Lakeview Investment Advisors, LLC
Commentary Date: Fall 2005
by Bill Westhoff, CFA
Lakeview Update: Personal Update
This fall we enjoyed a number of trips. The highlight was a trip to Italy to see the sights in and around Milan, Venice, Florence and Rome. Italy has significant history, outstanding museums and art, beautiful scenery, friendly people and delicious food and wine. Would we return? Absolutely!
Our grown children continue to provide us with excitement and pride. Brian and Tamara will become parents in April (and of course, we become grandparents!). Kelly and Quang are on a "Global Roam," which will take them around the world in seven months. They are currently in Uruguay. You can follow their travels by checking out their web site and clicking on the Global Roam icon.
Lakeview has been in business for three years and the opportunity to help clients' structure portfolios to manage risk and create opportunities for asset growth has been very rewarding. Rewarding in terms of personal satisfaction, and occasionally humbling when markets don't follow the planned script. On balance, the outlook for Lakeview's business is bright.
Market Performance 2005 YTD (November 30, 2005)
The U.S. markets have struggled to make much headway this year. Headlines which have reflected negative news have kept market participants worried about the outlook. Rising interest rates have added to the market's difficulties. However, the economy has continued to roll along, showing solid growth, adding jobs and creating an environment for profit growth for most U.S. corporations. Within the market, energy and utilities have produced the best results. Small companies continue to outperform large companies and international stocks have done well again this year, in spite of a rising dollar.
The Federal Reserve has followed a consistent path of raising the Fed Funds rate at each meeting this year; leaving the Fed Funds rate at 4%. Yields on bonds with ten year maturities and longer have increased only moderately, while shorter maturity bonds have increased significantly, in sympathy with the Fed's actions. This has led to an unusual situation where yields on two year maturity bonds are almost identical to ten year yields. In bond parlance, this is called a "flat yield curve." Historically, a flat or "inverted" yield curve (where short rates exceed longer maturity rates), has been a precursor to an economic slow down. Business cycles repeat similar patterns, but are never exactly the same. That is why economists use that favorite phrase, "on the other hand."
Source: Wall Street Journal 12/1/05
Source: Investors Business Daily 12/1/05
Valuation statistics show a market that is of fair to cheap value. Market P/E (share price, divided by earnings per share) is near its long term average of 15.8 x, while price to book and dividend yield are near the cheap side of the five year ranges. When the current level of interest rates is factored into most valuation models, market strategists believe the market is cheap. One should not forget that most bull markets are about three years in duration (the current bull market started in March, 2003). Bull markets don't just die of old age, they typically end when rising interest rates slow economic activity.
Lakeview's Advisory Board met in October when most economists were certain that the impact of the hurricane season would not have a lasting effect upon national GDP. One noted forecasting firm, Macro Economic Advisors (MEA), called for a Q3 rate of 3.8%, Q4 of 3.2%, followed by growth rates of 2.2% to 2.8% for the four quarters of 2006. Subsequent to the meeting, Q3 GDP was announced to be 4.3%—significantly above most forecasts. A quick check of economic forecasts in the Wall Street Journal, shows forecasts into 2006 being revised upward, with an average growth rate of 3.2%. The forecasters that have developed 2007 forecasts are showing GDP rates of positive 2–3%.
Economists in the WSJ anticipate inflation measured by the CPI to decline to a 3.2% rate by May, 2006, from the current high, energy effected rates. Unemployment is expected to decline very slowly, from the current 5.0% rate to 4.9%. The Fed Funds rate is expected to continue its rise, going to 4.75% from the current 4%. To put the Fed Funds rate in more perspective, the current Prime Rate is 7%. Which means the Prime Rate will be close to 8% at its peak.
Productivity, a very important factor in the Federal Reserve's assessment of inflation potential, is expected to continue its strong trend. MEA forecasts a trend productivity rate of 2.8%. The window for job creation is very small with an economic growth rate just over 3%, and productivity expansion of just under 3%. This factor combined with increased global competition is creating significant pressures for some major industries in our country.
Competition is the life-blood of a market economy. Economies that face competition adjust and grow more quickly than economies without competition. Collectively we all benefit, but it is the individual worker that is caught in the middle of these forces. To prepare for these challenges, individuals need to continually accumulate skills and build their own savings. Long term promises, such as defined benefit pension plans are becoming unreliable. Eliminating these plans has the effect of lowering the national savings rate; and sadly, the personal savings rate in the U.S. is already among the lowest of the developed economies.
Outlook (Current stock view: 0 or neutral exposure to stocks and bonds versus the benchmark).
This is a change from the last commentary. The stock market has improved from the lows reached in mid-October as I hoped it would. The economy has completed ten quarters of GDP growth over 3% and fourteen quarters of double digit profit growth. Capital spending is strong, productivity continues to expand, inflation is showing moderating signs and the forecast is for continued expansion. On balance, economic conditions are far better than the headlines would lead us to believe. So why become more conservative?
First, I still believe there are opportunities to make money in stocks. Almost all client portfolios have more weight on stocks than bonds even when they are at neutral. Second, short bonds are becoming more attractive, but it is still too early to back up the truck and fill it with bonds. The Fed is committed to fighting inflation and the new Chairman will be unlikely to give up the fight early.
After many years of watching and participating in markets, the following comment comes to mind, "Don't fight the tape, and don't fight the Fed". In spite of the underlying strength in the economy, the market (or the tape) has had difficulty moving up all year. Rising interest rates have not had much impact on slowing the economy, because longer term rates, such as home mortgage rates have not really moved up enough to discourage home buyers. To me, that means the Fed will keep moving up Fed Funds, or short rates, until the longer end of the bond market pays attention. When it does, bonds will be more attractive and corporate profits will be more at risk than they are now. The move to a more neutral stance is in preparation for this scenario.
Security Fund Selection
As the economic cycle ages, one can shift the asset allocation to a more conservative stance as mentioned above. However, individual security selection can also help create lower volatility in the portfolio. Such shifts often involve value stocks (typically with lower P/E ratios), stocks of companies operating in more stable industries (consumer staples, such as food and beverage companies), and stocks of larger companies which are better equipped to deal with higher interest rates.
PepsiCo (PEP) is a good example of a larger, consumer product company that I have been adding to portfolios. PEP has annual revenues of over $30 billion and a market capitalization of over $95 billion. Schwab gives PEP a "B", or Outperform rating (35% of the companies in Schwab's data base receive a rating of A or B. PEP ranks in the top 13%). On the basis of fundamentals such as the ability to generate free cash flow and the efficient use of working capital, PEP also gets positive marks and a B rating on fundamentals.
While revenues have shown high single digit growth, earnings per share have grown over 18% per year over the last three years. The company has achieved this by being more efficient and expanding their profit margins from 10% in 2000 to 14.7% in the twelve months ended May, 2005. In this period, dividends have increased 64%, from $0.56/share to $0.92/share. The number of shares outstanding has declined to 1.6 billion shares from 1.8 billion. PEP has a conservative balance sheet with long term debt equal to 25% of capital. Free cash flow is significant and expanding—increasing from $3.1 billion in 2002 to $3.7 billion in 2004. This has allowed the company to make significant capital expenditures, purchase shares, expand the dividend and increase cash on the balance sheet from $2.0 billion to $3.9 billion at May, 2005.
The company appears reasonaby valued vs. its recent past. The P/E ratio is currently around 23X, vs. its five year average of 27.5X and a range of 21.7 to 35X. While the dividend yield is only 1.7%, the company has recently become more aggressive at increasing its dividend rate.
This is not a racy story where you expect to double your money in a short time; but a solid, well managed company in a stable industry that should weather more difficult economic environments. For the three years ended September, 2005, the stock returned 17.2% per year and has produced an average annual gain of 10.9% over the last ten years. Of course, past performance is no guarantee to future performance.
Please contact me at Billw@lakeviewadvisors.net if you would like to discuss any of the ideas reviewed in this commentary.
© 2004 Lakeview Investment Advisors, LLC
Any information provided in these materials is believed to be from reliable sources. Lakeview Investment Advisors, LLC makes no representation as to its accuracy or completeness and is not responsible for any damages incurred as a result of your use of these materials. These materials do not constitute a solicitation to sell or offer to sell investment advisory services to residents of any state in which Lakeview Investment Advisors, LLC lacks authority. Part II of Form ADV, which details the business practices, services offered, and management fees charged by Lakeview Investment Advisors, is available upon request.
Lakeview Investment Advisors, LLC participates in a Board of Advisors consisting of professionals in the investment field; however, members of that Board who are not employees of Lakeview Investment Advisors, LLC do not participate in providing investment advisory services offered to clients.
The Economics and Markets Advisory Board consists of the following members:
Theodore H. Busboom, CFA, President, Prospective Value, formerly Senior Vice President and Portfolio Manager, American Express Financial Advisors
William C. (Bill) Melton, PhD., President, Melton Research, Inc., formerly Chief Economist, American Express Financial Advisors
Former Advisory Board member Ray Goodner has moved to Seattle. Jim Walline has returned to the working world, accepting a senior position with Piper Jaffray.