July 2007 - From Client Review Letters

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Over the period from March 31, 2000 through June 30, 2007 Standard & Poor’s 500 large stocks have seen the average price to earnings (PE) ratio go from 26 down to 16.  Earnings grew at a respectable rate while the stock prices languished somewhat.  Standard & Poor’s 400 mid-size stocks and Standard & Poor’s 600 small-size stocks essentially maintained the same PE ratio.  Large stocks that once traded at a significant premium to small and mid-size stocks now trade at a discount.  The result is many good large companies with very attractive valuations.  Many of the stocks favored by Eads & Heald Investment Counsel lie in this undervalued area awaiting a change in investor sentiment.

The second quarter of 2007 saw larger stocks doing well relative to mid-size and small-size stocks.  Also, growth stocks generally performed better than value stocks in the quarter.  Moderation in the economy should continue to drive a rotation toward large quality growth stocks.

Stock buybacks and private equity deals continue to propel the market.  The long-term sustainability of these factors driving the market higher is questionable.  Nonetheless, they appear likely to be key factors driving the market in the near term.

Oil prices have again pushed above $70 per barrel.  Some see this as causing the demise of consumer spending.  However, the consumer will likely remain resilient.  With demand likely to outstrip supply for the foreseeable future, elevated energy prices may be around longer than previously expected.

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The sub-prime lending mess continues to linger with many speculating that the worst may be yet to come.  Most financial institutions are exposed in one form or another in ways difficult to quantify due to derivatives, leverage, etc.  Rising mortgage delinquencies along with higher interest rates are contributing to weakness in the housing market.  This may well contribute to weakness in the economy as consumer spending in some sectors has been slowing (e.g., the recent Home Depot earnings warning).

In spite of a slowing U.S. economy, the global economy continues to grow at a strong pace which favors multi-national companies doing business around the world.  U.S. multi-nationals are also benefiting from the falling dollar.

Recent news regarding numerous defective products produced in China may cause some backlash against an already unpopular trading partner.  There are some concerns that incidents such as these could lead to increased trade restrictions.

Rising food and energy costs in the U.S. have contributed to a rise in the overall inflation rate which is likely to keep the Federal Reserve from lowering rates any time soon despite some weakness in the economy.  The Fed is intent on keeping inflation tamed as its first priority.  Through June of this year, consumer price inflation grew at an annualized rate of 6.6%.  However, over the past decade, this number tends to moderate considerably by the end of the year.

The stock market has been remarkably resilient considering all of the negatives that have been thrown at it in recent months.  In spite of the sub-prime/housing mess, higher food and energy prices, a deceleration in earnings growth, a slowing economy, war, political turmoil, etc. the market is pushing toward record highs.  Sentiment among individual investors has remained negative and according to some measures there is still a large amount of cash on the sidelines as the market continues to climb the so-called “wall of worry”.

Some simple truths are worth reviewing periodically.  Ultimately, stock prices rise at the rate of earnings growth.  Over longer time periods the effect of PE changes disappears.  That is, PE’s go up and go down but over time the effect of PE changes is washed out.  Investing in super slow growing stocks or super fast growing stocks is a hard way to accumulate wealth over long periods of time.  Focusing on stocks with growth rates almost double the national norm (say, 13% growth) is a good reasonably conservative middle ground.  Of course, in addition to receiving stock price appreciation due to earnings growth, we also receive stock dividends as a return component.  Albeit a recent somewhat slow period for our type stocks, Eads & Heald Investment Counsel is confident we are well positioned for good longer term appreciation with excellent risk protection by using high quality stocks coupled with broad diversification.

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