September 30, 2006

Market Summary – 3rd Quarter, 2006

In “The Graduate,” a classic 1960’s film, young Benjamin Braddock (Dustin Hoffman) is given sage advice by a family friend. In one of the memorable scenes in movie history, the unsolicited tip consisted of “just one word….plastics.”

Today that single word of advice might just be “politics.” More and more, the people we elect to office are there because they are politicians rather than governing figures. They are well connected, know how to rub elbows, protect certain interests for their own benefit, and quite regularly build contacts in government to benefit themselves later in the private sector. Taxpayers, the traditional constituency, are often an afterthought.

Take the case of Jim Johnson. He made his mark, initially, in the political world, eventually becoming a top aide to Vice President Walter Mondale. In the true ways of Washington today being connected to the powerful in the halls of government is a great way to ingratiate yourself with potential private sector employers who offer opportunities far more lucrative than exist in public service.

A recent issue of Barron’s told the tale of Johnson (see “Meet Mr. Generosity’ in the Aug. 21, 2006 issue). Among the highlights of Johnson’s post-political life, according to the Barron’s piece are:

From 1991 through 1998, he was Chairman of Fannie Mae (FNMA), the quasi-government company that is the nation’s biggest mortgage firm. Johnson collected $21 million a year in compensation.

Although no longer with the company, Johnson managed to negotiate terms that pay him $1 million annually in pension payments and consulting fees.

Johnson sits on six corporate boards and heads the compensation committee for five of them. One of those corporations, UnitedHealth Group, is under fire for possible backdating of $1.6 billion(!) in options given to Chairman William McGuire.

Johnson has been criticized for his role in overseeing what some consider excessive compensation for executives of other companies where he helps make decisions on those matters. According to Barron’s, Johnson and others, who, as members of a board overseeing executives, develop a reputation for helping corporate executives make a lot of money, and that makes Johnson and others attractive candidates to sit on many boards.

While Fannie Mae’s stock rose 700% during Johnson’s tenure at the company, regulators later uncovered accounting manipulations, and Fannie Mae admitted to overstating income by $11 billion(!).

Along with Johnson’s own payday, other Fannie Mae executives were rewarded too for the less than stellar results. Chief Executive Franklin Raines, who left the firm under a cloud when the accounting discrepancies were revealed, receives $1.37 million a year for the rest of his life, PLUS health and dental insurance coverage. On top of that, he left with more than $10 million in stock options in deferred compensation.

Initially, Fannie Mae’s problems did not go unnoticed. Congress grilled Fannie Mae executives for the alleged book-cooking two years ago. The Justice Department began investigating the matter. So did the SEC (led by a former Republican Congressman, Christopher Cox). The SEC opted this year to avoid a significant court battle and settle with Fannie Mae for a $400 million fine. Of course that penalizes the innocent shareholders who didn’t cause the problem in the first place.

The individuals responsible for these questionable practices are still able to enjoy every dollar of their remuneration from the company including those generous lifetime pensions.
To top things off, the Justice Department ended its investigation in August, deciding to no longer pursue legal action against the company (individuals involved aren’t off the hook yet, but nothing has happened since that announcement). The excesses and accounting mis-deeds were obvious, but apparently, no crime was visible to the taxpayer-paid lawyers and investigators put there to protect us.

Bob Dole was quoted as asking, “Where is the outrage!” during his unsuccessful 1996 Presidential campaign. To date, we have not heard a single member of Congress express concern that Fannie Mae executives apparently manipulated numbers to benefit their own stock options.

This Congress feels no hesitation about hauling executives and board members from public companies (such as Hewlett-Packard’s recent leak investigation follies) in front of the cameras and lights, so they can express their shock and disbelief. Speaking of misplaced outrage, there’s the Senator from Minnesota who demands an investigation of the National Weather Service for its failure to predict a recent tornado.

Doesn’t the Fannie Mae issue have a greater impact on the financial well being of the nation, a task we charge our elected officials to manage? Is it possible that both parties would have been embarrassed by potential revelations related to this politically connected firm?

The Fannie Mae situation and subsequent lack of oversight by our elected leaders is just one of many examples of government mismanagement that can have damaging, long-term effects on the value of the dollar against other currencies.

Gold in an enviable position
Speaking of the lack of oversight, the federal government added $2.8 trillion of debt in the 1990s. Already in this decade, the growth of the national debt is approaching $3 trillion (based on figures published by the U.S. Department of the Treasury).

This is clearly a case of mismanagement of our public funds. Along with adding significant interest payments to our federal budget, growing debt tends to have a negative impact on the dollar in relation to other currencies over the long run. In that environment, commodities become more important. That’s one reason gold, despite a recent drop in value, still looks like a great long-term play.

A second point is that gold production does not keep pace with demand for the metal. In 2005, mines produced a net of 2,407 tons of gold. In that same year, demand (for jewelry, industrial uses and investment purposes) was 3,727 tons. This deficit in new supply is an ongoing reality.

The shortfall is made up by the sale of gold reserves, primarily from central banks. Official statistics (from the World Gold Council, an industry organization) indicate that there are about 31,000 tons of reserves held worldwide, some believe that number is suspect. An analyst for a European financial firm, Cheuvreux, believes the actual amount of gold reserves is more like 16,000 to 21,000 tons. His report notes that a significant amount of gold reserves included in the official tally has actually been lent out, and used for jewelry and other items. That leaves even fewer reserves to help offset the supply crunch.

Demand is likely to continue to rise, particularly with the growth of emerging economies like India and China. At the same time, new production is not able to keep pace. If present trends continue, production could continue to be on the decline.

While the fundamental supply-demand story appears favorable for gold investors, it is equally important, in our view, for investors to take out a bit of “insurance” against the lack of fiscal discipline demonstrated in our nation. Deficits cannot continue forever without taking a toll on the purchasing power of the dollar. Our clients come to us with their accumulated wealth and expect us to take it seriously. In our estimation, it wouldn’t be prudent acting indifferent to the nation’s fiscal mismanagement and the likely negative impact on our currency. Protecting your wealth is part of our job, and a strategy that includes a gold investment, appears to be an appropriate one under the current circumstances.

Oil Crisis? What Oil Crisis?
From early August through the end of the third quarter, the price of a barrel of crude oil dropped by 18%, to just a bit above $60/barrel. Good news for SUV owners. Not so good for energy-related stocks.

We’ve been believers in the long-term value of owning an energy position. This has worked out very well. Since the two-month free fall began, oil prices have stabilized around the $60/barrel mark. It is notable that this is still about 45% higher than the price of crude oil at the end of 2004. It wasn’t until February of 2005 when oil first topped the $50/barrel mark in the current cycle.

So is the run over for oil? We don’t deny that a correction in oil prices is underway. The bigger question is whether we can return to oil at $30 to $40/barrel, or if the $50 to $60 mark becomes the new basement for oil prices.

The case that oil is likely to remain pricey over the long term is built on these six, rock-solid realities and a startling prediction on prices cited recently by Charles Maxwell, considered the Dean of energy analysts in the investment industry:

Currently, the world uses about 98% of its crude oil-producing capacity. The system is considered “stressed” at 95%.

World oil demand increases by 2% per year, but about 4% to 5% of production is depleted each year (existing wells that go dry). That means we need to create enough new production to make up 6% to 7% of our output each year.

From 1982 to 2004, the world consumed 500 billion barrels of oil. Prior to 1982, it took 100 years to burn through that same amount of oil.

Today, the world consumes 30 billion barrels of oil per year, but we discover about one-third that amount. In the 1960s, we were discovering 45 billion barrels a year and using 15 billion.

Production by non-OPEC nations will peak in 2010. At that time, the world will become more dependent on OPEC’s output (note that OPEC just announced plans for a 4% production cut in an effort to bring prices back up).

Maxwell predicts the price of a barrel of oil could jump to $180 in less than a decade. In other words, the golden age of oil (from a price perspective) has only just begun.

Maxwell and others consider anything below where we stand today in terms of oil prices unsustainably low. Recent excitement over a new oil discovery in the Gulf of Mexico is tempered by the simple fact that it takes 13,000 feet of drilling to get at these reserves. No oil company will make such an investment unless the price of crude justifies the expense. If Maxwell is right these companies will find the price of oil in the future fully justifies their drilling expenses.

Energy-related stocks have underperformed for the last two months. This may be frustrating. However, it is not a reason to “cut-and-run” from our long-term belief that the secular trend is upward, a trend that favors prospects for well-positioned energy companies.

On Creating Wealth
So gold supplies are dwindling. Oil production won’t keep up with demand. Government’s lack of fiscal discipline is putting additional stress on our nation’s economic system. You might be thinking we’re gloomy about the prospects for U.S. equity investors.

That couldn’t be further from the truth. Markets will always have their ups and downs. So will specific stocks and sectors of the market. That really doesn’t matter. One of the advantages of our value approach is that we can always find opportunities, in any market. Our long-term clients who have been with us during these previously challenging times understand what we mean.

For us, it all starts by being anchored in our investment beliefs. In these times when many investors are enamored by alternative investments that make big bets or move into and out of positions in a matter of days, we remain steadfast in the same beliefs that have helped our clients build on and protect their wealth.

Believe in the power of the free market system
Investors have faced many challenges in the long history of U.S. stock investing – from the depression that began in 1929 to the crash of 1987 to the bear market of the early 2000s. The outlook can seem downbeat from time-to-time. But, history has shown that it can be expensive to be negative.

You may recall that in the immediate aftermath of September 11, 2001, the U.S. economy was in a state of shock. It was a dramatic shift from the euphoric growth of the 1990s that was best summed up by former Federal Reserve Chairman Alan Greenspan as “irrational exuberance.” Virtually every sector felt the effects of the terrorist attacks and even the stock market had to close for days. Pessimism and gloom clouded the future. So what happened to investors who embraced that attitude?

Look no further than a family of investment funds known as the Inverse ProFunds for the answer. These funds are structured to make bets against the market (using strategies like short selling stocks with the expectation that they will drop in value). The track record says a lot. Since September 2001, a time when we were in the midst of a three-year bear market, their best performing fund in the series was down 29.31%. Two more are down 56.15% and 79.74% respectively over the five years ending September 30, 2006. In that period of time, it clearly was very expensive to be negative. We present these funds as evidence that it can be costly for investors to be bearish about the U.S. economy over the long term.

Good companies find solutions to make the real world work, and good investors find those companies to include in their portfolio.

The world has only just begun to invest
One reason for our optimism is the potential of the world market. Consider that the two most populous nations in the world, China and India, each with more than one billion people, are considered “emerging markets” in an investment sense. Can you imagine just how much potential there is to make money in the decades ahead? These are countries that are increasingly promoting free enterprise. It is happening all over, and the result is a whole new world of investment opportunity that will continue to create potential for investors.

In the fast-developing global marketplace, good companies are finding opportunities. This table shows just how much. Among our holdings, here are the ten firms with the highest percentage of 2005 sales that were generated from overseas markets;

Price is what matters
No matter where the opportunities might be, we invest only when we feel the price is right. We aren’t looking for momentum plays and we often don’t own the best companies that are currently the talk of the town, but well-managed companies that are being overlooked by the markets and stand a good chance of seeing their stock prices increase over time. This is a proven, solid, long-term investment strategy. Investing is a marathon, the saying goes, not a sprint.

Today’s investment environment, with CNBC giving us minute-by-minute updates and countless websites devoted to the latest market news, can easily convince investors that they too have to make quick decisions. But the style we follow is that same one that made great investors like Benjamin Graham and Warren Buffet long-term champions.

When MPMG began managing portfolios in the 1990s, the phenomenon of “day trading” was all the rage. We don’t know what ever happened to the day traders (maybe they run hedge funds now), but we’re still here and so is our investment style. Over the past 75 years, many investing fads have come and gone. Theories based on market timing, momentum, waves, cycles, indexing, sector rotation, the “nifty fifty,’ limited partnerships, and of course the investment strategies “du jour,” of private equity and hedge fund investing, have all had their proverbial 15 minutes of fame. During this same 75-year period, Graham’s ideas (detailed in his seminal 1930s works, “Security Analysis” and “The Interpretation of Financial Statements”) have stayed in vogue. The philosophy of a value-based approach to stock selection continues to withstand the tests of time and market fluctuations, and makes sense for anybody who is investing for the long run.

~MPMG

Although the information in this document has been carefully prepared and is believed to be accurate as of the date of publication, it has not been independently verified as to its accuracy or completeness. Information and data included in this document are subject to change based on market and other condition. All prices mentioned above are as of the close of business on the last day of the quarter unless otherwise noted.

The information in this document should not be considered a recommendation to purchase any particular security. There is no assurance that any of the securities noted will be in, or remain in, an account portfolio at the time you receive this document. It should not be assumed that any of the holdings discussed were or will prove to be profitable, or that the investment recommendations or decisions we make in the future will be profitable. The past performance of investments made by MPMG does not guarantee the success of MPMG’s future investments. As with any investment, there can be no assurance that MPMG’s investment objective will be achieved or that an investor will not lose a portion or all of its investment.