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Letter dated April 2006 reporting on the first quarter of 2006

     The stock market got off to a good start this year with the S&P 500 Index gaining 3.73%.  The Nasdaq Composite Index did even better, with a 6.1% gain.   We produced a gain for the quarter of 6.8%, outpacing the Nasdaq and gaining a full 3.1% more than the S&P 500.   These results had much to do with the relative strength of mid and small cap stocks in this period. 

     The dominance of small and mid-cap stocks was pronounced in January.  Thereafter, smaller stocks had no clear edge.  In fact, there was one unusual day in early March when the Dow finished 22 points higher but the Russell 2000 Index actually finished 1.4 % lower – an unhappy day for our portfolio.  The Dow would have to decline by about 150 points to have an equivalent decline.  Although that day did not mark a trend change, it underscores the fact that smaller stocks can be more volatile. 

     We have been able to capture much of the edge provided by smaller cap stocks while still providing some measure of portfolio stability with a preponderance of large cap stocks.  In mid-quarter, accounts on average had about 40% invested in stocks with market caps of over $10 billion, about 15% in $5-10 billion companies, about 33% in $1-5 billion stocks, and about 12% in small cap companies (under $1 billion).   Although it was mostly the smaller companies that gave us good performance this quarter, we bought some big cap stocks at good prices in March. 

     Since March 1999, the Russell 2000 Index has appreciated by 89%.  In the same time frame, the Dow has appreciated by only 15%.  That shows you why sector selection as well as individual stock selection really matters.  Some analysts are saying that it is time for the Dow stocks to have their turn in the sun.  I heard the same comments two years ago.  It is bound to happen at some point, but I’m not sure I can time it.  I still see more good opportunities outside of the largest cap stocks, but some good relative values are starting to show up among large cap names as well. 

     Our biggest purchases this quarter reflected that.  We bought xx shares of General Electric at $33.25; it ended the quarter at $34.78.  GE was a $60 stock (albeit an overvalued one) in mid-2000, when it earned $1.29 a share.  Earnings have risen by 33% to $1.72 a share and the price has fallen nearly in half.  One could argue that the PE ratio is still well above the growth rate, but I don’t expect this PE compression to last forever.

     We also bought Cisco Systems in mid-February at $19.91.  It ended the quarter at $21.67.  Although Cisco’s earnings growth is slowing somewhat, it has still grown earnings at  rates of 76%, 28% and 15% in the last three years respectively.  It is expected to earn $1.04 in the fiscal year ending in June, so we bought at a PE 19, which seems pretty reasonable given this growth and the prospects for further growth with the acquisition of Scientific Atlanta. 

     Nevertheless, I am not inclined to move too far into Dow-type names.  In fact, my model projects only a 3.2% average annual return on the Dow stocks.  By contrast, my model projects an average annual return of 11.7% for our ten largest holdings.  Those numbers assume that earnings grow at the consensus rate projected by analysts over the next five years, and that PE ratios reflect these growth rates at the end of that period.  Needless to say, this approach is useful for assessing probabilities and establishing investment parameters but has no predictive value. 

     To give you a clearer sense of where our performance came from in the first quarter, I have listed a few representative holdings together with their gain for the quarter and their market capitalization.

(1) From January purchase price of $23.59
(2) From January purchase at $56.20 

To put the market cap figures in perspective, Walmart has a market cap of $195 billion, Johnson & Johnson is $176 billion, IBM is $130 billion and Exxon Mobil is $372 billion.    

     The other thing that helped us was the strong performance of some of the foreign stocks we own.  I have talked before about Tata Motors (TTM) as being both a good value and a compelling story that is analogous to the US auto makers in the 1950s.  Tata was one of our largest holdings and gained 45% for the quarter.  We also had a gain of 29% in Korean steelmaker Pohang (PKX), which continues to benefit from strong growth in China and throughout Asia.  An Indonesian phone company (symbol TLK) advanced 27%.  Some diversification out of strictly US equities is advisable because good relative values can be found elsewhere and more diversification tends to produce more uncorrelated positions and thus reduce the risk in a portfolio.  That is particularly helpful at a time when the valuation in the US market strikes me as quite rich. 

     Interest rates may be the key variable affecting stock prices in the near future.  Some of the rationale for the market’s rise is that investors are anticipating the end of the upward interest rate cycle in the near future.  I cannot help but wonder if this eventuality is so over-anticipated as to be anti-climatic when it occurs.  Meanwhile, stocks strike me as rather expensive relative to bonds and thus vulnerable even in the event of a minor shift in fundamental forces.  Here is one way to look at the relative valuations.  The P/E ratio on the Value Line Index at March 31 was 19.1.  The earnings yield is the reciprocal of the price/earnings ratio, so was 5.24%.  Loosely translated, this means that if you bought a stock for $100, it would have $5.24 in earnings.  It wouldn’t necessarily all be paid out in dividends but it would be your “share” of the company’s earnings.  Alternatively, you can buy a bond for $100 (or usually $1000).  If you invested $1000 in US Treasury bonds maturing in five years on March 31, you would have gotten a yield of 4.83%.  The earnings yield of 5.24% divided by the Treasury yield of 4.83% produces a ratio of 1.085.  That is low by historical standards.  This ratio was at about 2.25 when the stock market bottomed in October 2002.  Nevertheless, my database shows that stocks can rise, albeit usually modestly, when the ratio is in its current zone.  This may be in part because most dividends receive more favorable tax treatment than bond interest. 

     At the risk of sounding too jumbled on this point, a more optimistic case can be made using estimated earnings for the S&P 500 for 2006 (Value Line calculates its PE by looking two quarters back and two quarters forward).  Presently earnings are forecast to come in at around $84.75 (versus $76.43 for 2005).  That translates to an earnings yield of 6.55%, which is more attractive relative to current interest rates.  (The calculation is the S&P’s March close of 1294.87/84.75 = forward PE of 15.27, reciprocal of which is 6.55%).  All this assumes a growth rate in earnings of 11%, which is reasonable. 

     My approach is simply to keep looking for stocks that can reasonably be expected to do better than average, and to make more use of stop-loss orders and other defensive investing tools such as more frequent profit-taking.  Of course, if corporate earnings continue to grow at a double digit pace, these defensive measures may be largely unnecessary. 

     I was mindful of the relationship between stocks and interest rates when I established a relatively large position in a fund called Diversified Income Strategies (DVF).  We bought in at an average price of $16.90, and this security ended the quarter at $17.94.  Even after this gain, it was still at a 4.9% discount to the net asset value of the underlying portfolio.  Moreover, it pays a dividend of $1.60 per share annually, which translates to a 9.5% dividend yield at our average purchase price.  The fund invests in debt securities that are just below investment grade quality.  They buy a lot of floating rate paper, which minimizes the risks associated with rising interest rates.  If we can maintain the modest appreciation and realize this dividend yield, that is a nice overall annual return on a reasonably defensive investment.  The major risk here is of a substantial widening in the spreads between investment grade debt securities and lower quality paper.   

     Finally, I must say that there was a cost to the market’s volatility in that we got stopped out of some good positions this quarter, particularly in early March.  For instance, we got nicked on a portion of our position in JLG Industries, albeit after the stock had risen as much as 80% from our purchase price.  It fell 14.3% in three days before moving back to a new high.  I had a similar frustration on Amkor Technology.  But stops also helped us to lock in gains on stocks that did not come back, such as Ceradyne and Cephalon.  Stop-loss orders impose a discipline of locking in gains or at least limiting losses.

     The economy and the markets continue to hum along despite rising interest rates, twin deficits and assorted other bogeymen.  My approach is to be vigilant with respect to overall market conditions, but to focus more heavily on finding good relative values given the conditions that exist.  We’re off to a good start this year, and I’ll do my best to keep it going.  Thanks for your continued confidence.