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All economic and financial market cycles have varying degrees of length and durability that are difficult to predict. So, considering average length of previous cycles provides little insight into the current one, since each cycle is unique. However, we think it appropriate, three years after the “Second Great Contraction” to review where we are in relation to the three broad market phases: denial, acceptance, and exuberance. As our clients are well aware, we focus on identifying and investing long-term in high-quality, growing companies that earn economic profits. We do not forecast the economy or the stock market because there is no evidence that anyone has ever been able to do this consistently well. However, it is important to use common sense judgment to gauge in which phase of a market cycle we currently preside, since each phase presents different risks.  

Our best guess is that we have just completed the first three innings of a nine inning baseball game – we are just starting the transition to acceptance from denial. However, there probably will be rain delays, like in the summer of 2011 when the S&P 500 declined 19% due to the European financial crisis. We have considered whether or not the game will be called after five innings. Probably not, in our opinion, but we have identified two looming scenarios that could qualify as severe weather: a dramatic military conflict between Israel, Iran, and inevitably the U.S., and a U.S. fiscal debt crisis similar to what is happening in Europe.

In our view current trends in the economy indicate continued slow growth as leading indicators, such as Initial Unemployment Claims, have improved. While this recovery’s 2.4% GDP growth has been the lowest historically in the U.S., the low growth should give the cycle increased longevity. Greater risks are sometimes present in the stock market when capacity utilization is high, inflation and interest rates are rising, and the economy is expanding at a strong pace. The economy is far from these characteristics, which are typically present in the eighth or ninth innings.

A strong support for the current bull market has been good valuations. While the price-to-earnings ratio of the S&P 500 is currently trading at slightly over 13x earnings (a reasonable multiple), this is misleading because the index is weighted by size, placing emphasis on the valuation of large capitalization companies. Large capitalization stocks have underperformed fast growing, mid-sized companies – many sell at well over 30x projected earnings. The Value Line 1700 universe helps expose the distortion because it is equal-weighted and includes smaller companies. Its forward price-to-earnings ratio is well over 15. To give perspective, the March 2009 market low had a P/E ratio of 10.1 and at the 2007 market high it was 19.7. In our opinion, the stock market is no longer cheap but valuations are still reasonable compared to ten and fifteen year averages. Excessive valuations exist in some areas and we are taking an increasingly cautious approach to our stock selections – waiting for a fat pitch in baseball parlance. Overall we still strongly favor stocks over bonds, especially after considering that the yield on the 10-year Treasury note is negative after deducting expected inflation.

Current investor psychology also supports our analysis that we are in early innings of the market cycle. Notable to us has been the widespread disbelief and skepticism towards the durability of the market advance over the past three years. As previously mentioned, we observe investor psychology and try to place the market cycle in three general phases: denial, acceptance, and exuberance. Undoubtedly we have been in the denial phase. According to the Investment Company Institute, stock mutual funds have seen net redemptions of $167 billion from 2009 to 2011 versus bond fund net inflows of $747 billion. Furthermore, a look at institutional asset allocation decisions shows that the percentage of assets in stocks is well below 15 year averages. An exuberance phase would show the exact opposite trend, like during the dot.com bubble from 1999 to 2000 when mutual fund net inflows into stocks were $436 billion versus bond fund net redemptions of $54 billion. Bonds outperformed stocks over the ten years following the tech bubble; we believe the opposite could occur over the next ten years. Given the current artificially low interest rates, an increase in rates to just historically normal levels will produce large principal declines, which will be described in the media as losses. When greater optimism returns the shift into equities should push valuations higher.

We have identified two major risks that could challenge our thesis of having several innings left to play: a possible military conflict between Israel and Iran and a rising U.S. debt to GDP ratio that becomes unacceptable. The probability, timing and severity of both events are impossible to predict – likewise there are many events to transpire that we cannot even imagine.

An Israeli attack on Iran would likely draw the United States into the conflict with unknown, unintended consequences. If the major shipping lane through the Strait of Hormuz (where 18% of the world’s crude oil passes) is successfully blocked by Iran, oil prices would increase sharply, putting pressure on the global economy. Recent reports indicate that Israel is more sensitive to Iran’s progression towards nuclear armament capabilities than the Obama administration. Israel feels directly threatened while Obama and his team are focused on the upcoming election. This potential geopolitical event, regardless of when it might occur, would present a major short-term shock to the global economy.

The United States’ fiscal problems have been known and discounted for years but it appears that several factors are weighing on investors’ minds all at once and creating an unprecedented level of uncertainty. The political divisions are quite deep now and the proposed solutions to our debt problems are starkly different. Meanwhile the expiration of the Bush tax cuts and various fiscal stimulus packages at year-end, which are estimated to be a 3% drag on GDP, present additional concerns. We will leave predicting the election outcome to the pundits and cocktail party chatter, but we think Obama’s re-election would likely have little impact on the stock market near-term since he is already a slight favorite. If Romney is elected and/or more than two Senate seats are gained by the Republicans, the impact could be marginally positive since Republicans are perceived to place the debt issue as a higher priority. At this juncture we feel that a wait and see approach towards U.S. fiscal credit health is appropriate, acknowledging that the issue could flare up again as election year rhetoric drives the public discourse over the next year. However, sometime over the next presidential term a plan must be in place to address the structural imbalances of the U.S. government budget, or the bond market will force the issue.

In summary, we think we are in the early innings of an economic and stock market cycle based on historically slow growth, still reasonable valuations, and negative investor sentiment. This environment does not call for above-normal caution, except for certain sectors where some stocks are undoubtedly overvalued. We have and will take action on these overvalued securities and we will hold cash if no replacement is obvious. Remember that any changes in cash levels should not be interpreted as a reflection of increased risks at this time.

April 2012

James F. Jollay

During the early 1950’s, one of the most popular cartoonists was Walt Kelly whose major character was Pogo. His characters were a reflection of human nature. He also ventured into politics and his most famous quotation, “We have met the enemy and he is us,” was a parody of Commander Perry’s message in 1813 after the Battle of Lake Erie. This phrase was Kelly’s response during that time period to the McCarthy Hearings but may also be appropriate in trying to answer the question as to why studies of mutual funds and investment management firms have demonstrated that over time periods of 10 years or more, most managers underperform the stock market indexes. Given that our profession has very talented, highly educated and motivated professionals, why is this a fact? It is “us”. Our thoughts on this subject are not to present any air of superiority or arrogance, but are based on years of experience and in analyzing our own mistakes. Accordingly, we have incorporated many reasons for underperformance into our investment philosophy, decision making and disciplines in order to improve our odds for success.

The dynamic duo of fear and greed detracts the most from investment returns. Fear has four main components according to many psychologists: 1) A lack of personal control 2) Sudden occurrences 3) Unfamiliarity and 4) Large scale consequences.  Investing in stocks means accepting that you cannot control short term market movements or sudden occurrences such as 9/11 or the Lehman bankruptcy. However, you can control your emotional reactions, especially by understanding fear and having the mental fortitude to look at these large market declines as opportunities. A long term time horizon and a sense of history, which demonstrates market recoveries from episodes of sudden events, are very helpful. Warren Buffett frequently cites these historical patterns during times of high fear. Unfamiliarity is mitigated by a thorough understanding and knowledge of your holdings (the higher the quality, the better). One of Buffett’s valuable traits is rigorously staying within his circle of competence- perhaps another reason he has not seemed afraid while markets panicked. In this regard, this also mitigates the unfamiliarity, which affects your emotions. The large scale consequences, large financial losses for investors, can be controlled by specific diversification of investments. Of course large scale consequences usually occur after large scale appreciation, the last phase of which is marked by greed.  

 The emotion of greed is infused with many negative behavioral characteristics and is not as obvious to identify as fear. Greed may be expressed as an excessive pursuit of financial gain or for notoriety. It often leads to a focus on the immediate reward, not long term success. Investment managers with performance fees or an all-important track-record might pursue riskier short-run investments or trading strategies. The parts of the brain active during greedy thoughts are poisonous and inhibit thoughtful execution of a reliable investment strategy and often result in lower investment returns due to higher taxes, transaction costs, and investments in fundamentally unsound or over-priced businesses.

Overconfidence and ego can result in overestimating one’s ability and has popularized the phrase “don’t confuse a genius with a bull market.” When looking at the low cost basis of successful investments, a strong feeling of self-esteem arises. This, of course, is ego. The consequences of this ego can result in ignoring valuation disciplines or failing to notice changes in business fundamentals which could result in the loss of those paper profits. Overconfidence can also lead to thinking that your forecasting ability is far superior. Earnings estimates by Wall Street research analysts have been documented as very inaccurate, as they basically follow corporate guidance which in turn suffers from overconfidence, especially at major trend reversals. 

Another emotional behavior is the effect of crowd psychology and the phenomenon of “herding” or “groupthink,” which can lead to faulty decision making and too much uniformity of opinion. According to John Train, who wrote the book “The Money Masters,” a study of eight of the best investment managers including Warren Buffett, John Templeton, and T. Rowe Price, independent thinking was a common trait among them even though all had different investment philosophies. None made decisions within a committee framework. The power to conform is also present in the investment environment when new concepts take hold and depart from reality. Those who disagreed with the “new economy” and dot.com phenomenon in the late 1990s were scorned and many industry veterans were told they were too old. Of course the penalty for not being correct short term can be ostracism or worse, loss of a job. As Lord Keynes wrote, “Worldly wisdom teaches that it is better for the reputation to fail conventionally than to succeed unconventionally.”

Finally, there is a human tendency toward strong biases which can prevent open-mindedness, the flexibility to recognize and anticipate change, or worse, admit mistakes in judgment.  One of the biggest reasons for underperformance is too many large losses on individual stocks, known as “torpedo stocks.” They blow large holes in your portfolio. Taking losses and admitting mistakes is difficult because of loss aversion, another behavioral trap, where people avoid realizing losses. Psychologists have documented that most individuals feel a loss 2.5 times greater than the same level of gain. Waiting until “my stock gets back to my cost” is not conducive to good relative investment returns. If you purchased Eastman Kodak in 1973, it took 25 years for the price of the stock to barely establish new highs and of course, now, twelve years later the company filed for bankruptcy. Leaving the topic of behavioral finance behind, there are also other reasons for underperformance and a short term time horizon is right at the top.

The average portfolio turnover in the mutual fund industry is now over 100% per year. This is a trading mentality in the quest for short term performance. We are bombarded daily with this trading mentality as demonstrated by CNBC. Studies by Morningstar, with a few exceptions, proved that the best long term records were achieved by low turnover, a characteristic of an investment mentality. Another common characteristic noted in “The Money Masters,” was discipline and patience. This does not mean a “buy and hold forever” decision as the business and investment worlds have changed, not just in relation to technology, but to the higher risk of global competition. Selling highly overvalued stocks, even in great companies, is appropriate. Volatility is higher than 30 or 40 years ago, so a 25% turnover ratio is not excessive. Good valuation disciplines are important and it leads to lower turnover in some years and higher in others, usually near market valuation extremes.

Adopting and executing a disciplined investment philosophy and decision-making process is the cornerstone of superior long term investment returns. This is very easy to say and yet difficult to implement at investment firms. Staying true to your philosophy when your style is out of favor in the current market environment and facing one or more years of underperformance becomes even more challenging as client pressures for better relative returns increase. The fear of losing clients and revenues can result in diluting your disciplines to avoid the consequences of possible loss revenue. Although a change could result in better short term relative returns, it usually occurs toward the end of any speculative excesses. Thus when the cycle ends, the end result is short term underperformance becomes a greater long term problem. Some will argue that this pressure is better understood than 30 years ago and I would agree to some extent. However, human nature does not change totally. For example, if you are a consultant that recently hired an investment manager and they subsequently experience short term underperformance, the current short term time horizons will increase the pressure they experience from their clients. Popular strategies advocating greater diversification in styles, including hedge funds, private equity and other asset classes have lessened this risk. However, this solution by itself contributes to average returns through over-diversification and higher fee structures. 

There is no one way to “skin a cat,” so different philosophies can work if executed well over the long term. We do take exception to any approach which puts great emphasis on economic forecasting and specific sector approaches. The evidence is overwhelming that the odds of this approach producing superior long term returns are very low. It is simple fact that no one can predict the economy consistently, especially at key turning points. That also relates to any strategy that attempts to time the stock market. One of the best examples occurred after the speculative excesses in the late 1990s. If you had been able to predict the collapse of the technology and large capitalization growth stock bubble and the subsequent 46% decline in the S&P 500 from 2000-2002, cash would have been favored. Yet due to the excellent values available in the smaller sized quality growth stocks, it was possible to produce very positive returns over those three years. The conventional wisdom that large caps are less risky than small caps did not apply then, due to valuation discrepancy of companies of similar quality. Cash is appropriate when opportunities are not present and/or the risk environment is excessive.

In summary, the reasons for not attaining superior long term relative returns are a result of our own failings which can be controlled. The environment for emphasis on short term performance that has been a complaint since the 1970s has only gotten worse and may not change any time soon. Human nature will not change either. The study of financial history and the repetition of stock market fads and manias is testimony to our short memories. However, the execution of sound disciplines on a consistent, long-term basis, as well as a healthy, independent, and contrary mind can go a long way toward improving our record.

­January 2012                                                                                              James F. Jollay

Every kid loves a birthday party, especially their own, and all kids get fired up about birthday cake!!!! Without birthday cake there might be no party at all, which is why it is served at the end. The following birthday cake allegory encapsulates the utter collapse in US consumer confidence, the stunning number of apocalyptic queries- e.g. “Should I sell all my stocks?” and S&P’s downgrade of the United States’ debt rating.

Congress consulted with experts and decided to drop in on a kid’s birthday party; they were there to help. After everyone sang “Happy Birthday” and the candles were blown out, Congress swiped the cake. The kid threw a tantrum as he had every reason to expect cake on his birthday. Some members of Congress explained, “Your parents have bad cases of diabetes. They are probably going to die from diabetes related complication unless they change their lifestyle.” Because the kid had been worked up into a tantrum, the only thing he heard was, “My parents are going to die!” and this greatly exacerbated the tantrum. Other members of Congress added, “You are genetically predisposed to diabetes and you should start avoiding sweets. If not, you might die from diabetes related complications.” Again, the kid was in such a state that he only heard, “My parents are going to die and I am going to die!?!?!”

Wrong Message! In our opinion the Congressional handling of the debt ceiling put people into a mental state where they heard, “The US economy will crash and burn, because it is bankrupt!”

Wrong Time! After an economic recovery has been underway for a while, there is always a pause before growth resumes. In our opinion the economy was queued up to pause and for economic figures to weaken a bit. The economy had been in steady recovery for almost two years, so it was naturally tired. Japan, which has the third largest economy in the world, experienced horrific earthquake, tsunami, and nuclear reactor catastrophes. North African governments were being overthrown. European issues were coming to a head. The price of gold was screaming higher. With that backdrop, the Congressional behavior was appalling and weakened a sluggish economy!  

It is no wonder that we were drawn into so many apocalyptic conversations, in both social and professional settings. And those conversations occurred before the big market drops in August. This is not to say that the US debt and budget issues are not important. They are of critical importance. Generational changes are an especially interesting topic for discussion in that regard. Many consider the Baby Boomers to be fiscally childish as their use of debt has left the majority unprepared for retirement. Generation X leaders seem to be primed to make sweeping reforms. Perhaps it is worth a healthy debate about the likelihood of Generation X leaders making the tough choices that prior generations would not.

Our optimism about the future of the United States is unwavering. Even if Markel Corporation helps bail out Greece by buying the island of Crete and recreating Utopia, we will still think the USA is the best place in the world. America is indeed “The Land of Opportunity” and the culture primes the pump of innovation. We attract the best, the brightest, and in many cases the bravest. As we have said before, “our Asians are better than Asia’s Asians, our Mexicans are better than Mexico’s Mexicans, etc…” In many cultures, failure results in deep stifling shame; in the USA, entrepreneurs are expected to fail a few times before succeeding. We have heard from biotechnology analysts, but have not independently verified, that the rate of attempts to discover a new drug has been remarkably steady over the past several decades despite ebbs and flows of policies discouraging or encouraging the pharmaceutical industry. This anecdote and others suggest the innovative American Spirit cannot be altered even in face of abominable politics.

Speaking of birthdays, I recently turned forty. A friend gave me a collection of magazines that were as old as I.

Notable stories included:

Too much violence and advertising on TV is turning kids into violent, mindless consumers.

China policy is awful (Nixon surprised everyone there); Vietnam is a disaster.

New regulations and centralized trading are going to cause Wall Street firms to go out of business in droves. New York City will never be the same. (They said this after 9/11 and were equally wrong!)

The test tube baby is a viable concept.

Advice on how to find a job: Dark Clouds Over the Land of Opportunity and A Grave New World.      

There were advertisements for:

Cigarettes and Liquor (in abundance and often with sexual appeal).

Kodak Instamatic, Polaroid 400s, Smith-Corona typewriter, Marchant portable calculator.

Trim Jeans- guaranteed to reduce your waist, tummy, hips and thighs by at least 6 inches in 3 days!

BankAmericard- (one of the first credit cards) – “Think of it as money.”

No one could have predicted the innovations that drove the next 40 years, 20 years, or even 10 years. The US GDP cracked the $1 trillion mark in 1970. Such a number may have been as inconceivable in 1930 as today’s $15 trillion run rate may have been to someone in 1970, and as $225 trillion in 2050 seems now. In the forty year periods of 1930-1970 and 1970-2010 there were several wars/military conflicts, seven recessions, and many more than seven financial crises. Just because you cannot see how the economy will grow doesn’t mean it will not grow. For most it is simply distressing to be confronted by the fact that the future is unpredictable.

We are constantly confronted that our predictions about essentially everything are wrong. One of the most patently wrong predictions was in 2007 to think that Apple might earn $10-12/share in 2011 (Apple will earn about $27/share). Yet because we were wrong in the right direction, there is a tendency to think “Hey, they really got the Apple story right…” Wrong! We continue to believe that being owners of great companies is the primary way to create wealth. We look forward to seeing what great companies come up with next.

It is always difficult to purchase any asset when fear is present. However, for longer term investors, it is an opportunity. To quote a great investor, Sir John Templeton, “To buy when others are selling and to sell when others are euphorically buying takes the greatest courage, but provides the greatest profit.” If we were to add one other thought, it would be that patience will also be required as the current problems will not be solved overnight.

One of the things that many legendary music groups are able to do is to play a song that ends with free form riffing and morph the riff into the beginning of another song. The transition happens gradually such that in the free form riff the musicians will play a cluster of notes that are not definitively the melody of another song but are the basis from which the new melody can emerge. Then the next thing you know the music group is playing a different song.

In June of 2009, not long after what proved to be the stock market bottom we wrote: “The prospects for earnings growth in the S&P 500 have never been better, literally. There is a non trivial chance that earnings grow 22% in 2010 and 22% in 2011. We know that earnings for the S&P 500 have never grown by more than 20% for two consecutive years…” It is especially interesting to us that others are starting to note the unprecedented earnings growth that has occurred. (Side note: the lethargic economic improvement seems logically to preclude the revenue and earnings growth that occurred- yet another example of the irrelevance of economic forecasting) Other anecdotes are also signaling that a transition is coming. Small changes in your portfolio are harbingers that we are working our way into playing a different song. We are quite optimistic the transition will not be from “Trucking” to “Going Down The Road Feeling Bad”, a la The Grateful Dead.    

China has been “Trucking” for a long time; however, it may have some really difficult challenges in the coming decade. It was stunning that Reuters reported that up to 3 trillion Yuan of debt (~$465 billion) may be shifted from local governments to the central government. Other reports suggest it is possible that bad debts total a third of the entire county’s GDP! Our general sense is that older Chinese have a hard line communist orientation while younger generations have strongly clashing entrepreneurial views. When my sister toured Tiananmen Square the guide told her that the massacre did not happen. Upon leaving the square the guide apologized that he could not tell the truth because the government had tight surveillance over the area and he would face hardship if he did not stick to the script. Such a culture is not especially fertile ground to spawn innovation. In fact, the only unsatisfied objective in China’s previous five year plan called for innovations in industries dominated by American companies like Emerson Electric and General Electric. A broad review of China’s most recent five year plan bodes well for innovative American companies.

Looking much further down the road, it seems that the world’s population growth may come to a crawl as educational and medical endeavors impact birth rates. A question for the coming century is whether inflation rates will be similar to population growth rates, but we digress. In a low growth environment, it is worth musing about the long term effects of share repurchase programs on the price of the stock. There are large companies repurchasing shares at a rate that if extrapolated imply that all the shares will be repurchased in a few decades. In a reduction by absurdity musing, the remaining share of a company with a market cap of $100 billion has a share price of $100 billion by definition- and some think that Berkshire Hathaway’s stock price is ridiculous. As a practical matter, after unprecedented earnings growth it seems there is likely to be a transitional period of mixed growth followed by low growth. The next song that we will be singing will have a verse about enormously profitable companies with low sales growth but high earnings growth per share due to share repurchases. There will be another verse about how critical innovation is in a low growth environment. Indeed, in a low growth environment there is no major tide to lift all boats. Individual stock selection will be of enormous importance. As always and more than ever, it will be important to “know what you own and why you own it”- perhaps a fitting title for the song.

They say that if you listen closely, preachers give different versions of a few sermons for most of their lives. If that is the case, then our letters would make such sermons look like a variety of variety shows and us like a perpetual repeat of Bob Ross painting “happy trees” on PBS’s The Joy of Painting.

The strong are getting stronger at the expense of the weak. Strong companies were able to reinvest in their businesses, widen the competitive gap, and are garnering an increased share of their now larger industries. But the slowdown also caused growth companies to defer plans for growth and focus on internal efficiencies. The revelations were quite alarming in many cases.

CarMax is one of our “happy trees”, and it has processed well over a million cars to date. The first step in processing a car is to work through a check list of: does the turn signal work, do the windows go up and down, ad nauseam. Until the recession the company grew geographically and financially by leaps and bounds. Such efforts used most all of the company’s resources. It seems no one had time to ask if it made sense for a highly trained mechanic to spend up to an hour working through a checklist that required little, if any, training. As simple as it may seem, using less trained and lower compensated people in the first phases and highly trained and highly compensated people to do the technical work seems to be resulting in an extra hundred dollars or so of profit per “Maxworthy” car sold. If sales reach $15 billion and efficiencies create an extra couple hundred dollars per car, the result could be more than an extra $1 of earnings per share per year. That is about as much as the entire company earned in the fiscal year ending February 2010. When and if CarMax can reach $15 billion of revenue is anybody’s guess. But it is clear that CarMax has much brighter prospects BECAUSE of the recession.

The phases of the behavior cycle seem to be progressing as expected. Several quarters ago a sample of clients indicated that they thought their accounts were worth twenty percent less than was the case. A recent sampling indicated that they thought their accounts were worth ten percent less than was the case. These anecdotes mark the transition from despondence to depression to hope. I expect the next anecdotes will be of clients being on top of account values followed by clients asking if they are up twenty percent for the year yet. These anecdotes would mark the transition from hope to optimism to euphoria and be a signal to be extra cautious.

Despite all the worrying, the U.S. GDP is actually at all time high levels and the economic recovery is fully underway. Europe is the key short term issue and the machinations are innumerable. We are monitoring policy statements, paying attention to the level of rioting, and keeping watch for simultaneous panic across Europe. Planning for the resolution of state and national debt levels is also a short term issue. China is a potential intermediate term issue as their growth has been fuelled by internal construction while other emerging countries are successfully competing for the business of multinational companies. We do not anticipate major long term problems from these issues but each has the potential to trigger a temporary correction in stocks. We will probably survive all these risks in a similar fashion to a country boy’s first navigation through New York City with a paper map. He will feel like it took much longer than it did. There will be a panicky moment when he misses a turn. But he will arrive safely, nearly on time, relieved, and appropriately more confident.

We continue our positive outlook on stocks, although some corrections from the strong September increases should be expected. There are still many investors who remain too cautious on the stock market. This is evidenced by the large purchases of bonds this year by individuals and low trading volumes on the principal exchanges. Given the average earnings yield (the reverse of the P/E ratio) on the S&P 500 of approximately 6.5%, compared to the recent low in the ten year treasury at 2.4%, equities should be favored. Furthermore, corporations have rushed to the bond market this quarter to obtain new debt financing at these record low interest rates, even though in many cases (e.g. Pepsico and Microsoft) there was no need for any debt other than to lock up low cost funds. At current levels of interest rates, it will not take much of an increase in interest rates over the next three years to cause market value declines that will not be offset by the small level of income received for many years. This does not mean double digit returns from equities given the secular economic problems this country faces, but an absolute return of 6%-7% after inflation is a realistic expectation, in our opinion. Our principal worry remains rising protectionism, either through legislative action or in competitive currency devaluations, which result in the same unhappy results of destroying global trade.

We recently completed research trips to the Mid-West and Washington D.C., visiting companies we own and a few we do not. Our conclusions from those trips are as follows:

1) There clearly is a mixed picture, depending on the end markets served and international exposure, but the economy is not facing any double-dip recession.

2) International exposure, especially to the emerging economies in Asia and South America, can be effective in off-setting slower revenue growth from the more developed nations. We have stressed international exposure in our research for the last two years.

3) Those companies we own which are domestic are doing well because of their strong market position. Many are increasing their market share and have new growth initiatives which will give them better revenue growth. Since all of our holdings have superior margins, with little room to improve, this will be a very important factor to monitor.

4) Regulatory changes in the for-profit education space should lead to stronger leaders and fewer weak companies and may provide significant investment opportunities.

Gold has been a headline grabber this year, so I was rather surprised to observe recently that the appreciation in gold fell somewhere in the middle of the pack of all commodity returns for the year. But the main point I would like to make is that our perspective on gold is much less insightful than the perspective of an alien hovering over Earth. From the alien’s perspective: humans go to great lengths to excavate tiny gold nuggets and flakes, intensely purify the yellow metal, melt and pour it into gold bars, stick the gold bars back into the ground, and pay meaningful sums of money to have the gold bars guarded.

Exerpt from 2010 Second Quarter Letter to Clients

Appended to this letter is a summary on the lion’s share of topics that seem to be keeping people up at night. Please call to discuss these any of these issues or to offer additional comments. Last quarter we communicated our expectation that above consensus economic growth would probably materialize in 2010, and at least through the first quarter, this has been dead wrong. Our optimism came from the close contacts we keep with the companies we follow which usually we expect to grow sales at around two and a half times the rate of GDP growth. We have been encouraged by sales growth for the companies we follow, yet first quarter GDP growth was a puny 2.7%. There seems to be one simple explanation for sales growth of our portfolio companies vaulting to more than five times GDP growth: the companies we follow generally dominate their industries. And as we have said time and time again, the strong should emerge from the crisis even stronger at the expense of weaker, more poorly run competitors.

Presumably individual investors are taken by the numerous circulating comparisons to the 1930s and general uncertainty because money continues to flow out of stock mutual funds and into bond mutual funds. Historically their timing is so bad that this is good news for long term investors who can stomach taking an unpopular contrarian view. At the pit of the depression in 1932, President Hoover enacted the largest tax increase in US history; for example, the top marginal tax rate was increased from 25% to 63% – and President Roosevelt later increased it to 79%. Smoot-Hawley increased tariffs on international trade and the economy suffered mightily for these government policy errors. In our opinion the sum total of effects of policies that President Obama has considered would not hold a candle to the policy errors in the 1930s. It is worth further mention that President Obama has been woefully unsuccessful in many critical policy endeavors.

In summary, we view the current situation and market conditions in a favorable light and look forward to catching up with you soon.

Exerpt From 2010 First Quarter Letter To Clients

Coming out of a severe economic recession we think it is “normal” to have a swelling of popularity around an outlook akin to today’s “new normal” (sluggish economic growth with persistently high levels of unemployment). We suspect the “new normal” is rooted in the mantra of “this time it is different,” and that is “normally” wrong. The Chief Economist for DuPont recently spoke at the Richmond Association of Business Economics and commented that the strength of an economic recovery is directly related to the magnitude of the downturn and that the current pace of economic recovery is right in line with what one could project using prior economic cycles. Such a projection yields an expected initial economic growth rate above 8.0%, yet we surmise the “new normal” view only expects economic growth between 2% and just over 3%. It is also interesting how some pundits have stated that the decline in economic activity from inventory destocking was normal, but increase in economic activity from inventory restocking is to be discounted as a temporary event. Either way, we expect 2010 economic growth to be well above the average forecast, though economic forecasts do not affect the long term value we see in your holdings.
It is also interesting to look at the movies that lead box office sales, as an indication of the state of mind of the US population. The top three movies of 2000, presumably with a genesis in 1999 which was preceded by a decade of stellar economic growth and a massive bull market, fit the broad category of “amazing feats of the common man” (Mission Impossible 2, Gladiator, and Cast Away). Yet three of the top five movies of 2009, presumably with a genesis in 2008, fit the broad category of “the innocent suddenly facing the possibility of the end of the world” (Avatar, 2012, and Transformers). As an aside, Planet of the Apes hit theaters at the height of the Vietnam Conflict and was re-released in 2001. Being weary of crowds at extremes, this would normally make for a fine opportunity to identify stocks which inappropriately reflect an end of the world scenario.

The present phases of the psychological market cycle seem to be progressing nicely. Our estimation is that most people have moved past despondency and depression. The next phase is one of hope. I can share that I have had conversations with a handful of clients each of whom estimated their portfolio values to be nearly twenty percent below where they actually were. A great many people were concerned about an “end of the world scenario” as GE’s stock price declined from $40 to $18, and not as many are relieved to see GE’s stock price rise from $6 to $18. But once everyone is relieved, we think the stocks of GE’s and many others will be higher.

Excerpt from 2009 Fourth Quarter Letter to Clients

So where are we now? We are in one of the most exploitable stages of the emotional cycle of investing. We think some people are still despondent, most people are depressed, and some people are starting to feel hopeful. We characterize despondency as a state of mind in which one has an aversion to mental activity, specifically an aversion to thinking about investments. When despondent people start thinking again they become depressed. We characterize depression as a state in which people do not want to own stocks but they do not want to sit on cash; the end is not in sight; change is desired but nothing is trusted; so many questions remain unanswered the problem cannot be solved; turning to experts yields even more confusion because their opinions vary wildly. Asset values have recovered significantly from March 2009 which is requisite for people to move from depression to feeling hopeful. We think the start of feeling hopeful is marked by contemplation of questions about the recovery in stocks being for real or the evidence of stabilization being enduring.

This is one of the most exploitable conditions because we believe:

• Tremendous amounts of information have been garnered since Lehman Brothers went under sixteen months ago (the financial crisis ended, the economy recovered, business has generally stabilized, employment has stabilized, residential values have stabilized, housing has stabilized, energy prices have stabilized, even the commercial real estate crisis seems to have passed the midpoint).
• Yet today with the S&P 500 at 1133, it is 5% below where it closed on the day Lehman Brothers declared it would file for Chapter 11 bankruptcy, credit markets froze, and stocks tumbled.
• Ten trillion dollars is available to flow into equities
• Most people are despondent/depressed

Over the past ten years Wal-Mart’s earnings doubled and dividends quadrupled as the company expanded internationally with masterful success. The stock has basically been flat for ten years with the primary difference being that ten years ago Wal-Mart traded with a PE above fifty and today it trades with an estimated PE of thirteen. It has been a situation where one could sleep well with the company and sleep on the long flat stock chart. Do not be surprised if stocks of the Wal-Mart ilk comprise a portion of purchases in the coming months. Such a thesis may also be timely as it would seem a likely recipient of investment dollars from the newly hopeful.