With half of 2005 now in the books, it’s reasonable to assess our major investment themes, examine funds that have disappointed, as well as those which have performed above expectations, and see if we need to make any adjustments to the portfolios for the last half of the year.

That said, one of our governing principles is that “we will not speculate in an attempt to generate short-term gains,” so we don’t fire money managers on the basis of poor performance over a short time period (unless, of course, there is a significant process or personnel change). However, examining short-term performance is still a worthwhile exercise in terms of trying to understand a fund’s behavior and expected performance moving forward.

While there are clearly areas we could have done better (more on this later), we are reasonably satisfied with our total returns this year, particularly given the level of risk we have taken. All client portfolios are basically flat to modestly higher on the year despite the stock market being down on the year. With some exceptions, more conservative accounts have higher returns due to larger allocations to fixed income.

As I noted in my January Report, heading into 2005, we continued to favor the same investment themes as in 2004 and 2003, but with much less emphasis. As such, our positioning was closer to neutral on many factors than it had been in some years.

We still favored international funds, especially those with substantial emerging market exposure, but we were more guarded because we felt the dollar might be stronger in the first half. Our emerging market positions did boost returns nicely, but with a few exceptions, our diversified international funds failed to add value largely because the dollar was even stronger than we expected, rising over 10% versus a basket of major currencies.

A new theme for 2005, and a significant positive for our more aggressively oriented client portfolios, was exposure to commodities. PIMCO Commodity Real Return gained 12.1% in the first six months of the year. Though the area remains subject to volatility we continue to favor it but will be watching closely (more on that later).

1st Half Returns By Market Sector

Thanks to soaring oil and real estate prices, commodities and REITs led the way in the first half. Both emerging market stocks and bonds were strong, and, in general, U.S. bonds outperformed U.S. stocks. Hardest hit were technology stocks (Nasdaq) and foreign bonds, the latter being damaged by the U.S. dollars strong 10%+ gain.

On the negative side, one trend that we expected to reverse has yet to do so. After overweights in small cap stocks in 2003 and 2004 which proved successful, we shifted some of that exposure back to large-cap stocks as we expected that area to begin to outperform. In fact, large and small caps were in a virtual dead heat through early July, but mid-caps were the stand out performers. And while our additions to larger cap stocks focused more on growth fare (where valuations were more attractive), value remained the place to be.

For our more conservative client portfolios, some well-timed tactical asset allocations in the fixed-income area, most notably extending our maturities when long-term rates (briefly) rose and then reducing our interest rate exposure when rates headed back down, added to performance. Reducing exposure to “credits” (corporate and high-yield bonds) in favor of “governments” was also beneficial.
Of course we would like every decision to go our way, but that is simply not a reasonable assumption. As one of our underlying portfolio managers, Bill Nygren of Oakmark and Oakmark Select, has said: “… let me caution that even though Oakmark has a good track record, does extensive research, and evaluates our results over very long time periods, we still are wrong on about 40% of our (security) selections.” And he’s good. While we hope that the majority of our decisions are correct as well, we also rely on our diversified, tactical asset allocation approach to minimize how much mistakes cost us.

Oakmark and Oakmark Select
Speaking of Mr. Nygren and his funds, this year, despite being in the favored value area of the market, they are below average relative to peers and a drag on our overall performance. Yet, his Oakmark Select fund is still in the top 2% of large value funds over the last five years and his more diversified Oakmark Fund is in the top 7%.

Bill's performance this year has been negatively impacted in a couple areas. Unlike other value managers, his exposure to energy and utility stocks has been minimal. A couple of his underlying stocks, particularly in media, have not worked so far this year. In addition, he has moved his portfolio towards higher quality, larger-capitalization stocks. We too, have made this move on the margin of client portfolios, though, as mentioned earlier, neither of us has realized significant value from these moves as yet.

Given Bill’s strong long term track record and historically strong stock selection skills, combined with our desire to avoid chasing performance (given the statistical odds against success), we would suggest that now is a better time to buy his fund than to sell it.

REITs: Missed Opportunity?
Perhaps our most significant “miss” this year has been our avoidance of real estate investment trusts (REITs). While REITs have enjoyed strong returns, we believe they are overvalued and despite the “pain,” remain comfortable with our decision. According to the Leuthold Group, the stocks of REITs are currently trading at a 12% premium to the value of their underlying real estate, whereas they have averaged a 2% discount to their assets for roughly the last decade. So from an expected total return basis, they do not look attractive.

Perhaps more significantly, from a portfolio construction point of view, their risk characteristics are not typical of their historical behavior. First, the volatility of REITs has been more than double its long-term average. Second, REITs have not provided the level of diversification benefits they have in the past due to their rising correlations to the broad stock market.

As I have noted in the past, we would rather leave some money on the table than subject your portfolio to excessive risks. Investors who avoided (what in hindsight were clearly overpriced) tech stocks in the late ’90s were scoffed at, but ultimately proven correct.

Large Growth Stocks
As I discussed earlier, this year we have gradually moved more of our client’s assets into large cap growth funds, particularly those emphasizing classic, high-quality, blue chip stocks. This area of the market is attractive to us for a combination of reasons, including: superior relative valuations; an anticipated weaker dollar environment moving forward (a weaker dollar favors larger exporters); and the likelihood of a slowing economy (smaller companies are typically more levered to the economic cycle than larger companies). We believe those reasons are still valid.

While economic growth through the first quarter remains strong, a variety of signs are pointing to slower economic growth ahead. Most prominently, the yield on short maturity bonds is getting closer to the yield on longer-maturity bonds. All else being equal, this so-called “flattening” of the yield curve is often a precursor to slower economic growth.

Another signal from the bond market that suggest economic softness is the yield spread between U.S. Treasuries and corporate bonds. The spread between the two has been very low by historical standards, suggesting overvaluation of the riskier, more economically-sensitive, corporates, and is now starting to “widen” again. Historically, this kind of overvaluation followed by a widening of the spread has heralded a sustained period of small-cap underperformance.

Are Commodities Now Overextended?
We are getting lots of questions on commodities, particularly oil (which makes up about 30% of our commodity exposure). At $60 is oil a buy — or a sell? We are definitely long-term bulls on commodities as an asset class (as shown in the April Portfolio Manager’s Report, commodities tend to move in multi-year price cycles). In the shorter-term, however, while we aren't necessarily negative, we don't have a high degree of conviction that the rally can continue. Long-term investors should look to buy commodities on price weakness.

Low Volatility Limits Opportunities For Tactical Shifts
Coming out of the locker room at halftime, we don’t feel any dramatic adjustments are warranted. While some of our positions haven’t worked so far this year, we still have a high level of confidence in our course of action there. Moreover, while we have been able to take advantage of volatility in interest rates to add value through tactical shifts on the fixed-income side, so far in 2005, stock market volatility has been 30% below normal, so there have been fewer opportunities to take advantage of changes in relative valuations on the equity side.

Sincerely,

Eric Kobren

P.S. Please continue to send us feedback on www.kobreninsightmanagement.com. Our latest pieces are a “Research Perspective: Investing Lessons for the Next 20 Years” and our upcoming “Analyst Spotlight” will be on mid-cap stocks.