22 Feb 2002 ‘Buy Straw Hats in the Winter’
The disconnect between the market and the economy continued in earnest this week as the major averages declined while the economic releases continued to be favorable.
Yesterday afternoon, the National Association for Business Economics said that there’s a 60% chance that the contraction is over. Their assessment is based on a survey of 37 Wall Street and corporate economists conducted this month. If it’s true, the recession will have lasted no longer than the 11-month average for the nine other recessions since World War II. It began last March, according to the National Bureau of Economic Research, the unofficial arbiter of U.S. business cycles.
The National Association for Business Economics panel also projected the recovery will develop more quickly than in earlier estimates. The economy should grow at a 1.3% annualized rate in the first quarter, up from an estimate of 0.2% growth in the last NABE survey, three months ago. At that point, many analysts were concerned that consumers would take a breather after a record pace of auto spending in October. The strength of consumer spending has kept this economy out of a worse recession.
This week’s releases have been quite good. US housing starts in January showed a significant rise of 6.3% to an annual rate of 1,678,000 the highest level since February 2000. Building permits, which lead the housing starts data by about a month, were also up sharply; rising 3.1% to an annual pace of 1,706,000, again, the highest level of permits in a year.
Consumer prices rose in January, posting their first increase in four months, amid a rebound in gasoline and other energy costs. But, the slight increase is unlikely to fan worries about inflation.
The U.S. trade gap narrowed much more than expected in December as oil prices declined, contributing to the first annual drop in the deficit since 1995. For the year, the trade deficit was 7.8% narrower than the 2000 deficit. The U.S. imported 6.3% fewer goods and services last year, while exports fell just 5.8%.
Also on Thursday, the Conference Board said its index of leading indicators rose 0.6% to 112.2 in January, the fourth consecutive month of increase. The increase marked the fourth consecutive rise in the index, lending further support to views that the U.S. economy is recovering from recession.
Unemployment numbers were slightly negative as the number of workers filing first-time applications for unemployment benefits rose by 10,000 to 383,000 last week. Economists had expected claims to rise by just 2,000. However, the four-week average (a better measure) rose by only 5,750 to 381,750.
Finally, on Thursday, the federal government said it tallied a $43.73 billion budget surplus in January. For the fiscal year so far, individual income taxes fell 4.8% from last year at the same time, while corporate income taxes rose 6.9% from a year earlier.
The Market and Our Portfolios
To say that market conditions have been volatile and uncertain would verge on absurd understatement. The tendency for bad news in one industry or company (Enron) to take on nearly universal characteristics continues to be the rule. Problems at Tyco led to explanations of accounting practices by General Electric, IBM, and others. Both the bond market and the stock market responded by taking almost all corporate bonds and stocks down as it was all sorted out. In fact, the spreads in yield between high grade corporate bonds and US Treasuries is as wide as it has been in over fifty years – a sign that bond buyers fear a rise in defaults. That fear carries into the equities markets as investors lower stock prices on credit worries as well as uncertainty over the viability of reported earnings.
At the heart of it all is trust. Investors trust corporate management to make the right decisions as they investment the capital entrusted to them. Managers trust that their customers will buy the products they order, and their customers trust that the products or services will perform as they are represented. That trust was severely shaken by the Enron scandal and by other disclosures since then; the proof is reflected in stock prices. But we must keep in mind that the few problems that have come to light do no suggest that all corporate managers and their auditors are not to be trusted. Indeed, the US stock market has thrived throughout our history in large part because of our laws and our trust in those laws.
Another major notable is the extreme selling pressure born by telecom, technology, utilities, and energy stocks. Cisco is halfway back to its post September 11th lows. Duke Power is trading near its 52 week lows. Microsoft has declined 18% from its recent highs. Lucent and Nortel are priced as though they are going broke.
There is an old adage that you buy straw hats in the winter and sell them in the summer. Yes, we got caught holding too many straw hats last summer. But doesn’t it make sense to hold them through the winter months in anticipation of better prices in the inevitable return of summer? It is not easy holding these ugly ducklings while everybody seems to be saying why you shouldn’t.
I am reminded of two upstart technology companies getting started in the mid-eighties. Virtually everyone said they were too volatile and would amount to very little. Guess what, they were wrong. If you ignored the conventional wisdom in 1986 and bought Microsoft, you would have seen your investment return 38,567% (yes, that’s a comma, not a decimal). Its partner in the marvelous technology explosion was Intel. Intel came along in ’71, but didn’t really grow wings until Microsoft and IBM gave them the vehicle they needed (the PC) to thrive. An investment made in 1986 in Intel would have grown 6,213%. These returns include the crash of ’87, recession of 90-91, slowdown of 93-94, global currency meltdown of 98, and the bubble burst of 2000.
Please keep several things in mind as you review our holdings by portfolio below. Fundamentally we believe that the future of the US economy and standard of living is tied to productivity. Our economy will not thrive on the backs of Alcoa, Caterpillar, and General Motors (we do not mind owning them from time to time, however). Indeed, our economy is currently 73% services. Manufacturing’s share of the economy will likely continue to decline as US labor gets more expensive and in shorter supply.
We believe that information, communication, and medical technology will be the fastest growing industries in this country over the next decade. Information technology and communications have historically improved productivity better than any other investment; we expect that trend to continue, once the economy begins to recover. We think several of our companies are already seeing substantial improvement in their business as their customers look to improve efficiency and cut costs. Medical technology promises huge new discoveries and cures. We balance our portfolios with non-technology companies, but a major criterion for selection of these companies is their use of the latest productivity-enhancing technologies. Now, here are some brief summaries of the companies held in each of our model portfolios:
Quality Portfolio:
Affiliated Computer – a leader in business process outsourcing and electronic commerce, growing 22% annually, last earnings up 42%.
Best Buy – leading retailer of music, consumer electronics, and appliances, growing 20% annually, last earnings up 37%.
Cisco – leading supplier of supplies that tie information systems to the Internet , growing 25% annually, last earnings down 50%, but 73% better than expected.
Biotechnology Index Ishares – exchange-traded fund representing top biotechnology and pharmaceutical companies. ETF provides diversification in a promising, but volatile industry.
Johnson & Johnson – a major pharmaceutical and medical devices company, growing 14% annually, last earnings up 20%.
Laboratory Corp of America – the largest clinical laboratory in the industry, growing 24% annually, last earnings up 93%.
Lowe’s Companies – #2 retail distributor of building materials, growing at 21% annually, last earnings up 23%.
Microsoft – the largest supplier of software in the world, growing at 16% annually, last earnings up 4.3%
SEI Investments – provides global investment and business solutions to banks, insurance companies, money managers, mutual funds, and individual investors, growing at 26% annually, last earnings up 16%.
Stryker Corp. – develops, manufactures, and markets specialty surgical and medical products, including orthopedic implants, growing at 20% annually, last earnings up 20%.
Veritas Software – a pure play in the software side of enterprise storage management, the fastest growing part of the information technology industry, growing at 36% annually, last earnings down 21%.
Wachovia Corporation – a multi-bank holding company, recently merged with First Union, growing at 12% annually, last earnings down 16% with merger-related expenses.
Growth Portfolio:
Best Buy – leading retailer of music, consumer electronics, and appliances, growing 20% annually, last earnings up 37%.
Celestica – a major contract manufacturer (manufacturers products for customers including IBM, Sun, Dell, and Nokia. Companies are increasingly outsourcing their manufacturing processes to concentrate on development and marketing. Celestica is growing at 30% annually, last earnings were down 40%.
Cisco – leading supplier of supplies that tie information systems to the Internet , growing 25% annually, last earnings down 50%, but 73% better than expected.
Dell Computer – the leading manufacturer of computers and servers, taking market share in this recession and growing at 18% annually, last earnings down 6%.
Amdocs – provides customer care and billing systems to 65% of the world’s wireless and wireline network operators, growing at 24% annually, last earnings up 33% – a very consistent grower.
Biotechnology Index Ishares – exchange-traded fund representing top biotechnology and pharmaceutical companies. ETF provides diversification in a promising, but volatile industry.
Intuit Inc. – provides financial management software for small businesses and households, growing at 24% annually, last earnings up 27%.
Laboratory Corp of America – the largest clinical laboratory in the industry, growing 24% annually, last earnings up 93%.
Microsoft – the largest supplier of software in the world, growing at 16% annually, last earnings up 4.3%
Starbucks – retailer of its own brands of specialty coffees in North America and Pacific Rim countries, growing at 24% annually, last earnings up 25%.
Siebel Systems – leading provider of business intelligence software systems, growing at 30% annually, last earnings down 35%.
SEI Investments – provides global investment and business solutions to banks, insurance companies, money managers, mutual funds, and individual investors, growing at 26% annually, last earnings up 16%.
Veritas Software – a pure play in the software side of enterprise storage management, the fastest growing part of the information technology industry, growing at 36% annually, last earnings down 21%.
Aggressive Portfolio:
Applied Materials – leading manufacturer of semiconductor fabrication equipment, growing at 21% annually, last earnings down 97%, industry is turning, this company should be an early beneficiary.
Broadcom Corp. – provides integrated silicon solutions that enable broadband digital transmission of voice, data, and video content to the home and business enterprise, growing at 37% annually, company expects profitability in second half of 2002.
Cisco – leading supplier of supplies that tie information systems to the Internet , growing 25% annually, last earnings down 50%, but 73% better than expected.
Dell Computer – the leading manufacturer of computers and servers, taking market share in this recession and growing at 18% annually, last earnings down 6%.
Flextronics Int’l – a major contract manufacturer (manufacturers products for customers including Cisco, Microsoft, Phillips, and Ericsson. Companies are increasingly outsourcing their manufacturing processes to concentrate on development and marketing. Flextronics is growing at 28% annually, last earnings were down 34%.
Handspring Inc. – develops, manufactures and markets a family of expandable handheld computers. With the introduction of the ‘Treo’, Handspring has the most affordable and most functional cell phone/pda combination on the market. The company is growing at 42% annually, but saw earnings fall 71% in the latest quarter.
Microsoft – the largest supplier of software in the world, growing at 16% annually, last earnings up 4.3%
NetIQ Corp. – provides performance and availability management software for Microsoft Windows NT-based systems and applications. Facilitates companies maximizing the functionality of the hardware and software they have in place.
RF Micro Devices – develops and markets proprietary radio frequency integrated circuits. Their capabilities are not matched by Texas Instruments or Intel. The company is growing at 30% per year and stated at yesterday’s CSFB technology conference that they expect to meet their earnings target; ahead of street expectations.
Siebel Systems – leading provider of business intelligence software systems, growing at 30% annually, last earnings down 35%.
Speechworks International – a leader in automated speech-activated software. It is growing at 35% annually.
Symantec – a leader in Internet security technology. The company has a new product suite offering to enterprises that promises to be a major revenue source in the future. The company is expected to grow at 20% or more annually.
Visionics Corp. – the leader in identification technologies using facial, fingerprint, and other biometric identification systems. Numerous major airports, sports facilities, casinos, and other businesses have adopted their products. Honeywell and ADT, leaders in their fields of security, have recently partnered with Visionics. Growth is expected to be in the 25% range.
