The Essex Essex Investment Management Company, LLC Exchange 1st Quarter 2005 Volume II, Number 1 A Message From Our CEOs Inside this issue: BY CHRISTOPHER MCCONNELL & MALCOLM MACCOLL T he start of a new year is often the time to take a fresh look at our portfolios and investment A Message From 1 strategies and to provide our clients with an Our CEOs update on the firm. Our Review and Outlook discusses the events of the past quarter, our economic forecast, Industry Spotlight 2 and our positioning among the major industry sectors. Energy The dominant market theme in the first three months of 2005 was the sharp rise in both oil and energy share prices. We delve further into our thoughts on the Review & 3 energy sector in the Industry Spotlight. Outlook 1st Quarter 2005 Also in this edition of The Essex Exchange, we highlight Nancy Prial in our Meet the Team segment. Meet the Team 5 Last quarter, we announced the addition of Nancy and Nancy Prial her team of analysts from the Burridge Group in Chicago. We are particularly excited about one of the Around & About 6 strategies her team manages that is new to our firm: the CHURCHILL & KLEHR PHOTOGRAPHY Essex Essex Small/Micro Cap Growth Strategy. Growth Investing from “Beantown” to “Chi-Town” Over four years ago, Nancy applied her proven approach to growth investing to the micro cap and small cap stock arena. In short, she uses a three-step process to identify companies at the earliest stage of earnings growth acceleration – well before the company’s potential is fully recognized by the market. The first step is the use of a quantitative screen to identify stocks with market capitalizations between $50 million and $1.5 billion where earnings are growing at a faster rate year-over-year. Second, the analyst team evaluates the sustainability of this earnings acceleration and assesses the degree to which the future earnings potential is reflected in the current stock price. For a variety of reasons, the small/micro cap market is much more inefficient than other areas of the market. Lastly, Nancy picks the best candidates to assemble a diversified portfolio and carefully monitors each stock to make sure a stock is replaced before earnings decelerate. With the addition of the Essex Small/Micro Cap strategy, our clients can now choose from a full spectrum of investment strategies ranging from the smallest stocks to the largest stocks and many combinations in between – while remaining true to our 28-year focus to growth stock investing. As always, if you have any questions or comments, please send us an email at email@example.com. Page 2 The Essex Exchange Industry Spotlight Energy BY LAUREL A. GORMLEY, CFA A fter significantly valuations led to a twenty-year lowest in three decades with production capacity and outperforming the bear market in energy stocks, an estimated surplus of only growing demand will lead to broader indices in resulting in the sector 1.5m barrels per day, mostly higher and more volatile 2004, the energy sector contracting to an all-time low in Saudi Arabia. Worldwide average prices over a longer surged to new highs in the first 5% weighting in the S&P 500 supply and demand period of time. quarter as investors revised Index in February 1999. In conditions have tightened to China is once again upwards their expectations for 2000, with emerging signs of a the point that any significant projected to comprise one long-term commodity prices. global recovery in demand, Stock price gains were broad- the sector came back into Oil Industry Capacity based, with exploration and favor. We are now four years production (E&P) companies, into the cycle and the S&P 8 96 major energy producers, and 500 sector weight stands at 7 94 oil service firms participating 8.5%. We believe energy 6 92 Spare Capacity (MMBbls/d) outperformance will continue Capacity Utilization (%) in the rise. As a reflection of 90 5 more optimistic investor as the industry has 4 88 86 sentiment towards this group, underinvested in additional 3 84 mutual fund flows into the capacity for the past twenty 2 82 energy sector this year have years. Although the stocks 1 80 reached a five-year high. In have moved up rapidly in the 0 78 addition, as of year-end, short-term, we continue to be (1 ) 76 Jan-01 Jul-01 Sep-01 Jan-02 Jul-02 Sep-02 Jan-03 Jul-03 Sep-03 Jan-04 Jul-04 Sep-04 Jan-05 Nov-01 Nov-02 Nov-03 Nov-04 Mar-01 Mar-02 Mar-03 Mar-04 May-01 May-02 May-03 May-04 hedge funds held the largest positive on the long term long position in oil futures in fundamentals of the energy Sau d i A rab ia O t h er O P E C 1 0 C ap acit y U t iliz at io n (R H S) the history of this contract, sector. Reference: International Energy Agency and Banc of America Securities according to “The Essex’s Chief Investment Commitment of Traders Officer, Joe McNay, believes supply disruptions would third of this year’s global Report”. Finally, during this that while the energy market cause oil prices to soar above demand growth, with past quarter, Exxon Mobil will be volatile, there will be a today’s price levels. OPEC is consumption expected to rise surpassed General Electric’s gradual, longer-term increase intent on keeping oil above 6% this year compared to a market capitalization making it in demand. He commented, $40/barrel but is fearful that 16% increase last year. The the largest company in the “Emerging markets are too high of an oil price will Chinese government recently S&P 500 Index. growing rapidly and helping to choke off demand. So far, reported severe power drive the demand side of the worldwide demand continues outages in 24 out of 31 To put the recent rise in oil equation for the foreseeable to look strong as the provinces prompting the prices and energy stocks in future. The hesitancy of the International Energy Agency government to ration electric historical perspective, the major oil companies to sharply has revised up its forecast supply for its industrial energy sector entered a bull increase exploration has led to again and is now expecting customers and forcing them to phase in April 1972 which a set of conditions that will consumption growth of 2.1% use their own electrical lasted for eight years until enable supply/demand to be for 2005. Last year demand generators which burn mostly November 1980. The peak favorable longer-term.” growth was 3.3% compared to diesel and fuel oil. With weighting in the S&P 500 an initial estimate of 1.8%. continued economic reached 40%. Excess As indicated in the Oil Therefore, we believe we are expansion, exploding capacity, significant Industry Capacity chart, in a new paradigm where automobile usage and the overinvestment, and high OPEC’s excess capacity is the minimal excess OPEC Olympics in Beijing in 2008, Monthly Relative Price Chart of Energy Index to S&P 500 an imminent slowdown does not seem to be in the offing. 0 .2 1 Higher commodity prices 0 .1 9 translate to strong cash flow 0 .1 7 for the majors, national oil 0 .1 5 companies, and E&P firms. 0 .1 3 These companies are 0 .1 1 increasing their capital 0 .0 9 spending, particularly on 0 .0 7 drilling, as worldwide rig 0 .0 5 utilization is over 95%. A Jan-70 Jan-72 Jan-74 Jan-76 Jan-78 Jan-80 Jan-82 Jan-84 Jan-86 Jan-88 Jan-90 Jan-92 Jan-94 Jan-96 Jan-98 Jan-00 Jan-02 Jan-04 (Continued on page 5) Source: Merrill Lynch Global Equity Trading Strategy, Rhodes Analytics, Federal Reserve Bloomberg 1st Quarter 2005 Page 3 Review & Outlook 1st Quarter 2005 F ollowing a strong oil prices spilled over into after their substantial finish to 2004, equity other commodities, and raw gains in the fourth As January, so goes the year? prices see-sawed in materials stocks were likewise quarter. In addition, the first quarter of this year strong performers. Other fears over rising fuel winners included the stable- costs put pressure on Market historians, like baseball statisticians, with the major indices generating modestly negative growth consumer staples the cruise lines. look for uncanny patterns and correlations as returns. Rising bond yields companies, as well as However, we remain a guide to future performance. A perennial and surging oil prices proved selected healthcare names. confident in the favorite is the “January Barometer” which to be powerful offsets to Conversely, financials, outlook for these generally constructive transportation, and industries and have states that the S&P 500 Index’s performance earnings reports. It was a technology were generally retained positions with in January predicts returns for the full year. challenging quarter for growth poor performers in the companies that are Since 1970, the January Barometer worked stocks which underperformed quarter. Following is a more expected to provide detailed review of the major the best long-term 86% of the time when January was up and the broad market as investors shifted to more defensive sectors of emphasis as well as returns such as Yahoo 46% of the time January was down. In 2005, sectors and styles. Small- our outlook for the next six to and Carnival Cruise. the S&P 500 declined 2.5% in January, but as sized stocks bared the brunt twelve months. In our small and mid the Red Sox proved by winning the World of this change in sentiment, cap portfolios, we posting returns well behind Series in 2004, history is not destiny. increased the weighting their larger-sized peers in the PORTFOLIO/SECTOR in several restaurant quarter. COMMENTARY operators, such as Texas home-related turning in A more cautious stance by Roadhouse and CKE, given disappointing results. We investors was reflected in the continued strong sales results continue to favor companies CONSUMER relative performance of and the expectation of some that are focused on specific industry sectors in the past Performance in the relaxation of food costs. demographic niches such as three months. Energy stocks consumer sector was mixed Retail sales so far in 2005 Coldwater Creek and Joseph of all sizes were the in the first quarter with have been mixed, with Banks. several of the Internet apparel retailers generally The performance of media standouts, rising sharply Services stocks pulling back outpacing expectations and and advertising stocks varied during the quarter. Escalating in the quarter, with large cap media outperforming Index Returns January 1, 2005 - March 31, 2005 its small cap counterparts. We retain investments in Walt Disney, punctuated 2.0% by the recent management 1.0% change, and are looking to News Corp. to broaden 0.0% our exposure. -1.0% -1.6% ENERGY -2.0% Energy stocks continued -2.2% -3.0% their impressive -4.1% performance of 2004 into -4.0% -4.3% the past quarter -5.0% significantly besting the broad market. Our -6.0% exposure to the energy -7.0% -6.8% sector overall is unchanged versus year-end 2004, with -8.0% -8.1% a sizeable overweight -9.0% across most strategies. We January February March have, however, made a modest shift towards oil Dow Jones Industrial Average S&P 500 service stocks versus exploration and production Russell 1000 Growth Russell 3000 Growth NASDAQ Composite Russell 2000 Growth (Continued on page 4) Page 4 The Essex Exchange Review & Outlook 1st Quarter 2005 continued (Continued from page 3) boosted our exposure to the finance and bank stocks and/or a major downturn in companies. This is based in generics industry, reflecting suffered the worst declines, the value of the US dollar part on improved relative attractive relative valuations while diversified financial would cause a spike in price attractiveness of the for this group, a belief that services and insurance faired inflation fears, giving the Fed services sector compared to generics will take share from better than financials on enough ammunition to the producers and branded drugs as cost average. Brokerage stocks abandon its policy of importantly, on our containment efforts from outperformed the sector, measured rate increases. We continued expectation for an private insurers continue, and driven partly by rising M&A believe this is unlikely, as acceleration in capital the expected positive impact activity. continued strong productivity spending this year which of the Medicare drug benefit Our selective approach to growth and tough global would favor the service in 2006. As a result of these investing in this area, with a competition in traded goods, sector. Please see the trends, consolidation activity focus on companies which particularly from Asian Industry Spotlight on page 2 is heating up in this area and can deliver above-trend regions, should keep inflation for a more detailed discussion we expect further revenue growth such as relatively subdued. of our energy outlook. combinations as the year Investors Financial, Citigroup For the majority of last year, progresses. Lastly, we and Goldman Sachs, and an the equity market was HEALTHCARE continue to prefer avoidance of companies insulated from the impact of The healthcare sector biotechnology, as it linked to the consumer credit Fed tightening and rising oil performed modestly better represents the fastest, most cycle, generated solid returns prices by the drop in longer- than the broad market across dynamic growth in the in this difficult environment. term bond yields and better all capitalizations this quarter, healthcare sector. We also continue to favor than expected earnings. With led by healthcare services and TECHNOLOGY insurance including AIG due yields no longer falling and oil pharmaceuticals. to robust underlying prices marching higher, stocks Biotechnology, and to a lesser During the past quarter, fundamentals, despite recent have become more sensitive degree, medical technology technology stocks were weakness related to the to profit disappointments. stocks performed worse than among the market’s worst CEO’s departure and ongoing Companies that have high healthcare as a whole, performers, giving back much regulatory investigations. In visibility into their revenue reversing some of the better of their gains experienced in total, we made no significant growth are likely to be relative performance in 2004. the final months of the past changes to our weightings or rewarded with expanding Biotechnology faced a year. We retain our cautious positions in financial services valuations. Our strategy is to particularly volatile quarter view of the sector as this quarter. continue to unearth driven by unanticipated safety evidenced by our companies across all market and efficacy news on several underweighted positions. OUTLOOK capitalizations that can not high-profile products. Looking ahead, as a general The US economy is only exceed expectations this Specifically, Genentech’s theme, we are emphasizing expected to deliver another year, but also that will positive findings regarding the companies that are expected year of solid growth demonstrate strong growth effectiveness of Avastin in to benefit from continued accompanied by moderate relative to their industry peers treating lung cancer, and modest growth in IT business inflation in 2005. and the market over the Biogen Idec’s withdrawal of spending particularly in the Employment indicators have longer-term. its multiple sclerosis drug, storage, outsourcing and firmed, business confidence Tysabri following newly-raised communications equipment has revived as evidenced by safety concerns led to areas. We remain less the surge in mergers and significant market moves for positive on the more acquisitions, and housing these stocks as well as the consumer oriented hardware activity continues to be sector. areas of technology, such as strong. The Federal Reserve We increased our exposure PC’s, printers, and handheld remains determined to shift to to healthcare in most devices. a more neutral policy, strategies this quarter, suggesting further increases in reducing the degree of our FINANCIAL SERVICES short-term interest rates over underweight position. In Our underweight position the next several months. particular, we added to in financial services stocks However, we believe the companies that increase the paid off this quarter as rising pace of tightening will slow as efficiency of the bio-medical bond yields caused the sector the federal funds rate reaches laboratory such as Beckman to significantly underperform the 3% level. Where could Coulter, Fisher Scientific, and the broad market across all we be wrong? Further Serologicals. We also capitalizations. In a reversal escalation of energy prices of last quarter, consumer 1st Quarter 2005 Page 5 Meet The Team Nancy Prial, Senior Principal and Portfolio Manager N ancy graduated from Bucknell University in 1980 with a Bachelor of Science degree in electrical engineering and a Bachelor of Arts degree in mathematics. In addition, she earned an M.B.A. from the Harvard Business School in 1984. when Burridge Growth Partners became a part of Essex. Nancy joined Essex in December 2004 Tell us about your overall lack of liquidity in my team of analysts to think investment experience. small and micro cap stocks of themselves as analysts and I have a strong background in leads to limited Wall Street also portfolio managers. the management of small to coverage and often times, Essex’s structure allows its mid cap stocks. Before joining reduced ownership. As a investment professionals to Burridge in 1998, I spent four result, small cap stocks tend flourish in their research years with the Twentieth to be less well understood by efforts. Additionally, I found Century division of American investors. Secondly, many the historic stature of Essex Century Investors, a large companies fall into the small within the growth style to be mutual fund firm best known capitalization range from a quite appealing and am for the management of small larger market cap after a price pleased to join such a well- Nancy Prial and mid cap growth stocks. decline. These previously mid estee med o rganization. Prior to that, I spent ten years to large cap stocks are often Finally, this was a great way an edge by thinking outside with Frontier Capital discarded as bad investments for me to return to my of the box. While I would Management in Boston as a and subsequently ignored by Bostonian roots, without never suggest that one should fundamental analyst and former investors who lost physically moving back to the always be contrarian, as often portfolio manager. I began money. Such lingering biases area. the consensus turns out to be my career as a technology create a host of opportunities, correct, there is an analyst, eventually adding as we believe that investors What lessons have you opportunity in having a few other industries and do not quickly pick up on learned? different ideas. If one has an ultimately becoming the positive inflection points in One important lesson my insight in contrast to the investment manager for the smaller-sized companies. We experience has taught me is majority of the market and firm’s mid cap portfolios. I seek to uncover those that it is often best to follow can back it up with think this experience is opportunities by looking for your initial instincts. Back in conviction, that idea can lead particularly relevant to companies with earnings school, I quickly learned to go to powerful investment managing small cap acceleration. with my first answer on an results. portfolios, especially since exam question. I never had what was considered mid cap What are your thoughts on much luck with changing my What do you do for fun? during the early part of my being a part of Essex? answers on exams! I think this If you asked my husband that career is now considered I have known Essex for many is relevant to investing as well, question, he’d say that I have small cap. years, having worked at as my experience has been the most fun picking stocks! Frontier Capital Management that, on average, my initial Besides stock-picking, I enjoy What do you find special in Boston, which is also an buy or sell opinion is correct. spending time with my about small and micro cap AMG affiliate. I am If I have to search for reasons husband and my two investing? particularly excited to be a to change my initial children. In particular, we The small cap universe is an part of an organization with a perception of an investment, I enjoy sailing, skiing, camping, inefficient segment of the research-driven focus. I am probably trying too hard and travel. We are lucky to market, and the micro cap consider myself a portfolio to make it work. Another live near Lake Michigan and area is even more so for two manager first, but also an important lesson that I have spend a great deal of our free main reasons. First, the analyst. In addition, I want learned is that one can gain time on the water. Industry Spotlight continued (Continued from page 2) appreciation. Steve Cutler, there is more to go as Wall slowdown leading to reduced prolonged drilling cycle will President of Essex, makes the Street is underestimating the demand, our outlook for benefit the earnings of many observation that “while the oil earnings potential for this energy remains favorable oil services and equipment services and equipment cycle." supported by strong companies and result in stocks appear overbought in In summary, barring a fundamentals and still continued solid share price the short-term, we believe worldwide economic reasonable stock valuations. Volume II, Number 1 Page 6 ESSEX INVESTMENT Around & About Essex MANAGEMENT COMPANY, LLC Our New and Improved Web-site 125 High Street If you’ve perused our web-site www.essexinvest.com recently, you may have noticed the 29th Floor Boston, MA 02110-2702 redesign of the site. The improvements we have made are more than superficial, though, as we 617-342-3200 have also enhanced and broadened the content. The expanded Products section now displays www.essexinvest.com quarterly data and characteristics on all of our strategies, including top holdings, sector weights, firstname.lastname@example.org and our current market outlook. To find out more about our people, please check out the newly updated profiles of our investment and research professionals. We hope this site will serve as an informative resource for Essex’s clients and prospects. Please stay tuned for additional offerings The Essex Exchange and we encourage you to check back often. Newsletter Editor Laura Allen Joe McNay Addresses The BSAS Graphic Design April Whitman On March 3rd, Joseph C. McNay, Essex’s Chairman and Chief Investment Officer, addressed Contributors the Boston Security Analysts Society at Trey Bowers their 19th Annual Market Outlook Stephanie Crumb Laurel Gormley Dinner. Joe gave the standing room David Goss only audience an overview of the Michael Grossman Deirdre Julian financial markets in the past year as well Karen Korn as his prognostications for the coming Christopher McConnell Stephen Scinicariello year. According to Joe: “Despite the sell- Valerie Sullivan off in the first quarter, I see a number of positive influences for the equity market. The opinions and analyses expressed in this newsletter are Interest rates and inflation, while rising based on Essex Investment cyclically, should remain at low levels. Management Company, LLC’s More importantly, short interest ratios research and professional experience, and are expressed as have once again hit record highs of the date of our mailing of this suggesting to me that investors are quite newsletter. Certain information Joe McNay at the 19th Annual Market Outlook Dinner skeptical of the market and for growth on March 3, 2005 expressed represents an assessment at a specific point in stocks in particular.” For a video time and is not intended to be a presentation of Joe’s speech and a printable file of the charts used in the presentation, please visit forecast or guarantee of future the News/Market Commentary section of www.essexinvest.com. results, nor is it intended to speak to any future periods. Essex makes no warranty or representation, express or implied, nor does Essex accept The Eagle has Landed: New Statements, New Reporting any liability, with respect to the Those of you with a discerning eye for detail may have noticed a change in your most recent information and data set forth herein, and Essex specifically Essex statement. It is the result of our conversion to a new, state-of-the-art data management and disclaims any duty to update any performance/accounting system. For more than a year, we have been diligently working on the of the information and data integration of the new system from Eagle Investment Systems Corporation to streamline back- contained in this newsletter. The information and data in this office operations. This system, launched earlier this year, is designed as a central data hub for the newsletter does not constitute entire organization in order to best serve the needs of our clients. legal, tax, accounting, investment or other professional advice. This is an exciting time for us as the new system has many added features that will allow us to enhance our internal controls, improve client reporting, and provide portfolio managers with new investment tools. As we move ahead with this integration, we expect to offer additional report customization for our clients. While our team has been vigilant about maintaining account accuracy as we transition to this new system, we need to know of any portfolio discrepancies. We welcome your questions, and encourage you to e-mail us at email@example.com.
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