Review and Outlook
My Clients, Friends & Observers:
July 16th, 2002
You have to be optimistic as a rule. Sometimes it's not
easy. War in the middle-east is interminable, and has been exported
to our shores by ideologues and ethnic types. We labor under irrepressible,
political, public and private bureaucracies. The line between public
and private sectors is blurred by patronage, lobbying, inside deals,
non-public information, power-socializing, parliamentary grandstanding,
interlocking directors and legislation by appointed -not elected-
The FDA remains without a director for almost two years
because Senator Kennedy will not approve any candidate who will not
guarantee approval of RU-486, the morning-after abortion pill. And
why would the government be in any hurry to streamline approval of
new, expensive, patent protected drugs? It can take up to a dozen
years, after patenting, for a drug to get approval, fairly well using
up the life of the patent. After all, the government has Medicare
and Medicaid programs which provide half the cost of inpatient pharmaceuticals.
The sooner the government can get rid of patented medicines and get
us all on generics the cheaper it will be. No?
Senators McCain and Dingell are leading the righteously
indignant against corporate accounting scandals. Do recall that McCain
and Dingell are two survivors and prime beneficiaries of the "Keating
Five" savings and loan rip-off.
The Financial Accounting Standards Board is political
by its nature and construction. It cannot be otherwise. Perhaps we
should hold our federal government to the accounting standards required
of industry. There are no GAAP audits required of federal agencies.
Would we find any scandals there if they were audited?
Here in the Commonwealth our looming budget deficit can
be explained by just two words. Are you thinking "economic slowdown"?
No, the words are Big Dig, the $15 billion, twelve year, public works
debacle in Boston.
And our lame duck governor, who drummed up a $2 million campaign war-chest
before withdrawing from the race is busy
spending it on herself and on her own patronage schemes. Campaign
funds do not have to be returned. One more law that we will never
see: a requirement to return unused campaign funds or turn them over
to the state treasury for public use.
The circus has come to Washington
as politicians point fingers at business and each other over whose
inside deal is the most unethical or, more to the point, the most
embarrassing. Who would have thought that the movie "Animal House"
was prophesy? Ladies and gentlemen, Senator
and Mrs. John Blutarski are in office -
My father told me when I was quite young that it is not
law enforcement that keeps the general citizenry from robbing and
killing each other, it is the profound sense of personal morality
and obedience to a higher law. Man's law will never be nearly as effective.
What place does this have in an investment commentary?
None, other than to tell you that all the current ethical scandals
sell newspapers and television shows, that nothing will change regardless
of legislation, regulation or who runs the SEC. Nothing will fundamentally
change until people change fundamentally. I assume we'll have a few
tar-and-featherings of some poor cloutless
pawns and then we'll get back to business as usual.
For those convinced that our accounting standards are
lax here, be cautioned not to listen to the investment gurus who are
recommending international investing at this juncture. Accounting
standards elsewhere are far worse, and this is not just a reference
to emerging market nations, I refer to Europe
In addition to auditing financial statements accountants
are paid well to decipher the gobbledygook of the tax code and keep
their clients compliant with the IRS. The government provides the
profession with a constant stream of revenue for as long as the tax
code remains enigmatic and undecipherable. The accounting profession
is the practical enforcement arm of the IRS. If this relationship
is informal, the alliance is no less real. It is perfect political
machinery. The government is guaranteeing for the accountant an income
stream from the client. The loudest opposition to the movement for
a flat tax came from the AICPA.
One would think that this would be enough to keep the
accounting profession satisfied with accounting. However the nature
is akin to a juggernaut: it can only grow; it can never be stopped.
In 1995 I lost a very good client to the Arthur Andersen accounting
firm. My client was president of a publicly traded corporation. I
took care of all his family's accounts. Among his executive perq's
was a suite of accounting and financial planning services provided
by Andersen. As he explained it to me, "My board has accepted
from our auditors their proposal to manage all the officers' investments
as part of their service. Although I'm very happy with everything
you've done for me and my family I have to get on board with this
and lead by example. I'd appreciate it if you'd continue to handle
the rest of the family accounts."
This was an alarming new precedent. The accounting
firm of Arthur Andersen was now in the investment business and in
a big way, with a lot of leverage to bring to bear on their auditing
clients. Let us consider the possibility of this hypothetical scenario:
You, the company, want the benefit of every doubt and
widest latitude of every rule from us, your auditors. We, your accountants,
in turn, would like the benefit of fees from consulting and investment
management for your company." If Andersen was doing investing
all the other firms would likely follow.
According to Larry Kudlow, on
the television program Kudlow & Kramer,
there have been 18 companies tainted with accounting irregularities
or questions. Of the 18, Arthur Andersen was auditor for 11, or 61%
of the total. No other firm audited more than two.
What I would be interested in knowing, and no one as yet
seems interested in answering, is this: Did Arthur Andersen counsel
Enron officers as to their investments in Enron stock? If so, when,
and what actions were advised?
Since 1995 almost every accounting firm of any size now
offers its clients investment services. This is an appalling conflict
of interest to me. Far better it would be if accountants were left
to accounting, only, and investment managers were left to manage investments,
A final note on accounting "scandals": in my
well-qualified opinion there is none at Merck. Merck used a not-unreasonable
bookkeeping procedure that was reported and that had absolutely no
effect on their earnings or the quality of their earnings.
One of the few products that has remained basically unchanged for the last 75 years is the
mutual fund and yet it still sells, in a big way, in its original
configuration. There are today as many mutual funds as there are stocks.
They are generally not tax-efficient and not tailored to an individual's
specific financial needs. They are, by and large, more expensive than
other investment alternatives considering management, administration,
and distribution fees. Only a very small percentage of them have ever
beaten the major indexes with any consistency. They are popular because
they are sold, not bought. Why anyone would buy a bond fund instead
of a bond is beyond my comprehension. Yet there are investment advisers
who manage portfolios of diverse mutual funds for clients for a fee
(on top of the funds' fees). Many mutual fund companies have institutional
relationships with company analysts, investment bankers and even the
companies they invest in. To give them their due, mutual funds are
an easy way for an individual to systematically invest inside a retirement
The Brae Head first principle is to build and
preserve purchasing power over time. That implies a real rate of return
beyond the inflation rate. In all but the most aggressive Brae Head
portfolios the cash flows alone from dividends and interest well exceed
the inflation rate. A typical portfolio has 28 positions, spread across
10 industry groups and 5 equity sectors. Unlike mutual funds, Brae
Head portfolios are managed for each client's unique needs. For example,
in 1999 Brae Head took over a 66 year-old client's portfolio, liquidated
all equities and established for her a managed, fixed-income account.
Time-weighted, annualized total return through 12/31/01 was +7.64% and, more importantly,
she has the cash flow she requires
Our equity selections favor companies with significantly
greater profitability than the S&P 500 index, significantly lower
valuations (P/Es), predominant share in their markets, and significant,
sustainable, dividend strength where applicable. We buy the best managed,
strongest companies. These companies are managed, first and foremost,
through economic cycles
as opposed to market cycles. Their share prices are more a reflection
of investor sentiment than of economic performance. However, over
time, investors take notice of companies with growing earnings and/or
dividends and drive their share prices up. These are the companies
we like to own.
Absent a compelling need in a specific client's portfolio
we will not sell a well-managed, reasonably valued company just because
of a systematic market downturn. The market rises two days out of
three historically. Market upturns tend to be dramatic. If one is
not invested one misses these dramatic upturns and fails to beat the
Over the last seven trading sessions the DJIA has lost
almost 10% of its value. The people who have been selling are most
likely the ones who were buying at Dow 11,000,
NASDAQ 5000, and S&P 1400.
They are late and
will undoubtedly be late again getting back in. Emotional
decisions are invariably bad decisions. What they
are providing for us is a type of selling climax that tends to occur
at market bottoms, not market tops. I've been complaining for almost
two years about sentiment remaining far too bullish. Finally we're
getting bearish sentiment, exactly what we need to see for an upward
One of the mega-trends of the last twenty years has been
time compression, change occurring at a faster rate. In my opinion
we are not in for a five to ten year stalled market although I enjoy
seeing such prognostications in the press.
GDP growth was revised up to 6.1% in the first quarter.
Second quarter earnings are coming in generally better than expected.
Get used to more expensive oil. It has risen to $27 and won't drop
below $22 anytime soon in my opinion. The cost of sub-$20 oil is too
disruptive, socially and politically to most of the OPEC economies.
We don't need that.
The dollar has finally fallen significantly, about 10%
off its highs. This is constructive for manufacturing exports. The
dollar will not collapse in the foreseeable future. There is no safer,
stronger nation on earth in which to invest. No other economy comes
close. We are prepared for an uptick in
inflation and higher yields from ten-year debt. We remain overweighted
in ethical pharmaceuticals. We have found municipal debt compelling
for the last few quarters but have begun to find shortages of suitable
paper. Munis have been bid up in light of impending state tax increases
and by investor flight to after-tax safety.