The Way It Is

One immutable feature of the investment business is the Annual Review: a cold hard look at the year just completed and some predictions about the one just begun. Or as Winston Churchill said in 1898: “I pass with relief from the tossing sea of Cause and Theory to the firm ground of Result and Fact”. The long term secular bet that we took in 2003 that favors commodity oriented and foreign investments produced another good year—our accounts solidly beat the relevant benchmarks, and perhaps more importantly, we enjoyed our fifth straight year in positive territory. The 2006 outlook is eerily similar to that of 2005, with one exception—I believe large cap US companies serving global markets will outperform for the first time in seven years, and we have added positions there from cash. Here is my 2006 Outlook:

The world has entered a “tri polar” investment stage where Europe and Asia have increased their economic power relative to the US-50% of equity market capitalization consists of non-U.S. companies. Asian markets will continue their out performance this year, and Japan’s recovery is in an early stage

The era of long-term disinflation, in place since 1981, ended in 2004. Traditional earnings growth asset returns will under perform relative to commodity related asset returns for the next decade

The end of a Fed tightening cycle in the US favors large growth companies serving global markets. Demographics, namely an affluent, aging population favor pharmaceutical companies and biotech

Fixed income strategies must be global, multi-sector and contain exposure to real return, inflation – indexed bonds.

Much of this Outlook is already incorporated in our accounts, although some of you who joined us last year are just starting to see the positioning take effect: 200 + point one -day drops in the market like we had two weeks ago are ideal entry points for our long term strategies. Let us consider a few of the more important elements of the Outlook. The first is commodity inflation. The sharp (and fortuitous for us!) up tick in 2005 energy prices certainly fits the pattern—aluminum, copper and sugar soared to 5 year highs. Most of this is demand-derived as emerging and emerged economies across the globe are building infrastructures and making investments with their reserve surpluses. I believe this is a secular trend is still in the early stages.

The second element (literally) is gold, and what it is telling us about inflation, the dollar and global fixed income. Part of this is investor reaction—gold tends to do quite well in inflationary environments. It is also a hedge against the dollar, which is one of my favorite long-term themes: the US current account deficit and “guns and butter” spending is not a formula for currency appreciation. Here is the picture.

You can make the argument that rising US interest rates in 2005 kept dollar/gold flat, but what happens when the Fed (as widely expected) stops raising rates this year. Will the dollar begin to slide again? I think so, although I believe that there is a better than even chance that the Fed will continue to be alarmed at commodity inflation and surprise the “experts” who believe that rate increases end in early 2006. In any event, I believe there will be a flight to quality in US equity markets, and that large growth companies that serve global markets are poised to do well and, after five years, represent better value.

This is not to say that I do not like our foreign holdings—as you can see from the Outlook, I do like them, and we are still overweight Japan, other parts of Asia and Europe. Finally, I am excited about the global prospects for pharmaceutical and biotech. There is a real confluence between developed countries’ demographics, spending power and the discovery rate for new drugs.

So to paraphrase Churchill, so much for “Result and Fact”. We return to the tossing sea of “Cause and Theory” and in the investment business that is just the way it is.