Commentary and Articles

3rd Quarter 2004 Quarterly Synopsis

“Equities Trip on the Way to the Finish”

Like a runner who fails to clear the hurdle, equities stumbled during the 3rd Quarter of the year and were passed by the fleet footed bonds. The hurdles faced included the poor weather from a straight month of hurricanes, oil prices rising to $50 per barrel, and a continuing bias at the Fed to raise rates.

As the Federal Reserve has continued to raise rates, they have indicated their belief that the economy is improving. Even with the positive outlook, we continue to see corporations paying down debt and deciding against any significant investments which would facilitate expected business expansion on the horizon. The continued unrest in Iraq, insecurity over oil prices, and a close Presidential race have all contributed to the wariness.

However, the U.S. Economy has, as the Fed suggests, shown signs of strength. The revised GDP numbers indicate annualized growth of 3.3%, and this level is expected to continue through 2005. Compared with the 3rd Quarter of 2003 (with growth at more than 8%) this is paltry, but still respectable. Our Fair Value calculations show that stocks are inexpensive relative to bonds; approximately 20% undervalued given earnings projections. The Price-to-Earnings ratio for the S&P 500 is now 15, at the lowest level since early 2003.

It is strange indeed to see bonds outperform equities in such a climate. With positive corporate earnings, and rising short-term rates, combined with a rising Federal Budget deficit, one would expect that equities would easily have the upper hand as the preferable asset class. Again, the lack of predictability in factors such as terrorism and oil prices leads investors to look more to bonds, particularly US Treasury instruments for security.

Our equity holdings did not fare well in this environment. Normally defensive sectors lagged. Healthcare was disappointing and was the sector in our portfolios with the lowest performance for the quarter. In addition, our holdings in Consumer Staples were a poor showing as well. Our holdings in both sectors represent good long-term opportunities but failed to achieve our expectations in the short-term period of the 3rd Quarter.

Sectors which did perform well were Energy and Industrial Cyclicals. Our recent Focus List addition, Apache Corporation (APA, NYSE) rose 13.50% for the period, along with Burlington Resources (BR, NYSE), up 12.99%, both helped by rising fuel costs. Long-term Media sector holding McGraw-Hill Companies (MHP, NYSE) rose 4.61% for the quarter, and recent Financial sector addition National City Corporation (NCC, NYSE) outperformed its sector, returning 9.67% for the quarter.

As noted in the previous quarter’s commentary, we moved significant portions of cash into bonds which helped portfolios with a fixed income component as bonds appreciated in spite of rising short-term rates. Our durations have stayed consistent as we seek to limit fixed income interest rate risk.

Even with a difficult quarter, our portfolios continue to outperform for the 2004 year-to-date, and we believe the 4th Quarter will continue to reward our efforts at outperforming markets while reducing investment risks.