Thursday, July 31, 2008

Mid-Year Thoughts

Is there a recession or isn’t there? Technically speaking, we aren’t in a recession, because GDP continues to grow slowly. Ok, tell that to the American who just put 25 gallons into their gas-guzzling SUV and added $100 to an already overflowing VISA, at 18% interest, which they can’t pay off. Tell it to the family that stopped making payments on their 12% floating-rate home mortgage, because they have to keep their credit cards alive so they can get to work and eat. Multiply that by the thousands of people who do that every week and it gives you some perspective that all is not well out there.

Many people made poor financial decisions and corporate executives, especially those in the banks, didn’t understand their risks. The world economy is more competitive, as we realize that demand from countries such as China and India now dictate the price of scarce commodities that we have taken for granted. A recession is generally upon us, and the lessons are being learned. However, there is tremendous opportunity in the global economic world for everyone, and the key is to encourage investment toward the efficient use of capital.

Through these very turbulent times, we believe that we and our clients are well positioned in a volatile market that we think will continue over the next several years. At mid-year our fully invested accounts were generally 6-8% ahead of the S&P 500. That followed our strong 2007 performance in which we also exceeded the benchmark.

Within our strategy we have been pursuing long-term investments in global infrastructure, commodity and energy companies that meet our internal rate of return and valuation criteria. Our investments in oil, natural gas, biotechnology, infrastructure, and steel did particularly well for us in the first half, but some have turned down in July, which we believe is a temporary phenomenon that may afford the opportunity to average down several positions.

We hold two companies in the financial space (Goldman Sachs and U.S. Bank), which continue to be negatively impacted by perceptions that anything in this space is toxic, despite their own internal performance and long-term prospects. However, it’s not too hard to understand why the perception of financial companies is so negative, given that the majority of banks, brokers, insurers and rating agencies, as well as the government sponsored entities Fannie Mae and Freddie Mac, apparently did not understand their own lending activities in the housing space and did not see the mortgage securitization problems coming until it was too late to act. Witness the multi-billion dollar disasters of Bear Stearns, and Countrywide Financial and the potential disasters of Lehman Brothers, Merrill Lynch, Wachovia and Washington Mutual, to mention just a few, and you begin to understand why this area remains so difficult to invest in, despite any good that is being done by companies like Goldman Sachs and U.S. Bank.

To get an idea of the current status of the problems in housing and mortgage financing, take a few moments and read this excellent analysis, entitled Mooooooo!, published this week by Bill Gross of PIMCO Investments:

When we see things happening that seem proportionately worse than the events that caused the stock market disasters of 1929, 1933 and the ensuing depression (which really didn’t end for most people until after World War II), we have to remind ourselves that we live in a global economic environment that is far more able to endure the kind of financial shocks that essentially shut down the U.S. economy and stock market nearly 80 years ago. The actions of the Federal Reserve and the U.S. Treasury in the last six months are clear evidence of the progress we have made since 1929. Also, take note of the multi-billions of off-shore dollars flowing back into this country as capital investments in some of our ailing financial institutions. These kinds of things could not have happened 80 years ago.

And yet it’s important to realize that the Fed and Treasury do not have all the answers and are not omniscient in their respective abilities to solve all of the ongoing problems of our financial system and economy. In the short-run, they are largely powerless in dealing with the price of oil and the related weakness of the dollar. Such problems must be fixed by changes in our consumption behavior accompanied by long term fiscal and monetary discipline (i.e. reduced government borrowing and responsible monetary policy).

Accordingly, we believe the issues that directly affect investments of capital in the stock and bond markets are likely to be with us for several years. People will get used to paying five to 10 dollars a gallon for gas (as Europeans have for years because of taxation that has deliberately held down their consumption) and maybe just might get the message to shut-off their engines and open the windows when sitting still, instead of burning gas to run the air conditioner. Or they might just get out of their cars to get a cup of coffee at Starbucks instead of idling in line at the drive through window (not to mention the related pollution). Or, heaven forbid, they might just ride the bus or train to work, like people all over the world have been doing for many years.

Economic growth will depend more on investment and less on the largest component, consumption. Reduced credit availability will slow the pace of any future home price appreciation and end the indiscriminate use of home equity to fuel consumption. Higher commodity and energy costs will alter economic decisions and personal behavior. For example, we are using three to five percent less gasoline than just a year ago; use of public transportation is up over 2%; wind power investments are motivated by a goal of providing 20% of U.S. electricity demand; current investments in natural gas will provide access to a plentiful source of domestic energy that can be used to replace much of our dependence on foreign oil. China’s growth mandate along with growth in India and neighboring emerging economies, while slowing from time to time, will continue to drive demand for technology, infrastructure development, and industrial commodities such as copper and steel. Also, investments in diverse, internationally exposed companies that provide essential products for a more conservative U.S. consumer, as well as an emerging global population demanding increases to their standard of living, will continue to do well.

In other words, we continue to see the glass as half full, even though we are well aware of the problems that are causing it to be half empty. Until we see significantly higher long-term bond yields, we continue to believe that the best place to invest capital is in the high-quality, dividend-paying equities defined by our investment strategy. That encourages us to take profits when we have them and not be reluctant to hold 10-15 percent cash from time-to-time (as we currently do) when we believe greater opportunities might lie ahead.

Our strategy, which rigidly takes into account internal rate of return performance and long-term valuations of every company we own, or expect to own, is literally made for the circumstances we expect to face in the years to come, as our country works its way through one of the most difficult economic times in its history. One thing remains very clear to us, however: History has taught us that the United States is remarkably resilient in times like this. It is definitely not the time to bet against this country.

That’s the way we see it at mid-year 2008. Let us know what you think.

Jack and Peter Falker

Note: At the time of publication, Jack and Peter Falker, as well as the clients of FalkerInvestments, owned the common stock of Goldman Sachs and U.S. Bank.