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.

Mid-Year Thoughts

Is there a recession or isn’t there? Technically speaking, we aren’t in a recession, because GDP continues to grow slowly. Ok, tell that to the American who just put 25 gallons into their gas-guzzling SUV and added $100 to an already overflowing VISA, at 18% interest, which they can’t pay off. Tell it to the family that stopped making payments on their 12% floating-rate home mortgage, because they have to keep their credit cards alive so they can get to work and eat. Multiply that by the thousands of people who do that every week and it gives you some perspective that all is not well out there.

Many people made poor financial decisions and corporate executives, especially those in the banks, didn’t understand their risks. The world economy is more competitive, as we realize that demand from countries such as China and India now dictate the price of scarce commodities that we have taken for granted. A recession is generally upon us, and the lessons are being learned. However, there is tremendous opportunity in the global economic world for everyone, and the key is to encourage investment toward the efficient use of capital.

Through these very turbulent times, we believe that we and our clients are well positioned in a volatile market that we think will continue over the next several years. At mid-year our fully invested accounts were generally 6-8% ahead of the S&P 500. That followed our strong 2007 performance in which we also exceeded the benchmark.

Within our strategy we have been pursuing long-term investments in global infrastructure, commodity and energy companies that meet our internal rate of return and valuation criteria. Our investments in oil, natural gas, biotechnology, infrastructure, and steel did particularly well for us in the first half, but some have turned down in July, which we believe is a temporary phenomenon that may afford the opportunity to average down several positions.

We hold two companies in the financial space (Goldman Sachs and U.S. Bank), which continue to be negatively impacted by perceptions that anything in this space is toxic, despite their own internal performance and long-term prospects. However, it’s not too hard to understand why the perception of financial companies is so negative, given that the majority of banks, brokers, insurers and rating agencies, as well as the government sponsored entities Fannie Mae and Freddie Mac, apparently did not understand their own lending activities in the housing space and did not see the mortgage securitization problems coming until it was too late to act. Witness the multi-billion dollar disasters of Bear Stearns, and Countrywide Financial and the potential disasters of Lehman Brothers, Merrill Lynch, Wachovia and Washington Mutual, to mention just a few, and you begin to understand why this area remains so difficult to invest in, despite any good that is being done by companies like Goldman Sachs and U.S. Bank.

To get an idea of the current status of the problems in housing and mortgage financing, take a few moments and read this excellent analysis, entitled Mooooooo!, published this week by Bill Gross of PIMCO Investments: http://www.pimco.com/LeftNav/Featured+Market+Commentary/IO/2008/Investment+Outlook+Bill+Gross+Mooooooo+August+2008.htm

When we see things happening that seem proportionately worse than the events that caused the stock market disasters of 1929, 1933 and the ensuing depression (which really didn’t end for most people until after World War II), we have to remind ourselves that we live in a global economic environment that is far more able to endure the kind of financial shocks that essentially shut down the U.S. economy and stock market nearly 80 years ago. The actions of the Federal Reserve and the U.S. Treasury in the last six months are clear evidence of the progress we have made since 1929. Also, take note of the multi-billions of off-shore dollars flowing back into this country as capital investments in some of our ailing financial institutions. These kinds of things could not have happened 80 years ago.

And yet it’s important to realize that the Fed and Treasury do not have all the answers and are not omniscient in their respective abilities to solve all of the ongoing problems of our financial system and economy. In the short-run, they are largely powerless in dealing with the price of oil and the related weakness of the dollar. Such problems must be fixed by changes in our consumption behavior accompanied by long term fiscal and monetary discipline (i.e. reduced government borrowing and responsible monetary policy).

Accordingly, we believe the issues that directly affect investments of capital in the stock and bond markets are likely to be with us for several years. People will get used to paying five to 10 dollars a gallon for gas (as Europeans have for years because of taxation that has deliberately held down their consumption) and maybe just might get the message to shut-off their engines and open the windows when sitting still, instead of burning gas to run the air conditioner. Or they might just get out of their cars to get a cup of coffee at Starbucks instead of idling in line at the drive through window (not to mention the related pollution). Or, heaven forbid, they might just ride the bus or train to work, like people all over the world have been doing for many years.

Economic growth will depend more on investment and less on the largest component, consumption. Reduced credit availability will slow the pace of any future home price appreciation and end the indiscriminate use of home equity to fuel consumption. Higher commodity and energy costs will alter economic decisions and personal behavior. For example, we are using three to five percent less gasoline than just a year ago; use of public transportation is up over 2%; wind power investments are motivated by a goal of providing 20% of U.S. electricity demand; current investments in natural gas will provide access to a plentiful source of domestic energy that can be used to replace much of our dependence on foreign oil. China’s growth mandate along with growth in India and neighboring emerging economies, while slowing from time to time, will continue to drive demand for technology, infrastructure development, and industrial commodities such as copper and steel. Also, investments in diverse, internationally exposed companies that provide essential products for a more conservative U.S. consumer, as well as an emerging global population demanding increases to their standard of living, will continue to do well.

In other words, we continue to see the glass as half full, even though we are well aware of the problems that are causing it to be half empty. Until we see significantly higher long-term bond yields, we continue to believe that the best place to invest capital is in the high-quality, dividend-paying equities defined by our investment strategy. That encourages us to take profits when we have them and not be reluctant to hold 10-15 percent cash from time-to-time (as we currently do) when we believe greater opportunities might lie ahead.

Our strategy, which rigidly takes into account internal rate of return performance and long-term valuations of every company we own, or expect to own, is literally made for the circumstances we expect to face in the years to come, as our country works its way through one of the most difficult economic times in its history. One thing remains very clear to us, however: History has taught us that the United States is remarkably resilient in times like this. It is definitely not the time to bet against this country.

That’s the way we see it at mid-year 2008. Let us know what you think.

Jack and Peter Falker

Note: At the time of publication, Jack and Peter Falker, as well as the clients of FalkerInvestments, owned the common stock of Goldman Sachs and U.S. Bank.