Newsletter Q2 2001
April 14, 2001
What Recession?
The Department of Commerce's Bureau of Economic Analysis (BEA) reported that gross domestic product grew at an annual rate of 1.0% during the fourth quarter of 2000. Federal Reserve Bank of Dallas President Robert McTeer recently described economic growth during the first quarter as "somewhere close to zero." If it seems as though many companies are already operating in a recessionary environment, there's a reason.
Jim Grant is the publisher of Grant's Interest Rate Observer and has analyzed the little-known statistical enhancements that the BEA uses to calculate gross domestic product and productivity. During the 1980's, government econometricians devised a methodology to estimate the value of investment spending on computers and peripherals by deconstructing the value of the machine's characteristics (speed, hard-drive capacity, graphics capability, etc.) rather than the real dollars spent on the machines.
Lynne E. Browne, director of research at the Boston Fed, points out that the calculated value of information technology spending surpassed the nominal value in 1995 for the first time and the gulf proceeded to widen until by the fourth quarter of 2000, it reached an annualized difference of $210.8 billion. Browne writes, "While nominal investment in computers and peripherals rose roughly 10% per year between 1995 and 1999, real (statistically enhanced) investment rose 45% a year." In a $10 trillion economy, the portion of capital spending due to phantom revenue from statistical enhancements represents about 2 percent of GDP. Thus, the real economy entered a recession in the fourth quarter although the BEA's press releases say otherwise.
Corporate profits of the S&P 500 Index companies are expected to decline by 8 percent for the first quarter compared to the prior year's first quarter according to analysts surveyed by First Call/Thomson Financial. Chuck Hill, Director of Research at First Call, expects second quarter earnings to fall by a percentage in the "low teens" and comparisons for the third quarter to be even worse. Consensus first quarter estimates for the technology sector are down 32% from the prior year, while communications companies are expecting a decline of 32%. By contrast, positive earnings growth is expected for the health and utility sectors: +12% and +10%, respectively.
I expect a continuing weak economic environment for a variety of reasons: a decline in capital spending due to overcapacity in the communications and technology sectors, high debt levels of corporations and consumers, low consumer confidence, and the expected shortfall in electricity production on the West Coast this summer. The Federal Reserve will probably continue to lower interest rates but the economic benefits will most likely be negligible by comparison. Although stock valuation levels are now at lower levels, they are not cheap and do not fully reflect the potential for further earnings disappointments. I expect to maintain the current overweighting in the utility and real estate investment trust sectors, where earnings are less volatile. Cash levels in your portfolios may remain higher than normal for the near future.
My friend Dave Grapperhaus sent me a poem befitting the current market environment. Somebody wrote this in his mother's high school yearbook:
As you travel down life's highway
Whatever may be your goal
Be sure you look at the doughnut
And not the doughnut hole.
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Updates
The Meditrust Companies (MT) completed the sale of its beneficial ownership interest and mortgages relating to 78 long term care facilities and one medical office building. The Companies received gross proceeds of $441 million, of which $406 million was in cash. The remaining portfolio of healthcare properties represents 16% of the total real estate portfolio with a net book value of $468 million as of December 31, 2000. MT is on track to deleverage the Companies and become lodging-focused, consistent with its announced plans. During the last quarterly conference call, MT expected to continue to see positive REVPAR (revenue per available room) trends and announced that they had 21 franchisees who had signed contracts. Until now, all La Quinta Inn properties were owned by MT. Franchise royalties will provide an additional revenue source and increase earnings in future years. MT continues to sell at a modest valuation of 4.6X estimated funds from operations.
MFC Bancorp reported fully diluted earnings of $1.85 per share for the year ended 12/31/00, an increase of 21% from the prior year. Based upon a recent phone conversation with Rene Randall, CFO, the merchant bank has seen better quality deals as the economy has softened. The company expects to complete a shopping center in Washington by early next year, which should increase earnings. MXBIF may consider a stock repurchase program before the end of the year if the stock price remains low. The company currently sells for 4.3X earnings.
Holly Corporation (HOC) has continued to rise in price and has become a larger percentage of your portfolios. A combination of this year's cold winter and high natural gas prices caused some power plants to switch to oil for fuel. U.S. gasoline inventories are now 9% below normal levels, so the refining industry and HOC can be expected to maintain high product margins through the summer. HOC sells for 4.5X estimated earnings for the current fiscal year.
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Additions
Telefonos de Mexico (TMX) provides domestic and international fixed-line telephone services in Mexico. TMX recently spun off it mobile unit, America Movil and capital spending requirements should be reduced. TMX sells for 8.4X estimated earnings for 2001 and has a dividend yield of 3.1%.
Positions were increased in Harmony Gold (HGMCY). The company continues to sell at a low valuation of 5X earnings. HGMCY should provide an effective hedge against a lower dollar, which seems increasingly likely.
New Plan Excel Realty Preferred B (NXL.PRB) shares were purchased for accounts with taxable fixed income requirements. New Plan Excel Realty (NXL) was founded in 1926 and is a self-managed real estate investment trust. NXL has a national portfolio of more than 340 properties. 83% of its net operating income comes from shopping centers and the largest tenants include Kmart, Wal-Mart, Kroger, Winn-Dixie, and Albertson's. The dividend yield on the preferred is currently 9.3%.
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Deletions
Autodesk (ADSK) and Abercrombie & Fitch (ANF) were sold at a profit as they met my price targets.
Finova Group (FNV) was sold at a loss. The proposals that were being suggested for the company's financial restructuring involved filing for bankruptcy and the ability of common shareholders to maintain any significant interest was doubtful.
Interstate Bakeries (IBC) was sold at a profit. IBC was anticipated to have narrower profit margins due to higher electricity and fuel costs, especially in California.
Silicon Storage Technology (SSTI) was sold at a loss after the company revised its first quarter outlook. After having a large order backlog and a very good fourth quarter, the company experienced a dramatic turnaround in its business. First quarter revenue declined by 46% due to cancelled orders and returned product as customers reacted to weakening demand and higher inventory.
If you have any questions regarding your accounts, please do not hesitate to call me.
Sincerely,
Robert G. Kahl,
CFA, CPA, MBA
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Sabino
Investment Management, L.L.C.