CAZ Investments Quarterly Letter

Quarter 3 - 2003

A Pause to Refresh?

The third quarter was characterized by stabilization. The stock markets were relatively benign, while slightly higher. Interest rates saw much lower volatility and rose slightly during the quarter.(?) Corporate profits were fairly consistent and beginning to show signs of improvement. Economic indicators came in more or less as expected, again showing some slight signs of a healthier economy. The geo-political landscape, while still uncertain, was free from any large scale disruptions. During this period, the S&P 500 rose by XX%. The CAZ Cornerstone Portfolio performed better than the market(?) and stretched its sizable advantage vs. its benchmark. We are extremely pleased with the performance of the vast majority of the companies that we own. Valuations certainly are more rich than they were six months ago but, for most of the portfolio, we still feel the market is placing reasonable prices on our companies. There certainly are some stocks that have outpaced their fundamentals, and we are watching those positions very carefully, and in some cases reducing our exposure. Our overall posture is that of “cautious optimism.” For our clients that have been with us for a long time, you will recall that the last time we spoke like this was in 1998. We feel like the market still has room to the upside, but that the risk profile of the market has increased. There are still many very good valuations in the markets and we are excited about our portfolio, it is a simple fact that compelling ideas are harder to find.

As we stated in our last letter, this is a critical juncture for the markets. Valuations have risen dramatically and earnings have to match or exceed expectations for these valuations to hold. As of October 20, 159 members of the S&P 500 had reported earnings for the 3rd quarter. Of those, 81.1% had met or beaten expectations. This is an improvement over the 2nd quarter when 75.5% had delivered results above expectations. This is encouraging and we will be watching closely each and every company in our portfolio for their results versus our expectations. The most dramatic results have come from companies that have seen significant benefits from cost cutting measures. As we illustrated in our last letter with Merrill Lynch, when the revenues begin to improve for these companies that have trimmed expenses dramatically, the expansion of profitability is magnificent. The challenge for these companies is to find a way to accelerate revenue growth in a still sluggish economy. Most all of our companies have started to see fairly consistent increases in demand, but not increases that we would consider dramatic. This top line growth will be one of the most important metrics that we will watch in coming quarters as we know the cost cutting benefits are close to fully utilized.

The news on the job front is starting to improve and has gotten tremendous amounts of attention. The September employment report showed a nice gain in jobs, and manufacturing hours worked increased. A forward indicator that we like to watch, temporary employment, experienced its fifth straight increase. At some point companies will stop hiring temporary help and add to their permanent payroll. We also feel that it is important to take a step back at historical rates of unemployment. During the 1982 recession unemployment reached 11%. In 1992 the highest level was 8%. Therefore the current level of 6.1% is not outside of historical norms and, one could argue, very mild compared to recessions past. This is why we are not more concerned about the apparent lack of jobs growth, but it is a statistic that stays firmly planted on our radar screen.

Psychology and the “three P’s”

The bigger question is what is the outlook for jobs creation going forward? We feel that the there will be two factors that will dramatically effect jobs growth over the next few years, psychology and productivity maximization. As many companies realized that they needed to reduce their cost structures, they began to take aggressive measures. This psychology is slow to turn around. People must be more confident in order to stop cutting, and extremely optimistic to start adding staff. Usually the actual increases do not occur until well after the recovery is under way. There is a very clear pattern in the investment banking/brokerage business. It seems they are always clamoring to add more people when the market is hitting all time highs and then they seem to finish laying off people right around the time the market bottoms. This last cycle was no exception. Unfortunately, corporate America across all industries seems to suffer the same fate. It is an interesting psychological study and it repeats itself like clockwork.

The second area that is going to effect jobs growth is productivity maximization. In times like this the main question on everyone’s mind is, “how do we save money?” This causes companies to first make “easy cuts”. We refer to this as “the three P’s”, people, perks and palaces. They cut payroll, excess expenses from travel and rewards and luxuries, as well as real estate. After that saving money becomes more ambiguous and so companies begin to seek savings from technology projects and outsourcing. All of these are very good steps for a company to take and improves profit margins, but none of it requires new hires. In many cases these actions drive more payroll cuts, as many times companies find that computers can do more and more the role of a person and they can farm out a task for less than they can hire it to be done internally. We are on record in the early 90’s stating that one of the biggest challenges we saw for general employment in the future would be the fact that more and more companies would be able to replace people with machines. Machines driven by more and more sophisticated technology can work longer and cheaper. They don’t get sick, take vacations, or demand a raise etc. We think we are in the mid stages of this phenomenon. The other issue that continues to effect job growth in the U.S. is the continued movement of jobs offshore, particularly in technology. In many cases companies can hire workers internationally that are just as capable, for a literal fraction of the cost. While we love the effect that this practice has on profit margins, we are concerned about the long term effects on the job market and economy of the U.S. We believe that these factors will continue to be a drag on jobs growth and we will watch closely how this drives end demand for goods and services, and therefore revenues, of the companies we own.

The Worse the Better

The markets appetite for risk has continued to expand and we felt it would be helpful to update the chart we posted last quarter. Many clients were shocked to see how dramatically the “worst” companies stocks performed. Nothing in the 3rd quarter changed the phenomena, it actually expanded. As you can see from the chart below, the lowest quality companies, measured by financial strength, have increased in price by 57.8%. Compare this to the “best” companies, whose stock prices have risen by only 14.5%.

2003 3Q

This is very disconcerting and creates some concern in our minds from the return to speculative behavior. How perverse has this become? As of, October 9th there were approximately 195 companies in the S & P 1500 (The 1500 largest companies in the U.S. tracked by Standard and Poor’s) that had operating losses in the previous four quarters and there were 1305 companies that had operating profits. Over this period from the markets lows in October the profitable group had rallied substantially. That can be expected in a market recovery. What is shocking is how the companies that lost money in their business over that period rose by more than 100%. This is a very bizarre statistic and one that can not continue for an extended period of time. In the short run the market can be irrational but, over the long-term profits and cash flow drive stock prices. We have delivered superior results and have done so without changing our approach. We are not going to change now.

The focal point of the next six months will be profits, profits and profits. Companies, so far, are delivering the results. As long as the expectations continue to be met, this market can move higher. We continue to love our portfolio companies and look forward to what they will achieve in this better geo-political and economic environment. As always, if you have any questions or suggestions as to how we can serve you better, please let us know. We appreciate the confidence you have in us.

All our best,

CAZ Investments