|IBD MF Index
|CRB Commodity Index
|3-Month Bill Rate
|Long Bond Rate
Last year was a frustrating time for us. (We invest our own funds alongside our clients, buying for us what we buy for you, so we experience the same indigestion from eating our own cooking.) In the face of soaring stock market indices, most of our accounts rose modestly or trended sideways. We were left out of the rising index experience because we didn’t have any exposure to fifty stocks which are dragging around the Dow Jones Industrials, S&P 500 and the NASDAQ. As I’ve said before, these are good companies but they are overpriced. If you weren’t in this group, the going got tough: even though the NASDAQ rose over 85% for the year, more stocks declined than advanced. In addition to not being in the path of this narrow market, our performance suffered from substantial positions in income-related investments. As shown in the above table, interest rates rose throughout the year, causing bond prices and other income issues to fall in price. (Many of our clients, of course, have income investments by design. They shouldn’t be perplexed because the markets one year place a lower value on their income streams than in other years.) Lastly, our exposure to Real Estate Investment Trusts and Master Limited Partnerships proved detrimental; as the gains we did achieve were erased by our REIT investments whose prices declined all year and ended up succumbing to a vicious wave of tax-loss selling in December.
Obviously, these results were disappointing and need to improve. Our exposure to technology, telecommunications and international investments is weak; and we would like to increase our presence in these areas. (Although we don’t want to chase the fifty stocks of NASDAQ-100 fame.) In the future, we will be more proactive in employing No-Load mutual funds to help us expand in areas where we have little expertise. Doing what we’re already doing also will improve our performance, as the companies we continue to own are growing in value, even though today’s lopsided markets don’t show this value. Speaking of lopsided, today’s market represents a perfect example of volatility. Volatility is supposed to be the friend of the value investor, since it reveals so plainly the value of an investment. We still believe this principle to be valid. While the market is a voting machine in the short-run, it is a weighing machine in the long-run. Thus, the lack of attention to many areas of the market represents a buying opportunity for investors willing to examine values. As long-term investors, we’re happy to have these opportunities and are taking advantage of them.
In summary, our investment platform needs to be tweaked, but this is not a time to abandon principles just because they have led us to experience a frustrating year. Going forward into the new year, the new century and–yes–even the new millennium, we will drag along the following baggage of beliefs and ideas. We think these principles have governed and will continue to exert an important influence on long-term investment results. Consider them for yourself. If they have any applicability to investments, then we expect our long-term results will be much more competitive in the future.
The Market Will Decline, If Not In 2000, Some Time When It Will Be Inconvenient. With the age of the average mutual fund manager dropping below thirty, the idea of a market decline is becoming hard to remember and even more difficult to sell as a possibility, let alone a probability. While we profess not to worry about market timing, we are concerned that the popular mutual funds of today–with mouth-watering short-term returns making us green with envy–have something very obvious in common: they all own the same stocks. If for no other reason, this fact by itself is a reason the market will experience a drop. When this eventuality is realized, all equity investments could be effected, so it will be important to own companies with which we are comfortable. We simply can’t subscribe to the idea that there is no risk in the market. Bear markets have not been repealed, even by today’s “new economics.” This means we don’t want to own Home Depot ($68.75), or similar quality companies, at seventy times earnings; because, even though it is a good company, a market decline could adjust its price-to-earnings ratio. If it declined to thirty-five times earnings, it would be a long time before we would be rejoined with half our principal.
The Internet Won’t Put The Country’s Retailers Out Of Business. Internet retailers such as Amazon.com ($76.125) represent the equivalent of adding thousand’s of catalogue companies to our economy. They definitely will change the face of retailing. However, it will be a long time before strip centers with grocery store anchors disappear from our landscape. They might change, but the tenets in strategically located shopping centers–the gridlock of D.C. Metro Area comes to mind–will continue to pay the rent and allow owners to earn a profit. And who cares? Those of us who own New Plan Excel Realty ($15.75), and several similar REIT’s, should find comfort and opportunity if this assumption is correct. The stock’s current yield was 11% before tax-loss selling abated, and the Company has instituted an aggressive stock buy-back program. For the record, New Plan Excel REIT’s balance sheet is so strong it has an A-grade bond rating; and the Company has increased its dividend every quarter (that’s not a typo) for eighty-two consecutive quarters. We won’t need much appreciation from our REIT holdings this year. If their stock prices simply stabilize, we will experience a nice investment return from their 10% plus current yields alone. Should some appreciation materialize to accompany these generous current yields, we could easily be staring a big investment opportunity in the face. Tax-loss selling in the REIT industry was ridiculously indiscriminate; we tried to be buyers.
Garrison Keeler Not Withstanding, Global Warming Hasn’t Eliminated Cold Weather In Winter. In like fashion, the dozen of us who own Cornerstone Propane Partners ($11.375) experienced a price decline approaching 50%, as investors dumped the shares in response to four warmer-than-normal winters accompanied by disappointing operating results–and tax-loss selling ensued. A recent edition of “The Prairie Home Companion” stated that children don’t play outside in the winter anymore because we’ve punctured the O-zone with aerosol sprays, which makes winters warm and stops snowfall. I think we could all name some reasons children don’t play outside as much in the winter as during other seasons. As far as snowfall and cold winters are concerned, one of things we can do as a result of today’s technology is determine that it’s been getting cold and snowing in many parts of the U.S. for the past several million winters. We like the odds of a few more cold winters. The stock yields 18%. We’re buyers.
Microsoft ($116.75) Won’t Grow To The Sky. Courtesy of Bloomberg, here’s a little exercise in using the “Rule of Seventy-Two.” Based on current growth rates and stock price appreciation, Bill Gates will be worth $1 trillion (that’s not a typo) in the year 2005, only five years from now. In ten years, his personal fortune (that’s Bill’s alone, not the whole company) will equal the nation’s Gross Domestic Product. This doesn’t seem reasonable to us. Yet many Internet companies have built-in assumptions even more outrageous in their pricing structures. We think the Internet represents an exciting new field, and we’re anticipating it will create many investment opportunities over time. At today’s prices, though, frankly we’re scared. We’d rather experience another mediocre year with your money, and ours, than get in on some of these investments at the top.
It’s Not Good To Be On The Cover Of Time. Tongue-in-cheek, maybe. But history has demonstrated that appearing on the cover of national magazines is often the end of an era, not the glorious opportunities depicted in the articles. Jeff Bezos (president of Amazon.com) was Time’s Man of The Year in December. Having never earned a profit but sporting a market capitalization large enough to buy over 70% of General Motors ($72.75), we’re not buying here either.
After holding on to Piccadilly Cafeterias ($4.00) too long, we finally threw in the towel. Competition from new concepts and higher wages were not surprises. These were problems which management should be well-equipped to handle. Following the Morrison takeover, however, an ominous capital question began to take shape, at least in my opinion. With EBITDA declining upon conversion from Morrison to Piccadilly, with many of the company’s 235 cafeterias in need of substantial remodeling, and with net debt already exceeding $90 million, the future may continue to hold disappointments for shareholders. We hope we’re wrong and wish management success in their endeavors, but we think there are other investments without such an uphill struggle.
We took advantage of a buy-out offer for Chicago Title & Trust ($46.25) to sell into strength. We were a little skeptical of the currency (the offer was for stock), and we think the demand for mortgage refinancing–an important component of Chicago Title’s revenues–may be close to a cyclical peak. For most of you, the position in Chicago Title had no cost since it was a spin-off from Alleghany Corp ($185.50). From an IRS standpoint, however, your cost basis was slightly higher than your selling price, which means everyone who sold the shares in a taxable account will not recognize any taxable gain. Speaking of Alleghany, in early December the company announced the sale of its Underwriters Re Group for $725 million. Thus, when this deal closes Alleghany will have approximately $100 a share in cash, and we will have reduced our exposure to the insurance industry to two positions. Both of these remaining positions–CNA ($38.875) and Berkshire Hathaway, Class B ($1,830)–are in property and casualty lines, which we believe are close to the bottom of a long cycle.
A takeover was announced for Providence Energy ($37.125) in November. Shareholders will receive $42.50 per share in cash when the deal closes, compared to its recent price of $37.75, reached after the announcement. Since the deal isn’t expected to close for a year or so, we sold into the arbitrage market, giving up the last 12.5% appreciation to pursue more positions in the utility industry which we think are also prime takeover possibilities (see last quarter’s Letter) with considerable upside. We are especially pleased with this transaction because, being a natural gas distribution utility company, our risk of ownership was quite low in relation to the returns we achieved. Twelve of you purchased Providence Energy in 1997 for approximately $18 per share.
Elsewhere, we took advantage of indiscriminate tax-loss selling (anticipated in last quarter’s letter) to increase positions in several high-yielding REIT’s, MLP’s and utilities. We also continued to reduce exposure to oil and gas stocks as oil prices topped $25 per barrel. As for new positions, we made minor commitments in A C Nielsen ($24.625), Longs Drug Stores ($25.875), Leggett & Platt ($21.50) and Smuckers, Class A ($19.50). We will write in more detail on these positions when they are more significant.
FIRST SAVINGS BANCORP(SOPN/ $18.50)
Late in the quarter, First Savings Bancorp announced plans to merge with First Bancorp (FBNC/ $16.50) of Troy, NC. The preliminary numbers look interesting, but we need to examine the registration statement before reaching a definitive conclusion about the planned transaction. We will communicate our views directly to clients with positions in SOPN as information becomes available, perhaps writing more on the subject in next quarter’s letter.
STICK A FAT HOG
No changes were made to our SAFH portfolio during the quarter. Of note is that Heilig-Meyers ($2.75) continues to slump, even as new management is proceeding with its plans to turn the company around. As mentioned in last quarter’s Letter, we anticipated tax-related selling in the shares, but much of the recent selling must reflect skepticism of management’s initiatives. The company definitely needs to show some earnings progress to refute the market’s dire implications; if it doesn’t, the shares will continue to languish. The clock is ticking.
The following table shows the complete history of SAFH. I am sure you understand that no representation is being made regarding the portfolio’s future investment results. The portfolio is maintained to describe investment decisions made in a narrow investment arena, so it is not representative of the diverse investment universe used by Dreher Capital Management. It is not updated regularly, and you will not be notified on a timely basis of any changes.
|| Seagate Tech
|| Sun Microsystems
|| Varin Crop (1)
|| General Motors*
|| Budget Group
|| Alexander & Bladwin
|| Ameron Intl
| *Recent price adjusted for special dividends.