The magnitude of the 2003 stock market surge worldwide was a big surprise following the late 1990’s speculative bubble.  Although the three year market decline (2000-2002) was very painful especially in selected sectors; overall we did not see the depressed valuations normally associated with a post bubble period.  Massive monetary and fiscal stimulation appears to have overwhelmed a normal correction and instead created a dynamic economic recovery.  We anticipate further stock market progress in 2004, but not at the rate seen in 2003.

Productivity in the United States increased at a stunning 8.1% rate in the third quarter of 2003. Increased productivity has been the hallmark of our country and the wonder of the world for at least two centuries. The use of interchangeable parts by Eli Whitney around 1800 formed the base for industrial mass production. The developments in transportation, energy and science in the nineteenth and twentieth centuries continued the rapid pace of productivity enhancement.

Fifty-five years ago the lights dimmed in West Philadelphia when the University of Pennsylvania fired up the first computer. The computer had 18,000 vacuum tubes. The equivalent circuits today would fit on a small fingernail or less. The use of the computer is still evolving, which with other inventions keep the gains in productivity moving ahead.

The current productivity increase of 8.1% comes from a variety of sources. As the year 2000 approached, considerable capital was spent upgrading computer systems to deal with the prospects of Y2K. The optimism of the late 1990’s further expanded capital spending. The effects of these expenditures were not limited to the year of expense, but continue to have an impact. The same is true for the massive spending on research and development. Third, it is normal to see productivity improve coming out of a recession. Business works to be more efficient in a recession; the efficiency gained is magnified in the subsequent recovery. While productivity gains will continue, it is unlikely that the rate of gain will persist in the high single digit area. However, the current high level suggests that the economy is quite healthy and expanding.

As knowledge advances, opportunities expand. Creativity is not at an end; in many ways it is at a beginning. We have spoken before about the medical areas where so much has been accomplished; just think of the increase in the average life span in the last hundred years. Yet more will be done to produce improved medical outcomes. Johnson & Johnson, Medtronic and Boston Scientific among others, are in the forefront of creative solutions. The whole domain of genomics, which has great promise, has just started to unfold. 

We continue to focus on science and technology where we see

substantial increases in productivity.  From these increases will come a better life as well as profits and investment gains.  This is why research effort is, and will continue to be, so imporant in our investment thinking.

Eafe: Any Performance Left?

After a year of great absolute and relative performance, it’s natural to wonder if international equities are tapped out.  The Morgan Stanley Europe, Australasia and Far East Index (EAFE) advanced 39% during 2003, while the S&P500 posted a 29% return.  It’s interesting to note though, that almost half the EAFE return was the result of currency gains.  In local currency terms, foreign stocks once again underperformed those in the US !  In light of that fact, it’s not surprising to find that non-US stocks still compare very favorably to their domestic counterparts, with lower valuations on average, and in many cases, higher growth.

Just where are the interesting international investment opportunities?  Based on our quantitative screening process, selected financials still look attractive, despite the potential for interest rates to move higher in the coming months.  A sizeable number of consumer-related stocks also screen well.  Interestingly, and for the first time in several years, some traditional pharmaceutical stocks appear to offer an attractive balance of valuation and growth potential; perhaps we are finally nearing the end of the de-rating process.  Also notable is the recent increase in the number of Japanese companies within the top quintile of the universe.  The Japanese market has pulled back a bit recently, while earnings estimates have trended higher, creating an increasingly attractive investment picture.

Getting back to the initial question, yes, the underpinnings needed for EAFE out-performance appear to be in place.  We’re off to a good start this year, with EAFE outpacing the S&P 500 by more than 100 basis points as of this writing.  Even excluding the positive currency return, EAFE is ahead, but only by 50 basis points.  Of course, as history has shown many times, relatively attractive valuations don’t necessarily produce out-performance in the short term.  As bottom-up stock pickers though, we’re finding lots of interesting investment opportunities to be enthusiastic about.