Market Watch - November 24, 2006

Millhalf's Market Portfolio Up 14% For The Year

Dr. and Mrs. Millhalf’s grandchildren’s portfolio has passed its first anniversary with very good results. Their portfolio is up 14.2% in the first year. During that same time the Dow Jones Industrial Average was up 14.4%. The Millhalf’s original goals were to invest $500,000 for their grandchildren in A-rated securities. They were interested in purchasing companies that paid a high dividend yield and that dominated their industries. Their dream is to see their grandchildren’s money grow at 15% a year.

Mrs. Millhalf: I remember when we started this a year ago and Market Watch pointed out that the Dow gained an average return for investors of about 10.5% since World War II. Our 14.2% return beats the long term average. But, last year the portfolio gained less than the Dow Jones Industrial Average.
Market Watch: The Dow is only a tool to gauge ones overall investment gain against the 30 most dominant companies in the world. To compare your portfolio with the Dow would require taking the Tax Free Bonds out of your portfolio so just the stocks in the portfolio could be compared to the Dow.

Dr. Millhalf: More than 50% of our portfolio is still in tax free securities and not invested in stocks. The “tax frees” have only increased in value from interest payments of about 4%. So the stocks in our portfolio must have out performed the Dow stocks.
Market Watch: You are correct. Your stocks were up 38% as compared to the Dow stocks that were up 14%. Also, your gold investments gained 30%.

Mrs. Millhalf: I have heard the expression that “cash is trash”. With returns like this, why don’t we get rid of all our money market cash and buy more stocks.
Market Watch: When you started investing in this portfolio, you pointed out how important you felt it was to be invested safely. You and Dr. Millhalf decided that you would use the tried and true Dow Theory of value investing and apply that theory to securities as Warren Buffet has applied it. Mr. Buffet’s philosophy is to buy larger positions in great, but fewer, companies. Using that theory of investment, last year there were not many undervalued securities available that met your requirements as dominant companies in their industry that paid a high cash dividend, and that were selling below their historical price earnings average. You have accumulated some fantastic companies. These industries were undervalued last year: banks, tobacco stocks and drug stocks. You own one of the best companies in each industry, and you purchased them at the right price.

Mrs. Millhalf: Will we be able to find some more good securities this year?
Market Watch: One never knows. The only thing an investor can do is establish their own criteria as you have, and then stick with that criteria rigidly. When these top stocks become available, buy them. But wait until they become available based upon your investment parameters.

Mrs. Millhalf: I just worry that we might miss the market—no pun intended. How much higher can the market go? It’s already exceeded records set in the year 2000. It’s over 12,000, and it seems to be gaining every day.
Market Watch: It’s possible you could miss a big surge in stock values. Such a surge, however, is unlikely as the market is currently hovering at price earnings ratios equal to its all-time highs. By purchasing stocks now that do not meet your criteria, your portfolio is exposed to a greater potential degree of loss should the market turn around in a direction towards its average long term values. With all the negative economic problems existing today, which we have discussed in the past, the market could go down quickly in the event of any one, or more, of these looming economic catastrophes materializing. If the market were to return to only it’s average historical price-earnings values, the Dow would sink below 10,000 points.

Mrs. Millhalf: Not to be greedy, but I would like to hone in a little more on this 38% gain in our stocks last year. 38% is almost three times as much as the 14% produced by the Dow. Wouldn’t it have been better to reduce the cash part of our portfolio and to have purchased two or more of the great companies in each of the industries that Market Watch mentioned was depressed last year? As it is we only bought one stock in each of those industries.
Market Watch: A lot of people invest money that way. As you can see, that can be very profitable. The essence of investment management, however, is the management of risk, not the management of returns. Well managed portfolios start with this precept, and over a period of many years, if 15% compounded portfolio returns can be obtained, wealth doubles every five years. There is no answer to your question other than pointing out that we could have obtained higher gains. But in the meantime, you would have incurred substantially more risk. Remember that this has been a very good year in the stock market. A downturn in the market last year would be yielding an entirely different conversation than we are now having. It is frugle to always remember that part of your job entails risk management, and risk management means not losing money.

Dr. Millhalf: What is the outlook for the market next year?
Market Watch: That is a question with no answer. Why is the market going up at all with the real estate industry currently suffering, corporate earnings expected to go down, record trade and budget deficits, and consumer spending, which represents almost 70% of our GDP, decreasing?

Last year saw hundreds of hedge funds go out of business. The Bank for International Settlements recently pointed out that the global market for derivatives soared to a record of $370 trillion in the first half of 2006. This kind of euphoria in derivative trading has never been seen before. Derivatives were initially designed for hedging. They have now become instruments of trade. The $370 trillion mentioned above exceeds world-wide wealth by almost 4 times! What happens if all these contracts turn against the market?

The hedge fund Amaranth a few months ago took a position on the wrong side of the natural gas market. In days the fund lost billions of dollars causing it to liquidate its entire portfolio and wiping out a considerable amount of the capital of many investors. Amaranth’s problems created a whole bunch of complicated credit swaps in London that had the London markets teetering on the verge of catastrophe for a few days. This was a “little” hedge fund. Imagine the problems that could ensue from the forced liquidation of a bigger hedge fund, or several hedge funds at the same time.

Conclusion

While we do not know what will happen next year that could affect your portfolio, you do have a plan based upon Dow Theory that focus’ your purchases of securities strictly upon values. As long as you stick with that plan, you will stay even with, or ahead, of the market. If you deviate from that plan, risk only increases.

Caveat Emptor.
George Rauch
November 24, 2006