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Q&A: How to Invest Wisely in Net Stocks Expert James O'Shaughnessy relies on skeptical analysis -- then holds for the long term James OíShaughnessy, CEO of OíShaughnessy Capital Management, says he is a fully invested bear. The author of What Works on Wall Street and How to Retire Rich advises long-term investors to stay in the market and pay no attention to its ups and downs. Stocks are superior investments for those who can stay the course, he argues. Of course, OíShaughnessy recommends investing in some sectors and avoiding others. He expects a huge rally in small caps over the next three to five years. Internet stocks, on the other hand, especially those that rely heavily on advertising revenues, are still overvalued even after their recent correction, he says. In a chat hosted by Business Week Online on America Online on Aug. 26, OíShaughnessy shared his investment strategies. Here is an edited transcript of his answers to questions from the online audience and from Business Week Online moderator Jack Dierdorff. A full transcript is available from BW Online on AOL, keyword: BW Talk. Q: The market is strong, but it keeps tracing these jagged lines. What's your cosmic view? A: Cosmically, I like to say I'm a fully invested bear. If you take the long view, which is what I believe most investors should take, then the market is always the best place to be, provided you have at least seven years to go until your objective comes due. So, for the most part, I believe that the vast majority of people investing in the market are doing so to fund long-term goals, such as retirement or a childís education. For all of those people I say, pay absolutely no attention to the daily, quarterly, or even annual ups and downs of the stock market. The facts show us that if investors can stay the course, the market has been the best investment for any long-term player. Q: Tech stocks have been taking a beating the past few months. Is this the start of another new "new paradigm," or is it just the usual summer tech dump? A: I have long been critical of the dotcom sector of tech stocks. Indeed, in April I wrote a commentary for our Web site www.osfunds.com detailing why I thought such marquee names as AOL and Amazon.com have gotten way ahead of themselves. Since that time, many Internet related issues are down 50%-plus. But, in many instances I believe they face a further correction. Other tech stocks have been more sanely valued. Even using fairly stringent value parameters, we are able to hold names like Sun Systems, IBM, and Dell Computer. Q: Would having more Republicans in office cause the market to decline? A: If we look at the government we've had for the past several years, it has essentially been Republican-driven legislation from a Republican-controlled Congress going to a fairly moderate Democratic President. Indeed, there is more than a little truth to the quip that Bill Clinton has been the best Republican President in quite some time. So when we look at the field of candidates running for 2000, I would say expect more of the same type of legislation and therefore anticipate little impact on the stock market. Q: How should one decide whether or not to invest in an Internet-related company? A: In general, you should look at its business model long and hard before committing your funds. If it has solid revenue items that are not related to advertising and a very clear position as to where and why they add value, and where it expects to be in terms of profitability in, say, the next three years, it might be worth a look. However, I believe there are precious few Internet companies with solid business models. Take Amazon.com for example. I love the look of its site as well as many of the services and conveniences it offers, but its business model really doesn't take future profitability seriously. Already there are online companies that will take you to the best book price possible -- and that is rarely found on Amazon's site. Remember, unlike the situation with regular stores, where I am not inclined to run all over town looking for a better price, there are no such limitations in cyberspace. Amazon's business model depends on its ability to charge premium prices for commodity products such as books, CDs, and pharmaceuticals, but the rub is that in cyberspace the experience is pretty much the same no matter where you buy your commodity product. I can go to Amazon, read the reviews, and make maximum use of its site's ambience, and then in 10 seconds click over to bestbookbuys.com and find the lowest price. Amazon has to figure out some way to actually make money. Q: Why donít you like Internet companies that rely on advertising? A: When you study the evolution of Internet companies and business plans, it goes something like this: First-generation companies had a huge line item in their business plan for revenues from advertising and very little in actual revenues from sales of goods or services. The idea was that content could be given away and you'd make up the difference in advertising. That was a reasonable assumption in 1996, but the last three years have shown us that advertising on the Internet is not taking off. Indeed click-throughs from banner ads have fallen precipitously in each of the previous four years. As a result, Yahoo! has been forced to aggressively lower its ad rates. Quantitative studies have also proven that users have banner blindness and do not look at the position on the screen where banner ads are usually found. All of the information we have suggests that ads as a revenue source aren't going to cut it for second and third generation Internet companies, and they will have to rely on real revenues to make their businesses work. Q: So what are some of the names on your buy list? A: In the cornerstone growth approach, current names include Measurement Specialties (MSS), Salton (SFP), Best Buy (BBU), Pohang Iron & Steel (PKX), Unilab (ULB), CAM Data Systems (CADA), JD Oxford (JBOH), and Advanced Digital Information (ADIC). Q: Do you see a market correction and if so, when? A: I have absolutely no idea whether the market is going up or down by 15% or 20%. I believe that people who confidently make such predictions should be forced to wear long flowing robes and pointy hats with stars on them to remind people of the quality or lack thereof in their advice. There are no market timers on the Forbes 400 list of the richest people in this country, but there are many, many investors. The deal with being an investor is that you must tacitly admit that you have absolutely no way of knowing if the market is about to go down 20% or 30%. But the good news is, if you are truly an investor, why should you ever care? Change your focus and you can change your future. Attempts at market timing have robbed investors of huge sums of money. A recent study by Dalbar [a market research firm] found that between 1994 and 1997 the S&P gained more than 800% whereas the average investor had a gain of just a little over 150%. It theorized that virtually all the difference came from investorsí inability to remain fully invested over the period. Q: What do you think of commodity stocks, and the fact that underlying commodity prices finally seem to be rising? A: Instead of thinking in terms of commodity stocks, we would think more in terms of strategies that might uncover those types of stocks. For example, our large-cap cornerstone value fund focuses on market-leading companies with high dividend yields. That tends to give you names like British Steel, Dow Chemical, Atlantic Richfield, Weyerhauser, and Shell Transport & Trading. All have done well for us this year as the market has expanded beyond the few big-cap growth stocks it adored in 1998 and the first quarter of 1999. Q: What is your long-term view of Lucent and Dell, given that they have such high price-earnings ratios? A: Lucent and Dell actually look a lot better when you look at them in terms of their price-to-sales ratios. Research that I did for my book What Works on Wall Street found that price-to-sales was a much better indicator of future stock price performance than price-earnings. Both companies fit into our market leaders growth strategy because their price-to-sales ratios are lower than the average market leading company. Q: What do you think about AT&T and all the cable properties it recently bought? A: AT&T is transforming itself into a growth stock. What once used to meet our dogs of the Dow strategy now seems ready to show up in our market leaders growth strategy. All in all, a remarkable transformation for that company. Q: Would you change anything now in your thinking about What Works on Wall Street and How to Retire Rich? A: Fundamentally, no. The laws of economics remain the same as when I did the research and as they have been for centuries. As long as men and women price securities and let their emotions play into their pricing decisions, those of us who use a disciplined consistent strategy will be the long-term winners. Q: What is your outlook for small-cap stocks? A: I believe that small-cap stocks have the potential to go into a huge rally over the next three to five years. History shows us that we might be looking at a once-in-a-lifetime opportunity with small stocks. The philosopher Soren Kierkegaard said that life can only be understood backward, but it must be lived forward. The same is true of the stock market. Today's events often blind us to the bigger picture, and I believe that is the case with small-cap stocks. Since 1994, the market has been extraordinarily biased toward big-cap growth stocks. And 1998 was one of the worst years for comparisons between big and small stocks. But the good news is, that pushed small-cap stocks to an historic low in terms of valuations against the S&P 500. I believe we are at a beautiful time to be a small-cap investor. By Amy Barrett in Philadelphia
EDITED BY LORI BONGIORNO
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