Monday, August 04, 2008

2007 Year-End Update

January 25, 2008

“The financial markets are currently in a state of uncertainty that will take some time to work itself out. This uncertainty will likely create some volatility in the near term as more information is disseminated in relation to subprime exposure and the like.” You may recall these statements from our last update letter and unfortunately they were more correct than even we realized. 2007 turned out to be a year of extremes for investors as the financial markets experienced dizzying new highs in the first half of the year, only to be dropped like a bag of rocks to finish the year in unspectacular fashion. It would seem that the investing world was caught by surprise as the subprime crisis reared its ugly head and put a stop to what was becoming a very profitable year for financial market participants. Of course this type of event is not unprecedented as we are often reminded that we should fear most what we don’t know to be afraid of than what we already know exists. The dislocation in the markets caused by the current credit crisis has been severe and to say the least unpleasant. The market dislikes uncertainty and that is exactly what the current environment is facing each day. Every weekday morning, and perhaps weekends too, the financial markets wake up wondering what new shoe might drop, fostering an environment of extreme volatility that has many wondering “what is it that we don’t know?”

And now for the other side of the coin. Volatile markets often provide good opportunities if one is patient and willing to look for them. While it is little solace to anyone losing money in the financial markets today, it’s the long term picture that we must focus on. That long term picture has been clouded as of late, however we are of the opinion that the U.S. still has a chance of avoiding economic recession and the strong global economy shows few signs of abating. What we are clearly experiencing now is a market that is trying to price in an obvious slowdown as well as the possibility of a recession. Given that the market is a forward looking discount mechanism the odds are good that once the economic weakness is at its worst it will already have been priced in, allowing us to find that bottom so many have been looking for. Are we there yet? It’s impossible to say at this point and only in hindsight is this observation a credible one. What we do feel strongly about, however, are the positions we have built in client portfolios over the last few months by picking through the rubble created by the current financial malaise. Our opinion is that global growth will remain on track and we are positioned for such a continuation. Its times like these that it so important to have confidence in your assessment of your companies’ quality and intrinsic value. To quote Ben Graham, “The investor who permits himself to be stampeded or unduly worried by unjustified market declines in his holdings is perversely transforming his basic advantage into a basic disadvantage. That man would be better off if his stocks had no market quotation at all, for he would then be spared the mental anguish caused him by other persons’ mistakes of judgment.”

So what are the keys to the fate of the financial markets in 2008? We believe that there are four major ones. In no particular order they are: the consumer, real estate, politics and obviously the economy. You’ll recall in our last update we stated that “consumer spending will likely slow domestically as a result of the changing real estate climate, however we do not believe that it will collapse as some may have you believe.” We are still of the opinion that consumer spending will not collapse, but given recent retail sales figures it appears clear that consumer spending has slowed considerably. It will be important to keep a close eye on consumer spending in the coming months however and this is a key reason why we have so little exposure to retail and other sectors which might be negatively impacted by this spending slowdown. In many ways real estate goes hand in hand with consumer spending. The consumer feels much “less wealthy” when the value of his or her home seems to be dropping on a daily basis. While it is unlikely that the bottom has been reached in the residential real estate market it is our opinion that we will see a bottom at some point in 2008. If this is in fact true then we should see some stabilization into the second half of the year in real estate, thereby keeping the consumer in the game so to speak.

Whether we like it or not, politics does play an important role in the economy and in turn the financial markets. Political allegiance aside, unless something changes dramatically between now and November it is likely we will see the Republicans swept out of the White House in 2008. As we’ve discussed before, the market disdains uncertainty and the idea of a Democratic majority in Washington leaves open the question “What will they change?” A Democratic Washington would remove the current state of gridlock from the equation, opening the door to change, something financial markets fret over regularly. But is it true that the Republican Party is better for the financial markets? History does not show this to be the case. In fact the opposite is true. Historically stocks have performed better under Democratic Presidents than Republican ones. Thus, simply because the country elects a Democratic President is no reason to sell every share you have and in fact may turn out to be a positive for the markets. For emphasis, we are not stating a political opinion or claiming to know the outcome of this year’s election, however it is our job to prognosticate to some degree in order to be better prepared for what is to come.

Certainly the most important factor affecting the financial markets in 2008 will be the economy. As we have stated above, it is clear that the economy has slowed in the past six months and we are of the opinion that growth is likely to remain sluggish in the first half of 2008. Does this mean it is time to give up on 2008? Not necessarily. It is likely that the market will continue to struggle in the coming months as it attempts to discount the slowing growth we are experiencing, however the important question investors must ask themselves is how much of the slowing economy is already reflected in forecasts, earnings projections, and stock prices. We are of the opinion that prices have been reflecting this slowing growth for many months now. Each day brings new and slightly redundant information which is consistent with slowing GDP growth. The market responds each time as if this is fresh information but we can’t expect companies to make wildly bullish comments on their prospects at this point. It is our opinion that those who wait for this optimistic outlook from companies will have waited too long.

So while it may be too early to search for value in this beaten down market, we are of the belief that many opportunities will present themselves in the coming months as many sectors and stocks within them will reach what many refer to as “stupid value.” If we are correct in our opinion that global growth will remain strong over the coming year then it stands to reason that many good values are being created as many babies are being thrown out with the bathwater so to speak. Many strong global growth stories have seen their share prices beaten down along with the market even as their stories remain strong. Companies such as Freeport-McMoran (FCX), Cleveland-Cliffs (CLF), Research In Motion (RIMM), Petroleo Brasileiro (PBR), Lockheed Martin (LMT) and the like have all suffered through this ugly downturn yet their markets remain robust. It is positions such as these that should recover quickly once the market feels it has sufficiently priced in the current U.S. economic slowdown. There are other places to find value as well in this market, one of which is healthcare. We have added a few positions in this sector as we believe it is an area that should remain fairly well insulated as the market attempts to bottom. Companies such as Zimmer Holdings (ZMH) and MedcoHealth Solutions (MHS) provide excellent value at these levels and should perform well despite a slowing domestic economy.

The second half of 2007 was a very difficult time for the U.S. financial markets and the first half of 2008 is likely to be challenging as well. We are optimistic, however, that slowing domestic growth will have been priced into the market in the first half of this year, opening the door to a potentially strong second half if one chooses his or her positions wisely. We appreciate your continued support and welcome the opportunity to assist anyone that you may feel is in need of our help. As always, we appreciate the confidence and trust you have shown in us by hiring our firm as your investment manager and we look forward to working with you in 2008.


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