Forum Archive Index - September 2000

["Ben Dutton" <bendutton@sharechat.co.nz>]

I just recieved one of the excellent Email newsletters that Red Herring, a
superb U.S. venture capital and investing magazine, send out.

It's relevant to the talk about value investing etc. so I thought I'd post
it in.  Happy reading, and check out the Red Herring homepage at

http://www.redherring.com/

Best Regards

Benjamin Dutton


PERSONAL CAPITAL: New Age value

Should companies be valued the same as they once were -- or
is there a need for an entirely new way to value technology
companies? It's a debate that seems to grow more heated
every day, as investment bankers, fund managers, and
individual investors spend hours arguing over the seemingly
infinite rise in value of technology companies. The market,
meanwhile, seems to dictate a new answer every day.

Sometimes the debate gets hackneyed: the valuation
curmudgeons scoff at the "astronomical" valuations of
technology companies, and New Age prophets proclaim the
advent of the "New Economy."

You could basically break the debate into two separate
camps: The Fundies, who believe that nothing has changed
about valuation methods and that technology companies should
be valued the same way that large industrial companies were
valued 50 years ago; and The New Agies, who largely believe
in the efficient market theory -- which says that the market
always sets the right price -- and that fundamental changes
in the economy dictate that we use new valuation
methodologies for fast-growing enterprises such as
technology.

FUNDIES VS. NEW AGIES
The truth, as usual, probably falls in between. But
essentially, the world has changed, and the Fundies have
clearly been in denial. Technology stocks have a premium
built into them because they represent the fastest growing,
most efficient sector of the economy at large. In many cases
-- especially areas such as networking hardware and software
-- such companies have used outsourcing models that greatly
diminish the need for capital expenditure, and they can,
therefore, invest capital in more rewarding areas such as
research and development (R & D). These same factors, of
course, lead to volatility. As soon as a fast-growing
company stumbles, the rug can get pulled out from under its
share price.

"All valuation tools that rely on traditional accounting
methods are misleading investors in this period of rapid
change," says Andre Desautels, a CFA and analyst at Trilogy
Advisors, an investment firm that manages CI Funds, a set of
Canadian mutual funds.

A recent interview with Mr. Desautels confirmed many of my
suspicions about the market. It was comforting to find a
qualified CFA to scientifically explain what I'd believed.
You cannot value a company simply by looking at the
quarterly earnings. There are hidden values in companies
that don't turn up in the financial profile.

These are often referred to as "intangible assets," and Mr.
Desautels believes they explain the seemingly high
valuations of many stocks. For example, in the Old World, R
& D expenditures are accounted for as an expense, whereas in
the New World, you should account for R & D as earnings that
are reinvested in the company, rather than simply lost
expenses. Think about it, would you rather have a company
that's earning $1.00 per share and reinvesting none of that
money in R & D, or do you want to hold onto a technology
company that reinvests 25 cents of every dollar of earnings
back into R & D?

The official term that often applies to such intangible
value is called "goodwill," but goodwill often falls short
in explaining how valuable a company is. Another huge,
intangible value lost in conventional models is the value of
management expertise.

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MANAGEMENT METER
If you think about the most well-managed companies in
technology, they have been constantly underestimated over
the years because traditional accounting methods have
discounted the hidden value of their superior management.
Think about Cisco Systems (Nasdaq: CSCO). How many times
during the company's lifetime have we heard the valuation
curmudgeons moan about the overvalued price/earnings ratio
on Cisco's stock? Well, Cisco's management team and well-
oiled acquisition machine has consistently proven
traditional assessments wrong. It is now one of the three
most highly valued companies in the world. This, of course,
leads to a whole new set of questions about the company's
leadership, but it is Cisco's management team and
acquisitions prowess that have accounted for the premium on
the stock, not some kind of misguided investor bubble.

Baruch Lev, a professor at New York University's Stern
School of Management, has studied this theory extensively,
and he has come up with a term for it that Trilogy has
borrowed in creating a methodology to value its investments:
"knowledge capital." Using the knowledge capital concept,
Trilogy analysts such as Mr. Desautels actually cook up
numbers and assign a value to knowledge capital, which
includes items such as the management team, the quality and
number of patents and technology, and the skill of the
engineering team. For example, Trilogy has pegged
Microsoft's (Nasdaq: MSFT) knowledge capital value as $210.9
billion. That's $210.9 billion in value that would be
largely ignored by traditional accounting. Cisco's knowledge
capital is valued at $105.4 billion, and Intel's (Nasdaq:
INTC) knowledge capital is valued at $170.5 billion.

The valuation curmudgeons have constantly missed the boat on
emerging market leaders that were considered overvalued by
conventional means. Some examples in just the last two years
include Juniper Networks (Nasdaq: JNPR) and Brocade
Communications (Nasdaq: BRCD). These companies were often
cited as being overvalued, with this column being one of the
offenders. The people that dug down deep into the market,
got to know how powerful each of these players were in their
respective emerging markets, and understood the knowledge
capital embedded in the organization could have identified
this value. Was there ever a time to get them at the right
price? That's always hard to nail down -- but buying such
companies on the dips over time has been a golden strategy.

So, under this premise, what is Trilogy holding? Mr.
Desautels still believes storage and networking technologies
hold promise for the long term. Some of the long-term core
holdings of his fund, identified through these valuation
methods, include Brocade, EMC (NYSE: EMC), Network Appliance
(Nasdaq: NTAP), Nortel Networks (NYSE: NT), Juniper, and JDS
Uniphase (Nasdaq: JDSU).



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