1^st Quarter

Anticipation of the war in Iraq overshadowed most of the quarter. Europeans, already struggling with their economies, expressed frustration in their inability to influence geopolitical events. The extreme pessimism boiled over to the stock market: the European insurance sector was forced to liquidate some holdings causing what at times seemed a downward spiral in European markets. At the end of the quarter, the war had started and, in the eye of European press, was not going particularly well; in addition, SARS caused further anxiety and depression. „Window dressing“ was rampant: window dressing refers to last minute reshuffling of a portfolio before the end of a reporting period where portfolio managers want to show that they hold the recent winners and not the losers.

We did not submit to this window dressing, but instead purchased stocks in the travel industry. Travel stock prices were extremely depressed; while we do not expect an immediate rebound in travel activity, we believe the war will eventually pass, and so will SARS. We focused on the European travel industry as the US travel companies we evaluated were financially not sufficiently stable to survive an extended slump in a worst-case scenario. The German DAX listed travel company TUI closed as of this writing today (Friday April 11, 2003) at €10.96; its recent low was € 7.56 and it closed at the end of March at €8.74; in the past year, it had a high of over €34. At the end of March, it looked like the war in Iraq was running behind schedule and the negative coverage in the European media led portfolio managers to reduce or eliminate their TUI holdings for the end of the quarter. We opted to do the opposite despite the likely risk that our numbers at the end of March may not look as good as if we were to follow the leader of the day.

Times are tough, and we need to take a long-term perspective. As we have pointed out many times, we can only position us for the future we envision, but we cannot predict what is going to happen on a day-to-day basis. We stay disciplined guided by our macroeconomic assessment, which we gradually adapt to new situations. With the large-scale military offensive in Iraq winding down, we have removed a big obstacle that has been overshadowing the markets. However, the world is far from perfect as a result. Securing the peace in Iraq causes many challenges. It remains to be seen what the implications for the surrounding countries are – serious risks lie ahead.

At the same time, both the US and Europe have an opportunity to focus more on domestic issues. The Bush Administration and the US Federal Reserve Bank are determined not to replicate the Japanese deflationary model by, among others, keeping short-term interest rates low, cutting taxes and increasing spending. The dollar may remain weak and weaken further as a consequence, and longer-term interest rates are likely to rise. Companies dependent on imported raw materials will suffer as they cannot pass on their costs to consumers whose purchasing power is unlikely to increase fast enough in this economic environment. However, a tremendous amount of goods in the US is imported from China these days: China has a fixed exchange rate with the US and is going to resist efforts to have a stronger currency, thereby financing the US recovery. We believe China may become a much larger holder of gold in the future as they look for ways to stash away their trade surplus; with the “war premium” dissipating out of gold, we can now hold it for what we bought it for: a long-term hedge against the dollar.

Companies that have their costs under control may excel in this environment. We do not expect a surge in sales, but profitability of select technology, cyclical and financial firms should disproportionally benefit. While there are opportunities in the financial sector with a widening spread between short-term and long-term interest rates, long-term damage has been done in this sector during the turmoil of the past months: we will be very careful in evaluating possible investment targets.

Europe’s biggest problem is widespread pessimism. The ending of the assault phase of the war is a welcome relief. The German government is trying again to push through some long overdue reforms, and we believe there is a fair chance it succeeds. It remains to be seen if and when European governments deem it necessary to follow the US approach and to boost their economies by giving up financial discipline thereby weakening the Euro.

In summary, Europe has had a strong rebound after what looked like a collapse of financial markets in the middle of the quarter. The US also had a difficult quarter, but nothing compared to what Europe went through. Going forward, there will be some euphoria, some realism. There may be a slow return to more “normal” times with a chance that stocks will be valued based on their prospects and not on fear and propaganda by US, European or other governments.

Please contact us with any questions.

Axel Merk
Merk Investments