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
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
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
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
In technology, we have been buyers of Symantec
$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
$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
Please read our important notice
about these letters and the securities they mention.