Letter - February 2011





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Cyclical Recovery

Fourth quarter 2010 GDP has recovered to its pre-recession levels according to the Wall Street Journal. The United States is clearly in a cyclical recovery. Corporate earnings are rebounding sharply, investment is trending up and Wall Street is again witnessing a resurgence of takeovers and acquisitions. The bailout of banks clearly stabilized the financial system. It is controversial whether fiscal stimulus delayed or accommodated the recovery. More certain is the fact that the historic easy money policy of the Federal Reserve has forced capital to seek a return in riskier assets like stocks, junk bonds and commercial real estate.

Stock markets worldwide rallied from the 2009 low as it became clear that systemic failure was going to be avoided.  In the US, the market continued to rally in early 2010 as recovery was anticipated but gave back gains as fear of a double dip in economic activity took hold. Those fears dissipated again in September, which led to a second year of double-digit gains in the stock market as it anticipated the 3.2% gain in fourth quarter GDP. Overseas, stocks in emerging nations did well in 2010 as growth continued strong while economies in developed nations struggled to come out of recession.

The US stock market is off to another robust start for 2011. Corporate earnings reports for last yearís fourth quarter are coming in strong. Guidance for 2011 is generally upbeat. Corporate profitability is near historically high levels as the cyclical recovery builds.

As always, we are on the lookout for clouds on the horizon. We are still not convinced that this year will prove to be profitable for investors. Corporate profitability to date has in large part come from the realization that companies can do more with fewer employees. As the economy grows, companies will eventually start to increase hiring, a good thing for the country but maybe not so good for profitability as increasing labor expense may pressure margins.

Input costs for businesses are also increasing. Prices of commodities are hitting new highs from cotton to iron ore to corn and soybeans. Oil, though off its high, has nonetheless more than doubled from its recessionary low. High commodity prices are particularly hard on many emerging countries where inflation is heating up driven largely by rising food prices. Food in these countries represents a relatively large share of the average citizenís disposable income. This may negatively affect demand for other goods slowing growth.

To date, the Fed has been in denial concerning inflation. It insists that record low short-term interest rates are not forcing prices higher or the dollar lower. Should it ever decide otherwise and raise interest rates, the US economy could slip into a 1970s style stagflation or outright recession.

Since September, the stock market has had a pretty good run. We would not be surprised to see a short-term correction.  Nonetheless, as the US economy moves from recovery to growth, we look forward to higher prices later on this year, barring some unexpected shock to the system. Having said that we note that we are in the third year of a rising market. The S&P 500 is now 100% above its 2009 low. With the challenges noted above, we contemplate taking profits should the market move materially higher.

Some investment areas of promise: New technology called horizontal drilling is enabling energy companies to exploit profitably for the first time vast North American reserves of oil and gas known as shale or tight sands deposits. Oil service companies are enjoying boom times and there is a shortage of capacity. This has created opportunity for investors. We are focusing our investments on companies that bring the latest technology to the industry.  

We are also interested in oil and gas exploration companies that early on saw the potential of the new technology and have amassed large claims to acreage that promises to hold large reserves. By methodically drilling and proving up those reserves, these companies can create real value for investors.

Finally, we maintain our exposure to home building and real estate. So far, the housing market has been a wormy apple for investors. Foreclosures, documentation problems and high unemployment continue to damper investor expectations. Nonetheless, we believe that it is important to have exposure to this beaten up and hated industry. It is our contrarian bet. It will work out, though it is difficult to know when and to what degree.

Tom Herzig


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