Morningstar Advisor - Fall 2008 - 51

big-cap bank index took off. It was up 47% right there in 1991 and almost 100% within 18 months. The news was horrible in 1991. The news was even worse in 1992. Charge-offs and delinquencies and capital raises were still extended in 1992, but the market took off. As you well know, Kunal, being a student of markets, is that when you get a bull market recovery coming out of a bear market, it’s the first few months that could be two thirds of the advance of the market. So we’re really trying to position the portfolio today for our payoff 12 to 24 months from now. Is that the right call for this quarter, next quarter? I have no idea, but I do have a strong sense that we’ve got the portfolio right for the payoff in the next 12 to 24 months. Do we have it right? That question is all that I need to worry about. KK: I have to ask you about Yahoo YHOO. You a third of the position at that time because it went through 10% of the portfolio, which is where we typically back a stock down. We thought $31 was an attractive price, but we didn’t think it gave us full value for our shares. If it all worked out well and [Yahoo CEO] Jerry [Yang] nailed this thing and the search improved and he could stop losing position to Google GOOG, we thought the stock was a $40 stock. That’s the reason why we bet it the way we did. But we also thought, even if it doesn’t do well, margins would improve because they quit spending money and it really just becomes a cash-flow generator. We thought that was a $35, $36 number. At $31, we thought, “Yeah, that’s interesting, but if you really want us to take the bird in hand now, then it’s got to be $35, $36, and we’ll give up the $40.” KK: I hear you on that, but why not take the bid at a time when the market’s down and reinvest it into other ideas where the potential payoff was high? RH: We did take a third of the position of the portfolio off, but we still thought even at $30—maybe we played the hand too long, but I thought that Microsoft needed Yahoo more than Yahoo needed Microsoft. If Microsoft had any chance of being a player in this space, particularly how I think desktop software is going to work years from now, they needed to go to an advertising-based model. The only way you can go to an advertising-based model is you better have a lot of eyeballs falling through there, and when you look at the Microsoft Internet space versus the Yahoo Internet space, it was like, this is a no-brainer. Now, I like the point you raised. We owned Amazon AMZN. Go back to 2006, and it’d gone through a two- to three-year period of big technology and content spending. Margins were down, everybody’s kind of depressed about Amazon. Everybody’s saying that the only reason why they can sell new products is that they keep cutting prices, blah, blah, blah. It’s the No. 1 position in the portfolio at the end of 2006 as a $25 stock. In 2007, it’s up 175%, and it was the reason why we beat the market last year. A big win for us. I thought to myself, “Well, what would you have done if Amazon was $25 and Wal-Mart WMT offered to buy it at $42. Would you have taken it?” Had I taken it, I would have left a lot of money on the table. If you really thought about what Amazon was going to be able to accomplish on the other side of its technology and content spend, that was worth a lot more. If you had offered me 60% on Amazon at the end of 2006 and I had accepted it, that would have been the wrong decision to make. In many ways, we thought about Yahoo and Amazon as being similar. If a big technology and content spend works, it’s going to be worth a lot more. If it doesn’t work, it will still be worth more because the margins are going to get higher. KK: Do you think Microsoft will come back voted against Carl Icahn in his proxy fight against management. The result of that was the takeover bid by Microsoft MSFT. Discuss your view of Yahoo. Is it a growth company? RH: I do think it’s a growth company. The way in which I think about growth is that if you can grow at least 10% in sales, earnings, or cash flows over a three- to five-year forecast period then you qualify as a growth stock for me. Yahoo definitely can do that. Even at its most pessimistic scenarios, it’s going to grow cash flow at a double-digit rate. The question is, is it going to grow 10%, 11%, or 12%, or is it going to grow at 18%, 20%, and 25%. If everything works well, it’s a high teens, low-20% grower. If it doesn’t work out well, I still think you can go up to 11%, 12%, and that’s what the market’s wrestling with right now. for Yahoo? RH: Yes. I can’t imagine how Microsoft can get this done without Yahoo. Think about Microsoft’s revenues and earnings that come from selling software. Let’s just talk about desktop. The day Google gave that away for free I imagine Gates and Ballmer fainted in Seattle, because that’s a lot of their business that you’re giving away for free. Yahoo has been an incredible roller-coaster ride. It was the largest position in the portfolio at the end of last year, when nobody liked Yahoo. They were going to go through a big technology and content spend. I think the stock was at $21, $22. The stock dropped to $19 after the fourth quarter, and then Steve Ballmer made the bid and the stock went to the high $20s. It didn’t quite cross the $31 bid. We sold If we consummate the deal, Microsoft would be No. 2 in global search with almost 30% global share, No. 1 in ad display, and No. 2 and No. 3 in video. I thought that this is just too good for them not to do it. And obviously, egos got involved. There’s a lot of issues there and the deal ultimately came apart, but to this day, I still say that Microsoft needs Yahoo more than Yahoo needs Microsoft. The writing is on the wall for a lot of software: It’s going to be given away, if not for free then at much lower prices and subsidized by advertising dollars. If you believe that, then Microsoft has a lot more economic risk than Yahoo does. Remember, Yahoo has 400 million registered users. There’s about 200 million MorningstarAdvisor.com 51

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Morningstar Advisor - Fall 2008

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