Thursday, October 09, 2008

What’s Happening and What We’re Doing

Given the state of the markets and economy, we would like to update everyone with our strategy and outlook. Over the past four weeks we’ve had some success trimming back and selling certain profitable long-term holdings that had not yet suffered from the broad-based selling of the last two weeks. These were gains that we had planned on taking under normal conditions that have helped build a significant cash position to buffer the portfolios during this downturn. Focusing on our bank stock exposure, we eliminated our US Bancorp position, near all time highs, and reduced our Goldman Sachs stock holding by taking advantage of dramatic short-term market swings. Given the uncertainty in financial stock valuations due to the need to raise capital, we decided to “move up the balance sheet" with senior bonds in Goldman and GE Capital that were trading at seemingly distressed levels. We have seen yields to maturity of 9% on Goldman and 7.5% on GE for bonds that mature anywhere from 2 to 4 years. At this point, those are the only purchases we are willing to make until we see signs of stability in the markets.

The rest of our positions likely represent extraordinary opportunities for long-term investment. Unfortunately, because of the massive credit freeze, a disorderly unwind of leverage and a race to cash for those in distress, particularly hedge funds with significant energy and commodity holdings, has heaped enormous pressure on the entire stock market. This process is having a definite impact on economic fundamentals, which affect overall equity valuation in the market. The problem for investors is discovering when the liquidation of assets has run its course. This unwind is happening very fast and when it ends we can assess the collateral damage to the economy.

We expect markets to stabilize with the assistance of an unprecedented amount of money being made available from the Federal Reserve and Treasury. While somewhat controversial and by no means a panacea, these efforts must be done efficiently and quickly to provide needed capital and lending facilities where credit markets are dysfunctional. In a way, this injected money can be considered a surrogate for the capital that investors and institutions are hoarding. It essentially buys time for good credits until confidence and clarity return. The risks of inflation are low because the money already in the system is unwilling to be invested and will not, in the short term, result in the classic “too much money chasing too few goods” scenario. However, there is likely to be a period down the road when inflation risks will run higher, as the Federal Reserve attempts to drain the excess money supply from the system.

Our investment strategy remains the same. We continue to look only at companies with strong cash flow and limited needs for credit. Companies with significant cash flow and steady returns on capital will be rewarded with premium valuations in years to come. We will continue to look for companies with stocks and bonds that pay steady and sustainable dividends and interest. As we have maintained for several years, returns on most assets will be subdued. Quality and consistency will be rewarded over time.

Let us know of your thoughts and questions.

Peter and Jack Falker

"Note:  At the time of publication, Peter and Jack Falker, and the clients of FalkerInvestments Inc. were long both the common stock and bonds of Goldman Sachs and General Electric."