Second Quarter, 2006
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“An optimist is a person who sees a green light everywhere, while a pessimist sees only the red stoplight. The truly wise person is colorblind.
— Albert Schweitzer| Second Quarter 2006 | Since Inception (Annualized) 1/1/98 – 6/30/06 | From Month of Peak 3/31/00² | |
|---|---|---|---|
| Grisanti Brown & Partners LLC¹ | -2.6% | 11.5% | 79.9% |
| S&P 500 | -1.5 | 4.8 | -6.3 |
| Russell 1000 Value Index | 0.6 | 7.4 | 46.8 |
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
The problem with being an optimist is that you sound naïve, if not downright stupid. Imagine if someone at a dinner party blurts out, perhaps after too much wine, that he thinks the economy is just fine, interest rates are eventually headed lower, productivity continues to increase and the unemployment rate seems pretty darn low. After promising yourself not to go to such boring parties in the future, you give a little light-hearted laugh and set this fellow straight – that is if the person to your right or left hasn’t already beaten you to it. You might mention (if you’re as boring as he) that the dollar is clearly headed lower, China is on the rise, the war has ruined our reputation, and commodity prices have climbed to record highs. What you don’t say, partly because you’re too polite but more because everyone knows you’re thinking it anyway, is that the optimist is a blithering idiot who is simply not intelligent enough to see all the bad factors assailing our nation and its markets. Saying you’re optimistic about the current state of economic affairs is like fessing up to being a member of the Dick Cheney fan club – it’s just not done, especially in New York City.
For the week ended June 23rd, pessimism about U.S. stocks rose to the highest level since October 2002. Clearly, from these letters you know we like to talk, but sometimes a picture says it best. Below is a chart of the S&P 500 Index, with the points of maximum pessimism shown for the last ten years.* It bears out what many students of the market already know, that pessimism is a contrary indicator. It accurately measures not future prospects, but current pain, and it increases as prices decline. But as prices go down, valuations become more attractive. As you can see on the chart, the S&P is at its lowest forward price-earnings ratio in at least 10 years. It’s been said that many an optimist has become rich by buying out a pessimist, which was certainly true in October 2002, as valuations dropped as pessimism rose. But this begs the important question: have we returned to an equally attractive buying opportunity?
*Our thanks for these statistics go to Investor Intelligence, a market forecaster that has measured the mood of investment newsletters over a long period of time.
Getting back to both Albert Schweitzer and our optimistic dinner guest. In order to be color blind and not see all green lights, we must evaluate the facts both with regard to the market and more importantly with regard to our portfolio investments. Those “naïve” statements by our dinner guest were all factually correct: The economy is growing not contracting; interest rates will eventually peak, though we can all argue over when; productivity (an important restraint to inflation) does continue to increase; and the unemployment rate is near a 45-year low.
To be sure, there are red lights out there too. Maximum pessimism does not mean that stock prices have bottomed. Higher interest rates lead to a danger of economic contraction (which normal people call a recession). Both the budget deficit and the trade deficit are negatives. Commodity price increases have been headline news for some time now, though for two decades they were moribund and greatly lagged appreciation in other sectors like services and financial assets. Finally, we are troubled by the lack of capitulation in the market. Bottoms are usually marked with panic and fear so wide spread that investors sell at virtually any price just to get out.
But trying to be “color blind” we see more long-term positives than negatives, especially at our portfolio companies. Earnings continue to grow, markets keep expanding and our managements continue to use their cash to enhance shareholder value. We have continued the process of reducing the commodity exposure in your portfolio, and in the second quarter we sold Cleveland Cliffs, the iron ore miner, and Encana, the Canadian energy company, both terrific stocks since their initial purchase several years ago.
Our portfolios lagged the market in the second quarter, partly because of the transition we continue to make away from the inflation sensitive commodity stocks and into financial based companies. We wish to be clear: We are not doing this because of our views about either inflation or interest rates. We are doing it based on valuation of the companies we are both selling and buying. We are selling the expensive ones, and buying the cheap ones. The consensus view that financial stocks are to be avoided due to higher interest rates creates our opportunity. Interest rates move in cycles of indeterminate length and amplitude. We cannot tell you when they will head back down. We can, however, say with confidence that the financial stocks we are buying are both well run and extremely cheap. We will stay the course because in the long run ‘value will out’. As the cycle plays itself out investors will return to the shares of well-managed financial companies as the economic environment becomes more favorable for them. When that happens, we will already own those shares. We will be pre-positioned to benefit from both an expected earnings growth rate increase due to the more benign environment and a P/E multiple expansion. This combination should give a leveraged effect to share appreciation.
We purchased three stocks in the second quarter, Legg Mason and American International Group, both financials, and YRC Worldwide, a trucking company. Legg Mason is the fourth largest asset manager in the world with $850 billion under management. In December Legg closed its acquisition of Citigroup Asset Management, nearly doubling the size of assets under management, and the first quarter of 2006 was the first time the company reported operations as one entity. Wall Street was disappointed with how slowly Legg was realizing the cost savings it promised when the merger was announced. This perceived failure drove the stock lower and created a buying opportunity for us. We were not overly surprised that it would take more than one quarter for the company to fulfill its goals. After all, this is basically a merger of two $400 billion companies. (We tried to imagine the combination of two asset management firms, both 130 times the size of Spears Grisanti & Brown!) We were able to buy this wonderful franchise at less than 15 times 2007 earnings and close to 13 times cash earnings. That is a sharp discount to other publicly traded asset managers. We believe that over the next year or so, after all of the merger related issues go away and the company is operating soundly, it will trade closer to 17 times a growing earnings stream.
Another new addition to the portfolio during the quarter was American International Group. AIG is one of the largest financial services companies in the world. It has had a cloud over its head since last year concerning New York Attorney General Elliot Spitzer’s investigation into its business practices. The result of the investigation was long-time CEO Hank Greenberg’s retirement from the company. He was one of those personality-cult CEOs who not only ran the company but also orchestrated a two-decade business plan and built the company into a global powerhouse. We believe Greenberg’s departure was a negative, but we also think that the assets left behind are quite valuable and the stock’s drop after the CEO’s firing was overdone. The man who took over as CEO of AIG was in fact Hank’s handpicked replacement. This kept a certain continuity within the organization that was important during and after the investigations. AIG is comprised of personal and commercial insurance companies, life and retirement insurance companies, financial services that include aircraft leasing and an asset management company. AIG trades close to 1.5 times book value, a very reasonable multiple for an insurance company, and too low for a global financial services giant. The current valuation implies that AIG is a run of the mill competitor in all of its operating units. We think that’s wrong. Also, AIG trades at 11 times 2006 earnings and 9.5 times 2007 estimates, a 14-year low. We think the company’s dynamic market position and strong future prospects make it a very attractive investment.
YRC Worldwide is the largest less-than-truckload carrier (LTL) in the US with over $10 billion in revenues. The company is in the process of integrating two large acquisitions that should enable YRC to become the leading provider of a full suite of transportation and logistic services to its LTL customers. In addition, the company expects to realize $450 million of cost savings/synergies (over $4.00 pre share) as the integration is completed by 2008. After disappointing investors in the first quarter, the shares were selling at slightly over 6 times estimated 2006 earnings, making it one of our cheapest stocks. At almost half the multiple of its competitors and with the prospect of material earnings power from cost savings in the next two years, we felt shares of YRC Worldwide were very attractive with significant upside potential.
With the deliberate transformation of your portfolio away from commodities and towards more attractive stocks, especially in the financial sector, comes the risk that we are too early, or that we have gotten it completely wrong. We cannot predict the timing of these stocks working out, though we have bought them in the expectation of a more than 50% gain over a three-year period. But we certainly do not believe we have “gotten it wrong”. At the very least, the risk of holding commodity-related stocks, many of which have doubled or tripled in price, is now too great. When we sold incredibly over-valued technology stocks like Cisco in late 1998 we were early, but we were ultimately correct. At that time we began to purchase a large position in various financial stocks. These suffered for more than a year before performing excellently in a terrible market in 2000 and 2001. History may or may not repeat itself, but we refuse to continue to own expensive stocks simply because they have strong momentum. Again, we return to our guiding principle: Value will out.
While we don’t see all green lights, we do remain optimistic, even in a difficult period, and we thank you for your support.
Grisanti Brown & Partners LLC