BakerEllisLLC_Commentary

INVESTOR UPDATE
JULY 2002

The second quarter was another grim one for investors. The S&P 500 declined 13.8% while the technology-oriented Nasdaq Composite plunged another 25% during the quarter, leaving it 73% from its bubble-era peak. Adding to the market’s woes, the mighty U.S. dollar dropped 8% compared to a basket of currencies, discouraging foreign investment and driving up the cost of living in our global economy. Even if one anticipated the slide of the greenback, investments in international stocks hardly proved rewarding. For the quarter, London’s FTSE dropped 11.7%, the Paris CAC 40 dropped 17%, Frankfurt’s XETRA dropped 19%, Japan’s Nikkei dropped 3.7% and emerging markets fell and average of 10.75%. Back at home, virtually no industry group was safe. One of the few exceptions was long-neglected gold mining stocks, which rose an average of 25.5%. The indices disguised even broader damage for many investors. According to fund tracker Lipper Inc., growth-oriented, multi-cap mutual funds tumbled 17.01% in the quarter, and for the first time in a quarter decade the average stock fund now shows a negative return for the trailing three-year period. From where we are mid-year, we would not be surprised to see the market accomplish a feat it has not accomplished since 1941: three down years in a row.

The market’s dismal performance occurred against a backdrop of low interest rates, low inflation, a recovering economy, strong consumer spending and a roaring housing market. While these factors should be good for stocks – gross domestic product grew an adjusted 5.6% in the first quarter – investors have many reasons to feel afraid and disgusted. The possibility of another devastating terrorist attack, the fallout from the Enron, Adelphia, and the Worldcom debacles, lack of honesty in financial statements, increased government deficits, a “guns and butter” policy by the Bush Administration, tensions between nuclear rivals India and Pakistan and a weakening dollar are all fueling bearish sentiment. Most important, however, is the lack of ethics, integrity and diligence demonstrated by some stockbrokers, analysts, portfolio managers, and corporate boards and managements. Investors feel that Wall Street is a rigged game. Take your pick between the allocation of initial public offerings, the objectivity of analyst recommendations, inadequate enforcement of securities laws and regulations, lack of transparency, overpaid executives and accounting irregularities – the drumbeat of negative news is overwhelming, and much of it valid. We cannot recall a time in history when so much money has been made by people who were affiliated with companies headed for bankruptcy.

How bad could it get? By many measures, equity prices are still high. As we write this update, the multiple on the S&P 500 is around 22 times next year’s expected earnings. The historical multiple is around 14. By historical price-to-earnings, price-to-book or dividend-yield standards, the market is still highly valued. In the last decade, corporate America’s earnings got a lift from overfunded pension plans. In the next decade, underfunded pension plans will be a drag on corporate earnings. In addition, the tailwind
from declining interest rates is largely over. In 1982, the 30-year Treasury Bill yielded 14%. Today it is 5%. While lower interest rates in theory should support higher P-E ratios, markets often overshoot both on the upside and the downside, and the market could easily have further to fall.

That said, periods of confusion also bring the greatest opportunities, and this is no time to be getting out of stocks. Rather, our focus has been on identifying good-quality companies with reasonable growth prospects trading at bargain prices. In our quest for value, we look for companies that are being managed for the benefit of the shareholders, rather than founders or executives. It is also imperative that the companies have the ability to generate substantial amounts of free cash flow, which can be used to pay off debt, buy back stock, pay dividends, or make intelligent investments or acquisitions. Before buying a stock, we like to ask ourselves if we would purchase the entire company for its current enterprise value (market capitalization less cash plus debt) if we had to finance the acquisition by borrowing at prevailing interest rates. In general, this discipline prevents us from buying companies at high P-E multiples unless the companies have substantial assets that are not reflected in the price of the stock.

For example, during the quarter, we accumulated positions in a basket of phone companies, including BCE Inc. (BCE), which owns Bell Canada; TelMex (TMX), which dominates the market in Mexico; and SBC Communications (SBC) here in the U.S. The price destruction in the telecom sector has been widespread, but we do not expect people to stop using the telephone and we expect data traffic to continue to grow. These utility-like companies have stable cash flow, pay substantial dividends and are trading as cheaply as they have in a decade.

We also found opportunities in a wide range of other industries. We bought shares in Green Mountain Power (GMP), a small Vermont utility trading near book value with an allowed 11% return on equity and a P-E ratio below 10; First Bancorp Puerto Rico (FBP), the second-largest bank in Puerto Rico with an enviable record of growth and profitability; and Globespan Virata (GSPN), a producer of chipsets enabling high-speed Internet service. As an example of how far some former high-fliers have fallen, GSPN plunged from over $150 per share in 2000 to its current price of $3.50, where it trades at half of book value with a market capitalization only slightly higher than the cash balance the company has in the bank. Similarly we bought shares in Flextronics International (FLEX), the Singapore-based contract electronics manufacturer. The stock has plunged 77.5% in the last year to about $6 a share, where it trades at a fraction of annual sales. While the industries FLEX serves are in a slump, we believe the outsourcing trend in electronics manufacturing remains intact and the company has strong recovery potential to mid-decade.

Finally, we bought shares in Aquila (ILA), an energy producer and marketer headquartered in Kansas City, Mo. As value investors we often will look for opportunities in the most out-of-favor sectors of the market, which carries the risk of further short-term pain. We first looked at ILA after it had been cut in half from its yearly high. We purchased it when it was trading below book value at about 7 times our expected earnings forecast, with a 7% dividend yield. We figured we had some downside protection on ILA, which has substantial physical assets and over the past 16 years has earned an average of $1.41 a year. Unfortunately the stock dropped further after the company announced that in order to maintain its investment-grade credit rating it would curtail its energy trading raise capital through a secondary offering and reduce its dividend. We will continue to hold ILA, which at current prices is trading at about 6 times reduced estimates of current-year earnings.

In addition, we have raised cash levels in most portfolios to be ready to make aggressive purchases if the market has a meltdown; and diversified most accounts to include REITs, international exposure and fixed-income components. In our view, it is desirable to have a portfolio of stocks that are not overly correlated with each other or the S&P 500, thus insuring less volatility than the overall market without sacrificing potential returns.

We congratulate you on your patience through this difficult phase in the market, and are confident you will be rewarded over time for owning a well-balanced portfolio. We noted the other day that if you had bought 100 shares of Home Depot in 1982, your shares would be worth more than $1 million today. Over long periods of time, equities outperform other asset classes. While nobody can know for sure where the market will go in the next month or the next year, we are working hard to make sure you own companies that will grow and prosper in the years ahead.

Sincerely,

Brian C. Baker, CFA
Barnes C. Ellis, RIA