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Capital Markets Perspective Fall 2003


Percentage Change
S&P 500
Long Bond Yield
1-Jan-03 to 30-Sep-03 13.25% 56.52% 1.05%
52 weeks prior to 30-Sep-03 19.20% 30.43% 6.50%
Estimated FY 2003 P/E 28.7 P/E    
Estimated FY 2004 P/E 19 P/E    


What Were They Thinking?

Is it possible that Bill Gross, Warren Buffet and Jeremy Grantham could know a thing or two about investing? Or are they are getting old? Becoming wealthy and complacent, loosing the vigor for taking the risk inherent in investing? Well, it is true that the prospect of poverty, when one has some assets, may serve as a determining motivation.

What these three investment sages of respectively Pimco, Berkshire Hathaway, and Grantham MayoVanOtterloo, with their combined successful investing experience exceeding 90 years, and stewardship of over $100 billion are saying is, that there is nothing they like at the moment.

Stocks, bonds, REITS, commodities, they say, all look pricey, and taut with the risk of excessive valuation.  Warren Buffet, whose firm has $6 billion in cash, said in an interview that he's seen similar environments, and while it is a challenge, he has the patience to wait out current (high) valuations, for more reasonably priced investment opportunities.


Capital Market Review - First Three Quarters

Stocks started the year at near all time high valuations based on earnings. That was before the year-to-date run-up in prices of approximately 13.25% for the S&P500. Earnings have increased, but not nearly 25%. The earnings growth has been due largely to cost control -read, layoffs. This is one of the great things about America. Few countries would tolerate dismissing millions of workers, and the havoc wrested on the lives of these individuals and their families.

Other driving forces of increasing corporate earnings are new money from consumers re-financing their houses, tax cuts and the wealth-affect of home owner's increased spending. The importance of housing can not be underestimated. Lester Thurow was kind enough to send us a copy of his seminal new work, Fortune Favors the Bold.  Lester states, "For 90 percent of American families, the value of their home is at least three times as important as the value of their stock market portfolios."

None of these factors: lay-offs, re-financing, tax cuts will sustain growing sales and earnings which are essential for investment and a growing economy. It does appear, however, that economic activity is increasing.

We've always heard, and believed, that the most reliable leading economic indicator is the stock market. The stock market is up, earnings are increasing, job prospects may be brightening, housing stays strong, mergers and acquisitions increase. When Saks 5th Ave. has a four-fold profit increase reportedly based on increased  sales of women's evening dresses and hand bags, one thinks there are more parties to attend, and more money to carry around.


What Does It Mean

Standard & Poors ranks stocks in three groups based on credit quality: A, B, and C. A companies have strong balance sheets. C companies have weak credit ratings, but are not in bankruptcy. B are between. For the first three quarters of 2003 the stock market value of A firms increased 5%, B firms increased 15%, and C firms increased 25%. The weaker a firms credit quality, the more its stock price increased during the first three-quarters of 2003.

One interpretation of the A, B, C phenomena, is that the markets have become more speculative. Reflect on the recent bubble. Stocks which appreciated most were those with the riskiest earnings prospects, and greatest losses. As a measure of the near insanity, our friend, Dr. Larry Pholman, Research Director at PanAgora, reminds us that in 1999 companies were valued on 'clicks'. During this bubble epoch, old-line like firms, like Proctor & Gamble, Pfizer, and Berkshire Hathaway, declined in value.

The other interpretation of the A, B, C's is that investors sense a genuine economic improvement. Earnings will increase the credit quality of C companies. C companies will have the opportunity to become B rated. As their earnings and credit quality rise, share prices will increase doubly compared to A firms, and C companies will represent greater long term investment opportunities.

Which interpretation is correct; how much do you want to bet on the second scenario, and at what stage of the stock price curve?


A Great Investment Opportunity, Getting In At The Beginning?


A Long Term Investor In The Japan Stock Market Lost 80%


Current Investment Perspective

Does it sound like we at Davidge & Co, along with the great investment sages, are pessimistic? The answer is yes, guardedly so. We consider the positive signs in contrast to many negative factors: the potential for rising interest rates, the exceedingly high valuations in virtually every investment sector, tepid job creation, contraction of the money supply, the large current account deficit, low factory utilization, the 'China' factor.

The investment environment has become markedly more challenging from the beginning of the year to the present. We have been fortunate to have performed most of our re-balancing toward the beginning of the year.


What Has Been Working?

Master Limited Partnerships MLP
We invested heavily in these starting 18 months ago. Yields based on purchase price have risen to an average of 9%, and the unit prices have appreciated approximately 23% which yields a total return of 31%.
12 to 18 months ago, after a terrific run-up while the market was collapsing, we felt the underlying economic trend was dodgy for office space, apartments, shopping centers. We reduced holdings. The total return in the first 3/4's was 24.5%. Reducing REITS was mitigated by the movement into MLP's
We have stuck to municipal bonds with maturities of mid-term or less, and the middle of the credit range. This has provided nice yields in the 5 - 7% range, while limiting interest rate risk.
Some Equity Purchases
Our purchases of Verizon and SBC have declined modestly. The fact that these represent defensive holdings, backed-up by substantial assets, income generating ability, and a nearly 5% dividend, consoles us.
Most Equity Purchases
Our value oriented equity purchases have done well, some doubling or tripling. Most also provide a yield in the 2-4% range. The selection criteria follow our standard criteria, outlined in the Summer Investment Letter.


We continue to find opportunities in mid-term municipal and corporate bonds, where we try to keep funds available should there be a market correction.  Most of our clients have substantial equity portfolio's.  We have continued to lighten-up on equities as Stock-Bond-MLP-REIT-Foreign-Commodity ratio's have exceeded the targets for individuals.

If you would like to discuss a complimentary portfolio evaluation, please contact John Davidge at 212-292-4256.

2005 Davidge&Co. All rights reserved.

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