Inside Technology: JM Dutton's Aaron Lehmann

As a securities analyst specializing in technology, it doesn't hurt to have both the academic background (undergraduate degrees in Math and Physics, and Master's degrees in Theoretical Physics and Operations Research) along with professional experience as a practicing physicist/engineer for companies like Raytheon, Control Data and IBM. Add to that an MBA, followed by more than 34 years experience as a securities analyst, portfolio manager, director of investment research, and a consultant to emerging growth companies, and you begin to get your arms around the resume of Aaron Lehmann. JM Dutton & Associates' senior analyst specializing in technology, Lehmann, was previously employed at The Bank of America, Goldman Sachs (where he was elected to the Institutional All Star Team in 1973), The Hartford Insurance Group, Westinghouse Investment Pension Corporation, Chase Investors Management Corp., Steinhardt Partners, and several other organizations.

How did you become involved and interested in technology?

My educational background included a bachelor's degree in physics and math from Rutgers University in 1961 and a Master's degrees in Theoretical Physics from Yeshiva University in 1963 and Operations Research in 1967 from New York University. I also attended MIT graduate school in naval architecture and operations research to supplement my knowledge in the areas I was working in at that time. I later earned an MBA in finance to round out my investment research education.

I started my professional career as an electrical engineer at various companies including Raytheon, Sylvania Electric, IBM, Control Data and fundamental research of materials at UniRoyal. I worked on radar systems, anti-submarine war systems, cryogenic materials research, laser systems, communications systems, and a variety of other interesting things, such as information retrieval technology when I was at IBM, which was the forerunner of the Internet. So with my diversified background in technology, I began my investment career as an analyst with an emphasis in the technology area.

What areas in technology did you focus on?

I began my career in 1969 at the Bank of America in San Francisco as a Senior Research Analyst covering technology. I was responsible for all areas of technology, which included electronics area, computers area, software companies, office equipment companies, aerospace and a number of conglomerates. Most aerospace companies had become conglomerates and it was actually this area which strengthened my researching abilities, since most conglomerates consisted of many entities, and were non-technology in nature. I had to learn a lot of those industries, in depth, very quickly in order to properly analyze the respective business fundamentals and the financials of those operations.

You became an Institutional All Star early in your career. How did that come about?

My reputation was made first for recommending selling stocks rather than buying, which is almost unheard of in the institutional world. When I joined Bank of America, I recommended selling every single technology stock that we owned; the majority of them declined by at least 50 percent, with some as much as 80 percent. I really established my credibility when, eight months later, I reversed my sells into buys and recommended some of those very same names on the long side, including Hewlett-Packard, National Semiconductor, Texas Instruments, Motorola, and IBM--about 18 companies altogether. The stellar performance of my recommendations put me on the Bank of America map and my reputation was known to the vice-chairman of the B of A, which led me doing some corporate banking work. At the same time I gained the recognition of a lot of investment firms because I went against the grain both times in a very short time--first on the sell side and then on the buy side--and was right in both cases.

A few years later at Goldman Sachs, I wrote a position paper on the aerospace industry. The 70-page document that I wrote was considered to be too long and the Director of Research had me reduce it to 15 pages. However, many of the industry executives that I had sent it to thought that it was fantastic. In fact, Dr. Henry Singleton from Teledyne, who was one of the true geniuses of the conglomerate period, and perhaps the most successful one at that, asked if he could send a copy of my report to every congressman and senator in the United States because they needed to be educated on the workings and condition of the Defense industry. Goldman also allowed me to send draft copies, without the Goldman Sachs endorsement, to those clients who requested it and needed a more in-depth analysis. So the draft report got much more mileage then the actual report that Goldman let me publish. The final report had about a dozen recommendations, many of them subsequently appreciating between 5 and 100 times from their recommended price. That led to my being elected in my second year at Goldman, in 1973, to the Institutional All-Star Team in the aerospace sector.

What enables you to find these companies and be able to evaluate and value companies as well as you have?

In brief, I do a tops-down analysis rather than a bottoms-up analysis. A bottoms-up analysis really confines one to initially picking companies before having any insight into the macro factors. I'd rather find companies from the top down by getting an overall picture from an economic, demographic, and geopolitical perspective before making investment judgments. Economics, of course, is an overriding factor, and I look at various projections by economists and form my own view on what I read, since most market projections tend to be wrong most of the time.

As an example, assuming that there's a trend towards the elderly because of living longer and so forth, I might want to examine this trend and see what companies sell to that market--the health care area, pharmaceuticals, generics, the rehabilitation area, assisted living, nursing homes, etc. Then I would find the best companies, and why they are considered the best companies and determine the validity of the data, trying to understand the accounting and all the other information that is contained in company documents. What we've seen in the last two years with the Enrons of the world is nothing new, by any means. It's been going on forever. It's just a question of how you find out about it. The way I find out about the fundamentals is to see if a company's growth rate is at 15 percent, and the industry is growing at only 3-5 percent, something is wrong somewhere. What is the company doing so dramatically different that allows them to grow at 4 or 5 times the industry growth? If you're miles apart from the rest of the industry, something is going on that doesn't necessarily agree with normality. So I then look carefully for anomalies within that area that will enable me to make the correct decision about that company.

Do you look at other research?

If there's a lot of coverage, I like to see what the Street has to say, not that I necessarily believe what the Street has to say. I like to see what these people are saying after I've done my initial analysis. More often then not, I don't necessarily go with the consensus view but come up with my own view, which is often significantly different from the Street. That's after I've done the appropriate due diligence and analysis on the industry and of course on the micro level of the company. I examine the public documents and interview management in order to understand where they have been and more importantly where they think they're headed. I like to understand how they expect to outgrow the industry and what they're doing that's so different. There are rare occasions when that can certainly happen, and again I look for red flags. Assuming there are no obvious red flags or missteps here, then I go to the next step and come up with an estimate and a valuation. How does this company compare with its peer group? How does this compare with the overall market? Was it justified that dot.com companies sold at the multiples of revenues that they did? In the end, obviously, it was not. So I stayed away from them. In 1973-74, conglomerates were selling at 20-50 times earnings, although their earnings growth was not substantially better than the S&P 500 companies. [Was this justified?] The clear answer was no and the subsequent decline to the norm created numerous buying opportunities in 1974. Consequently, using my approach I have been able to identify may successful ideas over a period of years by being willing to be different from the consensus.

Is there a way you approach technology companies that's different than you would other companies?

There are three essential ingredients that are common to every company, whether it's technology or non-technology, and that is what I call my three M's: money, marketing, and management. Every company you deal with has to have the money to finance what it does, the management to make sure that it comes about, and it has to be able to market -- sell -- that product to the marketplace. If they don't have those three components, just walk away.

In technology, you have a fourth ingredient, which is crucial: the ability of a company to be able to reinvent itself every so often so it may move ahead of the curve in technology; this requires a lot of effort and spending on research and development. If you become a "me-too" company, that's okay, provided that me-too company is cheap enough in the valuation scheme of things and that has the resources to survive. If the company is in a service business it may be able to operate successfully. The service side includes many IT companies that engaged as problem solvers and don't need to be on the leading edge. They allow IBM, Dell, Sun Microsystems, Cisco or others to come up with the hardware for them to solve their problems. However, if a company is in an innovative field like in the semiconductor area or equipment area, or the computer field, it has to be able to be one step ahead of the curve in order to compete with the other companies in its industry sector.

So I look for a company that has those three M's. I look for a company that has the technology that can stay on the forefront with competitors, or alongside competitors at the very least. Price is also a major determining factor in any investment. Believe it or not, we saw this recently in another industry, the airlines, when American Airlines was able to settle with the unions, avoiding bankruptcy--the stock nearly tripled. So there is a price where you buy a stock, and you have to be able to assess whether that price is the correct price, given the company's position fundamentally. A technology company is no different and must, in fact, be on the leading edge or, if on the service side, be able to compete.

When you talk about price, I would imagine there are a lot of companies that are getting close to the right price in technology.

Let's put it this way--many of these companies both large and small have cut back their employee levels drastically, some by as much as 40 percent. The revenues have gone down by almost as much or more. So the issue really now is where is the recovery coming from? And are they still the same companies that they were, in terms of their ability to compete in the future? Markets change. If you go back into the 1950s, the telephone industry was hot. AT&T was a hot stock. Of course we know what happened to AT&T in the ensuing years--it became a cold stock. So, who says that Dell, Cisco, or Broadcom, etc., needs to be the company of the future? They have to reinvent themselves.

3M is a classic company that reinvents itself every few years. They come up with a host of new products, which is a major reason for the company being one of the finest companies in America. They give responsibilities over to their line managers, appoint many vice presidents, and have excellent short- and long-range planning, so they know where they are going. Unless you know where you're going, how do you get there? There are many wonderful companies that looked like they would never decline during the bull market of the 1990s but have since seen their business slow down precipitously and haven't come up with new products or solutions to problems, and have fallen by the wayside. So you really have to take a micro look at each company, and each industry to determine what's going on and likely to happen.

You take a look at Lucent, Nortel or Ericsson, whose stocks were 10-20 or even 40 times higher (in the case of Lucent, the stock went from the $70s to the low single digits): These companies may never come back on the grand scale that they had before because their industry changed. We went from undercapacity to overcapacity in the telecommunications field. So it will be quite a while before Corning Glass and the other companies in that space turn around. Even so, Corning's stock already has quadrupled off of its bottom. I'd argue that the multiples of the technology stocks are still extremely high. The people who are projecting all kinds of growth in earnings are smoking something strong. Earnings may grow handsomely from their depressed levels, but the multiples are still too high relative to the kind of numbers that some of these people are projecting. What will happen, I believe, is that those companies that can rise to the surface will get premium multiples because they're the dominant players in their group, and an investor will make a ton of money in technology stocks if one selects a basket of these companies that not only have the ability to survive but will thrive because of the measures they took during the lean times. Over the next two years, I think a properly selected portfolio in technology stocks should be up no less than 50 percent and some cases well over 100 percent.

Looking at your top-down analysis, where would you be focusing your investing or your research right now?

We are now in a time that is extremely difficult to assess. We have very high corporate, personal, federal, state, and local debt levels, extremely high spending requirements to fund the military efforts and the rebuilding of Iraq, a weaker US dollar, record level trade deficits, shrinking demand, low consumer confidence, and a high unemployment rate. Many states are in dire straits and don't have the taxing capacity of the federal government. At the same time, we're looking to have a tax cut, which on some level is positive but may not be the best thing right now. Although, I'm very much in favor of tax cuts, because I think they create stimulus, I think it has to be in the right areas. Offsetting these negatives are: historically low interest rates, low investor expectations, and about $7 trillion of cash on the sidelines.

If you're looking to see what looks promising based on a top-down analysis in technology, I would look for companies where there's going to be a rejuvenation of the cycle. Operating capacities are at a very low rate and many companies have no reason yet to enhance capacity, but I do think selected semiconductor equipment companies could be in a good position, as the next generation of semiconductor problems will require new equipment. I think a company like Intel at some price could be very interesting. Intel has emerged as a stronger company than before the decline that started in 2000. Texas Instruments could be interesting. Motorola is at a price level which may make it quite attractive; however, it operates in industries which have serious problems that they have to overcome. IBM is not cheap right now; it had to redefine itself. Today, it must rely on its services business as the engine for growth, as opposed to being just a mainframe or a server company. The services business and consulting business has taken on a new dimension at IBM, and it is very crucial that IBM emerges and defines itself as to where it's going. It has cut back as far as it can, because right now they're down to bare bones and appear to be operating efficiently. The major issue, as we see it, is can IBM show significant overall top line growth and what is the P/E for the stock.

Of the smaller companies, I'd like to stick with some of the leaders. There's controversy over whether Sun Microsystems will be able to compete in the next generation. There are people who say no, but I would say that there's a good chance, 70/30, that they will emerge in a different form as an interesting and successful company. I think Cisco is a survivor and will probably thrive, but the question is at what level does one make a commitment. There are many small companies that most people haven't heard of that I think are going to be interesting stocks. Many have niche markets. I think it's important to find where you want to be as an investor. Take a look at the IT service companies like EDS, which has undergone tremendous hardship. At some point in time, EDS and a host of other service companies could be interesting and be successful because a lot of companies don't want to do it themselves and outsourcing eliminates a lot of fixed costs for them, like benefits packages, which kill a lot of companies. Companies like Flextronics could be interesting on the manufacturing side. There are a host of companies that are potentially interesting.