To My Clients, Friends & Observers:
June 19th, 2001
In a down market you beat the indexes by allocating away from them.
At the end of year 2000 Brae Head total assets were allocated 42%
to shorter term fixed income instruments and cash and 52% in equities.
Total return for the year was significantly positive. There was no
place to hide in the first quarter. Brae Head total return was down
8.9%, still beating the S&P 500 by 29% and the NASDAQ by 68%.
We are in the uncomfortable, if inevitable, process of an economy
working its way back to a level of sustainable economic growth. We’ve
stated in prior commentary that we are in a secular period of assimilating
new technologies and that many technologies will not be assimilated.
Those that missed the cut in this last cycle will have to wait for
the next or never be used at all. Capital spending cuts are enforcing
this assimilation period.
A friend asked me about Corning Inc. a year ago when the race for
optical fiber dominance was in full heat. I told him the timing of
such a position was crucial and recommended that a stop loss order
of no more than 10% below his purchase price would be prudent. There
isn’t much of a secondary or replacement market for glass fiber.
When all the fiber is laid revenues and earnings would fall off a
cliff. As a lead article about the glut of telecom fiber in the Wall
Street Journal yesterday reveals, revenues, earnings and share prices
have fallen off that cliff. The article quotes some Merrill Lynch
research that estimates that only 2.6% of capacity is currently in
use and "much of it may remain dark forever." We’ve stated that
the telecom revolution isn’t dead, just pushed back a couple
of years. In light of halting growth of wireless set sales by Ericsson
and Nokia and slowing momentum in global internet usage we may have
to add another couple of years. The reason given by Credit Suisse
First Boston analysts for Nokia’s slower sales growth of handheld
phones is a lack of expected replacement sales. This is an industry
that is already in stage three, maturity. Growth will come from enhancements
and replacements, market share gains and productivity. I could make
the same case for the internet, though I could be wrong. Motorola
has the most visible pipeline of product and productivity enhancements.
Ditto the scenario for the wireless TV industry (satellite dishes).
There is consternation over the future of the industry. Seems nobody
wants to own a marginally profitable infrastructure. Duh.
Look for PC sales to lead "tech stocks" back to growth. Someday we’ll
stop calling computer related companies "tech stocks." This too is
a replacement industry, cyclical but tangible, with generations of
enhancements ahead and visible margins.
Reviewing the game tapes…
We noted that real interest rates (coupon rate minus inflation rate)
were historically high even as the Fed began raising rates. It is
doubtful that the Fed will lower to the point of negative real interest
rates. The Feds’ current target rate is 4%. CPI inflation rose
to 3.6% in April, up from 3.3% in April 2000. The core rate was 2.5%
vs. 2.6% for the same period. M3 money supply rose 11% from May 2000
to 2001, and increased over a 13% rate for the last three and six
months. This leads me to expect no more than a .25% cut from the Fed
next week, a little less than inspirational for the equity markets.
Industrial capacity usage in May was 77.4%, the lowest since August
1983. Oil has shown trenchant support at $27.50/brl. The economy,
globally, could really use a 10% drop from here.
Credit quality is poor and looking poorer which gives one pause to
consider the long-term merits of lending at lower rates to lower quality
borrowers. The U.S. actually has a negative savings rate. This economy
is in the hands of the consumer. The simplest summary of the difference
between the Japanese economy (which is in recession despite virtually
zero interest rates) and the American is that Americans spend and
Japanese save. Unfortunately the probability of outright recession
here has increased. Slowdown, slower-down, or recession the market
will anticipate the recovery by a couple of quarters.
If things are looking a bit glum domestically they look worse abroad.
The best evidence of this is the strong U.S. dollar which, despite
blooming money supply and interest rate cuts, has yet increased from
115 to 120ish since the first of the year (JP Morgan Index vs. 19
currencies.) I am wary of a dropping dollar and an increase in longer
term bond rates.
I spent three days in Newport, Rhode Island last week at a financial
industry conference. From the many excellent presentations a couple
of notes stand out. One speaker predicted a 60% drop in trading commissions
in the next three years and declining to zero by the end of the decade.
The speaker also addressed the costs embedded in account maintenance
and the technological solutions being developed to mitigate same.
If this prognostication comes to pass it will force substantial reorientation
for investors, as follows, in my opinion.
It will consolidate the "do it yourself’ internet investor
(which ranks have been substantially decimated over the last year.
Schwab’s first quarter net dropped 68%.) Full service broker-dealers
will increasingly move their clients to fee based accounts or respectfully
decline the accounts that don’t. The market for independent,
fee-based, objective money managers will expand.
These changes will be good for investors. The first question an investor
needs answered before shopping for services is "who is going to manage
the money?" The answer is multiple choice. 1) The investor can manage
the money. 2) The broker can manage the money. 3) An independent money
manager can manage the money. "All of the above" is not an answer.
In fact, no two can manage the money at the same time. The "do-it-yourselfer"
will have more tools than ever before to manage his or her own. The
broker will have a reasonable fee schedule for his clients helping
to eliminate the inherent conflicts of interest with trading commissions.
The independent money manager has no conflicts of interest, a specific
investment system, and a history of performance. The investor can
choose the most suitable.
Brae Head currently manages the securities of about eighty companies
for its client portfolios. Portfolios have as many as forty and as
few as fifteen stocks, depending on the client and the characterization
of the account. Our target is twenty-seven, which is optimal for purposes
of diversification. Our entry level account minimum of $100,000 is
just barely enough to achieve diversification and balance. Brae Head
clients have neither the desire nor wherewithal to stay abreast of
fifteen, twenty-seven, or forty different companies in their particular
portfolio in an uncertain economy. A particular advantage to the client
working with us is our ability to be objective and disciplined, to
stick to the system, to act when it is necessary for the portfolio.
In January 2000 we established two new client relationships. At the
time we were allocating new equity portfolios 15% to 20% in technology.
Initial purchases included Dell, Sun Micro, EMC, Cisco, Applied Materials,
among many others. After a 20% to 30% run-up in the space of three
months we had to sell out these same positions despite our reluctance
to hand our clients short-term capital gains. The companies were overvalued
and the market was teetering. It is an extraordinary broker or individual
investor who would have had the discipline to exercise such trades.
The function of Wall Street is capitalizing industry. It is not the
function of Wall Street to make the investing public wealthy. Nowhere
was this better illustrated than in the May 14 issue of Fortune magazine
in which a Morgan Stanley analyst, whose judgement is supposed to
be independent and unbiased, candidly admitted to "supporting" the
companies she follows if they give her firm investment banking business.
In a related article it is noted that during the internet IPO (Initial
Public Offering) boom an astounding 57% of the money raised went to
the investment banks and their best institutional customers. This
goes a long way toward explaining why the analysts were so pathetically
late in downgrading the companies they follow – after perhaps
90% of the damage was done. It further supports the necessity of independent
money managers for the investing public.
We have available a white paper summarizing the Economic Growth and
Tax Relief Reconciliation Act of 2001. You may contact the office
for a copy.