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Letter dated July 2010 reporting on the second quarter of 2010

In our last letter, I said: “I don’t think it is a great time to be too much further out on the risk curve.” I guess that was an understatement. But we saw clouds gathering, pulled back accordingly, and maintained investments in some bright spots. The S&P 500 Index lost 11.4% (total return) for the quarter. Even though we made some mistakes, we beat the market by a healthy amount. If we can continue to outpace the market over time, we should do fine. But it is still not pleasant to report a loss of 7.36% for the quarter.

What changed from the rally in the first quarter? Several things:

• The European crisis came into sharper focus. Why now when it’s been out there for awhile? Who knows exactly when a dam will break? The mortgage crisis brewed quietly for a while in 2007 before it hit full force in 2008. Market psychology is incredible and not always rational or in a predictable rhythm. In this case, I think the problem came into much sharper focus when the EU actually had to commit capital of €30 billion to rescue Greece. More recently, European budget austerity measures have been seen as necessary but also as a brake on economic growth. Finally, the situation in Spain may be worse than that in Greece because their economy is three times as large and the country’s problems include unstable banks as well as sovereign debt concerns.

• There are growing concerns about our country’s own debt situation. Our total government debt now exceeds $13 trillion. This includes $4.5 trillion that the Treasury has “borrowed” from Social Security and Medicare. Our GDP was $14.4 trillion in 2009. So our aggregate debt now exceeds 90% of GDP. The peak ratio of about 120% was reached during World War II. There is no peacetime precedent for this level of debt; all we can say it that it is worrisome. As was the case with Europe or the mortgage crisis, it is hard to predict when these issues will impact the financial markets. But there are several reasons for concern:

o About 45% of outstanding Treasury debt comes due within the next two years and must be refinanced. If foreign buyers pull back from the refinancings, interest rates would inevitably rise to attract other buyers. (I’m not sure if we will then blame the bankers or the Chinese, but surely it won’t be our government’s fault).

o This discussion refers only to sovereign debt. The direct mortgage-related debt of Fannie Mae and Freddie Mac is another $1.5 trillion. Moreover, these agencies guarantee an additional $3.9 trillion of mortgage debt that they do not own outright. Total mortgage debt in the US is about $10 trillion.

o The overall debt level continues to grow. Congressional Budget Office projections have the annual deficit figures narrowing slightly between now and the next presidential election to “only” $1 trillion annually, and then snowballing at an alarming rate to an aggregate of over $20 trillion within the next decade.

o Fed chairman Bernanke has said that this debt is on “an unsustainable path” that would do “great damage” to the economy if not corrected. In a Wall Street Journal piece, Princeton economics professor Burton Malkiel concurred: “The only viable solution is reform of entitlement programs. What frightens investors most is that political processes seem incapable of dealing with long-run budget deficits before an economic crisis forces action.”
http://online.wsj.com/article/SB10001424052748704269204575270702838532246.html?KEYWORDS=malkiel

• Mark to market accounting may be a bearish factor again. The Financial Accounting Standards Board in November 2007 suddenly decided to require investment banks to ascribe market values that were difficult to ascertain to all of their assets. That forced these firms to take massive writedowns and to raise new capital when it was hardest and most expensive to do so. Now FASB wants to extend the same requirements to commercial banks. This could cause a sharp contraction in credit. Former FDIC chairman William Isaac says this proposal would "destroy banking as we know it." But accountants don’t seem to see the broader picture. I do not believe that this proposal is discounted yet in stock prices. Steve Forbes just wrote an intelligent piece on this subject which is available at:
http://www.forbes.com/forbes/2010/0628/opinions-steve-forbes-fact-comment-stop-this-horror.html.

So those are some of the headwinds we face. Despite them, we have found some very attractive investments. Apple was up 7% for the quarter. Cirrus Logic, a maker of specialized computer chips, gained 88% from our purchase price. Valeant Pharmaceuticals rose 21.9%. The energy pipeline companies (KMP, EPD, WPZ) did well. We had a gain of 11.7% in our GLD position, which is the exchange-traded fund for physical gold.

The GLD position is one of our largest, and the easiest to explain. It goes back to the debt discussion. With all of this debt, there is some loss of confidence in so-called fiat currencies. The dollar and Euro are backed simply by the full faith and credit of respective governments, and if people lose faith in that credit, they will seek an alternate store of value. Gold has been regarded as precious since ancient times. The supply of gold is limited. The US government owns about $300 billion worth of gold, which equates to just over 2% of our outstanding government debt. If all US currency in circulation were to be redeemed by the government’s holdings in gold, the clearing price today would be about $3500 per ounce. Gold is trading at about $1245 per ounce.

Needless to say, not all of our positions did so well. My biggest disappointment was the energy sector. Exxon Mobil dropped 14% during the quarter. As the saying goes, the stock didn’t know we owned it. My quantitative system now projects a compound annual return of 14% on Exxon stock. It has a return on equity of 17%. Morningstar sees fair value at $87, versus the quarter’s closing price of $57.07. The obvious problem is that energy usage tends to decline in a recession. Electricity generation is one proxy. It declined 1% in 2008 and an additional 3% in 2009. A recent article in The Economist noted that demand for energy is quite inelastic, meaning that even very small changes in either supply or demand can lead to big changes in price. I still believe that the phenomenal GDP growth and large increases in per capita energy use in Asia will put upward pressure on energy prices over time. This should benefit our energy stocks, even though the latest quarter was disappointing.

Our hope for a turnaround in Eastman Kodak was based in part on aggressive moves in printers and ink has been dashed or at least put on hold. The company’s most recent earnings report was sub-par, and the stock fell sharply. We got out of most of it.

Let’s turn to market valuation. Operating earnings for the S&P in 2010 are estimated to be $74.98. At a level of 1030, this produces a PE ratio of 13.7. Significantly, this is the lowest PE ratio since 1994 (using year-end figures only), when the market began a sustained rally. With interest rates as low as they are currently, historical data suggests that a substantially higher PE multiple would be justified – all else equal. But the PE ratio may be where it is because of the headwinds discussed earlier and because market participants generally expected interest rates to move higher. Earnings estimates may also come down. Valuation is tricky; when I look at the average payback periods on the stocks in our database, the valuations look remarkably similar to those in early 2008. As events that year made clear, cheap can get cheaper. However, there are a fair number of individual securities where our system projects returns above 20%. There are always some reasonable opportunities.

The Chinese apparently agree. Recent reports indicate that they intend to increase their investments in US stocks. There is other good news out there. Corporations have record levels of cash to invest. Individual investors are still largely on the sidelines, and can have a huge impact if they come back into equities. In fact, respected market analyst Lazlo Birinyi compares the current environment to the situation that existed shortly before the stock market’s great lift-off in 1982.

If that proves to be correct, I don’t think we need to be the first movers. I am inclined to remain defensive until enough evidence suggests otherwise. In our last letter, I referred to the 200 day moving average not as a predictive indicator but as an indicator of trend. Back then, the market was above the 200 day moving average. Now we are below it. This is simply another indicator that suggests caution.

The big financial reform package is nearing a vote in Congress. Politicians are suggesting that these reforms will increase public confidence in the markets. I see it as more akin to shifting gears on a mountainous road. If you were going up, you are still going up. Ditto for going down. The journey might be slower, but the direction remains the same. Politicians are doing very little to address the fundamental debt issues that will be a major influence on the markets. Disturbingly, leaders of the G-20 nations can’t agree on what needs to be done.

As I’ve said many times, we devote our energy to looking for assets which are attractively priced. If we can continue to augment the market’s return by a few percent a year, we will do fine over time. There is no guarantee of that, but we’re doing our best to continue in this vein. We greatly appreciate your continued confidence and welcome any questions. We’re available whenever you need us.