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2006-05-21 :: Recent Overview (lengthy discussion)

The last two weeks have been really ugly.

The hedge funds and computer managed portfolios have whipsawed the market, knocking back a lot gains that have accrued this year.  This major selloff is a repeat of the October/November 2005 and January/February 2006 selloffs, when the hedge funds exited the sectors that had the best performance.  

What we’ve seen this time is that the best performing sectors (Energy, Metals, Chips, Brokerage, Infrastructure) have sold off significantly simply because they had best performance since the Jan/Feb selloff.  In addition, the large cap stocks represented by the Dow Jones Industrial Average that recently was bumping up against its all-time high, also took a major hit.

As I look at the markets, there are some fundamental changes happening.  The hedge funds, which are momentum based investment managers, now have a huge impact on the markets.  I recently read that the hedge funds account for 65% of a typical days trading activity in the stock exchanges; mutual funds and pension funds (many of which are also momentum traders) account for much of the rest; and indiviual investors (primarily investing on company fundamentals) have been marginalized to a small percentage of the day’s activity.

Momentum investing significantly adds to the volatility in the stock market.  Here’s how it works, in a very simplified outline:

  • Momentum investors follow the cash flows. 
  • As the fundamentals of a stock improve, fundamental investors buy shares, creating demand for the stock which pushes the stock price up.
  • As more and more cash moves into the stock the increased demand pushes the price of the stock up, allerting the computer programs that trade much of the hedge funds, mutual funds, and pensions.
  • The computer programs see that cash flows are increasing so they start to make buys based, not on the underlying fundamentals of the companies, but simply on the fact that the stock is becoming more popular and there are more buyers than sellers.
  • This process feeds upon itself and pushes the stock price higher and higher.  The fundamental investors benefit from the improved stock price as their analysis is proved correct and they make money.  The momentum investors’ computers continue to invest in the stock, creating a short-term self-fulfilling prophesy.
  • Then, fundamentals change – something like the Federal Reserve making statements contrary to ones they recently made on the potential for additional interest rate increases or oil trading above $75 per barrel – and fundamental investors begin to lock in profits.
  • The momentum investors’ computers see this initial selling happening, and begin to sell some of their holdings.  Once the selling starts, you again begin to see the short-term self-fulfilling prophesy pushing pushing down stock prices in a significant way as more and more sell programs kick in.  This is the situation we have been in over the last couple of weeks.

In anticipation of this sort of selloff happening, we used the late April signal of oil hitting $75 as our key to take some energy profits.  We sold shares in many of the companies that had recently run up.  We used the metric of companies whose prices were rising on decreasing trading volume – an indicator that fewer and fewer computer programs were commiting new money to these stocks – to select sale candidates. In some cases we sold all of our holdings; in some cases we sold 1/2 of our holdings.  With the sale proceeds,  we kept part of it in cash and used part of it to buy shares in other companies either not connected with energy, or if connected to energy  in a higher growth or later stage area of the energy sector.

As the market has fallen, we have used the cash generated from these sales to pick up shares of some of our favorite companies at lower prices.  As the metric to key our buying activity, we tried to determine when specific companies and sectors had bottomed or neared the bottom of their correction.  This is a very subjective determination based upon analysis of cash flows and relative strength.  We were very much on the money with our calls to buy more of the Chip stocks – Broadcom and Marvell have been clear winners in this strategy.  Other sectors – Energy, Metals, and Infrastructure –  have been more mixed, but ultimately should prove to be quite profitable.

In terms of where I see the fundamentals from this point, my views on Energy, Metals, Chips, Infrastructure, and Brokerage have not changed. 

  • The supply/demand imbalance in energy and metals supply vs. the increasing demand from a moderately growing US economy and the fast growing economies of China and India and lesser emerging markets will continue to provide a floor under the stock prices in these companies. 
  • The growth of the middle class in the emerging market countries and the rebuilding from the hurricanes in North America and the Carribean puts a floor under the stock prices of the infrastrucure stocks.
  • The growth of smart technology in handheld devices, cable TV boxes, cell phones, kids toys, and just about everything else we use (excluding PC’s, their components and software, which are now cyclical in nature and should no longer be considered growth investments nor be valued as such) will  continue to put a floor under the  Chip stocks that produce chips for these markets.
  • The earnings for the brokerage stocks continue to grow, providing compelling valuations. and diversification opportunities.

Absent a worldwide recession, the earnings growth for these sectors will continue to improve and push their stock prices up.  There will be shifts in emphasis with sectors – like emphasis in the energy shifting to the later cycle drillers and service companies from the exploraiton companies –  and there will be changes in specific subsectors – like the rotation into aluminum companies and our taking positions in those Alcoa as a result – but the major themes are still intact for making these companies the winners in portfolios.  The unfortunate part of this is that, given the positive fundaments in these sectors, they will continue to draw interest from the momentum investors, causing them to be volatile.

In retrospect, if I had anticipated that the selloff would have been this severe, we would have sold more in late April and kept it all in cash.  However, the hedge funds are changing the investing rules and we are all learning how to adapt to the increasing swiftness and severity of the momentum investors’ computer program trading activities.  Volatility is here to stay, providing both opportunities and risks.  It is simply my job to adapt and continue to provide superior investment management results by capitalizing upon those opportunites and protecting from those risks.

Traditional investment strategies, like buy-and-hold, will be harder for indiviual investors and professional investors to execute over the long term.  Information flows are changing and its is increasingly critical to keep up with those changes.  As a professional investor, it is imperative to understand those changes and recognize how your investment activites have to change as a result.  I feel very confident that, as your portfolio manager, we are keeping pace with those changes and reacting accordingly.  I truly believe that is a major reason that our investment management results have been so strong.

We will continue to take a five-year forward view in our investment strategies.  By taking a longer-term perspective, we will experience the volatility and capitalize upon it as we can, but it allows us to focus on providing consistently superior results and keeps us from being sidetracked by short-term distractions.  

At this time, we will continue our strategy of focusing on the sectors described above.  These sectors will grow and we will take profits as events provide indicators that they may be topping out in the short-term.  We will use the proceeds to diversify the portfolio and to hold some cash in anticipation of a short-term correction providing reinvestment opportunities at lower prices.  This two-steps-forward-one-step-back strategy appears to be the best way to work with the market’s evolution.  As the market’s evolution continues, as hedge funds get marginalized and some new catalyst materializes, our strategy will change accordingly.

As always, thanks for your confidence and support.

Mark