TWST: Will you start by explaining the objectives and investment strategies that you implement in the John Galt fund?

Mr. Dunn: The fund's basic objective is to get above- average returns while mitigating the inherent risk of the market using a dedicated hedging strategy. My goal is to double the money every two and a half to three years, which works out to a 25-28% return, while attempting to take out the market risk. The fund utilizes a modified A. W. Jones strategy. A.W. Jones was the first hedge fund manager, who started his fund in 1949. He would typically be about 90% long and 70% short. So he'd be using a lot of his buying power but would have an equity risk to the market of 20%, the difference between the long and the short exposure. And basically he used all individual names on the long and short side. He ultimately ended up kind of being a fund of funds where he would have a lot of different managers picking a certain number of stocks on the long and short side. My long-side strategy centers on stock picking small and mid-capitalization stocks with market caps from $250 million to $6 billion. I will buy bigger capitalization stocks if the risk/reward is there, but I tend to buy small and mid-cap. My short- side strategy is to short the indexes via the products on the American Stock Exchange like the SPDRs', and the DIAMONDS', with the biggest part of my short exposure in the MDYs, which are the S&P 400 mid-cap depository receipts. I use those because they provide a better hedge against the long side of my portfolio. I basically want to run a fully invested long side. I tend to run around a 90% gross long and around 75% gross short. So I'm usually at 15% net exposure. The strategy has proven to be very effective in a multitude of market scenarios. On large down days in the market, I tend to be flat or slightly positive because my indexes really kick in. Since the fund has been open, I've basically been cautious. I felt the market has been fundamentally overvalued in many ways, and though the broad market isn't overvalued, there is some craziness taking place in the big cap tech, the Internet and optical sectors. So I've been pretty cautious, running about 15% net long.

TWST: Tell us what the competitive advantage of funds such as you've been describing can be for an investor's portfolio.

Mr. Dunn: I believe that for the individual investor, the real competitive advantage is twofold. First, my style tends to mitigate the market risk on the downside, and I've consistently shown the ability to do that. At some point we are going to have a substantial market correction, a real decline where investors suffer a 30%-plus move. And my style should protect principal in that kind of market. Second, and more importantly, I believe my real value lies in the long side, in my stock-picking abilities. I've consistently been properly positioned in the right sectors and the right names to significantly outperform the market, and I have achieved that with substantially less risk. Much of the performance nowadays is based on owning a really overvalued stock that just gets more and more overvalued. My performance is based on owning a cheap name that gets discovered and runs up a lot to a fair valuation. My style allows investors to sleep at night because I protect them from the market downside and I am not living in ridiculously overvalued names on the long side that rely on the irrationality of another buyer to buy it. My portfolio relies on the rationality of another buyer to hopefully buy it.

TWST: What do you look for in a long investment?

Mr. Dunn: I use fundamental analysis with either a top-down or bottom-up approach. I would say the majority are top-down-driven. I basically have my view of the business world and spend a lot of time thinking about and articulating that view. I then try to find the sectors where I think the money is going to be spent and the interest in the stock market is going to be focused. Today, and for the foreseeable future, communications is the driving force in the world. If you don't have companies that benefit from the continual build-out and advancements in the communications infrastructure, you are not well-positioned. What I do is go down deeper in the sector, whether it's in wireless or the local loop, and look for undiscovered companies that are really well-positioned for what I see happening in the sector and in the economy. It's amazing how many excellent small to mid-cap companies you can find that are really well- positioned and executing very well that people aren't aware of. One important element is the catalyst; I always look for a catalyst. A lot of value guys out there are great at finding really cheap stuff, but the companies are not properly positioned and have no meaningful catalyst which will make investors care about owning the name. So for me, it's really important that not only are my names cheap, well-managed, and have a good articulated business plan, but I also need catalysts. I also go bottom up, where I just find a great name that again meets my risk/reward parameter. I generally look for a risk multiple of 10 to 1. If I buy a stock, I usually accept a potential 20% downside decline, feeling there's a possibility for a 200%-plus gain. I tend to buy stocks that are growing their revenues and earnings 30-100%, and that trade at 10-20 times earnings. So I usually pay a half to a quarter of the growth rate, which is the complete opposite of what you see in the big caps where you're paying 5 times the growth rate. You're paying 50 to 100 times multiples for 5-20% growers. My strategy provides a cushion on the downside because my names are not only trading at a significant discount to other stocks in their sector, but also at a significant discount to the general market. That should also protect the fund in bad markets because the names are cheap and should have less multiple contraction. In terms of how we find the name, we don't get any help from the Street, all the research is done in-house. The Street is not looking for names that just have value. They're looking for names that have investment banking business opportunities and offer substantial liquidity.

TWST: How challenging has it been to find companies with a 10 to 1 reward-risk ratio?

Mr. Dunn: You know, it hasn't been that difficult. The difficulty has been in establishing a significant position. In this market, everything moves so fast that you don't always have the time to do the research you'd like to do before you get in a name. You find a name, and then literally in as quick as a week, other people find it and it's off to the races and you miss the whole opportunity. So what you have to do in this market is find a name, do quick but efficient work and establish a small position. It's amazing how a stock goes unnoticed forever and then the second they become aware of it, they just can't get enough of it.

TWST: Would you share with us some of the names you've discovered as well as the catalyst?

Mr. Dunn: One of my larger positions is in one of the smaller caps I own. It's a company called Steve Madden (SHOO). They actually started as a shoe manufacturer for young girls and young women, and I started buying the stock around three years ago at around $3.75 per share. Right now it's at $14, having declined from just below $20 in the last two months. This is a great story which started four years ago with a great designer, Steve Madden, but it was a classic case of a great creative mind not really knowing how to run a business. He realized that and about three and a half years ago hired a COO who's done a phenomenal job and built up a very solid infrastructure. I would argue it is the best run company in the sector today. Over the last four years, they went from selling one line, Steve Madden Shoes, to department stores and specialty shoe stores, to being a multi-brand manufacturer and retailer. They started their retail division with two stores in New York that they primarily used to test their own shoes. They would design shoes in their Long Island City facility, put them in their own stores, and they would get a real good read on whether or not the shoe was going to take. Their retail stores did so well, they said, 'Well, let's try to see if this could be a business.' And now, four years later, they are up to over 50 stores that do just great. They do around $800 a square foot. They're just incredible, wonderful stores. They're very selective in their store site location. They control their growth very well and are really concerned about not overgrowing. They are mostly in malls, but now they are going to locations by major colleges. They opened one in Georgetown, which has been a real success. So they're looking at potentially opening another 100 or so locations that they could locate near colleges and universities.

TWST: Is this a business model that might work online?

Mr. Dunn: Yes. When I buy a stock, I like something that has three, four, five, six catalysts where I feel I'm getting what I like to call a 'free call option.' This has that, and so I've got this wholesale and retail business. The stock right now is trading at around 10 times earnings going forward based on my numbers and I'm being conservative. (Subtracting out their $3 per share of cash, they're trading at 8 times forward earnings.) This is a company that's grown revenues and net income at 86% and 94%, respectively, in fiscal 1999. Back to your online question, they have a Steve Madden Web site, which they opened around a year and a half ago, that has done very well. They did about $1.2 million total sales in 1999 at the site, with over half the sales in the fourth quarter. They had almost 50 million hits in 1999 and 163,000 unique users in the fourth quarter. In addition, they will be opening a new site, Stevie's, this month for their younger customer. What's happened is Steve Madden has evolved from a shoe brand to a head-to-toe fashion and lifestyle brand for young women. And that's a major, major step for a company like this. You now have a company that is not relying solely on 12- to 24-year-old women, a potentially fickle market. Now they have a line called David Aaron, another called LEI, and they just announced Stevie's, where they are now selling shoes, apparel and accessories to girls from the ages of four to basically 60 in a lower- middle to upper-middle class demographic. So they've really expanded the demographics of their customer, which should ultimately be a huge success for them. They've got eight different licensees now which, if successful, just drop to the bottom line. A good portion of their new brands and licensees are not built into the Street's earnings models, which I believe are very low.

TWST: Do you have any thoughts on how the company might react in a downturn, to say nothing of the stock?

Mr. Dunn: In terms of a downturn in the economy, they are trading at such a minimal valuation and they have so many different catalysts right now, I think the stock should weather a downturn well. If this should trade at 1 time its growth rate, it's going to take a lot to bring a 90% growth rate down to 10%. In terms of their business, I think they would still perform very well as people still have to buy what they sell and they provide value. They also have a test and react model which is a very important part of the reason I like them. This model, which they initially used in their first two stores, has expanded to their other stores across the country. And based on the results, they can turn a shoe over in six weeks. So they could design something and literally have it on the shelf of their wholesale accounts or their own retail stores in about six weeks, which is a tremendous advantage. It keeps them from having a huge inventory problem (they turned inventory 10 times in 1999), if they pick the wrong shoe. It gives them a closer feel to when the buyers are buying, which keeps them from picking the wrong shoe. The department stores love this model because they can now buy shoes closer to their customer's purchase. I was just at a major shoe convention in Las Vegas, and it was just amazing to see the response Steve Madden was getting there and the orders that were pouring in. So that's an example of a bottom-up company that I've found that I like, which I've owned for the last couple of years, and that I like even better now. It's cheaper today than the day I bought it, due to the excellent execution and the growth they've had. They just announced the opening of Stevie's at the shoe show which caters to teens and girls between the ages of four to 12, and that could become as big as the rest of the company. The response was just huge from the buyers.

TWST: A lot of money there.

Mr. Dunn: There's a lot of money there and a huge opportunity. Manufacturers didn't really try to design a decent-looking, quality shoe for that group because I guess it didn't matter. Stevie's is basically like a little Steve Madden shoe in a sense, and the price points are low enough so that most people can buy them. As often as kids change shoes, you can't be spending $50 on shoes. Stevie's is going to be coming out as a full brand with shoes and accessories, and the response to date has been great. They don't deliver their first shoe until June, so they really are not going to be selling that line until the back-to-school season.

TWST: Tell us some more of your long ideas.

Mr. Dunn: Another long idea is in the communications space, what I like to call a value-arb.

TWST: What does that mean?

Mr. Dunn: I find a company that owns another company or two or three other companies, either public or private, that's trading at a significant discount when you add up the pieces to the main holding company. Usually, I like to do that in a name where I think what they own is actually even cheap. So if you had company A owning company B and C, and company B and C added together was $20 and company A was trading at $10, I'm getting it at a $10 discount, plus B and C are cheap companies or stocks in their own right. I wouldn't want to have A owning B if I thought B was ridiculous, except actually in the case that I am going to tell you about. Within the communication spaces, I own a lot of the CLECs, the competitive local exchange carriers. I just think that they are a very well-positioned group that should see a lot of acquisitions in the near term. I think a lot of the major communications companies will need to acquire CLECs just to fill in the local US footprint and to get Internet and data infrastructure. But one of my major positions in that group is Intermedia (ICIX). Intermedia bought a company called Digex (DIGX) a couple of years ago, which is in the Web hosting business, like an Exodus. They went public with Digex and as of today, they still own approximately 39 1/2 million shares of Digex, which now trades at $160. So that works out to approximately $122 a share to Intermedia, which is only trading at $62 a share. So on that $122, you're getting around $60 a share more than Intermedia's trading for. Intermedia itself, outside of Digex, is the most fully integrated CLEC right now. Most of the acquisitions that have occurred in the CLEC group in the last two years have gone for 5-7 times net property plant and equipment. If you give Intermedia a conservative multiple on their existing infrastructure, that's another $100 a share. So right there is around $222 if you add it up for a $62 stock. Now Digex is overpriced. I don't know if Digex is worth $20, $40, $60, $80 or $120 a share, but I have enough of a cushion and I'm getting it all for free. The Street only recognizes the Digex piece of Intermedia, but Intermedia's real business is great and is going to go for some multiple, and probably more like a 3 to 4 times multiple. I have what I like to call value-arb and I'm getting a nice back-end play on the Internet because the more infrastructure you need to build for the Internet, the more you need companies like Digex and Intermedia. That's how I've played the Internet for the last three years, by just being around the edge of the Internet. I owned Fingerhut because I felt that product fulfillment was going to be an important piece of the whole e-commerce pie, and they got acquired by Federated (FD). I now own Hanover Direct (HNV), which is a similar play to Fingerhut. I basically started my Hanover Direct position when Fingerhut got acquired. It's a classic catalog company and you've probably seen a lot of their names like Domestications, The Company Store, Kitchen and Home or Gump's. What they did around six months ago is they reorganized. They said, 'Okay, we're going to split the company into two divisions: brands and Internet.' Around three and a half years ago, they started building a company Keystone Internet Services. They spent approximately $60 million and have built both a front-end and back-end fulfillment system for anybody who wants to get on the Internet and software services group. Many of the new e-tailers are having problems fulfilling orders because they just don't have the infrastructure. The old-line retailers have a problem with the software and the integration of running a site. So Hanover, through its Keystone division, which they've changed to the name erizon, can handle all your needs for e-commerce basically from the mouse to the house. Whether it's putting together a site, credit card processing, call centers, returns, or actual fulfillment, they do it all. They've picked up some incredible customers in the last six months in terms of the Internet space. They picked up Fogdog (FOGD), which is one of the bigger sports sites. They have KBkids (KBKD proposed), which, along with eToys (ETYS) and Toys R Us (TOY), is a major toy site. They picked up Mercata (MCTA proposed), which is a very hot cooperative buying site that is partially owned by Paul Allen. They've also picked up Fair Markets, which is an auction consortium that is competing against eBay (EBAY). So their fulfillment business is going great and no one gives them any credit for it. Their brand business is getting a lot better. They've moved over a lot of sales from their catalog to the Internet sites. It saves them a lot of money when you sell an order on the Internet versus basically selling it through the catalog. And ultimately you can send out that many less catalogs. They now are up to around 10-11% of their catalog or brand sales on the Internet. The margins already went up 200 basis points, and they could go up from 500 to 1,000 basis points just in the brand side. And their brands are well-suited for the Internet, in terms of their being lifestyle or home furnishings. But the real play is on their whole fulfillment and e-services side, and their experience at direct marketing and customer relationship management.

TWST: How do you pick your shorts on the American Stock Exchange?

Mr. Dunn: I used to spend a lot of my time picking stocks for shorts. Now what I do is short indexes. And basically going with the overall feeling that the market is overvalued, I'm constantly very hedged. So then once I decide that I'm going to be hedged, I just have a basket of these indexes that somewhat mirrors my capitalization and exposure in sectors as best I can. You can't do it perfectly; there's just no way. So that's why I have a lot of the S&P 400 mid-caps that I short, and I also buy a lot of Russell 2000 puts deep in the money with a longer-term expiration. When I buy puts, I like them to be more equity-like than option-like because if you use an option properly, they are a good tool. If you use it as people think you're supposed to use it, you lose. If you use them for the maximum leverage and the minimum time period, they usually go away. And I short the XLKs to try to reduce some of my technology and communications exposure. But again, I'm really trying to take out the market. I am trying to protect principal in bad markets, and feel comfortable running a relatively fully invested long side.

TWST: How do you know when to get out of a short position, get out of the index?

Mr. Dunn: I don't get out of them, I adjust my short exposure based on short-term sentiment. I don't make micro-bets. I am not a micro-player; I'm just trying to take out the market. And I don't add value by sitting there trying to one day be 100% long and the next day be 50% short.

TWST: You've been very clear in your strategy. Where do you feel hedge funds are vulnerable to criticism in general?

Mr. Dunn: Well, I feel they're vulnerable because a lot of them don't hedge. I think that a lot of funds I know just don't hedge; they just leverage investment partnerships. They take advantage of all the flexibility you have in a hedge fund for using leverage, for concentrating in positions, but they don't really hedge. I think it's fine to use leverage if you're hedging yourself. I feel I use leverage very intelligently. I use leverage to reduce my exposure, not to accentuate my gains. A lot of guys use leverage just to accentuate gains, and I find some of them concentrate a little too much in names where they're really going for the home run and being somewhat greedy. I think they're throwing some risk discipline out the window.

TWST: What do you find most rewarding about your discipline?

Mr. Dunn: I guess what I find most rewarding about my discipline is that my investors and myself (being a big investor in the fund) are protected during the bad days. I can sleep at night. And that discipline gives me a lot of comfort. I'm also big on content. I just feel that we really are going to need content for the Internet, for the digital boxes that are being deployed and also for the increased use of the satellite dishes, as they are becoming really prevalent out there for people. I've been building a position the last year in Playboy (PLAA).

TWST: What do you see in Playboy that others don't?

Mr. Dunn: What I see in Playboy is a company that's very well-positioned for electronic media. They have built a library of assets that they can re-purpose and reuse. Their biggest problem was in getting into the home, but now with the digital boxes coming out, they're basically going to have access to all cable homes in a couple of years; it's not going to happen over night. Also, the growth of the satellite dishes has opened up millions of potential new customers. Now if they make a movie or a show, it costs them the same so they have a fixed cost. It is just a matter how many people will end up watching it, or how many times they will get paid on that same piece of content. And between the domestic market taking off and the international market, they should see significant viewer growth and substantially increased margins. It's mostly the entertainment and the Internet group that I like about Playboy. They have and Cyber Club, and they've already announced that they are going to spin them off. Most Street analysts think that they could be worth from a half billion to a billion dollars. The whole Playboy company trades at a valuation of $470 million. They've also built a good management team over the last few years.

TWST: What's the call option you've seen for this stock?

Mr. Dunn: Well, the call option is the Internet. The bottom line is if you broke up Playboy just by assets, it would be a $30 stock. Just the brand name, the film library and the artwork they have at the mansion and the mansion itself justify that valuation and so you're getting, I think, a free option. Someone might say, 'Well you're getting a free option on everything else and the value is in the Internet piece.' But you have the Internet piece, you've got the explosion of the international market and you've got the deployment of digital in the entertainment group. I actually think that all of this will really propel their merchandising effort, which they're taking a bigger interest in. They're back into licensing the name to gaming and selectively licensing merchandise. I think all the good work they have done on the Internet and in their entertainment group might even help the magazine, which still has 3.2 million subscribers domestically, see increased interest. It's still the number one selling magazine in the men's leisure category, and it still makes a profit and that could be reenergized. They could also take advantage of the cross-promotion opportunities between TV, publishing and the Internet. The stock is sitting here trading at $20, and they're giving it away. If Hugh Hefner were willing to sell the company, analysts value it at $80-100 a share. I don't think he's selling it and that's not in my model, but again, it's one of the few places you could find content. It's really hard to find content out there unless you want to own Disney (DIS), Time Warner (TWX) or News Corp. (NWS). There are not a lot of public content plays. This is one of the few with a really great brand name. Whether you like what they do or not, it's still a very good brand name with tons of content, and they make content real well and cost effectively. And I think you need content plays and this is one of the few I found out there. And again, it fits in with my overall model of where the world is going.

TWST: What's the significance of the name, John Galt?

Mr. Dunn: John Galt is based on the character John Galt, from the book Atlas Shrugged, which is one of my favorite books and also a book that is similar to my investment philosophy. It's very contrarian, basically Ayn Rand's philosophy of individualism. She feels people should be rewarded for their own work, and that's kind of how I feel about the market. I do my own work, I get my own names, I don't jump on stocks after everyone's run them up. And that's kind of why I thought it would be more interesting than just Dunn Capital Management.

TWST: Thank you.

Note: Opinions and recommendations are as of 3/22/00.

LAURENCE P. DUNN John Galt Capital Management LLC 12636 High Blaf Drive Suite 350 San Diego, CA 92130 (858) 793-2337

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