2005: A Positive Year for Equity

By Harvey Rowen, Starmont Asset Management, Keiretsu Forum Member hrowen@starmont.com

2004 In Review

It is said that the stock market is driven by greed and fear. If that is true, than 2004 certainly was dominated by fear. Fear of a terrorist attack at the Olympic Games in Athens; fear of a terrorist attack at the Republican convention in New York; fear of a Madrid like terrorist attack prior to the November elections; fear that those elections would not produce a clear winner and the United States would endure weeks if not months of uncertainty about who the President was going to be; fear that spiking oil prices would damage or reverse economic growth; fear that the Fed would raise interest rates further and faster than the economy could stand.

As a result of these fears domestic and international equity markets were down through the first three quarters of 2004. Than the fear abated, and the equity markets staged an impressive rally, and finished up for the year. For the year 2004 the Russell 3000 Index (domestic equity) was up 10.1% and the EAFE Index (non U.S. developed country markets) was up 20.1%.

For the fifth year in a row (since the bubble burst in March 2000) small cap stocks did better than large cap stocks, and “value” stocks did better than “growth” stocks. So small value did the best, large growth did the worst. Just the opposite of the bubble years of 1998 and 1999.

For the second year in a row, stocks of companies headquartered outside the United States did better than those domiciled here. Like 2003 much of this had to do with the declining value of the dollar, and the boost that gave to the profits of those companies when their profits were translated from the home currency into dollars.

2005—Equity Up, Bonds Down

What will 2005 bring? Starmont’s complete 2005 forecast appears in the December 31st edition of the East Bay Business Times, and can be accessed by going to www.starmont.com and clicking on the Articles button. In short, we believe that 2005 will be a positive year for the equity markets. GDP will be high enough to support job growth, but not high enough to cause significant inflation. So the Fed will continue to raise interest rates, but at a measured pace. This will allow corporate profits to grow, but at a slower pace than the last two years. Equity prices will rise, but not spectacularly.

As a result, more investors will be looking for alternative investments that promise higher returns, although at a higher risk. Private equity will be in demand, but hedge funds will lose some appeal as new disclosure requirements cause a scandal in the hedge fund industry.

We expect there to be a rotation in leadership, with large cap and growth taking over leadership from small cap and value. Five years is a long time for any sector of the market to lead. We also expect the return on international stocks to decline from the very high levels of 2003 and 2004 as the value of the dollar stabilizes. But a portfolio should be diversified and contain domestic and international stocks, small cap and large cap, value and growth. How much of each depends on what your objectives are, over what period of time, and how much risk you are comfortable with.

Fixed Income and Real Estate Markets

These were the real surprises of 2004.

The chief investment officer of one large financial institution called the 2004 bond market “a miracle.” What was miraculous is that while the Fed was increasing short term interest rates in 2004, intermediate and long term rates (as measured by the yield on the 10 year Treasury bond) were falling, and thus intermediate and long term bond prices were rising. Indeed the Lehman Brothers Aggregate Bond Index (an intermediate term bond index) was up 4.3% for 2004 notwithstanding the Fed raising short term rates five times in 2004.

Starmont does not expect another bond miracle in 2005. The Fed has made clear that it will continue to raise short term interest rates, and we expect intermediate and long rates to rise as well. The yield on the 10 year Treasury bond as we write this the second week of January is around 4.2%. We expect it to be over 5% by the end of the year, with a corresponding decline in bond prices.

Rising interest rates mean rising mortgage rates, which should slow the increase in home prices and the pace of home sales. Commercial real estate should be less affected, as businesses hire new people and need a place to put them, and they in turn travel and shop. REITs were the highest yielding sector of the market in 2004, with the REIT index up 30.8%. We do not expect that again, but holding real estate in your investment portfolio is a good diversifier.

Starmont believes that all portfolios also should contain an allocation to fixed income, since bonds are less volatile than stocks, and provide a “shock absorber” when the equity market hits bumps in the road. But in a rising rate environment, bond portfolios should have short to intermediate durations. And some exposure to foreign bonds, easiest done through a foreign bond fund, will add to a portfolio’s value since foreign central banks are not raising rates like our own Fed is doing, so foreign bond prices will not be declining at the rate ours are likely to decline.

The Role of Valuation in the Investment Decision

By Steven Kam (kam@houlihan.com), Managing Principal of the San Francisco office of Houlihan Valuation Advisors

So many times I have participated in presentations and listened to the entrepreneur summarize his expectations for growth and projections of cash flows and assign a multiple to one or both of these metrics and conclude with an exit price that is five, or ten or more times the value he has placed on the company today. Often the logic and progression of assumptions hold together throughout the short presentation, and are supported by the multicolored power point slide show. But then come the audience questions; some of which are informed, and others reflecting interest it specific points delivered in the formal remarks, but not particularly useful to the decision process.

So, what should a private investor know and how will he confirm his understandings sufficiently to make an informed investment decision? Said differently, what should the fellow seeking money cover, how should he present his points, and what should he bring to bear to support his proposition of value that is so thorough that the private investor writes the check?

When we approach the subject of valuation together, we must talk about risk, and returns, and timing, and identifiable market proxies in addition to the generally held notions stemming from unsubstantiated conclusions asserted by people whom we believe to be in a position to know, but who are obviously on the opposite side of the transaction from the investor. Sellers and buyers can differ materially on their respective perceptions, but still be motivated enough by personal needs to consummate a deal.

Below, I will talk about some of the issues, questions, and answers that everyone should be talking about relative to an informed investment decision from a financial point of view. This is an article that distinguishes, in a practical manner, a Valuation from a Schmaluation.

When the seller (that is the entrepreneur who is trying to sell investors shares in his company in exchange for cash investment in his start-up venture) begins the company valuation discussion by telling the prospective investors that the company is worth three million dollars pre-money and after this one million dollar round will be worth four million dollars post-money, the first thing that comes to the investor’s mind is: “Thank you for the arithmetic lesson.”

Often times, entrepreneurs show their projections without underlying assumptions and a basic tactical plan of how the execution of certain activities will produce customers and generate revenues. The investor expects that these activities will be brought to the bottom line and represent positive cash flow. Now this is really important, because the future cash flow of the company is the critical element to the investor’s decision. That’s the piece of the story that determines whether the investment dollars will make an adequate amount of money to justify having a stake in the company’s future.

Every presentation should address the internal rate of return on a highly risky business. The investor needs to assess the annual rate of return on his investment in order to see whether he is being compensated adequately for the uncertainty of the company’s projected future cash flows actually coming to pass. This risk/return analysis on investment can be likened to the credit officer’s determination of the appropriate interest rate on a bank loan, only here becomes a much, much higher rate because the uncertainty, which can be measured and quantified through a risk factor, is much, much higher than the uncertainty associated with the payback of loan principal.

Further, when the entrepreneur tells the investor to expect five, ten, or twenty times return on his/her investment without solid empirical data as to how he can say these things, the premise for the investment is both hollow and wrongheaded in the first place. A five times return on investment dollars in three years is far different to the investor than a five times return in seven years. The holding period is critical to the calculation of the internal rate of return on investment. A return of six times on investment in one company in five years could have a lower or higher internal rate of return than another with seven times return on investment over six years. The investor is owed an explanation regarding the uncertainties of the future cash flows of alternative investments and has a clear picture of the expected annual returns on each in order to make that informed decision.

Next, what is the genesis of the entrepreneur’s multiples? You know, when he says he priced his start-up venture today based on the multiple of revenues or EBITDA or net cash flow of other similar companies, or on multiples of similar companies that recently were purchased by a financial or strategic buyer. What similar companies? And how does or will the subject company stack-up to the ones he is identifying as comparables? Are they truly comparable and how do the differences (such as operating strengths, financial weakness, business model, diversification, growth rate of revenues, respective competitive market advantages) get translated into the appropriate multiple to be applied to the subject’s metrics like revenues and cash flow? He better have a terrific explanation if he compares his start-up venture to a highly branded company and declares they are both getting the same multiple in the market. Otherwise its checkout time; take a moment to ponder your golf game.

We want lots of support for every assertion. We need presentation on meaningful ways to gauge an investment’s merits. Finally, if the presenter’s remarks sound like too much pie-in-the-sky, he must assure the investor of what steps he took in his attempt to develop supporting data and what conclusions he draws from its absence.

In the next Issue of the K-4 Newsletter, reconciling ten times return with the appropriate internal rate of return and the relationship, if any, in the pricing of branded companies and venture start-ups.

Financial Markets, 2004-2005
By Dr. Tapan Munroe tapan@munroeconsulting.com

Investors welcomed the outcome of the November 2004 election despite concerns about rising interest rates, high oil prices (toping at $55 a barrel), and a prolonged war in Iraq. The stock market ended 2004 with a “Bush Surge” after the election. This was good news for most businesses as it meant more government and private spending, lower taxes, and a pro-business administration in Washington, D.C.

For most of the year the market drifted until the last couple of months of the year. With the reelection of the President (clearer political outlook) as well as a drop in oil prices that were rising ominously for many months' things turned around for the stock market. Much of the gain for the year came after the election—this was a Red-Sox like comeback for the market. What could have been a ho-hum year at best became a reasonably good year by historical standards.

Here are the financial market numbers for 2004:
The S&P Index added 9% for the year, the Nasdaq 8.6%, and the Dow 3.15%. As a prudent investor you did very well if your stock portfolio beat the S&P.

The market’s late comeback was not just a fluke. There were significant economic factors that helped the market’s surge at year-end by outweighing the many negatives that included rising oil prices, growing federal deficit, and the declining dollar. They included 1) rising GDP throughout the year (~4% real growth), 2) improving job market – a major concern in this economic recovery, 3) Reasonable level of unemployment-- 5.5%, a little lower than when George Bush took over the Presidency four years ago, 4) Improving consumer confidence, 5) rapid increase in household net worth in 2004-mostly a result of rising home values, 6) impressive corporate profits –increase of 75% in the last three years, 7) moderate inflation, and, 8) historically low real short term interest rates despite five preemptive rate increases by the Fed in the second half of 2004 in order to prevent inflationary pressures from building up in the economy.

Compared to 2003 when the Dow and the S&P rose by more than 25% and the Nasdaq by 50% stock market results for 2004 were lackluster. But let us not forget that 2003 was an unusual year in that the market was recovering from the painful Dot-Com boom bust cycle. Only those of us who are “irrationally exuberant” were expecting a repeat of 2003 in 2004.

In 2004 the best performing sectors of the S&P 500 were energy (up nearly 29%), utilities (up nearly20%), and telecom (up 16%), respectively. The year-end “Red-Sox” like rally helped out the three beleaguered sectors---healthcare, information technology, and consumer staples as investors felt more reassured about the political and economic outlook.

It would surprise many of us to know that the best performing stock of 2004 was K-Mart (up 313%) and not Google (up by 100% since IPO in August 2004.) as I expected .It is an amazing story— an Old Economy company, K-Mart, came out of bankruptcy in 2003,bought out the American icon, Sears, Roebuck in November 2004, to become the largest retailer in the U.S. Another success story was Apple Computer (up 201%)—its success to a large extent was because of the iPod and eye-catching design of its products. The success of Starbucks (up 88%) confirms that in the 21st century marrying a mild addiction (coffee) with a seductive environment that includes Internet connections is a winning formula.

The year 2004 was good for IPO’s with 250 deals and total proceeds of nearly $49 billion—a gain of nearly 300% over 2003.The IPO level is comparable to the amount of dollars raised in 1998 ($46) the year prior to the dot-com boom year of 1999 ($65 billion). Undoubtedly Google was the IPO star of 2004—an extraordinary company -- loyal users around the world with its spectacular growth, and selling its stock via an on-line auction system, and smart acquisitions throughout the year The best news is that most IPO’s made money for its investors with average stock appreciation of 32 % in 2004.It is the best financial performance for IPO’s since the boom year of 1999.What are the IPO prospects for 2005? They look good with promising and well-established companies in the pipeline such as Dolby Systems (San Francisco), FTD.com (online florists), and Morningstar Research. Although the supply of new prospects is excellent the actual deal outcome will depend on the state of the economy and investor optimism.

One of the real surprises of 2004 was the bond market. It was truly unsinkable and really defied expectations, as there were several reasons for bond prices to decline. With the economy growing stronger, the Fed raising interest rates with the expectation of rising inflation, and a sliding dollar (also inflationary), the bond market was supposed to fizzle. Surprising the pundits the bond market did not go into the tank. What actually happened is that the yield on the 10-year Treasury note (benchmark for most long term lending including mortgage rates) declined slightly in 2004.This means bond prices held up well in 2004 against heavy odds. The most likely explanation would be that investors view the Fed action to be prudent and sufficient to contain inflation in the coming months. It will be amazing to see if bond prices can repeat the same performance in 2005 in light of rising inflation .The obvious plays in the fixed income area include TIPS bonds (inflation hedged treasury bonds). They have done well in 2004 and will continue to do so in 2005.

How does 2005 look for equity investors? Reading the financial Tealeaves here are my conclusions and recommendations:

1. Outlook for Private Equity Investments in 2005: The year 2004 was good for private equity investments. In the first half of 2004 U.S. private equity funds returned over $30 billion to limited partners. Private equity fundraising rose to $75 billion in 2004 compared to only $49 billion in 2003. I expect a fairly active 2005 for private equity in all areas including fundraising and investments. The 2004 IPO market was the best since 2000 and that significantly helped the performance of private equity investments in 2004 and that IPO trend is likely to continue in 2005 as interest rates rise (as debt capital becomes more expensive) and the concerns about how Sarbanes Oxley section 404 might affect valuations are alleviated It is expected that in 2005 private equity fundraising might surge as high as $115 billion in 2005.

The factors that would influence deal making in 2005 include:

a. Acquisitions to enhance business growth-as the economy slows down a bit in 2005 businesses will use acquisitions to drive value.

b. Weak dollar---this will motivate bargain hunters in Europe and Asia to acquire attractive businesses.

c. Flight to Quality—Since the bursting of the Dot-Com bubble in 2001;there has been a flight to quality. Private equity investors have become more cautious and the level of due diligence is high in order to sac out the quality deals. The idea is to hit home run with lower risk.

2. The economy and the financial markets face a set of major risks including—the possibility of a prolonged war in Iraq; with soaring budget and trade deficits it is unlikely that the U.S. dollar will rebound soon (read higher inflation); higher oil prices with OPEC cutting production (read higher inflation); and, higher interest rates with the Fed the in a inflation fighting role.

3. In light of these risks my advice to the prudent investor is to get used to single digit returns in 2005—the S&P is expected to be in the 7%-9% range. (This is respectable as long as inflation is in the 2% to 4% range. We are not going to go back to 2003, and certainly not to 1999.).

4.Where to place you equity investments in 2005? My advice is to be conservative—migrate to quality stocks—companies with consistent growth and strong balance sheets, low debt and decent cash flow. Quality stocks are particularly important for 2005 as profits slow down a bit from 2004.With interest rates on the rise cash rich companies will do better, as they have to borrow less than cash poor companies. They will also have the cash to acquire companies—a key strategic advantage in 2005.

5. Look out for the old-fashioned winner--companies paying respectable dividends. These companies usually have strong cash flow and solid earnings and they have outperformed non-dividend paying stocks over the long haul. Part of the Bush economic agenda for the next four years is to make favorable tax treatment of capital gains and dividends permanent. Implications of this are clear—more companies will be paying dividends and initiate stock buybacks as they accumulate cash. In December 2004 General Electric Company purchased back $15 billion worth of socks and raised dividends by 10%. The company’s stock rose by $2 on the day of the announcement.

6. It is quite likely that the best opportunities for equity U.S. investors are outside the U.S. with the likelihood of recovery of the dollar in the next one to two years is quite slim. This is a riskier option but well worth a 10% to 15% asset allocation in light of he realities of the world economy. Emerging markets are a good play particularly with quality companies in India and China (and Taiwan). Other countries that look promising include Singapore, Australia, and South Korea. For most investors I would advise selecting a high quality international mutual fund or country funds rather than trying to pick stocks from countries we know little about.

7. Niche plays in equity markets include:

a) alternate energy companies—with high oil and gas prices and concerns about the environment (global warming) renewable energy industry is hot; solar power is increasing at nearly 30% a year; with tax credits for solar and wind power the investment attractiveness of these energy sources will continue to be enhanced; Ethanol production is at a record high and investment in Fuel Cells are also attractive options; key concern is that many of the renewable energy companies are yet to be profitable. This is a fairly risky option in 2005 but it is bound to become increasingly more attractive in the coming years. My recommendation is to invest in a mutual fund that has a basket of these companies that are potential winners.

b) Internet Advertising---- The time for Internet advertising has finally arrived; by 2005 Internet advertising revenues are expected to reach more than $11 billion; this is not unrealistic in light of doubling of ad prices in 2004—the daily price of a banner ad on marquee sites like Yahoo or MSN in December 2004 stood at $300,000.This is a risky and an exciting option for investors in 2005.Thrill seekers should look into this promising Internet business play.

c) Hispanic Market-----This is a booming market for media, financial, and healthcare companies. Companies that target this demographic play (40 million strong market growing three times faster than the U.S. population) should do very well as Hispanic incomes continue to catch up with the U.S. average. One opportunity in this area will be new IPO’s in this market. Some of the well known currently traded companies includes Avon Products (cosmetics), Doral Financial (big in Puerto Rico), and Univision (large Hispanic media company). This is another risky play, which is full of promise and may be worth the ride for the long term.

In summary, there are many ways to generate wealth, and they range from stocks and bonds, to real estate, and commodities, and even art and antiques. My focus in this article is primarily the stock market. The year 2005 is likely to be full of surprises not unlike 2004.There are major challenges in 2005 ranging from a growing federal budget deficit to a declining dollar and rising inflation and interest rates, and the risks associated with a protracted conflict in Iraq. The prudent course for investors in 2005 would be to stick with tried and true principles –stay with or seek out stocks of companies that are profitable, cash rich, and pay dividends. The other strategy for 2005 would be to diversify into international stocks and bonds in light of the declining dollar. Finally, there are many exciting opportunities in niche markets as well as in the IPO market in 2005.