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Thursday, April 8, 1999

An Investment Opinion
by Dale Wettlaufer

Random Thoughts

Since I can't seem to come up with any unified theories of how the world works today, I thought I'd hit you with some random thoughts on a couple topics.

1. Cable modems and xDSL

It's easy to see that xDSL is a superior choice to cable modems, based on technical merits. The shared bandwidth architecture of cable modems decreases the value of the network as each additional subscriber is added to the loop. This is a reverse network effect, which is a very bad circumstance. Metcalfe's Law describes a positive network effect: A network's value increases by the square of the number of terminals attached to it.

Cable modems follow a bizzaro world variant of Metcalfe's Law: Each additional terminal attached to the network reduces the value of the network because each additional user reduces the average bandwidth per user. That's not made up by the additional resources each user brings to the local network, either. With negative network effects working against it, switching costs are not as high as they could be. Users will flow to another distribution medium, such as xDSL, that can deliver more utility for the same price. Put together with the fact that at present the potential reaches of DSL and cable modems are not all that different and there's no compelling argument as to why cable modems are technically a superior solution to xDSL

If I had to come up with a valuation on cable network access providers, I would take the following into account: The bizarro network effect, the lack of other technologically compelling attributes, the significant probability that regional Bell operating companies (RBOC) won't always be sleeping giants, and the forces of deregulation on RBOC assets.

2. A very good fund manager recently made a good point about the S&P 500. I believe I've mentioned the point before, but it bears repeating. The S&P 500 is not a passive market index. A passive index of the broad market is the Wilshire 5000 or maybe the Value Line composite. The S&P 500 is a low-turnover buy-and-hold portfolio that is focused in a relative few companies that have world-beating economic characteristics.

"Value" managers that dogmatically sell things when they are thought to be too expensive and cycle into beaten-down stocks, a process that I think of more as asset arbitrage and a modified greater fool's game, are not going to have a chance of beating the index if they constantly re-balance their winners and cycle into stocks that look statistically cheap. The quality of decisions is almost always going to suffer in some inverse proportion to the number of decisions a portfolio manager makes.

3. Speaking of statistically cheap things, the large Charlotte banks don't excite me as much as they used to. Not that they don't have the makings of good companies, but they constantly shoot themselves in the foot with poor retail service. I know of no companies that are as universally loathed because of their poor customer service as these. Of course, you have to put that into context. AOL had huge service problems in 1996. But that was a fairly unique and fast-growing company at the time. You can switch banks. For this reason alone, I would pay more for Wells Fargo (NYSE: WFC) or U.S. Bancorp (NYSE: USB), all else being equal, because of the customer service competition fostered between the former Norwest and First Bank.

U.S. Bank, which First Bank acquired with the successor company assuming that name, was a great customer service-oriented company on its own. You don't even have to worry about converting low-touch to high-service as you do with Wells Fargo. Even then, I think the Norwest philosophy and the retail thinking of CEO Richard Kovacevich are going to do great things for Wells Fargo. Just as the Charlotte banks grew within a certain milieu, that being the regional banking compacts that protected them from larger interstate acquirers from outside their territory, I think the competitive customer service environment in the upper Midwest shaped Norwest and First Bank Systems, now Wells Fargo and U.S. Bancorp. Given that these are still retail customer service organizations, you have to give some regard to these companies, especially U.S. Bancorp, which provides the good retail experience with ridiculously low overhead and great net interest margins.

4. Hershey (NYSE: HSY) near $50 looks a lot more interesting than when it was hanging around $60. Still, though, when you annuitize its current earnings at an equity rate of return, the extra you pay for assumed growth opportunities is large. Hershey is not Coke (NYSE: KO). Its taste is not loved around the world. Some people hate it. And confections in this country is not a fast-growth business, though a company can, of course, outgrow the industry when it can come up with a number of hits. Just because some of the huge consumer brand name companies are near their lows doesn't automatically make them cheap. At their lows, you still need to test your assumptions about the price you're paying for prospective returns. I personally believe companies like Coke or Hershey are priced like 5-year government bonds, the market is so sure of their staying power and blue chip status. Not that Coca-Cola can't outperform over a long period of time -- its economics are superb. But over ten years, it'll be a stretch for the company to outperform the S&P 500.

5. What's with the same-store sales data for March? The economy is doing well, sure, but those are big numbers. I think one of the reasons is that Easter fell early this year, pulling some planned purchasing activity into March. Here's the data from last year and from this year that may help your thinking on that.

That's it. Have a good Thursday evening.

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