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Lakeview Investment Advisors, LLC

Commentary Date: April–May 2003

by Bill Westhoff, CFA

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Lake Views

Lakeview Update

Greetings from Cedar Lake. As spring weather returns to Minnesota, our view has changed from the desert to the lake. Thankfully, the war in Iraq was short, and the nation has also changed its view. The market has heaved a giant sigh of relief, and hopefully the economy will soon show more signs of improvement.

On our return to Minnesota, we again listened to a book tape to fill the hours. John Adams, the story of the second president of the United States, proved to be a compelling story about the fight for the independence and early development of our country. The debates among the country’s leaders about the future course of action paralleled the recent discourse over Iraq. There were many lessons in this story, but when faced with difficult decisions, conviction and leadership are of utmost importance.

The last two months have been extremely busy for Lakeview Investment Advisors, as our business is now developing nicely with the addition of several new clients. This involves analyzing existing portfolios, setting up new accounts, structuring the portfolios to achieve better diversification, and exposure to the stocks of companies with winning strategies.

A number of you took advantage of Schwab’s “Fresh Start” program to make deposits between January and May and get commissions waived on portfolio restructuring. Schwab has a new opportunity for new clients or existing clients to make additional deposits. The new program is the “2003 Golf Promotion.” Deposits of $75,000–$149,000 get two complimentary rounds of golf at a participating course choice; deposits of $150,000–$499,999 get four complimentary rounds of golf plus their choice of wedge or putter; deposits of $500,000 or more get four complimentary rounds of golf, a choice of a golf club, and two nights at a participating luxury hotel. If you are interested in this opportunity, please let me know.

YTD Performance (4/30/03)

Index

Level

YTD change

Dow Jones Industrial Average 8480.09 +1.66%
NASDAQ Composite 1464.31 +9.64%
S&P 500 916.92 +4.22%
Russell 2000 (small stocks) 398.68 +4.07%
DJ World 105.06 +0.51%
Nikkei 225 (Japan) 7831.42 -8.71%
DJ Euro Stoxx 50 (European) 2324.23 -2.61%
MSCI EAFE (Europe, Australia, Far East) 950.03 -0.28%
DJ Corporate Bond Index 169.28 +6.31%
Lehman Bros. MBS (Mtg. Backed Securities) 1062.73 +1.33%
10 year Treasury Note (Yield) 3.93%  
3-month Treasury Bill (Yield) 1.10%  
Euro (Currency in US dollars) 1.1181  
Japanese Yen (Currency in US Dollars) 118.89  
British Pound (Currency in US Dollars) 1.600  

Commodities

 

04/30/03 close/
2002 close

DJ-AIG Commodity Futures   112.360/110.276
Oil bbl.   $25.80/$31.20
Gold, troy oz.   $339.10/$347.60
Wheat, bu.   $3.66/$4.14

Source: Wall Street Journal 5-1-03

Valuation Statistics

Current

5 yr. High/Low

Price to Book Value - DJI 3.94x 8.29x/3.45x
Dividend Yield - DJI 2.3% 2.6%/1.28%
S&P 500 P/E (Argus Research) 18.87x NA
52-Week Highs & Lows (4/30/03) 250 new highs 31 new lows

Source: Investors Business Daily 5-1-03

The market enjoyed a good month, with all the major US Indices now in positive territory for the year; NASDAQ is showing the best YTD performance. This is a good indication that market participants are willing to accept more risk than they have for some time. Another indication of a willingness to accept risk is the narrowing spread between BBB rated bonds and AAA rated bonds. Confidence is returning to the business of lending money to corporations, and this is ultimately good for the growth of the US economy. In late April, I heard a presentation by some mutual fund bond portfolio managers who cited the fact that the Lehman Bros. Corporate Bond Index enjoyed its best six-month performance period in its history (for the six months ended 3/31/03). Given the debacle in this sector of the market, I believe there is still room for additional narrowing of yield spreads between lower and higher grades of corporate bonds.

This month, I have added some additional statistics on market valuation. Hopefully, you will find this useful. We continue to hear debates about whether the market is cheap. The above data indicates that the market is cheaper than it was, and given the low level of interest rates, it is “fair to cheaply valued” by many measures. The long term average for P/E ratios is about 16 xs, so there are some who claim that the market is not at historically cheap levels. However, interest rates are a key factor in determining P/E ratios, and bond yields remain near 40 year lows. One has no way of determining the “fear premium” built into the markets from the terrorist activities of 9/11. Progress in Iraq and improvements in Homeland Security will eventually reduce this fear premium in the market, which should allow valuations to increase. Over the long term, the price of stocks is more heavily determined by profit growth than by valuation levels, so it is heartening to see stocks responding positively to corporate profits being reported better than expectations.

Economic Outlook

The economic and market discussion group that I mentioned in previous commentaries met again recently. We added another experienced professional who still likes to discuss the economy and markets: Ray Goodner, who recently retired from a long and outstanding career as a bond portfolio manager of American Express, is now participating in our periodic discussions. Below are some highlights of our recent discussion.

We continue to believe that the economy will not do a “double dip” into recession, but that it is bumbling along at a growth trend of slightly less than 3%. With occasional weather and “CNN” impacts (US consumers staying home to watch the war instead of shopping!), the economy can appear to stall as it did in the first quarter with a growth rate of only 1.6%. A 3% growth rate is respectable by historical standards, but productivity is increasing at a similar rate. Unemployment will remain high unless the economy can grow above this 3% rate. As Bill Melton added, “This will become a more prominent part of the headlines as we enter the election period.” In spite of the weakness in the employment picture, corporate profits will get better as companies reap the benefits of productivity growth and continual cost cutting. However, profit growth will be muted as long as the overall economy continues to expand at only a 3% rate. If the economic growth rate should expand into a 4–5% range, corporate profits could explode on the upside. This is unlikely to happen this year, but the stage is getting set for a better environment next year.

What is setting the stage for improvements next year? First, we see confidence returning to the business side of the economy. As stated earlier, the spread in corporate bond yields between BBB and AAA bonds is narrowing. We are also starting to see significant strategic corporate takeovers (at current stock valuations, it is cheaper for many companies to purchase businesses rather than build them). Recent examples: HSBC’s acquisition of HFC (Household Finance) last October and the recent purchase of Linksys (a maker of wireless internet connections) by Cisco. Ted Busboom pointed out several purchases of smaller biotech companies by large pharmaceutical companies. Second, a “carefully engineered” weaker dollar improves the competitiveness of US manufacturers. The Euro has appreciated from the low 80s to 112 over the last year, for an appreciation of over 30% (and a similar depreciation of the dollar vs. the Euro). Third, the narrowing bond spreads makes it possible for companies to finance at low interest rates. Consumers had clearly benefited from record-low mortgage rates, but that benefit had not fallen on business until recently due to high corporate interest rates (default fears, general distrust of corporations, etc., were keeping rates for most corporations very high). Fourth, expanding business capital spending will result from the replacement cycle, expanding demand (some being driven by the export markets) and access to the capital markets. Fifth, tax cuts to keep the consumer in the game. I add this last, because there is much debate about the structure and need for this tax cut. As mentioned in an earlier commentary, this tax cut will be substantially different than initially proposed—it now appears that it will be smaller, and the tax free dividend component will be substantially scaled back. All of this is improving market sentiment. The major stock market indices have all crossed their 200-day moving averages. This is not necessarily a predictor of a huge new bull market, but an indication that the markets have bottomed, moved sideways for a significant period of time, and have now started to move up at a moderate rate—all healthy signs.

Portfolio Structure

Lakeview Investment Advisors was founded on two key principals of investment management: first, managing risk; and second, finding opportunities. With years of experience managing money for insurance companies, the principal of risk management was always the primary consideration. It is not possible to eliminate risk and still make attractive returns in the markets. The idea is to understand the risks in the situation and the ability of the company to accept a level of risk and then structure the portfolio to manage the risk to appropriate levels. This concept applies to individuals and their ability to accept risk, either by their level of resources, time to recover from market setbacks (even when managing risk, you can experience market setbacks!), and their psychological makeup. After a three-year bear market, it would seem that many people have a lower tolerance for risk than they initially thought.

After assessing a “risk ability quotient,” the next step is to structure the portfolio around this concept. Lakeview believes that every portfolio should be well diversified among various classes of assets: cash or money market investments; high-grade, low-grade, and international bonds; large, mid-size, and small-cap value and growth stocks; real estate related stocks; and international stocks. We also believe that the weighting of the asset classes should change over time as the various asset classes go in and out of favor. For example, in early 2000, large-growth technology stocks were extremely popular and very over-valued by historical measures; conversely, value stocks, real estate stocks, and bonds were unwanted, unloved, and cheap. With perfect hindsight, it is now clear that an investor should have sold the over-valued growth stocks and purchased bonds, value and real estate stocks. By watching valuation measures and forcing a diversification discipline, we hope to avoid over-exposure to richly-valued asset classes. It is also important to recognize that no one asset class wins the performance derby every year; and while it is possible to recognize when one asset class is richly valued vs. the other asset classes, the timing of the correction is uncertain. That is why Lakeview Investment Advisors strives to maintain a balanced exposure to various asset classes and fill all of the “style boxes” in its equity positions.

Another asset class that we have started adding to portfolios is REITS, or Real Estate Investment Trusts. These trusts invest exclusively in real estate and by law must pay out at least 90% of their earnings in dividends to their shareholders. While they are not rapid growth vehicles, they pay steady, attractive dividends well above the yield of the S&P 500 and money market funds. They also provide a good hedge against inflation as real estate returns increase during periods of inflation (from increasing rents and the sale of appreciated property). Finally, REITs, and REIT mutual funds offer excellent diversification within a portfolio. In simple terms, diversification is a concept easy to grasp since we have all heard the term “don’t put all of your eggs in one basket.” Statisticians use another term to measure diversification: co-variance. For a portfolio to have good diversification, it should contain asset classes with low co-variance; i.e., investments that do not all move in the same direction at the same time. I have seen many portfolios where the investors believed they had good diversification because they had several different mutual funds. However, each of the mutual funds was invested in large-cap growth stocks, many in the exact same names. REITs offer good diversification because they have low co-variance with bonds and the S&P 500. It is human nature to want to put all of one’s assets in the sector of the market that is appreciating the most, but portfolios that perform best over time have significant diversification. These portfolios stand to benefit from exposure to whichever sector happens to be hot at the time, but also lower price volatility as “co-variance” dampens the overall variability of the portfolio.

In the next commentary, we will finish the discussion of risk management and focus more attention on the concept of finding opportunities. If space permits, we will focus on additional stock or fund holdings in Lakeview’s portfolios.

© 2004 Lakeview Investment Advisors, LLC

Any information provided in these materials is believed to be from reliable sources. Lakeview Investment Advisors, LLC makes no representation as to its accuracy or completeness and is not responsible for any damages incurred as a result of your use of these materials. These materials do not constitute a solicitation to sell or offer to sell investment advisory services to residents of any state in which Lakeview Investment Advisors, LLC lacks authority. Part II of Form ADV, which details the business practices, services offered, and management fees charged by Lakeview Investment Advisors, is available upon request.

The Economics and Markets Advisory Board consists of the following members:

Theodore H. Busboom, CFA, President, Prospective Value, formerly Senior Vice President and Portfolio Manager, American Express Financial Advisors

Ray S. Goodner, CFA, Private Investor, formerly Senior Vice President and Portfolio Manager, American Express Financial Advisors

William C. (Bill) Melton, PhD., President, Melton Research, Inc., formerly Chief Economist, American Express Financial Advisors

Jim Walline, CFA, President, Walline Capital Advisors, LLC, formerly Vice President and Portfolio Manager, Thrivent Financial Services

Lakeview Investment Advisors, LLC participates in a Board of Advisors consisting of professionals in the investment field; however, members of that Board who are not employees of Lakeview Investment Advisors, LLC do not participate in providing investment advisory services offered to clients.

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