October 2005 Letter

Thanks to our clients and friends, Covington Capital Management’s first year has been gratifying.  Our portfolio management team and staff have done well and we continue to exceed our business plan.  We are looking forward to a bright and positive future focused on solid investment results and outstanding service. 

As we look at the current financial markets, the ability to understand and evaluate both short and long-term trends continues to be a real challenge.  The following thoughts are intended to highlight a number of key themes that we are analyzing in order to make sound investment decisions.

The stock market remains in the same trading range that has persisted since December 2003.  Significant events in the third quarter included hurricanes, strength in the prices of oil, gold, and other commodities, and further Federal Reserve tightening.  None of these changes have altered the trading range environment for stocks or the uptrend in the economy and earnings. 

We want to focus on four long-term trends that investors should think about:

Change and demographics:  In 1905, the average life expectancy was 47, 14% of homes had a bathtub, 8% a telephone.  Alabama, Mississippi, Iowa, and Tennessee were each more heavily populated than California.  With 1.4 million people, California was only the 21st most populated state in the Union.  95% of all births in the U.S. took place at home and 95% of all doctors did not have a college education.  Crossword puzzles, canned beer, and iced tea had not yet been invented.

Technological change has been incredible.  It used to take hundreds of years between significant inventions.  Now, the world reinvents itself every fifteen or twenty years.  For example: wheel-spoon-gunpowder-typeset-match-TV-computer-cellphone-the complicated TIVO that you need your kid to show you how to work.

Today, if we shrink the Earth’s population to 100 people, it would look like the following: 57 Asian, 21 European, 14 Western Hemisphere, 8 African; 70 would be non-white; 70 would be non-Christian; 70 would be unable to read; 50 would suffer from malnutrition; one would have a college education; six people would possess 59% of the entire world’s wealth and they would all be from the U.S. 

Think about populations in the developed countries.  In 1965, the average American lifespan past 65 years was 12.7 years.  It is now 17.6 years and is projected to increase to 21.6 years by 2080.  Good luck, Social Security and Medicare.  There are 77 million baby boomers in America (born between 1946 and 1964, 27% of the nation’s population) that are nearing retirement age.  Is this a positive or negative?

By the middle of this century, the economy of China is projected to be twice as large as that of the U.S. and as big as the economies of North America, Europe, and Japan—combined.  Today, the developed world provides more than half of the world’s output.  This will shrink to less than one-quarter by 2050.  By the year 2050, China is predicted to have nearly 1.5 billion people—nearly four times the projected U.S. population. India, with a population that is now equal to China, is beginning to grow rapidly.  It, too, will be an economic giant whose size will outstrip the U.S. economy.  Is there any doubt that the center of the world’s economy will shift to the East?

Closer to home, what about U.S. trade deficits, federal and consumer debt levels, and savings rates?  On the latter, the U.S. savings rate as a percent of income is nearly zero versus approximately 10% for Europe, and 40% for China.  Regarding trade deficits, the U.S. has had 29 consecutive years of net deficits with the rest of the world.  In 2004, the trade deficit was $618 billion.  We exported $1.1 trillion of goods and services last year and we imported over $1.7 trillion.  We are running up obligations to the rest of the world and foreigners are buying our assets at the rate of almost $2 billion a day.  Currently, our net position versus the rest of the world is that they own $3 trillion more of us than we own of them.  How long will foreigners keep accepting our currency?  This will have consequences.  The current trade deficit of almost 6% of Gross Domestic Product (GDP) needs to be reduced.

U.S. state and federal budget deficits have been well publicized.  The federal deficit amounts to approximately 3.6% of GDP and is financed by borrowing.  Foreign central banks have been large buyers of U.S. debt and have helped keep our interest rates low.  What if they reduce their buying, or worse, start selling?

These savings, debt, and trade deficit patterns are a long way from past norms.  They can’t last forever.  Household savings cannot keep falling and America’s borrowing cannot keep rising.  When and how will the tide turn and what will be the economic implications?

In its simplest terms, stock investing is jumping on the back of the expected growth of corporate America.  This has been a winning strategy for a long time.  Will it still work?  Warren Buffett says you never want to go short on America. This is still the richest economy in the world, and we have a long history of innovation and working through our problems. 

Covington Conclusions:

On a more personal note, you have recently received mailings announcing Covington’s hiring of two outstanding investment professionals.

Scott Sanford joins our firm as President and will assist in formulating our longer-term strategic business plan in addition to developing new client relationships.  Scott most recently served as Chairman and Chief Executive Officer of Mellon West, overseeing Mellon’s investment and banking businesses in the fourteen Western States.

Amy Lange has joined us as Vice President and portfolio manager.  In addition to managing client accounts, she will add significant depth to both our equity and fixed income research.  Amy comes to us with over twelve years of research and portfolio management experience, having managed accounts for high net-worth individuals, endowments, foundations, and retirement funds.  She most recently served as a portfolio manager at U.S. Trust Company, N.A. in Los Angeles.

We are delighted to welcome Amy and Scott to this exceptional team of professionals.  As always, please contact us if we can be of any service or answer any questions you may have.


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