Newsletter Q3 2002
July 15, 2002
Return of
the Risk Premium
In
recent years, some stock prices were bid to valuation levels that ignored risk
and left little room for disappointments. Investors
now appear more aware of risk and want to be compensated for taking it.
Despite recent stock price declines, many investors still view the U.S.
market as expensive.
The price/earnings (P/E) ratio of the S&P 500 Index is now 37X
trailing (most recent four quarters) earnings.
The Index sells for 21X forecasted 2002 earnings, but First Call’s
Director of Research says that current estimates are “unrealistic.”
According to Paul Desmond of Lowry’s Reports, the average P/E ratio at
major market bottoms has been approximately 11, and the highest P/E ratio at a
major market bottom over the past 60 years was 12.5 (in June 1962).
Consistent
with high valuation levels, equity exposure remains high for investors.
According to BCA Research, household holdings of equities as a percent of
discretionary portfolios increased from 30% in 1990 to 56% in 2002.
For pension funds, equities increased from 44% in 1990 to 68% in 2002.
The
U.S. dollar is likely to continue its downward adjustment process. The
dollar’s decline has not yet reduced the trade deficit, which increased to a
record $35.9 billion for the month of April.
Foreign investors have been reducing their purchases of U.S. financial
assets and the impact on financial markets appears significant at the margin.
At the end of the first quarter of 2002, foreign investors owned 35.7% of
outstanding U.S. Treasury securities and 13% of U.S. corporate stocks.
The S&P 500 Index declined by 13.8% for the first six months of the
year but returns were even worse for foreign investors.
After taking into consideration a dollar decline of 10.6% relative to the
euro, a European who invested in the S&P 500 Index would have a loss of
22.8% for the first half of the year.
There
are some positive developments coming out of the Enron- Adelphia- WorldCom-
Tyco- Xerox- etc. fiasco.
After investors have lost billions, there appears be some consensus that
stock options should be expensed and loans to company executives should be
prohibited – two steps in the right direction.
Eight years ago, the Financial Accounting Standards Board backed down
from requiring companies to expense options, in response to extraordinary
pressure from lawmakers and their corporate donors.
Hopefully, legislators and corporate directors will now be committed to
restoring investor confidence.
How
much would reported earnings decline if options are expensed?
According to a recent study, Merrill Lynch found that total earnings for
S&P 500 companies would have been 21 percent lower in 2001.
The effect is even more dramatic for technology companies, which tend to
be more generous in granting options; reported earnings would have been 39%
lower in 2001.
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Additions
The
American Century International Bond Fund (BEGBX) was purchased to increase
foreign currency exposure.
BEGBX should benefit from the continued decline in the U.S. dollar
because it invests primarily in European government bonds. The
average credit quality of the portfolio is AA and the average duration of the
portfolio is 5.7 years.
A
Canadian Government bond (6.0% due 6/1/08) was purchased for many accounts.
In contrast to the United States, Canada has both a current account
surplus and a budget surplus. According
to BCA Research, leadings indicators suggest that the Canadian economy and
currency should remain strong relative to the U.S.
JMAR
Technologies (JMAR) is a leading developer of semiconductor X-ray lithography
systems and advanced laser, X-ray and EUV light sources for other
microelectronic products.
JMAR believes that its next-generation lithography system is the most
efficient, cost-effective method for processing the higher performance gallium
arsenide and silicon chips of the future.
Since the beginning of the year, JMAR has been awarded multi-year
research and development contracts of up to $45 million by the Defense Advanced
Research Projects Agency and IBM.
JMAR will commence demonstrations of its advanced lithography system this
summer and expects to begin shipping systems in 2003.
If its lithography system is successful, the company expects to generate
revenue of $200 million by 2006, a tenfold increase from 2001.
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Deletions
The
Strategic Global Income Fund (SGL) and Aberdeen Commonwealth Fund (FCO) were
sold as the discount to net asset value on both declined to low single digit
levels.
The
Highmark Bond Fund (HMRBX) was sold at net asset value.
The shares were received as a result of a merger of the Current Income
Shares Fund (CUR), a closed-end fund that was originally purchased at a discount
to net asset value.
The
PIMCO Foreign Bond Fund (PFODX) was replaced by the American Century
International Bond Fund (BEGBX).
Unlike BEGBX, PFODX hedges a good portion of its foreign currency
exposure back into the U.S. dollar – an undesirable attribute at this time.
Profits
were taken in Gold Fields Ltd. (GFI).
As a result of the recent rise in prices, the portfolio weighting in
South African gold mining companies was becoming large.
I intend to continue holding Harmony Gold (HGMCY).
Profits
were taken on Pacificare Health Systems (PSHY) during the quarter.
Although PHSY has been able to raise prices on its commercial business,
Congress has not increased Medicare premiums enough to keep up with rising
costs.
Given the rise in the price of the stock and the absence of pricing power
for its Medicare patients, which represented 54% of first quarter revenues,
continued appreciation appeared to be limited.
Profits
were taken on Teekay Shipping (TK).
Shipping rates and earnings estimates declined more than expected.
Updates
Aquila,
Inc. (ILA) has declined in price, reflecting investor concerns about companies
that have energy trading operations or wholesale energy generation services.
ILA appears to have avoided the sham transactions reported by others in
the industry, and has a manageable debt load.
In an effort to appease the credit rating agencies, ILA announced that it
would reduce its dividend to a new rate of $.70 per share and reduce its trading
operations.
It also completed a concurrent debt and equity offering of $780 million
in July to refinance 2002 debt maturities and provide permanent funding for two
recent acquisitions.
ILA has lowered its earnings guidance for the full year to a range of
$1.30 to $1.40 per share.
In
June, Large Scale Biology Corporation (LSBC) announced a reorganization which is
expected to reduce annual expenses by more than $10 million.
Since the reorganization announcement, LSBC has announced five agreements
with companies and universities for the development or production of products.
The potential revenue from these agreements remains unclear at the
present time.
Additional information may be forthcoming on the July 24 conference call.
ICN
Pharmaceuticals (ICN) announced that net income per share, excluding
non-recurring and extraordinary items, would be between $.15 and $.20 for the
second quarter, below analysts’ consensus estimate of $.44.
The reduced earnings resulted primarily from the reduction of certain
product inventories at the distributor level.
In the past, distributors had increased inventories in anticipation of
price increases.
Sales in Russia were also lower than expected as lower margin products
are being phased out. Royalties
for ribavirin, however, are expected to meet expectations.
Methanex
Corporation (MEOH), the world’s largest methanol producer, has realized higher
product prices during the second quarter.
Methanex’s non-discounted U.S. reference price for June was $186 per
ton, 49% higher than March.
The company has demonstrated its ability to generate cash throughout the
economic cycle and has a strong balance sheet.
Consequently, the Board of Directors is considering the initiation of an
annual dividend payment of approximately $20 million to shareholders, which
would give the stock a 2% dividend yield.
Shell
Oil announced that it would replace MTBE as an additive with ethanol in its
California gasoline by the end of 2002.
Approximately 26% of global methanol supply is used to manufacture MTBE.
The European Union endorses MTBE and it is not a health issue in Europe
or Asia.
As a result of political lobbying efforts by Archer Daniels Midland and
Midwest corn farmers, Methanex expects MTBE to be phased out in the U.S. by the
end of the decade.
However, MEOH expects other sources of demand to replace U.S. MTBE
demand.
If
you have any questions regarding your accounts, please do not hesitate to call
me.
Sincerely,
Robert
G. Kahl,
CFA,
CPA, MBA
Sabino
Investment Management, L.L.C.