A Foolish Review of HOLDRs[Fool on the Hill] February 2, 2000

An Investment Opinion

A Foolish Review of HOLDRs

By Bill Mann (TMF Otter)
February 2, 2000

Do you think telecom is the future? How about biotech?

One of the big challenges for individual investors is to determine just which company or companies within a sector are going to come out on top. But a rising tide raises all ships, and in some industries it would be quite nice for investors to be able to buy a fixed list of the top companies.

Enter Holding Company Depositary Receipts, or HOLDRs, a new form of financial product offered by Merrill Lynch (NYSE: MER). Merrill first launched a HOLDR product in June of 1998, when it offered a way for investors to purchase in a single transaction the 12 companies resulting from the breakup of Telebras (NYSE: TBH), the former monopoly telecommunications provider in Brazil. Since then, Merrill has offered four additional HOLDRs, Internet (Amex: HHH), Biotech (Amex: BBH); and yesterday two additional ones began trading, Telecommunications (Amex: TTH) and Pharmaceuticals (Amex: PPH).

To date, more than $3.5 billion has been invested using these four products, which means that Merrill has hit a nerve with investors. Looks like there's some hunt left in that old dog after all.

The question is, are these something that the Foolish investor should be interested in? There's certainly a lot to like about them, and also some inherent flaws that one needs to consider very carefully.

So What Are They?

Each HOLDR is a fixed basket of 20 stocks (except the Telebras HOLDR, which holds 12 companies). They work operate much like American Depositary Receipts (ADRs), which allow U.S. investors to purchase foreign-owned companies on the U.S. exchanges in dollar-denominated amounts. In just the same way, the HOLDR holder (sorry, I couldn't resist), actually owns the shares of each underlying company, receives dividends, proxies, and annual reports from each. The HOLDRs are not managed, and once the companies and amounts have been determined they are fixed, no companies will be substituted.

In this way, the HOLDRs differ somewhat from Spiders (SPDRs, or Standard & Poor Depositary Receipts, which trade on the Amex under the ticker SPY) and other Exchange Traded Funds, which will add and delete stocks, usually in conjunction with an index that they are tracking.

Buying and Trading HOLDRs

The real benefit for HOLDRs lie in their low cost and versatility. The purchasers of HOLDRs pay no management or maintenance fees, nor any sales loads, two of the major knocks against actively managed mutual funds. HOLDRs trade just like stocks, with valuations that fluctuate throughout the trading day. To buy them, investors place an order with their brokers just as they would any other stock. The only other expense associated with HOLDRs is a $0.02 per share quarterly custody charge paid to Merrill Lynch for holding the shares, any portion of which not covered by dividends is waived. This comes out to be a significant savings from buying each company separately, as buying the same series of stocks even from a deep discount broker would cost $200-300 on average.

These products will likely serve as a shot across the bow of the industry specific mutual funds with their hefty annual fees and loads. But there are some limitations on HOLDRs. First and foremost is the minimum purchase requirement. HOLDRs can only be purchased in 100 share "round lots," which means that, for example, the minimum investment level for the Telecommunications HOLDR is currently $8,600, a 100-share purchase of the Internet HOLDR would be in excess of $15,000. The reason for this limitation is due to the composition of the baskets themselves. For example, with the Telecommunications basket, for each 100 HOLDR shares the investor holds 27 shares of SBC Communications (NYSE: SBC), 25 shares of AT&T (NYSE: T), on down to 1 share of Broadwing (NYSE: BRW-B). There are no fractional shares.

One feature of the HOLDRs is called "Redemption in Kind." For a fee of $10 per 100 shares, Merrill Lynch will exchange the HOLDR for the shares in the underlying companies. And because the shares were already held in trust, this transaction would be tax-free for the investor.

So what's not to like? Well, a few things stand out. First is the significant lack of diversification within each HOLDR. Of course, a product that is supposed to hold telecommunications companies should in fact be comprised of -- big surprise -- telecommunications companies, but this product will do little to protect the investor should the entire sector get clobbered. Although we Fools do not put too much faith in spreading our money too thin between investments, some balance among industries and sectors is in fact prudent.

I point this out specifically because the industries that Merrill has chosen to feature really are the flavors du jour in investing, ones that have been granted some very generous multiples. These highly competitive industries are going to have some successes and some failures. Some biotech companies are going to go down in flames, and some newer entrants are going to set the world on end. What you have in the HOLDRs currently is a representative list of companies circa 1999. The farther out we move from that date, the less representative this basket will be.

Also, as a few corporate actions in the Internet industry have shown, the baskets consist of a constant list of companies in a fluid corporate environment. Already, since September of last year two of the basket companies, Mindspring (Nasdaq: MSPG) and EarthLink (Nasdaq: ELNK) have agreed to merge. If they do so, the number of companies in the basket will be reduced to 19. And what happens when AOL (NYSE: AOL) merges with TimeWarner (NYSE: TWX)? Will it look like an Internet company at all? Merrill has already conceded that should AOL TimeWarner look more like a media company, it may also need to be removed from the HOLDR. In telecom already, of the 20 companies, 6 (USWest/Qwest, BellAtlantic/GTE, MCIWorldCom/Sprint) are merging. Since no additional companies can be added, how fast do these HOLDRs become irrelevant, or at least unrepresentative?

But in the end, I find these products to be an intriguing way to invest in some growth industries. I'm just not sure that they provide the margin of safety for the disinterested investor that an S&P 500 Index fund or a Spider would.

Fool on!

Bill Mann

By the way, in case you haven't noticed, it's Tax time! Check out the Foolish advice in our newly updated Tax Section.

Related links:
Merrill Lynch Press Release on Telecom and Pharmaceutical HOLDRs
Merrill Lynch Press Release on Biotech HOLDR
Merrill Lynch Press Release on Internet HOLDR