Letter – 2002 Q3

The stock market continued to post its worst year since 1974, when the S&P 500 fell 34.9 percent through September and 26.5 percent for the full year.  After three quarters, the S&P 500 was down 29 percent year-to-date.  Meanwhile, the Nasdaq has fallen 39.9 percent and continues to nearly mirror the performance of the Dow between 1929-32, as the enclosed graph shows.  I have been able to shield you from over a third of this decline.  So far this year, your account is down xx percent – unpleasant, but a lot better than the overall market.

One change from the first half of the year is that we’ve had a “nowhere to run, nowhere to hide” market since June.  In the first half of the year, there were areas of the market (such as health care stocks, consumer stocks, housing stocks, or mid-cap stocks in general) that were pockets of relative strength.  But in the second half of the year, weakness has been much more across the board.  Thus it has been tougher to outperform the market recently. While we still managed to do so, it wasn’t by as much.  For the third quarter, the S&P 500 Index fell by 17.6 percent and your account dropped by     percent.  There hasn’t been a quarter this bad in 15 years – since the ’87 crash.

I have done my best to maintain a reasonably defensive posture until there is some evidence in prices themselves that the downtrend has ended.  The S&P 500 remains under its 200 day moving average, as it has been for almost all of the past two years.  A sustained movement above the 200 day moving average would be one strong indication of a change in overall trend.  But absent that, I have kept high cash balances, built positions in some defensive names with good dividend yields, tried to buy stocks at the lower end of trading ranges or during mini-panics, and sold to cut losses or lock in profits where it seemed appropriate.  In such a volatile market, more such selling was triggered than is normal.  I also lightened up on some of the consumer cyclical stocks that had been strong earlier in the year, because those stocks can drop far more than the market as a whole in bad times.  Similarly, I have reduced our exposure to housing stocks.  Even though certain ones like Hovnanian have performed well, any downward adjustment in that sector is likely to be rapid.

I am doing my best to keep you well-positioned in stocks that seem priced to offer solid returns over the next few years.  To illustrate this, here are your ten largest holdings with their projected earnings and the projected compound annual return projected by my model.  These stocks could fail to meet these projections for any number of reasons; the best I can do is base these projections on current views of likely earnings.

Stock     Sep 30
FY 02
FY 03
Annual Return
L-3 52.70 2.25 2.65 18.6 11.1
Cisco 10.48 0.56 0.65 19.2 17.9
GE 24.65 1.63 1.74 13.9 9.1
Wyeth 31.80 2.54 2.63 13.6 12.5
US Steel 11.61 0.43 2.24 8.2 15.3
Home Depot 26.10 1.58 1.85 17.2 17.2
Everest RE 54.86 5.45 6.60 13.0 21.2
Thornburg 18.79 2.37 2.25 9.2 9.3
Fischer Scientific 30.35 1.74 2.01 15.2 10.7
Michaels 45.70 2.12 2.53 18.5 13.4

As you know, one part of my model assumes that at the end of five years, the PE ratio of the stock will equal the growth rate over the most recent five years.  We then apply that PE to the expected earnings in year five to calculate an expected stock price and relate that back to today’s price to project a compound annual return.  As you can see, these are quality companies with projections that are far superior to those available in the bond market or cash today.  My database still has hundreds of stocks where the projected returns are far lower, or even negative.  So I comb through a lot of data to find stocks that seem poised to do especially well.

Even so, there have been plenty of disappointments.  For example, I purchased xx shares of Maytag at $30.58 in August.  The stock was down from the high 40s earlier in the year, and consumers have been investing in homes and home-related items.  My model projected a compound annual return of about 26% on the stock.  But since then, earnings estimates for 2003 have fallen from $3.45 to $3.17 per share, and the stock has been punished.  It is at levels last seen in 1996, and may still turn out to be a good buy.

Another frustrating stock has been Skechers.  The company passed the Peter Lynch test – do your wife and kids like the product?  Yup.  They like shoes and sneakers that they don’t have to tie.  But here again, we had an earnings warning and a large drop in the stock.  It seems overdone; even with the lower earnings estimates, we still project a compound annual return of over 25%.  But this market has been very unforgiving of any bad news.

Another disappointment has been Six Flags.  We bought xx shares at $xx after it had been as high as $18 earlier in the year.  I thought it was a good bet for a highly leveraged turnaround situation; in my view, park attendance would rise if management were a bit more imaginative.  But so far, the stock has continued to weaken.  Similarly, Polycomm soared above $40 after 9/11 on expectations that video conferencing would replace some travel; we sold some between $28 and $36 and bought back in at much lower prices, but it also has continued to decline.

These and some similar situations have caused turnover in the account to be higher than usual, but volatility is at an extreme and creates more than the normal need to sell to cut losses or preserve gains.  For instance, Fleming has fallen by over two-thirds since we exited the stock.  This discipline is part of why we’ve outperformed.  When volatility calms, the level of activity in the account should decline as well.   I have done my best to add value by maintaining a disciplined approach to selling, and using accumulated cash to buy at opportune times.  All things considered, we’ve done reasonably well with this approach.

I believe that the stocks we own will do relatively well given the current market environment.  We have a profit in L-3 Communications, which is a leader in electronic warfare.  Defense stocks have been one of the few bright spots in this market.  We re-established a big position in Cisco shortly before their May conference call suggested that their business was finally starting to turn, but even so, analysts have recently been trimming earnings estimates here too.  It is now about 90% below its peak.  If you bought Nifty Fifty stocks down 90% in 1974, you did very well.  The same could be true here, even given Cisco’s revised earnings projections.  Michaels Stores has been a core position for about a year, and continues to be one of the strongest consumer stocks.  Thornburg Mortgage is a mortgage REIT that hedges interest rate exposure, maintains high credit quality, and has a dividend yield of 12%.  It has been a great defensive holding for us over the past year.  We recently took a position in US Steel.  The stock traded in a range of $17 to $24 in the first half of the year; we bought it at an average price of $13.35.  Earnings are highly cyclical, but if the company meets the current estimate of $2.24 a share in 2003 (which is less than half the $4.88 earned in 1997), my model projects a compound annual return of 15% on this stock.   We’ve already had a good run in Steel Technologies on similar logic.  And so on.

The portfolio is more tilted toward “blue chip” stocks now than it had been.  This is because the recent price weakness has finally made these stocks attractive in absolute terms and relative to mid or small cap stocks.

As you know, I try to find the best relative values in a given market rather than rely on any ability to divine the direction of the overall market.  Nevertheless, it is only sensible to try to monitor certain macro trends and developments for clues as to attractive sectors and key influences on the market.

The two worst cases we know of in this century, the 1930s Dow and the 1990s Nikkei bear market in Japan, both spent themselves within three years.  (However, despite some sharp rallies, Japan continued to drift lower over the next decade).  There are some intelligent observers who believe that a bear market will exhaust virtually everyone within that time frame.  But historical patterns can only offer reference points, and nothing guarantees that a decline will stop after three years just because that’s what happened in the “worst case” of the 1930s.  But I have been mindful of the enclosed overlay.  It suggests two things – (i) that we are approaching the maximum sustainable time of a sharp downtrend in the past century, (ii) that prices could still have considerable downside momentum into a major bottom.  On the other hand, the S&P fell in half between 1972 and 1974, and bottomed in early October after marginally taking out the September lows.  It then provided a return of 37% in 1975.  It’s possible we’re seeing a similar scenario develop here.

Corporate earnings are beginning to stabilize after a sharp drop in the past two years, but there is no sharp rebound.   Despite a high number of negative pre-announcements recently, year-over-year earnings growth for the third quarter is likely to be in the 6-8 percent range.

The market no longer seems overvalued in terms of price-earnings ratios.  The consensus seems to be that the S&P 500 Index companies will earn an aggregate of about $52 in 2003.  At the quarter-end level of 815, that gives the S&P 500 a forward P/E of 15.7, and thus an earnings yield of 6.38%.  That compares favorably to the five year Treasury yield of 2.7%.  The PE as measured by Value Line is almost identical. This suggests that additional price declines can no longer be blamed on overvaluation.  But there are skeptics who think that PE measure is overly bullish because of the poor or suspect quality of earnings.  And some observers believe that the pendulum may now swing to a period of undervaluation, which would imply further price declines.  And still others say that stocks won’t be a good value until the dividend yield on the S&P is considerably higher than today’s 2%.

I am starting to hear murmurs of bullishness from smart people.  Some big cap tech companies are starting to consider acquisitions again.  Several investors who have done well in the past few years on the short side are starting to believe the market is in a bottoming phase.  We are nearing the time of year when the market has tended to exhibit the most seasonal strength.

As I have cautioned in earlier letters, external shocks or mere fears of them could still help to drive prices lower.  That could be war in Iraq, a banking collapse in Japan or elsewhere, or some less anticipated event.  I cannot predict market direction, but I do believe that most of the excess has been driven from the system.  Unless the housing and consumer sectors of the economy weaken a lot, there will be good reasons for stock prices to stabilize soon.

I have been reluctant to take cash levels much higher than the quarter end level of xx percent in an account designated for stocks; obviously there is a risk of substantially underperforming on the upside once stocks turn around.  Already on most up days, we are underperforming the market.  (However, in early October, we did a lot of buying especially in the tech sector).  But at least thus far, it has been worthwhile to maintain this defensive a posture.  I am certainly willing to tailor individual accounts to be more conservative, or more aggressive, upon specific direction.

You should always feel free to call me to discuss anything related to your portfolio or the overall market.  The current environment is certainly at least as frustrating to me as it is to you.  But this country is still growing and innovating.  We have had other boom and bust cycles, from the early days of the railroads to the internet.  Markets overreact, first to the upside, and then to the downside.  But the overall trend has been one of ever more wealth creation in this country.  I don’t see that changing.

* Past performance is not necessarily indicative of future performance. Results for individual clients may vary. Results are not audited. Byrne Asset numbers reflect the addition of certain dividends and deduction of all fees. S&P numbers are based on the total return of Vanguard’s S&P 500 Index Fund.

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