Letter - January 2004





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Welcome to 2004

For investors the year 2003 will be a tough act to follow. Over the last 12 months, the popular equity averages gained approximately 26%. Can we expect an encore? For an answer, keep your eyes on President George W., who will be running for a second term this fall. A downtick in the economy in 1992 cost his father his re-election, a situation Junior will certainly do all in his power not to repeat. Meanwhile, the war in Iraq should continue to grind towards a resolution and remain a low-level concern for investors. International terrorism remains a wild card.

Election years are usually good for the stock market, and true to form, an economic recovery is beginning to take hold. The national gross domestic product was up an amazing 8% in the third quarter of 2003 and a 4% gain is expected in the fourth quarter. The 2004 number is looked to be between 3.5% and 4%, well above the normal 2.5% long-term growth rate. Continued improvement will rely heavily on Mr. Bush's not so secret weapon, Federal Reserve Board Chairman, Alan Greenspan. Mr. Greenspan, considered the "A-Rod" of the financial world, has intimated that he will keep interest rates low, perhaps longer than prudent to keep the economy on course.

Interest rates, not profits, are what make the stock market go up and down. Low interest rates breathe liquidity into the economy. Over the past several years they have fueled the housing and auto markets, keeping an otherwise sagging economy afloat. Although Chairman Greenspan has pledged to keep interest rates low for the "foreseeable" future, there are questions about his eyesight. The possibility of a financial cold shower is keeping investor "exuberance" under control. Rising interest rates put pressure on price/earnings ratios. Currently, the Standard & Poor's 500 stock index is selling at 18 times anticipated 2004 earnings, several points above where the ratio typically is at this stage of the cycle. The probability of rising interest rates should be the greatest challenge facing investors in 2004 and that ain't all.

Like the weather, everybody talks about the twin deficits but never really does anything about them. The trade deficit (money owed to our trading partners) and the Federal budget shortfall (money owed to everybody) have resulted in a decline in the dollar vs. foreign currencies. Before President Nixon closed the "gold window" in 1974, foreign governments could exchange their dollars for gold. No more. Now they have the choice between U.S. government bonds or soybeans. It is a weird situation whose solution appears to be further erosion of the dollar. But shed not a tear, at the end of WW II (1945) the English pound was worth $4.95. Today it is down (but up recently) to $1.75 and that "blessed island" has still not sunk into the sea. In fact, it is enjoying record prosperity.

Although the outlook for business is improving, investors have been slow to "belly up to the bar." At the moment, the direction of the stock market could be described as a coin toss, even though odds favor a profitable first half. Asia, with China as the focal point, has been receiving a lot of attention. In fact, many overseas markets from South Africa to Germany outperformed our own. For the New Year, Japan still looks interesting but we still ponder how to invest safely in the long term growth of China. On this side of the Pacific, we're putting our money on the following:

CANADIAN OIL SANDS (COSWF.PK $33) heads a syndicate developing shale oil deposits in northern Alberta, Canada. The working deposits are huge, as are the reserves (rivaling those of the Mid-East). On an asset basis, this is the most under-priced oil company we follow. The dividend payout to investors is currently around $1.45, which should double when the current expansion is completed in 2005. RISK FACTOR: Collapse of the oil price.

WYETH (WYE $42) is a blue-chip pharmaceutical company, whose stock has been penalized by lawsuits over the company anti-obesity drug. Although most claims have yet to be settled, Wyeth has reserved funds it believes sufficient to meet projected payouts. For 2004, the company estimates $2.75/share earnings, which puts the P/E at the bottom (cheapest) of the drug list. RISK FACTOR: Government pressure on drug companies to reduce prices.

CNA FINANCIAL (CNA $24) is a Chicago based property-casualty insurance company, 90% owned by Loews Corporation, which, in turn, is controlled by the Tisch Family. In the late 1990s, along with many companies in the casualty business, CNA mispriced its policies, a costly error. To replenish reserves, Loews Corporation recently injected $750 million dollars into the company which should allow a normalization of business. Book value is around $30/share and 2004 earnings are estimated at $2.50/share. If all goes well, CNA could become a takeover candidate. RISK FACTOR: Unexpected catastrophe losses.

SONY (SNE $34.70) As a world class business acknowledged by many to be master engineers and designers in the field of consumer electronics, SONY has few peers. However, over the last decade the company has done a poor job managing costs which has resulted in falling margins and disappointing earnings. Management has recently unveiled plans to cut costs and deliver earnings growth by boosting operating margins from 2% to 10% over the next five years. If they deliver only half of that, SONY should be a great investment. RISK FACTOR: Management cannot execute turnaround plan.

FEDERAL HOME LOAN MORTGAGE CORP, aka Freddie Mac (FRE $58): A major force in the home mortgage business, Freddie has exhibited steady growth over the last decade. However, it has recently been tarred with the brush of scandal which has driven down its stock price to a point where it sells at only 10 times estimated earnings of $5.80 for 2003 and 2004. Freddie's crime was to understate past profits by $4.5 billion in order to smooth out the volatility of its earnings. The real issue we suspect is that Freddie has many competitors who would like to see the company stripped of the implicit Federal backing that enables it to borrow at rock bottom rates. We are agnostic on the merits of the charges leveled at Freddie though we acknowledge that it is a controversial pick. However, we do feel that what happened at Freddie should not have dramatically changed the company's worth and the current price more that adequately discounts future risks. RISK FACTOR: The government removes Freddie's special privileges.

To one and all, we at P.R. HERZIG& CO. wish HEALTH AND HAPPINESS in the NEW YEAR!

Phil and Tom Herzig

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