Newsletter Q2 2002
April
13, 2002
Dueling
Economists
Ed
Hyman of the International Strategy and Investment Group (ISI) has been
rated as the top economist by Institutional
Investor magazine for the last 22 years.
In mid-March, his partner Nancy Lazar, shared their views in Barron’s.
They continued to forecast a strong recovery based upon low interest
rates, low energy prices and inventory replenishment by businesses.
They are also forecasting zero inflation and a stock market that
trades within a 10% range for the year.
However, their perfect recovery scenario is subject to one caveat –
if the dollar declines, all bets are off.
Stephen
Roach, an economist with Morgan Stanley, believes that the dollar is likely
to decline because of America’s ever-widening current account deficit.
The current account balance represents the sum of transactions with
foreign countries of goods, services and unilateral transfers.
The U.S. current account deficit was $417 billion in 2001 and is
expected to be 4.2% of GDP this year.
When a country has a current account deficit, it must be offset by a
capital account surplus (investment by foreigners) or by the transfer of
official reserves (foreign currency, gold, etc.) between central banks. Increases
in the current account deficit have benefited the U.S. economy, as American
consumers spent more and saved less.
For every dollar borrowed, there must be a lender and foreign
investors have obliged.
This process is now likely to reverse.
Roach
cites a study by Federal Reserve economist Caroline Freund, who examined 25
current account adjustments that occurred among industrialized countries over
the 1980-1997 period.
It took, on average, about three years for the adjustment process to
run its course.
During the adjustment process, the currency of the adjusting country
typically declined 20%.
In only two of the 25 instances did the currency appreciate.
Real GDP growth slowed by an average of three percent.
Short-term rates also typically rose at the beginning of the adjustment
process as central banks raised interest rates to limit currency depreciation.
What are the implications for the United States?
Roach is emphatic: “History is utterly devoid of examples when such a
massive external imbalance did not trigger a realignment in relative growth
rates and/or a sharp currency depreciation.”
The
S&P 500 currently sells for 43X GAAP (generally accepted accounting
principles) earnings.
This represents a historical high and is about three times higher than
the low hit in the last recession.
Apparently, not many investors are listening to Stephen Roach and
Caroline Freund even though their reasoning seems compelling.
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Additions
A
second gold stock was added to many of your portfolios during the quarter.
Gold Fields Limited (GOLD) is among the largest gold mining companies
in the world.
Like Harmony Gold (HGMCY), it is based in South Africa and its
production is unhedged so it will benefit from higher gold prices.
The company also has mines in Australia and Ghana.
GOLD currently sells for 15X estimated earnings for FYE 6/30/03.
The
Blackrock North American Government Income Trust (BNA) was purchased for
several accounts.
BNA is a closed-end fund that invests in government and agency bonds of
the United States and Canada (approximately 50% each).
BNA currently has a yield of 7.6% and sells at a discount of 10% to net
asset value.
The
PIMCO Foreign Bond Fund (PFODX) is a mutual fund that invests primarily in
European government bonds.
Normally, I prefer to buy closed-end funds but at the present time, BNA
is the only one in the foreign bond category that is selling at a discount to
net asset value of 10% or more.
Consequently, I am using PFODX as an investment vehicle with foreign
currency diversification until better values emerge among closed-end funds.
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Deletions
Elan
Corp. PLC (ELN) was sold at a loss early in the quarter after a Wall Street
Journal article shed some light on certain accounting practices related to
joint ventures and revenue recognition.
It appears that several transactions during recent years were designed
to meet the technical requirements of accounting standards but lacked economic
substance. As
a result, I lost confidence in the financial statements and the management of
the company.
Genzyme
Transgenics (GZTC) was sold at a profit.
GZTC competes with Large Scale Biology Corp (LSBC) and I wanted to
reduce the concentration in the industry sector.
I now believe that LSBC has a superior technology and offers better
investment prospects.
Allegheny
Energy (AYE) and Xcel Energy Inc. (XEL) were sold.
Both companies have increased their debt levels while growing their
asset base in unregulated power generation and trading activities in recent
years. I
prefer more conservatively managed utilities, given the current economic
environment.
Telefonos
de Mexico (TMX) was sold in most accounts.
While the fundamentals of TMX remain sound, I wanted to raise cash
levels in portfolios at the time.
Several
closed-end fixed income funds were sold during the quarter (SGL, HTR, VKI and
EVP). All
of these funds were purchased when the discounts to net asset value were
higher. A
good portion of the capital appreciation realized was due to the decline in
the discount to net asset value.
As interest rates rise, discounts to net asset value often expand and
they may once again represent good buying opportunities in the future.
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Updates
Both
Harmony Gold (HGMCY) and Gold Fields (GOLD) have appreciated during the
quarter. They
have benefited from higher gold prices and lower operating costs.
The fundamental outlook remains positive for gold and there has been
renewed investment interest.
For example, Japan’s leading gold retailer reported a ninefold
increase in gold sales for the month of February compared to a year ago.
Sirius
Satellite Radio (SIRI) declined in price early in the quarter after management
announced that car manufacturers would delay introduction in many models until
2003. The
car manufacturers are most likely awaiting the second generation chipset,
which SIRI expects to have available by early 2003.
The second generation chipset will result in fewer parts, easier
installation, lower cost and less power consumption. Product
availability for the first generation radios has been limited so far, but that
should change in the current calendar quarter.
SIRI expects to be offering its service nationwide by July 1.
ITLA
Capital Corporation (ITLA) filed its application to convert to a
state-chartered commercial bank.
Subsequent to regulatory approval, the company intends to convert its
six savings branches into retail commercial bank branches over the next 12
months. Although
the price has moved up steadily, ITLA continues to sell for a relatively
modest 9.7X estimated earnings for 2002.
Utilicorp
United (UCU) repurchased the 20% of Aquila, Inc. (ILA) that it sold in an
earlier public offering.
UCU had planned to spinoff the remaining 80% of ILA to shareholders but
decided instead to make a tender offer for the minority interest of ILA after
the price had dropped along with other energy marketers.
Utilicorp has since adopted ILA’s name and stock symbol.
FirstEnergy’s
(FE) stock price fell recently amid concerns of a prolonged shutdown at its
Oak Harbor, Ohio nuclear plant.
During a scheduled refueling outage, corrosion in the vessel head was
discovered. The
company subsequently lowered its 2002 earnings guidance to a range of $3.30 to
$3.45, excluding the effect of the nuclear plant outage, which is expected to
reduce earnings by 11 cents per share.
FE is purchasing replacement power while the unit is offline.
The company is seeking approval of its repair plans from the Nuclear
Regulatory Commission.
The negative developments seem to be fully reflected in the price of
the stock and I expect it to recover.
Large
Scale Biology Corp. (LSBC) reported that fourth quarter revenues declined to
$0.7 million, as the research and development phase of its agreement with Dow
Chemical Company was completed.
The company should begin generating revenues from several other sources
in the future.
LSBC recently announced the availability of Plurigen™, a cell growth
factor that can be used for biomedical research.
Later this year, it should begin selling protein chips for use in
medical research and diagnostics.
Protein chips are devices that are designed to measure the amounts of
many proteins at once.
Management believes that the market for protein chips is in excess of
$500 million per year and they have not yet identified any direct competitors.
LSBC has also announced agreements with ApoImmune, Weyerhauser, and the
U.S. Navy, although details have not yet been disclosed.
The market capitalization of the company ($66 million) now exceeds its
cash in the bank by about $20 million.
I believe that LSBC’s potential for generating revenues and profits
in the future is not reflected in the price of the stock.
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.