Letter - January 2006





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Bringing up the Caboose… But for How Long?

The U.S. is said to be the locomotive of world economic growth, though you wouldn’t know it from the performance of our stock markets, which lately have been bringing up the caboose. In 2005, the S&P 500 returned a paltry 4.9%, including dividends, compared with returns before dividends of 34% in Japan, 47% in Austria, 26% in Germany, 50% in South Korea, and 42% in India. This is the second year of relative underperformance, and many U.S. investors, heeding the clamor in the financial press, are rushing to place more of their investments abroad. We think they may be disappointed.

That is not to say that foreign stocks do not belong in most portfolios. Indeed, Japanese and Canadian holdings contributed significantly to the 13%+ performance for our managed client accounts in 2005. We doubt, however, that foreign financial markets in general will continue to outperform in 2006. Chasing hot markets, like chasing hot stocks or hot funds, usually does more for Wall Street commissions than it does for portfolio performance.

Emerging economies are likely to continue to perform well in 2006. (Pay no heed to all the negative reports in the press.) A well traveled friend of ours observes that capitalism is breaking out all over the world. Emerging middle classes, numbering in the hundreds of millions of people, are gaining a critical mass of prosperity for the first time, and are demanding world-class lifestyles. Housing estates from Jordan to Indonesia to China and India increasingly resemble those of Orange County.

But financial markets tend to anticipate what lies ahead, unlike the financial press, which is often a rear-view mirror. We suspect the sharp rise in many emerging markets already discounts most, if not all, benefits of the political and economic reforms that have swept the globe. For the U.S. investor still looking to saddle up, there is a good chance that most of the emerging markets horses are already out of the barn. A possible exception is greater China, where the economy continues to gallop but the financial markets, always a ride on the wild side, lately have stumbled.

Stock markets in developed economies may also disappoint. In Western Europe, markets have risen in anticipation of a recovery in corporate profits driven not so much by demand growth as by increased efficiency. German companies in particular are re-emerging as strong competitors. But further growth in corporate profits will depend on expanding sales, which is difficult to achieve against the backdrop of a sluggish home market. As economic growth in Western Europe continues to lag other parts of the world, the stock markets there are likely to be less dynamic as well. The same may be said for Japan, though to a lesser extent as that economy finally awakens from a 15-year slumber.

U.S. investors, to be sure, may find scant reason to believe they will fare any better by keeping their money at home in 2006. There is no shortage of things to fret about, including such widely reported problems as the housing bubble, huge trade and fiscal deficits, the uncertainties of the mid-term election and the second presidential term, rising interest rates, the flattening of the yield curve, and anxiety that the U.S. economic expansion and three-year bull market may be getting a bit long in the tooth.

Nevertheless, we see many reasons for optimism for 2006. U.S. economic growth is expected to remain respectably above 3%. Business demand for goods and services seems likely to pick up the slack if consumers take a breather. Corporate profits, though growing more slowly after their sharp rebound off the 2001-2002 bottom, remain robust. After surprising strength in 2005, the dollar may once again weaken, making U.S. exports more competitive. Finally, and most important, we think there is a distinct possibility that robust economic growth elsewhere may benefit the U.S. economy and U.S. companies in ways that are not yet fully reflected in the U.S. stock market.

It is often said, for example, that the U.S. has been the engine of growth, dragging the world economy out of recession. China, India, and other countries owe their recent growth in part to U.S. demand for their low-cost goods and services. It is sometimes forgotten, however, that locomotives can work equally well in reverse. Internal demand is rapidly becoming the primary driver of growth in China, India and other countries. This makes them less dependent on exporting to the U.S. consumer and creates new markets for U.S. companies, which unlike European competitors also have a strong domestic market. Ultimately, this will benefit the U.S. economy, U.S. corporate profits, and the U.S. stock market. And the stock market, as always, is likely to move first.

All this may take some time to materialize. “Exogenous events” (Iran next?) could derail the train. The world and Wall Street remain dangerous and volatile places. Nevertheless, the current high expectations for foreign markets and low expectations for the U.S. stock market make our contrarian ears perk up.

As we venture into 2006, we will be opportunistic and particularly mindful of maintaining a margin of safety to limit downside surprises. The booming stock market of 2003 represented an indiscriminate bounce off a bear market bottom, while 2004 and 2005 consolidated those gains. As the bull market ages, we will focus on stocks that have done poorly but hold promise that the market may have missed. Those sectors that have done so well in recent years—energy, housing and interest rate-sensitive issues—are unlikely to provide the big returns this year. In the absence of obvious sector opportunities, where we can place bigger bets, we expect to take a greater number of relatively small positions. While this strategy may generate more confirmations than in the recent past, we remain committed to keeping expenses low as we strive to extend our string of above average returns. Past performance, of course, is no guarantee of future results.

In deep cyclicals, we favor commodity chemical producers Lyondell (LYO $24.06) and Georgia Gulf (GGC $31.42). Selling at single digit price/earnings multiples with improving balance sheets, they should do well should the economic recovery prove more durable that generally expected. Risks include a premature recession.

In technology, we have been buyers of Symantec (SYMC $19.29), a company that sells security software to protect against computer viruses and unwanted hackers. The recent $11 billion acquisition of Veritas, which sells software that backs up data, was poorly received by the market, causing the stock price to decline sharply. Also, there are concerns that a new version of Microsoft Windows, due later this year, will incorporate more security features, taking away business. We feel that the company, which has expected 2006 earnings of $1 and has been growing in the double digits, is less vulnerable than generally appreciated. Risks include a successful Microsoft challenge and the possibility of another value- destroying acquisition.

We also have bought small positions in International Rectifier (IRF $34.46), which specializes in computer chips that manage and lower energy consumption in electronic devices, thus lengthening battery life. Though IRF is likely to sustain double-digit earnings-per-share growth, a recent revenue shortfall has sent the stock sharply lower, creating a buying opportunity. Though we would prefer to see more weakness in the stock price before buying more, this is one to watch. Risks include technological risk and the possibility that the company cannot match production capacity with what their customers want.

In the energy sector, we are not buyers but nonetheless remain fans of San Juan Royalty Trust (SJT $43.60), Hugoton Royalty Trust (HGT $36.76) and Canadian Oil Sands Trust (COSWF $125.23). All three hold the prospect of paying dividends in excess of 10% of their stock prices this year and into the future. We love that cash flow! Any negative developments affecting oil and natural gas prices would cause us to reassess our opinion.

Finally, some comments on gold, which recently hit a long-term high of $550/oz. Gold bugs today are in high form. We hear the time-worn explanations: large deficits, inflation and an excess of debt. Our particular read on gold’s performance is more Economics 101: supply and demand. Supply is slowly falling as gold deposits in South Africa and North America are depleted. Demand is rising as a result of growing prosperity in developing countries, notably India. And so: higher prices. We continue to hold moderate positions in what we consider the most conservative and speculative issues: Newmont Mining (NEM $57.48) and Vista Gold (VGZ $4.95), respectively. The major risk here, of course, is a substantial decline in the price of gold.

All of us at P.R. Herzig & Co. wish our clients a happy and prosperous 2006. We value your confidence in us and we will do our best to continue to earn it in the coming year.


Tom Herzig


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