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A View From Wall Sweet ROBERT H. B. BALDWIN It can be expected that volatility will persist in high-tech stocks and that there will be very quick reactions to disappointments in earnings. More high-growth companies will look to large corpora- iwns as a source of capital. However, if the Treasury Department's proposal to increase the capital gains tax passes, the future of small- growth companies looks very uncertain. In contrast to more formal presentations in this volume, the following discussion flows from personal experience in this case, forty years of ex- penence on Wall Street at Morgan Stanley. I joined the firm in 1946, and will highlight here some pertinent points in the history of growth stocks as I observed Hem and then will comment on some present problems and prospects in this area. My experience with public offerings of high-growth stocks began early in my career. ~ started working on the Texas Instruments (TI) account in 1954, when the company had approximately $16 million in sales and approximately $~.6 million of net income. It took me a long while to even begin to un- derstand the product TI was making. Morgan Stanley underwrote a common- stock offering of IBM in 1957, when the stock was selling at40 times earnings and at less than a 1 percent yield basis. Our major job was to convince people that they should buy a stock that was selling at such a high earnings multiple and such a low yield. That was the beginning of the growth cult in stocks Mat lasted until 1973. In 1958 we did an issue for Upjohn, and that issue was so much in demand that it was hard to believe, In fact, it was quoted in Me market at 80 times earnings before Me prospectus was even out. We finally sold Me issue at 30 467

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468 ROBERT H. B. BALDWIN times earnings when all the over drug stocks were selling at about 20 times earnings. The result in the marketplace was that all the other drug stocks went up and Upjohn did not come down. Then in spring of 1962, there was a sharp drop-off in the market. We had filed a registration statement for a then-little-known company called Schlumberger. We could not proceed with the issue in such an unsettled market until after we had done a General Motors issue that had a good dividend with a resultant high yield. With confidence reestablished in the market, we were finally able to offer Schlum- ber~er successfully, and it subsequently became one of the great growth stocks of the next 20 years. In 1972 the market reached the peak of the grown cult when we sold four issues Avon, Kresge, Johnson & Johnson, and Lilly" all between 35 and 50 times earnings, and Hey were all snapped up. I might remind readers that the pension funds at Mat time were investing in the area of 125 percent of their cash flow in equities. The advent of high interest rates in 1973 and 1974 and the impact of the 49 percent capital gains tax rate brought the end of Me initial public offering (IPO) market for some time. William Perry (in this volume) stmed tracing what happened win the high-growth stocks in 1973, so his index markedly outperfo~`ed the Standard & Poor's 500 average. If he had started with the year 1969, the high-growth stocks' performance relative to the Standard & Poor's 500 average would have been substantially lower but would still have outperformed the market. Ed Zschau ~ in this volume) describes what went on when the capital gains tax was reduced in 1978. He and I appeared before the House Ways and Means Committee in early March 1978, when he was representing He A}ner- ican Electronics Association and I was chairman of the Securities Industry Association. In Hat one day, we explained from two different points of view, he, from the empirical point of view and I, using a very complicated ma~- emai~cal formula developed by Data Resources, Inc., what we thought would happen to the economy and several economic factors if the capital gains tax was reduced. The late Congressman Bill Steiger was instantly persuaded by our arguments and took up the crusade. He was followed by Jim Jones and, fortunately, by Russell Long, and Congress cut the capital gains tax from 49 percent to 28 percent. The Treasury Department calculated the potential loss of tax revenues by taking the 21 percent difference between the 49 percent rate and the proposed 28 percent rate and dividing it by the 49 percent rate. Then they multiplied the resulting percentage by the total dollar amount of capital gains paid in the previous year and said that was what the Treasury would lose. The Treasury Department continues to make these static assumptions even now He assumption that people do not change their investment behavior if tax rates are changed. While some Treasury officials insisted for as many as

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A VIEW FROM WALL STREET 469 2 years after the capital gains Arc was reduced that no positive impact had resulted, even they finally admitted that the reduction produced worthwhile results. Many of the figures mentioned above are noted in other chapters, but it is important to realize that once we got through Me period of high interest rates brought on by tight money, which we had to do to bnug inflation down, the record number of IPOs and the money for venture capital went hand in hand with the capital gains tax reduction. In 1983 the market had $12.6 billion worm of IPOs; in 1984, $3.S billion; in January-February 198S, $0.8 billion. This last surge of issues was really the result of the jump in the market in January 1985. Dunng the period 1983-1984 money was thrown at start-ups, which were overvalued both initially and when they went public. Barton Biggs, who was in charge of investment strategy at Morgan Stanley, warned in his investment strategy letters of May and June 1983 that market valuations were being overdone, but it took until late 1983 to slow the flood of new issues and reduce the valuations. The role of Me institutions in Me IPO market is of interest here. According to Morgan Stanley's syndicate department, 40 to 50 percent of Me issues Morgan Stanley sold in the 1960s and early 1970s went to individuals. In the 1983-1984 period, the figure was more like 20 percent. Only when Mere was a very difficult job to do and someone added a big selling co~runission to the sales effort did the figure get up to the 40 or 50 percent range. When the market for Pose high-flying stocks broke in late 1983 and early 1984, the performance record of many of the insutunona1 buyers who overstayed the market was dismal. Of course, this was one of the reasons why 82 percent of the invesunent managers unde~perfonned the Standard & Poor's averages in 1984. As a member of Me board of the Geraldine Rockefeller Dodge Foundation, I have heard the presentations of a number of investment managers who came before the board for periodic reviews. Two of Me investment managers were leading buyers of the smaller companies' common stocks and had done very well in the several years before rnid-1984. However, their comunents to the board in mid-1984 were that they had had a wonderful time in the market but were going on to other things. Neither of them has done much investing in small stocks since then. Many institutions came back into the high-tech market in early 1985, but some did not, which has caused quite a difference in the performance of the two groups. If an investing institution was not in high-tech stocks in the fist few months of 1985, it underperfonned the market. However, if an institution was in high-tech stocks and stayed too long, it lost a good bit of its January gains in early March. The big question after the early rise in Me market was whether an institution wrapped up its profit then and hoped that a conservative

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470 ROBERT H. B. BALDWIN policy for the rest of the year would enable it to outperforms the Standard & Poor's index. That is a very important point when talking about who the buyers in the stock market are going to be. Turning to the venture capital firms, I believe these companies are faced with a crisis that has several dimensions. First, there is a crisis of management in the high-tech companies; as a result, We management in venture capital firms is stretched very thin. Second, it is estimated that there are 2,500 high- tech companies that are going to need an estimated $6 billion to $8 billion in capital over the next 3 to 5 years a time when capital sources will be drying up. My associates tell me that "mezzanine" financing (those sub- ordinated securities which are junior to debt but senior to equity in a com- pany's capitalization) has tended to dry up; it is interesting to note that a great deal of this type of capital was coming from Europe. This means that the venture capital firms must put up more of their own money in third- and fourth-round financings and spend their time on companies that they had previously financed which need help. Thus, ~ suspect Mere will not be as much money available for start-up companies. ~ recently tied with members of Tree of the oldest venture capital firms who said that they are spending the majority of Weir time working with old clients in need of help. At Me same time, they see a positive side to ~is, Mat is, Me opportunity to get good positions at reasonable prices in what they consider to be sound com- panics. As ~ consider the future, ~ recall the words of the head of Morgan Staniey's research division, Dennis Sherva, the acknowledged expert in the investment world on small-growth stocks: "The Double with investing in small-growd~ companies is that every week they take one of those stocks out and shoot it." There have been a number of excellent examples recently. As a result of unexpectedly poor earnings, some highly regarded highfliers have been shot, if not in the head, in Me foot. Wang set a high in 1984 of 375/e, and then in 1985 a high of 29~/4, after which it dropped on poor earnings estimates to 20~/~. Data General hit a high in 1984 of 593/4, went to 76 in early 1985, and then fell to 485/~. Computervision was selling at 33; it dropped 10 points in one day. Apollo, which has really done quite well, has been extremely volatile. It had a range in 1984 of 29~/4 to 153/4. In early 1985, it dropped from the 29-to-30 range to 20~/2, and then came back to 23~/ in one day. That kind of volatility is worrisome to investors, particularly individuals. They see a stock lose one-third of its value in one day and think that an insider has taken advantage of them. In early March of 1985, Barrons camed a list of 25 issues brought public in 1984 that gained anywhere from 116 percent to 36 percent and a list of issues that had declined between 37 and 95 percent. I am happy to say that Morgan Stanley was the underwriter of 3 of the top 6 performers and sponsored none of the 25 underperformers. Bllt as James D. Marver (in this volume) says, very few of the top performers

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A VIEW FROM WAIL SIREET 47 were high-tech companies and a substantial number of poor performers would be classified as high-tech. It is not a surprise that it has been Me quality companies that have done well. They will be able to obtain financing, but it will take very good quality companies to accomplish this feat. In conclusion, it can be expected Mat volatility will persist in high-tech stocks and that there will be very quick reactions to disappointments in earnings; the IPO market will return, as it has in the past, but only slowly; valuations for both public offerings and private placements will be much lower. I also believe that more high-:,~owth companies will look to large corporations as a source of capital, the way Intel and Rolm went to IBM. Finally, and of great importance, if Me Treasury Department's proposal to increase the capital gains Sac by 75 percent passes which I consider to be extremely ill-advised Me future of the small-growth companies looks very uncertain.

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