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Edgewood Management Company

VIEW FROM EDGEWOOD



ECONOMENTS

Edgewood Management LLC
January 8, 2007

The View from Edgewood

The year ended with a continuation of the rally that started in the third quarter. The Federal Reserve remained firmly on hold and by all indications, both from its own statements and the ongoing flow of economic data, it will remain there for some time. The mid-term elections came and went and, contrary to some predictions, the world did not end. The Russell 1000 Growth index had a decent year with a 9% gain, but the average Edgewood growth account returned approximately 15% despite the fact that 2006 was another year when value stocks outperformed growth stocks.

It became evident during the quarter that the Federal Reserve was not convinced there was a need to be quickly cutting short-term interest rates. The inflation indicators they track as well as continued strength in many sectors of the economy (excluding housing), pushed out even the most optimistic forecasts for rate cuts until at least the middle of 2007. A few analysts talked about hikes again, and several predicted the FOMC could remain at the current Fed funds rate of 5.25% for the entire year. As the year ended the economy had slowed from its 5% growth rate in the second quarter, but signs were emerging that the rate of GDP growth as we entered 2007 was staying around 3%, which is too strong for the Fed to consider a change in policy. While the effects of the slowdown in the housing industry have not fully flowed through the economy, the spring is traditionally the strongest period for housing sales. A decent spring could reduce the inventory of unsold houses, creating some strength in that sector, and further delay a loosening in Fed policy. That is not a negative if more moderate economic growth is accompanied by declining inflation.

Energy prices and the prices of many commodities have declined dramatically from their summer peaks: both oil prices and the price of copper have plunged. Winter in the eastern United States and Western Europe has been bizarrely mild and this is adding to the pressure on prices due to slowing global oil demand and the greatest supply increases outside of OPEC in twenty years. Lower energy prices will increase the discretionary funds in consumer’s pockets, but also remove a potentially large inflation threat.

Private equity funds now have close to $1 trillion in buying power worldwide and the size of their potential target company has grown to the point where a company the size of Home Depot is bandied about as a buy-out candidate. Public companies are flush with cash and are increasing buybacks. Activist investment funds are putting pressure on recalcitrant managements to not sit on excessive amounts of cash and return it to shareholders with either special dividends or more share buybacks. All of these factors have led to almost $500 billion in equity shrinkage over the last year, and we think that will continue. These are all positive factors for stocks.

While value stocks did outperform growth in 2006, for the seventh year in a row, in the second half of the year the gap began to narrow. This is an unprecedented length of time for one asset class to dominate another one, and makes us all the more confident about the reasonable valuations of growth stocks. Large cap growth stocks are still at ten year lows in valuations (P/E, earnings yield), a theme we have been repeating for most of the last year. We still believe profit growth in the main Edgewood portfolio is running at 19% annually, compared to an expected slowing to below 10% growth in profits in the S&P 500. As we have mentioned several times in our recent letters the best environment for growth stocks is that point where interest rates have peaked, the overall economy is slowing and the corporate profit growth rate is declining. We are reaching that spot in the economic cycle where these factors are aligning.


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