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Newsletter Q1 2001
December 31, 2000
A Time for Adjustments
Most
Wall Street strategists are optimistic about the equity markets for 2001.
Their rationale is that a series of interest rate cuts by the Fed
beginning with the January 30 meeting will stimulate the markets, even though
corporate profit growth is expected to be weak.
Time will tell if I am more realistic or pessimistic than most.
I expect several adjustments to take place during the first half of the
year, if not longer. Corporate
balance sheets will have to improve before banks and credit markets make
credit more available. The U.S.
dollar will decline in value relative to the euro.
Consumers will moderate their spending habits as the reverse wealth
effect of lower equity markets and an economic slowdown continue to effect
consumer confidence. Equity
valuations (P/E ratios) will probably continue to decline in the face of slow
corporate profit growth.
Nancy
Lazar, economist at ISI Group, points out that there has been a large deficit
between corporate cash flow and capital spending. This has been accompanied by a surge in debt growth and a
deterioration in credit quality. According
to Standard & Poor's Credit Week, there were 144 credit upgrades and 559
downgrades for domestic bonds during the year-to-date period through December
13. This unfavorable ratio has
accelerated in recent months and has been accompanied by larger yield spreads
for corporate bonds relative to U.S. Treasury bonds.
The higher spreads are most pronounced in the high yield bond market,
where the spread over U.S. Treasuries is now 8.66% (as of December 19 per the
Merrill Lynch High-Yield Master II index), an increase of more than 4.15%
since the start of the year. Moody's
12-month forecast of global speculative-grade defaults is now 9.1%, the
highest level since the U.S. recession of 1990.
Consistent with the bond markets, banks have been tightening credit
standards in recent months as nonperforming loans have increased.
Joe
Carson, chief economist for UBS Warburg, contends that money and financial
flows have slowed considerably in the latter half of 2000, accompanied by
higher energy prices. This is the
reverse of 1998, when liquidity flows were stronger and energy prices were
declining. Higher energy prices
limit the flexibility that the Fed has in lowering rates because of the effect
on other prices that may raise inflation expectations.
Another
consideration that may limit how much the Fed can lower rates in 2001 will be
the value of the dollar. The U.S.
current account deficit for the twelve months ending in September was $416
billion, 4.5% of GDP. The
U.S. current account deficit is forecast to remain the largest in the world,
both in absolute terms and relative to GDP.
The dollar can maintain its current exchange rate only if foreign
investors inject capital of sufficient magnitude to offset the current account
deficit. This seems unlikely in
2001. Real interest rates
(nominal rates less inflation) on government 10 year bonds are now higher in
Europe than the U.S. The economic
growth rate of Europe is also expected to be approximately the same as the
U.S. in 2001. A lower U.S. dollar
is almost a certainty if foreign investors can no longer receive higher yields
on bonds and a slowing economy provides fewer opportunities for equity
investments in the U.S.
This
past week, the Conference Board's consumer confidence index posted its lowest
reading since December 1998. This
was consistent with recent holiday retail sales, when the wealth effect
appeared to be working in reverse. Several
analysts have demonstrated that there is a strong correlation between the
returns of the stock market in the months prior to Christmas and retail sales
during December.
Can
we count on higher stock prices to revive consumer confidence?
Although the NASDAQ Composite Index declined 39% during 2000, it
currently sells for approximately 100X earnings - not exactly cheap.
The S&P 500 Index is currently selling at 24.6X trailing earnings -
a much lower P/E ratio than NASDAQ's but subject to contraction during an
economic slowdown. The
speculation that was pervasive in certain sectors of the market earlier in the
year has dissipated somewhat and more attention is now being given to
companies that generate cash for one's investment dollar.
On
a more positive note, a cut in federal income tax rates will probably be
passed in the coming year, providing some stimulus for the economy.
While I expect that the financial markets will be a challenging
environment, there will continue to be profitable opportunities in undervalued
companies.
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Additions
Silicon
Storage Technology, Inc. (SSTI) is a supplier of flash memory devices for
digital electronic products. Flash
memory is nonvolatile memory that is used to store program code for devices
such as personal computers, digital cameras, digital cell phones, MP3 players,
personal digital assistants, DVD players, and set-top boxes.
Flash memory is the fastest growing segment of the semiconductor
industry and some industry analysts expect revenue to more than double by
2003. SSTI has achieved market
dominance for low density (up to 8 megabits) flash memory due to its
proprietary, patented SuperFlash technology.
Revenues for the first nine months of the year were 331% higher than
the prior year. SSTI's management
expects revenue for 2001 to grow by 125% and earnings per share to increase to
$2.90 per share from an estimated $1.20 for 2000.
At the end of the third quarter, SSTI had an order backlog that
extended into the third quarter of 2001, when some new foundry capacity should
start production. SSTI currently
sells for 4.7X the consensus estimate for 2001.
If management expectations are fulfilled, SSTI should sell at a higher
P/E multiple of higher earnings.
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Updates
General
Motors (GM) expects to be able to complete some type of transaction for its
interest in Hughes Electronics (GMH) in the early part of next year.
In December, auto industry sales declined about ten percent from a year
ago. The consensus analysts' estimate
for 2001 has also come down to $5.66 per share.
Nevertheless, free cash flow is about $4 per share higher than reported
earnings and a Hughes transaction should be highly accretive to GM earnings
and cash flow per share. GM's
interest in GMH is now worth nearly $16 per GM share.
Equity
Inns (ENN) reported RevPAR (revenue per available room) growth of 3.1% for the
third quarter and has since forecast higher than expected fourth quarter
earnings based upon RevPAR growth in November and December of 5%.
The higher growth rate is due to strong lodging demand in a number of
markets and favorable results for their Homewood Suites brand, which is still
in a ramp-up phase. ENN also recently completed a debt refinancing at favorable
rates due to its conservative capital structure. 75% of debt is now fixed at an overall rate of 8.1% with an
average maturity of 9 years. ENN sells
for 4.6X funds from operations and has a dividend yield of 15.2%.
Holly
Corp. (HOC) reported unexpectedly high earnings of $2.70 per share for the
quarter ending October 31. Refinery
margins were 70% higher than the prior year, partially due to increased
production capability for cleaner-burning gasolines.
HOC also benefited from increased sales volumes, cost reductions, and
the production efficiency program that was announced in May.
The refinery industry can be expected to continue to have high margins
as there have been no new refineries built in the U.S. for 20 years, while
product demand has grown at 3-3.5% per year.
Value Line now estimates that HOC will earn $5.50 per share in the
current fiscal year. After the
recent rise in the price of the stock, HOC continues to sell for only 3.4X
estimated earnings. The $1
billion lawsuit by Longhorn Pipeline Partners continues to be a drag on the
stock, even though it appears to be frivolous.
A prior lawsuit by Longhorn was dismissed in federal court.
The remaining lawsuit in the Texas State Court should begin proceedings
in January.
PacifiCare
Health Systems (PHSY) reported $0.15 earnings per share for the third quarter,
much lower than expected. The
earnings shortfall was due to rising medical costs related to the company's
transition from capitated contracts to fee-for-service or shared risk
arrangements with hospitals. The
company has since allocated more resources to the medical management area to
control medical costs. Congress
appears likely to increase Medicare premiums paid to HMOs next year.
PHSY also expects to improve profit margins in 2001 by raising premiums
for non-Medicare customers.
I
swung at a bad pitch. FINOVA
Group (FNV) has continued to disappoint investors with negative developments.
FNV common stock now sells for a small fraction of its book value
($23.45 per share as of September 30). In July, the company sold some loans
that had been securitized and I expected them to sell additional assets in
order to improve liquidity. Instead, FNV entered into an agreement with Leucadia National
Corporation to sell convertible preferred stock, which is highly dilutive for
the common shareholders. Their
solution raises the possibility that other problems exist in the loan
portfolio that have not been publicly disclosed.
FNV is also proposing a restructuring to creditors that involves some
debt forgiveness and extension of maturities.
In one positive development, Warren Buffett has recently bought a large
amount of FNV's bonds at distressed prices.
Although I am very disappointed with the management of the company, I
would like to see some recovery in the price of the stock before selling
remaining holdings.
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Deletions
An
attempt has been made during the quarter to reduce the economic sensitivity of
the portfolios and raise some cash. Profits
were taken in Federated Department Stores (FD) and P.H. Glatfelter (GLT).
Gehl
Company (GEHL) and Kulicke & Soffa (KLIC) were sold. Both have had earnings estimates revised downward recently.
Given the current economic environment, further downward revisions are
possible. Tax losses were
realized for taxable accounts.
If
you have any questions regarding your accounts, please do not hesitate to call
me.
Best
Wishes for a Prosperous New Year,
Robert G. Kahl,
CFA, CPA, MBA
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Sabino
Investment Management, L.L.C.