VIEW FROM EDGEWOOD
| Year 2003 | Year 2004 | Year 2005 | Year 2006 | Year 2007 | Year 2008 |
| 1st Quarter | 1st Quarter | 1st Quarter | 1st Quarter | 1st Quarter | 1st Quarter |
| 2nd Quarter | 2nd Quarter | 2nd Quarter | 2nd Quarter | 2nd Quarter | 2nd Quarter |
| 3rd Quarter | 3rd Quarter | 3rd Quarter | 3rd Quarter | 3rd Quarter | |
| 4th Quarter | 4th Quarter | 4th Quarter | 4th Quarter | 4th Quarter |
ECONOMENTS
Edgewood Management Company
July 6, 2004
The View from Edgewood
The small market advance of the first quarter was matched almost exactly by a tiny advance in the second quarter. While the first quarter’s performance weakened over concerns that the economy was stumbling, the second quarter was spent fighting the headwinds of worry about bigger problems in Iraq as well as higher gasoline prices, higher inflation, higher interest rates, all the result of stronger growth.
Despite the early gloom this is turning out to be a good year for the U.S. economy. GDP growth should be around 4% and job growth has been robust since March, even considering June’s weaker results. Productivity growth has continued at above average rates, even as the economy has recovered over the last two years. This pushed inflation almost to nothing in a weaker environment; as long as productivity growth continues it will help keep a ceiling on inflationary pressures in a stronger economy and on the Fed’s ultimate interest rate target.
Short-term interest rates have been at a 45 year low for a year. This was an emergency rate set by the Fed to head off what it feared most last year at this time: deflation. Whether or not it was an actual threat can be debated, but it is not a threat now. We have seen a cyclical up tick in inflation as the U.S. and Japanese economies have strengthened and China’s economy has stayed red-hot. Most of this has come from commodity price increases, which are less than 30% of industrial inputs. Even with the large jump in the price of oil, the Fed does not currently view this as a long-term trend in prices. What they keep their eye on is wage inflation which is a much larger portion of business costs and is much harder to reign in once it gets moving. So far, even with a few months of better job numbers there is no indication that wage inflation is re-appearing.
Because the market hasn’t had much else to do it has been extremely focused on the length of this Federal Reserve tightening cycle. How high rates will go and how long the cycle will last is being relentlessly debated. The Fed wants to get back to a neutral rate, which would mean the Federal Funds Rate equals the rate of inflation (right now it is lower than the rate of inflation). That would put a neutral rate at around 3%, still low by most standards but high in relation to the last couple of years. Just getting to that rate will slow the economy somewhat, probably enough to take much of the pressure off of prices and slow the current inflationary up tick. Given that and the decrease in fiscal stimulus that is coming next year, it is hard to see the Fed moving much above 3%. At the end of June we had several indicators that the economy’s momentum may be slowing on its own, which will help the Fed maintain its “measured” pace.
For many years cash flow has been one of Edgewood’s prime considerations when analyzing a stock, we see no reason to change that focus now. We continue to believe that companies with strong cash flow will be the winners in the stock market over the next several years. Coming out of the 2000 -2002 bear market, the stocks of many companies did well in 2003. Those companies that had been, or were perceived to be, on the brink of bankruptcy saw their stocks sharply advance, but many have flattened out this year. The market seems to be saying: fine, you survived, but what have you got left? In the next stage of the economy’s and the market’s recovery we believe there will be a much more careful consideration of companies based on both their earnings prospects, their balance sheets and their cash flow. Cash flow will be the differentiator because it is less easy (though not impossible), to manipulate and it is a clear measure of the strength of a company’s business model. It provides financial flexibility and removes capital market dependence. As the economy settles into a more “normal” pace quality earnings growth will be harder to find and its first derivative, the production of cash, will take on more importance.
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