Letter - April 2006





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Red Sky at Morn…. Investors Take Warn?

When all seemed calm, sailing ship captains in the tales of Joseph Conrad stayed on the lookout for heaviness in the air and clouds gathering over the horizon. Investors might well do the same.

The first quarter of 2006 was kind to many investors. The S&P 500 was up about 4.1% including dividends, and most of our clients continued to outperform. The stars of 2005, the metals and oils and many foreign stocks, continued their run. Specialty semiconductors and fiber optics suppliers, where we have little exposure, came to life. The Fed continues to raise interest rates, but has mitigated the sting by signaling its intentions. Markets hate uncertainty and surprises.

The outlook for the second quarter appears equally benign. The bulls say that the Fed is almost done raising interest rates, and that the market will rally sharply as it did after rates last topped out in late 1994. Bears line up the usual suspects—deficits, war and inflation—but those worries seem imbedded in market expectations and so far have fallen on deaf ears. It will be the unexpected that will halt the bull.

So for the time being, smooth sailing and gentle breezes. Nonetheless, we are uneasy about recent developments on the political front that threaten the very basis of our prosperity in recent years—the free and efficient flow of goods, capital, and people within and across borders in an increasingly global economy.

Economic nationalism—a new word for protectionism—seems to be on the rise. The French government has intervened repeatedly in recent months to stop the takeover of French companies by Italian and U.S. competitors. And this isn’t just happening in France.

Last year U.S. politicians played to national security fears by blocking a bid by a Chinese company for the Asian assets of Unocal, a mid-tier U.S. oil company. This year they once again invoked national security to stop Dubai Ports World, of the United Arab Emirates, from acquiring the owner of several U.S. port facilities. That rings particularly false to us. The largest U.S. naval facility overseas happens to be in Dubai; the United Arab Emirates provision it and provide its security. Meanwhile, there are persistent rumblings in Congress about invoking trade tariffs against China unless that country revalues its currency.

Particularly troubling is the thought that a weakened Bush administration may no longer be able to block short-sighted policies that pander to fears and parochial interests. Not only will this threaten general economic prosperity; it may hit investors directly in their pocketbooks. For example, Bush tax cuts will expire in 2008. If the cuts are not renewed, tax rates paid on dividends and capital gains may return to their former levels—a big negative for the stock market. That would also mean lower receipts for the Treasury (contrary to popular belief, lower rates have actually increased the amount of capital gains taxes paid) and would once again distort how investors allocate their capital.


In client portfolios, we continue to reposition investments as we harvest gains from holdings purchased over the last six years. As noted before, the best years for energy, housing and interest rate-sensitive securities appear behind us. With no compelling new sector opportunities in sight, we have been focusing on individual companies.

INTEL (INTC, NASDAQ $19.40) is a stock we thought we would never own, but now we do. The company makes microprocessors, the electronic brains for PCs and notebook computers. Compared to the 1990s, this is now a slow-growth, highly cyclical industry. In recent years, product development and production miscues have compounded Intel’s problems, leaving an opening for market share gains by its smaller and more nimble competitor, Advanced Micro Devices. At a forward P/E of 19, Intel is not the cheapest stock we have, but we think its tremendous resources may be underestimated. Its $5 billion research budget and $9 billion cash flow dwarf Advanced Micro. First half results are likely to be soft as consumers defer purchases in anticipation of a new line of microprocessors expected in the second half. We see little price potential near term but look to 2007 for healthy returns. Risks include an early economic slowdown and the possibility that Intel will fail to innovate fast enough to bring new products to market in a timely manner.

FIDELITY NATIONAL TITLE (FNT, NYSE $23.50) is a recent spinoff from Fidelity National Financial (FNF, NYSE $36), one of our great long-term investments, which continues to own 82.5% of the company. FNT is the largest U.S. title insurer, a business that has begun a cyclical decline as interest rates rise and the housing market cools. Nonetheless, we have been increasing our position as the stock seems out of favor and too cheap. Expected earnings of $2.80 this year puts the P/E at 8.3 while the $1.16 dividend yields 4.9%. (We love those dividends.) Furthermore, as a spin off, many investors sell the small positions they receive, in this case 175 shares of FNT for each 1000 owned of FNF. This puts short-term downward pressure on the stock. An opportunity, we believe. Risks include a severe drop in real estate prices that depress housing turnover and title originations more than expected, thereby significantly lowering earnings.


Tom Herzig


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