|Market Commentary - November 2004|
Profit Prospects, Probabilities, Prudence, and Policy
Optimists are born winners, while bears intermittently get to feast on road kills. That’s the way it is in strong nations with stable governments. Notwithstanding this metaphorical description that is devoid of details, the verification is seen in an incontestable historical profile. Market phases of advancing equity valuations endure longer and traverse greater distance than retreats. Downthrusts are commonly steep, and of shorter duration. The last four years have unique peculiarities derived in large part from extra-market matters; that is, not endemic to the American economy, or its financial markets.
The case for optimism is quite fundamental, residing deeply and enduringly in human aspirations and inventiveness. This is as basic as procreation (not an insignificant contributor to growth as well). One of our Firm’s primary emphases in selecting shares is drawn from enterprise inventiveness, or intellectual property as it is commonly referenced. Never should this be abandoned. It is necessary, however, to acknowledge a broadening of sobering challenges to optimism.
Optimism is now squeezed between putative increased instability throughout the Muslim world, and instability of financial markets. It is not at all easy to perceive how readily, and in what degree of comity, Americans can move from their present understandings of the disguised misbegotten formation and promulgation of the Iraqi War toward an acceptance of its broader and deeper consequences. In addition to the specific damages that have been partially visualized within Iraq, centrifugally damaging influences throughout much of the world might well prove to be more broadly and more deeply pervasive than any of us can now understand. We can only find out from observing succeeding events. Among citizenry of so many nations who historically have been our friends, dismay has turned to disapprobation. This is not a scene that supports confidence in surmises. Surely, it does not support confidence in the strength of the American dollar, or in dispositions of non-Americans to own dollars or dollar denominated financial assets.
In addition to attitudes having moved from sympathy to disapprobation, as mentioned, foreigners have also a more fundamental reason for diminished interest in holding dollar denominated financial assets. The alternatives to dollars have much improved. The Euro has proved itself as a strong reserve currency, and even sterling has also gained against the dollar. Moreover, the yen, the renminbi, and the ruble are also gaining, as investments in Asia and Russia have gained in attractiveness. Asset managers in the financial capitals of Europe and Asia are correspondingly less likely to send their money to New York because of the growing attractiveness of other regions, including Latin America. All combined, expectations are weakened for renewal of strength in the American dollar, encumbered as it is with open-ended military costs, and reconstruction costs of military damage.
For decades, governmental agencies (charged with supervision) were merely going along with an over-build of our financial markets according to profit motivations of participants, applying few effective constraints. Still more worrisome, no one can comprehend the mountainous compilation of derivatives, or discern the activities of private trading funds. In small scales, these funds are not threatening; in scale so large as to be overwhelming, this is another matter. Long Term Capital Management proved that point in 1998. As it overwhelmed the bond market, and collaterally ruffled the stock market, authorities demonstrated so little familiarity with this development, in spite of the fact that the funds for extraordinary positions were built on borrowed money. Through the years, there is nothing quite so frightening as to listen to an expert on derivatives show how understanding falls so far short of comprehending this colossally large and complex scene. For all of the modern-era high-speed communications accessible to participants, never has the market had such difficulty in communicating inter-sectorally, or has it possessed so little capability for participants to see what might surprisingly hit them next. These words are not intended to make the case that financial matters and the consequences of the Iraqi War are worsening. However, it seems probable that the awareness of these consequences will grow, and the growing awareness could have the same affect on markets as a worsening of circumstances. Thus, there is a judgmental shift in our management of assets. This is not so much a change of hope and expectations as it is a shift, in the argot of the trade, from a nervous bull to a prudent bull.
We have not ruled out the prospect that the American stock market is moving from the buffeting of the past four years toward years of buoyancy based on improving worldwide economic circumstances. That has been a viewpoint to which we accorded a higher probability rating than we attributed to alternate viewpoints. We still wish to orient asset allocation to such a viewpoint, yet prudence suggests reducing the vulnerabilities of exposure to the increased possibilities that it might not work out so well in the short run. Those who cannot well afford to assume risk for sake of gain, or who are not by temperament disposed to do so, should give preservation of capital an increased emphasis in their selection of investments.
In our Firm’s deliberations, we have approved an increased number of low-risk equities in the universe of our interests. We desire to provide a larger selection among our “rock solid” investment choices such as Union Pacific, Burlington-Northern, and several electric utilities. The rails are safe ways of participating in the growth of Asia, inasmuch as these railroads carry items to and from our seacoast portals to Asia. These railways also carry compliance coal to fill the persistently growing needs of electric generating plants in much of the USA.
American producers of field crops face ongoing, rising prosperity, as do sellers of crop protection, plant growth promotants, and farm production and transportation equipment. Field crop farmers throughout the Mississippi Valley (and in certain regions elsewhere as well) have major positive influences going their way. Asian nations, especially China and India, have earned the financial means from both exporting goods to the USA as well as the American outsourcing of services to Asia to purchase more food. Do not lose sight of this factor in gauging the American growth pattern.
In addition, there are new markets, or expanding markets, for farm products from new bioscience applications derived from enzymatic protein development. These discoveries bring much improved efficiencies in the conversion of starches, sugars, and biomasses (say, other cellulosic materials) as well as the remediation of offensive effluences and waste. Remember the late 1970’s and early 1980’s. Such applications were among the most hopeful of horizons when the biotech age first caught the attention of financially oriented minds. Much has since been adopted, but much less than hoped for. Now genomic engineering has produced enzymes of such greater effectiveness that there is a new, and broader, range of opportunities. These enzymes afford revisions in many chemical processes, and the production of new materials.
We have added the following companies to our universe of interest: Syngenta, Monsanto, ADM, Bunge, Novodyme, Danisco, and FMC. For these companies, the risk/reward ratios are improved from both sides; that is, risk is reduced and opportunities increased. Valuations appear to be cheaper than for other companies with comparable prospects for growth of revenues and earnings. These additions are world-class companies, with a very minimum of enterprise risk.
The cautionary steps we have in mind are: 1) shifting assets toward more predictable or more solid enterprises, 2) increased emphasis on utility stocks providing moderate dividend yields, and 3) increased use of medium-term or shorter high quality bonds. We will also be comfortable with a few companies that address niche markets with proprietary products that dominate over alternate products. Thus, we would be counting on the exceptional utility of such products to attenuate risk while insuring growth. For our Young Enterprise Shares (YES) program, we shall increase emphasis on those companies with higher degrees of probability, plus still using a very few with highest degrees of upside potential. It seems prudent to give up some gain prospects for better chances to navigate through turbulent circumstances, if such should come our way.
As for the current rally, surely there is enough fuel in the form of cash having built up on the sidelines to carry the rally forward. However, the rally itself is not based on underlying economic improvements (indeed, growth of the American economy slowed in recent weeks). The election victory seems to have been catalytic to moving some monies in from the sidelines. One side always wins, and the relief of uncertainty eases the mind while the enjoyment of victory excites the spleen. Accordingly, we would use the rally to thankfully sell the hyper performers as these move to higher capitalizations. These sales will facilitate a move to the more conservatively valued shares as mentioned earlier in this memorandum.