Return to letters menu

Letter dated October 2007 reporting on the third quarter of 2007

     The stock market was more of a roller coaster than usual this quarter.  The mini-panic hit the stock market suddenly and violently in late July.  The S&P 500 Index fell from a closing high of 1553.08 on July 19 to an intraday low of 1371.60 on August 16; a drop of nearly 12% in only 20 days.  Although it was a stressful period, we came out of it quite well.  The S&P 500 Index had a total return of 2.03% for the quarter (1.56% appreciation and 0.47% dividend yield), and your account gained 2.98%.  Our risk controls protected the account well during the sharp sell-off early in the quarter, and we outperformed in September as the market rallied back.  I’m pleased that our risk control systems helped to limit losses in July and early August; capital preservation is paramount in investing.

     We did three things well.  First, we paid attention to the key macroeconomic and valuation factors that had increased risk in the overall marketplace before the correction began in July.  Second, our sector allocation was tilted toward the right industry groups.  Third, we have migrated much more toward large cap stocks, which helped a lot given that the broader Russell 2000 Index was down 3.4% for the quarter.  Fourth, we did some buying when the market was near the height of the panic.

     As I noted in my last letter, there were flashing yellow lights at the beginning of the quarter.  At the end of June, the earnings yield on the Value Line Index was barely above the yield on five year treasury notes (5.15/4.93=1.04).  That made the market vulnerable to any bad news which came in the form of deteriorating prices of some mortgage-backed securities with sub-prime credit quality.  Hedge funds owned those securities often with 10% down and 90% margin.  This leverage magnified losses, making them a huge part of such an investor’s capital base.  As hedge funds scrambled to meet liquidity needs and similar players scrambled to preserve capital, the selling panic in the credit markets spilled over into the stock market.

     At the same time, credit for other types of risky transactions dried up too.  In particular, banks were no longer so anxious to make the kind of short-term bridge loans for leveraged buyouts that they had been making earlier in the year.  So the buying pressure from private equity that was underpinning the stock market dried up too.  It’s amazing how quickly a financial panic can develop.  As you know, the Fed acted quickly to stem this panic.  By cutting interest rates, the Fed decided to make sure that the panic was contained before any serious damage was done to the economy, knowing full well that the stimulus from a rate cut might have inflationary consequences down the road.

     That leads right into the discussion of sector allocation.  The stocks and groups that led the market tended to be issues that benefit from inflationary pressure.  There are different aspects to this inflation theme.  Gold stocks did well because of anticipation of inflation, tied to the Fed easing and the weaker dollar.  Industrial materials stocks rose because the supply of industrial metals and materials cannot keep up with the rising demand in Asia and in other parts of the developing world.  Finally, oil stocks rallied as some of the same forces pushed crude oil prices ever higher.

     Technology was another strong sector this quarter, with some of the biggest cap stocks leading the way.    In fact, the Nasdaq Composite Index finished the quarter 3.8% higher.  Cisco has benefited from increased capacity needs for voice and video over the internet.  Oracle has moved higher thanks to some smart acquisitions and dominance of the database world.  Intel has yet another new generation chip in the market.  EMC benefited from increased need for storage, and from the embedded value of VMWare, a wholly owned operation until EMC sold part of it to the public in the year’s hottest IPO.  All four stocks have probably benefited from a migration by many money managers to larger cap stocks in recent months.  They tend to be more stable, and are increasingly seen as a good relative value after years of dominance by small and mid cap stocks.

     There were small pockets of strength in other sectors as well.  Best Buy has done well in the consumer area because everybody seems to need a LCD TV.  Corning Glass Works should continue to benefit from that trend, as well as their supply of fiberglass to Verizon and others for Fios.  We have also had a long and very prosperous run in Gamestop (GME), which came to us as a spin out of Barnes & Noble.  Many other consumer stocks really hit the skids during the third quarter as fears mounted of a terrible holiday season.  As a result, we have cut back our exposure to consumer discretionary shares a lot in the past month or two.

     The housing stocks continued to be dismal.  Certain historical analogues suggest that they may be nearing a bottom.  During the 1970s, the so-called Nifty Fifty stocks crashed about 90% on average over two years from 1972-74.  The housing stocks peaked in the summer of 2005, and some have fallen nearly 90 percent.  In early 2007, most economists called for the housing market to bottom by year-end.  Now their predictions tend to be much more negative, which indicates that worst-case expectations are starting to be reflected in stock prices.

     If the sub-prime mortgage crisis is so bad for the economy, a valid question is why did the stock market rally back to near its high for the year?  Five things:  (i) the Fed’s 50 basis point cut in interest rates sent a clear message that the central bank will be aggressive in fighting off recession; (ii) stocks became a good relative value to bonds, as the Value Line earnings yield / five year treasury ratio moved from a danger level of 1.03 to as high as about 1.40; (iii) international demand for industrial materials is not affected by dislocations in the US economy, so those stocks stayed strong; (iv) certain stocks just got very cheap; (v) sovereign funds such as China and Dubai are huge buyers of US assets.  For example, at a price of $50, one could buy Lehman Brothers at 6.6x its average earnings from 2003-06.  You really had to believe the firm could go out of business not to want to own Lehman at that multiple of historical earnings.  On a related note, many investors believed that a quality mortgage REIT like Thornburg Mortgage (TMA) could indeed go out of business, even though all of its assets remain of prime quality.  TMA plunged due to guilt by association and hurt us a bit this quarter, but as a quality operation, should rebound.

     I continue to look for good risk-reward opportunities.  My system flagged housing stocks five years ago when they were (ironically) out of favor.  Now I’m hoping for the same type of opportunity in oil service stocks.  They are very cheap relative to earnings estimates.  Oil prices keep rising, as housing prices did back then.  I have cut back on refining stocks such as Valero as refining margins have fallen, and re-deployed some funds toward the oil service stocks such as Rowan Drilling (RDC).  I am also cognizant that “energy” stocks are not all alike; natural gas prices have been falling even as crude oil prices are rising.  At some point, natural gas may reach a seasonal low.  We have held Penn West Energy, which is sensitive to natural gas prices, in part because it has a 13% yield.  There are other stocks that have done less well than expected, but that I think are worth holding.  My system projects an annualized return of over 15% from giant insurer AIG, but the stock had a modest loss last quarter.  There are other holdings like that, and it generally seems best to give them time.

     Right now, I see a good environment for stocks.  They are reasonably priced relative to bonds.  The proverbial “wall of worry” is back in place after a period of too much complacency toward risk earlier this year.  The Fed has shown a willingness to act aggressively to limit financial shocks.  We are beginning a period that tends to be seasonally strong for stocks.

     We will re-evaluate this optimistic viewpoint continuously, and I am already thinking ahead to next spring.  Interest rate re-sets on adjustable rate mortgages will kick in heavily then, which could force further declines in consumer spending and add stress to some financial institutions.  Some investors may start to anticipate a peak in construction in China before the Olympics, and markets may begin to discount that six months or so ahead of time.  The presidential election may start to change views about the prospects for capital markets, or at least of certain industry groups.  But those concerns seem too distant to affect market prices in the near term.

     I search an ever-wider database of stocks to find what I hope will be the best relative values out there.  My average account has outperformed the market this year, and on a three and five year basis.  I hope that with the same disciplines in place, we can continue to deliver above-average returns with below-average risk.  Thank you for your continued confidence.