Letter - November 2004





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The Ship of State ... She Floats

The Stock Market Yawns?

The presidential election has come and gone and the winner is … the American people! No terrorist disruptions, no legal challenges by predatory lawyers. Life goes on. The truth is that no matter who had been the winner, the ship of state would have continued to float. America is not key man dependent. And if we have learned anything from 9/11, it is that America is resilient.

The stock market this year has rallied, sold off, gone up a little. To date, returns are meager, mid-single digits. Mr. Bush’s reelection matters a little, but it doesn’t alter underlying economic realities. Corporate earnings, after rebounding sharply off a bottom, are now growing more slowly. The federal and trade deficits are rising. The dollar is under pressure. High oil prices are eating into consumer discretionary income. And housing prices…could they be slowing down or, heaven forbid, leveling off? These are the real issues for the economy. What’s a stock market to do?

We continue to believe we are in a low return environment for investments not unlike the late 1960s and early 1970s. Stocks do not appear cheap but select opportunities exist. Investing today is like waging guerilla warfare: strike when opportunities present themselves and run when you hit your target.

“Through a glass darkly” is an apt metaphor for investing in corporate securities today. Like other investors, we have been drawn to low valuations of triple A stocks like American International Group (AIG), Federal Home Loan Mortgage Corp (Freddie Mac), and Merck (MRK), the giant pharmaceutical company, only to see these icons of American business accused of unsavory business practices by zealous and perhaps politically motivated prosecutors. Wherein lies the truth? Like Caesar’s wife, is none above reproach? This is an important issue for investors that is holding the market back. If asked, we would say that this is the residue of the go-go years of the late 1990s and will pass in time. In the meantime, we have to acknowledge that when we buy, we are peering “through a glass darkly…”

So what can clients expect? Singles, an occasional double, and an emphasis on avoiding a big error. We have to be defensive but we also have to be imaginative, adventurous and eclectic, not an easy task. We put ourselves on record below with trepidation:

Gold: To date we have held modest positions in gold mining shares. We intend to increase these positions in an opportunistic way. The large trade deficit never seems to go down, a bad omen for the dollar. Should the dollar decline, gold should rise. It took 25 years for the stock market to recover its high after the Crash of 1929. It has now been almost 25 years, a generation, since gold hit its high in 1980, long enough perhaps for the market’s institutional memory to have forgotten the value of the yellow metal. We aren’t looking for a sharp rise but we do see the potential for profit. We don’t see much point in trying to build a diversified portfolio of gold stocks. We just want some exposure. We think a barbell approach makes sense: quality on one end and a speculative bet on the other. When gold rises, institutions tend to flock to quality (and liquidity), so those shares rise first. The speculative shares then hold the possibility of outsized gains (and of course losses). For quality, we own NEWMONT MINING (NEM, $49); for speculation, VISTA GOLD (VGZ, $4.20). The risk is very simple: gold goes down.

The oil sector: We are conflicted. While these stocks have been among the best performing ones that we own, indications of additional supply and lower oil prices may well begin to weigh on stock valuations. Also, when we think back to the previous oil boom in the early 1980s, we recall that there was a frenzy of takeovers. The saying back then was that it was cheaper to drill for oil on Wall Street than on Main Street. Today, to the contrary, there is a dearth of deals despite the high oil price which suggests to us that drilling for oil on Wall Street at these prices may not be so profitable going forward. We will continue to trim positions where representation in the portfolios is excessive.

Individual stocks: We are buyers again of LA QUINTA CORP (LQI, $8), an operator and franchiser of limited service hotels. The company has come through hard times and should achieve profitability in 2005. The stock sells at little more than asset value. New management has done a good job of turning the company around. Earnings momentum and an improved hotel market characterized by a lack of new supply should help the stock price. Risks: another 9/11 disruption of travel.

Finally, I am happy to announce that we will have a new, more functional (though intentionally Spartan) website up and running by the time you receive this letter. Those of you who like to use computers will find this and previous letters on the site, as well as a description of the firm, our investment philosophy, our professionally qualifications, and our history. You will also find such practical information as directions to our office, our new money wiring instructions (they've just changed), our privacy policy, how to reach us in the event of an public emergency, and other pertinent facts. So please visit www.prherzig.com at your leisure and be sure to give us your comments so that we can make the site better meet your needs.

Tom Herzig


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