2011 1st Quarter Report

(Download a printable .pdf version here .)

Perhaps the word that most exemplifies the first quarter is "frightening." Middle Eastern and North African political turmoil can perhaps be considered fairly positive, as corrupt regimes fell and populist movements seeking more of a political voice took hold. Revolutionary democracy and self-determination are generally positive developments though the evolutionary process that some of these countries will endure following years of graft and exploitation may prove very challenging and protracted. The Japanese earthquake, tsunami, and ultimately nuclear disaster remind us of the fragility of our planet and the ageing nuclear infrastructure of this country. About 70 miles south of Hoboken and 55 miles east of Philly is America's oldest nuclear plant, which also uses a GE Mark I Boiling Water reactor identical to those that lost power at Japan's Fukushima plant. Continued uncertainty regarding European debt problems also factored into the first quarter fears. As an example, buried in Irish news late on the Friday afternoon following the Royal wedding was an announcement of some revised economic forecasts:

• Ireland revises 2011 GDP growth to +0.8% from +1.7%; 2012 to +2.5% from 3.2%
• Irish government revises 2013 deficit forecast to 7.2% from 5.8%; 2012 to 4.7% from 2.8%
• Ireland revises 2011 debt/GDP forecast to 111% from 98.6%; 2012 to 116% from 102%

A little closer to home, the most striking news was Standard & Poor's announcement of a potential downgrade of US Treasury debt. As we all know, Standard & Poor's has taken its share of flak for years for its rather belated assessment of deteriorating credits. After all, these are the same folks who viewed Enron's debt as investment grade as late as four days prior to bankruptcy. These are the same folks who decided that bundles of dubious sub-prime mortgages magically transformed themselves into AAA credit when structured into a CDO. Despite this history, the firm wasn't too shy to recognize the obvious regarding America's debt situation. S&P's shift to a negative outlook on Uncle Sam's AAA credit shouldn't come as any surprise. But it should act as a reality check.

In our view, the United States is simply not at risk of default. Default is essentially impossible for a sovereign currency issuer. Financial history demonstrates quite effectively that defaults have been a result of foreign currency denominated debt. Please read that again, foreign currency denominated debt. The trigger to sovereign debt defaults is the debt burden in a foreign rather than domestic currency. Examples abound: Post WWI Germany had huge reparations of war, an industrial infrastructure that was handed over to the French as part of the reparations of war, and humongous debt service denominated in foreign currency. Russia in 1998 was a more recent default. The trouble started in August of '98 when the country missed payments on its local Treasury obligations, but escalated when foreign currency obligations and MINFIN (Ministry of Finance) foreign currency bonds were included in the default. The Ukraine defaulted in 1998 on $1.3 billion in US denominated bonds, then defaulted again in 2000 on a similar amount of both DM-denominated Eurobonds and USD-denominated bonds.

When and why does a sovereign borrower default on its foreign debt? Clearly, this happens when available foreign resources fall short of needs. Even if the debt-to-GDP or debt-to exports ratio is high, expectations of a default are likely to be low when debt service is low. In addition, if the costs of default are high, a sovereign is likely to simply roll over its debt, even under significantly worse terms. Policymakers seem to prefer to avoid default even if that implies running down reserves, shortening the maturity of the debt, and ceding part of their economic policy sovereignty to multilateral institutions. This suggests that a default occurs when the government is in a vulnerable situation owing to high debt service so a deterioration in economic fundamentals leads to a negative change in creditor expectations and a sudden stop in capital flows follows.

The whole premise of the rating seems incorrect. If there is any political judgment at work here, it is S&P falling for politically motivated scare mongering. But given its track record with some corporate bonds and collateralized debt obligations, why should we be surprised to see a rating agency relying on conventional wisdom rather than analysis?

The U.S. may eventually experience unacceptable levels of inflation, but the experience of the last twenty years in Japan shows that stop-and-start fiscal stimulus is more likely to result in protracted near-term deflation. Every time Japan tried to lower its public-debt-to-gross-domestic-product ratio by cutting spending, the resulting drop in economic activity actually made that ratio worse. We are seeing the same results in Ireland and Latvia. The United Kingdom tried the same experiment 10 times in the last 100 years, and every time it got the same results: cutting spending to reduce budget deficits results in a fall in GDP, that makes the debt burden worse, not better.

Remember that S&P's focus on a catalyst for potential default is premised on the debt ceiling sideshow in Congress. I like to think that this is highly unlikely though I wouldn't be totally shocked to see the some members of Congress force a default of a few bond payments for purely political purposes and thus win more votes. Yes it would be colossally stupid and therefore, not out of the question. S&P puts the odds at 1 in 3. Sadly, the shenanigans in Congress are impacting our creditors' perception of rising confusion and dissent in the US. Rather than default, we would expect further debasement of the currency for some time.

Understandably, our clients and investors in general have been concerned. We also have been quite cautious in our equity selection and our deployment of more cash than is normal for us. So far this year, markets have been quite ebullient despite a rather uninspiring backdrop. Confidence levels for most investors have remained low since the debacle of '08, and risk aversion has become paramount. Surveys show that individual investors believe the odds of a one-third stock market drop is over 50% in any given year whereas historically, true odds are closer to 2%.

We are sensing some rather cavalier attitudes toward risk. Take the Japanese situation for example. After the disaster, some economists have pointed to improved growth prospects as Japan rebuilds. To us, this seems to be what is called the “broken-window fallacy.” A French economist, Bastiat (in the 19th century) developed a parable of a glazier whose son breaks a shopkeeper's window and is paid $10 for the repair. Though the community's GDP increases by the $10, should the glazier's son be encouraged to break more windows? Obviously, the $10 spent by the shopkeeper could have been spent on something else other than the repair; yet, economic scorekeeping would show a growth in GDP rather than the net impact which was zero. Similar erroneous thinking is being applied to the potential positives that Japan may derive from its disaster. Near term, GDP could rise with increased spending on rebuilding. However, Japan has the worst positioned fiscal situation (Debt to GDP is 200%), demographics and growth prospects in the developed world. Optimists have maintained that Japan could carry on as long as it had a trade surplus and domestic savings to finance its fiscal deficit. The recent events put these two variables in doubt. In the aftermath of the nuclear disaster, more realistically, Japan may be unlikely to sustain a positive savings rate or a trade surplus. In a country where one half of its revenue is derived from bond issuance, where its debt service constitutes almost 25% of the budget and social security another 30%, the dependence on continued positive savings and trade is critical. By the way, the credit agencies' verdict on Japan remains quite sanguine at “AA minus”…still high in the investment grade strata.

Switching back to the US, one of the more momentous decisions that we will soon face is what tact the Fed will take with respect to the winding down of QE-2, the quantitative easing that has kept interest rates near zero. Following the 2008 recession, the US economy received mighty government tailwinds through enormous fiscal and monetary stimulus. What have been very strong tailwinds for the US economy and financial markets are set to fade as we move into the back half of 2011 and surely as we move into 2012. The all important key economic growth baton handoff between the public sector and the private sector lies dead ahead as government and Fed sponsored tailwinds for the economy and financial markets fade. To the point, the key private sector players are necessarily US corporations and households. As is evident, corporations excluding the financial sector are in very good shape financially. Do they have the ability to be a meaningful driver of forward US macro economic growth? You bet they do. But necessarily the corporate sector very much needs the US consumer to play along and hold up aggregate demand. Certainly a part of corporate strength in the current cycle up to this point has been attributable to strength in foreign demand. But US exports alone cannot carry the show for the entirety of the US economy. And that puts the spotlight very much on US households as we move into late 2011 and early 2012 as being a key focal point in terms of the success, or otherwise, of the public sector to private sector economic baton handoff.

Since last summer, consumers in the US have in many respects held their own as one looks at the aggregate numbers. Of course unprecedented extensions in unemployment benefits and the fact that more than a fair amount of homeowners have stopped making mortgage payments many moons ago has helped the macro consumption cause. Both of these will be temporary factors and continue to fade in importance as we move ahead. Additionally, government "transfer payments" have become more significant both as a percentage of personal income and personal consumption. Moreover, as we've suggested in past discussions, the method to Fed Chairman Bernanke's madness in targeting equity prices since last summer was to goose the wealth effect among the top, let's say, 20% of the wealth demographic in the US. It's this very wealth demographic that accounts for over 50% of total personal consumption expenditures stateside. Bernanke knew full well that if he goosed equities meaningfully, he would get a desired response in headline consumption growth. But again, the equity price driven wealth effect will only drive this outcome for a time. At some point the broad household/consumer base in the US must become a key instigator in helping to advance macro economic growth independent of further Fed/Government stimulus. This is the point we believe we are directly headed toward as QE2 concludes and the last remnants of the 2009 stimulus bill hit the domestic economy over the remainder of this year. Are households up to the task, and if so what will tell us a successful private to public sector transition has been made?

It's still a bit of a mixed bag as housing remains mired in uncertainty. Recent housing data painted a slightly better picture, with housing starts rising 7.2%, building permits (a leading indicator) gaining 11.2%, and existing home sales advancing 3.7%. These improvements should be taken with a grain of salt, however, as the first two months of the year saw numbers that were near record-lows in some cases. Additionally, we saw existing home prices fall again, indicating that this is not yet a firm bottom. We expect a multiyear process is necessary to work through the existing home inventory on the market now and the foreclosures that are still coming down the pipe. However, the stock market seems largely unfazed by the continued weakness as it appears to be discounted and housing now makes up much less of the American economy than it did during the height of the housing boom.

And while housing affordability remains near record highs, it will likely take continued improvement in the labor market to start to see sustained recovery in housing. We are becoming more optimistic that we will see a rapidly increasing rate of job recovery as we move through the year. Surveys of CEO confidence are at multi-year highs, which should translate into more willingness to hire. Generally, the tone of unemployment claims has been downward and a seldom mentioned, but nonetheless interesting job indicator with the acronym of JOLTS (Job Opening and Labor Turnover Survey) showed job openings jumped to 3.1 million at the end of February from 2.7 million the previous month and up 46% from the low seen in July 2009.

The improvement in the labor market and continued economic growth should enable the Federal Reserve to return to a more normal monetary policy, but at their most recent meeting and subsequent first-ever press conference by Chairman Bernanke they indicated they were in no hurry to do so. Despite rising headline inflation, with the Consumer Price Index (CPI) moving up 0.5% in March, core inflation remains relatively contained with a gain of only 0.1%. More importantly to the Fed, capacity utilization remains three percentage points below the 1972-2010 average, indicating continued slack in the economy; while wage growth, which is what they believe is really needed to have sustainable inflation remains nonexistent.

Looking back at QE-2, which was instituted a year ago, has it been effective in getting the economy going again? If the primary objective was avoiding a deflationary bias, the program has been overwhelmingly successful. The banking system's balance sheets have strengthened. However, looking at the employment and lending statistics, the impact has been minimal as this table portrays:

Indeed the apparent dual mandates of quantitative easing were to increase domestic employment and provoke an increase in bank lending (general credit creation). On the employment front it has been an outright bust. Turns out it's the same deal on the bank lending side of the equation point to point since the end of QE1. As you can see above, C&I loans in the banking system in April of 2010 stood almost exactly where we find them today. As money supply measured by M2 has grown, banking system excess reserves have grown by almost a half trillion and finally the Fed's own balance sheet is up almost another $400B and counting. In essence, all of the sound and fury of money printing has never made its way into the real economy.

A very noticeable and an important differential in this table is the change in inflationary expectations. Both the Conference Board and University of Michigan inflationary expectations subcomponents of each survey have gone to new multi-year highs with recent readings. Just so you remember, inflationary expectation numbers seen last April were near historic lows of the last three decades. This is a much more than noticeable differential as we approach the end of QE2. If nothing else, the Fed won the game in raising inflationary expectations. So although labor market and bank/consumer credit numbers remain for all intents and purposes unchanged over the prior year, the rise in commodity price pressures as well as expectations infuses a much different risk profile to a post QE2 economic and financial market environment.

Finally, and this remains to be seen in terms of action ahead as opposed to words, the question looms meaningfully as to who will pick up the US Treasury buying slack in the wake of the Fed in a post QE2 environment. The current Fed playbook will be to reinvest existing balance sheet MBS maturities back into Treasuries as they roll off. We give this a three to six month life, plus the dollar magnitude of maturities will be a shadow of what we saw with QE2. Secondly, publicly we have a number of headline bond fund managers walking away from even holding US Treasuries, let alone buying them. We have no qualms whatsoever that the Treasury will be able to float new debt. Of course the key issue is price, not lack of buyers. There is always a buyer at the right price. Also, of note, China is once again calling for Chinese foreign reserves diversification farther away from US dollars than has been the case up to this point. To be honest, as long as China runs the export model, this is only wishful thinking on their part. It's when China and the Asian economic community ultimately decide to truly revalue that the game changes in a really big way. At that point the inflation Mr. Bernanke has been exporting will likely come tsunami like back to US shores. Depending on what happens with global inflationary pressures ahead, that revaluation may be closer than was once thought. Our horizon for this is within 12-24 months. We maintain our policy of avoiding US Treasuries as we have for some time.

It seems that in response to quantitative easing, investors now fear inflation and have sold bonds. Interest rates have risen to a small extent and housing prices have declined further. The housing recovery has faltered, creating another negative wealth effect and putting additional strain on the banking system. The money that the private sector might have lent to the government if interest rates were higher and had the Federal Reserve not printed the money instead, has gone to other goods, notably commodities and stocks to the extent investors see them as a better inflation hedge than bonds. Though the Federal Reserve has produced “research” that purports to show that quantitative easing has not caused commodity prices to rise, many observers disagree. As the Bank of Japan put it in March, “It is safe to say that globally accommodative monetary conditions are a key driver of the rise in commodity prices by stimulating both physical demand for commodities and investment flows into commodity markets.” In our equity strategy, we have chosen not to chase the commodity freight train, viewing it as an over-exploited and expensive theme based on our view of earnings and cash flows. To our chagrin, the momentum has continued.

From our standpoint, our equity portfolio holdings have below-average risk. We always look down first, and today, even in our downside risk analysis, most of our holdings exhibit low-case valuations that are still higher than current share prices. Accordingly, we think the likelihood of permanent impairment in our securities is minimal, if any at all, inasmuch as our downside analysis forecasts higher prices. We have been active in repositioning the portfolio into securities that reflect this philosophy.

We sold our position in Broadridge Financial Solutions. Its trade related revenues remain soft and we have seen declining returns on capital since last year. The company also made a much larger acquisition than we would have anticipated (over $200 million when we have expected $50 million) in Matrix Financial Solutions. In addition, we sold a position in National Semiconductor, a security we have held for some time. National Semi hit our target price based on our discounted cash flow model. Despite earning almost a 50% premium to our original purchase price, our victory was short-lived as Texas Instruments bid about 20 times trailing earnings shortly thereafter.. Finally, we sold our position in Femsa, the Mexican conglomerate and former brewer. As you will recall, FEMSA was the largest brewer in Mexico and the second largest in Latin America. Shareholders were fortunate to have enjoyed the sale of these businesses to Heineken in exchange for 20% of Heineken. Though we continue to like Heineken, the growth of the convenience store side of FEMSA is likely to slow from its torrid pace. Same store sales have grown at a 20% pace and the company continues to add stores. Though we admire management and its ability to continue to generate substantial free cash flow, the share price is within 5% of our target price and lower risk ideas reside elsewhere.

We also recently sold our position in Quest Diagnostics. We do not favor the recent acquisitions of Celera and Athena which to us smack of building the empire more than building shareholder value. We are not convinced that increased investments in its infrastructure will result in compensating volume and revenue, especially following a 10% slide in operating income in the first quarter.

Our new names are predominated by technology. Cisco Systems provides routing, data and networking products for the internet. The company's clients include corporations, public institutions and telecommunications companies worldwide. Cisco is financially strong and we think statistically cheap. It has a dominant market position and has been growing within a category that we believe still has a lot of room for future growth. Perceived competitive threats, dumb capital allocation moves which are now being reversed, and concerns about possible slower rates of growth have put pressure on Cisco's stock price, which has allowed us an entry point in the stock that we believe is at roughly a one third discount from a conservative estimate of the company's intrinsic value. Despite management's perceived outbreak of stupidity, the business did generate over $9 Billion in free cash flow as compared to an enterprise value of only $72 Billion or a 12.5% free cash flow yield.

CA Inc., the former Computer Associates is an independent enterprise IT software and service company with capabilities across IT environments from mainframe and physical to virtual and cloud. The company had a sordid history of poor accounting about 10-15 years ago, but management has been completely replaced and credibility has been restored. Historically, the majority of CA's sales have been directed to the IBM mainframe environment in very large global companies. The current management team has meaningfully increased the focus on the 'emerging enterprise' segment of the market, which encompasses companies in the $300m to $2bn revenue range. This part of the market represents only about 10% of CA's current sales, and is meaningfully underpenetrated relative to CA's core markets. We like the recurring revenue nature of much of CA's business where renewal rates have been in the 90% area. Again, the stock is quite cheap with a free cash flow yield of about 11.5% and more cash than debt.

Tessera Technologies, Inc. develops licenses and manufactures technologies related to semiconductor packaging and thermal management as well as imaging and optics. TSRA has a patent portfolio including 953 issued US patents and 393 issued international patents, as well as more than 900 applications currently outstanding. While the company does purchase intellectual property, it is far from being just a patent troll as it also engages in R&D, spending upwards of $60 million per year.

The company has no debt, trades at a P/E ex-cash of just 7x (the company has cash of $9.40/share vs a share price in the low $16's). Furthermore, the company has strong free cash flows, with a 5-year average of $83 million per year, representing a FCF Yield (using Market Cap ex-cash) of 21.5% !

Looking at the company's recent history, we see that the company's revenue and gross margins have been improving, and the company has been fairly consistent in generating high returns on capital. The gross margins are like those of a pharmaceutical company, in the 90-92% range. Operating margins, after paying off their fleet of lawyers and scientists, are around 33%.

The company is currently engaged in a significant number of lawsuits which it has brought in order to protect its intellectual property. These lawsuits cost the company $20 million per year (approximately equivalent to what the company spends on cost of goods sold). The company has had many victories in these lawsuits historically (the company says it has generated $1.2 billion on the $200 million it has spent from 2004 to 2010 on defending its patents - quite a return on investment), with the most recent being a US Court of Appeals victory affirming the company's earlier victory at the International Trade Commission.

In healthcare, we added Medtronic. Medtronic Inc is the largest medical equipment maker and has sustained close to 50% share in its core heart devices. It also holds market-leading positions in spinal products, insulin pumps, and neuromodulators for chronic pain. MDT's vision is to establish a significant presence in chronic diseases, in addition to its historical stronghold in heart disease. Investments in neuromodulation, diabetes, and spinal products from the middle to late 1990s have developed into new revenue streams and reduced the reliance on heart products. Revenue from those three product areas increased from 25% of total sales in fiscal 2000 to 40% in fiscal 2010. Foreign sales are about 41% of total revenues. We admire the crossover of innovative technologies across various Medtronic platforms. Medtronic often finds novel ways to apply familiar technologies--like using the implantable electronic-stimulation technology in pacemakers to address overactive bladders, chronic pain, and symptoms from advanced Parkinson's disease. The company has a solid record of more than a decade of free cash flow generation Though trading at a free cash flow yield of 6.5%, Medtronic is trading at a discount to other medical device companies, and significantly below its ten year historical valuations on most metrics.

In conclusion, we think that given our economic backdrop, stocks today are by far the preferred asset class over Treasury bonds. We continue to favor corporate high yield bonds and our "eclectic" selections in business development corporations and mortgage REITS as fixed income analogs. Inflation is now annualizing at more than 3% in the U.S. and 5% worldwide. Treasury bond yields are currently not compensating at all for inflation. At these escalating levels investors need to seek higher returns to simply maintain the real value of their assets. We continue to believe that our portfolio offers above-average return potential with less risk than the overall market.

As always, we appreciate your confidence and trust. We welcome your questions and comments.

Richard H Conrad, CFA, CFP®