Fourth Quarter 2011 Client Letter
What a year! Over the course of this past twelve months, we saw regime changes in Egypt and Libya, the war in Iraq officially ended for the U.S., Europe came dangerously close to breaking up, Greece, Italy, Ireland, Spain and Portugal all teetered on the edge of bankruptcy and for all of the ups and downs in the market, the S&P 500 Index ended up almost exactly where it began the year (1,257.60 close this year versus 1,257.64 close last year). I guess the market is giving us a “do over”.
Even given the total lack of movement in the stock market, we really saw a lot of volatility. Between December 2010 and June 2011, the broad market rose 5%. Between June and September, the market fell just over 14%, then rose enough between October and December to close essentially unchanged for the year. You may want to strap on your seatbelts as we could well see this same level of volatility this coming year. Europe still has long-term debt issues as does the U.S. We are gearing up for a presidential race that may wind up being more divisive than inclusive. Typically, presidential election years are up years. In fact, since 1928, there have only been three presidential election years that were down years (1940, 2000 when the tech bubble burst and 2008 when the housing bubble burst). While this portends well, we still believe that economic factors are far more important to our investment decisions than odd stats like this over the long run.
In spite of the volatility, we had a decent year for clients. For the most part, client accounts finished slightly up on the year. This was helped by several securities including Progress Energy (up 35%), Rent-A-Center (RCII) which was up 21%, ConocoPhillips (COP), also up 21% and Innophos Holdings (IPHS) which was up 34.5%. However, there were a few securities that hurt our overall performance including Overseas Shipholding, International Shipholding – sensing a theme here? – Delhaize Le Lion, the parent company of the Food Lion grocery chain and Nash Finch, another grocer – sensing another theme? Thankfully, we had far more committed to the securities that increased in value than to the ones that fell.
We have been more active in trading securities recently than in the past. For example, we waded in to purchase some shares in Bank of America in mid-August. This was just before Warren Buffett committed $5 billions to the company. Despite his commitment to the company (he obviously got a much better deal than we did with the common stock), we still see too much risk in the company, but we did see a good trading opportunity here. By using options, we managed to earn a nice return. While it didn’t quite pay off as well as we had hoped, we still earned just over 2% (5% on an annualized basis) during our time holding Bank of America.
So what can we expect going forward? Well, as we stated in the beginning of this letter, we are looking for more volatility. We are also anticipating that this year should be an overall up year for the markets. But we’re not sitting back waiting for things to come to us. We have gotten a little more aggressive in seeking out opportunities. We are putting new research to work in finding new investment opportunities. We’re being more proactive about using options to both hedge our risk and augment our returns. We successfully used options to purchase one stock at a great price. We used put options – taking on the obligation to purchase shares of Norwegian oil giant Statoil (STO) for $25 per share – to successfully purchase the shares for a net price of $23.91 per share. At that price, the stock will provide a dividend yield around 3.93% annually. We’re supplementing that income with additional options that will pay us at least an additional 1.6% income. At the worst, we’ll be forced to sell our stock in April for a total gain of just over 16%. We anticipate finding more situations like this going forward. So long as we can secure a good return, we’ll continue to make investments like this.
As always, we recognize that you have many choices when it comes to your money. We really do appreciate the trust you have placed in us by letting us manage a portion of your assets. If you have any questions or concerns, please do feel free to give us a call.
Sincerely,
Alan R. Myers, CFA
President / Senior Portfolio Manager
Aerie Capital Management, LLC
(336) 306-5496
(866) 857-4095
www.aeriecapitalmgmt.com
Third Quarter 2011 Client Letter
Wow! What a quarter we’ve had! As the quarter started off, the U.S. was embroiled in a debate on whether and how to raise the debt ceiling. If you recall, the U.S. needed to raise the debt ceiling in order to meet obligations we had already committed to spending. Many on the far right of the political spectrum were refusing to raise the debt ceiling and, going a step further, were calling for cutting spending by dramatic amounts. In my last newsletter, I wrote about the debt ceiling debate in the second quarter letter which you can read in our blog: http://www.aeriecapitalmgmt.com/news/.
We actually set up clients well for the impending vote on raising the debt ceiling. We were anticipating we might run into a situation similar to the first TARP (Troubled Asset Relief Program) vote in September 2008. When that program first came up for a vote, many in Congress didn’t want to bail out the banks. When the vote failed, the Dow Jones Industrial Average dropped over 700 points in minutes. About two weeks later, the vote came up again and passed, but the damage was done. Going into the debt ceiling debate, we purchased some options in client accounts that would gain in value if the markets fell.
While the debt ceiling was raised with little trouble, that does not mean that all went smoothly this past quarter. Much to the contrary, this was a very tough quarter for the markets. In spite of raising the debt ceiling, major credit rating agencies cut their credit rating on the U.S. for the first time ever. Turmoil was not restricted to just the U.S. markets, however. There were continuing troubles in Europe as Greece continued to threaten to default on their debt, French banks ran into troubles from their exposure to Greek debt giving us the threat of a French version of Lehman Brothers – the U.S. investment bank that went bankrupt in September 2008 triggering the credit crisis – and China’s growth rate showed signs of slowing down.
All of this made for some very wild swings in our markets this quarter. As an example of how volatile things were this past quarter, we had more 200-point swings in the Dow Jones Industrial Average (i.e. either closing up or down by 200 or more points) than any quarter since early 2009. In fact, during the second week of August, the Dow closed up or down by more than 400 points on four of the five days that week – closing up only 125 points on Friday! Does anybody have anything for motion sickness?
Out of all of this volatility, we ended up with the markets essentially trading within a broad range. For most of August and September, we stayed within a range that bottomed around 1,100 (using the S&P 500 Index) and 1,220 on the top end. This roughly corresponds to 10,600 and 11,750 on the DJIA as the range. We tested the lows of this range on six separate occasions in August and September carrying on into the first week of October.
We tried to use this volatility to our advantage, but frankly, we feel like we missed it on this one. While that is not entirely true – borne out by the fact that most client accounts fell far less than the broad market did for the quarter – we still feel like we could have done a better job. We entered trades to purchase put options – options that benefit from falling markets – on three separate occasions. The first time paid off handsomely, but the next two times, not so much. We only entered these trades, though, when it looked like markets were in danger of completely melting down. Rather than view these as bad trades, we prefer to view them as insurance premiums paid to insure against a catastrophic loss.
In addition to these option trades for insurance purposes, we made a few additional equity trades along the way. We added Johnson & Johnson (JNJ) to many portfolios as the stock dropped to a price that essentially assumed the company would never grow at all. Since we clearly think that JNJ has the ability to continue to grow, if even at a modest rate of inflation, and since we were getting a dividend yield comfortably above 3.5%, we were happy to add JNJ to accounts. We also bought more ConocoPhillips (COP) for clients – adding this as a new position in a few client accounts and cost averaging down in some other accounts. With COP, we managed to purchase shares at a price that provided a 4% dividend yield.
On the downside, we didn’t take advantage of the dips as much as we would have liked to, in retrospect. While much of what was going on was very headline-driven, we did see reasons to worry. There were comparisons of this year to 2008, often unfairly. The comparison was of Europe and the European banks today with our banking system in late-2008 just before Lehman Brothers declared bankruptcy and credit markets ground to a halt. The big fear was that Greece would default on their debt, leaving European banks, mainly in France, holding the bag with a lot of worthless debt. This would make these banks insolvent, ruining the credit markets around the world.
While this was a worst-case scenario, there were enough signs of market uncertainty and risk that we chose to be more cautious with client funds. Instead of wading in to the bloody mess and snapping up stocks left and right, we chose to take profits when we reached the top of our trading range and opting mainly to remain in cash. This higher cash balance – often approaching a third or more of accounts – helped reduce the volatility a bit and kept the losses for the quarter from being worse. While we may have dampened gains down the road, we also limited losses, which we view as our primary job.
Going forward, we feel like we are positioned well. We have higher cash balances at the moment but we also have a good list of stocks that we want to purchase and prices that we are willing to pay for shares of these companies. We are not going to ‘chase’ stocks. We’ll continue to do what we’ve always done. That is, we’ll look for good companies trading at great prices with a margin of safety to protect us. When we get more volatility – and we will – we’re ready now to wade into the fray and selectively buy some good names.
As always, we recognize that you have many choices when it comes to your money. We really do appreciate the trust you have placed in us by letting us manage a portion of your assets. If you have any questions or concerns, please do feel free to give us a call.
Sincerely,
Alan R. Myers, CFA
President / Senior Portfolio Manager
Aerie Capital Management, LLC
(336) 306-5496
(866) 857-4095
Second Quarter 2011 Client Letter
One thing that I have studiously tried to avoid is getting political. In fact, I tend to be apolitical about things when it comes to money management. I truly do not care which party is in control as there is, to quote CNBC pundit Jim Cramer, “always a bull market somewhere!” That’s not to say that I don’t care about what happens politically. I do care. It’s just that regardless of the outcome – whether I like it or not – I have learned that we can always find ways to turn lemons into lemonade.
This quarter, though, I have to get a bit political. We are in the middle of a crisis. We just witnessed two petulant groups of children fighting about raising the debt ceiling. Lost in this whole mess were too many actual facts. So, this quarter, let’s lay out some very basic facts surrounding the crisis in America. I’ll let you make up your own mind about the next step to take, though I would be interested in your feedback with comments regarding this letter on our web site.
The recent debt ceiling debates were infused with much political rhetoric. Further muddling the situation is the fact that much of what has happened in the past few years has been completely lost on folks as the real story has not really been told. So let’s set the record straight with some key facts here.
- Let’s start with what the deficit ceiling is really all about. What it’s not about is future spending. What it does deal with is paying bills we have already accumulated. Think of this as “overdraft protection” as you are paying your bills for water, electricity, gas, cable and so forth. We’ve already committed to spending the money. We just don’t have the money to spend unless we dip into our credit line (debt limit).
- Where did the large and growing deficit come from? When Bill Clinton left office, there had been four straight years of budget surpluses. In 2001, when Clinton left office and George W. Bush took over, the budget surplus was $127.3 billion. The very next year, we had a budget deficit of $157.8 billion – a turnaround of $285.1 billion. By the end of Bush’s term in 2008, the deficit was $455 billion, caused largely by two wars (Afghanistan and Iraq) that were not funded. In 2009, the year Obama took office, the deficit swelled to $1,416 billion. In 2010, the deficit actually fell to $1,290 billion, but is back on pace this year to be $1,410 billion.
- The nearly $1 trillion jump in deficits in 2009 was largely due to the American Recovery and Reinvestment Act of 2009 (unofficially, the “stimulus bill”). This bill was signed into law in February 2009 in response to the mortgage meltdown of late 2008 and the ensuing credit crisis and recession. This bill was an attempt to “kick start” the economy to get it growing again. It was roughly modeled after our response to the Great Depression of the 1930’s. Some of the key provisions of this bill included:
- Tax incentives for individuals ($237 billion or 30% of the total)
- Tax incentives for businesses ($51 billion or 6.5% of the total)
- Healthcare benefits with Medicaid being the largest recipient ($155.1 billion or 20% of the total)
- Education for retraining workers ($100 billion or 13% of the total)
- Aid to low income workers and retirees ($82.2 billion or about 10% of the total)
- Infrastructure investment ($105.3 billion 13% of the total)
The total projected stimulus package was estimated to be $788 billion, though not all of the funds that were originally allocated have been spent. In fact, information about how the stimulus money has been spent and the direct results of this spending can be found at www.recovery.gov. For example, here in NC, $7.6 billion has been awarded for projects affecting 29,407 jobs (either kept or created).
The budget for 2011 (according to some politicians in recent heated exchanges on TV, there is no budget for 2011 from the President. However, you can see it for yourself at http://www.gpoaccess.gov/usbudget/fy11/index.html) totals just over $3.8 trillion with projected income of about $2.6 trillion, leading to a shortfall of an additional $1.2 trillion this year. Included in this budget is nearly $2.1 trillion for safety net programs including Social Security ($730 billion), Medicare, Medicaid, unemployment benefits and so forth. The budget also includes $846 billion for “security” including nearly $160 billion for the war in Afghanistan.
Now, we clearly cannot keep spending like drunken sailors. But we also cannot abide what is going on in Washington. The “Tea Party” bloc of Republicans offered up a bill labeled as the “cut, cap and balance” proposal. The idea was to cut the deficit, cap spending at no more than 18% of GDP (the total output of our economy) and pass a Constitutional amendment that requires a balanced budget every year. That sounds great, but if we return to the previous paragraph for a moment, we see that we have $2.6 trillion coming in and $3.8 trillion going out. Where exactly do you propose that we suddenly whack 32%? Should we cut all spending equally or just certain “sacred cows”? Cut, cap and balance doesn’t address this very thorny issue at all.
The second part of that proposal, capping spending at 18% of our total economic output, sounds simple enough, but the reality is far different. In fact, if we look at spending under past presidents, we see that the average spending (as percentage of GDP) was:
• Carter 21.1%
• Reagan 22.3%
• George H.W. Bush 21.8%
• Clinton 19.4%
• George W. Bush 20.5%
So, this 18% spending cap is an artificially low level. This says nothing about how bad an 18% cap on spending would be in the event of recessions. And, going one step further, if our economy were to slow down again, we would be forced by this bill to reduce government spending which would further exacerbate the situation. This would cause a further shrinkage in GDP causing more cuts in spending and so forth. The government needs the ability to spend more than we take in on certain occasions but we need to do this wisely and prudently.
This type of government intervention is very similar to what happened after the Great Depression of the 1930’s. There are many who argue that government intervention did little to bring the U.S. out of the depression and it was only our gearing up for World War II that led to our recovery. This is partially true, though this does little to dissuade the argument for government intervention during recessions. In fact, if we look at a timeline of the government response to the Great Depression, we see that Keynes was indeed correct in his calls for deficit spending.
In 1932, the year Roosevelt was elected, our economic output fell 13% and unemployment hit 23%. The following year, when Roosevelt took office, the free-fall in the economy slowed as production fell only 2.1% though unemployment did reach almost 25%, the worst during the Depression. Roosevelt started implementing many of the suggestions of noted British economist John Maynard Keynes to spend, though he ultimately ignored one of Keynes’ key suggestions – to borrow and spend (create a deficit). In 1934, as a side note, Sweden became the first country to emerge from the Great Depression. They had followed Keynes’ call for deficit spending. Back in the U.S., by 1937, the unemployment rate has fallen to around 14%, but Roosevelt was obsessed with keeping to a balanced budget so he cut spending for the year. That led to another recession starting during the summer of 1937. The following year, unemployment rose to 19% and total economic production fell around 4.5% for the year. It was finally the borrowing of nearly $1 billion to build up our military that dragged the U.S. out of the Depression.
As we can see, deficit spending is sometimes critical to a country’s short-term and long-term health and well-being. This does not mean that we need to have deficits forever. The idea is to borrow short-term to invest for the long-term. You also need to spend the money appropriately. Many politicians are calling for continued tax cuts as a way to boost our economy. Often, these politicians will continue their argument by pointing out that the stimulus bill did little to spur economic growth. However, if we look at the bill, you will note that over one-third of the bill involved tax cuts. Politicians who point out the stimulus bill failed to jump start the economy tend not to point to the tax cuts in the stimulus bill that didn’t work.
I don’t think anyone would argue that we are at a critical juncture in our history. What happens from here is going to be a defining moment in where America is headed. Our problem is not that that we have debt outstanding or that we have deficit spending. Our problem is that we have too much debt to continue deficit spending for much longer. From all of the rhetoric, one would think we were the most indebted nation on the planet. We are the worst from the standpoint of nominal debt – that is the total dollar amount of debt outstanding. However, on a relative basis, we are far from the worst. In fact, if you measure our debt as a percentage of our GDP (total economic output) we rank eighth in the world based on the debt-to-GDP ratio. Now, that’s not anything to brag about (Greece and Italy are numbers five and six on the list), and the key is the direction we are headed. Currently we are climbing the list and that is not what we want to happen. This means that we do need to reign in our spending and pay down our debts. No one – Democrat or Republican – would argue with this simple fact. We need a more sustainable level of debt-to-GDP ratio. Historically, a ratio less than 90% has been very sustainable (currently, we are at 100.2%). The compromise we got for raising the debt ceiling doesn’t address the issue of this growing debt. There are really only two ways to get our fiscal house in order – cut spending and raise revenues – and both of these methods need to be put on the table in our county’s fiscal discussions. There are some hard decisions to be made and everyone is going to need to sacrifice. At least now, when the debates rage, you will have a better idea of what is fact and what is rhetoric.
As always, I am honored that you have entrusted us to manage a portion of your assets. If you ever have any questions or need any information, please feel free to contact us.
Sincerely,
Alan R. Myers, CFA
President / Senior Portfolio Manager
Aerie Capital Management, LLC
(336) 306-5496
(866) 857-4095
First Quarter 2011 Client Letter
What a wild and wooly quarter we just came through! Just to recap a little bit about what we survived last quarter:
• There was major unrest throughout the Middle East leading to regime changes in Tunisia and Egypt, unrest in Syria and civil uprisings in Bahrain and Libya
• On March 10, an earthquake registering 9.0 on the Richter scale hit Japan, damaging much farmland, followed by a tsunami that wrought major damage to a nuclear power plant northeast of Tokyo
• Oil, which started the year at $91.44 per barrel, ended the quarter at $106.77, up nearly 17%
• The unemployment rate continued to decline ever so slightly from 9% in January to 8.8% by the end of March
• Housing starts fell to the second lowest level since 1941
• The Consumer Price Index (CPI), the chief measure of inflation in the U.S., continued to tick up from an annualized 1.6% in January to 2.1% in February (March has yet to be released).
So, with all of this turmoil, strife, unrest and general malaise, stocks obviously tanked… didn’t they? Actually, no. For the quarter, the broad stock market, as measured by the S&P 500 Index, actually gained 5.4%, and the more popular Dow Jones Industrial Average (DJIA) rose 6.4%. One Wall Street aphorism is that a bull market will climb a wall of worry. Obviously, this held for this quarter. However, this positive quarter did not come easily. In fact, the S&P 500 Index climbed 6.6% to its peak in mid-February before dropping 6.23% over the next month only to claw its way back about 5.5% over the last two weeks of the quarter. While that does sound like a wild and wooly ride, there are two key things to note from these market moves.
The first thing is that volatility can be our friend. We took advantage of the recent volatility to either lighten up on a few securities or to add to some current positions. We trimmed positions in client accounts in several stocks including ConocoPhillips (COP), Innophos Holdings (IPHS) and P.H. Glatfelter (GLT) as the market run-up had caused these positions to carry too much weight. By selling off a portion of the holdings, we locked in gains yet held on to shares so we don’t miss any future price increase.
We added a couple of new positions including Delhaize Le Lion (DEG), a Belgian company that is the parent of grocery chain Food Lion, and furniture rental company Rent-A-Center (RCII). In the aftermath of the Japanese earthquake and tsunami we added two Japanese small company funds to several accounts and added to current holdings of these securities in a couple of other accounts. We fully expect that, as Japan rebuilds from the devastation, small companies will be earlier and bigger beneficiaries than larger companies. This may take some time to come to fruition, but we are patient and willing to wait.
We have said many times – and this bears repeating – while we understand that volatility can be stomach churning to you as you watch the value of your portfolio go up… and down… and back up… and back down… we really do embrace volatility as a useful tool. It often gives us the opportunity to sell stocks that reach unreasonably high levels or purchase stocks that are temporarily marked down on sale or to find some other way to take advantage of the mania of Mr. Market’s temporary insanity. Please know that, while we do pay attention to the market on a daily basis, we don’t get caught up in this irrationality.
The second thing to note from this past quarter is that we may be heading for trouble sooner rather than later. The biggest red flag is the rise in the price of oil. Trying to predict where oil is headed is tricky, partly because there is no way to know just how much risk there is in the Middle East. In other words, what are the chances of an extended civil war in Libya that severely disrupts the flow of oil? How much will this affect the long-term price of oil? After all, Libya only produces 2% of the world’s total oil and Libyan oil only accounts for 0.63% of our total imports. The threat, though, is that this civil war spreads to the rest of the peninsula and disrupts oil from Saudi Arabia and other larger producers.
We are currently in a very fragile recovery. The most visible commodity price we see is oil (well, gasoline), but there are many other commodities whose prices have been steadily climbing. Sugar is 62% higher than it was last year, corn has nearly doubled in price, cotton is 145% higher, coffee has doubled, copper is 25% higher and on it goes. We can see the end effects of this in higher food prices, higher prices at the gas pump, and higher costs for manufactured goods. This inflation threatens to derail our recovery, keeping unemployment high. Welcome to the 1970’s – stagflation is back! Now, where did I store my leisure suit?
For those of you old enough to recall, from 1974 through 1981, we had a period of “stagflation” – high inflation coupled with a stagnant economy. This was not supposed to happen according to all economists. If you have high inflation you shouldn’t have high unemployment as unemployed people cannot pay ever increasing prices. However, someone forgot to tell the American economy that the impossible couldn’t happen. I fear we are in grave danger of going back to this very situation. Growing economies around the world, namely Brazil, India and China, are demanding more and more raw materials which is driving up the prices of basic commodities. This is likely to drive our inflation rate higher, as well as costs for basic inputs into the things we buy, build and use go up. Add to that the relatively jobless recovery, lackluster housing starts due to an oversupply of homes for sale and an economy awash in cash that can only contribute to inflationary pressures, and we have a recipe for stagflation.
As the writer of Ecclesiastes said, ‘there is nothing new under the sun.’ Thankfully, we are students of history, so we have some idea of what did work during this period and what didn’t. That period of stagflation was driven by oil (it started with the oil embargo and oil price hike by OPEC nations). There are some key lessons that can be taken from that period. One is that, to quote Jim Cramer of CNBC’s program Mad Money, there is always a bull market somewhere. Investors in oil company stocks, for example, did really well. Many doubled and tripled in price during this period before inflation was tamed by a very determined Federal Reserve led by Paul Volker. We have already positioned clients for potential inflationary pressures with holdings such as the Market Vectors Agribusiness ETF (MOO) and ConocoPhillips (COP). In addition to commodity related stocks, surprisingly small company stocks (small cap stocks, in investing lingo) did well during this period. For example, from 1974 through 1980, when the broad stock market barely moved 1.7% annually, stocks of the smallest 40% of stocks had double-digit gains during this period. As you are aware, we favor small cap stocks such as Oil-Dri (ODC), Nash Finch (NAFC) and recent addition Lifetime Brands (LCUT), so we are well positioned if this trend repeats.
As we look forward, we can only anticipate more volatility, and we expect the unexpected. We will continue to position portfolios for whatever Mr. Market may toss our way and will try to take full advantage of whatever mispricings he provides us. We continue to seek out solid businesses to invest in rather than randomly buying stocks. As long as we focus on good businesses at great prices we should be fine over the long term.
As always, we want to thank you for entrusting us with a portion of your assets. If you have any questions about your portfolio or any other financial planning issue, please feel free to contact us.
Sincerely,
Alan R. Myers, CFA
President / Senior Portfolio Manager
Aerie Capital Management, LLC
(336) 306-5496
(866) 857-4095
www.aeriecapitalmgmt.com
It’s No Surprise – We Have Earnings Growth
A few weeks ago I penned my quarterly letter to clients. In the letter I noted the good earnings coming from companies reporting third quarter results. I noted, however, that I was not sure if the earnings were the result of cost cutting or sales increases, but I promised to follow up on this question. Thankfully, Standard & Poors and Bloomberg have made my job somewhat easier.
Before I get into specifics of this question, let me explain why there is a difference in the way earnings growth matters. As I noted above, there are two ways we can see a company grow their bottom line. One is through cost cutting. This, of course, could be layoffs but also productivity gains from working smarter or harder. The problem with these types of gains is they are not sustainable. That is, you can only cut so much of your workforce, and people can only work but so hard or fast. After a certain point, companies will have wrung all the gains from cost cutting that are available. The only way net income rises after that is from gains in total sales (revenues).
This brings me to the second half of this question. If companies are growing their top line – sales or revenues – even if they are keeping their costs consistent, this will lead to higher net income. This is also a much more sustainable model for growth. In fact, there have been several academic studies of this phenomenon. One of the most recent found the stock of companies that not only reported an earnings “surprise” – higher earnings than anticipated by analysts – but also a revenue or sales surprise significantly outperformed the market. In fact, companies that reported both earnings and sales that exceeded analysts’ expectations returned about 27% annually [Jegadeesh, Narasimhan and Joshua Livnat. 2006. “Post-Earnings-Announcement Drift: The Role of Revenue Surprises” Financial Analysts Journal, vol. 62, no. 2 (March/April), pp 22-34.]! Now, this is not to say that you should expect any particular company that reports higher sales and earnings than predicted to reward you with such a high return. What you can expect is that a portfolio of such stocks should outperform the broad market.
This brings us back around to the two key questions we need to ask. First, have earnings increases been a function of sales increases or cost cutting and if it’s the former, how many surprises were there? In an article on Bloomberg’s website [http://www.bloomberg.com/news/2010-10-27/third-quarter-of-10-s-p-500-sales-summary-table-.html], Standard & Poor’s, the keeper of the data for the S&P 500 Index, reports the statistics roughly through the end of October. What we see is that nearly half of the S&P 500 companies have reported third quarter results (231) so far. Of the companies that have reported, about 4 out of 5 (182) have reported higher earnings compared to the same period last year and with a 7.8% average sales gain.
More important, however, is the number of companies that are reporting positive earnings surprises. This turns out to be a positive sign, as well. It seems that 55% (128 companies) have surprised analysts by reporting better earnings. On average, earnings have only been about 0.8% higher than expected, but any growth is certainly better than no growth. If, based on the academic research, we can expect these 128 or so companies to outperform the market, this bodes well for continued growth in stock prices.
Let’s dig just a little deeper though to see what we might be able to infer about future growth prospects. When we look at just the sectors reporting higher sales, the overwhelming leader is the tech sector where hardware manufacturers (computers, for example) showed sales growth of nearly 55% over last year. This is not too surprising given the uncertainty of the economy last year and the recovery into this year. Companies are feeling a little better about things and willing to upgrade equipment again. After the tech sector, we see a few surprising things. While food and beverage companies have shown earnings growth – not surprising if consumers are pulling their horns in and hunkering down against a long, slow recovery – but we also see sale growth in some surprising areas. Other notable sectors with increasing sales include consumer durables (think ‘washers and dryers), retailing (malls) and transportation (railroads). These would tend to point to a recovery happening in the economy. However, much of these sales increases were expected as analysts’ estimates were not all that far off for most of these sectors. In fact, analysts tended to overestimate food and beverages and transportation.
When we look at the sectors that have surprised analysts the most, the two that have surprised the most (so far) have been auto sales and real estate. Auto sales is a little surprising given the government’s “Cash for Clunkers” incentive last year to buy a new car that everyone seemed to think was going to “pull forward” car sales. The thought was that the bulk of the sales under the government’s program were car sales that might have happened over the next couple of years, but those trade-ins and trade-ups were hurried to take advantage of government incentives. Real estate is another matter, of course. The general consensus is that real estate is still in the doldrums with a lot of inventory of unsold homes still on the market. Until these homes are sold and inventory reduced, real estate prices will not likely recover. Seeing higher unexpected sales in this sector bears further research. It could be that analysts were just too negative on this sector of the economy, making it easy for these firms to surprise to the upside.
The bottom line here is that we are looking at a mixed picture. There are some signs that we are slowly clawing our way out of a very deep recession. I refuse to go back to the ‘green shoots’ of last year since most of those turned out to be weeds. I will admit that things are slowly getting better but we still have a long way to go. However, much uncertainty remains. Until businesses get more clarity and take the initiative to hire more employees and increase spending on capital goods – the machines and moving parts of companies that make widgets and such – we will remain in a slow-moving funk. Over the long-term, however, America has been quite resilient. I’ll continue to believe that we will come out of this mess better, stronger and healthier but I will continue to take every advantage of the volatility that ensues to snap up good companies at great prices.
Third Quarter 2010 Client Letter
Hear ye! Hear ye! The recession is over! Well, that was the headline news on September 20th anyway. It seems that the National Bureau of Economic Research (NBER), a leading private, non-profit, non-partisan research organization released their findings on the economy. What was more surprising than the announcement the recession was over was just exactly when it was over. According to the NBER, the recession officially ended as of June 2009!
According to the Bureau of Labor Statistics, the national unemployment rate stood at 9.6% as of the end of August 2010. This is little changed from the 9.7% rate as of the end of June 2009 when the recession officially ended, but down from the peak of 10.6% in January 2010. Meanwhile, gross domestic production – the output of goods and services in our economy – grew at an annual rate of just 1.7% for the second quarter of this year. Real disposable income grew an average of 0.3% per month through the end of August. Meanwhile, prominent NYU economics professor Nouriel Roubini predicted in early September that the chances of a ‘double dip’ recession were greater than 40%.
In the face of all of this negativity, it’s very easy to become sullen and depressed. After all, in spite of what the NBER stated, it would seem the opposite is true and we are still mired in a recession. However, there are a few nuances that you must understand before the scoffing begins. The first thing you need to understand is the official definition of a recession. Officially (according to economists) it is “a period of falling economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.” [http://www.nber.org/cycles/sept2010.html#navDiv=6] What the NBER release actually stated was that June marked the end of the trough or the lowest point according to all of the measures combined. Some started to improve in July while others, such as employment, have lagged a bit and did not seem to peak until a little later in the cycle.
In the face of all of this negativity and the media’s attempts to keep it going, I would like to offer up some positive words for this quarter-end. After all, things may not be as bad as they are portrayed. This is not to say that we are seeing more of the infamous “green shoots” of last year or that all is back to normal. We can all agree that we are not back to normal. Well, not the normal we came to know and love before 2008. We may be in what PIMCO CEO Mohamed el-Erian has stated, we may be in for a “new normal” for some time to come.
What does this “new normal” look like and what can we expect? Prior to this meltdown, our economy was largely built on credit. Borrowing against homes, against credit cards, against stocks and anything else of value was normal. For example, margin debt – people who borrowed against their stock portfolios – grew from a low of $130 billion in October 2002 to $314 billion by June 2008 before the market crashed in September 2008. The level of this debt fell to around $173 billion by February 2009 and while it has bounced back with the market recovery to around $235 billion, the borrowing is still 25% below the peak levels of 2008. Mortgage debt peaked at $14.6 trillion in 2008 and had fallen to $14 trillion by the June of this year. While that may not seem like a big drop (it’s only about 5%) understand that in absolute terms, that is $600 billion of debt that is now gone.
While getting rid of this debt is great for the borrower, it is not so great for the recovery. All of that debt was going somewhere and that somewhere was into purchasing “stuff”. Now that people are reducing their debt, the money formerly earmarked for goods and services now goes to pay down debt. The bottom line to all of these numbers is that any recovery we see will take longer than normal. In the past, we were able to “spend” our way out of recessions. That is clearly not going to be the case in this recession. Spending promises to be slow, housing prices are likely to remain depressed and unemployment is likely to remain high for some time to come. With messages of much slower economic growth, lower spending by consumers and higher unemployment for more extended periods, it is easy to be pessimistic. What doesn’t help are the depressing headlines about depressed housing prices, rising foreclosures, and political discord in Washington DC.
Actually, in spite of all the negativity, there is positive news. The good news is that, in spite of the sluggish pace, we are in a recovery period. Things are getting better. Granted they are getting better at a glacier’s pace, but our economy is in a recovery. Further bolstering this assertion, consulting company McKinsey & Company surveyed leading executives around the world. Fully 51% say the world economy is in recovery and 58% say their country’s economy is getting stronger. Nearly 40% expect to hire more before year-end*. The better news for us is that corporate profits are recovering. So far, companies that are in the S&P 500 Index that have reported earnings are showing nice gains versus last year’s earnings. In fact, we are seeing net income up just over 25% versus last year’s earnings. What is more time-consuming to measure is whether these gains are the result of top line (sales) growth, cost cutting (think lower head count due to unemployment), or share buybacks (the companies needed to deploy excess cash somewhere, and one way to do that is to buy back shares of their own stock). This is something that we will look into over the next week or so and blog about on our web site.
During the late spring and early summer, there were rampant fears of a double dip to this recession. Those fears are largely gone. Certainly the recovery is going to take a lot longer than anyone would like, but we are undeniably in a recovery. The stock market, in spite of this negative sentiment, is booming. In fact, the stock market is up over 10% for the quarter. This strength has allowed us to trim some positions to take some profits to be redeployed elsewhere. For example, in several client accounts we trimmed positions in stocks such as GE and Innophos Holdings (IPHS). During August, which was actually a down month for most stocks, we took advantage of this weakness to add to positions in CRH plc and Span-America Medical Systems. Both are still very good companies but have some short-term weakness that seems to be more market-driven than fundamental. In addition, after seeing quite a number of bargains in the agri-business sector, rather than trying to pick and choose from among five or six different companies, we managed to buy all of them (and more) via an exchange-trade fund.
We continue to remain cautious about stock prices. As far as the broad stock market is concerned, we think stock prices are getting a little ahead of themselves. We will continue to trim positions when appropriate and have started “hedging” client accounts by buying put options – options that will profit if stock prices fall. These are short-term solutions, though, to a long-term issue. Over the long-term, we continue to look at good companies that are trading at great prices. As stocks continue to climb, we are more cautious about buying and prefer to await better entry prices on many positions we are watching.
As always, it remains a privilege to serve you by managing a portion of your assets. If you have any needs or questions regarding any of the decisions in your portfolio, please feel free to give us a call.
Sincerely,
Alan R. Myers, CFA
President / Senior Portfolio Manager
Aerie Capital Management, LLC
(336) 306-5496
(866) 857-4095
www.aeriecapitalmgmt.com
Second Quarter 2010 Client Letter
I have often cited as one of my role models, Warren Buffett. One “Buffett-ism” is that it only takes two things to make money – having a plan and sticking to it – and of those two, it’s the sticking to it that most investors struggle with. One thing that we have is a long-term plan for each and every investor. This does not ignore short-term needs or goals. In fact, we factor short-term needs and goals into long-term plans. The key though, is to stay focused on the long-term goal. This sometimes becomes challenging when markets are bouncing around like an airplane in turbulence. I know that many of you feel as if you, or rather your portfolios, have been jostled around so much that you want to reach for an airsick bag. The key is to not get too caught up in the short-term gyrations but remain focused on the long-term.
We certainly had enough jolts and jostles during the first half of the year. Some of the key headline events included Greece teetering on the brink of bankruptcy with Spain and Portugal not far behind apparently; a BP oil rig exploding and sinking in the Gulf leaving an uncapped oil well spewing thousands of gallons of oil daily; a “flash crash” apparently caused by some errant trades (see my blog on this topic at http://www.aeriecapitalmgmt.com/2010/05/07/a-fat-fingured-discount/); deeply disappointing jobs reports; plunging home sales here in the U.S. and worries over a new real estate bubble in China, of all places.
All of this headline risk caused market volatility to dramatically increase, especially during the month of May. In fact, in spite of the problems out of Greece and Europe, markets seemed to be relatively sanguine about these issues. There just was not much fear in spite of the headlines. Volatility turned around in early May with the “flash crash” that took the Dow Jones Industrial Average down nearly 1,000 points in the matter of a few minutes – the largest single one day drop ever – before it recovered 700 of those lost points by the end of the day.
By late May, when we received a truly disappointing jobs report that showed absolutely no job growth (essentially, all jobs added were temporary census workers), fear of a double-dip recession caused volatility – which translates into big stock price movements both up and down – to levels not seen since early 2009. This, of course, represented opportunity to us and we took advantage of this fear.
We took full advantage of this increased volatility mainly through the options market. When volatility increases, the prices investors pay for options increases. We profited by selling options. For selling these options, we collected a premium. How did we benefit from this selling? Most of the options that we sold expired worthless which means we kept the premium we collected with no obligation. This is very much like what we did during the first quarter of 2009 when again, volatility was high and option prices were high. The premiums we earned are additional cash we would not have had otherwise – cash we will redeploy into other investments. Please understand that when we sold these options, we were perfectly willing to buy or sell the underlying stock at whatever the contract price stated as we considered the prices we set to be fair prices for the stocks in question.
If you will recall, I started this letter by citing Warren Buffett’s quote about sticking to a plan. We most certainly have a plan for each of our clients, and we actively monitor each and every account on a regular basis. As a testament to our discipline, in spite of the S&P 500 Index falling 11.86% for the quarter, our accounts were pretty much spared across the board from this dramatic fall. While accounts did lose a little ground for the quarter, most declines were closer to the 2 – 3% range. Some of the key reasons for our smaller decline was our allocation to fixed income (bonds), the performance of several of our stocks including the oil royalty trusts (companies that own oil wells) such as Dorchester Minerals and Hugoton Royalty Trust as well as the newest edition to many portfolios, Oil-Dri Corporation of America. This diversity of holdings – asset allocation, in ‘finance-speak’ – helped to protect us from more downside risk.
But this is still thinking in the short-term and not the long-term. Looking out a little longer, over the past three years, the broad stock market has fallen over 31%. While we haven’t been spared the fall, we have dramatically limited the decline with most accounts falling 11-14% over the past three years. While this is not exactly the outcome we had hoped for (we prefer positive returns to ‘relative’ returns that are better than the market), we believe we are positioned for better performance over the long term.
I do want to comment on the charts to the left. These charts (courtesy of www.Horsesmouth.com) show the average return on large capitalization stocks after inflation is taken out from 1926 – 2009. Over this time period, U.S. stocks have gained 6% after inflation.
The first chart shows the returns over one year periods. This is truly a roller coaster ride. The middle chart shows the average three year return on stocks and, while still bumpy, is a bit gentler. The last chart shows the returns over ten-year periods. This chart shows that the longer you own stocks, the more likely you are to avoid the dramatic highs and lows found on the yearly chart. We think this chart clearly shows that investors should remain focused on the long-term and make sure portfolios are positioned to meet their goals over an extended period of time.
Finally, I would like to take this moment to thank you again for the opportunity to work together. As always, I welcome your calls with questions or concerns, and I am happy to talk with you at any time.
Sincerely,
Alan R. Myers, CFA
President / Senior Portfolio Manager
Aerie Capital Management, LLC
(336) 306-5496
(866) 857-4095
www.aeriecapitalmgmt.com
A “Fat-Fingured” Discount?
I know what is going to be on the minds and lips of just about everyone for the next couple of days. “Did you see that stock market?!” Everyone, of course, will be talking about the nearly 1,000 point plunge in the Dow Jones Industrial Average around mid-afternoon on Thursday. This is the largest single point decline ever in the history of the average, even though the market managed to recover and only close down a little over 347 points. So just what the heck happened and how worried should we be?
From based on all the scuttlebutt running around the market, it appears that someone pulled a major goof today. Further, as if to add insult to injury, there is talk that the huge error occurred at, of all places, Citigroup. The assumption at the moment is that some trader accidentally entered “billion” when he meant “million”. Oopsy! So what did this huge error mean? Well, let’s look at what we saw during the day versus reality, first. Then we’ll dive a little deeper into the long term implications for today on our holdings.
So what exactly went wrong? Well, let me try to explain, given the limited information that has come out so far on the trading day. It seems that some trader did apparently enter an order incorrectly for some futures on the S&P 500 stock index. It seems that it was a “b” that was entered instead of “m”. This means that somebody was mistakenly trying to sell billions of dollars of stock when they only meant to sell millions. Now, selling millions of dollars worth of stock may sound like a lot to mere mortals such as you and I, but the truth is, that’s not a lot given the size of our stock market and the number of shares that trade every minute of many securities. Heck, Apple Inc. stock trades about $12 million worth of shares every minute.
So, this errant trade for billions is accidentally entered into the system. The folks on the floor of the New York Stock Exchange, who are responsible for making sure that orders flow smoothly, see this sudden request to sell untold thousands of shares of the stocks in the S&P 500 Index. Well, these specialists (as they are known), are sort of stock retailers. They first try to match up buyers and sellers. However, if there is no one willing to take the opposite side of trade, they must be willing to take the trade.
Now, think about it from an eBay perspective. You are selling rare wine on eBay. You have listed a bottle of a fine Rothschild vineyard wine that you believe is rare with only a few hundred bottles known to be in existence. You can command a pretty fair price for this wine. Others see you earning some nice profits on this wine, so a couple of other folks list their bottles. Well, with more choices now, prices would drop a little bit. Suddenly, someone errantly types in ‘Rothschild’ when they meant to type in ‘Boone’s Farm’ and suddenly it appears as if thousands of bottles are for sale. Prices plunge.
This is essentially what happened. This errant trade came across to these specialists who realized that it had to be an error. Even if it wasn’t an error, these guys needed a little bit of time in order to find enough volume to meet that demand. So, they slowed the market down – literally. The specialists put in place a “time delay” between when orders came in and when they were executed. The put a thirty second delay in place. However, some brokerage firm computers were impatient. Rather than wait the thirty seconds, the computer searched elsewhere for the same security to sell. The computer stumbled across some old order on another computer that had been entered months ago to buy, for example Proctor & Gamble for $40 per share. The would-be buyer may have entered that order in March of last year hoping against hope that P&G would come back to them. It didn’t and now the stock was trading around $60 per share – until yesterday. When these brokerage firm computers went searching for anyone buying P&G stock, they found that one order for 1,300 and a sale was done. This was sort of a “rogue” trade, though. The real price for P&G on the NYSE was never below $58 per share. Trades like this were happening throughout the market.
What made yesterday frustrating was that most stocks that were affected by the severe drop never should have dropped. For example, I sat and watched as Buckeye Partners (BPL) stock, which we own for a number of client accounts, fell from $58 at the start of the day to as low as $45 at one point before rebounding to close at $54. Buckeye is a company that acts as a giant taxi for gasoline and other refined products. It moves gasoline, jet fuel and other end products from refineries to storage facilities and stores these distillates until shipped to the end users such as gas stations. Buckeye Partners is paid not on the price of oil but on how much is shipped and how far. At the current price, Buckeye shares are yielding 6.94% based on their recent quarterly dividend – which has increased every quarter since the second quarter of 2004.
Another stock that we own in some client accounts that was momentarily hit hard is Exelon Corp. (EXC). Exelon is a utility. In fact, it’s the largest generator of nuclear power in the nation with eleven plants. During the time of this mysterious plunge, Exelon theoretically sold for zero! Yes, you read that right. Zero. It’s one of several stocks that supposedly were sold for absolutely nothing. In all likelihood, that particular trade will be ‘busted’. That is, the trade will not be honored by the stock exchange as a valid trade, so the seller will get his or her shares back and the buyer loses out on owning EXC at a cost of, well, nothing.
All of this insanity essentially took place during a very short twenty minute window from around 2:30 pm until 2:50 pm today. Making it more difficult to profit from this bizarre incident, it was impossible to find the stock to purchase. For example, going back to Proctor & Gamble, the lowest price occurred on the sale of only 1,300 shares. Consider that on a normal day, about 28,000 shares of PG trade every minute of the trading day and you see how small a single trade of 1,300 shares really is. To put the dramatic move in our Buckeye Partners stock into perspective, on a typical day the stock trades within a narrow range of a little over $1 per share. Today’s range was over $13 per share.
So how are we affected by all that is going on? Well, obviously, we’re not really affected by errant trades. If we don’t panic and sell into insanity, we’re fine. As for the Greek problems that were already causing weakness in our stock markets yesterday, even before the rogue trade, we are somewhat protected against that, too. Many of the stocks that we own are U.S. companies with a focus on the U.S. economy. Sure sales could decline somewhat if the economy does slow down, but we are largely protected from heavy exposure to Europe at the moment. With companies such as Buckeye Partners or Frisch’s Restaurants (FRS), a company that runs Big Boy and Golden Corral restaurants in Ohio and Indiana, or Nash Finch (NAFC), a company that supplies grocers and commissaries on military bases with groceries, we are betting, like Buffett, on the recovery and growth of America.
How will we be handling this volatility and opportunity? Well, let me start by telling you how I handle our accounts. I have a Sunday evening ritual whereby I will go through each and every stock we own and look at it on a point-and-figure chart (one just like you see in the article “Pointing the Way Out of Confusion” below). What I am looking for in these charts is a trend, direction and a “stopping” point or the trigger point that I would cause me to either seriously re-evaluate our stock holding (i.e. question the reason and thesis behind the purchase) or sell it outright.
As stocks were tanking today, we did take a little money off the table based on the research we did this past Sunday night. While a part of me regrets acting in haste, the one stock that we sold, an exchange traded fund of high-yield bonds (HYF), did reduce risk for our clients. There are a few names in client accounts, names such as ConocoPhillips (COP) that we own and the charts tell us ‘sell’. However, the charts can’t look at the intrinsic value of the company and tell us the stock is undervalued. By our calculations, the stock is worth about $105 per share. Conoco is working to unlock shareholder value by selling off underperforming assets, raising cash to reinvest in higher margin investments, reduce debt and likely returning some cash to shareholders through dividend increases and stock buybacks. Oh yeah, and the stock is currently yielding 4% based on the current price. I think I’ll trust my investment thesis over the charts on this one.
There are a few stocks that we are likely to try to pick up if this slide continues. We are likely to use options, just as we did in late-2008 and early-2009, to take advantage of this increased volatility. We’ll probably sell some puts, obligating us to purchase shares of companies, but only on stocks we want to own anyway. While the recent declines have given us pause, we are nowhere near levels of a year and a half ago. In fact, we are still 67% above the March 2009 lows. In other words, stocks have become a bit cheaper, quality stocks are moving back towards bargain territory and volatility opens up some opportunities for us, but we’re not getting greedy and we’re not at a “screaming buy” just yet. We’ll continue to look at ways to hedge our client accounts, take money off the table when it’s appropriate, reduce risk across accounts and play a good offense by playing better defense.
First Quarter 2010 Client Letter
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.
- 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.
- 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.
- 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.
- 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.
- 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.
Sincerely,
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