September 2002, Volume II, Issue 8
George Cole Scott, Editor

Marking The Bottom

The U.S. equity markets may have hit their lows on July 23rd, according to a report put out by J. & W. Seligman & Co. On that day, the Dow Jones Industrial Average closed at 7702.30, the S&P 500 Index closed at 797.7, and the NASDAQ Index closed at 1229.10. In the opinion of the firm, which has a long history, investors should increase exposure to U.S. equities for the following reasons:

	The strong rally in U.S. equity prices since July 23 is symptomatic of a market bottom.
	The crisis of confidence has dissipated.
	The concerns over fundamental strength of the economy are exaggerated.
	The U.S. equity market on the whole appears undervalued.

The threat of renewed deflation or a contagion from Brazil’s current economic difficulties could cause us and the markets to reassess this outlook. Moreover, the risk of further acts of terrorism remains a clear and present danger. However, after one of the longest and deepest equity contractions in history, long-term investors may find opportunity in equities in general and U.S. equities in particular. Valuations appear to discount risks involved with investing in today’s market without reflecting fully the potential positive developments that we believe may occur in the next six to twelve months.

J.& W. Seligman is the manager of the closed-end fund Tri-Continental Corporation (TY-NYSE) For a continuation, go to www.seligman.com for the economic commentary.

A World of Opportunity Outside the U.S. —
Bargains In Foreign Markets May Be The Best in 30 Years

During the bull market of the last decade investors had little reason to invest outside the U.S as far more could be made at home. When the bear markets took hold, most foreign markets fell victim too. The next decade could be quite different, as stock valuations in most foreign markets are now significantly lower than in the U.S. and earnings potential is now as good as it is at home. Any weakness in the long-strong U.S. dollar will make non-dollar investments all the more rewarding.

Isolation isn’t just a piece of American history. For many Americans, it’s a standard investment strategy. The typical American has less than 5% of his assets in foreign holdings because there was no reason to look overseas. Foreign currencies were weak and often unstable, and regions around the world suffered major down turns. The Asian contagion in 1996 and the Russian Crisis of 1988 followed the Mexican tequila crisis of 1994 when the country’s entire market imploded. For most U.S. investors, foreign stocks became poison.

As a result, Morgan Stanley Capital International’s European, Asia and Far East Index declined each year from 1988 until 2000. The EAFE, weighted 46.7% Europe, 6.8% Asia, 21.6% Japan and 24.8% United Kingdom, started the 1990s at about 3.5 and finished the decade at 1, or 72% below its 1988 peak.

Nevertheless, many advisors were bullish on international stocks in the early 1990s. Advisors who were recommending 30% allocation outside the United States did exactly the wrong thing to do at the time.

The EAFE experienced booming earnings growth from 1976 to 1988, ranging from 1% to 3.5%. But such a growth rate was impossible to maintain because weakened currencies and attractive U.S. markets made it nearly impossible to attract capital. The result was a series of deep recessions, weak foreign currencies, and severe restructuring of corporate debt throughout the 1990s.

Fast Forward to 2002

Americans are now ready to look abroad in search of higher returns. U.S markets are in their third year of a decline so profound that investors are pulling out of U.S. equities and looking for growth prospects. They are moving into real estate investments and bond funds so rapidly that may work for the short term, but investors will miss the next boom in equities if they don’t look at the foreign markets for part of their portfolios.

The valuation gap between U.S. equities is extreme: foreign stocks are selling at a 34% discount to U.S. stocks. During the 1990s, the discount averaged 9%; in the 1980s, foreign markets traded at a 6% premium to the U.S. This is especially true in Asia, where average return on equity among Asian stocks is nearly on par with the US, at about 10%-11%. Yet Asian stocks are still trading at a discount of 30 to 40% to those on Wall Street.

An apparently criminal series of corporate accounting scandals and management missteps have cast doubt on the integrity of U.S. markets and corporations. Even if these are a small minority, it is the perception that the U.S. is a less viable place to invest will not disappear for sometime.

Corporate governance and accounting practices have improved rapidly in other countries, especially in Asia, as these countries are realizing that they must. Mark Mobius, manager of the Templeton Emerging Markets Fund and other Franklin Templeton Funds, serves on the board of directors of companies in many parts of the emerging markets world to be sure they comply to accounting and other disclosure standards.

Financial Research Corp. in New York reported in July that since January 2002 world funds have shown net inflows of $4.79 billion compared with net outflows of $16.2 billion in 2001.

This could be the first hint of better performance in international markets. It could also signify the beginning of a new era, where foreign investment allocation will be just as important as U.S. equity holdings.

Year-to-date (06/20/02) six of 12 international categories showed positive returns, according to Lipper Inc., a fund research company. The best performers through June included: gold-oriented funds, up 62.36%; Pacific ex-Japan funds up 7.88% emerging markets up 5.43%. The worst international performers were Latin American and global funds. Overall, the world equity market has shown dramatic improvement. From average world-fund losses of 17% in 2000 and 2001, the new numbers are promising. Year-to-date, world fund losses average only 1.5%, which shows an upward trajectory that is causing investment companies to beef-up foreign holdings and urge clients to consider overseas investments. Many fund managements are launching new international funds. People have forgotten that from 1969 to 1994 international stocks outperformed U.S. stocks.

Where are the best foreign opportunities? In recent months, the strongest rallies have been in emerging markets stocks, including many Asian, Latin American and Eastern European nations. Developed nations are also attractive, especially in the smaller markets where the price/earnings trade below 15. Closed-End Fund Advisors favors regional funds so the managers can use their expertise in the region to pick the stocks with the highest potential rather than taking the risk of exposure to one country.

The Case for Europe

Fidelity, the nation’s largest investment company, said recently that the time has come to increase international equity allocations to at least 15% of your holdings. Of the regions it covers, Fidelity said the strongest growth prospects are in Europe where a lot of European counterparts to U.S companies are selling at discounts to the U.S stock market. Europe is also considered the most stable market outside the U.S. The new currency, the euro, has allowed corporations to save money and act like one united financial market. Europe also has better corporate governance than in the past, as more companies are focused on the shareholder instead of stakeholders. European pension funds in large corporations are grossly under-funded, which means large cash flows are expected to flood the marketplace, according to Fidelity research. Even though performance of funds in this region has been a mixed bag, some European funds have turned in stellar performances. There is a strong case for funds in Eastern Europe because many of the countries are in negotiations to join the European Union.

“There is a definite change of direction in currencies, and many corporations have now leveraged their debt,” says Gavin Caldwell, chief executive of KBC Asset Management in Dublin, Ireland, one of the largest fund companies in Europe. “European markets are in a prime position to outperform U.S. equities for at least the next 10 years.”

With any overseas investing, currency is part of the equation. For 10 years, the U.S. dollar has soared against most currencies. That meant U.S. investors suffered when the value of their foreign holdings dropped because the securities were denominated in local currencies. But they benefit when the greenback falls. One analyst thinks a dollar decline will add two percentage points per year to overseas returns for U.S. investors over the next decade.

Forecasting currency movements is even dicier than predicting stock prices. But dollar watchers say the trends are not in the greenback’s favor. First, the U.S. current account deficit, which measures how much imports exceed exports, is now $417 billion, the highest in history. That deficit has largely been offset by foreign investors buying dollars in order to acquire U.S. securities, especially bonds. In the managed portfolios, Closed-End Fund Advisors holds The Europe Fund, (EF-NYSE) Central European Equity Fund(CEE-NYSE) and MSDW Eastern Europe (RNE-NYSE).

Asia Pacific

After years of rising and falling whenever Wall Street moves, Asian markets have been showing signs of greater independence this year. While they have been hard hit in line with global trends, most are still a long way off the lows on Wall Street. Unlike the US, Asia’s bubble burst five years ago with the regions financial crisis. Since then many companies have been paying down their debt and improving average interest coverage ratios. The region’s average stock valuations remain cheap, at 1.5 times price/book and 13 times prices/earnings, compared with 3 times book and 18 times prices/earnings in the US. In some countries, notably Korea and Thailand, easier access to consumer credit has boomed sales of new homes, cars and televisions as incomes have risen and a new middle class emerged.

China’s economy is one of the very few sources of significant world growth this year. GDP may rise by 8% in both 2002 and 2003 and this alone is pulling-up other Asian economies until growth in the U.S. resumes.  Chinese exports are soaring, aided by the weaker U.S. dollar. Analysts expect a better year for Hong Kong in 2003 as the growth in world trade resumes. “If you haven’t put your money to work in any serious way in Asia, then you’ve underperformed,” says Ajay Kapur, regional equities strategist with Salomon Smith Barney in Hong Kong.

Mutual funds in this region including Japan are up 4.85% year-to-date but showed losses of more than 9% during the past 12 months. Asian Pacific funds excluding Japan are up 6.46% year-to-date after showing a loss of more than 5% in the past 12 months. The funds investing in Japan have lost on average about 27% in the last two years, as Japan has been such a risky category over the past three years. But year-to date, Japanese funds show average returns of 3.83%, Lipper reported.

Investors are regaining confidence in the Japanese market this year, as Japanese companies, particularly the smaller ones, have been doing better. The blue chip companies have been suffering because of the selling of shares by the troubled big banks, making the smaller companies more attractive. Moreover, a weakening dollar and a stronger yen are expected to boost performance, and the funds are reflecting this.

Small companies tend to be better run than larger companies and have a record of out-performance over time. Management usually has a big personal stake in the business, and the companies tend to be of a better quality and more focused. In Japan, small companies have less debt and money losing subsidiaries. The Japanese market itself remains a big question mark as Japanese executives continue to be indifferent to shareholders after an 11-year bear market. Yet some managers think Japan is ripe with opportunities and could be the best performing market going forward. The country is driven by exporters, which are very sensitive to the world economic cycle. As the global economy recovers, their earnings will improve dramatically.

The smartest investors are the ones who carefully do their homework and find inefficiencies in overlooked markets as John Templeton, the pioneer of global investing did.

The choices in the China region for closed-end fund investors include Asia Pacific Fund(APB),Templeton China World(TCH and Templeton Dragon(TDF). The Japan Small Capitalization Fund(JOF) has had high returns all year and has been trading near net asset value as a result. In early September, it was trading at a discount of nearly 10%.

Since the U.S. lowered rates sharply last year, foreign investment flows have slowed. At the same time, demand for foreign equities has picked-up. In the past six months, money flowing into European equities from the U.S. and other countries has been two or three times that of foreign money moving into U.S. stocks. If these trends persist, the dollar will have nowhere to go but down. The smart thing is to get there before everyone else.

Source: Business Week, Financial Times and Ticker Magazine

Despite Recent Gains, REITS Can Still Generate Tidy Returns

Equity REITs, which make money by buying and renting out offices, apartments, shopping malls and other buildings, have had a 55% cumulative return since year-end 1999, according to Washington’s National Association of Real Estate Investment Trusts. Over the same time, the Standard & Poor’s 500 stock index has slumped 35%. In spite of the signs of froth, Real Estate has been seen as a no-lose investment. Over the past year, AIM Management Group, Citigroup, Cohen & Steers and John Nuveen have all launched exchange-listed closed-end funds that buy REITS can use leverage to boost returns. The S&P now includes four REITs which don’t have much in common with closed-end funds except they sell at discounts and premiums to “net asset value”. Closed-End Fund Advisors has used them in their client’s portfolios to boost returns and provide steady cash flows for income-oriented accounts. Ironically, we have shied away from the REIT closed-end funds because we chose to analyze the companies themselves.

There is no guarantee that REITs will continue to perform well. They behave less and less like other stocks so they help smooth out your portfolio’s performance. The evidence suggests that REITs still have room to roam.

Source: Jonathan Clements, The Wall Street Journal

According to the monthly review on the Real Estate Investment Trust industry published by A.G. Edwards for August, shares of Pan Pacific Retail Properties (PNP) were the top performer during the trailing three-month period ending July 31, generating a total return of +10.5%. This company remains almost singularly focused on its core business, the acquisition and ownership of grocery anchored shopping centers and maintaining a clean corporate structure that is absent any off-balance sheet arrangements or tenant issues of any significance. As a result, occupancy remains high (approximately 96%), the balance sheet is solid. The brokerage firm estimates for FFO per share ($2.94 for 2002 and $3.15 for 2003) suggest PNP will provide one of the better growth rates in the community shopping centers sector.

The October Scott Letter will feature an interview with Stuart Tanz, Chairman of PNP. This will be the first REIT interview in our eight-year history, but, after our interview with William Walton, Chairman of Allied Capital in our last issue, we have decided to broaden coverage of investments in our portfolios, particularly those which have been so outstanding as Allied Capital and Pan Pacific Realty.

Note: None of the information contained herein should be construed as an offer to buy or sell securities or as recommendations. Performance results shown should under no circumstances be construed as an indication of future performance. Data, while obtained from sources we believe is reliable, cannot be guaranteed.

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