It's Not as Easy as It
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
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
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.
Please read our important notice
about these letters and the securities they mention.