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."

How We See Things

We were very surprised and disappointed that the Paulson plan did not pass the House of Representatives on Monday. The markets’ reaction was not unexpected and, while we did not expect this to happen, we were prepared for it. Here is where we stand:

• We have approximately 20% cash in all of our accounts, which is securely invested in U.S. Treasury money market accounts. This is the result of consistently taking profits off the table for the last several months.

• Last week we invested approximately 2.0% of our portfolios in Goldman Sachs’ AA3/AA- rated senior notes, yielding 8.5% to maturity in January 2011. We saw this as an opportunity to position ourselves two steps ahead of Warren Buffett on the Goldman balance sheet, after Berkshire Hathaway invested $5 billion in Goldman preferred stock, yielding 10%, and Goldman simultaneously raised another $5 billion in the public equity market.

• The balance of our portfolios are invested in strong, undervalued companies, many of which have been relatively unaffected by the market downturn, while some, particularly those in oil, metals and infrastructure, are being affected by a now well-documented world recessionary scenario. Many of our companies present compelling values, but we are being patient in committing additional capital, while waiting for stability to return to the markets.

• Our year-to-date performance, while in negative territory, continues to track well ahead of the S&P 500 Index benchmark.

We are paying very close attention to everything that is happening in the markets and it is our opinion, at the moment, that we will still see some form of bailout plan in the next week or so.

As always, we are happy hear from you.

Jack and Peter Falker

Note: Both Jack and Peter Falker, and the clients of FalkerInvestments Inc., are long both the common stock and bonds of Goldman Sachs, as well as the common stock of Berkshire Hathaway.

Trading in a Turbulent Week

Our clients know that our strategy ordinarily does not involve short-term trading, but last week was a notable exception.

Goldman Sachs (GS), which in our judgment is the premier investment bank (now commercial bank) in the world, fell sharply last week and by Wednesday was trading at its book value of just over $100 per share. This was such an unusual circumstance that we felt we should take advantage of it to average down our cost basis in this core holding. We bought the stock at 108 on Wednesday, which had the effect of significantly lowering our average cost.

As the week went on and the entire financial system literally began to fail, the U.S. Treasury announced, on Thursday night, its plans to initiate a huge purchase of the toxic mortgage-backed debt that had frozen the system. On Friday, financial stocks rallied strongly on the news, and that enabled us to lock-in a 21 point (19%) gain on the GS position we had just taken. We decided that taking this gain was prudent in the face of the turbulence of the market. We also took additional gains in U.S. Bank (USB), which, despite the fact that it is one of our favorites, had gotten well ahead of its valuation on Friday, in the euphoria following the Treasury announcement.

In combination with other actions we have taken over the last few weeks, these moves have enabled us to protect a significant amount of client capital, which we believe is prudent, given the seriousness of the situation. All of this cash is invested in a U.S. Treasury fund; not quite under the mattress, but close to it.

We have continued to outperform the market, year-to-date, and we intend to keep it that way.

If there are any questions about our strategic moves, we will be pleased to respond.

Jack and Peter Falker

Note: Both Jack and Peter Falker and the clients of FalkerInvestments Inc. are long both GS and USB

Breaking the Buck ’08 (Not!)

Last November we moved all of our cash holdings to Schwab’s U.S. Treasury Money Market Fund in anticipation of conventional money market funds potentially “breaking the buck”, i.e. falling below $1 share value as the result of losses in asset backed commercial paper or the commercial paper of bankrupted companies.  Therefore, our clients’ funds have been protected from that unfortunate scenario for nearly a year now.  We have paid a price in terms of lower yields on cash that result from this level of security, but we have felt it was worth it.

We wrote a blog note in November 2007 describing our concerns and actions.  You can read that post: “Breaking the Buck (Not!)” by clicking on the 2007 on this link.  Breaking the Buck (Not!)

Here are a few words from that article: 

“We had been suspicious that this might happen for some time now, so we have moved all of our clients’ cash investments to U.S. Treasury money market funds (or the equivalent), thereby insuring that we will continue to receive some positive return on all of our cash investments.  Even though it is widely assumed that major brokerages would support the value of their funds, a large exodus from money funds could impair their ability to do so on a timely basis.  We feel it is important to be early in our decision if in fact this scenario develops.”

With all the attention being paid to money market funds in the press over the last few days, we thought it would be a good idea to remind everyone that their cash is invested in U.S. Treasury securities. 

Jack and Peter Falker 

Current Thoughts

Here are a few of our thoughts in the midst of a very turbulent time. First, it is important to recognize that what we are experiencing right now is probably equal to or greater in magnitude to anything that has happened in the history of our financial system. The mechanisms that were set in place after the great depression have protected the financial markets thus far but, make no mistake about it, these mechanisms are currently being severely tested.

At this time, it is yet to be seen if the Federal Reserve will be able to offset increasing systemic risk in the financial system by extending their charter to the protection of commercial banks from the counterparty risks of non-commercial bank financial entities, such as investment banks and large insurance companies. As we write this note, they have opted not to directly backstop the counterparties of Lehman Brothers in the way they protected the counterparties of Bear Stearns; a rather strange and oddly political call in our minds. Now, it is unknown if they will protect the counterparties of AIG, which is a potentially far more serious problem for virtually every large bank in both the United States and Europe. In our judgment, they must step up to this situation to avoid financial chaos, but their unwillingness to try and calm the markets seems odd to us. We can only assume that their own capacity may be in question.

Having said all of this, it’s worth repeating what the CFO of Goldman Sachs said in their conference call this morning: “In difficult times, nothing is ever as bad as it seems at the bottom and, in good times, nothing is ever as good as it seems at the top.”

With that in mind, we have left considerable cash on the sidelines to protect ourselves from downside and to take advantage of some rather extraordinary opportunities that we are currently seeing. Recently, our biotech, consumer staples, and medtech/pharma sectors have held up very well, offsetting some of the weakness in commodities, infrastructure, and energy, where many good values are being exposed. While we are well aware of the weakness in the economy, all of our holdings have significant value that will continue to rise over time. Under current circumstances, we may trim positions, where sensible in the near term, while keeping an eye toward investment opportunities that are developing.

Given the challenges of today, we find comfort and confidence in sticking to our conservative strategy and valuation process. It will guide us through these chaotic and volatile markets and provide significant returns to our investors over time.

We welcome your comments and questions.