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volume 5 issue 3 June 2005

Night (and Day) of the Living Dead

In the 1968 horror classic, "Night of the Living Dead", radiation from a fallen satellite caused the recently deceased to rise from the dead and seek to use the living for food. It seems to us that a number of industries are experiencing the same thing.

Similar issues have haunted the airline industry since the dawn of de-regulation. Fare competition has driven prices down creating profitability problems within an industry that has high capital requirements (the purchase of airplanes). Industry players declare bankruptcy and re-emerge with a

Some would point to the beginning of Detroit's problems as the Chrysler bailout that occurred in the 1980's. The problem, they would say, is there was (and is) too much capacity in the global automobile industry ­ we don't disagree with the issue. The bailout of Chrysler, rather than clearing out excess capacity, simply allowed unproductive capacity to continue ­ albeit with a lower cost structure. While excess capacity was certainly an issue in the early 1980's, it has only gotten worse with developing nation auto manufacturers entering the US market on a regular basis over the past twenty years. (New car makes that have appeared and disappeared over the past twenty years include Yugo, Hyundai, Daewoo, Saturn, Kia, Scion and Suzuki.)

General Motors' debt has been downgraded by two out of three rating agencies to junk level, and there is some speculation that Ford may not be far behind. US Air (in Chapter 11 bankruptcy) announces a merger with America West to try to create a healthier airline. Last issue we lamented the attempt that Qwest Communications was making to acquire MCI (they have since conceded defeat). While these companies' problems might seem to be distinctly unrelated, they all, in fact, suffer from a similar affliction.

What are legacy costs? Legacy costs are those items built into the cost structure by management of years gone by that are still being paid for by current shareholders (and by all accounts will continue to be born by shareholders and taxpayers). While the auto, airline and telecom industries are far from the only industries facing the issues of legacy costs (i.e., the steel industry), they are currently in the news and will be the focus of our discussion. In particular, we shall focus our attention on pension and healthcare costs.

While we sincerely lament the inability or unwillingness of the federal government and the capital markets to allow these "walking dead" to simply go away via liquidation (we have written about this in previous issues), we believe the companies (in this case) are simply the victims of the "living dead" feeding off of the living. The real "Living Dead", the real issue creating the problems for these and other industries (i.e., steel) is that of "legacy costs".

newly restructured (lowered) cost structure to fly another day. Telecom faces a similar fate. New players drive down prices creating severe profitability problems.

The story in the airline industry is similar. US Air (in Chapter 11 bankruptcy for the second time in five years) offloaded to the Pension Benefits Guaranty Corporation (PBGC) a $2.1 billion pension liability for its pilots during their first bankruptcy, and is offloading the rest of its defined benefit plans to the PBGC in its current reorganization. (The three remaining plans had an underfunded liability of nearly $1 billion, with "promises" made to current and retired employees totaling $3 billion. This for a company with annualized revenues of approximately $6 billion.) Legacy costs are also creating a drag for the telecom industry ­ in particular the old wire-line companies (i.e., Qwest, Bell South, Verizon). Qwest Communications, the bad company we wrote about in our last column, faces an under-funded liability for post-retirement benefits of $3.4 billion and ongoing funding for its various pension and postretirement plans of nearly $200 million per year. Even the healthiest player in the business (Verizon) faces huge current and future costs, with employee benefit obligations of $17 billion, and funding expenses of $960 million as of December 31, 2004. (By way of comparison, Qwest had operating cash flow of $1.8 billion and Verizon had operating cash flow of $21 billion in 2004.)

(By way of comparison, General Motors' total market capitalization is just over $17 billion.) If that wasn't enough, General Motors paid $13.51 billion in fiscal 2004 to beneficiaries and contributions to various pension and benefit plans (this was down from $24.7 billion in 2003, but up from $9.49 billion in 2002). By many accounts General Motors' "legacy costs" per vehicle is more than $2,100 across its product line (about $1,500 per vehicle more than its Japanese competitors).

Since both workers and employers are either unwilling or unable to deal with the issues surrounding legacy costs, the ultimate "food source" for the living dead is we, the taxpayers of the United States. That is because companies will continue to take the most obvious route to kill off the zombie, throw in the towel and turn over their obligation(s) to the PBGC ­ as has been the case with US Air, United Airlines, numerous steel companies, etc. While we (as citizens) may not be able to avoid being fed upon by the living dead, we can (as investors) avoid investing in those companies facing large legacy cost issues. As investors, one of the things we look carefully at is the size of the unfunded benefit obligation (if there is one) and the ongoing funding requirements of benefits. We like to invest in companies that have a competitive advantage and a lower cost structure by-way-of minimal or no legacy cost issues can be a significant advantage. I

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Pension and healthcare legacy costs are a double whammy for many of the companies within the auto, airline and telecom industries in that they show up as a liability on the companies' balance sheets and as an ongoing expense on their income statements. Looking at General Motors, for instance, we see that they currently face an under-funding within their pension plan of $7.5 billion (Source: 2004 General Motors Annual Report ­ Total US and NonUS Pension Benefits). While that certainly is a large number, it pales in comparison to the under-funding status of its "Other" Post Retirement Benefits (post-retirement health benefits, etc.) of more than $61 billion.

INSIDE THIS ISSUE: Night (and Day) of the Living Dead Outspoken Investor: Some Things That Bother Me Briggs & Stratton Baseball and Investment Decisions Selected Rates and Indices


2 2



Outspoken Investor Some Things That Bother Me

One of my favorite comic strip comics is a strip called "Non Sequitur". In this strip, one of the characters is a superhero called "Obviousman" who springs forth to point out the obvious answers to life's challenges. I bring up Obviousman because he comes to mind so readily as I see some of the things that pass for information in the news today. The Federal Reserve always goes too far in both raising and lowering interest rates. Trying to time the exact moment when they should stop cutting or raising rates is even more difficult than trying to time stock purchases and sales. If timing stock purchases and sales can't be done with any reliability, why should we think that timing monetary policy with economic activity can be done any better? At best, monetary policy is a ham handed approach to managing economic activity. Couple that with the Fed's dual mandate of full employment and price stability and you have a recipe for overshooting in either direction. What has made Fed Chairman Greenspan's tenure at the Fed so remarkable is not that he has been able to keep from overshooting with monetary policy, but that he has been so effective in using it to keep a lid on inflation, and engineer long periods of economic growth with short periods of contraction. One dead lock certainty in economics is that cycles will continue to happen and (periodic

As some of you may know (and if you are a long-term reader, you have read this in previous issues), I have CNBC running on the TV in my office all day. Most of the time it is simply background noise that covers up the distractions of normal office life. However, on occasion, I will hear something through the noise that will make me sit up and utter (to borrow a phrase from my teenage daughter), "Like, Duh!" Such was the case when I was listening the week before Memorial Day. The question of the day from CNBC was, "Will the Federal Reserve go too far in raising interest rates?" At the risk of repeating myself ­ "Duh!"

I am also REALLY bothered by something that happens with regularity ­ not just on CNBC, but in every media outlet and between individuals. Perhaps an example will suffice... One of today's economic releases was the ISM (formerly the Purchasing Managers') Index, which fell for the sixth straight month. The market's reaction to the negative news was "predictable" ­ it rose. Of course, two portfolio managers were brought on CNBC and asked the following question, "Why is the market up so strongly given the drop in the ISM data?" Both proceeded to give lengthy answers why the market would rise given disappointing economic data. I wanted to scream at my TV, "Why don't you tell the truth and say you simply don't know why the market is up today!" The answer, of course, is saying that they don't know why the market is up (or down)

reports of the death of economic cycles to the contrary) there is nothing any Fed official past, present or future can do to change that fact.

doesn't make for very good TV (or quotes for the print media).

Much of what passes for information today is really nothing more than noise ­ it fills the time slots (print space) available to try to keep the listener's (reader's) attention. We as investors should understand that it is noise and take the time to find those nuggets of information that are useful or relevant. Unfortunately, the investment noise often gets in the way of real, relevant information. I

The reality is that no one really knows when or how far the market(s) will go up or down, and no one can predict with any accuracy either event ­ there are simply too many moving parts. Trying to answer questions that are unknowable is a practice in futility, and most great investors realize that they shouldn't try. Rather, they take should the advice of Warren Buffet who says that it is much easier to concentrate on what is knowable and important.

Briggs & Stratton NASDAQ: BGG

In 1908, Briggs & Stratton (B&S) started making automobile parts before settling on lawn and garden engines in the 1940s. B&S faced organized labor struggles throughout its history, but is less dependent today. The union headcount peaked in 1981 at 11,000 jobs, and today stands around 2,000. Their engines are primarily assembled in the USA (one exception is joint ventures in Japan for larger Vanguard engines). Most of B&S's sales come from lawn and garden equipment. While its business can be exposed to cycles caused by a draught or to a lesser degree unseasonably cold weather, the grass grows, people cut it, and when they buy something to cut it, there's a good chance it has a

B&S engine (as long as its not a string trimmer). B&S designs, manufactures, markets and services 4-cycle air-cooled aluminum alloy gasoline engines ranging from three to thirty-one horsepower. They are used in outdoor power equipment including walk behind & walk riding mowers, garden tillers, industrial products, construction, agricultural, generators, pumps and pressure washers. B&S engines are marketed under the following brands: Classic, Sprint, Quattro, Quantum, INTEK, I/C, Industrial Plus and Vanguard. B&S has two segments: engines and power products. Power products are end products, completed outdoor equipment, and many using B&S engines. They created

and expanded their end product segment with the acquisition of Generac Portable Products in 2001 (known for pressure washers and generators), the 2004 Simplicity (a higher end lawn and garden manufacturer) acquisition, and the recent purchase of Murray's (an end product manufacture) assets. Synergies exist in acquisitions of power products that don't fully use B&S engines.

B&S enjoys a dominant market share in air-cooled engines estimated by most to exceed 70%. Their brand recognition and reputation enhances this position, as the B&S engine is prominently highlighted on many OEM products. A high market share is important because it allows B&S to spread fixed costs as well as

obtain negotiating power with the OEM buyer of their engines. Three OEM customers made up 42% of B&S sales in fiscal `04 (Electrolux ­ mostly sold in Sears, MTD ­ mostly sold in Lowe's & Wal-Mart, and Murray ­ mostly sold in Home Depot and Wal-Mart). Now that B&S owns Murray, the engine business for those end products should grow and become more loyal.

At another level, B&S entrance into the OEM market exposes them to the mass-merchants buying power. Its estimated that Sears share of outdoor equipment is 35%, Home Depot and Wal-Mart both have about 15%, and Lowe's has 8-10%. Overall, B&S believes that in fiscal 2004, (continued on page 3)


Baseball and Investment Decisions

Warren Buffet says, "In investing, just as in baseball, to put runs on the scoreboard one must watch the playing field, not the scoreboard". Baseball players understand Warren's point, however many investors don't. Fundamentals are the playing field of the investment world. What fundamental factors should investors focus on when selecting a business to invest in, and when selecting a mutual fund?

When selecting the type of business to invest in, nothing is more fundamental than understanding competitive positioning. Dell has a huge advantage as the lowest cost producer of a product whose sales are largely impacted by price. Some like Wal-Mart and some dislike it, but because they buy more Coke and Pepsi (along with many other goods) than anyone else they can negotiate a lower price. The competitive rivalry in the telecommunications industry between cable and phone companies is causing a race to spend money to get into each other's business. While it will lower prices for consumers, the rivalry is bad for business. Many perspective buyers of Harley-Davidson's motorcycles are willing to wait months to pay

When evaluating a mutual fund many investors ignore fundamentals and focus on the one thing they can easily understand, past performance, and in particular shorter-term performance; nothing is more self-destructive. An ongoing Dalbar study shows from 1984 to 2003, the average stock fund earned 11.4%, while the average stock fund investor earned about 3.5%, underperforming by 7.9% per year. Someone that started with $50,000 in 1984 could've ended with $99,489 (with 3.5% returns) or they could've ended with $433,185 (with 11.4% returns). The biggest reason for the underperformance is investing in

a premium versus their competitors (Honda, Polaris, etc.), demonstrating their brand's power. These are examples of competitive factors investors must be able to recognize, understand, and evaluate sustainability in order to make an investment decision. The other half of the fundamental picture is determining if the current asking price (stock price) is reasonable or better yet a bargain. No matter how good the company, there is still a maximum price to pay. Great companies aren't necessarily great investments.

funds that have just experienced a strong period of performance, and dumping those funds that had a weak period of performance. More often than not, a fund's investment process (or any changes in it) isn't evaluated.

I'll list fundamental factors (and signs the factors aren't present) as evidence for an understanding of the investment decisionmaking process, all of which are more valuable in evaluating a fund than short-term performance. The funds semi-annual or annual report can be a good

We're convinced the problem with selecting a mutual fund starts with (and for the most part ends with) the inability to identify and understand mutual fund fundamentals. Those best equipped to analyze mutual funds aren't in possession of more sophisticated data but they have a solid understanding of the investment decision-making process (see paragraph three). These people are able to determine if fund managers are applying an investment process to deliver long-term results to fund investors. Unfortunately, many fund investors, including professionals that recommend funds don't understand the investment decision-making process.

The business of investment management, like many others, is ultimately about results. Contrary to what many believe chasing short-term success doesn't breed success; it seems to guarantee failure. Attention to detail and focusing on the relevant facts gives the best chance of producing good results. I

source. If it feels like a sales pitch, if the focus is on investing in stocks that will go up because they are popular (without mention of the underlying company fundamentals), stop wasting your time. Look for evidence that they understand what they are buying, employ a value-based discipline that allows them to manage their emotions, and have humility so they can not only admit their mistakes, but also learn from them. Dig deep enough and you may find if the managers have their own money invested alongside fund shareholders and if their incentive structure compensates them based on the performance of the assets they manager not the amount of assets. Favor funds that share these characteristics and typically have low turnover and at least a reasonable expense ratio.

Briggs & Stratton NASDAQ: BGG

over 80% of all lawn and garden sales were through mass merchants. While the Murray asset acquisition increases their exposure to mass merchants, we emphasize it gives them a low cost chance to test the waters.

The main competitors on the engine side are Honda (10-15% market share, mid to high end), Tecumseh (10-15% engine share low to mid) and other smaller competitors including Kawasaki, Ltd., and Kohler. Honda could drop down to mid-range and low-range engines (and they

Looking back on the past 25-year dividend history, we see they've paid special dividends (although not since 1984), and increased their quarterly dividend 17 times (not increasing their dividend from 84-92 as they struggled with labor cost issues. We feel it

would probably be successful at it) but there's not enough financial incentive, based on their overall size. New entrants may come internationally over time, but the emissions environment complicates a low-wage entrance.

(continued from page 2)

is likely they will increase their dividend in August with their earnings announcement. They have been increasing their dividend at a rate of 1/2 cent/share on a split-adjusted basis. Continuing this pattern would lead to almost a 3% increase.

We have followed B&S for 14-16 months understanding their business and waiting for their dividend yield to exceed the S&P 500, a criteria for the Equity Income Portfolio. It certainly has been an eventful period with the Simplicity acquisition, a horse-

power rating lawsuit and now acquiring Murray assets. We feel investors will be rewarded for holding B&S shares because of its dominant market position, excellent returns on capital (well in excess of their cost of capital) and very reasonable valuation at 11-1/2 times fiscal 2006 earnings. I


Selected Rates and Indices

Yield Curve Fed Funds 3 Month 6 Month 2 Year 5 Year 10 Year 30 Year Current

(as of 5/31/05)

As of 5/31/05

Treasury Yield Curve Comparison

6% 5% 4% 3% 2% 1% 0% 3 Mos. 6 Mos.

Current (5/31/05)

3.00% 2.95% 3.06% 3.47% 3.63% 3.90% 4.25%


(as of 2/28/05)

2.50% 2.75% 3.04% 3.72% 4.21% 4.53% 4.81%

S&P 500 Fair Value: 1796.00 Value DJIA 10467.48 S&P 500 1191.50 NASDAQ Comp. 2068.22 Russell 2000 616.71 Hang Seng 13867.07 4964.00 FTSE 100 DAX 4460.63 Nikkei 225 11276.59

(as of 5/31/05)

2 Yr.

Previous (2/28/05)

5 Yr.

10 Yr.

30 Yr.

Equity Markets

YTD Return -2.93% -1.68% -4.93% -5.35%

Currencies (as of 5/31/05) Japanese Yen Australian Dollar Swiss Franc Canadian Dollar British Pound EURO

Per US $ 108.2 1.324 1.248 1.255 0.550 0.813

S&T Bank, its officers or affiliates may own options, rights or warrants to purchase any of the securities of companies recommended. Further information on any of the recommendations made herein is available upon request. The information provided is believed to be reliable, but its accuracy and completeness and that of the opinions based hereon are not guaranteed, and may be subject to change without notice. Under no circumstances shall this information constitute an offer to sell or a solicitation to buy. Because investors' situation and objectives vary, this information is not intended to indicate suitability for any particular investor. Investment products are not FDIC insured, are not deposits of, obligations of or guaranteed by S&T Bank or any of its affiliates, and involve investment risks, including the possible loss of principal invested.


Insight is a publication of the Wealth Management Group at S&T Bank. Items of interest and article ideas are welcome and encouraged, as are your comments and suggestions. Send information or feedback to Malcolm E. Polley at the address below. Editor Malcolm E. Polley, CFA Senior Vice President and Chief Investment Officer

Contributing Writer Matthew A. Di Filippo, CFA Vice President and Portfolio Manager

Write to us at: S&T Wealth Management Group ATTN: Malcolm E. Polley 43 South 9th Street Indiana, PA 15701 or email to: [email protected]

43 South 9th St. PO Box 220 Indiana, PA 15701




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