Lakeview Investment Advisors, LLC
Commentary Date: January 2003
by Bill Westhoff, CFA
Happy New Year!
I hope that you each had a good holiday season and you are ready for a new year. As investors, we are ready to say good riddance to 2002. As rare as three-year bear markets are, last year was the weakest of the last three by many measures; yet there are many reasons for optimism as we look forward. In the comments below, I offer a few comments updating you on the progress of Lakeview Investment Advisors. Next, we review 2002 and some interesting statistics on market performance in the year. The following section provides a preview of economic forecasts and the basis for my optimism; and the final section will offer an example of the type of stocks that we are using in Lakeview Investment Advisors portfolios. If you received my initial mailing, you know that we will be using 20–25 individual stocks in our portfolios and future commentaries will provide more examples of investment ideas. These examples will hopefully provide insight into the philosophies used in selecting securities for our portfolios.
In December I attended an all day training session on Morningstar Principia, a software database program providing incredible detail on over 7,000 individual stocks, and thousands of mutual funds. The system also offers a powerful program for structuring and measuring the efficiency of portfolios. This is a program that I have used for several years as a self-taught student. It was helpful to fully explore all the capabilities of this powerful tool.
Also in December, I met with a group of former associates and contemporaries to discuss the economy, the market and investment philosophies. As retirees and exiles from corporate positions, we determined that we missed the regular exchange of ideas in an office. We agreed to meet periodically and exchange regular e-mails on investment and economic ideas. The individuals: Ted Busboom, former Senior VP of Fixed Income for IDS/American Express (Ted was a peer, boss and mentor of mine for many years); Bill Melton, former VP, Senior Economist, Global Economist and senior portfolio manager of money market funds at IDS/American Express (Bill and I worked closely for may years and have maintained continual contact on economic and investment ideas since leaving AMEX. Importantly, Bill is also a bicycle rider!); Jim Walline, former VP, Bond Portfolio Manager and Stock Mutual Fund Manager of Lutheran Brotherhood (now Thrivent Financial for Lutherans) for 33 years. While this is an informal group, the combined resume of this group is very impressive with well over one hundred years of investment experience! I will share some of the ideas discussed in future mailings.
Source: Wall Street Journal 1-2-03
As you can see, it was a truly difficult year for stocks in the US and around the globe. Bonds did very well and yields touched a forty-year low in October. Bonds benefited as a “safe-haven” investment and from a weak economic environment with reduced corporate investment and borrowing. The dollar weakened against other currencies as record low interest rates and the return of deficits caused foreign investors to consider other alternatives. The Euro, in particular enjoyed a significant increase off a low of about 0.83 to the dollar. In spite of concerns about a continuing recession, many commodities enjoyed a significant increase in price over the year. The increase in gold and oil is attributable to war concerns, but the increase in other commodities is not consistent with a global economy in contraction.
As stated earlier, this was the third year of negative returns from the major market indices. One might expect the third year of a bear market to show some moderation in the declines, however that was not the case in 2002. The following statistics from Credit Suisse/First Boston indicate the depth of market psychology. Every sector of the S&P 500 Index was down in 200; this has not happened since at least 1981 (prior records are not comparable). The worst declines were in areas still adjusting to the excess of the late 1990s (Information Technology -38%, Telecommunications -36%, and Utilities -33%). Only 131 stocks of the S&P 500 were up and 368 stocks were down (the most number of declining stocks since 1990, with 359 declining stocks. Interestingly, this is the last time that our country was preparing for war). The average decline of the 368 stocks was 18.4%. Finally, there were 76 stocks in the index that declined more than 50%. This more than doubled the 35 stocks that declined over 50% in 2001, and more than quadrupled the 17 stocks showing a 50% decline in 2000.
There were many reasons for this disastrous market environment. As one reviews the year, it appears that 2002 was a “Perfect Storm” for a bear market. Investors Business Daily provided a good summary for the “Worst Bear in 71 Years” with their Top Ten (which I will just summarize below).
Although the review in such detail is painful, it is a valuable exercise before thinking about the outlook for 2003. For example, while 1990 was the last year that the US prepared for a gulf war, the actual war was short lived and the S&P 500 was up 26.3% in 1991.
Every six months The Wall Street Journal surveys a number of business economists to develop a consensus on a number of economic statistics. The detailed information is in the January 2, 2003 edition. The headline of the article: “Economists Expect Spending by Business to Lead Recovery.” The average forecast of the 55 economists calls for real GDP to increase 2.7% in Q1, 3.2% in Q2, and 3.7% in the final two quarters of ‘03. Other points show a modest increase in interest rates, stable inflation and unemployment staying near 6%. Although consumer spending has held up better and for longer than many have expected, the economists see a passing of the baton to business spending in 2003. This view is endorsed by Paddy Jilek, Senior Economist of Credit Suisse/First Boston in his weekly piece, “Underlying fundamentals point to a mix shift in economic growth this year, favoring business spending over consumer spending, at the margin. The greatest risk to this outlook is the obvious one: that the fog of geo-political risk, which is already having a ubiquitous impact on market risk premiums and business behavior, persists.”
This improved business climate forecast by economists should prove market friendly, particularly to industries that have been hit hard by the collapse of business capital spending over the last three years.
As we think about structuring portfolios for this environment, several themes emerge (this assumes that a conflict with Iraq is not prolonged). First, stocks are ready to out-perform bonds after three years of underperformance. Second, within the bond market, investment grade and high-yield corporate bonds should out-perform US Treasuries. For taxable accounts, municipal bonds offer a higher after tax yield than Treasuries. Third, international stocks which have had been abysmal performance, now have a better chance of offering diversification to portfolios as the US dollar struggles against the Euro. Fourth, in spite of the horrendous environment in 2002, there were stocks that offered significant returns. A stock selection process sensitive to valuations and focused on finding companies with winning strategies should prove helpful in finding some of these stocks.
Below is an example of a stock owned in Lakeview Investment Advisors portfolios that has a solid corporate strategy, a strong balance sheet and a reasonable valuation compared to its growth rate and its historical price/earnings ratio.
Sysco Corporation is a company that “sells shovels to gold miners in a gold rush.” Sysco delivers food and related products to the food service industry. The restaurant industry is littered with failures on a regular basis, yet new restaurants open every day and restaurants will open where a previous restaurant failed. Sysco has shown an ability to grow revenues consistently because overall sales continue to increase in the restaurant industry. The basic theme at work for Sysco is to benefit from the “Graying of America” and increasing wealth around the globe. As people age and as incomes rise, people eat out more frequently. While restaurants compete fiercely for the consumers’ dollars, each restaurant needs efficient, dependable suppliers. Sysco Corp. stock has increased from about $10–11/share in November 1997 to about $28–30/share recently.
After identifying a theme that has validity, the next step in the process is to identify companies that are executing successfully. One screen used by Lakeview is the process developed by Investors Business Daily. Each stock is compared daily against the universe of all stocks selling at $10 and above on five criteria: earnings per share growth; relative price strength vs. the market; industry price strength vs. the market; fundamental ratings (sales, profit margins, and return on equity); and Accumulation/Distribution rating (measures buying vs. selling pressure on an individual stock). According to IBD, an ideal stock would rank in the top 20% vs. other stocks in each of these ratings (the nomenclature in this system would be 80/80, B/B/B.). The chart below for Sysco in late December shows a score of 92/73/D-/A/C+. This system basically says that Sysco has performed very well as a company and as a stock over the last year. As with any system, one should not rely solely on this process. However, it is a good beginning point to identify companies that are performing well.
Note: There are cases where two or more stocks have the same Rank within an Industry Group. This reflects that the companies had an equal rating after computing and weighting all components in the category.
The next step is to review the company’s financial condition in more depth. While Sysco has increased revenues by 56% over the last 4-1/2 years, earnings per share have increased by 144% and dividends have increased by 62%. The company has been able to increase earnings faster than revenues by increasing its profit margins and reducing the number of shares outstanding. Although the company has a significant capital spending program, it still generates free cash flow which allows it to increase its dividend, repurchase shares and make acquisitions. Given the company’s success, this is not a “cheap” stock (28X P/E). However, the stock is selling at the average P/E over the last five years and below its 5 year high of 34X. On balance, Sysco is a reasonably priced stock for it past and expected growth. The company is well managed; demonstrating successful growth in a difficult environment and it operates in a business that should benefit from significant trends in the economy. Although, this appears to be a lot of detail, this commentary just summarizes the amount of information reviewed on a typical stock. Any individual stock purchase should be weighed against an individual’s overall portfolio and risk profile.
© 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.