Return to letters menu

Letter dated July 2007 reporting on the second quarter of 2007

     The stock market is up over 6% so far this year as measured by the S&P 500 Index, and our returns are even better. The market has been strong despite increases in interest rates, oil prices and our trade deficit and a slowdown in economic growth to a 0.7% annualized rate in the first quarter. Why? There are other forces at work. The market has been heavily influenced by three intertwining forces: interest rates, developments in China, and renewed considerations about the proper pricing of risk.

     Before we get ahead of ourselves, the total return for S&P 500 Index was 6.3% for the quarter and is now 6.9% for the year. Your account gained 6.4% for the quarter and is 8.1% higher for the year. I am fairly pleased with these results especially since many of the smaller companies that have outperformed the S&P in recent years have lagged this year; the Russell 2000 Index was up only 4.1% for the quarter after having led the S&P 500 in recent years. As you know, I have shifted funds into more large cap stocks in the past several months. That benefited us this quarter.

     It is somewhat counterintuitive to have such a strong stock market in the face of rising interest rates. So what is going on? I believe that China is having an ever-greater impact on our financial markets. China is re-allocating some of its vast reserves from bonds to stocks. They have over $1 trillion in foreign exchange reserves . The Chinese government’s apparent recent decision to direct about $250 billion of this into equities has, in effect, created the largest private equity fund in the world. As a frame of reference, the two biggest private equity firms in the world (Carlyle Group and KKR) have invested capital of $32.5 billion and $31 billion respectively.

     China recently made one of its first moves with this money by investing $3 billion into The Blackstone Group, another major private equity investor. In effect, they are doing indirectly what they have not been able to do directly. Back in 2005, a Chinese firm attempted to buy Unocal but was rebuffed by political pressure in Washington. So instead of buying entire companies directly, one avenue is to buy into companies that buy other companies. Moreover, a PE ratio of 20 or 25 might seem expensive to us but may be seen as a bargain by the Chinese given the fact that the average PE ratio of a stock on the Shanghai exchange is 65. That is part of what I mean when I refer to the pricing of risk. Beyond that, certain private equity deals are being done with riskier structures than have been used in the past. Certain banks are risking unsecured exposure of hundreds of millions of dollars in temporary financing for LBO outfits in order to collect fees of just 1.5% of the amount at risk. It may be that there is no perceived downside for those who structure these loans, just as there was no perceived downside for aggressive stock analysts shortly before the tech bubble burst early in this decade.

     China is affecting our market in other ways. It is no coincidence that the market is being led higher by stocks in the capital goods, industrial raw materials and energy sectors. When you see the number of cranes on the Beijing skyline or the number of bridges being built across the Yangtze River, it is stunning. It is no wonder that a stock like Korean steelmaker Pohang (PKX) has risen 43% this year.

     Of course, no one knows exactly how the Chinese scenario ultimately plays out. If a reduced rate of buying US treasuries is only the beginning of a trend, interest rates might head higher than is presently expected, and that in turn could put a lid on stocks. If the Chinese building boom slows markedly after the 2008 Beijing Olympics, stocks that have been leading the market higher could reverse course. If currency controls are eased, it might be possible to arbitrage certain stocks that are listed in both Shanghai and Hong Kong. Unbelievably, there are situations where the same company is trading at a much higher price in Shanghai because different classes of investors are restricted to trading only in Shanghai or only in Hong Kong. Few are paying much attention to these risks.

     Given this backdrop, the behavior of various market segments and individual stocks right now makes sense. As one would expect with higher oil prices and higher interest rates, consumer stocks are not having a particularly good run. The Morningstar index of consumer service stocks was up only 1.9% for the quarter and its index of consumer goods stocks was up a modest 4.3%. We had one bright spot with a 17% rise in men’s retailer Joseph A Bank (JOSB).

     The Morningstar Financial Services stock index rose only 3.6% for the quarter, held back by concerns over sub-prime mortgages and a yield curve that is still somewhat flat (thus cutting the profit margins of banks and brokers). Although we have some large individual holdings, we were underweighted in the financial sector. Bank stocks such as Citigroup, Bank of America and JP Morgan were flat to slightly lower. Investment banking stocks had single digit gains; for instance, Lehman rose about 8%. Insurers were mixed. Everest Re gained 13% after being stuck in neutral during the first quarter. AIG reported a 30% year-over-year profit increase in May but could eke out a gain of only 4% despite being quite reasonably valued. Hurricane season will be the big variable for these stocks in the next few months.

     Morningstar’s health care index was up a rather modest 3.1%. We were underweighted in this sector as well, and I wish we had been even more underweighted. I was really disappointed in Amgen and Genentech; Amgen was a victim of stories about possible heart complications from one of its drugs. Genentech seems to be the victim of general malaise in the biotech world right now, but the company is on the leading edge of cancer research and I would like to hold onto it despite a loss of 8% for the quarter. Celgene (+9.3%) was the one bright spot among the biotechs. Schering Plough (+19%) was another bright spot in the health care sector.

     In contrast, energy stocks as measured by Morningstar were up 15.5% for the quarter and industrial materials shares were 12.7% higher. Conoco was 15% higher despite the expropriation of some of its assets by Venezuela. Refiner Valero rose by 14.5%. Canadian producer Penn West rose 13.6% and currently yields 11.5%. Even though we are already overweighted in energy shares, I have recently increased our exposure to some oil service stocks because they are very cheap relative to anticipated earnings. We have also done well in our remaining tanker holding, Stealth Gas, which rose 30%. I have mentioned this firm in previous letters as having young, aggressive management and an impressive board.

     We did quite well in a selection of industrial stocks. Industrial parts supplier Park Ohio was trading at a PE of about 6 in March; not surprisingly, it rose by 47% for the quarter. I sold some of our shares in chemical manufacturer Huntsman, thinking it was dead money, only to have takeover talk push the stock up 27%. Crane supplier Manitowoc (+26%) and diesel engine maker Cummins (+40%) were other winners.

     We would have done better but for some of the aforementioned dead money. As mentioned, Amgen and Genentech were not helpful. Nor were Pfizer (+1%) and JNJ (+2%). Nor were relatively large holdings such as Disney (-1%) or Direct TV (flat).

     Part of investing is what you do not own. I have stayed away from the housing stocks, because: (i) trends often take longer to play out than most pundits predict; (ii) there is still an overhang of unsold homes; (iii) interest rates have risen. Hovnanian fell 35% for the quarter, and that was an acceleration of a downtrend that began in July 2005. That’s why they say don’t try to catch a falling knife.

     But we also missed some big winners. My system assumed annual earnings growth for Amazon of 24%, which seemed reasonably aggressive. But Amazon said its profit nearly doubled in its most recent report, and the stock soared 71% for the quarter. There were others. No one can catch them all, and we are still ahead of the market for the year. Importantly, we’ve obtained these results with a rather conservative investment posture.

     As we go into the third quarter, my biggest concerns are interest rates and external shocks. At quarter end, the Value Line Index had an earnings yield of 5.15% (based on a PE ratio of 19.4). In comparison, one could have bought five year Treasury notes and earned a 4.93% yield. Historically, a ratio of 1.04 (5.15/4.93) has not been favorable for stocks, particularly in a climate where rates are expected to rise. Moreover, this pricing makes the market more vulnerable to external shocks. It is hard for me to protect you against a sharply lower opening in reaction to some event. The best way to protect against sudden moves is through put options; this requires a margin account. I’m happy to discuss details here with you if you are interested.

     I don’t know if private equity, Chinese and otherwise, or the relationship between stock yields and bond yields will be the dominant factor in the third quarter. But I do know that energy expended on good stock selection can pay good rewards over time. I will continue to try to make intelligent decisions about the best industries and stocks in which to invest, and to be mindful of changes in the macro-level influences on the markets. Hopefully, this will keep us ahead of the curve as the year progresses.

     Thanks again for your continued confidence.