First Quarter, 2006
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“To be interested in the changing seasons is a happier state of mind than to be hopelessly in love with Spring.”
— George Santayana| First Quarter 2006 | Since Inception (Annualized) 1/1/98 – 3/31/06 | From Month of Peak 3/31/00² | |
|---|---|---|---|
| Grisanti Brown & Partners LLC¹ | 5.2% | 12.1% | 84.6% |
| S&P 500 | 4.3 | 5.51 | -4.9 |
| Russell 1000 Value Index | 5.9 | 7.5 | 45.9 |
¹Performance is shown for the Core Value Composite, which is a weighted average of all accounts that are (1) fully discretionary, (2) mandated to be fully invested in equities, (3) tax-exempt and (4) over $5,000,000 in total assets. Prior to January 2002, the Composite also included certain taxable accounts which the firm had authority to manage without regard to tax consequences. SGB believes that the Composite provides a better illustration of the execution of the firm’s investment approach by excluding taxable accounts whose management is subject to more diverse objectives. Investors should anticipate that results for taxable accounts will differ from results for tax-exempt accounts. Prior to June 1999, the accounts in the Composite were managed while the principles of SGB were employed by its predecessor firm, Spears Benzak Salomon & Farrell. Past performance is no guarantee of future results.
Performance for the Core Value Composite reflects the reinvestment of dividends and other earnings. Performance does not reflect the deduction of advisory fees paid to SGB or its predecessor. A client’s return will be reduced by such advisory fees. For example, the effect of deducting a 1% annual fee from an account, compounded over a period of five years, would have reduced performance in such account by 1.12% per annum. SGB’s advisory fees are described in Part II of its Form ADV.
²Peak of S & P 500 Index
Don’t get us wrong. We like Spring just as much as the next bunch of certified financial analysts. The forsythias and the daffodils are already brightening the muddy paths in Central Park, the summer tourists are not yet crowding Fifth Avenue, and the Christmas ones are gone. Only the crustiest contrarian could fail to love New York in the Spring. Santayana, though, was underscoring the downside of being too enamored of any one environment, no matter how wonderful it appears at the time. We agree, and want to focus attention on the change we perceive occurring in the market and in your portfolio, and why we think it is so important. We anticipate a valuation shift that threatens the price of certain, long-held equities, while rewarding new investment in others. If we remain ‘hopelessly in love’ with what has worked so well in 2004 and 2005, your portfolio runs the risk of holding assets far beyond their prime. Who, after all, wants a vase of faded forsythias in October, as the maple leaves burn orange and red?
The market had its best opening quarter in six years. More importantly, your portfolio performed well in the period, but the performance in both cases was driven by continued appreciation of companies that rely on hard assets and inflation. Reminiscent of 1999, when high-priced technology stocks continued to climb, the first quarter featured continued appreciation by groups that have outperformed for three years now. The two best performing sectors in the U.S. were precious metals (up 52%) and steel (up 44%). Copper stocks, railroads and construction firms continued to exceed record valuation levels. Interestingly, one group that did not perform as well this quarter was Oil and Gas, with returns that underperformed the market. This may seem strange, as underlying energy prices remained quite strong. To us, though, this is an example of the old adage that no investment is so good that it can’t be ruined by a high enough entry price. As we have written in the last two letters, the euphoria surrounding energy equities -- leading to three- and four-fold appreciation in some cases -- can’t be a good thing from here for long-term investors. For this reason we have reduced energy exposure in the portfolios to around 10% from over 25% a year ago. In one of the more significant investment debates of this decade, we are siding with those who believe that the lion’s share of the gains have already been made in the energy sector. To put it another way, the days of throwing a dart at a list of energy stocks with the virtual certainty that you will come away a winner is over. The energy companies that remain in your portfolio each have a specific investment thesis other than merely the high price of oil and gas.
As hard asset investments increase in price their attractiveness as part of your portfolio decreases for two reasons: First, by simple mathematics they are closer to their ‘fair value’ and thus have less appreciation potential. The second, often over-looked, but perhaps more important reason is that appreciation increases risk. As the price of Encana (a large Canadian energy company that has been a superlative portfolio investment for three years) has risen from $14 to $55, the risk of absolute loss increases dramatically. This is especially true for investments that rely on hard assets like oil and gas, because there is little secular growth to drive stock performance if the underlying commodity price declines. Most oil and gas firms won’t extract much more energy from the ground this year than they did in 2005. The stocks are up significantly only because the price of each barrel of oil or cubic foot of gas is much higher than it was three years ago. Contrast this with Dell Computer’s or Intel’s business model, in which the price of the computers or semiconductors has steadily declined for more than a decade, but the secular growth of computer usage and semiconductor technology has overwhelmed (at least to date) the price declines. We are not advocating pure “growth investing”, and there are numerous reasons why technology (or other growth fields like communications or pharmaceutical) stocks may not be good investments right now. But all other things being equal, there is a greater chance that a poorly-timed investment can be saved over time when the underlying company is in a growing industry as opposed to a firm that relies on commodity price hikes to increase its share price.
This principle has had a direct effect on your portfolio this quarter. We continue to reduce our reliance on hard asset names, and have eliminated or reduced some of our strongest performers. Cleveland Cliffs, the iron ore miner, has more than doubled in price since our initial investment less than two years ago. We have started taking profits. Foster Wheeler, the construction giant, has more than tripled. While we see no clouds in the sky there, the stock is obviously not the bargain it once was, and we have taken profits there as well. While not an asset story, we have also sold our remaining shares of CVS, the drugstore chain, a successful investment that is now selling at nearly 20 times earnings (we bought it below 12 times).
Recognizing that hard asset investments are approaching full value and taking profits is only half of the transition. The more difficult decision is how to redeploy the money. The answer for us has always been found in bottom-up analysis of individual companies. When we assert that hard asset stocks are “expensive”, it’s not simply because they have gone up in price. They are expensive because when we compare the cash those companies can produce over the long term – the measure of worth of any business – to the price we are required to pay for it, we get too little return on our investment. On the other hand, partially because investment dollars are being siphoned away from other areas and into hard asset businesses, we are finding other companies that are historically inexpensive. (Ironically, hard assets have been such a great investment at least in part because in 1999 and 2000 money was being drawn into technology and communications, leaving hard assets high and dry and cheap.)
Not surprisingly, many of the businesses left behind are the antithesis of hard asset firms. Some are financial companies where the specter of inflation and accompanying higher interest rates has driven shares prices lower. We have doubled the financial exposure in our portfolios in the last year, and we suspect the weighting may go higher. Although the timing is always difficult to predict, we know that these companies are out of favor and historically have reacted in tandem with interest rates. In short, you want to own them before interest rates peak.
One such company is Washington Mutual, the coutry’s largest savings and loan, whose shares we have owned successfully in the past. We have uncharacteristically included a chart of “Wamu” so that you can see what we see:
The company is selling at the same share price as it did five years ago, and near a ten-year low price-to-book valuation. In addition, the stock pays a 4.6% dividend, about the same payout as the ten-year U.S. Treasury bond. The reason the stock has underperformed lately is its reliance, like most savings and loans, on mortgage income. As interest rates rise, and as the market worries about a potential housing bubble, the stock has dropped. Investors worry that defaults will rise and the spread between the interest rates that Wamu has to pay to borrow (in the form of deposits) versus what it can earn by lending (as a mortgage) will narrow. Some of this is true, but we feel the issues holding down the stock are overblown, and will fade during our three-year investment horizon. Credit remains strong, interest rates seem to be nearing a peak, and Wamu is as cheap as it’s been in ten years. Given the strong dividend, we think this is a compelling investment.
As we mentioned in our last letter, another group of companies that appears inexpensive to us are certain fallen growth businesses. This category would include new additions to the portfolio over the past six months that we have discussed in previous letters: Dell Computer, American Standard and even DuPont, where genetically engineered seeds are now the largest source of profit.
So, out with the old and in with the new, an especially arduous task when the ‘old’ has treated us so well. We do not know yet if this transition will bear fruit, and we probably won’t find out for several quarters or even a year or two. But we do believe that remaining enamored of Spring, in the words of George Santayana, will not serve us well when autumn arrives.
We have had some developments at the firm that we believe will increase the effectiveness of our business, including the appointment of a new Chief Compliance Officer, the first time we have hired someone solely to fill this role. Susan Grant is a compliance lawyer who has worked in the field for over 20 years, and we are thrilled that she is joining us. In addition, as we wrote to you last quarter, we have launched the Steepleview Fund, a no-load mutual fund whose portfolio mimics that of our separately managed accounts. It now has about $45 million in assets and is available for accounts above $250,000. Information can be found on the fund’s website at www.steepleviewfund.com. Our minimum separately managed account size remains $5 million. Finally, in accordance with SEC regulations, we are pleased to offer you a copy of our ADV. If you want it, please call Kerriann Johnson at (212) 218-5326. As always, we appreciate your support and look forward to continuing to serve your interests through thoughtful portfolio management.
Grisanti Brown & Partners LLC