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Look for the "Hungry No. 2"

Investing is all about growth, and the best place to look for it is in stocks of companies that are the "hungry No. 2" in their sectors, says Don Luskin, co-founder and chief executive officer of The Web-based information site also runs the Open and IPO New Era funds.

As examples of his thesis, Luskin points to Juniper Networks instead of Cisco, BEA Systems instead of Oracle, and Advanced Micro Devices instead of Intel. He believes this approach should be applied to all sectors, not just technology.

These comments were among his responses to questions posed by the audience in a chat presented May 31 by BusinessWeek Online on America Online. The questioners also included Jack Dierdorff and Amey Stone of BW Online. Following are edited excerpts from the chat. A full transcript is available from BusinessWeek Online on AOL at keyword: BW Talk.

Q: What's your prognosis for the coming weeks?

A: We're at the most delicate possible point in the market, where the rally that began on Mar. 22 for the Dow and Apr. 4 for the Nasdaq is going to be tested. This is where we find out if it's just a bear-market rally or the real thing. I believe it's the real thing, and that we won't make new lows in the major indexes.

Q: Sounds like you're pretty optimistic. So I take it we should be buyers in the current market?

A: Based on what we know now, yes. But there are several indicators you should keep your eye on. For example, you want to make sure the yield curve stays steep... [and] we want to make sure gold prices don't make new lows. These are two critical indicators of stabilizing monetary policy, and if they're violated, it means that Alan Greenspan has made a terrible mistake, and all bets are off.

Q: Where would you put new money now?

A: ...If you're willing to take some risk, I believe that some of the tech stocks that have been so damaged in the last year are incredible bargains. I could name a dozen. You wouldn't go wrong with the brand-name tech stocks -- the usual suspects such as Cisco (CSCO), Oracle (ORCL), Sun (SUNW), Intel (INTC). However, I think the more interesting bet is in each category to look for the player that is the hungry No. 2. So in the case of Cisco, Juniper (JNPR). In the case of Oracle, BEA Systems (BEAS). In the case of Intel, you would look to AMD (AMD), and so on.

Q: Don, how would you describe your analytical approach?

A: For individual stocks, I want to understand the story. I want to understand the lasting competitive advantage that a company enjoys, and I want to understand exactly how they are going to make money.... The great failure of the dot-com stocks was that there were no business models, no idea of how the customer would pay these companies.

Some people say biotech stocks are today's dot-coms, but I disagree. Because I know how they will make money. They'll find a cure for cancer, they'll put it in a pill, and you'll pay heavily for that pill, and they'll protect themselves from competition by patenting that pill.

Q: What do you recommend in the energy sector?

A: When I think of energy, I think of the companies involved in the California electricity crisis. There have been significant retracements in the independent power producers such as Calpine (CPN) and Mirant (MIR). They're getting back to levels where you can feel comfortable buying them. You should also think about the alternative energy players such as Capstone Turbine (CPST).

Q: What sectors will recover first?

A: I believe the recovery has already begun, and we already know which are recovering first. In tech, semiconductors have led the way.

Q: Do you like GE (GE)?

A: I like GE very much. They've proven that you can be a New Economy company that is in Old Economy's not what you do but how you do it. For example, GE is building business-to-business marketplaces that will rationalize all their purchases and all their materials processes. When this is complete, it will slash $5 billion per year, every year, from their cost structure. Now, show me a B2B company doing that.

Q: Don, what are some of the current top picks in your funds?

A: Our largest holding is Microsoft (MSFT). And I'm sorry that answer isn't sexier. But we think Microsoft is at a very special point. We think they'll win a grand-slam victory in the appeal of their antitrust suit. And we think their X-box gaming console will be a smash hit that will get them out of the desktop ghetto and into America's living room.

Q: You mentioned that you think investors should look at the "hungry No. 2" rather than the leading tech name. What's the philosophy behind that advice? And is it true for other sectors?

A: I believe that it...should apply to all sectors. It's based on the belief that investing is about growth, and the No. 2 player generally has more room to grow.... The No. 3 player, however, while you could argue that it has even more room to grow, is subject to disproportionately more risk. Most industries can tolerate a competitive duopoly. But the No. 3 player ends up getting shut out.

Q: Besides GE, are there any classic Old Economy stocks you like these days?

A: For the same reasons that I like GE, I like Wal-Mart (WMT).... There's probably no company that has better control of its data and puts it to better use than Wal-Mart.

Q: Earlier you talked about the potential in biotech -- any names to mention here?

A: If you want a kind of poster-child stock for the new biotech generation, look at Millennium Pharmaceutical (MLNM), Human Genome Sciences (HGSI), Protein Design Labs (PDLI), and Abgenix (ABGX). If you want to look at the ones exploiting the new field of proteomics, you should look at ImClone (IMCL).

Q: How is your IPO New Era Fund doing? Are there some new IPOs that you recommend?

A: We've gone through a terrible drought with almost no quality IPOs at all. They are finally beginning to surface. Last week, the IPO of Tellium (TELM) was the first high-quality tech IPO in many months, and we were delighted to participate in it. If Tellium pulls back into the teens, I would consider picking some up.

Q: Don, what are your thoughts on gold?

A: Gold is a unique commodity. It's a global currency. Therefore, it's extremely hard to predict what it'll do.... The conventional wisdom is that gold is the enemy of the stock market. Many times over the last 25 years, when gold has performed the best, the market has performed the worst, and vice-versa. But at this moment in history, gold and the stock market are linked. The price of gold is depressed now for the same reason that stock prices are depressed. And that is because Alan Greenspan has starved the economy of the liquidity it needs, and the result has been deflation.

It is almost heretical to say this, but what this country needs now is a little inflation to undo that damage. I think that's beginning to happen. That's why gold and the Nasdaq hit their bottom in April within two days of each other. And then they hit their tops last week within two days of each other as well.

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