HCMI Client Letter - January 2nd, 2007

Dear Clients and Friends,

For the most part, our clients trailed the averages for the year by about 4% despite a late year rally in technology stocks.  As this was the second year in a row of underperformance (last year by 1%), we reviewed our strategy from top down to see whether flaws exist.  Our philosophy is that 50% of a portfolio’s return is driven by the overall market, 30% by the sector allocation, while only 20% of a portfolio’s return depends on specific companies.  In other words, if the stock market is rising in general and we’re invested in the fastest growing sectors, almost any companies in those sectors will do.

The fastest growing sectors in the S&P 500 since 1950 have been technology, healthcare and financial services.  Technology does best when the economy is expanding rapidly (businesses upgrade capacity, consumers spend), healthcare does best when the economy is contracting (healthcare spending is independent of the economy) and financial services do best when the economy is coming out of recession (interest rates are still low, but demand for credit is picking

up, leading to expanding lending margins.) 

Accordingly, we typically invest 25% of our clients’ equity allocations to technology, healthcare, with the balance spread across industrials, consumer discretionary and staples, energy and materials.  We have virtually no allocation to utilities or telecommunications stocks.

Actual sector returns for the S&P 500 for the last 5 years and for 2006 are:

Literally, no money was made in healthcare in the last 5 years and just 3.5% in technology; these sectors performed the worst in 2006.. 

Telecommunications snapped back in 2006, but remains negative over the last 5 years.  The top performing sectors for the last 5 years were energy and materials, and energy delivered another 22.2% in 2006.

So does this mean the strategy is broken?  No, it merely reflects the digestion of the technology craze of the late 1990s’, some problems in the healthcare sector, and an unusual period where energy and commodity prices tripled in less than 5 years.  Also, despite having half our assets in the worst performing sectors, we still delivered reasonably good returns by picking good companies within those sectors.

Let’s consider sector by sector what might happen over the next year.

Consumer Discretionary  - Bullish-Neutral

This sector includes home builders, automobiles, recreation and retailers, and generally does well when consumers are feeling optimistic.  Home building obviously is in a slump right now (we are doing some bottom feeding in companies like KB Homes) and US automobiles appear to be in a death spiral, but there’s only a slim chance of recession next year, and consumers are generally in a good mood.

Consumer Staples - Neutral

This sector includes food, soaps and detergents, and drugstores, items that consumers buy no matter what the state of the economy.  Money flows into these stocks when the economy heads into recession as these companies deliver slow but reliable growth.

Energy –Neutral-Bearish

This sector includes oil and natural gas drillers, producers, refiners and distributors.  After hitting $78/barrel in July, oil finished the year at $61.05 versus last year’s close of $61.04.  Natural gas closed at $6.299 versus last year’s $11.225 (and a peak of $13.633 in mid December 2005.)  Unusually warm weather (El Nino, not just global warming) depressed demand for heating fuel and natural gas in the US.  El Nino years also have fewer hurricanes, which allowed Gulf Coast refiners to recover post-Katrina.  Four successive OPEC cuts have lifted prices only temporarily.  We expect oil to trade back into the $50’s through Spring 2007.

Financials - Neutral

This sector includes national, international and regional banks, brokerages, mortgage intermediaries and REITS.  We expect Fed Funds to remain unchanged at 5.25% through at least the first half of 2007.  Since a July peak near 5.25%, the yield on the 10 year sank to 4.40%, which is the equivalent stimulus of three Fed Funds rate cuts.  At year end, ten year yields were at 4.71%, which is still pretty accommodative.  With an inverted yield curve, bank lending margins are squeezed.   Brokerages set a record year in 2006, but their earnings, which are dependent on trading and deal making, are particularly volatile.

Health Care – Bullish-Neutral

This sector includes conventional drugs, biotechs, medical instruments and supplies, health insurers and HMO’s.  The conventional drug makers have had a terrible 5 years as their biggest money making drugs have gone off-patent and there’s little in the pipeline to replace this cash flow.  On top of that, senior management is distracted by a rash of class action lawsuits.  We have found more opportunities in smaller, nimbler companies in this sector.

Industrials – Bullish-Neutral

This sector includes manufacturers like General Electric and transportation companies like Fedex.  While the US will grow at a subdued pace next year, the rest of the world’s economies seem to be growing just fine. 

Information Technology – Bullish-Netural

This sector includes hardware and software makers, and providers of telecommunications gear.  There’s nothing on the horizon to suggest another 1990’s boom (combination of replacement upgrades for Y2K and buildout for the Internet) but there’s solid demand for these products.  Indeed of the technology companies that survived, most are delivering 50% more revenue than in 2000 with dramatically improved earnings quality.

Materials - Neutral

This sector includes base metals such as copper, lumber, gold and specialty metals, plastics and additives.  Like Industrials, this sector is dependent on world economic demand.  A lot more capacity will come online in the next few years, so we see prices stabilizing and even falling for outputs.

Telecommunications Services – Neutral-Bearish

This sector includes fixed and cell phone companies, cable and satellite providers.  This sector is recovering from an enormous glut of capacity and pricing remains cutthroat.  We would invest here after more consolidation and after capacity becomes better aligned with demand.

Utilities - Neutral

This sector conventional and nuclear power plants, water and sewerage services.  Demand generally grows in line with population growth, and prices are heavily regulated.  Dividends, the primary attraction of utilities’ investors, are more volatile and less secure than a generation ago.

Strategy

S&P 500 earnings grew 18.6% in Q3 2006, well above the initial estimates of 9.0% and continuing the trend of upside surprises and double digit growth that has prevailed for 18 quarters.  Estimates for Q4 2006 are for S&P 500 earnings to grow 10%, falling into the 8-9% range for Q1 and QA2 2007.  We expect the ten year treasury to head back towards 5%, which would help stabilize the dollar (dollar fell through most of 2006 as investors could get higher returns in Euros.)  Housing will remain flat to lower, depressing GDP growth in the US to the 2.6-2.9% range for 2007.  Energy prices appear to have stabilized.  Add that all together and we see the S&P 500 up another 8-10% in 2007.