CAZ Investments Quarterly Letter
Quarter 4 - 2006
The market was very kind to us in 2006, and investors were rewarded for their patience with strong double-digit returns. The rally from the lows in July was not unprecedented, but was very impressive. Even more striking was how the market increase was almost completely unabated. The largest pullback the S&P 500 experienced during that 6½ month rally was only a bit more than 2%! This is very uncommon, but we are certainly not going to complain. Well, maybe we will take issue with it, but more about that later…
What caused the surprise upside in the markets in 2006? As we stated in our letters this year, we were looking for 10-11% cash flow growth and an approximately 2-4% pullback in valuations. Both of these metrics proved to be conservative. The companies we own delivered cash flow growth that was higher than we expected, and the market slightly expanded valuations during the year. These two factors allowed our portfolios to increase by approximately 15% for the year which was well above expectations.
How did it happen?
What caused this pleasant surprise? There were several factors that allowed the market to perform so well:
The above factors were somewhat surprising, but we also saw some positives occur that were expected by most investors. The Federal Reserve stopped increasing interest rates. Company balance sheets continued to get stronger. More companies chose to be acquired and go private. All of these factors also helped lift equity values.
Enough celebrating. Where do we go from here?
Let’s talk about what we know at this point. These are things that are obvious as we enter 2007:
None of the factors above are definitive reasons for concern, but they cannot be ignored. There are the typical uncertainties we have documented before (geo-political, etc.) but none of those are quantifiable or predictable. Therefore, let’s focus on what we do know and what we project for the year.
This is what we believe will occur in 2007:
That’s all well and good, but what does it mean for me?
The net result of all of these projections is we are more cautious as we enter 2007 than we have been in several years. Let us be TOTALLY clear—we are NOT bearish. We are NOT forecasting a dramatic decline in stock prices for 2007. We are advising people to not be complacent. We are emphatically encouraging people to assess their risk tolerance and take a fresh look at their asset allocation. Make certain you are comfortable with the potential volatility in your portfolio. This is not a time to be greedy. This is a time to be prudent.
We showed a chart last year of the Volatility Index (VIX) and commented on how it was at historic lows. Well, if you recall, volatility did indeed spike in the 2nd quarter of 2006 (actually, it more than doubled), and it caught a LOT of investors off guard. The interesting thing to note is how quickly volatility dissipated, and now we have a situation where today’s level is actually LOWER than it was a year ago. Mark it down, volatility will be higher this year than it is today, and every investor must factor that into their allocation decisions for 2007.
As stated above we are looking for 9-10% cash flow growth and potentially a 3-5% decrease in valuations. This generates an expectation of approximately 4% to 7% upside for the year. While this is not an exciting number, it is still positive, and we believe 2006 simply borrowed some of the return from 2007.
Now, what could cause our estimates to be too conservative?
This is a time of sensible opportunity, and we believe when the volatility increases it will create attractive entry points into selective stocks. We have been quoted in the media that we would be more comfortable with the market if it were 5-8% cheaper. This is definitely the case as we feel the risk/reward picture would be more favorable. We may not see that pullback, but every investor should be prepared and should feel comfortable with the impact it would have on their portfolio value.
On the housekeeping front, with this letter you will find your 4th quarter Portfolio Review. As always, this report includes a summary of your realized gain and loss information for the quarter AND for the entire year. The report is also broken down by short term and long term gains so, for a taxable account, your tax preparation should be simple.
We appreciate your confidence in us and while we are celebrating an extremely profitable 2006, know that we are continually focused on creating solid results for you in 2007. We hope that this year brings many blessings to you and your family.
All my very best,
Christopher Alan Zook