A TOP PRO LOOKS AHEAD THE FORMER CHIEF STRATEGIST AT GOLDMAN SACHS TALKS ABOUT HIS VALUE APPROACH, HIS FAVORITE STOCKS, AND THE BULL'S PROSPECTS.
By LAWRENCE A. ARMOUR; LEON COOPERMAN

(FORTUNE Magazine) – LEON G. COOPERMAN Chairman, Omega Advisors, a $2.4 billion hedge fund Age: 53

Leon Cooperman's waistline is a dead giveaway. He's relatively trim at the moment, which I assume means that he's long Microsoft, Intel, Cisco, and a few other highflying tech companies. "No way," says Cooperman. "Not our style. We're a value-oriented, research-driven firm that buys undervalued stocks, shorts overvalued ones, and participates in selected overseas debt and equity markets. May not be an exciting approach, but it works. We're up 26.4% this year."

We're in front of a Home Depot in northern New Jersey. It's Saturday. I'm buying lumber for a fourth-grade science project I'm working on with my granddaughter Sara. What brings you to these parts? I ask Lee.

"Economics. My building charges $30 to change a light bulb. I can buy bulbs here for $3 and install them myself. Also, I used to own the stock. You know me. I like to kick the tires whenever I get a chance."

I know Lee best from the 1980s when he was the Goldman Sachs partner the press turned to when we needed a reality check on the market. I also know that Lee grew up in the South Bronx and that Goldman partners make big bucks, so I was surprised when he jumped ship in 1991, raised $450 million, and set up a hedge fund.

I always wondered why. I also always wanted to ask a hedge fund manager some loaded questions, so I suggested a cup of coffee at a nearby diner and let fly.

Lee, if a guy can get professional management from a mutual fund that charges 1%, why would he go to a hedge fund that's going to skim 15% to 20% off the top?

I'm not sure I like your choice of words, but the answer--once again--is economics. People will pay a premium price if you give them premium performance. If the stock market's low, my investors assume I'll figure out an appropriate way to amplify our returns when it rallies. If it's high, they assume I'll insulate our portfolio against a possible decline. And if the U.S. markets are uninteresting, they know there will be interesting things going on in other parts of the world and we'll be smart enough to find them.

You're not saying Omega has a monopoly on smarts, are you?

No. What I'm saying is that we are fundamentally oriented, do our own research, and stay flexible. Most conventional money managers just buy stocks. Over the course of our five-year history, we've been long, we've been short. We've done U.S. equities, foreign equities, U.S. bonds, foreign bonds, junk bonds, and emerging-market debt. We've dealt in foreign exchange, not only in major markets like Japan, Germany, and Switzerland but also in emerging markets. And we've taken modest positions in a variety of commodities.

This kind of flexibility gives us an edge. Most portfolio studies I've seen conclude that being in the right class of asset over any one-year time frame is more important than individual stock selection.

So how have you done?

Net of all fees, we were up more than 19% in 1992, vs. roughly an 8% rise in the S&P 500. The market was up 10% the next year. We did 66%. Then we got clobbered. We overstayed our welcome in foreign bonds in 1994 and fell 24%.

Rumor has it your weight went off the charts that year too.

True. This is a stressful business. But we bounced back about 27% in 1995. We're up about 26% this year, which compares with a 13% gain for the S&P. With the exception of 1994, we've delivered. Net of all fees, we've beaten the market by more than 50% since our inception.

What's your take on the current market?

We're about 60% long equities, which is a fairly conservative posture. We think it's late in the game. A lot of what worked for the market last year is no longer present, and some criteria associated with tops have already occurred.

I assume one of the drivers you're referring to is interest rates.

Right. The long bond yield dropped from nearly 8% at the beginning of 1995 to about 6% at the end of the year. Thus far in 1996 it's gone the other way, from 6% to 7%. The market typically tops out about a year after interest rates bottom.

Equities were also helped last year by a big increase--better than 20%--in corporate profits. Profits are more spotty this year. They'll be up 5% to 10% at best. The business cycle is aging, and corporate profit margins and profitability are in the process of peaking.

The political environment has undergone a significant change. No one is talking about the Contract with America or reductions in the capital gains tax anymore. Today's focus is on the size of executive compensation packages, corporate layoffs, the decline in real worker income, gas taxes, the minimum wage, and other little-man economics. And more often than not, the first year after a presidential election has been difficult for the market.

Lastly, we're seeing technical signs that the bull market is growing long in the tooth: the surge in IPOs back in May, the huge explosion in over-the-counter volume relative to the New York Stock Exchange, and the enormous amount of money that has poured into mutual funds. When you realize that the funds have taken in more in the last 32 years than they did in the entire preceding 50, it's reason to take a hard look at where we are.

If that's your thinking, why is Omega even 60% in equities?

One, we could be wrong, so we always hedge our bets. Two, stocks are heterogeneous, not homogeneous, which means that stocks with superior earnings prospects that are selling at a discount to the market's multiple have an opportunity to outperform the market. Three, we're equity-oriented. Our bread-and-butter business is finding undervalued stocks. It's becoming increasingly difficult, but you can find them if you look hard.

Even with the market at these levels?

Absolutely. I was in Pittsburgh yesterday visiting General Nutrition Cos., which we're convinced is a very undervalued security. We're willing to wait for the market to vindicate our view.

Sounds like you got bagged.

Not at all. The stock's at $17. Our cost is around $142. GNC is a very profitable, fast-growing company that sells vitamins, dietary supplements, herbs, and other types of nonprescription health medications. It's a great business that plays to today's concerns about health and the aging of the population.

GNC has about 2,600 company-owned and franchised locations. We expect its U.S. base to expand to about 4,000 in the next few years, and there is plenty of room for overseas expansion. One of the powerful things about GNC is the economics of its franchisees. Between the wages an owner/operator takes out of an outlet and the financial return on investment, franchisees have a shot at an annual return in excess of 75%. Which explains why there's a backlog of people wanting to open stores.

If Adam Smith were here, wouldn't he be pointing out that returns like that attract competitors?

Sure, but it would be hard for anyone to duplicate GNC's market position. It's the only national retailer dedicated to selling vitamins and nutritional supplements, and it has a tremendous manufacturing capability. A substantial portion of sales comes from self-manufactured products, which accounts in part for its high operating margins.

Didn't the stock take a big hit recently?

Yes. The newspapers carried stories a few months back about side effects of ephedrine, a high-performance additive in some of GNC's herbal supplements. A couple of states banned it. This had a negative impact on sales and earnings, and almost overnight the stock dropped from the 20s into the low teens. We established our position at that point. We had been studying the company, liked what we saw, and felt that the market overreacted.

We like it even more today. GNC is reformulating its herbal products, and sales are beginning to perform better. The multiple probably won't get back to the 30 to 40 level, but we could see it in the 20s. A 20 multiple on the $1.20 a share in earnings we envision for 1997 would put the stock at $24.

So you see this as a classic earnings-multiple play?

Plus a play on surplus cash flow, which is a beautiful thing to behold. It gives a company the fodder it needs to raise dividends, repurchase stock, and do other things that benefit shareholders. Three months ago when GNC took that hit, the company repurchased 7.6 million shares at an average of $16 a share. Given its balance sheet, cash flow, and owner-oriented management, I wouldn't be surprised to see more buying on any future weakness.

What about IBM, my ex-employer, which is a big buyer of its own stock?

It's one of the things we like most about IBM, which is essentially a cash-flow machine. IBM generates $4 billion to $5 billion of free cash a year. Last year it used part of it to buy back about 8% of its stock, and it's continuing on the same path this year. Gerstner obviously thinks the stock is cheap. If I were Gerstner, I sure wouldn't want to engage in a transaction that made me look foolish.

With its name and dominance of so much of the computer business, why does IBM sell at such a low multiple?

People are generally negative on hardware. Conventional wisdom maintains that the power has moved from the mainframe to the desktop and that IBM's so-called heavy iron is a thing of the past. I always have a hard time with conventional wisdom. More important, IBM leads the industry in large-scale Internet products, and it has an attractive, high-growth services business that's benefiting from the complexity of the large systems it and others sell. Customers need increasing amounts of help designing, installing, and managing their IS infrastructure, and IBM is getting more and more of the business.

What are your numbers on IBM?

If you assume continued stock repurchases in the 5%-a-year range, revenue growth of 9% a year, and after-tax profits of about 7%, you're talking per share earnings of $11.50 this year, $13 next year, and $14.75 in 1998. That kind of growth should support at least a market multiple. If it doesn't, I wouldn't be surprised if somewhere down the road the company made it easier for the Street to analyze, and disaggregated itself into three or four stand-alone vehicles. On a sum-of-the-parts basis, IBM looks to be significantly undervalued.

Do you own a lot of IBM?

At 4%, it's our second-largest holding.

What's your first?

W.R. Grace, also at 4%.

That's a surprise. How come?

Grace falls into our event-driven category. In September, Grace and Fresenius USA merged their kidney dialysis businesses into a new company called Fresenius Medical Care. Grace stockholders wound up with 44.8% of the new company, $2.3 billion in fresh cash, and their old plastic packaging and specialty chemical businesses.

Is that good or bad?

Very good. Grace's principal business is now Cryovac packaging, which involves encapsulating meat and other food products in plastic wrap. The company installs its packaging machines in food-processing plants and supplies the plastic. This is an attractive business that has had 20 years of uninterrupted sales growth. Grace's margins have trailed its competitors', however, and we see potential improvements in the SG&A line turning annual 8% to 10% revenue growth into 20% to 25% earnings growth through the end of the decade.

That's part of the story. While Grace management is working to get operating margins up to industry levels, it's our hunch that one or two other packaging/chemical companies are convinced they can do a better job. Hercules was interested in acquiring the Cryovac operation at one point, and Tenneco, Dow, and ICI are three others I can think of that would be good fits. We view the odds of a takeover offer for Grace before year-end at greater than 50%. Yet at $52, there's no takeover premium in the shares. In the meantime, Grace says it plans to repurchase 20% of its stock--roughly 18 million shares--so there's downside protection.

Speaking of downside, where's the 40% of your capital that's not in equities?

We have a modest position in U.S. government bonds and more significant ones in European and emerging-market debt.

If a fresh $1 billion landed on your desk tomorrow, where would you put it?

Into more of what we already own. A good example would be Barnes & Noble, which is run by a guy who lives, eats, and sleeps books. The company has a credible competitor in Borders Group, but Barnes & Noble is the country's premier book superstore with over three times the number of outlets, a lower multiple, and superior growth prospects. Barnes & Noble expects to double its outlets in the next few years, and earnings should grow 25% to 30% a year as the stores mature and profitability improves. By the end of 1997 the company should be able to finance growth completely with internally generated funds, and it should begin generating free cash flow in 1998. At 18 times our 1997 estimate, the stock at $35 sells at a P/E well below its growth rate. Our target for next year is $45 to $50.

And I'd buy more Pogo Producing, which is a well-run gas and oil exploration company that's had success in the Gulf of Mexico, Texas, and New Mexico. It also has promising acreage in the Gulf of Thailand, which should be producing by early 1997. We look for cash flow in 1997 to be about 50% higher than the 1996 level. At $35, the stock is selling at less than seven times our estimated 1997 cash flow.

Airtouch Communications is another stock I like. Everywhere I look people are using cell phones, and Airtouch is the best-in-class operator in virtually every facet of wireless communication. The stock has been held down by increased competition from newly licensed providers and by potential dilution from acquisitions, but the company has wonderful franchises around the world and cash flow growth should remain above 20% for the next few years. It's a growth business selling at a very low multiple of future cash flow.

Let's talk about some of your other underperformers.

Comcast has been an underperformer longer than I care to remember. The entire cable group has been hurt by the market's overestimation of the competitive threat from satellite operators and its underestimation of the industry's competitive response and potential for developing new revenue streams. Cable companies have one of two lines into the home, which gives them the unique ability to provide guys like you and me with high-speed access to the Internet. Comcast is the cheapest stock in the group, trading at less than seven times estimated 1997 earnings before interest, taxes, depreciation, and amortization, vs. an industry average of 7.5. Comcast has three distinct operations: cable, cellular, and QVC. When you back out marked-to-market valuations for cellular, QVC, and off-balance-sheet assets, you wind up with the core cable business selling for less than six times 1977 cash flow.

What are those below-the-line assets?

Comcast owns two professional Philadelphia sports teams, 15% of Sprint Spectrum, 10% of PrimeStar, and pieces of publicly traded companies like Teleport Communications. We put the public market value of these investments at approximately $5 to $6 a share, and one thing the company could do to deal with the lackluster performance of its stock would be to shed some of its nonstrategic businesses.

Time Warner, the country's second-largest cable company, is in a somewhat similar boat. Once the merger with Turner is behind them, we suspect they'll focus on reducing debt. This probably means selling their cable assets to US West or selling a piece of Time Warner Entertainment, the unit that holds the cable interests. The merger will create a one-of-a-kind entertainment giant with leadership positions in movies, television, music, and publishing. The stock's now around $38. Our 12-month target is $50 to $60.

I'm also enthusiastic about Viacom. I chatted with Sumner Redstone at the premiere of The First Wives Club. It's a great movie, and he's a 72-year-old I'm happy to vote for. He's got a vision and an excitement about him. I particularly like the fact that everyone's kind of negative on him. We like to be contrarian. A year and a half ago, when we got Viacom stock out of the Paramount deal, every Wall Street analyst was bullish. We sold four million shares at that point at over $50 a share. We recently reestablished our position at $35 and below.

Our optimism reflects our belief that Blockbuster will do substantially better than expected, that the other Viacom businesses will do as well or slightly better than the consensus estimates, and that cash flow will be in excess of what the Street is looking for. They've got some world-class radio and television assets, and they should be in a position next year to start paying down debt in a meaningful fashion. We wouldn't be surprised to see the stock at $50 in 1997.

Let's end with two tough questions. First, in addition to serious egg-on-the-face, that 24% drop in 1994 must have been painful. What's to prevent it from happening again?

A lot. The depth of the team that's now managing our foreign investments. The sophisticated risk controls we've established. And a clearly articulated mandate that puts a limit on our foreign investments. We may have a difficult year again, but it won't be because of foreign bonds.

Okay. Goldman reported pretax earnings of $589 million for the third quarter. Any regrets about leaving?

I had a 24-year love affair with the firm, but the bulk of my time was spent managing people and pontificating on markets and strategy. A famous philosopher said everyone should have more than one career. Omega is my second career. It gives me the opportunity to focus on managing money. Do I have any regrets over that decision? None whatsoever.