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Note From Edward Hemmelgarn

The commentary by Rick Campagna and interview with Ray Rund in this issue of the Shaker Investments’ newsletter share a common theme. Both Rick and Ray believe there are tangible reasons why stock prices may have room to move higher in 2004. As a firm we are, indeed, constructive in regard to selected segments of this year’s market. However, we are by no means blindly optimistic. A considerable amount of our time is devoted to identifying trends that might dampen economic growth and investment returns. For example, we are sensitive to the significant pressure on the U.S. dollar, due to the very large trade and budget deficits incurred by the United States. A declining dollar is good for U.S. exporters, but the Euro is in danger of becoming excessively overvalued if China and a number of our other trading partners continue to refuse to allow their currencies to increase against our currency.

We also are carefully watching U.S. consumption demand, especially from low and middle-income families. These consumers are in a greater debt position than ever before, and are entering an environment where rates may begin to trend up. Also, the ability of corporations to produce more goods almost anywhere in the world is holding down or actually reducing U.S. wages.

Nevertheless, the U.S. economy looks strong, and we believe that there are numerous opportunities for superior small and mid-cap companies to increase their earnings. Our mandate, as always, is to find those companies before their potential becomes evident to the market at large.

Corporate Profit Outlook
By Richard Campagna, Managing Director - Equity Research

Since the start of the economic recovery, corporate America has shown a surprising degree of operational and fiscal discipline. In sharp contrast to the corporate excesses of the late 1990s, the past 18 months have been characterized by very conservative business models. This ‘corporate conservatism’ is having a meaningful impact on the labor market, productivity, corporate profits and the stock market.

At this point in a typical economic recovery, the US economy experiences a 7% increase in employment, equivalent to approximately 9 million new jobs in today’s economy. Since the recovery began at the end of 2001, the US economy has actually lost approximately 800,000 jobs. This job loss has occurred despite the economy growing by over 7% since the recovery took hold.

When the economic and stock market bubbles of the late 1990s burst, corporate managers responded to a sharp fall in revenue by dramatically cutting costs, especially labor costs. With mass layoffs still fresh in their collective memory, corporate managers are simply not adding workers as the economy recovers. Instead, they are leveraging technology to grow output using roughly the same labor force. The result is that productivity gains are higher than they have been in 50 years.

Since productivity gains are not accruing to the labor force, it stands to reason that they must be accruing to the corporate sector. Indeed, the corporate sector has captured virtually all of the benefits of theproductivity gains since the recovery began. The end result is that corporate profits reached a record high in the third quarter of 2003, exceeding their late 1990s peak.

Despite record profits, corporate America has shown restraint in capital expenditures as well as in the labor market. During 2002, nonresidential capital expenditures had their largest year-over-year decline in 40 years. Capital expenditures have been so low, that many companies are spending at levels well below their depreciation.

In addition to keeping capital expenditures low, corporations have continued to maintain tight inventory controls. The business inventory-to-sales ratio is currently at a record low. On the capital side, corporate America clearly learned its lesson from the over-build of the late 1990s.

The combination of record profits and limited spending has resulted in a dramatic increase in corporate free cash flow. The financing gap — corporate cash flow minus capital expenditures — is negative for the first time in almost 30 years. Corporate cash balances have ballooned. Microsoft alone has over $50 billion in cash on its balance sheet. Cisco has more than $20 billion in cash and Intel has close to a $15 billion cash hoard.

With returns on cash balances at 40 year lows, the corporate sector is looking for better ways to use its cash. Companies are aggressively paying down debt. The reduction in supply and the strengthening balance sheets have reduced corporate bond spreads to 1998 levels. Some companies, such as Microsoft, are paying dividends for the first time in their history. Other companies are buying back stock at record rates. Bank of America alone bought back $4.5 billion of stock in the 4th quarter of 2003. Intel bought back $2 billion of its shares in the 4th quarter.

Increasing profit margins, record corporate profits, strengthening balance sheets, falling bond yields, increasing dividends and large stock buy-back programs all spell good news for the equity markets. Corporate America is in better shape than it has been in years. At the same time, companies are exhibiting an operational and fiscal discipline that should prolong and improve their condition. The combination of these factors has created a strong foundation for economic and stock market growth for years to come.

Analyst’s View
Raymond Rund, Managing Director - Head of Research
Discussion on Semiconductors

Q: What is the “semiconductor cycle”?

A: The semiconductor cycle is the pattern of growth and contraction experienced over time by the semiconductor industry. The overall industry has grown at an average annual rate of almost 13% per year for the last 25 years. During this period, the industry has recorded 21 years in which the growth has been positive and only 4 years in which sales declined. The industry’s growth has been driven by a long-term trend of increasing demand for computing and communications. The response by the industry has been to build new semiconductor manufacturing capacity. At some point in the cycle, new capacity coming on-line exceeds the growth in demand, or the demand temporarily slows. At this point inventories start growing, orders are cut back, prices fall, and industry sales decline. Eventually, in past cycles, GDP growth would resume, and demand and sales would pick up again.

Q: How does the cycle impact investment returns?

A: There’s been a pretty strong long term correspondence. A broad index of semiconductor stocks we track has gained an average of 16.8% per year during the same 25-year period mentioned above. The stocks have been more volatile than the industry’s overall sales, with 8 years showing annual declines and 17 years showing gains.

Q: How does Shaker Investments use its knowledge of the semiconductor cycle to invest in semiconductor companies?

A: The conditions that produce accelerating growth in the semiconductor industry are growing demand, low inventories, low levels of investment in new manufacturing capacity and increasing capacity utilization. These conditions lead to firm pricing and expanding profit margins for the semiconductor device manufacturers. We carefully follow the demand drivers, track supply chain inventories, and stay abreast of capacity utilization and investment in new manufacturing capacity in order to predict when profit growth is likely to accelerate.

Q: The economic cycle and the semiconductor cycle both “hit bottom” at approximately the same time – Q3 of 2001. As both the US and global economies have been recovering, what has happened to semiconductor manufacturing and how has the semiconductor cycle progressed?

A: The semiconductor industry was really hit hard in this past recession. While GDP declines in the US were fairly mild (three consecutive quarters, with the greatest quarterly decline a mere -1.3%), the semiconductor industry declined five consecutive quarters. Overall, the industry was down 32% in 2001, and bottomed in Q4 of that year. Since then, industry growth has been accelerating. We saw about 1% growth in 2002, and expect to finish 2003 with close to 18% growth.

Investment in new semiconductor manufacturing capacity was hit even harder. Semiconductor manufacturing equipment sales peaked in 2000, and have declined for the past 3 years. We estimate that purchases of new semiconductor equipment in 2003 were down more than 60% from the peak investments of 2000.

However, the semiconductor industry is still in an environment of low capacity additions, low inventories, and growing demand. This is an ideal environment for semiconductor device makers to grow earnings.

Q: Have there been any major changes in the demand drivers, and if so, how will that affect the way this cycle plays out?

A: During most of the industry’s history, computing has been the greatest driver of semiconductor sales. Since the mid 90’s, networking and wireless communications emerged as major users of semiconductors. Automotive applications and consumer electronics have become significant in the past few years. This diversification is good for the industry’s health, and should allow device makers to profitably focus on specific applications and really add value.

An example is the importance of battery and power management in portable devices like cell phones, laptop computers and digital cameras. These devices are seeing strong growth, and this is driving demand for the circuits that control and manage battery power. Companies like Intersil, International Rectifier, and Power Integrations are all benefiting from this trend.

Q: Given the run-up in stock prices in 2003, have semiconductor stocks as a group reached their peak?

A: Valuations have definitely increased off their lows, so we are more cautious than we were at the beginning of 2003. Given the current environment we expect industry revenues to grow another 18-20% in 2004, with profits increasing at a greater rate than revenues. If world GDP continues to grow, and capacity additions are modest, earnings will continue to accelerate. Accelerating earnings usually drive stock prices higher.

When we start seeing significant additions to semiconductor manufacturing capacity, or inventories building up in the supply chain, the valuation risk in these stocks will outweigh the opportunity for positive returns and we will reduce or eliminate our holdings.