Letter - July 2004





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Patience ... Patience

Investors checking their monthly statements since the beginning of the year no doubt have begun to wonder what happened to the resurgent bull market of 2003. For all the rallies and sell-offs, the market remains almost exactly where it was on January 1. Ask a professional what he thinks of the market and the reply is invariably, "dull, dull, dull!" Trading by hedge funds and the like has made up over half the volume on the New York Stock Exchange for most of the year. We are sympathetic to those investors who conclude that the only ones making any money this year are the brokers!

Much ink has been spilt in the financial press over the tight trading range the market has experienced so far. Pundits have assured us that every time a similar pattern has occurred in the past, the market always has "broken out" (?). We know that ... but which way? The negatives facing the market are well known: rising interest rates, terrorism, the potential for a tight presidential election, slowing growth of corporate earnings. The problem for investors is that while the risks are apparent it is difficult to quantify them. We know interest rates are headed higher but by how much? Most people expect another terrorist attack, but how bad and disruptive will it be? Such concerns have forced a lot of money onto the sidelines.

Despite piles of cash, professional money managers, ourselves included, are finding it difficult to find attractive new investments on which to spend the money entrusted us. The recent decision by Microsoft to return $30 billion to its shareholders is an admission by Mr. Gates that he cannot find anything to invest it in (so he'll just take his $3 billion in cash). Calls to long-time Wall Street friends bring forth the same lament: the market doesn't look cheap and I'm sitting on a lot of cash. Yet there are positives developing that may well bring higher prices in the months ahead. While stocks have stagnated, earnings have grown strongly over the course of the year. This has made stocks increasing attractive. We expect earnings growth to continue well into next year suggesting that at some point stocks could become a good investment again. There is an old Wall Street saw that says that they don't ring a bell at the bottom (or the top). In our experience, market moves usually catch investors unawares. We do not know when or if the market will begin to perk up but once it does all that uninvested cash sitting on the sidelines should help produce a powerful rally. Patience, patience.

Clients of P.R. Herzig with few exceptions have seen their accounts perform very much in line with the market indices. Despite this, the year has produced its pleasant surprises as well as disappointments? On the plus side, investments in oil and gas stocks have surpassed expectations. Energy prices have defied gravity though it's not yet time to trade in your car for a camel. Stock valuations have increased substantially as well and the sector no longer seems cheap though we see no sign of an imminent "energy bubble." Nonetheless, we question whether the sector will continue to produce outstanding returns going forward. We continue to take profits in accounts where there is a significant overexposure to energy investments.

With the graying of America, healthcare would seem to be a logical sector in which to invest but we have found the sector fraught with pitfalls. Healthcare costs now represent almost 15% of GDP, compared with less that 10% for other developed countries. New therapies, drugs and machines are life extending and in increasing demand. One problem though is that many of these new technologies are tremendously expensive. This has helped drive health care costs through the roof, up 41% in the last three years according to the Brookings Institute. But you can't tell someone they can't have a new life saving drug or test because it is too expensive. So how do we control healthcare spending so that we all don't go broke paying our insurance premiums? One way is for government agencies and healthcare providers to attack the profitability of companies providing healthcare forcing them to sell their products at ever lower prices. Obviously (at least in retrospect), this is not good for investors and has been the source of much disappointment for us so far this year. Companies like Curative Healthcare, AmerisourceBergen, and King Pharmaceuticals have seen their stock prices rise only to be shot down by such unexpected developments as lowered reimbursements from state agencies or premature competition from generic substitutes. One of the lessons we think we have learned from this is to look for companies that actually lower the cost of healthcare rather than ones that sell lifesaving but expensive therapies. The other lesson is stay healthy!

While we have admittedly had difficulty finding new attractive investment ideas, we do feel comfortable and exectant about the stocks that we do own three of which we highlight below?

H&R BLOCK (HRB $48 NYSE): a solid, long term growth stock selling at only 11 times this year's earnings of $4.30 with an excellent balance sheet and strong free cash flow generation. Since tax preparation, the company's main business, never seems to get less complex, there is ample room for moderate growth. The company also has a strong internet initiative to serve customers. If you are one of those, like me, who always seems to get a smaller tax refund than expected, maybe you should try H&R Block.

MNBA (KRB $24.25 NYSE) The second largest credit card issuer after CITIGROUP, MBNA has an enviable track record of growth based on excellent credit risk management and well priced acquisitions. Earnings of $2.00 in 2004 and $2.30 for 2005 makes this stock attractive as it sells at almost half the PE of the market. We look for multiple expansion and rising earnings to make this a rewarding long term investment

CHRISTOPER AND BANKS (CBK $15.50 NYSE) This largely regional retailer of practical clothes for older working women stumbled badly last year by offering merchandise that failed to excite its typical customer. A lag in same store sales together with a soft retail environment has caused the stock to sell of sharply. Nonetheless, the company remains strongly profitable, loaded with cash, has no debt on the balance sheet and is buying back stock. We expect earnings in excess of $1.00 per share this year. Furthermore, the company has aggressive expansion plans to double the number of stores in the next three years. Christopher and Banks remains an attractive turnaround story.

Tom Herzig


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