Counterpoint — The Quarterly Commentary of Jurika, Mills & Keifer
Second Quarter 2007

We’ll always have Paris …

 Hilton, that is, or so it seems. Between the 24-hour news coverage of Paris Hilton’s incarceration and subsequent release from jail, not to mention Apple’s much anticipated iPhone launch, one might reach the conclusion that nothing else of great concern was going on in the world.

One might have missed the ongoing fall-out of the sub-prime mortgage meltdown as Bear Stearns and other investors in mortgage-backed derivative instruments are forced to revalue these securities in a rapidly deteriorating market. Who would’a thunk that lending money to people who can’t afford to pay you back if housing values stop rising, or if interest rates start rising could be risky? Who would’a thunk that leveraged portfolios of derivative securities based on these loans might be even riskier?

One might have missed the very private Blackstone Group’s much-heralded IPO, setting the stage for other private equity and hedge funds to follow suit in search of capital gain;

Or the political soap opera in Washington as the President’s approval sinks to a new low, and unbelievably, Congress’ sinks even lower than his.

And one certainly might have missed the steady stream of grim news from the Middle East, the Sudan, Afghanistan, Pakistan, Nigeria and other parts of the world to remind us that after Paris’ 15 minutes of fame are up (and it’s been a long 15 minutes), they will still be there and will still matter.

We make this point not to be negative. We are opportunistic contrarians at heart and actually see a few good opportunities for investment. But it does seem that from an investment standpoint, investors have grown comfortably numb, focused more on glitter than grist, and asymmetrically disposed seeking return rather than avoiding risk.

As a result, we continue to believe that risk is mispriced in the market and that many assets are fully if-not-overvalued. This isn’t to say that stocks can’t go higher but the risk versus the potential reward is not particularly attractive except in a few notable areas.

Right now, the markets remain awash in a sea of liquidity, with large amounts of capital chasing incremental return. This tends to drive asset prices higher and higher, until one day, the liquidity dries up. As we have pointed out in past Commentaries, a sea of liquidity can become a desert overnight. Then fundamentals tend to matter a lot.

One needs merely look at the historically low spreads between high yield and government bonds to see this. Stocks tell a similar story. Valuation levels, especially among small to medium sized companies are high relative to historical levels and relative to much larger and much higher quality companies. Investors are willing to pay a significant premium for the promise of future growth or the possibility of the next buyout.

Far from Paris and deep under the sea of liquidity there is fundamental cause for both optimism and concern.

On the positive side, we think investment fundamentals are good. Corporate America is in good shape even if the consumer is stretched thin. Corporate balance sheets are healthy and we expect solid results for second quarter earnings. There may be some weakness in consumer discretionary stocks and in financials, but this will be offset by strong results in other sectors like energy and technology.

Overseas, the lure of oversize gains in developing markets continues to attract large investment flows, disproportionate to domestic inflows. Ironically, we think the cheapest way to invest in these markets is by buying large domestic multinational companies.

Although we think that valuation levels in emerging and developing markets are way ahead of fundamentals, we do believe the long-term growth in China and other emerging markets is one of the great secular investment themes for the next decade and beyond. Global growth is strong and will continue to be so for many years. But it is a force that cuts both ways, creating new demand for goods and services and also creating competition for raw materials, human resources and capital.

Interest rates are rising and may lead to valuation contraction, but they are not prohibitively high and should not hinder sensible investment. For reference purposes, they were a percent higher at the peak of the 2000 bubble. Deals that don’t get done because rates are now half a percent higher than they were a few months ago are deals that should never have been done in the first place.

We believe that the chapter of our involvement in Iraq may be coming towards a close. How this will play out is unclear, but we are fairly confident that the aftermath will be different than what anyone expects. Potentially better, potentially worse, but almost certainly different. What is clear is that the status quo is untenable. The United States cannot afford to continue to play the role of the World’s self-appointed policeman, especially if we have to keep borrowing hundreds of billions of dollars from China and others to do so, growing our national debt and under investing in infrastructure, education and other factors that give our economy long-term competitive advantage. The current course puts our country on a certain path towards economic peril that rivals and eclipses any real or imagined terrorist threat.

So, beyond the allure of Paris, the appeal of the iPhone, or the saga of the next private equity firm or hedge fund to mint a few new billionaires by going public, we see an environment where many of the opportunities are priced into the market, while many of the risks are not. Like the restaurant business, location matters. So where do you go?

It was a year ago that we started to beat the drum about the favorable valuation disparity between large companies -particularly classic growth stocks - and the rest of the market. The once “nifty fifty” stocks of the 1970’s and 1990’s had become the “thrifty fifty” stocks of 2006. As the chart above shows, this disparity and this opportunity still exists and is one of our central investment themes.
The chart divides the top 3000 public companies as measured by the Russell 3000 into ten deciles, weighted by market capitalization. There are only six companies in the top decile, while there are 2008 in the tenth. We did the analysis this way to demonstrate the valuation spread between the very largest (decile 1) and very smallest companies (decile 10).

As the chart shows, the very largest companies, companies like General Electric or Microsoft, sell at about half the valuation of the very smallest companies based on 2007 earnings, and at a 50% discount based on 2008 estimated earnings.

So in a world where the risks are many and the opportunities are few, we really like these big, multinational companies. They offer reasonable valuation, dominant business franchises, fortress-like balance sheets, good exposure to emerging and developing economies, all for a very attractive price. And many of them pay a nice dividend to boot. They are unlikely to double overnight, but they are also unlikely to get cut in half should some event come out of left-field as it does from time to time.

This is not to say that there aren’t also opportunities among small and mid-sized companies as well, nor that all very large companies are attractive investments. With every specific investment, we evaluate the tradeoff between business quality, valuation, and potential return. Today, we find the more favorable combinations of the three factors among the largest multinational companies, particularly in technology. Tomorrow, or some time in the future, as risk and return expectations are repriced in the market, we will almost certainly gravitate elsewhere. Opportunity, like Paris (the City, that is) tends to be a moveable feast.

Jurika, Mills & Keifer
July 2007

Important Disclosures

Past performance is no guarantee of future results.

Opinions expressed are those of Jurika, Mills & Keifer, LLC and are subject to change, are not guaranteed and are not recommendations to buy or sell any security.

The S&P 500 Index is an index 500 large capitalization companies selected by Standard & Poors Corporation. The Dow Jones Industrial Average is an index of 30 large capitalization stocks selected by Dow Jones & Company. The NASDAQ (100) Composite is an index of 100 of the largest domestic and international non-financial companies listed on the NASDAQ stock exchange. The MSCI EAFE is an index of non-US stocks maintained by Morgan Stanley Capital International. The Russell 3000 is a broad index of 3000 companies. One cannot invest directly in an index.

The Price to Earnings (P/E) Ratio reflects the multiple of earnings at which a stock sells.