Y H& C November Investment Newsletter

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Y H & C Monthly Newsletter- November 2009 Edition #18
Index Yearly Return
Dow Jones +10.67%
S&P 500 +14.72%
Nasdaq +25.30%
Russell 2000 +12.68%
October 2009 Picks +0.68%
September 2009 Picks +2.95%
August 2009 Picks +9.13%
July 2009 Picks +23.33%
June 2009 Picks +24.86%
May 2009 Picks +30.75%
April 2009 Picks +61.28%
March 2009 Picks +94.12%
February 2009 Picks +118.2%
January 2009 Picks +63.78%
Y H & C December 08 Picks +142.58%
Y H & C November 08 Picks +42.32%
Y H & C October 08 Picks +9.85%
Y H & C September 08 Picks +0.78%
Y H & C August 08 Picks +7.44%
Y H & C July 08 Picks -2.13%
Y H & C June 08 Picks -31.36%
Y H & C May 08 Picks -31.06%

US Economic & Financial Markets Outlook: “The Great Recession,” The Unanswered Question, and All Asset Classes Have Issues.

During the month of October, the Dow Jones Industrial average gained .45%, the S&P 500 lost 2%, the Nasdaq lost 3.6%, and the Russell 2000 lost 6.9% (according to the October 31,2009 issue of Barron’s). The U.S. economy continues to try to rebound from the “The Great Recession,” or the worst economic period since the Great Depression. Many economic statistics indicate the country has serious problems that have not yet been solved. For example, the unemployment rate stands close to 10%, and in many states it is over 13% (here in Nevada, the official number is 13.9, but unofficially it may be closer to 20%). Over the last year, approximately 7 million jobs have been lost. The U.S. Government is running an annualized deficit of approximately 1.5 Trillion dollars (that is with a T, not a B, or an M). Most state government are still running large budget deficits and will have to eventually cut jobs, salaries, and benefits (probably all three) in order to become close to break even.

Over the last year, GDP growth has been negative. Corporate profits are typically running on average down about 10% for the last year. In many industries, there is significant overcapacity and probably will continue to be so in the foreseeable future (gaming, retail, anything housing related, oil and gas exploration, engineering, state and local governments, commercial real estate- as a personal anecdote, the owner of the Venetian in Las Vegas recently said he does not think a large gaming project will be built in Las Vegas for the next 10 years).
The country also faces issues with its lack of a pipeline for high value, intellectual property based employees. The United States has a great many incredibly profitable corporations that are market leaders in high value industries like engineering, consulting, computer science, software, biotechnology, pharmaceuticals, nanotechnology, etc. In order to maintain the country’s competitive position, our educational system has to improve the quantity and quality of the students who can possibly enter into these areas.

As a response to the current economic conditions, the U.S. government has been trying to keep economic conditions as favorable as possible, especially for U.S. financial institutions. If you look at current U.S. Treasury bond yields, the 30 yr Treasury bond has a yield of 4.28%, the 2 year note has a yield of .92%, and the 3 month note has a yield of .03%. Consider this possibility if you are a large multicenter bank- you borrow for 3 months at .03%, and invest the proceeds into U.S. Treasury Bonds for 30 years at 4.28%. Your spread is 4.25%, which is greater than the dividend yield on an S&P 500 Index fund (approximately 2%). If one looks at the profits the large banks had in trading, I am not saying they used this strategy, but maybe something like this- (remember, they are investing multiple hundreds of millions of dollars).

So a real quandary economists and investors have is which market has it right, the bond market or the gold market? Gold currently trades at about $1035.00 per ounce, very close to an all time high. Bond yields for U.S. treasury bonds are historically very low, as stated earlier. High gold prices are typically an indication of large inflation rates, while low bond yields suggest no inflation pressures in the economy. If there were tremendous inflation in the system, bond yields should be closer to 10% or 15%. Maybe it is possible both markets have it a bit right and a bit wrong?

Lastly, consider the plight of an investment manager trying to pick where to put capital. Cash yields little to nothing, and so do money market accounts, so if inflation pops up, an investor gets a negative real return. Bond yields are minimal, and do you want to loan money at low rates where at the very least, potential defaults are increasing, and maybe even worse, you tie your money up for 30 years at 4% with the risk of interest rates or inflation rising? You think, maybe commodities because of emerging market demand? The issue here is possibly weakening demand in mature markets, which compose most of the demand in the first place. Real Estate you say, as in many markets prices are down almost 50%? Other investors believe real estate won’t see capital appreciation for another two years (or more) because of the overbuilding issues and the yet to come foreclosure wave. See where I am headed? My answer is to try and find the stocks of good companies at good prices and watch them grow.

Global Economic & Financial Markets Outlook: A Look All Over the World, and What to Bet On in The Global Economy.

A key point about investing money in the quest for higher return is the idea of relativity. Everything can be compared to something else to give you a better understanding of how you are doing. For example, if my portfolio dropped 10% last year, one might consider that a poor performance. However, if you compare a drop of 10% to the performance of most major indexes where the average loss is 35%, 10% does not look too bad. Hedge funds are called hedge funds because most of them are structured to make money in any kind of market, which is the idea of absolute performance. There are all kinds of hedge funds and an abundance of different strategies that are employed, but typically it involves “selling short” a percentage of stocks to offset the stocks that are held in long positions. Just because a fund is called hedge fund does not mean they will be successful. Many hedge funds had to liquidate assets and had negative returns last year because of the extensive use of leverage. My point is every asset class or investment style can use the idea of relativity to get a gage on performance.

For example, let’s look at how the Global Dow Jones Industrial Index is performing this year versus various country indexes across the world. The Global Dow is up about 20% during 2009. By itself, this looks like a very good result. However, if that number is compared to the China Shanghai index of +80%, or the Bombay Index (India) of +65%, or the Bovespa Index (Brazil) of +65%, or the DJ Russia Titans Index (Top10 companies in Russia) of +50%, and the Tel Aviv Index of Israel +40%, the Global Dow does not look so great.

However, if you compare DJ Global Index number(+20%) to the Nikkei Index of Japan +15%, or the Swiss Market Index (+3%), or the Euro 50 Index (+5%), the Global Index looks pretty good. Comparing the DJ global index to indexes in emerging markets, the JSE/FTSE all Africa index was +25%, and the Nigeria Index was -40% (interesting place to invest because of the oil factor, you would think) is a mixed bag. How about comparing the DJ Global Index to Iceland, where the currency was devalued? Iceland was down 60% during this year, which makes me wonder if Iceland is not worth investigating a bit more. Anyway, the point I am trying to make is comparing your performance to other indexes, a hedge fund, different parts of the world, or just large indexes in general give an investor a better understanding of how they are performing, and possibly where to look for investments in the future.

My take on global investing is the continuing growth of consumerism in large foreign countries will be a secular theme that will not change for many years. I want to invest in large U.S. based companies that are targeting countries like China, Russia, Brazil, India, Egypt, Indonesia, and Nigeria because I believe the consumers in those countries are going to benefit from their higher income levels and participate by wanting to increase their standards of living. In my opinion, global brands that are well known are only going to grow bigger and more profitable.

The Psychology of Investing: How Serious Was Last Year, and Warren Buffett and Li’L Abner Show Us Why Holding On To Winners Could Make A Huge Difference in Your Portfolio.

In order to be a great investor, I believe you need to constantly keep learning. Typically, this involves reading about what has gone on in the market, what is going on in the market, how market participants see the market, and who is buying (and why) and who is selling (and why). In my opinion, and I keep going back to this, last year was a once in a lifetime kind of year where no matter who you were, or what you did, you were going to have terrible returns, unless you were short everything or had everything in cash. In reading a book by the NY Times Dealbook columnist Andrew Ross Sorkin, (“Too Big To Fail,” Page 3, The Viking Group, 2009), just look at this quote by Jamie Dimon, the CEO of JP Morgan Chase (This is the week before Lehman Brothers failed and he is talking to his top two dozen members of his management team, to give you some context:
“Here’s the drill,” he continued. “We need to prepare right now for Lehman Brothers filing (bankruptcy). Then he paused. “And for Merrill Lynch filing.” He paused again. “And for AIG filing.” Another pause. “And for Morgan Stanley filing.” And after a final, even longer pause he added: “And potentially for Goldman Sachs filing.”

When an investor thinks about those possibilities, it puts the current situation in a perspective that maybe the world was very fortunate. Markets have recovered from the Lehman bankruptcy and the world is dealing with (so far) the government takeover of AIG. The other large investment banks survive, in a different form for sure, but they have survived. All in all, as an investor continuing to learn about past events should help lend perspective to the current economic environment.

The current theme in the investment world is to always take profits when you can. I think much depends on the situation an investor is, but I am not a big believer of that philosophy, especially if you own stocks that have done very well for you. In many cases, stocks can generate wealth for many decades, not just a 20% or 50% return. Sometimes I have wondered would it have been better to sell and take large gains when I could. However, let me share with you a story Warren Buffett uses to explain how he thinks about taxes and selling versus selling after a long period of holding a stock.

“Through my favorite comic strip, Li’L Abner, I got a chance during my youth to see the benefits of delayed taxes, tough I missed the lesson at the time. Making his readers feel superior, Li’l Abner bungled happily, but moronically, through life in Dogpatch. At one point he became infatuated with a New York temptress, Appassionatta Van Climax, but despaired of marrying her because he had only a single silver dollar and she was interested solely in millionaires. Dejected, Abner took his problem to Old Man Mose, the font of all knowledge in Dogpatch. Said the sage: Double your money 20 times and Appassionatta will soon be yours (1,2, 4, 8, ….1,048,576).
My last memory of the strip is Abner entering a roadhouse, dropping his dollar into a slot machine, and hitting a jackpot that spilled money all over the floor. Meticulously following Mose’advice, Abner picked up two dollars and went off to find his next double. Whereupon I dumped Abner and began reading Ben Graham.
Mose clearly was overrated as a guru: Besides failing to anticipate Abner’s slavish obedience to instructions, he also forgot about taxes. Had Abner been subject, say, to the 35% federal tax rate that Berkshire pays, and had he managed one double annually, he would after 20 years only have accumulated $22,370. Indeed, had he kept on both getting his annual doubles and paying a 35% tax on each, he would have needed 7 and 1/2 years more to reach the $1 million required to win Appasssionatta.
But what if Abner had instead put his dollar in a single investment and held it until it doubled the same 27 and ½ times? In that case, he would have realized about $200 million pre-tax or, after paying a $70 million tax in the final year, abut $130 million after tax. For that, Appassionatta would have crawled to Dogpatch. Of course, with 27 ½ years having passed, how Appassionatta would have looked to a fellow sitting on $130 million is another question.”

The Essays of Warren Buffett: Lessons for Corporate America, Lawrence A. Cunningham, First Edition, Pages 230-231, Copyright Lawrence A. Cunningham, 1997 and 2001.
Notice nobody from the trading desk or the Fast Money Show on CNBC will mention something like this. Might be a reason Buffett is the wealthiest guy in the world? Maybe he thought about these things a bit and reckoned it was worth a person’s while to find a company that might double 27 times. Gee, maybe that is why so many people spend so much time on finding stocks. Finally, if you are interested in sharing with me your current investing situation or are a bit stumped with your portfolio, please send us an email, and as always, if you have any comments, questions, or concerns, certainly contact me at info@y-hc.com.

As always, on any company mentioned here, past performance is not a guarantee of future returns. One should research any investment and make sure it is suitable with your objectives, risk tolerance, risk profile liquidity considerations, tax situation, and anything else pertinent to your financial situation. Also, the CFA credential in no way implies investment returns will be superior for any charterholder.

Yale Bock, CFA
President, Y H & C Investments