Quarterly Commentary:
October 2006
Housekeeping
We are substantially redesigning our website at www.prassascapital.com. There is already quite a bit of information on the current site, masterfully hidden under a relatively blank front page. The material will become much easier to access, and should add support and perspective to our Commentaries. We will also add a blog. Too many events occur to limit communication to a quarterly basis. We had hoped the site would be done by now. We will e-mail everyone when it is complete, and look forward to your comments.
The Quarter in Review
We generally look at each of the various market indices to illustrate the relative strength and weakness in the market for the past quarter. This time we believe it is at best, irrelevant and at worst, misleading. Interest rates have fallen, apparently in anticipation of a pending recession. The overall stock market, in response to lower rates and declining energy costs, rallied somewhat in anticipation of a “soft economic landing” and a Federal Reserve rate cut in January. The reaction of the stock and bond markets are contradictory and, in our view, utterly absurd. We feel this is one of those many examples of market noise and as such, not worthy of acknowledgement.
We had substantial profits until about mid-August, when our wonderful gains in oil, natural gas, and coal evaporated as bonds rallied and defensive stocks came into favor. We ended the quarter relatively flat in spite of the dramatic sell-off; a validation, in our view, of our risk-mitigation strategy of buying cheap, yield-bearing securities. We are still satisfied with our positions, at our cost basis, but the market volatility has been startling.
Strategy for the Fourth Quarter
We see risks mounting as the indices flirt with record market highs while the “costs” of business (interest rates, energy, and raw material) threaten to climb, and climb quickly. Even during the last six weeks when “cost” prices fell, stock markets rallied in anticipation of a “gentle recession.” The reward of a few percentage points is dwarfed by the perceived risk.
We are in the hard landing opinion camp, particularly at these prices levels. Borrowing is still cheap and easy, reflecting no risk premium or default risk. We also believe it is a zero-sum game between the costs of business, and the markets as a whole. As interest rates, energy and other costs increase, we are unable to be optimistic about the overall market. In fact, we are more inclined to short the overall market if we took any position at all.
Tactics for Fourth Quarter
Equities
Energy/Commodities. We believe there is a self-correcting nature to any pronounced decline. Natural resource companies can (and have) reduced output in response to lower prices. And economic growth is sufficient in other parts of the world to assure demand in all but the most significant slowdown. But commodities markets do behave differently. Oil prices can decline by 40%-50% and still be in a bull market. Volatility alone (in any asset class) does not invalidate the underlying trend.
We especially like royalty trusts because, if we get our cost basis right, there is very little that can go wrong. Particularly, we like the fact that management cannot mismanage or plunder the asset. Unless, of course, they let the damn pipes corrode. We had substantial gains and income from the Prudhoe Bay Royalty Trust (BPT) until corrosion was discovered, and the price melted back to about our cost basis. We continue to collect the dividend and are patient until oil price increases return. But jeez…
San Juan Royalty Trust (SJT) continues to break our heart as natural gas prices bottom. But again, we collect about 10-11% dividend as we wait. Natural gas is the most undervalued of the energy plays.
Southern Peru Copper (PCU), the third of our core holdings, has done well. We have about a 20% capital gain, in addition to collecting about 11% dividend.
There are a smattering of other companies we will trade as the opportunity presents itself: Valero (U.S. oil refiner), Peabody Coal, Chesapeake Energy (natural gas), others.
We have taken our eye off foreign equities, as most merely duplicate the commodities exposure we already have. We may watch a few Latin America countries, but are otherwise inclined to stand firm this quarter.
U.S equities. We see a trend-less market as higher energy/natural resource prices eat into mainstream business earnings and are, by definition, bad for the economy. As we are optimistic for energy and metal prices, we must be cautious about the general market in accordance with our own theory. At best, there may be brief trading opportunities (such as the last six weeks), but we are often not smart or nimble enough to effectively catch them.
Real Estate. While some commercial (especially apartment) REITS have done well over the past year, the fundamentals are so bad for most categories that we would urge our clients to reconsider any holdings. We ourselves are quite active in the 1031 exchange market for very select properties, but cannot imagine the investment of after-tax dollars for the foreseeable future.
Fixed-income
We believe long-term bonds are the most risky investment on Wall Street. And we believe dramatically higher interest rates will at some point be triggered by a noteworthy default, probably a real estate or construction firm. As such, we must dismiss the entire asset class other than the following exceptions:
The Rydex Juno fund is a derivative fund that is one of the few vehicles for a rising long interest rate market. We may take a small position to hedge the balance of the portfolio, if we can find comfort in an appropriate price. It is a viable tool, but much more of a speculative vehicle than we are often comfortable using.
Adjustable-rate bank loan funds are the only logical fixed income investment in a rising interest rate market. Yields are currently about 8.5%, and prices are generally stable. These funds are not as attractive as the royalty trusts, which pay better and have better capital appreciation potential. However, at times we will sell our core holdings if prices rally too high, too quickly. These bank loan funds are an appropriate parking place for idle funds, or during periods of market uncertainty.