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Journal: Feb. 25, 2002

• Place order to buy an additional 250 shares of Industrias Bachoco (IBA) at 9 or lower. • Cover short position in Magma Design Automation (LAVA) at 9 or lower. • Cancel outstanding orders in Reuters (RTRSY). Playing chicken Industrias Bachoco (IBA), a current portfolio holding, took a hit Friday as it released earnings. However, the valuation remains very compelling.

The market capitalization of the stock is $450 million as I write this. The company has just $33 million in debt paired to $128 million in cash, for an enterprise value of $355 million. Earnings before interest, taxes, depreciation and amortization (EBITDA) was $145 million during 2001. Free cash flow was $100 million. The trailing enterprise value: EBITDA ratio is therefore 2.45, and the free cash flow yield is 22%. The company continues to trade at just over half book value, and it paid a dividend during 2001 amounting to 7.7%. The price/earnings ratio is just under 4. All these numbers are not so bad at all, especially when one considers that 2001 was a difficult year for the industry, as the economy softened along with pricing. In all probability, the sell-off occurred because of the recent run-up -- a sell-on-the-news phenomenon.

As I noted before, the company is the leading producer of poultry products in Mexico, where chicken is the No. 1 meat. Pilgrim’s Pride (CHX) and Tyson Foods (TSN) lag Bachoco in Mexico, where fresh chicken products are much more broadly accepted than processed chicken products. Bachoco, having been in the Mexican chicken business for decades, has a natural advantage that can be exploited if the company is run well, and it does seem to be run well. Regardless of the recent run-up in the share price, I continue to target a $15 or greater share price for Bachoco. As time goes by, shareholders equity will continue to grow and dividends will be paid. This should be a solid total return investment. I’m not asking for an extravagant valuation; 8-9 times earnings and par with book value would provide tremendous price appreciation from the current level, especially when paired with the dividend. If it falls to 9 or lower, buy another 250 shares.

Regarding Magma Design Automation (LAVA), the position is working out pretty well – a roughly 50% gain on this too-small short position. Just in case it has a midday meltdown followed by some short-covering, I’ll enter an order to cover the entire position at 9 or lower. Sounds ridiculous to enter such an order, but while I did not expect the stock to fall as fast as it did, I do not see any reason that the stock doesn’t crash the $10 level soon as well. Any rallies in this stock are likely to be short-covering rallies as shorts lock in their quick gains.

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Journal: Feb. 21, 2002

• Place order to buy 100 shares of Reuters (RTRSY) at $42, good until canceled. • Place order to buy 100 shares of Reuters (RTRSY) at $40, good until canceled. • Place order to buy 100 shares of Reuters (RTRSY) at $38, good until canceled. • Change my order for National Service Industries (NSI) to buy 1,000 shares at $7 or lower, good until canceled. • Place order to buy 200 shares of Canadian Natural Resources (CED) at $26.75 limit, good until canceled.

Magma still has room to fall Since I shorted Magma Design Automation (LAVA) common, the stock is down considerably. I do not feel the need to cover the position at recent prices. The company recently filed its form 10 with the SEC. This filing reveals, as I suspected, that the company is not showing a cash profit in line with its pro forma profit claim. Rather, the company continues to produce negative operating cash flow. The filing also reveals an interesting relationship with a large customer that received 100,000 Magma options in November in exchange for ‘advisory services.’ I am attempting to clarify that relationship, as well as several stock repurchase agreements Magma has with its founders. These, too, were disclosed in the 10Q. Any individual who is long or short the stock ought to be looking at these things -- all the disclosure in the world will not help those who do not read the filings. In any event, the stock is not worth even double digits, so I will not cover here in the high teens. I expect another 50% gain or so from recent levels, possibly even during this Strategy Lab round.

Reuters (RTRSY) stock has been in a free fall. The value is higher than the current price by a large degree, however, and therefore falling prices are beneficial. The company produces a prodigious amount of free cash flow -- my estimates are that the recent share price will reflect less 10% free cash flow yields during 2002 and less than 12% in 2003. For these estimates, I assume top-line growth will be flat in the face of a sluggish world economy. The shareholder base is likely turning over as we speak – overanxious growth investors selling to patient value-oriented investors. Several other factors are contributing to the depressed share price, but none contributes more to the low valuation than the myopic views of investors in general. I should note that this is a very volatile stock, so I have no illusion that I’ve found the near-term bottom here. In the event that I’m not watching closely when it happens, place an order to buy another 100 shares at $42, an order to buy another 100 shares at $40, and an order to buy another 100 shares at $38, all good until canceled. I do not necessarily expect that this position will recover before the end of the round.

National Service Industries (NSI) keeps squirting higher. I won’t pay more than $7 per share, and I will change my order to just that: buy 1,000 shares at 7 or lower, good until canceled. Maybe one of these days I’ll get some in the portfolio here. I’m expecting a horrible quarterly report, so maybe that will do it.

Canadian Natural Resources (CED) is a boring favorite of mine. One of the largest Canadian exploration and production companies, with among the best returns on invested capital in the sector, Canadian Natural has thus far missed out on the mergers and acquisitions binge involving North American exploration and production companies. The recent acquisition of Canada’s Alberta Energy gives another decent comp for valuation purposes. All signs point to Canadian Natural being worth over $35 share, although it might be as much predator as prey. It is relatively illiquid for such a big market capitalization, so I’ll set a low limit price in hopes of taking advantage of the volatility. Buy 200 shares at $26.75 limit, good until canceled.

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Journal: Feb. 18, 2002

• Sell position in Elan (ELN) at the market and cancel all outstanding trades. • Change previous order to short Magma Design Automation (LAVA) to 400 shares at $22 or higher. • Change previous order to buy National Service Industries (NSI) to 1,500 shares at $6.85 or lower.

Whoops. Elan doesn’t look so hot Time for a mea culpa. I am selling the entire Elan (ELN) position at market and will cancel all outstanding orders regarding this security. The accounting here is pretty tricky, as the world knows, and it takes some creativity on the analyst’s side to interpret the numbers presented. I believe I made several errors in judging the safety of this common stock investment, and so I will unload the position.

After further review of historical filings and after discussing my concerns with the company, I feel the net issue here is that the company has put itself in a more precarious financial position than was prudent. It has leveraged itself in order to ramp its pipeline as fast as possible, and has been capitalizing much of the expense of doing so. I find it very difficult to foot the valuation from a financial buyer’s perspective. In my world, it is primarily the financial buyer’s perspective that is meaningful, even if the strategic value to a corporate buyer might be somewhat higher.

With that lead-in, I’ll emphasize that common stock is the most precarious portion of the various layers of capital structure. In a bankruptcy preceding, it is most likely that the common stock is canceled altogether. Therefore when assessing the safety of a common stock investment, one must also evaluate the probability of bankruptcy at some point in the future.

The simplest way to look this is to examine capital flows. If a company does not earn its cost of capital, then it will have to access capital markets periodically. If the hope of earning its cost of capital is perceived to be fading, the capital markets will become less accessible for the company. In such cases, bankruptcy will ensue, with the associated destruction of stockholders’ equity.

In the interest of not wasting some previous picks, I’ll change some trades so that they are more likely to get executed fairly soon here in Strategy Lab. National Service Industries (NSI) -- change the order to buy 1,500 shares at 6.85 or lower. Magma Design Automation (LAVA) -- change the order to short 400 shares at 22 or higher.

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Journal: Feb. 15, 2002

• Place order to buy 200 shares of Reuters Group (RTRSY) at $46 or lower. • Place order to buy 1,000 shares of National Service Industries (NSI) at $6.75 or lower. • Buy an additional 200 shares of Elan (ELN) at $13.25 or lower. • Change previous order to short Magma Design Automation (LAVA) to 300 shares at $22.50 or higher.

Two stocks that look cheap Coming up on the deadline, so I’ll make this quick. Reuters Group (RTRSY) looks cheap. A cash-flow machine with significant brand equity and a solid balance sheet, the business is in the midst of a turnaround at the hands of a new American-for-the-first-time CEO. The company owns sizable stakes in Instinet (INET) and Tibco (TIBX), and it has a significant venture portfolio. It recently bought Bridge Information Systems assets out of bankruptcy. Buy 200 shares at $46 or lower  National Service Industries (NSI) is a cigar butt trading at a deep discount to tangible book. The reason: asbestos. The company has also been the subject of a recent restructuring and reverse stock split. None of this looks very appetizing to nearly any institution, and so the shares have been getting dumped lately. It takes some work to understand the true earnings power of the business, not to mention the asbestos liability. After doing this work, I’ve concluded the stock should be trading at levels at least twice the current level based on a variety of measures. Buy 1,000 shares at $6.75 or lower.

Also, reviewing prior picks, buy another 200 shares of Elan (ELN) at $13.25 or lower, and change my order on Magma Design Automation (LAVA) to short 300 shares at $22.50 or higher.

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Journal: Feb. 8, 2002

• Buy 800 shares of Elan (ELN) at $12.70 or lower. • Buy 200 shares of Kindred Healthcare (KIND) at $36.25 or lower. • Buy 1,000 shares of Industrias Bachoco (IBA) at $8.50 or lower. • Short 400 shares of Magma Design Automation (LAVA) at $25.00 or higher.

Amid ‘Enronitis’ scare, three Buys and one Short Those of you that have been reading my journal entries here for a while know that I’ve been a fairly vehement critic of accounting shenanigans. In the past, I’ve whacked Cisco Systems (CSCO) over the head, dissed WorldCom (WCOM), and I’ve had a few choice words in general for the way the professional stock market works to take advantage of the amateur stock market.

I of course still believe that companies, in the long run, will not be able to fool anyone. Either value is created, or it is not, and the share price ultimately reflects this. Sometimes, and maybe even most of the time, a company that has been involved in scandal will be overly punished in the marketplace. What’s more, as long as the company has the cash flow and the balance sheet such that it does not need access to capital markets, and as long as its customers don’t care about the stock price, a company can have a very decent shot at long-term redemption.

The real Elan Take Elan (ELN). This is a real company. Real shenanigans. Real debt. Real cash and real cash flow. Real drugs. Real pipeline. Real customers. Real value. Drug companies don’t generally trade to 9-10% free cash flow yields. Remember folks, this is the pharmaceutical industry.

There are plenty of strategic buyers for Elan, and now it has fallen to a financial buyer’s price range. Such circumstances usually don’t last long. Ethically-tainted, scandal-plagued companies trading at real financial buyer multiples in an industry full of potential strategic buyers -- well, such situations usually deserve another look.

Kindred’s spirit Kindred Healthcare (KIND), a nursing home and long-term acute care operator, emerged from bankruptcy early last year. Very few are watching this as it drifts lower over worries that two key pieces of legislation benefiting Medicare revenues will essentially be reversed. I won’t get into the specifics, but only half of what is feared might actually come true. The other half is 50-50, but for once I’m rooting for Tom Daschle.

This too is trading down at a roughly double-digit free cash flow yield, and has a net cash position. The downside in the event of a bad legislative outcome is maybe a 20% fall from current levels, and maybe even just stabilization at current levels. The upside to a good legislative outcome is a near doubling of the share price from here.

Poultry profits Industrias Bachoco (IBA) is a Mexican chicken products producer. No. 1 in the country, trading at about a 20% free cash flow yield and at half book value. Enterprise value/EBITDA multiple is just over 2.5X. Economic trends vary, but this company has been around for the last 50 years, and in the last several years it paid off, out of free cash flow, an acquisition of the No. 4 player in the industry.

Nos. 2 and 3 in the industry are associated with Pilgrim’s Pride (CHX) andTyson (TSN). I admit -- this is not a great business. Maybe just worth book value. OK, double the share price and give me book for my shares.

Unlocking short value Finally, if Magma Design Automation (LAVA) ever gets near 25 again, short the heck out of it. I believe I’ve already provided my rationale. In light of their earnings announcement reporting a one penny per share profit, investors should just realize that the company booked a fairly significant perpetual license order late in the quarter. They disclosed this on the conference call. Perpetual orders allow for significant revenue recognition up front, as opposed to revenue from time-based licenses, which are recognized ratably over time.

Also, we should realize that during the conference call management did not describe the non-cash stock compensation charges as non-recurring, but excludes them from its pro-forma profit calculation anyway. Management did say it was "hopeful" that these charges would eventually decline.

Lock-up expiration is just a few short months away, and then we find out what all the insiders really feel the stock is worth.

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Journal: Dec. 28, 2001

• Short 100 shares of Magma Design Automation (LAVA) at $29.50 or higher.

Magma is one of a handful of companies that supply the semiconductor industry with the software to design semiconductor chips. Two other 2001 IPOs in this industry have performed decently.

Magma also has the meteoric price rise, up over 120% from its offering price. The stock has broken free from any rational valuation and now seems to go up simply because it is going up. And the offering price of $13 was a heck of a stretch in the first place.

True to its heritage, Magma’s appeal suffers when one peeks under the hood. Here are the basics, culled from the company’s own prospectus, news coverage and my own due diligence, including conversations with top management and insiders in the industry.

The company is not profitable. In fact, it has been losing tens of millions of dollars a year. Earlier this year, Magma laid off a significant portion of its workforce even as several of its competitors were doing very good, even record, business.

Also earlier this year, after filing in May for a public offering, the company found itself the subject of intense criticism as industry pundits noted that the filing revealed Magma’s precarious financial position. The filing also helped heave doubt on the veracity of Magma’s prior claims as to the size of its backlog and market share. This followed reports that Magma had been actively shopping itself to its four biggest competitors in the electronic design automation industry and that all had said no quite quickly. The IPO was thus delayed.

The delay created stress on the cash-hungry business, and in August Magma required a bridge loan of $25 million for working capital. The interesting terms of this loan included giving the creditor the right to convert the loan into stock at 67% of the IPO offering price. Indeed, this is what ended up happening, as Magma went public amid renewed investor appetite for risk on Nov. 20.

Primping for the public What did Magma itself do to spruce up for its debut? Plenty, its filings show, and it is not pretty. First, starting in April, Magma imposed on its sales staff new rules: Commissions would no longer be paid upon the initial sale, but rather would be paid in installments over time. By spreading out the commissions expense, Magma delays cash outflows as well as near-term expenses.

While Magma acted to make expenses appear less than they really are, it also acted to make revenues appear greater than they really are. During the quarter ending Sept. 30, the company changed its sales model to emphasize perpetual sales over subscription sales. This has the effect of allowing greater revenue recognition in the near term at expense of revenue recognition down the road.

The net result of these two actions was to delay short-run expenses while boosting short-run revenue. The company also acted to beautify the cash-flow statement, reducing the capital expenditure run-rate to less than 50% of historical levels.

All this should give investors pause. Clearly, the last thing investors need is yet another management team with tendencies toward aggressive accounting. And investors ought keep in mind the reason for all these maneuvers was to look good enough to pawn the company off on the public at an IPO price that values the company at roughly $375 million. Magma discloses that the small portion of this that goes to company coffers allows only about 12 months of operations at current levels.

Over the next 12 months, other issues will arise.

Magma specializes in an area of electronic design automation that has historically been the lair of embattled Avant! (AVNT). In fact, Magma has benefited from Avant!’s legal troubles with industry leader Cadence Design Systems (CDN) and from the associated marketing headwind that Avant! faces. After Magma’s IPO, it was announced that the widely respected Synopsys (SNPS) is acquiring Avant!. The resultant Synopsys/Avant! combination is going to be a powerful one for several reasons that I will not detail here. The net effect on Magma, however, is that one of Magma’s reasons for being has been severely weakened even as the resources of its largest competitors just doubled at minimum.

An exit for early investors As well, of the nearly 30 million shares outstanding, some 24 million or so will come out of lock-up during the first half of 2002. The high percentage of shares in the hands of pre-IPO investors is reflective of the tremendous venture capital support this company required, and without a doubt one key reason for this IPO was to provide an exit for early investors. In time, this will bring selling pressure even as it multiplies the float available to buyers. Engineering tiny floats was a key tool in achieving rapid run-ups of IPOs during 1999.

In the short run, I also expect that the effective float has been made temporarily even smaller, as purchasers over the last month nearly all have gains, and a good portion may be unwilling to realize those taxable gains before year-end. It is possible that early January could see some of those buyers move to lock in these gains.

The three main underwriters of Magma’s IPO have had their research arms come out with thoroughly unimpressive ‘Buy’ ratings on the stock. Other aspects to consider include that short covering may be driving a good part of the recent rally. There is also speculation that Cadence might be forced to acquire Magma in response to the Synopsys/Avant! combination. This is hard to imagine at Magma’s current valuation, however.

I saved the valuation for last. It will be hard to nail the price of this security one day in advance. In the last half hour or so, the stock has risen another 7% or so and appears ready to crack $30 a share.

Valuation is out of whack Valuation is a bit difficult for other reasons. After all, it has the requisite 1999-era quality of massive cash losses paired to no reasonable expectation for actual profit in the foreseeable future. Still, I’ll take a shot. At $30 a share, Magma approaches a $900 million market capitalization. That represents about 36 times its (inflated) trailing revenues, although I’m being a bit overprecise here in assigning more than one significant digit to either this volatile stock or the uncertain business underlying it. Its strongest comparables across all market caps trade for between 3 and 6 times revenue – and are generally plenty profitable.

We also can look to a recent deal to help clarify valuation. Synopsys is paying an all-things-considered price of about 3 times revenues for Avant!, which generates tremendous free cash flow and has the best margins in the business.

Realize that this IPO occurred for two main reasons: to provide an exit for venture investors and to provide cash to allow Magma to survive a bit longer. My feeling is that insiders would sell like mad at $30 a share if they could. As Strategy Lab just loosened the rules to allow shorting, I will short 100 shares of Magma at $29.50 limit, good until canceled.

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Journal: Dec. 14, 2001

• Don’t worry about missing a rally. Worry about losing your money.

Why I’m all cash – for now Cash seems quite conservative, quite boring. Yet the typical professional investor finds cash a little too hot to handle, and therefore high cash balances become the too-frequent prelude to forced investments and poor results. As this round started, the market roared ahead before most of us Strategy Lab players had acquainted ourselves. Indeed, the market was just continuing a massive rally from September lows. And then there we were, each with $100,000 cash. Absent the ability to short or use options, I chose, as a strategic decision, not to invest the cash, and I continue to choose not to invest the cash. This is by no means a permanent decision.

continue to avoid forecasting either market or economic direction. Rather, I simply attempt to keep both eyes and mind open to the inputs that influence the prevailing market environment. I use any resulting insights to help target areas of potentially lucrative investment. Currently, I am finding most opportunity in investments that would not be appropriate for posting here in Strategy Lab. Below, I describe my view of the current investing environment.

The equity ethic continues to circumscribe American investment philosophy. That is, America’s taste for stocks is not yet diminished, and tremendous cash liquidity exists, ready to race to the next hot or quality or safe sector. Yet some basics of investing go unhindered, not the least of which is valuation.

When I speak of overvaluation, I do not refer to aggregate price-to-earnings ratios. Rather, I survey common stocks across all market capitalization ranges and find that the market continues to find ignorance bliss. That is, off-balance sheet and off-income statement items are ignored even as complex pro forma accounting obscures on-balance sheet and on-income statement items. Insider related-party dealings, despicable corporate governance and other such issues continue to take a back seat to an intense focus on expected growth rates. Greed continues to conquer fear.

Don’t try to dig your way out A key phenomenon driving the recent stock market advance is the need for so many fund managers to catch up. Having had discouraging years through the end of September, many professional investors took on increased risk in order to dig themselves out of a hole. I warned against this tendency during the last Strategy Lab round. The math of investing requires a 50% gain to wipe out a 33% loss, and the only catch-up tool most professional investors have at their disposal is to take on increased risk.

Moreover, the year-end represents a nail-biting finish to a very grand one-year performance derby. The winners of the derby reap massive rewards. For most, missing a year-end rally would be fatal to such aspirations. Hence, just as happened twice earlier this year, Wall Street has climbed the wrong wall of fear; the common fear has been of missing the next bull market, not of further stock market losses. Fundamental valuations have been cast aside in the scramble. And once again, in the short run, mob rules.

One argument that has been used to sell and to sustain this rally as the real thing is the idea that the stock market rallies 25% or so 4-6 months in advance of an economic recovery. Therefore, as a rally reaches those proportions, predictions of a recovery 4-6 months out become ever more confident and full of bluster. Yet, to borrow a phrasing, the market has predicted two of the last zero economic recoveries in 2001 alone! Circular logic remains an oxymoron.

Of course, even if we have economic stabilization or recovery, it would be wrong to assume that this would be a boon for stocks in general. Indeed, for most investors, it would be better to watch interest rates. Interest rate changes become more significant in stock valuation when valuations are very high. That is, investment in a stock with a price/cash earnings multiple of 25 will be much more sensitive to interest rates than investment in a stock with a price/cash earnings multiple of 5. Rising rates paired to a richly valued stock market ought not result in a significant new bull market, despite an expanding economy. To put this in other terms, most widely held stocks have already (over)priced in a substantial economic and earnings recovery – even as they sit far below their highs of yesteryear.

Contrary to the somewhat absurd notion that all we have to really fear is missing a rally, I truly only fear permanent and absolute capital loss. Over the course of this round, I will place my investments as very good opportunities arise.

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Journal: Dec. 3, 2001

• Don’t worry about indexes. Worry about your stocks.

Brace for yet another new paradigm Welcome to Round 7 of Strategy Lab. The strategy entry pieces together outtakes from the quarterly letters I write to Scion Capital’s investors.

The cumulative return of my picks over the previous two discontinuous rounds has been just over 23%. Over the same 14-month span, the S&P 500 ($INX) returned a cumulative -22%, and the Nasdaq ($COMPX) returned a cumulative -58%. While the relative performance looks respectable, I am not happy with the absolute performance. It is not generally true that my portfolios correlate with the various indices anyway, and I know I could have done better with my stock picking here within Strategy Lab. Last round’s performance was particularly harmed by my special situation airline and hotel holdings. I will attempt to do better here this round.

A good friend and portfolio manager recently related a conversation he had with a sell-side analyst. "Never in history have we seen interest rate cuts like this," the analyst waxed, surely prophetic in his own mind, "and not seen the economy and the stock market recover quickly."

My friend’s response? "Unless you’re Japanese."

You never see a bubble until it pops The standard argument against a Japan 2000 scenario here in the United States is that we never had the real estate bubble like Japan did. For us it was just stocks. Or so the story goes. Of course, most people don’t recognize bubbles until they’ve burst, while precious few seem quite capable of recognizing asset bubbles even while they are still intact. Good portfolio managers -- of which there are precious few, by no small coincidence -- belong to the latter camp. And good portfolio managers ought realize that the U.S. real estate bubble is simply not yet popped.

Another standard argument against a prolonged recession or depression is that the U.S. markets are freer, allowing quicker adjustments. However, if by adjustments, such pundits mean hurricane-force layoffs, greased-lightning monetary policy and the great disappearing act that is the federal budget surplus, I am at a loss. After all, none of this will change the fact that the economy is mired in a sea of stranded costs -- courtesy of about five years of moronic capital investment strategies. The country simply neither wants nor needs much more of what additional capital investment might produce. After all, when was the last time a new computer actually seemed faster than the old computer?

Moreover, there is a downside to a low interest rate policy in a nation of ever-expanding seniors. That is, lower rates mean lower income for the growing fixed-income population. Which means less spending if not crisis in certain quarters. Unlike stimulation of capital investment, this consequence of lower interest rates is both certain to occur and generally ignored. I have already had several of my own investors inquire as to sources of higher yield.

The yield chase The need for yield has been apparent in the new issue bond markets of late. The Ford (F) deal was doubled in size even as Ford made it clear that the company would be lending out at 0% that which it borrows. Stocks don’t pay dividends anymore, savings and money market accounts yield too little. The remaining option is bonds. To the degree the need for yield results in a mass panic for yield, however, the consequences will be dire. While earnings yields on equities are commonly mispriced, bond yields are much less commonly mispriced. So what is my recommendation to those who approach me in search of higher yields? Caveat emptor. In other words, work hard not to be seduced when a too-good-to-be-true higher yield investment comes along.

Moreover, should deflation become a factor, the tremendous debt burden under which many U.S. companies and consumers operate will become much more of a burden, even as consumers hold off on consumption as they wait for lower prices.

Paradigms are continually turned upon their heads. This how the United States as a country progresses. We ought brace for yet another new paradigm -- one that few if any pundits including me -- can predict. Regardless of what the future holds, intelligent investment in common stocks offer a solid route for a reasonable return on investment going forward. When I say this, I do not mean that the S&P 500, the Nasdaq Composite or the market broadly defined will necessarily do well. In fact, I leave the dogma on market direction to others. What I rather expect is that the out-of-favor and sometimes obscure common stock situations in which I choose to invest ought to do well. They will not generally track the market, but I view this as a favorable characteristic.

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Journal: August 10, 2001

• Buy 1000 shares of Mesaba Holdings (MAIR) at 8.80 limit, good until canceled.

To own or not to own Cisco Cisco Systems, market capitalization $141 billion, reported combined earnings for the last two years of $1.66 billion, and it is uncertain how or when Cisco will grow again. Moreover, it is possible and maybe probable that Cisco will write off $1.66 billion as a one-time charge sometime in the next few years. As usual, details regarding Cisco's options compensation programs are scarce.

So, which is the bigger risk: owning Cisco or not owning Cisco? One need not be short Cisco to experience the risk of not owning Cisco. For professionals, performance is benchmarked. That is, performance is relative. In the relative performance game, one is effectively short every stock not in one's portfolio that is nevertheless a part of the benchmark. To illustrate, a 100% cash position benchmarked against the S&P 500 Index is 100% short the index in the relative performance game. If the S&P 500 rises 10%, then in the relative performance arena the cash portfolio is down 10%. This is how Wall Street works.

So who in their right mind would short Cisco now? Virtually no one. Despite mustering every ounce of confidence possible, most analysts, portfolio managers, economists and corporate executives have no clue as to when either the economy or Cisco will again rebound. And on the off chance that the rebound occurs next month, well, better not be short Cisco.

What we have here is greed overruling fear, despite the fact that for a financial buyer -- a buyer that does not think strategically but rather thinks in terms of pure proven cash flows -- the public stock market offers precious few opportunities. And almost none of them are in big caps. Cisco does not qualify. I have given some reasons why in previous journal entries.

This lack of value should be troubling to thoughtful investors. Tremendous liquidity continues to grace the stock market. Hence, when investors flee from growth, they rush to value.

Any big publicly traded company with a low price/earnings ratio or low price/book ratio and without obvious warts has seen its stock have a big run recently. Indeed, the bull run for value that started last fall has continued right up into the present. Now, however, most stocks are at least fairly valued. I would argue most remain overvalued.

Given the current valuation scenario across the market -- and evident in my daily reviews of anything and everything that looks either undervalued or overvalued -- investors would do well to start replacing fear of missing a rally with fear of further capital loss. Before the bear goes back into hibernation, the time will come when fear overrules greed. We are not there yet. Though we may soon be.

With little doubt, this round has been a disappointment. Now that I'm a short-timer, it seems hazardous to enter a position now, knowing that it is only a guess where the price will be in a few weeks when the totals are recorded for eternity. Nevertheless, the spirit of the Strategy Lab is not to remain idle. So here goes.

Hoping for a Mesaba takeoff Buy 1000 shares of Mesaba Holdings (MAIR) at 8.80 limit, good until cancelled. Mesaba is a regional airline that was recently dumped at the altar by Northwest, which is also minority shareholder in Mesaba. Mesaba's primary business is to be an operator in the Northwest Airlink system.

Mesaba is the cheapest domestic airline. It gets paid by the capacity it makes available rather than the number of passengers it carries. It also has a favorable long-term fuel contract that buffers it from fuel cost fluctuations. Currently, one of its largest cost centers is the training of pilots. That will become less of an issue when Mesaba opens its new domestic pilot training center inside of a year from now.

The other potential catalyst is the winning of additional routes and jets from Northwest. Mesaba primarily competes with Express Air, a wholly owned subsidiary of Northwest. Therefore it follows that Mesaba will not get the majority of the new business from the recently announced large purchase of regional jets by Northwest. It is this lack of near-term growth that really turns off most analysts.

Mesaba will get some of those routes, however, and growth isn't terribly necessary given the valuation. With approximately $5 a share in cash, no debt and $2.31 a share in trailing EBITDA, $9 seems a cheap price for the stock. And it is. Book value per share checks in at around $8, and it is growing at a nice clip. A rational valuation is probably in the mid-teens, all aspects of this investment considered. Northwest turned away from buying Mesaba at $13 after an industry pilot strike resolution made the deal unfavorable for Northwest. Nevertheless, Northwest was not the only company interested in buying Mesaba. Last fall, another airline group made an inquiry to the board regarding purchasing the company and was rebuffed in favor of the Northwest deal.

If one looks at the valuations accorded peers such as Mesa Air (MESA), SkyWest (SKYW), and Atlantic Coast Airlines (ACAI) and adjusts for the lease structure at each, one would find Mesaba worth $16 a share or more. For now, it is just an illiquid stock knocked down by arbitrageurs rushing for the exits after the Northwest deal blew up. It has yet to recover, and it probably won't recover within the next month. Near-term downside may be as much as 12% to 15%, but such downside would be far from permanent.

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Journal: June 22, 2001

• Sell the entire Grubb & Ellis (GBE) position at a 6.25 limit, good until cancelled.

How to get even An outsider might think find investors’ thinking odd. Presented with new money to invest, most set goals of growing that money. They set targets of 20%, 30% or sometimes much more. And they set off fully intending to do so. Not so odd, yet.

However, once having lost money, investors tend to set a seemingly conservative new goal: breakeven. The irony is that breakeven math is one of life’s crueler realities. That is, breakeven requires a percentage gain in excess of the percentage loss incurred. Not so conservative.

Moreover, losses are the ultimate slippery slope. If one has lost 20%, then one requires a 25% gain to break even. If one has lost 50%, one requires a 100% gain to break even.

As a result, the goal of breakeven is often much more aggressive than one’s initial investment assumption. In an attempt to get back to breakeven, most investors simply ratchet up the risks they take. Of course this usually just ratchets up the losses – and increases the required return back to even. Talk about a death spiral.

My experience is that when one has losses that look other than temporary, there is usually a reason. The appropriate corrective action is to investigate the reason for the loss. More often than not, I find that I have strayed from the consistent method of investment that has served me so well for so long. Indeed, this finding often needs no investigation – I knew at the onset of the investment operation that I was straying, yet foolishly plowed ahead anyway.

All investors stumble. Usually some stubborn insistence plays a role. But fools will not be suffered lightly in a bear market. The risk of ruin is real. As investors, we must continually guard against the missteps that might lead to losses – and react rationally if we find ourselves down. Acting like a fool after the fact will only compound the error.

Portfolio updates Senior Housing (SNH) is acting beautifully and pays a nice dividend. I would not be a buyer here, and I do not expect fireworks for the remainder of the round. The stock was a steal at 10 or below, and fair value is between 15 and 17. The upper end of that range may be reached as the payment situation in senior living improves even more. The dividend certainly enhances the return for long-term holders.

Huttig Building Products (HBP) remains significantly undervalued. I value this stock north of 10. $30 million could be squeezed out of the real estate acquired from Rugby (and on the books for nearly zero) by just rearranging some properties. I continue to anticipate a buyout or some other value-realizing activity, as this is a company that does not need to be public.

American Physicians (ACAP) was a no-brainer at 13.50, which is the price at which it demutualized last fall. Below 17, I’m a buyer. This company is overcapitalized with tons of excess cash and hence I view the move from 17 to 20 as more of a move from 5 to 8. That’s why I’m willing to reduce the size of this hefty position in the 20.50 range. The biggest risk is that management carries out a dumb acquisition. Tremendous value could be created by just buying back the shares, which carry an intrinsic value north of 26.

Grubb & Ellis (GBE) under 5 is a decent buy, but there are structural ownership issues that limit the upside. Meanwhile, a new CEO has taken over and will want to make a mark even as the commercial real estate industry is entering a funk. I continue to believe that my long-term downside risk is that the company gets bought at a 40% premium to what I paid. In the near-term, this illiquid stock can bounce quite low. But I won’t worry about that. Last quarter, some big institutional investors dressed up the stock at the end of the quarter in order to enhance their returns. That may happen again. In anticipation, I’ll enter an order to sell the entire position at 6.25 limit, good until cancelled.

GTSI (GTSI) is prepping a blowout for last half of the year. Operational changes and a couple of contract wins have boosted business at this government technology products distributor, which sells at a multiple of around 5 on this year’s earnings. The business is much less cyclical than the stock price, which bounces around a lot. The stock is finding its way into stronger hands, however. I believe the stock is worth at least 8 and probably more.

So that’s it. With my previous sale of IBP (IBP), I have only five positions left. When I sell half of the American Physicians position, another slot will be open. I am being patient for the end-of-quarter selling that often occurs in downtrodden names as institutions rush to window dress their portfolios. In the meantime, my standing order to buy Wellsford Real Properties (WRP) at $18.50 might execute.

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Journal: June 20, 2001

• Sell the entire position in IBP Inc. (IBP) at the market.

Taking the easy trade Buy stocks cheap enough and the news is bound to be good. As the deal for Tyson Foods (TSN) to buy IBP Inc. (IBP) blew up in late April and went to the courts, IBP stock fell to around $15, despite the fact that competitive bidding for the company less than six months earlier had priced the company at $30 to $32 a share. Moreover, $15 represented a 50% gain back to the $22.50 price at which a management-led group had offered to buy the company. And finally, $15 meant that if the deal went through as planned -- roughly 50% stock, 50% cash -- then you were getting Tyson stock for free. If the deal did not go through, one was getting a significant cash-generating business at less than book value. In short, at $15, one could argue that any news was going to be good news.

IBP won its fight to have the merger agreement stand, and so now I sit on appreciated shares of IBP. If Tyson's current share price holds and the previously negotiated merger agreement stands, then IBP will be bought for a sum total of about $25.40 per share. IBP closed at $23.52 Tuesday.

So the natural question is, "What now?" Risk arbitrageurs would now buy IBP stock and short a pro rata amount of Tyson stock in an effort to obtain the difference between that $25.40 and the $23.52. That's an 8% spread, which, if realized in a reasonable time frame, represents a good return. Risks for these arbitrageurs include that the deal price is reduced or that the deal does not pass antitrust muster. In such a case, Tyson's stock would rise and IBP's would fall. On the arbitrageurs' side is a court order mandating Tyson do the deal and Tyson's statement that it would not likely appeal.

I am not a risk arbitrageur. I believe that risk arbitrage is a quite overcapitalized field and, by and large, not currently a very profitable endeavor unless one has significant access to borderline inside information. Because there are only a few months left in this round of Strategy Lab, the only logical option for me is to sell IBP now and take the gain.

Those with a longer-term horizon could make a good argument for holding onto IBP and taking delivery of the $15 per share plus Tyson stock when the deal closes. Indeed, selling IBP now is equivalent to selling the Tyson stock at $7.16 per share before even receiving it. The key to remember is that the value of the deal is not the same thing as the short-term compensation to be received by IBP shareholders. That is, the value of Tyson stock is not necessarily that which the market is now quoting, as the stock is under intense short pressure from risk arbitrageurs. Longer-term holders who feel they can correctly judge the underlying value of Tyson stock as possibly $11 or greater would find the implied price of the Tyson shares embedded in their current IBP stock to be quite a bargain.

With respect to IBP, I'm a bit late here in Strategy Lab -- the news was announced Friday after the deadline for submissions for Monday trades. Making myself even more late, I did not submit an entry on Monday. Hence, my "automatic sell" of IBP is on time-delay and it has cost me a buck or so. Two days late and maybe a buck and a half short.

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Journal: June 13, 2001

• Place order to sell 500 shares of American Physicians Capital (ACAP) at a limit of 20.40. • Place order to buy 900 shares of Cascade Corp. (CAE) at 9.00 limit. • Increase the limit buy price on Wellsford Real Properties (WRP) to 16.45; change order to 600 shares.

A nickel between me and break-even Still pushing to get back to break-even. I’d have achieved that goal by now if I had been a nickel more generous with my limit buy on Wellsford Real Properties (WRP). Wellsford just bought back 24% of its shares at a huge discount to intrinsic value. Hence, intrinsic value per share just jumped at least $3 per share. The shares moved up to reflect this accretive action by management, but now they’re soft again. It’s not often that I’ll raise my initial buy price on a stock (usually, I let missed opportunities be), but in this case 18.50 now is cheaper than 16.45 was back before the buyback. Increase the limit buy price on Wellsford to 18.50, but reduce the number of shares to 600.

Also, sell 500 shares of the American Physicians Capital (ACAP) position at 20.40 limit, good until canceled. I took advantage of a no-brainer price when I took such a large position, but at this price I’ll scale it back to a still large but more average-sized position. I continue to be quite bullish on American Physicians, with the biggest risk being a dumb acquisition by management.

Back to basics With only a couple of months until the end of Strategy Lab, I have to say I’m quite disappointed with my performance thus far. As I did during my first Strategy Lab last round, I kicked off the round buying several stocks that possessed a lot of short-term price risk. Optimism (associated with the beginning of a new round) and a wad of cash (fake, granted by MSN MoneyCentral) make for toxic twins in the world of investing. I should have been smarter, even if it is only fake money. And once having bought such securities with near-term price risk, I should never have sold them simply because they fell in the near term. Had I simply held all the stocks I bought this round rather than selling some of them, I’d be much better off. This was largely true last round as well. Ok, two strikes. Will MoneyCentral give me a third chance?

It is not in my nature to scramble for excess short-term return by taking on extra risk. Hence, you will not see me take massive stock positions or leveraged options positions simply to try to shoot the lights out in these last few months. As I did last round, I’ll try to recover by going back to basics.

Start off with a new order to buy 900 shares of Cascade Corp. (CAE) at 9.00 limit, good until canceled. Cascade, a maker of forklift parts with significant branding and market share, was the subject of a management-led buyout offer earlier this spring. The offer put Cascade in play, and after a well-run bidding process that included more than 10 parties, an outside group offered to buy the company out for 17.25. Management came back with a late 17.50 offer that was properly rejected by the board.

The buyout fell through when the outside group encountered some skittishness on the part of lenders. Not surprising; several deals have been scuttled because of weak debt markets. What is surprising is that there was a final offer from the group -- $15.75 a share -- that was rejected by the board as well. In other words, a leveraged buyout can be done at prices 50% to 100% greater than the current price, and sharks are circling.

Recently CB Richard Ellis’ (CBG) going-private transaction got a shot in the arm when it successfully placed junk debt in an oversubscribed offering. This is a good sign that with lower interest rates offsetting the economic risk, the junk markets are attempting a comeback. I expect Cascade to be taken out in a reasonable time frame. This illiquid stock, which was transferred from the hands of long-term owners to arbitrageurs during the bidding process, was unceremoniously dumped by those arbitrageurs when the deal fell apart. Now approaching half the price bid just a few months ago, the shares of this old economy diehard appear a bargain at 4.3 times trailing nonpeak EBITDA (earnings before interest, taxes, depreciation and amortization) with significant free cash production. The stock is at about three times peak EBITDA. No doubt the company faces rougher economic times ahead, but with a trio of bidders willing to pay over $16 a share just a few months ago, there is a margin of safety here.

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Journal: May 30, 2001

• Sell the entire ValueClick (VCLK) position at a limit of 3.20. • Increase the limit buy price on Wellsford Real Properties (WRP) to 16.45.

Watch for return to April lows and lower The last few trading days notwithstanding, chances are that you feel as if every stock you look at has moved up recently. You would be correct in that feeling. The recent rally has been incredibly broad, with over 80% of NYSE stocks participating almost regardless of market cap or sector. The problem is, very few people actually bought the April lows. Hence, chances are you have also watched several of your favorite or most wanted stocks creep (or leap) steadily upward without you. It's a fateful and frustrating experience, no doubt. But it does give some insight into what professional managers are feeling.

Yes, the phenomenon is no different for professional investors -- they missed the early April lows en masse and have had to deal with tremendous lags in performance ever since. The difference? Professionals by and large were not fully invested when the turn came, while the indices by definition were. You have seen the results of this phenomenon here in the Strategy Lab, where all the players received $100,000 as the market entered one of the steepest four-week dives in history only to rebound within two and a half weeks of hitting its lows.

Of course, with each passing day of the rally, a few (hundred) more institutional holdouts crossed the line and started buying. After all, mutual fund investors never did pull money out of mutual funds altogether. It went to the money market funds, not to the mattresses. That money came rushing back with the ease of a click or a phone call, compounding the cash-on-hand problem. Hence, we got a "can't miss" rally, as in "can't miss the next bull market." Yet, the indices inched achingly ahead of the institutions' performance nonetheless. Which of course begets even fiercer buying. The aggressive ones are using leverage, if they are able, to catch up.

I can only conclude that it is quite possible we have not yet seen the bottom. Speculative booms like the 1920s and the 1960s were followed not only by steep stock declines, but also by stocks falling to absurd values. The aftermath of the speculative boom of the 1990s has seen ostensibly severe stock declines, but never during the April lows did I find stocks, generally speaking, go on sale. There was no sale in tech, but neither was there a sale in the financials, consumer products companies, cyclicals, etc. Gilt-edged brand names like Coca-Cola (KO) and Gillette (G) have seen their valuations reduced slightly, but they remain quite highly priced.

Indeed, by my calculations -- taking into account the massive corporate governance abuses borne of the bull market -- many of the biggest tech names and some of the biggest non-tech names that did fall fell only to fair value at worst. No fire sale in a fundamental sense at all. What is fair value? I use an annual 10% return to shareholders after dilution, slings and arrows.

Conventional wisdom says that either we've seen the bottom, or that there will be one more leg down, creating a W-shaped bottom. It is possible, even likely, that conventional wisdom will be proven wrong, and that the only alternative to these two options will instead occur. That is, the April lows will not only be tested, but pierced.

Bull markets: gifts that keep on giving This is not a common viewpoint, but you shouldn't expect it to be. Such a viewpoint would imply we don't know where or when the bottom will be hit. But surely, "I don't know" does not sell. It doesn't sell advertising, generate commissions, generate deals or attract investors.

Thus, everyone from CNBC to any broker, sell-side analyst, market maven or personal finance magazine has a vested interest in advancing confident-sounding market prognostication. And the bias, of course, is for a bull market, not a bear. Bull markets are simply the gifts that keep on giving.

Meanwhile, several if not most CEOs of our greatest corporations are by and large blowing the proverbial sunshine ... well, you get the idea. To the degree they can attempt to talk consumer confidence and capital spending up, they will all do their darndest. After all, when Jack Welch speaks, people listen. No matter that he's simply cheerleading his own exit. Think of management as a car salesman desperate to please. It's an overreaching metaphor, but it puts one in the correct defensive mind frame when listening to such charismatic characters. It is quite likely that the glimmers of hope we are hearing from such sources are simply just that -- glimmers, easily explained away in the future as never having been certain in the past.

So, I will go on record right now as saying that this is a time of tremendous uncertainty about market direction -- but no more so than at any time in the past. I continue to believe the prudent view is no market view. Rather, I will remain content in the certainty that popular predictions are less likely to come to pass than is believed and that absurd individual stock values will come along every once in a while regardless of what the market does.

Trade updates I'm moving the limit price on my outstanding order to sell the ValueClick (VCLK) position down to 3.20. This stock was a case of good assets, bad business, bad management. The result was certainly predictable, and hence this was a mistake on my part. By and large I was looking for a fluctuation upward to net asset value. Looking at this conservatively, that's where we are now. The target came down to meet us, and hence it is time to minimize the impact of this trade to a small loss.

I will also raise the limit a nickel on the Wellsford Real Properties (WRP) buy. The limit buy price should now be 16.45.

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Journal: May 23, 2001

• Place order to buy 700 shares of Wellsford Real Properties (WRP) at 16.40 limit, order good until canceled.

A cheap piece of real estate I waited a few days to post this here, and so this stock has run up a bit. The phrase "cheapest piece of real estate on the stock exchange" is bandied about quite frequently, so I won't use that hyperbole here. Nevertheless, I can make a good case for net real asset value here over $30/share, and it has been basing around $16 for the last four years.

What has changed is that Wellsford Real Properties (WRP) is liquidating its most visible investment -- a joint venture with Goldman Sachs. This joint venture specialized in rehabilitating office buildings -- turnarounds. So the book value underestimates true asset value. A recent sale went for a 25% premium to book value.

The chairman of this New York real estate investment trust is dedicated to buying back stock, and the company has retired 20% of its shares in the past two years. Wellsford invests in commercial real estate mostly around the Northeast.

But at this point, I've let others do the waiting for me long enough. Time to take a position.

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Journal: April 27, 2001

• Place a buy stop on previous position in Krispy Kreme (KREM) at 46, good until canceled. • Place a buy stop on previous position in Standard Pacific (SPF) at 22, good until canceled. • Place a buy stop on previous position in Kohl's (KSS) at 62, good until canceled. • Place a buy stop on the previous position in General Electric (GE) at 51, good until canceled. • Place order to sell 1,500 shares of ValueClick (VCLK) at 4 limit, good until canceled.

When things go wrong Considering I've had four shorts go the wrong way lately, I can't be too upset with my position in the Strategy Lab. Shorting things like GE (GE), Krispy Kreme (KREM) and Kohl's (KSS) in the face of one of the fiercest bear market rallies in history could have left me in much worse shape.

As it is, I tried to get out of my Standard Pacific (SPF) short before they released results. I anticipated a typically promotional press release, and got it. Earnings, revenue, backlog all up. Unfortunately, so are inventories -- well in excess of sales -- and debt, and cash is way down. No cash flow statement provided. And just as unfortunately, no sooner did I enter my order than it rallied 21% in two days on short covering – gapping its way out of reach of my limit order. An example of a limit order working out the wrong way. I would much rather have covered earlier, but with no opportunity to alter the order in the wake of the new housing numbers -- we're on a 24 hour delay here -- it wasn't possible. I'll put in a buy stop at 22, good until canceled.

The Kohl's short, a position I entered on a market order that went off quite badly, has been similarly unfortunate. My thesis remains intact there. I will put a buy stop at 62, good until canceled, however. No need to lose my shirt if the market goes haywire to the upside. Kohl's is a great short at 62, but it's also a better short at 70. No need to lose 8 on the way to the better short.

General Electric is a stock I am convinced will trade substantially lower in the wake of Jack Welch's retirement and the Honeywell acquisition. Its collective powers to manage earnings are considerable, but a slowing economy will showcase GE's weaknesses. Notably, absent the 110% surge in profit at GE Power, GE would have shown a 25% decline in operating profit this past quarter. Those kinds of surges will not be an ongoing event at GE Power. At this point, given its recent strength and tendency to rally hard with the market, I will place a buy stop on the position at 51, good until canceled.

Krispy Kreme trades in a manner decoupled from any reasonable fundamental valuation, much like the internet stocks of 1999-2000. In such cases, the stock floats on sentiment alone. My thesis remains intact -- the stock is worth at best 1/3 current levels, and eventually sentiment will correct its error. Actually, I'm being generous – 1/3 current levels approximates the IPO price, which was surely a bit high. In the interim, there can certainly be wild swings to the upside as shorts rush to cover on any change in general market sentiment, as has happened recently. Hence the stock has tremendous short-term upside risk. Given that Strategy Lab is a short-term activity and the current trend seems to be higher, I'll place a buy stop at 46, good until canceled.

In real life, I never enter market orders, nor do I enter limit orders with good until canceled features. I look at stocks I want to buy and short, set target prices, and watch the market action -- along with my trader -- for the best price in light of market conditions and recent news. When I attack, I attack with intraday limit orders. But such orders are not practical here. I've had a few fits and starts here in Strategy Lab trying to find the optimum mix of market orders and limit orders, and I'm not sure I've found a satisfactory method yet in light of the delay. As a practical matter, the amount of control I have in real life will never be attainable here in Strategy Lab, so I must make do. Attempting to cover a housing short with a limit order the night before national new homes data is released is not a good way to go about things. Noted.

ValueClick is a good example. Today ValueClick (VCLK) releases earnings, and a good part of my decision on what to do with that position will depend on what the earnings release reveals – and especially how the balance sheet looks, since this is to a large degree an asset play. I figure the stock is worth at least 4.30 as a stand-alone entity accounting for recent share dilution. To a strategic buyer like DoubleClick (DCLK), ValueClick could be worth much more. But without knowing what today's news will reveal, I'll make a conservative move that will likely result in a non-event. Sell 1,500 shares of ValueClick at 4 limit, good until canceled.

I had previously bought stock in DiamondCluster (DTPI) this round at 14 per share or so (and subsequently offloaded it at 10 or so, thinking I could buy it back cheaper later). My thesis was that DiamondCluster was worth about twice the price I paid and would make a nice acquisition. In that same entry, I brought up Proxicom (PXCM) as an alternative to DiamondCluster. Yesterday, Compaq Computer (CPQ) announced it was buying Proxicom for 5.75 per share cash. Normalizing various multiples over to DiamondCluster based on this new standard for valuing e-business consultants, and adjusting for the higher margins and better cash production at DiamondCluster, one finds DiamondCluster to be worth about 21.50.

This is a bit lower than my original estimate of value, and no doubt reflects the distressed future facing many of these firms as stand-alone entities. DiamondCluster had the best shot, in my opinion, of remaining profitably independent, and because of this it might deserve a higher valuation. As for the opportunity to buy DiamondCluster back cheaper later, I doubt that opportunity will occur now. No investor has a 1.000 batting average, but every mistake deserves scrutiny and this one will get it.

I will note that it seems likely that there was a leak in the Proxicom deal with Compaq. Proxicom stock has been leaping in a manner out of proportion to its brethren in the industry-over two days late last week the stock jumped 158%. That was about the time this deal was probably starting to come together. Hence, someone knew something -- and many people traded on that knowledge, since volume was up to five times higher than normal. Security regulators will probably never investigate, but investors should be outraged at this transfer of wealth based on what looks on the surface to be inside information.

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Journal: April 25, 2001

• Cover short position in Standard Pacific (SPF) at 16.25 limit. • Place order to buy 1,000 shares of American Physicians Capital (ACAP) at 16.50 limit. • Place order to buy 400 shares of IBP Inc . (IBP) at 15.25 limit.

Two buys with upside to spare Cover the entire Standard Pacific (SPF) short position at 16.25 limit, good until canceled. Earnings will be released after the close, and I cannot ask for much more from this short. If you remember, I started this short last round with an initial short around 30. I re-entered the short this round substantially in the low 20’s. Now with the price flirting around book value, the stock no longer violates one of my most successful rules of thumb: Public homebuilders should not trade much above book value. Presently, Standard Pacific doesn’t.

This is not a buy recommendation, though. I anticipate that Standard Pacific will warn going forward and that it may have to write down some of its book value. But certainly the easy money has been made on the short side, and hence it is time to cover.

Buy 1,000 shares of American Physicians Capital (ACAP) at 16.50 limit, good until canceled. A mutual insurance company that demutualized in an IPO this past December, American Physicians is a terribly cheap stock. Book value is north of 30 a share, and a share buyback will only increase the per share book value. The company underwrites low-limit medical malpractice policies as well as some workers compensation insurance. The ratios are headed in the right direction, and the company is quite profitable as well as tremendously overcapitalized. At the very least, this stock should be trading at a more modest discount to book value.

Buy 400 shares of IBP Inc. (IBP) at the 15.25 limit, good until canceled. IBP is the gargantuan $17 billion sales beef and pork processor. After a bidding war that involved a management group and Smithfield Foods (SFD), Tyson won the right to buy IBP for

30 a share. Tyson Foods got heat from its shareholders over straying so drastically from chicken. After all, many portfolio managers had bought Tyson as one to benefit from the mad cow scare, not as one to suffer from it. In any case Tyson found a reason to back out and did. So IBP has fallen all the way down to 15 -- half the winning buyout offer and at about 65% of the initial buyout offer from the management group. IBP is no great shakes in terms of its business economics, but it is worth substantially more than 15 a share. In time, I expect Smithfield to make a substantially reduced offer at a substantial premium to the current price. The downside here is fairly limited.

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Journal: April 18, 2001

• Hold all positions. Intel is much more difficult to tear apart than Cisco Systems, but I'll try.

Deciphering Intel's news Now it's Intel's turn. First thing one notices is that the press release is not structured to hide much. That's because Intel (INTC) beat its lowered guidance, and is indicating its microprocessor business has stabilized. No need to hide good news.

And to be perfectly honest, Intel is much more difficult to tear apart than Cisco Systems (CSCO). The abuses are simply not as egregious. I'll give it a college try, however.

One big number that stands out is the $23.2 billion that Intel has spent since 1990 buying back shares. Pretty impressive. Unfortunately, there is roughly the same number of shares, adjusted for splits, outstanding now as back then. In fact, there may be even a few tens of millions more shares. Was that entire $23.2 billion diluted out of existence by options programs and stock issuances for employees and management under the GAAP table? Almost.

When the employee executes a $2 option and turns around to sell the stock at $30, the company gets that $2 plus a tax benefit, both of which are offset by dilution of the common shareholder. Over the last decade, Intel has realized about $8 billion in cash inflows from these options exercises and from the associated tax benefits. So if the share count stays about even over the decade, the absolute dollar amount of dilution to shareholders is roughly $23 billion minus $8 billion, which equals $15 billion.

That $15 billion is only roughly one-third of the $46 billion in net income Intel reported from 1991-2000. Over the long-term, this is how much Intel's options compensation and stock compensation policies dilute shareholders, and hence a rule of thumb might be to dock Intel's reported earnings numbers by a about one-third when trying to figure out value. If Intel demonstrates a penchant for re-pricing -- a practice that is just sheer theft from shareholders, in my opinion -- then earnings get docked a lot more.

Another aspect of Intel's earnings reports is that it reports earnings before goodwill write-offs, amortization and in-process R&D charges. If you are going to add back goodwill charges to earnings, then you have to add back the goodwill amortization and charge-offs to the balance sheet. Intel charged off $660 million this past quarter, $1.7 billion in 2000, and $803 million in 1999. These are significant amounts of cash out the door. So while they are non-cash charges now, it is important to remember that all these charges are only money spent by Intel in the past finally making its way through the income statement.

I am a big fan of the proposal to eliminate the amortization of goodwill. Let the goodwill stay on the balance sheet for all to see. This way we can tell exactly how much money the company has wasted in the past by simply looking at what the company is earning now and looking at what the company has invested to get to the now. Goodwill amortization hides mistakes. When the goodwill amortization doesn't hide mistakes fast enough, you see extra charge-offs, as we saw with Cisco earlier this week. Shareholders should not want mistakes hidden.

As for inventory concerns, nowhere did you see in Intel's report anything close to the horrendous wipeout of 60%+ of inventory that Cisco reported the day before. Cisco wrote that inventory off and then said they expect to increase inventory turnover. I would hope so! All in all, that sort of big bath accounting/funny business is not in Intel's quarterly statement. It is clues like these that lead me to have much more trust in what Intel is telling me than what Cisco is telling me.

Not all is rosy in inventory-land at Intel, though. I see inventories jumped over 29% during the quarter even as revenues fell 23% sequentially. When you are in a business that sets the gold standard for planned obsolescence, such an inventory bloat is not generally good. It also hits operating cash flow. In fact, the $411 million jump in inventory nearly obliterates the $485 million in first quarter net income.

Last year, with business picking up, inventories jumped only 5.7%. Could there be an inventory writeoff in the future? Sure. In fact, we should expect it. But I don't expect Intel to claim anything about improving inventory turns when they do.

By the way, it was reported in the Bay Area that Intel would not build any more plants here due to the high costs of doing business. Smart. Cisco, meanwhile, was plowing ahead with plans for the new campus in my neighborhood. Not smart.

By and large, I don't think success went to the head of Intel as much as it did Cisco. And so it is not surprising that scathing commentary on Intel is not so easy to write as it was for Cisco. Companies that manage themselves to please some Wall Street bogey are bound to say and do stupid things when they can no longer please Wall Street.

But just because Intel is relatively better doesn't mean it is absolutely good. For the reasons given above, I do not believe that Intel's current valuation is justified, the after-hours 10% pop in the share price notwithstanding.