Beating the Street (46 page)

Another interesting development in 1993 was that the natural gas business had revived to the point that energy and energy service companies could do well. These sorts of enterprises had been in the doldrums for as long as I could remember, but years of cost-cutting and consolidating and shutting down the drilling rigs had produced a promising situation for the survivors.

The risk/reward ratio was excellent in these companies. Many a natural gas stock had been thrashed so thoroughly that they could hardly be beaten down much further, and the odds were favorable that some of them would rise and shine. So I recommended five energy companies in 1993: two service companies and three producers.

Based on the pent-up demand indicator described on pages 241-242, I also thought that the auto industry would sell more cars and trucks than a lot of people were predicting. After a down cycle in autos, it normally takes five to six years of an up cycle before the pent-up demand is satisfied, and we were entering only the third year of the latest up cycle. With that in mind, I recommended three automakers plus Harman International, which supplies car stereo equipment to the automakers.

Table PS-1. LYNCH'S 1993
BARRON'S
PORTFOLIO

In my discussions with various analysts and also with executives of various companies that buy and sell steel, I learned that steel prices were starting to firm. Moreover, the U.S. steelmakers were expecting the government to take action to protect them against the “dumping” of cheap steel by foreign producers in our markets. (As it turns out, they didn't get the protection they wanted.) I was also hearing that several of the old and inefficient steel plants in Europe, which for decades were run with massive government-subsidized losses in order to give tens of thousands of workers unproductive jobs, would be closed. Privatization would accelerate this process even further. This would be bullish for steel prices worldwide. I ended up recommending three steel companies and two other metal companies as well.

So my 1993
Barron's
lineup was heavy on the cyclicals, although I didn't start out with the idea of buying cyclicals because that's what you're supposed to buy in the early stages of an economic recovery. It just happened that in the companies and industries I investigated, the biggest bargains were in cyclicals, and that's where earnings were on the move.

The seven S&Ls I recommended in 1992 all moved up. In 1993, I recommended eight new ones. I continue to be amazed at the performance of this entire group—doubles, triples, quadruples in dozens of issues that have come public since 1991, and hardly a dog in the bunch.

Many of the S&Ls have been doing well for several years, so this is not a situation in which you have to get in and get out. And there are still great opportunities as I'm writing this. If there's another part of the market where so many solid franchises are selling for less than book value and have good earnings growth, with the likelihood that sooner or later they'll be bought out by larger banks or S&Ls at a premium, I haven't discovered it.

The conventional worry on Wall Street is that the S&L party will come to an abrupt end as soon as the economy gets moving and interest rates begin to rise, thus wiping out the profits that S&Ls are making on the current and favorable interest rate “spread.” I disagree. A very speedy economy with double-digit inflation could hurt the S&Ls, but an economy that lopes along at a reasonable pace would not.

In fact, the S&Ls will benefit from a steady economic improvement, because in a better real-estate market they can unload their foreclosed real estate more quickly and at higher prices, and they
will suffer fewer defaults and delinquencies and thus fewer new foreclosures. This will strengthen their balance sheets and boost their earnings, because they won't have to set aside as much money to cover their loan losses. Also, as the economy improves, these thrifts can increase their lending to creditworthy borrowers, which in turn will add to their earning power.

Finally, I began to take an interest in California companies in 1993. This was because California was in a deep recession and the press reports were so negative you would have thought the entire state was going out of business. New England, my own home region, was in precisely the same predicament in 1990, and the headlines were just as gloomy, but if you managed to ignore the headlines and buy shares in depressed New England companies, particularly banks and S&Ls but also a few retailers, you've been well rewarded to date.

Taking the optimistic view that California would somehow survive its recession the way we New Englanders have survived ours (so far, we've done it with no job growth!), I put three California companies on my 1993 recommended list: Coast Savings Financial, Inc.; H. F. Ahmanson & Co., the nation's largest thrift holding company; and the Good Guys, Inc., a retail chain that sells TVs, stereos, and related electronic devices. I also recommended Fannie Mae, my long-term favorite company, which owns and packages mortgages. Its stock price was depressed because 25 percent of its mortgages are written on California real estate.

To the six-month checkup of the Lynch portfolio that appears on pages 284–304, we can now add the 24-month checkup. With so much attention given to the ups and downs of stock prices, it's easy to forget that owning a stock is owning a piece of a company. You wouldn't own a rental building without checking every once in a while to see that the units are well maintained and the place isn't falling apart, and likewise, when you own a piece of a company you must stay in tune and watch for new developments.

After doing my lastest round of homework on the companies described in the text, I can report the following:

Allied Capital Corporation II
has been a short-term disappointment,
as reflected in the stock price. Through no fault of the company, what I hoped would happen in 24 months is going to take much longer. The company had all its equity ready to invest in loans, but it hasn't been able to put all its money to work. Part of its plan was to buy loans from the Resolution Trust Corporation out of the portfolios of S&Ls that were taken over by the government. The idea was to invest in creditworthy borrowers, who were paying 10–11 percent interest.

The unforeseen problem was that a lot of other investors, including banks and the so-called vulture funds, were also trying to buy these loans. Allied couldn't get the ones it wanted, and it wasn't about to lower its standards and purchase the riskier variety. So it sat on its cash, getting 3 percent in the money market. This was not a productive situation for shareholders, who were paying Allied Capital an annual 2 percent management fee.

Allied Capital II is gradually buying loans, but at a slower pace than anyone expected. Meanwhile, the best investment has been the company that manages the Allied funds, Allied Corporation, whose share price has doubled in a year.

Speaking of management companies,
Colonial Group
had a gain of 69.7 percent in 24 months. Once again, when billions of dollars are pouring into mutual funds, as they have in recent years, it pays to invest in the folks who own and operate the mutual funds.

My passion for the nursery companies
(General Host, Sunbelt
, and Calloway's) was a big mistake. I deluded myself about the entire matter. I was so impressed with the fact that consumers were buying plants, rakes, shovels, mulch, etc., in record numbers and that gardening would be to the 90s what cooking was to the 80s that I overlooked the fierce competition among the gardening stores. It's as fierce in plants and flowers as it is in the airlines.

Much of the traffic has gone to the discount centers at K mart, Home Depot, etc., which sell a minor assortment of greenery and huge quantities of fertilizer, mulch, pesticides, and gardening tools that otherwise might be sold by Sunbelt or General Host. I underestimated the impact of the discounters and also the perseverance of the moms and pops in small gardening centers, who are toughing it out and lowering their prices to compete with the discounters. The chain store nurseries are being squeezed at both ends. The extreme weather that we've had—deluges, droughts, etc.—hasn't done them much good either.

Calloway's, a company that made a favorable impression on me when the stock was selling at $8, sold for $3.00 at the end of 1993, and what looked like a growth opportunity a few months ago is now a potential turnaround. It's also a potential asset play, with $1.30 in cash, no debt, and 17 buildings in the Dallas area.

I thought of Sunbelt as a possible takeover candidate, and sure enough, it was taken over by General Host. Alas, the stock was selling for $6.25 when I recommended it, and the buyout price was $5. This was a Pyrrhic victory.

If you still believe in Sunbelt, you can continue to own a piece of it by buying shares of General Host. This hasn't been such a hot prospect either. The sales at its Frank's Nursery & Crafts outlets have been disappointing. Overall, 1993 was a terrible year for Frank's. We've had record heat waves across the country, causing a lot of people to stay indoors and avoid the garden.

General Host may turn around and prosper in the future, but as in the case of Allied Capital, it's going to take longer than I expected.

Pier 1 Imports
is also part of the nursery story—it owned a majority interest in Sunbelt before Sunbelt was bought out by General Host. Pier 1 has struggled with the sluggish economy, but it continues to gain market share from the neighborhood furniture stores. I'd say the company is definitely on target.

The immediate future of
CMS Energy
was riding on a judicious settlement of its rate case with the Michigan Public Service Commission, and I had no clue what the outcome would be. I understood the company well enough to know that at $18.50 a share, the stock was a decent buy even if the company got a lousy settlement. So the risk/reward ratio was favorable.

In March 1993, the Michigan PSC made its ruling, which wasn't terrific from the CMS point of view, but was favorable enough to cause the stock price to advance to the mid-$20s. At this level, it became a hold.

Phelps Dodge
had a prosperous 1992 because of cost-cutting and because copper prices went up. A softer copper market in 1993 caused the company, and the stock, to stall. If you own shares in a mining company, you'd better keep tabs on the market for whatever is coming out of the mine.

Body Shop
is a case where the company did not perform well in 1992, but the fundamentals improved in 1993. When I recommended the stock, it was selling for 325 British pence, and I suggested that
investors take a small position that could be increased if the price went down. Did it ever. In February 1993, it hit a low of 140 pence! I never imagined it would fall that far, but one can never predict how far a price may fall. If you own enough stocks, one of them is bound to suffer a similar decline.

When that happens, it's time to review the story. If the story is still good, then you're happy the stock price fell 50 percent, because you can buy more at a bargain level. So the important issue was not that Body Shop had fallen, but why it had fallen.

I called the company and got caught up on the story. Body Shop still had no debt and was continuing to expand into new markets. This was all positive. On the other hand, the company was hurt by the terrible sales in Britain, its home market. Apparently, the British recession had caused people to cut back on soaps and shampoos, an unfortunate development for the crowds in the underground. Or maybe they were buying normal shampoo and not spending 4 pounds on seaweed-and-birch shampoo or Rhassoul mud shampoo from the Body Shop.

Three of the four countries with the most Body Shops, Canada, Britain, and Australia, were all in recessions. And in the U.S., several competitors had appeared with their own lotion-and-potion stores. But the Body Shop will get most of its future growth from other countries, such as France and Japan, where its stores have opened without competition. I see this as a global enterprise in the second decade of a three-decade story. If anything, the story has gotten better than it was when I started following it in 1992. I've checked with my friend the ex-librarian, and she's so delighted with her Body Shop franchises that she's bought one more. I recommended Body Shop again in January 1993 at less than half the price I first bought it at in 1992.

At
Sun Distributors
, a major development occurred four years ahead of schedule. In September 1993, the company announced that it was considering a plan to sell off its various divisions. Investors expected that such a sale might occur, but not until 1997, the last year Sun Distributors will enjoy the tax advantages of being a master limited partnership.

After the company is sold, the owners of Sun's Class A stock will get $10 apiece for their shares, and the owners of the Class B stock will get whatever is left from the proceeds of the sales. I recommended Class B in
Barron's
in 1992 and 1993.