Lakeview Investment Advisors, LLC
Commentary Date: March 2003
by Bill Westhoff, CFA
Lakeview Update: Desert Views
Greetings, again from Fountain Hills, Arizona. You will note that I added a title this time. In thinking about a title, I intend to use either “Lake Views”, or “Desert Views,” to indicate my location. However, the current title is apt, because it says volumes about what each of us and the market collectively is watching. This month’s note is coming later that usual for a couple of reasons. Initially, family visits and personal travels delayed the writing of the comments. The War in Iraq created another delay as the start of the conflict initiated a huge rally on Wall Street to seemingly change the market environment overnight. Now we are back to watching the “desert,” instead of the debate at the UN. However, the effect on the market is the same—uncertainty—which markets do not like. As we witnessed, the end of uncertainty will likely create a better economic and market environment. In the meantime, the market is unlikely to rally very far until the situation in Iraq has more clarity.
Ruth and I drove back to Arizona in late February and on the long drive, we listened to two book tapes that provided a very rich history lesson on American business from the 1850s to the 1990s. The first book was Titan: The Life of John D. Rockefeller, Sr. and the second was The Katharine Graham Story. For the historians in the audience, these were excellent stories about the development of two different industries: oil and publishing. As a market observer, I was struck by the tenacity of the individuals and their incredible faith in the American economy. Through panics, wars, depressions, recessions, union troubles, legal troubles, etc., these business leaders kept investing and building their businesses. I felt this was a good lesson on the current environment. The American economy is a very powerful machine for growth, because it unleashes the power of individuals to improve their current situation. There are always periods of uncertainty and setbacks, but over time the economy keeps growing and the market rises.
YTD Performance (3/13/03)
Source: Wall Street Journal 3-14-03
Through the middle of the month the market was pretty much unchanged vs. the middle of last month. However, the war uncertainty had allowed the market to drift and some indices were approaching previous lows. Notably, the international markets were performing badly and bond yields were approaching previous lows. As I said last month, I believe the market reached its low in early October, 2002.
For support of this argument, I found a piece written by John Mendelson, a market technician who writes for the Market Analysis Group for Schwab. John believes that one should also watch the daily and weekly new low list when the market index is “testing” a prior low, since individual stocks are really what are being bought and sold. The actual market low on the S&P 500 was 776.76 on October 9, 2002; yet the largest number of daily lows was seen on July 24, 2002 at 917 issues, followed by 604 new daily lows on October 9, 2002. This compares to 319 new lows on March 12, 2003. “A test of a prior low is more than just a number on some index.” When market sentiment is as negative as it was on October 9 or March 12, the market is poised for a significant rally if it can be sparked by good news. Such was the case on March 13 when the market had the biggest rally in five months as the debate stopped and the conflict started in Iraq. The market went on to record its largest eight day advance in twenty years. The above table is reproduced below through March 21 to show the dramatic changes that can occur.
YTD Performance (3/20/03)
Source: Wall Street Journal 3-24-03
Beneath the volatility of the current market, interesting things are happening. Note that after the recent rally, the NASDAQ is showing strong relative performance vs. the other indices. This is an indication of the depressed nature of these stocks and the fact that the replacement cycle of many technology stocks is providing some growth opportunities. Note also the powerful upsurge in all stocks once the cloud of uncertainty is “potentially lifted.” One has to be in the market to participate in these rallies. However, there is a risk that the war news will continue to irritate for the immediate future. My approach is to buy companies that are doing well in this economy and balance the volatility with a decent exposure to cash, bonds and/or bond funds (decent depends on each person’s circumstances and ability to deal with market risk).
A recent chart in Investors Business Daily points out the risk of being too cautious over a long period of time. Investor A puts $10,000 in a fixed income investment that returns 5% per year—after 25 years the initial $10,000 grows to $33,864. Investor B puts $10,000 in 5 different investments of $2,000 each; investment one loses all of its value, investment two earns 0% per year, investment 3 earns 5% per year, investment 4 earns 10% per year, and investment five earns 12% per year. After twenty-five years, Investor B has a total value of $64,442, or almost twice the amount of Investor A. Putting all of your eggs in one basket can be a costly mistake if you are too aggressive and if you are too conservative.
In January, I mentioned Sysco Corporation (SYY) a food service distributor. Sysco as a company is still doing well, but the stock took a hit in the last month, falling to about $25.50 from around $30 when mentioned. Sysco as a company is still doing well and its competitors are running into a series of problems. Ordinarily, this would be a good reason for the stock to move up in price. So what happened? Ahold NV, a competitor ran afoul of regulators when they disclosed accounting irregularities involving the rebates they get from food manufacturers to sell their products. Sysco is regarded as using conservative accounting and its market share is only 12% of the total potential food service market. Therefore, the company’s long term growth rate of 18% per year over the last five years should not be in jeopardy. However, in this environment of accounting scandals, even good companies can get tarnished by the problems of their competitors. Lakeview still owns the stock and would look for opportunities to add to positions.
Donaldson Company (DCI) 3/31/03 close: $36-5/8, 4/1/02 close: about $40
Lakeview has owned this stock for a number of years. Donaldson produces filtration equipment used in industrial and electronic machinery. Its engine products division makes hydraulic-fluid, oil and fuel filters, air cleaners and mufflers for heavy equipment used in construction, mining and transportation industries. Donaldson also makes air intake and exhaust filtration systems and filters used in computer disk drives and artificial respirators.
Basically, DCI serves the industrial markets. The growth opportunity is a continual push for improved air quality, inside and outside. Since many of the industries served are cyclical, one would expect DCI to have cyclical results. The company appears to be extremely well managed, showing continued earnings growth through very tough industrial economic environments. Relative to industry competitors, Donaldson has shown top quintile results in Revenue, Net Income and Cash Flow growth over the last one, three and five years. The company has also shown top quintile results in return on equity, return on assets and return on invested capital versus competitors over one and five years. Interestingly, the company is in the lowest quintile versus competitors in debt to capital. In the last year, the stock is down about 10%, while the S&P 500 is down about 25%. The stock appears reasonably valued at about 18X P/E vs. a five-year average of 19.5X.
Stryker Corp. (SYK). 3/31/03 close: $68.65; 4/1/02 close: about $60
Lakeview has added this stock to its portfolios in the last six to nine months. Stryker manufactures specialty surgical and medical products. The company’s products include endoscopic systems like medical video cameras, light sources, and manual instruments; orthopedic and spinal implants; powered surgical instruments and patient handling equipment.
Stryker is well positioned to take advantage of the aging baby boomers wearing out their joints. This is a demographic play and a beneficiary of increased medical spending in the US and other developed countries. The company is growing very rapidly, showing a three year growth in revenues of 33%/year and a three year growth in net income of 64%/year. The company appears to manage its finances well, having expanded its pre-tax profit margin and its return on equity over the last five years. The stock carries a premium multiple, reflecting its superior growth rate and future prospects: currently selling at 41X trailing earnings, versus its five year average of 74X. The stock is up about 15% in the last year compared to a 25% decline in the S&P 500.
Next month, I will spend some time describing how Lakeview structures portfolios and creates diversification across various asset classes to balance total return potential against volatility. As has been the case for the last several months, we will also continue to explore individual stock holdings in our portfolios.
© 2004 Lakeview Investment Advisors, LLC
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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.