2008 2nd Quarter

(Download printable .pdf version here.)

"My Mama says that alligators are ornery because they got all them teeth and no toothbrush."
– Bobby Boucher, Jr. "The Waterboy"

The quote from the movie, "The Waterboy" summarizes the way many investors felt in the second quarter of this year. The last quarter has been unpleasant across the board. The aches and pains were real and no effective remedy was to be had. The backdrop of news was grim, clients were uneasy, and most markets (domestic and foreign), sectors, and strategies provided negative returns. Our All Cap Equity portfolios underperformed applicable benchmarks in the quarter. Though we are never happy to report negative results, we continue to outperform our benchmarks year to date.

The first half of 2008 can best be described as arduous. The major indexes ended the second quarter with double-digit declines and were close to levels indicative of a bear market. As we wrote in our first quarter letter, capital markets have been adversely impacted by the ongoing strain in the global financial system and the collapse of the housing bubble. This process continues and the second order outcomes of the deleveraging we had alluded to at that time, both at the individual and the corporate level, are by now fairly obvious. It is clear that markets have experienced and are continuing to absorb what has become known as a Minsky moment – the point in a credit cycle when cash flow problems are brought on by spiraling debt incurred to finance speculative investment. The late economist himself said it best when he stated that “all panics, manias and crises of a financial nature, have their roots in an abuse of credit.” The reversal of that abuse can, as the world has recently been reminded, be quite painful.

The framework that Minsky, along with Kindleberger (an economic historian who wrote Manias, Panics, and Crashes) gave us for the analysis of financial innovation and crisis suggests that all bubbles begin to meet their end in a critical stage and financial distress, during which the excess leverage and overconfidence that amplified returns becomes problematic. This is followed by the final stage of a bubble’s life cycle – revulsion, when speculators are so disgusted with their former behavior that they can no longer stomach participation in the market at all. Our own sense is that the market is well into the critical stage at this point, but has not yet truly reached revulsion. The spasms caused by the natural unwinding of credit and leverage have been further aggravated by increasing inflation, with prices for many basic food stuffs and key commodities increasing at a rapid pace. We found it somewhat alarming to learn recently that 50 countries around the globe now have inflation above 10% – this figure includes six out of the ten most populous countries, or 42% of the world’s population. The inflationary risk is not inconsequential, particularly in certain emerging markets. Whether driven by a short-term speculative bubble or longer-term supply and demand dynamics is largely irrelevant – increasing commodity costs present an additional challenge to the global economy and markets.

Against this backdrop, we continue to receive client inquiries about how we have positioned ourselves for continued strain in the financial system, a severe recession, or stagflation. As we wrote earlier this year, we maintain our belief that it will turn out to be a huge mistake to take drastic action if the outcome is anything short of a total financial calamity. The odds remain high that the world will manage to get through this period, much as it has in past periods of uncertainty and financial stress. Financial institutions will, by and large, unwind leverage, bolster capital, and move on over time – perhaps somewhat less profitably and/or under a somewhat more constrained regulatory framework. Likewise, the second order outcomes, while sporadic and difficult at times, will dissipate over time. While the observable rise in global inflation introduces a somewhat more serious risk, high quality companies with pricing power should make more money in such environments, all other things equal, and therefore be better able to maintain profitability.

With respect to inflation specifically, there are three reasons suggesting that today’s environment may be temporary. First, as de-leveraging and recapitalization continues at the individual and institutional levels in the developed world, risks to employment, profits, and growth tilt toward the disinflation side. While it may not always be the case, the majority of raw materials continue to be consumed in North America, Europe, and the developed parts of Asia. We concede that structural issues may cause food and energy prices to remain elevated, but the rapid increases in commodity prices over the recent past strike us as somewhat peculiar at this juncture given that most developed economies are slowing. Second, excluding food, energy, metals, and healthcare (in the US), price inflation in just about everything else is either nonexistent or weak – this includes many larger categories of consumer expenditure such as housing and household goods, autos, and clothing. Finally, unit labor costs, which for most companies represent a large variable cost, remain benign due to modest wage inflation and increased productivity.

As you know, our portfolio positioning is typically little changed by macroeconomic factors. In response to the current situation, or any other situation for that matter, we believe that purchasing high quality businesses at meaningful discounts to their worth offers far better protection for clients’ assets than any macro-based structural shifts, market timing measures, or thematic/sector allocation steps we might otherwise take in creating so-called defensive portfolios. This may set us apart from some of the other managers you use. However, the careful evaluation and pricing of businesses is where we believe we can add the most value for you and your clients. We therefore continue focus the vast majority of our time and resources on this pursuit as opposed to macroeconomic forecasting. Please rest assured, as we do, that your clients’ portfolios are dominated by companies with the following characteristics:

• A high quality business with above average profitability measures
• Attractive longer term demand characteristics and sustainable competitive advantages
• Decidedly capable management teams, typically with ownership stakes

We are steadfast in our belief that superior investment returns are best achieved through a process designed to purchase businesses with these characteristics at prices that are substantially discounted to estimated fair business value. While this investment philosophy will not produce significant outperformance in every quarter or every year, it has historically produced more than satisfactory risk-adjusted returns over long periods of time. We note that at quarter-end the median return on invested capital (a quick approximation of quality) for the businesses in the Value Architects model portfolio is in excess of 15% compared to low double-digits for the average S&P 500 company. Likewise, the quarter-end market price relative to our estimation of the core operating earnings of the businesses in the model portfolio was below the 13.6x P/E (a quick approximation of cheapness) of the S&P 500. In simple terms, your clients own a diversified portfolio of businesses with above average quality, trading at below average prices.

With that in mind, we believe it is important to highlight our exposure to the financial sector, where our performance has lagged considerably. Financials, broadly defined, have struggled in the past quarter and through the first half of 2008. This underperformance has been ongoing since last July when serious credit issues emerged. As measured by the Financial Select Sector SPDR (XLF), the sector was down nearly 30% in the first half, with almost 19% of that decrease coming in the second quarter. Within client accounts, we own financial services businesses that declined by 40% or more in market value over the first six months of the year. We have, bluntly, been too early and so far incorrect with our investments in the sector. This has been a particularly disappointing setback for Value Architects given what we perceive to be our core competency in the sector.

Our weighting in financials is currently between approximately 10% and 12%. Our largest exposure in financial stocks is Berkshire Hathaway, a company of unquestionable financial strength that is benefiting from current market dislocations and is run by the best allocator of capital the world has seen to date. Legg Mason, another larger exposure is a world class asset management business valued at less than 0.65% of assets under management compared to its industry at 2.00% or higher. Current market prices suggest that the market believes that more than half of its more than $900 billion in assets under management will disappear. Rather, we view this as a highly unlikely scenario and contend that it is quite undervalued at current prices. US Bancorp, arguably the best run large bank in the country, can be purchased at current market prices for less than 6.5x trailing earnings after adjusting for the value of its wealth management and payment services business and has minimal exposure to the capital markets risks that have dogged many of the country’s largest institutions. Alleghany Corporation is a high quality property and causality insurance business with significant excess capital that, like Berkshire, is positioned to benefit from current market dislocations. This business was purchased for client accounts at book value after adjusting for the value of real estate. Your clients own the world’s most dominant insurance franchise at prices below book value due to a perfect storm of negative developments at AIG. Because of these known issues, market expectations currently discount extremely negative outcomes ignoring at the moment that the company:

• remains a premier global multiline insurance franchise with several unique/difficult to replicate business;
• maintains scale operations across the globe;
• has been nimble in exploiting opportunities in emerging markets;
• retains a strong credit rating despite recent downgrades; and
• has a highly diversified revenue stream.

Over the years the markets, and our own portfolios, have suffered dramatic setbacks on many occasions, only to post satisfying returns when, each time, stability was restored. We see no reason to believe that the outcomes this time should be any different. Let’s review a bit of stock market history of the last fifty years:

Significant Declines in the S&P 500 Over the Last 50 Years

Down Market	Duration (months)	Total Return	Return in 12 Months after Decline
Aug 1957 - Dec 1957	5	(15)%	+43%
Jan 1960 - Oct 1960	10	(8)	+33
Jan 1962- Jun 1962	6	(22)	+31
Feb 1966 - Sep 1966	8	(16)	+31
Dec 1968 - Jun 1970	19	(29)	+42
Jan 1973 - Sep 1974	21	(43)	+38
Jan 1977 - Feb 1978	14	(14)	+17
Dec 1980 - Jul 1982	20	(17)	+60
Sep 1987 - Nov 1987	3	(30)	+23
Jun 1990 - Oct 1990	5	(15)	+34
Apr 2000 - Mar 2003	36	(41)	+35

Source: Roger Ibbotson and Rex Sinquefield. “Stocks, Bonds, Bills, and Inflation: Year by Year Historical Returns.

The historical declines varied in intensity and length, but averaged about 23%.The ensuing recovery provided an average recovery of 35% just twelve months later, more than making up for the pain of the decline. While many investors turn to cash in their despondency, cash doesn’t have the return potential to contribute much when the market rebounds.

In closing, we hope you agree that while short-term outcomes may not always be what we expect, the process we employ to manage your clients’ long-term assets is fundamentally sound. That process, given an adequate time horizon, tends to result very satisfactory returns. As always, we remain dedicated to building your trust and we appreciate your continued support.

Respectfully,

Rick Konrad, CFA, CFP®
John Moran, CFA