Letter to Clients: 3rd Quarter 2011

"Money will always flow toward opportunity, and there is an abundance of that in America… Human potential is far from exhausted, and the American system for unleashing that potential… remains alive and effective"

– Warren Buffett, February 2011

"We are telling investors if you're worried about sovereign credits, if you worry about U.S. Treasuries, there may be greater safety in equities, especially high-dividend stocks."

– Larry Fink, June 29, 2011

"In terms of the stock market, there are amazing opportunities… [Compared to U.S. government bonds,] there's a huge gap and a huge differential."

• – Bill Gross, June 7, 2011

"We've almost never seen valuations [on the U.S. stock market] this low when interest rates are as low as they are today… Relative to bonds today, I've almost never seen such compelling values."

• – Professor Jeremy Siegel, June 28, 2011

 

Dear Clients and Friends:

Have you ever seen the headline "Don't panic. Everything will be okay"? I never have but strangely enough, despite many complicated global problems, everything usually turns out okay. The message of calm and peace just does not draw an audience as large as the message of doom and gloom so our news is seldom optimistic.

Given the recent concerns about European debt and uncertainty about economic growth, in this quarter's letter I am sharing recent perspectives from three of today's most respected stock market observers; Warren Buffett, PIMCO fund manager Bill Gross, and Wharton professor Jeremy Siegel.

Before recapping the market so far and getting into their views, some quick housekeeping. I have been updating and improving our database so that we can better customize services in the future. For example, I have had some requests to receive this letter via email instead of a printed copy. That capability should be available before the end of the year. If you prefer an email version instead of a paper copy, please make certain we know of your preference and double check that we have your preferred email address.

Market Performance in the First Half

Developed markets registered solid gains in the first quarter, despite the setback from March's earthquake and tsunami in Japan.

The second quarter was quite a different story with concerns arising from growing inflation threats in emerging markets, sovereign debt worries in Europe, and a downgrading of growth forecasts for the global economy. Below are first-half results for key markets. Note that these are reflected in local currencies, so that the effects of swings in the dollar are not reflected here.

Warren Buffett: "Betting on America"

In November 2009, Berkshire Hathaway spent $26 billion to buy the 77% of rail giant Burlington Northern that it didn't already own. Warren Buffett referred to this as "betting on America". Buffett has been consistent in his positive outlook for the U.S. economy, looking past short-term events to focus on America's ingenuity, resolve, and its ability to attract the best and brightest from around the world.

Buffett is consistently voted the greatest investor of all time. In the 46 years he has run Berkshire Hathaway, annual growth in book value has exceeded 20%, more than twice the gains for the U.S. stock market index. Even more remarkable, Buffett's numbers are after tax while the index's gains are pre-tax. Even though he had lagged in individual years, in his last letter to shareholders, Buffett pointed out that there has never been a five-year period where Berkshire Hathaway has under-performed the S&P.

To put his record in dollar terms, $1,000 invested in the S&P index at the start of 1965 would have risen to $62,620 by the end of 2010. By contrast, the same $1,000 under Buffett's stewardship would have grown to over $4,000,000.

Here is an excerpt from this year's letter to investors, published in February:

Last year – in the face of widespread pessimism about our economy – we demonstrated our enthusiasm for capital investment at Berkshire by spending $6 billion on property and equipment. Of this amount, $5.4 billion – or 90% of the total – was spent in the United States. Certainly our businesses will expand abroad in the future, but an overwhelming part of their future investments will be at home. In 2011, we will set a new record for capital spending – $8 billion – and spend all of the $2 billion increase in the United States.

Money will always flow toward opportunity, and there is an abundance of that in America. Commentators often talk of "great uncertainty". Throughout my lifetime, politicians and pundits have constantly moaned about terrifying problems facing America.

Yet our citizens now live an astonishing six times better than when I was born. The prophets of doom have overlooked the all-important factor that is certain; Human potential is far from exhausted, and the American system for unleashing that potential – a system that has worked wonders for over two centuries despite frequent interruptions for recessions and even a Civil War – remains alive and effective.

Larry Fink: "Greater safety in equities"

The next two experts are not nearly as well known to the investing public, but they are household names among professional investors.

Larry Fink is the CEO of Blackrock, the world's largest asset manager at over $3 trillion. Blackrock's roots are in bond investing. Despite that, here's what Fink said in a June 29 interview with CNBC: "Corporations worldwide are bigger than ever… [T]heir cash holds are gigantic right now… We are telling investors if you're worried about sovereign credits, if you're worried about U.S. Treasuries, there may be greater safety in equities, especially high-dividend stocks, and there may be greater safety in a very high-quality corporate bonds worldwide."

Bill Gross: The case for dividend paying stocks

As manager of PIMCO Total Return Fund, the world's largest bond fund, Bill Gross turned in a track record matched by few others and was named Morningstar Fixed Income Manager of the Decade. In part, this stems from his willingness to take contrarian views: in 2010 he went on record talking about the "new normal" of lower growth, higher inflation, and increased risk in holding debt of governments around the world.

He has recently turned negative on U.S. government bonds, recommending high-quality corporate bonds and Canadian and Australian government bonds instead of U.S. Treasuries. In a June 7 interview on CNBC, he also discussed the appeal of brand-name stocks that pay dividends:

In terms of the stock market, there are amazing opportunities in real interest space. I mean, a Procter, a Johnson & Johnson, a utility company, Southern, Duke, as a whole they yield 3.5% to 4% in terms of their dividend, compared to a negative 0.5% in Treasury space on that five-year. And so there's a huge gap and a huge differential if an investor is willing to take a minor downgrade in terms of credit.

Corporations are in the catbird seat. They've got cheap financing, cheap leverage. They've got cheap labor and the ability to move from one country to another at their will. And so corporations basically have done very well, will probably continue to do very well.

Gross did add a note of caution:

But to expect their margins to expand at the expense of labor here in the United States, at the expense of laying off additional workers, relative to their wages, real wages, and their total nominal wage growth I think is an unrealistic expectation. I think corporations basically are at the top in terms of profit margins. Doesn't mean that stocks are going up or down. It simply means that the catbird seat basically has been taken advantage of and that the heyday is probably in the past as opposed to the future.

Jeremy Siegel: "Why valuations are attractive"

The final expert is Wharton's Jeremy Siegel, considered today's leading stock market historian. His book Stocks for the Long Run examined 200 years of financial market performance and has been ranked as one of the most influential investment texts of all time. Among Siegel's claims to fame is a March 2000 Wall Street Journal article about the excesses in tech stock valuations at the peak of the Internet bubble.

In a June 28 interview on Business News Network, he explained why he is bullish on U.S. stocks: "We've almost never seen valuations [on the U.S. stock market] this low when interest rates are as low as they are today… relative to bonds today, I've almost never seen such compelling values."

And here's why he, like Bill Gross, likes dividend-paying stocks: "History shows that dividend-paying stocks beat inflation and are good investments for income, especially in the early stages of a financial recovery such as we see today. The top 100 dividend yielding stocks of the S&P 500 over the last half century beat the index by 2.5% and did so with lower risk."

What all of this means

In today's low interest rate environment, it is hard to make a compelling case for cash except as a portfolio diversifier and as a source of liquidity. As for bonds, Bill Gross represents the growing sentiment that the risk in bonds is rising as economies recover and interest rates start to rise.

When it comes to stocks, it does not matter if you adopt the "lesser of two evils" view of stocks as opposed to bonds like Larry Fink and Bill Gross, or join Warren Buffett and Jeremy Siegel in embracing stocks more enthusiastically, there are clear values to be found in stocks.

For almost two years, I've tilted the equity component of client portfolios toward stocks with strong cash flows and prefer strong dividends. These "higher-quality" positions have not always outperformed firms with weaker balance sheets and low or no dividends. In 2008, all stocks dropped dramatically regardless of quality. Since the spring of 2009, we have seen a rally in highly leveraged firms which have benefited from the low interest rates. I don't believe that's likely to continue, as over time quality stocks will outperform.

Despite popular media, there are excellent opportunities that exist in the investment marketplaces. Should you have any questions about your portfolio, this letter, or any other issue please give me a call. I would be happy to answer your questions.

In the meantime, I thank you for your trust and confidence. Use us as a resource. We are here to serve you.

Sincerely,

Art Dinkin, CFP®