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Letter dated October 2004 reporting on the third quarter of 2004

     The S&P 500 Index and the Nasdaq diverged in the third quarter as energy stocks helped to stabilize the S&P while technology stocks pulled the Nasdaq sharply lower.  The S&P fell 2.3% for the quarter, while the Nasdaq tumbled 7.4%.  Your account outpaced the market, but sill lost 1.4% for the quarter.

     The tone was set early on.  The Nasdaq plunged about 4% in the first five trading days of the quarter.  Shortly thereafter, Bill Gates announced that Microsoft would pay a special dividend of some $40 billion.  The immediate reaction was giddiness that Bill Gates was distributing all this cash, but reality quickly set in.  It meant that technology’s king saw nothing worth buying with all this cash, and so decided a dividend was its best use.  But not a regular dividend.  It sounds like Mr. Gates also decided that the odds of a big tax increase were high enough that it made sense to pay it all out quickly.  Not a bullish statement on either count.  Many tech stocks had a double digit percentage decline for the quarter.  We didn’t escape the damage entirely, but we were underweighted and became even more underweighted as the quarter went on (thanks in part to Taiwan Semi, Which I bought way too soon).

     One the flip side, we participated reasonably well in the energy rally.  Even so, in retrospect, I wish I had been more aggressive sooner in this sector.  We’ve maintained a core position in Tesoro for a long time.  Ditto on oil tankers; we’ve had OMI Shipping from und $7 to over $16.  We added more exposure to the integrated major oils in August and have had a good run (there; in xxx) in the past tow months.  The best play now may be in the oil service stocks.  They have been good values, and my view is that capital expenditures will continue even if oil prices drop somewhat.  We’ve already done well with our recent purchased of Cal Dive (marine oil services) and Lone Star Technologies, which has been a double play – steel tubular products for oil drilling.

     We’ve capitalized more directly in steel.  In my last letter, I mentioned that we bought back into US Steel at just above 427.  It ended the quarter at $37.62, a gain of nearly 40%.  I sold some too soon when it got back near its old highs.  I am even more pleased with the performance of Steel Dynamics, which owns mini-mills, though I sold a small amount of this stock too soon as well.  As of June 30, this stock was at $28.63 and was projected to earn $3.96 this year and $3.58 next year.  Based on those numbers and a projected earnings growth rate of just under 15% my system projected a 25.7% compound annual return even with the stock already up $10.  Earnings estimates can change more rapidly in cyclical stocks than in some other sectors.  Certainly the stock could tumble if we get another “China panic” like that of last April, when the whole investment community concluded at once that China’s buying of steel would drop sharply.

     I am concerned that the rise in oil prices, together with record levels of consumer debt, may dampen consumer spending in the months ahead.  Moreover, a lot of consumer cyclical stocks are pretty richly valued now.  We’ve cut back some this sector, but we still have good sized positions in Home Depot, Dicks, Michaels, Barnes & Noble and some others.  We’ve also had a very good run in Lions Gate Films, which strikes me as a very clever upstart in the film business.

     Our biggest holding remains Johnson & Johns, which was up one percent for the quarter.  But one of my biggest disappointments has been the dull performance of Pfizer.  It’s a great company, and I thought that the stock had gotten cheap enough that there was good upside potential there.  But the stocks feel over 10% during the quarter.  I guess we can look at the bright side; at least we didn’t own Merck!  I did by some at a little over $33.  If Merck maintains its dividend as promised, we’ve locked in a dividend yield of 4.6%.  The company may become a takeover target.  The risk is that it gets overwhelmed by tort lawsuits on Vioxx.  Merck is a fine company, but the 27% one-day plunge in its stock clearly illustrates the importance of diversification.

     We did have a few things that made up for Merck.  A year ago, we enjoyed a good run in Bennett Environmental, sold most of it and got back in when the stock feel back to our original entry point.  I expected them to get back on track, but the stock went into a freefall.  Credence Systems was just one of many tech stocks that got clobbered, and we sold a decent sized position at a loss.  Eresearch Technology has enjoyed phenomenal growth in the past three years, but its good run came to an abrupt end this summer.  Freidman Billings Ramsay fell back to earth after its prospects cooled for underwriting new mortgage backed securities.  I probably should have sold more aggressively in these declines instead of giving these stocks the benefit of the doubt.  But July was just plain nasty.  August was better, and September was great.

     So what about the rest of the year?  Signals have been mixed, so it is no surprise that the overall market has been confined to a range.  Corporate earnings have been good, but the market seems neither compelling cheap nor unsustainably rich relative to these earnings.  The S&P 500 is expected to tally earnings of about $65 in 2004, and early estimates are for about $70-73 in 2005.  At the September 30 level of 1114 on the S&P, that translates into a PE ration (earnings yield) of 17.1 (5.84%) on ’04 earnings and 15.2-15.9 (~6.40%) on 2005 earnings.  That suggest stocks are a pretty good relative value as against a five year Treasury yield of about 3.4%.  But stock market bears would argue that Treasury yields are that low because the bond market is forecasting economic weakness, which in turn means weaker earnings than forecast.

     Indeed, earnings are already forecast to grow more slowly than has been the case in the past year.  But that seems well recognized in the market, and is presumably discounted in prices.  Earnings are still expected to climb at a 14% pace in the fourth quarter, which is still well above the historical mean.

     So much for muddled forecasts.  Rather than try to divine market direction, I prefer to use a disciplined system for ranking stocks according to the best relative values.  There’s more of an edge there than in trying to forecast absolute price levels.

     I am mindful of the effect that the presidential election and its aftermath had on the market in 2000.  The post-election uncertainty corresponded with an acceleration to the downside in the stock market.  I am prepared to be more defensive if events should suggest that is warranted.

     Finally, I do monitor the 200 day moving average of the S&P 500 – simply as an indicator of the primary trend.  This helped me to stay appropriately defensive in 2001-02.  Also, the upside breakout about the 200 day moving average did indeed mark an acceleration of the 2003 bull market – while analysts were still crying about poor earnings.  The S&P 500 fell below its 200 day moving average in mid-July for the first time this year, but has since whipsawed around it somewhat.  The Nasdaq broke below its 200 day moving average in early July and had not climbed back above it by quarter end.  So unlike 2003, there is no clear primary bull trend.

     The major fundamental influences on the market for the next quarter will likely be things that are slick – ie, presidential candidates and oil.  Root for three more months like we had in September!