The Portfolio

Internet stocks are back!  Internet stocks were the best performing sector in the second quarter rising a whopping 69%.  Other top performing sectors included the airline group, biotech, semiconductors and wireless communications.  What do all these groups have in common?  RISK.  As we see it, the riskiest, most distressed stocks delivered the largest gains.  One probable explanation for this is that many investment managers are deathly afraid of being left behind by a rally in any particular sector, especially tech stocks.  Therefore, when the most battered stocks eventually bounce, this might trigger a short-covering rally which pushes them up further, which may bring in some momentum players pushing the stocks up even more.  At this point, many managers begin to fear being left behind and decide to buy those stocks that appear to be working.  It is a still-too-common theme that most folks who manage other people’s money are more concerned with underperforming their benchmark (relative performance) than they are with taking excessive risks with their clients’ money.  One might assume they are not so cavalier about risking their own money.   

Margin debt is on the rise again, online trading volumes at such brokers as Schwab and E Trade are rising rapidly, and at least one indicator of bullish sentiment is as high as it has been since just before the 1987 crash.  In an environment like this PWM performance has lagged and typically will lag.  Value investors lagged the market in the late 90’s when risk was priced unacceptably low and fundamentals didn’t matter.  At the moment, the market seems to be replaying that movie.  At this point, we would rather be too conservative and achieve smaller gains than to be too aggressive and risk permanent losses.  You may love us or hate us, but one thing should be clear, we are not following the crowd. 

Two stocks were eliminated from the portfolio during the quarter.  Sturm Ruger was sold for several reasons.  While the company has taken some action to restore sales in the beleaguered metal castings division, the company is run more like a family controlled fiefdom than a public company with shareholders who expect some value creation on a reasonable schedule.  Furthermore, the climate of class action lawsuit abuse in this country seems only to escalate.  Anybody with deep pockets is a target as shown by the recent lawsuit against McDonalds, alleging culpability in customer obesity.  A recent class action filed by the NAACP against the gun industry suggests that lawsuits are not the fading issue we once believed. 

Fleetwood was sold because we underestimated the duration and magnitude of the problems facing the manufactured home building industry.  We still believe that Fleetwood will survive the downturn and is even likely to provide attractive returns eventually.  However, in retrospect, the risk is great enough that even with a nice potential return, we do not feel that the stock is appropriate for our conservative clientele and our stated goal of capital preservation.  A large run up in the price (probably a short-covering rally) allowed us a reasonable exit opportunity.   

In the energy group, we trimmed our position in Burlington Resources (a natural gas producer) as it had run up significantly following the rising price of natural gas.  We are still optimistic about the natural gas market for the foreseeable future, but it seemed prudent to trim our large position on such strength.  While natural gas related stocks have done well, oil service stocks have not.  The world continues to fear a glut of oil when Iraq returns to the market.  We believe a glut is unlikely and think that the price of oil will maintain a reasonably high level for quite a while.  The current pessimism on oil has allowed us an opportunity to purchase Tidewater at an attractive level.  Tidewater owns and operates boats used by the offshore oil exploration/production industry.  These boats are used for such things as ferrying supplies and crews to offshore oil rigs as well as moving giant anchors which hold offshore oil rigs in place.  Business has remained soft even while oil prices have been high.  Most oil producers held off making commitments to oil service companies like Tidewater because they have been afraid that oil prices would soon fall.  This is slowly changing and the oil service industry is gradually improving.  Tidewater is the premiere operator in the marine vessel market, has a strong balance sheet, good management, and an attractive valuation. 

The Fed’s War on Savers

At PWM, we find it absolutely amazing that, three years into the worst bear market since the 1930’s, the cult of the Fed is alive and well.  Not long ago, many believed that the collective central banking wisdom of the ages had rendered economic cycles a thing of the past.  After all, the Fed could simply cut interest rates to stimulate the economy alleviating any unwanted weakness, right?  After 13 interest rate cuts we are still waiting for the improvement.  Yet investors are undaunted.  Each new rate cut brings out the faithful.  This rate cut will be the one that finally gets the economy moving again, right?   

Investors unquestionably accept that the next rate cut will be just the thing to jumpstart the economy.  Tech stocks smell a recovery around every corner and investors have no fear of deflation occurring.  The Fed could easily defeat it by simply printing more money, right? 

The Fed’s current game plan seems to be ‘spend our way to prosperity’.  The wonders of falling interest rates encourage consumer spending in a big way.  Falling mortgage rates and zero percent car loans are the secret to our success.  Savers, and debtors too, are encouraged to spend like there is no tomorrow.  Perhaps we can grow into our overcapacity.  In their all out war on savings, some at the Dallas Federal Reserve Bank have even ventured into the realm of the absurd.  They have proposed a tax on savings! 

“The strategy … is to make money pay a negative nominal interest rate, by imposing some type of "carry tax" on currency and deposits.”  Koenig and Dolmas, Dallas Fed, May 2003. 

Let us hope that this is only an academic exercise.  Perhaps we are old fashioned but we believe that prosperity derives from savings, not spending.  We believe that easy money (and consequent over spending) during the ‘90’s is the disease, not the cure.  We must rebuild savings, which entails a period of under consumption, to repay our debts. Artificially low rates only keep zombie companies alive pressuring profits for all competitors, forestalling any recovery, and perhaps even encouraging deflation.  Artificially low rates steal from the saver and give to the debtor.  Manipulating interest rates lower is not the costless fix the markets seem to believe.  For every refinanced mortgage there is a lender who, his higher interest rate loan having been repaid, must now re-lend his money at the new lower rate.  Retirees who live on the income from bond and CD investments are finding their income drying up.  Banks are seeing their net interest margins (a measure of the profitability of lending) shrink.  Insurance companies earn less on their bond investments and are forced to raise insurance premiums as a result.  Money market funds will soon need to cut their fees in order to maintain a positive return for their investors.  It seems that artificially low interest rates have plenty of unintended consequences while, so far, failing to produce the intended consequence of economic prosperity. 

But these worries are trivial in the world of politics.  The political death knell is high unemployment.  Every good politician knows that you avoid rising unemployment as if your re-election depended on it.  And that is where we are today.  The markets want to purge the excesses built up during the boom.  Stock prices fell and bond credit spreads widened.  This is the market’s way of weeding out the marginal competitor in a low return environment.  However, this would lead to a rise in unemployment which we have already established as being politically unacceptable.  The obvious response is for the Fed to cut interest rates.  Keep the maximum number of people employed, even if that means short circuiting the free market mechanisms.  This is an old story and it has been tried before.  The prolonged economic weakness in Japan may offer us a glimpse into our own future.  In the end, we believe that the markets will have their way.  Risk will again be priced appropriately.   

We have a hard time seeing a new economic boom or bull market in the making for a couple of basic reasons.  First, the well-aired argument that stocks are still too expensive is hard for value investors to get past.  Secondly, aside from the fall in the stock market and some concentrated shrinkage in the tech and telecom industries, it does not appear that we have had the economic rebalancing necessary to restore the health of the system.  For those out of work, this may seem like a very bad economic situation.  However, when viewed dispassionately, the unemployment level has only risen slightly above the 6% level, which was not long ago considered full employment.  In many respects, this recession has been even milder than 1990, itself a very mild recession.  Gross Domestic Product (GDP) did shrink briefly in 2001.  However, the two quarters of GDP decline were so modest that the entire year (2001) still produced GDP growth of .3%!  This is compared to the 1990 recession when GDP shrank -.5% for the full year.  And what about household net worth?  It has indeed fallen since 1999, but only by a miniscule 2% per year.  This has hardly been a typical economic retrenchment.  It is hard to believe that such a mild recession can contain the fallout from the largest boom in history.  The corrective down-cycle is likely not complete and risk is still priced too cheaply.  We remain cautious. 

As always, comments, critiques, and questions are encouraged.   

We want to thank you for your business and assure you that we will continue to watch over your money as carefully as we watch our own.

 Sincerely,

Clayton Bryan, CFA                                                     Doug Manz, CFA

Principal                                                                       Principal

*This letter is for informational purposes only.  Nothing contained herein shall be construed as an offer or recommendation to buy or sell individual securities.  Data has been obtained from sources believed to be reliable but there can be no guarantees concerning errors or omissions.