The Birds

April 11, 2006

Dear Investor:

The market often catches a cold, as they say, but what if it catches the avian flu? The bird flu has become, like terrorism, the world economy’s persistent bogeyman. When dealing with an amorphous but potential cataclysm like a global pandemic, it’s important for investors to evaluate the risks and decide if tactical changes are warranted.

We’ll start with the investing axiom that changes are rarely appropriate for problems that have already hatched. The market usually prices in such problems and the possibility of gaining an advantage by shifting assets in response is limited. Once a problem becomes known, its chances of causing hardship become discounted by the markets. Bird flu is already ubiquitous—a well-advertised problem that’s reached beyond Asia to Europe, the Middle East and Africa. As such, it has already reached the collective consciousness. The question is whether the markets have fully discounted an economic disaster caused by a pandemic of avian flu. The answer is no.

Currently, the avian flu strain that’s deadly to humans is H5N1, a mutation of prior types that claimed its first human victim in Hong Kong in 1997. The virus can be spread from bird to bird and from bird to human and, in a very restricted way, from human to human, but there is no conclusive evidence (yet) that it can be passed from human to human in the type of multiple transmission needed to cause an epidemic. The current mortality rate of 50% would likely decline if the virus were to mutate into an easily transmissible form (because the microbe would ironically evolve to better preserve its host). Expert predictions of worldwide deaths range from 2 million to 50 million. Antiviral drugs like Tamiflu would be of limited use and there is not yet a viable vaccine; though, according to the CDC, a few are in development.

The virus is likely to reach North America and the U.S. soon. It would not be surprising to read about a case too close to home any day now. According to experts, we could also see the virus reach full human to human multiple transmission in the next twelve months.

Clearly, if the virus were to cause fatalities at even the lower end of its projected range, it could cause enormous economic dislocation. The world is statistically due for a pandemic. Such a massive death toll is not something the developed world is used to. In the worst case scenario, global travel would be greatly curtailed, if not shut down. Businesses dependent on travel such as restaurants, hospitality and airlines would be devastated. Energy stocks, which are priced for perfection, would swoon, and stocks in general would be caught in a downdraft of ugly proportions. Stocks would recover, of course, as the pandemic burned out, but the economic consequences could last a long time.

Given this bleak scenario, why would one wish to own stocks at all? The primary reason is because the timing and severity of the avian flu are inherently unknowable. There could be a terrible pandemic starting tomorrow that could wipe out 1% of the world’s population, or the virus could burn itself out before causing large-scale human casualties. The secondary reason is that a full-scale disaster, though by no means priced fully into the market, has been discounted somewhat, and thus a pandemic would be no surprise. When disasters are expected, their eventual toll on markets is muted, especially when the disaster evaporates without reaching its potential (witness Y2K).

The ultimate reality of the bird flu comes down to a classic race between technology and nature. If the virus is able to secure a significant human foothold before the vaccine arrives, chalk one up for the virus. But if even an imperfect vaccine can be developed in advance of the flu, the disease will become less of a threat.

We’re not willing to place significant bets on the winner. Our admittedly conservative strategy in such a situation is to identify potential sectors that can outperform in such a cataclysm and increase exposure there, so long as those sectors would be good long-term investment prospects anyway. The only asset classes that would likely do well in a pandemic would be healthcare stocks (especially pharmaceuticals and biotechs with significant vaccine/antiviral franchises), government bonds (including foreign sovereign debt of financially strong countries) and, perhaps, precious metals. Of those, only the first two make sense as long-term investment options. Some other sectors might have qualified gains in a pandemic, such as online retailers, selected telecom providers and couriers.

We are overweight healthcare in client accounts anyway, mainly for demographic and valuation reasons, even before regard for avian flu. We are underweight bonds due to our macro view on rising rates, but are poised to reverse, especially if rates were to come up significantly. We also have weightings in telecom, mainly through technology sector funds. In the average balanced account, our combined healthcare and bond weighting exceeds 35% and thus could provide some buffer. Ultimately a bond position serves as the best defense, since it amounts to a call option on equities if the market takes a big hit. In such a situation, we would be able to quickly switch from bonds to stocks, as we did in the wake of 9/11.

Hopefully, this will be our last letter about the bird flu. If humans win the race, that would be a great victory in the history of epidemiology. We’ll close on a sincerely optimistic note. There has been no time when the world has had such advance warning of a potential pandemic, when health agencies have had such sophisticated real-time information on a spreading disease, and when advanced diagnostics and potential vaccines have been developed with such heartening speed. Fifteen years ago, the world would probably not have even known an avian flu was brewing at this stage. It’s the 21st Century: though hardly prepared, we are alert and aware. Technology could very well tip the scales in our favor.