We believe there has been a distinct and accelerating negative change in market sentiment since March 10, 2000 when the Nasdaq Composite Index peaked at 5132.52. The underpinnings of the stock markets had been weak for quite some time, but the crash in the Nasdaq has really gotten peoples’ attention. On April 14th the Nasdaq Composite lost 355.49 to close at 3321.29 — off 9.67% for the day, while the Dow Jones Industrials lost 617.78 to close at 10305.77 — off 5.66% for the day. The Dow’s high was 11750.28.

It reminds us of last September’s Commentary: “INVESTING — STILL LIKE SHOOTING FISH IN A BARREL? or DON’T TRY THIS AT HOME!”

At that time we pointed out 10 very large and well-known Nasdaq stocks where the combined difference between their highs and their August 4, 1999 price had resulted in lost market value of $1.9 Trillion. Subsequently a number of those stocks rebounded, and additional extraordinary market gains were made by many new IPOs which would trade up five to 10 times above their offering price on the same day.

But this time we think things may be different as the Fed continues to tighten by raising interest rates. Please note:

– March 31st — the Wall Street Journal reported: “Tiger Makes It Official: Hedge Funds Will Shut Down” “Value-Investing Chief Decided He Couldn’t Make Sense of Market.” Julian Robertson was closing down his hedge funds and returning about $4.5 billion to investors while walking away with about $1.5 billion of his own funds. Although he does not expect fundamental analysis to be forever out of fashion, Mr. Julian H. Robertson, Jr. (head of the Tiger Management LLC hedge fund) said: “The market goes through these periods of irrationality, where the worst stocks do best. We’ve been in a period of irrationality for such a long time that it hurts a rational strategy. You have a group of irrational investors carrying the market.

– March 31st — In the same article, Stanley Druckenmiller, managing partner at Soros Fund Management, the world’s biggest hedge fund which had temporarily helped to improve its fortunes by switching into tech stocks, said of the Tiger developments and Mr. Robertson: “It’s not a sad day …. It’s like a guy who double bogeys the last holes but still wins the golf tournament; he has a phenomenal record.

– April 28th — Stanley Druckenmiller left the Soros Funds as George Soros opted to close down his funds. Mr. Druckenmiller who had been with Soros Fund Management since 1987 and assumed control in 1989 of Quantum (Soros’ largest fund with $10.4 billion in assets at the end of last year).

– April 29th — At Berkshire Hathaway’s annual meeting Warren Buffet, America’s richest investor, announced that his aversion to investing in technology stocks contributed to its worst ever absolute and relative returns in 1999. Later he said: “When we look back, we will see this as a period of enormous amounts of wealth transfer [rather than wealth creation]. He later said that he could have made more money last year by going to the movies instead of going to the office.

What is the common thread running through Robertson’s, Soros’ and Buffet’s problems? The short answer is Valuations. The long answer is Valuations.

– The American economy continues to be very strong
– The American unemployment rate at 3.9% is the lowest in 30 years.
– The American dollar is very strong as the Euro has fallen 24% to 88 to
90 cents which is down from about $1.18 where it began on January 1, 1999.

Valuation – an example: Everyone loves Cisco Systems.

Obviously everyone loves Cisco because it is arguably the most successful company in the hottest sector of the Internet. Even at its May 5th closing price of 67 3/4 (52-week Range of 25 15/16 – 82) its stock was valued at $470 billion, second only to General Electric now that Microsoft no longer is numero uno as a result of its anti-trust problems.

Cisco has grown at more than 50% per year. At 67 Cisco sells for

– 190 times its 35 cents per share earnings for the fiscal year ending July 31, 1999,
– 130 times estimates of 52 cents per share earnings for fiscal 2000 and
– 100 times the estimate of 67 cents per share for the fiscal year ending July 31, 2001.

On May 5th Cisco paid $6.1 billion in stock for ArrowPoint Communications Inc. that is located in Acton, MA, has 337 employees and makes software for the Web traffic-management field. If our math is correct, that works out to $18,100,890 per employee!

It is important to note that ArrowPoint’s initial public offering was less than five weeks before Cisco’s purchase at a price of $34 per share. It is also important to note, as we have heard, that ArrowPoint had set a price range of 14 to 16 for its initial public offering before coming to market at $34 on March 31st. On May 5th ArrowPoint’s stock closed over $140 per share representing a price increase in those few weeks of 412% above its offering price.

ArrowPoint, a company that was valued at about $1 billion on March 31st and had a market valuation of $3.67 billion about a week ago, really hit the lottery being sold for $6.1 billion in Cisco stock. (And we think a $320 million lottery jackpot is a lot of money!)

This example of Valuation – coupled with extraordinary Volatility – is what has been so difficult for Julian Robertson, George Soros, Warren Buffet and ourselves to reckon with after years of fundamental analysis and value-investing.

To repeat one more time, but probably not the last time:

“The problem continues to be what prices should be paid for these companies. Meanwhile, avoiding the land mines in these tumultuous markets is not easy.”

John, W. Hamilton
May, 2000