2009 4th Quarter Report

(Download printable .pdf version here.)

"We live in an age disturbed, confused, bewildered, afraid of its own forces, in search not merely of its road, but even of its direction."
‐ President Woodrow T. Wilson

As we look back on 2009 and the early part of this quarter, we often reflect on just how confusing and nerve‐wracking the capital markets must be to you, our friends and clients. Though we take considerable pride in having provided portfolio performance in excess of our benchmarks, despite a fairly conservative posture, we are humbled by the uncharted waters through which this country now sails.

Our philosophy and process is to seek consistent outperformance for our investors with the understanding that financial markets in which we invest are inherently inconsistent. By focusing on a disciplined approach, we strive to make performance as immune as possible to the whims of the markets and investor psychology. In essence, our approach is built on the two pillars: dogmatism and pragmatism. Dogmatism is the fundamental analysis of sectors and companies and is supported by our research, our study of managements’ conference call transcripts, and our discussions with analysts and experts; it is the main driver for our long term performance. Pragmatism is flexibility and risk management; its role is to enhance consistency; to save us from ourselves when we are wrong.

After the wave of ebullience in equity markets, we sold a number of holdings at decent gains. We were not surprised by the extent of the ongoing recovery, given the depressed levels of last year, but the speed at which it has occurred has been faster than we imagined.

For those of you who have been involved in fixed income markets, our shift into the preferred market has paid off in spades. By most measures, key aspects of the preferred market are returning to normal levels following the severe conditions of early last year. Trading has improved, there are new issues coming to market, following the tap being completely turned off, and valuation metrics are more consistent with other market segments after providing yields that “screamed” at us. The good news is predicated by perceptions of credit quality improvement which have boosted prices in preferreds and other corporate paper. Regrettably, the lowest risk segment of the fixed income market, US Treasuries, faces what appears to be an ever‐growing supply which transforms this into a bogus sanctuary.

Economic Overview

The massive recovery of capital markets in 2009 that started in the first quarter came as a result of a Uturn by governments and regulators on how to deal with bank woes. Banks around the world were massively undercapitalized. Excess leverage and lax lending standards, the collapse of the global real estate bubble, and the resulting global recession wiped out much of their capital. Though I suspect that nationalization of the banks may well have been a real alternative, governments chose to provide financial assistance while leaving equity holders intact. The US Treasury, the Federal Reserve and the Financial Accounting Standards Board came to the rescue followed by the rest of the world. The balance sheets of the government, the Fed, Fannie Mae, and Freddie Mac were transformed into a repository for the commercial banks’ toxic waste not unlike Nevada’s Yucca Mountain.

Paul Myners, the UK Treasury’s Financial Services Secretary said recently, "Our banks are only alive because the government has taken decisive, innovative action to protect the sector and the economy." As George Soros put it much more succinctly, "the profits of the banks are 'gifts' from the state."

Consequently, we believe that investors must incorporate the influence of politics into their analysis and decision making this year in order to be successful Not only are we still dealing with macro credit cycle and economic cycle issues of generational importance, but 2010 is a mid‐term election year. Moreover, the government remains the key driver of the current economy as the private sector continues to heal in the balance sheet ICU ward. We expect a job related stimulus package soon if payrolls do not begin to pick up. We also expect some type of effort to assist or provide stimulus for small businesses, a very meaningful component of the macro economy that has so far received about zero in the way of government largesse. The FIRE (finance, insurance, real estate) industry may be the largest nominal dollar campaign contribution source in the US, but it’s actually those with and without jobs, as well as those operating small businesses that vote. Remember, the influence of politics is not confined to the Administration solely. We expect the Fed to announce continued market support (printing money and buying) for MBS and CMBS securities (residential and commercial mortgages) beyond their current expiration dates in 2010.

Here are a couple of political issues that currently weigh on our minds:

Government intervention of historic proportions has been of tremendous benefit to economies and markets around the world. But what happens when such support expires? We may soon have a test as GSE (Fannie Mae and Freddie Mac) mortgage‐backed securities will no longer be purchased by the Fed as of March (although this deadline may well be pushed back). Mortgage rates are currently at all time lows, but if the largest purchaser of mortgages effectively disappears that may end quickly, with consequent negative impact on US housing prices This is just one of a myriad of government programs and support mechanisms that exist around the world today.

The regulatory environment is arguably now more unpredictable than any time since the 1930’s introducing an unprecedented level of uncertainty for a wide range of businesses. Just a few months ago, it appeared that managed care companies may cease to exist as we know them. Yet, remarkably, healthcare legislation now appears to fortify their existence. More recently proposals have been floated that could force major financial institutions to change their business models significantly – in some cases unwinding major portions of shotgun marriages that the same government strongly encouraged less than eighteen months ago.

For equity markets to transition into sustainability and for the cyclical bull in equities to remain healthy, the real economy likewise needs to transition from being cared for in the government sponsored economic intensive care ward to being driven autonomously by the US private sector. Ask yourself, just what type of a valuation multiple would you put on an economy being supported and driven largely by the government sector? What type of a multiple would you put on an economy being supported and driven by excessive government borrowing and central bank money printing? If we believe that longer term the financial markets reflect the reality of underlying private sector and the earnings prospects of companies operating within that economy then, we need to focus on the private sector broadly and the components of final demand specifically that define the very health of the private sector.

Despite the robust 5.7% growth demonstrated in the fourth quarter, almost two thirds of that was a result of a swing in inventory building from the contraction which has been in place for some time. But, as far as final demand is concerned, a far direr picture is evident:

Deficit hawks – especially among the bankers who laid low during the government bailout of their institutions, but who have now come back with a vengeance – use worries about the growing deficit to justify cutbacks in spending. But these views on how to run the economy are no better than the bankers’ approach to running their own institutions.

Trying to "square the circle" between the need to stimulate the economy and please the deficit hawks, Obama has proposed deficit reductions that, while alienating liberal democrats, were too small to please the hawks. Other gestures to help struggling middle‐class Americans may show where his heart is, but are too small to make a meaningful difference.

Three things can make a difference: a second stimulus, stemming the tide of housing foreclosures by addressing the roughly 25% of mortgages that are worth more than the value the house, and reshaping our financial system to rein in the banks. There was a moment a year ago when Obama, with his enormous political capital, might have been able to achieve this ambitious agenda, and, building on these successes, go on to deal with America’s other problems. But anger about the bailout, confusion between the bailout (which didn’t restart lending, as it was supposed to do) and the stimulus (which did what it was supposed to do, but was too small), and disappointment about mounting job losses, has vastly circumscribed his room for maneuver.

Recent European news regarding fiscal problems in Greece and other parts of the EU has drawn attention to fiscal deficit issues as a global problem. Putting things into context, the size of the Greek economy is about two thirds that of the state of New Jersey; the California economy is more than five times as large as that of Greece. Here is some additional perspective on deficits, net debt and interest payments.

As is strikingly apparent, several states in the U.S. are in just as bad shape as any foreign nation. While much of the concern with the weaker sovereigns in Europe centers on their inability to print the currency in which their debt is denominated, the same is certainly true of U.S. states.

Overcorrecting, on the other hand - closing the spigot on the American Recovery and Reinvestment Act, in particular, before the economy has fully recovered - would both jeopardize our economy and kill the prospect of job growth, while also making it harder, over the long run, to address the deficit outlook over the next decade. Pursuing drastic and immediate deficit reduction when the economy has only recently returned to growth, and unemployment is still at 10 percent, would be an enormous mistake; fiscal retrenchment right now could lead to a double‐dip recession. Those who would use current deficits as an excuse to curtail or prevent policies designed to speed the recovery are doing the country and future budgets a disservice. Recovery spending today is both necessary and entirely appropriate, even in light of the long-term budget challenge. It accelerates the recovery. Taking these appropriate steps today, in order to bring the economy back to its full health, will put us in the strongest position from which to undertake deficit reduction over the longer term. Deficit spending in the near term will help produce a return to robust economic and employment growth, yielding significant dividends in terms of future deficit reduction.

Perhaps this is a false dilemma. Though at times these problems seem intractable, I am far more optimistic than that. Government, much like private enterprise, can and must find innovative solutions to these issues. As a Canadian, I can point to some elements of reform that were embraced to bring Canada to fiscal sovereignty and responsibility, after a long period of squandering wealth.

In the early 1990s all levels of government in Canada were running a budget deficit of 9.1% of GDP. The deficit of the federal government itself stood at 5.3 % of GDP and public debt was 65% of GDP and rising. Canada's currency was weak and it faced the prospect of being crippled by debt if investors lost further confidence. Just a few years later, Canada's budget deficit was cut to zero and, in eight years, public debt was cut by a third. So how was this turnaround achieved? In short, a complete assessment was made of all government programs and services within the overall fiscal framework. A program of zero‐based budgeting was introduced. The exercise was less about what to cut and more about what to preserve in order to give Canada the comparative advantages needed to prosper in the future.

We certainly believe that similar programs involving a complete review of government spending could capture similarly positive results here.

The Market

A shaky start to the year does not necessarily command the ultimate outcome for the rest of the year. Though a couple of recent up days has brought the dimensions of this correction to down about 7.2% from the January 19th peak, I think there is reason for optimism in US equities.

Part of the rationale for the correction was caused by fears of monetary policy tightening in the emerging markets accompanied by fears of contagion from the Greece debt crisis. In my view, these are unlikely to derail the turning of the fundamentals within the global economy. As U.S. net exports continue to surge and have hit their highest levels in 20 years.

The most obvious weakness in the US economy relates to the labor market. Productivity growth has been incredible:

Productivity growth like this, as the chart indicates, is quite unsustainable. One wag has pointed out to me that if productivity gains were to continue at this pace, in another 15 years there would not be a single working soul in the U.S., a great example of reductio ad absurdum.

In fact, economic history demonstrates that elevated levels of productivity growth lead to strong employment growth in subsequent periods. In work done by Strategas, let’s have a look at employment growth following greater than 2.9% productivity growth since the Second World War:

Extrapolating the past trends into today translates into 3.5 million jobs in 2010, or about 300,000 a month, a robust forecast well above consensus estimates. However, with official unemployment running at 10% and more broadly defined levels at 17%, the nation is dangerously under‐employed. Given the unsustainable levels of productivity improvement, the recovery in employment may occur much more rapidly than most believe.

Labor participation, as history demonstrates, will lag. More immediate growth for the economy will come from net exports as we see in our first chart and also capital spending and investment. As you can see, the inventory adjustment has been "off the map."

Let’s not lose sight of the strong earnings that have been reported by S&P 500 companies. No longer is it just cost-cutting that is beating consensus estimates, revenue growth is also playing a role:

In addition, the guidance from managements has been very strong. According to Bespoke Investment Group, the spread between the percentage of companies raising guidance and the percentage lowering guidance is at its highest level since 2001 with more companies raising guidance than lowering for three consecutive quarters.

Perhaps we had gone through a period in the fourth quarter where investors had become quite complacent about investing and expectations had become excessively optimistic. I am finding the recent caving in of investor sentiment against a backdrop of reasonably good earnings news, as well as positive guidance to be fairly compelling.

As our opening quote indicates, there are confusing and bewildering cross currents that provide significant headwinds to the market’s progress. The wave of disinflation that equity and bond investors have ridden since the early 1980’s is ending. Associated with this, the most important economic story since the 1980s has been the sweeping triumph of free market capitalism, which had unleashed huge productivity growth around the world. In the aftermath of the 2008 stock market crash and what has been labeled the "Great Recession", it appears the pendulum has already begun to swing in the opposite direction, i.e. less free market innovation, more regulation, bigger government and more protectionism.

We continue to be optimistic about the opportunity set in front of us and look forward to markets which we believe will be far less tumultuous than those we experienced in the last two years. We think that our discipline of careful and disciplined stock‐picking will continue to serve us well. For balanced accounts, we will continue to look for creditworthy corporate instruments to provide superior returns to the quickly fading rewards of the Treasury market.

Thank you for your continued support and confidence.

Rick Konrad
Managing Partner