Monday, August 04, 2008

2008 Quarter 2 Update

July 25, 2008

It has become fairly clear that by almost any standard the U.S. equity markets are in a bear market, plain and simple. It’s still up for debate as to whether or not the economy has entered a recession but for all intents and purposes it appears to be close enough. That being said, we have still managed to make money in this difficult market and feel blessed to be able to say that. How have we managed to post positive returns while the major market averages are off by more than 20% from their highs in October of last year? We have stuck with our thesis that global growth will remain robust and therefore natural resource and infrastructure plays are the place to be. Thus far this has proved to be the case and our avoidance of companies exposed to the U.S. consumer has allowed us to circumvent a large portion of the losses suffered by the overall market. Of course the first half of 2008 is over, putting all that happened in the history books for now. This forces us to focus on what occurs going forward and how we can capitalize on what’s to come.

In our first quarter update letter we made two statements, one of which turned out to be correct and the other incorrect. We stated that we believed we might have witnessed a bottom in the equity markets following the collapse of Bear Stearns in mid-March. This turned out not to be the case of course. The U.S. markets have continued to grind lower over the summer and it’s very difficult to ascertain where the bottom may actually lie at this point in time. We also made a statement regarding the continued growth in China and other global economies that has thus far proved to be correct. Despite the slowdown in the U.S. and Europe, countries such as China and India have continued their blistering growth and it would appear that this upward trajectory is being maintained. We have yet to see any compelling evidence that this trend will change in the near future and therefore explains our continued excitement with regards to our portfolio.

So what do the two statements mentioned above mean for our clients’ portfolios going forward? Quite a bit actually. Of course we were incorrect in thinking that the markets might have bottomed back in March of this year. Fortunately we were not convinced of this fact and for the most part did not attempt to “bottom fish” some of the more beaten down sectors, i.e. housing, financials and retailers. We maintained our global growth thesis as mentioned above and have performed very well as a result. At some point in the not too distant future, however, we are going to find a bottom in this bear market, at which time there will be a plethora of opportunities in the aforementioned beaten down sectors. The advantage we have at this moment in time is the ability to watch from the sidelines as these sectors continue to be taken down, waiting patiently for the opportune moment to pick up “diamonds in the rough” when this market finally shakes out. This is the distinct advantage that being opportunistic managers provides us. We have been able to seek out the best performing sectors in this bear market, therefore taking advantage of the positive performance of the group, while all the while keeping our ear to the ground and listening for the right time to dip our toe in the water of the more damaged sectors in this economy. Clearly we are not there yet, however that time will come and we will be ready.

The big question on everyone’s mind at this point is when will things turn around here at home. We do not pretend to have the answer to that question, however we do feel strongly about a few things in the current environment. As evidenced by our current portfolio, we feel very strongly that energy and other natural resources will outperform in this atmosphere. Thousands of new cars hit the roads every day in China and other growing economies, a fact that will continue to keep the price of oil and other natural resources elevated in the future. These same people continue to demand a better way of life, a desire that will continue to support the massive migration from an agrarian to an urban society. Of course room will be necessary to accommodate all these new entrants and natural resources and corporate know-how will be in high demand. And with the price of oil likely to remain high for the foreseeable future it will become increasingly attractive to find and use more clean burning fuels. Natural gas is positioned perfectly in this environment and it is why we continue to hold large positions in many of these producers.

It is important to note that we are not naïve enough to believe that there will not be corrections in some of the commodity markets that we are exposed to and therefore corrections in the positions that we own. In the first half of July crude oil, natural gas and steel have all experienced pullbacks as investors begin to wonder when demand destruction will begin to affect the price of the commodities. This has naturally resulted in a decline in some of the positions we hold in client portfolios which are exposed to these sectors, albeit from extreme highs. While we are never happy about giving back even the slightest bit of our gains we have yet to see anything indicating a true sea change in the overall climate for these sectors. We firmly believe that we remain in the midst of a long term bull market for all things related to global economic growth and that this trend is yet to run its course. Should oil be trading at $130/barrel? Natural gas at $10/btu? It is difficult to know what the fair value of many of these commodities is, however it is not difficult to see that demand is clearly outpacing supply and short of a global economic recession this is not likely to change anytime soon. What we are likely experiencing in the commodities complex is simply money rotation. Shorter term investors have taken the stance that momentum is leaving the sector and they have therefore chosen to do the same. When the fundamental backdrop proves there is little reason for commodities to correct in an extreme fashion the tide will turn again towards this sector and we will be the beneficiaries. In summary, we feel very confident in our positioning and look forward to the second half of 2008.

As always, we appreciate your continued support and welcome the opportunity to assist anyone that you may feel is in need of our help. 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 the future.

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