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Letter to Clients: 4th Quarter 2011

"This country comes back. We came back from Pearl Harbor, and we're coming back now."

—Warren Buffett, on Charlie Rose, Sept. 30, 2011

"You can't count out the largest, the most innovative economy in the world. The U.S. has the economic, political, and legal constitution…to solve issues. Those factors aren't apparent in the Far East; they aren't apparent in China."

—Jim Leech, CEO, Ontario Teachers Pension Plan

I knew precisely when third quarter statements started arriving in mailboxes. It was moments before my phone started ringing off the hook. I cannot remember a particular quarter where so many clients got so nervous. The third quarter ended with a thud and the statements reflect that. But we cannot look at the account value of a single day and jump to a conclusion about the portfolio in its entirety or the markets as a whole. Fortunately, the fourth quarter is starting with enthusiasm.

Each quarter, I attempt to provide perspective on the last 90 days. To do this I have selected two sources. One is a 30-minute interview with Warren Buffett that was on PBS Friday, Sept. 30. The other was a September panel discussion, "The End of America?", moderated by CNBC's Maria Bartiromo and featuring four market experts with long experience and outstanding track records:

  • Larry Fink, CEO of Blackrock, the world's largest asset manager
  • Pierre Lagrange, a highly respected hedge fund manager based in London
  • Jim Leech, head of Ontario Teachers Pension Plan, a leader among global institutional investors
  • Meredith Whitney, an investment analyst who was among the first to identify the looming problems for U.S. banks

Before focusing on the themes emerging from Buffett's interview and the panel discussion, let's recap the third quarter.

Market performance in the third quarter

This has been a year of contrasts, starting with a first quarter that saw strong increases, with the second quarter flat.

The third quarter was ugly with a capital U, with extreme volatility and the sharpest decline since the first quarter of 2009 when we were in the throes of the global financial crisis. The main drivers of this decline were sovereign debt worries in Europe and a dramatic downgrading of growth forecasts for the global economy, a slowdown in China, and mounting talk of a double-dip recession fueling anxiety.

Here are results for key markets. These are in local currencies, so the effects of swings in the dollar are not reflected here.

I once heard someone remark, "Jet airplanes do not have rearview mirrors." which tells us we need to focus on what may be ahead. Four themes emerged from Warren Buffett's interview and the September panel discussion—the real challenges facing the U.S. and Europe; confidence in America's ability to respond to those challenges; the cost of risk avoidance in investing; and the opportunities for solid companies in the period ahead.

Theme 1: Challenges for Western economies

The first theme relates to some of the troubling issues facing the United States and Europe. None of the experts sugar-coated the real challenges ahead.

Warren Buffett on the challenges for Europe:

"It was clear well over a year ago that we were headed towards a cliff…. [Europe] tried a grand experiment where the imperfections in it are becoming manifest and the numbers are big…; the solvency of the banks is intertwined with the solvency of sovereigns and vice versa…while they melded the currency for 17 countries, they didn't meld the culture; they didn't meld the fiscal policy."

Jim Leech on dealing with uncertainty:

"It's tough to know where to have conviction in this market. In my lifetime never have we been so vulnerable to the whims of policymakers in the U.S. and in Europe, and nobody has figured out where the consensus is and where they're going, they're not united."

Larry Fink on the role of government:

"I don't think this environment is any different than the 1970s. In the 1970s, the United States was worried about Japan. We really questioned the vitality of this country. We were questioning the kinds of things we were manufacturing. We had Watergate, the oil crisis, and during those 10 years the S&P was up 1.5% a year and yet corporate earnings were up 12% a year during those 10 years.

"The same thing is going on now, where we're seeing earnings growth, but we're obviously seeing a flat market, and a lot of it has to do with the uncertainty around government, very similar to the 1970s. As investors in the 1980s and 1990s and the first part of this past decade, government was not part of our thought process, and now we're trying to get rebalanced. Today we don't even know what the foundation is."

Meredith Whitney on U.S. housing:

"What really powered the U.S. economy for the past 20 years was housing. The biggest structural unemployment problems are in those states like California and Florida that were wed to housing. Housing's not coming back, and it's hard to imagine housing becoming a driver of the U.S. economy going forward."

Theme 2: The end of America…or a new beginning?

Despite the issues facing the country, there was broad consensus about America's ability to make the changes needed to compete.

Warren Buffett on a double-dip recession:

"I don't buy that we're going into another recession…. I'm looking at 70-plus companies—they're not galloping, but there has been no downturn except for construction, which is on its rear. We have a wonderful economy in the U.S. …. This country comes back. We came back from Pearl Harbor, and we're coming back now."

Jim Leech on why the U.S. will adapt:

"When I got this topic, I sat down and said, 'Maybe America is in its denouement.' And then you sit back and look on a relative basis and say, 'No, you can't count out the largest, the most innovative economy in the world….' The U.S. has the economic, the political, and the legal constitution to have the flexibility to solve issues.

Those factors aren't apparent in the Far East; they aren't apparent in China. We don't have a democratic government in China. We're not sure how the laws work. …I think it would be foolish to go rushing off thinking the solution is totally in China and India."

Larry Fink on opportunities for U.S. companies:

"Today we have opportunities that our corporations never had…. At a time when our country is not doing as well, our corporations are doing quite well by building and manufacturing products, selling products to the emerging world…. People forget that we are still the largest exporter in the world. We just happen to be the largest importer in the world by a little more.

And so having a stronger world actually is stabilizing this economy. It's not hurting this economy; it's providing the engine for stronger corporate growth… in most cases, when selling products overseas creates jobs here too. And it is a myth that all of these jobs are being exported overseas."

Meredith Whitney on emerging markets within America:

"You have incredible opportunities that are created outside the U.S. that actually help the U.S. get out of its morass…

"Every generation the U.S. re-creates itself economically…. We're doing that now, even though it's a painful process…. If you look at the strength in America, agricultural rich states, what I call the emerging markets of the U.S., which also have the cleanest balance sheets, you have 22% plus growth dynamics. What they're really doing now is attracting businesses, attracting jobs. You've got incredible job opportunities, growth within these markets."

Theme 3: The price of avoiding risk

One topic that got a number of comments was risk avoidance as the paramount objective for many investors.

Larry Fink on the biggest risk for investors:

"I would avoid 2% Treasuries—it's very hard to make a living earning 2%. So if I had to look where to invest, I would own a core amount of Treasuries just for liquidity purposes, and I would be looking towards dividend stocks. I would be looking towards credit opportunities. Especially with the European banks selling assets, there are going to be some great credit opportunities for investors in Europe. The greatest worry I have is under-investing and destroying your foundation, and I think that will be the greatest risk in the next few years."

Pierre Lagrange on being ruled by fear:

"There are quite a few sectors like the Swiss franc that make no sense, where you're only there because you're scared of everything else—and that always backfires."

Theme 4: Opportunities in global markets

Another area on which experts agreed was that valuations make U.S. and European stocks exceptionally attractive.

Warren Buffett on buying back Berkshire shares:

"When we buy back our own stock, we are intensifying our interest in mostly American companies…. Each shareholder will own a greater percentage of Burlington Northern, a greater percentage of GEICO."

Pierre Lagrange on the upside for European companies:

"Europe is making adjustments at the political level structurally, which is very good. What's less accepted is [that] the return on capital employed is really very strong.

"Since 2008, [companies] have really had the license not to spend money. And you have had an extraordinary drive to productivity increases and cost rationalization, so we have a lot of companies which have an extraordinary operating leverage. Now in some areas of the most cyclical nature, it is going to be eaten away by raw material increases, but in other areas you are going to be very strongly, [positively surprised] by the earnings of these companies, which is sort of defying expectations in quite a few industrial and consumer stocks."

Larry Fink on European multinationals:

"We're of the view that European companies are probably a good place to invest. They're benefiting like U.S. companies—the Siemens, the Nestlés— we're talking about companies with incredibly low valuations now that are benefiting from the world. They're being harmed right now because of the instability in Europe, but I do believe that over a longer cycle you will benefit from owning those companies.

"Investors worldwide are diversifying. I think that is one thing we have to accept as a nation. The world going forward—because of the successes of South America and China and India—the world has a greater ability to diversify than ever before. There's going to be a bias toward more global investing, less dollar-oriented investing."

Jim Leech on investing in Asia:

"The rise of Asia and the east has helped us a lot in the last number of years, and it will continue to grow. But it's not a place to go rushing into right now; there have to be fundamental changes in their political situation, their legal regime before you can feel comfortable putting a lot of money on the ground there…. Doing it from afar is a lot easier."

What this means to you

The key points that emerged from Warren Buffet's interview and from the panel reinforced the conversations I have been having with clients over the past year. Clearly we should be cautious given the challenges ahead, but for those investors who need growth to achieve their long-term goals, we also need to take a longer view on outstanding companies available today at inexpensive prices.

The panel's consensus that the best opportunities are in solid, high-quality companies paying substantial dividends is one that I agree with as well. I also subscribe to Larry Fink's suggestion that for investors with cash on the sidelines, now is the time to start putting some of that money to work. Yes, there will still be ups and downs in the short term. But I believe there is amazing potential soon to be realized in the markets.

One final point pertains to anyone who doubts America's ability to compete. Each year, Britain's Financial Times ranks universities around the globe on quality and reputation. In its last ranking, the U.S. held the top five and 15 of the top 20 of the world's universities. For all of its challenges, the best and the brightest talent is still clamoring to come to the U.S.—a testament to America's ability to do what it takes to compete and to maintain its global lead.

As the year comes to a close, I will be looking at how investment portfolios are positioned. Should you have any questions about your portfolio, the contents of this note, or any other issue, please give me a call—I would be happy to answer your questions.

In the meantime, here are links to Warren Buffett's interview and to the panel discussion

Warren Buffett on Charlie Rose: http://www.charlierose.com/view/interview/11919

September panel: http://video.cnbc.com/gallery/?video=3000045524

As always, thank you for your trust and confidence. I am here for you. Whenever you have questions, I am happy to take your call or meet with your personally.

Best regards,

Art Dinkin, CFP®