Letter – 2005 Q3

In football, “three yards and a cloud of dust” isn’t too exciting.  The stock market wasn’t very exciting this quarter either, but the S&P 500 index quietly produced a return of 3.1%.  If you annualize that, it’s not a bad rate of return.

One mistake that many people make is to focus only on where “the market” may be going.  They’d be better off to focus more on what is happening with individual stocks.  There was great variation among stocks within that 3.1%, and that worked to our benefit.  Your account was up 5.8% for the quarter, outpacing the S&P by an appreciable amount.

We did this well in part because we were overweighted in energy stocks.  At the end of the quarter, energy stocks comprised about 10% of the S&P 500 Index.  Your account had about 16% energy stocks.  We did especially well in Petroleo Brasileiro (+37%), Lone Star Technologies (oil service, + 22%), and Arc Energy Trust (Canadian tar sands, +27% plus an annual yield of about 7%).  It was interesting to me that energy stocks rose in the immediate aftermath of Hurricane Rita.  The conventional wisdom was that minimal damage to refineries was good news that should produce lower oil prices.  The opposite result suggests continued tightness in the market, due in particular to the refining bottleneck.  I’d prefer to hang on to energy stocks so that we might profit if this trend continues.  Thus I think the optimal strategy is to stay with the trend as long as there are valid reasons to do so, and to protect ourselves with stop-loss orders that we can adjust upward if prices continue to rise.

Energy prices indirectly affected other industry groups, such as consumer stocks.  There is a nervous anticipation that as home heating bills climb, consumers will have less money to spend on discretionary items.  Moreover, most consumer stocks are more expensive relative to projected earnings than they were a few years back.  At this time of year in 2002, I projected an average return of 15% annually on the consumer stocks in my database; now that projection is only 8%.  I have reduced our exposure to consumer cyclical stocks a little bit.  For instance, we got stopped out of some Michaels Stores this quarter.  And part of a fairly new position in Bed Bath and Beyond was sold at a modest loss.  But we’ve had an excellent run in Gildan Activewear, a Canadian maker of casual clothing, which rose 45% for the quarter.

One other notable movement this quarter was a decline in housing stocks.  Hovnanian has been stellar for several years now, but fell from a peak of $73 in mid-July to $51.20 on September 30.  (That’s why you don’t put all your eggs in one basket).  Although HOV fell the most, other housing stocks fell sharply too.  What happened here?  The earnings news is still good.  One can be right for the wrong reasons, but here is my analysis:  on July 21, the Chinese government announced that the yuan would no longer be pegged to the US dollar.  What might that have to do with housing stocks?

I believe that traders decided that this event might cause the yield curve to steepen.  Until that announcement, long-term interest rates had stayed at very low levels relative to three month Treasury bills.  Even Alan Greenspan said he was puzzled.  But the Chinese government has been buying huge amounts of Treasury securities with the dollars generated by their trade surplus with the US.  That buying put upward pressure on the price of Treasury notes, and thus downward pressure on those yields.  A floating yuan would likely reduce the Chinese trade surplus, so they would have fewer dollars to recycle back into the Treasury market, hence there would likely be less foreign buying and consequent upward pressure on rates.  If Treasury rates go up, mortgage rates follow.  Bad for housing stocks.

The housing stocks peaked the day of that announcement.  We liquidated our position in Hovnanian at reasonably good levels and avoided much of the plunge in the stock. After the two hurricanes, we bought lightly into some of the homebuilders that build a lot in the South.  But we remain underexposed now to this sector.

There is lots of talk about a “housing bubble”.  But housing stocks are different than tech stocks, which suffered in 2000-02 from the primary effect of declining earnings momentum and the secondary effect of PE ratios compressing.  The PE ratios of housing stocks are already quite low, so there should be minimal bearish influence from declining PE ratios.  However, earnings momentum could certainly slow or decline considerably.

In the financial sector, I’m most interested in insurers and investment banks.  Wall Street is humming and Lehman Brothers is knocking the cover off the ball.  The stock was up 17% for the quarter.  I also bought Morgan Stanley when it seemed as though the news couldn’t get any worse.  Although we bought near the lows, the company’s earnings have not kept pace with competitors and the stock is stagnant.  We have sold some.  Analysts keep looking for a top in the property/casualty market, but the stocks are priced reasonably relative to earnings expectations and have done well.  Everest Re gained 5% for the quarter, and my system still projects a compound annual return of 23% for the stock.  I’m less optimistic about commercial banks, who tend to fare poorly when the yield curve is as flat as it is today.  Given the discussion about housing stocks, I’m similarly far less interested than I had been in mortgage lenders.

The health care sector is more a matter of special situations.  My system identified Biovail as a buy in early September. At that time, an FDA announcement was pending and I knew it could send the stock sharply in either direction.  I took a risk and bought before what turned out to be favorable FDA news and added more afterward; we have an overall gain of 17.7% in Biovail.  This stock fell from a high of over $50 in 2003 to a low of about $14, but with new management, investors seem willing to take another look.  We also had a great quarter in Amgen, up 32%.  Finally, we have decent size positions but more modest quarterly gains in Teva Pharmaceuticals (+7%) and WebMD (+8%).

There is not much to talk about in the tech / communications sector.  My biggest disappointment of the quarter was Seagate Technology.  My system liked it, but we sold most of it at a modest loss.  We also got stopped out of some Itron, but the stock doubled from where we bought it.  We did have a 21% gain for the quarter in Mobile Telesystems (MBT), the Russian cellular provider.  Although the stock may be a bit ahead of itself, my system still projects a compound annual return of about 15% on it.

My most embarrassing move of the quarter was the purchase of Tempur Pedic, which gave an earnings warning several days later.  What can I say?  My “reliability filters” don’t always work.  If nothing else, it re-affirms the old investment rule about cutting losses and living to play another day; we still had a good month and quarter.

We own plenty of big cap stocks:  Johnson & Johnson, Intel, IBM, Hewlett Packard, Prudential, Aetna, and some others.  But I don’t equate “big” with “profitable”.  Walmart was down 9% this quarter.  General Motors lost 10%.  Exxon Mobil was up 10.6%, but we found better ways to invest in the energy sector.   “Blue chip” does not always translate to “optimal”.

I’m not sure what to make of the overall market here.  The S&P 500 Index has traded above its 200 day moving average for most of the year, which suggests that a bull trend remains intact.  I would get a bit more defensive if the market broke below that moving average.  The market is still no great bargain relative to interest rates.  Its earnings yield is about 5.43% (based on the Value Line index).  You can invest almost risk-free in five year Treasuries at a yield of 4.15%.  Historically, an earnings yield / 5 year Treasury yield ratio of 1.3 is barely bullish for stocks.  With rates poised to go higher, this ratio is a yellow flag.  But earnings growth continues stronger than most analysts anticipated, growing at a pace of about 16% to 17% year-over-year.  That is arguably quite bullish, though earnings growth is about 11% when the energy sector is netted out.  Furthermore, the recent sharp decline in consumer confidence does not bode well for earnings momentum.

There is every chance that the market just keeps plugging along in a manner that may not be thrilling, but still allows us to generate pretty respectable returns.  I hope I can offer a similarly good report at year-end.


* 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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