Monday, February 01, 2010

Letter to Clients - February 2010

Video Introduction

Note: We are publishing this blog post in three installments this week, because of its length. If you would like to read it in its entirety or send it to a friend, here is a link to a pdf file on Google Docs of the entire article: FI Letter to Clients - February 2010

Good News is Welcome

It should come as no surprise that we are genuinely pleased about the stock market’s performance in 2009. We are also very pleased with the performance of our client investments. What gives us the most satisfaction, however, is the chance to catch our breath and evaluate where we stand. Certainly, at the depths of Dow 6,440.08, on the morning of March 9, 2009, we all needed a break, no matter how much or how little exposure one had to the markets. That was quickly becoming irrelevant. The rate at which we were heading toward a second Great Depression was remarkable, and it is equally remarkable how it has so far been avoided.

First, the Conclusion

With an outlook for modest, below-average growth in the economy, we stress our high regard for businesses that generate consistent returns on invested capital and deliver high cash flow yields to investors. Staying alert for reasons to reduce market exposure will remain important. Our number one concern is, as always, protecting the wealth of our clients. We are not predicting another crash and by no means desire that outcome. As we’ve said before, preparing in earnest for a crash can leave you with years of significant missed opportunities. We are simply being careful to safely navigate the challenges that will come to define the era in which we live.

The market collapses of 2002 and 2008, being so close in proximity, have combined to create a significant inflection point. There are changes occurring in financial behavior that will linger with us for many years, and this greatly influences how we manage our client assets. The stock market over the last decade has produced great gains, only to be overcome by even greater losses. In the years ahead, avoiding loss will gradually replace the pressure to make high returns, which marked the late 1990s and early 2000s. Indeed, that will ultimately serve as a positive for investors just as too much optimism, which leads to complacency, is a negative.

During the last 10 months, we have witnessed an historic swing from pessimism to optimism with the stock market rising 70%. Possibly that optimism today is more appropriately called hope, as many in the economy are clearly worse off than they were just a year ago. I expect that we will bounce between fear and optimism, panic and complacency, in ever shorter cycles, until the excess leverage in our economy is burned off. We are still very much in a transition period toward a more general public acceptance of risk-aversion. Change may already be signaled by a turn in the savings rate, greater household ownership of U.S. Treasury Bonds, and the first signs of deleveraging in the private sector since the 1930s. If these turns continue into trends, risk-aversion will become the norm, which eventually creates better opportunities for more speculative investors.

We like our portfolio of investments right now, and we are making new investments, patiently adding attractive cash yields while selling certain positions that have benefited the most from the rebound in commodity prices. We are always focused on protecting and adding to our clients’ future wealth, even if that means holding higher cash balances for a period of time, as we have for much of 2008 and 2009.

Our investments will increasingly focus on sectors that keep us close to cash. We are talking here about owning companies that serve needs rather than wants in the economy; companies close to their customers’ pocketbooks; companies that give consumers basic necessities (i.e. consumer staples, select utilities), or provide technology to enhance business productivity in an environment of challenging revenue growth. We want to be where dollars need to be spent, and where investors can earn a high proportion of their returns in cash flow from dividends. We will continue to add investment-grade bonds that meet our yield criteria, as we did during the crisis lows. Of course, remember, our overriding discipline is that every company we own creates EVA by generating profits in excess of their cost of capital. There isn’t a better time than now to focus on that quality.

The most important component of our client portfolios is that they remain risk-averse. While this may cause them to lag the market on the way up, if we wake up tomorrow morning to a “black swan” event that again shocks the market into a tailspin, we don’t want to be wishing we had been risk-averse today.

That’s our bottom line. Here are the reasons why.

What, me worry?

Well, to be honest, yes. Understand though, only because it is a big part of our job, and it’s not the same as pessimism.

“Navigating our clients’ assets through this very fluid world, is not about what we want to happen, but what is likely to happen…The financial crisis exposed structural problems that require a structural response…The temptation to relax too early is disastrous.”

- Mohamed El-Erian, CEO of PIMCO January 15, 2010 on CNBC

Managing investments for other people over the last 12 years continually reminds me of the value of having something to worry about. Hopefully, this helps our clients worry less about their investments while giving them more room to improve their careers or better their families. Certainly I am an optimist in life, especially when it comes to raising my kids. (My wife rejects worry in life as “negative energy” and reminds me of that regularly). Yet, a money manager is largely a risk manager. And while risk can measure the likelihood of making money, it more importantly measures the likelihood of losing money. Studies show that the risk of loss is of greater importance than the risk of gain. When you lose what you have, of course you have much less ability to gain it back.

The structural defects that the financial crisis revealed have been there for a long time, and it is hard to reconcile how they existed all this time without being exposed. Similar to balancing on a high wire, all you need is a misstep or a nudge to knock you off. The nudge came in 2008, and the question quickly turned to how far down the safety net was, assuming there would even be one. The net, in the form of massive infusions of dollars from the government, finally appeared and indeed broke the fall.

We are all now enjoying the free flight of a rebound from the high-wire safety net. Certainly, investments held through the crash have recovered significantly, while investments made during the crisis (primarily in corporate bonds) have added considerable value. We could grow complacent and marvel at how conventional wisdom triumphed once again as it “paid to buy pain” at the lows in March of 2009. People who did so feel like heroes. But I’m not impressed. The risks of entering a second Great Depression were real and the fundamentals of those risks remain. The stock market is, indeed, lower than it was 10 years ago, and today we face very significant challenges.

To be continued

Peter J. Falker, CFA

February 1, 2010

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