Research and development have always played an important role in our investment thinking. A recent book by Kevin Manley, “A Maverick and His Machine,” chronicles the vibrant life of Thomas J. Watson, who took over the CTR Company in 1914. He transformed it into IBM; in doing so he was relentless in applying research to build better machines for his customers. While everyone was cutting back in the Depression, IBM proceeded to build a new state-of-the-art research center and to expand and upgrade facilities. At the same time, no IBM employee was laid off.

On August 14, 1935, President Roosevelt signed the Social Security legislation, which created immense record-keeping problems. IBM had the solution, with a large inventory of tabulating machines, not just any inventory, but product far ahead of the competition. Through research, IBM had dramatically widened its lead over the industry.

Like Watson, we look to the future and try to base our investments in companies that create new products through research. We continue to search for businesses that are growing at an above-average rate, primarily through internal development. Acquisition just to gain size has little to recommend it, other than short term cost reductions. Acquisition to gain technological advantage, however, has merit, especially when the advantage is achieved more quickly than if created internally. Johnson & Johnson, Medtronic and Boston Scientific, among others, have spent heavily on internal research, but they also have purchased technology to advance their position. Where the cash flow is adequate, both approaches to research appear valid. 

Congress has passed a new tax bill including changes in the Alternative Minimum Tax, the Marriage Tax Penalty and other regulations. However, the bill also lowers the top tax rate on most ordinary dividends and the long-term capital gains tax to 15%. These changes make equities and dividends more attractive, especially relative to both current and long-term yields.

Interest rates have fallen to lows not seen in 45 years. The Federal Reserve Board has cut rates 13 times since January 2001 to help stimulate the economy. The most recent rate set for Fed Funds is now at 1%. With little room for further cuts, the bond market reacted negatively with ten year U.S. Treasury Bond yields rising from a low of 3.1% in June 2003 to 4.4%. 

Stock prices have risen sharply since March. Higher stock prices suggest that an economic recovery is at hand. If so, then bond prices should start to fall from current highs, as rates are driven up by increased demand for funds. If the recovery is not at hand, stocks seem full relative to earnings and dividends. Something has to give. Much will depend on corporate earnings in the second half of the year. We are optimistic the economy will pick up along with corporate earnings.


Stock Comment

Our portfolios have been becoming less “luxurious” lately as we liquidate our position in Gucci ($98). We first became interested in the company after the dramatic turnaround that CEO Domenico De Sole and designer Tom Ford brought about in the mid-1990s. The brand’s premium image was restored and even enhanced by the team after years of overspending and mismanagement by the founding family had brought Gucci to the brink of liquidation. De Sole emphasized professional management, transparent accounting and a commitment to shareholder value, while Ford’s creative vision for Gucci was one of trendsetting fashion that is glamorous, fun and irreverent. Operationally, the company was back on track when the Asian currency crisis in 1997 hit luxury-goods stocks hard and created a low-risk entry point; we began to purchase the shares late that year and early in 1998. Over the next few years, the price of Gucci almost tripled, before pulling back a bit. Then, in September 2001, Pinault Printemps Redoute, a French retailer, acquired more than 50% of the company’s shares, and agreed to pay $101.50 per share to all minority shareholders by March 2004. Since that time, Gucci has been a significant outperformer, with the bid providing support in a very difficult operating environment. The shares are currently trading at a small discount to the offer price, and based strictly on fundamentals, we believe they are significantly overvalued.