Letter – 2004 Q1

The stock market’s momentum has slowed after a strong rebound year in 2003, but the S&P 500 Index still managed to eke out a gain of 1.3% for the first quarter.   We were able  to outpace that by a respectable amount; your account gained 3.7%.   There was also some shifting of leadership in the market; many tech companies lost ground while energy, financial, and many consumer and commodity companies did well.  The tech weakness contributed to a loss for the Nasdaq Composite Index of 0.5% in the quarter.  But many other types of small and mid-cap stocks rose.  In fact, the Russell 2000 Index (which reflects such stocks) rose by 6%.

Some of the stocks that propelled us last year simply cooled off in the first quarter.  These stocks were across industry groups; shares including UT Starcom, Nextel, Humana, and Hott Topic were all down by more than 10 percent.  We lost 14.6% on our remaining shares of Intel and had similar experiences in other tech stocks.

I was a little bit defensive, which kept us well protected from the decline in the Nasdaq.    But the same cautiousness caused me to miss big rebounds in a few stocks such as American Eagle, Jill Group, or AT&T Wireless (AWE).   Even so, I’m pleased to report that we had a number of great performers in stocks across many industry groups.

Although I missed AWE, we did well in the cellular sector.  Growth overseas has been particularly strong.  We still own a lot of  Mobile Telesystems OJSC (MBT), which operates in Russia.  It advanced 58.8% from $82.80 to $131.50.  We added some of the Turkish carrier TKC at prices under $28; it ended the quarter at $35.75.  And we have smaller positions in some other attractive carriers.  The sector struck me as a rarity; an area of promising growth which had pretty cheap stock valuations.

The energy sector had been dull for quite some time, and we were long underweighted in  it.  But the conventional wisdom that oil prices would recede at the “end” of the Iraq War was wrong.  We are still long a lot of Tesoro Petroleum (much of it from under $5 per share), though we have lightened the position.  As refining margins have continued to improve, TSO rose 29% from $14.57 to $18.79.  The oil tanker market also tightened, and we did well on our shares of OMI shipping (OMM), which gained 28.1% for the quarter.  Alternative energy supplier Headwaters moved up 31.3%.  Those more specialized issues did better than majors such as Conoco Phillips, which still gave us a respectable 6.5% return for the period.  Petrobas, the Brazilian producer, seemed more attractive than the traditional major producers.  We have a good sized position, and the stock gained 14.6% for the quarter.

We had good gains in a lot of consumer names:  Dicks +19.5%, Pacific Sunwear +17.1%, Black & Decker +15.5%, Brinker’s +14.4%, Ruby Tuesday +12.8%, etc.  There were two standouts, both held in Leslie’s account.   One was was Joseph A Banks, the men’s clothier.  We bought it at a split-adjusted price of $26, and it ended the quarter at $36.24.  It was depressed on rumors of high inventories, but the price was cheap relative to earnings estimates and we stepped up.   The other big winner may be the most mundane of these stocks, Helen of Troy.  They own brands such as Dr. Scholl’s and Vidal Sassoon.  Hair brushes, shampoo, powder, etc.  They’ve grown earnings at a compound annual rate of 45% over the past three years, and the stock was up 34% for the quarter.  The business may not be exciting, but the stock return is.  Despite the good news in this sector, I’m tightening some stop-loss parameters on certain consumer cyclical stocks, due to richer valuations and the recent spike in interest rates.  Consumer cyclical stocks are traditionally among the most vulnerable to higher rates.

We had some other winners too.  The health care sector was relatively quiet, but Cytyc gained a stunning 60% on the strength of a new cervical cancer screening product.  Fischer Scientific (clinical lab products) rose 33%.  Our biggest health care position is in Pfizer, which was almost unchanged.  But it is perhaps the strongest of the major pharmaceuticals, its valuation is reasonable, and I think the stock can provide a decent return with below average risk.

We even had a few winners in tech land, such as Open Text (information management), up 55.5%.  Equally important, we got out fairly well in some other tech stocks.  Remember that we bought Foundry way back in October 2002?  After moving from about $5 to $33 in sixteen months, the stock fell in half in only two months.  We got out of most of it at about $25.95 or above – a good example of the utility of stop-loss orders to lock in profits.

But we didn’t dodge every bullet; in fact, we walked right into one or two.  Most notably, drug company Biovail.  I thought it screened well as a turnaround play, but its earnings just continued to disappoint.  My timing on the purchase of Brooks Automation (chip equipment automation) was bad, and I felt I had to cut back a little as the stock fell, but we still have a decent position at about breakeven now.  Similarly, in Lexar Media, I didn’t catch the bottom but came close enough that we now have a good and marginally profitable position in a company that is a leader in digital film.  It has a 67% compound annual sales growth rate over the past three years.  If revenues can continue to grow at a mere third of that pace with reasonably consistent margins, this stock should deliver excellent returns.

Another major addition to the portfolio this quarter was AIG.  This stock had been prohibitively expensive for years.  The bear market took a lot of the air out of the stock, and it fell from a peak of over 100 to under 50.  It has regained earnings momentum, and the stock price became reasonable in the overall market decline.  We have a modest profit to date.

I also added mining stocks Freeport McMoran and Inco.  Earnings projections on commodity stocks are notoriously volatile.  But based on current projections, my model forecasts a double digit annualized return on these stocks.  And they should be good holdings if we move toward an inflationary environment.  Also, nickel is a key ingredient in stainless steel, so Inco may benefit from the continued demand particularly in China.  We have owned a small stake in gold stocks to date, which have been disappointing so far.  They are generally negatively correlated to the overall market, but have disappointed even during periods when the market was weak.  I suspect that’s because gold stocks have a greater tendency than most issues to trade ahead of their fundamentals.    Nevertheless, gold bullion is at an eight year high, and I think maintaining this position makes sense. There is at least some chance that we are in a relatively early stage of an inflationary cycle in metals and other commodities.

The price of gold is as good a transition as any into some more general market commentary.  I’ve been a little more cautious than I was a year ago because I see some clouds on the horizon.  It’s just hard to tell how distant the horizon is.  But it seems to me that there is some risk of the same type of guns-and-butter problem that eventually hurt the market when we were spending for the Great Society and Vietnam at the same time.  Or more recently, consider 1994, which is the last time the Fed raised interest rates.  Despite sharply higher corporate earnings, the S&P 500 Index posted a small loss that year.   Given the difficulty of projecting geopolitical and other broader influences on the market, I tend to view all this for the moment as distant rumblings.  Valuations, especially from a top down perspective, are still reasonable.

I have often compared the earnings yield on the S&P 500 with the yield on the five year Treasury.   So let me reprint a box showing this relationship at some market tops:

Period PE Ratio SPX
Nov 68 18.7 5.35 5.65 -0.3
Aug 87 16.7 6.00 8.32 -2.3
Jul 90 16.4 6.08 8.31 -2.2
Mar 00 28.2 3.55 6.51 -2.9

Stock yields have been below bond yields often enough that we can’t say the 1968 reading is highly persuasive.  But we can say that once the five year Treasury has a yield advantage of 2 or 2 ¼ percent, there is good reason to be very cautious.  So where are we now?

The consensus among analysts is for S&P 500 earnings to be about $63.00 in 2004.  The SPX ended the quarter at 1126, so the P/E ratio based on projected 2004 earnings is 17.87.  The reciprocal gives us an earnings yield of 5.60%.  The five year Treasury finished the quarter with a yield of 2.80%.  So the yield on stocks was twice as attractive as this Treasury yield, with the gap at a positive 2.80%.  That is better than at some market bottoms in the past two decades!  But just two days later, the Treasury yield had jumped by 25 basis points, after the strong employment report issued on April 2.  There is some risk that an upward movement in rates could wipe out or at least significantly narrow this advantage over the course of this year.  Just as a frame of reference, the five year Treasury rates rose from about 5% to about 7 ¾% during 1994.  My bottom line is that the Fed will try very hard to limit any rise in rates between now and November, in part because I think Greenspan remains very sensitive to criticism that the Fed cost the elder Bush his re-election in 1992.  And even a 50 percent rise in the five year Treasury yield, analogous to 1994, would produce a yield of only 4.20%.  Thus the earnings yield relative to Treasuries should continue to be a bullish influence on stocks in 2004.  But that doesn’t mean that we’ll have another year where the S&P returns over 20 percent; it’s not a good idea to get accustomed to returns like that.

In addition to geopolitical conditions and valuation, I keep my eye on earnings momentum and the 200 day moving average as an indicator of primary trend.  The S&P 500 and Nasdaq Composite spent the last 12 months well ahead of their 200 day moving averages.  Then in March the Nasdaq traded right down to its 200 day moving average, but never below it.  There was never a serious test on the S&P 500.  So the market held, another indication that the primary trend remains bullish.

Earnings momentum is useful because the market is sensitive not only to absolute direction but also to rates of change.  The acceleration in earnings gains may have peaked in the fourth quarter of 2003, when earnings were 26.5% ahead of where they had been 12 months earlier.  That rate slowed to 16.1% for the quarter just ended, and is expected to slow a bit more as the year progresses.  So while earnings should continue to rise, the open question is how much those expectations are already factored into current prices.

The beauty of the stock market is that there is almost always a wide dispersion of returns among individual issues.  For instance, I now have about 750 stocks on my permanent database.  With the benefit of hindsight, the top decile among these stocks returned 35% in the first quarter.  The bottom decile returned a negative 18.3%.  One on hand, the probability of owning all of those top decile stocks and no others is truly beyond remote.  On the other hand, this dispersion suggests that there is always opportunity somewhere.

I will continue to do all I can to capture as much of that opportunity as possible.

* 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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