2006 - 2nd Quarter Report

(Download printable .pdf version here.)

We are pleased to bring you the Value Architects Asset Management second quarter report for 2006. As with prior quarterly reports, we will overview the markets in general and then provide a topical discussion of issues that have received considerable press the past few months.
The old adage of “sell in May and go away” certainly held true in 2006.  From May 9 to the trough on June 13 US stocks lost 8%.   Investor uncertainty about the growth of the economy and the inflation outlook brought on by the Fed’s negative outlook were too much for the stock markets to withstand.  For the quarter the S&P 500 lost 1.9% on a price basis while the broader based Russell 3000 index lost 2%.  Additionally we are all painfully aware that commodity prices have skyrocketed, including oil, to unprecedented levels in some cases, supporting many investors’ fears that inflation is here to stay and the equity market is overvalued.

To the contrary, our view of the markets remains positive.  Corporate earnings continue to improve, albeit at a slightly slower pace than in prior years and corporate balance sheets are flush with cash. Corporations have done an excellent job of improving margins and holding costs in check. While the current strong earnings cycle won’t go on forever, markets appear to be already discounting slowing earnings growth, as PE multiples have steadily contracted over the past three years.

The jury is still out on whether the Fed will achieve the proper balance between growth and inflation, but it appears the last of the increases is closing in. This brings to question what typically happens to US equity markets in the period when the Fed stops increasing rates and begins decreasing rates. Historically there have been eight such periods in the past 35 years. On average the period lasts 7.3 months during which time the market has provided an average of a 3% return. Most interesting, the worst performing sector during this period is the sector that has been performing the best, raw materials (commodities included), losing on average 7%.
If you look at your portfolio with Value Architects there is little exposure to commodities or oil. Are we missing the commodity “gold rush”? Cycles are inevitable when it comes to commodities. Inflation fears and increased demand from countries such as China are a fundamental push to increased commodity prices but there are other non-fundamental factors influencing pricing as well. Fundamentally commodities tend to fluctuate around a central price known as the marginal cost of production. This is the price to bring the next, or the marginal project on stream. Both supply and demand key in on this figure. When prices are low, high cost, inefficient production closes down. Supply dwindles, and prices begin to rise. When prices are high, even inefficient production can make money and new mines are built to cash in. When prices are too high, conservation kicks in, and we look for substitutes. The only cure for high prices is higher prices.

In today’s markets, all commodities are trading above their marginal costs of production. In the chart above, one sees the price of copper is trading at over $3.00 per pound. This compares with a marginal cost of production that is estimated to be around $1.30 per pound. Clearly, given these economics, the price of copper is unsustainably high. We see numerous projects coming on stream in all kinds of mining as well as in energy. New supply will ultimately exceed demand, so it is not a matter of whether commodity prices will fall but when.

The huge influx of capital into hedge funds and commodities has added fuel to the speculative fire. This is not unlike the capital that was “thrown” into highly speculative Internet stocks in 1998 and 1999 which propelled these expensively valued stocks into complete absurdity.

The dimensions of the influx of capital are staggering. According to Barclays Capital, institutional investors are holding over $100 billion in direct commodity investments, compared to $6 billion in 1999. And Scotia Capital, in an April 2006 Metals and Minerals report called “A Financially Engineered Supercycle,” states that investments in metal index funds alone are $70 billion, up from $15 billion two years ago.

Putting these numbers into perspective, the annual consumption of these metals annually is about $110 billion, using 10-year average prices.

So it is no surprise that a lot of money is chasing commodity exposure, whether through direct ownership or ownership of resource stocks. Of course, with little or no income from these commodity holdings, and with their history of volatility, these are “trading vehicles” hardly buy and hold investments. So these new buyers will eventually be sellers. And with risks increasing with rising prices, all we can say is: look out below! In Canada, investors are fearless, as resource stocks today make up 47% of the S&P Canadian Index, much larger than high-tech exposure ever was.

Most assuredly, new supply will come on, with a lag. Whether copper, gold, or oil, there is considerable supply that is on its way. Despite what appears to be enormous growth in Chinese demand for oil over the last five years, about 70% of this is for power generation. A new coal-fired power plant opens up every month and by next year, China will produce surplus electricity. Despite increasing oil demand from transportation, we believe overall demand for oil in China will moderate.

Much as we said in the early 2000’s regarding Internet stocks, we have no idea when the music stops, or when the trend will end for the commodity cycle. But we have every confidence that it will end very badly for the late-arriving speculative capital.

The potential for losses is very high in our opinion. And apparently, this is also true in the opinion of some commodity stock insiders. Check out the following chart of insider activity in Phelps Dodge (symbol PD), the large American copper producer:

As you can see, not one share purchased by insiders, compared to a total of $53.5 million worth sold. Ironically, Phelps has been attempting to purchase both Inco and Falconbridge, two Canadian based nickel and copper mining companies, largely because management feared that Phelps Dodge itself could be a target of others. Clearly, Phelps Dodge insiders are moving to the sidelines and voting for cash rather than any rosy outlook for metals!

Judging from the behavior of Exxon Mobil insiders, their energy outlook is not terribly different than Phelps’ insiders for metal as $52  million of Exxon was sold by insiders without a single purchase!

That said, we continue to believe that our intrinsic value approach will provide ample opportunities to achieve satisfying returns with less market risk. We don’t chase “hot” themes nor rely on non-fundamental speculation. We do rely on our ability to generate our own ideas through traditional methods of security analysis. We set out to understand the underlying value of each investment utilizing conservative assumptions and common sense.

We thank you for choosing us and look forward to a long and successful relationship.

Richard H Konrad, CFA, CFP®