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But that was a long time ago—in what might as well have been a solar system far, far away.
Yes, this is the 21st Century. But human nature hasn’t changed. These trends take a long time to unwind. It is interesting in today’s market to see the whole power sector come unwound again. Even companies we used to think were pretty high-quality, like Duke. When you can take the big capital raising sectors and unwind them like that, this play-out still has a long, long way to go.

And your point is that even if investors are now acknowledging the problems, they’re still in denial about how long it will take to repair the damage?
Exactly. It was a bubble without consequences. 

You’re implying the consequences will have more in common with Japan’s experiences over the last decade than with our own, after the 1987 crash?
Well no, I am not sure the comparison is relevant. We’re not Japan. Our banking system is healthier and better capitalized than theirs ever was. But the flip side is that we can’t grow bank assets. And if we can’t grow the asset side of the banking system’s balance sheet, it is irrelevant how well-capitalized it is. The assets simply aren’t there— and what assets are there are either too high risk—corporate lending or sub-prime consumer lending—or they just don’t offer much yield. Which means that you can’t grow or even sustain the size of our financial sector. The reason why I think that money rates can collapse to something less than 1% somewhere down the road is that the money rate—the 90-day rate—is essentially the price of a financial sector liability, a deposit or some commercial financial paper or some other financial instrument with which the financial sector finances itself. Now, if you are collapsing the financial sector, you are reducing the size of its balance sheet. You are liquidating its liabilities . And if you liquidate its liabilities, the price of those liabilities could go astonishingly low. So the most important capital market observation to make here is that the price of a financial sector liabilities can collapse and that is what the 90-day rate is. That is the realization that still has further to come. 

I’ll say. But if that’s your call, what are you doing with your portfolio?
Well, we are still trying to find bond substitutes. One interesting paired trade is to buy small local banks with pretty good franchises and clean balance sheets—because they can fund those balance sheets, and there might even be a few good adjustable-rate mortgages around. 

What is the other side of that trade?
You might maintain some shorts on the money center side to pair off the trade beautifully. The other thing, in a deflationary world, and that is what follows a credit bubble—debt is deflationary—as you unwind the credit bubble, deflation becomes more and more pervasive. But there are a few pockets where there has not been over-investment. So we look at those. 

Meaning you’re looking for industries that have some pricing power? 
They are far and few between, but there are some. The hospital sector is one. I think property/casualty insurance is another. And those stocks have held up well, so the market is recognizing that there are sectors of the economy that are going to be okay. 

I take it your portfolio is pretty completely hedged in here?
Not totally, but fairly hedged. 

Thanks, Charlie

Harvey Eisen
The in reality not-very "elfen" Harvey Eisen runs his hedge fund, Bedford Oak Advisors, from Mount Kisco, NY in between TV appearances.
How are you doing?
Well, you caught me just before I was ready to jump out the window.

Glad I did. Maybe I can stop you.
You can’t

There’s no hope?
The world has ended.

Gee, if you feel that way, it’s lucky that your office, as I recall, isn’t exactly in a skyscraper. 
I am livid about all this. I am just absolutely too old to get snookered. I had the whole scenario perfectly— and I still get caught in some of this junk. It really is annoying.

Isn’t that what a bear market is all about?
Well, the definition of a bear market is that stocks go down—

Also, that everyone gets bagged—long or short, retail and professional.
Yes, but most people, No. 1, don’t get the script right. No. 2, most people don’t have the flexibility that people like me have. Everybody basically has to be long stocks in the mutual fund world and all that nonsense. But this is like a combination of ’29 and ’74. This is the perfect storm. This is horrendous. But it is 90% done. The market is going to scream coming out of this—like it always does—but they are making the pain almost intolerable in the meantime. 

It seems to me that the market just keeps grinding down, with just enough upside thrown in to keep most investors from barfing—which they’ll have to do.
It hasn’t barfed!?! It had a barf after September 11. And you didn’t think July was a barf? Are you kidding? Hello? The S&P is down 45%. In two years. That is ’74 all over again. Nasdaq is down 80%. That is ’29 in the Dow. 

Clearly, a lot of damage has been inflicted. But individuals and funds are still holding onto trillions of shares that haven’t been dumped. 
Every share doesn’t have to be sold. 

Right. Prices are set at the margin, of course. But my point is that a lot of individuals, funds and institutions are going to be forced to make sales, to reliquify.
The problem is that you are paying for the excesses of the bull market. We always have to pay for the excesses and this is a legitimate major league bear market. Probably the first real bear market since ’73-’74. Nobody understands that. I mean, how can you own stocks when that means that every day you are playing Russian roulette when you wake up?

You’re saying that you never know which stock in your portfolio is going to be taken out and shot today? 
That is a big-time problem. If you own the wrong stock on any given day they just rip your head off. That is the real definition of a bear market. When this is over, somebody is going to announce a disappointment and the stock will be unchanged. But now, if companies miss by a penny, they go down by a third. If companies miss by more than a penny, they go down by a half. It is mind-boggling. Now, you are starting to do it to really superior businesses. Look, my message is real simple: You’re there. It is still probably going to make everybody who is long a single share of stock just absolutely want to throw up, but that is the way it works. The ultimate bear trap will be if they take out the July lows. And there is so much news that can pop up now—You’ve got the war, you’ve got terrorism, you’ve got corporate scandals, you’ve got the economy. It is perfect.

Perfectly awful, you mean. Your perfect storm.
Any day I expect Alan Greenspan—Here is what the bottom should look like: It should be like Orson Welles’ fake radio broadcast of “The War of the Worlds.” You turn on your radio, or your television, or your Bloomberg and hear, “We now take you live to Washington for an unprecedented emergency address by Alan Greenspan. ‘Hello, I am resigning. Nothing works anymore. We have got to bring in somebody who is different than me. I am too old. The Viagra isn’t working. The game is over.’”

And that, you’re saying, would bring about the cathartic capitulation that would mark the bottom? 
Something like that. I mean, this is beyond belief, what is going on. Actually, it is not beyond belief. But it is outside of the scope of experience in our society today. The world was a far different place when it happened before. I am just annoyed that I don’t own a share of anything!

An exaggeration, I know. But isn’t that exactly it? If the bear market is 90% over, you should be taking a longer term view and starting to buy.
Oh, sure! Are you kidding? This is what you wait for. But everybody is lying in the gutter bleeding. You don’t have objectivity to do what you intellectually know you should do. But this is it. This is when you want to come to the party.

Assuming you have the guts, not to mention the cash to pay the admission. 
That is one problem.

But this market is still full of fully invested bears. That’s why I said we need a good barf. 
True. But you have had some very good imitations of barfs, if they weren’t barfs. I mean, when you took Citigroup down by a third in a day. You are talking now IBM, GE, McDonalds. Forget the stock market nonsense. These companies are the backbone of American business.

That doesn’t mean their stocks didn’t get overpriced. They are also the supposedly safe, defensive stocks lots of folks have been hiding in—
But that is the way it always works. So you don’t want to own those now. Some of the safety stocks are not such safety stocks. This is a textbook case. It is just painful going through it. You have to separate the intellectual process from the emotional stuff, which is why everybody gets it wrong. Because we all come in here every day. And what do we see? Hedge funds folding. No business on the sell side.

Speaking of which, how many hedge funds do you expect to still be in business, come 2003? 
Whatever it is, it will still be 90% too many.

Quite a few are already deciding to quit instead of trying to claw their way back to high-water marks that might as well be on the moon—
But the amazing thing is that some are also starting to come back already. I mean, Larry Bowman is back and people are giving him money! It is mind-boggling. John Meriwether is back. It is unbelievable!

You’re right about that. 
These hedge fund operators all close down because they are lowlifes. That they all come back is just mind-boggling to me. I mean, anybody who invests with them deserves what they get. But look, I advise people, I sit on boards. A lot of these hedge funds guys have made obscene amounts of money because they took out their fees in their big years.

And knew better than to leave them in their own funds. 
No kidding. I find it disgusting. It is one of those things that will continue— and it is just wrong. Meanwhile, it is very painful to go through a bear market like this. If you have any kind of longer term horizon, you are invested in companies and they just seem to disintegrate before your eyes. It feels horrendous. I wish you would tell me that everybody you talk to is bearish—but you are not going to tell me that.

No, but I am hearing a lot more bearishness than I did last spring.
And what is the bear case you’re hearing? That this is the end of the world? No, valuation is the bear case: 16 times earnings is too high at a bottom. 

Or 19 or 20 times, depending on what sort of earnings forecasts you’re plugging in. That is part of what I am hearing. Another part is that people have awakened to credit problems, corporate criminality, war risks, etc.
Bulletin: There is a credit problem. 

Right. Big surprise. But the realization is dawning that the consumer can’t go it alone forever—especially if he doesn’t have a job. 
Well, the consumer is done. The consumer did it because of refinancing. The key has been low rates. But they have been giving cars away, giving houses away—and everybody owns two. Delinquencies now are at a 30-year high in houses and new starts are booming. It is a mess.

Not to mention that there’s a glut of mansions on the market.
Well, look at those prices! Can you believe it? I thought—a mansion—maybe $5 million. No, $35 million, $40 million, $50 million. It boggles the mind. For a house.

How many Dennis Kozlowskis can there be out there?
Plenty of them. It is just a question of who gets caught. Now the market is rolling over and going to zero again as we talk. Boy, this is just a bummer! People are going to go crazy now because the third quarter is so bad and mutual fund redemptions are starting to rise. I mean, it is right out of the textbook. It is just the way they write it.

Wouldn’t the textbook also call for some sort of substantial fourth quarter bounce—as soon as everyone is convinced this is the end of the world?
Probably. But first the pain gets so great that nobody believes it. So then, when the market rallies for 5 or 6 weeks like it did in August coming off the July lows, it takes that sort of big rally to convince everybody that the worst is over. Then they come back and they get their heads ripped off again. Look what’s going on now: A lot of major companies are making new lows. 

I guess the good news—and you have to take good news where you find it in a bear market—is that we finally are in the stage of the cycle in which no one believes a rally. Did you notice the skepticism in the headlines and news stories coming off of the July lows? It was, “The bear’s progress was interrupted for a day.” Not, “Hurrah, the bull returns.”
Isn’t that the way it always is?

Exactly. It’s part of the process. But look back a year. That sort of skepticism certainly wasn’t in the headlines then. So we are making progress.
True enough. You have to turn the mood and the sentiment totally bearish. But we still are not totally there yet. You had the advisors bearish for two weeks—and now they are all bullish again. And you still have all the Street strategists bullish. 

But when have all the Street strategists not been bullish?
I agree with you. That is how they make their living.

In fact, the ones who’ve dared to come to a different conclusion now work, if at all, from different addresses. 
Yes, there were one or two that got it right—and now they are running hedge funds or something. The reality is that bear markets are just crummy to go through. This is the third year—that’s a long time. Unless you are one of the few people who are perennially bearish, these are painful times. And we have to have this, because we haven’t had a bear market in 30 years. Not since 1974—which was a hell of a lot worse than this.

Few investors remember that. 
It was. You could buy any apartment in Manhattan for the maintenance charges and people weren’t putting roofs on beach houses. There was none of this crap, “Okay, I am selling the house. Give me $15 million.” What a joke. Who the hell is going to write that check—Who can do that today?

Not even Dennis Kozlowski, evidently.
That guy! What a load of crap. His ex-wife has to give him $10 million to make bail? That is pocket change to that guy. What a joke.

If it’s not in his pocket, the real question is where did it go. 
You know where it went. You know what all these scumbags do. They all hide it, the really nasty guys. The other ones are just the garden-variety crooks. 

Right. You’re right, too, that almost no one in this market has seen a really nasty bear in 30 years. Everyone’s expectations are based on the bull market they so recently knew and loved. 
And a real bear market is defined by time, as well as by points lost. In that sense, even 1987 didn’t count, because it was over in 2.5 hours. 

Well, 2.5 days, maybe—
But that was it. And the declines in ’91 and ’94 and ’98 were all over before we knew it. The four-year cycle worked perfectly. 

Sure, and now we know, with perfect 20/20 hindsight, that they were “just” cyclical corrections in a monster, multi-generational secular bull market. Something that no one had seen since the days of most contemporary investors’ grandparents. 
But that was what it was. And people made staggering amounts of money—and most of them are still way, way ahead of the game. 

Your friends, maybe. But not buy-at-the-top-and-hold Joe and Jane Sixpack. And isn’t it conceivable that correcting the excesses of that monster bull could require a secular bear market of similar size—and duration? Or, at the very least, a long frustrating trading range, circa the ‘70s?
It could be like the ’70s, when the averages didn’t do anything. Look at all these jerks in index funds—indexing is going to be so bad. 

Already is. The flip side is that it was possible to make big bucks back then—with superior stock picking and—gasp—market timing. 
Yes, but this market is just plain ugly now. Really, really nasty.

And even though you “know” you should start, you’re not buying what others are dumping?
Not really. I mean, I do own a few things that I like; that I think are fine; that I couldn’t sell if I wanted to– Well, I guess maybe the company would buy back the stock. But I have a huge amount of cash. I have been covering whatever shorts I have, though—just because I think you are in a bottoming process. The problem is I have no idea how long that takes. What should happen is that after we test the July lows—and make some new ones here—we should have some sort of rally that nobody believes in October, November. Then we should muddle around until we have our next war. And then the market should run next year. Next year should be a big year, simply because nobody thinks it can be. But not for Nasdaq. Nasdaq, is unfortunately finished, of course, because it is the ultimate crash. It will really take a long time to repair that damage. But the rest of the world should be fine.

That would really surprise a lot of investors.
But that is what “should” happen. The GAARP—growth at a reasonable price—companies with businesses people understand, they should be okay. 

Like we’ve been saying, if you really believed that, you’d be buying like crazy, Harvey. 
Exactly. I do nibble at some things that are trading around cash or that don’t have any debt and that are marginally profitable. There are things to do. But the problem is that the land mines continue to go off. Intellectually, it is simple. Emotionally, living through it is not simple. But the bear market has now done 90% of what it has to do. Maybe more, in my view. The problem is that these things can get out of control on the downside, just like on the upside. So the Dow could go to 5,000 or 6,000. It shouldn’t, but it could.

You don’t have to be a technician to see there’s not a lot of obvious “support” in the charts between the July lows and those levels— 
Investors could go crazy. The big boogey man is mutual fund redemptions. Because that is what will force involuntary selling and that is what makes bottoms. That’s like the story Peter Lynch told me about 1987. That’s when the PMs go into the trading room, assign their portfolios by the alphabet and just say, “sell.” Forget the names, forget the prices, just sell what you can. As someone wrote recently, the Dow went from 800 to 8000 in 20 years and mutual funds grew their equity assets by 85 times. There is an obscene amount of money sloshing around in these things. If people want their money back—and they don’t even have to take their money back, they could just move it to a money market or bond fund—those equity assets will have to be sold. But who is going to buy them? That is a prescription for disaster. When people want their money back, you have to sell, period. That is all.

What gets sold is what you can sell. But the question isn’t who buys it, it is at what price.

True. And what you can sell are the 50 names that everybody owns so they go down, which by definition takes the averages down—which by definition puts the decline on the front page of the newspaper. That is how you make a bottom. But these things always go farther than you think. It was too bad, really, that we had that rally off the July lows that people bought. It was a textbook bear market rally that gave you a window to sell, yet everybody said, “You see, the bear market is over.” It was all very tempting.

Although the one thing you won’t hear at “the” bottom is a lot of folks calling the bottom—I hope you’re right that the bear is 90% over, but—
I am just saying—you asked my opinion and I am telling you that the brain side of me is telling me that the bear market should be 90% over. My stomach is telling me that this just a nightmare, because you could still lose a lot of money from here. 

Last legs down have been known to be killers—
Oh yeah. The worst part of a bear market is losing your money and the second worst part is that you cannot function objectively. So you don’t buy anything near the lows, so you don’t make it back. Then there will be some clown saying, “Well, the market rallied back,” like everything was constant. But it is not. It takes a lot more than a rally to repair the damage. The thing is, you don’t know how bad this could get. What, $6.5 billion went out of stock mutual funds last week? Wait until next week. If the market goes lower, you will get redemptions. And when the redemptions start, they will feed on themselves. At some point, the Fed will announce that they have set up an emergency relief package. That will be what marks the final bottom, but who the hell know where it is going to be. None of the stuff that we all talk about, like valuation, will matter. It’s just so typical. But look at the bright side we’re 90% there. Go back and look at what happened in the market during all of the years that followed bear markets. They have just been monsters. I mean, ’91 was a monster. ’88 was a big year. ’99 was a humongous year. 

Let’s end on that optimistic note! Thanks, Harvey.

Scott Black
Delphi Management, Scott's Boston-based firm, manages value portfolios for institutions. Scott also manages the Kobren Delphi Value Fund [in which Kate Welling owns shares] and he is a regular on Barron's Roundtable.
So, Scott, you must be finding lots of tempting values, with the market down so far over the last couple of years.
You would think so. But not really. I was in my office late last night, screening the Merrill Lynch database, and other than the stocks that we own or ones that we’ve looked at, there really aren’t a lot of low P/E, low price-to-book companies that have really great fundamentals that we don’t own. A couple of new names turned up, so I have to call the managements to set up visits, because we call and visit all the companies. But it’s not like the bottom of the ’82 market, when lots of things were below book. When you could buy Ogilvy & Mather at a 6 P/E and The Washington Post at a 7 P/E. Those types of deals aren’t around these days. 

Which tells you?
The market on a whole is still expensive. I think the real mistake is that you’ve got a lot of the Wall Street sell side and the press still pushing estimates of $52-$54 in S&P earnings next year. I don’t see that kind of profits recovery at all. I see earnings coming in closer to the $42-$43 range, which means that the market is trading at 20 times earnings and 3 times book overall. Sure, there are individual stocks you can pick that are more attractive. But to me the market is still very expensive. I see nothing like the valuations at the bottom of the ’82 market. In the meantime, you’ve got some of these Wall Street economists saying that we’re in a robust economy. I don’t know what they’re looking at!

Allow me to speculate. They aren’t looking past their own paychecks.
I hate to say it, but they are paid to be bullish. At Merrill Lynch you don’t sell a lot of stocks or at Goldman Sachs you don’t sell a lot of stocks if you have a negative view of the economy. Simply because most people they deal with aren’t short sellers. If I sound a little bit jaundiced, don’t be surprised. But Abby—she was born bullish.

Most people are. Then again, most people aren’t promoted to guru status. 
I’m just a realist. I’m hoping the economy recovers, but I don’t see it happening out there in a real big rush. Tech land is a disaster. We see tech companies all the time. Route 128 is nearby. I was in California a couple of months ago and talked to those companies. There’s no recovery on the way. We have a lot of small high-tech companies come through our office to see us. But we barely have any holdings in the tech sector. We have no semiconductor equipment companies because they’ve been bombed out. We sold them nine months ago or even earlier, at their highs, because they were all trading at 3 and 4 and 5 times book with no earnings. So we’re certainly not rushing back in. Even a company like Applied Materials (AMAT), which is really the Big Kahona, is at $12, or 2 times book—with no earnings. I don’t see the novelty.

It’s only a “value” at 12 compared with the 55-plus it traded at a couple of years back. 
I agree. People still look at names like Oracle (ORCL) and Cisco (CSCO), reminiscing about 1999 and 2000. But their backlogs are still rolling over, there is no book value in these companies and they’re still sporting pretty high multiples. Hope springs eternal, but that’s not going to make Oracle and Cisco go up. So while we obviously cover a lot of little companies, we’re not finding real values in the tech sector, that’s for sure. 

Are you finding, say, the oil patch any more productive?
We own a lot of those, and we own some small financial service companies. Ones with high ROEs that have been bombed out, we’re buying in here. These are companies with sustainable earning power that are already down to 10 multiples; that earn 16-17% on book with no debt. 

It must be frustrating to see them get cheaper in every downdraft—
That’s right. Valuation doesn’t protect you from a bear market. They go down anyway. You just have to scale into them, that’s all. There’s no place to hide; they take them down when they take everything else down at this point. That’s what’s frustrating.

And part of what makes it a bear market. 
You’re right. This is the worst one—it’s worse than '73-'74, as I remember.

Worse? How so?
I’ll tell you the difference. The Nifty Fifty rolled over back then, but there were whole loads of second- and third-tier companies that you could buy that were trading at 5, 6, 7 multiples. Like I said, I remember buying things like Houghton Mifflin and Lin Broadcasting and Ogilvy & Mather and it was like shooting fish in a barrel. These things were trading at 5 and 6 multiples in the mid-’Seventies; you could make very good money. I bought things like Atlantic Pepsi and Coke Bottling in Daytona, great franchises, Coke of LA. You could make a fortune buying smaller companies that weren’t related to IBM, Polaroid and Xerox. But it’s different this time. We’re not finding great businesses at 5, 6, 7 P/Es at this point. Even regional banks—the bulk of them—sell at over 10 times next year’s earnings. We don’t like paying more than a 9 multiple for regional banks. We have a few, but they’re few and far between.

All those secondaries had already been through their own long bear market, in the late ‘Sixties-early ‘Seventies, before the Nifty Fifty rolled over and died. This time around, you couldn’t give value stocks away for several years at the top of the tech mania, but they’ve had such a huge rebound since the bubble burst that they no longer qualify as “values.” Maybe it has something to do with the way information flows so much faster these days. Maybe, too, with institutional investors’ need to always be fully invested, instead of going to cash as managers did 30 years ago. 
I agree. History repeats, but not exactly. Meanwhile, the market acts terrible.

Still, you have found a few stocks cheap enough to buy?
Right, and they are nice and cheap. The first one I’d like to talk about is IPC Holdings (IPCR). It is 24.3% owned by AIG. 

It sells insurance, then?
They are basically a catastrophe reinsurer, based out of Bermuda. The stock now is at 28 and there are 48.3 million fully diluted shares, which gives it a $1.35 billion market cap. They have a tangible book of about $23.50 a share so the stock is selling at roughly 1.19 times hard book. They only have about a $75 million exposure to the World Trade Center disaster, and they’ve already booked that. This company essentially distributes through brokers: 80% of their business goes through three brokers, Marsh & McLennan and Aon in the United States and Willis Corroon in England. They seem to be very smart in spreading their risk profiles worldwide. Luckily, they did an underwriting last year to raise new capital. They issued 20.35 million new shares, raising several hundred million dollars, so now they have a bulletproof balance sheet.

Nice timing.
It is good; their gross premiums have been up almost 125% quarter over quarter for the last couple of quarters. We’re looking for about $300 million in gross premiums this year, at the low estimate, with a 60 combined ratio, because they haven’t had too many natural disasters where they carried the reinsurance. So they should make about $3.60 a share. Some Street estimates are as high as $4 for this year and $4.20-$4.25 next, but even on $3.60, it’s a 7 multiple. If you really think they can do $4, it’s still a 7 multiple, just 7 even, instead of 7.8 times. But even the higher one is not exactly expensive. 

What’s the potential for unhappy surprises in IPC’s investment portfolio?
They have no junk in their portfolio; the duration is only about 2.7 years. The portfolio is a little over $1 billion, the bulk of which is in fixed income and cash. So I like it. When I talked to John Weale , who is IPC’s senior vice president of finance, he told me that people who have good credit and didn’t file any claims in the last couple of years are getting price hikes about 25%. But for people who had claims in the prior year, rates are going up 200%-300%. Overall, that means they are rolling their book at over 30% price increases. And we expect to see another 10-15% price hike next year.

They have that much pricing power? Property/casualty rates have already gone up for the last couple of years. 
I really think it is sustainable. If you ask anybody on the corporate side, they’re getting price hikes on insurance and there’s nothing they can do about it. Now, IPC basically sells catastrophe insurance, and excess loss coverage is 88% of the book, so obviously if you get a Hurricane Andrew or a World Trade Center-type disaster, it’ll take a hit. Then again, they don’t cover terrorism risks anymore, so a lot of its exposure is fickle, depending on the weather. Which makes it hard to make single point estimates for any given year, but so far there haven’t been that many natural disasters this year. I think there is a big enough cushion when you’re at 1.19 times tangible book and you’re selling at roughly 7.5 times some sort of reduced earnings estimate. As Ben Graham used to say, there’s a margin of safety.

Which is usually the result of others seeing risk, or problems, where you see value. What has held IPC’s shares back?
The earnings can be volatile, as you well know. All it takes is a few disasters to swing the combined ratio from 60 to 120 in a given year.

And it is hurricane season.
Yes, and you also can have a hail problem, or floods or tornadoes like the one that recently ripped through Indiana.

You did say they’ve been smart about spreading their risks, geographically?
Yes, they spread their book of business to avoid too much concentration in any one area; they have a fairly sophisticated computer model for allocating risk. It’s a reasonable play in here. I really like the fact that they have pricing power—so few industries these days have any pricing power. 

What else has caught your eye?
My next stock is sort of a fallen angel; it has gotten down to under $27 a share. I’m sure you know this one: Outback Steakhouses (OSI). There are 77.2 million shares outstanding, so it’s at $2.08 billion market cap. The company earns, year in and year out, like 16%-17% on book. There’s no debt on the balance sheet, there’s no financial risk. Last year, they were only modestly free cash flow positive, but this year they really will be. They plan capital expenditures of about $200 million a year, and they should generate over $250-$270 million in operating cash. What’s been happening is that they’ve had some margin restoration. If you go back to fiscal ’99, which ended Dec. 31, their operating margins were up at 13.5%. By the end of last year, they were down to 11.1%. But already in the first half of this year operating margins have been restored by about 100 basis points. We like that. Over the last two quarters, even though the economy has been sluggish, Outback’s top line has been growing at 11%. They’re also honest about figuring comparable store sales. They’ve budgeted for 0% comp growth for the rest of the year. They’re adding square footage at about a 10%-11% per year clip—and that’s their goal for the next 5 years. In the Outback format, that amounts to 40-50 new units a year. They also have a new format, called Carrabba’s Italian Grills. They’re going to open up about 25 of those each year. We’ve got them penciled in ending this year with about $2.35 billion in revenue, which is up from $2.127 billion. That’s about a 10.5% gain in revenue, and I have them budgeted conservatively next year, in case the economy doesn’t come on. Instead of putting 2% in my model, which is the gain they’re budgeting in comps, and which would get them to a 12%-13% revenue gain, I put them in for 10% top line growth. That’s a 100 basis point improvement over 2001, so it gets them to about a 12% operating margin, which gets you $310 million in operating income. There is a provision for minority interest of about $30 million, so that leaves you with about $280 million, pre-tax. They have a 35% tax rate, so that produces $182 million in net income, or $2.36 a share. The stock is now trading at about 26.90. Divided by 2.36, that is an 11 P/E. That’s for what I would consider a legitimate 10%-12% grower. They will throw off more than $50 million in cash next year. They have an authorization to buy back 4 million shares; they have already bought back 1.3 million. So there are 2.7 million to go. Considering that the market is selling at almost 19 times forward earnings and this thing is at 11 times—with earnings that have been sustainable—and it’s a cash machine with no debt, I think it is a pretty good value. 

People do have to eat, but they don’t have to eat at Outback.
No, they don’t. And Outback’s average ticket is $18, which it’s higher than a Ryan’s, which we also own. But it’s much less than a Capital Grille or a Morton’s. Outback just seems to have a nice franchise; and they do a lot of consumer advertising, which is smart in terms of branding the image. 

If Outback has no debt, how does it finance all its new restaurants?
They’re self-financed. Last year they spent $200 million. These are free-standing restaurants, all internally financed. These aren’t leased; they own them. And there’s no funny accounting. They expense all pre-opening costs. I asked. There are absolutely no deferrals whatsoever. And longer term, although I budget them for 12% operating margins, they think they can get back to a 13% rate in a good economy. They get operating leverage when the comps go up at 3% or more, so if you get a nice recovery at the end of ’03 into ’04, it’s possible the margins could add a little more.

If commodities costs stay tame— 
Right now they are going their way. They had a little bit of an increase in gross margin in the past year due to lower food costs. The other thing I should point out is that beverages and alcohol contribute about 13% of sales at Outback; at Carrabba’s, it’s closer to 18%. So as they roll out more Carrabba’s, that will help overall margins. I’m not telling you this is the next Haloid becoming Xerox in the 1970s, but for a company that’s does 16% on book with no debt and generates cash, an 11 P/E is pretty reasonable.

Okay. What’s another morsel you’re willing to try a bite of?
Here is an unusual small cap stock; you may know it: Helen of Troy (HELE). It’s nothing fancy. They make hair care products. Or rather, everything is made for them in China; 85% of it is distributed from Hong Kong, but the stuff is really made in the People’s Republic, Thailand, South Korea and Taiwan. It’s on a March fiscal year. Even in a sluggish economy, its first quarter revenues were up 12%, net income was up 43%. They made 22 cents against 16 cents, which was nice. Their gross margins jumped nicely from 45.9% to 48.3%, operating income jumped 180 basis points from 8% to 9.8%. The stock trades around 10 and change. In the model I did, I budgeted them conservatively for the year ending next March at $496 million in revenue. With a 10% operating margin, that gets you $49.6 million in operating income, that’s an 80 basis point change. They have interest expense of $4 million, interest income on some of the cash at $2 million, so I guess you’re at about $47.6 million in profits before tax. They have a 28% tax rate, which gets you to $1.15 a share in earnings. If you think it can sustain top line 12% growth, that’s a $505 million top line that gets you to about $1.20. But either way, the stock is at 10.5. On $1.15, that’s a 9 P/E. They’ve done a pretty good job over the last 2 or 3 years of keeping the earnings going.

How much debt is on the balance sheet?
Net debt is zero. They have more cash than debt on the balance sheet. They have $88 million in cash and equivalents and $55 million in debt. I have $8.65 in hard book, so it’s trading at about 1.2 times book. There are virtually no capital expenditures in this business, a couple of million a year. They have net cash at $33 million so even if the economy turns a little soft, they’ll live to fight another day.

Isn’t this stock almost a perennial value pick?
It is. Occasionally, it moves. They have licenses to make Revlon and Vidal Sassoon Hair Care products. The biggest competition, not in the pin curler business, but in the blow dryer business, is Conair. Wal-Mart is their biggest customer with 22% of sales. About 50-60% goes through the mass channels of Wal-Mart and Target; drug chains like the Walgreen’s of the world account for about 20%-30%. Their long-term targets say they want to grow revenues at about 10%, grow earnings at about 15%. At this juncture 91% of the sales are in the United States and only 9% are in Europe but they feel over time they’ll do more distribution into Europe. It’s not a terrific company, I’m not going to tell you that it is. But it’s a decent company and it’s selling on the cheap at 9 times earnings with a debt-free balance sheet.

The stock has been a lot cheaper just in the last year.
You’re absolutely right, post-September 11, it got down to around $8. And I bought some. But it has also been a lot higher. It has come back down here from over 15, and we’ve been buying it here around 10 and change. They have had 8 consecutive up quarters in double digits in earnings and they’ve been getting concomitant top line growth. Since the September 2000 quarter, they’ve had all double-digit growth in revenue so it’s not that they’re just manipulating the middle lines, they’re doing it by growing the revenue as well.

What’s propelling that growth? It’s a competitive market—and their customers are consolidating. 
It is. Obviously people are still buying their products through these mass channels. And they have done some product line diversification. From Schering-Plough they got Dr. Scholl’s Foot Bath and Foot Massager, and they have a new division called Tactica International, Inc., in Europe, which did about $109 million in revenue. It’s marginally profitable so that will give them some operating leverage on the bottom line, as well.

It must cost them practically nothing to make their stuff in China.
Exactly. It’s plastic junk, let’s be honest.

Utterly disposable.
Again, it’s not a barn burner, but the company has consistently demonstrated over the last few years double-digit growth and you’re buying it at a single-digit multiple. There are just under 30 million fully diluted shares outstanding and Gerald Rubin, the CEO, owns 8.82 million shares of the company— common, not some funny class, so he’s working in his own best interest.

If the stock drops low enough, do you see him doing a Murdoch? 
I don’t think he’s going to LBO the company. I should point out last year that they generated free cash flow of $49 million. Its ROE is lower than most Delphi companies’ because of the cash. They did just under 13% on book. Normally we like companies that do 15% or more. Obviously both IPC and Outback do well in excess of 15%. But Helen of Troy’s ROE is improving gradually, so that’s fine as well. On the prior peak in 1998-’99, the company earned a little over 16% on book, debt-free, so that’s not bad. Anyway, all three are stocks illustrate that we’re trying to do what we’ve always tried to do—emphasize companies that have clean balance sheets, that sell close to tangible book, that have sustainable earning power and are selling cheap. Between a 7 multiple and an 11 multiple. Even though the market multiple has come down some, we’re still trying to build in that margin of safety that Warren Buffett and Ben Graham talk about. 

As a concept, a margin of safety is certainly more appreciated today than it was a couple of years ago—
The irony, though, is that they’re taking down all the stocks here. You’ve got 12 multiple stocks going to 10 multiples in a hurry, even with sustainable earnings. That’s the problem. I can’t tell you I’m bullish, that we’re going to see a big upturn in the general market. Not when technology is in the doldrums. It is still 20% of the S&P earnings and its earning are close to zero. The economy is weak overall. Every day there is a new surprise in corporate earnings, whether it’s Electronic Data Systems last week, or Morgan Stanley coming in at 55 cents but saying it’s the worst investment banking environment in four or five years. Day after day, there is a disappointment.

There is the occasional reversal day or two—
I don’t see a quick resuscitation. If I’m allowed to speak my mind, I’ll say again what I have said before: What we need is—yes, a tax cut—but we need a middle-class tax cut. They should rescind what they did at the upper echelon and put in a tax cut for working class Americans who are going to spend that incremental dollar. Who probably will go to Outback and Wal-Mart and Target. That’s what you need to kick start the economy. I don’t think monetary policy alone is going to work. I’m pretty sure that over the next six to nine months we’re going to see a lower Fed fund rate, but I don’t think that’s going to work.

Because it hasn’t worked up until now?
Because you’re already at absolute low levels we haven’t seen since John F. Kennedy. It’s good for the housing market, that’s about it. At the margin, we’re not going to have corporations spend more money on capital expenditures if we lower interest costs—not with factory utilization at 70%, or with utilization in tech at 65%. Why would people spend at the margin to buy new capacity when what we have is way under-utilized to begin with?

Good question. Why doesn’t it dawn on your friends in Washington?
Because Washington is run by politicians who have constituencies. You’d think they might get together and share collective wisdom, but I’m not sure there is much collective wisdom, to be frank. That’s why they’re in Washington. You know the old Woody Allen line, “Those who can’t teach, teach gym and those who can’t teach gym run for office.” He was funny in the 1970s.

A collection of zeros still adds up to zero—
I agree, and I say this as a Democrat, but Daschle is an obstructionist. Republicans are wed to the right wing. George W. was told he had to give a tax cut to his buddies, so he did. And he knows his father lost when he raised taxes—“read my lips”—so he’s not going to make that mistake. The result is governmental gridlock again. Instead of having appropriate public policy, we’re floundering economically. And truthfully, even though I am a Democrat, I have to say that they haven’t had a lot of new ideas in the last 20 or 30 years, and it’s coming home to roost. They really have to get into the 21st century. Democrats are still sitting on the New Deal and the Fair Deal. They need to re-invigorate the party with some new ideas.

I’m not holding my breath. But thanks, Scott.