November 24, 2003

November 24, 2003

Remember our last letter? We stated that we thought that commodities would rise in value and that inflation would return in the long run. Well that is the lead-in to this letter in which we cover some points omitted in our recent missive.


In our opinion short-term interest rates are very important in determining the value of stocks and precious metals. Why would I say something like that? This is an issue that I discuss every few years in these notes and now may be a good time to restate our opinion.

We believe short-term interest rates compete with stocks and precious metals for investors’ dollars. A simplistic view of our model is as follows. When short-term interest rates are above the current and expected inflation rate, growth stocks and precious metals are less attractive to investors. This is because investors may feel that the higher interest rates will cause a slowdown in economic activity and thus a moderation in inflation. Therefore they curb their borrowing to buy stocks or precious metals.

If short-term interest rates are below the current and expected inflation rate, as is now the case, then investors see borrowing to purchase growth stocks and precious metals as a wise decision.

Today, for example the one-year Treasury bill rate is about 1.36% and the last 12 months CPI is 2.0%. To us, this CPI number is inaccurate and ridiculously low. (See ‘Am I Crazy’ below.) For this reason and others, investors and speculators are bidding up the price of precious metals and growth stocks. Big stocks that aren’t growing are not rising as rapidly as growth stocks for the reasons outlined above.

We believe that long maturity bonds are, and will be, an unattractive place for investors for years to come. Bonds, of course, vary in quality of issuer currency of issue and duration of instrument. Currently, bonds are rallying slightly as mutual fund investors afraid of stock funds are adding money to their bond accounts. To them, bonds yielding 4% are attractive while inflation is at 2%. Our argument is that soon inflation will be well above 4%. Even today, many investors intuitively believe that inflation is well above 2% and that rates should rise.

Bonds will be in trouble in a rising interest rate environment, which we expect could last for a long time.

Many investors purchased bonds with longer maturities as interest rates fell in order to lock in a suitable yield so they can meet their expenses in years to come. The problem with this type of behavior is that it assumes their cost of living will not escalate rapidly and their bonds will maintain their value.

If, as we predict, interest rates and inflation rise in coming years, bond holders will be left holding the bond bag. They will be holding a bond with a yield of maybe 4% or 5% in an environment where newly issued bonds of similar maturity might be yielding 6% or even 8%. If the maturity is long enough, the investor could see a capital loss of 50% on his or her investment. Unfortunately, not only US bonds are at risk, but long maturity bonds over five years in most European, Asian and other issuers are at risk of higher inflation. This is not a pretty picture.

We suggest that investors sell their long term bonds denominated in U.S. dollars and replace them with shorter maturity bonds. What about an investor who has a need for higher income and is willing to tolerate a bit of risk? There are other vehicles, such as energy MLP’s (master limited partnerships). MLP’s of natural gas pipelines, energy storage or other energy assets can offer higher payouts as energy prices rise. These instruments, require analysis and are volatile. The risks are specific to each issue and should be thoroughly and continuously analyzed. You should have an advisor who analyzes and picks them for you.

Another option is to hold TIPS or inflation adjusted US Treasury notes for 98% of more of your account and hold a basket of commodities for the remaining few percent. Thus, you will get an inflation adjusted return (with a lag) from the notes and a profit on your commodities if we are correct and inflation increases.

Am I out of my mind or have I recently read that the CPI in the US was flat in the most recent reporting month? I do not know how the numbers could have been managed to produce a flat consumer price index in the current environment.

From where I sit in California, everything is up except long distance telephone services, computer and cell phone hardware and Federal Income taxes. The Rogers Raw Material Index, an index of commodity prices is up about 17% year to date. Services area also up a minimum of 5-10% in this area. By services I mean not just dry cleaning and hair cuts but also insurance, tuition, healthcare, parking, cleaning services etc. Prices of fixed assets (like cars) are also up, and with higher interest rates car leases will also rise.

I travel a lot, and as far as I can see worldwide inflation is on the move. Could it be that the public intuitively understands this and that is why gold, silver and many other commodities have been rising in price?

In about August, 2003 some officials in China let it be known that they were trying to reign in the growth rate of credit in the banking system to more manageable levels and to assure that credit was being allocated more wisely. As a result, officials of at least one and possibly more major brokerage firms began to propose a slow down in the Chinese economy. They went on to say that commodity prices would decline as a result of less growth in bank credit. It was their fear that there could be some liquidation of inventories in China sending the prices of some commodities down.

The concept was elaborated to state that there is about a three month lag from the slowdown in lending to the falling of prices. So after three months from August commodity prices could start to fall in China. Obviously, this could impact the rest of the world as well. It is now November, 2003, approximately three months later.

We have been aware of this opinion for weeks. We do not know if it is correct. It is possible that commodity prices will continue to rise. After all, no one is talking about a shrinking of bank credit. The officials are saying only that they are trying to engineer a slow down in the rate of growth. It is possible that a slowdown could run away on the downside but we do not view this outcome as probable.

Personally, I hope we do get a slight decline in commodity prices. Then the naysayers will come out and say “see commodities are going to bust”. We can use the ensuing panic to buy a lot of things cheaply.

Let us revisit our big picture assumptions. China and India are going to grow and there will be a continuing impetus to economic growth in that part of the world. This growth has begun but is probably decades away from completion.

In our last letter we mentioned that we like growth stocks that are self-financing. We are GARP investors. GARP stands for growth at a reasonable price. We like growth, but we want to buy a growing company at a P/E ratio which is a fraction of its growth rate.

In order to find growth companies we relay on our internal research and a group of friends who are private investors and money managers, and who know how to pick winning companies. In my last letter I mentioned Steve Emerson. Now I would like to extend kudos to our friend Gary Mintz who has been invaluable contributing analyst in this area for years. His insight has been an important part of our growth stock research.

We will continue to keep you informed of the opportunities that we see on the horizon. We look forward to hearing from you and wish you the very best in the coming holiday season.