Q2 Commentary (2005)
We did not distinguish ourselves during the second quarter. Performance lagged in April, when a few of our most consistent performers, uncharacteristically disappointed the myopic Wall Street crowd. In May and June, our performance was similar to that of the benchmark index.Year to date, we are slightly behind the S&P 500.
Interest sensitive industries, such as utilities and financials did well this quarter and our financials did particularly well. Our consumer staples, where we tend to be over weighted most of the time, fared less well, which was surprising to us. Some of their underperformance was attributable to the rising dollar because these companies generate an above average amount of their revenues outside of the US and some was due to a rotation out of staples and into technology and other higher beta areas.
Our philosophy is oriented to protect principal during the difficult times, while staying competitive during the good periods. To do this, we maintain an over weighted position in “demand defensive” industries, such as consumer goods and staples, healthcare, integrated oils and service industries. The companies within these industries tend to have consistent growth in earnings, dividends and cash flows. During down periods, these industries tend to provide a safer harbor than some of the more economically sensitive industries, such as technology and cyclicals.
Our economy may be slowing slightly but it is still growing at a healthy and sustainable rate. First quarter GDP growth was a solid 3.8%. As long as the consumer, which tends to account for about two-thirds of our GDP remains healthy and confident, we see no reason to expect the market to turn down. The two biggest risks to the consumer would be further increases in energy prices or a downturn in the housing market. We see both these risks as manageable over the foreseeable future.
Higher energy prices lessen the purchasing power of the consumer. There is very little we can do to cut back on our gasoline purchases, because the majority of our use is for essential, non-deferrable purposes. We can dial down our thermostats when it gets cold, but there will be a point beyond which we will likely not let the temperature go. If oil prices remain in the high $50 range, it will pinch, but not kill the consumer.
There are forces at work that will be pushing energy prices down. Specifically, industries that are highly energy dependent will reduce their demand for oil because higher oil prices will necessitate the need to increase the price for their goods to offset their rising production costs. Higher product prices could easily reduce demand for these manufactured goods, so production will decline to meet the lower consumer demand. Therefore, there will be a downward shift in demand for oil by certain industries, which will marginally dampen further price increases.This industrial phenomenon is likely to impact foreign countries more than us because our economy has migrated over the past century from a manufacturing base to a service economy. This outlook is consistent with our thesis that the US economy will slow, but remain healthy.
If oil prices remain at present levels, we will surely see the development of alternative energy sources. There will be development of the Canadian oil sands and there will be substitution to other energy sources, such as coal and more nuclear power. We believe that we are closer to the high end of the new oil range and, as such, we see this threat as manageable. We would not be opposed to lower prices, which would be beneficial to all and time will tell on that front.
The demise of the housing market has been incorrectly predicted for the past few years. Like a stopped clock, someone will ultimately be correct at some point, but that point does not appear imminent. The single largest asset for most families is their home and more specifically, the equity within that house. The best tonic for the housing market is continued growth in employment and low interest rates. Monthly job creation is running around 175,000 or just over two million new jobs a year, which is a very acceptable rate. The fact that the yield curve has flattened in the face of the Federal Reserve’s decision to increase the Fed Fund’s rate by ¼ point at each of its last nine meetings, suggests that the economy is not overheating and that rates should remain low to support the recovery.
Most investors seem overly pessimistic about equity valuations and the outlook for our economy. Candidly, we are optimistic about the future and we still believe double digit returns for 2005 are possible. Looking at the portfolio, we continue to see an overall dividend yield that is higher than the yield for the S&P 500, dividend growth that is faster than the market, a forward four quarter P/E of less than 15x, which is lower than the S&P 500, and faster earnings growth for the portfolio than the market. These characteristics have been a constant for us since our founding and we believe that these are some of the factors that help produce the downside protection and upside participation that we seek.
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