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Lakeview Investment Advisors, LLC

Commentary Date: Fall 2004

by Bill Westhoff, CFA

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Lake Views

Lakeview Update

We recently returned from a leaf peeping trip to New England, visiting sites in Vermont, New Hampshire and Maine. The scenery was incredible, and we can understand the popularity of this area in the fall. I spent the last weekend leaf raking at the lake and realize that beautiful fall leaves also mean a lot of work!

Several changes were made recently to Lakeview’s Web site, including a new Links page. This page provides links to other Web sites that contain interesting comments on the market or investments in Lakeview’s accounts.

Market Performance 2004 YTD (October 29)

The chart below shows the performance of various indexes through October 2004. Other market statistics are included.



YTD change

Dow Jones Industrial Average 10,027.47 -4.08%
NASDAQ Composite 1,974.99 -1.42%
S&P 500 1,130.20 +1.64%
Russell 2000 (small stocks) 583.79 +4.83%
MSCI EAFE (Europe, Australia, Far East) 1,362.19 +5.70%
DJ World (ex. US) 155.10 +7.07%
Nikkei 225 (Japan) 10,771.42 +0.89%
Merrill Lynch Corporate Bond Index 1,510.68 +5.00%
Lehman Bros. Aggregate 1,107.30 +4.62%
Merrill Lynch High Yield Bond Index 705.21 +8.00%
10-year Treasury Note (Yield) 4.03%  
3-month Treasury Bill (Yield) 1.89%  
Euro (Currency in US dollars) 1.2798  
Japanese Yen (Currency in US Dollars) 105.84  
British Pound (Currency in US Dollars) 1.8378  

Source: Wall Street Journal 11/1/04

Valuation Statistics


5 yr. High/Low

Price to Book Value - DJI 3.97 8.29/3.45
Dividend Yield - DJI 3.63% 3.70%/1.28%
S&P 500 P/E (Argus Research) 17.0x NA
52-Week Highs & Lows (8/2/04) 306 vs. 48  
Public/NYSE Specialist Short Sales 2.34 2.52 (7/9/04)/

Source: Investors Business Daily 11/1/04

Although the Dow is down YTD, it is back above 10,000. The Dow was hit particularly hard in the last month with two components (AIG and Merck) taking big hits on issues specific to these companies. The other indexes have responded well for the last two months and provided some optimism for positive returns for the year. While oil prices reached a new high of over $55 per barrel, the stock market seems to be dealing with it. Earlier in the summer, the market struggled with oil going above $40 and continuing difficulties in Iraq, while ignoring strong second quarter earnings. Now with oil trading above $50 and a growing Iraq insurgency, the market has noticed the strong earnings reported for the third quarter.

Interest rates have trended lower as continuing fears have led many investors to seek safety in bonds. This accounts for the solid returns in the bond market this year. High yield bonds are again showing the best returns as a stronger economy and their higher coupons are attractive to investors. Within the US stock market, small stocks are performing the best, while the weak dollar and pre-election fatigue have given a lift to global stocks. As the economic cycle matures and interest rates continue to move up, look for larger cap stocks to perform better than small stocks. Larger stocks have historically absorbed the cost of higher interest rates better than small cap stocks.

Valuation statistics show the stock market to be fairly valued. Relative to the last five-year extremes, the market looks cheaply valued, but one must remember that the stock market achieved extreme valuation levels in 1999/2000. Note the dividend yield on the Dow is at a five-year high. The yield on the Dow Industrials has moved up all year as the companies have been aggressive at raising their dividends. The dividend yields on Dow stocks are now very competitive to yields on short term bonds. Sentiment indicators continue to indicate a high degree of concern as the public is still shorting stocks at over twice the level of the NYSE Specialists. However, the level of public shorting is down from the extremes seen on this ratio is July.

Economic Outlook

The third-quarter GDP report showed growth of 3.7%. This was below expectations, but it is solid growth. Higher oil prices and additional increases in the fed funds rate by the Federal Reserve will likely reduce economic growth in 2005. Corporate profits ought to continue their growth, but the rate of growth will be reduced from the recovery levels of 2003–04. Low inflation and productivity growth have been two surprising factors of this recovery, and both should continue to be supportive to the continuing economic expansion.

Market Outlook (Current stock view: +, over-exposed to stocks, but below maximum stock exposure)

In the last Commentary, I reduced exposure to stocks from the maximum level. At this point, I believe the market is poised for a good finish to the year and wish to maintain a healthy exposure to stocks. As you read this, the election may be decided. The market has struggled with this uncertainty all year and could respond favorably, regardless of the outcome (unless there is a protracted court battle to determine the winner).

Mutual Fund Selection

In previous commentaries, I have discussed various individual stocks and bond funds. It has been some time since I have discussed issue selection, and I think it would be instructive to discuss the selection of one of the equity funds used in client portfolios. The first tool I recommend is a screening process. There are a number of good screens available on the internet; however, I use Morningstar Principia. This is a powerful database that includes many data elements on the over 17,000 mutual funds in their data base.

Most of the stocks that I use are mid-cap to large-cap in size, so I often use mutual funds to gain exposure to the small-cap style. Small cap stocks are numerous, but the published research on these stocks is less accessible and the quality of information is less reliable. Therefore, I believe a good small-cap manager can add significant value by focusing resources in this area. To find good small-cap managers, I developed a fairly simple screen to narrow the research.

Ariel Fund (ARGFX): When Lakeview Investment Advisors started about eighteen months ago, I was looking for small-cap value funds with Morningstar ratings of four or five stars and consistency of performance over three, five and ten years. Ariel was one of the funds that met these criteria.

Further research showed a number of attractive characteristics. First, Ariel Fund has been managed by John Rogers for over 17 years. Rogers is the founding partner of the management company that manages the fund. Ariel focuses on carefully selecting stocks that are selling at “bargain prices.” As a demonstration of this focus, the fund typically holds less than 50 stocks (currently 44) and has very low turnover (4% turnover in the last twelve months) as it waits for the stocks’ true value to be realized.

This style works well over longer time periods; for a ten-year period, Morningstar rates the fund as having below average risk, but above average return, relative to its peers. The overall Morningstar rating is four stars. Over the ten years ended 9/30/04, Ariel has shown an average annual return of 15.31%, exceeding the average annual return of the S&P 500 by almost 4.25% per year and ranking in the top 17% versus its peers in this time period. Through September 2004, the fund is up 12.19%, exceeding the return of the S&P by over 10%. Of course, past performance is no guarantee to future results.

In summary, the Ariel Fund demonstrated a well-executed philosophy. The small number of stocks held and the low turnover indicate returns coming from stock selection rather than market timing. Low turnover results in reduced trading costs and fewer surprises in capital gains distributions in taxable accounts. Management of the fund has an ownership stake in the management company; reducing the risk of changing styles due to management turnover. Finally, the philosophy has demonstrated ample success versus the S&P 500 Index and industry peers.

Ariel Funds’ Web site is one of the links posted on Lakeview’s Web site. Part of my research included reviewing the company’s Web site and the information posted. I found the site easy to navigate and full of interesting facts and articles on their philosophy. The investment philosophy seems uniquely well developed and integrated into the culture of the company.

In addition to Ariel’s Web site, I have selected the Web sites for Leuthold funds, Meridian funds, and Third Avenue funds. Each of these funds was selected for their unique styles and strong historical performance. The Web sites offer insight into their unique styles and interesting commentary on the market. I will provide more discussion of these funds in future Commentaries.

Please contact me at Billw@lakeviewadvisors.net if you would like to discuss any of the ideas reviewed in this commentary.

© 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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