Q3 Commentary (2005)
Performance in the third quarter was disappointing. Higher energy prices, further increases in short term rates and two unprecedented hurricanes pressured the consumers’ buying power. For the past couple of years, energy, energy related (such as drillers and refiners), and material companies (such as coal and copper) have posted some of the largest advances within the S&P 500. In 2005, the investing environment changed in that these highly cyclical companies continued to perform well, while almost all other sectors struggled. This divergence in relative performances became very acute over the past few months as investors became increasingly fixated on industries that sell their product in a barrel, by the ton, or by the board foot. Said another way, commodity related industries have taken center stage, and as usual, we do not perform well under these conditions. The fortunes of these industries are closely tied to the underlying commodity’s price change and we are not particularly skilled in predicting changes in commodity prices.
We prefer to focus on understanding the long term operating and financial strategies of companies, so that we can monitor their progress over time against their plans. On this front, we believe we are quite skilled, despite what this year’s performance suggests. We view the past couple quarters as an aberration to what has otherwise been an outstanding inception to date performance record. We remain encouraged by our portfolio and optimistic about the future.
Throughout 2005, our economy has been facing rising short term interest rates and rising energy costs. Both of these forces are crimping the buying power of the consumer, which is the engine for the majority of our economic growth. The recent devastation in the Gulf region by Hurricanes Katrina and Rita will slow economic activity in the near term, but there will likely be a more significant economic stimulus to our economy during the rebuilding phase in the impacted areas. As we all now know, the Fed recently raised the federal funds rate by another ¼ point to 3.75%. This was the eleventh ¼ point increase in the last fifteen months and it would appear that further ¼ point increases will be forthcoming. During such periods, there are numerous economic forces at work, which can cloud the investment outlook. The S&P 500 is trading with a low teens P/E on a forward four quarter basis. With such a multiple, we believe there is investment merit in many high quality companies with earnings growth rates comparable to their P/E multiple. Said another way, we believe that consistent growth can be bought reasonably cheaply right now.
Coho Partners believes that it is prudent to assume that there will be a slowdown in our GDP growth in the 4th quarter from the 3.3% GDP growth during the 3rd quarter, and that growth in 2006 will be positive but not overly robust. As such, industries that are highly economically sensitive may not get the operating leverage necessary to expand margins and reach what might be overly optimistic earnings estimates by Wall Street analysts. We would prefer to keep our focus on industries that provide more essential services to the consumer, hopefully, where valuations are more reasonable. To that end, we remain overweighted in “demand defensive” industries, which include our “consumer staples,” “health care” and “energy” holdings. These companies produce products that are necessary, affordable and in demand at all times. We expect the earnings of these companies to grow consistently over time and allow for annual increases in their dividends.
Energy is likely to remain a good investment area, although volatility will stay high. In light of recent events, there does appear to be a movement afoot to increase our domestic refinery capacity. The US has not built a new refinery since 1976, which is why we commented in an earlier letter that we are not short of oil, but rather constrained by our refinery capacity. Adding new capacity will take some time and we will have to see how receptive the citizenry is to this idea. In the meantime, the cost of filling your tank and the cost to heat or cool your home will stay high.
We have a resilient economy and we will regain our footing. Focusing on good companies, with understandable operating and financial strategies seems logical at this time. Overlay a solid valuation discipline and you should have a program in place to create value consistently over time. To that end, the portfolio continues to have a responsible dividend yield with all but two of our companies having increased their dividend this year. The P/E multiple for the portfolio is less than that of the S&P 500, despite the fact that the earnings growth rate is better than that of the S&P 500. All of our companies remain financially strong and we estimate that all but three of our holdings will reduce their outstanding share base in 2005. These repurchases underscore the financial strength of our companies, as well as a signal on their attractive valuations.
