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Letter dated April 2007 reporting on the first quarter
of 2007
The average pundit
surveyed by Business Week for their January 1 issue predicted that the S&P
500 would reach 1501 by the end of 2007, up from 1418 at the end of 2006.
By February 20, we were already halfway there - at 1460. A week later,
things seemed even better as the private equity world re-affirmed that
“liquidity” was driving the market ever higher with a $32 billion buyout of
Texas Utilities – the largest buyout ever.
I was at an
investment conference in Colorado with CEOs and CFOs of major corporations
and remember saying to whoever would listen that when the main bullish
argument hinges on “liquidity”, I get uneasy. Just because people have
money doesn’t mean they have to spend it. That word was too frequently
thrown around at market peaks in the 1960s, 70s and 80s (eg: “There’s just
too much liquidity out there” – WSJ quoting Piper Jaffray’s chief market
strategist on the day the market peaked in 1987). At the least, the 3.5%
plunge on February 27 is a reminder that the S&P is not going to 1501, or
anywhere else, in a straight line. The market is still reasonably valued if
not cheap, and should be able to grind modestly higher absent external
shocks.
Note - The February
27 plunge was blamed largely on the unwinding of the so-called yen carry
trade. A detailed explanation would not fit in this letter, but if you are
interested in more detail, email me and I will forward a brief narrative.
Grind modestly (or
barely) higher is pretty much what the market did this quarter. After the
zigs and zags, the S&P 500 Index gained 0.2% last quarter. Your
account gained 1.5 %. Once again, we demonstrated that even in a
flat market, one can still make money with allocation to appropriate sectors
of the market and selection of good stocks.
In most cases, we
did that allocation reasonably well this quarter. For instance, the energy
sector had an excellent 3 months, with refiners leading the pack. I was
particularly pleased with the results of our purchase of Valero Petroleum,
the nation’s largest refiner, midway through the quarter. Refining margins,
as measured by the so-called “crack spread”, were rising sharply in late
January and early February while Valero stagnated. Moreover, the price of
Valero had deviated substantially from its historical relationship with Tesoro, another major refiner. So we bought Valero at $54.07, and it ended
the quarter at $64.49. Crude oil itself rose in price, and we benefited
from our holdings in Conoco. I am amazed that one of our largest energy
holdings, Canadian producer Penn West, is not trading higher given its 11.8%
yield. Investors are reacting to the Canadian government’s plans to raise
taxes, effective 2011, on companies organized as royalty trusts. The stock
seems cheap even when you account for the direct and indirect effects of
this tax increase.
Another place that
we did quite well was in steel stocks. Ryerson (RYI) is instructive. My
system had it dirt cheap during the second half of last year, and it
couldn’t budge from the low 20s. It ended 2006 at $25.09 and finished the 1st
quarter at $39.62, up 58 %. I can’t explain the timing, other than to say
that I don’t think markets always reflect information as efficiently as some
academics would have you believe. Global demand for steel in general was as
strong when RYI was at $25 as when it hit $39. Korean steelmaker Pohang (PKX)
was our other big winner, up 29% for the quarter. Pohang’s rise has been
steadier in the past year than Ryerson’s. Steel stocks are volatile, and
are susceptible to big percentage declines anytime that Asia sneezes, so our
exposure to them is limited.
Most
telecommunication stocks have remained strong, and we have continued to do
well in Mobile Telesystems (MBT), the Russian provider. My system agrees
with Morningstar research that Tele Norte in Brazil is perhaps the best
value among such companies globally at the moment, and we recently took a
position in this carrier as well. We have owned positions in other overseas
telecomm providers for some time.
Both steel and
telecomm benefited from economic growth outside of the United States,
particularly in Asia. This is a long term trend that I expect to continue.
Thus we have some general exposure to this region through an exchange-traded
fund called the MSCI Pacific ex-Japan i-shares (ticker symbol EPP). This
fund appreciated by 7.3 % for the quarter, well ahead of the US market. We
also own a modest amount of the Japan Equity Fund.
Part of why we did
well is a function of what we avoided. We had a great run in housing stocks
a few years ago, when many investors had trouble believing that housing
would thrive while the tech bubble was bursting. Now we may have the
opposite phenomenon in housing. Normally, economists can’t agree on
anything. But I saw a survey in February that said 96% of economists
thought the housing market would bottom no later than the end of 2007. This
view of housing prices was apparently discounted into the prices of housing
stocks as they rallied nicely in January. We missed it. Good thing.
Housing stocks (as measured by Morningstar) were 17.7 % lower for the
quarter as sales numbers disappointed and the sub-prime loan picture
worsened. People have a tendency to underestimate the length of trends.
Housing stocks have low PE ratios and can be good “value” stocks as long as
you judge the volatile “E” part of the PE ratio reasonably well. I hope to
identify another good entry point, but am glad that we missed the sucker’s
rally in January.
Some other sectors
were simply unexciting. Technology stocks had a poor quarter. Financial
stocks dropped about a percent. Banks face an inverted yield curve,
investment banks face concerns that they may be leveraged in sub-prime
mortgage vehicles, and insurers are heading into another hurricane season.
I did take the rare step of putting some of your money into a mutual fund
that invests in overseas real estate (FIREX) because capacity is very tight
in office markets in parts of the world where this fund is concentrated.
Despite concerns that consumer spending would suffer from falling home
prices and rising oil prices, the Morningstar Consumer Goods Index managed
to rise 3.6 %. Among the bright spots were Joseph A Bank (+20%), Tempur
Pedic (+27%), and the rebound in Avon Products (+12%).
A major
disappointment was the continued lag of some big cap stocks that are
becoming better and better relative values. I prefer situations like Valero
that became a good relative value when we owned little if any, and then went
up after we bought a lot! But some stocks like Johnson & Johnson (- 8.7 %
for the quarter), Amgen (- 18%), Home Depot (- 8.5%) and Microsoft (- 6.7%)
have continued to disappoint and cost us. The Morningstar Large Cap Core
Index fell by 0.9% for the quarter while the Morningstar Mid-Cap Core Index
rose 4.1%. At some level, if we can outperform while owning things that are
cheap and defensive, that is not altogether bad. However, I’m hoping to
report better results on these stocks later this year.
We were
underweighted in one sector that has continued to do very well – utilities.
We have small positions in utility stocks, but it is the one place where I
have regretted taking profits. Although utility valuations are high by
historical standards, the atmosphere for utilities has been favorable due to
de-regulation, low interest rates, and increasing demand for electricity,
gas and water. Of course, one must wonder what it says about the overall
market when the best performing sector is the most defensive.
Can the market move
higher from here? A recent research piece from Goldman Sachs called the
market 11% undervalued. An analysis from Morningstar called it 4%
overvalued. Value Line predicts 40% appreciation over the next 3-5 years.
There are few radical departures from this general band of views.
As long-time
clients know, I focus on a few measures. One is the earnings yield on
stocks versus the yield on the five year Treasury note. The PE ratio on the
Value Line Index at quarter-end was 18.6, and the earnings yield is its
reciprocal of 5.38%. The five year Treasury yield ended the quarter at
4.54%. That produces a ratio of 1.18. Based on historical data, that ratio
suggests room for the market to go up modestly. If the ratio gets to the
1.05 – 1.10 range, it is often a barrier to further gains. If rates and
earnings both stay where they are, we could have 7% price appreciation
before that ratio gets to 1.10. Beyond that, if earnings grow 7% in the
next twelve months, the same ratio band would allow stocks to appreciate by
at least 14%. But that is only one variable; there are countless other
variables that can influence the overall direction of the market.
The market is
generally sensitive to earnings momentum, and particularly to rates of
change there. Corporate earnings have been growing at a double-digit rate
for nearly four years, and many analysts are forecasting only about 6%
growth in 2007. That is still reasonably healthy.
As I have said
before, I see no predictive value in moving averages. However, if the
market has been consistently above its 200 day moving average, it indicates
a bullish trend. The S&P 500 Index has not been below its 200 day moving
average since last August. Unless and until that changes, it is reasonable
to assume that a bullish trend is intact. With the tension around Iran and
other hot spots, there may be more potential than usual for external
shocks. This does not strike me as a period in which to be overly
aggressive, as I was in early 2003. But it does strike me as a time when we
can earn a solid return from stocks. I will continue to search as broadly
as possible for the best investment opportunities available.
Finally, some
administrative notes. TD Waterhouse has merged with Ameritrade. They are
combining their clearing systems, which means you will get a new, improved
monthly statement. They promise that tax basis information will be included
going forward. Your account number will change, but nothing else should.
As required by the SEC, your annual privacy notice is enclosed. Finally,
the SEC also requires that I formally offer to deliver to you annually a
copy of Part II of SEC Form ADV (a registration document) or a similar
document containing at least as much biographical and related information.
Kindly let me know if you require such documentation. As always, please do
not hesitate to get in touch if there is anything you want to discuss at
greater length.