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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