Letter – 2006 Q4

In the last few months, the stock market has been predicting a strong economy in 2007 while the bond market has been predicting weakness.  One of these prognostications must be “wrong”.  The markets could meet in the middle, or there could be a major price adjustment in one of these markets in 2007.  But that is getting ahead of things.

The stock market closed the year very well, and so did we.  Your account gained xx percent in the final quarter, versus a xx % gain for the S&P 500.  So the year began well and ended well, sandwiching a problematic middle.   Your account began the year with a balance of $xxx and ended with a balance of $xxx.  Your annual return was xx%, compared to a xx% gain for the S&P 500 Index.

According to industry analysts, including pension consultants with whom I meet regularly, this was an unusually difficult year for most active money managers. In addition to political uncertainty that roiled international commodities markets and increased concerns about new regulation given the change of control in Congress, 2006 witnessed peculiar financial currents. Specifically:

  • there were some sudden shifts in macro trends
  • leadership see-sawed back and forth between large and small cap stocks
  • many of the stocks that did well this year  defied logic

Sudden Trend Shifts.  Commodity-related stocks were hot until May and then plunged quite suddenly.  For instance, Goldfields rose 46% for the year through May 11, and then tumbled 23 percent in 9 business days and then another 13% two weeks later.  Phelps Dodge followed a similar pattern, before soaring on a takeover bid in the fall.  Oil stocks broke sharply in 2006 with only temporary respites in early and late summer.

Large Caps v Others.  I have argued in earlier letters that most of the large cap stocks have seen their best growth, and that there are better investment opportunities elsewhere.  I still think many large cap stocks are priced rather expensively relative to their growth prospects.  But some of the largest companies in America have grown earnings at surprisingly fast rates.  For instance, Comcast Cablevision, the nation’s largest cable provider in terms of market capitalization, saw its 3-year 30% earnings growth rate accelerate to over 38% through the first 3 quarters of 2006.  Moreover, many of these stocks traded at even higher PE multiples in the late 1990s, so it is arguable that large cap stocks can again trade at such valuations.  To illustrate, GE’s earnings per share have doubled since 1998, but the stock is no higher than it was then and in fact sits at half its mid-2000 level!  That is because the PE multiple on the stock has fallen considerably.  But that cannot go on forever.  At some point, GE becomes a “value” stock.  It has grown earnings at a compound annual rate of 4.4% during the period 2003 to 2005 but accelerated to 8.2% in 2005 and double digits this year.  So after not having owned it in recent years, we have just reestablished a position.  I have done the same in several other mega-cap stocks because by most measures, the valuation parameters between these stocks and their smaller brethren have been stretched too far in favor of smaller stocks.  Corporate boards must feel the same way; 29 of the 30 Dow companies have stock buyback programs in place.

I track the relationship between larger and smaller stocks by monitoring the ratio of the S&P 500 Index, which includes the 500 largest publicly traded U.S. companies, to the Russell 2000 Index, which reflects the broader market.  That ratio peaked in March at about 0.6 when the S&P was just under 1300 and the Russell 2000 was at about 770.  Imagine if that ratio fell back to its decade low of about 0.3.  That would happen if, for example, the S&P stayed at its current level while the broader market lost half its value!  Nothing is that simple in the stock market, but recognition of imbalances between sectors us vital to prudent investing.  We’ve done that well all decade by having a large exposure to mid and small cap companies.  It may be time to shift more money toward larger, more established companies.

To that end, we executed research  calculating historic PE ratios of selected large-cap stocks during economic times similar to the present.  Multiplying the average PE ratio by the expected 2007 earnings for each company, we obtain a projected hypothetical stock price.  Relating that projection to the current price, we  get a sense of potential appreciation assuming valuations return to their historic averages.  By this metric, some large cap names could appreciate substantially.  Below is a chart summarizing some of what I did. Note the we’ve increased our exposure to most of these names:

Stock Average
PE Ratio
2007 Earnings
Per Share
Price as of
This Letter
Potential (%)
Disney 43.2 1.72 74.30 34.54 115%
United Technologies 48.4 4.16 201.34 63.13 219%
Coca-cola 46.8 2.54 118.87 48.65 144%
Microsoft 44.1 1.45 63.94 29.84 114%
AIG 26.6 6.26 166.50 72.35 130%
Kohl’s 57.5 3.84 220.80 69.15 219%
General Electric 33.6 2.22 74.59 37.76 98%
Boeing 21.8 4.74 103.33 88.85 16%

One must ask whether a return to such PE ratios is justified.  For example, the average PE of Cisco during the analyzed period was over 60.  By this type of analysis, Cisco could quadruple in price.  I am not predicting that.  Any model like this serves merely as a frame of reference; a common sense overlay is always necessary.  For instance, there is no clear reason why Microsoft’s PE ratio should return to 49, but it could certainly expand from today’s 21.  Or, as media stocks return to favor, could Disney’s PE return to the 40s?  Perhaps.  We own more Disney than we have in a long time.

Another insight from this analysis is that utility stocks are quite expensive.  For example, applying the historic PE metric to projected earnings of Public Service Enterprise Group produces a hypothetical 2007 stock price of $57.68. It is currently above $66.  One reason for the favorable valuation shift is the repeal of the Public Utility Holding Company Act of 1935 prohibition on takeovers in the utility field.  Now a utility stock can trade at a price that anticipates a possible takeover.  Furthermore, the dividend yields on utilities have gotten more attractive as interest rates have fallen.  Even so, valuations seem stretched.  We owned the major utility stock ETF and sold it (ticker XLU) at a 10% profit in 4 months.

Another reason to own large cap stocks at this stage is that most of these companies derive a high proportion of their earnings overseas.  In other words, Coke and McDonalds are in Europe and Asia but Dicks Sporting Goods and Tower Insurance Group are not.  As foreign currencies continue to strengthen against the dollar, earnings of companies with operations abroad will tend to grow more rapidly than purely domestic counterparts – partly due to pace of foreign economies, partly due to the repatriation of profits into increasingly cheap dollars.

Speaking of the dollar, it comes to mind when I think about what factors could undermine the stock market in 2007.  If the dollar continues to weaken versus the Euro and other currencies, the Federal Reserve might feel pressure to raise, or delay cutting, interest rates to make the currency more attractive to hold.  Whether the  Fed actually lifts rates or  if there is merely the perception that such might occur, stocks could suffer.  Higher interest rates make bonds more attractive relative to stocks, and higher rates can weaken rate-sensitive sectors of the economy such as housing and consumer products.  The prospect of a bearish surprise from interest rates is particularly troubling when the conventional wisdom has been that rates will move lower in 2007.  One of the key factors we monitor is the relationship between bond yields and the earnings yield of the overall market. With 5-year  Treasuries yielding 4.7% and equity earnings at 5.38% for the S&P 500 and X.XX% for broader Value Line Index,  that ratio is sending a fairly neutral signal.

We began by noting the contradictory signals being sent by the stock and bond markets.  There is potentially good news here.  Quoting Business Week (Dec 25, 2006): “This isn’t the first time the stock and bond markets have sent contradictory messages.  Westport (Conn.) research and money management firm Birinyi Associates found 16 such instances since 1982.  In 100% of the cases when both stocks and bonds hit new 52-week highs, stocks were up six months later, with an average gain of 8%.”

Price Leaders in 2006.  Although we missed things like Google, we did have some very good gains in stocks such as Lehman Brothers and Goldman Sachs, Continental Airlines, Phelps Dodge, Cisco, Direct TV, Dicks, Mobile Telesystems, Celgene, Tempur Pedic, and AIG.  We also got solid returns by investing in such un-sexy things such as the Blackrock Diversified Income Strategies Fund (DVF), which appreciated xx% from our purchase price while supplementing this with a xx % annual dividend yield.  As is true in any year, we had our disappointments in stocks ranging from Chico’s (which lost earnings momentum after xx great years in a row) to Avon (not hitting it in China).  Moreover, I should have taken big profits in our energy stocks the day that British Petroleum announced that they had to shut production in Alaska.  Oil stocks peaked the day that the news about oil prices could not have gotten any worse!  Though I probably held onto some positions for too long, these stocks are now remarkably inexpensive, and the PE ratios are so low that there is potential for another big rally in the event of more supply disruptions.

The good news is that you only need a few big winners to have a good year in the stock market.  Our analytical methodology continues to identify a reasonable number of these, though we admittedly had fewer huge scores in 2006 than in other years.  However,  xx% is not a bad year in the stock market; it is above what Warren Buffett suggested the average annual returns for the decade would be.

We were well-positioned in the fourth quarter of 2006, and I believe we are soundly positioned to begin the new year.  I am digging ever deeper to identify the best opportunities for a good overall return for your portfolio.  Assisting me in this endeavor is a new colleague, Art Ernst  Art comes to Byrne Asset Management with over 28 years of experience in the industry, an MBA from Wharton, and highest honors in economics from Rutgers.  I am pleased to have him on board, and hope his presence will translate into value-added for your portfolio.

Thank you for your continued business, confidence and friendship.  Best wishes 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.

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