Before founding The Galleon Group in January 1997, Raj Rajaratnam spent more than 11 years with Needham & Company, Inc., rising from analyst for the electronics sector to Managing Director of investment analysis for technology, healthcare and specialty retailing and becoming President of the firm in 1991. Raj played an important role in the exceptional success of Needham, an investment banking firm specialized in emerging growth companies which raised over $6 billion in more than 120 public offerings from 1986 to 1996. In 1992, Raj began managing an investment partnership focused on the various sectors of the technology industry and a parallel offshore fund was started in July 1995. By the time Raj left Needham to concentrate on managing money, he was responsible for over $250 million in hedge funds which had achieved a net compound rate of return of 37% from July 1992 to December 1996. Needham agreed to let Raj assume control of the offshore funds and he started a new domestic partnership in January 1997. Today, The Galleon Group manages approximately $400 million and the funds are up about 3% for the first four months of 1997. Raj Rajaratnam spoke with HFN publisher, Antoine Bernheim, in late April.
Profile of Raj Rajaratnam
Born: June 15, 1957 in Sri Lanka
Education: BSc. Engineering, MBA Finance,
University of Pennsylvania
Family: Married, three children
Last vacation: Bermuda
Last book read: The Seasons of a Man's Life
by Alan Levinson
Hobbies: Travel, world affairs and sports
Favorite quote: "Only the paranoid survive", Andy Grove
How he best describes himself: "Focused"
Q. How do you analyze the technology sector and the current state it is in?
A. We segment the technology sector into six broad groups: semiconductors, semi-equipment, PCs, networking, storage and software and we analyze the trends in each group separately. The business fundamentals appear pretty solid for the next six to twelve months except for networking where conditions are weak compared to expectations for companies like 3Com, US Robotics, Cascade and Fore Systems. Having said that, the psychology toward technology stocks is as bad as I have seen it in a long time. It is important to understand that a lot of the technology hedge funds and mutual funds are down significantly, as much as 15% to 25% for the year. As a result, the selling in the group has been indiscriminate. I see opportunities on the long side as well as the short side because of this divergence between fundamentals and psychology.
Q. What do you see as the driving forces in technology companies going forward?
A. Technology is driven by the need for faster and cheaper information. It took the PC industry about six years to reach 10 million users. It has taken the Internet about ten months to reach 10 million users. The killer application for the PC was the spread sheet whereas on the Internet it is E-mail. The money to be made in the Internet area is going to be far greater than the money that was made in the PC revolution because when the PC started, we did not have an installed base. Now we have an installed base of 150 million PCs that enable the rapid adoption of the Internet. The first PC was shipped in 1980. The PC industry created about $400 billion in shareholder value between 1980 and 1995. However, 40% of the companies that went public during that period are today trading below their IPO price. As a technology-based hedge fund going long and short, we have an unfair advantage because the rate of wealth creation and the rate of wealth dissipation is greatest in the technology sector.
Q. The technology sector has gone from a "one decision stock" environment to short and perilous cycles. How has your turnover been affected by that and more generally how would you describe your trading style?
A. We have increased our short position and our net long position is probably less than 10%. We have become a classic hedge fund. We are trading around 25-30 core positions, both on the long and short sides. That is one of the reasons we have three traders. I look at the beta of technology stocks as a positive. For instance, if we own 100,000 shares of Intel and the stock is up 5 points, we may cut our position to 75,000 shares and if it is down 5 points we would increase it to 125,000 shares. The dominant investment style of most money managers in this sector is momentum investing and when the momentum changes, they head for the exit door no matter what the prices. It is very important for us to monitor the sentiment and we do that primarily by looking at how stocks react to earnings. In the first quarter, stocks of companies where the Street expected earnings to be good went down when the numbers came out: Seagate, Western Digital, KLA Instruments, even Intel traded down when the numbers came out. On the other hand, companies with a large short interest where the Street did not expect a huge number opened up substantially on good earnings reports, like IBM which went up 11 points when the numbers came out. The fact that people are now selling the stocks into the earnings is a sign of the poor psychology. We would see a change in psychology if a leader like Cisco would go up on beating expectations.
Q. Could you describe your research process and where you see your edge?
A. We build the portfolio from the bottom-up, looking at sectors and within the sectors looking at companies. We have three analysts/portfolio managers who visit with approximately 400 companies every year. We all spend about a week a month on the West Coast doing that. Secondly, we have a network of 60 to 70 technology executives who are investors in our fund and they are a great resource to bounce ideas off. If we ask any of them which of their customers and suppliers are doing well or badly, we get four stock ideas, two on the long side, two on the short side. Also, we are engineers by training and have some understanding of technology.
Q. What stocks do you like as a long-term investment?
A. I have no doubt that the long-term future for the information industry sector is very bright. In the current environment, we have to navigate between the fact that business is OK and psychology is very bad. Cisco is a great stock for the long term. It is a leader in the networking sector and the company has met every number. But the stock is down about 40% from its high because a lot of its competitors have missed Wall Street expectations. The company continues to gain market share and is becoming as dominant in the networking sector as Intel or Microsoft are in their sector. It is our largest position.
Q. Why should a managed portfolio of technology stocks outperform Microsoft and Intel over the next several years?
A. This is a sector that is far from being mature. You could have raised the same question about IBM and Digital Equipment about ten years ago when the cover of Business Week asked if anybody was going to stop the IBM juggernaut. This is a sector where innovation is very high, where a lot of bright people always try to figure out a better mousetrap. Among the 600 companies that went public between 1980 and 1995 during the PC revolution, sixteen went up 10 times or more, like Microsoft and Cisco. The challenge is to identify the next Microsoft and Intel early on and stick with them. If you can do that, you have a good chance of outperforming Microsoft and Intel even though I think that both stocks should be core parts of a technology portfolio, at least for the foreseeable future.
Q. How do you control risk and what is your approach to cutting losses?
A. First, we do not leverage our portfolio and the sum of our longs and shorts is less than our capital. Secondly, we always have a fair amount of shorts and we also use index options as a hedge. Thirdly, we have a fairly diversified portfolio where a 5% to 7% position is a full position. Every time we buy or short a stock, we write down why. If it goes 5% against us, we revisit the analysis. If it has not changed, we stick with our thought process.
Q. Could you describe how your organization functions?
A. We have three portfolio managers and three traders. I am responsible for the hardware side of technology, another partner looks at networking and software and one does healthcare where we have about 15% of our portfolio. We have five partners and the equity in the firm is fairly broadly divided. Each portfolio manager has the responsibility to come up with long and short ideas in his or her sector and present them to the group. We meet every morning and every afternoon at 2pm.
Q. Could you describe the adjustment to being on your own and where would you like to take your business in terms of organization and assets under management?
A. One of the primary reason I left Needham was to focus on the investment management side. I was spending two to three hours a day as a shrink, dealing with people issues, organizational issues and strategic planning issues. It is a refreshing change to be able to focus on what I enjoy doing. Our assets are going to be limited by our ability to perform. If we find that we can't manage $400 million, we will go back to $250 million because I know we can manage that. At some point, you stop working for money, you work for pride. We want to win, we want to be the best investors in this emerging growth sector. Long term, what I would like to do is to build a technology fund as well as a healthcare fund and maybe a consumer/retail fund so that we offer investors broad exposure to the emerging growth sector. u