Letter - January 2005

 

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Outlook 2005: Not so hot ... Not too bad

The year 2004 was a difficult one during which we struggled as investment managers to earn our keep for most of the year. It was a year of uncertainty and challenges. The war in Iraq, the presidential election, ever present fears of terrorist attacks, a weak dollar, soaring commodity prices, an emergent China, and corporate scandals continued to hit the headlines. And yet the economy made steady progress. Corporate earnings advanced, long-term interest rates stayed low (the biggest surprise of the year) and the S&P 500 (with dividends reinvested) had an above average return of 10.9%. Fortunately, a late year rally lifted portfolios to the extent where most clients should be satisfied with solid if not spectacular returns. But as the new year begins, excessive year-end investor optimism has turned to concern as the market has sold off. Smiles have turned to anxious frowns.

Our record as stargazers is somewhat checkered, yet we are paid to look ahead to the New Year and try to assess the possibilities. On the one hand, the challenges seem daunting (for a change!) though familiar. It has been over three years since the attack on 9/11/2001 and our enemies seem quiescent but no less determined. As more time passes, the probability of attack on the homeland grows. The war in Iraq drags on; the news doesn’t seem to get better. Perhaps that is the negative bias of the media. But the fact remains: Osama, al-Zarqawi and Sheik Omar remain at large. The budget deficit increases as does the trade deficit. And the dollar seems destined to sink to ever new lows. After robust growth in 2004, corporate earnings will probably grow more slowly in 2005.

On the other hand, things don’t seem too bad. A weak dollar does not necessarily mean a weak America. A weak dollar improves the global, competitive position of US exporters, which could bolster corporate earnings and help to reign in the trade deficit. The surge in commodity prices is likely behind us and as such should not ignite a 1970s like inflation. After rising from $30/barrel to $50/barrel, oil is unlikely to rise to $80/barrel. So despite the Fed’s commitment to higher interest rates, inflationary pressures seem under control for now. As we see it, in the new year the economy will likely experience modest economic growth although some pundits are looking for as much as 4%. However, as the economy moves toward full employment of resources and labor, rising interest rates and  growing inflationary pressures will at some future point (late next year?) check robust growth. The economic upturn is maturing.

There is one area about which we are concerned. Commodities and commodity-related stocks have produced strong returns over the last three years. We worry that stocks of natural resource companies, gold and petroleum related industries are over-hyped and over-bought. We tend to agree that a good case can be made that oil will rise, that China and India have insatiable appetites that will drive commodity prices higher for a decade. But we are bothered by the nearly universal acceptance of these received truths and wonder if stock prices don’t already reflect the consensus view. Making a big bet on natural resources at this time, we fear, is a high risk proposition. We intend to take a balanced portfolio approach to our commodity based investments as we have over the past year. We will continue to pare back positions which become too large so that capital is not at undue risk should expectations turn out to be over inflated.

It is worth noting that while the US market performed well over the last year, the real star performers were the so called “Emerging Markets.” The stock markets soared in such places as Egypt (+102%), Colombia (+87%) and the Czech Republic (+55%). With returns like that, we really should get our passports renewed!

All in all, it is a muddled picture, as usual. But perhaps, that is the best we can ever hope for. And, perhaps, that is not so bad for the stock market. We believe that 2005 will be a year where stock selection will continue to determine performance. The rising tide of 2003 which lifted most stocks and the more selective gains of 2004 (which together produced a two year gain of 42.7% for the S&P 500) should give way to an even more discriminating 2005.

Turning to stocks, we wish to highlight three unloved and seemingly washed out issues: AT&T, CP Ships and Chiron. All three are characterized by a depressed stock price and low investor expectations. Each has experienced a business disruption that has led to investor disappointment. In each case, the business model going forward appears sound though that is notably controversial with regards to AT&T. Any positive developments should result in higher stock prices.

AT&T (NYSE T $18.90) may be the most hated stock on Wall Street. It has buried a whole generation of widows and orphans. After years of trying to figure out where to focus its attention (cable?, long distance?, wireless?) and years of wasted investment, T is shrinking down to its last viable business: building and managing large enterprise data and voice communications systems. On the plus side, the company generates substantial cash flow which has been used to pay down debt, buy back stock and support the dividend. We also suspect that T is a more robust incubator of technology than is generally acknowledged. Analysts’ mean estimate for 2005 earnings per share is $1.78. With a dividend yield of 5%, we feel T has the chance to finally reward shareholders over the next two or three years. After years of disappointment, investor expectations seem too low. Risks include (1) inability to maintain pricing in the enterprise business resulting in greater than expected declines in revenue and cash flow, and (2) failure to turn technological initiatives into profitable products.

CP Ships (NYSE TEU $13.65) came to life as a public company after a spin-off late in 2001 from the old Canadian Pacific conglomerate. It owns or leases a fleet of 81 container ships around the world. The stock is depressed due to the poor performance of management which was not up to the demands of running a public company after years in the sheltered embrace of Canadian Pacific. Poor cost accounting uncovered by a new computer system led to a downward restatement of earnings totaling approximately $50 million over two years. Management found itself in the embarrassing position of having to pay back bonuses from previous years. Then there were stock sales by senior employees ultimately deemed illegal even though vetted by legal counsel. And to top this all off, the CEO was asked to leave.

Despite all this “noise,” TEU remains a strong company with a good business. World trade is booming and the shipping companies are enjoying high rates. Last year, TEU completed a major capital expansion program. As a result capital spending is down and free cash flow is expanding. Earnings of $0.82 are estimated for 2004 and $1.16 in 2005. Our experience suggests that in a year all the “noise” will be forgotten and TEU will enjoy a valuation more in line with its peers as the market focuses on the fundamentals. Risks include the possibility of additional financial statement revisions and a future glut of industry capacity which would weaken shipping rates.

We present as our last idea, Chiron (OTC CHIR $34.50), the company that did not bring you the flu vaccine this past year. Chiron hit the news when its vaccine plant in England, which accounted for 50% of the US flu vaccine supply, was shut down due to quality control issues. While the company is working to rectify the deficiencies, there is concern that it might miss the 2005-06 flu season, affecting earnings for the year. In addition to the flu vaccine CHIR makes 30 other vaccines. It has a profitable blood business. Another division develops drugs with biotechnology. Consensus earnings for 2004 are $0.82 and $1.74 for 2005. Should they get the flu vaccine plant running for the 2005-06 season, estimates would likely rise. We note that Novartis, a giant European based multinational pharmaceutical company, owns 42% of Chiron. We think it is reasonable to expect them to utilize their resources, if needed, to get Chiron back on track. Risks: Failure to rectify problems at the flu vaccine manufacturing facility.

Tom Herzig


 

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