Lehman's Raging Bull
When Lehman Brothers Inc.'s chief U.S. investment strategist Jeffrey M. Applegate crisscrossed the country two years ago, his bold ideas about making big bets in technology stocks as the way to play the New Economy were greeted with skepticism. "Some clients just blasted Jeff," recalls Stephen D. Slifer, the firm's top U.S. economist, who often makes the client rounds with Applegate. "He was asking them to throw out everything they had learned in the last 20 to 30 years about how markets and business cycles operate. That can be difficult to swallow."
These days, Applegate, 49, is likely to be greeted with high fives. "If you followed Jeff, you would have been in the right areas of the market and avoided the areas that didn't perform well," says Mary Lisanti, chief investment officer for equities at Pilgrim mutual-fund group, which counts $12 billion in assets. Adds Peter L. Mitchelson, co-manager of the top-performing Sit Large Cap Growth Fund: "Jeff has helped us to make a lot of money."
In a market that increasingly favors New Economy stocks one day and Old Economy stocks the next, the burning question for investors is whether the Applegate formula will continue to be a moneymaker. "You bet," says the trim, boyish Applegate. Seated in his airy office overlooking the Hudson River in lower Manhattan, Applegate declares: "Technology stocks are the growth stocks of our era, period."
Applegate's views are being questioned even by bullish market gurus. Consider this, say the tech critics: In 1995, the largest 100 stocks in the tech-heavy Nasdaq Composite Index traded at an average of 23 times trailing earnings while the typical stock in the Dow Jones industrial average traded at 15 times. Today, the Nasdaq 100 trade at 161 times trailing earnings, while the Dow trades at 25 times. "Technology stocks are finally getting the respect they deserve," Goldman, Sachs & Co. investment strategist Abby Joseph Cohen recently told clients on Mar. 16. But, she added, "As such, they no longer offer the unique valuation opportunities enjoyed through much of the 1990s." On Mar. 28, Cohen also reduced her recommended stock allocation from 70% to 65%, citing the rise in stock prices.
NOSEBLEED. Indeed, tech stocks have gone so far so fast that skeptics say they have little mooring in earnings reality and that tech investing now is getting more risky. Analysts at Morgan Stanley Dean Witter, for instance, believe there's a 50% chance that Internet stocks will experience a major correction this year, with many issues dropping 25% to 50%.
For Applegate, who has urged investors to load up on tech stocks since 1993, the bigger risk is being left behind. This champion of the New Economy believes that technology is at the start of a period of unprecedented growth that could last for years, so it's crucial that investors be there big-time. It's true that price-earnings ratios are at nosebleed levels for many hot technology stocks, but such traditional measures of valuation are as useful as typewriters in the Internet era, his thinking goes. "Is the stock market riskier today than two years ago simply because prices are higher? The answer is no," Applegate says. He is telling Lehman clients that they should hold 80% of their assets in stocks and invest at least 75% of those stocks in technology and telecommunications.
Most investment strategists create broad-based portfolios of recommended stocks and sector weightings based on the Standard & Poor's 500-stock index. But Applegate has taken the unusual step of creating a recommended portfolio made up exclusively of Internet stocks. In late 1999 and earlier this year, when the tech rally seemed to defy gravity and more cautious investment gurus shook their heads in disbelief, Applegate stuck to his guns--and it paid off.
His Virtual Economy portfolio, launched on Nov. 29, has surged 66.6% since then, an impressive performance even compared with the Dow Jones Internet index's 42.1% climb in the same period. This year, Applegate figures that growth stocks will again trounce value issues--read Old Economy stocks--for the seventh year in a row.
Aside from his Virtual Economy portfolio, Applegate compiles the standard recommended portfolio of major U.S. stocks and sector weightings. But even here, in contrast to his peers, Applegate shuns broad diversification to make big bets on tech stocks, especially premier names such as America Online, Cisco Systems, IBM, Oracle, Microsoft, and Sun Microsystems, and up-and-comers like fiber-optics powerhouse JDS Uniphase. Technology stocks, plus telecommunications giants such as AT&T, Qwest Communications, and Sprint, make up a hefty 75% of the portfolio, vs. a 41% weighting in those two sectors in the S&P 500. The rest of the portfolio includes a few token Old Economy companies such as Alcoa Inc. and Warner-Lambert Co.
Applegate's tech fever is so high that most stocks in his portfolio's non-tech categories are really tech plays. On Mar. 17, for instance, he dumped his fifth-largest portfolio holding, General Electric Co., which was in the capital-goods category, and replaced it with Jabil Circuit Inc., a designer and manufacturer of electric circuit boards. Jabil and two other electronics manufacturers, Flextronics International and Solectron Corp., now make up his portfolio's capital goods category. As a result of its heavy tech slug, Applegate's portfolio has consistently beaten the S&P 500. In 1998, the portfolio, which comprises 35 stocks, gained 40%, compared with the S&P's 28.6% rise. Last year, it surged 50.6%, while the S&P was up 21%. So far in 2000, the portfolio is up 14.9%, vs. the S&P's 4% gain.
BY COMMITTEE. At other brokerage firms, the stocks on such recommended lists are sometimes picked by committee. At the very least, the equities in recommended portfolios are usually ones rated highly by the firm's analysts. When Applegate arrived at Lehman in October, 1995, after being Credit Suisse First Boston's investment strategist for two years, he says he felt stymied by the firm's policy that his stock picks be exclusively those with Lehman buy ratings. Wanting the same freedom that he had enjoyed during a nearly six-year stint as a money manager in the late 1980s and early 1990s, Applegate pushed for more control. Since August, 1997, he has been able to select stocks in the Lehman U.S. Strategy Portfolio without regard to whether Lehman analysts cover the stocks or rate them positively.
At Applegate's urging, Lehman has created investments based on his portfolios for its own trading account. Last month, Lehman also began selling the Virtual Economy portfolio as a customized investment portfolio for individuals who pony up $100,000 or more. The product is marketed through Lehman's fledgling retail brokerage business that targets the wealthy.
Applegate's money management experience--which he believes gives him an edge in his present job--was, oddly enough, at Shearson Lehman Hutton. He came to the job from Hutton, where he first worked as a political analyst in Washington before being promoted to the firm's chief investment strategist. When Hutton merged with Shearson Lehman Bros. in 1987, Applegate's position was eliminated; Shearson Lehman already had an investment strategist, Elaine M. Garzarelli. So Applegate took another job at the newly merged firm to oversee a $1.5 billion institutional portfolio. Eventually, he missed the analyst side of the Street, so he went to work as an investment strategist for Credit Suisse First Boston in 1993.
At Lehman, Applegate's reputation has been on the rise. Last year, he moved up in Institutional Investor's annual analysts' rankings, which are based on the opinions of brokerage firms' institutional clients. In the latest 1999 poll, Applegate ranked as the third-best investment strategist: Above him were Goldman's Cohen and PaineWebber Inc.'s Edward M. Kerschner. In the prior year, Applegate got his first mention in the rankings, making the runner-up list. What helped to cement his reputation was sticking to his bullish stance during the August, 1998, stock market rout triggered by the Asian crisis. Some market seers thought the crisis would lead to a recession, but Applegate, who had hiked his asset allocation in stocks from 70% to 80% the prior month, was unperturbed. His rationale: The world's central bankers would take the necessary steps to avoid disaster. His forecast was on the mark: By October, stocks rebounded as Federal Reserve Chairman Alan Greenspan eased rates.
VIRTUAL WORLD. At heart, Applegate is more policy wonk than tech guru, and his policy outlook is why he remains a raging bull. "The argument we make is that well-run government policy leads to high stock valuations," he says. His optimism demands a high degree of faith in the Fed's ability to continue "to get it right," as he puts it. He figures the Fed is likely to follow its Mar. 21 action with three more rate increases over the next few months, each a similar 25 basis points. But he doesn't believe this degree of tightening will trigger a bear market.
The Fed will not have to tighten further, Applegate says, because the dynamics of the New Economy will keep inflation in check. "The shift of economic activity from the physical world to the virtual world is the most deflationary event of our lives," he says. Take today's tight labor market, which Greenspan has pointed to as a worrisome sign of potential inflation. At the late stages of past economic expansions, low unemployment inevitably pushed up wages. But in the Internet Age, the prospect of higher salaries simply gives Corporate America one more incentive to shift labor-intensive tasks, such as purchasing, to the World Wide Web.
Applegate sees additional pluses on the policy front. The U.S. budget is running big surpluses, and the national debt is shrinking fast. Elsewhere, increasingly open trade policies are facilitating what Applegate terms a golden age for globalism.
Meanwhile, Applegate believes the productivity gains wrought by the New Economy will continue to propel stocks higher even as product prices fall. Prices of PCs, cell phones, and many other consumer goods have declined in recent years, but technological advances have enabled companies to slash overhead costs and so expand profits margins.
The average company in the S&P Industrial Index saw its profit margins jump from 4.2% in 1992 to 6.6% in 1999, a level last matched in 1966, and Applegate expects those margins to hit an all-time high of 7.7% in 2001. That kind of margin expansion should lift corporate earnings 13% to 14% in each of the next two years, while sales rise just 5% or so annually, Applegate figures. As a result, he expects the S&P 500 to reach 1675 within the next 12 months, a 10% rise from current levels.
Applegate expects the tech sector to notch better returns as the earnings of big tech stocks continue to grow twice as fast as the rest of the market. That doesn't mean there won't be any pain, however. The strategist thinks e-commerce geared to consumers will continue to suffer a shakeout, which is why the Virtual Economy portfolio avoids that area and instead focuses on infrastructure plays. And while rich p-e's don't faze Applegate, a company's lack of profits does. The 12 stocks of the 32 in the Virtual Economy portfolio that have yet to earn a dime--such as Exodus Communications and Phone.com Inc.--had to meet stringent criteria like sales growth in excess of 200% annually and gross margins of 70% or more.
Despite his success, Applegate isn't breaking out the champagne quite yet. "I learned early on that, in this field, you can be at the top of the heap one moment and out of a job the next," he says. He knows his almost euphoric predictions make him more vulnerable than other bulls.
Applegate won't be considered a world-class market seer until he accurately predicts the next downturn. But he believes that call will be a long time coming. And if past performance is any guide, that's great news for investors.
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