Letter - December 2006

 

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It's Not as Easy as It Looks

As we finish out the last week of 2006, the US stock market is poised to show double-digit returns for the year, beating inflation and creating wealth for investors. Nonetheless, returns paled compared to overseas markets that continued to boil this year leaving US investors holding their hats and scratching their heads. Peru up 193%, China up 107%, India up 47%...

The US economy no longer dominates the world as it once did. Worldwide growth continues to sizzle and overseas markets reflect that as foreign corporate profits outpace those here at home. Indeed, the current domestic slowdown is being tempered by continued growth in demand from Europe and Asia and India. It is ironic that the ascendancy worldwide of capitalism and liberal economic thought for which America has worked and fought so hard in the past is likely to result in diminished power in years to come.

We, as a firm, are often too early. Last year we doubted whether overseas markets could improve upon their performance in 2005. We were wrong. Nonetheless, we continue to caution investors as we enter 2007. We would suggest that overseas investment needs to be highly selective at this point. Booms have a nasty habit of unexpectedly turning into routs. Witness the Saudi Arabian market which rose 104% in 2005 but is now down 51% for 2006. Japan seems an exception; its stock market has been the worst performer among major bourses this year (Topix index +0.9%). Meanwhile economic fundamentals continue to improve there.

Like the 1970s, the world economy today is experiencing a sharp accumulation of dollars overseas, largely petrodollars. These dollars have to be invested and flow back into the US partly through purchases of US government securities. This “liquidity” keeps bond prices high and interest rates low. Unlike the 1970s, inflation has remained subdued due to the growth in productivity and the availability of low cost imports through global trade.

In the 1970s, the excess of dollars (liquidity) was recycled into loans to developing countries, many of which ultimately repudiated those debts. Today, some of the money is being funneled into hedge funds and private equity firms, contributing to their formidable presence on Wall Street and in the press. When 30-year US government bonds yield 4.75%, the promise of double digit-returns from the smartest guys around is seductive.

As if often the case, the past success of hedge funds may lead to lower returns in the future. Money follows success and as the hedge fund industry has grown, so has competition. As more and more money chases typical hedge fund strategies, the returns have begun to diminish. It appears that this year the industry has lagged the return of the S&P 500, according to the folks who follow that sort of thing… It’s not as easy as it looks.

Private equity is now the new hot area. These firms raise pools of money from investors and borrow heavily to buy public companies and take them private. Remember the leveraged buyout craze of the 1980s? Early investors in private equity, as in hedge funds, have been rewarded handsomely. As with hedge funds, money is now following success into private equity.

In the 1970s, the legendary chairman of Citibank, Walter Wriston, declared that sovereign countries do not go broke and so lent billions of recycled petrodollars to countries which proceeded to do just that. Today, leaders of private equity firms extol the benefits of what they are doing: Private equity does not have to deal with onerous regulatory oversight and can be more efficient; private equity can be more long-term oriented, not subject to Wall St. expectations and therefore can do the right thing; private equity is more efficient, challenging public competitors to improve their returns, for the good of all. There’s a hitch, though, we suspect. Private equity today is paying premium prices while borrowing money at record low rates. Will these investments weather an economic downturn or a rise in interest rates? Some will, some won’t. Are these private equity guys really that much smarter than the rest of us? Probably not… It’s not as easy as it looks… except for the Wall Street bankers and lawyers who get paid to put the deals together and will get paid to pick up the pieces of the inevitable failures that are to come. Now that’s a business!!

As to the outlook for 2007, we remain on the fence. After four years of positive returns, the bull market looks somewhat winded. It is no longer a stock pickers market; we don’t see any obvious bargains cast by the wayside. Yet, we anticipate new money flows into the market in the New Year from pension funds and the like. Private equity buyouts also encourage higher prices. On the other hand, many people wanting to defer gains from the 2006 tax year are waiting to sell in 2007. It’s a toss up. Though we are not particularly bearish, we will be taking some profits in early 2007.

 ….

Our 50th Year

During 2007, P. R. Herzig & Co. will commemorate its 50th year in business. Founded by my father, the late Philip Herzig, the firm has changed and adapted over the years as the world has changed. However, our mission has remained constant throughout: P.R. Herzig & Co. remains committed to the investment process, creation of wealth for our clients and attention to their needs. In the 27 years I worked with my father, his message resonated clearly: if you do the right thing for the clients, the firm will prosper. I might add that having my name on the door helps keep me focused on that thought.

As we proceed into the next 50 years, our goal is to grow but not for growth’s sake alone. We cherish the independence and flexibility that being a small specialized money manager affords us. Yet, technology has empowered the capabilities of the firm to the point where we have the capacity to expand our client base without compromising our mission.

Over the years, the firm has expanded its asset base largely by growing the assets of existing clients, not by marketing actively to new clients. In the years ahead we intend to be more active in reaching out to potential new customers. As long time clients, many of you have been gracious enough to help us in the past with introductions. Should you find yourselves in the position to do so in the future, we would be grateful for the opportunity to tell our story.

 To our clients: thank you for your confidence in us over the years and steadfastness in times past when it may have seemed that we and the market had taken leave of our senses.

My colleagues, Sumner Gerard, Art Pesner and Jon Ciaio join me in wishing all a healthy and prosperous 2007.

Tom Herzig


 

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