Letter – 2006 Q2

This was a difficult quarter (in fact, my worst relative to the S&P in over five years).  The S&P 500 Index only fell by 1.9%.  However, the Nasdaq Composite Index plunged by 7.2% as blue chips substantially outperformed the broader market.  I have been gradually rotating into more blue chip stocks; too gradually given the sudden shift in the market.  Thus we underperformed the S&P; your account lost 4.5% for the quarter.  This puts us back to about even relative to the S&P 500 for the year.

The 1.9% drop in the S&P 500 masked a lot more underlying volatility.  The sharpest decline occurred between May 10 and June 13.  In this time frame, the S&P fell by 7.5% and the Nasdaq  plunged 10.7%.  The good news is that we raised a fair amount of cash early in the selloff.  The bad news is that we owned several energy and commodity-related stocks that were particularly hard hit.  Conoco Phillips sold off by 14.5% in this period.  It is a big holding and there was every temptation to panic and sell part of the position.  But this is a quality stock with a PE ratio of 7 in what appears to still be a bull market in energy stocks.  Despite its sharp selloff, COP actually rose modestly for the quarter.

We did bail out of some commodity stocks that were even more volatile.  For example, Goldcorp opened about 10 percent lower on May 15, and we were stopped out of part of our position there.  But that sale turned out to be prudent because the stock tumbled another 25% before stabilizing and beginning to recover.  It is a good example of how stop-loss orders help to limit risk.  Even so, it was frustrating because gold and the stock market tend to be negatively correlated most of the time.

Other quality companies got clobbered too.  For example, Goldman Sachs lost over 15% of its value in this May 10-June 13 time frame.  We’re all quite familiar with people who have done very well by ignoring short term blips in Goldman stock, and it is worth maintaining a core position in this stock and in Lehman Brothers.  However, investment banking stocks can be volatile and vulnerable to any sort of financial crisis; just look at 1998 during the Long Term Capital hedge fund crisis.  In balancing these considerations, I’ve kept our core positions in these stocks but cut back slightly.

Some of the blue chips that I thought would help stabilize the portfolio did not do so.  For example, my system projects a 16% compound annual return on Home Depot – but the stock apparently does not realize this.  It fell 15% during the quarter, tracking the weakness in the housing stocks even though its earnings grew by 22% in the most recent year-over-year quarterly comparison.  This bears no relationship to earnings patterns in the housing sector, which have cooled considerably, but there is no arguing with the market.  General Electric has also shown compound earnings growth of about 23% annually over the last two years, but the stock is stuck in neutral.  It was off 5.2% for the quarter.  Another stock that seems overdue for some upside is Microsoft.  We bought it at $23.51 in May (it was at $27.21 on March 31), and it ended the quarter at $23.30.  So three of the most “prudent” stocks out there did poorly too.

I think a couple of things happened during the quarter.  First, as I mentioned in my last letter, stocks were getting expensive relative to interest rates.  That relationship got a bit better for stocks thanks to the selloff.  Second, analysts have been saying for at least two years that it was time for large cap stocks to finally outperform their smaller brethren.  They did so this quarter, simply by not going down as much.  Third, so-called “momentum” stocks (such as commodity, energy, domestic steel and certain tech stocks) were severely punished.  If it went up a lot in the first quarter, it probably went down a lot in the second quarter.

A number of stocks that had particularly strong gains in the first quarter were 30% or more below their peaks by mid-June.  Nvidia is a good example.  It was up 56% in the first quarter and down 25% in the second quarter.  I’m not sure that either move reflected such a large shift in the fundamentals.  We bought some just off the lows in mid-June, with a tight stop-loss parameter.  Omnivision is a similar case.  The stock rose 51 % in the first quarter.  Then it fell 30% in the second quarter, despite a mid-June announcement of 28% earnings growth and a projected return on my system of nearly 20% annually.  We used stop orders to protect most of our gain.  The best explanation I can provide regarding both of these companies is that the investment community constantly worries about pricing pressure and thus profit margins in the specialty computer chip business.

Another place where momentum reversed was in foreign markets, and especially emerging markets.  This is another example of where diversification is theoretically supposed to limit risk, but did not.  We own an ETF (exchange-traded fund, symbol ADRE) that is indexed to emerging markets, and it fell about 25% before recovering almost half of that loss.  Tata Motors had an even larger fall, plunging 32% from peak to trough.  Although I sold a small amount of Tata near its peak, I am reluctant to sell too much of it.  As I’ve said before, a quality auto company in India is a pretty good bet these days and my system projects an annual return on the stock of almost 20%.  There are certain stocks where our overall return has been excellent, prospects remain excellent, and we should do our best to hang in there even if there is some short-term pain.

Unfortunately, not all of our positions fall into that category.  In the last two years, we had doubled our money in men’s clothier Joseph A Bank.  But the stock plunged sharply on news of sales below forecast and reduced projections.  Fortunes can change quickly in retail and JOSB management is not overly forthcoming and therefore is not particularly trusted in the investment community.  Thus there is a tendency to sell first and ask questions later in this stock.  I have also taken a position in ChipMos Technologies (IMOS).  Analysts following the stock had been heralding a big turnaround in earnings, and my system was (and still is) projecting a return of over 30%.  That is the kind of chance I feel we must take and we bought in late May.  But during an overall market decline like this, investors can lose their nerve over a turnaround story.  The stock has declined, and  we have a stop-loss order that would get us out if it tumbles more from here.  One other stock really hurt us this quarter – Headwaters.  Although year-over-year comparisons in quarterly earnings growth had been great through March, the company is suffering from the double whammy of concern over less demand for construction materials and a possible loss of congressional support for alternative fuel tax credits.

There were some bright spots this quarter.  Celgene was marginally higher.  Emdeon (formerly WebMD) was up 15%.  Boeing rose about 5% from our purchase level.  Our transportation stocks held their own.  Our Canadian tar sands holdings (Arc Energy and Petrofund Energy Trust) both did well and have high yields  We had some good defensive holdings, such as JNJ which rose 1% for the quarter.  But we didn’t have much in the way of big winners this quarter.

So what else did well that we missed?  Walmart was up 2%, and has a big weighting in the S&P.  Exxon Mobil was up less than a percent, and there are better energy plays.  Coca-Cola was up 2.7% and Pepsi rose nearly 4%.  Merck rose 3.4% despite the ongoing litigation risks.  You get the idea – it was a good quarter to own big cap stocks that have not gone up or down much in recent years.  For example, Pepsi was at 55 two years ago and is at 60 today.  The one contrarian play that I regret missing is General Motors.  It rose 40% for the quarter, even as market share continued to erode, because the turnaround plan seems to be gaining credibility.  Analysts were projecting losses until recently, and I simply didn’t anticipate this degree of change in momentum.  Finally, some of the stocks in my database that did well this quarter were stocks that my system had ranked as neutral.

There has been talk for many months about a slowing in the economy and a consequent slowing in corporate earnings.  Remember the articles a few months back about whether an inverted yield curve foreshadowed a recession?  Now the talk is about whether the Fed can really afford to stop raising interest rates because the economy still seems so robust.  Moreover, overall earnings for the S&P 500 are expected to grow at a pace of about 12% for the second quarter.  That is slightly ahead of projections made three months ago, so there is no loss of earnings momentum.  Corporate America has been growing earnings at a double digit pace for three years.  Given the strong economic underpinnings, it is hard to see a sustained downtrend in stock prices absent some kind of external shock.  But we cannot discount the risk to the markets from the likes of Iran, North Korea, Hamas, or some unforeseen event.

My bottom line is that it was an ugly shakeout but not a reason to change our fundamental outlook on stocks.  Earnings momentum is still strong.  Valuations are neutral, with stocks neither too rich nor especially cheap.  The market traded below its 200 day moving average for long enough to scare people but has moved back above it.  As yet, there is no evidence that the long term bull trend has been broken.

Given that, we are sticking with core positions such as Tata, Korean steelmaker Posco, Carpenter Technology (CRS), Goldman Sachs and Lehman Brothers (similar to Goldman but a less risky proprietary book), Genentech, and others.  We also initiated some new positions.  For instance, Turkcell is the ubiquitous cell phone provider in Turkey and its shares appear to have fallen too far due to the overall weakness in emerging markets.  My system projects a compound annual return of 28% on Turkcell.  Direct TV has moved from losses to a period of accelerating earnings growth.  My system projects a 25% compound annual return on this stock, and we just initiated a position.  I will continue to look for such opportunities, and to limit downside risk if conditions require.  Thank you for your continued confidence during a tough quarter.


* 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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