Letter – 2003 Q2

It is a pleasure to write after a quarter in which the market did well, and we did even better.  The S&P 500 Index rose 14.9 %, and your account gained 23.8%.  For the year-to-date, your account has gained 22.1% while the S&P is up 10.8%.  As always, your returns include any dividends and reflect the deduction of my 22 ½ basis point quarterly fee (ie, 0.9% per year pro-rated quarterly).

As my last letter indicated, we knew there was a good possibility that the market was poised for a rally.  I cited the bullish relationship between the earnings yield on stocks versus the yield on bonds.  Corporate earnings have not been great, but have at least stopped their precipitous decline.  The Nasdaq market had stopped tracking the Dow’s pattern from the 1930s.  The major averages were pressing against their 200 day moving averages, and a move above those averages would be seen by some as a key sign of a change in trend.

Government policy is providing a strong tailwind.  The Fed has pushed interest rates to record lows, and money supply (M-2) has grown 7.9% in the past 12 months.  Fiscal policy has been very stimulative in general, and the cut in the tax on dividends has to help underpin stocks.  Yet the market has a tendency to overreact in both directions and to get ahead of itself.  There is at least some risk of that at this juncture.  Sentiment has gotten very bullish (more so than at any time since 1987 by one measure), while earnings estimates have not moved up that much.  At some point, that matters.

The market looks ahead, so it’s worth taking a minute to look at how some earnings estimates for this year have changed in the past three months:

That’s enough of a snapshot to make the point.  Housing continued its market leadership.   Tech stock earnings began to show some signs of improvement, and that was enough to move those stocks.  Much of the other earnings data was pretty unexciting. Prices anticipated better earnings news than has occurred so far.

It has gotten harder to identify new stocks to buy at these levels.  We trimmed our tech holdings a bit in the past few weeks.  I’ve used Cisco as an example in earlier letters, so let us return to it now.  The stock ended the quarter at $16.79.  It is projected to earn $0.59 in the fiscal year ending this month, and $0.64 in the fiscal year ending July 04.  Earnings are now expected to grow at “only” 15% in the next few years.  If those projections turn out to be accurate, the company would earn $1.12 for the year ending July 2008.  If its PE matches the expected earnings growth rate of 15%, the price in July 2008 would be $16.80 – right where it is now.  Not very exciting.  (We own it at good levels, and we’ve sold about 25% of our position recently).  There are many other situations like this, which explains why I think the market has great momentum but is a little ahead of earnings here.

There are still some great situations.  In my last letter, I ran through the same sort of analysis on UT Starcom and said we bought it at $21.05.  It ended the quarter at $35.60, and while its valuation is no longer compelling it is still reasonable.  Thus I will use the “let profits run” approach and use a trailing stop-loss (ie, protect profit) order on part of the position.  Thanks in part to its appreciation, the stock is presently our largest position.  Nam Tai Electronics (NTE) seems to be almost as attractively valued now as UT Starcom was three months ago, and has recently started to move.

We’ve continued to have a great ride in the housing stocks.  To illustrate the beauty of buy-and-hold, we own some Hovnanian ($58.95) from the mid-teens.  Only recently have I started to wonder if the housing stocks might be peaking, for several reasons:

• certain housing stocks are no longer cheap relative to projected earnings
• certain housing stocks really accelerated on the upside recently, and may have finally gotten ahead of the fundamentals
• the closer scrutiny of Fannie Mae and Freddie Mac may lead to a tightening of credit standards and thus of mortgage availability
• the yield curve steepened considerably after the most recent Fed rate cut

The financial sector was strong.  We did particularly well in the insurance group, where property-casualty companies and re-insurers seem to have decent pricing power.  We have also done fairly well in banking and mortgage company stocks.  And we’ve done quite well in Lehman Brothers, which has a particularly strong fixed income franchise.

We’ve had a great run in the biotech sector.  I’ve said many times that about 80% of what I do is pursuant to my quant model, and about 20% is pure discretion.  The investment in the biotech sector was discretionary.  The sector had stabilized between October and March after a three year downtrend, and for many reasons, I thought that it would have a good run in an up market.  Since individual companies are risky and highly specialized, I bought a basket of stocks using the Hambrecht & Quist Life Sciences Fund and the Amex Biotech i-shares.  We have a gain of 17 % there for the quarter.

Another essentially discretionary trade was the purchase of Owens Illinois at $9.51 in March.  While the stock did well on the quantitative screen, the purchase was primarily an assessment that the market was overreacting to its potential asbestos exposure; the stock is up 45% from our purchase price in response to congressional steps to limit asbestos liability.

Although many traditional healthcare stocks tend to lag in an up market, we still had healthy gains in a number of healthcare names.  Inamed (obesity treatment) gained 49% this quarter.  Pfizer is more slow and steady, but has a good pipeline and better valuation than most of the drug majors, and was up 9.6% for the quarter.  Sunrise Assisted Living has been disappointing; it is the market leader in assisted living and screens very well.  But every time it gets near $30, the same Merrill Lynch analyst comes out and trashes it with what I see as a flimsy argument about their real estate holdings.  I keep thinking the market will ignore this guy one of these times.  Meanwhile, I’ve recently bet on a turnaround at Orthodontic Centers; too soon to evaluate the investment.

There are two other categories of stocks to discuss briefly: losers, and winners that we missed.  In any up market, there are certain high-fliers.  Yahoo, Amazon, and Ebay come to mind at present.  All three had big runs during the quarter, and based on the approach to earnings shown in the Cisco example above, all are way too rich on my model.  They may be great companies, but they are very richly priced.  If the market turns down again, it is stocks like these where there is a high likelihood of the type of substantial losses that really clobbered people in the last few years.  I do my best to avoid investments where the risk seems to substantially outweigh the potential reward.

We had some disappointments in the quarter, but not many.  We were stopped out of  NBTY, the nutritional products company, a month before it rebounded sharply.  We were also stopped out of Steel Technologies, which was just as well in that the stock has not rallied back.  I was particularly disappointed to be stopped out of much of our position in Webex, which I still think has promising technology for video-conferencing.

We added a number of new positions in the quarter.  Ann Taylor seemed cheap and well-positioned for a rebound; we bought xx shares at $22.23 and it ended the quarter at $28.95.  I took a similar view of Barnes & Noble; their earnings multiple has contracted a lot and they have reasonable prospects for good growth with Harry Potter, Gamestop, DVDs, and the move to more in-house publishing.   It’s up 20% from our $19.25 purchase price, but there is a good chance of much better appreciation.  Nextel has excellent cell phone technology with direct connect, and screened well when we bought it at $13.30.  We bought a small cap company called Bennett Environmental, which seems cheap and appears to have a near-monopoly in much of the soil remediation world.  This is not a complete list of purchases; we can discuss the others at any time.

We took profits on some stocks in addition to the trimming of the Cisco position.    Foundry Networks is a great company with terrific growth prospects, but it got rich enough that my model was projecting a negative return over a five year time horizon, so we lightened the position a bit.  I liquidated our Six Flags position at a nice profit.  The weather on the East Coast has been so bad that I would be shocked to see this company announce a quarterly profit.  If they announce anything disastrous this quarter or next, I might well look to get back in as we did last fall.  And I lightened up some on Tesoro; the stock seems to have settled into a trading range after a great run in the first quarter.

I noted earlier that it has recently been more difficult to find new stocks to buy.  Typically, I’ve bought stocks where my model shows a good chance of a 20% compound annual return.  There are few such opportunities right now.  But if market selloffs do not give us the opportunity to invest at such target levels, we might have to ratchet down our bogey to the 16 – 18% range.  With five year Treasuries yielding about 2 ½ %, that is still a very wide gap.  In other words, I am mindful that the equity risk premium may be undergoing a secular shift.  Economists incessantly debate the proper level of the equity risk premium; my job is to monitor market conditions in the hope of staying just ahead of the curve.  The advantage of using the quantitative model that I developed is that it will always seek the best relative values in any market environment.

As always, there are plenty of things to worry about.  If the Fed lowers rates, the dollar will crash.  If the Fed raises rates, the housing market will crash.  The Fed has already used all its bullets, and so monetary policy won’t be of much help if there is further economic weakness.  If the Fed gets it just right, the terrorists will strike.  What can I say?  If there were nothing to worry about, prices would go up every day, and anyone could do my job!

On that note, I’m leaving for a week in Vermont – don’t worry, I’m still plugged in from up there!  Never hesitate to call with any questions, comments, or concerns.  Thank you for your continued confidence.  Let’s hope the sun shines both on Wall Street and the Jersey Shore this summer!

* 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.