Friday, February 02, 2007

2006 Year-End Update

January 30, 2007

Wow. What a year 2006 turned out to be on Wall Street! Going into the year, even entering the third quarter of the year, one would have had a difficult time finding many in the investment community who believed the markets would turn around so quickly. The malaise that was the late spring and summer of the year turned around abruptly, catching many professional money managers off guard to say the least. In mid-December Merrill Lynch commented on this reality by stating that there were a record number of fund managers underperforming their benchmarks in 2006. Why was this happening? Many believe that there were a large number of managers who were caught holding energy stocks too long and then, by design depending on the manager’s focus and style, did not rotate into mega-cap stocks in the late summer.

The reality is that the market in 2006 failed to reward “stock picking” and instead rewarded those who invested based on liquidity. What this means in a nutshell is that managers who favor mega-cap stocks were aided by the proliferation of ETF’s (ETF’s are funds that track the indexes but can be traded like a stock) because these large stocks make up most of the weight in the ETF. If you buy the RTH (an ETF made up of retailers), for example, 16% of it is allocated to Home Depot. The result is that smaller stocks within the group that may deserve a premium don't receive it because the group as a whole is being boosted. This means good stock picking is not nearly as important as is being in the most liquid names in the hottest sectors in a year like 2006.

All this to say that 2006, while rewarding, was extremely frustrating for money managers, ourselves included. And this reality brings up an interesting anecdote that’s worth mentioning. There exists a gambling competition in Las Vegas where a polished pro plays a rank amateur. In one of these recent competitions the pro applied optimal, back-tested strategies to each game. The amateur was just having fun, going on gut instinct, letting the chips fly. The stakes were small -- $25 per game. At the end of the contest, the amateur had $70; the pro was broke. This happens quite a lot in this competition and there is a valuable lesson to be learned. Within a short period of time, there's really not much difference between luck and optimized strategies. The edge just isn't that great. Slots have a very high payout, and everybody gets a blackjack if they sit at the table long enough. But over time, the disciplined pro with the best strategy will pull away from the amateur.

Now, apply this to investing. If you trade solely on gut instinct, you have a good chance of doing quite well -- for a while. Just ask everyone who used to trade back in the late '90s. In 1999 and early 2000, the only dumb ones were the pros. The amateurs were long any stocks with a ".com" and making tons of money, while Warren Buffett was eating at Dairy Queen. Who needed Vegas when you could trade online? But over time, the pros remained in the game, the amateurs went back to their old jobs, and Warren Buffett still eats at Dairy Queen.

The above story does not imply that only professional managers have any business investing in the stock market or that 2006 was anything like the climate in 1999/early 2000. The main thrust behind the example is simply that over a long time horizon investment discipline and strategy will trump the lack thereof. It is for this reason that we feel very good about the strategy and investment philosophy we employ for our clients. The hard work and study doesn’t always payoff in the short run, however over time it certainly does. The market cannot perpetually ignore value and it is this reality that ultimately wins out over time.

So what’s in store for 2007? We happen to like the equity market very much in 2007 and there are a number of reasons why we believe it should continue to rise. The first reason is one we’ve repeated over and over again, and at the risk of sounding like a broken record we’ll say it again. All that money has to go somewhere! There is so much cash on corporate America’s balance sheets that they will ultimately put it to work in the form of stock buybacks, dividends, and in many cases mergers and acquisitions. And that’s just corporate America. This does not take into account the huge amounts of cash being raised by private equity and leveraged buyout firms who are obligated to put their investors’ money to work at some point in the near future. All of this keeps a nice bid under the stock market and should continue in 2007.

Another huge catalyst for the market in 2007 continues to be the collapse in commodity prices, namely oil. This acts like a tax cut for consumers and businesses alike and assuming oil and other commodity prices remain stable, much less continue to decline, we will see strength reflected in consumer and business spending, a good thing for all investors outside the energy complex. And what about housing’s decline? We believe that the trend will be down in 2007, at least enough to keep the Federal Reserve on the sidelines and their finger off the interest rate trigger. Another result of a continued decline in housing is that investors will begin to look for other places to put their money. The stock market is likely to be an early recipient of this good fortune.

Another interesting, albeit slightly unusual reason for a potentially good year for equities in 2007 involves the presidential cycle. The third year of a President’s term in office almost always turns out to be a positive one for equities. Why is that? The reason tends to center around the fact that the current administration does its best to manipulate the economy to positively impact elections in the coming year. Whether this will hold true in 2007 is difficult to say as this presidency is far from typical given the issues being dealt with in Iraq in particular. But it is a potential positive for the markets none the less. Finally, bond yields continue to be low and we believe that they should remain relatively low throughout 2007. This removes a major competitor to equities for some time to come.

Of course there are always potential pitfalls in any given year and 2007 has some as well that are worth paying attention to. As stated above, housing’s decline has been a relatively good thing for the market for a number of reasons thus far, however any sharp downturn or prolonged weak activity would likely begin to take a toll on the economy and the markets in turn. The situation in Iraq is a difficult one to predict as it has been from the beginning. Of course that situation could take a further turn for the worse and cause problems in American’s sentiment and continue to cost the tax payer more and more money. The Democratic victories of last fall could always put a damper on the markets should the newly elected make things difficult for corporate America and the taxpayer, however in our opinion this is not likely to be a major issue in the coming year as there remains a large amount of gridlock on Capital Hill that will find it hard to make drastic changes. And of course the specter of more terrorism is never far from our collective consciousness either.

All of the above concerns are real, however we are of the opinion that the aforementioned positive catalysts for the market far outweigh the risks in the coming year, a fact we plan on taking advantage of.

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 the remainder of 2007.

Cordially, Paul R. Ray III Brian M. Phillips