Market Commentary

Bears and Sheep

December 2008

"Bulls make money. Bears make money. Pigs and sheep get slaughtered." - Anonymous

We write at the beginning of a year where economic direction is now clearly negative. We are a year into what we expect will be both a deep and long recession, deeper and longer than most we have all lived through. This recession in large part was caused by credit being too easy for too many people and companies for too long. Now we are in the conundrum of credit being too hard for both individuals and businesses. The government is taking actions aimed at making sure credit is appropriately available again, as well as to sustain spending to support employment. From an individual perspective, the nation's consumers are in retreat, and a new (and positive) reality may be developing in that we are going to be a nation of savers again. In short, our entire economic system will need time to come back into balance.

Your portfolios took it on the chin last year. While they generally outperformed on a relative basis, the absolute losses remain dramatic. Our bearish stance which we began to take in the end of 2006 helped guard you somewhat from the worst the market had to offer last year – stock and real estate market declines in the range of 37%-43%.* While we expected stock declines in 2008, the extent of the negative returns in the market and your portfolios was a surprise to us and we don't like it one bit. We were bearish but as it turned out we were not bearish enough.

The next question of course is, where do we go from here? For a period of time we've written to you regarding our bearish stance and the fact that we didn't want to be greedy – the 'pigs' of the quote above. We started making a significant reduction in international stocks a year early. We began to sell energy and commodities many months ahead of their peak. Those asset values have since declined to an even greater extent than U.S. stock and bond values. This leads us to recall another favorite saying from Bernard Baruch, the noted early 20th century investor and presidential adviser: "I made my money by selling too soon." We would rather be too early than too late. Now that we are looking at the second-worst 10-year trailing return in the 200 year history of the stock market, with fear at every turn, we are counseling you not to act like sheep. This means not following the crowd who assume the trend of the past year will now continue undisturbed into the future.

The investment changes we made in your portfolios this fall were intended to position you for the volatile and uncertain market of the coming years. First and most fundamentally, the mutual fund managers your money is invested with are investing in good businesses. They invest only when they have a high degree of confidence based on fundamental research and experience that these businesses will produce real profits, and not need access to additional capital even in a very tough economic environment. They are not investing based on macro themes, promises of unit growth, or good relationships with management. They are investing based on what kind of cash a business can reasonably produce when run by a management team that has already done the job of navigating well through difficult times.

We are confident that the companies your mutual fund managers are investing in are good companies that will be well positioned to survive this rough economy. This fall, stock prices generally fell in tandem. But, as your core managers remind us, there is a big difference in your investments between price volatility and permanent capital impairment. We think your investments certainly have seen price volatility, but we don't think these assets are permanently impaired. In fact, we think the single thing that could impair your assets the most would be to sell good investments at depressed prices.

We are heartened to see these same managers active in the evaluation and purchase of corporate bonds, even in what remain principally stock-oriented investment vehicles. Their thinking, which we agree with, is that if a corporate bond can be acquired at a significant discount (i.e. it is 'on sale'), and they are confident that the company can make its bond payments, why not take the bond coupon and enjoy the appreciation in the price of the bond for a year or two? We think this is prudent investment behavior. It takes a degree of risk out of the portfolio, and could very well in the end enhance your returns by providing cash flow for your portfolios regardless of the direction of the market.

Whither the market in 2009? We return to Bernard Baruch, who when he was asked in the 1930s what the market would do, he famously said: "It will fluctuate." It's true. We know that for sure. Similarly, Bruce Berkowitz, the manager of the Fairholme Fund, which many of you own in your investment portfolios, said the following recently when asked about the direction of the market in 2009:

"I don't mind tough questions but this is an impossible question. There are two ways to invest – either predicting or reacting. I admit I have no skill at predicting. To predict would be foolish, so we react. We invest based on free cash flow relative to the price of a stock.

"We could be bouncing around the bottom of the market. But I don't know whether the true bottom will come in 31 days or 31 months. Prices today are as attractive as I have seen in my career and it will be worth the wait for the market to deliver the true value of these companies."**

In the end, we can only invest in what we know, and what we can fundamentally ascertain. We believe there are good returns in store for these investments which are made in the stocks and bonds of fundamentally sound and cheap companies. In an environment where everyone seems to be selling, all evidence points to staying invested and waiting for the market, like the economy, to come back into balance. As that happens, we think your portfolios are positioned appropriately. To the extent that the market psychology remains negative, your portfolios could certainly weather further hits. We believe, however, that you are well-positioned for a variety of outcomes, and we are looking forward to a more stable future.

This is a general assessment of client portfolios and does not reflect the specific circumstance of every client.

* 2008 Performance: S&P 500 -37%, MSCI EAFE -43%, NAREIT -37%
** Quoted in the newsletter "Advisor Perspectives," January 6, 2009