Letter – 2005 Q4

Although it was not an easy year to make money in US markets, we did better than most.  Your account gained 8.14% for the year, besting the total return of 4.77% on the S&P 500 Index by a healthy margin.  Our returns were even better relative to other indexes; the Nasdaq Composite gained only 1.37% and the Dow Industrials lost 0.61% in 2005 (the latter measures are price change only; I have total return data only for the S&P so far).  So given what we had to work with, it was a pretty good year.

It would have been even better, but the fourth quarter was our weakest period in terms of relative performance.  Although we eked out a gain of 0.74%, we lagged the S&P 500 gain of 1.6%.  That is primarily because energy stocks, which had been strong all year, softened during the fourth quarter.  For example, Amerada Hess plunged from 137.50 on September 30 to as low as 114.50 just four days later.  Needless to say, the fundamental outlook for Hess did not change by 16% in four days; this was mostly hedge funds panicking all at once.  Some of the selloff was sparked by the arrival of the “shoulder season” when demand for gasoline drops as the summer driving season ends, and the demand for home heating fuel has not yet picked up.  I thought that might cause a slight dip in energy stocks, but I did not anticipate the swiftness or suddenness of the move in Hess and other stocks.

There were some frustrating inconsistencies in the fourth quarter.  In early October, stocks that should be negatively correlated, such as energy and consumer stocks, all sold off sharply.  Stocks that are normally positively correlated, such as oil service giants Schlumberger and Halliburton, diverged sharply.  (We own neither).  And housing stocks, which normally correlate pretty well, were up (Beazer), down (Toll Brothers), and sideways (Hovnanian).

We’ve done extremely well in housing stocks in the past few years, but they were puzzling in this quarter.  The conventional wisdom was that Toll Brothers would do relatively well because it catered to wealthier buyers who were less sensitive to interest rates, while a stock like Beazer would suffer more because it catered more to first-time buyers.  Well, TOL fell 22 percent for the quarter and Beazer rose 24 percent!  Beazer was more attractively valued at the start of the quarter (probably because of that conventional wisdom), but not by a compelling amount.  Less wealthy buyers were more active than had been anticipated, due in part to a strong housing market in New Orleans and also to increasing migration of 20-somethings to exurbs.  The market is not always perfectly efficient in discounting such developments.  I think we have beaten the market pretty consistently over the past five years because markets are not always efficient!  But no edge in this case; our biggest holding in the sector was Hovnanian and it was up just modestly from where we jumped back in during mid to late October.

The best investment returns for 2005 were found overseas.  For instance, after a bear market since 1989, Japan’s market rose 40%.  I have confined my international investments in individual securities to limited use of ETFs (exchange-traded funds) and ADRs (American Depository Receipts) because earnings data is readily available.

Thus one of our biggest and best positions is in Tata Motors, an Indian company with ADRs  traded here.  We own Tata from $xx, and it ended the year at $14.37.  Even now, my system projects a compound annual return on the stock of 17 percent.  And it is reasonable to assume that the Indian auto market is poised for the type of growth that the US market had in the 1950s.

We did well in a number of domestic issues too.  Generic drug producer Teva was up almost 29%.  We had good results from Cephalon, a mid-cap pharmaceutical with promising drugs to treat alcoholism and sleep disorders.  At September 30, my system projected an 18% compound annual return on the stock, and it gained 39% for the quarter.  Specialty firms including biotechs and the generic drug companies still seem to be the better plays in the drug world; compare those quarterly returns to Pfizer (- 6.6%), Schering Plough (- 1%), or Bristol Myers Squibb (- 4.5%).

We had a 19% gain for the quarter in Middleby Corp., a maker of food service equipment.  This is my system at its best, picking up a company in a plain vanilla business whose price was well below that justified by its recent and projected earnings growth.

In the financial sector, P&C insurer WR Berkley rose 20% and life insurer Prudential gained 8%.  Investment firm Lehman Brothers was up nearly 10%.  Particularly after October, there were plenty of other successes.

But we had some “misses” and disappointments this quarter.  For instance, Continental Airlines stock doubled this quarter – not because it is making any money, but because its competitors are gradually disappearing.  We missed a 70% move in Gymboree, which posted great comparable store sales growth, but my system was only projecting a 9% compound annual return on the stock back in September, which was ok but hardly compelling.  And I simply missed Google this year.  Long story.  And I was underweighted in gold shares.  You can’t win ‘em all.  But you can miss things and still make good money in the markets.

Opportunity cost is one thing, but absolute losses are another.  My system was projecting a 22% compound annual return on EchoStar Communications (satellite TV), but the stock fell 8% and we have cut our position at a modest loss.  The system saw 17% annually in WedMD (now Emdeon), but the stock fell from 11 to as low as 6.61, and we were stopped out [at xx].  My last letter mentioned my disappointment in being stopped out of Seagate Technology, which plunged by a third and then rallied all the way back!  Over time, we’ve done well by cutting losses when it seemed necessary in tech stocks but this was a very frustrating exception.  Well, with this much counter-intuitive stuff occurring in a quarter, I suppose we could have done a lot worse.

Time to look ahead.  What might 2006 bring?  Let’s start with relative values.  If you want off the stock market roller-coaster, you can buy five year Treasury notes at a yield of 4.3% and five year A-rated corporate notes at about 4.75%.  Let’s compare that to the likely earnings yield from stocks.  The consensus among analysts is for earnings to grow a bit more than 10% in 2006, producing earnings for the S&P 500 Index of about $85.  With the index at 1248.29, that produces a forward PE ratio of about 14.7 and thus an earnings yield of about 6.8%.  By this measure, you would expect to get about 2 ½ percent more from stocks than from treasury bonds – a reasonable but not compelling premium.

I’ve done the same exercise using the Value Line statistics, where my database is more extensive.  Here the PE of 18.3 is calculated from a broader universe of stocks and uses the prior six months and estimates for the next two quarters.   That translates to an earnings yield of 5.46%.  And 5.46 / 4.3 on Treasuries equals a ratio of 1.27.  Historically, that has suggested only modest gains on average for stocks.  If rates move higher, stocks obviously become even less attractive.

The rate of earnings growth is healthy, but is also decelerating from recent years, as the following table shows.  The stock market can be sensitive to changes in momentum as well as to absolute changes.

The same table shows that earnings have about doubled since 2001 and the market has more or less treaded water.  Some smart analysts believe that the market will continue to climb a “wall of worry” thanks to bearish sentiment – perhaps due to the fresh memory of the 2000-02 bear market.  For instance, Smith Barney cites its proprietary “panic / euphoria model” to predict a 95% chance of a rally in 2006.  But others say that the PE ratios back around 2000 were unsustainably high, and this treading water represents a rational reduction of the PE ratio.  My view is that PE ratios have returned to reasonable enough levels that continued gains in earnings should suffice to drive stock prices higher.  So then the question becomes what can derail this projected earnings growth?  After all, analysts were projecting higher earnings well into the 2000-02 bear market.

Oil prices will be a major variable, and very smart people disagree about where oil prices are going.  Many say there is too much of a fear premium in these prices given today’s reasonably high inventories, and that this premium will continue to melt away.  But billionaire investor Richard Rainwater points out that there is no excess production capacity among oil producers today.  He says that in 1988 the world consumed about 55 million barrels of oil a day, and that an extra 15 million barrels a day could have been produced if necessary.  Today, the world consumes 80 million barrels a day and there is no excess production capacity, setting the stage for continued price spikes.  So higher energy prices could slow economic growth and consumer spending, and thus impair earnings growth (for all but energy stocks).

The market has also recently been spooked by an “inverted” yield curve, meaning that rates on short-term debt instruments are higher than rates on long-term notes and bonds.  Historically, an inverted yield curve has very often foreshadowed a recession.  The “this time it’s different” argument is that other yield curve inversions occurred in periods of high real interest rates, and it is those high real rates that have a recessionary influence.  That is not the case today.  Real interest rates are about 1 ½ percent below their average of the past decade (measured as the difference between the rate on the five year Treasury versus the year-over-year change in the consumer price index).

Others are spooked by the view that a new Fed chairman tends to face some sort of crisis early in his tenure.  That was certainly true for Alan Greenspan; the ’87 crash occurred shortly after his term began at the Fed.  Will the market try to test Bernanke in some fashion?

There is an interesting juxtaposition of cash balances in our economy.  Consumers may be overextended, and that problem could worsen if housing prices decline significantly.  On the other hand, corporations are flush with cash as are many private investment funds.  This suggests that capital spending should be robust.  The 2001-02 recession was sparked by a decline in capital rather than consumer spending; conversely, capital spending could spur a strong economy in 2006.  Moreover, there could be more stock buybacks and takeovers as a result of all the cash in corporate treasuries and in investment pools.  Certain takeover targets may be companies that do not look so great based on current earnings, but may be asset-rich or ripe for efficiencies that often come from new management.

Absent shocks that inhibit earnings growth, the stock market is positioned for reasonable appreciation in 2006.  But the market is unlikely to move in a straight line.  Hopefully we can continue to spot opportunities to add to the overall return provided by the market.  Meanwhile, I thank you for your continued confidence and wish you all the best for the New Year.

* 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.