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A CONUNDRUM

The first quarter came to a close with a bit of a whimper caused primarily by yet another interest rate increase by the Federal Reserve. Over the quarter, however, equity markets behaved quite well while bonds did poorly.

It was another quarter in which small companies did much better than their large brethren. Blue Chips lagged broader market averages once again, causing much concern and consternation amongst high-quality oriented longterm investors. It was even worse if you held the absolute leaders in their industries. The March 20 issue of Fortune Magazine featured an article entitled First, examining the misfortunes of the biggest and the best, concluding that being #1 in an industry means you become a natural target for competitors. According to the Yearbook, published by Ibbotson Associates, Inc., large company returns so far during the 2000s is –1.1% while small companies have returned +12.8%. One well-known Wall Street strategist has been studying this rate of return divergence in quantitative terms, and has concluded that the numbers suggest a 95% probability for some near term reversion toward a more normal performance relationship between large caps and small caps.

At Cadinha & Co., we have not been spared any of the angst surrounding the underperformance of the “biggest and the best”. As a matter of fact, I have spent a lot of time studying this issue (now that I no longer have corporate administrative duties). Here are my thoughts:

To gain some perspective, consider that the NASDAQ Composite at 2,200 has doubled in the last three years from a low of 1,100, but still remains 56% below the peak set six years ago at 5,000. The Dow Jones Industrial Average, on the other hand, is approximately 6% from its peak set six years ago. Clearly, the NASDAQ must more than double to return to previous highs while the Dow Jones Average need only advance 8%.

In the words of legendary investor Warren Buffett, “The Dow increased from 65 to 11,497 in the 20th Century and that amounts to a gain of 5.3% compounded annually. (Investors would also have received dividends, of course.) To achieve an equal rate of gain in the 21st Century, the Dow will have to rise by December 31, 2099, to—brace yourself—precisely 2,011,011. But I’m willing to settle for 2,000,000; six years into this century, the Dow has gained not at all.”

Today, money is chasing hedge funds, private equity deals and last year’s hottest mutual funds. These vehicles for investing carry high fee levels. For example, a typical hedge fund charges a 2% annual management fee in addition to 20% of all profits. The typical mutual fund charges approximately 2% per year. For the long-term investor in a high-quality stock, there is no fee. If your portfolio of stocks is supervised by a professional, the standard fee is usually 1%…a fraction of the fee charged by mutual funds or hedge funds. Clearly where the fees are lowest, there is little or no hype! Conversely, where fees are high, one can expect an armada of sales people, advertising and promotion. History has taught us to beware of mob psychology and manias. Consequently, I’m always more comfortable investing where there is little company. Today, there is close to $1 trillion chasing hedge funds.

When viewing corporate earnings growth, the evidence shows that smaller companies have grown earnings at a faster rate than larger companies over the last three years. This is undoubtedly the reason for the recent outperformance of “small caps”. How long this rapid earnings growth will continue is a major question in today’s environment, but we feel there is still some time left. For clients who can take some risk, we have chosen to use Exchange Traded Funds (ETFs) for exposure in this area. ETFs will mirror a market segment while mitigating against individual stock risk. They are very inexpensive (another reason we like them) and efficient in that we can be in and out of an area very easily.

The ETF approach is also our way of investing in foreign markets. To date, we have confined our foreign exposure to specific countries exhibiting the right politics and economics. We much prefer to bring a rifle to this hunt than a shotgun. As the sound of Protectionism begins to resonate through the halls of Congress, one can be sure that we are very vigilant with regard to foreign investments.

Cash as an asset class is now paying over 4%, so cash is a viable option for part of many portfolios. Cash gives one the opportunity to invest at lower prices. After all, this is what strategic long-term investing should be about.

Bonds have been victims of higher interest rates and have penalized portfolio returns. We believe that the bond market is near a low and if interest rates reverse, bond investors will be rewarded handsomely. We are confining bond positions to the 5- to 7-year average maturity range, as we do not yet have the confidence to move into longer maturities. A plummeting dollar will be our sign that much higher interest rates are right around the corner, but we frankly don’t see this happening at this point in time.

So where does this all leave us? Clients should expect us to continue using the large high-quality companies as core holdings. We still believe that this area represents a bargain price compared to other options. Small-caps, midcaps, foreign exposure, bonds and cash will be used in varying proportions according to the evolving investment climate and each particular client risk profile. After much introspective thought, I don’t believe “changing our spots” is the prudent thing to do. We will, however, work very diligently at sharpening our skills and tactics.

The environment is giving us mixed signals. Ever-increasing short-term interest rates are likely to be at or near a peak. Any further significant rise will cut into profit margins negating any incentive to borrow money and likely causing an economic slowdown.

Additionally, the high price of oil resulting in a high price of gasoline will likely cut into consumer discretionary spending as we enter the high travel months.

Higher interest rates also mean that adjustable rate mortgages will increase the home carrying costs for many wage earners. This factor, along with the increasing costs of new housing, could point to a consumer-led economic slowdown.

The politics of the country are clearly turning negative. The war in Iraq has put the Bush Administration on the defensive. A Protectionist bias is rearing its ugly head in the form of proposed tariffs for Chinese goods, an immigration bill and legislation against foreign ownership of American corporations. These trends are antigrowth but can be quickly reversed with good, sound leadership. So far, we haven’t seen any such leadership from the Administration or Congress. To borrow an analogy from my favorite sport, Republicans seem to have fumbled the ball on their own six-yard line…but time will tell.

Meanwhile, corporate earnings are strong and American companies are very solvent. These traits are not typical of the end of an economic expansion, so we stay our course, taking it day by day…

We appreciate your continued loyalty and believe that it will be handsomely rewarded in the near future.

About the Author


Harlan J. Cadinha
Founder, Chairman and Chief Strategist
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