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.

US stock returns after inflationI 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