Monday, April 24, 2006

2006 Quarter 1 Update

April 20, 2006

Despite the positive market action demonstrated in the first quarter of 2006 the future of our economy remains a hotly debated issue. On one side stands the ursine group, consistently pronouncing an end to capitalistic society as we know it. What they see in front of us is a continuously hawkish Federal Reserve resolute on raising short term interest rates until business comes to a standstill, rising inflationary pressures sure to club both the consumer and businesses alike into submission, the potential for the Democratic party to grab a foothold in this year’s mid-term elections, the ever present threat of terrorism (this time in the form of Iran) and high energy prices that are sure to put a damper on consumer spending as well. Not included in the above concerns are the ever ubiquitous bird flu fears that continue to paint the front pages of our periodicals and the opening monologues of our evening news. Just writing about these issues makes us want to buy a nice little cabin in the woods with a fully stocked gun closet at the ready! Sarcasm aside, the doomsayers do have some legitimate concerns and they always will. They are paid to be in a bad mood and as we’ve said before, market participants will always find something to worry about.

It is important to note that as investment managers we do not have the luxury of choosing to be either unequivocally bullish or bearish. Instead we must take what the environment gives us and act accordingly. At this very moment in time we find ourselves very cognizant of the perilous issues mentioned above, however we do not believe that the world, and hence the domestic or the global economies, are going down the tubes either. It is true that we have been in the grips of a hawkish Federal Reserve for quite some time now. The Fed funds rate stood at a mere 2.25% at the beginning of 2005, a full 2.5% below the current rate of 4.75%. However, despite this incessant rise in short term rates the economy has steadily increased in strength. Even if Bernanke wishes to raise rates another 50 basis points to 5.25% (a very likely scenario in our opinion) we are still in excellent shape to absorb the impact given the relatively low level at which interest rates currently reside. Of course one cannot rule out the potential damage to the consumer that might be caused by higher mortgage rates, however it is worth mentioning that if the yield on ten year Treasury notes were to rise to 5.5%, from 4.9% at the time of this writing, thirty year mortgage rates would be in the 7%-7.5% range, a mere $65 more per month added to a mortgage payment for each $100,000 of principle. This hardly sounds like a blow that the consumer cannot handle and it does not appear to be the proverbial straw that broke the camel’s back when it comes to really hurting the value of people’s homes.

Regarding inflation, it is to be expected that as the economy improves prices are likely to rise along with it. The concern is not only how quickly prices rise but of course by how much. On April 4th of this year Richmond Fed president Jeffrey Lacker stated that the price index for core personal consumption expenditures, a favorite Fed indicator, showed inflation well-contained. This is not to say that we find the prospect of more inflation ahead to be a benign issue. We are comfortable, however, with where inflation stands at this point in time and we believe the Fed will continue to do a good job at keeping it in check going forward. As energy prices are concerned, in lieu of any large shock to the system we believe that we are in a range here with oil between $50 and $70, with occasional spikes here and there. Thus far businesses and the consumer have adjusted quite well and will likely continue to do so.

As we stated above, it is our job as investment managers to read the so-called tea leaves and make both macro, and subsequently micro decisions for our clients. A case in point would be the recent decision to significantly decrease our exposure to energy, namely natural gas. Clients saw us sell their long-term position in Chesapeake Energy (CHK) for very nice gains. Do we believe that the energy story is over? Absolutely not. What we do believe however is that there are likely to be few near term upside catalysts for the commodity (natural gas) and hence the stocks themselves. Rather than watch these positions trade down over the next six to nine months (as we believe they might) due to seasonality and high storage numbers, we felt that it was best to take advantage of the high prices with the knowledge that we could always re-enter these positions at a later date should the environment still warrant it. Of course we still have a reasonable exposure to energy and will maintain one going forward. In short, we chose to avoid potentially giving back hard fought gains and to put that money to work in areas where we see more potential for upside in the coming quarters.

One such place would be Apple Computer (AAPL), a company in which we’ve invested before but never as a core position. What is going on at Apple is probably not a secret to many. Their dominance of the market in portable music is phenomenal (think iPod and iTunes). What they have achieved in this area will be very difficult for the competition to surmount. Top this off with the recent announcement that the company will be making Microsoft’s Windows operating system available to its MacIntosh computer users and you have the makings of a former also ran turned giant killer. We believe that the stock will continue to outperform as it continues to execute.

New positions are not the only ones that are exciting us at this point in time. Knight Trading (NITE), a core position that we’ve held for our clients for quite some time, has finally begun to live up to our expectations. Knight is both an asset management firm and a provider of trade execution to the financial industry. We originally took a position in Knight because we saw a company that was trading for little more than the cash it had in the bank yet still had a strong business model. At the time of this writing Knight reported its first quarter 2006 results and they are nothing short of astounding. Revenues doubled over last year and earnings were $0.47 versus $0.05 in the first quarter of 2005. Sometimes it pays to be patient and wait for others to realize the value that you might believe was already there.

In closing, while we do believe that there are risks to both the domestic and global economies (aren’t there always?), we feel comfortable that the state of the world’s economies provide more reward for investors in the coming year. Of course we reserve the right to change that opinion given the fact that we always remain data dependent, however we do not expect this will be the case in the near term.

As always, we appreciate the confidence and trust you have shown in us by hiring our firm as your investment manager and we look forward to a great 2006.


Paul R. Ray III Brian M. Phillips