3rd Quarter 2004: Growth, Value, and Yield

Third Quarter 2004
Market Commentary

Growth, Value, and Yield

Over the course of the past six months, (and indeed, over the past year), we have been constructive on high quality common stocks, in that our analysis has led us to the conclusion that the economy is strengthening, and corporate earnings are growing at a steady rate.

Moreover, we have commented that the backdrop of both monetary and fiscal policy has been very accommodative to the financial markets. Add to this some major changes in tax policy, and many economic ingredients are in place for a strong recovery; both in the economy and the equity market.

Nevertheless, the stock market has been essentially flat for the first six months of this year. Since we view economic and corporate financial results as being positive, we can only conclude that increasing concerns about geopolitical problems (Iraq) as well as deficits from fiscal policy have acted as a dampening influence on the stock market; but no stronger in its influence on the market, than the positive news coming out of corporate America. Thus, we have seen a neutral bias to the market. Yet within the infrastructure of the market, subtle changes are taking place upon which we feel compelled to comment.

We begin with the question of valuation. Historically, investors have chosen investment managers that reflect their growth objectives and risk tolerance. In this vein, growth investing is usually associated with purchasing those companies that demonstrate consistent earnings power, and a high rate of growth of earnings. Over time, those companies that show consistency in earnings, and the ability to grow earnings in recessionary years, have been accorded higher price/earnings (P/E) multiples on those earnings. This has been doubly rewarding; in that one receives both a higher level of earnings, and a higher multiple on those earnings. Through it all, the income statement has been the primary focus for growth investors.

Value is usually associated with companies that have maintained strong balance sheets, and are priced at a lower multiple on the earnings they create. Value investors like to see low
valuations placed on a companies sales, earnings, and book value. They also like to see low or no debt as a percentage of a company's net capital.

At any given point in time, both strategies have been successful; and depending on the climate and mood of investors, one style of investing will usually predominate over a market cycle. We try to incorporate what we consider to be the better ingredients of both into our recommendations. We begin with value, but also view earnings and earnings growth as a key determinant of equity values.

In the past, growth investing brought momentum investors into the market, which led to unsustainable values and high volatility. It may also have been responsible for some of the shenanigans that transpired with faulty accounting; in that it may have influenced some CEO's to take a more aggressive stance with accounting, so as to create maximum value for their option positions.

Overlaying all of this is the direction of interest rates, and the impact it might have on the direction of stock prices. If rates rise sharply, it will paralyze the bond market, and cause all fixed income investments to falter. If interest rates rise slowly, but do not return to double digit levels, it will very possibly help the stock market, and do significantly less damage to bonds and fixed income alternatives than most investors perceive. In fact, if fixed income alternatives continue to provide superior returns verses a ten-year treasury (now 4 ½ %), we believe those values will hold firm as well. By fixed income alternatives, we include such asset categories as REITS, electric utility common stock, and convertible and straight preferreds.

We continue to believe that yields are important; so much so that we believe the market is moving in the following ways to accommodate yield:

1. In the late 1980's, and through the 1990's many corporations used excess cash flow to buy back stock, thus shrinking their capitalization, and increasing earnings per share. This, in turn, helped fuel the explosion of corporate compensation through options that we refer to above.
2. What we see today is an entirely different picture. The collapse of stock prices from 2000 to 2002, plus the events of 9/11 and the universal concern of event risk through another terrorist attack have made investors more risk averse, and more interested in current yield. Investors want more of their return sooner rather than later, and dividends have become key to that desire.
3. Corporations have sensed this concern, and many companies have responded by sharply increasing their dividends. A number of companies have done so in lieu of buying back stock. As an example of this, 20% of the Standard & Poors 500 increased their dividend in the first quarter of 2004.
4. The fact that interest rates are at a 40 year low has led us to favor common stock dividends, in general, and higher yielding stocks in particular; because they are providing cash (income) returns to investors which in many cases are up to several times that of money market alternatives. Treasury notes are 1.25% for 90-day bills, and 1.60% for 6- month bills. Money market funds are paying approximately 75 basis points (0.75%) and CD's are between 1 and 2%. The yield on the S&P 500 is 1.2%, but dividends on high quality utilities average between 4 and 5%, high quality bank shares average between 3 and 4%, and a number of high quality industrial stocks pay between 2 and 3%.
5. Further, as we have mentioned in previous commentaries, the last tax bill that Congress passed in 2003 provides an 85% tax exclusion on qualified dividends. So a 3.25% nominal rate - which itself is more than double short-term treasuries and CD yields, becomes close to 6% on an after tax basis if one allows for the tax break. We believe that makes a very compelling case for the aforementioned type of stock.
6. Looking forward, then, to the markets of tomorrow, we foresee a climate of investing wherein value will rule the day insofar as stock selection; but growth will also participate. We tend to think, however, that growth will manifest itself by growth of dividends as much as earnings. Thus, the real growth stocks of tomorrow will be found in companies who regularly raise their dividend to allow shareholders to participate in this earnings growth; and both will occur from a value framework.
7. Finally, we think it makes sense to own companies which have a record of raising dividends if for no other reason than to invest in a rising income stream versus a bond (municipal or corporate) where one's best hope is to get their money back after a period of stable - but not growing income.

Meanwhile, the economy keeps rolling along. Second quarter earnings results are being reported as we write. Thompson First Call Research predicts a third consecutive quarter of better than 20% profit growth once the final numbers are in. Further, the National Association of Business Economics look for continual growth in the second half of this year . They see both employment and capital spending continuing strong, and favorable results across the economic spectrum. Value line also chips in with a forecast of 4% GDP growth in the second half .

What can go wrong?

Over the past several months, our caveats to a favorable market environment have been primarily focused on two concerns; the geopolitical environment in general, (with Iraq in particular), and the deficits which are building as a consequence of the monetary, fiscal and tax stimulus referred to above. In addition to these concerns, we would like to address some concerns of others that could become problematic for the financial markets. Our comments are as follows:

1) Inflation.
$40 oil and $2.30 gasoline lead many to think we are at the verge of an inflationary spiral. Runaway Real Estate prices tend to underscore that opinion. We acknowledge both concerns, but disagree with the conclusion. We believe that there is enough slack in the economy to accommodate the excesses in both the oil and Real Estate market for the time being.

The real price of oil, adjusted for inflation, is about half of what it was during the Arab oil embargo in the 70's4, and will probably fall in value once Iraq and the Caspian Sea opens up.
Other commodities, which have experienced sharp price increases in the last six months, are largely a function of China (which is decelerating) and our own economic stimulus (which is high but leveling out).

Real Estate is another matter and needs to be looked at as a bifurcated, not an indigenous market. For example, we think residential property values - at least in large cities will probably fall; but industrial properties will probably rise. We think multi-family dwellings will hold their value, while strip malls might not. Above all, it's a local market, with a lot of moving parts and thus difficult to make a blanket statement.

Suffice to say that we agree that inflation and the expectation of inflation are key variables to pricing securities. We would become very concerned if the Federal Reserve ratchets up interest rates to double-digit levels; but our view is that inflation will be held in check, and that it will not be necessary to do so.

Per our previous commentaries, we think there is a greater long-term probability of deflation5 than inflation. We think labor costs are in a long-term secular downtrend, and that the pricing power of companies selling commodity products will be restrained by interest rates and by floating currencies.

2) Deficits
Economic forecasters are looking at a deficit this fiscal year ending September 30th of approximately $500 billion. The U.S. Government Office of Budget and Management agree with these numbers. Government estimates have these numbers falling as we go out in time, based upon prognostications of increasing tax revenues from a rising economy.

Yet there are many people who disagree with these policies, and view the immediate deficits - which are a given - as likely to get worse. They point to the likelihood of rising interest rates, which will increase the cost of carrying the debt. They further are unconvinced that the incremental tax revenue of a rising economy will be enough to offset the lower taxes being currently collected as a result of the President's tax bill.

3) A falling dollar
The dollar is the key currency in the world, and the United States is the locomotive pulling the rest of the world out from recession. Having said that, to the degree that we sustain balance of trade and budget deficits, we're likely to experience weakness in the dollar as well. But, the dollar has been stabilizing for the last several months after having fallen for two years, and some economists realize that a falling dollar may be necessary to accommodate our balance of trade. Nonetheless, if in fact our budget deficits gets worse rather than better, the dollar is likely to get worse and could jumpstart inflation as well, since it will then cost more to do business with the rest of the world. Despite all this, however, we don't believe foreigners' will choose to cash out their dollars, and unless they do, the dollar will be okay.

4) Slowdown
The last two weeks have seen somewhat of a slowdown in a) retail spending, b) downward earnings guidance from software companies, and, of course, c) the first of what could be several interest rate hikes by the Fed. We view this as a pause in a very strong economy, and will probably continue seeing it that way unless and until we see numbers to the contrary.

5) Iraq
As we mentioned in our last commentary6 Iraq and what evolves from the war on terror becomes the critical ingredient to both the future of the stock market, and to our own well-being. For now, as bad as it seems, we don't believe the current situation will topple either equity prices or our economy. We actually think things have gotten slightly better with the changing of the guard. Still very bad, but better than it was. We don't have a crystal ball, but we recognize that any one of these concerns could create a downdraft in the market.

In conclusion, we believe that we will remain in a choppy market during the near term as the market digests conflicting data points concerning rebounding corporate earnings vs. rising deficits and geopolitical uncertainty. Given this backdrop, we feel yield and value will become more important as investors take a cautious view on the market. In the meantime, we hope you and your families have a wonderful summer. As always, we continue to thank you for your support.


Bill Schnieders
Jim Schnieders, CFA
*Please call the office at 626-584-6168 for a copy of the graphs.

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