Newsletter Q1 2006
January 1, 2006
Early or
Wrong?
Artemus Ward was an
American 19th century humorous writer who seemed to capture the
attitude of many of today’s U.S. consumers when he said, “Let us all be happy,
and live within our means, even if we have to borrow the money to do it with.”
The U.S. consumption to GDP
ratio is now at 71% of GDP, higher than the average of 67% that prevailed over
the previous 25 years. The average for other G-5 countries (Europe, Japan,
Canada, and United Kingdom) and China has remained nearly unchanged at 57%
during the last decade. The high U.S. consumption ratio has been enabled by
foreign creditors’ purchase of U.S. securities and much of that capital has been
channeled into the residential mortgage market. The increase in total mortgage
debt accelerated further during 2005 to approximately $1.4 trillion, compared to
an average increase of $271 billion during the 1990s.
Stephen Roach, economist at
Morgan Stanley, believes that the perception that U.S. consumption is now
impervious to external shocks will be challenged in 2006. “Lacking in normal
support from labor income generation, the saving-short, overly-indebted,
asset-dependent American consumer could well be squeezed by the twin pressures
of a post-bubble housing market and higher energy costs.”
In his December 5th
commentary, Roach lists four other risks to maintaining trend line growth in the
global economy. First, an unbalanced world economy with two main growth engines
– the American consumer on the demand side and the Chinese producer on the
supply side – “reflects the persistence of subpar growth in the rest of the
developed world and lack of autonomous support from internal (consumer) demand
in the export-led developing world.” Second, the Chinese economy may slow down
as their banking system makes the transition from a policy-directed to a
commercial banking system that will diminish credit growth. Third, as the
interest rate differential theme fades and the Chinese are reluctant to increase
their overweight positions in dollar-denominated assets, the U.S. dollar
declines. Lastly, Roach suspects that the world’s central banks “will meet a
stern test in 2006.” The Bank of Japan is finally beginning to shift away from
its anti-deflationary policies. As the U.S. housing bubble pops, Ben Bernanke
may not benefit from the confidence factor that Alan Greenspan has enjoyed. The
European Central Bank is also beginning a process of policy normalization by
raising short-term interest rates.
I think Stephen Roach’s
risk assessment is appropriate and I share his concerns about the global
economy. I think he and others such as Doug Noland of PrudentBear.com are early
but not wrong in assessing the economic fundamentals. Accordingly, as we enter
2006, I will maintain a significant allocation to foreign government bonds and
equities, avoid companies that are economically sensitive or highly leveraged,
and may err on the side of caution.
Additions
Danish and German
Government bonds were purchased during the quarter. Denmark and Germany have
2005 forecasted current account surpluses of 2.9% and 3.9%, respectively.
Denmark has a government budget surplus while Germany continues to incur a
budget deficit. The European Central Bank has started to raise short-term
interest rates and the yield advantage of U.S. Treasuries is expected to decline
relative to European countries. Relatively short maturity bonds were purchased
due to expectations of further increases in interest rates.
Equity Inns 8.75% series B
cumulative preferred stock (ENN-B) was purchased for additional accounts.
Equity Inns, Inc. is a REIT that currently owns 123 hotels with 14,788 rooms
located in 36 states. It focuses on the upscale extended stay, all-suite and
mid-scale limited-service segments of the hotel industry. The preferred issue
has a current yield of 8.6%. It is redeemable by the company on 8/11/08 and has
a yield-to-redemption of 7.9%.
Nuveen Preferred &
Convertible Income Fund 2 (JQC) is a closed-end fund that invests primarily in
preferred stock and convertible bonds. The fund utilizes leverage equal to
approximately 30% of assets. At the time of purchase, JQC was selling at a
17.1% discount to net asset value and had a dividend yield of 8.6%.
Ocean Power Technologies
Inc. (OPWT in the U.S. pink sheets or OPT on www.londonstockexchange.com) was
purchased for selected accounts. OPWT is based in New Jersey, USA and is
commercializing its scalable offshore wave-powered electrical generation
systems. In November, the company deployed one of its 40kw PowerBuoys™ each for
the U.S. Navy in Hawaii and for the New Jersey Board of Public Utilities. OPWT
also has contracts with Total S.A. (French oil company), Iberdrola (2nd
largest electric utility in Spain), and Lockheed. In 2006, OPWT expects to
deploy a 125kw PowerBuoy™ that will reduce the cost of electricity generation to
7-10 cents per kwh, which is competitive in remote areas and with nuclear power
sources. Brokerage firm Collins Stewart in London is projecting revenue of $6.5
million, $14 million and $51 million for the fiscal years ending in April 2006,
2007 and 2008, respectively. OPWT has $38 million (75 cents per share) in cash
and does not expect to require additional financing as it is projected to lose
$3 million in FY 2006 and reach breakeven in FY 2007.
Deletions
Sinopec Shanghai
Petrochemical Co. Ltd. (SHI) was sold due to a reduction in earnings estimates,
as two new ethylene plants have increased supply in China.
Some large positions of
Petroleo Brasileiro (PBR) and Telefonos de Mexico (TMX) were reduced in selected
accounts. While the outlook remains positive for both, the increased values
had created some overweighted positions. The sales will be used as a source of
cash for other purchases.
New Zealand Government
bonds were sold in December. Although interest rates in New Zealand are among
the highest for developed countries, the trade balance has deteriorated
further. The current account deficit is now approaching 8% of GDP. If the New
Zealand economy slows down as expected after recent interest rate hikes, the
currency could decline significantly.
Updates
Sonic Environmental
Solutions Inc. (SNV on Toronto Venture Exchange or SEVSF in U.S. pink sheets)
announced the closing of the merger agreement with Terra-Kleen Response Group
Inc. The merger will allow the combination of two leading on-site technologies
for the remediation of persistent organic pollutants such as polychlorinated
biphenyl (PCB). The integrated Terra-Kleen and PCB Sonoprocess ™ treatment
provides a low-cost, high-volume extraction process followed by a low-volume
destruction process for concentrated contaminates. The combined process will
allow SNV to lower the price to customers to an attractive price point of $500
per ton of soil treated, while achieving higher volumes and gross profit
margins.
Sinovac Biotech Ltd. (SVA)
announced in December that it had initiated human clinical trials for its
pandemic flu (H5N1) vaccine Panflu™. China’s State Food and Drug Administration
approved a fast-track modification of the clinical trial process to two stages.
The first stage is expected to take nine months, although preliminary results
should be available by the end of March 2006. SVA estimates that it can produce
as many as 20 million doses per year of Panflu or 2 million doses of the
influenza vaccine from the same production facilities.
Tele Centro Oeste Celular
Participacoes (TRO) and three other Brazilian cellular phone companies
controlled by Portugal Telecom will be merged into a single company to be called
Vivo Participacoes S.A. The merger will simplify the current organizational
structure and allow the combined entity to reduce costs and achieve some
operational synergies. The merger is subject to shareholder approval at
extraordinary shareholder meetings for each of the companies scheduled for
February 8, 2006.
If you have any questions
regarding your accounts, please do not hesitate to call. I wish all of you a
happy and prosperous new year!
Sincerely,
Robert G. Kahl
CFA, CPA, MBA
Sabino
Investment Management, L.L.C.