This 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 Indash1)

I want to make one thing perfectly clear at the outset thoughWhat you will learn in this book is not a ldquoget rich quickrdquo method ofinvesting There are no sure things in the stock market except thisThere are no sure things I have seen countless systems and approach-es to stock selection and market timing come and go Many workfor a whilemdashsometimes for quite a whilemdashand then fall into disfa-vor and disrepute because they simply stop working Nobody knowswhy Some resurface years later and begin working again ldquodiscov-eredrdquo by a new generation of investors

But that is not what this book is all about This approach is nota ldquosystemrdquomdashrather 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 usingmdashit 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 market

In effect this approach will provide you with a sort of ldquoofflinerdquoportfolio 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 market

Almost all of the 48 stocks that received takeover bids duringthat 55-month period ending in September 2000 were on my newslet-terrsquos recommended list because based on the approach described

2 INTRODUCTION

Introduction 7901 844 AM Page 2

INTRODUCTION 3

T a b l e Indash1

Charles M LaLoggiarsquos 48 Takeover Bids in 55 Months

Percent PercentGain Annualized

Months Held (or Loss) Gain (or Loss)

Sep rsquo00 Advest 1 +19 +230

Sep rsquo00 AXA Financial 12 +70 +70

Sep rsquo00 Donaldson Lufkin 8 +85 +127

Aug rsquo00 PaineWebber 21 +119 +88

Dec rsquo99 Pittway 3 +41 +164

Dec rsquo99 Dexter Corp 5 +36 +864

Nov rsquo99 ErsquoTown Corp 11 +38 +414

Oct rsquo99 SJW Corp 10 +100 +120

Sep rsquo99 Nichols Research 19 +10 +63

Aug rsquo99 United Water Resources 9 +77 +1026

Aug rsquo99 Copley Pharmaceuticals 11 +23 +251

July rsquo99 Red Roof Inns 9 +30 +40

June rsquo99 Aquarion 7 +50 +857

June rsquo99 Sugen Inc 42 +169 +482

Mar rsquo99 Frontier Corp 28 +156 +54

Jan rsquo99 Alarmguard 21 +21 +12

Dec rsquo98 Brylane 2 +52 +312

Nov rsquo98 Genovese Drug Stores 27 +219 +973

Nov rsquo98 Pool Energy Services 56 +53 +113

Aug rsquo98 Clearview Cinemas 6 +75 +150

Aug rsquo98 American Stores 2 +25 +150

Jul rsquo98 Life Technologies 2 +20 +120

Jul rsquo98 Grand Casinos 7 +46 +788

May rsquo98 Union Texas Petroleum 8 +21 +315

May rsquo98 Giant Food 28 +36 +154

Feb rsquo98 Harveyrsquos Casino 1 +32 +384

Feb rsquo98 Arbor Drugs 17 +163 +115

Dec rsquo97 Showboat 25 +16 +77

Nov rsquo97 Holmes Protection 10 +43 +516

Nov rsquo97 Renal Treatment 28 +261 +1118

Sep rsquo97 Rexel Corp 23 +110 +574

Sep rsquo97 Rohr 27 +124 +551

Sep rsquo97 Riviera Holdings 1 +0 +0

Sep rsquo97 WHG Resorts 5 +100 +240

Aug rsquo97 Protection One 7 +105 +180

Continued

Introduction 7901 844 AM Page 3

in this book I considered them takeover candidates No ldquomagicrdquoinsights will be revealed here instead this book will describe whatI have observed to be true over 25 yearsmdashthat a certain event ordevelopment tends to lead to another which ultimately results inthe birth of a ldquosuperstockrdquo 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 atmdashor very nearmdashits intrinsic valueas a business

In 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 superstocks

Let me repeat that the approach to investing you are about tolearn is not a system The key to this approach is interpreting the news

4 INTRODUCTION

T a b l e Indash1

Charles M LaLoggiarsquos 48 Takeover Bids in 55 Months(continued)

Percent PercentGain Annualized

Months Held (or Loss) Gain (or Loss)

Jul rsquo97 Rotech Medical 36 +143 +476

May rsquo97 Logicon 40 +292 +876

May rsquo97 Smith Food amp Drug 7 +50 +857

May rsquo97 Vivra 36 +119 +396

Feb rsquo97 UNC Inc 6 +100 +200

Dec rsquo96 ADT Corp 9 +50 +666

Dec rsquo96 Roosevelt Financial 12 +22 +22

Oct rsquo96 Ornda Healthcare 4 +16 +48

July rsquo96 Fayrsquos Drugs 7 +87 +1491

July rsquo96 Bally Corp 2 +20 +120

Jun rsquo96 Community Health 11 +40 +436

Apr rsquo96 Hemlo Gold 12 +29 +29

Feb rsquo96 Loral Corp 10 +15 +18

Introduction 7901 844 AM Page 4

This 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 isnrsquot easy to implement

Over 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 naturemdashit describes what companies and their man-agement and major shareholders tend to do during the yearsmonths 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 someonemdasheither inside or outside the companymdashbelieves 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 it

To 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 seeingmdashand sticking to your convictions even whenthere is little or no support from Wall Streetmdashwell I just canrsquot imag-ine this approach becoming so popular that it simply stops working

A question often asked about investment books is Does thesystemmdashin this case the interpretive approachmdashalways work

The answer here is a resounding no There is no sure-fire keyto stock market riches There have been plenty of times when theldquoTelltalerdquo Signs yoursquoll read about here seemed to point directly to afuture superstock only to turn out in the end to be unprofitable

Does that bother youIt shouldnrsquot because reality should never bother you on any

levelmdashit should only serve as a means for better understanding theway the world really works Every mistake along the waymdasheveryroad you take or stock you buy that does not work out as hopedmdashshould be considered a learning experience that will make the nextexperience more likely to succeed

I can only say that if you follow the clues described here yoursquollend up with more winners than losers

INTRODUCTION 5

Introduction 7901 844 AM Page 5

Now I will describe some really interesting things I have learnedover the years Itrsquos an approach to investing that has served me welland if you learn to use it it will do the same for you

THE BULLS THE BEARS AND THE HORSES

The recent trend toward microanalyzing the stock market on aminute-by-minute basis has less to do with investing than it doeswith providing a ldquofixrdquo for stock market addicts In his classic bookThe Money Game author George Goodman writing under the nameldquoAdam Smithrdquo 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 A large part ofthe stock marketrsquos 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 life

I 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 gardening

There are many people who will tell you that the stock marketis actually just like horse racing and if you stop to think about itthey 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 ldquoTheyrsquore offrdquo

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 bell

It 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

6 INTRODUCTION

Introduction 7901 844 AM Page 6

Financial magazines are multiplying like rabbits while the DailyRacing Form has been sold and resold several times as its circulationeroded year after year

Letrsquos 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 nonstopaction for 61frasl2 hours 5 days a week and if yoursquore 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 hours

Wall Street never stops How can horse racing compete withthis

For one thing they might try out the concept of horse brokersIn New York State there are Off Track Betting parlors scattered allover the place Whatrsquos 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 business

And why stop there To support the sales forcemdashexcuse methe horse brokersmdashOTB could even hire analysts to write researchreports If you are a ldquovaluerdquo 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 ldquomomentumrdquo player whoconcentrates on technical analysis with a preference for followingthe ldquosmart moneyrdquo 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

ldquoWho cares why the odds are going downrdquo he would screaminto the telephone ldquoThis is a momentum horse Get your moneydown now before itrsquos too laterdquo

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

Introduction 7901 844 AM Page 7

ings to keep the stock price up so insiders can bail out at high pricesYou want to take a shot at big money Forget optionsmdashplay the dailydoublemdashhere are our top picks for speculators of course Whatrsquosthat Yoursquore wondering what to do with your pension funds Whythat calls for a more conservative approachmdashhow 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 way

This book is about a different way

8 INTRODUCTION

Introduction 7901 844 AM Page 8

P A R T O N E

The Making of aSuperstock Investor

Chap 01 7901 844 AM Page 9

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

This page intentionally left blank

TEAMFLY

Team-Flyreg

C H A P T E R O N E

A Defining Moment

LALOGGIArsquoS DICTIONARY

Su-per-stock (soo-per-stok) A stock 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 eventor ldquocatalystrdquo usually a takeover bid which if it occurred wouldforce the price higher

Since most stock market investors are obsessed with growth per-fectly good companies with consistent profitsmdashmany of which arecash rich with little or no debtmdashare passed over shunned by themajority of investors seeking growth and earnings momentum

Yet 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 ldquodeadrdquo money whileother stocks provide solid gains

These superstocks generally sell far below their actual value asa business but nobody cares because the companyrsquos earnings maybe erratic or even trending lower and the companyrsquos growth poten-tial may be unexciting

A number of events or ldquocatalystsrdquo 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 orindividualmdashand sometimes even the management of the companymdash

11

Chap 01 7901 844 AM Page 11

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

offers 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 A thirdcatalyst is a large onetime cash or stock dividend where a companydistributes accumulated cash or shares in a wholly owned subsidiaryto its shareholders A fourth 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 ownership

These potential catalysts as well as others can suddenly turna previously boring uninteresting company into a superstockmdashastock that rises dramatically in price usually over a one- to two-dayperiod regardless of what the overall stock market is doing

A LIGHTBULB GOES ON

The early 1970s were a difficult time for the US economy and alsofor the stock market A sharp rise in inflation in 1972ndash73 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 570

In the midst of this economic and financial downturn manycompanies saw their earnings evaporate and turn into huge lossesCompanies cut or reduced dividends on their common and pre-ferred stocks

By 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 again

I also noticed that some of the preferred stocks that had stoppedpaying dividends were ldquocumulativerdquo which meant that all unpaiddividends would accumulate and have to be paid in full before anydividends could be paid on the common stock

One such company was LTV Corporation which had sus-pended the dividend on its $5 Cumulative Preferred stock back to1970 By April 1975 $2250 of dividends ldquoin arrearsrdquo had accumu-lated LTVrsquos earnings were turning sharply positive by 1975 and its

12 PART ONE The Making of a Superstock Investor

Chap 01 7901 844 AM Page 12

shareholders who noted the improvement had begun to push fordividends on the common stock

LTV issued a statement that it would soon ldquoconsiderrdquo 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 wordsanyone who had bought the $5 Cumulative Preferredmdashthen tradingat about $57 a sharemdashstood a reasonable chance of getting a lump-sum payment of $2250 a share Also if the regular $5 preferred divi-dend were reinstated the stock would probably move higher

So if a certain event took placemdashthe payment of the $2250 pershare in back dividendsmdashLTV Preferred stock would literally beforced higher no matter what the general stock market did

Using this reasoning I recommended LTV $5 CumulativePreferred Not long afterward LTVrsquos Board of Directors announcedit would pay the $2250 in back dividends and reinstate the $5 annu-al preferred dividend The price of LTV Preferred soared when thisnews was announced

With this ldquotasterdquo of what would become superstock investingI looked for a company in a similar situationmdashand found it LikeLTV Avco Corporation had a cumulative preferred stock (the $320Cumulative Preferred) trading on the New York Stock ExchangeLike LTV Avco had fallen on hard times and suspended dividendpayments on the preferred and they were accumulating ldquoin arrearsrdquoAnd like LTV Avcorsquos earnings had taken a major turn for the betterand its common stockholders were pushing for dividends on thecommon shares which could only be paid if the arrears were paidon the cumulative preferred stock

I recommended Avco $320 Cumulative Preferred in August1975 at 181frasl2 After Avco paid all of the arrears on the preferred stockand reinstated the annual $320 dividend the stock was selling at$47 This literally forced the stock market to revalue the preferredstock at a higher level since that $320 annual dividend would havecreated a yield of almost 18 percent based on the original price of181frasl2mdashfar 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 developmentmdashthe reinstated dividendmdashthis stock had to go up

CHAPTER ONE A Defining Moment 13

Chap 01 7901 844 AM Page 13

Remember though higher earnings do not necessarily meanthat a stock has to go up even if those earnings beat analystsrsquo expec-tations A fat 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 situation

THE LESSON LEARNED

Herersquos what can be learned from these two successful recommen-dations Sometimes it is possible to anticipate a certain specific eventwhichmdashif it were to take placemdashwould 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 world

It is these events that create the world of ldquosuperstocksrdquo

14 PART ONE The Making of a Superstock Investor

Chap 01 7901 844 AM Page 14

C H A P T E R T W O

A Superstock Is Born

On August 3 1998 American Stores a supermarket and drugstorecompany jumped 53frasl4 points or 25 percent American Stores was thelargest percentage gainer on the New York Stock Exchange that daya day on which the Dow Jones Industrial Average dropped 96 pointsThe following day the Dow fell 299 points and American Storesonce again bucked the trend rising another 13frasl16

With that performance American Stores joined the ranks of thesuperstocksmdashstocks that have the ability to rise quickly and sub-stantially in price no matter what the general stock market is doing

What propelled American Stores into the ranks of the super-stocks A takeover 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 Storesrsquo 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 ldquocatalystrdquo waspropelling the price change and American Stores shareholderswatched their stock soar in price as the general stock market col-lapsed over a 2-day period

Takeover 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 dayrsquos closing price Itrsquos not uncommon fortakeover bids to drive a stock price higher by 25 percent 50 percent

15

Chap 02 7901 845 AM Page 15

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

or even more in a single daymdashusually in a single trade right at theopening bell following the announcement that Company A is offer-ing to buy Company B

And 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 finalpredictable event that is the culmination of a series of other eventsThey 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 donrsquot know what to look for

And herersquos 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 riskyoursquoll be taking is opportunity riskmdashand even that usually turnsout to be a temporary problem A neglected 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 underperfor-mance

And 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 2000

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 ldquoget richquickrdquo system backtested by computer and guaranteed to makeyou rich

This is a book for investors who recognize that successful invest-ing requires research and clear original thinking Itrsquos for investorswho understand that brains are often confused with bull markets andthat in a rising market anyone can look like a genius Those with theexperience or insight understand that the true test of investment

16 PART ONE The Making of a Superstock Investor

Chap 02 7901 845 AM Page 16

acumen comes when the general stock market is going against youThen and only then are the benefits of shrewd stock selection clear-ly apparent

Every 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 outcomemdasha profitable takeover bid

American 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 general

American 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 highercompletely disregarding the spreading weakness in the overall stockmarket That performance combined with the established takeovertrends in both the supermarket and drugstore industriesmdashtwo busi-nesses operated by American Storesmdashsuggested that American Storeswas acting like a potential superstock

When American Stores received a takeover bid from Albertsonson August 3 investors enjoyed large profits while the broad stockmarket was declining sharplymdashprecisely the result a superstock issupposed to deliver

By the time you finish this book yoursquoll know how to identifysuch potential superstocks as they tip their hand And by then yoursquollhave a framework to help you get started

CHAPTER TWO A Superstock Is Born 17

Chap 02 7901 845 AM Page 17

This page intentionally left blank

C H A P T E R T H R E E

Stock Selection

For most investors the traditional method of stock selection goessomething like this

Yoursquore sitting in your office trying to figure out where to go tolunch and the phone rings Itrsquos your broker

ldquoHello Mr SpinellirdquoldquoYesrdquoldquoTom Hayden from Dewey Pickum amp HowerdquoldquoOh Hi TomrdquoldquoListen Mr Spinelli our research department has come out

with their stock pick of the weekrdquoldquoIrsquom thrilled What is itrdquoldquoGeneral Electric We think itrsquos a great company at these pricesrdquoldquoYou need a research department to tell me General Electric is

a great companyrdquoldquoWell no the thing is we think theyrsquore going to beat the street

estimates by around a penny a sharerdquoldquoGeneral Electric has tripled over the past four years Itrsquos dou-

bled over the past year and a half Now you tell me to buy GeneralElectricrdquo

ldquoWell wemdashrdquoldquoWhat else do you likerdquoldquoWe like Dell ComputerrdquoldquoDell ComputerrdquoldquoYes Our research department thinks itrsquos amdashrdquoldquoI know itrsquos a great company What elserdquo

19

Chap 03 7901 846 AM Page 19

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

ldquoUh IBMrdquoldquoListen Tom no offense but I can hear about every one of these

stocks a hundred times a day on CNBC I can give you the entire listby heart I already own six mutual funds and these stocks are inevery one of them Every one Why donrsquot you guys recommend astock like WMS Industries Thatrsquos a great turnaround story thatnobodyrsquos talking about Plus the Chairman of Viacom has been buy-ing this stock on the open market and he owns 25 percent of thecompany He obviously thinks itrsquos undervalued Maybe hersquoll makea takeover bidrdquo

ldquoWMS IndustriesrdquoldquoYeahrdquoldquoUh Letrsquos see Here it is Well they have no debt And they

have lots of cashrdquoldquoExactly Itrsquos a great situationrdquoldquoWell no You see if they have no debt and they have lots

of cash we probably wouldnrsquot recommend itrdquoldquoWhy notrdquoldquoWell because they probably wouldnrsquot need to do any invest-

ment banking businessrdquoldquoAny whatrdquoldquoInvestment banking business See if they wanted to do a stock

or bond offering we could be their investment banker and then wersquodrecommend the stock Thatrsquos how it works with smaller companiesrdquo

ldquoIt doesrdquoldquoUsually yesrdquoBy the end of this conversation you have learned an invalu-

able lesson about Wall Street Much of the timemdashperhaps most ofthe timemdashmainstream 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 withbut they are also not even potential investment banking clients for

20 PART ONE The Making of a Superstock Investor

Chap 03 7901 846 AM Page 20

TEAMFLY

Team-Flyreg

the 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 poorguyrsquos 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

ldquoWe canrsquot get anybody to talk to usrdquo the president moanedldquoWhy notrdquo I askedldquoBecause we donrsquot want to do any banking business with the

brokerage firmsrdquoI asked him if he was jokingldquoNordquo he said ldquoThey 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 companyrdquo

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 targets

What 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

CHAPTER THREE Stock Selection 21

Chap 03 7901 846 AM Page 21

Imagine some poor junior analyst trying to convince his or herboss to recommend WMS Industries

ldquoMr GerardrdquoldquoYeahrdquoldquoI have this report Irsquod like you to look atrdquoldquoItrsquos a buy recommendation isnrsquot itrdquoldquoYesrdquoldquoBecause we donrsquot want to offend anybody Thatrsquos bad busi-

nessrdquoldquoYes I knowrdquoMr Gerard looks at the report ldquoWMS Industries huh Market

cap is only $500 million Thatrsquos pretty small for us How much do theywant to raiserdquo

ldquoExcuse merdquoldquoHow much money do they want to raiserdquoldquoUh I donrsquot think they want to raise any moneyrdquoldquoWhat do you mean they donrsquot want to raise money Look here

they have no debt Donrsquot they want to borrow some money Sellsome bondsrdquo

ldquoWell 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 andmdashrdquo

ldquoDo they want to acquire somebodyrdquoldquoNot that I know ofrdquoldquoWell then what are you bothering me for Get out of my office

Come back when you can recommend something that will generateus some revenuerdquo

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 clientEarnings 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

22 PART ONE The Making of a Superstock Investor

Chap 03 7901 846 AM Page 22

these stocks are so overvalued relative to their small-cap counter-parts that the pendulum must inevitably swing the other way

Years ago Doug Flutie electrified the college football world when hethrew a ldquoHail Maryrdquo 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 timescapped a stellar collegiate career for Flutie But after he graduatedFlutie 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 superstar

Flutiersquos shortcoming as far as the NFL was 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 yoursquore 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 downfieldAnd so the NFL said ldquoSorry too shortrdquo and Flutie went on to leadseveral Canadian Football League teams to championships

If you follow football at all you probably know the rest of thestory Flutie returned to the NFL in 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 Bowl

How 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 asideavoid the lumbering behemoths and scramble around until he spot-ted the receivers and completed passes

In his book Supermoney author George Goodman writing underthe name ldquoAdam Smithrdquo used the analogy of the small but nimblequarterback to point out that individuals can compete with the giantinstitutional investors by ldquotaking a quick look and stepping into thegaps between themrdquo 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

CHAPTER THREE Stock Selection 23

Chap 03 7901 846 AM Page 23

This page intentionally left blank

C H A P T E R F O U R

Investing Paradigms A New Way of Thinkingabout Stock Selection

A paradigm 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 wersquore 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 timeswe become dissatisfied with the results our actions create and itbecomes necessary to create a new paradigm

When it comes to selecting individual stocks 999 percent ofinvestors and Wall Street analysts are operating using a dog-earedshop-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 pricesThere are two problems with this paradigm First itrsquos been in exis-tence for nearly 20 years and itrsquos getting a bit creaky In fact itrsquos prob-ably on its last legs The second problem with this paradigm is thatitrsquos not new itrsquos only a new version of other paradigms that havecome and gone over the years The late 1960s version for examplewas called the ldquoOne-Decision Stock Paradigmrdquo In this version cer-

25

Chap 04 7901 846 AM Page 25

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

tain 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 wasnecessarymdashto buy them

That 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 normalrun-of-the-mill cyclical stocks

This book offers a new paradigmmdasha 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 favorWhen you read The Wall Street Journal ignore the market commentaryand the earnings digest and instead look for itemsmdashespecially smallitemsmdashthat 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 ldquogrowth through acquisitionsrdquo 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 andor 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 Report and 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 ldquoShareholder Rights Planrdquo designed to make a takeover more

26 PART ONE The Making of a Superstock Investor

Chap 04 7901 846 AM Page 26

difficult based on the theory that the company wouldnrsquot 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 ldquocatalystrdquo 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 bid

Finally 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 peersmdashoften a sign that some sortof takeover development is brewing

This way of thinking is new paradigm territory for 999 per-cent of investors and analysts At first it may seem difficult andunusual but if you have the courage to enter this new paradigmyou will find yourself in a fascinating new world where all sorts ofnew and exciting stock ideas will present themselves Yoursquoll 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 yoursquoll feel almost as if you can see the future andyou will marvel at the inability of others to do the same

And if you think thatrsquos exaggeration consider this real-lifeexample of old paradigm thinking versus new paradigm thinkingIn December 1998 I presented a front-page story in Superstock Investorentitled ldquoWater Utility Industry Could Be on the Verge of a TakeoverWaverdquo 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 placemdashthe purchase of Consumers Water byPhiladelphia Suburban and the purchase of National Enterprisesby American Water Worksmdashand that a third smaller takeover of

CHAPTER FOUR Investing Paradigms 27

Chap 04 7901 846 AM Page 27

Dominguez Water by California Water Service had just been an-nounced

In 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 basis

Later 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 $3705 per share a 50 percent premium over my original recom-mended price for Aquarion And remember we are talking hereabout a water utilitymdasha 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 takeoverCNBC 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 target

The 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 good

Unfortunately what followed was as classic an example of oldparadigm thinking as you could possibly hope not to see Here werethe questions Barr was asked

1 What are the possibilities of turning saltwater into drink-ing water

28 PART ONE The Making of a Superstock Investor

Chap 04 7901 846 AM Page 28

2 What about turning glaciers into drinking water3 What about turning icebergs into drinking water4 How difficult will it be for you to raise rates5 Do you think there might come a time when government

could confiscate your assets in the event of a water shortage6 What contingency plans have you developed in the event

terrorists attack the nationrsquos water supply

Terrorists Glaciers Icebergs These ridiculous questions are thetype that make superstock investors all across America groan withdisappointment A superstock investor would have immediatelyfocused on Mr Barrrsquos comment on growth through acquisitions andtried to pin him down with questions like these

1 What kind of water utility companies are you looking tobuy

2 What region of the country are you looking at for newgrowth opportunities

3 How big might a potential target be in terms of revenues4 What 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 Thatrsquoswhat 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 isnrsquot 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 yoursquore 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 ifyoursquore not used to thinking in these terms you miss golden oppor-tunities such as those the CNBC interviewers missed to bring newinformation to the surface

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

CHAPTER FOUR Investing Paradigms 29

Chap 04 7901 846 AM Page 29

plain view for everyone to see can be completely overlooked by themajority of investors and the people from whom they receive adviceand information

Just 10 months after this noninterview American Water Worksmade a takeover bid for SJW Corp SJW was on my recommended listas a takeover candidate Suppose for the sake of discussion one ofthe CNBC interviewers had asked J James Barr which region of theUS American Water Works might be looking at in terms of potentialacquisitions Suppose he had mentioned the western United StatesThis would have enabled superstock investors to zero in on the hand-ful of publicly traded western water utilities as possible targetsmdashSJW prominently among them But the question was never asked

And why wasnrsquot the question asked Well certainly not becausethe CNBC interviewers are not good at what 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 missedthe mark and the reason is that they were talking to a CEO who oper-ated in an obscure industry with a limited analytical following Upuntil 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 party

Making yourself aware of every industrymdasheven an obscureindustry like water utilitiesmdashthat is beginning to consolidate throughtakeovers requires a new way of thinking about the financial newsThe 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 ldquosuperstock paradigmrdquo and show youhow to think and invest within that new framework

But 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 letrsquos take a brief look atsome more of that landscape

30 PART ONE The Making of a Superstock Investor

Chap 04 7901 846 AM Page 30

TEAMFLY

Team-Flyreg

C H A P T E R F I V E

The Twilight of IndexInvesting

A lemming 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 Lemmingshowever 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 day

On Wall Street the herd instinct is a powerful force indeedProfessional money managers once they have been around for awhile discover there is great comfort in doing pretty much the samething everybody else is doing A certain 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 investing

We 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 naturalmdashand on Wall Streetit is extremely dangerous

31

Chap 05 7901 849 AM Page 31

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

The history of the stock market is replete with examples ofldquocanrsquot missrdquo investing techniques that were successful for a whileand then simply stopped working victims of an overpopularity thateventually created the seeds of their own destruction

In the 1960s for example small-cap stocks were all the rageWell-known large caps were viewed as too boring too predictableand 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 lemming

As 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 bornall of which were looking for the next IBM and all of which beganchasing smaller-cap stocks Eventually the bargains disappearedvictims 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 gears

More recently the focus has been on large-cap stocksmdashthe samelarge caps everybody used to shun If yoursquove heard it once yoursquoveheard it a thousand times The best way for individual investors tomake consistent profits in the stock market is to buy an ldquoindexrdquo fundthat tracks the performance of a broad-based stock market index likethe Standard amp Poorrsquos 500 Index which in turn represents a crosssection of Americarsquos most solid time-tested companies

Donrsquot try to pick individual stocksDonrsquot try to outsmart the stock marketDonrsquot go too far off the beaten path trying to find overlooked

values All pertinent information is so readily available and so wellanalyzed by the Wall Street geniuses that it is already processed andldquodiscountedrdquo by the market If yoursquore an individual investor donrsquoteven bother trying to find an edge It canrsquot be done

BaloneyLike lemmings stock market commentators and mutual fund

managers and investors who listen to their advice have run head-long toward the large-capindexing craze It sounds so simple whocan resist it This mantra has been repeated so often that you might

32 PART ONE The Making of a Superstock Investor

Chap 05 7901 849 AM Page 32

think 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 marketrsquos holy grailand that value asset-oriented stocks have always trailed the field

And yet those assumptions are not true Irsquom 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 maniamdashthat is the recent obses-sion with indexing and large-cap stocksmdashcontains the seeds of itsown destruction

Just a brief look at the past will prove the point Figure 5ndash1which tracks the relative performance of the SampP Low-Priced StockIndex to the SampP Big-Cap Index back to 1930 shows that smaller-capstocks and larger-cap stocks have taken turns outperforming eachother A rising 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 capsThe 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 again

What can we learn from this For one thing Anybody who tellsyou that the undisputed path to investment success is to index yourinvestments to the SampP 500 which is dominated by large-cap stockshas a limited sense of stock market history has never seen this chartor 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 itrsquos better to stop following the crowd

Early in 1999 the ldquovalue gaprdquo between large-cap and small-capstocks was at the highest level in history What this means is thatpriceearnings ratios accorded the large-cap stocks were at the high-est level ever relative to small-cap stocks

CHAPTER FIVE The Twilight of Index Investing 33

Chap 05 7901 849 AM Page 33

This fact combined with the historical evidence shown in Figure5ndash1 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

34 PART ONE The Making of a Superstock Investor

464

414

370

331

296

264

236

211

188

168

150

134

120

107

96

86

77

68

464

414

370

331

296

264

236

211

188

168

150

134

120

107

96

86

77

68Falling = High-Grade Leadership

Rising = Low-Priced Stocks Lead the Market

SampP Low-Priced Stock IndexSampP High-Grade Stock Index

1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995

F i g u r e 5ndash1

Relative Leadership Index

Chap 05 7901 849 AM Page 34

C H A P T E R S I X

Experts What Do They Know

When you get to a fork in the road take it Yogi Berra

By taking the fork in the road marked ldquosuperstock investingrdquo youoften will find that you have little if any analytical or ldquoexpertrdquo sup-port This may produce an uncomfortable feeling at first

This chapter is designed to get you over that feelingOnce you begin to think in terms of the ldquonew paradigmrdquo of stock

selection you will have to get used to the idea when you go off thebeaten path that yoursquore not going to have a lot of company In invest-ment terms the path in this book is definitely the road less traveled

Itrsquos perfectly natural for any investor to feel more comfortablewhen buying a stock that is recommended by a large number ofldquoexpertrdquo 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 hasnrsquot 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 day

35

Chap 06 7901 850 AM Page 35

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

In Heaven Can Wait James Mason an emissary from heavenreveals a basic truth of life when he tells Warren Beatty that ldquothelikelihood of a person being right increases in direct proportion to thenumber of people attempting to prove him wrongrdquo This is anotherway of saying that if you are looking for truth insight or really greatstock ideas donrsquot be afraid to go down that untrodden pathmdashanddonrsquot waver simply because most people donrsquot think the way youthink or canrsquot see what you see

When 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 yoursquoll learn to spot will strongly suggest thatbeneath 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 ie the ldquoexpertsrdquo

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 yoursquove 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 prices

It can be pretty lonely and sometimes spooky when yoursquorestrolling down the untrodden superstock path

To 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 ldquoexpertsrdquo are wrong wersquoll show you some world-class exam-ples of expert opinion that turned out to be completely off the mark

WHAT IS AN ldquoEXPERTrdquo ANYWAY

One wonderful definition is that an expert is ldquosomebody from outof townrdquo which is another way of saying that distance lends enchant-ment

Another definition and probably the best one for our purpos-es would identify an ldquoexpertrdquo 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-

36 PART ONE The Making of a Superstock Investor

Chap 06 7901 850 AM Page 36

sion of media outlets in recent years devoted to finance and invest-ing including the proliferation of financial Web sites this definitionof an ldquoexpertrdquo would have to be considered fully diluted if you getmy drift

ldquoExpertsrdquo have always had a difficult time predicting the futurealthough this has never stopped any of them from making predic-tions And it probably will not surprise you to learn that the USgovernment ranks right up there when it comes to the list of ldquoexpertsrdquowho have made pronouncements about the future that have turnedout to be spectacularly wrong

For example every now and then over the past 30 years wehave been subjected to an ldquoenergy scarerdquo 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 ldquoenergy doomsday scenariordquo havebeen going on for the last 115 years

Take a look at the list of predictions about energy supplies fromvarious US government agencies given in Table 6ndash1 and rememberit well the next time some bureaucrat or Wall Street analyst tells youthat oil or gas supplies are running out

But 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 thingeven genuine experts are out there taking their best educated guessjust 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 time

One 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 Time or Newsweekitrsquos time to consider the possibility that this particular trend has pret-ty much run its course A classic example of this phenomenon is theNewsweek cover dated December 2 1974 entitled ldquoHow Bad aSlumprdquo When this issue of Newsweek hit 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

CHAPTER SIX Experts What Do They Know 37

Chap 06 7901 850 AM Page 37

rates were in the stratosphere So ldquoHow Bad a Slumprdquo 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 peaked

A more recent example of a magazine cover signaling the end ofa financial trend was the December 27 1999 issue of Time magazinein which Amazoncom founder Jeff Bezos was named Timersquos ldquoPersonof the Yearrdquo That issue of Time coincided with the exact peak ofAmazoncomrsquos stock price which proceeded to fall from $113 to aslow as $1938 over the following year This does not imply that JeffBezos did not deserve the honormdashonly that Timersquos 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 Timersquos cover story signaled the end of the bull market notonly for Amazoncom but for every other Internet stock all of whichplunged dramatically during 2000 and many of which actually wentcompletely out of business

38 PART ONE The Making of a Superstock Investor

T a b l e 6ndash1

ldquoExpertrdquo Oil Supply Predictions from the USGovernment

Year Prediction

1885 Little or no chance for oil discovery in California (US Geological Survey)Little or no chance for oil to be discovered in Kansas or Texas (USGeological Survey)

1891 Little or no chance for oil to be discovered in Kansas or Texas (USGeological Survey)

1908 Maximum future supply of oil to be discovered in the United States will be225 billion barrels (US Geological Survey) (Note By 1949 35 billion barrels had already been discovered with another 27 billion barrels proven and available)

1914 Total future US production of oil will be a maximum of 57 billion barrels(US Bureau of Mines) (Note By 1976 another 34 billion barrels had beendiscovered with no end in sight)

1939 US oil supplies will last only 13 more years (US Department of theInterior)

1947 Sufficient oil for US energy consumption can no longer be found in theUnited States (US State Department)

1948 End of US oil supply almost in sight (Secretary of the Interior)

Source Herman Kahn The Next 200 Years (William Morrow amp Co New York 1976)

Chap 06 7901 850 AM Page 38

This 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 Illustrated ran a cover story on theinvincible Oakland Arsquos who were about to face the Cincinnati Redsin the World Series

ldquoThe 1988 Arsquosrdquo the story said ldquoare the best team the AmericanLeague has sent to the World Series since Charlie Finleyrsquos teams ofthe early 1970s These Arsquos may be even betterrdquo Having thus beenanointed one of the greatest baseball teams of all time the Arsquos wenton to lose four straight World Series games to the Cincinnati Reds

The ldquoexpertsrdquo arenrsquot very good at predicting recessions eitherEconomic recessions do not announce their arrival the way Jack

Nicholson announced his arrival in The Shiningmdashby breaking downa door with an axe and scaring Shelly Duval out of her wits as heannounced ldquoHoney Irsquom homerdquo Rather recessions tend to arriveon muffled oars quietly arousing little or no suspicion until one daythe Commerce Department announces that ldquoGuess 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 momentrdquo

Yet another classic example of the ldquoexpertsrsquordquo inability to pre-dict recessions was evident in July 1989 when Fortune announcedthere would be ldquoNo recession this year or nextrdquo Of course the reces-sion of 1990 was already in the process of beginning but none of theexperts Fortune relied on saw it coming

Just take a look at thr chronology of headlines in Table 6ndash2 tosee how much help the ldquoexpertsrdquo will be in preparing you for the nextrecession

CHAPTER SIX Experts What Do They Know 39

T a b l e 6ndash2

Chronology of Headlines

Source Headline

Fortune July 17 1989 ldquoNo Recession This Year or Nextrdquo

Newsweek September 1989 ldquoIs there Ever Going to Be Another Recessionrdquo

New York Times February 1990 ldquoEconomyrsquos Slide May Have Ended Greenspan Saysrdquo

Investorrsquos Business Daily January 1991 ldquoItrsquos Official The US Is in a Recession But It Wonrsquot Last Long Government Saysrdquo

Chap 06 7901 850 AM Page 39

You can also use the media to call turning points in both interestrates and oil prices Herersquos a classic On September 16 1987 The WallStreet Journalrsquos front page lead story was headlined ldquoThe Bond BearsDebt Securities Prices May Slide for Years Many Analysts Thinkrdquo

The implication was that interest rates would be rising for yearsinto the future This front-page story amazingly enough coincidedwith the exact peak in long-term interest rates When this storyappeared the 30-year Treasury bond was yielding around 1025 per-cent (see the arrow on the chart in Figure 6ndash1)

Bond prices then embarked on a relentless 6-year rally whichcarried the yield on the 30-year Treasury down below 6 percent bylate 1993

In another classic example Associated Press managed to catchthe exact bottom in crude oil when it ran a story on March 9 1986entitled ldquoNo Bottom to Oilrdquo Again check the arrow on the chart inFigure 6ndash1 This story managed to appear at the precise bottom in the

40 PART ONE The Making of a Superstock Investor

11

10

9

8

7

6

9075604530150

ndash15ndash30ndash45

36343230282624222018161412

11

10

9

8

7

6

907560453015

0ndash15ndash30ndash45

36343230282624222018161412

30-Year Constant Maturity Treasury Bond Yields

BOND PRICES MAY SLIDE FOR YEARS

NO BOTTOM FOR OIL

30-Year Treasury Yield PointsAnnum When

63-Day Change in Points ofCrude Oil Is Annum Time

Above 118 25 135Between ndash5 and 118 ndash43 546ndash5 and Below ndash75 319

West Texas Intermediate Crude Oil(NY Mercantile Light Sweet13-Week Perpetual Contract)

$ Per Barrel

72498 = 1455

72498 = ndash89

2144 2227

1800

3650

1735

2332

1807

2263

1885

2114

1434

1971

1694

1971

1657

2478

1916

1429

Crude Oil Prices63-Day Rate of Change

M1985

J S D M1986

J S D M1987

J S D M1988

J S D M1989

J S D M1990

J S D M1991

J S D M1992

J S D M1993

J S D M1994

J S D M1995

J S D M1996

J S D M1997

J S D M1998

J

F i g u r e 6ndash1

Examples of How the Media Can Call Turning Points

Source Ned Davis Research 2100 Riveredge Parkway Suite 750 Atlanta GA 30328

Chap 06 7901 850 AM Page 40

TEAMFLY

Team-Flyreg

price of oil which rose from $12 to $3650 a barrel within 4 years ofthe storyrsquos appearance

How did The Wall Street Journal manage 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 Journal andAssociated Press reporters went to their ldquoexpertrdquo sources thesesources had also gotten used to a trend that had been in force andsimply extrapolated that trend into the future Itrsquos 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 out

Pack 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 Fortune hit the newsstands the very week of the1987 stock market crash and it said ldquoWhy Greenspan Is Still BullishrdquoOn October 19 1987 the same week this issue appeared the Dow JonesIndustrial Average fell 508 points a 1-day plunge of 18 percent

Of 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 ldquohard timesrdquo were coming andthat investors and businesspeople should batten down the hatchesWrong again The media went overboard on the meaning of the 1987crash just as it went overboard on the rally that preceded the debacleThe consensus of the media and its ldquoexpertsrdquo 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 SamuelsonNewsweekrsquos economic columnist and a man about as mainstream asyou can get ran a column after the crash entitled ldquoThe Specter ofDepressionrdquo in which he asked the question Did the market crashserve as a warning that an economic depression was imminent Hisanswer delivered not entirely convincingly ldquoProbably notrdquo

CHAPTER SIX Experts What Do They Know 41

Chap 06 7901 850 AM Page 41

As 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 US economic advance that contin-ued with only brief interruptions for more than a decade

But you sure wouldnrsquot have guessed that in October 1987 if youhad listened to the ldquoexpertsrdquo

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 News ran abanner headline on page 5 ldquoEXPERTS NO RECESSIONrdquo I donrsquotknow about you but I did not find this headline reassuring

WHY EXPERTS CAN BE WRONG

So what is it with these ldquoexpertsrdquo anyway How can so many well-informed people be so wrong so often

Part of the problem may be that the pool of ldquoexpertsrdquo is gettingdiluted

A few 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 radio

Not anymore These days talk shows have multiplied to suchan extent that the supply of ldquoexpertsrdquo has increased to meet thedemand Of course common sense will tell you there is a limitedsupply of experts on any particular subject but this doesnrsquot seem tomatter very much because there is so much babble sprouting up inall forms of media that itrsquos possible to say almost anything no mat-ter how outlandish or uninformed and get away with it

The proliferation of Internet financial sites has also createddemand for more ldquoexpertsrdquo Every site needs columnists and ldquoana-lystsrdquo to expound on the daily developments on the financial sceneMost of them are excellent writers and it sure sounds like they knowwhat theyrsquore 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 ldquomomen-tumrdquo and ldquoindexrdquo investing

Itrsquos tough to tell if yoursquore reading truly informed analysis orjust plain nonsense that has been created to provide content

42 PART ONE The Making of a Superstock Investor

Chap 06 7901 850 AM Page 42

This nonsense cuts across ideological boundaries No matterwhat your personal political or business agenda it is possible toput your own ldquospinrdquo on almost anythingmdasheven historical mattersthat are not really open to debatemdashand 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 ldquothose gas lineswere a direct result of foreign oil powers playing tough with us becausethey didnrsquot fear Jimmy Carterrdquo But the firstmdashand worstmdashOPEC oilprice hike took place between 1973 and 1974 during the administra-tion of Richard Nixon Not only that but one reason for OPECrsquos 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 oil

Everywhere you look ldquoexpertsrdquo are spinning facts to promotean agenda To this day Democrats still try to deny that the economyperformed well under Ronald Reagan

Oliver 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 Live by calling the tapes ldquoallegedtapesrdquo which apparently means that North could not even bringhimself to acknowledge that such tapes even exist If he had acknowl-edged their existence after all it would have reflected badly onFalwell a philosophical and political ally

Everybody 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 days

When the media confronted Bellersquos agent the agent borroweda page from the OJ Simpson defense playbook and claimed the inci-dent was ldquoconcocted by the Chicago White Soxrdquo

So given the surging supply of ldquoexpertsrdquo and the heightened prob-ability that any given expert you may be listening to is promoting anagenda donrsquot be terribly concerned if you seem to have uncovered anexciting stock or two that is totally bereft of analytical ldquosponsorshiprdquo

CHAPTER SIX Experts What Do They Know 43

Chap 06 7901 850 AM Page 43

Even Federal Reserve Chairman Alan Greenspan is a ldquospinnerrdquowith an agenda In his book The Agendamdashan appropriate title for thisdiscussionmdashauthor Bob Woodward says that Greenspan managed toconvince thenndashTreasury Secretary Lloyd Bentsen early in PresidentClintonrsquos first term that the bond market would respond favorably ifthe Federal Reserve were to begin raising interest rates Bentsenimpressed with Greenspanrsquos reasoning performed the spin on Clintonwho 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 Reserversquos interest rate hike

So one reason why an ldquoexpertrdquo may be off the mark is that heor she is selling you a bill of goods ie promoting an agenda ratherthan trying to get at the truth

Another reason experts donrsquot always hit the mark is that theyare not really trying to deliver the goods for a different reason andthat reason is that theyrsquore not always rewarded for telling the truthmdashespecially when the truth is something their superiors do not wantto hear Sometimes they are even punished for telling the truth

In his book 1929 Again author Terry R Rudd points out thatldquoone of the underlying problems making it virtually impossible forknowledgeable people to tell us the truth is that we canrsquot accept itwithout reacting unfavorablyrdquo

ldquoWhen the recipient doesnrsquot receive news in a manner beneficialto the giver ldquo Rudd writes ldquothere is no incentive for the giver to do sordquo

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 scene

Perhaps 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 ldquoSooner 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 depressionrdquo

Now that is about as accurate as you can get in terms of pre-dicting the stock market and the economy Babsonrsquos reward was that

44 PART ONE The Making of a Superstock Investor

Chap 06 7901 850 AM Page 44

he 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 ldquowe will not be stam-peded into selling stocks because of the gratuitous forecasts of awell-known statisticianrdquo

The stock market actually began declining on the very dayBabson made his historical forecast and that particular drop becameknown as the ldquoBabson Breakrdquo By late October the crash that Babsonhad predicted was under way culminating on ldquoBlack TuesdayrdquoOctober 29 1929 the worst day in stock market history

And what was Babsonrsquos 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 Babsonrsquos ldquofearmongeringrdquo

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 ldquosellrdquo signal on a big-name company with apopular stock and a penchant for doing investment banking business

Therefore you should not expect much help from the ldquoexpertsrdquowhen 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 attitude

One of the all-time great examples of an ldquoexpertrdquo 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 destruction

And so the father of the ldquoKondratieff Waverdquo 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 at

Not all experts receive such harsh treatment for trying to reportthe truth as they perceive it Some of them like the brokerage firm

CHAPTER SIX Experts What Do They Know 45

Chap 06 7901 850 AM Page 45

analyst who issued a negative report on one of Donald Trumprsquos com-panies several years ago merely got fired

Others meet with a more subtle form of resistance

Case Study Sunbeam Corp

If you want to get a feel for how difficult it can be for mainstream WallStreet analysts to say ldquosellrdquo 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 Corpfrom buy to hold

Sunbeam 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 shareholders

Wall 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 plantsand issue optimistic projections for the future Wall Street totallybought Dunlaprsquos performance and Sunbeam shares took offVirtually every analyst who followed Sunbeam sang Dunlaprsquos prais-es and expected a breathtaking turnaround followed by an eventu-al takeover of Sunbeammdashin other words they expected an exactreplay of the Scott Paper scenario

Mr 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 phenomenonmdashbut he recommendedthe stock along with everyone else based on the premise that Dunlaprsquosname and reputation alone would probably take the stock for quite aprofitable ride The trick he thought would be to get out in time

Finally in 1997 Andrew Shore began to notice warning signsdeep within the Sunbeam financial statements filed with the SEC As

46 PART ONE The Making of a Superstock Investor

Chap 06 7901 850 AM Page 46

it 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 Sunbeamrsquos financial situation hecould only bring himself to change his rating from buy to ldquoneutralrdquoBut even this move which in retrospect proved to be a timid andincomplete decision made him a virtual Nostradamus compared tohis colleagues

The first reaction to Mr Shorersquos 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 ldquoYourealize what yoursquore doing here donrsquot yourdquo he asked Shore

ldquoIf wersquore wrong wersquore going to be firedrdquo Shore replied ldquobutwe have to do thisrdquo Shore even felt compelled to contact the legalcompliance department at PaineWebber to explain his downgrade ofSunbeam before the downgrade was issued

When 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 firedmdashfiredmdashif 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 later

On April 3 1997 Andrew Shore got on the PaineWebberldquosquawk boxrdquo and reported his downgrade to PaineWebberrsquos 5000stockbrokers Within minutes Sunbeam stock dropped $4 a shareShortly thereafter when Andrew Shore checked his voice mail hewas stunned to hear a barrage of ldquocaustic and bitter messagesrdquo ldquoMostof the callersrdquo author John A Byrne says ldquowanted Shore firedrdquo

Shore according to Byrne who documented these events in hisbook Chainsaw was ldquohorrified by the contentrdquo of the messages whichranged from calling him ldquostupid and irresponsiblerdquo to even worse

ldquoIt was a nightmarerdquo said Shorersquos assistant who bore the bruntof the flak from clients and brokers reacting to Shorersquos downgrade

The story had a happy ending for Andrew Shore Shortly afterthe downgrade Sunbeam shocked Wall Street with the announce-

CHAPTER SIX Experts What Do They Know 47

Chap 06 7901 850 AM Page 47

ment that earnings would come in far below expectations Thosewho had acted on Shorersquos advice saved a bundlemdashand of coursethe congratulatory calls began to flow in

Lessons 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 ldquoneutralrdquo 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 $025 down 99 percent from its Dunlap-maniahigh as the news from Sunbeam got progressively worse

But even that downgrade to neutral caused fear and soul-search-ing for Andrew Shore which gives you an idea of why so few ldquosellrdquorecommendations 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 ldquomessengerrdquo 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

ldquoA sell signal from an analyst is as common as a Barbra Streisand concertrdquo Arthur Levitt Chairman of the Securities amp Exchange Commission

It 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 colleaguesyou 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

48 PART ONE The Making of a Superstock Investor

Chap 06 7901 850 AM Page 48

But 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 Journal ran a story enti-tled ldquoBearish Call on Banks Lands Analyst in Doghouserdquo The storydescribed the travails of Michael Mayo of Credit Suisse First Bostonand 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 dry

The head trader at Sun Trust Funds said The Wall Street Journalldquoangrily grabbed a picture of Mr Mayo blew up the photo on thecopier scribbled lsquoWantedrsquo over his face and pinned it to her bul-letin boardrdquo When questioned about this response by The Wall StreetJournal the trader replied that ldquomy impression [of Mr Mayo] as ahuman being is that hersquos somewhat self-promotionalrdquo as thoughthis were a rare trait among analysts on Wall Street

Another bank analyst angered by the sell signal referred toMayo derisively as ldquoMayo-naiserdquo in a conference call with clientsaccording to The Wall Street Journal Other analysts also questionedMayorsquos 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 Magazine

Even after Michael Mayorsquos negative call on bank stocks turnedout to be accurate the critics refused to let up on him A few 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 ldquosellrdquo on Bank One (ONE) at$5981 a share the stock ultimately fell as low as $2319 following thedisappointing earnings a 61 percent decline

But 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 for

Mayorsquos general negative attitude toward the bank stocksstemmed from his belief that the earnings growth being reported by

CHAPTER SIX Experts What Do They Know 49

Chap 06 7901 850 AM Page 49

many banks was of ldquolow qualityrdquo in other words the accountantswere becoming increasingly creative in their ongoing effort to giveWall Street the earnings momentum it craved and expected Anyonewho understands financial accounting knows there are about 50 dif-ferent and perfectly acceptable ways to look at almost everythingand that your earnings may be up 5 percent up 10 percent or evendown 10 percent depending on which way the accountants decidethey are going to paint the picture this particular quarter

Eventually though the accountantsrsquo bag of tricks gets deplet-ed and if a company is not growing all that rapidlymdashor worse if cre-ative accounting has directed analytical attention away from a fes-tering problemmdashthe piper must be paid

This is not an uncommon occurrence with popular stocks thatare under tremendous pressure to meet Wall Street expectations andthe general observation that a particular company or an industry ingeneral has begun to resort to accounting gimmicks to meet WallStreet expectationsmdashie that reported earnings are of ldquolow qualityrdquoas Mayo statedmdashis a valid and sufficient reason to turn negative Ifyou smell something rotten you donrsquot have to rummage through thegarbage to figure out what it ismdashyou can just walk away from it

When 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 Mayorsquos critics up

But it wasnrsquotldquoCritics sayrdquo The Wall Street Journal reported with a straight

face ldquothat Mr Mayo had not pinpointed the credit card problemrdquoWhen another bank stock cited by Mayo as having ldquopoor earn-

ings qualityrdquomdashNational City Corpmdashwarned that earnings wouldbe lower than expected that stock took a nosedive as well But TheWall Street Journal pointed out ldquoMr Mayo didnrsquot specifically have alsquosellrsquo recommendation on that stockrdquo

The overall tone of The Wall Street Journal story 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 clients

You can see that the bar is raised considerably higher when youare bearish than when you are a conforming bull The Wall StreetJournal could have run a story about the 99 percent of analysts who

50 PART ONE The Making of a Superstock Investor

Chap 06 7901 850 AM Page 50

TEAMFLY

Team-Flyreg

were incorrectly bullish on Bank One for example and interviewedtheir clients to see how they enjoyed riding that stock down by 61percent But it didnrsquot Instead The Wall Street Journal dissected Mayorsquosbearish (and correct) call with a fine-tooth comb and created theimpression that while he turned out to be right he wasnrsquot really allthat right and that he was a publicity hound to boot

Michael Mayorsquos 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 ldquoItrsquos hard to doinvestment banking for a client with an analyst who is negative onthat clientrdquo a source told Reuters

It doesnrsquot work the other way around by the way If yoursquore acheerleader for a stock and it goes up nobody complains that itdidnrsquot go up for the reasons you said it would Yoursquore just a brilliantanalyst who made the right call But if yoursquore 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 indefinitelymdashif you say all that and youturn out to be rightmdashthat 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 anyway

The 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 disappointment

Back 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-panyrsquos prospects they could barely contain themselves The stockhad run up from $010 a share to $130 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 cancer

Everything was going swimmingly until the scientist who ranthe company called the president of the brokerage firm with the badnews that the process doesnrsquot work

ldquoWhat are you talking aboutrdquo the brokerage firm presidentsaid

CHAPTER SIX Experts What Do They Know 51

Chap 06 7901 850 AM Page 51

ldquoWe cannot cure cancer with shark fluidsrdquo the scientist saidldquoYes you canrdquo said the brokerage firm presidentldquoNo we canrsquotrdquo said the scientist ldquoThe process doesnrsquot workrdquoldquoYes it doesrdquo said the brokerage firm presidentThe scientist was taken aback at this response ldquoI wish it did

workrdquo he said again ldquoBut it doesnrsquotrdquoldquoHold onrdquo said the brokerage firm presidentWhen 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 indeedcure cancer through the use of shark fluids

The scientist tried his best to hold his ground ldquoIt doesnrsquot workrdquohe said pleadingly

ldquoIt has to workrdquo screamed one broker ldquoYour stock is at $130all of my clients own it and wersquore almost ready to do your secondaryofferingrdquo

And so at the urging of his ldquoconstituencyrdquo 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 wellas he continued his research that the process didnrsquot work

The scientist admitted long after the fact that listening to thoseguys nearly convinced him that he had missed something

I was reminded of this story on December 1 2000 when TheNew York Times reported that certain analysts were ldquoskepticalrdquo ofcomputer maker Gatewayrsquos 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 slumpdidnrsquot 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 ldquooverreactingrdquo which onlygoes to show you that whether wersquore talking about shark fluids andpenny stock brokers or computers and big-time Wall Street analysts

52 PART ONE The Making of a Superstock Investor

Chap 06 7901 850 AM Page 52

there are few things so constant as human nature As songwriterPaul Simon reminded us in The Boxer ldquoa man sees what he wants tosee and disregards the restrdquo That is a fundamental truth of WallStreet that every investor should keep firmly in mind

So one thing to keep in mind when yoursquore listening to the opin-ion of an expert Who is the expertrsquos constituency Or to put it morebluntly who pays the expertrsquos salary If it isnrsquot youmdashand it usuallywill not be youmdashconsider the possible agenda of the expert andorconstituency and view the expertrsquos point of view in that light

Even 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 6ndash2 shows

IT ALSO REALLY HELPS IF YOU CAN MAINTAINSOME PERSPECTIVE

ldquoTo understand what the outside of an aquarium looks like it is better not to be a fishrdquo Andreacute Malraux

Back in 1974 when I was working as a junior analyst on Wall StreetI 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 Street

In 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 anywayThings were so slow that a major investment magazine ran a coverstory entitled ldquoThis Is Not Just a Bear Market This Is the Way ThingsAre Going to Be from Now Onrdquo (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

CHAPTER SIX Experts What Do They Know 53

Chap 06 7901 850 AM Page 53

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

54 PART ONE The Making of a Superstock Investor

F i g u r e 6ndash2

ldquoExpertsrdquo and Their Statements

bull It was ldquoexpertrdquo Jimmy the Greek who declared ldquoImpossiblerdquo 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

bull It was ldquoexpertrdquo Thomas Edison who said in 1922 that ldquothe radio craze will die outin timerdquo

bull It was ldquoexpertrdquo Harry Warner President of Warner Bros who in 1927 laughed atthe idea of using sound in motion pictures saying ldquoWho the hell wants to hearactors talkrdquo

bull It was ldquoexpertrdquo Emmeline Snively Director of the Blue Book Modeling Agencywho told Marilyn Monroe in 1944 ldquoYoursquod better learn secretarial work or else getmarriedrdquo

bull It was an ldquoexpertrdquo (a United Artists executive) who turned down actor RonaldReagan for the starring role as the President in The Best Man by saying ldquoRonaldReagan doesnrsquot have that presidential lookrdquo

bull It was ldquoexpertrdquo Jim Denny manager of the Grand Ole Opry who told ElvisPresley on September 25 1954 ldquoYou ainrsquot goinrsquo nowhere son You ought to goback to driving a truckrdquo

bull It was ldquoexpertrdquo Ken Olson President of the Digital Equipment Company who saidin 1977 ldquoThere is no reason for any individual to have a computer in their homerdquo

bull It was ldquoexpertrdquo Charles H Duell Commissioner of the US Office of Patents whourged President William McKinley to abolish the Patent Office in 1899 based onthe incredible logic that ldquoEverything that can be invented has been inventedrdquo

bull It was ldquoexpertrdquo Professor of Economics Irving Fisher of Yale University whodeclared on October 17 1929 ldquoStocks have reached what looks like a perma-nently high plateaurdquo

bull It was ldquoexpertrdquo Thomas J Watson Chairman of IBM who declared in 1943 ldquoIthink there is a world market for about five computersrdquo

bull It was ldquoexpertrdquo Eric Easton manager of the Rolling Stones who said of MickJagger in 1963 ldquoThe singer will have to gordquo

Source Christopher Cerf and Victor Navasky The Experts Speak (Pantheon Books New York 1984)

Chap 06 7901 850 AM Page 54

My friends got a big laugh out of that oneA few days later I published my weekly stock market ldquoreportrdquo

in which I imagined what it would be like if Howard Cosell FrankGifford and ldquoDandyrdquo Don Meredith the hosts of ABC-TVrsquos MondayNight Football were to host a live daily television program directfrom the New York Stock Exchange

As 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 dayrsquos stock market action

Meanwhile Don Meredith a former Dallas Cowboysrsquo 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 scoops

What a laugh right Little did I knowTherersquos nothing wrong with minute-by-minute analysis of the

financial 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 results

And 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 thereon live television and respond to question after question from view-ers calling on the telephone asking about a series of random stocksHow can this ldquoexpertrdquo possibly provide a thoughtful informedresponse on every single question)

You can wonder about all of this but you canrsquot 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 tradingbased on instant analysis is a perfectly acceptable way to approachthe stock market Just ask any trader

CHAPTER SIX Experts What Do They Know 55

Chap 06 7901 850 AM Page 55

But 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 minutes

You 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 estimatesdown to the last penny you will also know the ldquowhisper numberrdquo youwill know if the company that has just reported earnings managed tobeat the official estimate the ldquowhisper numberrdquo 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 moment

You 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 perspective

This vantage point involves looking for stocks that are showingsigns that something significant is changingmdashfor the bettermdashon 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 business

In this book you will learn how to spot some of the Telltale Signsthat will enable you to buy these out-of-favor stocks with confidenceWe will show you how to determine when a formerly sleepy seem-ingly uninteresting stock may be about to emerge as a huge winner

In short we have arrived at a fork in the stock market roadmdashthis book will take you on a trip down the road less traveled

And once yoursquove been down this road you will never look atthe frantic three-ring circus of urgent day-to-day stock market com-mentary and ldquoexpertrdquo analysis in quite the same way

56 PART ONE The Making of a Superstock Investor

Chap 06 7901 850 AM Page 56

C H A P T E R S E V E N

What Is Value

Yoursquove heard a lot about ldquovalue investingrdquo 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

1 What is ldquovaluerdquo2 Why canrsquot a stock that is undervalued remain underval-

ued theoretically indefinitely

Itrsquos 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 ldquoIn the long run weare all deadrdquo

What we need is an investing approach that not only focuses onldquovaluerdquo but also provides for some sort of catalystmdashsome outsideeventmdashthat will literally force the stock market to take an under-valued stock and reprice it at a higher more appropriate value

Letrsquos start with this premise A stock is worth what the stockmarket says it is worth on any given daymdashno 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 now

Where does that price come fromIt comes from two places (1) earnings expectations and (2) the

present value the market is willing to place on those earnings expectations

57

Chap 07 7901 851 AM Page 57

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

Think of a stock as representing a small piece of ownership inan estimated future stream of earnings Those earnings are unknownand investors rely on the best guesses of Wall Street analysts to deter-mine what theyrsquoll be When you buy a share of stock today yoursquorebuying a stake in that future earnings stream

Of course analyst estimates of that future earnings stream maybe wildly off the mark which adds another major variable to thequestion of determining value But letrsquos assume charitably that theanalysts are going to get it right and you know precisely what a com-pany will earn over the next 10 years

Even 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 priceearnings ratio And if you think predicting earningsis difficult you havenrsquot seen anything yet

Take a look at Figure 7ndash1 which shows the priceearnings ratioof the Standard amp Poorrsquos 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 earningsmdashbut a wildly different con-cept of value

58 PART ONE The Making of a Superstock Investor

Bargains

Expensive

Average from 1970 to 1998 = 1465Average from 1950 to 1998 = 1478

63098 = 2625

1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 199528272625242322212019181716151413121110987

28272625242322212019181716151413121110987

Norm (- - -)

F i g u r e 7ndash1

SampP PriceEarnings Ratio

Chap 07 7901 851 AM Page 58

What causes priceearnings ratios to shift so dramaticallyThe major determining factor is interest rates When interest

rates rise priceearnings ratios tend to fall When interest ratesdecline priceearnings ratios tend to rise

There are two reasons for the profound effect of interest rateson priceearnings 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 stocks

For some investors the stock market competes for funds withthe bond market Stocks carry risk but long-term bonds carry lessrisk A 20- 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 Stocksobviously carry no such guarantee

When other money managers are deciding whether to commitmore or less capital to the stock market what theyrsquore really lookingat as an alternative is the ldquono-riskrdquo alternativemdashcash

By ldquocashrdquo 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 priceearnings multiple placedon a given level of earnings

Suppose 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 A teamof 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 thatrsquos been left for you to manage there will be enough moneyto pay the retirees and everyone will be happy

CHAPTER SEVEN What Is Value 59

Chap 07 7901 851 AM Page 59

As you sit there and survey the investment scene you see thatlong-term US government bonds are yielding 6 percent That willdo you no good because you need to earn 8 percent or the retireeswill be calling you up for loans so they can maintain their standardof living 20 years from now The yield on money market funds at 475percent is even less

To earn the required 8 percent therefore you will have to takesome riskmdashand that means yoursquoll have to invest in the stock marketAlthough stocks do not come with guaranteed returns they do offerupside growth potential And since therersquos no other way to get the8 percent you need you take the plunge into the market

Across the street there is another money manager in charge ofanother company pension fund His job is just like yours except hiscompany has a lousy union and the pension benefits for its retireesare going to be a lot less than yours According to the actuarial tablesthe money manager across the street needs to earn only 65 percenton his investments to fund the retirement plan

So yoursquore both in the same boatmdashat least for now You need toearn 8 percent and the money manager across the street needs toearn 65 percent but neither one of you can get what you want inbonds or money market funds so yoursquore both buying stocks

Now letrsquos 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 planBut the money manager across the street now faces an interesting sit-uation He needs 65 percent to fund his plan he can get 7 percent inUS 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 stressAnd 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 ldquocashrdquoinvestments like money funds and short-term treasury bills alsoreaches 7 percent he will likely move a lot more money out of stocks

In other words as interest rates on less risky investments risea certain amount of money will leave the stock market to lock in thatreturn At 7 percent a certain number of investors will determine

60 PART ONE The Making of a Superstock Investor

Chap 07 7901 851 AM Page 60

TEAMFLY

Team-Flyreg

that 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 investorrsquos goal which isone reason why rising interest rates almost always put downwardpressure on the stock market

The 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 Greenspanrsquos briefcase as a potential clue as to whetherthe Federal Reserve is about to shift its interest rate policy

There is another reason why rising interest rates usually meanlower stock prices Itrsquos a bit more complicated but its worth know-ing and it explains a big part of the mystery of the wildly gyratingpriceearnings ratios touched on earlier

This concept is called ldquodiscounted present valuerdquo 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 todayAgain what the market is willing to pay today for those future earn-ings is the priceearnings ratio

Letrsquos use this exampleSuppose Totterrsquos Rollerblades Inc (TRI) is estimated to earn a

grand 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 highthe present value of 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 higher

For 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

CHAPTER SEVEN What Is Value 61

Chap 07 7901 851 AM Page 61

Think 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 Totterrsquos 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 earningsprojectionsmdashthe only difference is what those earnings are worthright now in any given interest rate environment

That in simplified terms is how most stocks trade For the mostpart theyrsquore at the mercy of earnings forecasts that are constantlychanging and may or may not be on the mark and theyrsquore 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 accurate

Given all of this how can anyone define ldquovaluerdquoLet me tell you one wayWhen thinking of value think of this What would a company

be 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 operates

The actual value of a stockmdashas a businessmdashis only fleetinglyrelated if it is related at all to the gyrations of the stock marketAgain 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 itrsquos there

The only time this concept of value matters is when someoneis willing to step up to the plate to pay that value In other wordswhen a takeover bid takes place

My concept of a ldquovaluerdquo situation therefore is stocks that are sell-ing at clearance-sale prices significantly below their value as a businesswhere 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

62 PART ONE The Making of a Superstock Investor

Chap 07 7901 851 AM Page 62

When 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 levelmdashas a businessmdash and it is nolonger subject to the whims of the stock market and all of the unpre-dictable variables that determine where most stocks trade

You may think that choosing stocks that are likely to becometakeover targets is an impossible task The reason why you maythink this way is that yoursquove 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 candidates

But picking takeover targets is not an impossible taskAs 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 bid

By 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 of

You will be on the lookout for superstocks

CHAPTER SEVEN What Is Value 63

Chap 07 7901 851 AM Page 63

This page intentionally left blank

C H A P T E R E I G H T

If Everybody KnowsEverything Then NobodyKnows Anything

By 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 market

Which is precisely the point When yoursquore dealing with super-stocks pegging your stock selections to specific events or ldquocatalystsrdquorelated to a particular company that are likely to force the stock pricehigher for the most part yoursquore removing the behavior of the gen-eral stock market from the equation

When you begin to think in terms of the new paradigm yoursquollfind yourself zeroing in on news items that relate to the stocks yoursquoreholding or to other stocks that could become potential superstocksYoursquoll find yourself paying attention to ldquomicrordquo news items ratherthan ldquomacrordquo news items Yoursquoll become less interested in grandiosegeneralizations concerning the big picture and more interested in spe-cific news items that will impact individual stocks yoursquore following

For example yoursquoll find yourself paying more attention to CEOinterviews (ldquoWe believe the consolidation in our industry will con-tinue and we intend to be one of the major players by making addi-tional acquisitionsrdquo) merger announcements (ldquoWe will continue to

65

Chap 08 7901 852 AM Page 65

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

look for opportunities to grow our defense electronics segmentrdquo)or ldquoshareholder rights plansrdquo (ldquoAlthough 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 bidrdquo)

You will find yourself taking note of stock buybacks (ldquoWebelieve our stock is undervaluedrdquo) 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 companyAnd your ears will perk up when you hear that a company plans tospin off one of its subsidiaries to ldquoenhance shareholder valuerdquo espe-cially if the parent company or the subsidiary operates in an industry wheretakeovers are proliferating

You 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 itselfmdashand 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 yoursquoll 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 Reserversquos Open MarketCommittee meeting You would be more interested in the fact thatWMS Industries has announced that it will spin off its three PuertoRico hotelcasinos as a separately trading company because you willhave noted a takeover wave in the hotelcasino industry (see Chapter13) Therefore while the TV talking heads are wringing their handsover what Greenspan may or may not do yoursquoll be more interested inthe possibility that the WMS spinoff might become a takeover targetonce the hotelcasinos are trading separately as a ldquopure playrdquo (It did)

You will also begin to realize that if Rexel SA 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 wonrsquot mat-ter to Rexel SA if Apple Computer missed its earnings estimates bya penny And you will know that Rexel SA 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

66 PART ONE The Making of a Superstock Investor

Chap 08 7901 852 AM Page 66

The superstocks yoursquoll be tracking will be marching to theirown drummers and yoursquoll pay less attention to what ldquothe marketrdquois doing and more attention to the stream of information and scat-tered clues and evidence that directly impact the themes trends andspecific superstocks yoursquore tracking

If yoursquore like me you wonrsquot miss the market ldquoanalysisrdquo at allIn fact you may find itrsquos a relief to get it out of your hair because somuch of it is meaningless anyway

The 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 gyrationno matter how unexplainable it may be As a result financial com-mentators stockbrokers and analysts are expected to have an answerfor everything

Most 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 conversation

For 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

ldquoHowrsquos the marketrdquo you askldquoDown 80 pointsrdquo he saysldquoEighty points Why is it down 80 pointsrdquoldquoProfit-takingrdquoNow you may not be the smartest investor who ever lived but

yoursquore smart enough to know that since the market has declined in17 of the past 20 sessions it is definitely not profit-taking thatrsquos push-ing the market lower today Your broker knows that too but has totell you something because he or she is supposed to know whatrsquosgoing on Consequently the broker will have an answer for any ques-tion you can possibly come up with

How does the broker do thisOn any given day there are probably 5 or 10 potentially bullish

news 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

CHAPTER EIGHT If Everybody Knows Everything Then Nobody Knows Anything 67

Chap 08 7901 852 AM Page 67

tape like some Miss America from the crowd in Atlantic City andthis news item will be used to explain what the market did that day

Let 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 52 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 it

Your broker can use any one of these news items to put a ldquospinrdquoon why the Dow Jones is down 200 points

Your stockbroker is sitting at his deskThe phone rings Itrsquos youldquoHowrsquos the marketrdquo you askldquoItrsquos down 200 pointsrdquo your broker saysldquoTwo hundred points How comerdquoldquoWell the market has been depressed by a couple of news items

this morning First the President says he wants a tax cut and thatrsquosbearish 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 alsordquo

ldquoOhrdquoOn the other hand the market might be up 200 points With

the very same items on the tape the conversation would then gosomething like this

ldquoHowrsquos the marketrdquoldquoUp 200 pointsrdquoldquoUp 200 points How comerdquoldquoWell the President says he wants a tax cut and thatrsquos bullish

for the economy and for corporate earnings Also durable goodsorders were up 52 percent another sign of economic strength Alsothe bond market is higher this morningrdquo

ldquoOhrdquoSince 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

68 PART ONE The Making of a Superstock Investor

Chap 08 7901 852 AM Page 68

the Presidentrsquos tax cut proposal how come the bond market is up Orwhat 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 ldquobearishrdquo items will miracu-lously be interpreted as bullish as in ldquoWall Street had second thoughtsabout President Clintonrsquos tax cut proposal rdquo 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 commentariesin an entirely different lightmdashthat is if you bother to see them at all

Can 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 marketitrsquos 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 itrsquos time to thinkabout reducing your market exposure

Other than that nobody knows anythingWhich brings me to William GoldmanWilliam 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 hersquod ever learned about the movie business

Here it is ldquoNobody knows anythingrdquoWhat Goldman was saying was that you could take all of the

sophisticated 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 moviesmdashand that sure isnrsquot hap-pening

Says Goldman

CHAPTER EIGHT If Everybody Knows Everything Then Nobody Knows Anything 69

Chap 08 7901 852 AM Page 69

bull If anybody knew anything BJ Thomasrsquos advisers wouldnot have been so upset after the first sneak preview ofButch Cassidy and the Sundance Kid After hearing Thomasrsquosnew song ldquoRaindrops Keep Falling on My Headrdquo in thecontext of Butch Cassidy they were convinced that Thomashad made a potentially fatal career move

bull If anybody knew anything Raiders of the Lost Ark would nothave been turned down by every studio in town beforeParamount decided to make the film

bull If anybody knew anything Columbia Pictures would nothave told Steven Spielberg that it decided not to make ETeven after the studio spent a million dollars developing thefilm (ET wound up at Universal)

bull If anybody knew anything Paramount Pictures would nothave offered The Godfather to 12 directors (all of whomturned it down) before they got around to offering it toFrancis Ford Coppola and they would not have offered therole of Michael Corleone to Robert Redford Warren BeattyRyan OrsquoNeal Dustin Hoffman and Martin Sheen beforethey got around to offering it to Al Pacino

Now if you think about it you can apply William Goldmanrsquospremise to the stock market but with a slight variation

In the stock market when everybody knows everything nobody knowsanything Overall the evidence seems to indicate that the stock mar-ket as a whole is a pretty good ldquodiscountingrdquo 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 ldquoefficientrdquo 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 ldquoedgerdquo 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 therersquos no ldquoedgerdquo 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 Goldmanrsquos moviestudio executives are all poring over the same current and historicaldata regarding box office grosses If all of this ldquomacrordquo publicly avail-

70 PART ONE The Making of a Superstock Investor

Chap 08 7901 852 AM Page 70

TEAMFLY

Team-Flyreg

able information meant anything everyone would be making theright move all of the timemdashand theyrsquore not This strongly suggeststhat the way to hit a home run is to take a left turn when the lem-mings are turning rightmdashto take the road less traveled as it were

The same holds true for large-cap stocks A 1999 study by PeterSchliemann a money manager formerly with David L Babson ampCo 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 donrsquot know for sure but Irsquod 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 instan-taneously

Since everybody expected earnings of say $060 for the quar-ter everybody knew everythingmdashtherefore they knew nothingNow that everybody knows earnings came in at say $050 every-body knows everything once againmdashbut they still know nothingsince there is no way to take advantage of that information to avoidthe 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 allmdashor maybe we should say that nobody really knows anything more than any-body elsemdashor anything really worth knowing

When yoursquore looking for an edge in an area of the stock marketwhere everyone else is looking yoursquoll find that new business becomesold business pretty darn quicklymdashusually too quickly to be of any

CHAPTER EIGHT If Everybody Knows Everything Then Nobody Knows Anything 71

Chap 08 7901 852 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 itrsquosa good bet that it will be old business already no matter how new itseems to you

Now compare this instantaneous reaction to new business in thelarge-cap stocks to the way the market reacted to Laidlawrsquosannouncement 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 investors

But 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 Dellrsquos management whatdo you think would happen to Dellrsquos stock price Most likely theWall Street analytical community would immediately take its bestguess as to Dellrsquos potential takeover value and the stock would risetoward that level almost immediately

This did not happen as we will learn with ADT Nor did ithappen with Rexel Inc even though the parent company RexelSA 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 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-ketrsquos efficiency in processing significant information is directly relatedto the audience for that informationmdashie whether institutionalinvestors and the analysts who are fighting for their commissionbusiness are paying attention will determine how accurately themarket reflects new information

You 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

72 PART ONE The Making of a Superstock Investor

Chap 08 7901 852 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 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 situation

In 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 examplewhen Brylanersquos outside shareholder Pinault Printemps began rais-ing its stake in Brylane I saw a connection to the Rexel takeover bidbecause Rexel SA which bought Rexel was a subsidiary of PinaultPrintemps (see Chapter 9) But how many investorsmdashor professionalanalystsmdashwould have known that if they had not lived through theRexel takeover drama

So lesson number one is Research individual stocksmdashandsmaller stocks at thatmdashand donrsquot 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 isavailable out there that is not reflected in stock prices especiallywhen yoursquore dealing with stocks that are not widely followed by themainstream Wall Street analysts

So lesson number two If you really want to get an edge on WallStreet you should focus your attention on smaller-cap stocks thatare not widely followed by analysts and their institutional clientsThat 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 price

This principle explains why stocks like Rexel ADT Brylaneand 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 way

When you start to focus more of your attention on individualstocks and less attention on the general market yoursquoll be better ableto 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 7901 852 AM Page 73

subtle change in the way you perceive the news Yoursquoll think in termsof 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 ableto identify potential ldquosuperstocksrdquomdashand the less interested yoursquollbecome in the daily blather that passes for stock market analysis

74 PART ONE The Making of a Superstock Investor

Chap 08 7901 852 AM Page 74

P A R T T W O

Identifying TakeoverTargets

Chap 09 7901 853 AM Page 75

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

This page intentionally left blank

C H A P T E R N I N E

Creeping Takeovers

Letrsquos 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 prices

To 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 Andletrsquos suppose further that your management team has decided it wouldbe a good idea to acquire this company within the next 2 years

If 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 thestockrsquos 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 ldquofairness opinionrdquo 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 to

77

Chap 09 7901 853 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 thecompany you want to buy All of this means that yoursquoll probablyhave to pay a hefty premium over the stockrsquos current $10 tradingpricemdashespecially if the growth prospects you envision are apparentto the target companyrsquos management and to the financial advisers thetarget company retains

Given all of this what would you doWhat many outside owners do is embark on what is called a

ldquocreeping takeoverrdquo 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 monththe 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 company

This 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 you

CASE STUDY HOW REXEL SA ACQUIRED REXEL INC

If 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 ldquoben-eficial ownerrdquo and must report all additional purchases and sales ofstock Once a ldquobeneficial ownerrdquo crosses that 5 percent thresholdeach additional purchase of stock becomes a matter of public recordLater you will learn where to find this information so you can buyright along with these outside beneficial owners But first letrsquos lookat Rexel Inc and the ldquocreeping takeoverrdquo engineered by its largestshareholder Rexel SA of France

78 PART TWO Identifying Takeover Targets

Chap 09 7901 853 AM Page 78

We recommended Rexel Inc in October 1995 at $101frasl4 for threereasons Rexel SA had recently raised its stake in Rexel from 435 to45 percent through additional open-market stock purchases Rexelhad turned itself into a pure play electrical 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 ldquoTelltale Signsrdquo of a potential takeover target

As you will see throughout this book we will spend some timepresenting original recommendations and ongoing analysis of thesetakeover targets for one important reason Wersquore not discussingldquotheoretical examplesrdquo or how you ldquomight have done thisrdquo or ldquomighthave done thatrdquo Wersquore 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 outcome The 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 superstocks

Rexel was what could be called ldquosneaky strongrdquo 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 doing

In other words Rexel was beginning to act like a superstockmdashmarching to its own drummer oblivious to the manicdepressivegyrations of the overall stock market A ldquocreeping takeoverrdquo 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 everythingyoursquove ever learned about risk and reward which is that if you wanta big reward you have to take a bigger than usual risk

But when it comes to a ldquocreeping takeoverrdquo this is simply notthe case The reason is that if the outside beneficial owner continuesto purchase large blocks of stock on the open market itrsquos a strongindication that there is good value at 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 beneficialownermdashand especially if these purchases take place at successivelyhigher price levelsmdashit becomes logical that when the price dips too

CHAPTER NINE Creeping Takeovers 79

Chap 09 7901 853 AM Page 79

far below that level it is viewed as a bargain not only by the outsidebeneficial owner but also by the handful of stock market partici-pants who focus on situations like this The result is often strongsupport on pullbacks no matter what the stock market is doing Soeven if there is no takeovermdashand sometimes even if the overall stockmarket is exceedingly weakmdashsituations like this tend to hold upvery well thereby creating less risk

Tell that to the next know-it-all stock market pundit who tellsyou that investing in takeover candidates is ldquotoo risky for the aver-age investorrdquo

Following a Business Week story on Rexel the price bumped to$14 however Rexel drifted back to where it had started meetingsupport in the $12 area Rexel met strong support at that price Andthen the ldquocreeping takeoverrdquo really got under way

In the stock market you can tell where the value is by who isdoing the buying That notion is seen clearly in the fact that a Rexelvice president had gone into the open market to purchase 4000 sharesof Rexel at a price of $113frasl8 This created what I call a ldquotriple playrdquo situ-ation usually the most powerful of all signs that a stock is going high-er A triple play occurs when an outside beneficial owner the company itselfand 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 higher

In February 1996 there was another major purchase of RexelsharesmdashRexel SA bought another 150000 Rexel shares at pricesbetween $12 and $121frasl2

It was clear by March 1996 that Rexel SA had begun to ldquocreeprdquoThe French company had once again gone into the open market tobuy 59100 additional Rexel shares at a price of $123frasl4 The continu-ing purchases of Rexel SA suggested that Rexel could become atakeover target at any time

So Much for the ldquoEfficient Marketrdquo Theory

At this point the Rexel story becomes a bit more interesting for a dif-ferent reason The information age has arrived in full force and itrsquos safeto say that therersquos virtually no piece of information on any public

80 PART TWO Identifying Takeover Targets

Chap 09 7901 853 AM Page 80

TEAMFLY

Team-Flyreg

company that is not readily available to anyone who is interested inlooking for it

The problem is fewer and fewer analysts are looking for themost significant informationmdashbut that leaves the playing field wideopen for the rest of us

Previously you learned that Wall Street research is increasinglygeared toward servicing those who generate the largest commissionsmdashmutual funds pension funds hedge funds and other large-scaleinvestors who require big-cap stocks with lots of liquidity Smaller-cap stocks and micro-cap stocksmdashand also stocks in out-of-favor indus-tries that are too boring to interest the momentum playersmdashare sim-ply not followed as closely as their better known counterparts

The theory of the ldquoefficient stock marketrdquo 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 SA for example had uppedits open-market purchase price for Rexel from the $9 area to the $12to $123frasl4 area should have sent a strong signal that Rexel was a greatvalue at a $12 to $123frasl4 price If Rexel SA 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 SArsquos lead And certainly if Rexel shares trad-ed below the $123frasl4 area that Rexel SA had been willing to pay thatwould make Rexel a very good value Right

Not necessarily Again remember that wersquore 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-uationmdashnamely that Rexel would have been a logical buy anywherebelow $123frasl4mdashsimply did not register with the vast majority of WallStreet analysts and the investors who received their advice from them

Which leads to an important point You would be amazed at howmuch time you have to accumulate genuine takeover candidates thatare undergoing a ldquocreeping takeoverrdquo before Wall Street catches onto whatrsquos happening And you would also be amazed at how often youcan buy these ldquocreeping takeoverrdquo candidates at a significantly lowerprice than the outside beneficial owner has been paying

CHAPTER NINE Creeping Takeovers 81

Chap 09 7901 853 AM Page 81

In the case of Rexel Wall Street greeted Rexel SArsquos continuingpurchases up to the $123frasl4 area with a collective yawn and Rexelshares drifted back below $12 again

By midyear Rexel SA had made two additional purchases ofRexel Inc stock 21000 shares and 275600 shares both at $111frasl2 to $113frasl4To many investors takeover bids may seem unpredictable and tocome ldquoout of the bluerdquo 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 patienceSuch buys by Rexel SA 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 bid

By the end of the summer in 1996 Rexel SA had made twoadditional purchases of Rexel Inc stock 46000 shares at $131frasl4 and175700 shares at a price as high as $141frasl4 And there was continuedscattered buying of stock by Rexel Incrsquos officers and directors

In September 1996 Rexel SA purchased another 162000 sharesof Rexel Inc at prices between $133frasl4 and $137frasl8 an indication thatRexel SA was accomplishing a takeover by attrition through itscontinuing open-market purchases

On November 7 1996 I reported to my subscribers that RexelSA had purchased another 79000 shares of Rexel Inc at $133frasl4 Andyet amazingly despite the sizable open-market purchases by RexelSA that I had been documenting month after month Rexel Incshares were trading in November 1996 right at $14 no higher thanthey had been trading at the start of 1996

This proved two things First no one on Wall Street was pay-ing the slightest attention to the Rexel situation And second as Irsquovesaid before and Irsquoll say again if yoursquore going to invest in off-the-beaten-path stocks with genuine takeover potential yoursquore 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 Streetrsquos disinterest

And 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 confidencemdashwhichmeans the ultimate payoff when it comes will be even sweeter

By the end of 1996 Rexel was still trading near $14 a shareright where it began the year despite the fact that Rexel SA had

82 PART TWO Identifying Takeover Targets

Chap 09 7901 853 AM Page 82

spent most of the year adding significantly to its Rexel stake anddespite the fact that Rexel SA had just paid as high as $147frasl8 for an addi-tional 167000 shares

In the first week of January 1997 Rexel Inc finally broke out toa new high (See Figure 9ndash1)

Then in February 1997 I reported to my subscribers that RexelSA purchased another 43500 shares of Rexel Inc paying as muchas $157frasl16 a new high for Rexel SArsquos open-market purchases

In March 1997 Rexel Inc stock suddenly pierced the $20 levelon very large volume Prior to that Rexel SA had purchased anoth-er small block of 8000 shares paying a new high of $163frasl4

One Last Chance

At this point yoursquore 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 RexelSA paid for the stock at so many different points and for such

CHAPTER NINE Creeping Takeovers 83

F i g u r e 9ndash1

Rexel Inc (RXL) 1995ndash1997

Source Courtesy of Mansfield Chart Service Jersey City NJ

Chap 09 7901 853 AM Page 83

extended 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 meal

And then Wall Street provided dessertShortly after it was announced that Rexel SA had just pur-

chased another 184000 shares of Rexel paying as high as $201frasl16 Rexelshares dipped down to the $16 to $17 area and stayed there for sev-eral months In other words the perfectly efficient stock marketwhich sees all knows all and discounts everything provided one lastextended opportunity for investors to buy Rexel shares for signifi-cantly less than Rexel SA had just paid

In April 1997 Rexel SA went into the open market and boughta small block of 10000 Rexel shares at $167frasl8 The purchase made per-fect sense Rexel had just paid as high as $201frasl16 for 184000 shares sowhy not buy more at lower prices By June 1997 Rexel stock hadspent nearly four months trading listlessly between $16 and $18despite the fact that Rexel SA had paid over $20 for the stock justmonths earlier All told Rexel SA had purchased a grand total of1734900 shares of Rexel over the past two years

Takeover Time

Finally in September 1997 Rexel SA announced a takeover bid forRexel The offer was initially at $1950 per share then ultimatelyraised to $2250 per share That takeover price represented a premi-um of 119 percent over our original recommended price of $101frasl4 injust 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 patient

THE OTHER SIDE OF TAKEOVERS SELLING BY ABENEFICIAL OWNER

This next case study illustrates another method of spotting takeovertargets which is the mirror image of the approach used with RexelIn 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

84 PART TWO Identifying Takeover Targets

Chap 09 7901 853 AM Page 84

The 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 stockholders

In 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 takeover

Therefore what seems to be a negative to ldquoold paradigmrdquothinkersmdashthat a large outside beneficial owner shareholder wants tosell its stakemdashis usually a sign that the target company is about toenter the ranks of the superstocks

CASE STUDY THE TAKEOVER OF ADT

An example of this approach is ADT Ltd a security alarm moni-toring company

In February 1996 a small news item appeared about ADT Ltdwhich 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 dealLaidlaw had also granted Western Resources an option to buy theother 12 percent of ADT owned by Laidlaw by May 15 1997

One 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 ldquononcorerdquo 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 ldquoin playrdquo as a genuine takeovercandidate

CHAPTER NINE Creeping Takeovers 85

Chap 09 7901 853 AM Page 85

My 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 amp Light was seeking to diversify into the nonutility businessIn fact recent press releases from Western Resources indicated thatthe company had publicly stated it was thinking of expanding into thehome security alarm business through acquisitions

Western 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 separatebut related news items

ADT became part of the master list of recommended stocks inour Superstock Investor newsletter

At the time some utilities including telephone companiesviewed home security companies as a cost-efficient ldquoadd-onrdquo 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 Laidlawrsquos remaining 12 per-cent of ADT and then to make a bid for the rest of the company

The same reasoning suggested that two smaller companiesProtection One (ALRM) then trading near $11 and Holmes Pro-tection (HLMS) then trading below the $8 area were also potentialtakeover targets

This analysis of the security alarm industry provided a detailedroad map for investors for an upcoming takeover wave in the secu-rity alarm industry

By mid-March Western Resources had exercised its option topurchase the additional 12 percent of ADT owned by Laidlaw at$1480 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 ADTrsquos market price Western Resources mayhave acted as quickly as it did because they thought ADT shareswould move higher

In May 1996 a rather curious development took place ADTrsquosmanagement team had exchanged their low-priced ADT stock

86 PART TWO Identifying Takeover Targets

Chap 09 7901 853 AM Page 86

options (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 $15

Why 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 range

Following my ADT update subscribers were once againreminded that Protection One (then trading at $73frasl4) could also getcaught up in a takeover wave involving security alarm companies

On March 16 1996 CNBCrsquos 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 overhead

In a May 3 report an item was included about a hostile takeoverbid that Western Resources had just made for Kansas City Power ampLight It was reported that Westernrsquos bid for Kansas City Power amp Lightwas unsolicitated and that it disrupted a friendly merger agreement thathad already been negotiated between KCPampL and another company

Western 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 WesternResourcesrsquo unsolicited bid for Kansas City Power amp Light was a clearsignal that Western was looking to grow through takeovers

This observation demonstrates another strategy of pickingtakeover targets It pays to know the track record of the outside beneficialowners Just as our experience with Rexel SA and Rexel Inc led usto the takeover of Brylane (see Chapter 10) this hostile bid by WesternResources for Kansas City Power amp 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 answer

Next ADT announced a 5 million share buyback anotherTelltale Sign that ADT was seriously worried about a takeover bid at

CHAPTER NINE Creeping Takeovers 87

Chap 09 7901 853 AM Page 87

an unreasonably low price Remember the Telltale Sign When a com-pany whose stock is being bought by a third-party ldquobeneficial ownerrdquoannounces 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 ldquolow-ballrdquo bid that might be above the current market pricebut still below the true value of the company as a business

Both Western Resources and Kansas City Power amp 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 at$181frasl8 up 20 percent in less than three months since the news thatWestern Resources had bought 12 percent of ADT from Laidlaw

Surprise Republic Industries Makes aTakeover Bid for ADT

On July 1 1996 ADT became a superstock jumping 51frasl2 points in oneday to $241frasl2 on news that ADT had received a takeover bid That 51frasl2-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 earlier

But 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 companiesRepublic 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 price

Western Resources was strangely silent over the RepublicIndustries bid from ADT And the strangest twist in this story wasyet to come

ADT Followers Get Another Chance to Buy at Bargain Prices

During the discussion of the Rexel Inc takeover you learned howmany opportunities a patient informed investor can get to buy a

88 PART TWO Identifying Takeover Targets

Chap 09 7901 853 AM Page 88

genuine 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 ldquoefficient marketrdquo the-ory is that information is only properly discounted when the Wall Streetpowerhouses are paying attention Mutual 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 microscope

But 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 window

By 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 announced

As a result on July 26 1996 an investor following the ADTstory could have bought ADT formdashwould you believe itmdash$173frasl4

The 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 WhyBecause neither ADT nor Republic thought it important to check with WesternResources which owned 24 percent of ADT

You 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 theRepublicndashADT agreement Western said only that it was ldquoexploringits alternativesrdquo

The intent of that statement was probably an indication thatWestern Resources had intended to ultimately buy the rest of ADTand 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 ldquopersonality pre-miumrdquo based on the popularity of Wayne Huizenga

At 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

CHAPTER NINE Creeping Takeovers 89

Chap 09 7901 853 AM Page 89

was that Western Resources would find another buyer for ADT whowas willing to pay cash or stock with a more stable or reasonablevalue than Republic Industries A third possibility was for WesternResources to force Republic to substantially increase its offer in lightof the decline in Republic shares All three of these scenarios shouldhave resulted in a sharp rise in ADT shares from their trading levelof $17 to $18mdasha price level lower than where ADT traded prior tothe Republic bid Yet another possibility was for Western to simplyoppose the merger but do nothing but vote against itmdashpossible butunlikely considering Westernrsquos aggressive personality

Finally the Republic IndustriesndashADT agreement carried with itan unusual arrangement that seemed to indicate that both Republicand ADT were actually expecting a higher bid ADT granted Republica warrant to purchase 15 million ADT shares at $20 if the agreementwas terminated for any reason This by the way is another reasonwhy Western Resources was understandably miffed In effect itmeant that anybody making a competing bid for ADT at any priceover $20 had to buy 15 million additional shares and hand RepublicIndustries 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 yoursquoveobserved 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 fight

And you would expect that a ldquoperfectly efficient stock marketrdquowould have processed all of this public information and decidedthat ADT should be selling perhaps in the low to mid $20 rangeespecially in light of the fact that Republic had already offered $26in stock to acquire the company

Because of the drop in its own stock price by early October 1996Republic 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 $1975 price Western Resources

90 PART TWO Identifying Takeover Targets

Chap 09 7901 853 AM Page 90

TEAMFLY

Team-Flyreg

had paid for part of its 13 million share purchase just a couple of monthsearlier Republic withdrew its bid even though Western had notuttered one public comment on the RepublicndashADT takeover dealBut Western really didnrsquot have to say anything to Republic

Westernrsquos purchase of an additional 13 million shares of ADTin August after the Republic bid was announced was Westernrsquosway of saying ldquoGet lostrdquo

Sure enough just 1 month later Western Resources purchasedanother 13 million shares of ADT in the open market this time pay-ing between $181frasl4 and $19 ADT shares once again rose above $20 butjust barely trading around $203frasl4

Now those of you who are thinking ldquoAha A creepingtakeoverrdquo 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 takeoverdetectivemdashin other words trained to think in superstock paradigmtermsmdashit 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 intentions

Finally after buying another 209500 ADT shares at the end ofOctober at $193frasl4 Western Resources made its move Western offered$2250 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 companyrsquos hostile takeover bid for Kansas City Power ampLight and also in light of the arrogant and cavalier manner in whichADT had disregarded Westernrsquos interests when it accepted theRepublic takeover bid

A hostile bid from Western Resources in other words shouldhave come as no surprise to any new paradigm thinker who hadbeen following this situation Westernrsquos anger by the way was evi-dent in the fact that its $2250 takeover bid was significantly lessthan Republicrsquos previous $26 bid In fact Westernrsquos bid was so stingythat we advised subscribers to hold ADT based on the possibility

CHAPTER NINE Creeping Takeovers 91

Chap 09 7901 853 AM Page 91

that Western Resources would raise its bid or that the situation wouldturn so hostile that ADT would find a competing bidder

And 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 ADT

On 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 stock

That $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 ldquoin playrdquo 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 higher

If you look at Figure 9ndash2 yoursquoll 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-

92 PART TWO Identifying Takeover Targets

Chap 09 7901 853 AM Page 92

out 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 therersquosalways a new story always another stock moving The ldquohotrdquo moneyobsessed with short-term performance can quickly lose interest ina takeover situation that temporarily runs out of steam When theldquohotrdquo 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 opportunities

So itrsquos not just the 120 percent you could have made in ADT ifyoursquod 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 ldquotakeover detectiverdquo you would

CHAPTER NINE Creeping Takeovers 93

F i g u r e 9ndash2

ADT 1995ndash1997

Source Courtesy of Mansfield Chart Service Jersey City NJ

Chap 09 7901 853 AM Page 93

have 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 prices

And 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 1997because ADT was on its way to finding its proper value as a businessInstead of being tossed about by the whims of the market respond-ing to analystsrsquo estimates and interest rate movements ADT wasbeing analyzed as a business by three potential acquirers And even-tually that bid by Tyco forced the stock market to place a realisticvalue on ADT as a business

In 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

94 PART TWO Identifying Takeover Targets

Chap 09 7901 853 AM Page 94

C H A P T E R T E N

How to Create Your OwnldquoResearch Universerdquo ofTakeover CandidatesmdashThe Telltale Signs

Two roads diverged in a wood and ImdashI tookthe road less traveled and that has made all the difference

Robert Frost

Now that you have seen how Rexel and ADT became takeover tar-gets you can probably see the difference between ldquosuperstockrdquo 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 yoursquore 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 ie a takeover bid that forced the stock mar-ket to value Rexelrsquos and ADTrsquos stock according to their values as businessesregardless of what the general stock market was doing at the time

So how do you find a stock like Rexel or ADT in the first placeTo answer that question I am going to point you down the road

less traveled toward an entirely new direction in terms of thoughtprocess and analysis

95

Chap 10 7901 855 AM Page 95

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

First forget about the trendy ldquomomentumrdquo stocks everybodyknows and loves If you want to own some of them finemdashbut wersquoregoing 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 DellBill 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 weekmdashbut they live on a highly traf-ficked and overly developed road and wersquore headed for a far morebarren piece of terrain These guys and the stocks theyrsquore involvedwith are so widely followed so idolized and analyzed that there isabsolutely nothing you and I can discover that hasnrsquot already beennoted rehashed a thousand times and factored into their stock prices

Instead I am going to suggest that you become a browserThe definition of browse is to look wander or meander through

something or somewhere in a casual and unfocused manner Whenyou are browsing you do not always have a specific goal in mindyou 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 path

This is a very different mindset than setting out to find a spe-cific piece of information

The Internet is a wonderful tool It provides a bottomless pit offacts and figures virtually anything yoursquore looking for But what ifyou donrsquot know exactly what yoursquore 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 yoursquore 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 waymdashby 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 then digdeeper using the Internet

96 PART TWO Identifying Takeover Targets

Chap 10 7901 855 AM Page 96

Reading every single item in The Wall Street Journal for exam-plemdashespecially the smaller items that may be only a few sentenceslongmdashcan 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 yoursquore going to browse for antiques you wonrsquotmake 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 yoursquoll encounter information that can leadyou to superstock takeover candidates

Investorrsquos Business DailyThe Mansfield Chart ServiceThe New York TimesThe Vickers Weekly Insider ReportThe Wall Street Journal

Create Your Own ldquoResearch Universerdquo

Your goal as you begin your new career as a ldquosuperstock browserrdquowill be to create your own ldquoresearch universerdquo Every Wall Streetanalyst has a ldquoresearch universerdquo that consists of a group of stocksthe analyst follows on a regular basis Most of the time these stocksare organized by industry group A chemical stock analyst for exam-ple will follow a universe of chemical companies and select one orseveral as his or her top pick

As a superstock browser your goal will be to create your ownresearch universe a list of potential ldquosuperstockrdquo takeover candi-dates that possess one or more of the characteristics addressed inthis chapter Yoursquoll 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 target

One advantage you will have over the average Wall Street ana-lyst is that your ldquoresearch universerdquo will not be confined to a cer-tain industry group Instead once you learn to spot specific charac-teristics of potential takeover targets yoursquoll find yourself following

CHAPTER TEN Create Your Own ldquoResearch Universerdquo of Takeover Candidates 97

Chap 10 7901 855 AM Page 97

a diverse group of stocks that span a wide variety of industry groupsAnd once yoursquove constructed your ldquoresearch universerdquo you shouldlook at it as a potential shopping list of investment possibilities

For 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 list

In 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 theyrsquollhave the potential of rising suddenly and substantially in price nomatter what the stock market is doing

And herersquos the best part This ldquoicing on the cakerdquo 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 price In other words to the outside worldthese stocks will look like boring mild-mannered Clark Kentsmdashbutin reality each will have the potential of slipping into a phone boothat a momentrsquos notice and emerging as a superstock

WHAT YOUrsquoLL BE LOOKING FOR

I 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 yoursquoll be looking foras a superstock browser

Eighteen Telltale Signs

1 An outside company or individual (ldquobeneficial ownerrdquo)accumulates more than 5 percent of a companyrsquos stock

98 PART TWO Identifying Takeover Targets

Chap 10 7901 855 AM Page 98

and then files a Form 13-D with the Securities andExchange Commission

2 A company that already has one outside ldquobeneficialrdquoowner attracts a second or even a third outside investorwho accumulates a position of 5 percent of more

3 An outside beneficial owner in its Form 13-D filing saysthat it is seeking ways to ldquoenhance shareholder valuerdquoldquomaximize shareholder valuerdquo or speak to managementor other shareholders about ldquoexploring strategic alterna-tivesrdquomdashall code phrases for potentially putting a compa-ny up for sale to get the stock price higher

4 An outside ldquobeneficialrdquo 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 optionrsquos 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 stock

5 An outside beneficial owner adds to its stake in a compa-ny through additional open market purchases of its stock

6 An outside beneficial owner expresses an interest in sell-ing its stake in a company and says it will review strategicalternativesmdashoften a code phrase for a desire to have thetarget company acquired by a third party to maximize thevalue of the beneficial ownerrsquos investment

7 A dispute between an outside beneficial owner and thecompany in which it owns a stake breaks out into theopenmdashoften 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 bid

8 A company in which an outside beneficial owner holds astake or is accumulating additional shares andor whichoperates in an industry where takeovers are proliferatingannounces a stock buyback program

CHAPTER TEN Create Your Own ldquoResearch Universerdquo of Takeover Candidates 99

Chap 10 7901 855 AM Page 99

9 A company in which an outside beneficial owner holds astake or is adding to its stake is the subject of insider buy-ing by its own officers andor directors

10 A company with an outside beneficial owner andoroperates in an industry where takeovers are proliferatingannounces a ldquoshareholder rights planrdquo designed to makea hostile takeover more difficult

11 A company in a consolidating industry sells or spins offldquononcorerdquo assets or operations thereby turning itself intoa ldquopure playrdquo (see Chapter 14) which is often a signalthat the company is preparing to sell itself to a largercompany within its core industry

12 A company in a consolidating industry takes a largeldquorestructuringrdquo charge in effect putting past mistakesbehind it and clearing the decks for future positive earn-ings reports Such action can be important to a potentialacquirer and is often a sign that a company is preparingto sell itself

13 A company in a consolidating industry announces arestructuring charge that causes the stock to declinesharply and becomes the subject of significant insiderbuying andor 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 horizon

14 A company in a consolidating industry is partially ownedby a ldquofinancially orientedrdquo 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 ldquoexit strategyrdquo for itself by engineer-ing a takeover of the company in question should theopportunity present itself

15 The 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 stockmdashin other words a desireto have the company acquired

100 PART TWO Identifying Takeover Targets

Chap 10 7901 855 AM Page 100

TEAMFLY

Team-Flyreg

16 Two 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 companythere 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 list

17 A small-to-medium-size company in a consolidatingindustry achieves a breakout from a ldquosuperstock breakoutpatternrdquo ie the stock penetrates a well-defined resis-tance level at least 12 months in duration following aseries of progressively rising bottoms or support levelswhich indicates that buyers are willing to pay increasing-ly higher prices to establish a position This pattern cre-ates the appearance of a ldquorising trianglerdquo on the chart Thebest superstock breakout patterns occur when volatility decreas-es markedly in the weeks or days prior to the breakout

18 A company 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 ldquoinheritedrdquothrough a takeover of another company Many times ifCompany A acquires 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) CompanyA may eventually bid for the rest of Company C if this fitsits overall businessacquisition 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 A take-over of a company whose stock is ldquoinheritedrdquo throughanother takeover becomes even more likely when there isalready a business relationship between Company A andCompany C

For illustrative purposes letrsquos 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

CHAPTER TEN Create Your Own ldquoResearch Universerdquo of Takeover Candidates 101

Chap 10 7901 855 AM Page 101

ldquoinheritedrdquo a 49 percent stake in Trus Joist a Boise Idaho manufac-turer of lumber products which was partially owned by MacMillanThe other 51 percent of Trus Joist was owned by TJ International apublicly traded company listed on NASDAQ

There 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 Joist

At first TJ International stock rocketed from the low $20s to ashigh as $337frasl8 based on the second scenario a potential takeover bidfrom Weyerhauser But TJ shares then fell back sharply falling aslow as $213frasl8 based on the emerging consensus that TJ would prob-ably buy out the 49 percent Trus Joist stake from Weyerhauser

A superstock observer who noted that Weyerhauser was themajor distributor for Trus Joistrsquos 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 TJInternational

On November 23 1999 just 5 months after it bought MacMillanBloedel Weyerhauser agreed to buy TJ International for $42 pershare TJ International jumped $93frasl8 (or 22 percent) in one day as aresult of the bid which was nearly 100 percent premium to TJrsquos stockprice just 4 months before

OTHER THINGS TO LOOK FOR

In addition to these telltale signs that a formerly sleepy and over-looked stock is about to become a superstock takeover candidateyou 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

102 PART TWO Identifying Takeover Targets

Chap 10 7901 855 AM Page 102

clues are available by simply listening carefully to companies that areactively acquiring other companies

USING THE VICKERS WEEKLY INSIDER REPORT TOFIND AND TRACK ldquoBENEFICIAL OWNERSrdquo

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 ownerRexel SA a browsing coup that led to a 119 percent profit

The Vickers Weekly Insider Report is available by mail and alsoonline Published by Argus Research the report is a summary ofbuy and sell transactions by corporate ldquoinsidersrdquo (officers and direc-tors) and also outside ldquobeneficial ownersrdquo of 10 percent or more ofa companyrsquos stock (see Figure 10ndash1)

Of particular interest is the ldquobeneficial ownerrdquo transactionsWhen an outside investor accumulates 5 percent or more of a com-panyrsquos 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 ldquoinvestment purposes onlyrdquo 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 ldquomaximizingrdquo orldquoenhancingrdquo shareholder value

In the Vickers Weekly Insider Report look for outside beneficialowners that are accumulating additional shares on the open marketWhen 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

CHAPTER TEN Create Your Own ldquoResearch Universerdquo of Takeover Candidates 103

Chap 10 7901 855 AM Page 103

Simply sitting in a comfortable spot with a highlighter and a penand browsing through the entire Vickers Report each week high-lighting those beneficial owner (BO) transactions that seem inter-esting and making notations relating to names you have seen before

104 PART TWO Identifying Takeover Targets

F i g u r e 10ndash1

Sample of Vickers Weekly Insider Report

Chap 10 7901 855 AM Page 104

(or never seen before) will often lead to new and profitable ideasyou would not have otherwise encountered

For one thing yoursquoll 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 see

There 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 freeedgarcom 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 company

But there are connections that would not show up in a normal13-D filing or through a search of 13-Drsquos only

For example one key reason to use the Vickers Weekly InsiderReport is that it focuses on ldquoForm 4rdquo 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 ldquoin theknowrdquo stockholders than you would get simply by focusing on 13-D filings by outsiders

You may notice for example heavy insider buying by officersand directors in a company where an outside beneficial owner isalso accumulating sharesmdasha 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

CHAPTER TEN Create Your Own ldquoResearch Universerdquo of Takeover Candidates 105

Chap 10 7901 855 AM Page 105

You 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 industrywhich raises the possibility that something bullish is going on in thatparticular industry that has not yet been perceived by the market

Or you may notice heavy insider buying andor outside ben-eficial owner buying in a stock where you have previously noticeda potential ldquosuperstock breakout patternrdquo (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 whileyoursquoll 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 browse

Let me give you a real-life example that illustrates the useful-ness of this tool

CASE STUDY SPOTTING BRYLANE AS A TAKEOVERTARGET

In 1997 Vickers reported a purchase of 429400 shares of a companycalled Brylane Inc by an outside beneficial owner Pinault Printemps-Redoute SA The Vickers data indicated that Pinault-Printemps hadpurchased these Brylane shares between June 3 and June 30 1998 atprices ranging from $453frasl4 to $51 Brylane was added to the potentialldquoresearch universerdquo of stocks to look into and monitor on a regularbasis

A few weeks later the following transaction appeared

BLACKROCK INVT S-1756 JULY29 rsquo98 81frasl2 0 SABATH KAREN H SEC

BORG WARNER D-400 X JULY30 rsquo98 487frasl16 100 X DRUMMOND JERE A DIR

BRYLANE INC B-128300 X JULY 1-28 rsquo98 401frasl4-453frasl4 8568617 PINAULT-PRNTMPS RDT SA BO

BUCKLE INC S-20200 JUNE 5-28 rsquo98 5411frasl16-557frasl8 NA NELSON DENNIS H PR

And a few weeks after that these transactions appeared

BRUSH WELLMAN B-5000 AUG 5-10 rsquo98 163frasl18-171frasl2 10000 ROBERTSON WILLIAM R DIR

BRUSH WELLMAN B-8700 Aug 3-04 rsquo98 157frasl8-16 17200 HARNETT GORDON D CB

106 PART TWO Identifying Takeover Targets

Chap 10 7901 855 AM Page 106

BRYLANE INC B-25000 AUG21 rsquo98 25 8808017 KRAMER HARTMUT

BRYLANE INC B-8000 AUG25 rsquo98 263frasl4 6000 JOHNSON WILLIAM C DIR

BRYLANE INC B-2000 AUG21 rsquo98 243frasl4 6000 STARRETT PETER M DIR

BRYLANE INC B-214400 X AUG13-19 rsquo98 245frasl8-383frasl4 8783017 X PINAULT PRNTMPS RDT SA BO

BUCKEYE PARTNERS B-5000 AUG25-26 rsquo98 2615frasl16-27 40000 BUCKEYE MGMT CO PART

Here 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 429400 shares in Junetook place at prices as high as $51 By July Pinault-Printemps wasbuying Brylane shares as low as $401frasl4 By mid-August Pinault wasin the open market buying additional Brylane shares as low as $245frasl8mdashless 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 and2000 shares respectively at $263frasl4 and $243frasl4

The continuing large purchases by Pinault-Printemps com-bined with the apparently large decline in Brylanersquos 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 intomdashright now

A chart 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 fastmdashafter all individual stocks are collapsingevery day on Wall Street and itrsquos 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 quickly

By 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 managementand they are therefore well-aware of how things are going and whatthe companyrsquos prospects are

Usually though when you see an outside beneficial owner step-ping into the open market to buy big blocks of stock you assume he

CHAPTER TEN Create Your Own ldquoResearch Universerdquo of Takeover Candidates 107

Chap 10 7901 855 AM Page 107

or she has reached an informed conclusionmdashie 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 opinion

When you add insider buying into the mixmdashie when you seeofficers and directors buying shares along with the outside benefi-cial owner at a certain price levelmdashyou have a double-barreled voteof confidence that a stock has reached a compelling price point interms of its value as a business

Apparently 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$38 and $245frasl8

Two Brylane directors also thought the stock was a great valueat $243frasl4 and $263frasl4

Yet in a breathtakingly short period of time Brylane hadplunged all the way to the $14 to $15 area

So 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 thoughtBrylane was a good value all the way down from $51 to $245frasl8 whywouldnrsquot it consider buying the rest of the company now that thestock had fallen to $14

For all of these reasonsmdashand to answer all of these questionswhich emerged as a result of browsing through the Vickers WeeklyInsider Reportmdashwe 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 Itrsquos 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 rangeor base pattern which indicates that buyers are finally stepping inand that the supplydemand situation is coming back into balance

So why would you try to catch this falling piano Because Brylanewas 4753 percent owned by a French company Pinault-Printemps-RedouteSA the parent company of Rexel SA

Thatrsquos rightmdashPinault-Printemps turned out to be the parent compa-ny of Rexel SA of France the very same outside beneficial owner that

108 PART TWO Identifying Takeover Targets

Chap 10 7901 855 AM Page 108

methodically 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 companya major catalog retailer that published among others catalogs forSears Lane Bryant (thus the name of the company) Lerner andChadwickrsquos Thirteen months after Brylanersquos February 1997 publicoffering Pinault-Printemps purchased a 437 percent stake in Brylanefor $51 per share

Shortly 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 1998Brylane dropped 111frasl2 points to $243frasl4 on news that sales of the compa-nyrsquos 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 masse

Shortly after Brylane stock plunged 111frasl2 points in one day the com-pany announced a $40 million stock buyback This 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 ldquoEighteenTelltale Signsrdquo numbers 8 and 9 earlier in this chapter)

But even though Pinault-Printemps several Brylane insidersand Brylane itself all apparently believed that the stock was a greatvalue in the mid-to-high $20s Brylane shares were blasted again onSeptember 24 and 25 1998 following another analyst downgradeand earnings estimate reduction

This second price plunge took the stock down to the $14 to $15area

Research into Brylane revealed that Pinault-Printemps hadagreed to a ldquostandstill agreementrdquo which limited Pinault to own-ing a maximum of 475 percent of Brylane for three years endingApril 3 2001

Normally a ldquostandstill agreementrdquo might be viewed as animpediment to a takeover However thatrsquos not always the case

CHAPTER TEN Create Your Own ldquoResearch Universerdquo of Takeover Candidates 109

Chap 10 7901 855 AM Page 109

Further research into Pinault-Printemps revealed this company tobe Europersquos third-largest mail order company Pinault was a companythat generated $145 billion per year in revenues So paying $300million or so for the rest of Brylane which operated a mail orderbusiness that obviously fit right into Pinaultrsquos business mix did notseem like a very big dealmdashespecially in view of the fact that Pinaulthad paid $51 for its original stake over three times what Brylanewas trading for in October 1998

As a superstock investor you could have taken a gradual andpatient approach with Brylane Tax-loss selling could have hurt thestock as year-end approached since it is indeed tough to catch aldquofalling pianordquo But all of Wall Street loved Brylane at $61 Nowclose 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 thistime at a price of $1515frasl16 In December Brylane had once again issuedan earnings warning and the stock had retreated to the $10 to $11 areaAt these low prices it would be a safe guess that Pinault-Printempsthe French company that owned that 475 percent stake should atleast be thinking about a potential takeover bid

Several 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 Report and 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 SA of Francea company that had already taken over one of my previous takeoverrecommendations

A combination of experience and research together with thefact that Brylane itself and Brylane insiders were buying stock onthe open market right along with Pinault-Printempsmdashtwo of the

110 PART TWO Identifying Takeover Targets

Chap 10 7901 855 AM Page 110

TEAMFLY

Team-Flyreg

Telltale Signs I always watch formdashcreated a logical and compellingsuperstock takeover candidate

That is how you use the Vickers Weekly Insider Report

CASE STUDY SAM HEYMAN AND DEXTER CORP

Experienced 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 notAnnouncers can usually determine which horses are looking ldquostrongrdquoand 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 characteristicsthrough 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 thehorsesrsquo strides how high the jockeys are riding in the saddle whetherthe reins are loose or taut the position of the jockeysrsquo 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 outcome

Experience is an invaluable asset when you are browsing forsuperstock takeover candidates The more you browse the moreyoursquoll notice and the more you notice the more yoursquoll be able tomake certain connections that other investors will be unable to makeGiven the identical set of circumstances yoursquoll see something thatothers do not see and you will be able to see a high probability of acertain outcome and thatrsquos where you gain your edge Each expe-riencemdasheven those that do not turn out profitablymdashwill lay thegroundwork for future experiences Eventually yoursquoll find yourselfextrapolating a certain set of circumstances all the way to their log-icalmdashand profitablemdashconclusion

Dan Dorfman one of the most respected financial reporters onWall Street and the former author of The Wall Street Journalrsquos ldquoHeardon the Streetrdquo column was writing a column for Jagnotescom whenhe called me on November 1 1999 His request was straightforward

CHAPTER TEN Create Your Own ldquoResearch Universerdquo of Takeover Candidates 111

Chap 10 7901 855 AM Page 111

enough He asked me to list my top three takeover candidates in thecoming 12 months I offered the following three stocks Ersquotown Corpa 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 Ersquotown jumped 10 points in one day fol-lowing a bid from Thames Water PLC of Britain (For more on theErsquotown takeover and the reasoning that went into it see Chapter 18)

The other company to receive a takeover bid was Dexter CorpDexter 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 Barronrsquos I noticed that International Specialty Products (ISP)had purchased 365200 shares of Dexter at prices ranging from $3625to $3863 per share giving ISP a total of 1996900 shares or 867 per-cent of Dexterrsquos outstanding shares

Many if not most of the 13-D filings reported in Barronrsquos 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 threat

In browsing through these filings each week it helps to lookfor 13-D filers who are either corporationsmdashie real businesses whomay want to acquire another businessmdashor individuals who for onereason or another seem to have the ability the inclination or bothto mount a takeover bid

Another 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 playermdashie 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 way

In 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 ldquolife sci-encesrdquo industry where LTEK operated had seen a wave of takeoversWhat really sparked the LTEK recommendation as a takeover targethowever was a simple statement found in a series of Dexter pressreleases Press releases are yet another useful tool that can help you

112 PART TWO Identifying Takeover Targets

Chap 10 7901 855 AM Page 112

get a feel for a company and its thinking in terms of either acquiringcompanies or selling itself to someone else In one of Dexterrsquos releasesthe company said that it was actively seeking acquisition candidates

Now 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 company

It seemed pretty logical that LTEK might be on Dexterrsquos radarscreen as a takeover target and that Dexter might bid for the 47 per-cent of LTEK it did not already own

Soon 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 LTEKshareholders Dexter eventually raised its bid to $391frasl8 Part of beinga superstock investor is knowing when to sell and that was the rec-ommendation made for this stock at this point in time

It had been a year since the LTEK takeover and now somebodyhad filed a 13-D on Dexter and was raising its stake

Research 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 lot

I 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 wage

In 1982 long before the term ldquohostile takeoverrdquo 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 GAFrsquos assets were worth far more than its stock priceand that GAFrsquos management was not running the company in amanner that was making optimal use of those assets

In other words to put it bluntly Samuel Heyman thought thatGAFrsquos management was doing a lousy job and that he could do

CHAPTER TEN Create Your Own ldquoResearch Universerdquo of Takeover Candidates 113

Chap 10 7901 855 AM Page 113

better Heyman announced that he intended to wage a proxy fightto replace GAFrsquos management and that he would then embark on aprogram to maximize GAFrsquos value for its shareholders

Today 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 1982Samuel 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 GAF

Wall 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 Heymanrsquosbattle with GAF was viewed with a combination of amusement anda decided lack of respect in the investment community

GAF meanwhile was not amused and its management reactedangrily to Sam Heymanrsquos audacity GAF questioned Heymanrsquos credi-bility and management abilities and generally scoffed at the idea thatHeyman and his inexperienced group of outsiders could unseat GAFrsquoswell-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 stockholders

Heyman won the proxy fight ousted GAF managementrestructured the company liquidated some assets and completely fol-lowed through on everything he said he would do Along the wayhe accumulated a 99 percent stake in Union Carbidemdashan especial-ly audacious move since Union Carbide was many times larger thanGAFmdashand actually threatened to take Union over GAF made a hugeprofit on its Union Carbide stock GAF had soared to $67 a share again of 375 percent in 21frasl2 years Heyman ultimately took GAF privatein 1989 then sold 20 percent of International Specialty Products aGAF subsidiary to the public in 1991

Now 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

114 PART TWO Identifying Takeover Targets

Chap 10 7901 855 AM Page 114

was 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 growthThis was one of the major reasons Dexter had made the takeover bidfor the 47 percent of Life Technologies it did not ownmdashDexter hopedthat LTEKrsquos high-growth business would inject some badly neededexcitement into a stock that was being neglected by Wall Street

There was more to the Dexter situation than met the eye especiallyto someone looking at this situation in terms of a potential superstocktakeover target First 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 Streetbecomes a superstock because itrsquos a takeover target

These 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 ldquoscreenrdquo that directs investorsrsquo 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 companyrsquos 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 unappealingmdashprovided you can see the potential of some sortof ldquocatalystrdquo that would force the stock market to recognize the inherentvalue in these situations

Dexter had a catalyst and his name was Samuel Heyman Herewe had a company operating in a consolidating industry where anoutside beneficial ownermdashHeymanmdashwas accumulating shares onthe open market Even better the outside beneficial owner had a his-tory of acquiring companies

CHAPTER TEN Create Your Own ldquoResearch Universerdquo of Takeover Candidates 115

Chap 10 7901 855 AM Page 115

But there was even a more interesting twist to the DexterndashSamHeyman story that convinced me absolutely and without a doubt thatHeyman and International Specialty Products would soon be making ahostile takeover bid for Dexter Corp

It turned out that a group led by Sam Heyman and InternationalSpecialty Products had been major stockholders of Life Technologiesa year earlier when Dexter angered LTEKrsquos shareholders by makinga takeover bid that was perceived to be too low

The controversy over Dexterrsquos bid still lingered Actually I hadstopped following Life Technologies after Dexterrsquos takeover bid CherrieMahon went back and pieced together the chain of events that had cul-minated in Sam Heymanrsquos steady accumulation of Dexter shares onthe open market I discovered that following Dexterrsquos offer for LTEKtwo directors of Life Technologies resigned because they believed thatDexterrsquos bid was too low Remember Dexter already owned 53 per-cent of LTEK which put it firmly in the driverrsquos seat Life Technologiesformed a special committee to evaluate the Dexter bid they retainedGoldman Sachs which estimated that LTEK was worth as much as $60per share compared to Dexterrsquos upwardly revised bid of $391frasl8 Dextermeanwhile had retained Merrill Lynch which said that Dexterrsquos $391frasl8offer was fair and reasonable The discrepancy between Goldmanrsquosestimate of LTEKrsquos value and Merrill Lynchrsquos value estimate proves thatvalue like beauty is in the eye of the beholder

Then again it may prove something else Dexter armed witha ldquofairnessrdquo opinion from Merrill Lynch and having proved thatcomparison shopping can save you money on Wall Street proceed-ed with its $391frasl8 per share tender offer for Life Technologies Theoffer attracted another 18 percent of LTEKrsquos shares giving Dexter atotal of 71 percent of the company

Meanwhile the rest of LTEKrsquos 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 LTEKrsquos 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 OTCldquoBulletin Boardrdquo because there were not enough public sharehold-ers left to qualify for NASDAQ listing

116 PART TWO Identifying Takeover Targets

Chap 10 7901 855 AM Page 116

And 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 itmdasha group led by Samuel Heyman and Inter-national Specialty Products

Thatrsquos 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 Dexterrsquos takeover bid for LifeTechnologies Not only that Heyman and ISP actually went into theopen market to purchase additional Life Technologies shares just asthe Dexter tender offer was expiringmdashand they paid more for LTEKstock than the value of Dexterrsquos bid which amounted to one morethumb of the nose at Dexter and a clear signal that Heyman was notgoing to take this lying down

During December 1998 the same month that Dexterrsquos bidexpired International Specialty Products went into the open marketand bought 1471320 LTEK shares paying as high as $3928 per shareOther investors associated with Sam Heyman and ISP also 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 LTEKrsquos remaining public ldquofloatrdquo

To someone who did not know Sam Heymanrsquos history the factthat Heyman and ISP were now buying Dexter shares on the openmarket may have had little or no meaning In fact there was noshortage of analysts who dismissed Heymanrsquos 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 ISP was so highly leveragedthat it would not be able to obtain the financing for an offer

But Sam Heyman did not operate that way Heyman was notlooking for Dexter to ldquobail him outrdquo 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 valuemdashinclud-ing Dexterrsquos stake in Life Technologiesmdashand 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

CHAPTER TEN Create Your Own ldquoResearch Universerdquo of Takeover Candidates 117

Chap 10 7901 855 AM Page 117

Sam Heyman was serious was that ISP had been selling off its ldquonon-corerdquo operations

The conclusions reached from all of this were that Sam Heymanwas trying to put Dexter ldquoin playrdquo and either ISP or a group head-ed by ISP or possibly a third party would soon be making a takeoverbid for Dexter Heymanrsquos intent toward Dexter would be what WallStreet would call hostile and ISP would attempt to gain control ofDexter sell off various Dexter operations that it did not want retainsome of Dexterrsquos specialty chemicals operations that fit the ISP busi-ness profile and possibly sell off the LTEK stake to another bidderwilling to pay a more reasonable (and much higher) price

Sam Heyman went into the open market to purchase additionalDexter shares raising his stake to 998 percent of the company andhe filed a notification that he intended to raise his stake to at least 15percent

Dexter responded by lowering the threshold of its ldquosharehold-er rightsrdquo plan from 20 percent to 11 percent Under the terms of theplan a ldquopoison pillrdquo would kick in if any outside person or grouppassed the 11 percent ownership threshold without Dexterrsquos 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 impossible

Meanwhile Dexter shares were drifting slowly but surely downtoward that $30 to $33 support area that I advised subscribers towatch for

This was yet another example of Wall Streetrsquos remarkable abil-ity to overlook the obvious in spending its time obsessing over ahandful of high-profile ldquomomentumrdquo stocks while ignoring virtuallyeverything else

On Friday December 11 1999 Dexter closed at $329frasl16 On thattrading day Dexter was just another basic industry ldquovaluerdquo stock withuninspiring revenue and earnings growth of little or no interest totrendy ldquomomentumrdquo investors seeking to beat the stock market

On Monday December 14 1999 Dexter was the best-performingstock on the New York Stock Exchange soaring 85frasl8 points or 265 per-cent in a single day In other words Dexter had become a superstock

Why

118 PART TWO Identifying Takeover Targets

Chap 10 7901 855 AM Page 118

Because Sam Heymanrsquos International Specialty Productsannounced a hostile $45 per share takeover bid for Dextermdashatakeover 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 bid

And it certainly came as no surprise to anyone who knew any-thing about Sam Heyman

You probably think this is the end of the Dexter story In fact themost lucrative part of the story was yet to come

Following Sam Heymanrsquos $45 bid for Dexter Dexter stock spent thenext 4 months trading within a range of $34 and $40 The Wall Streetanalytical community you see still did not take Sam Heyman seri-ously

Following the jump in Dexterrsquos stock price to $413frasl16 which wasstill nearly 4 points below the value of Sam Heymanrsquos takeover bidDexterrsquos stock began to erode again because analysts openly ques-tioned (1) whether Heyman was seriously trying to buy Dexter and(2) whether Heyman and ISP had access to the financing to actual-ly do the deal

It took Dexter nearly two weeks to respond to Heymanrsquostakeover bid Finally in a letter that literally dripped with sarcasmand insults Dexterrsquos Chairman and CEO K Grahame Walker reject-ed Heymanrsquos offer calling it ldquoinadequaterdquo

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 Heymanrsquos true motiva-tionmdashas though a securities analyst had any insight into whatHeymanrsquos actual intentions were

Walker then laid into Heyman for ldquoopportunistically interven-ingrdquo to frustrate Dexterrsquos objective of acquiring Life Technologies Heaccused Heyman of ldquoinviting himselfrdquo to a meeting with Dextermanagement and ldquodisregarding the interests and welfarerdquo of Dexterrsquosstockholders an ironic charge when one considers how this situationultimately turned out

Walker concluded his letter by suggesting to Heyman that ldquowefervently hope (and strongly recommend) that you return your man-agerial focus to your own companies leaving the stewardship ofDexter where it belongsrdquo

CHAPTER TEN Create Your Own ldquoResearch Universerdquo of Takeover Candidates 119

Chap 10 7901 855 AM Page 119

In January 2000 we offered the following analysis of the situation

The stock market is reacting to this takeover bid with caution As thisis written Dexter is trading around $381frasl4 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 ofDexterrsquos letter to Heyman is only likely to take this battle to another leveland my view is that Dexter will ultimately be bought by ISP or a third partymore to Dexterrsquos 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 lowering the threshold of itsldquopoison pillrdquo to pointedly single out Heyman and prevent him fromincreasing his stake in Dexter they had thrown down the gauntletto the wrong guy virtually guaranteeing a hostile bid Then by send-ing such a condescending letter in response to Heymanrsquos $45 takeoverbid they had very likely ticked him off again Based on everythingI knew about Heyman it was very clear to me that this sort of arro-gant responsemdashwhich was precisely the sort of response Heymanreceived from GAF back in the 1980smdashwould only serve to makeHeyman more determined to win this fight

Then on January 20 Dexter made its other blunder by offeringto buy the remaining publicly traded shares of Life Technologies at$49 a sharemdasha price $10 higher than it had previously paid the restof LTEKrsquos 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 offerthe overwhelming interpretation on Wall Street was that Dexter wastrying to get Heyman to drop his bid by offering him a premiumprice on his LTEK shares

Here is a perfect example of how a superstock investor whounderstood the history and motivations of Sam Heymanmdashand whostopped to think about how Heyman could benefit most from thissituationmdashcould look at precisely the same set of circumstances aseveryone else on Wall Street and come to a diametrically opposedmdashand absolutely correctmdashconclusion If Heyman accepted the Dexteroffer for his LTEK shares the value of Heymanrsquos Dexter stock wouldundoubtedly drop further once the takeover threat evaporated

120 PART TWO Identifying Takeover Targets

Chap 10 7901 855 AM Page 120

TEAMFLY

Team-Flyreg

And 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 Heymanrsquos Life Technologiesshares smelled an awful lot like ldquogreenmailrdquo 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 bid

The target company would then essentially bribe the raider togo away by offering the raidermdashbut not the public shareholdersmdashapremium 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 ldquogreenmailrdquo deal was announced the stock of the target companymdashwhich had risen on word of the takeover bidmdashwould plunge leav-ing the public shareholders holding the bag The raider meanwhilewould pocket a huge profit and move on to the next victim

Greenmail 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 mannerThis put an end to greenmail

If Dexterrsquos 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 Heymanrsquos his-tory remembering that he had more at stake in Dexter than in LTEKand realizing that to Heyman this was not only a matter of princi-ple but also a financial question to be decided in a rational mannera superstock investor would have come to the clear conclusion thatthe smart move was for Heyman to reject Dexterrsquos 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 Dexter

On 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

CHAPTER TEN Create Your Own ldquoResearch Universerdquo of Takeover Candidates 121

Chap 10 7901 855 AM Page 121

Technologies offer inappropriate under the circumstancesmdashwhich isprecisely the response one would have expected from a man likeHeyman in a situation like this

ldquoIt is apparent from the timing of Dexterrsquos offer for our LifeTechnologies shares coming on the heels of ISPrsquos $45 per share offerfor Dexter that Dexter is seeking to divert ISP from a course ofaction designed to maximize shareholder values for all Dexter share-holdersrdquo Heyman wrote ldquoIn this connection we believe thatDexterrsquos attempt to deter us by providing benefits to ISP not avail-able to other shareholders is simply inappropriaterdquo

Heyman also called the Dexter bid for Life Technologies in 1998ldquoan attempted squeeze-out of LTEKrsquos minority shareholdersrdquo whichonce and for all made Heymanrsquos motivation in this situation crystalclear He was paying Dexter back in spades for what he perceivedas Dexterrsquos mistreatment of ISP in the Life Technologies tender offer

In the letter Heyman also informed Dexter that ISP wouldlaunch a hostile proxy fight in which it would nominate a slate ofdirectors to Dexterrsquos board He also told Dexter that Chase Securitieshad agreed to provide the funds for the acquisition and he noted thatISPrsquos stake in Dexter amounted to ldquomore than five times that held byDexterrsquos entire boardrdquo a pointed reference to the question of whichslate of directors had the most incentive to act in the best interests ofthe shareholders

Heyman 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 ourmotivesmdashwhich by the way I do not appreciate

All the best Samuel J Heyman

Heymanrsquos rejection of the Dexter bid for Life Technologiesresulted in a jump in Dexter shares back to the $38 to $39 areamdasha nicebounce to be sure but still far lower than the $45 takeover bid

When 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

122 PART TWO Identifying Takeover Targets

Chap 10 7901 855 AM Page 122

situation the more likely that the target company will wind up being acquiredusually by a third party Even 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 deterredthe target company is usually left with only one alternative findanother bidder more to its liking willing to pay a higher price thanthe hostile suitor

Proving once again that things change on February 28 2000Dexter announced that it would open up its books and records toother third parties and that it had hired Lehman Brothers Holdingsto ldquoexplore a possible merger sale or restructuring or the spinoff orsale of a business unitrdquo

Dexterrsquos shares jumped $49frasl16 or 12 percent to $42mdashstill wellbelow Sam Heymanrsquos lowball $45 takeover bid

In 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 somebody

Even now following Dexterrsquos announcement that it will entertainpotential takeover bids from other buyers Dexter shares are tradingbelow ISPrsquos $45 per share lowball bid lower than they should beunder the circumstances By the time this soap opera plays itself outI think Dexter shareholders will receive $55 a share or more for theirstock and that one of three things will happen (1) Mr Heyman andISP will 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 andor stock toshareholders on a tax-free basis thereby passing through the truevalue of Life Technologies and Dexterrsquos other assets to the stock-holders

On March 23 2000 ISP raised its takeover bid to $50 ldquobased on ourevaluation to daterdquo of Dexterrsquos books and said it might raise the offereven further if its continuing evaluation warranted such a price increase

The continuing hostility between Dexter and ISP made it quiteobvious that Dexter would move heaven and earth to avoid beingpurchased by Sam Heymanrsquos group Dexter shares jumped to a highof $561frasl4 then fell back to the low 50s again as the general stock mar-ket slumped At their highs of $561frasl4 Dexter shares were already up53 percent from my original recommended pricemdashand the final actin this superstock drama was yet to unfold

CHAPTER TEN Create Your Own ldquoResearch Universerdquo of Takeover Candidates 123

Chap 10 7901 855 AM Page 123

Finally on September 14 2000 Dexter shareholders approvedthe sale of Dexter to Invitrogen Under the terms of the takeoverDexter shareholders were offered $6250 per share

The Dexter opportunity came about from a 13-D filing in Barronrsquosinvolving 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

124 PART TWO Identifying Takeover Targets

Chap 10 7901 855 AM Page 124

C H A P T E R E L E V E N

How to Use the Financial Press

There is a growing tendency for the media to downsize categorizeanalyze and trivialize the newsmdasha sorry trend that panders to thedesire of an American public suffering from information overloadto have the news prefiltered explained and generally oversimplified

When 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 opinionmdasha 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 ideas

The financial media is becoming increasingly infected with thisinformation virus because it has learned that many investorsmdashespe-cially those who have only recently become enamored with the stockmarketmdashwould prefer to believe their research ldquohomeworkrdquo can beeasily done for them and the process of making money on Wall Streetis really not all that difficult

Certainly 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 ldquomomentumrdquo stocks you hear about day in and day

125

Chap 11 7901 856 AM Page 125

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

out based on the premise that todayrsquos market leaders will be tomor-rowrsquos 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 alone

The 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 Cafter 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 IBM

When 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 yearmdashan amaz-ing story especially in terms of risk and rewardmdashwhich 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 place

Some of the best sources to browse are Investorrsquos Business DailyThe Wall Street Journal and The New York Times Business Day section

Investorrsquos Business Daily (IBD) published by William OrsquoNeil andCompany in Los Angeles is a pioneer of financial journalism In

126 PART TWO Identifying Takeover Targets

Chap 11 7901 856 AM Page 126

many important ways IBD is a unique and highly useful sophisti-cated publication that has made giant inroads into areas where TheWall Street Journal has 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 ldquospikesrdquo 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 IBD

But when it comes to actually reporting the financial news IBDis sort of the USA Today of financial journalism Everything is report-ed in sound bites Whatrsquos worse IBD has become a prime exampleof the ldquoBig Brotherrdquo approach to financial journalism that is makingit increasingly difficult to find the sort of original ideas that wersquorelooking for as superstock browsers Because of this if yoursquore goingto be looking for off-the-beaten-path stock ideas you will not be ableto rely solely on IBD for all the information you need

As I said IBD has taken it upon itself to become your ldquoBigBrotherrdquo information filter directing its readers toward the popu-lar high-profile relative strength ldquomomentumrdquo stocks and steer-ing them firmly awaymdashlike a parent with an all-knowing guidinghandmdashfrom the lower-priced thinly traded stocks that might getyou in trouble IBDrsquos attitude is that the big winners come from acertain ldquogene poolrdquo 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 volumeand limited upside potential

In an incredibly bold move that stands as possibly the ultimateexample of Big Brother financial journalism on October 19 1998IBD proudly announced that it was taking its stock tables ldquoto thenext levelrdquomdashIBD did not specify in what directionmdashby exiling low-priced low-volume stocks to the financial netherworld In a frontpage story written by IBD chairman and founder William OrsquoNeilIBD 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

CHAPTER ELEVEN How to Use the Financial Press 127

Chap 11 7901 856 AM Page 127

When 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 Cainersquos 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 endangered

To Investorrsquos Business Daily these ldquoDirty Rotten Stocksrdquo 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 themmdashsort 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 them

As William OrsquoNeil explained in his articles to IBD readers ldquoWithmore than 500 initial public offerings added a year the tables getlonger and get harder to scan for future big winnersrdquo

Good Heavens Too much informationTherefore ldquoTo save you time we will separate lower-priced

and less active NYSE and NASDAQ stocks from the main tablesThese tables show NYSE and NASDAQ stocks priced at $7 or belowor trading less than an average of 10000 shares a dayrdquo

Later in the article Mr OrsquoNeil gets around to explaining the realreason for IBDrsquos decision to banish lower-priced and less-popularstocks to the financial dungeon ldquoStudies have shown that most stockspriced below $7 or trading less than 10000 shares a day have lowerquality less institutional ownership or weaker recent performanceThey usually carry greater risk or offer less long-term potentialrdquo

There are several problems with this logic that superstockinvestors should be aware of For one thing the term ldquolower quali-tyrdquo 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 trend

And yet if you had looked for water utility stocks likeConnecticut Water Service (CTWS) in the main NASDAQ stock list-ings carried in IBD you wouldnrsquot have found it because its tradingvolume fell below the respectability line which makes this stock

128 PART TWO Identifying Takeover Targets

Chap 11 7901 856 AM Page 128

riskier 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 ldquograduatedrdquo to IBDrsquos more respectable neighborhood Butwhen Middlesex was neglected and a much better value it was stilllisted in the dungeon section

Or 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 ldquopure playrdquo 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 theldquocrimerdquo of having average daily trading volume of less than 10000shares Pittway had been exiled to the IBD ldquoDirty Rotten Stocksrdquolist Barely a month later Pittway soared 16 points in one day to $45(+55 percent) following a takeover bid from Honeywell (see Figure11ndash1) Also in November 1999 the IBD dungeon list was pepperedwith numerous low-priced energy stocks Their only ldquocrimerdquo 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 A number of low-priced health care stockswere also on the list just before this group returned to favor in 2000In IBDrsquos eyes all of these stocks were of lesser quality than sayStampscom (STMP) which was trading at $9850 in November 1999and had a market cap of $35 billion with zero revenues STMP wasright there on the ldquorespectablerdquo mainstream list even though it wason the verge of making a stunningly swift trip down to $250 a sharea decline of 97 percent Pricelinecom (PCLN) was on the ldquorespect-ablerdquo list too before it dropped from $150 to $119 along with count-less other Internet stocks with out-of-this-world valuations that ulti-mately crashed Of course you can prove anything with 2020hindsight 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

CHAPTER ELEVEN How to Use the Financial Press 129

Chap 11 7901 856 AM Page 129

of the information you will need to implement this approach willnot be easily accessible to you and some of it may not be availableat all

And since when does ldquoless institutional ownershiprdquo translateinto the financial version of The Scarlet Letter To a genuine super-stock sleuth that is the whole point A dearth 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

130 PART TWO Identifying Takeover Targets

F i g u r e 11ndash1

Sample of Investorrsquos Business Dailyrsquos Section ldquoWherethe Big Moneyrsquos Flowingrdquo

Source Investorrsquos Business Daily December 21 1999

Chap 11 7901 856 AM Page 130

TEAMFLY

Team-Flyreg

The crime of ldquoweaker recent performancerdquo 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 here

IBD 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 stockswith 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 thanInvestorrsquos Business Daily to get all of the information you need

Another problem with Investorrsquos Business Daily is that in itsongoing drive to categorize everything the newspaper often allowssignificant news items to fall through the cracks In contrast IBDrsquosldquoTo the Pointrdquo section which appears on page 2 of the newspaperis 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 candidates

But 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 ldquoComputers amp Techrdquo ldquoTelecomrdquo ldquoInternetrdquo ldquoMedicalrdquo and othersuch groupingsmdashin 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 moment

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 itrsquos not available In November1999 for example Ersquotown Corp a NYSE-listed New Jersey-basedwater utility which we discussed earlier agreed to be acquired byBritainrsquos Thames Water PLC Ersquotown 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 Ersquotownrsquos stock price jump Ratherit was that the takeover bid for Ersquotown was part of a continuing andastonishingly rapid trend toward takeovers of US water utilitiesmany of which were being acquired by foreign companies eager toestablish a major presence in the US water industry

CHAPTER ELEVEN How to Use the Financial Press 131

Chap 11 7901 856 AM Page 131

The takeover bid for Ersquotown 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 pricesmdashtoonce again repeat this notable phenomenonmdashwas probably the singlemost interesting takeover story of 1999 especially considering the excel-lent riskreward 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 barrel

Immediately preceding the takeover wave in the water utilitystocks five of the nine stocks I recommended in my water utilityldquoWater Worldrdquo portfolio were listed in IBDrsquos second-class stock list-ings presumably too risky andor uninteresting for the averageinvestor to bother with

By the time Ersquotown received its takeover bid the water utilitytakeover trend was in full force Yet the Ersquotown takeover did notmanage to make it into the news section of Investorrsquos Business DailyEither it did not fit the cookie-cutter mold of categories that IBD usedto present its news items on that particular day or Ersquotownrsquos marketcapitalization or industry group was too small andor uninterestingto present to IBDrsquos readers who were constantly being schooled inthe high-profile follow-the-leader momentum school of investing(IBD has since abandoned its news ldquocategorizationrdquo approach)

Compare this total lack of analysis in IBD to the way The WallStreet Journal reported the Ersquotown story The Journal presented a com-plete background report not only on the Ersquotown 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 hadnrsquot alreadynoticed it months before

Despite the efforts of Investorrsquos Business Daily to portray itself asan alternative to the The Wall Street Journal there is really no com-parison between the twomdashespecially 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

132 PART TWO Identifying Takeover Targets

Chap 11 7901 856 AM Page 132

The moral of all of this is that you should not depend on a sin-gle source for all of your businessfinancial information

If 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 ldquoTo the Pointrdquo sec-tion of Investorrsquos Business Daily every day paying special attention tothe smaller seemingly unimportant items You should also scan thefront page of IBD particularly the ldquoIBDrsquos Top 10rdquo section whichcontains IBDrsquos version of the 10 most important business stories ofthe previous day

But that will not be enough and if you want to cover all thebases you should also browse the ldquoCompany Newsrdquo column in TheNew York Times Business Day section ldquoCompany Newsrdquo 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 sleuth

By browsing through certain sections of certain publications likeInvestorrsquos Business Daily and 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 havenrsquot hadthe time to investigate or may have seemed an isolated eventmdashuntilanother seemingly isolated event or piece of information places theprevious item in a new and more meaningful context

The Wall Street Journal is the financial ldquonewspaper of recordrdquo 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 Journal to find it Of coursethe high-profile takeovers spinoffs asset sales and so on will oftenbe discussed on the front page of The Journal in the ldquoBusiness ampFinancerdquo section of the ldquoWhatrsquos Newsrdquo 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 story

Another ldquomust readrdquo section of The Wall Street Journal for super-stock sleuths is the ldquoCorporate Focusrdquo column which appears in Section

CHAPTER ELEVEN How to Use the Financial Press 133

Chap 11 7901 856 AM Page 133

B 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 Journalrsquos ldquoIndustry Focusrdquo columnwhich also appears in the B Section

You never know where you will find interesting and useful infor-mation It often wonrsquot be on the front page of The Journal because themore obscure the information the more useful it will be to you sinceitrsquos less likely that the Wall Street ldquodiscountingrdquo mechanism will havefactored the information into the prices of the stocks involved (TheErsquotown takeover for example did not make the front page)

For example our old friend Pinault-Printemps-Redoutemdashacquirer of both Rexel Inc and Brylanemdashmade the news again inOctober 1999 by buying out the 428 percent of French office supplycompany Guilbert SA that PPR did not already own

You could have learned two things from this story whichappeared in the international section of The Wall Street Journal FirstPPR was still out there acquiring companies in which PPR alreadyowned a stake so this article served as a reminder to keep an eye onPinault-Printempsmdashespecially 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 items

Since 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 notedPPRrsquos partial ownership of Gucci if you did not already know itand added Gucci to your ldquoresearch universerdquo for further study

Among 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

134 PART TWO Identifying Takeover Targets

Chap 11 7901 856 AM Page 134

terms 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 1999

So 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 Swedenrsquos Securitas AB

You should have noticed that Abbott Labs (NYSE ABT) hadenacted a ldquoshareholder rights planrdquo 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 wingsyou 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 companyrsquos true worth

You would also have noticed that an outside shareholder of Dunamp Bradstreet (NYSE DNB) was trying to organize other sharehold-ers in an attempt to prod DNB management to sell the company

And 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 yoursquoll 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 formedmdasha picture that only you and others who thinkas you do will be able to see

CHAPTER ELEVEN How to Use the Financial Press 135

Chap 11 7901 856 AM Page 135

OTHER PLACES TO FIND ldquoTELLTALE SIGNSrdquo OFFUTURE SUPERSTOCK TAKEOVER CANDIDATES

Irsquove noted some of the shortcomings of Investorrsquos Business Daily ButIBD is a unique and innovative publication that provides a greatdeal of information you will not find in any other daily or weeklyfinancial publication

So letrsquos look at some things that IBD does extremely well thatcan be useful to you as a superstock sleuth

There are three sections of IBD in addition to the general newssummaries that are often helpful in the ongoing search for superstocktakeover candidates

Industry Profiles

Investorrsquos Business Daily regularly 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 andor 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 largerhigher-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 thatrsquosfine 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 targets

Another extremely useful aspect of the industry profiles sec-tion is a listing of companies that operate within the industry beingprofiled Headlined ldquoWhorsquos Who in the Grouprdquo 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 IBDrsquos

136 PART TWO Identifying Takeover Targets

Chap 11 7901 856 AM Page 136

industry profile was entitled ldquoPaper Products Tighter SuppliesConsolidation Fuel Upswing in Long-Suffering Industryrdquo 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 amp 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 takeoverpotential

Of course Investorrsquos 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 InsteadIBD lists the companies from top or bottom in terms of stock per-formance andor earnings growth The stocks says IBD are ldquoranked(not lsquolistedrsquo mind you but lsquorankedrsquomdashthis is Big Brother we are talk-ing about remember) by a combination of their earnings per shareand Relative Strength rankingsrdquo

So you will have to do a little reshuffling of the list if you wantto focus on the smaller companies in the group

But thatrsquos a small price to pay for a very useful presentation andI have uncovered quite a few takeover targets by reading IBDrsquos indus-try profiles section on a regular basis

ldquoWhere the Big Moneyrsquos Flowingrdquo

Another useful section of Investorrsquos Business Daily to look at on a reg-ular basis which can contain clues that may direct you to futuresuperstock takeovers is ldquoWhere the Big Moneyrsquos Flowingrdquo (seeFigure 11ndash1) This table which precedes the listings for the NYSEAmerican Stock Exchange and NASDAQ listings is designed to

CHAPTER ELEVEN How to Use the Financial Press 137

Chap 11 7901 856 AM Page 137

highlight stocks with significant increases in trading volume bothon the upside and downside

As 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 ldquoresearchuniverserdquo suddenly pop up on IBDrsquos 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 stock

If a stock has already exhibited one or more of the Telltale Signsof a potential superstock and suddenly begins showing up on IBDrsquoslist 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 ldquofilterrdquo this information for youthat only stocks trading at $18 or higher ($16 or higher on NASDAQ)and moving at least 1frasl2 point will be included in the table (For theAmerican Stock Exchange a stock must be trading $12 or higher andmove at least 1frasl4 point) In addition a stock must trade at least 60000shares to pop up on IBDrsquos NYSE volume-alert table and the stockrsquosEarnings Per Share and Relative Strength Ratingsmdashboth assigned byIBDmdashmust 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 ldquovaluerdquo stock with stagnant earnings pop up on this vol-ume-alert sectionmdasheven if the stock begins acting out of character

Still 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 activity

Charts IBDrsquos ldquoStocks in the Newsrdquo

Another area where Investorrsquos Business Daily is head and shouldersabove The Wall Street Journal is in its presentation of stock charts

138 PART TWO Identifying Takeover Targets

Chap 11 7901 856 AM Page 138

IBD correctly recognizes that technical analysismdashincluding chartanalysismdashis a valuable tool that can be used to your advantageAgain the whole premise of technical analysis is that there willalways be somebodymdashusually many somebodiesmdashwith more infor-mation than you have and this information will usually be put to useeither buying or selling the stock involved

The premise of technical analysis is that while you may notknow what the ldquoinsidersrdquo 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 ldquosuperstock breakoutrdquo 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 ldquoStocks inthe Newsrdquo sections of Investorrsquos Business Daily

IBD has a ldquoStocks in the Newsrdquo chart section for the NYSEAMEX 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 ldquoWhere the BigMoneyrsquos Flowingrdquo IBD provides valuable information in ldquoStocks inthe Newsrdquo

And herersquos another reason to pay particular attention to IBDrsquosstock 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 atmdashor not very far abovemdashkey break-out levels on the chartsmdasha valuable combination of characteristics for our pur-poses which you can only find in Investorrsquos 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 sections The 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

CHAPTER ELEVEN How to Use the Financial Press 139

Chap 11 7901 856 AM Page 139

as a market leader is often a tipoff that some good news such as atakeover is about to break This can often be the final catalyst thatprods you to take the plunge and buy the stock in question

Ersquotown Corp as an example popped up in IBDrsquos NYSE ldquoStocksin the Newsrdquo section just several weeks prior to its takeover bid fromThames Water PLC So did SJW Corp (SJW) in the months preced-ing the announcement that it might put itself up for sale If you hadbeen a superstock browser at the time both of these water utilitieswould already have been very high on your radar screen

Barronrsquos Financial Weekly

One other financial publication you should browse on a regular basisis Barronrsquos You will often find interviews with industry analysts whodiscuss industries where consolidation is taking place Barronrsquos veryoften asks these analysts to zero in on some potential takeover tar-gets You should use these interviews in the same way we are usingmost of the rest of the information discussed here Look for familiarnames that have managed to achieve a spot on your ldquoresearch uni-verserdquo 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 reason

Another important section is Barronrsquos listing of selected Form13-D filings which usually appears in the early pages of BarronrsquosldquoMarket Weekrdquo section Many if not most of the 13-D filings Barronrsquospresents 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 ldquoactivistrdquo 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 inBarronrsquos each week will prove worthwhile on many occasions

CASE STUDY THE TRIPLE PLAY AND MIDWAY GAMES

One 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 companyrsquos officers or directors

140 PART TWO Identifying Takeover Targets

Chap 11 7901 856 AM Page 140

TEAMFLY

Team-Flyreg

The 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-panyrsquos true value than most outsiders And it goes without sayingthat a companyrsquos own management would know better than anyonewhat the underlying fundamentals of a company look like and whatits future prospects might be

When you see a situation where the outside beneficial owner anda companyrsquos officers and directors are consistently buying stock onthe open market this is the ldquodouble playrdquomdasha bullish signal thatshould not be ignored When you also have the company itself buy-ing back stock this is the rare ldquotriple playrdquomdashone of the closest thingsyou will get to ldquoa sure thingrdquo on Wall Street

An example of a ldquotriple playrdquo 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 A man-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 share

Early in 1996 however analysts began to see signs of an earn-ings slowdown Midwayrsquos 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 Midwayrsquos stock collapsed as Wall Streetanalysts began pulling their buy recommendations

As you can see in Figure 11ndash2 Wall Street does not show anymercy when a ldquogrowthrdquo stock stops growing Midway shares plum-meted from near $25 in the spring of 1998 to a low of $75frasl8 by 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 companyrsquos support among the mainstreamWall Street analysts had evaporated A former Wall Street darling inthe high $20s Midway was totally unloved at $8 by January 1999

CHAPTER ELEVEN How to Use the Financial Press 141

Chap 11 7901 856 AM Page 141

Well 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 Midwayrsquos own chairman and CEO Neil Nicastro

Several of Midwayrsquos 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 Midwayrsquos 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 rebound

The analysts did not want to hear it They wanted to know whatwould happen in the next quarter which Nicastro had already

142 PART TWO Identifying Takeover Targets

F i g u r e 11ndash2

Midway Games (MWY) 1997ndash1999

Source Courtesy of Mansfield Chart Service Jersey City NJ

Chap 11 7901 856 AM Page 142

explained 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 1999

But 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 it

Neil 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 businesswhile the analysts were talking abut the short-term momentum (or lackthereof) of a number that appears in The Wall Street Journal every dayMidwayrsquos stock price

Meanwhile something very interesting was appearing in VickersWeekly Insider Report which clearly suggested that Midway share-holders would soon be experiencing better times

The first clue that Wall Street might have been overreacting toMidwayrsquos short-term speed bump appeared in the June 10 1998issue 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 115500 shares atprices ranging from $131frasl4 to $137frasl16 The purchase that really stood outwas a 100000-share buy on the part of Midway chairman Nicastroat $131frasl4 on May 21 1998

These insider purchases combined with an announcement that Midwayitself would buy back 1 million shares of its own stock strongly suggestedthat Midwayrsquos stock price decline was far out of proportion to the short-term earnings problems the company was experiencing When a compa-ny announces a stock buyback it can be misleading Though theBoard of Directors has ldquoauthorizedrdquo a buyback ldquoup to 1 millionsharesrdquo it does not necessarily mean the company will actually buythe shares In most cases the authorization will say that the timing

CHAPTER ELEVEN How to Use the Financial Press 143

Chap 11 7901 856 AM Page 143

andor implementation of the buyback will ldquodepend on the stockprice or market conditionsrdquo 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 ldquoauthorizationsrdquo to buy back shares

However 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 Itrsquos 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 marketrsquos 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 stock

So by the summer of 1998 there was evidence of two-thirds ofa ldquotriple playrdquo 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 ldquotriple playrdquo A few weeks later Midway insiders purchased7500 shares at $137frasl16 another bullish omen

By mid-1998 Midway had dropped below $10 and the Sep-tember 16 1998 issue of Vickers Weekly Insider Report noted moreinsider buying Once again Midway chairman Neil Nicastro had

144 PART TWO Identifying Takeover Targets

Chap 11 7901 856 AM Page 144

purchased a large block of stock this time buying 20000 shares onAugust 31 1998 at $93frasl4 to $97frasl8 Also on August 31 Midwayrsquos VPByron Cook purchased 5000 shares at $107frasl8

It was in September that the last piece of theldquotriple playrdquo 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 Redstonebought 107800 shares at $101frasl2 Then during the second half ofOctober Redstone bought a huge block of 573200 shares at $91frasl4 to$125frasl8 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 setback

And the open market buying did not stop there Nicastro pur-chased another 25000 shares bringing his total purchases to 169000shares And in late November Sumner Redstone bought another 140000shares followed by an additional purchase in early December of 119800shares This brought Redstonersquos total purchases since September 1998 to940800 shares a nearly $10 million commitment to Midway stock which isquite a vote of confidence even for a man of Sumner Redstonersquos means

Itrsquos 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 1998

First 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 and there was heavy insider buyingin the stock were the reasons to not bail out along with everyoneelse on Wall Street Instead I became more aggressive with the stockas it fell because these purchases by Redstone Midway insidersand 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 superstock

Here is a classic case of Wall Street focusing on momentumwhile Redstone Midway chairman Nicastro and other insidersmdashas well as the company itselfmdashwere focusing on Midwayrsquos longer-term value as a business The ldquovaluerdquo assigned to Midway by the

CHAPTER ELEVEN How to Use the Financial Press 145

Chap 11 7901 856 AM Page 145

Wall Street momentum crowd and the analysts who pander to themcompared to the ldquovaluerdquo 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 beholder

To continue with the clues that made Midway a superstock inJanuary 1999 Midway chairman Nicastro bought an additional303950 shares at $8 and Sumner Redstone bought another 80000shares between $81frasl2 and $10 In February however Midway sharestook another plunge falling to the $75frasl8 to $8 range

In 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 analystsrsquo attention to what they believedwould happen in the second half of 1999 which would be the first6 months of Midwayrsquos fiscal year 2000 In particular Nicastro triedto direct the analystsrsquo 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 yoursquore 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 blockbusters

When 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 priceThis 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 you

In 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

146 PART TWO Identifying Takeover Targets

Chap 11 7901 856 AM Page 146

The $64000 question or in this case the $5 million questionwas why had Nicastro spent roughly that amount of his own moneypurchasing 461450 shares of Midway stock over the preceding 12months The Midway chairman said ldquoI believe that at some point themarket will value our business much differently than it values it today Ijust donrsquot 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 stockrdquo

You may have noticed that Neil Nicastro used the phrase ldquovalueour businessrdquo Too often Wall Street treats a stock as nothing morethan a piece of paper Terry Rudd author of the book 1929 Againmakes 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 ldquomomentum investingrdquo 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 ldquostocksrdquo represent shares in a business andbusiness is not always a one-way street Even a true ldquomomentumrdquobusiness a true ldquogrowthrdquo company can hit an occasional potholeor speed bump To a companyrsquos 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 clients

When Cherrie Mahon asked Neil Nicastro ldquoWhy are you buy-ing so much stockrdquo Nicastro said in effect because Midwayrsquos prof-its were going to go back up and Wall Street would be nuts to placesuch a low valuation on this company

Despite Nicastrorsquos comments and the outlook for Midway stockanalysts 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 ldquotriple playrdquo in which an outside beneficial owner companyinsiders and the company itself are all buying stock at the same time

CHAPTER ELEVEN How to Use the Financial Press 147

Chap 11 7901 856 AM Page 147

It also shows a rare behind-the-scenes glimpse at how company insid-ers beat the professional Wall Street analysts and investors at theirown game by simply taking a step back to take a longer-term pointof view In fact ldquolonger-termrdquo in this case only meant 6 to 12 monthsmdashbut to the Wall Street ldquomomentumrdquo 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 perspective

The ultimate outcome of this little drama Midwayrsquos 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 wouldEverything transpired just as he suggested in early 1999mdashin thatsame conference call that led to a rash of analyst sell recommenda-tions virtually at the bottom of Midwayrsquos stock slump

By November 1999 Midway had reached $247frasl8 as earningssoared to record levels and the same Wall Street analysts who hadbeen issuing sell recommendations at the bottom reinstated theirbuy recommendationsmdashat triple the price from Midwayrsquos lows inJanuary or February 1999

So the next time you see a ldquotriple playrdquo 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 itrsquos almost alwaysa signal that you have a potential superstock on your hands and thatthe news is about to get better A lot better

148 PART TWO Identifying Takeover Targets

Chap 11 7901 856 AM Page 148

C H A P T E R T W E L V E

Family Feuds

Herersquos 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 bid In the case of ADTndashWestern 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 investorThe 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 ldquobene-ficial ownerrdquo especially when these disagreements break out into a publicsquabble

Consider the following case study as another example

CASE 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 Copleyrsquosoperations by continuously changing its mind about what it wantedto do with its Copley stake Hoechst said Ms Varis ldquowas demoralizing

149

Chap 12 7901 856 AM Page 149

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

management and depressing shareholder valuerdquo She complainedthat Hoechst ldquoforced Copley to hire investment bankers and spendmillions of dollars in fees and time of key Copley personnel who couldhave been developing new products and expanding Copleyrsquos busi-nessrdquo She claimed that after forcing Copley to go through the processof hiring an investment banker Hoechst decided it did not want to sellits stake after all

In a parting shot Varis added ldquoIrsquoll serve Copleyrsquos shareholdersbetter from outside the company You canrsquot do anything insiderdquo

Agnes Varisrsquos stinging public criticism of Hoechst AG was high-ly unusual From time to time you will see private disagreementsbetween officers or directors of a company and a major sharehold-er Usually these disagreements come in the form of structured let-ters written by attorneys that are ldquoleakedrdquo filed with the SEC as a13-D amendment or simply released to the press In most cases thesedisagreements arise between mutual fund companies or pensionfunds that hold sizable stakes in a company and that for one reasonor another are unhappy about the direction the company has taken

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 Itrsquos not unusual for an insti-tutional investor to take a stake in a company sit with it for a whileand then fire off a letter to management suggesting the companytake steps to ldquoenhance shareholder valuerdquo or ldquomaximize shareholdervaluerdquo 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 mismanaged

In reality in most cases the institutional investor is trying tolight a fire under a losing positionmdashie trying to bail out of a mis-take by bullying the management into taking short-term actions thatcould boost the stock price

For 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 itInstitutions 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

150 PART TWO Identifying Takeover Targets

Chap 12 7901 856 AM Page 150

TEAMFLY

Team-Flyreg

more likely to send up a few threatening flares see what happensand then quietly liquidate its position on any runup in the stock asa result of the brouhaha

So donrsquot 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 ldquoenhance shareholder valuerdquo Anymanagement that has been paying attention to recent trends shouldrespond with a polite letter thanking the institution for its thoughtsand then go back to running the business This sort of publicity gam-bit usually wonrsquot lead to a takeover bid

The situation at Copley Pharmaceuticals as you will see wasquite different The background of the Copley Pharmaceuticals-Hoechst AG situation following Agnes Varisrsquos 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 companywhich would effectively result in Copley throwing out its 51 per-cent shareholder

Copley Pharmaceuticals had gone public in October 1992 at$1267 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 Copleyproving 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 1997

The drop in Copleyrsquos 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 companyrsquos prospects and the future direction of itsstock price

In September 1996 Hoechst publicly stated that Copley did notfit its ldquocorerdquo business strategy and forced Copley to hire an invest-ment banker to look into the possible sale of the company This move

CHAPTER TWELVE Family Feuds 151

Chap 12 7901 856 AM Page 151

according 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 Hoechst

In August 1998 we noted that a ldquostandstill agreementrdquo whichprevented Hoechst from buying additional Copley shares wouldexpire in October 1998

What is a standstill agreementSometimes 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 A cannot increase its stake in Company B beyond a certainpercentage without expressed permission from Company B Thatrsquosa standstill agreement

Whenever a big chunk of one company is owned by anotheryou 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 companyrsquos 10-K reportwhich 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 unfold

As a result of this research Copley was recommended in thenewsletter as an ldquoadditional ideardquo

In September 1998 Copley Pharmaceuticals was added to thesuperstock recommended list The stock price for Copley at the timewas $83frasl4 The news that Hoechst AG had decided to undergo a cor-porate restructuring was significant In a situation like this where ageneral corporate ldquohousecleaningrdquo such as Hoechst was about toundergo would take place a decision was likely to be made aboutHoechstrsquos 51 percent stake in Copley

Now all of the pieces were in place for a takeover drama tounfold

Every relationship even personal relationships start out withhigh hopes But when the relationship sours and both parties beginto get on each otherrsquos nerves it is only a matter of time before a sep-aration has to take place

152 PART TWO Identifying Takeover Targets

Chap 12 7901 856 AM Page 152

When 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 in The 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 doingwhatrsquos 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 eye-to-eye

It seemed clear to me that Hoechst or some third party wouldhave to make a bid for Copley Unfortunatelymdashor perhaps fortu-nately depending on how you look at itmdashit wasnrsquot 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 brieflythen sagged back and traded listlessly in the $8 to $10 range

In December 1998 with Copley trading at $87frasl16 there wererumors that Hoechst AG was about to merge with Francersquos Rhone-Poulenc SA The rumors if true would create the worldrsquos second-largest pharmaceuticals company Remember Hoechst had an-nounced a planned ldquorestructuringrdquo and in fact Hoechst had alreadysold several of its noncore operations including its paints business

Here is how we analyzed this rumor of a potential HoechstndashRhone-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 Copleyrsquosbook value of $530 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 goodriskreward ratio anywhere in the $6 to $9 range

CHAPTER TWELVE Family Feuds 153

Chap 12 7901 856 AM Page 153

In February 1999 with Copley trading at $911frasl16 Hoechst hadbeen selling off some of its smaller noncore operations and we indi-cated that ldquothe 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 trendrdquo

And then we added ldquoThe 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 stakerdquo

As things turned out that last statement was significant Itrsquos 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-miummdashsometimes a significant premiummdashto a stockrsquos 52-week highIn nearly all cases a takeover bid will a carry a premium to a stockrsquosaverage trading price over the past 30 or 60 days Only in rare caseswhere 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 dayrsquos closing price And once in a blue moonwhen word of a takeover has leaked so badly that the target com-panyrsquos stock has really soared you will witness what is called a take-undermdasha situation where the takeover price is actually lower thanthe previous dayrsquos closing price because advance word of the dealwas so widespread that speculators got carried away and simplybid the price of the target company too high

In the case of Copley Pharmaceuticals we had a buy limit of$111frasl2 on our recommendation However based on some apparentimprovement in Copleyrsquos earnings and influenced by the fact thatHoechst had paid an incredible $55 per share for its original stakeit seemed that raising the buy limit on Copley to $13 would be asound move

At that point Copley was trading near $101frasl4 By April 1999Copley had crossed $113frasl4 For the next several months Copley trad-ed quietly between $83frasl4 and $101frasl2 Then in June 1999 a news itemwas the clincher Copley was trading at $915frasl16 when Hoechstannounced that it would spin off its Copley stake as part of CelaneseAG a Hoechst operation containing most of Hoechstrsquos chemical and

154 PART TWO Identifying Takeover Targets

Chap 12 7901 856 AM Page 154

industrial 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 Copleyrsquos other major shareholderswould try to take Copley private or sell it to a third party

For the next 2 months Copley traded quietly between roughly$81frasl2 and $101frasl2 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 dealHoechst AG also agreed to sell its 51 percent stake in Copley to Tevafor $11 per share

Anyone who had bought Copley at $83frasl4 would have made aprofit of 25 percent based on this $11 takeover bid in 10 monthsAnyone who had followed the growing body of evidence that atakeover bid for Copley was brewing and had taken advantage ofdips in Copleyrsquos 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 bid

To 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 industrieshowever pegging a value is more difficult

In the end Copley proved solidly profitable although less prof-itable than anticipated

But the most important lesson to be learned from the CopleyPharmaceuticals saga is that the original analysis based on the orig-inal evidence proved to be accurate

The next time you see a public disagreement erupt between acompany and its largest shareholdermdashespecially if that sharehold-er is another corporation and not an investment companymdashyou

CHAPTER TWELVE Family Feuds 155

Chap 12 7901 856 AM Page 155

should think in terms of a potential takeover bid The next time yousee a public disagreement between a director and a companyrsquos man-agementmdashespecially if the director resigns and makes statementsabout protecting shareholder interests or enhancing shareholdervaluemdashyou 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

156 PART TWO Identifying Takeover Targets

Chap 12 7901 856 AM Page 156

P A R T T H R E E

Takeover Clues

Chap 13 7901 858 AM Page 157

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

This page intentionally left blank

C H A P T E R T H I R T E E N

ldquoBeneficial Ownerrdquo Buying

CASE STUDY SUMNER REDSTONE AND WMS INDUSTRIES

Knowing how to read a stock chart can be a valuable tool in select-ing potential superstocks A stock that is breaking out above a well-defined multiyear resistance level is usually telling you somethingie that something bullish is going on Herersquos how chart analysisled to a recommendation of WMS Industries

In spring 1989 the chart in Figure 13ndash1 caught my attentionResearch indicated that WMS Industries manufactured pinball andvideo games and owned two hotelcasinos in Puerto Rico Here wasa stock with a terrific long-term chart that was acting like it wasabout to attempt a superstock chart breakout

In April 1989 WMS was trading at $75frasl8 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 levelsThis can often be a signal that a stock is about to make a seriousattempt at a major breakoutmdasha superstock breakout pattern

By 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 company

159

Chap 13 7901 858 AM Page 159

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

The 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 157500 shares inearly 1989 at prices ranging from $55frasl8 to $8

This 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 thisexplosive combination was a breakout above the $8 to $81frasl4 area themultiyear resistance level that had contained WMS since 1986

160 PART THREE Takeover Clues

F i g u r e 13ndash1

WMS Industries (WMS) 1987ndash1989

Source Courtesy of Mansfield Chart Service Jersey City NJ

Chap 13 7901 858 AM Page 160

TEAMFLY

Team-Flyreg

When a well-defined multiyear resistance area in a stock is beingpenetrated it usually means something has changed significantly forthe better Sometimes itrsquos 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-uationmdashin 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 entrepreneurwas also a suggestion that something bullish was brewing

At 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 ldquospinning offrdquo its hotelcasino as a separatecompany

When 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 analysis

In 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 real reason 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 WMSrsquos desire to

CHAPTER THIRTEEN ldquoBeneficial Ownerrdquo Buying 161

Chap 13 7901 858 AM Page 161

maximize the value of its hotelcasino operations When a compa-ny is thinking of getting into a new business itrsquos hard to keep itunder wraps And WMS was a leading manufacturer and distribu-tor of pinball and video gamesmdashwith the trade names ldquoWilliamsrdquoldquoMidwayrdquo and ldquoBallyrdquomdashthat could be found in restaurants and tav-erns throughout America Now a brand new industry was emerg-ingmdashvideo lotteries and video pokermdashthat 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 on

The superstock chart pattern and the major breakout came aboutas a result of buying pressure in the stock Who was doing the buy-ing A good guess would have been that a growing number of peo-ple close to WMS andor 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 ldquomaximize the valuerdquo of itsPuerto Rico hotelcasinos which were carried on WMS Industriesrsquobooks at far below their actual values)

These are the sort of ldquounder the surfacerdquo developments thatcreate bullish chart patterns and major breakouts Sometimes thereasons for the major breakouts are apparentmdashand 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 noticedmdashwhich is precise-ly what happened in tracking WMS Industries

On April 28 1989 I noted the major breakout in WMS ldquoThisstock seems to have a lot going for it A solid story an apparent earn-ings turnaround a great long-term chart and steady accumulationon the open market by a potential acquirerrdquo

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 ldquospikerdquo Again the chartist may nothave known why WMS shares were being bought with such urgency

162 PART THREE Takeover Clues

Chap 13 7901 858 AM Page 162

but the chart was clearly suggesting that something very bullish wasgoing on

By 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-ket this time buying 101100 shares at prices between $81frasl4 and $115frasl8Redstonersquos stake in WMS had now increased to 288 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 story

By mid-August 1989 WMS had fallen back below $12 per shareRevenues and earnings continued to rise sharply due to rapid growthin the companyrsquos pinball and video arcade games On September 11989 our recommendation was that ldquosince Sumner Redstone paid asmuch as $115frasl8 for WMS stock this should serve as somewhat of abenchmark for usmdashie 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 levelrdquo

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 advancedecline line weresinking relentlessly In October a sharp sinking spell took the Dowdown a quick 11 percent but smaller stocks suffered much more

Meanwhile WMS had announced some disappointing newsThe company said it would report a loss at the quarter due to aplanned shutdown of its manufacturing line for ldquoretoolingrdquo 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 $8

According 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

CHAPTER THIRTEEN ldquoBeneficial Ownerrdquo Buying 163

Chap 13 7901 858 AM Page 163

disaster struck this time a natural disaster Hurricane Hugo dam-aged some of the WMS hotelcasino properties in Puerto Rico Thecombination of Hugo and the assembly line shutdown caused WMSto report a loss of $076 per share for the quarter and the stockslumped back toward the $8 support area again

1990 Convictions about WMS Are Put to the Test

What happened during 1990 to WMS stock was a classic example ofhow superstock investing differs from almost any other method ofstock selection A combination of recession Iraqrsquos invasion of Kuwaita 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

Redstone had paid up to $115frasl8 for 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 market

Without those open market purchases by Redstone there would havebeen no benchmark of value with which to work But since we did have thatbenchmarkmdashand since we were betting on Redstone or on something Redstoneknew about WMS as a potential catalyst to get the stock price highermdashweadded to our stake in WMS during nearly all of 1990 at single digit prices

It was not easy to watch WMS decline as far as it did in 1990but 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 notmdashand that as it turned out made all the difference

By late December 1990 WMS Industriesrsquo stock had fallen to$37frasl8 But two new Telltale Signs emerged during that year to indicateit was still a potential superstock

The two catalysts were the announcement that WMS would seekto spin off its Puerto Rico hotelcasinos to ldquoenhance shareholdervaluerdquo and WMS would write off its investment in a company calledDivi Hotels even though the investment still had apparent value

164 PART THREE Takeover Clues

Chap 13 7901 858 AM Page 164

These two Telltale Sign announcements along with the continuing288 percent ownership of Sumner Redstone and the fact that Redstonehad paid as high as $115frasl8 for WMS stock was a sign that WMS hadsignificant unrecognized values lurking beneath its low stock priceThe decision to write off the investment of Divi Hotels was an exam-ple of what is called kitchen sink accountingmdasha 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 year

As a superstock detective these telltale signs clearly suggestedthat something very bullish was lurking beneath the surface atWMSmdashsome development or some value that the stock market hadnot yet recognized Yet WMS shares plunged throughout the year

To 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 US bank stocks whichwere suffering from a rash of bad loans

In an environment such as this it is not easy to disregard the gen-eral stock market and focus on specific events or potential ldquocatalystsrdquothat 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 timesmdashin fact they were the worstof times for small stocks and WMS spent all of 1990 eroding in price

Sooner 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 ldquoCutting your lossesrdquo is easiersaid than done Nobody has perfect timing you may have bought

CHAPTER THIRTEEN ldquoBeneficial Ownerrdquo Buying 165

Chap 13 7901 858 AM Page 165

precisely 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 invalidPerhaps some mutual fund is getting out of a position and the stockis dropping Does that make you wrong and the mutual fund right

Thatrsquos 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 declineBut if you donrsquot really know why you bought a stockmdashif you boughtit for some vague reason (an analyst recommended it on televisionitrsquos a ldquogood companyrdquo itrsquos a growth stock etc)mdashthen yoursquore goingto have a difficult time deciding what to do when the stock startsmoving in the wrong direction

Superstock investing while it is by no means perfect at leastgives you a guidepost In the case of WMS Industries the stock tooka sickening plunge from $10 to as low as $31frasl4 between July andDecember 1990 It was not pleasant But I knew why I had recom-mended the stock in the first place and did not see anything thatcaused me to doubt my original premise

To reiterate here are the reasons I stuck with WMS 1 Sumner Redstone an outside beneficial owner with a stel-

lar track record owned 288 percent of WMS and hadrecently bought stock for as much as $115frasl8 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 company

2 WMS had raised the possibility of spinning off its PuertoRico hotelcasinos as a separate company to enhanceshareholder value The term ldquoenhance shareholder valuerdquois a key phrase and a telltale sign for superstock investorsIt 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 value

3 The earnings disruption at WMS had taken place for a spe-cific reasonmdasha shutdown of the manufacturing facility for

166 PART THREE Takeover Clues

Chap 13 7901 858 AM Page 166

retooling Yet the stock marketmdashdue to a lack of analystcoverage of WMS mdashwas overacting to the temporary loss

4 The 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 ldquoclear the decksrdquo for better news around the cor-nermdashanother Telltale Sign

There is no way around this If you want to make the right deci-sion when a stock starts moving against you you have to know exact-ly why you 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 reasonmdashyou should be looking at a specific ldquocluerdquo or potentialldquocatalystrdquo that tells you to buy this stock Then if the stock movesthe wrong way you should ask yourself Is the reasoning still validIf 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 valid

But if the original premise remains sound you should hang intheremdashand if you can you should buy more to take advantage of thelower price

On December 31 1990 WMS closed at $31frasl4 Despite whatseemed to be a logical analysis the stock had now declined 57 per-cent from my original recommended price of $75frasl8

I did not use a stop loss on the way down and did not recom-mend a ldquosellrdquo of WMS for year-end tax loss In other words I did notfollow any of the simplistic ldquorulesrdquo for intelligent investing

And itrsquos a good thing too because in 1991 WMS Industries turnedout to be the best-performing stock on the entire New York Stock Exchange

On February 8 1991 WMS had broken out of a nice base in the$31frasl2 to $41frasl2 area The stock moved up quickly trading above $6Earnings rebounded nicely following the onetime charges and theretooling which really was not much of a surprise since WMSIndustriesrsquo basic business was continuing to grow

But 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

CHAPTER THIRTEEN ldquoBeneficial Ownerrdquo Buying 167

Chap 13 7901 858 AM Page 167

reassure 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 WMSlate in 1990 on its way from $10 to $31frasl4

Once again Sumner Redstone had paid over $10 for large blocksof stock and there was WMSrsquos desire to enhance shareholder valuemdashone of the key code phrases for superstock investorsmdashspinning offits hotelcasinos operations as a separate company

Research into this plan led to some interesting informationabout appraisals of the value of the WMS hotelcasino propertiesThe Condado Plaza was worth between $105 and $110 million whichmeant that the 80 percent owned by WMS was worth about $84 mil-lion (about $10share) Yet WMS carried its 80 percent ownershipof the Condado Plaza on its books at a value of $37 million (about$435share) 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 $6share) However this asset was also carried on theWMS books at only $37 million ($435share)

In a situation like this itrsquos important to focus on the differencebetween ldquobook valuerdquo and true ldquoasset valuerdquo especially when yoursquoredealing with real estate A great 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 value and 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 ldquobook valuerdquoUsually the asset is initially valued at its historical cost which mayor may not reflect the actual value several years down the road

In the case of a piece of machinery for example the value of thatmachinery will decline over time as the machinersquos 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 assetrsquos cost each year from its earnings The depreciationldquoexpenserdquo is not really a cash expense it is just a bookkeeping entry

168 PART THREE Takeover Clues

Chap 13 7901 858 AM Page 168

that allows the company to reduce its tax bill somewhat and alsoreduces the carrying value or ldquobook valuerdquo of the asset each year

For 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 $100000depreciation charge (one-tenth of the machinersquos cost) that is deduct-ed from earnings If the company earned $2 million that year itwould only report $19 million after the $10000 depreciationldquoexpenserdquo The ldquoexpenserdquo did not involve a cash outlay but savedperhaps $40000 in taxes because it reduced reported earnings That$40000 saving is supposed to allow the company to accumulate cashto replace the machine when its useful life wears out in 10 yearsThat is the purpose of the depreciation allowance

The other effect of that $100000 depreciation ldquoexpenserdquo is toreduce the carrying value or ldquobook valuerdquo of the machine on the com-panyrsquos balance sheet At the end of the first year that $1 million machinewill be carried on the books at its newly depreciated value of $900000The book value of that machine will decline each year by $100000 untilthe machine wears out and a new one must be purchased

Of 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 ldquobook valuerdquo of the com-pany will understate the actual value of its assets

It 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 ldquobook valuerdquo may overstate the actual value of the asset

On the other hand letrsquos 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

CHAPTER THIRTEEN ldquoBeneficial Ownerrdquo Buying 169

Chap 13 7901 858 AM Page 169

what you paidmdashbut their true worth is not reflected in your compa-nyrsquos ldquobook valuerdquo

Book Value and Kirby Industries

The term ldquobook valuerdquo can be very misleading In 1974 in the midstof a crushing bear market a small oil and gas company called KirbyIndustries announced that it would sell off its assets and pay outcash to its shareholders This type of self-liquidation is fairly com-mon today it usually occurs when a company believes its assets areworth far more than its stock price and when the stockholders wouldbe better served by selling the assets and paying the proceeds direct-ly to the stockholders

In 1974 however the concept of voluntary liquidation wasnovelmdashso novel in fact that nobody seemed to know how to analyzethe situation I was still a junior analyst at Merrill Lynch when Kirbyannounced it would liquidate itself and the only reason I noticed theannouncement was that I had a friend who owned a substantial num-ber of Kirby shares I called him and asked him what the announce-ment meant

ldquoThe assets of this companyrdquo he told me ldquoare 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 theyhavenrsquot even started drilling yet but they know the oil and gas arethere They even have a small auto insurance company in PuertoRico thatrsquos worth way more than its book value They think sellingthe company off piece by piece will create a better value for the stock-holdersrdquo

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 plan

The 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

170 PART THREE Takeover Clues

Chap 13 7901 858 AM Page 170

TEAMFLY

Team-Flyreg

company was too small Their advice was to stay away from the sit-uation because it appeared ldquotoo riskyrdquo

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 termldquotoo riskyrdquo means ldquoIt doesnrsquot fit the paradigm in which I am usedto operatingrdquo Everybody is used to a certain way of doing thingsboth personally and professionally When a situation arises thatbreaks the mold the initial reaction is to not deal with it Ignore itPretend it does not exist Just go on doing what yoursquore used to doingwhile an opportunity sits there outside the box waiting to be expe-rienced and profited from

In the case of Kirby Industries a voluntary liquidation was out-side the familiar paradigms of most securities analysts So insteadof ldquothinking outside the boxrdquo the oil and gas analysts just didnrsquotthink about Kirby at all They ignored it because it did not fit theirpreferred and preconceived manner of thinking

The 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 previouslytraded at $151frasl8 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 $28mdashup 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 $2828 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 ldquobook valuerdquo and ldquohistorical costrdquo in relation tooil and gas properties

More 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 lettermdashand decided to make Kirby Industries my very first recommendation

CHAPTER THIRTEEN ldquoBeneficial Ownerrdquo Buying 171

Chap 13 7901 858 AM Page 171

And 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 Ricohotelcasinos Because the hotelcasinos had been depreciated onWMSrsquos books they were therefore undoubtedly worth more thanldquobook valuerdquo 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 value

Then 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 correctHe had paid far in excess of WMSrsquos current market price for stockand he must have seen something that the market was missingCould it have been the value of the hotelcasinos Or somethingelse that was not on Wall Streetrsquos 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 stock

By early February 1991 however WMS had doubled in pricefrom its 1990 close of $31frasl4 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 companyrsquos 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

172 PART THREE Takeover Clues

Chap 13 7901 858 AM Page 172

Now the true earnings power of WMS was becoming apparent onceagain and the stock was moving higher

By 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 atprices between $33frasl8 and $61frasl8 This was a major reinforcement to hangin there and continue to follow Redstonersquos 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 ldquoroadmaprdquo to guide you) and adding to your stake in a declining stockKnowing why you bought the stock in the first placemdashin this casebecause we were following a sophisticated outside beneficialownermdashtells you what to do if the stock starts going against youRedstone by adding to his stake in WMS at these lower prices hadjust updated the road map WMS was still a buy

At the same time there were also some interesting ldquotechnicalrdquoor chart patterns in WMS Take a look at this chart in Figure 13ndash2and you will see that WMS on the way up from its low at $31frasl4 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 pattern

What 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 pointsBy 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 market

In May 1991 Redstone purchased an additional 193100 WMSshares at prices between $87frasl8 and $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 price

Now think about what this would mean to you as an investorSuppose you had been a WMS shareholder at the time You boughtstock at $8 and watched it slump to a low of $31frasl4 ldquoOld paradigmrdquo

CHAPTER THIRTEEN ldquoBeneficial Ownerrdquo Buying 173

Chap 13 7901 858 AM Page 173

investors would have been discouraged and confusedmdashbut as asuperstock investor you would not because yoursquod be following tworoad maps Sumner Redstonersquos continuing purchases of WMS andthe WMS plan to unlock the value of its hotelcasino propertiesWhile 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 Yoursquod 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 greater

Compare this confident attitude to the plight of someone whobuys a stock for some vague reasonmdashletrsquos say because it is a ldquogrowthrdquostock You buy the stock and it starts to decline What do you do Youhang in there because you have been told it is a ldquogrowthrdquo stockPretty soon the stock is down 25 percent Now what do you do

174 PART THREE Takeover Clues

F i g u r e 13ndash2

WMS Industries (WMS) 1989ndash1991

Source Courtesy of Mansfield Chart Service Jersey City NJ

Chap 13 7901 858 AM Page 174

Cutting Your Losses

Do you follow the simplistic ldquocut your lossesrdquo routine or do youbuy more Well itrsquos hard to say because you really donrsquot have a han-dle on why you bought the stock in the first place Even if itrsquos aldquogrowth stockrdquo what is it worth Are interest rates rising If they areyour growth stock might be growing nicely but the stock price isgoing to be worth progressively less as interest rates rise because itspriceearnings 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 ldquonew businessrdquo which is immediatelytaken into account by the market results in your ldquogrowth stockrdquoopening another 25 percent lower in a single trade which meansyou should have followed the ldquocut your losses rulerdquo

On the other hand maybe you did follow the ldquocut your lossesrdquorule 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 stupid

But should you How could you have possibly known what todo You were operating without a road map without guidelinesmdashwithout a guiding principle if you want to put it in those terms

Compare 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 knew that WMS management was aware of this andthat they were looking for ways to force the stock market to reflectthis value You knew that 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 dropped

This mind-set is the major difference between superstock invest-ing and any other approach to the stock market It wonrsquot always lead

CHAPTER THIRTEEN ldquoBeneficial Ownerrdquo Buying 175

Chap 13 7901 858 AM Page 175

to profitable investmentsmdashbut it will lead to peace of mind a coher-ent strategy and the ability to make decisions for rational reasonsAnd there is a lot to be said for that

In June 1991 I received a letter from a subscriber who askedwhether WMS might eventually become a manufacturer of videolottery terminals

Video 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 A small 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 machines

Further 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 devicesFor 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 Suddenlythere was an answer to this question The growth in demand wouldcome from state-run video lotterypoker terminals and the prolifer-ation of Native American casinos across the country

Some 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 percentmdashall 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 casinos

Would WMS Industries enter the market for video lottery ter-minals If so the effect on its stock price could be huge

176 PART THREE Takeover Clues

Chap 13 7901 858 AM Page 176

WMS was not commenting But Dow Jones News Service hadtalked to a distributor of WMSrsquos pinballvideo games which as Isaid were ubiquitous in restaurants and taverns all over the countryThe distributor confirmed to Dow Jones that WMS had told him it wouldsoon be unveiling a video lottery terminalmdashpossibly 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 WMSrsquos productsmdashWilliams Bally and Midway Now if WMS were about to unveil avideo lottery terminalmdashwhich in manufacturing terms was not allthat different from what WMS was already producingmdashthe rela-tionships of WMS distributors with bar and restaurant owners acrossthe country could mean that WMS would be in the driversrsquo seat ver-sus IGT when it came to placing these machines

The 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

By June 1991 WMS had already advanced from $31frasl4 to $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 ease

In retrospect itrsquos easy to see why WMS was performing so welland 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 notWMS had to retool itrsquos manufacturing facilities it had to conductmarket research it had to bring in teams of designers and it had to

CHAPTER THIRTEEN ldquoBeneficial Ownerrdquo Buying 177

Chap 13 7901 858 AM Page 177

prepare its distributors around the country for the introduction of thisnew product The increasing awareness of WMSrsquos upcoming entryinto this exciting new growth industry was undoubtedly one of themajor factors in the bullish patterns being created on the companyrsquosstock 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 WMS

This is another example of how charts can help point youtoward potential stock market winners Itrsquos 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 ldquofoot-printsrdquo on the chart By recognizing the signs of informed and con-fident demand you can pretty much know what the smart moneyis doingmdasheven if you do not know what the smart money knows

By 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 industrySometimes there will be no ldquolag timerdquo at all and all of the stocks inthe industry group will move together Other times there will be a brieflagmdashdays or a week or two at the mostmdashbefore the other stocks inthe industry group start to move up in sympathy with the leader

In 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 earlierSince 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

178 PART THREE Takeover Clues

Chap 13 7901 858 AM Page 178

no 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 thegroupmdashbut 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 stockswhich 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 individualsmdashjust like youmdashwho are willing to put two and two together and come up withfourmdasha 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 us

The 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 companyrsquos entrance into the VLTmarket by dropping from $13 to $10 providing yet another buyingopportunity for those who were keeping their eye on the ball

Finally in late July 1991 a brokerage firm analyst noticed WMSand published a report recommending it as a buy

Take a look at the chart in Figure 13ndash3 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 allymdashbrokerage firm sponsorship This was thefinal ingredient necessary for WMS to follow in the footsteps of

CHAPTER THIRTEEN ldquoBeneficial Ownerrdquo Buying 179

Chap 13 7901 858 AM Page 179

International 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 revenueseach time another state decidesto legalize VLTs we think the handful of stocks involved in VLTs willget a boost

WMS 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

180 PART THREE Takeover Clues

F i g u r e 13ndash3

WMS Industries (WMS) 1990ndash1992

Source Courtesy of Mansfield Chart Service Jersey City NJ

Chap 13 7901 858 AM Page 180

TEAMFLY

Team-Flyreg

with 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 WMSrsquos new VLTHe told me that ldquoWilliams 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 reliableproductrdquo Nicastro also confirmed that ldquoif 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 WMSrdquo

Meanwhile back on the chart WMS was sketching out thatfamiliar superstock chart pattern once again A short-term resistancearea near $15 to $151frasl2 was being attacked over and over again bybuyers with demand coming in at progressively higher levelsmdashastrong signal that WMS stock would be moving higher

By late September 1991 WMS had broken out above its resistancearea at $15 to $153frasl8 to 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 ldquoconcentrating on stockswhich will not depend entirely on an economic recovery to do wellSuch stocks would include takeover candidates and companies whichmay be involved in an industry which could actually benefit from asluggish economy An example would be WMS Industries whichreached another new high and which is up an astonishing 85 percentsince late Junerdquo

In OctoberndashNovember 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 WMSrsquos pinballgames could be developing in Eastern Europe where communism

CHAPTER THIRTEEN ldquoBeneficial Ownerrdquo Buying 181

Chap 13 7901 858 AM Page 181

was giving way to democracy and also in South America where pin-ball games were catching on with young people

Only 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 IndustriesAll 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 ldquorespectablerdquo price range and the stock hadmorphed into a ldquomomentumrdquo stock

Wall 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 ldquoleisurerdquo 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 wouldnrsquot officiallyrecommend WMS he told me it was ldquonot an institutional sort ofstockrdquo whatever that meant

Finally 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

ldquoNow that itrsquos a $20 stock I can get our institutional clients inter-estedrdquo the analyst said

ldquoExcuse merdquoldquoLookrdquo he said ldquothese guys arenrsquot going to buy a $7 stock with

no research coverage that nobodyrsquos ever heard of Itrsquos too risky If itgoes down yoursquoll get all sorts of heat and who needs that Now thatWMS is a $20 stock and itrsquos moving and itrsquos a relative strengthleadermdashsee I can sell that story Theyrsquoll listen to me at this price levelThe stock is more recommendable at these levelsrdquo

ldquoAre you telling merdquo I said ldquothat even though you knew thesame things about WMS at $7 or $10 that you know now that youdidnrsquot recommend the stock simply because it was too cheaprdquo

ldquoYesrdquo

182 PART THREE Takeover Clues

Chap 13 7901 858 AM Page 182

ldquoAnd now that WMS is more expensive you are willing to stickyour neck out because you wonrsquot get criticized as much as if it doesnrsquotwork outrdquo

The analyst sighed ldquoI know it sounds ridiculousrdquo he said ldquoButyes that is what Irsquom telling yourdquo

Do you think things have changed since thenOn November 19 1998 a mutual fund portfolio manager

appeared on CNBC In response to a viewer question the fund man-ager launched into an informed and enthusiastic analysis of what youwould call a ldquovalue stockrdquo which carried a rich dividend yield soldat a low priceearnings ratio and seemed like an undiscovered gem

ldquoWould you buy the stock hererdquo the host asked ldquoWellrdquo the portfolio manager said ldquoI would if I didnrsquot have so

much short-term performance pressure on me It would be a greatstock to buy and tuck away But you know I canrsquot do that itrsquostoughrdquo

The portfolio managerrsquos voice trailed away and the host went onto the next question But his comments spoke volumes about the ldquolem-mingrdquo 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 underpricedmdashuntil 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 have loved to buy and ldquotuck awayrdquo in his fundrsquos portfolio buthe didnrsquot 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 lemmings

On December 31 1991 WMS Industries closed at $277frasl8 up 669 per-cent from its 1990 closing price of $31frasl4 That performance made WMS thebest-performing stock on the New York Stock Exchange for 1991

By 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 sharemdashan incredible gain of 1161 percent fromits closing level at year-end 1990

What is the lesson to be learned from the WMS story

CHAPTER THIRTEEN ldquoBeneficial Ownerrdquo Buying 183

Chap 13 7901 858 AM Page 183

Actually there are severalWMS Industries had three of the Telltale Signs for identifying

future 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 ldquounlockrdquo that value

These 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 WMSrsquos bullishchart pattern was created by persistent buying among those whowere becoming aware of the companyrsquos impending entry into thevideo lottery terminal industry Itrsquos possible that Sumner Redstonersquosbuying was related to this insight as wellmdashor perhaps SumnerRedstone was buying because he knew that the WMS hotelcasinoswere worth far more than WMSrsquos stock price was reflecting

Who knowsThe point is this The signs were there even if the information

that created those Telltale Signs did not emerge until laterWMS Industries is a textbook example of how a superstock

chart pattern together with outside beneficial owner buying canlead you to a huge winnermdasheven if you donrsquot know why that stockis going to be a winner

Postscript to the WMS StoryEventually WMS Industries got around to spinning off its

hotelcasino 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 share

The takeover bid for WHG Resorts valued the company ataround $130 million Based on the fact that WMS Industries hadaround 104 million shares outstanding when the company first

184 PART THREE Takeover Clues

Chap 13 7901 858 AM Page 184

announced that it was seeking to ldquounlock the valuerdquo of its hotelcasi-nos WMSrsquos hotelscasino 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 properties

Which is why you should always take a close look at ldquospinoffsrdquoas potential superstock candidates

CHAPTER THIRTEEN ldquoBeneficial Ownerrdquo Buying 185

Chap 13 7901 858 AM Page 185

This page intentionally left blank

C H A P T E R F O U R T E E N

The ldquoPure Playrdquo and theDrugstore Industry

There is always a disposition in peoplersquos 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 with

this which make it unlike its predecessors andgive assurance of permanency

Charles H Dow JournalistJune 8 1901 The Wall Street Journal

Things changeDon Ameche Actor

Things Change

Charles Dow founder of Dow Jones amp Company and Don Amechea 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 becausemdashwell because things change

On 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 fads

187

Chap 14 7901 858 AM Page 187

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

appear 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 yoursquore riding the final glorious upward arcmdashitalways 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 otherwise

In this chapter you will learn about ldquopure playsrdquo and spinoffsand how they can lead you to superstocks and superstock takeoversBut first letrsquos go back to the 1960s when ldquoconglomeratesrdquo were allthe rage and Wall Street was discovering the meaning of the latestbuzzwordmdasha fad called ldquosynergyrdquo

The technical definition of synergy is ldquothe joint action of agentssuch as drugs that when taken together increase each otherrsquos effec-tivenessrdquo 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 ten

In the 1960s the concept of ldquosynergyrdquo 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 timesThe 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 companymdashcalled a ldquoconglomeraterdquomdashwouldreport 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 homesmdashor whatever else you owned thatmight be doing well while something else was performing poorly

That 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 manner

So synergy and the conglomerate craze slowly petered outmdashproving once again that Charles Dow and Don Ameche knew whatthey were talking about (Of course some ldquosynergiesrdquo are too powerful

188 PART THREE Takeover Clues

Chap 14 7901 858 AM Page 188

and obvious to be denied In an obviously well-thought-out strategyNetherlands-based Unilever PLC announced two takeovers on thesame day in April 2000 First Unilever said it would buy ice creammaker Ben amp Jerryrsquos Homemade whose products include the notori-ously calorie-laden ldquoChubby Hubbyrdquo brand for $326 million Also onthat day Unilever announced the $23 billion acquisition of diet prod-ucts company Slim Fast Foods thus putting Unilever in the businessof both causing and curing obesitymdasha synergistic win-win situationif ever there was one)

Interestingly however there are some vestiges around of thetrend toward synergy even todaymdashand when these vestiges beginto jettison operations that do not fit their core businessesmdashin otherwords when a company decides it wants to be more of a ldquopure playrdquoin a well-defined industrymdashit can lead you to potential superstocks

In recent years a growing number of companies have decidedthat theymdashand their stockholdersmdashwould be better off as ldquopureplaysrdquomdashie 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 stations

In 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 company

In 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 spinoffrsquos business once it is separated from the parent

Another 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-

CHAPTER FOURTEEN The ldquoPure Playrdquo and the Drugstore Industry 189

Chap 14 7901 858 AM Page 189

arating the fast-growing subsidiary and turning it into a separatelytrading company the growth rate that had been previously obscuredwill become more apparent which could lead to a higher priceearn-ings multiple for the spinoffrsquos stock

A third possibility is that by spinning off a company in an indus-try where there is a lot of takeover activity the spinoff could becomea takeover target This is what happened to WHG Resorts thehotelcasino spinoff of WMS Industries which following its sepa-ration from the parent company in 1997 more than doubled in pricewithin 6 months

Most Wall Street analysts recommend investing in spinoffs forall of these reasons but there is a different way to look at spinoffsAs a superstock investor you should look at every announced spin-off and ask yourself Which company operates in an industry wherethere is a great deal of takeover activity the parent company or thecompany being spun off

The answer to that question may surprise you In fact in manycases you would be better off buying the parent companymdashespe-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 sale

A rule 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 companyrsquos industry

If 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 bidder

CASE STUDY FAYrsquoS AND GENOVESE

In 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 thenationrsquos largest drugstore company was never consummated becauseof regulatory opposition But in commenting on the reasoning for

190 PART THREE Takeover Clues

Chap 14 7901 858 AM Page 190

TEAMFLY

Team-Flyreg

Rite Aidrsquos bid for Revco Rite Aidrsquos chairman Martin Grass com-pared the fragmented drugstore industry to the banking industrywhich 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 companyrsquos bid for Revco

Although the Rite AidndashRevco merger never took place this inter-view was the ldquoroad maprdquo 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

1 Rite Aid (see Chapter 17)2 Revco3 Walgreens4 Eckerd5 Melville Corp (which owned CVS Drugs which was

eventually spun off and acquired)6 Cardinal Health (which owned Medicine Shoppes)7 Thrifty-Payless8 American Stores (which owned Osco and Sav-On Drugs)9 JCPenney (which owned Thrift Drugs) (see Chapter 17)

10 Longs Drug Stores11 Big B12 Fayrsquos13 Drug Emporium14 Arbor Drugs15 Genovese Drug Stores

If 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

CHAPTER FOURTEEN The ldquoPure Playrdquo and the Drugstore Industry 191

Chap 14 7901 858 AM Page 191

behind his bid for Revcomdashwhich only goes to prove that Yogi Berraknew what he was talking about when he said ldquoYou can observe alot just by watchingrdquo Or in this case browsing

The 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 takeovers

My first successful drugstore takeover candidate recommen-dation was Fayrsquos Inc and it was recommended for one reasonmdashthissmall drugstore company was selling off noncore assets makingitself a ldquopure playrdquo drugstore company By December 1995 Fayrsquoshad just sold its Wheelrsquos 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 industrymade Fayrsquos an obvious takeover candidate Fayrsquos was readying itselffor sale by getting rid of ldquononcorerdquo operations a move that wouldmake it more attractive to a larger drugstore company seeking acqui-sitions At the time Fayrsquos was trading at $63frasl4

In January 1996 another small drugstore company was addedto my list of takeover recommendations Genovese the nineteenthlargest drugstore companymdashwith 113 stores in the New York CityLong Island areamdashhad also recently become a pure play by sellingoff its nondrugstore operations

I quoted Rite Aid chairman Martin Grass on the rationale ofpotential drugstore industry mergers being ldquovery analogous towhatrsquos going on in the banking industry Wersquore able to absorb storeseliminate tremendous overhead and take costs off the systemrdquo

Our view was that the managements of Fayrsquos 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 Fayrsquos management might be preparing to sell the com-pany

ldquoAs I previously reported Fayrsquos has been selling off its nondrugstoreretail operations Now Fayrsquos has announced the elimination of 90administrative jobs which would save $3 million per year or about

192 PART THREE Takeover Clues

Chap 14 7901 858 AM Page 192

$014 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 industry

Fayrsquos stock continued to languish at $73frasl4 As part of its cost-cut-ting move Fayrsquos had taken a ldquorestructuringrdquo charge and the stockmarket reacted by pushing Fayrsquos shares briefly down to the $61frasl2 areaHere was another situation where a complete lack of analytical coverageresulted in the stock market putting the wrong interpretation on this newsExperience in noticing the Telltale Signs of an impending superstocktakeover targetmdashie any company selling off noncore assets andcutting costs in an industry where a takeover trend was in forcemdashwas practically hanging a ldquoFor Salerdquo sign on the front door But whenFayrsquos took its restructuring chargemdashwhich would yield future ben-efits to cash flow and earningsmdashall the stock market saw was a lossfor the quarter There was no room for nuance A low-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 Fayrsquos shares lower was another clue thatFayrsquos would soon become a takeover target

In April 1996 the Rite AidndashRevco 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 consumersHowever the FTC left the door open for other drugstore industrymergers which would be smaller in scale By May 1996 Fayrsquos stockwas moving highermdashever since the Rite AidndashRevco deal was ter-minated

By July 1996 Fayrsquos had finally sold its Paper Cutter office sup-ply stores for $14 million which meant it was now a pure drugstorecompany

Anyone concentrating on the ldquopure playrdquo concept and the factthat Fayrsquos 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 Fayrsquos was a genuine takeover candidate And yet despitethe fact that Fayrsquos had finally sold off its last nondrugstore operationand taken a ldquoclear the decksrdquo restructuring chargemdashand despite thefact that the Federal Trade Commission had pretty much publiclystated that it would encourage smaller drugstore mergersmdashdespiteall of this Fayrsquos shares were trading at $75frasl8 only slightly higher thanthe original recommended price of $63frasl4 six months earlier

CHAPTER FOURTEEN The ldquoPure Playrdquo and the Drugstore Industry 193

Chap 14 7901 858 AM Page 193

Suddenly just 8 days later on July 11 1996 Fayrsquos announcedthat it had received a takeover bid from JCPenney which owned theThrift Drug Store chain The stock market reacted as though it wasshockedmdashshockedmdashat the news Fayrsquos shares jumped to $107frasl8 onthis news Fayrsquos 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 ended

In July 1996 discussing the Fayrsquos takeover proposal I againraised the possibility that Genovese Drug Stores could become atakeover target for precisely the same reason that Fayrsquos had Genovesehad sold off its nursing home division in the previous year a movesimilar to Fayrsquos selling off its nondrugstore operations in 1995ndash1996prior to selling itself to JCPenney

Also the Genovese chain of drugstores was located almost pre-cisely in the middle of the geographic areas that would be servedby Penneyrsquos Thrift Drugs chain and a newly acquired Fayrsquos chain Atthat time Genovese Drug Stores was trading near $8 adjusted fortwo subsequent 10 percent stock dividends

Within two weeks Fayrsquos announced that it had agreed to beacquired by JCPenney for $1275 per sharemdashan 85 percent gain fromthe recommended price of $63frasl4 in just 7 months and all because Fayrsquoshad tipped its hand by selling off its noncore operations and becoming apure play in an industry where a takeover wave was under way

The Fayrsquos recommendation had turned out to be on target sowe next turned our attention to Genovese a very similar companyIn addition to operating in the same general area of the country asFayrsquos and like Fayrsquos recently becoming a pure play by selling offnoncore assetsmdashin its case a nursing home divisionmdashGenovese hadsomething else going for it a potential superstock chart pattern Thechart showed a well-defined multiyear resistance area at $11 to $12mdashprecisely 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 status

Research showed that 43 percent of Genovesersquos stock wasowned by the family who founded the company Now you mightlogically think that would be a roadblock to a takeover But in fact

194 PART THREE Takeover Clues

Chap 14 7901 859 AM Page 194

the opposite is true Around a third of Fayrsquos outstanding stock wasowned by the founding family yet Fayrsquos 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 ldquocash outrdquo and become part of a larger company

Look at it from this point of view You start a small companybuild 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 competitors

What do you do Do you stubbornly hold on to your indepen-dence and take the risk that your companyrsquos 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 stockrsquos 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 familytax considerations come into play Take a look at the JCPenneyndashFayrsquosdeal this buyout was structured as a tax-free transaction under whichFayrsquos shareholders receive $1275 worth of JCPenney stock For thePanasci family which founded Fayrsquos they were sitting with a $7 stockwith the realization that the company they founded was worth almosttwice that amount A cash buyout would result in a huge tax liabilitybut 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 position

So 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 outmdashand youwill find that many of these family-controlled companies will become

CHAPTER FOURTEEN The ldquoPure Playrdquo and the Drugstore Industry 195

Chap 14 7901 859 AM Page 195

willing takeover targets rather than run the risk of being left by thewayside as minor players in an industry dominated by a handful ofgiant competitors

On 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 holdings

According 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 ldquoanti-takeoverrdquoagreement

But our view was that the press had it all wrong and it wasmisleading to characterize this as an ldquoanti-takeover pactrdquo 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 shareholdersmdashwho control 574 percent ofGenovese stockmdashrecognized 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 future

As 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 future

In the case of Genovese Drug Stores this pact between the twolargest shareholders of the company indicatedmdashin no uncertaintermsmdashthat they were discussing what they would do in the eventof a takeover bid

In November 1998 Genovese agreed to be acquired for $30 pershare by none other than JCPenneymdashprecisely 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 $911share

196 PART THREE Takeover Clues

Chap 14 7901 859 AM Page 196

So 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 wasnrsquot 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 investor

When it comes to stocks that are not widely followed by ana-lysts or sometimes not followed by any analyst news items andindustry trends that seem to have clearly bullish implications for asmaller off-the-beaten-path company have no effect on the stockYou see news you make the connection you buy the stock andmdashnothing 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 ldquoroad maprdquomdashie remem-bering why you 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 deduced

Take a look at the chart of Genovese Drug Stores (Figure 14ndash1)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 approachingGenovese stock plunged from $251frasl2 to $15

Genovese had also had a sinking spell a year earlier after thecompany announced a ldquostrategic restructuringrdquo in which it cut costsand closed underperforming storesmdashprecisely the sort of movesFayrsquos 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 takeoverInstead Genovese was punished

In 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 Fayrsquos acquisition the stock should be doingbettermdashand it wasnrsquot

Here was my response

CHAPTER FOURTEEN The ldquoPure Playrdquo and the Drugstore Industry 197

Chap 14 7901 859 AM Page 197

This is a fact of life on Wall Street Unless a widely followed estab-lishment analyst with a connection to a strong retail sales force (ielots of stockbrokers) is delivering a certain story that storymdashno mat-ter how logicalmdashwill not be fully reflected in the stock price This isa major problem with small-cap and microcap stocks and I canrsquot 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 ie generate fees as an investment banking client

198 PART THREE Takeover Clues

F i g u r e 14ndash1

Genovese Drug Stores (GDXA) 1996ndash1998

Source Courtesy of Mansfield Chart Service Jersey City NJ

Chap 14 7901 859 AM Page 198

It 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 companiesmdashtherefore some terrific stories gounreported

When Fayrsquos 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 forsalemdashespecially in view of the fact that the drugstore industry wasrapidly consolidating But Fayrsquos stock did nothing for a long timedespite the fact that it was trading far below its takeover value untilthe company finally announced that it was talking to JCPenney abouta possible buyout

Getting 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 Aidrsquos 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 mergers

Although the Rite AidndashRevco 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 Fayrsquos 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 Fayrsquos indicates that JCPenney islooking to build its Thrift Drug unit into a major player A recent TuckerAnthony research report on Arbor Drugs suggests that Arbor has the cash

CHAPTER FOURTEEN The ldquoPure Playrdquo and the Drugstore Industry 199

Chap 14 7901 859 AM Page 199

and the infrastructure to handle an acquisition Melville Corp will soonbe spinning off its CVS Drug Store chain as a separate company and analystsbelieve CVS will attempt to get bigger through acquisitions Other potentialbuyers include Walgreens Eckerd and Longs

Also in another interesting development the chairman of Revcorecently told Dow Jones that he expects drugstore industry consoli-dation to continue Now that the Rite AidndashRevco merger is off Revcorsquoschairman told Dow Jones that Revco now plans to be an aggressive buyer itselfof smaller drugstore chains

So we have a very large list of potential buyers out there andit seems obvious that some of the smaller drugstore companies willbe receiving takeover bids Other than Genovese Drug Stores whoare some of the other candidates

If you want to look further afield consider Big B a 383-storechain After the Fayrsquos takeover Big Brsquos executive vice president saidthat Big B has ldquono interest in entertaining acquisition offersrdquo and thatthe company is trying to expand on its own That could mean thatBig 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

This lengthy quote illustrates what is meant by the term ldquoroadmaprdquo Here was the analysis from beginning to end Any investorwho read this analysis had two choices It either made sense or itdidnrsquot 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 idea

Genovese 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 1996BusinessWeekrsquos ldquoInside Wall Streetrdquo column had two articles on theprospects of a buyout of Genovese Drug Stores by JCPenney andthe takeover of Fayrsquos Here was the complete story on GenoveseDrug Storesmdashthe road map if you willmdashin an international maga-zine read by millions of people brought to you by an analyst whohad just predicted the takeover of Fayrsquos in the very same publica-tionmdashand yet Genovese stock continued to languish for 2 yearsright up until the takeover bid forced the stock to triple

It 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

200 PART THREE Takeover Clues

Chap 14 7901 859 AM Page 200

TEAMFLY

Team-Flyreg

coverage 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 ldquoefficient stock marketrdquo which meansyoursquoll be able to see things that the Wall Street pros are completelyoverlooking

As Irsquove noted more than once though it is worth repeating Itrsquosdifficult to sit with a stock doing nothing or drifting lowermdashespeciallywhen you see evidence that this stock should be selling at a sub-stantially higher price But when this happens you have to stick toyour gunsmdashas long as the original ldquoroad maprdquo is intact

There is no other way to do itA few weeks later Big Bmdashthe drugstore company that had publicly

stated that it would remain independentmdashaccepted a takeover bid fromnone other than Revco the company that had publicly stated that it wouldstart shopping for smaller drugstore companies

Big 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 Fayrsquos 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 onArborrsquos small size and on the fact that the founding family controlled a largestake in this company Arbor Drugs was likely to be acquired itself

In September 1996 following the Big B takeover Arbor Drugswas added to my recommended list at $83frasl4 And in February 1998Arbor Drugs accepted a $23 per share takeover bid from CVS

CASE STUDY SMITH FOOD amp DRUG CENTERS

In November 1996 browsing through a list of 13-D ldquobeneficialownerrdquo filings in Barronrsquos revealed that Transamerica Corp the giantinsurance company was accumulating shares of Smith Food amp DrugCenters (SFD) on the open market Research indicated that SFD wasa potential superstock takeover candidate

CHAPTER FOURTEEN The ldquoPure Playrdquo and the Drugstore Industry 201

Chap 14 7901 859 AM Page 201

SFD operated in two industries where takeover activity wasrampant supermarkets and drugstores The company operated 147food and drug centers mostly in the southwestern United StatesInterestingly 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 openmarketmdashanother Telltale Sign and a strong signal that a companybelieves its stock is undervalued

What initially drew my attention to SFD was the open marketbuying by Transamerica which had recently raised its stake to 1642percent of the company paying as high as $2825 for SFD shares Butfurther research revealed something far more interesting About 14percent of SFD was owned by the investmentbuyout firm of YucaipaCos which had already been involved in several supermarket dealsYucaipa owned a controlling interest in supermarket giant FredMeyer Inc and also owned stakes in publicly traded DominickrsquosFoods a Chicago-based supermarket chain and Ralphrsquos a privatesupermarket company Clearly Yucaipa was the sort of sophisticat-ed outside investor who would have the ability to ldquocash outrdquo of itsstake in SFD at the right time and the right price if it chose to do soSince 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 sale

A look at SFDrsquos 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 SFDrsquos 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 operationsall indicated that SFD was a takeover candidate

In November 1996 SFD was added to my recommended list at$291frasl2

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

202 PART THREE Takeover Clues

Chap 14 7901 859 AM Page 202

Ultimately Dominickrsquos Foodsmdashthe other publicly traded super-market company which was partially owned by Yucaipa Cosmdashalsoreceived a takeover bid Remember I began browsing through those13-D filings in Barronrsquos which resulted in a single piece of informa-tion involving Transamericarsquos purchases and that touched off someresearch That research yielded additional clues which eventually ledto information about Yucaipa Cos

Thatrsquos an example of why it pays to browse

LESSONS LEARNED

Lesson number one is this If you believe a takeover wave is aboutto strike a particular industry and if yoursquore on the lookout for poten-tial takeover targets you should concentrate on smaller to mid-sizedcompanies because they will be the most vulnerable to takeoversThis stands to reason because the economies of scale being achievedthrough takeovers will tend to make it more difficult for smallercompanies to competemdashand this is one reason why these small com-panies may decide to link up with a larger company

The second lesson is to look for companies in a takeover-livelyindustry that appear to be transforming themselves into ldquopure playsrdquoFayrsquos 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 itself

The 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 ldquoFor Salerdquo 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 market

The fourth lesson all things being equal is that you shouldtake special note of companies in which a large block of stock (say10 percent or more) is held by a single shareholdermdashespecially 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 shareholdermdashtry 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

CHAPTER FOURTEEN The ldquoPure Playrdquo and the Drugstore Industry 203

Chap 14 7901 859 AM Page 203

and 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 ldquoseize themomentrdquo by cashing out

Finally look for superstock chart patterns Pay particular atten-tion to smaller companies that are bumping up against well-definedmultiyear 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 betterWhen 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 hands

Keep 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 RevcoAfter considering his reasoning the conclusion was that more drug-store takeovers were likely That observation led to Fayrsquos a pureplay in the making which led to Genovese Drug Storesmdashand so on

One 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

204 PART THREE Takeover Clues

Chap 14 7901 859 AM Page 204

C H A P T E R F I F T E E N

Using Charts

The market feels what cannot be observed It is continually alerting us to those things which are not readily foreseeable

AJ Frost

The 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 existedmdashoften withhighly profitable results

The 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 stocksIf an industry is in the doldrums and harbingers of a new positivetrend begin to emerge someone will be the first to get wind of itAnd as the information becomes more widely disseminated a light-bulb will go on in somebodyrsquos 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 thebettermdashand certainly long before individual investors become awareof itmdashthe stocks that will benefit will be bid higher and Telltale Signswill emerge to be noticed and interpreted by investors who are

205

Chap 15 7901 900 AM Page 205

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

familiar 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 noticed

This chapter will describe to you the specific chart pattern calleda ldquosuperstock breakoutrdquo pattern This chart pattern involves a stockthat is breaking out to the upside above a very well-defined multiyearresistance level Resistance level is 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 again

The 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 higher

The significance of a breakout from a ldquosuperstock breakoutrdquopattern 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 theyrsquore buyingstock at levels that have contained every previous rally attempt

Either way a breakout above a multiyear resistance level is usu-ally a sign that a stock is going to move significantly higher

The best way to introduce you to this type of chart pattern is tostart with an actual example

In late 1993 and early 1994 there was an emerging trend towardhealth care takeovers In January 1994 we wrote that ldquoif there is oneclear trend developing in the takeover area right now it is thisHospital companies are looking to get bigger by acquiring smallerhospital companies and they are also looking to broaden their healthcare services by lsquovertically integratingrsquo or acquiring companies thatprovide other types of health carerdquo

206 PART THREE Takeover Clues

Chap 15 7901 900 AM Page 206

CASE STUDY SALICK HEALTH CARE

Browsing through charts of every small hospital and ldquospecialty healthcarerdquo company in search of the ldquosuperstock breakoutrdquo pattern justdescribed a stock called Salick Health Care (SHCI) popped up Itschart pattern had that of a potentially powerful superstock breakoutpattern (Figure 15ndash1)

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 A close 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 highas $161frasl4 in January 1993 Sellers won that battle once again and Salickdropped back down to the $10 area By summer 1993 Salick was

CHAPTER FIFTEEN Using Charts 207

F i g u r e 15ndash1

Salick Health Care (SHCI) 1992ndash1994

Source Courtesy of Mansfield Chart Service Jersey City NJ

Chap 15 7901 900 AM Page 207

attacking that $17 resistance area again and once again the stockretreatedmdashbut this time the buyers stepped in just below the $14 areaIn early 1994 the stock was in the process of making its fifth attemptat a breakout in the multiyear resistance area near $17

The strong suspicion was that eventually Salick would be ableto break through the resistance level Why Because something fun-damental had changed Takeovers of ldquospecialty health carerdquo 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 ldquoin theknowrdquomdashie 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 stock

When 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 hands

As 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 Yetafter 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 breakoutareamdashbut 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 targets

There 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

208 PART THREE Takeover Clues

Chap 15 7901 900 AM Page 208

may have to endure a 20 percent 30 percent or even a 50 percentdecline in the stock price

If you insist on limiting your losses to 10 percent you will beldquostopped outrdquo 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 investment

There is no easy answer to this problem The bottom line is thisIf a stock starts going against you you should know two thingsFirst is the original premise on which you based your decision to buystill intact And second where is the support level on the chartmdashie 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 line

In 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 Miami

By 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 way

The 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$3735 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 $16

And 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-

CHAPTER FIFTEEN Using Charts 209

Chap 15 7901 900 AM Page 209

out pattern that was instantly recognizable because it had worked ahundred times before By determining that there were likely to betakeovers in the specialty health care stocks I searched for a super-stock breakout pattern and found it

Thatrsquos how I did itmdashand thatrsquos 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 ldquoequipmentrdquo gets its useTerry 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 next

The ldquosuperstock breakoutrdquo 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 Finallywhen a stock is able to break through this long-term resistance levela 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 ie a paradigm shift is taking place

When Salick Health Care finally broke out above its long-termresistance area near $17 to $171frasl4 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 A takeover 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

210 PART THREE Takeover Clues

Chap 15 7901 900 AM Page 210

TEAMFLY

Team-Flyreg

Sellers 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 industryand the general stock market environment just like every other stock

But the emerging takeover wave in the specialty health care stockschanged the paradigm for Salick That takeover wave transformedSalick from an obscure cancer treatmentkidney 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 wasWhat would Salick Health Care be worth as a business to a potentialbuyer And based on this new paradigm Salickrsquos supplydemandequation shifted

That breakout above the $17 to $171frasl4 resistance area was a clearsignal that Salick was being perceived in a different light by WallStreet

Here is another example of how a superstock chart breakoutmdashand nothing but a superstock breakoutmdashled me to the takeover bidfor Rohr Inc

In June 1995 an emerging takeover trend was taking place inthe defenseaerospace industry Scanning through the charts in theMansfield Chart Service which are arranged by industry groupsindicated 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 15ndash2 and 15ndash3) 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 ldquodogrdquo 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

CHAPTER FIFTEEN Using Charts 211

Chap 15 7901 900 AM Page 211

Rohr was added to my recommended list Much like an elec-trocardiogram can tell an experienced physician what is going oninside a patientrsquos 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 stock

Just a few weeks after the initial recommendation an outsidebeneficial ownermdashan investor named Paul Newton of NorthCarolinamdashhad accumulated a 52 percent stake in Rohr

Within a year of the original recommendation based on its super-stock breakout pattern Rohr had soared from $13 to $233frasl4 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 ldquoclearingthe decksrdquo so to speak for future positive earnings reports If you are

212 PART THREE Takeover Clues

F i g u r e 15ndash2

Rohr Inc (RHR) 1991ndash1993

Source Courtesy of Mansfield Chart Service Jersey City NJ

Chap 15 7901 900 AM Page 212

running 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 you

As Fayrsquos Genovese Drug Stores and others demonstrated thestock market usually takes news of an unexpected restructuringcharge at a sparsely followed company as a negativemdashbut the mar-ketrsquos initial reaction is often completely mistaken

Rohr 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 Sign

As a rule of thumb When corporate officers and directors pur-chase shares in their own company on the open market immediately

CHAPTER FIFTEEN Using Charts 213

F i g u r e 15ndash3

Rohr Inc (RHR) 1993ndash1995

Source Courtesy of Mansfield Chart Service Jersey City NJ

Chap 15 7901 900 AM Page 213

following 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 considerablybetter

In 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 ldquoroad maprdquo remained intact

Rohr shares eventually fell as low as $14 following the restruc-turing write-offs and the quarterly loss Just several months laterthough Rohr roared back to $21 following a better-than-expectedearnings reportmdashwhich is precisely what you would have expectedin light of the insider buying following the previous earnings reportThat insider buying provided a road map to Rohrrsquos valuemdashin 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 situation

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

214 PART THREE Takeover Clues

Chap 15 7901 900 AM Page 214

C H A P T E R S I X T E E N

The 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 ldquoDomino Effectrdquo 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 fallingdominoes

The 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 theindustry

The 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 action

CASE STUDY VIVRA AND REN-CORP USA

Another 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 16ndash1) Here is that superstock breakout pattern again a well-

215

Chap 16 7901 918 AM Page 215

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

defined multiyear resistance level with a recent series of rising bot-toms indicating that buying pressure is coming in at progressivelyhigher levels In Vivrarsquos case the key price level was around $24ndash$26As a kidney dialysis company Vivra fell into the general category of spe-cialty health caremdashan area where takeover activity was very lively

Vivra was added to my list of recommended stocks at $24Fourteen 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 Caremdashwhich also operatedsome kidney dialysis facilities you will recallmdashhad 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

216 PART THREE Takeover Clues

F i g u r e 16ndash1

Vivra (V) 1992ndash1994

Source Courtesy of Mansfield Chart Service Jersey City NJ

Chap 16 7901 918 AM Page 216

Ren-Corp had a ldquobaby superstockrdquo breakout pattern The majorbreakout took place when the stock moved above $141frasl2 Had I focusedearlier on the kidney dialysis industry in particular I might havecaught Ren-Corp sooner But I was a bit late Still Ren-Corprsquos chartdid show a long-term breakout crossing $141frasl2 and another potentialshort-term breakout crossing $163frasl8

But Ren-Corp had something else going for it an outside bene-ficial owner

By this time yoursquore 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 candidateFifty-four percent of Ren-Corp it turned out was owned by GambroAB of Sweden

By 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 ldquodueto underexposure in the financial community but if Vivra con-tinues to be one of the best-performing stocks on the NYSE theyrsquollget around to Ren-Corp eventuallyrdquo

This is another example of a phenomenon discussed earlierThe 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 Pavlovrsquos 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 way

In 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 Pavlovrsquos 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 time

These days if you think of Pavlovrsquos dogs on Valium it will giveyou an idea of how Wall Street reacts to the same stimuli Itrsquos almost

CHAPTER SIXTEEN The Domino Effect 217

Chap 16 7901 918 AM Page 217

as 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 discovered

And what did Ren-Corp USA do next It dropped from $16 to$12 thatrsquos 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 USA was owned by a Swedish health care com-panymdashdespite all of this Ren-Corp dropped 25 percent almostimmediately after we recommended it

We continued to recommend Ren-Corp because the ldquoroad maprdquowas intact Not only was it intactmdashit 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 industry

Aleveraged 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 Itrsquos not just the deals that get done itrsquos also the proposals or trial bal-loons that do not get done that can lead you to future superstocks (Rememberthe frantic takeover wave in the drugstore industry was foreshadowedby the Rite AidndashRevco 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 circumstancesldquoPavlovrsquos dogsrdquo 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 Pavlovrsquos 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 brownies

In addition to the rumors swirling around Vivra Dow JonesService had reported on June 14 that National Medical in a defensive

218 PART THREE Takeover Clues

Chap 16 7901 918 AM Page 218

move would seek to buy Ren-Corp USA In response Gambro ABthe Swedish company that owned 54 percent of Ren-Corp issued adenial that it was seeking to sell its stake in Ren-Corp

Obviously takeover clouds were rolling in on the dialysisindustry

Meanwhile Pavlovrsquos dogs had apparently passed outThe July 3 1995 issue of BusinessWeek ran a story by Amy

Dunkin entitled ldquoPlugging Into Merger Mania Without Burning YourFingersrdquo In that story I recommended Ren-Corp USA as a takeovercandidate

On Friday July 14 1995 just 2 weeks later Ren-Corp USAsoared from $41frasl8 to $197frasl8 or 26 percent in 1 day following a takeoverbid frommdashwhat a surprisemdashGambro AB of Sweden

Ren-Corp a formerly sleepy and virtually unfollowed dialysiscompany had soared from $12 to nearly $20 in a period of 6 weeksmdashin other words it had turned into a superstock

To 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 owner

And that is how charts can help lead you to exciting new super-stock ideas

CASE STUDY RENAL TREATMENT CENTERS

What do you do when you suspect that you are about to witness theldquoDomino Effectrdquo 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 ldquosuperstock breakoutrdquo patterns Renal Treatment Centers wasanother company I had never heard of but by now Im sure all youneed to do is glance at the chart (Figure 16ndash2) to understand why Irecommended this stock

There it was A well-defined long-term resistance area near $25to $26 in a little followed company in a rapidly consolidating indus-try A series of rising bottoms indicating rising demand

CHAPTER SIXTEEN The Domino Effect 219

Chap 16 7901 918 AM Page 219

In July 1995 we recommended Renal Treatment Centers at $23 The chart in Figure 16ndash2 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 thatRenal Treatment Centers had recently dropped back from $261frasl4 toaround $23mdashan amazing thing when you think about it in light ofthe fact that Ren-Corp USA had just received a takeover bid and thatRenal Treatment Centers and Ren-Corp were nearly identical in sizein terms of revenues Itrsquos surprising that this short-term chart ofRenal Treatment Centers looked as uninspiring as it did Again inthe old days when Wall Streetrsquos ldquoconnecting mechanismrdquo 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 donrsquotmdashbut it can also give you time to accumulate more stockand at lower prices before the payoff arrives

220 PART THREE Takeover Clues

F i g u r e 16ndash2

Renal Treatment Centers (RXTC) 1993ndash1995

Source Courtesy of Mansfield Chart Service Jersey City NJ

Chap 16 7901 918 AM Page 220

TEAMFLY

Team-Flyreg

Even 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 patternmdashyou can see the advantage that a longer-term per-spective can give you

In 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 $16

In November 1997 Renal Treatment Centers which had split 2-for-1 since our recommendation received a $4155 per share takeoverbid Take a look at the chart of Renal Treatment Centers in Figure16ndash3 and you will see that the original superstock breakout patternin mid-1995 that prompted the initial recommendation at a split-adjusted $111frasl2 looks like just a distant memory on this long-term

CHAPTER SIXTEEN The Domino Effect 221

F i g u r e 16ndash3

Renal Treatment Centers (RXTC) 1995ndash1997

Source Courtesy of Mansfield Chart Service Jersey City NJ

Chap 16 7901 918 AM Page 221

chart Again the importance of having just the right perspective can-not be overestimated

We recommended three kidney dialysis companies between1994 and 1997 all of which were taken over and all of which gener-ated huge profits for my subscribers

How did it happenIt happened by recognizing a potential superstock breakout

pattern 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 ldquoDomino Effectrdquo in this industry I wenton the lookout for other potential candidates with superstock break-out patterns (Renal Treatment Centers) andor outside beneficialowners (Ren-Corp USA)

In other words it happened by using several of the toolsdescribed in this bookmdashin particular with a chart pattern that direct-ed my attention to this industry in the first place

222 PART THREE Takeover Clues

Chap 16 7901 918 AM Page 222

C H A P T E R S E V E N T E E N

Merger Mania Take theMoney and Run

My son my son if you knew with what little wisdom the world is ruled

Oxenstierna

What causes the ldquoDomino Effectrdquo 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 greed

When 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 occurmdashsometimesit only takes onemdashother 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 competitiveand 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 fearful

223

Chap 17 7901 902 AM Page 223

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

that once they do figure out the rationale there may not be any attrac-tive acquisition candidates left to be purchased at a reasonable price

And then they become fearful that if they do not play ldquofollowthe leaderrdquo by acting now and buying somebody they will be left outof the parade when the reasoning becomes apparent to everyoneor theyrsquoll be forced to pay too much even if they do identify atakeover candidate And sometimes it is simply the fear of beingacquired itself that leads a company to take over another company asan act of self-defense the reasoning being that if you make yourselfbigger yoursquore less likely to become a target and more likely to beone of the survivors once the consolidation trend runs its course

I 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 yoursquore 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 company

Well sometimes that is exactly how these decisions come aboutAnd sometimes notBack 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 list

The CEO told me that ldquowe 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 rdquo Hisvoice trailed off and then he added ldquoThat was off the record by theway Donrsquot quote me on that okayrdquo

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 wersquore not at all sure why wersquore doing this and whetherthese details make any business sense But what the hell

224 PART THREE Takeover Clues

Chap 17 7901 902 AM Page 224

In 1993 Merck amp 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 Basicallythey 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 didnrsquotwant to bother with it Merckrsquos bright idea was to buy one of thesePBMs and to use it to direct business toward Merck products

Nobody knew at the time whether this would turn out to be afantastic idea or an absurd ideamdashbut after Merck made its moveother 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 $23 bil-lion ldquoOver the past yearrdquo SmithKline declared in announcing thetakeover ldquowe have conducted an exhaustive analysis and con-cluded that the unique alliance announced today positions us to winrdquo

Less than 5 years later SmithKline would unload its $23 billionldquounique alliancerdquo for $700 million But of course nobody knew thisat the time

Meanwhile Eli Lilly amp 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 Lillyrsquos chief financial officersaid at the timerdquoWe looked at Merckrsquos move and said lsquoWhat thehell is a pharmacy benefits managerrsquordquo

In other words it was not as though Eli Lillyrsquos 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 Merckrsquos entry into that business

The truth was that Lilly was not even thinking along those linesand the PBM business was not even on the Lilly radar screen

But that did not stop Eli Lilly from paying $4 billion or 130times earnings for PCS Health Systems on July 11 1994

Hot on the heels of Merck and SmithKline Eli Lilly amp 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

CHAPTER SEVENTEEN Merger Mania Take the Money and Run 225

Chap 17 7901 902 AM Page 225

ldquoWe believerdquo said Lilly ldquoitrsquos the jewel of those that are outthere and we believe we acquired that jewel at a very attractivepricerdquo

Barely 4 years later Lilly wound up selling its $4 billion ldquojewelrdquoto Rite Aid for $15 billion

ldquoOur experiencerdquo said Lilly as it exited the PBM business ldquohasbeen that certain businesses can benefit from new ownership arrange-mentsrdquo

In November 1999 Rite Aid announced that it would attemptto sell PCS Health Systems for a price in the neighborhood of $13 bil-lion which was $200 million less than it paid for the company a yearearlier

There were no takersOn February 25 2000 a Rite Aid spokesperson told TheStreet

com that the company had ldquomultiple biddersrdquo for PCS HealthSystems ldquoWe need to sell it because we need to pay debtrdquo said thespokesperson Rite Aid you will recall had gone on an acquisitionspree during the drugstore takeover mania The companyrsquos overlyambitious expansion strategy combined with accounting irregulari-ties had pummeled its stock which had plunged from a high of $511frasl8in January 1999 to as low as $41frasl2 a decline of 91 percentmdashone of theall-time great examples of a respected predictable company in a sta-ble industry self-destructing by turning into a serial acquirer

Also on February 25 2000 The Wall Street Journal reported thatrival drugstore company CVS was interested in buying PCS HealthSystems from Rite Aid for between $800 million and $1 billionmdashaprice that would have been 33 to 46 percent less than Rite Aid hadpaid a year earlier

CVS denied that it was interested in buying PCS HealthFinally on April 11 2000 Rite Aid announced that it was unable

to sell PCS Health Systems at a reasonable price ldquoWhile we will con-tinue to explore opportunities to sell PCS at some pointrdquo said RiteAidrsquos new CEO Bob Miller he conceded that the price Rite Aid couldget for PCS at the current time was ldquovery depressedrdquo

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 JPMorgan agreed to convert $200 million of debt into Rite Aid commonstock valued at $550 per share

226 PART THREE Takeover Clues

Chap 17 7901 902 AM Page 226

PCS Health Systems would be part of the collateral to secure thisnew debt restructuring said Rite Aid

The saga of PCS Health Systems by this point was beginning toresemble a Wall Street version of ldquoOld Maidrdquomdashonly this time Rite Aidwas finding no takers And it was all touched off by Merckrsquos decisionback in 1993 to diversify into the pharmacy benefits business whichled Merckrsquos 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 price

These stories will help you understand one of the major reasonswhy the ldquoDomino Effectrdquo 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 dandy

Other times however the mad rush to imitate and consolidateis based on less perceptive reasoningmdashsuch as the fear that one ofyour competitors has figured out something you havenrsquot eventhought of yet which means you had better do the same thing fastand you can figure it all out later

So that is how ldquofearrdquo can touch off the ldquoDomino EffectrdquoThen there is the ldquogreedrdquo factorIt will probably not surprise you to learn that corporate CEOs

can 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 business

In September 1989 Sony the Japanese electronics and enter-tainment giant purchased Columbia Pictures for $34 billion plus$16 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 businessSony in fact had paid $27 a share for Columbiamdash36 times the value

CHAPTER SEVENTEEN Merger Mania Take the Money and Run 227

Chap 17 7901 902 AM Page 227

of Columbiarsquos stock after the shares were spun off from their formerowner Coca-Cola company just 2 years before

When the deal was announced most observers believed theprice to be preposterous Vanity Fair magazine called the acquisitionldquoa comic epicrdquo Forbes magazine called it an example of ldquounprece-dented naiveteacuterdquo

A source on Columbiarsquos side of the negotiations told authorsNancy Griffin and Kim Masters who chronicled Sonyrsquos Hollywoodmisadventure in Hit amp Run that the price Sony paid for Columbialdquohad no relationship to the worth of the entityrdquo

But that was only the beginning Sony also paid $200 million forGuber-Peters Entertainment a production company that had lost$192 million on revenues of $237 million in its most recent fiscalyear because it wanted the expertise and management services ofits owners producers Peter Guber and Jon Peters

Under their guidance SonyColumbia proceeded to embarkon a spending and production spree that culminated in a November1994 write-off of $32 billionmdasha gargantuan loss even by the stan-dards of Hollywood which knows a thing or two about losing themoney of outsiders

For years afterward Hollywood insiders Wall Street analystsand others who witnessed Sonyrsquos 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 Nathanwho was granted access and cooperation by Sony in the writing ofhis book Sonyrsquos CEO Norio Ohgamdashwho had been the leading pro-ponent of the Columbia takeovermdashtold a meeting of Sony execu-tives in August 1989 that he had a change of heart Sonyrsquos founderand chairman the revered Akio Morita responded that he too washaving second thoughts about the wisdom of buying Columbia

According to the minutes of that board meeting the decisionwas made to withdraw the takeover bid The minutes read ldquoPerChairman Columbia acquisition abandonedrdquo

But later that evening the Sony executives changed their deci-sion and agreed to go ahead with the takeover of Columbia

228 PART THREE Takeover Clues

Chap 17 7901 902 AM Page 228

WhyWhile Sony executives were having a dinner break some of the

board members overheard Sonyrsquos chairman Morita say softly ldquoItrsquosreally too bad Irsquove always dreamed of owning a Hollywood studiordquo

When the board meeting resumed Sonyrsquos CEOmdashapparently indeference to the emotional desire of his beloved and respected chair-man who had already concurred with the cancellation of the dealmdashtold theexecutives that he had reconsidered the situation during dinner andnow believed that Sony should buy Columbia Pictures after allmdashassuming of course the Sony chairman Morita concurred with hischange of heart Which of course he did

And that is how Sony blundered into the Godzilla of all write-offs

Size power industry leadership statusmdasheven childhooddreamsmdashthese are all potential driving forces for corporate takeoversprobably more so than many corporate executives would care toadmit

In September 1995 the New York Daily News ran 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 businessesldquoFrom a businessmanrsquos point of viewrdquo Dornemann told Der SpiegelldquoI can only say the Americans are crazy to pay such pricesrdquo

In the interview Dornemann said that prices being paid forUS media properties were in the immortal words of Crazy Eddieinsane 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

ldquoThe big media companies are in a kind of race to see who willhave the biggest operationrdquo he said ldquoand the prices are simplyhyped up This sort of thing will never pay off I predict that manyof these mergers will not last

ldquoThe desire for size and power can be a dangerous secondarymotiverdquo for many mergers Dornemann went on to say He said thatWall Street investment bankers had learned to use the egos of CEOs

CHAPTER SEVENTEEN Merger Mania Take the Money and Run 229

Chap 17 7901 902 AM Page 229

to their advantage prodding them to do deals by playing on a CEOrsquosdesire to be the biggest or to simply keep up with a rival ldquoDo not befooledrdquo he said ldquoWall Street has big interest in having big deals likethis The investment bankers earn good money on such takeoversand for that reason they make sure that the necessary euphoria existsrdquoThat last comment can be taken as as implication that Wall Streetrsquoseuphoric reaction to certain megamergers even so-called mergersof equals where no premiums are involved can be more contrivedthan real and that it only serves to encourage the next round ofmegamergers

Dornemann also scoffed at the idea that ldquosynergyrdquo (see Chapter14) can justify sky-high buyout pricesmdashie that producers of pro-gramming must absolutely own a network or other distribution out-lets and that cross-promotion among various media propertieswould enhance the value of the entire enterprise ldquoHistory hasshownrdquo he told Der Spiegel ldquothat a lot can be justified on the basisof synergy with very little ultimately achievedrdquo

Which brings us to the investment bankersOf all of the forces that can touch off a Domino Effectndashtype

takeover wave in any given industry the Wall Street investmentbanking communityrsquos 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 in

Some 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 which

But 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 shares

Over the years a curious ldquospinrdquo on the takeover scene has devel-oped among mainstream Wall Street analysts and institutional money

230 PART THREE Takeover Clues

Chap 17 7901 902 AM Page 230

TEAMFLY

Team-Flyreg

managers They claim investors are better off owning shares in theacquiring companies rather than the target companies

I have always suspected that much of Wall Streetrsquos 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 in

In 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 ldquoEven more alarmingrdquo saidKPMG ldquoover half actually destroyed valuerdquo

The shareholders KPMG was talking about of course were theshareholders of the acquiring companymdashthe ldquogobblerrdquo that was sup-posedly going to manage the assets of the target company betterachieving 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 operationswith 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 ldquosynergyrdquo as in twoplus two equals five

What KPMG demonstrated however was that much of the bal-lyhoo surrounding many of these deals was just a lot of hot airmdashnot 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 ldquosynergyrdquo hook line andsinker (On the other hand when you consider that many of todayrsquosmoney 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 companyrsquos stock

CHAPTER SEVENTEEN Merger Mania Take the Money and Run 231

Chap 17 7901 902 AM Page 231

The 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 bids

Some examples of ldquosynergisticrdquo losers

bull Quaker Oats was a loser when it bought Snapple for $17billion in November 1994 and so were its shareholdersQuaker Oats unloaded Snapple for $300 million 21frasl2 yearslater The big winners were the Snapple shareholders whotook the money from Quaker Oats and moved on

bull Novell shareholders were losers following that companyrsquospurchase of WordPerfect for $14 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

bull Albertsons stockholders saw the value of their stock plungewhen it proved far more difficult than expected to integrateitself with American Stores

Whatrsquos 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 ldquosynergiesrdquo and the ldquoeconomies of scalerdquoand all of the future growth prospects to the Wall Street analysts andinstitutions who invest on this basismdashthey may turn out to be rightor wrong but most of the time that will not be the reason you boughtthe target company in the first place and you should not stick aroundto find out

Read 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

232 PART THREE Takeover Clues

Chap 17 7901 902 AM Page 232

release announcing a takeover bid and why you are usually betteroff taking the profit from the takeover and walking away

CASE STUDY JCPENNEY AND RITE AID

JCPenney 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 Fayrsquos 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 operationsRemember when drugstore consolidation was sweeping Wall Streetit seemed to make all the sense in the world to everyone involvedand there was little reason to doubt that the strategy of combiningsmaller chains would reap major benefits

The ldquogururdquo 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 takeoversIndeed 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

ldquoDrugstore consolidation is going to continuerdquo Grass told TheWall Street Journal on September 12 1996 ldquobecause the economiesare overwhelming The smaller chains canrsquot survive as independentcompanies The independent operators are doomedrdquo

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 ldquoSay a brand new medicinecomes out that is just far superior to anything that is on the marketrdquohe said ldquoWe could be able to look at our customer base and see who

CHAPTER SEVENTEEN Merger Mania Take the Money and Run 233

Chap 17 7901 902 AM Page 233

might be better served by this new medication We would informthose people lsquoHey therersquos a new change on the horizon Ask yourphysician about itrsquordquo Larger customer bases would provide the drug-store consolidators more information on medical histories and there-fore create new and innovative marketing possibilities ldquoIf one storeserves a large number of diabeticsrdquo The Journal said in 1996 ldquothechain can establish special services at the locationrdquo In January 1997The Journal ran another story on the logic behind drugstore consoli-dation explaining that ldquomergers 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 efficiencyrdquo

A warning signalmdashand a prescient one at thatmdashwas also sound-ed in The Wall Street Journalrsquos January 2 1997 story on the mergermania in the drugstore industry The mergers it was noted ldquodo notaddress a range of endemic problems for drugstores from their gen-eral laziness about marketing to their typically lackluster serviceand staffrdquo

So here was the choice faced by Fayrsquos 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 Penneyrsquos growth strategy in thedrugstore industry

There were two ways to look at it If you owned both Fayrsquos 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 aldquopure playrdquo drugstore company rather than a company weigheddown by slower-growing department stores

On the other hand if you had purchased Fayrsquos and GenoveseDrug Stores strictly because you believed they were superstocktakeover candidatesmdashand if you turned out to be correctmdashwhywould you want to exchange these stocks for shares in JCPenneyThe original premise had proven correct both companies became

234 PART THREE Takeover Clues

Chap 17 7901 902 AM Page 234

takeover 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 half

On 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 charges

By mid-April JCPenney shares were trading under $13mdashdown81 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 industryrsquos 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 Aidrsquos problems you see were not confined to PCS HealthSystems

Rite Aid discovered that cost-cutting andrdquoefficienciesrdquo some-times impacted customer servicemdashoften with disastrous resultsCustomers 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

CHAPTER SEVENTEEN Merger Mania Take the Money and Run 235

Chap 17 7901 902 AM Page 235

operating heritages and a distinctly different mix of people alongwith them

In particular Rite Aid ran into trouble with its acquisition ofThrifty-Payless a 1000-store chain it bought in 1996 for $14 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 storesrsquo merchandising offerings sharply reducingadvertising and generally trying to turn Thrifty-Payless into whatRite Aid wantedmdashwhich was Rite Aid stores

The only problem with this was that Thrifty-Payless customersshopped at Thrifty-Payless because they liked Thrifty-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 decline

As the chart in Figure 17ndash1 illustrates Rite Aid stockholdersmdashincluding those who owned the drugstore companies Rite Aidacquired and took Rite Aid shares in returnmdashsuffered 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 ldquoshould not rely on forward-looking profitability and cash flowinformationrdquo the company had just recently given to analysts at anOctober 11 1999 meeting Shortly thereafter Grass resigned and sodid Rite Aidrsquos accountants

At year-end 1999 the Motley Fool summed up the sorry sagaof Rite Aid this way ldquoThe root of the companyrsquos problems stemsfrom an aggressive acquisition play that has failed miserably leav-ing Rite Aid mired in debtrdquo

Meanwhile JCPenneyrsquos stock price continued to feel the falloutof the Rite Aid debacle Penney after all had been one of the biggestdrugstore ldquogobblersrdquomdashand Wall Street which had cheered on thedrugstore merger wave while it was happening now began to recoilfrom the entire premise

236 PART THREE Takeover Clues

Chap 17 7901 902 AM Page 236

As a result a Fayrsquos 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 Fayrsquos 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 time

Meanwhile those who simply sold their Fayrsquos 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

CHAPTER SEVENTEEN Merger Mania Take the Money and Run 237

F i g u r e 17ndash1

Rite Aid (RAD) 1998ndash2000

Source Courtesy of Mansfield Chart Service Jersey City NJ

Chap 17 7901 902 AM Page 237

CASE STUDY THE ALARMING STORY OFPROTECTION ONE

Herersquos another horror story that illustrates a grand acquisitiondiver-sification strategy gone awry

Between 1996 and 1998 the security alarm business experi-enced the Domino Effect as a series of companiesmdashincluding ADTHolmes Protection Alarmguard and othersmdashwere acquired in rapid-fire order All of these were on my takeover list (see Introduction)and all were taken over one after another

Among 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 ata price of $91frasl2 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 Resourcesrsquo own home security opera-tions with those of Protection One creating a much larger companythat could benefit frommdashyou guessed itmdasheconomies of scale

At 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 Wittigwho 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 ofWittigrsquos first moves was an audacious 1996 hostile takeover bid forKansas City Power amp Light What made this bid audacious otherthan the fact that hostile takeovers in the genteel utility industrywere rare was that Kansas City Power amp Light had already agreedto be acquired by a neighboring utility Utilicorp United A nastyfight ensued with charges and countercharges flying all over theplace among the three combatants But in 1997 Western Resourcesand Kansas City Power amp 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 $40s

As a result of Westernrsquos rising stock price Westernrsquos invest-ment bankers decided that Kansas City Power amp Light stockholderswere getting too good a dealmdashso the terms were revised

238 PART THREE Takeover Clues

Chap 17 7901 902 AM Page 238

In light of what was about to happen this proved to be the ulti-mate irony

Western 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 leanmean acquisition machine

After 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 Resourcesrsquo major push into the home security industrywould be accomplished through the acquisition of Protection OneWestern 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 ldquomonthly recurring rev-enuesrdquo 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 interviewsWittig was talking about further diversifying Western Resources alongthe same lines into areas such as telecommunications or cable TV

And so when Protection One soared from the original recom-mended price of $91frasl2 in 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 POIrsquos 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

CHAPTER SEVENTEEN Merger Mania Take the Money and Run 239

Chap 17 7901 902 AM Page 239

I told my subscribers ldquoSince I am focusing mainly on takeovercandidates I am going to bid farewell to Protection One If you wereprescient enough to own Protection One I would suggest a switchto either Holmes Protection or Alarmguardrdquo two other securityalarm takeover candidates

This turned out to be the correct move Both Holmes Protectionand Alarmguard ultimately received takeover bids and the DominoEffect continued to sweep through the security alarm business

Western Resources pleased with the reception that its growthstrategy had received on Wall Street promoted David Wittig to chair-man and CEO in May 1998 Westernrsquos stock price had jumped from$30 when Wittig arrived in 1995 to a high of $487frasl8 in March 1998mdashnot bad for a conservative utility company in the midst of meta-morphosis

In October 1998 Western Resources kept the dominoes falling inthe alarm industry when its now 85 percent-owned Protection Oneunit agreed to acquire Lifeline Systems a company that provided alarm-paging services to elderly people through a nationwide network ofhospitals Lifeline customers wore paging pendants around their neckswhich could be activated if they needed medical assistance A signalwould then be sent to a Lifeline Systems control center which wouldthen alert the nearest hospital to the emergency situation

To 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 Wall Street Journal that 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 company

The Wall Street Journal noted that utility companies had tried oncebefore to diversify and ldquohad failed at it in the 1980s when they boughtcompanies such as savings amp loans a drugstore chain and even aninsurance companyrdquo But The Journal reported that unlike the pastMr Wittig said that ldquoWestern is investing in businesses that are sim-ilar in terms of the relationships wersquore having with the customersrdquo

The Journal also 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 US and also overseas in the year since it was bought by Western

240 PART THREE Takeover Clues

Chap 17 7901 902 AM Page 240

TEAMFLY

Team-Flyreg

Meanwhile Protection One stockholders were beginning tohear alarm bells of their own Following the $7 per share cash pay-ment the stock fell from its ldquoex-dividendrdquo 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 spring

Obviously Wall Street sensed a problemBy 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 attritionthat its accounting practices had come under the scrutiny of theSecurities amp Exchange Commission that the company would lose$169 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 ldquoWestern Resources has expe-rienced some short-term financial challenges with regard to itsProtection One investmentrdquo the company said in a press release whichhad to be in the running for ldquoUnderstatement of the Yearrdquo Westernadded that ldquowhile the security alarm business generates strong cashflow it has not generated net incomerdquo Therefore said Western it wasnow ldquoconsidering alternativesrdquo for its 85 percent-owned security alarmbusiness which had by this time declined to under $2 a sharemdasha 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 time

While Western Resources was ldquoconsidering alternativesrdquo 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 were no 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

CHAPTER SEVENTEEN Merger Mania Take the Money and Run 241

Chap 17 7901 902 AM Page 241

Meanwhile 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 Westernrsquos merger withKansas City Power amp Lightmdashwhich had been held in regulatory pur-gatory for nearly 3 yearsmdashwas now in jeopardy

Just 2 years earlier the deal had almost fallen apart becauseWesternrsquos stock price had risen too quickly based on Wall Streetrsquosperception of David Wittig as an astute deal maker The terms hadbeen negotiated downward in deference to Western shareholderswho owned an increasingly popular stock and did not want to givetoo much of it away to Kansas City Power amp Light stockholdersNow the opposite was taking place Because of the Protection Onedisaster Westernrsquos stock price had slumped so far that the deal wasin danger of coming apart once again

On January 3 2000 Kansas City Power amp 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 ResourcesndashKCPampL merger was undone inlarge part by the Protection One fiascomdasha takeover that turned outvery badly for the acquiring company and its shareholders

Indeed 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 ldquogobblerrdquo

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 asmdashdrum rollpleasemdasha 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 ldquoconglom-eraterdquo had been a failure

242 PART THREE Takeover Clues

Chap 17 7901 902 AM Page 242

In 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

ldquoWe believerdquo said Mr Wittig ldquothat a pure play electric utilitycompany will unlock the value associated with our electric assets byproviding shareholders an investment opportunity exclusively inour electric utility operationsrdquo

The press release stated that Westar Energy the new ldquopure playrdquoutility company would consist of two electric utilities Kansas Poweramp Light and Kansas Gas amp Electric which provide electric service to628000 customers in Kansas The nonelectric utility company whichwas yet to be named would consist of Westernrsquos 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 LLC

By the time Western Resources decided to change paradigms bygoing back to the strategy of being a ldquopure playrdquo (which is what thecompany was in the first place) rather than a collection of unrelatedbusinesses Westernrsquos 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 Westernrsquos stock price to unravel

This 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 consolidation

In 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

CHAPTER SEVENTEEN Merger Mania Take the Money and Run 243

Chap 17 7901 902 AM Page 243

more efficient and profitable there is a very good possibility that thetakeover wave which struck the utility industry during the late 1990swould have engulfed Western Resources much to the delight of itsshareholders

But Western did not want to become a ldquogobbleerdquo in fact thecompany aspired to be a ldquogobblerrdquo 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 businessmdashsecurity alarmsmdashthat turned out to bea disaster for everyone except the shareholders of Protection Onewho decided to take the money and run

Now 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 utilitiesmdashabout 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 Westernrsquos 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 ofWesternrsquos 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 parts

So the logical assumption would be this Itrsquos very possible thatseparating the electric utility assets was the first step in having theseassets acquired and even if that were not the primary purpose of cre-ating the utility pure play Westernrsquos 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 emerge

In other words Westar Energy once it began trading separatelywould have to be viewed as a potential superstock takeover candidatemdashand

244 PART THREE Takeover Clues

Chap 17 7901 902 AM Page 244

this stock should have been added to your universe of potential superstocksto keep a close eye on

On the other side of the equation was the company that wouldown Westernrsquos nonelectric utility assetsmdashtemporarily 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 company

A well-trained superstock sleuthmdashwhich would be you by thistimemdashwould 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 amp ExchangeCommission) of the company whose stock is owned by the outsidebeneficial owner The 10-K Report is available by going to the Website wwwfreeedgarcom 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 companyrsquos most recent10-K you would have learned that this company provided naturalgas transmission and distribution services to 14 million customersin Kansas and Oklahomamdashright in Western Resourcesrsquo neck of the woodsAnd you would also have learned that in 1998 Oneok acquired thenatural gas distribution assets of Western Resources in exchange forOneok stockmdashand that is how Western Resources wound up with its45 percent stake in Oneok In other words when Westernrsquos 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 Oneok

In reading the history of this transaction in the Oneok 10-Kyou would also have learned that there was a ldquostandstill agreementrdquobetween Oneok and Western Resources that prevented Western fromincreasing its ownership above 45 percent And you would also havelearned that Oneokrsquos stated corporate strategy was to ldquoacquire

CHAPTER SEVENTEEN Merger Mania Take the Money and Run 245

Chap 17 7901 902 AM Page 245

additional distribution and transmission facilities and other assetsrdquoand in fact Oneok had recently announced the $3077 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 agreement

By 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 1999

A superstock 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 letrsquos put it to you this way This situationwould appear to be pregnant with possibilitiesmdashand both the WesternResources companies and Oneok should have been immediately placed onthe superstock sleuthrsquos list of stocks to monitor just in case future TelltaleSigns were to emerge

The fact that Western Resources had been selling off someOneok stock combined with the fact that Oneok appeared to be acompany determined to acquire other companiesmdasha ldquogobblerrdquo inother wordsmdashwould 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 ldquostandstill agreementrdquo

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 bid

Who knowsThe point is this There were possibilities here a situation to be

monitored just in case one or more additional Telltale Signs were toemerge that might point you toward a clear and logical opinion asto what happened next

And 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

246 PART THREE Takeover Clues

Chap 17 7901 902 AM Page 246

On 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 growthdiversification strategy wouldhave been reduced to wishing and hoping while watching theirinvestments shrink dramatically in value

The 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 interestingmdashand hopefullyprofitablemdashsituations

CASE STUDY HOW MATTEL GOT PLAYED BY THELEARNING COMPANY

In December 1998 Mattel announced that it would acquire TheLearning Company for $36 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 ldquoa global childrenrsquos productscompanyrdquo In announcing the acquisition Mattel called The LearningCompany ldquoan excellent strategic fitrdquo and said it would immediate-ly add to Mattelrsquos earnings

Some observers were not so sure Among them was HerbGreenberg columnist for TheStreetcom 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 Companyrsquos ldquoaggressiveaccountingrdquo 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 trouble

Greenberg openly questioned Mattelrsquos judgment in paying $36billion 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

CHAPTER SEVENTEEN Merger Mania Take the Money and Run 247

Chap 17 7901 902 AM Page 247

On October 4 1999mdashjust 5 months after the transaction wascompletedmdashMattel 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 hadinherited

Mattel shares which had peaked near $30 earlier in 1999plunged 5 points to $117frasl8 following the announcement wiping outover $2 billion in shareholder value in a single day

The only winners in the Mattel takeover of The LearningCompany were those Learning Company shareholders who tookthe money and ran following Mattelrsquos 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 losses

However as in the case of Western ResourcesndashProtection Onethe MattelndashLearning Company fiasco also had an ironic ending inwhich several Telltale Signs emerged

When 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 stockholdersrsquomoney 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 time

But 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 ldquogobblerrdquo over thecoals sometimes the final chapter of an acquisition that has gonebad can turn out to be the opening chapter of a superstock story

The key as usual is to watch for the Telltale SignsIn the case of Mattel soon after its stock collapsed on the news

of The Learning Companyrsquos 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

248 PART THREE Takeover Clues

Chap 17 7901 902 AM Page 248

a big ldquorestructuringrdquo charge or some sort of corporate reorganiza-tionmdashor some other piece of bad news that takes Wall Street by sur-prisemdashyou 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 view

Shortly after The Learning Company debacle a massive waveof insider buying began with several Mattel insiders buying a totalof 464000 shares between October 25 and November 24 1999 atprices between $13 and $141frasl2

Nevertheless Mattel shares continued to fall below $10 eventhough these insidersmdashwhich included Mattel director JohnVogelstein the powerful vice chairman of the investment firmWarburg-Pincusmdashhad paid much higher prices for the stock theypurchased on the open market

In an interview following The Learning Company newsVogelstein categorically rejected comparisons to Mattelrsquos troubles inthe late 1980s telling a questioner ldquoThis company is not broken Ithas a core business that is vital and well-runrdquo

ldquoCore businessrdquo By now that term should be music to your earsHere was a sophisticated well-connected Mattel insider who

certainly 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 Mattelrsquos ldquocore businessrdquo

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 usuallyldquobottom fishingrdquo turnaround investors lurking around waiting basedon the premise that they can come in take the company over andrestore it to its former luster

Also by February 15 the American Federation of State County andMunicipal Employees Pension Fund announced on Valentinersquos Day that itwanted to have a heart-to-heart talk with Mattelrsquos Board of Directors aboutseveral matters including the possibility of dismantling Mattelrsquos takeoverdefenses The pension fund owned around 37 percent of Mattelrsquos stockHere 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

CHAPTER SEVENTEEN Merger Mania Take the Money and Run 249

Chap 17 7901 902 AM Page 249

Nobody cared and Mattel stock continued to languish below $10In March 2000 John Vogelstein had purchased another 100000

Mattel shares on the open market this time at a price of $109frasl16In April 2000 two more insiders had purchased an additional

56750 shares at prices ranging from $969 to $1112 per share Alsoin April 2000 Mattel had decided to bite the bullet by selling The LearningCompany The Wall Street Journal had reported on the morning of April3 that Mattel would soon announce that The Learning Company wasfor sale and estimated that company for which Mattel had issued$35 billion worth of its own stock just a year earlier would probablyfetch between $500 million and $1 billionmdashwhich has to rank as oneof the most striking examples of how rapidly an acquisition can go badin the annals of American business

Later that day Mattel confirmed that it had retained CreditSuisse First Boston to sell The Learning Company but Mattel wentout of its way to make it clear that it did not intend to sell any of itsldquocore brandsrdquo

In other words Mattel had decided to revert to being a pure play toycompany

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 Companymdashbut 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 tar-get

On September 29 2000 Mattel announced that it would virtu-ally give away The Learning Company by ldquosellingrdquo it to a privatecompany in return for a share in any future profits In reporting thistransaction the Associated Press called Mattelrsquos acquisition of TheLearning Company ldquoone of the worst deals in recent corporate his-toryrdquo This was almost certainly truemdashunless you were a shareholderof The Learning Company who took the money and ran

The MattelndashLearning Company saga is important for three rea-sons First it illustrates why itrsquos almost always better to ldquotake themoney and runrdquo when a stock you own receives a takeover bidSecond it shows how accumulated experience with various com-panies and individuals can lead you to anticipate future develop-

250 PART THREE Takeover Clues

Chap 17 7901 902 AM Page 250

TEAMFLY

Team-Flyreg

ments which you might perceive in a different light than almosteveryone else because of your awareness of Telltale Signs And thirdit 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 longrunmdashif yoursquore willing to think ldquooutside the boxrdquo when it seems likenobody else around you can

The 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 amp Poorrsquos 500 at least seven could be traceddirectly to acquisitions that turned out badly or at the very leastdid not deliver the benefits Wall Street expected JCPenney WasteManagement Allied Waste Industries HealthSouth McKessonHBOC Rite Aid and Service Corp International

All 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 mark

As 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 madethe 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 pains

Remember 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 1999tumbling nearly 60 percent They were led on the way down by thetwo industry giants Waste Management and Allied Waste Industries

CHAPTER SEVENTEEN Merger Mania Take the Money and Run 251

Chap 17 7901 902 AM Page 251

both 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 SampP500 one year later tells you all you need to know about how thatstrategy turned out

The trend toward garbage company takeovers was initiated inJuly 1998 when USA Waste bought Waste Management in a $19 billiontakeover The new industry giant kept the Waste Management nameand then one month later announced the acquisition of anothergarbage company Eastern Environmental Services for $15 billion

Got 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 $11 billion which everybody onWall Street agreed was a sound move because of the obviousldquoeconomies of scalerdquo 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 InvestorrsquosBusiness Daily reported that ldquoanalysts continue to see the waste man-agement companies as a safe haven that can be counted on to gen-erate double-digit earnings growthrdquo

On March 8 1999 Allied Waste struck again when it agreed to buyBrowning-Ferris Industries for $73 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 since

Remember all of this frantic takeover activity was touched offby the USA WastendashWaste ManagementndashEastern 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 deals

Trouble is the premise turned out to be a bit shakyOn 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 Managementrsquos Board of Directorswho were trying to figure out why chaos had ensued at Waste

252 PART THREE Takeover Clues

Chap 17 7901 902 AM Page 252

Management almost immediately after the three companies werecombined

ldquoThe lawsuitrdquo said The Wall Street Journal ldquoarose out of asprawling effort by Waste Managementrsquos Board of Directors to deter-mine how the companyrsquos $19 billion merger with USA Waste Serviceswent wrong and how the companyrsquos management lost control ofits operations and accounting systems in the months after the July1998 mergerrdquo In a follow-up story on February 29 The Journal report-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 quarter

The first hint of troublemdashand it was quite a hintmdashcame on July6 1999 when Waste Management shares dropped from $53 to $25 ina single day following word that the companyrsquos 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 andinventorymdashalmost all a result of the chaos surrounding the compa-nyrsquos inability to integrate its acquisition

To help sort out its problems Waste Management enlisted theservices of Roderick M Hills former chairman of the Securities ampExchange Commission who wound up as chairman of the AuditCommittee ldquoThe big story hererdquo Mr Hills concluded ldquois that theymade terrible acquisitions and didnrsquot know how to run the mergedcompanyrdquo

The most telling comment of all from The Wall Street Journalwas ldquoAnd the pioneers of the practice proved not much better atfiguring out when to run for cover than the average investorrdquo 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 mergers

Shortly thereafter Allied Wastemdashthe other serial garbage acquir-ermdashannounced it would miss its earnings estimates for the fourthquarter of 1999 and also for the year 2000 due to ldquocosts associatedwith the BrowningndashFerris acquisitionrdquo

Stewart Scharf an analyst at Standard amp Poorrsquos commentedthat ldquocompanies need to ensure what they are acquiring is a good fitrdquo

CHAPTER SEVENTEEN Merger Mania Take the Money and Run 253

Chap 17 7901 902 AM Page 253

Another analyst Jaimi Goodfriend told CBS MarketwatchldquoOver 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 itrsquos sort of been more of a lsquobuynow integrate laterrsquo strategy They would buy a lot of companiesand acquire all of this new revenuemdashbut in doing that they neglect-ed the systems integrationrdquo

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 1998ndash99 turned out to be basedon a foundation that was about as solid as a landfill Which explainswhy the ldquosaferdquo waste management stocks dropped over 60 percentin 1999

Meanwhile keep in mind that any Eastern Environmental share-holder who accepted $2987 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 doing

The purpose of this chapter was to illustrate in no uncertain termsthat ldquobrilliantrdquo corporate executives often make dumb acquisitionsfor poorly thought-out reasons and that they are advised and encour-aged to do so by ldquobrilliantrdquo investment bankers who are just outthere taking their best guess like the rest of us at bestmdashand who atworst are motivated in part by the desire to generate investmentbanking fees which cannot be generated unless transactions likethese take place

Meanwhile ldquoanalystsrdquo who are compensated in large part basedon their ability to bring investment banking business to their firmsand whose bonuses depend in large part on investment banking feesearned by their firms in general disseminate voluminous researchreports that may say a ldquobuyrdquo ldquostrong buyrdquo ldquoaccumulaterdquo ldquooutper-formrdquo or ldquoneutralrdquomdashbut only say ldquosellrdquo 09 percent of the time

You 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

254 PART THREE Takeover Clues

Chap 17 7901 902 AM Page 254

combined entity based on their visions of the future and the ldquoanaly-sisrdquo of some investment banker that the deal makes all the sense inthe world and that it will turn out just peachy

The next time you are in a situation like that do what chocolatebaron Milton Hershey did Sell your ticket on Titanic to someonewho is frantically bidding for a chance to go on the Synergy Cruiseand 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 PaineWebberDonaldson Lufkin Advest Daine-Raushcer JP 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 fromldquoOld-Economyrdquo companies which could be an early warning of aneconomic downturn and possibly a bear market

None of that mattered to the ldquogobblersrdquo however Buying abrokerage was the ldquoinrdquo thing to do and independent stockbrokersstarted disappearing like puddles on a sunny afternoon

(One notable exception to the lemming syndrome was FrancersquosAXA Group a multinational insurance company that decided totake advantage of the mad rush to buy stockbrokers by selling itsstake in Donaldson Lufkin to Credit Suisse First Boston)

All of which should reinforce the following concepts1 The ldquoDomino Effectrdquo or the ldquoLemming Effectrdquo or whatever

name 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

CHAPTER SEVENTEEN Merger Mania Take the Money and Run 255

Chap 17 7901 902 AM Page 255

sober Wall Street analysts and sometimes even the wildest dreams ofthe controlling shareholders of the target companies themselves

In other words if you smell a Domino Effect in the making donrsquotbe 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 emerge

2 If you do buy a stock because you are betting on a DominoEffect takeover wave and yoursquore 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 right

Let the mutual funds and the institutional money managerswho absolutely must own the big-cap stocks take the risk that theldquogobblersrdquo will be right Because very often in fact more than youmight expect they wonrsquot

3 The same holds true for the high-publicity ldquomergers ofequalsrdquo like AOLndashTime WarnerDaimlerndashChrysler or any futurecombination of two huge companies that results in no premiumbeing paid to any shareholder of either company More often than notthese 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 ldquomerger of equalsrdquosell 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 ldquosynergiesrdquo 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 Wall Streetspin 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 future

Just 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

256 PART THREE Takeover Clues

Chap 17 7901 902 AM Page 256

By the end of 1999 the Wall Street 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 anybodybased on the premise that two plus two equals five companies thatproposed mergers of equals began to find that their stock pricesdeclined on the news

On Christmas Day 1999 the Associated Press ran a story en-titled ldquoDrug Deals Stumble as Shares Fallrdquo which discussed the factthat the MonsantondashPharmacia amp Upjohn merger of equals as wellas the Warner-LambertndashAmerican Home Products merger hadreceived a collective thumbs-down from Wall Street in the form offalling stock prices for all four companies

ldquoThe Warner-Lambert and Monsanto transaction raises funda-mental questions regarding the viability of mergers of equalsrdquo saidTom Warnock of Credit Suisse First Boston ldquoGiven the market reac-tion to both of these deals Boards of Directors will be more circum-spect before pursuing such a partnerrdquo

The Associated Press concluded that ldquoinvestors want a merg-er to offer them a premium for their shares in the target companyrdquo

No kiddingYou canrsquot have a true takeover if everybody wants to be the

gobbler and with nothing but gobblers you have no superstockTherefore any merger without a true ldquogobbleerdquo is not a takeoverthat should interest you

CHAPTER SEVENTEEN Merger Mania Take the Money and Run 257

Chap 17 7901 902 AM Page 257

This page intentionally left blank

C H A P T E R E I G H T E E N

Look for MultipleTelltale Signs

I have owned a lot of race horses in my life and Irsquove 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-1mdashnot outrageouslong shots by any means just decent horses with ability that were per-fectly capable of winning and had been overlooked by the crowd

I asked him how he managed to come up with so many winnersat such generous odds

ldquoIt took me a long time to learn thisrdquo he said ldquobut I finallylearned to trust my instincts

ldquoI see a lot of racesrdquo he said ldquoI notice things and after a whileI learned that if I see certain things a certain result usually followsBut it took me a long time to learn to trust in what I have observedbecause when I see something and then I look up and a horse is 10-to-1 I used to think lsquoWell I must be missing something otherwisethe horse would be 2-to-1 or 3-to-1rsquo 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 doesnrsquot 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 donrsquot care about the odds anymore Why should I The

259

Chap 18 7901 902 AM Page 259

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

odds only reflect what everybody else thinks and I am more inter-ested in what I think Irsquove learned to trust my own judgmentrdquo

Once you become accustomed to reading the financial news interms of the list of Telltale Signs you will begin to understand whatmy friend the horse bettor was talking about Yoursquoll begin to noticesmall items which to most readers of the financial news are insignif-icantmdashbut they will be of great significance to you You will be see-ing them in a totally different light than virtually everyone elsebecause yoursquoll be operating in a different paradigm

Eventually you will encounter situations where more than oneTelltale Sign is present These can sometimes be the most profitablesituations of all because there will be no one outstanding or terriblyunusual development that would attract the attention of the finan-cial community thereby leading them to suspect that a superstocktakeover is brewing However when taken together a combinationof several apparently unrelated developmentsmdashall of which are onthe list of Telltale Signsmdashcan clearly point you in the direction of awinning stock

The trick is When you do see these multiple Telltale Signs pop-ping up you will have to trust your instincts even though yoursquollhave virtually no support from the ldquoexpertsrdquo 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 thismdashif you can recognize the sign and have the courageto stick to your guns as long as the evidence is on your sidemdashyou canoften run rings around the Wall Street professionals

Here are several examples of how I zeroed in on takeover can-didates that were overlooked by Wall Street simply by noticing mul-tiple Telltale Signs

CASE STUDY SUGEN INC

On December 211995 Sugen Inc (SUGN) was recommended as atakeover candidate at $111frasl2 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 Britainrsquos Zeneca Ltda large pharmaceutical company had purchased 281875 Sugen shareson September 29 1995 at $12 per share Some further research

260 PART THREE Takeover Clues

Chap 18 7901 902 AM Page 260

TEAMFLY

Team-Flyreg

revealed that Zeneca had already held a stake in Sugen and thatthis new purchase had increased Zenecarsquos interest in the companyto around 20 percent

Part 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 Sign

Looking into Sugen a bit further revealed that Amgen anoth-er large biotech company also owned a 35 percent stake in SugenThis 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 Amgenrsquos stake fell below the 5 percentthreshold that makes an outside company an ldquoofficialrdquo 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 future

What finally led to my recommendation of Sugen howeverwas the news on December 6 1995 that Asta Medica a Germanpharmaceutical company had purchased 495000 Sugen shares Thispurchase was made as part of an agreement that gave Asta Medicathe right to jointly develop manufacture and market Sugenrsquos anti-cancer drugs in Europe and it gave Asta Medica a roughly 5 percentstake in Sugen

This development gave Sugen a total of three outside beneficialowners each of which was a legitimate candidate to someday takeover Sugen

And that wasnrsquot all The final Telltale Sign in a series of TelltaleSigns was the fact that Asta Medica had purchased those 495000Sugen shares at an above-market price of $2088 per sharemdashwhichwas two times the prevailing market price of Sugenrsquos stock at thetime of the purchase

Sugen shares had briefly spiked up to the $14 area from around$101frasl2 when the news broke of Asta Medicarsquos above-market purchasebut 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

CHAPTER EIGHTEEN Look for Multiple Telltale Signs 261

Chap 18 7901 902 AM Page 261

after another even in the face of a news development that makes ithighly likely that something very bullish is brewing

Nearly 1 year later Sugen had gained exactly one-eighth of apoint from the recommended price So far I did not look like a geniusBut I had enough experience with the Telltale Signs to know that theodds were on my side and I continued to recommend Sugen

In December 1996 1 year after the initial recommendationZeneca purchased another 509000 Sugen shares at $12 raising itsstake to 249 percent of the company I also noted that Allergan(AGN) another large drug company had purchased 191000 sharesof Sugen at the same above-market price of $2088 that GermanyrsquosAsta Medica had paid a year earlier

These new Telltale Signs now gave Sugen a total of four out-side ldquobeneficial ownersrdquo two of which had paid nearly twice thevalue of Sugenrsquos 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 Sugenrsquosresearch 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 target

By January 1997 another Telltale Sign appeared Sugenrsquos stockprice was starting to sketch out a potential ldquosuperstock breakoutrdquo 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 horizon

Toward the end of 1996 a Sugen director bought nearly 22000shares at $121frasl8 on the open marketmdashflashing yet another Telltale Signwhich was the strongly bullish combination of insider buying and multipleoutside beneficial owner buying Sugen was piling up Telltale Signs allover the placemdashbut the stock was still stuck in neutral

Still the signs kept coming on On November 13 1997 Zenecapurchased another 456000 Sugen shares paying $16 a share OnJanuary 16 1998 another Sugen director bought 20000 shares ofstock on the open market at $125frasl8 to $123frasl4

On May 8 1998 we reported that Sugen was in later-stage tri-als for several antiangiogenesis agents designed to kill cancer tumorsThe reason for this story was that on May 3 1998 The New York Times

262 PART THREE Takeover Clues

Chap 18 7901 902 AM Page 262

had 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 story

We had noted that Sugen was also in the forefront of antian-giogenesis research yet Wall Street had not yet focused on this facteven though Entremed stock had gone through the roof following TheNew York Times story

It wasnt really necessary though to focus on Sugenrsquos leader-ship in developing antiangiogenesis drugs because Zeneca AstaMedica Amgen and Allerganmdashthe four outside beneficial ownersmdashhad 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 ldquoben-eficial ownersrdquo when they take positions in a companymdashyou maynot know what they know but you can know what they domdashand some-times that is all you really need to know

On June 2 1998 Sugenrsquos CEO appeared for an interview onCNBC He talked about Sugenrsquos innovative anticancer therapiesadding that he expected Sugen to be profitable within 2 to 3 years

It 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 CEOrsquos answer but also from theCEOrsquos body language You can learn to ldquoreadrdquo these interviewslooking for subtle clues that might help in your search for super-stock takeover candidates

For 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 companyrsquos 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

CHAPTER EIGHTEEN Look for Multiple Telltale Signs 263

Chap 18 7901 902 AM Page 263

of Frontier Corp which led to a recommendation that Frontier wouldbecome a takeover target)

In the case of the interview with Sugenrsquos 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 ldquothe goodsrdquo 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 canarymdashand my confidence inSugen went up a notch after watching his performance on CNBC

At the time of the interview with Sugenrsquos CEO the companywas trading around $16 compared to the original recommendedprice of $111frasl2 30 months earlier This was an okay but not great per-formance up to that point But by September 1998 Sugenrsquos sharesplunged all the way from $173frasl4 to $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 it

Pretty discouraging wouldnrsquot you sayWell yes So what do you think I didI stuck my neck out even further because I had the evidence to

back 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 think

By December 1998 two Sugen directors had purchased a totalof 21000 shares on the open market a few weeks earlier at $10 to$103frasl4 Not that we needed it but Sugen had just flashed another ina seemingly endless series of Telltale Signs

In April 1999 Sugen was featured on a CBS 60 Minutes segmentwhich discussed the promising potential of the companyrsquos anticancerdrugs During a period of four trading days prior to the 60 Minutessegment Sugen shares soared from $14 to $233frasl4 Following the pro-gram the stock promptly fell back to the $15 area

As it turned out that was the final buying opportunity in Sugenfor those who had been following the avalanche of clues along the way

On June 161999 Sugen jumped 7 points in one day a gain of31 percent in a single trading session following an announcementthat Pharmacia amp Upjohn had agreed to buy Sugen at $31 per share

264 PART THREE Takeover Clues

Chap 18 7901 902 AM Page 264

That takeover price represented a 72 percent premium over Sugenrsquostrading price at the time of my final front-page recommendation justtwo weeks earlier It also represented a more than 200 percent pre-mium over Sugenrsquos trading price as recently as September 1998 just9 months earlier when Sugen had briefly dropped below the origi-nal recommended price

It came as no surprise that Sugen finally received a takeoverbid The only surprise was the identity of the buyer Pharmacia ampUpjohn had emerged out of nowhere to become the acquirer ofSugen

The 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 Signmdashand remember Sugen had sketched out aldquosuperstock breakoutrdquo pattern along the way which is usually a signof major accumulation in anticipation of some major bullish event

All 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 ldquoroad maprdquo to recommend Sugendespite the frustration of seeing all of the obvious signs and havingthe stock market completely ignore them

There were literally hundreds of biotech companies floatingaround and there still are But not many of them got acquired Sugendidmdashand the Telltale Signs were there to foreshadow the takeoverbid for those who knew what to look for

And as you can see it was a long road between the first TelltaleSign to the final takeover bid A superstock 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 falsestart after another It took about 31frasl2 years from the original recom-mendation of Sugen for that takeover bid from Pharmacia amp Upjohnto create a 169 percent profit And remember if you were extremelyconfident (and how could you not have been with all of the TelltaleSigns)mdashyou could have bought Sugen in the $10 to $11 area inSeptember 1998 and wound up with a nearly 200 percent profit in just9 months

CHAPTER EIGHTEEN Look for Multiple Telltale Signs 265

Chap 18 7901 902 AM Page 265

No index fund could have matched that returnGranted 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 pricesmdashespecially 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 opportunitymdashand be thankful that you have developed aninsight that others simply do not have

CASE STUDY FRONTIER CORP

In 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 ldquorestructuringrdquo charge

Frontier it seemed was biting the bullet in certain areas takingwrite-offs and redirecting the company toward more profitable andpromising ldquocorerdquooperations 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 targetespecially since Frontier was operating in a consolidating industry

Wall 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 1996

Frontier was the nationrsquos fifth largest long distance company Asrecently as mid-1996 the stock had been trading at $331frasl2 And yeteven 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 ldquorestructuringrdquo moves

266 PART THREE Takeover Clues

Chap 18 7901 902 AM Page 266

that Frontier had announced were one of the Telltale Signs of a com-pany preparing to sell itself Wall Street took completely the oppo-site view of Frontier and knocked the stock down to the $21 areaproviding a great entry point

And there was more to the recommendation In a mid-DecemberCNBC interview with Frontierrsquos chairman CNBC reporter DavidFaber conducted a terrific ldquonew paradigmrdquo 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 Frontierrsquos chairman replied ldquoWe are not in anyactive merger discussions at this timerdquo David Faber did not move onas most interviewers would have he sensed that the answer wascarefully phrased and he pressed Frontierrsquos chairman with a fol-low-up question Are you saying you have not been approachedabout a takeover Frontierrsquos chairman replied ldquoI am saying we arenot in active discussions at this timerdquo

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 Frontierrsquos chairman was that Frontier had been ap-proached about a takeover but that there were no talks going onright now This impression combined with Frontierrsquos restructuringmoves and the fact that Frontierrsquos industry was seeing a number oftakeovers led me to recommend Frontier as a takeover candidate

By June 1997 Frontierrsquos stock had dropped again this time tothe $16 to $18 area Earnings continued to come in at disappointinglevelsmdashbut 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 candidate

In June 1997 the takeover trend in the telecom industry was con-tinuing with a proposed merger of ATampT and SBC Communications

CHAPTER EIGHTEEN Look for Multiple Telltale Signs 267

Chap 18 7901 902 AM Page 267

They say that beauty is in the eye of the beholder On Wall Streetyou can say the same thing about ldquobadrdquonews Each time Frontierannounced another restructuring-related write-off Wall Street dumpedFrontier stockmdashyet each of these announcements was a thing of beautybecause they were Telltale Signs that this company was setting itself up tobe acquired

By 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 industry

On October 311997 another Telltale Sign emerged the ldquomulti-ple biddersrdquo signal Three bidders emerged to buy long distance tele-com company MCI Communications British Telecom WorldComand GTE The multiple bidders concept is a strong signal that thetakeover wave in that industry will continue in full force Usually theldquomultiple bidderrdquo Telltale Sign involves two companies trying to takeover a company In this case there were three multiple biddersmdasha 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 Frontierrsquos 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 ldquocould be acquiredrdquo 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 improveFrontierrsquos 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 ldquonew paradigmrdquo and ldquoold paradigmrdquo thinking Thesame piece of information can lead to diametrically opposed con-

268 PART THREE Takeover Clues

Chap 18 7901 902 AM Page 268

clusions about the future depending on what you know what youhave experienced and how the information is interpreted

Nearly a year later in October 1998 Frontier stock was tradingin the high $20s We reported in Superstock Investor

Frontierrsquos new CEO Clayton has been selling off noncore and under-performing operations which is often a telltale clue that 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 possible

In light of what was about to happen those comments were about asclose to the mark as you can get in this business

In February 1999 a spokesperson for Frontier Corp deliveredanother Telltale Sign by uttering the words ldquorestructuring optionsrdquoand ldquoincrease shareholder valuerdquo 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-tion At the time Frontier was trading at $351frasl2

The interview with Frontierrsquos CFO Rolla Huff in which MrHuff made these statements did not appear in the national mediaIn fact the interview appeared in a Rochester New York businesspublicationmdashanother 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 ldquothe com-pany is evaluating a number of options including spinoffs initialpublic offerings and mergersrdquo

In particular Huff pointed to Frontierrsquos data and Internet businesswhich was hidden beneath the companyrsquos image as a long distance tele-phone company as being worth far more than the stock market was givingFrontier credit for

In March 1999 we reported that Frontier was attempting tobreak out of a superstock breakout pattern ldquoThe 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 Butthe recent move up to $391frasl4 combined with the willingness of Frontier

CHAPTER EIGHTEEN Look for Multiple Telltale Signs 269

Chap 18 7901 902 AM Page 269

management to make the bold forecast mentioned earlier stronglyimplies that this break-in process is the real thingrdquo

It had been 27 months since the original recommendation ofFrontier Corp The original recommendation had been based on aTelltale Sign of a company in a consolidating industry announcingrestructuring moves designed to rid itself of underperforming oper-ations and make it more of a ldquopure playrdquo This was followed by anoth-er Telltale Sign multiple bidders for MCI Corp which stronglyimplied that more takeovers of long distance companies would takeplace This was followed by Frontier officials using buzzwords likeldquoincrease shareholder valuerdquo and ldquorestructuring optionsrdquo which areoften code phrases used by managements who believe their stock isbadly 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 ldquosuperstockrdquo trading range by crossing the $34 to $37 area

By March 1999 Frontier received a $62 takeover bid from GlobalCrossing Frontier was originally recommended in December 1996at $21 when it was viewed as a hopelessly troubled company witherratic 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 thingWall Street is a lot like horse racing and also a lot like life in that

experience 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 see

That is a huge advantage and by becoming a ldquonew paradigmrdquothinker you can create this advantage for yourself when it comes topicking superstock takeover candidates

270 PART THREE Takeover Clues

Chap 18 7901 902 AM Page 270

TEAMFLY

Team-Flyreg

CASE STUDY WATER UTILITIES

Once you get used to the idea of reading the financial news in termsof the Telltale Signs certain news items that donrsquot 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 itrsquosnot just one news item but an accumulation of small items or cluesthat when taken together begin to form a clear picture of what liesahead Like the straw that broke the camelrsquos back it was not the strawthat finally touched off the eventmdashrather 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 anotherand based on an accumulation of evidence yoursquoll finally decide thata certain industry or a certain stock deserves your close attention

On 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 everything in 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 newspapermdashor possibly not even reported at all

The headline on this particular story was ldquoAmerican WaterAgrees to Acquire Utility for Stockrdquo and the gist of the report wasthat American Water Works (AWK) a water utility had agreed tobuy privately held National Enterprises Inc another water utilityin a transaction valued at $4852 million

There 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 anybodyrsquos 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 heavenrsquos sakemdashandhow exciting is that

But anyone who took the time to read this story would havefound several Telltale Signs that suggested a potentially profitable

CHAPTER EIGHTEEN Look for Multiple Telltale Signs 271

Chap 18 7901 902 AM Page 271

takeover 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 companies

The 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 considered

It might have been easy to miss this story if not for an excellentreport that appeared in the Investorrsquos Business Daily ldquoCompanies inthe Newsrdquo section just a month before The IBD ldquoCompanies in theNewsrdquo section is an excellent ldquobrowsingrdquo 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 ldquoIndustry Group Focusrdquo 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 ldquoCompanies in the Newsrdquo 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 reportwould 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 utilities

The IBD story quoted Philadelphia Suburbanrsquos CEO as followsldquoSince this is such a highly fragmented industry the acquisitiongives us a head start in the consolidation phaserdquo He added that he

272 PART THREE Takeover Clues

Chap 18 7901 902 AM Page 272

expected the combined Philadelphia SuburbanndashConsumers Waterto ldquotake advantage of what we think will be great opportunities forbuying up smaller companies in the futurerdquo

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 Effect

And 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 industry

The combination of thesemdashone in IBD and the other in The WallStreet Journalmdashtwo items appearing less than a month apart is whatfinally led me to take a long hard look at the water utility industry

The list of publicly traded water utility stocks was similar to thedrugstore industry just prior to the ldquodominolikerdquo 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 companiesmdashjust as the drugstore industry had

Moreover 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 values

And 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 rates

Finally several of the water utilities on the list were alreadypartially owned by an outside ldquobeneficial ownerrdquo which was oneof the Telltale Signs to always look formdashthe fact that two of theseoutside beneficial owners were acquisition-minded European com-panies was also a major plus

CHAPTER EIGHTEEN Look for Multiple Telltale Signs 273

Chap 18 7901 902 AM Page 273

In December 1998 I presented a front-page report in SuperstockInvestor entitled ldquoWater Utility Industry Could Be on the Verge of aTakeover Waverdquo 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 giants

In December 1998 nine water utilities (and one water servicesstock) were recommended (Table 18ndash1) and we suggested a crosssection of these stocks thinking of the portfolio as a sort of ldquomutu-al fundrdquo of water utility takeover candidates We noted that two ofthe water utilities in the portfolio were already partially owned byoutside beneficial owners 291 percent of United Water Resourceswas owned by a French company Lyonnaise des Eaux and 87 per-cent of California Water was owned by SJW Corp a neighboringCalifornia water utility

The 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 ldquosuperstocksrdquo 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 that strategy 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 investmentfirms

The concept of buying these stocks as potential takeover candi-dates had 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

274 PART THREE Takeover Clues

Chap 18 7901 902 AM Page 274

with interest rates in general When interest rates fell the water util-ity stocks bounced up a bit so their dividend yields would fall

But 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 targetsthese 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 values

It 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 25 times book value to the area of 29times 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 takeovermdashan incredible riskreward situationsince we were talking about water utilities for heavenrsquos sake

How 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 stocksmdashand yet for severalmonths these stocks could have easily been purchased at or belowthe original recommended prices

CHAPTER EIGHTEEN Look for Multiple Telltale Signs 275

T a b l e 18ndash1

Water Utility Stocks as of 1298 (original recommended prices)

United Water Resources (UWR) $201frasl16

California Water (CWT) $267frasl8

Ersquotown Corp (ETW) $451frasl8

Aquarion (WTR) (adjusted for 3-for-2 split) $243frasl4

American States Water $281frasl2

SJW Corp (SJW) $60

Connecticut Water (CTWS) $271frasl2

Middlesex Water (MSEX) $241frasl2

Southwest Water (SWWC) (adjusted for two 3-for-2 splits) $65frasl8

Chap 18 7901 902 AM Page 275

In 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 ldquoright on targetrdquo 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 industry

1 As 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 companies

2 The water utility industry is particularly suited toeconomies of scale resulting from combining companieswhich include elimination of general office operationsbilling operations lab expenses and the day-to-dayexpenses of running a business such as engineering costspurchasing accounting insurance and so forth

3 The increasing costs of complying with environmentalrequirements especially in the eastern United States coulddrive smaller water companies to merge with larger com-panies

This conversation with a well-positioned water utility executiveeven 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 value

Remember 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 personrsquos 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

276 PART THREE Takeover Clues

Chap 18 7901 902 AM Page 276

The 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 becomethe less information you are likely to elicit from that companyrsquosinvestor 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 description

But you will also find that as you begin dealing with companieswhose stocks are unloved and out of favormdashas will be the case muchof the time if you put these principles and thought processes to workfor youmdashyou are very likely to elicit interesting and valuable infor-mation simply by picking up the phone and calling the company Oftenyoursquoll find that these companies have attracted so little investor inter-est that they do not even have a full-time investor relations personand you will wind up speaking to the company treasurer a vice pres-ident or some other officer who doubles as the investor contact

In 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 dying for 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 know

This may seem like an exaggeration but it is not You should tryit sometime

This 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 thatrsquos thatmdashwhat more is there to say

CHAPTER EIGHTEEN Look for Multiple Telltale Signs 277

Chap 18 7901 902 AM Page 277

Suddenly the landscape changed Several water utilities hadbeen purchased by larger companies and consolidation was in the airThe 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 estatemdashcould these parcels inject avaluable ldquowild cardrdquo into potential valuations

Suddenly the water utility business was getting very interest-ingmdashbut 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 ldquonew paradigmrdquo 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 painted

Perhaps 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 donrsquotgive up if you donrsquot get the direct answers you are hoping for Andalways greet whatever response you receive in an understandinggood-natured way If you donrsquot 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 determine

Sometimes an executive will give you a ldquoYesrdquo for an answerwhen asked if his company has received a takeover bid More oftenthe question must be couched in different terms such as ldquoIf youreceived a takeover bid would you reject it out of hand or would you

278 PART THREE Takeover Clues

Chap 18 7901 902 AM Page 278

consider what is in the best interest of shareholdersrdquo Or if a com-pany already has an outside ldquobeneficial ownerrdquo the question mightgo like this ldquoHave you ever discussed the possibility of beingacquired by XYZrdquo Or ldquoIs it possible they might want to buy therest of the shares they donrsquot ownrdquo Or ldquoWould it make any sense forthem to eventually want to buy you outrightrdquo Or ldquoAre there anyunderstandings or agreements that would prevent XYZ from acquir-ing the rest of your companyrdquo

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 carefullyyou leave the executive enough ldquowiggle roomrdquo to respond to you ina manner that you may gain the information you are looking for ina roundabout waymdashor possibly even other information that you hadnot even considered asking about

In 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 25 and 29 timesbook value if they were to be acquiredmdashwith the potential valua-tion moving up toward the upper end of that range as time went onand fewer acquisition candidates were available

This 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 ldquogaprdquo between a companyrsquos stock price and its possible buy-out valuemdashin other words the most undervalued water utilities inthe group Three water utilities appeared to be particularly under-valued Ersquotown Corp SJW Corp and American States Water SJWCorp also owned an 87 percent stake in California Water whichcould give SJW an added attraction as a takeover candidate

Within 10 months two of these three water companies hadreceived takeover bids

By 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

CHAPTER EIGHTEEN Look for Multiple Telltale Signs 279

Chap 18 7901 902 AM Page 279

The two stocks in question were both water utilities Aquarion(WTR) a Connecticut-based water company and Ersquotown (ETW) aNew Jersey water company Generally stocks within a well-definedindustry group will tend to move in the same general direction notevery day certainly but over time When you have a situation wherea certain stock in an industry is moving up consistently while itspeers are doing nothing or even declining it can often be a sign thatsomething very bullish is brewing

Both Aquarion and Ersquotown were examples of this principle AlsoAquarion had large real estate holdings which could add to itstakeover appealmdashsomething 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 where Irsquod discovered that water com-panies might be under more pressure to sell themselves due to morestringent environmental regulations and higher compliance costs

You can see that a combination of various factorsmdashlessonslearned comments heardmdashled to focusing directly on both Aquarionand Ersquotown

On June 1 1999 Aquarion announced that it had agreed to be acquiredby Yorkshire Water PLC Britainrsquos largest utility for $3705 per shareAquarion a Connecticut water company was one of the water util-ities that owned large tracts of real estate

That $3705 takeover price represented a premium of nearly 70percent above Aquarionrsquos 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 occurs

This was a boring high-yielding water utilitymdashand yet super-stock analytical techniques led directly to the takeover of Aquarion Theconcept of risk vs rewardmdashin which an investor considers not only

280 PART THREE Takeover Clues

Chap 18 7901 902 AM Page 280

TEAMFLY

Team-Flyreg

the potential profit but also the potential riskmdashwas 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 takeovercandidates

That 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 still left 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 longermdashall the better for investors Even the fact thatAquarion had been acquired at 27 times book valuemdashwhich con-firmed the takeover value range I had been usingmdashwas not enoughto bring the water utility stocks significantly closer to their takeovervalues As a result of that 27 times book value figure in June 1999the potential takeover values of the water utility stocks in the port-folio were estimated And once again Ersquotown SJW Corp andAmerican States Water were the three water utilities that seemed tobe selling at the biggest discount to their potential buyout prices

On August 24 United Water Resources announced that it hadagreed to be acquired by Suez Lyonnaise des Eaux a French com-pany for $3548 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 surprisemdashespecially since SuezLyonnaise was already an outside ldquobeneficial ownerrdquo 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 ldquome toordquo 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 ldquolem-mingrdquo effect or the Domino Effect or whatever label you might

CHAPTER EIGHTEEN Look for Multiple Telltale Signs 281

Chap 18 7901 902 AM Page 281

want 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 them

For 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 ldquobeneficial ownerrdquo 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 ldquoinefficienciesrdquo

On October 29 SJW Corp announced that it had accepted a$128 takeover bid from American Water Worksmdashthe 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 before

Less than 1 month later on November 22 1999 Ersquotown Corpannounced that it would be acquired by Britainrsquos Thames Water PLCfor $68 per share a premium of 506 percent above the original rec-ommended price 12 months before Ersquotown jumped over $10 pershare in a single day on this news

It 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 506 percent to 113percent above the original recommended prices Moreover in eachcase these takeover targets could have been purchased at prices sig-nificantly below the original recommended price even as the evidence

282 PART THREE Takeover Clues

Chap 18 7901 902 AM Page 282

mounted that water company takeovers were coming resulting ingreater percentage gains

An article in The Wall Street Journal the day after the bid forErsquotown was announced clearly spelled out the reasons for thetakeover wave in the water stocks It all seemed so obviousmdashbut itwould have been just as obvious one year earlier if yoursquod 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 believeeven though the stock market is paying no attention to this evidencewhatsoever You have to ldquoknow what you knowrdquo 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

CHAPTER EIGHTEEN Look for Multiple Telltale Signs 283

Chap 18 7901 902 AM Page 283

This page intentionally left blank

A P P E N D I X

A Superstock Shopping List

As you have seen an important part of my approach has been tomake special note of companies that are partially owned by outsideldquobeneficial ownerrdquo investors I am particularly interested when one ofthese partially owned companies exhibits one or more additionalTelltale Signsmdashespecially when the outside beneficial owner had boththe ability and the desire to maximize the value of its investment

To help you start your own ldquoresearch universerdquo we have com-piled a sampling of companies that are partially owned by eitheranother company or a private investor or what I would call a ldquofinan-cialrdquo 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 ldquofinancialrdquo outside owners would be ready willing andable to cash out of their investments at a nice premium

We 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 ldquofinancially orientedrdquo owners companies that are partiallyowned by a family trust are also candidates for ldquovalue maximizationrdquowhen the timing is right

This list was compiled from the most recent data available at thetime this book was publishedmdashbut as we have learned things

285

Appx A 7901 903 AM Page 285

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

change Irsquod 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 wersquove pro-vided here

There are two ways to determine the very latest ownershipstakes of these ldquobeneficial ownersrdquo You can either call the compa-ny directly or you can go to wwwfreeedgarcom on the InternetOnce you access freeedgarcom simply enter the trading symbol ofthe company and click on ldquoview filingsrdquo You will then see a list ofthe companyrsquos Securities amp Exchange Commission filings The bestfiling to check would be the most recent Proxy Statement listed onthe site as ldquoForm DEF-14AndashDefinitive Proxy Statementrdquo Within thatfiling you will find a section listing all of the companyrsquos major share-holders including ldquobeneficial ownersrdquo with more than a 5 percentstake You should also make note of any recent Form 13 filingsincluding not only 13-Drsquos but also Form 13-Grsquos 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 surfaced

As 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 reasons

First 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 ofyour investment

The 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

286 APPENDIX

Appx A 7901 903 AM Page 286

I want to make it clear that this is not a recommended list of stocksand 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 owned

Our 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 ldquoprofessionalsrdquo tendto overlook As I said at the outset I make no claim that this is anysort of ldquofoolproof systemrdquo 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 lightmdashand 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

A SUPERSTOCK SHOPPING LIST 287

Appx A 7901 903 AM Page 287

Shopping List of Potential SuperstocksInformation as of 101700

Company Symbol Partial Owners

21st Century Insurance Group TW American International Group (621)

Abercrombie amp Fitch ANF JP Morgan Co (77)

ABM Industries ABM Rosenberg Family Trust (21)

Acmat ACMT Queensway Financial Canada (198)

Actrade Financial ACRT NTS Corporation (292)

ACTV Inc IATV Liberty Media (238)

Advanced Magnetics AVM BVF Partners (136)Eiken Chemical Ltd Japan (56)

Advanced Tissue Sciences ATIS Smith amp Nephew Inc England (795)

Aegon Insurance Group AEG Vereniging NV Netherlands (344)

AEP Industries AEPI Borden Inc (324)

Allied Waste Industries AW Apollo Advisers LP (172)Blackstone Mgt LLC (119)

Ambac Financial ABK JP Morgan (104)

AMC Entertainment AEN Fairmac Realty Group (113)Syufy Century Corp(72) Durwood Family Heirs (58)

American Classic Voyages AMCV Sam Zell Group (36)

American Express AXP Berkshire Hathaway Warren Buffett(114)

American Locker Group ALGI Estate of Harold Ruttenberg (225)

Ann Taylor ANN Morgan Stanley (54)

ARI Network Services ARIS Briggs amp Stratton (136)Witech (213)Vulcan Ventures (87)

Aristotle Corporation ARTL Geneve Corporation (508)

Astoria Financial ASFC JP Morgan (99)

Atchison Casting Corporation FDY Edmundson International Inc (118)

Autozone AZO ESL Ltd (162)

Bancwest Corporation BWE Banque National de Paris (45)

Barnes amp Noble BKS Forstman-Leff Associates (157)

Barrick Gold ABX Trizec Hahn Canada (8)

Battle Mountain Gold BMG Noranda Inc Canada (284)

Beringer Wine BERW Texas Pacific Group (517)

Berlitz International BTZ Soichiro FukutakeBenesse Corporation Japan (616)

Biosphere Medical BSMD Sepracor Inc (58)

288 APPENDIX

Continues

Appx A 7901 903 AM Page 288

Shopping List of Potential SuperstocksInformation as of 101700 (continued)

Company Symbol Partial Owners

Blockbuster Inc BBI Viacom Inc (823)

California Water CWT SJW Corporation Being acquired by American Water Works (85)

Campbell Soup CPB Dorrance Family Heirs (388)

Catalina Marketing POS General Electric (76)

CDI Corporation CDI Garrison Family Trust (292)

Centex Construction Products CXP Centex Corporation (615)

Cerus Corporation CERS Baxter Healthcare (162)

Chart House Enterprises CHT Samstock LLC (271)

Chiron CHIR Novartis (44)

Churchill Downs Inc CHDN Duchossois Industries (242)

CIT Group CIT Dai-Ichi Bank Japan (268)

Clorox CLX Henkel K GaA Germany (265)

CNAFinancial CNA Loews Corporation (868)

Coca-Cola KO Berkshire Hathaway Warren Buffett (81)

Coca-Cola Bottling COKE Coca-Cola Company (31)

Coca-Cola Enterprises CCE Coca-Cola Company (403)

Cognizant Technology CTSH IMS Health (61)

Congoleum Corporation CGM American Biltrite (683)

Conmed Corporation CNMD Bristol Myers Squibb (613)

Continental Airlines CAL NWA Corporation (846)

Cooper Industries CBE JP Morgan (71)

Coventry Health Care CVTY Principal Life Insurance Co (255)Warburg Pincus Ventures (306)

CPC of America CPCF CTM Group Inc (395)

Curtiss-Wright CW Unitrin (43)

Darden Restaurants DRI Prudential Insurance (136)American Express (93)

Dave amp Busters DAB LJH Corporation (113) Mandarin Inc United Kingdom (106)

Dawson Geophysical DWSN Pebbleton Corporation (181)

Detroit Diesel DDC Daimler Chrysler (21)

Devon Energy DVN Santa Fe Synder Corporation (166)

Diamond Offshore DO Loews Corporation (517)

Donnelly Corporation DON Johnson Controls Inc (151)

A SUPERSTOCK SHOPPING LIST 289

Continues

Appx A 7901 903 AM Page 289

Shopping List of Potential SuperstocksInformation as of 101700 (continued)

Company Symbol Partial Owners

Dreyers Grand Ice Cream DRYR Nestle (218)General Electric (188)

DST Systems DST Kansas City Southern Industries (323)

Dynergy DYN Chevron (289)

ETrade Group EGRP Softbank Holdings (261)

Ecolab ECL Henkel K GaA Germany (136)

Electric Lightwave ELIX Citizens Communications (102)

Entrust Technologies ENTU Nortel Networks (318)

Euronet Services EEFT DST Systems (117)

Excite Home ATHM ATampT (238)Comcast (46)Cox Communications (73)Cablevision Systems (52)

Family Dollar Stores FDO Bank of America (82)

Federal Realty FRT Morgan Stanley Dean Witter (149)

Fiberstars Inc FBST Advanced Lighting Technologies (33)

Fifth Third Bancorp FITB Cincinnati Financial Corporation (156)

Fleet Boston Financial FBF Kohlberg Kravis Roberts (55)

Footstar Inc FTS ESL Partners (221)

Franklin Electronics Publishers FEP Bermuda Trust Company (216)

Freeport McMoran Copper FCX Rio Tinto Indonesia Ltd (37)

Friendly Ice Cream FRN Prestley Blake (114)

Galey amp Lord GNL Citicorp Venture Capital (472)

Galileo International GLC UAL Corporation (17)Swiss Air (67)

Garden Fresh Restaurant Corporation LTUS D3 Family Fund

LP David Nierenberg (143)

General Binding GBND Lane Industries (628)

Gillette G Berkshire Hathaway (91)Kohlberg Kravis Roberts (49)

Golden State Bancorp GSB Mafco Holdings Ronald Perelman (32)

Great Atlantic amp Pacific GAP Tengelmann Group Germany (54)

Great Lakes Chemical GLK Berkshire Hathaway Warren Buffett(139)

GTS Duratek DRTK The Carlyle Group (231)

Guitar Center GTRC Chase Capital Partners (232)

Hagler Bailey Inc HBIX Cap Gemini SA (144)

Halifax Energy HX Research Industries (349)

Hanover Compressor HC GKH Investments (39)

290 APPENDIX

Continues

Appx A 7901 903 AM Page 290

TEAMFLY

Team-Flyreg

Shopping List of Potential SuperstocksInformation as of 101700 (continued)

Company Symbol Partial Owners

Harleysville Group HGIC Harleysville Mutual Insurance (566)

Hearst Argyle TV HTV Hearst Broadcasting (63)

Heska Corporation HSKA Novartis (11)Ralston Purina (67)

Hispanic Broadcasting HSP Clear Channel Communications (26)

Houston Exploration THX Keyspan (703)

Human Genome Sciences HGSI Bass Group (153)Merrill Lynch (66)

ICN Pharmaceuticals ICN Special Situation Partners (85)

IDEC Pharmaceuticals IDPH Genentech (67)Citicorp (77)

IDEX IEX Kohlberg Kravis Roberts (287)

IIC Industries IICR Kenyon Phillips Ltd England (778)

Immunex IMNX American Home Products (553)

Impco Technologies IMCO BERU Aktiengesellschaft Germany(121)

Insurance Management Solutions INMG Bankers Insurance Group (627)

International Home Foods IHF Hicks Muse (426)

International Multifoods IMC Archer Daniels Midland (86)

Interstate Bakeries IBC Ralston Purina (295)

Intrusioncom INTZ Science Applications InternationalCorporation (156)

Isis Pharmaceuticals ISIP Novarits Switzerland (72)

Kemet Corporation KEM Citicorp (76)

Keystone Consolidated KES Contran Corporation (408)

Kohlrsquos Corporation KSS AXA France (149)Prudential Insurance (54)

Laboratory Corporation of America LH Roche Holdings (462)

Ladish Company LDSH Grace Brothers (284)

Lafarge Corporation LAF Lafarge SA France (522)

Legg Mason LM AXA Financial (167)

Liberty Financial L Liberty Mutual (714)

Lifeway Foods LWAY Danone Foods (Dannon) France (20)

Ligand Pharmaceuticals LGND ELAN International Services (193)

Lilly (ELI) amp Co LLY Lilly Foundation (154)

Lincoln National LNC Dai-Ichi Mutual Life Insurance (7)

A SUPERSTOCK SHOPPING LIST 291

Continues

Appx A 7901 903 AM Page 291

Shopping List of Potential SuperstocksInformation as of 101700 (continued)

Company Symbol Partial Owners

Linens rsquoN Things LIN Marsh amp McLennan (122)American Express (53)

Litton Industries LIT Unitrin (278)

Lone Star Technologies LSS Alpine Capital (382)Keystone Inc (97)

Loral Space amp Communications LOR Lockheed (155)

Magnum Hunter Resources MHR Oneok Inc (38)

Mascotech MSX Masco Corporation (175)

McMoran Exploration MMR Alpine Capital (277)

Mediquist MEDQ Koninklijke Philips Electronics NV Netherlands (685)

Meemic Holdings MEMH Professionals Group Inc (82)

Midway Games MWY Sumner Redstone National Amusements (25)

Millennium Pharmaceuticals MLNM Bayer AG Switzerland (11)

Mylan Labs MYL American Express (105)

Neiman Marcus NMGA Harcourt General (181)

Neurogen NRGN Pfizer (184)

Nextel Communications NXTL Motorola (131)

Noland Company NOLD Edmundson International (164)

OMI Corporation OMM Mega Tankers Norway (11)

Oneida Corporation OCQ National Rural Electric Co-Op (86)

Oneok Inc OKE Western Resources (45)

Overseas Shipholding OSG Archer Daniels Midland (168)

Owens-Illinois OI Kohlberg Kravis Roberts (245)

Panamsat Corporation SPOT General Motors Hughes (808)

Payless ShoeSource Inc PSS ESL Partners (143)

Peoplersquos Bank PBCT Peoplersquos Mutual Holdings (597)

Petrocorp PEX Kaiser-Francis Oil Company (498)

Petsmart PETM Carrefour SA France (117)

Philadelphia Suburban PSC Vivendi France (18)

Phillips Van Heusen PVH Vaneton International Hong Kong

(18)Mellon Financial (51)

Picturetel Corporation PCTL Intel (99)

Primedia PRM Kohlberg Kravis Roberts (72)

Prodigy Communications PRGY SBC Communications (419)

292 APPENDIX

Continues

Appx A 7901 903 AM Page 292

Shopping List of Potential SuperstocksInformation as of 101700 (continued)

Company Symbol Partial Owners

Protective Life Corporation PL Amsouth Bancorp (96)

RCN Corporation RCNC Level 3 Telecom Holdings (328)Vulcan Ventures (279)

Redhook Ale Brewery HOOK Anheuser-Busch (25)

Regis Corporation RGIS Curtis Squire (157)

Ribozyme Pharmaceuticals RZYM Elan Intrsquol Ireland (159)Chiron Corp (86)

Rosetta Inpharmatics RSTA Vulcan Ventures (127)

Royal Caribbean Cruises RCL A Wilhelmensen AS (25)Pritzker Family (28)

Russell Corporation RML Merrill Lynch (81)

Safeway SWY Kohlberg Kravis Roberts (10)

Samsonite SAMC Artemis America France (302)

Scitex Corporation SCIX Merrill Lynch (607)

Scripps (EW) SSP EW Scripps Trust (493)

Seacor Smit CKH Geocapital Corporation (86)

Smart amp Final SMF Groupe Casino France (602)

Sodexho-Marriott Services SDH Sodexho Alliance SA France (48)TransAmerica Investments (12)

Sport Supply Group GYM Emerson Radio (232)

Sterling Sugars SSUG MA Patout amp Sons Inc (62)

Stolt Offshore SCSWF Stolt Nielson SA Luxemburg (449)

Sunrise Assisted Living Centers SNRZ Morgan Stanley (108)

Supergen Inc SUPG Abbott Labs (49)

Swiss Army Brands SABI Victorinox Switzerland (402)Brae Group (238)

Talbots Inc TLB Jusco Inc (613)

Targeted Genetics TGEN Immunex (72)Elan Intrsquol Ireland (59)

Tiffany amp Co TIF Jennison Associates LLC (104)

Timberland TBL Swartz Family Trust (369)

Titanium Metals TIE Tremont Corporation (391)

Transatlantic Holdings TRH American International Group (60)

Tremont Corporation TRE Valhi Inc (789)

Triton Energy OIL Hicks Muse (389)

True North Communications TNO Publicis SA France (94)

US Cellular USM Telephone amp Data Systems (431)

Ultramar Diamond Shamrock UDS Total FinanceTOTAL France (804)

A SUPERSTOCK SHOPPING LIST 293

Continues

Appx A 7901 903 AM Page 293

Shopping List of Potential SuperstocksInformation as of 101700 (continued)

Company Symbol Partial Owners

UnionBanCal UB Bank of TokyondashMitsubishi (646)

United Park City Mining UPK Loeb Investors (661)Farley Group (126)

UNOVA UNA Unitrin (227)

USG Corporation USG Knauf International (999)

VF Corporation VFC Barbey Trust (199)

Valhi Inc VHI Contran Corporation (789)

Venator Group Z Greenway Partners LP (144)AXA France (104)

Vicorp Restaurants VRES SE Asset Management (19)Quaker Capital (12)

Washington Post Company WPO Berkshire Hathaway Warren Buffett(183)

Westfield America WEA Westfield America Trust (647)

Westwood One WON Viacom Inc (173)

White Mountains Insurance WTM Berkshire Hathaway Warren Buffett(199)

Whitman Corporation WH PepsiCo Inc (396)

WMS Industries WMS Sumner Redstone National Amusements (25)

Worldtex Inc WTX Lockheed Martin Investment Management (215)EGS Partners (342)

Yonkers Financial YFCB Gould Investors LP (162)

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

294 APPENDIX

Appx A 7901 903 AM Page 294

R E S O U R C E S

Barronrsquos published by Dow Jones amp Company Inc New York

BusinessWeek published by The McGraw-Hill Companies New York

Byrne John Chainsaw (New York HarperCollins 1999)

Cerf Christopher and Victor Navasky The Experts Speak (New YorkPantheon Books 1984)

FreeEDGARcom a product of EDGAR Online Inc is the market leader inEDGAR data retrieval

Goldman William Adventures in the Screen Trade (New York Warner Books1989)

Griffin Nancy and Kim Masters Hit amp Run (New York Simon amp Schuster1996)

Investorrsquos Business Daily published by William OrsquoNeil amp Co Los AngelesCalifornia

JagNotescom JAGfncom a product of JAG Notes is a financial network

Kahn Herman The Next 200 Years (New York William Morrow amp Co1976)

Kiplingerrsquos published by The Kiplinger Washington Editors Inc Wash-ington DC

The Mansfield Chart Service published by PW Mansfield amp Co

Nathan John Sony The Private Life (Boston Houghton Mifflin 2000)

The New York Times published by The New York Times Co

Rudd 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)

295

Resources 7901 903 AM Page 295

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

Superstock Investor published by Superstocks Inc Rochester New York

Vickers Weekly Insiders Report published by Argus Research BaltimoreMaryland

The Wall Street Journal published by Dow Jones amp Co New York

Woodward Bob The Agenda (New York Pocket Books 1995)

Yahoo Finance a product of Yahoo Inc

296 RESOURCES

Resources 7901 903 AM Page 296

A

Abbott Labs (ABT) 135Accounting gimmicks 50ADT Ltd 85ndash94Adventures in the Screen Trade

(Goldman) 69Agenda The (Woodward) 44Allied Waste Industries 251ndash254Ameche Don 187American Stores 15ndash17American Water Works 27ndash30 282Aquarion (WTR) 28Arbor Drugs 201Asset values 26Avco Corporation 13

B

Babson Roger 44 45Babson Break 45Bank One (ONE) 49 50Barr J James 28 29Barronrsquos 140ldquoBearish Call on Banks Lands Analyst

in Doghouserdquo 49Belle Albert 43Beneficial owner transactions 103ndash105

285 286Bentsen Lloyd 43Berra Yogi 35Big B 201ldquoBond Bears Debt Securities Prices

May Slide for Years Many AnalystsThink Therdquo 40

Bonds 59Book value 170

Breakout 206Brokerage firm research reports 20 21Browsing 96ndash106 126Brylane Inc 106ndash111Burns International Services 134 135Byrne John A 47

C

Case studiesADT Ltd 85ndash94Brylane Inc 106ndash111Copley Pharmaceuticals 149ndash155Dexter Corp 111ndash124FayrsquosGenovese 190ndash201Frontier Corp 266ndash270JCPenneyRite Aid 233ndash237MattelThe Learning Company

247ndash250Midway Games 140ndash148Protection One 238ndash247Renal Treatment Centers 219ndash222Rexel Inc 78ndash84Rohr Inc 210ndash214Salick Health Care 207ndash210Smith Food amp Drug Centers 201ndash202Sugen Inc 260ndash265Sunbeam Corp 46ndash48VivraRen-Corp USA 215ndash219Waste ManagementAllied Waste

251ndash254WMS Industries 159ndash185

Catalysts 11 12Cautionary tabs (merger mania)

233ndash254Chainsaw (Byrne) 47

297

I N D E X

Index 7901 904 AM Page 297

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use

Change 187 188Charts 138 139 159 205ndash214Clayton Joseph 268Clinton Bill 44Conglomerate craze 188Connecticut Water Service (CTWS) 128Copley Pharmaceuticals 149ndash155Corporate-shareholder disagreements

149ndash156Cosell Howard 54Creeping takeovers 77ndash94

D

Dexter Corp 111ndash124Dirty Rotten Scoundrels 128Discounted present value 61Domino effect 215ndash222 227 255Dorfman Dan 111Dornemann Michael 229 230Double play 141Dow Charles H 187Drugstore industry 187ndash204

case study (FayrsquosGenovese) 190ndash201

case study (Smith Food amp DrugCenters) 201ndash202

Dun amp Bradstreet (DNB) 135Dunlap Al 46 47

E

Ersquotown Corp 131 132 140 282Efficient market 80 81Eli Lilly 225 226Examples (see Case studies)Excitement 6 7Experts 35ndash36

agenda 43 44conforming to prevailing ideology

48ndash53defined 36famous bloopers 54magazine coversarticles 37ndash42shortage of 42truth telling 44ndash48

F

Faber David 267Fairness opinion 77Family feuds 149ndash156Family trust 285Fayrsquos Inc 192ndash195Federal Reserve 61Financial press 125ndash148

Barronrsquos 140case study (Midway Games) 140ndash148Investorrsquos Business Daily 126ndash132

136ndash140(See also Investorrsquos Business Daily)

magazine coversarticles 37ndash42New York Times The 133Vickers Weekly Insider Report 103ndash105Wall Street Journal The 133

Flutie Doug 23Form 4 filings 105Form 13 filings 103 140 286Form 13-D filings 103 140Freeedgarcom 286Frontier Corp 266ndash270Frost A J 205Frost Robert 95

G

Gateway 52ndash53Genovese Drug Stores 192 194ndash201Gifford Frank 54Goldman William 69 70Goodfriend Jaimi 254Goodman George 6 23Grass Martin 191 192 233 236Greenberg Herb 247Greenmail 121Greenspan Alan 44 61Griffin Nancy 228

H

HealthSouth 251Heaven Can Wait 36Herd instinct 31Heyman Samuel 113ndash124

298 INDEX

Index 7901 904 AM Page 298

Hills Roderick M 253Hit amp Run (GriffinMasters) 228Horse racing 6 7Horror stories (merger mania) 233ndash254Huff Rolla 269

I

IBD (see Investorrsquos Business Daily)Illustrations (see Case studies)Index investing 31ndash34Interest rates 59ndash62 69Interpreting the news 4 5Investing paradigms 25ndash30Investorrsquos Business Daily 97 126ndash132

dirty rotten stocks 127ndash130ldquoIndustry Profilerdquo 136 137problems 127ndash132ldquoStocks in the Newsrdquo 138ndash140ldquoTo the Pointrdquo 130 132ldquoWhere the Big Moneyrsquos Flowingrdquo

130 137 138

J

JCPenney 233ndash237 251

K

Keynes John Maynard 57Kidney dialysis industry 215ndash222Kirby Industries 170ndash172Kondratieff Nikolai D 45

L

LaLoggia Charles M 3 4 303Large-cap stocks 32 33 71 72Learning Company The 247ndash250Lemming 31Lemming effect 225ndash227 251 255Limbaugh Rush 43List of potential superstocks 288ndash294Long-term bonds 59LTV Corporation 12 13

M

Magazine coversarticles 37ndash42Mahon Cherrie 124 146 147 303

Major shareholders 286(See also Beneficial owner transac-

tions)Malraux Andreacute 53Mansfield Chart Service 27 97 211Masters Kim 228Mattel 247ndash250Mayo Michael 49ndash51McKesson HBOC 251Mead Corp (MEA) 135Media (see Financial press)Merck 225Meredith Don 54Merger mania 223ndash257

blunders 231 232 251case studies

JCPenneyRite Aid 233ndash237MattelThe Learning Company

247ndash250Protection One 238ndash247Waste ManagementAllied Waste

251ndash254CEO egos 227ndash229investment bankingrsquos desire for fees

230lemming effect 225ndash227 251merger of equals 256 257take the money and run 232 256

Merger of equals 256 257Middlesex Water (MSEX) 129Midway Games (MWY) 140ndash148Money Game The (Goodman) 6Morita Akio 228 229Mudslinging contest 122

N

Nathan John 228National City Corp 50Negative surprise 213 214New paradigm vs old paradigm

thinking 27ndash30New York Times The 97 133Nicastro Neil 142ndash148 180 1811929 Again (Rudd) 441987 stock market crash 42

INDEX 299

Index 7901 904 AM Page 299

ldquoNo Bottom to Oilrdquo 40No-risk rate of return 69Nobody knows anything 70North Oliver 43

O

OrsquoNeil William 127 128Old paradigm vs new paradigm

thinking 27ndash30One-decision stock paradigm 25 26Oneok (OKE) 245 246Oxenstierna 223

P

Paradigm 25PCS Health Systems 225ndash227Pharmacy benefits manager (PBM) 225Pinault-Printemps-Redoute 134Pittway 129Potential takeovers (Telltale Signs)

98ndash101Priceearnings ratios 58 59Protection One 238ndash247Public mudslinging contest 122Pure plays 188 189

R

Redstone Sumner 145 159ndash166 168172ndash174 177 184

Relative leadership index 34Ren-Corp USA 216ndash219Renal Treatment Centers 219ndash222Research departments 20 21Research universe 97 98Resistance level 206Resources 295 296

(See also Financial press)Rexel Inc 78ndash84Riskless alternative to the stock market

59Rite Aid 233ndash237 251Rite AidndashRevco merger 190ndash193Rohr Inc 210ndash214Rudd Terry R 44 147 210

S

SampP priceearnings ratio 58Salick Health Care (SHCI) 207ndash211Samuelson Robert 41Scharf Stewart 253Schliemann Peter 71Service Corp International 251Shining The 39Shopping list of potential superstocks

288ndash294Shore Andrew 46ndash48SJW Corp 282Small-cap stocks 32Smith Food amp Drug Centers

201ndash202SmithKline Beecham 225Sony 227ndash229Sony The Private Life (Nathan) 228ldquoSpecter of Depression Therdquo

(Samuelson) 41Spin-offs 188ndash190Stock charts 138 139 159 205ndash214Stock market crash of 1987 42Stock selection 19ndash23Sugen Inc 260ndash265Sullivan Allanna 272Sunbeam Corp 46ndash48Supermoney (Goodman) 23Superstock 11Superstock breakout pattern 206Superstock Investor 1 17 303Superstock shopping list 285ndash294Synergy 188 189

T

Takeover indicators (Telltale Signs)98ndash101

Takeover-lively industry 203Talk shows 42Technical analysis 139Telltale Signs 98ndash10110-K Report 245The Learning Company 247ndash25013-D filings 103 140

300 INDEX

Index 7901 904 AM Page 300

TEAMFLY

Team-Flyreg

ldquoThis Is Not Just a Bear Market This Isthe Way Things Are Going to Befrom Now Onrdquo 53

TJ International 102Triple play 141 148Trus Joist 102

U

United Water Resources 281 282

V

Value 62Value investing 57Vickers Weekly Insider Report 26 97

103ndash105Vignettes (see Case studies)Vivra 215ndash222

W

Wall Street Journal The 97 132ndash134Wall Street research 20 21Warnock Tom 257Waste Management 251ndash254Water utilities 271ldquoWater Utility Industrial Could Be on

the Verge of a Takeover Waverdquo(LaLoggia) 27

Western Resources 86ndash92 238ndash246Weyerhauser 101 102ldquoWhy Greenspan Is Still Bullishrdquo 41Wittig David 238ndash244WMS Industries 159ndash185Woodward Bob 44

Y

Yucaipa Cos 202 203

INDEX 301

Index 7901 904 AM Page 301

This page intentionally left blank

A B O U T T H E A U T H O R S

Charles M LaLoggia is the editor and publisher of Superstock Investora monthly stock market newsletter he has published since 1974 Hehas also written numerous newspaper columns and magazine articleson investing Charles LaLoggiarsquos stock market views and stock rec-ommendations have been reported in virtually every major financialpublication in the world including BusinessWeek The Wall Street JournalBarronrsquos The New York Times Kiplingerrsquos Personal Finance Money FortuneNewsweek and many others He has appeared on numerous televisionand radio programs including Wall Street Week With Louis RukeyserThe Nightly Business Report on 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 ldquounquestionably oneof the countryrsquos hottestmdashif not the hottestmdashtakeover pickerrdquo In aDecember 2000 article entitled ldquoRiding the Buyout Waverdquo Fortunemagazine said that Charles LaLoggiarsquos Superstock Investor newsletterldquohas a solid record for predicting buyoutsrdquo

Cherrie A Mahon is copublisher and director of research of theSuperstock Investor newsletter Prior to that she was a stockbroker at amajor Wall Street firm

Further information regarding the monthly Superstock Investornewsletter is available by e-mailing ssinvestoraolcom or calling1-800-450-0551 or writing to Superstock Investor PO Box 30547Rochester New York 14603

About the Author 7901 904 AM Page 303

Copyright 2001 The McGraw-Hill Companies Inc Click Here for Terms of Use