April 7, 2010

As you know, I pen a letter each quarter that updates you on what has happened recently and gives you some insight into what may lie ahead.  This quarter, I am stealing from a website that is dedicated to financial advisors.  The website is www.horsesmouth.com and each quarter they provide examples of quarterly letters that advisors can use or borrow from.  I have never used any of their past letters, but this month the website had one particular letter that just captured my outlook on the markets as well as our philosophy in managing money.  I have made some modifications to tailor it for your accounts and my speaking “voice”, but much was done for me (thank you Horsesmouth).  So, without further ado, my quarterly letter to you all.

“I have no idea what the stock market will do next month or six months from now.  I do know that, over a period of time, the American economy will do very well, and investors who own a piece of it will do well.”

–        Warren Buffett in a CNBC interview, Oct. 10, 2008

After the market roller coaster of 2008 and 2009, the first quarter of 2010 has been blessedly uneventful by comparison.  The markets ended the first quarter up only about 4 – 5%, although up almost 60% from their lows of a year ago.  That said, there is still a cloud of uncertainty that is making many investors nervous.  Even with the stabilization of the global economy, there is no shortage of short-term causes of concern:

  • Continued questions on the direction and timing of the economic recovery in the United States and Europe
  • U.S. housing prices that are staying stubbornly low and unemployment levels in North America and Europe that are stubbornly high
  • And in late March, the deputy director of the International Monetary Fund made headlines as he talked about the need for advanced economies to cut spending in order to reduce deficits (http://www.nytimes.com/2010/03/22/business/global/22imf.html?scp=2&sq=IMF$st=cse).

The good news is that there are offsetting positives, even if the media headlines that feature them aren’t quite as prominent:

  • On Monday March 22 of this year, the Wall Street Journal ran a story about dividend hikes as a result of rising profits by U.S. companies.  The article also mentioned that cash on hand on U.S. corporate balance sheets was at the highest level since 2007.
  • On the same day, the Financial Times ran a similar story about dividend increases in Europe

Whether you choose to focus on the positives or the negatives, there’s broad agreement that the steps taken by governments stabilized the financial crisis that we were facing a year ago, and there is almost no talk today of a global depression.  So, the issue is not whether the economy will recover, but when and at what rate – and whether there might be another stumble along the way.

If you look for investing advice in the newspaper or on television, the discussion tends to revolve around which stocks will do well in the immediate period ahead – this week, this month, this quarter.  We refuse to participate in that speculation.  When it comes to short-term prediction – about the economy or the stock market – there’s only one thing we can say with virtual certainty:  Most predictions will be wrong.  Quite simply, no one has a consistent track record of successfully forecasting short-term movements in the economy and markets.  Which is why, in uncertain times such as today, one of the people I look to for guidance is Warren Buffett.

In one of his annual letters to shareholders, Buffett wrote that it only takes two things to invest successfully; having a plan and sticking to it.  He went on to say that of these two, it’s the “sticking to it” part that investors struggle with the most.  The quote at the top of the letter, made at the height of the financial crisis, speaks to Buffett’s discipline on this issue.

I try to apply that approach as well, putting a plan in place for each client that will meet their long-term needs and modifying it as circumstances warrant, without walking away from the plan itself.  Boom times such as we saw in the late ‘90’s and scary conditions such as we’ve seen in the past two years can make that difficult, but those conditions can also represent opportunity.  Indeed, in his most recent letter to shareholders, Buffett wrote that “a climate of fear is an investor’s best friend.”

On balance, I share Buffett’s mid-term positive outlook, not least because many of the positives that drove the market optimism two years ago are still in place.  In the meantime, here are five fundamental principles that we look for and that drive the portfolios we believe will serve clients well in the period ahead.

  1. Concentrate on quality.  The record bounce in stock prices over the past year was led by companies with the weakest credit ratings.  Some have referred to the last year as a “junk rally,” with the lowest-quality companies doing the best.  That’s unlikely to continue – and that’s why I’m focusing our portfolios on high-quality companies.  We are concentrating on companies with low debt levels and good cash flows such as P. H. Glatfelter Co.; Ennis, Inc.; and PepsiCo.
  2. Look to dividends.  Historically, dividends have made up 40% of the total returns of investing in stocks and helped provide stability during market turbulence.  Two years ago, quality companies paying good dividends were hard to find.  One piece of good news is that today it’s possible to build a portfolio of good-quality companies paying dividends of 3% and above.  Some stocks, such as pipeline companies Buckeye Partners and NuStar, which are in several of our client accounts, pay over 6%, most of which is tax deferred income.
  3. Focus on valuations.  Having a strong price discipline on buying and selling stocks is paramount for success.  History shows that the key to a successful investment in ensuring that the purchase price is a fair one.  Investors who bought market leaders Cisco Systems, Intel and Microsoft 10 years ago are still down 40% to 70%, not because these aren’t great companies, but because the price paid was too high.  We will continue to focus on buying stocks that are selling at a 30% discount to what we calculate as the intrinsic value.
  4. Build in a buffer.  Given that we have to expect continued volatility, we identify cash flow needs for every client and ensure that this cash is set aside in safe investments.  We also use asset allocation – spreading investments between stocks, bonds and prudently using options and other “alternative” investments – to help cushion portfolios.  This buffer protects clients from short-term volatility and reduces stress along the way.
  5. Stick to your plan.  In the face of economic and market uncertainty, another key to success is having a diversified plan appropriate to your risk tolerance and then sticking to it.  It can be hard to ignore the short-term distractions, but ultimately that’s the only way to achieve your long-term goals with a manageable amount of stress along the way.

In closing, let me express my thanks for the continued opportunity to work together.  Should you ever have questions, or if there’s anything you’d like to talk about, I am always pleased to take your call.


Alan R. Myers, CFA

President / Senior Portfolio Manager

Aerie Capital Management, LLC

(336) 306-5496

(866) 857-4095


P.S.  If you’re interested, here’s a link to Warren Buffett’s 2010 letter to his investors:  http://www.berkshirehathaway.com/letters/2009ltr.pdf