Letter - July 2005





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Fishing in Troubled Waters

Investing in the stock market today is truly like fishing in troubled waters. Buyers of stocks are beset daily with apocalyptic commentary concerning the many currents that course through our world,  political (Iraq, al Qaeda), economic (deficits, easy money) and speculative (real estate, hedge funds). The terrorist attack in the heart of London, while not surprising, nonetheless reminds us that we are in the midst of a protracted war.

Seldom has the traditional stock market investor experienced such competition for his investment dollars. Hedge funds promise returns regardless of whether the market goes up or down (Wanna buy the Brooklyn Bridge?) and some actually deliver. That business has gotten so big that over 50% of the volume on the New York Stock Exchange is driven by program trading, largely generated by hedge funds. Real estate offers speculators and others what appears to be low cost, no money down financing while the stock investor has to put up at least 50%. The stock market seems so out of the action. Yet, investing in stocks is a big part of what we do and we like to think that our clients are the better off for our efforts.

Reflecting the above currents, perhaps, the stock market has rallied and sold off repeatedly over the last six months during which the S&P 500 declined -0.8% (with dividends included) as of June 30. From one perspective perhaps this is not surprising.  We seem to be in a low return world. The market has adjusted to low interest rates, 4% for the 10-year treasury note, so double-digit gains by the broad stock market seem improbable. Nonetheless, we remain as fully invested as possible since the market seems to stall for long periods of time punctuated by brief but robust rallies. As we have said repeatedly in the past, success going forward will depend on successful stock picking and limiting losses. To limit risk, we continue to examine beat down issues for signs of long term value... fishing in troubled waters.

The economic scene has changed little since our last letter. Growth of the US gross domestic product (GDP) continues at between 3% and 4%, robust for a mature economy. Inflation remains low and interest rates continue to bounce along a multi-year bottom. One new development seems to be a nascent stirring of growth in Japan.  Japanese banks are largely back on a sound footing and real estate prices have begun to rise for the first time since the late 1980s. Importantly, growth is being driven by domestic demand rather than exports alone.  Should the expansion continue, it would be good news for the world economy, easing the US trade deficit and relieving some of the pressure on the US to be an engine of world growth.

Clients may note that sell confirmations are starting to pile up for long-held stocks that have had outstanding performance over the years. Real estate related stocks such as Forest City Enterprises, Centex, Fidelity National Financial and PICO continue to make new highs. Like the technology stocks during the bubble, they may go higher but we question whether the economic fundamentals support such lofty, underlying real estate values. Similarly, we watch oil stocks with a skeptical eye. Though the stocks seem reasonably priced on earnings, those earnings are inflated by what may turn out to be an unsustainably high price of the underlying commodity, oil. Our hat is on and our eye wanders toward the exitů but we are moving cautiously. We are mindful of the gold (read: commodity) boom of 25 years ago. Then, gold stocks did not hit their highs until the year after gold topped out at $800/oz. The average annual price of gold received by the mines continued to climb after the peak, driving up earnings and share prices.

Taking profits is fine. However, we are then presented with the challenge of redeploying the investment funds effectively. Unfortunately, we do not now see any sectors that could replicate the performance over the past five years of oil and real estate stocks. Going forward, investors should expect more modest returns and a shorter holding period.

A recent purchase of selected steel stocks holds the promise of competitive returns though we doubt that they will be multi-year holdings. The stocks are currently down 40% or more from their peaks and trading at about 7 times earnings. After struggling through years of bankruptcy proceedings, the steel industry consolidated and cut capacity, then enjoyed a boost from increasing demand from China and an improving domestic economy. By early 2005, however, demand began to cool, prices weakened and inventories began to rise as China brought on domestic capacity. Steel stocks took a tumble as investors anticipated another typical boom/bust cycle. However, the situation may not as bad as it appears. Unlike previous cycles, a smaller domestic industry with a better balance sheet has curtailed production to support pricing. Contrary to fears of some, China has indicated that it does not intend to become a net exporter of steel. More fundamentally, long term underinvestment in infrastructure worldwide has made it difficult to get raw materials to the mills and finished product out to customers. Transportation bottlenecks suggest that few new steel plants will be built as growth through capacity expansion is unrealistic. Restraints on capacity and continued demand due to economic growth could trim excess inventories, firm up product pricing and lead to a rebound in share prices.

By the time clients receive this letter, we will have completed our move to Pershing, LLC, our new clearing firm. We look forward to a long and productive association with them. We apologize for any inconvenience the move may have caused. Do not hesitate to call us if you have any questions.


Tom Herzig


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