Memo To: Alberto Vilar, Director, Amerindo Technology Fund
From: Jude Wanniski
Re: Nice Timing on Internet Stocks
As one of the outside directors of the Amerindo Technology Fund, I'm thrilled and delighted as we approach the end of the 2nd Quarter that you and your team had your crystal ball working just right. I just re-read the client letter you sent out at the end of the 1stQ and am amazed that you had just the right touch, keeping the Fund among the best performers of 1999. Where other funds kept chunking fresh investment into the Internet stocks and got caught in the downdraft, you saw the downdraft coming and stepped aside. So we are up 102.4% for the year! (Last time I looked, this morning.) Your first quarter letter still is so full of good information that I decided to post it here for my website fans and browsers... and for my other clients, even though they may get jealous about your performance. I also want to compliment you on the Amerindo website. What a nice touch running your current stock picks on a ticker tape! Best of luck in the 3rd and 4th quarters, Alberto. I know you are one of the smartest investors in the world, but it still helps to be lucky.
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Amerindo Technology Fund, First Quarter 1999 Letter To Clients
While the Internet stocks outperformed all other sectors of the stock market, including the indices over the past two quarters, it is important to recall that the emerging technology sector had dramatically underperformed the Standard & Poor's 500 (S&P) between May 1996 - October 1998 by some 60 absolute percentage points. The emerging technology sector, as measured by the Hambrecht & Quist Growth Index (H&Q), still lags the S&P for the past three years. We recently raised some cash, which is something we rarely do in size, specifically to take advantage of any correction in our sector, which now seems probable. We nevertheless continue to remain extremely bullish on the intermediate-to-long term outlook for the emerging technology sector centered around the Internet and feel that the bulk of the gains still lie ahead in what should be the best cycle in the 40-year history of electronic technology.
While the popular press widely acclaimed the Dow Jones Average reaching 10000 during the quarter, underscoring its normal penchant for sensationalism over substance, it is of little real investment significance. Whether it be Dow 10000 or 12000, it strikes us that the market is at least a little ahead of itself. This is not to suggest that these levels cannot be maintained or even go a bit higher. While the broad market could well remain in a range of plus or minus 10% from today's level, it seems a stretch to us to expect a straightline 10-20% gain from here. Stocks are probably in reasonable equilibrium now with the 5 - 5-1/2% ten-year government bond yield. It seems improbable to us that the market would rally much further, when no real progress is expected near term in either short-term rates, inflation, or earnings. We believe that there is an increasing likelihood of 10-20% correction from current highs near DJIA 11000. Unless interest rates move meaningfully lower, and/or 1999 earnings growth is meaningfully stronger than the 5-8% forecast, the market is likely to hover around current levels. Technology stocks would be expected to participate in any major market correction, but their correction should be short lived and their recovery quick and strong, which would enable them to produce a very strong overall gain for the year, something we doubt would be the case for the broad market itself.
Part of the reason the Dow hit 10000 was the economy's unrivaled performance during the 1990s. The unemployment rate stands at a 29-year low, inflation is at a 33-year low, corporate cost pressures are literally absent, and the federal budget surplus is growing, which collectively create an environment for continued low interest rates. The prime drivers for the economy's non-inflationary stellar expansion have been globalization, deregulation, economic policy, and the proliferation of information technology. These factors have raised the non-inflationary growth potential of the U.S. economy, largely by enhancing productivity growth, which has risen by 3.7% a year since the last cycle peak in 1990, the best on record. Services sector productivity is notably underestimated. A key driver of the increased productivity has been technology oriented-capital spending. The 1990s represent the strongest capital spending cycle of the past 50 years; real purchases of tech equipment rose 32% last year and by an average of 19% a year since 1991, the strongest cycle on record. This raises a question: If productivity is so good, why are corporate earnings under pressure? The answer is that a lack of pricing, not rising costs, is squeezing profits. Until recently, strong productivity gains have translated into healthy profit growth, as prices rose faster than costs. American corporations currently have almost no pricing power because of intense competition and low capacity utilization rates.
As the current economic cycle embarks on its ninth year, it is close to being the longest on record in the post-war period and yet it shows no signs of recession-creating imbalances that typically emanate from age. A new theory for this very positive economic setting has been the Internet's increasing impact on American business and life. The numerous benefits of the current generation of information technology, the third in 40 years, which we have labeled the Internet generation, are being diffused throughout the U.S. and global economies more quickly than other technological advances did during previous industrial expansions in the past. These benefits are effectively creating another industrial revolution. They include huge cost savings due to less need for capital, inventory and intermediaries, plus better and more timely information, which is resulting in more convenience, time savings, etc.
The build-out of the Internet infrastructure currently taking place will provide support early in the new century for one billion interconnected computers utilized by several hundred million people. The Internet will facilitate an explosion in electronic commerce (e-commerce), which will revolutionize business interaction. E-commerce can take corporate overheads, which have been under downward pressure owing to the containment of inflation and increased global competition, down another notch in costs. Key cost centers like distribution, communications, billing, etc., will become cheaper to run and easier to outsource. The opportunities for cost cutting are virtually endless through the substitution of many Internet-related technologies like video-conferencing, and through the outsourcing of key functions such as expense management, taxation, pay-per-use software, etc. While critical business functions will be performed in-house, many subordinate tasks will be outsourced to the best people available. The Internet also offers the opportunity to reduce some of the inefficiencies in corporations' supply chains by making it easier to implement just-in-time delivery and make bill collection and payment simpler and cheaper. Businesses will be increasingly incentivized to cut out the middleman in distribution, where such costs can range between 10 - 20%, by shipping directly from the factory to the end user. These Internet-induced changes will cause a fundamental restructuring of many business models over time. Companies that are successful in adopting Internet technologies will encounter a higher margin, more scaleable business model. On the other hand, a significant number of S&P 500 companies are at great risk because of their inability to integrate the new Internet economy into their business, which will place them in severe competitive disadvantage.
The Internet will be the catalyst for a massive increase in corporate investments as companies strive for a competitive edge. A spending boom to adapt Internet solutions to many business issues will be targeted at websites and at other peripheral areas that complement business e-commerce. Whether the Internet ultimately becomes a great low-cost method of distribution, or a disruptive force near term, it appears destined to be the next millennium's industrial revolution that could have as profound an impact as the Industrial Revolution did on the economy a hundred years ago. Business operations could become so efficient that profit margins could be maintained in the face of price reductions resulting from slow growth and intensifying competition. If Internet solutions are successfully implemented on a wide scale and actually impact corporations' global cost structure, as we have predicted, the world economy would embark upon a period of accelerated growth without inflation.
The powerful advance of the Internet sector raises the perennial question of current stock over-valuation, especially in view of their negative, or at best, modest earnings. We believe the investment significance of truly unique and profound, once-a-generation developments, like the Internet have the ability to significantly transform the global economy and cannot be initially assessed by traditional valuation yardsticks such as p/e's, price to book, price to sales, etc. that apply to companies well along in the maturation cycle. Technology stocks that offer the prospect of creating new multibillion dollar industries tend to move well ahead of their earnings, sometimes by several years. Successful investing in technology first requires the early identification of a new technology that can become a major business sector capable of immense growth. The second requirement for real investment success is to pick the companies with so-called "first mover advantage." Ultimate winners can increase from 10 to over 100 times, which makes the interim volatility of the stocks justifiable. We have been on record for some time in our prediction that we expect to see the Internet sector create $2 trillion in new market wealth over the next 5 to 7 years. This will be the result of the growth in Internet users in the next few years from 100 million plus to at least 300 million, plus a huge shift in business-to-business activity to e-commerce on the likely order of $1-2 trillion. So far only 10 - 15 % of this major new market wealth has been created. It is still very early in this revolutionary new technology cycle.
As noted above, we caution that a correction of both the broad market and the Internet sector is an increasing probability at some time in the second or third quarter. The broad market is selling at an unprecedented ratio of earnings growth to p/e of over four. The broad market could correct 15 - 20%. Further gains in the broad market still require a major turn up in global earnings next year, which is not yet in the cards. The Internet stocks are likely to have another "V" styled correction in the months ahead, and rebound strongly before the year closes, thus turning in yet another year of spectacular gains.