"Negatives Everywhere"

Author and market expert Tom Taulli is turning more defensive in his investment strategy -- but still spots some opportunities

The economy and the market are in "uncharted territory," in the words of Tom Taulli -- author, venture capitalist, and expert on mergers and initial public offerings. As a result, he expects investors to be "risk averse," and he himself has turned more defensive in his investment strategy.

"There are negatives everywhere you look," says Taulli, pointing to inflation, "massive" budget deficits, energy prices, the impact of hurricanes, a "weakened" Presidency and Congress, and higher interest rates, on top of uncertainties over the successor to Federal Reserve Chairman Alan Greenspan. However, the good news, he adds, is that Corporate America is cash-rich and very competitive.

In this situation, Taulli suggests investors would do well in short-term money. As for stocks, they should focus on large-cap names, with an emphasis on commodities and companies that will benefit from post-hurricane rebuilding efforts. Specifically, he names Exxon Mobil (XOM ). And he does see growth potential in a few smaller names, including iVillage (IVIL ), Bankrate (RATE ), and aQuantive (AQNT ).

These were a few highlights of Taulli's remarks in an investing chat presented Oct. 13 by BusinessWeek Online. He was responding to questions from Jack Dierdorff and Karyn McCormack of BW Online. Following are edited excerpts from this chat.

Tom, do you have any hope that the stock market will snap back from its doldrums?

I've actually been more negative on the market lately -- for the first time in a long time, actually. I wasn't even a teenager when inflation was big in the '70s, and I think we're going back into a time when inflation will be a problem. It looks like we'll have massive budget deficits and a lot of dislocations in the economy from the recent disasters. We also have the sustained high oil prices, and as we go into the winter, the consumer will get hit even harder on energy costs.

I think that this isn't particularly good for the equity market. There's also uncertainty on Greenspan's replacement. The Presidency has been weakened, Congress has been weakened. So there are negatives everywhere you look. The good news is that Corporate America is very strong, has a lot of cash, and is very competitive.

I think investors will be risk averse going forward because we are, in a way, in uncharted territory, due to the recent events that we've seen.

Have you made changes to your portfolio -- that is, become more defensive?

I have been more defensive. I've sold a variety of stocks over the last few months and, for the most part, have been pretty liquid in terms of money-market type of accounts. With fears of inflation starting to rise, we'll see higher rates (we're already seeing that), and being in short-term money isn't a bad place to be.

In general, what kind of stocks would you recommend for the risk-averse investor in this climate? Any specific names?

Definitely small-cap stocks would not be for the risk-averse investor. You would want to focus on big-cap stocks, but they do tend to have problems when the general market has problems. You would want to again be careful in terms of what stocks to look for.

I think that we're in a phase where we will have continued high oil prices, so it makes sense to put money in some of the major oil companies like Exxon Mobil (XOM ). These companies have defensive market positions without a lot of competition as far as new companies go, and they have strong dividends that will be paid for years to come.... I think anything in terms of commodities will do well in this environment.

We will also see the rebuilding from Katrina -- we'll see real estate companies, cement companies, and those types of companies do well as they repair a lot of the damage that occurred. In terms of what I'm looking at right now, those are the sectors that look good.

What are the small stocks that are still catching your eye?

The ones I'm looking at right now include a few in the Internet sector -- I mostly focus there. There has been a lot of merger activity in this area. News Corp. (NWS ) spent millions of dollars on acquisitions. eBay (EBAY ) bought Skype, a company with very little income, for a tremendous sum. A big part of this activity is that there's still a lot of growth in the sector, and advertising money is pouring into the online world.

Other players, like traditional media players, want to get a piece of the action, so they're willing to pay a tremendous premium for these Internet companies. There aren't a lot of the public pure-play Internet companies left -- most are the big ones like Yahoo! (YHOO ) and Google (GOOG ) or the occasional small scattered company. If some of these companies aren't bought, they'll continue to grow at a rapid rate.

I like iVillage (IVIL ). The company is a content play for women's issues, as well as health. They've been growing quickly, are profitable, and are attracting more traditional advertisers, like Pfizer (PFE ). I think they're unique, have a very strong presence in their sector, and would be an attractive buyout candidate for a traditional media company. It's only a matter of time before they're purchased.

I also like Bankrate (RATE ). They've been around for over 30 years. It got its start by publishing bank rates. When the Internet emerged, they transformed themselves into a dot-com. This was a smart move. They're heavily focused on mortgage and CD rates but brought in a new CEO with a strong background in the media world. He's someone who really understands the media world, and has done a great job of redesigning and rethinking the business at Bankrate. They've expanded into student loans, credit cards, etc.

There are a lot of traditional advertisers that like Bankrate's content, and this company will continue to grow over the next couple of years. This is certainly another good prospect for investors to take a look at.

Another stock I like is aQuantive (AQNT ). They're yet again a former dot-com high-flyer that's restructured its operations and is now starting to grow at a rapid rate. They provide a full platform for advertisers to take advantage of the online world.

If you're a Pfizer and want to target your customers through the online medium, aQuantive would do everything for you. They would create the campaign, form the Web site and track the progress, provide search-engine optimization -- it's a soup-to-nuts approach to online advertising. Companies that want to enter this world need some hand-holding and expertise, and that's what aQuantive provides.

While I'm in general negative on the market, I still can find companies with growth stories I like. I do think there are some good prospects still available to investors.

Tom, you track the IPO market closely -- what's happening there these days? Last time you were with us, you liked Baidu.com (BIDU ), the Chinese search-engine company.

Yeah, I think I wasn't the only person who liked Baidu -- it looks like it will be the hottest IPO of the year. It demonstrates that IPOs are highly volatile, and it's generally better to let IPOs get seasoned in the marketplace -- watch that first earnings report, etc. For me, there's no rush getting into an IPO. With Baidu, you would have lost money had you dropped in too quickly. I still think they're selling at too much of a premium.

What you should wait for is the lockup period to expire (which means essentially no insiders/employees can sell for six months). A bad market is actually a very good market for IPO investors. It may seem strange, but if markets are having difficulties, IPOs will have more difficulties. If it's a good company, you're getting it at a very low price. If the general markets continue to be bearish, that will give IPO investors far more opportunities to get good deals.

I see some interesting ones on the horizon. One of the more interesting companies is iRobot, which does, as the name implies, make robots. It started in 1990 with geniuses at MIT. They've gone through different iterations, with the business focused more at the consumer end.

The robots do things like mop your floors, and another one of the robots vacuums your floor. It won't vacuum the dog, or fall down the stairs -- they're very intelligent. I don't think there's any secret why they're doing their IPO right now, leading into the Christmas season. But again, if the IPO market is having difficulties, you might not get a jump on the first day, and you could get a company with excellent growth prospects (like iRobot) at an excellent price.

What do you think about the rumors surrounding AOL? The latest is Google and Comcast (CMCSA ) are trying to get a piece of it.

Yeah, the Time Warner/AOL deal back four or five years ago was lauded as a supreme example of synergy and the deal of the century -- and turned into the worst deal in recent memory. Now AOL's come back and is somehow the crown jewel of Time Warner (TWX ). That's just the nature of the field.

I think AOL is a prized asset that was neglected for a long time. Time Warner was concerned about a lot of other issues, but now they have time to devote to AOL and realize that there's a lot of growth as traditional advertisers are going online. AOL is certainly a great platform to take advantage of this, but in order to do this, it makes sense to take a partnership strategy. So why not get a Google or Comcast as not just strategic but also financial partners to give competitors a run for their money?

One way or another, AOL will do something here with a financial partner. That has been AOL's MO in the past -- they partner with other companies and leverage these relationships to get more growth and profit, so I think it's an ironic turn of events that hasn't really had a positive impact on TWX at this point. But if a deal is reached with Google or Comcast, TWX may get a boost. In terms of looking for more of a defensive stock, as we talked about earlier, Time Warner does look like an interesting play at this point.

Bank consolidations and AOL launch us into the world of mergers -- another of your areas of expertise. What's the outlook there?

In the near future, I think maybe the IPO market falls off a bit and the general market has problems, but I don't expect that to impact M&A. Companies have huge amounts of cash on their balance sheets, they're looking for ways to grow and expand, and there are a lot of midtier companies looking for exit strategies.

Venture capitalists have changed their views on things -- they're not just looking for IPOs, they're looking at getting their companies sold to bigger companies. This isn't just in certain sectors, it will be across many industries, and I think it's a long-term trend. For the most part, I think we'll see growth in M&A going forward.

What are the private equity guys doing in this market? Do you see more companies going private?

There's more private equity money than ever before, over $100 billion. Private equity money traditionally focuses on private companies -- buy one, merge it with another, then sell both, or maybe take it public. That tends to be their strategy. But you're even seeing hedge funds entering the private equity world, doing hostile takeovers -- this is all part of the trend toward M&A activity in the U.S. There's a lot of money to get deals done through private equity firms and hedge funds.

It's difficult for an individual investor to benefit from that, but there are some firms that you can buy. Apollo Investments (AINV ) is one of the more well-known. They're managed by one of the premier private equity firms, and you can buy the stock.

You can benefit from private equity very easily by investing in a company like this that has top-notch management. If you look at wealthy investors, they have some exposure to private equity, and this is something to think about when you're putting your portfolio together.

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