Letter - October 2011





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Taking on Ballast

Ballast: a heavy substance placed in such a way as to improve stability and control (as of the draft of a ship…) Merriam Webster Dictionary.

In an investment portfolio, cash can act as effective ballast providing a degree of stability in the face of turbulent economic and market conditions. Since economic and political conditions deteriorated over the summer, we raised cash in the last quarter by selling our weakest equity positions. Taking on ballast.

Trouble in the Euro zone banking system related to excessive public debt has the potential to stifle future economic growth, exacerbating high unemployment and forcing additional austerity across the European Union. Possible default of sovereign government debt hangs like dirty weather over investors. Many are concerned that trouble in Europe is beginning to spread to other parts of the world economy.

In the US, sharply differing visions of the role of federal government have blocked agreement between Republicans and Democrats on effective fiscal policy to deal with a sluggish, potentially recessionary economy, high unemployment and looming debt. Indeed, some consider the Euro crisis to be a window on our own future.

Other parts of the world continue to prosper though concerns are increasing that growth may subside somewhat. After outperforming many developed country stock markets over a 3 to 5-year period, most stock markets in emerging countries have fared much worse than the US over the past year or so; perhaps they have adjusted to moderating expectations of future growth.

On a more optimistic note, we believe that stocks are inexpensive. From a valuation perspective, we consider equities to be the most attractive asset class, in part because of the recent five straight months of decline. Dividend yields in many cases exceed the yield on the 10-year Treasury bond. Trailing 12-month P/E ratios are not historically high, especially relative to bond yields. Corporate balance sheets, in many cases are as strong as ever. Though the short-term outlook for the market may be uncertain (September-October can be a difficult period), odds are increasing that investors with a little patience and fortitude may enjoy a year-end rally.

During financial turmoil such as we experienced in 2008-09, investors learned that cheap stocks can get even cheaper. In a crisis, stocks become commoditized; panic selling can drive prices down in the short-term with little regard to future earnings, cash flows or dividends. Our strategy is to maintain positions in high quality equities and those with a particularly compelling narrative. Furthermore, we intend to be buyers at lower levels should the market get irrational as it did in 2008-09. However for now, tactically, we have additional ballast in portfolios, having raised cash as storm clouds gathered on the horizon.

Tom Herzig


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