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Investment Process
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  by Dennis M.
Brae Head Equity
 •Brae Head Total
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Past Commentaries

Current Commentary, Review and Outlook
January 11th, 2001

To My Clients, Friends & Observers:

One year ago we were optimistic for yet another double digit year from the major indexes predicated with several caveats regarding Fed actions, oil prices, consumer spending and statistical improbability. The first quarter of 2000 saw a rapid run-up in equity prices, in the face of interest rate and oil price hikes. The run-up to March 31 end of quarter valuations was clearly greed and window dressing and we sold into it. By early summer the rout was on. The Fed had inverted the yield curve, oil prices were stuck at $35, earnings warnings were regularly released, and valuations, particularly of the NASDAQ, were ridiculous. Second quarter earnings as they were reported in July clearly identified the sellers. "Investment Income" on the income statements of many of the largest-cap corporations was commonly in the range of 25% to 35% of earnings, with generally 3% to 5% of that from interest income. Supporting earnings per share by realizing gains in corporate investment portfolios roiled the markets with selling pressure but more importantly took future gains in those portfolios out of the foreseeable earnings picture for those same companies. This is the very definition of a negative feedback loop. The last one out of the restaurant picks up the check. By end of summer we were experiencing a dramatic increase in calls from non-clients who were interested in the Brae Head system because their portfolios were tanking and they didn’t know what to do. Cheers to those who listened and sincere sympathies for those who didn’t.

The P/E of the NASDAQ composite in June was over 120. As of the end of November it was still 107. In prior commentary we noted the Nikkei index had a P/E of 90+ back in the late ‘80s, at a value of 45,000 which has not been seen since. Nikkei P/E today is about 50, value 13,800. When we interview potential clients we try to qualify for them the concept of risk. One of the ways we illustrate risk is by using a couple of the most basic accounting principles and methods to value an investment, i.e., the going concern principle, and the payback method. Using these first, a company’s P/E ratio tells one how many years it would take an investor to get paid back using the existing level of earnings. Of course the common shareholder is not actually being paid back all or any of those earnings. Those earnings should accrue to the equity value of the investment. This helps sharpen the focus before discounting the value of future earnings. The S&P 500 Index P/E is at 25, down from 33 a year ago.

The idea that high-risk investments result in high-rewards is dogma for the unsophisticated. High-risk investments offer the potential for high rewards and the potential for high loss. Robert Arnott, of First Quadrant LP, Pasadena, California and Ronald Ryan of Ryan Labs Inc., New York, published a report recently titled "The Death of the Equity Risk Premium: Consequences of the 1990s." The sum and substance is that the premium investors historically have been paid to assume the additional risk of investing in equities instead of bonds is no longer there. In fact it is negative 0.9%. One reasonable translation: investors are paying a premium to be in equities, and presently, paying a high price. Appropriately enough, Brae Head fixed income, time weighted, total return for 2000 was 9.8%. It was a good year to be properly positioned in the bond market.

Dr. Scott Brown, Senior Economist for Raymond James Financial Services, grabbed our attention with some interesting numbers last spring. They showed historical market capitalization as a percentage of GDP, to wit: in 1960, 73%; in 1970, 81%; in 1980, 38%; in 1994, 88%; in June 2000, 207%. Woof…


Make an assumption that 90% of domestic households are within $1,000 of making it or breaking it in any given year. At 30 miles per gallon, 15,000 miles a year, each car consumes 500 gallons a year. If gas has increased from $.70 to $1.50 a gallon, $350 of the $1,000 has disappeared at the pump. Throw in a 100% increase in the cost of heating oil, or 150% for natural gas, and a return to colder winters, and the cost of heating a house has increased perhaps $800 on average. Poof, that $1,000 usually left over isn’t there this year. Apart from cut backs in available investment funds it’s worth speculating on what will be cut back in household expenditures. Housing starts have slowed. Retail trade was anemic at Christmas. The automobile cycle is finally winding down. Average age of the fleet is 8 years, yet sales are slowing. What else could be cut back? Premium cable service cut back to basic? Cell phone usage? Disney World? Dine out less and/or cheaper? It will be a challenging year for earnings, eventually rewarding the lowest cost producers with the best market share.

We are entering the third presidential term in a row where the sitting president has been elected with less than 50% of the vote, in a country that most recently split 50-50 on their most admired public figure: Pope John Paul and Bill Clinton. This divided nation could unite with one refrain on behalf of the consumer economy: "Give us more money or we’ll stop shopping!" Politicians on both sides of the aisle ought to be receptive to tax cuts of some sort this year.

The Fed has reversed course finally and has begun cutting short term rates. We are in the midst of a credit squeeze, Bank America and Fleet two of the most recent to write down huge loan portfolios. The junk bond market suffered record defaults in 2000. The Fed will cut in steps. It will take several cuts and perhaps a year for the effects to take hold though the yield curve should be positive before year end. The stock market will react ahead of the curve. The U.S. dollar remains the strongest global currency, reflecting the Fed’s hikes and the Euro’s difficulty.

Technology is still vital and vibrant. As an industry it is in a secular period of consolidation. Old economy rules still apply – a business has to make money. Capital budgets have become constrained. M&A activity will slow. There is not the appetite to support the IPO calendar of the last couple of years. Many tech companies will fade away. Many will not see their share prices recover for years. Many good ones are at bargain basement prices. Companies that are successfully assimilating and using technology for enhanced productivity and earnings present great opportunities and real value for investors. And most of these are "old economy" stocks. By way of example, in the last quarter we have positioned Diebold Inc., the premier manufacturer of ATM systems.

.The markets are laboring with uncertainty about earnings and about valuations. Uncertainty is the definition of a "trading range." Expect a period of consolidation and base-building. The longer the process takes the better will be the next move up. Dollars in money market funds increased almost 14% in 2000. To the extent those dollars chase bond prices even higher the door will open wider for a renaissance, if muted, of the bull market. Market psychology, put-call ratios, and sentiment are still too bullish to represent a bottom or a capitulation, undoubtedly reflecting the fundamentally sound, if slower, economy. However, breadth finally showed marked improvement across all the major indexes in December, probably indicative of some value shopping. It leads me to suspect a continuation of base building and slower growth. 2001 GDP expectations are in the range of 2 ½% to 3%. Upward revisions would be a market catalyst.

Targets for 12/31/01: Dow Jones Industrial Average 11,542; S&P 500 1425; NASDAQ Composite 2594. For the yield curve we forecast a 5% Fed Funds rate, a 5% five year note, 5 ¼% ten year and thirty year bond. Better flat than negative.

Best regards,
Dennis O'Connor