Market Thoughts
June 2006
Review of May
OUCH! May was one of the worst months for stocks in quite some time, especially for
the areas that had been doing well. :
S&P 500 (Big)
S&P 400 (Medium)
S&P 600 (Small)
Price Return:
Health Care
Information Tech
Telecomm Svcs
Consumer Staples
Anyone who reads my monthly commentary is probably aware that I had been
anticipating weakness in the markets in the near-term. With that said, I have to admit to being
surprised with the suddenness of the on-set and the rapidity and depth of the decline. On May
8th, I was quite pleased with the 11% year-to-date return for our clients. It was that Monday
afternoon that the financial markets realized that they had guessed wrong in the game of “Guess
when the Fed Stop Tightening”. At 3:15, Maria Bartiromo, of CNBC, decided to share the
details of her dinner conversation with none other than the new Fed Chief, Ben Bernanke from
over the weekend. Well, that was a pretty tough lesson for him on how NOT to disseminate
information. The markets reacted quite violently over the next two weeks, erasing almost all of
the gains for stocks, though recovering slightly by the end of the month. As you can see in the
table above, inertia was not a friend for those areas that had been performing best. By the second
week, though, everything was falling somewhat indiscriminately, a sign that the sell-off was
driven by liquidity factors. It wasn’t that the world is coming to an end, but rather everyone tried
to leave the party at the same time. This is also known as the typical correction rather than a
precursor to some sort of economic downturn.
Small-caps retain their lead year-to-date, but it was quite a tough month. Uniformly,
Utilities did well, with long-term rates stabilizing and the sector traditionally serving as a good
place to “hide out”. Similarly, Consumer Staples performed very well for similar reasons.
Energy stocks were extremely volatile. With a very strong close to the month, they ended up
Alan J. Brochstein, CFA
June 1, 2006
performing in line and remain one of the better sectors since December. Other “dirty economy”
sectors (Materials and Industrials) remain leaders for 2006, though Materials had a tough month
due primarily to the metals. The Consumer Discretionary sector has been very mixed by market
cap, reflective of growth struggles for less mature concepts in the smaller caps relative to the
larger companies meeting relatively low expectations. Healthcare had a very bad month,
especially in smaller capitalizations. Financials performed well in the smaller capitalizations.
Technology was a disaster, especially in the large-caps. Microsoft was the culprit for the largecaps, while weakness in semiconductors was responsible for part of the declines in smaller
capitalizations. The continuing proliferation of investigations of back-dating of options clearly
plagued the Tech sector. Growth had a terrible month, and, contrary to my expectations, Value
is winning now year-to-date. Growth investors typically migrate to Consumer Discretionary,
Health and Technology. Note the evidence of a massive unwind of longs by small-cap growth
investors in the weak performance of those three sectors last month.
Interest rates rose very modestly despite another Fed tightening. It is quite remarkable
that the Federal Reserve has raised short-term interest rates by 25bps at EVERY SINGLE
MEETING since June, 2004, yet the stock market is higher and 30yr interest rates are actually
slightly lower since that first hike to 1.25% on 6/30/04. The CRB declined about 3%, with
Gold falling slightly and Oil closing about unchanged. The Dollar weakened again relative to
the Euro and has now lost about 8% of its value in 2006. Against the Yen, it has declined 3%.
I stated in my year-end commentary that my crystal ball was cloudier than it was in 2005
and that I am not so great at calling market tops. If you recall, my forecast was for a good year
for stocks and a good year for the economy. More specifically, though, my original forecast was
for early strength, with an interim peak in late March or early April, shallow consolidation and
then a strong closing to the year. While the forecast seems to be playing out, the peak did come
a bit later than I expected and certainly fell short in terms of the level I projected (it is very hard
to get the exact timing or levels – I am actually pleased thus far with my road map). While I
continue to stick to my forecast, I certainly am aware that maybe this was THE top. At this
point, I believe that the lows may be in, but I am not yet confident enough to call it yet. We are
at a traditionally tough spot in the economic cycle, the point where the FED could go “too far”. I
continue to think that the market will do well when they are done with the tightening, but I have
stated previously and continue to believe that raising short-term rates to 5% is probably not
enough to really slow the economy if that is what the Federal Reserve really wants (typically,
one would expect that rates would have to exceed the GDP growth rate, which is above 6%). I
am not so sure that is the end game. Preventing bubbles (real estate) may actually be the real
goal. Sure, they talk about inflation, but is that really a risk? Despite massive increases in
resource prices and a very low unemployment rate (4.7%), inflation remains a non-event (except,
curiously, at Whole Foods!). So, at this point, I believe that the market is in a classic correction,
which will be followed later this year by strength again (the success of the “soft landing”). The
greatest risk is that short-rates continue to rise significantly, which could lead to an economic
downturn. With elections coming up, I tend to discount that risk. Speaking of elections, though,
the fear of increased Democratic representation will probably serve as headwinds over the
Alan J. Brochstein, CFA
June 1, 2006
summer. At the end of the day, this factor is absolutely irrelevant, but don’t discount the nearterm psychological impact.
Looking at some of the sectors, I continue to think that financials should do better in the
latter part of the year and wouldn’t chase this recent recovery. The end of a Fed tightening cycle
can be tough on banks and other creditors, as it is often accompanied by higher defaults and
fewer new lending opportunities. I backed off early-in-the year favorable expectations for
consumer stocks, but I have noticed that some of the stores that cater to lower-end consumers
have started to recover. The cyclicals – technology and industrials – remain in the best position
to capitalize on an economy that will be driven more by spending by corporations. I am
noticeably quiet on energy, though with much humility, I continue to think that it ultimately
won’t be a third great year. As far as the size of companies having an impact on performance, I
continue to modestly favor smaller companies, though the weakening dollar could alter my view.
Finally, I continue to expect that the trend of Growth over Value, which began almost a year ago,
will persist despite the recent setback.
(Intentionally Blank)
Alan J. Brochstein, CFA
June 1, 2006
Review of Past Focus Stocks
At the beginning of the year, I shared 4 health-care ideas for 2006. I have added two
technology ideas and another health-care idea last month. As a reminder, I jumped ship two
months on one of my original ideas (SLXP), which has continued to deteriorate and serves as a
great reminder of why one needs to cut one’s losses early rather than late. Reviewing the
remaining ideas, Covance (CVD), which was at 48.55 at year-end, closed last month at 58.35
and ended the month at 59.07 (yes, up!), remains very attractive despite the advance. This
premier Contract Research Organization benefits from clinical trial outsourcing, the growth of
biotech and small pharma and an increased focus on drug safety. They had an excellent report
and outlook in January and then a decent one in April. The high-volume pullback was due
primarily to the company only maintaining its original outlook for 2006. They announced what
appears to be a very opportunistic acquisition that expands their capacity. I have increased my
target from 60 to 70 over the next year, representing a multiple of 25X 2007 estimated EPS
(excluding options expense). This is my favorite industry in the healthcare sector, as we have
owned a peer, PPDI, for 30 months now as well.
Another January idea was Gen-Probe (GPRO), a company that is involved in bloodscreening and diagnostics (primarily for STDs). The big driver, beyond a robust pipeline of new
products, is the potential to acquire the blood-screening business from its marketing partner,
Chiron, which is being acquired by Novartis. They have some exciting initiatives to apply their
technology to the additional markets of biotech manufacturing and water safety, both of which
could be substantial longer-term drivers, especially considering that the target markets are
Alan J. Brochstein, CFA
June 1, 2006
significantly lower than what they currently address. They also recently began marketing a test
for prostate cancer. The higher specificity (less false positives than the standard PSA test,
leading to fewer biopsies) is what should drive adoption. The stock also is a potential
beneficiary of increased HIV testing being recommended. Their Q1 report in early May was
fine, and my dinner meeting with the CFO reinforced my view that this is a well-run company
with significant opportunity to grow long-term. This stock also advanced during this challenging
month and has appreciated to 54 from 48.79 since year-end. I continue to target 60 over the
next year.
The third original stock is Given Imaging (GIVN), an Israeli company that trades on the
NASDAQ and is focused on diagnostic imaging of the gastrointestinal tract. I was either early or
quite possibly wrong on this one, though I continue to believe that this company should perform
well over longer time-frames. Key product is the PillCam SB, which is for the diagnosis of the
small intestine. This has become the gold standard for unexplained anemia. The company
launched in 2005 the PillCam ESO, which is for diagnosis of the esophagus. While I was
initially skeptical of the potential success for this product, I now fully expect that it will
eventually become the initial diagnosis tool, replacing the EGD (scope). The ESO allows the
great majority of patients to avoid the scope (and the sedation and inconvenience that goes with
that procedure), is economical for the doctor and benefits the insurance companies (they reduce
the number of $1500 facility charges). The company’s next (and last) product will be for the
colon. While this is very speculative, the company has a very strong balance sheet and is
profitable. GIVN recently reduced guidance due to taking several initiatives to assure its growth
in coming years. I had stated that the stock, which I originally recommended at year-end at
26.10, needed to break 24 to become technically attractive again, broke down. While I do think
that this could become timelier in the future, I am no longer going to update this idea. Again, a
good lesson in sell discipline…
Alan J. Brochstein, CFA
June 1, 2006
I shared an additional idea four months ago, an exchange-traded fund (ETF) focused on
semiconductor and semiconductor capital equipment companies, SMH. As I conveyed at the
beginning of the year, I like the sector because sentiment is not very positive, valuation is fair
and, fundamentally, the outlook is strong. In a nutshell, inventories are low, demand is strong
and capital equipment requirements are quite high due to technology changes and capacity
expansions. The early-in-the-year weakness in Intel (INTC) created a divergence between this
index and the SOX index, though the gap narrowed by over 2% in February and another 3% in
March. This was a pyrrhic victory, as the long call stunk, though SMH regained 1/2 of its
underperformance, declining 5% less than SOX since I discussed it on 1/31. With that said, this
trade is no longer compelling. I had warned last month that if 35 broke, the technicals were no
longer positive. I don’t think that there is significant downside, and the most likely scenario is
that I am getting whipsawed. I personally have sold some of this to fund some other ideas, but I
retain exposure and am looking to potentially sell on strength (unless it gets quickly back above
35). To be clear, I am long but neutral – not my favorite position!
Alan J. Brochstein, CFA
June 1, 2006
Two months ago, I discussed APH, which had a great report in April and rallied sharply.
I expect that the stock, already up from 52.18 a month ago, can get to 66 (instead of the 61 I had
suggested) over the next year. I had mentioned that I thought that the significant driver of EPS
over the near term would be better-than-expected results from a rather large acquisition that they
recently completed. This in fact was the case in Q1, but there is more to come. I had mentioned
the strong support at 45 and 48. I now believe that 53 should be considered the support level.
The company is very exposed to the cell phone market as well as many broad industrial and
military applications, all of which appear to be robust.
Alan J. Brochstein, CFA
June 1, 2006
On April 18th, I sent a mid-month email regarding a stock that is WAY out of my league
in terms of what I do professionally and quite speculative but definitely worth investigating.
Acusphere (ACUS, which was at 6.05 when I sent the email) appeared to me to be under heavy
accumulation from what I would consider smart money. This process appears to be rather early.
The IPO has been a bust, but the company is getting closer to commercialization of a product
currently in P3 trials. Their product is a contrast agent to be used in nuclear stress tests and hits
the trifecta that I seek when looking for healthcare investments: Good for the patient (saves a lot
of time and avoids dealing with radiation), good for the payer (cheaper) and good for the doctor
(the cardiologist doesn’t have to send the patient elsewhere). The company addresses a very
large market – 9mm procedures a year. The company will be releasing data from one of its two
Phase 3 trials next week.
I have been disappointed by a couple of things. First of all, the stock went below the
level (5.60) that I felt was necessary to hold (either a sign that I should get out that I am not so
great at setting stops!). Secondly, the ownership structure in the first quarter (this data comes out
quarterly, and, importantly, precedes the equity offering from April) wasn’t as exciting as in
December, with very few new buyers of substance. As you can see in the chart below, we are
right on top of the bolus of volume since the IPO. The recent pullback was due to the company
raising money to finance the expansion of manufacturing facilities (prior to my email in April). I
think that the stock needs to trade through 6.50 next week on the data release to justify continued
involvement. Key to this thing working will be having good data (non-inferiority – seems like a
lay-up), finding a good U.S. marketing partner (already has a European partner) and making a
timely filing with the FDA in 2007 so that it gets to market in 2008. There are some other things
in development, but this is what counts. I am hoping to see 10.
Alan J. Brochstein, CFA
June 1, 2006
Final Thought
I am disgusted by the controversy unfolding surrounding the granting of options to key
executives. Just when we thought that the excesses of the late 90s were behind us, we are
learning that the leaders of many companies, who already had a very sweet deal in terms of
“heads I win, tails you lose” options compensation, rigged the game to be even more favorable
than we could have imagined. For those not following closely, the issue involves the setting of
the strike price (the price at which the executive can buy the stock in the future) retrospectively
after a stock had moved up significantly. I would liken it to being able to place a bet on the
favorite in the third quarter of a football game at the original line despite their being way ahead.
As this practice seems to have touched several of the companies in which our clients
invest, I am struggling with how to react. The more that it seems like an industry practice as
opposed to company-specific behavior, I suppose the less I should care. I do wonder though
what this says about the character of the management teams. I struggle with how to assess
significance, relevance and culpability. As one who firmly believes that the integrity of the
management team is a critical element to the success of the company and hence the stock, I
clearly don’t dismiss this as merely “headline risk”.
Have a great month!
Alan J. Brochstein, CFA
Piedra Capital
Houston, TX
[email protected]
Alan J. Brochstein, CFA
June 1, 2006