Market and Strategy Update

Stock Market Slogan...Print, Baby, Print

First, let’s explain some of what is behind the recent market rally. Perhaps the most important factor in the stock market’s rise this year has to do with recent actions by the European Central Bank (ECB). In December, amidst a brewing economic and banking crisis, the ECB offered European banks the opportunity to borrow unlimited amounts of money for 3 years at an interest rate of 1%. The reason for this Long Term Refinancing Operation (LTRO) was clear. Fears of insolvency, resulting from concentrated investments in potentially bad debt from certain European countries, had closed access to the credit markets for many European banks. Where no money could be found, the ECB turned on the printing press.

What the ECB did is important. In both Europe and the United States, central banks continue to fill the void in credit markets as the world economy recoils from a massive debt bubble. Perhaps in the short-term, by taking financial collapse off the table, we are better off. Even though the US stock market had zero return last year, the Federal Reserve’s launch of QE 2 in August of 2010 provided a powerful rally from that point until May of 2011. That rally was very similar in cause, magnitude, and character to the current rally.

Clearly central banks are buying time for policy makers to adapt and economies to adjust. Yet, it is necessary to remain aware of how much support is provided by their actions. The Federal Reserve has injected more than $2.5 Trillion into U.S. Treasuries and Mortgage Backed Securities since 2008. With LTRO alone, the ECB provided almost $700 Billion to support European banks.

As a result, the equity markets, which were starting to price in financial meltdown in Europe, are now pricing in a more optimistic view. Expectations have quickly turned positive with bullish sentiment of stock market forecasters approaching historically high levels. We have seen a significant rally in “low-quality”, beaten-down stocks, as they recover from last year’s lows. While those stocks have led the market, there has been a broad advance in US equity indexes, supported in part by decent economic data in the US.

With expectations for support from global central banks every time a problem appears, it seems likely that markets could hold up reasonably well this year. However, we would like nothing more than for the economy and market to move away from a dependence on easy money. While central banks have made it clear they will continue pursuing easy monetary policy, perhaps the only thing to get in their way will be politics. With the U.S. election straight ahead, their job could become more complicated. While the Obama administration might benefit from the Fed’s proactive policy supporting the stock market this year, Romney has already indicated that he is not in favor of reappointing Fed Chairman Ben Bernanke.

Taken in full context, we understand and appreciate the market rise this year. As always, it is good to consider both sides of the coin. Apparently Goldman Sachs does. Goldman’s Chief Global Equity Strategist recently issued a research piece (close to the recent market high) saying that now is the best time to own stocks in a generation. At the same time their Chief US Equity Strategist has a year-end target for the market about 11% below where it currently trades. Let’s just say cognitive dissonance has become a common psychological condition for any investor these days.

The Apple Effect

We would be remiss if we didn’t address one of the more remarkable impacts on the market: Apple.

Consider that the Dow Jones Industrial Average of 30 stocks was up about 7.5% to end the first quarter, while the S&P 500 was up nearly 12%. Also by comparison, FalkerInvestments’ equities were up about 7.5% year-to-date. Now consider that neither the DJIA nor FalkerInvestments hold Apple stock, while it is the largest component of the S&P 500. Looking at the table below, you can see that one stock, Apple, accounted for 15% of the total return of the S&P 500 Index in the first quarter! (click chart to make it bigger)

I don’t know the history, but this sounds like some kind of record. Anyway, the obvious question is: why don’t we own Apple? The simple answer is that it just doesn’t fit into our model. Clearly from an EVA perspective, it is one of the best value creators the world has ever seen in such a short period of time (their long-term history isn’t so great). However, from a valuation perspective it’s just too expensive. That may sound ridiculous with the stock up 54% in just 3 months (was it cheap 3 months ago?). But then also consider what the market underestimated then, it might be overestimating now. While not thought to be overvalued by most investors who own the stock, much of Apple’s value depends on keeping up a relatively torrid growth rate for such a large company. Who are we to doubt that Apple can continue with its recently stellar track record? (We love our i-Phones too). At the moment, Apple fits somewhere between a growth stock and value stock. Even though what they have been able to accomplish seems obvious now, it has been a speculative stock the whole time. While it’s unlikely Apple will fit our value model anytime soon, we keep a close eye on how it performs, because it just might dictate the next move in the market.

Strategy Update

Here’s an update on what we’re doing. As we said in our year-end blog post, after twelve months of zero return in the stock market, investors had generally become risk-averse and pessimistic. Entering this year we were making plans to start broadening out the portfolio, becoming more economically diversified and less defensive. As our clients are well aware, given the tumultuous and somewhat unprecedented economic events that have unfolded globally since 2008, we had chosen the path of protecting capital and focusing on dividend income. That served us well last year, providing positive returns and avoiding 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.

We have started to execute that plan, but have adjusted our timing somewhat with the market surge. We have increased our overall market exposure (i.e. reduced our cash position) by only a few percentage points, mainly focusing on becoming more diversified. By means of explanation, consider our investments in Consumer Staples and Utilities, two of the best performing sectors in the market last year (Utilities were the best performing sector). In percentage terms, our client portfolios were roughly 20% and 14% invested in Consumer Staples and Utilities, respectively. That compares to their weights in the S&P 500 of roughly 11% and 3.5%. Much of that overweight position was afforded by our underweight positions in Financials and Industrials, two of the worst performing sectors last year, Financials being the worst. Again, with Europe’s banking system looking vulnerable to a very severe economic crisis, we avoided the chance that insolvency “over there” could impact the financial system here.

So, as one might expect with the current rally, the first quarter has seen a complete reversal of fortune for those sectors, with Utilities the worst performer and Financials one of the best (as you can see from the chart above). Therefore, our transition, while well planned, has slowed somewhat as we are, in simple terms, reluctant to “buy higher and sell lower”. However, we have made significant progress finding what we consider to be compelling values in sectors where we have been underweight. Given the strength in the market, a few of those stocks have already exceeded our expectations. While not a topic for this blog, we will relay our thoughts on new holdings during client meetings and occasional blog updates.

We will continue trimming back our exposure to the Utilities and Consumer Staples sectors as we seek value opportunities in other sectors. How much we continue to reduce our absolute cash position will be somewhat dependent on market corrections. As we gradually transition the portfolio, our goal is to own around 40 stocks that together represent all 10 economic sectors of the market. At any given time we are considering roughly 120 companies that meet our basic criteria of generating EVA while trading at relatively low valuations. Historical analysis clearly proves that a disciplined strategy of owning value-creating companies at relatively low valuations outperforms the market.

Thanks for reading. Let us know if you have any questions.

Peter and Jack

April 9, 2012

From 2011 into 2012

FalkerInvestments’ investment strategy performed well in 2011, with equity returns of 7%, on average, as compared to flat price performance of the S&P 500 index. Our overall portfolios, which hold a mix of equities and bonds and were over-weighted toward cash during the year (depending on the risk tolerance of each client), also outperformed the S&P 500 benchmark. We are pleased with this performance given the high level of portfolio insurance afforded by our cash position during a turbulent year.

Europe’s sovereign debt problems dominated market psychology for most of 2011. The United States experienced a weak economic recovery, which was enough to at least partially offset concerns about Europe, and resulted in the S&P 500 Index ending the year almost exactly where it began, the first time that had happened in 64 years.

As we enter 2012, we will likely see a continued slow economic recovery in the United States. This is the result of several factors, including tight credit conditions in the private sector, limited fiscal stimulus due to growing levels of U.S. Government debt, and continued uncertainty about future government policy (e.g., financial regulation, taxes). At least one certainty has been the unprecedented support from the Federal Reserve. Given current conditions, the Fed has committed to a zero interest rate policy into 2013.

Unless some extraneous geopolitical or “black swan” event intervenes, it seems probable that the U.S. equity markets could increase moderately in 2012, treating Europe’s deepening recession only in terms of how it affects U.S. corporate earnings. Because U.S. financial institutions are intertwined in Europe’s affairs, they are the ones most likely to be affected, while multi-national industrial companies will fall back on their U.S. and non-European businesses.

We expect to capitalize on the good performance of our EVA-based equity strategy in 2012 by deploying a greater proportion of our client capital toward dividend-paying, value-creating equities, for those clients whose risk tolerance calls for equity investments. We think the valuation of the market, after zero appreciation in the past 12 months, now has a fair amount of risk-aversion embedded in it. This may well provide for a better-performing equity market in 2012 and, accordingly, we began this week to deploy at least some of our cash position toward high-quality stocks.

As always, we will be watchful of world economic and geo-political conditions, as well as being very selective about what we do. We are, however, encouraged by broader acceptance of these challenging conditions by investors and policy makers alike. Two years ago in this blog we spoke about an expected transition in the markets from excessive risk-taking to one of risk-aversion. That transition is underway and beginning to provide opportunity.

Thanks for your continued trust.

Jack and Peter Falker

January 6, 2012

Eurozone Issues

It seems increasingly likely that there will be at least one sovereign debt default in the Eurozone over the next several weeks and that, as a result, there will likely be some change in the composition of the 17 Eurozone countries using the euro as their common currency.

These Reuters quotes from the last week seem indicative:

Angela Merkel told her Christian Democrat party that: “Europe is in one of its toughest hours, perhaps its toughest hour since World War Two.” She said further that she feared Europe would fail if the euro failed and vowed to do anything to stop this from happening.

"In another conference, Merkel said “Europe's plight was now so ‘unpleasant’ that deep structural reforms were needed quickly, warning the rest of the world would not wait.”

"She called for changes in EU treaties after French President Nicolas Sarkozy advocated a two-speed Europe in which euro zone countries accelerate and deepen integration while an expanding group outside the currency bloc stayed more loosely connected -- a signal that some members may have to quit the euro if the entire structure is not to crumble.”

Also, European Central Bank (ECB) board member Peter Praet said it is not the role of the ECB to intervene “when there are fundamental doubts about the sustainability of some countries”, and outgoing ECB chief economist Juergen Stark rejected calls for the ECB to act as lender of last resort like the U.S. Federal Reserve or the Bank of England.

If the ECB is not to be the lender of last resort, such as our Fed, and the German people are to be heard politically, it seems clear that a Greek default is virtually inevitable, and that Italy and Spain, which are much too large to be saved by intervention, could easily follow, creating a severe crisis in the European banking system, which holds the greatest percentage of Eurozone sovereign debt.

How Does That Affect Us?

We can see day-to-day what Eurozone machinations do to our stock markets, which are acting a lot like they did in the 1930s, except that this time they are mostly reacting to the Eurozone’s problems (and now the failure of our own “supercommittee”). That raises the question of just how big a problem a major financial crisis in Europe is for U.S. businesses. Without a doubt, major U.S. banking institutions would be directly affected, depending on their actual exposure to European sovereign debt and the extent of their role as counterparties in derivative transactions. This would likely be quite large, but not nearly as big an issue as our own sub-prime mortgage scandal, which came close to burying several of our big financial institutions in 2008 and 2009, and has still not been resolved. Nonetheless, added to the problems these financial companies already have, it is likely to produce losses in the billions, but probably would not present existential issues (such as Lehman and AIG in 2008).

There is also recent concern that several large money market funds in the U.S., which hold significant amounts of Eurozone sovereign debt, could suffer losses, which would result in the “breaking the buck” scenario, which we wrote about in 2008. What this means is that investors in these funds would find that, not only do these funds cease to produce any current yield, but actually would become worth less than the dollars invested in them. All of our client cash has been invested in U.S. Treasury money market funds since 2008, in order to protect ourselves from this scenario, which begins to look more likely in 2012 than it did in 2008.

(See: http://falkerinvestments.blogspot.com/2008/09/breaking-buck-08-not.html)

As for multinational U.S. manufacturing companies, a crisis in the Eurozone creates the potential for reductions in sales and earnings. Companies with extensive sales in Europe, such as consumer and auto companies, can be expected to suffer earnings reductions and possible foreign exchange losses, depending on the relative strength of the euro vs. the dollar. For example, a weak euro would result in European goods becoming less expensive in dollars (e.g. European cars) and vice versa, which would be negative for the U.S. balance of payments and companies manufacturing goods for export to Europe. Again, these potential losses would not threaten the survival of the kind of manufacturing companies that interest us, i.e. EVA companies that generate internal rates of return on capital that exceed their costs of capital (but they could create interesting buying opportunities).

Because of the Eurozone threat and the yet to be fully resolved mortgage crisis in the U.S., we have continued to steer clear of owning large banks and investment banking institutions in our client portfolios. Our financial exposures are with Berkshire Hathaway through their insurance businesses, and with General Electric, through their GE Capital subsidiary, which, while still suffering from loan losses incurred in the last several years, is a relatively healthy company overall.

FalkerInvestments’ equity portfolios are largely invested in U.S. multinational consumer non-durable, energy, and technology companies, most of which pay good dividends. Plus, we have significant holdings of strong electric and natural gas utilities, all of which pay good dividends. We also have a small automotive holding, Ford, with the expectation that they should benefit more than any other world auto company in an economic recovery, when it comes. Before the U.S. financial crisis, Ford was the only U.S. auto company producing EVA and, of course did not require a government bail-out or bankruptcy.

Because of our belief that Europe’s problems and the obvious fiscal challenges here at home will keep market volatility high, we still maintain significant holdings of bonds and U.S. Treasury money market funds, which provide our clients with good insulation from most world events. These funds are ear-marked for investments in equities, when we believe the opportunities are right.

As we constantly review our portfolios in light of what is happening in the world around us, we continue to conclude that we are comfortable being positioned as we are. Our equity holdings have outperformed the market this year as investors have sought safety in the type of conservative, dividend paying stocks we hold. That could change, of course, if everything gets better all at once, but somehow we don’t think that’s going to happen right away.

As always, we value your observations and questions.

Thank you for your continued trust.

Jack and Peter Falker

November 21, 2011

A Few Thoughts

Since our last blog posting on August 2^nd, global equity markets have undergone a remarkable sell-off and have now retraced most of the gains made after Ben Bernanke hinted at QE2 about one year ago. Given the risks to the economy that we have discussed in past blog posts, perhaps these levels in the market are more reasonable and offer a healthier investment environment for the future. However, such a sell-off is disconcerting and requires our full attention.

While the failures of political leaders in Washington and the actions of Standard & Poor’s in downgrading United States sovereign debt would seem to be the immediate causes, the markets may be more influenced at this moment by the potential collapse of the Euro-zone and the likelihood of a Lehman-like systemic failure of the European financial system. The effects of such a failure on the U.S. financial system, while believed to be less severe than the financial crisis of 2008, are still relatively unknown.

The sell-off over the last few days has been swift and relentless. It is easy to surmise that one or possibly several significant funds or financial institutions may be under duress and undergoing a liquidation. There is no news of that at this point, but perhaps we will learn more when markets find new support levels. Also, we can’t forget the potential for computer or “machine” trading, which accounts for a significant amount of daily volume, to create volatility. While the decline in equity markets that started three months ago has legitimate fundamental reasons, forced or automatic selling over the last few days may be creating distortions to prices.

At this point our equity holdings are faring better than the market, as expected, and, of course, our cash and bonds are stable. Given our still-sizable cash position, we are looking at several, strong, dividend-paying EVA companies we would like to either buy initially, or add to existing positions. However, we are in no rush to “buy the dip” at this point.

Repeating the conclusion of our August 2^nd blog:

… We have been consistent in our message for the last several years, avoiding the impulse to anticipate every up or down move in the market based on the next government policy. We are working very hard to remain alert to potential downside risks while prudently investing our clients in the best, low-risk, wealth producing companies we can find. We continue to invest in EVA-producing companies with strong balance sheets and good dividends. We are being extremely careful to protect our client assets and continue to provide thoughtful insight via our fiduciary duty as investment advisors.

Stay tuned; and thank you for your continuing confidence.

Peter and Jack Falker

Policy Makers to the Rescue

Rewind

Last year, at this time, the stock market was struggling under the weight of worsening economic news. On August 27^th 2010, Ben Bernanke, Chairman of the Federal Reserve, gave a speech at an annual central bank symposium in Jackson Hole, Wyoming, hinting at his willingness to initiate what we have referred to in this blog as “The Bernanke Playbook”. (Recall that this refers to a paper he wrote as an academic, criticizing the monetary policy of the Japanese during the 1990s and providing his own policy prescriptions.) His speech introduced what became known as QE2 (the second round of quantitative easing) in which the Fed would buy $600 Billion of long-term US Treasury Bonds in an attempt to stimulate the economy.

Three days later the stock market embarked on a furious rally that topped out on April 29^th of this year. The market took the bait and gambled that QE2 would spark a sustainable recovery in the economy.

Last week we found out that the annualized growth rate in the economy for the first 6 months of 2011 was 0.8%. By some economists’ estimates, this is less than half of what is required to simply maintain current employment levels. Other very recent economic reports show that the economy is weaker than many would have expected. Needless to say, QE2 has fallen short of expectations. Today the market closed below where it started the year.

The silver lining here is that corporate profits have remained quite strong, due largely to productivity gains. Of course, productivity means doing more with relatively less (i.e. fewer employees). And there’s the rub. How long can corporate profitability withstand the effects of a weak job market? Given the recent economic data, we may soon find out. Importantly, even with the amount of discord among policy makers in Washington, corporate managers are performing exceedingly well in creating value for shareholders.

As for our portfolio strategy, back when Bernanke embarked on QE2 last fall, we maintained our conservative position (as we wrote in this blog in December). We did not believe that QE2 would really fix what ails the economy and lead to a sustainable recovery. What seemed like a very contrarian position then, appears to be the consensus now, as the market recoils from recent economic news. Our efforts have been to invest in lower risk, high-quality companies, with good dividends that, as always, generate EVA. We have conserved cash to be ready when opportunity arises and protect capital. In a volatile world, we have tried to be stable and consistent.

Another Leap of Faith?

While the Fed may distort asset prices, (like making the stock market go up just by saying they will print money) we are not taking issue with the Fed’s willingness to help; they are using every tool made available to them. Without their initial response in 2008, things would have been far worse. Even Bernanke has learned to sympathize with his own plight. At a recent press conference, a Japanese reporter specifically asked him whether he still agreed with the paper he wrote criticizing Japanese monetary policy, while still a professor at Princeton. Bernanke’s answer: “Well, I’m a bit more sympathetic to central bankers now than I was 10 years ago.”

Add this to President Obama’s recent comments about last year’s stimulus package that “shovel-ready wasn’t as shovel-ready as we expected” and you get the sense that policy makers are disoriented. Washington has lately been caught up in talking points and ideology with complete disregard for the tremendous risks they are adding to the economic recovery. However, this doesn’t come as a complete surprise. The country is divided, as demonstrated by the last election. In a way, they are doing what they were elected to do.

We do, however, take issue with investors blindly assuming that our economic problems can simply be overcome by government policy. Every new policy prescription from Washington appears only to be a red herring, diverting attention from the issues and giving investors hope without justification. Just look at the jubilant response of the stock market after the Fed committed to QE2. Or after the elections when the Bush Tax cuts were extended and payroll taxes were reduced. As if one more round of printing money is the solution. As if tax cuts will suddenly invigorate growth. As if spending cuts will put us on the path to stability. As if more government spending will create jobs. As if raising the debt ceiling will create more certainty. While several policies may be necessary at different times, investors have seemed intent on believing the solution is simply a matter of the next policy fix.

In what feels like a scene from the movie Groundhog Day, traders and investors are again anxiously awaiting Bernanke’s upcoming appearance at Jackson Hole later this month for hints of QE3, as the economy weakens. As if…well you get the picture.

Working Through It

We continue to think the world is upside down for policy makers, making them ineffective in overcoming the historic deleveraging occurring in many developed countries of the world. It takes cooperation, coordination, and communication. We have very little of that right now, which is a startling parallel to the 1930s. In Europe it is even more complicated.

There simply is no easy fix. In their landmark book, “This Time is Different”, Carmen Reinhart and Kenneth Rogoff describe the history of financial panic induced recessions (or depressions). Given history, one could expect a seven year period, or “tail”, after the initial shock, until a sustainable recovery begins. During those years, a multitude of policy risks exist with growth taking place in fits and starts. We are almost halfway there.

The irony of the title, and stated purpose of the book, is that it really is no different now than it ever was. Simply, our lifetime experience in relation to a much longer economic history is different. Rogoff and Reinhart show us that this has been happening for 800 years. We can only accept where we are and work through it.

While our politicians fail to inspire us, corporate managers have been brilliant. Dealing with vast political and economic uncertainties coming from Europe, China, and the U.S., they continue to do their part to create value for shareholders. While some pundits, and even members of Congress, proclaim that the U.S. is bankrupt, they fail to recognize the real value that exists in the private sector, regardless of how broken government has become. There is no doubt that policy risk will remain a drag on economic growth and missteps at the government level could have profound consequences. Business owners and managers are very well aware of these issues, yet they continue to look for ways to grow and prosper. We hear this from the management of companies we invest in and we hear it from our own clients, most of whom are making their own business decisions every day. This is what keeps us optimistic and what generally gives the equity market underlying support. The U.S. economy, built on free-market principles and entrepreneurial aspiration, is very much a going concern.

Repeating Ourselves

For investors it takes patience and a dedicated strategy. We have been consistent in our message for the last several years, avoiding the impulse to anticipate every up or down move in the market based on the next government policy. We are working very hard to remain alert to potential downside risks while prudently investing our clients in the best, low-risk, wealth producing companies we can find. We continue to invest in EVA-producing companies with strong balance sheets and good dividends. We are being extremely careful to protect our client assets and continue to provide thoughtful insight via our fiduciary duty as investment advisors.

Our basic goal during this period of elevated uncertainty is to earn a more consistent and predictable return than the market. We believe this is in the best interest of our clients’ ability to preserve and grow their wealth.

Thank you for your continued trust.

Peter and Jack Falker

August 2, 2011