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Letter dated July 2009 reporting on the second quarter of 2009

Chrysler and GM bankrupt.  Swine flu alarms.  Socialism.  North Korean and Iranian nukes.  Not the sort of things that one associates with a stock market rally.  But beginning in early March, rally it did.  The government has been pumping money into the financial system and broader economy at a pace that is almost unimaginable, and it is helping stock prices.  It is too soon to judge what all this will mean for economic growth and inflation, but the current situation has created investment opportunity.  We have taken advantage of that.  I am pleased to say that we outperformed the market in the first quarter when it dropped sharply, and beat it again in the latest quarter as it came back. 

The S&P 500 Index rose 15.93% in the second quarter, and is now up 3.2% for the year.  Your account rose 17.8% for the quarter and is now up 9.8% for the year.*  Certain industry groups are clearly leading the charge.  These groups are the financials, basic materials, discrete parts of the energy complex, and certain technology stocks.  These groups are loosely correlated by the huge increase in money supply and the effects of that – most notably a stimulative effect and an anticipation of inflation.

Inflation expectations have made the yield curve steeper.  Since banks are now realizing a higher margin between their borrowing rates and their lending rates, their profits are rising.  Stocks of the major banks began to rally in March when it became clear that the Obama Administration had no intention of nationalizing any of them.  We caught much of that move in various bank stocks.  These stocks are still very far below their peak prices because they are by no means out of the woods; there is still a huge overhang of questionable consumer debt and troubled commercial property loans. 

Concerns about inflation and the debasement of the dollar also produced a strong rally in gold from mid-April to early June.  It has since backed off from the $1000 level, but remains one of our largest positions.  The Euro-based economies have serious troubles too.  So when both the dollar and the euro are unattractive, gold becomes a proxy currency. 

Energy is a more difficult sector to judge.  Many energy stocks have rallied sharply, but there are sharp divergences within the sector.  Natural gas is only about half the price it should be in relation to crude oil in BTU-equivalent terms.  Natural gas has suffered from reduced demand from power plants, factories, and other industrial users.  Demand for oil tends to be less elastic as consumers want it for heating and cooling and transportation.  Thus holdings such as Penn West Energy, which produces mostly natural gas, have not appreciated as much as I had hoped.  But Penn West does provide a yield of 12% while we wait for greater appreciation.  Oil stocks that focus more on refining, such as Valero, have also been weak because refining margins are low.  In other words, the prices of gasoline and heating oil are not going up as much as the price of crude oil itself.  Both natural gas and refining margins should improve if and as the economy gains strength. 

We have been overweighted in banking, energy and commodity stocks.  If I were running a hedge fund, I would have had an even larger overweighting.  But a good part of my job is to keep you appropriately diversified, especially because commodity-based stocks such as Freeport McMoran (FCX) can be exceptionally volatile.  So we have maintained our exposure in sectors such as health care, consumer staples, and utilities.  These sectors have appreciated less, but they can be attractive particularly since many of these stocks pay good dividends. 

I’d like to turn to the importance of dividends and dividend paying policies of various companies.  Let’s start at the beginning:  what is a share of stock anyway?  It is the promise of a company to share its earnings with its owners.  Some corporate managers have gotten too greedy and have not appropriately shared the wealth.  When too much money goes to things like executive stock options, the shareholders are getting the short end of the stick.  For instance, I won’t buy Flextronics anymore even though its earnings have grown respectably, because its executives have awarded themselves too many stock options.  That dilutes the interest of others.  Investors have begun to get wise to this nonsense, and the stock remains depressed despite decent earnings.  Ironically, this makes executive greed self-defeating.  I have nothing against incentive compensation, but I also believe in fair distribution of gains.  A reasonable dividend is not the only way to share the wealth, but it is a strong indication of a willingness to do so. 

We will buy stocks that pay no dividend if they are using net income to fuel continued growth and keeping the compensation of their executives at reasonable levels.  Microsoft did not pay a dividend for years, but they were growing rapidly and early shareholders got a great total return as the stock rose based on the expectation of a good dividend someday.  But if that someday does not arrive, you essentially own a futures contract rather than a share of stock.  Microsoft began paying a dividend only a few years ago, and now yields about 2.2%. 

Dividend yields are still lower than they were at other bear market bottoms.  They were over 6% in 1982, over 7% in 1949, and over 10% in 1932.  This compares to a dividend yield of only about 3% in March.  But interest rates are lower now as well, so current dividend yields may be a good relative value. 

The market’s dividend yield has implications for the validity of a buy-and-hold investment strategy.  It is oft-repeated that it took 25 years for the stock market to make a new high after the crash of 1929.  True enough.  But given the fat dividend yields of the 1930s, it took only about seven years for buy-and-hold investors to be ahead of the game after 1929.  That tells me that long term investing is still a sensible strategy if a seven year breakeven is the worst case outcome in the past century. 

Of course, we cannot invest blindly in high-yielding stocks.  Stocks of many such companies plunged last year, and this was followed by cuts in dividends.  Needless to say, we will continue to monitor earnings trends and the ability of firms to maintain or increase dividends. 

We will continue to buy growth stocks where the fundamentals are genuinely good.  Google is one such stock.  It is cheap relative to projected earnings, and is in the sweet spot of a changing advertising market.  They are justified in plowing earnings back into continued growth, but hopefully someday will evolve like Microsoft and share the wealth.  Apple is another great company that doesn’t pay yet.  We like it, but we will sell if it reaches certain price appreciation targets. 

It is sometimes said that the market cannot rally without a good wall of worry.  It has sure done a good job of constructing one.  That worry will increase as the spooky season approaches.  Will the wall of worry continue to help propel prices higher?  I don’t know.  That is part of the reason that I use stop orders, and ratchet them higher as prices rise, to lock in gains  (or to limit losses in downturns). 

I’d prefer to let profits run for as long as possible.  Since analysts expect earnings to be down about 35% year-over-year, there is at least some chance that the surprises are on the upside (as they tended to be in the first quarter).  Moreover, a great many stocks remain quite cheap relative to peak earnings of the past decade.  Needless to say, some companies are unlikely to return to peak earnings, so we have to be discerning. 

The bigger risk to wealth may eventually be the dollar rather than the stock market.  I have begun to use currency ETFs to diversify certain portfolios with a small amount of direct exposure to “hard” foreign currencies such as the Canadian dollar and the Aussie dollar.  If you would like to discuss currency diversification, please let me know. 

We will continue to monitor fundamental developments, update valuations, and react accordingly.  I try to limit turnover.  But if a stock moves 30% in a few weeks, we realize that might have occurred over two years in another era.  There are times when a short holding period is justifiable. 

We’ll do our best to make hay while the sun shines, and to avoid the storms.  We can’t anticipate every lightning strike, but we can make intelligent judgments about probabilities and position ourselves accordingly.  We’re happy to share our thoughts and answer questions at any time.

Let me close with an optimistic scenario.  Before mid-September of last year, the S&P had fallen from a peak of about 1550 to a low of about 1200.  This was already a correction of about 20%, which was undoubtedly justified.  The bottom fell out only after the collapse of Lehman.  More and more, that is seen as a terrible policy blunder by former Treasury Secretary Paulson and others.  It was a giant financial accident that did not have to occur.  In that case, the market may be justified in returning to the 1200 area on the S&P.  Needless to say, the plot may not be quite so simple.  But America is still America, and we have overcome recessions and financial crises may times in our history.  Those who believed have been amply rewarded.