Although we would count ourselves among the nautically-challenged, "the doldrums" seems to offer an apt description of the current state of the U.S. financial markets. In technical terms, the doldrums represent a geographic area near the earth's equator between two belts of trade winds: typically, intense solar heat warms the area, resulting in high humidity, low pressure and long periods when the winds literally disappear. Sailing vessels can be trapped for days or weeks because of the lack of surface winds, although it's worth noting this is also the region where hurricanes and other forms of severe weather often originate.

At the halfway point for 2005, our nautical analogy goes like this: the markets are dead in the water, basically even for the past six months and, except for the last 60 days of 2004, uninspired for the past 18 months. Around us, however, we perceive intense, swirling winds: first, a surprisingly robust macro environment despite plenty of headwind from rising energy prices and a cautious Fed; second, record profitability is pressuring corporations to do something with their excess liquidity - growing cash balances are leading to increases in M&A and restructuring activity, as well as share repurchases and higher dividends. It is, to say the least, ironic that such environmental tumult has yet to push the market in any meaningful direction, yet this is a defining characteristic of the doldrums. Although an experienced sailor knows the winds will eventually return, it is difficult to imagine what in particular will ultimately fill the sails and move the ship forward.

The equity market has exhibited little movement this year when measured in distance traveled: the spread between the high and low for the S&P 500 is just about 8% (similar to last year and near a low in historical terms). Most broad measures of market volatility are at similarly low levels, and this makes it particularly difficult for investors to distinguish themselves versus peers. A further challenge active investors have faced is a tightly valued market, one where the valuation excesses of five years ago have been wrung out. But an analysis of daily market activity implies unsettled activity below the surface, as the number of trading days with at least 1% up/down moves is high and rising. When all of this is coupled with data that shows investors are trading in and out of stocks more rapidly than ever, one is left with the impression that most equity investors are focused on short-term tactics in order to grab even the slightest moves. Anecdotally, the rapid growth in hedge fund assets may help to explain this phenomenon, but it remains questionable whether such investment structures (with higher fees and trading costs) offer profitable long-term opportunities given their rapid growth and the increasingly crowded playing field. We readily admit our skepticism on these matters, preferring to emphasize our core competency: fundamental security selection of attractively priced equities for the long run.

As we stated earlier, one would have expected the striking features of the macro environment to provide the equity market with a more deliberate direction. Oil prices are up more than 50% in the past year, the trade deficit continues to worsen, and the Fed has reinforced the slowdown story with its nine rate increases since last June. The daily headlines forewarn of impending recession, yet the economy sails forward. Instead of fiscal disaster, we find low long-term interest rates, sustained GDP growth above 3%, rising consumer net worth, an improving budget deficit, and consumer confidence at a three year high. If nothing else, today's surprising mix of macro forces reinforces our long-held belief that macro outcomes are extremely difficult to forecast and probably of little help in setting an investment strategy. We see no reason at this point to change our belief that things are better than the headlines imply, and as always, we believe our portfolios are constructed to withstand most wind shifts.

The winds are quite powerful at the micro level, too. Corporate profitability is near record levels as we reach the fifth year of the U.S. economic recovery, and cash resources continue to build. While a good bit of this money has already been directed in recent years to clean up old balance sheet problems, boost capital spending and raise dividend payouts, there is more to do. According to ISI, cash as a percentage of assets at non-financial companies is at a 40-year high and dividend payouts are still below historical averages. Given changes to the tax code, as well as the hangover of recent corporate management scandals, it's likely that dividends will continue to be a primary use of excess cash. But another way companies are increasingly looking to deploy their cash is through acquisitions. While part of this story may be an attempt to invest lots of excess liquidity, it's also likely that companies are looking to boost their own growth prospects through these deals. In any case, the number and value of M&A transactions is rising rapidly today, particularly those deals favoring cash rather than shares as payment. At Harris Associates, we are always focused on these events in order to help us better estimate the intrinsic worth of a business. To us, there is important valuation information released when companies are acquired, or alternatively, split apart.

An interesting example today of rising corporate activity is the media industry, where we have a variety of holdings across our portfolios. Many of these stocks have been under pressure since the Bubble, as their share prices rose too high during that mania. But at the right price, these are businesses with much to offer: "distributors" (e.g. cable companies) enjoy favorable operating leverage and growing cash flows as their capital requirements diminish, and the "programmers" (e.g. cable networks like HBO and MTV) possess proprietary content and benefit from global growth opportunities. But as these stocks have become trapped in the doldrums, frustrated managements have taken matters into their own hands to unlock value, believing the market has overlooked a bright future. In cable distribution, there have been several recent announcements that, from our analysis, confirm our own intrinsic valuation work (Cox and Cablevison going-private; Time Warner and Comcast acquiring Adelphia's assets). And at programming businesses such as Liberty Media, Viacom and Clear Channel, equally-frustrated managements are now acting to separate their prized, high growth jewels from slower-growth businesses in order to highlight hidden values. While the industry faces a more challenging environment due to the multiplication in alternative outlets and choices, these companies continue to hold strong market positions and possess outstanding cash flow characteristics.

The media example is instructive. In general, we find the industry to be quite attractive from a fundamental standpoint, and the stock prices are even more attractive today given the doldrums effect. Management teams are taking sensible steps to highlight value in a listless market environment, and we expect it is only a matter of time before the swirling wind of corporate activity moves these ships forward. In the meantime, we keep our eyes on the long-term horizon, but we also monitor the fundamentals closely to see if we've missed anything. So far, we are not discouraged, and we do our best to not be influenced by meaningless, daily trading patterns.

Our view on the overall market remains watchful but positive as well. We are clearly aware of the intense, daily focus on oil prices and interest rates, yet we remain unconvinced that a correct short-term reading of these wind shifts will help us generate satisfactory long-term results for our clients. The oil price rise has been surprising, for sure, but the long-term fundamentals of a slowing worldwide economy, rising inventories and the self-correcting nature of any commodity market should bring relief. As for rising short-term interest rates, the more important factor for investors is long-term rates, which remain low and favorable for continued corporate activity and equity market returns versus most other asset classes. Like the doldrums - and our most recent commentaries - this state of affairs has persisted for some time now. The market's sails will surely fill, as they always do, perhaps from the growing corporate activity where management frustration is high. In any case, we believe the long-term horizon remains bright for experienced, patient sailors.


Edward S. Loeb, CFA
Partner & Portfolio Manager