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The Quarterly Report

  • The Quarterly Report
  • First Quarter 2006
  • Chuck Osborne

Have Passport, Will Travel

Investing outside the United States has always been a somewhat scary proposition. I remember my first real exposure to international investing like it was yesterday. One morning when I was a young analyst at INVESCO, my boss stormed into my office and asked if I had a passport. I stammered, “Yes”. He asked, “Is it current” and I sheepishly said, “I think so.” He said – and this I will never forget – “You’re going to Poland!” Then he disappeared out my door as abruptly as he had entered. I sat there for a moment in shock, and then got up went down the hall to his assistant and politely asked her if I was ever coming back.

It was scary. This was a different world, different culture, different political environment and a very different market. However, the fundamentals of investing remained constant, and that young analyst did pretty well.

For most Americans investing overseas is still a mysterious and somewhat scary issue. When we inherit portfolios from our client’s previous advisors, a lack of international exposure is one of the biggest issues we find. People tend to stick to domestic stocks for a couple of reasons. First, they are more comfortable investing at home in their local surroundings and in familiar companies. The same reasoning causes 401(k) participants to invest heavily in their own company’s stock if given the chance. They are familiar with the company and that gives them more confidence.

Secondly, some believe that investing overseas is somehow less than patriotic, and shows a lack of confidence in our country. On the contrary, nothing seems more patriotic to me than owning the rest of the world. If more Americans invest in Toyota, for example, Toyota will eventually become an American owned company. Still, some people remain politically averse to investing overseas and we certainly respect that, but those who feel this way are limiting their opportunities.

More than half of the world’s invested capital resides outside of the United States. We live in a global marketplace. I am not saying it is good, nor am I saying it is bad, I am merely stating that globalization is a fact of life. Investing internationally provides access to those global opportunities.

Investing internationally also provides diversification. Everyone has heard that they should diversify their investment portfolio, but few people really understand what that means. Diversification is achieved by investing in assets that have a low correlation to one another. In other words, their prices do not move in the same direction. International markets have a low correlation to our market and therefore exposure to them can reduce the overall risk of the portfolio. This is even true of emerging market investing, which while very volatile as a stand alone investment, can actually reduce the volatility of a diversified portfolio.

Globalization and diversification are good general reasons for always having some exposure overseas. However, as our clients are aware, we are not just mildly exposed to international markets; we have a large international position in our portfolios. This has been a great boon to our clients as over the last year the international index MSCI EAFE is up 24.94% in dollar terms versus the S&P 500 which is only up 11.73%. Emerging markets have been even better with the MSCI Emerging Markets index being up 47.98% over the last year.

So how did we know? Unfortunately, it isn’t because we have a crystal ball. Investing is all about process, and it is our process that led us to venture beyond our borders. When investing, you want to buy low (when securities are undervalued) and sell high (when securities are overvalued). Value led us overseas.

According to Morningstar, the price to earnings ratio on December 31, 2005 for the MSCI EAFE international index was 16 as compared to 17.3 for the domestic S&P 500. In other words, it cost you $16 for every $1 of earnings overseas and $17.3 for every $1 of earnings here at home. It sounds simple doesn’t it? Well unfortunately it’s not that simple. The international market has been undervalued relative to the United States for a long time, yet it underperformed dramatically in the 1990’s. In the market an undervalued asset can stay undervalued for a long time. Timing matters and in our process we look not only for value but for signs that the market is beginning to recognize that value.

So, we saw an undervalued asset class and took advantage of it with some fortunate timing. But, is international still a good place to be? We believe the answer is yes. The global economy is strong. Japan is doing better than it has in more than a decade. China is growing at over 9% a year and India is right behind. Europe is a laggard, but that is not all bad. Stock market prices reflect the consensus opinion of what is going to happen in the future. If what actually happens matches expectations the markets will not move dramatically. Market prices make large moves due to surprises, down for negative surprises and up for positive surprises. In other words, it is possible that China grows very fast, but not as fast as people thought, and that Europe grows slowly but not as slowly as people thought, and you make money in Europe and lose money in China. Sometimes low expectations can be a wonderful thing.

Review of Economy

THE ECONOMY HAD ITS WEAKEST SHOWING IN 3 YEARSduring the fourth quarter of 2005, with soft consumer spending limiting GDP growth to only 1.7%. The slowdown should be viewed as temporary. We expect the data to show that the economy rebounded strongly in the first quarter and grew at a 4.0% to 4.3% rate. For the remainder of 2006, growth is expected to fall within the 3.0% to 3.4% range.

Employment numbers remain robust. The economy created 2.1 million new jobs over the 12-month period ending in March. Payrolls increased by 211,000 in March, 225,000 in February and 154,000 in January. March’s unemployment rate stood at 4.7%. Despite the strong employment market, wage growth was modest, which helped keep inflation in check.

The market’s confidence in the Federal Reserve’s ability to control inflation has kept long-term rates relatively low. Since the beginning of the tightening cycle in June 2004, the Fed has raised short-term rates from 1% to 4.75%, while long-term rates have remained between 3.75% and 4.85%. The yield curve has flattened, with both the 2-year and 10-year Treasury posting the same yield of 4.56%.

The biggest threat to the U.S. economy is the potential for significant softening in the real estate market. The economy has benefited greatly from the wealth created by rising home values. In fact, households have experienced thirteen straight quarters of rising net worth, thanks largely to real estate. However, a slowing housing market will cause net worth to rise more slowly or even potentially fall, which will negatively impact future consumer spending and economic growth.

Despite these warning signs in the housing market, the underlying economic outlook is positive. The economy continues to create jobs, inflation is moderate and interest rates remain low. Furthermore, corporations are generating record levels of profits, and feel confident enough in the economy to reinvest the cash back into their firms. There is little reason to be overly concerned about the economy in 2006.

Finally, when you invest internationally, you also invest in other currencies. Your return in those currencies is inversely related to the strength of the dollar. When the dollar goes up international investors lose, when it goes down they win. The dollar has been strengthening over the last year as the Fed relentlessly raises interest rates, making US Treasury securities more attractive to foreign investors. That cycle is going to end soon. On top of that many foreign countries are beginning to raise their home country rates, for example Japan’s central bank raised rates this quarter for the first time in a long time. You also have to factor in our trade deficit. The US buys more than it sells. That means there are a lot of extra dollars floating in the market. Currently, foreigners who hold those dollars have been investing in US securities helping to keep the dollar relatively strong. When that stops, the dollar will fall and the dollar value of your international investments will go up. This is the most likely scenario for the intermediate term. Not good for international travel or buying international goods, but very good for international investment returns.

Look beyond our borders; you may like the opportunities that you see.


CHUCK OSBORNE, CFA, Managing Director


Review of Market

THE FEDERAL RESERVE hiked the federal funds rate by 0.50% to 4.75% during the first quarter. Since June 2004, the Fed has raised rates 15 times. Chairman Ben Bernanke’s comments suggest the Fed is likely to raise rates during the next few quarters. The rise in short-term rates, along with strong employment numbers, caused long-term rates to rise from 4.39% to 4.85% during the quarter.

Higher interest rates hurt the fixed-income market. The Lehman Brothers Aggregate Bond Index lost 0.64% for the quarter. High yield bonds benefited from tightening credit spreads and were up over 2% for the quarter.

Continued strong corporate profits and historically low interest rates helped the equity markets in the first quarter. Small cap stocks, up 13.94% as measured by the Russell 2000 Index, outperformed large cap stocks, up 4.21% as measured by the S&P 500 Index. Within the large cap sector, value stocks strongly outperformed growth stocks. The Russell 1000 Value Index was up 5.93%, while the Russell 1000 Growth Index was up 3.09%. Within the small cap sector, just the opposite held. The Russell 2000 Growth Index gained 14.36% versus 13.51% for the Russell 2000 Value Index.

International stocks continued to perform well in the first quarter. The MSCI EAFE index, a proxy for developed international equity markets, rose 9.47%. European stocks climbed 11.00% and Japanese stocks were up 6.82%. Foreign emerging markets, as measured by the MSCI EM Index, were up 12.12% for the quarter.

Market Forecast

By Paul Torregrosa :: PhD :: Chief Investment Officer

The economy is well positioned for sustainable growth throughout 2006. The economy is expected to have grown between 4% and 4.3% in the first quarter and is forecasted to grow in the 3.0% to 3.4% range for the remainder of the year. Job growth is expected to remain strong, inflation is under control, real interest rates are still low and corporate profit growth is forecasted to be in the low double-digit range. The strong economy in combination with only moderate increases in interest rates suggests a relatively positive outlook for stocks over the next 12 months.

At the end of first quarter 2006, the S&P 500 Index stood at 1293 with a Price/Earnings ratio of 16. Based on expected earnings of $88.38 over the next 12 months, the market appears attractively priced. If the S&P 500 Index’s P/E ratio remains constant, the index should be in the neighborhood of 1414 in 12 months, representing a 9% capital gain. Given that interest rates are rising slowly and corporate profit growth rates are expected to slow, a 9% capital gain over the next 12 months should be viewed as optimistic. If the index’s P/E falls to 15, the index’s value in 12 months would be approximately 1326, representing less than a 3% capital gain. Our outlook remains that the S&P 500 Index’s total return, which takes into account capital gains and dividends, will be between 7% and 9% over the next 12 months.

Within the domestic equity market, we believe large cap stocks are the most attractive. Mega cap stocks are selling at a discount to the rest of the market based on trailing and expected P/E and Price/Cash Flow ratios. Small and mid-cap stocks have significantly outperformed for the last 5 years and are becoming less attractive from a fundamental standpoint. We also believe investors are beginning to focus more attention on large cap stocks.

Foreign equities are likely to outperform domestic over the next 12 months. Based on traditional portfolio characteristics such as P/E, P/CF, Price/Book Value ratios, foreign developed and developing markets appear attractively priced. Valuations on domestic companies already reflect the competitive nature of U.S. firms. Foreign valuations reflect the regulatory and institutional challenges faced by firms domiciled in less business friendly countries. As many of these foreign countries become more free-market oriented, the productivity and profit growth potential could be substantial. In addition, rising interest rates in Japan and Europe, along with the large U.S. balance of payment deficit, are likely to put downward pressure on the dollar, which should enhance the dollar returns on foreign investments. Overall, foreign equity markets are slightly more attractive than domestic markets.