Quarterly Letters & Insights
CAZ Investments Quarterly Letter 2010 – Quarter 3
The Dog Days of Summer?
We would like to welcome our two new employees, Ms. Michelli Cockburn and Ms. Janet Jenkins.
Ms. Cockburn serves as Marketing Associate and Compliance Officer for Inroads Capital Management, coordinating marketing material and overseeing governmental regulatory and client contractual compliance issues for the firm. Michelli has over 12 years of experience in the financial services industry most recently including work as a Marketing Client Consultant for VALIC. Prior to VALIC, Ms. Cockburn worked for nine years for AIM Investments where she held several positions including Marketing Quality Coordinator and lead Design Project Manager for AIM’s marketing and financial PowerPoint presentations. Michelli earned her B.S. degree in Mass Communications with academic honors from Norfolk State University and her M.B.A. from the University of Phoenix.
Ms. Jenkins serves as Inroads Capital Management LLC’s Head Equity and Fixed Income Trader. She also manages operational activities regarding the firm’s portfolio management system. Having worked with a number of Houston investment advisory firms, over the past 20 years, Janet brings a wealth of experience and relationships to her roles. Prior to joining ICM, Janet was Head Trader at Chilton Capital Management LLC and at CAZ Investments / Roger H. Jenswold & Co (for eight years). At Maxxam, Inc., Janet began her career working as a Trading Assistant and over the next thirteen years performed a variety of roles, including Portfolio Manager of their Equity Arbitrage Portfolio. Her personal interests include volunteering for St. Jude Children’s Research Hospital, playing golf, and traveling.
Merely reviewing the market’s final outcome for the 3rd quarter might lead one to believe the quarter was mildly boring. However, the market’s reality was a bit different as the market experienced sharp volatility at times. Nonetheless, the final result was a modestly higher market value from the beginning of the quarter’s value. Most major indices increased by 3 – 6% during the quarter, leaving most indices in positive territory by approximately 2.5% for year-to-date 2010.
The old, but not necessarily certain, Wall Street adage, “Sell in May and go away until Labor Day” happened to be accurate this summer as the market was virtually unchanged during that period. As usual, ‘the devil was in the details’ as the market experienced sharp corrections in June and August. Both of these pullbacks were greater than 6% resulting in a negative year-to-date return of nearly 10% at the time of those lower price levels. Therefore, investors endured a bit of a roller coaster ride prior to arriving at the slight gains the market delivered by the end of the 3rd quarter.
The Tug of War Continues
We continue to experience a substantial tug of war regarding the market’s sentiment. On the positive side of the rope are improving corporate profits and very inexpensive interest rates. Pulling against those positive forces are anemic employment growth, sovereign debt concerns and wishy-washy/inconclusive economic indicators. Which side will win this tug of war? The outcome is still a toss-up; as soon as one side seems to get the opponents close to the mud pit, the opposing team finds a way to pull back from the abyss and keep the tug of war [read: debate and/or market indecisiveness] ongoing.
In spite of flat revenue growth, or at best modest increases in revenue, corporate profits continue to pleasantly surprise as managers continue to do an excellent job “squeezing blood from the turnip”. Companies continue to maximize cash flow via expense controls. We are pleased with the operating and financial results from the companies you own. The only negative is the lingering issue that expense controls are coming at the price of new hiring, resulting in a blasé outlook for employment, which dampens our expectations for revenue growth, which then lessen our outlook for growth, which then . . . . . . . and the cycle continues.
Last year we discussed how the market needed to take a breather to allow valuations [i.e., price/earnings ratios] to catch up with the higher stock price levels. Ways valuations can catch up with stock prices include: 1) a market price pullback or decline to make the price less expensive relative to corporate earnings, or 2) an extended sideways market movement [i.e., stock price stability] while corporate profitability continues to improve to make the prevailing price relative to corporate profitability less expensive. While the market has experienced relief corrections in the past nine months that acted to counterbalance the shorter-term rallies, the market has really made little progress since January of this year (only 2% higher than the stock indices were in January). This sideways trading range has been a positive, stabilizing development. While that may seem counterintuitive, it is very true. The longer the market goes sideways, while at the same time corporate cash flows improve, the less “expensive” the market becomes [i.e., more dollars of operating cash flow to support or justify the same or quite similar stock price]. This improvement in valuations provides for a higher level of safety and comfort for investors. After the strong market price performance of 2009, we could not have envisioned a more favorable result [i.e., stability in market price levels] than what we have experienced year-to-date 2010.
Does this mean we are now totally bullish? No! But the base established by this recent trading range means we are more constructive then we have been in a long time. Nevertheless, the long term issues about which we have written extensively have not gone away. In fact some would argue many of our economic challenges are getting worse. However, at least for the time being, those economic challenges are not at the forefront of investors’ minds. Therefore, the market has continued to hold its own. While we maintain our cautious long term outlook for now, our government is succeeding in “kicking the can [read: our fiscal, monetary, and economic challenges]” down the road which enables us to be a bit more constructive regarding the stock market for the near term.
The Final Stretch of 2010
As we find ourselves in the final months of the year, we are pleased that the market has risen year-to-date, even if ever so slightly. Valuations are better, psychology is better and stock prices have given us a positive return this year. So what does the last quarter of 2010 hold in store for investors? Barring a big surprise, we believe the last few months could be more of the same ~ modestly higher prices by year-end. There are a couple of catalysts that may allow the market to lift even a bit more and give us a fairly decent result by year-end.
The first catalyst we foresee is the resolution of the November elections. We will talk about the expected results in a moment, but the very fact that the elections will be over is a positive. The uncertainty of swings in Congressional power, regardless of the direction, are always cause for investor anxiety. The resolution of this uncertainty removes one item over which investors fret.
The second catalyst we expect to receive is from the Federal Reserve. They have made it clear that they are STILL committed to do whatever it takes to stimulate the economy. It seems that policy makers are fully committed to raising the “animal spirits” from their doldrums, regardless of the potential and probable longer term costs. A second round of quantitative easing [“QE2”] by the Federal Reserve should eliminate additional worry for investors that the Feds might become less accommodative.
The combination of these two catalysts, along with the normal allocation of cash that tends to seasonally occur at year end, could give the market a bit of strength as we finish out the year.
The elections themselves appear to be lining up to be consistent with what is being expected. It appears that the Republicans will regain control of the House while the Democrats will likely retain control, albeit by a thin margin, in the Senate. (A few key races can swing the Senate’s balance of power, but based on current poll numbers, a more balanced Senate is the likely scenario.) What is the result of such a return to Congressional balance of power? Gridlock! To some, legislative gridlock might be concerning. However for those that believe that the less Washington does, the better, then gridlock is apt to be viewed as a positive. Based on what we are being told, the results of gridlock will likely result in the following:
- The Bush tax cuts will NOT be extended and income tax rates will rise.
- Some resolution will be reached and the estate tax lifetime exemption will be set somewhere between $2mm and $4mm.
- No earth shattering legislation is likely to be passed in the next few years.
As always, one’s perspective will determine if the likely outcomes listed above are a positive or a negative. Nevertheless, the very resolution, albeit without total clarity, should be welcomed by corporate planners and investors alike. Naturally, if the election results are substantially different then what the current consensus believes to be the case, our outlook would be subject to change!
Of Bonds and Bubbles
Is there a bond bubble in today’s investment markets? Yes, we believe there is. A ten–year Treasury bond yield of less than 2.5% is hard to fathom. As the chart above indicates, this historically important benchmark interest rate indicator is currently at a 48 year low yield, which means the corresponding bond prices are at 48 year highs! Importantly, until we see real economic growth and pricing pressure [i.e., inflation], such low interest rates may be the norm for a bit longer. The “no brainer” that we foresee in the bond market is that interest rates are likely to rise, and rise a LOT, from these historically low levels! Our economy will likely battle a bit of deflation first; but, when our economy starts to experience inflation again, its force will shock people how quickly it will likely ramp up and how hard it will be to control.
When inflation does ignite, the Federal Reserve will scramble for their “tools” to slow the rate of inflation; all the while, interest rates will rise quite dramatically. Like all bubbles, if investors wait until the tangible signs of the bubble bursting and inflation being rampant, they will be late to the party and will likely suffer as a result.
So what should a bond market investor do? Invest in short term maturities, buy TIPS (Treasury Inflation Protected Securities), buy floating rate debt instruments and be patient with cash reserves. The most painful mistake an investor can make right now is to chase an extra 50 basis points of yield by buying long dated bonds. Be patient and be prudent.
Sometimes Boredom is Desirable
After the roller coaster ride experienced by investors in 2007 – 2009, an unexciting period of time is not necessarily a bad thing. We know that many investors believe they are “running out of time” as they prepare for retirement and, therefore, are getting anxious. Don’t let that anxiety cloud your judgment and cause mistakes. At times, it is tempting to throw “caution to the wind” and chase prices; but, we know that the rules of investing never change. Buy what is not expensive and sell what is expensive. Don’t focus on price alone, but assess value. Following that formula is the way to deliver consistent results. Never forget that at times the best investment decision a person can make is to sit on our hands and stay the course.
We continue to examine the landscape to find opportunities that we believe will be fruitful and as the economic cycle ebbs and flows, are attractive investments to make. With careful evaluation and consideration, we will continue to help you participate in those situations. Please don’t hesitate to let us know what questions you have and how we can serve you better. We appreciate the confidence you have in us.