Letter - May 2005





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

Last time we wrote clients and friends, we noted that the outlook for the stock market was not so good but not too bad. As it has turned out, even our guarded optimism was premature, at least for the short term. It has been not too bad, but not so hot either. After a couple of months of back and forth, the market took a painful stumble in March and April. High oil prices, the specter of higher inflation and rising short term interest rates (courtesy of the Fed) produced a serious case of the jitters for the stock market which accurately divined that the economy had slowed. First quarter GDP came in at 3.1%, below expectations. Anxiety was heightened by a weak April durable goods report, largely due to restrained corporate investment in capital goods, most likely an aberration.

And those corporate scandals, will they never stop? The New York attorney general, Eliot Spitzer, who is out to protect us all (and become Governor) bagged a big one, American International Group (AIG), forcing a paragon of corporate America, Maurice “Hank” Greenberg, to resign as chairman and CEO. And, the cover of a recent Business Week proclaimed that General Motors will go bankrupt if it doesn’t radically alter its ways (maybe we should buy the stock?) If things are not good for GM, what does that mean for America? With all these woes, can one blame investors for their lack of enthusiasm? The local wags have noted that the only ones who have made money this year are members of the New York Stock Exchange, one of our shareholders included, who have seen the value of “seats” rise from below $1 million to a record $2.6 million as the Exchange plans to go public. Go figure….

Actually, despite the gloom, the real world continues to be relatively prosperous. The US economy is growing at 3.1% which is above its long term trend. In the first quarter, reported corporate profits were stronger than expected. That growth has slowed somewhat is not without precedent. The same thing happened in mid 2004 only to see growth accelerate into the end of the year. The price of oil seems to have reached some sort of plateau which should temper inflation. Productivity remains strong. Corporations continue to improve efficiency, enabling them to restrain price hikes but still increase profits. This further helps temper inflation. Longer term interest rates have been surprisingly steady. It is interesting to note that the 10-year treasury note is lower today than when the Fed began raising short term rates in June 2004 though what that means is fodder for debate. Not too bad….

We generally do not comment on the prospects for real estate as an investment because we have limited expertise as to how one values it. However, such extensive coverage in the press and at cocktail parties concerning housing prices and whether there is a bubble in the making obligates us to offer some limited observations. Of course as investors in securities which have lately produced lackluster returns compared to real estate, we are envious. As housing prices continue to rise, real estate has clearly sucked money out of the stock market. Individual investors see greater returns from bricks and mortar than pieces of paper. We would venture, however, to say that 2005 may well represent a peak in prices. We don’t necessarily believe that prices will collapse, but speculation and the increasingly limited affordability of real estate suggest caution.

A Southern California friend recently pointed out a number of homes, clearly unoccupied, bordering a golf course that had been bought by speculators “playing” the market. One wonders how a 15% increase in mortgage rates, say from 6.5% to 7.5%, would affect those houses. It is helpful to think back to the previous real estate peak in the 1980s. In 1988, a year after the stock market crash I bought my home, paying top dollar. Thereafter, prices softened; it took ten years for prices to regain the level that I paid. Over, the next seven years, prices doubled. The return on my investment (a double in 17 years) turns out to have been 4.2% a year unadjusted for inflation or capital improvements, hardly a home run. We do not see a collapse in real estate prices, but believe that the upside limits are being tested. If we are correct, investment dollars may begin in time to flow back into the stock market as they did in the 1990s.

As we have written in the recent past, good returns for stock investors will depend on judicious stock picking. Though not wildly overpriced, stocks as a whole today are not exceptionally cheap either. Investors need to be opportunistic, buying individual issues when short term disruptions turn sentiment negative. The stocks below are representative of this strategy.

AIG (NYSE AIG $53.75) was until recently one of a handful of AAA companies and had an impeccable reputation for consistent growth. Now, it turns out that earnings and the balance sheet were manipulated in ways that have drawn the attention of securities regulators. With the company’s reputation tarnished and its debt downgraded to AA, AIG stock as fallen to its lowest valuation in years, approximately 10 times estimated 2005 earnings of $5.11. If the company can grow earnings at 8% for the next five years (versus a consensus estimate of 13%) and regain a PE multiple of 15, the stock would double over that time period. The fact remains that AIG is a world class company with worldwide reach and world class products. Major exposure and long experience in China and other parts of Asia make it a prime beneficiary of growth in that region. Risks include further disclosure of illegal activity at the company.

Lyondell (NYSE LYO $27.10) is one of the 10 largest chemical producers worldwide and has a 49% stake in an oil refinery in Texas. A highly cyclical business, the company turned profitable in 2004 after three years of losses. Because of its heavily leveraged balance sheet, LYO plans to use its substantial, estimated future cash flow to pay off debt. The recent slowdown in the economy has brought into question the durability of the cyclical upturn in chemical prices. This has contributed to a 27% drop in the company’s stock price over the last few months. Earnings forecasts, which depend heavily on estimates for the length of the economic recovery, range from $2 to $4 per share for 2005 and $3 to $6 for 2006. We have always liked big earnings and low PE ratios so LYO looks like an interesting investment in continued economic prosperity. Risks include excessive industry capacity expansion and/or a premature downturn in economic activity.

Tom Herzig


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