Category: The Outlook

Globalization has dramatically increased world trade and capital flows over the past few years and the effect on world growth and demand for resources has further accelerated since China entered the World Trade Organization in 2001. This has considerably increased the growth of China’s middle class which in turn has created new and exciting markets for U.S. goods and services. Over time this is a positive development for the U.S. that will help to reduce our trade deficit with China.

China’s share of global industrial metals consumption has grown from 10% to 25% since 1996. More relevant is that from 2002 to 2005 China accounted for 50% of the increase in world demand for copper and nearly all the increase in nickel demand. Since the year 2000, global energy consumption has been growing at 2.6% per year vs. 1.3% during the previous decade. Despite this growth, China still uses considerably less oil and other raw materials than do the major developed economies. China accounted for 1/3 of the increase in oil consumption in 2006. To put China’s consumption of oil into perspective, we note that China consumes approximately 2 barrels of oil per person per year as compared to the U.S. which consumes 25 barrels of oil per person per year.

Successful portfolio management involves strategic decisions that can exploit industry groups and the companies within industries that are benefiting in the global economy. Investing in well-managed companies within these industry groups at low valuations is a good recipe for investment success.

We wish our readers a happy, healthy, peaceful, and prosperous New Year!

We highlight below some current market concerns:

The fundamental purpose in owning equities is to compound rates of return over time in order to build capital and to meet present and future capital and income needs. Unfortunately, the fundamental purpose in owning equities gets lost in the day-to-day news and commentary from the financial media to which we are all exposed.

The world’s natural resources should remain in strong demand for a long time to come barring a major global downturn. The mining industry has also been badly affected by the lack of skilled workers, and many engineers will be retiring in the next decade. The energy industry will continue to struggle to find the people it needs within the U.S. labor force. In 1983 there were 11,000 petroleum-engineering students in undergraduate schools. That number, according to the Society of Petroleum Engineers is now about 1,700. Every industrial company we contact has the same story. There is a secular shortage of quality people, materials, and equipment, and there is no short-term solution on the horizon. We note here that many of these companies are selling at low multiples of earnings and cash flows, have strong balance sheets, and represent excellent investments in our view.

There is no doubt that today’s investment climate is more difficult, and this is being reflected in market volatility. This is also providing us with an opportunity to purchase many of the companies that we favor at particularly attractive prices. We also anticipate an increase in merger and acquisition activity in the sectors mentioned. If this occurs, we expect substantial premiums to the current market prices to be offered. The imbalances evident today should result in capital and income gains over the next several years for the companies positioned for this outlook.

Our view of the domestic and world economy has changed little in over three years, and we continue to find value in the critical areas listed above. Over this period we have often been asked if our investments should continue to be held. We continue to believe that the underlying fundamentals that are driving these investments will be longer lasting than many consider to be possible. Furthermore, Wall Street’s fascination with strict diversification without adequately considering the actual investment fundamentals or economic merit hinders the opportunity for success by limiting the investment in critically important areas. Consequently many investors are destined to experience only average returns. As these sectors become more popular their weighting in the S&P 500 will inevitably increase.

The U.S. Treasury department, by not citing China as a currency manipulator in its recent report, is in effect encouraging the decline of the dollar thereby putting upward pressure on the price of gold. This, in combination with the new availability of ETFs, encourages further investment and trading interest. If U.S. investors alone were to allocate just 1% of their investment portfolios to gold as an asset class, it would equate to the purchase of over $100 billion worth of the metal. By contrast the entire gold industry worldwide mines 88.2 million ounces per year and at $700 this equates to only $62 billion. In this case, U.S. investment demand would equal 1.6 times all the gold mined in a single year. In this context it is not surprising to see the price of the metal rising.

While many of our clients’ equity returns have far outpaced the major averages, the successes were not based on any market predictions; quite the contrary, we make it a point of avoiding predicting the stock market, but instead focus on the positive dynamics driving the U.S. and global economy and the companies that benefit from these forces.

The United States is running large fiscal and trade deficits. The liquidity being created by these deficits is flowing overseas and being used to create low-cost production. In addition, the excess dollars being created are flowing back to the United States in the form of foreign purchases of US Treasuries and fostering a lower long-term interest rate environment in combination with lower inflation brought about by excess productive capacity, particularly out of Asia. As long as our deficits continue to be successfully financed by foreigners, the U.S. economy should continue to expand. Consequently, the fact that short-term rates are higher than long-term rates should not be interpreted as necessarily forecasting a recession. Furthermore should Congress enact pension reform in 2006, this will tend to put further downward pressure on long-term interest rates as pension funds purchase more long-term fixed income securities.

As a consequence of Asian central banks’ ongoing purchases of U.S. treasuries, the global monetary environment should remain accommodative with excess liquidity continuing to build through our deficits resulting in relatively low long-term U.S. interest rates. The global economy should continue to grow as Asian economies expand. A growing Asia will also put upward pressure on commodity prices reflecting greater demand than supply. Moreover should the dollar weaken, exporting nations will be under pressure to devalue their currencies to remain competitive thereby further increasing global liquidity and tending to raise the prices of tangible assets.

While many consumer balance sheets remain stressed, corporate balance sheets are very strong, and we should expect continued dividend increases by companies generating significant earnings and earnings growth. Moreover in making our investment decisions, we put a higher premium on companies that are willing to share their good fortune with their shareholders. As discussed in our September 2005 Outlook, we believe that particularly good values can be found in the oil, natural gas, coal, railroad, insurance, defense, precious metals, machinery, and the industrial company sectors. As 2006 begins, we expect these sectors to continue to be among the most notable areas for investment in the coming year.

We wish our readers a Happy, Healthy and Prosperous New Year!

On a long-term basis according to the American Society of Civil Engineers’ report card for 2005 on America’s infrastructure, aviation, bridges, dams, drinking water, energy, hazardous waste, navigable waterways, parks and recreation, roads, schools, solid waste, transit, all received quality ratings of C’s and D’s. Since there has been little improvement since 2001 we expect the approximately $950 billion earmarked to be spent over the next five years to be insufficient. The required investment should be more like $1.6 trillion. Many of the companies that we favor have recently increased sharply in market value, but still remain worthwhile investments in our view. The market sectors in which we are most interested should be major beneficiaries of U.S. and global infrastructure needs.

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The Chinese energy sector is at a critical juncture as demand is currently 6.7 million barrels per day and rising. Supply is increasingly falling short of demand, and as the number two energy consumer in the world China has generated 1/3 of the world’s incremental demand for oil from 2002 through 2004. In addition we believe China plans to build a strategic petroleum reserve. At the same time OPEC is pumping at full capacity and will require an investment of hundreds of billions of dollars to significantly increase their production capability.

Political risks have also increased; for example Venezuela which produces 2.2 million barrels a day, has 32 private operating agreements which it wants to change to put the government more in control. Last year President Chavez raised royalties from 1% to 16.6% on the Orinoco Projects. He also increased taxes on operating agreements to 50% from 34%.

In 2003 most U.S. oil discoveries were in the Gulf of Mexico. During that year proved reserves of oil in the U.S. declined 3.5%, the first decline in 5 years, and operators replaced only 58% of production. In 2004 U.S. production declined by about 5%. Without trying to forecast the price of oil it appears that as long as global growth continues it will be costly to bring supply and demand into balance. Moreover because the environmental standards for diesel and gasoline purity will become much more stringent next year it will be more difficult and more costly for the U.S. to import refined product.

Overall we are optimistic about the sector’s long-term prospects. Our sense is that the second half of this decade may even see acceleration in the global demand for these materials. Given such an economic setting, sound balance sheets, powerful cash flows, and superior management, a period of solid earnings growth, dividend increases and stock appreciation should lie ahead. As noted in our prior Outlook, volatility will be a continued feature of any likely advance.

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Under these circumstances investors must continue to focus on the preservation of their buying power.

The current account deficit has been expanding since the mid-1990s, and for years economists and currency traders have been warning that it cannot continue to do so indefinitely. What can’t continue has to end; the only question is how and when.

One of our focuses has been in basic materials – iron ore, coal, steel, oil and gas, copper, and nickel. During the quarter the price of iron ore was raised by 71½%, and the price of iron ore pellets was increased by 86% by Cleveland-Cliffs. Now steel prices either will have to be raised or the steel industry must absorb higher costs. Iron ore and iron ore pellet costs are 10% of the cost of producing steel. Another example of a basic material in short supply is copper whose global inventories have been drawn down to 3-weeks of supply. As for energy prices, oil prices continued to rise as refineries operated at capacity while demand for oil products (i.e. gasoline and diesel) has kept increasing. The tightness in the energy market partly results from a lack of refinery capacity that will be with us for a considerable period of time.

We believe that world demand for raw materials will continue to remain strong and barring a global recession, we expect continuing industrial expansion. Congested highways, overflowing sewers and corroding bridges are a constant reminder to Americans of our neglected needs. We expect demand for basic materials that are needed for the growth of the global economy to continue to rise throughout the decade. Some of the companies benefiting from global industrialization sell at cash flow and earnings multiples of less than 5 times and 10 times respectively, and are in a position to raise their dividends significantly.

The U.S. faces numerous military challenges on a global scale. The challenge extends well beyond just Iraq and the Middle East. Top U.S. military commanders have warned Congress that China’s military power is growing at a rate much faster than China would seem to need for national defense. The growth has come particularly in the areas of maritime strength and aircraft attack capability.

Unlike mutual funds, hedge funds are basically unregulated. They are able to borrow securities and sell short, and they typically use significant leverage in their operations. Hedge fund trading tends to distort and force the prices of individual securities away from otherwise fundamental valuation considerations. The infrastructure, heavy industry, manufacturing, energy and basic materials sectors delivered a significant amount of the equity appreciation to portfolios during the quarter and had become a tempting target for hedge funds to sell and lock in profits as the quarter ended.

Over the past decade hedge funds have been the fastest growing component of the investment management community now representing over $1 trillion of investment capital. They also represent the lion’s share of daily trading volume on and off the exchanges. Hedge fund strategies are to generate positive rates of return and they are practiced on a daily basis. The goal is to garner near-term performance and lock in gains. Many are motivated by rumors and misperceptions as well as fundamental developments.

Hedge funds generate lucrative fee-based revenues for Wall Street through complicated trading strategies, creative financing deals and active trading, a major function of prime brokers. It is in the prime brokers’ interests to generate as much activity as possible which can add to volatility. It is estimated that hedge funds currently generate more than 30% of the Street’s equity commissions, and we expect that percentage to grow over the next several years. Hedge funds have become the focal point for profitability for prime brokers.

As an example of pronounced volatility, if one were to have owned Phelps Dodge through the first quarter of this year, the value of the holding would have fluctuated over 21% within that period…

If an investor with a buy and hold strategy disregarded the trading volatility that was in excess of 33% on the down side and held the stock for the past 2 years, the total return would have been in excess of 160%…

Volatility is a feature of today’s market. And while it can be uncomfortable for an investor to experience, it should not influence ones’ long-term investment discipline. However volatility does give investors the opportunity to purchase securities at more attractive prices when shares are undervalued.

Finally, our view of the outlook supports investment in selective dividend-paying equities and fixed income securities with maturities under 5 years.

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On November 19th, Federal Reserve Board Chairman Alan Greenspan gave a speech in Frankfurt, Germany, which actually encouraged further dollar weakness, and had the effect of giving many money managers the all-clear signal to short the U.S. dollar. Normally a protracted pressure on a currency leads one to expect that at some point a temporary counter-trend rally could develop. Moreover, recent legislative tax changes have encouraged U.S. corporations to repatriate significant amounts of cash that they have in their overseas divisions, which could also result in short-term strength in the dollar. However, it has been an uphill battle for the dollar to rally as the U.S. current account deficit continues to climb.

On November 1st the British pound was trading at 1.83 and it is now at 1.93. The Euro stood at 1.27 and it is now almost 1.36. Mr. Greenspan has also made clear his opinion that interest rates are in a rising trend around the world. The growing U.S. current account deficit is adding to the risk of a further decline in the dollar, which would cause world growth to slow. The current account deficit for October rose to $55.5 billion or an increase of 9% from September. Part of this was due to imports of oil that totaled more than 400 million barrels at a price of $41.79 a barrel. This compared to the prior month’s imports of 330 million barrels at a price of a little more than $36 a barrel. Moreover, our trade deficit with China was $16.8 billion and could total a record $160 billion for the year or double what it was three years ago. The current global trade imbalance is at the root of the dollar’s problem. The U.S. savings rate is almost zero, while the Asian economies have high savings rates and depend on exports rather than their domestic demand to generate economic growth – although domestic demand in China is growing rapidly. As we export dollars through our trade and fiscal deficits, they are being financed by foreign economies that hold over 1 trillion dollars of U.S. treasury debt, thereby making up for the lack of U.S. household savings to finance our needs.

The question for us now is how much should we expect the dollar to decline to bring these imbalances into a healthier balance. A brief historical analysis could be revealing. In the late 1980’s, our current account deficit had peaked at 3.5% of GDP and the trade-weighted dollar fell 40% versus the currencies of our major U.S. trading partners. At the present time our current account deficit is approaching 6% of GDP and the trade-weighted dollar has fallen only approximately 15% from its 2002 peak.

We should note that it is apparent to us that if China were to revalue its currency, it would cushion a dollar decline versus the euro, yen, and the other currencies of our trading partners, which are bearing the brunt of dollar weakness. However, we do not believe that a significant revaluation of China’s currency is a high probability. Therefore we expect further dollar weakness vs. the non-Asian currencies.

In addition to the current account deficit and its impact on the U.S. dollar, which can be seen in the chart below, the U.S. fiscal deficit of $400 billion is clearly too large for this stage of our economic recovery cycle. Moreover, the supplemental budget for our commitments to the war in Iraq and Afghanistan will add a further $80 billion to the fiscal deficit. Therefore the combined fiscal and current account deficits will total about $1.1 trillion or 10% of GDP. How long this can be sustained is an unanswerable question.

The administration’s current policy is to let the dollar decline in the hopes that the trade deficit would be brought into better balance. However, the point needs to be made that the heavy industrial and manufacturing base of the United States has shrunk considerably over the years, and we anticipate that it is highly unlikely that the same improvements of the trade imbalance that occurred in the past with devaluation as the tool to increase exports can occur at this time. The mathematics just does not support this approach to the degree that it did in the past.

As we have indicated in past Outlooks, the industrial base is an important beneficiary of both devaluation and the infrastructure needs of the U.S. and global economy. One of the basic components of infrastructure and heavy manufacturing demand is steel. The steel market has been quite strong and in some markets prices have risen as much as 60% since last year, and we expect further price increases in 2005. It is possible that steel supplies could remain tight for a considerable period of time as China and India as well as other countries experience strong demand. Steel demand from China is expected to grow 10% next year, and China has displaced Japan as the number one importer of iron ore. The Chinese have secured long-term contracts with Brazil as well as other suppliers. Iron ore prices are expected to rise as much as 30% next March and this in turn will put upward pressure on finished steel prices.

Whether we are talking about steel, copper, nickel, iron ore, coking coal, or oil we believe that world demand for raw materials will continue to remain strong. In our view, investment portfolios should include the common stocks of companies that benefit from global industrialization. Many of these companies sell at cash flow and earnings multiples of less than 10x. Moreover, the dividend yield and the prospects for dividend growth can also significantly improve the total return outlook for these companies and portfolios.

For many investors the market has been difficult for most of the year. Up to the Presidential election the Dow Jones average had been down -4.0%, the S&P up +1.7%, the NASDAQ was off -0.93%. All of the market’s strength occurred after the Presidential election in early November. In contrast, most of our equity investments performed well throughout the year. This has not been a product of market forecasting but an outgrowth of our focus on investing in the opportunities that are created by the imbalances in the system. This outlook focuses on select areas that benefit from the continuing imbalances in the fiscal and trade areas as well as the ongoing weakness of the U.S. dollar. Overall, in a weakening dollar environment it is not enough to emphasize just capital preservation; investors must also protect against a potential loss of purchasing power.

We want to wish our readers a happy and healthy New Year.

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There has been a significant decline in investor expectations over the past several weeks. The presidential election, price-fixing in the insurance industry, product recalls in the pharmaceutical industry and record high oil prices have been pressuring stock prices. We have gone above and below the 10,000 level on the Dow Jones Industrial Average several times this year. Surprisingly Treasury bond prices have shown a significant amount of resilience as investors in the equity markets moved to the sidelines. Crude-oil futures had crossed the $55 a barrel level, which is the highest point since oil futures started trading on the New York Mercantile Exchange in 1983. Rising oil prices can seriously hurt equity valuations over time as investors begin to fear higher energy costs, weaker corporate profits and lower consumer confidence.

Among Mr. Bush’s most ambitious domestic economic goals is additional income tax code reform. The President is expected to study ways to make the system less complicated and move it more toward a tax on spending, as opposed to income. He also wants to make permanent the tax cuts passed in his first term. The pressure to amend the tax code partly comes from the unpopular Alternative Minimum Tax provision that exists in the present code. Any significant tax-reform plan will be very controversial and hard fought in the Congress. We are optimistic that Congress will pass a rational energy bill that would benefit energy investments. We also believe that a meaningful tort reform bill has a chance of passing in the Congress, and this could have a broad benefit to the financial markets.

The first half of the year’s surge in job growth increasingly looks like an aberration. The hurricane season certainly did not help the situation in the third quarter, but The Bureau of Labor Statistics believes the effect of the storms will ultimately be small relative to the overall job growth picture for the entire year. The economy is still moving forward, but slower than expected as we indicated in our last Outlook. The strain on the U.S. economy from rising oil prices is a further risk to GDP growth in 2005.

The Federal Reserve Board is likely to stay “measured” in raising interest rates. We interpret “measured” to mean quarter-point steps are still the basic plan, with periodic pauses. December remains the best chance for a pause before year-end. We assume a 2% federal funds rate at the end of 2004 and 3.5% by the end of 2005. Core CPI inflation might inch up to around 2% by year-end. Given our GDP growth expectations, the risks associated with higher inflation are probably low. Our 2005 forecast for GDP remains at 3.5%, but high energy prices could significantly reduce that number. Obviously higher gasoline prices and home heating fuel costs could push total CPI inflation up and GDP growth down next year.

Unlike the period in the 1990’s when excess oil producing capacity was 5 to 10 million barrels per day at a time when worldwide oil demand was 72 million barrels a day, at the present time demand is approximately 82 million barrels per day and maximum capacity is considered to be approximately 83 million barrels per day. In 2005 the expectation is that oil demand will increase again and may even exceed current production and refining capacity.

In the meantime summer and fall inventories of crude oil, gasoline and heating oil have been drawn down, and they will probably not fully be built back in time for the winter heating season. Furthermore, refinery capacity and shipping capacity is fully utilized leaving no room for supply interruptions. Oil companies continue to justify capacity expansion on $25 a barrel oil, which suggests that supplies could remain tight for a considerable period of time.

The degree to which the exchange rate of the dollar will maintain its present level depends on foreigners’ willingness to reinvest these funds back into the United States. It is worth noting that in July net private purchases of U.S. treasury bonds and notes fell to $18.3 billion from $23.0 billion, and in August net private purchases of U.S. treasury bonds and notes swung to a negative -$4.4 billion from a positive $18.3 billion. Moreover, in July private net cash inflows into the U.S. were $73.8 billion and in August it declined to net cash inflows of only $37.4 billion. This represents approximately a 50% decline. Making up the short fall were dollar purchases from foreign central banks. Should the foreign exchange value of the dollar decline further, we can expect an improvement in our current account deficit if imports slow and exports increase. However it seems reasonable to assume that we can still expect a further devaluation of the dollar. Should this occur we would expect rising prices for precious metals, commodities, collectibles and imported goods.

The current price of energy, gold and industrial raw materials as well as overall market trends corroborate our view that equities representing “hard assets” offer some of the best opportunities for investors. The future earnings, cash flow and dividends from the companies we like often are not reflected in their present asset values. We expect that the high-dividend paying companies in this area will do particularly well in the current market environment. Other companies which should benefit from these conditions are in the following industries; defense, building materials, machinery and railroads. The companies we favor in these groups generally have extra cash on hand to allocate towards capital spending, dividends, share-buybacks and debt reduction.

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Most companies are richly valued at present even assuming the sustainability of the economic recovery. In the late 1990’s an Internet/technology driven business boom pushed the unemployment rate to record lows and economic growth to record highs. We do not feel that there is anything in the system today that can bring back so much economic excitement or investor optimism. High oil prices, terrorism and the structural imbalances caused by large federal budget deficits and trade deficits have altered the economic landscape.

It is noteworthy that many Wall Street firms have recommended an under weighting in energy and are now moving to a market weighting for portfolios. Energy (oil and gas) represents approximately 7% of the S&P 500 while financials represent about 25% of the S&P. However, in 1980, when energy prices peaked, energy company equities were 25% of the S&P while financial company equities represented 7% of that index. Today’s valuations of energy companies, particularly among the independent producers in the U.S., sell for as low as 3 times cash flow from operations. Moreover some of the great beneficiaries of current high energy prices are paying dividends yielding 7%-10% per year and have the potential to raise their dividends in the future. At a time when many investors are trying to increase their returns in a historically low interest rate environment, we still believe that investments in the energy sector are particularly attractive.

While consumers continue to benefit from cheap Asian imports, goods and services that are produced in the U.S. are rising in price more than the official inflation statistics are indicating. The overall price inflation view now suggests that consumer incomes are likely to get squeezed in the current environment. While corporations have been accumulating cash, paying down debt, buying back stock, and raising dividends, consumers are having to grapple with rising household expenses and heavy debt loads. Consumers may find it necessary to cut back on spending – particularly if interest rates keep rising.

We are always dealing with uncertainty and a range of challenges when attempting to describe future economic outcomes. However, the combination of the U.S. government’s fiscal and monetary policy becoming less expansive and record high oil prices suggests that the equity markets may well remain under pressure. Let’s not forget that the 4% growth of GDP has been built on large U.S. fiscal and trade deficits totaling 10% of GDP (a very high percentage) and a forty-year low in interest rates. Should we expect strong growth if energy prices remain high, interest rates rise, consumers find it necessary to cut back on spending and Washington attempts to rein in the deficit?

Deflationary forces still lurk in the background and high energy prices will act as a tax on consumption while the tools of economic management-fiscal and monetary policy-are in the process of being reversed. High quality fixed income investments should also do well in this environment. We believe that most economists will have to revise downward their growth expectations including the most recent Federal Reserve Board expectation of 4 1/2 – 5% growth for the second half of 2004. From what we see many investors are not prepared for this change.