Tuesday, July 03, 2012

Market and Strategy Update

As all of our clients know well, we have been very conservative in our market allocations since the financial crisis began in 2008, choosing the path of protecting capital and focusing on dividend income. That served us well over the last several years, allowing us to avoid much of the extreme market volatility. But we have always considered that position to be temporary. Our longer-term objective is to find value opportunities across the entire market, without a bias toward any particular industry or economic sector.  Given the current dynamics of the markets and global economy, we are making this transition gradually.

The second quarter was the polar opposite of the first quarter from both a market and economic perspective.  The best performing economic sectors in the first quarter became the worst performers in the second.   The European situation flared up again and the U.S. economy has been stagnant.  We are starting to see the impact on earnings expectations from the European troubles.  As a result of slowing growth around the world, particularly in China, oil prices have eased significantly, relieving some concerns about rising input costs and inflation. 

In relative terms, the U.S. economy has emerged as the winner.  Banks are far more resilient from a capital adequacy perspective and the housing market has stabilized.  This has removed concerns of possible systemic banking failure such as we faced in 2008-09.  Besides the effect of recession in Europe, uncertainties over our future government policy and leadership likely pose the most significant risk to the economy today.  Perhaps not so much the policy itself, but the uncertainty of what those policies will be.  With the so-called “fiscal cliff” looming and the elections in November, we will start to see more clarity on policy direction.

In response to slower growth, central banks are further pursuing easy monetary policy and leaders in Europe are again taking steps to fight their debt crisis.  Importantly, because of so many disappointments from such policy makers in the recent past, we think investors are increasingly more skeptical.  Such skepticism can be an important ingredient for a healthier investment environment.  The markets have been routinely buoyed by persistent hope and optimism.  That one-sided mentality has made it difficult for value investors to frame longer-term return expectations. 

In light of that development, we have continued to gradually diversify the equity portfolio, as we discussed in this blog in April.  With these steps to be more fully invested, however, comes greater market risk and we have not been immune from the decline in the market during the second quarter, most notably in several financial, materials and consumer discretionary stocks. However, we continue to be heavily weighted in the consumer staples sector (almost double the market weighting), where dividends are higher and earnings have been strong.  That continues to benefit us, as the sector is currently trading at its highest level since 1995.  So, as we have become more diversified, our equity performance in the second quarter was quite similar to the overall market. 

We plan to own about 40 companies in economically diverse sectors for the equity portfolio.  Our primary focus remains on companies that are generating good Returns on Capital and EVA, while trading at relatively attractive valuations.  We are not market timing or expecting short-term trading profits.  Not all of our investments will meet our expectations, so we are always considering necessary adjustments.  At any given time we are evaluating the prospects of roughly 120 companies that meet our basic criteria.  Historical analysis shows that a disciplined strategy of owning value-creating companies at relatively low valuations, outperforms the market over time.  As we move away from our very conservative sector allocation of the past two years and become more fully invested, we would expect our portfolios to reflect similar out-performance patterns.

Thanks for your continued trust.  Please let us know if you have questions.

The Falkers

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