The end of any year is typically filled with reflection and resolutions.  We reflect back on the past year and what we did well and what we did not so well.  It’s a time for self-examination, and out of this grows the resolutions – to lose weight, get in shape, travel more, work less, earn more, say “I love you” to the ones you care about more often.

When we look back over this past year, we were a bit taken aback at how much fear there was in the markets.  If you think back over the past year, the year started with fears about Greece defaulting on debt leading to the Euro zone falling apart and a potential global recession.  This gave way to Spanish banks nearly failing.  Next was a fear that China’s powerful economy would slow such that growth around the world would stall.  Here at home we faced a vitriolic Presidential election that stirred fears on both sides of the debate.  In the wake of the election that, in the end really didn’t change the face of politics in Washington D.C. all that much, we ended the year facing a fiscal cliff and the fear that taxes would dramatically increase for everyone and that, once again, we would face a severe recession.

In spite of these fears, stocks climbed for the year with the S&P closing over 13% higher and the Dow Jones Industrial Average gaining just over 7% for the year.  Here at Aerie we didn’t perform as well as the broad indexes as we chose to remain more cautious in the face of some of these crises and fears.  We kept a higher allocation to both fixed income and cash for the year, which ended up a drag on our performance.  We also had a couple of trades that went bad for us.

Fear about market volatility – and an anticipation of stock prices falling more than they did – caused us to miss out on a couple of trades that we perhaps should have entered.  We twice attempted to purchase RV maker Thor Industries (THO) for around $30 per share using an options strategy we have used successfully in the past.  While we didn’t succeed in purchasing Thor – a shame, too, as the stock ran from the low $30’s to just over $40 per share – we still made a tidy profit on our trades, earning a combined return of 17.4% on an annualized basis on our two options trades.  We also attempted to purchase Timken Industries (TKR) for $35 per share, but were denied the chance when it was revealed that an activist hedge fund took a large stake in the company, driving up the share price.  Nevertheless, we still earned a good return from our options strategy there with return of 14% on an annualized basis.

One new tactic we have undertaken recently across many client accounts has been a strategy of selling options on stock indexes.  This particular strategy, which can take advantage of fear, is normally a good way to earn some extra income as long as the trade does not go too terribly wrong.  In order to control our risks, we predefine the total risk we are willing to take.  In November, in the wake of the election, fear over the fiscal cliff battle ramped up dramatically.  This was compounded when tensions heated up in the Middle East caused by Palestinian forces firing rockets at Israel.  The fear of a major Middle East conflict caused the stock market to tumble and we were unable to close out of our option position prior to the market meltdown.  With our risk defined, we didn’t stress too much, but this one loss did hurt a bit.  In the absence of this one trade, we would have had a very good year.  On a more positive note, we did manage to recoup 20% of our November losses in December with another similar trade as fears subsided and calm returned to the markets.

There were two changes to our holdings during this quarter.  The first was the elimination of Hewlett-Packard.  We addressed more completely the reasons behind our selling out of this stock here:  http://www.aeriecapitalmgmt.com/2012/10/22/packing-it-in-on-hewlett-packard/.  In a nutshell, we sold because management does not seem to understand where the value in the company actually lies and we have no hope they will discover that any time soon.  This stock is, in our opinion, a “value trap”.  That is, it appears to be a great company with tremendous potential, selling at a deep discount to its intrinsic value.  In reality, management seems to have no clue how to unlock the value at the firm which will cause the company to underperform for the foreseeable future – or, at least, that is our fear.

The second change was selling out of most of our Johnson & Johnson (NYSE: JNJ) position.  This has been a good stock for us, but we do have some concerns going forward.  The largest concern is a lawsuit the company has already lost in one state court and yet has not bothered to recognize in their financial statements.  Management seems to believe the loss will be overturned on appeal.  While this may indeed happen, this is very bad management.  It’s akin to getting a water bill for $2,500 for the month and thinking “I’ll just ignore this because there is no way it can be right and will surely be tossed out when I appeal it.”  It may be, but it could be you have a leak and the bill is correct, so the prudent thing to do is to budget for this contingency.

Looking ahead, we are going to continue to look for opportunities to buy good companies at great prices.  We will continue to seek out opportunities to enhance value, whether through option strategies or finding contrarian reasons to buy good companies.  We will continue to focus on cash flows – both at the company level and in returns on our investments.  As always, we recognize that you have lots of options available to you, and we want to thank you for the trust you have placed in us with a portion of your assets.

 

Alan R. Myers, CFA

President / Senior Portfolio Manager

Aerie Capital Management, LLC

(410) 864-8746

(866) 857-4095

www.aeriecapitalmgmt.com