Investment Update, Fourth Quarter 2013

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Economic Conditions (Audio Version)
The over-arching theme for 2013, reminiscent of the Sherlock Holmes story, “Silver Blaze,” can be characterized as “the year the dog didn’t bark.” The US did not go over a fiscal cliff or default on its debt; the sequester did not suppress growth; the Eurozone did not disintegrate; China’s growth did not slow as much as feared; Middle East turmoil did not destabilize oil prices; and continued global central bank money-printing did not increase inflation (so far).

In the absence of negatives, equity markets responded positively with the S&P 500 having its best year since 1997, up 32%. Many safer, more defensive stocks underperformed in 2013. Bond markets were down as yields rose, and the ultimate “risk-off” asset, gold, declined almost 30%, its worst year since 1981.

Gold was not the only commodity to perform poorly. A slowdown in China’s capital spending led to declines in many commodity prices. This generalized decline marked the end, for now, of a “Commodity Supercycle,” a decade-long theme that was a very successful investment strategy for Chevy Chase Trust, until it reversed in 2013. Thus, some traditional Chevy Chase Trust core holdings in investment areas such as energy producers, mining companies and agricultural inputs were a drag on overall performance. We are deep into research in areas we believe are likely to dominate in the next decade. We will share some of that work in our next quarterly letter. Stay tuned.

For 2014, we expect inflation to continue to be muted, under the Fed’s target of 2%. While some commentators were concerned that inflation would be unleashed by three versions of Quantitative Easing, the reality is that these efforts have probably been more effective at skirting deflation than spurring inflation. Inflation in the U.S., as measured by the Core Consumer Price Index, was 1.9% five years ago and at a pace of 1.7% in November 2013. While we anticipate growth in the U.S. Gross Domestic Product (GDP) to be about 2.5% in 2014, it is worth noting that GDP growth may, for the first time in a long time, be stronger than expected given its momentum over the last four quarters.

However, continuing pressures on personal income and volatile inventory investment data in recent GDP numbers support our caution.

After the market’s “Taper Tantrum” negative overreaction last summer and overly positive reaction to the “Tabled Taper” a few months later, the market has digested the “Tiny Taper” announcement at year-end with equanimity. If nothing else, the Fed is signaling by modest and measured reductions in bond purchases and by keeping interest rates at virtually zero for the foreseeable future, its intent to continue providing monetary support until the economy is fully self-sustaining.

Investment Strategy
Stocks— With the S&P 500 having its best year in more than a decade, and up 170% from its low in March 2009, some believe the stock market is in bubble territory. While acknowledging the rise of the market and the possibility of a correction at any time, we are of the opinion that the stock market is returning to its trend from an oversold condition at the bottom of the financial crisis. Considering that U.S. GDP on September 30, 2007 was $14.6 trillion and since then has increased 16.1% to $16.9 trillion at September 30, 2013, we do not think the market’s price movement to be particularly “bubbly.” The S&P 500 rose a modest 10.1% from September 30, 2007 to September
30, 2013. The additional 8% increase during the fourth quarter of 2013, simply brings the stock market back to an historic trend relative to economic growth. We believe there is a real relationship between economic growth, profit growth, and hence, stock growth. If we get the long-term economic trends correct, we believe we will get the long-term market movements correct, even when markets overshoot or undershoot in the shorter term. Nevertheless, from a valuation standpoint, with stocks priced significantly above the bargain levels of the early recovery years, stock selection will be critical to portfolio management.

While the Commodity Supercycle may have run its course for this business cycle, we see opportunities in other sectors for new purchases. In our last quarterly investment review, we wrote about diverging middle classes in the developed world (where the middle class is shrinking) and in emerging markets (where the middle class is expanding). We see this theme yielding effective investment strategies in the years ahead. We also see opportunities in infrastructure investments in emerging economies to meet the needs of commerce and a growing middle class, as well as in the developed economies to address age and obsolescence.

Another area where we see opportunity is technology. Since the beginning of the recession, The U.S. has underinvested. For most countries, capital investment as a percent of GDP is 20%. The average for the U.S. during the period 1961-2012 was 21.1%, but as seen in the chart on the following page, U.S. capital investment has been significantly below average the last five years. Large-cap technology companies, as a group, have been performance laggards; we expect many of these companies to be beneficiaries of increased capital spending as the economy improves.

Bonds—The consequences of September’s “Tabled Taper” included a fall in the 10-Year Treasury interest rate to 2.61% at the end of the third quarter. However, the effects of improving economic growth, reflected in the third quarter GDP revision to 4.1% growth, the end of the Government shutdown, no debt default, and the much-awaited December announcement of the “Tiny Taper,” all led to the 10-Year Treasury rate increasing to just above 3%, nearly twice its May level. This upward move in rates means that the Barclays Aggregate Bond Index, the broad bond market benchmark, posted its first negative annual total return since 1999, down 2.02%. Hit particularly hard last year were inflation-linked bonds, such as TIPS, which plunged over 8.6% (the worst year since being introduced in 1997) and long-term Treasuries (20+ years) which were down 13.9%.

Municipal yields also rose with overall bond markets and were additionally fueled by selling pressure as monies exited most municipal bond funds. Unlike bond mutual funds, our portfolios of individual bonds may experience mark-to- market price declines but should return 100% of their face value at maturity. Generally, we welcome higher interest rates as they present opportunities for higher reinvestment yields. Given the significant tax benefits afforded municipal bonds and their current favorable yields relative to taxable bonds, we are finding attractive value in short and intermediate term investment grade municipals. This strategy benefits from the steepness of the yield curve without exposing portfolios to the significant volatility in longer duration and lower credit quality bonds.

Investment Update: Second Quarter, 2011

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This is a quarterly update of economic conditions and investment strategy.

Economic Conditions

Last quarter, we addressed the headwinds facing the global economy. First half, 2011 economic data confirm that the recovery in the U.S. economy and much of the rest of the world has lost momentum. Growth in the coming year is very likely to be subpar. First quarter GDP growth of 1.9%, a surprise to the downside, is even worse when one looks below the surface. Most of the increase stems from inventory building, not sales to consumers. Weakness continued in the second quarter: declines in wages; orders and production; and a series of poor employment data releases.

In the United States, GDP growth has been uncharacteristically tepid for a recovery from such a deep economic trough. This is most troubling given the fiscal and monetary stimulus applied to the economy, including Government spending far in excess of Government revenues, and interest rates held near zero for 32 months.

The unemployment rate ticked up to 9.1% at the end of May and new jobless claims were again above 400,000, in April and May, after dipping below this mark earlier in the year. Job creation has been sporadic, and with few signs of economic momentum, businesses are likely to remain cautious on hiring. Home prices continue under pressure; the S&P/Case-Shiller Home Price index showed declines for seven consecutive months through March. With home inventory levels high, large numbers of homes yet to work their way through the foreclosure process, and more stringent mortgage lending requirements, we do not believe that this important sector will provide much stimulus for some time.

Weak employment and housing means subdued spending. This translates into slow GDP growth and relatively high unemployment levels at least into 2012. Monetary stimulus will almost certainly continue in the form of very low short-term interest rates. A step-up in fiscal stimulus is unlikely given the current negotiations on spending cuts.

Outside of the US, major developed economies are experiencing even weaker growth. Aggregate real GDP growth for the countries in the Eurozone was 0.8% in the first quarter, 2011. This statistic masks a wide range of underlying economic health among EU countries. At one end, Germany and France have moderate growth; at the other end, the heavily indebted countries of the European periphery (Greece, Portugal and Ireland) are reliant on emergency external financing to function. The potential for sovereign debt default in one or more of these countries is a very real possibility, with pervasive implications. Japan, due to the impact of the tsunami and ensuing nuclear crisis, has fallen into a recession with -1.3% GDP growth in the first quarter, 2011. Recovery in Japan in the second half would offer hope of some improvement in economic conditions.

One looks to the emerging markets for more favorable economic results. India and China continue to lead the world with 9.7% and 7.8% growth respectively in the first quarter, 2011. Russia and some countries in South America turned in above average performances in the first part of the year. Global growth has become dependent on emerging markets.

Investment Strategy

Our forecast of continued weak economic growth, as noted above, has produced a strategic shift in our equity investments. We have stepped up emphasis in large, well-capitalized multinationals that we believe are well situated in the current climate. Additions to our holdings in defensive areas, e.g., health care, food, water and utilities continue. Also, technology and other sectors that have experienced sharp sell-offs, reaching prices that we believe are sensible on a long-term basis, are candidates for purchase.

Core holdings are in multinational firms that have the ability to direct sourcing and distribution networks based on costs and end market strengths. Many of these have low debt, high cash levels, and diverse product portfolios, all attributes that we favor in times of economic stress. We select those that support the long-term secular trends discussed in prior reports.

Valuations are attractive in some wireless and technology companies. Obsolescence risks are meaningful, but companies with low valuations, solid balance sheets, high free cash flow (that is, cash available to shareholders after spending to maintain the business) offer a margin of safety and exposure to areas of faster growth. Euphoria over newer “social media” companies has resulted in cheap valuations for a number of other technology companies with overlooked divisions that are very interesting, long term. We also find opportunities in the global health care sector where companies with stable earnings growth, attractive valuations, and research capabilities addressing aging populations offer multiple positive levers to price.

We have trimmed holdings in the energy and materials sectors. We continue to maintain core holdings in these areas and would add to holdings in a significant pullback. No other sector, in our view, has more compelling long-term upside. However, a sustained slowdown in demand from the emerging markets (China in particular) could result in declines in commodity prices in the short to intermediate term. During this interim period, enhanced portfolio performance may be achieved by measured changes in emphasis while maintaining core positions in energy and materials. In the coming decades, the increasing appetite for raw materials from the developing world and the scarcity of new supply will result in increasingly higher prices for energy, metals and agricultural products. Finally, the prospect for stability in parts of Latin America and its leverage to developing market growth makes this region an interesting area for investment.

Fixed income portfolios continue to be high quality and short-term coupled with purchases of some longer-term issues that emerge from time-to-time offering compelling value.

Investment Update: First Quarter, 2011

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This is a quarterly update of economic conditions and investment strategy.

Economic Conditions

The first quarter of 2011 showed a continuation of the major trends in the U.S. economy that were evident at the end of 2010. Fourth quarter, 2010 GDP was revised upward to 3.1%, from 2.8%, with growth for the full year at 2.8%.

The employment picture improved at a moderate pace although the unemployment rate, at 8.8%, is still very high by historical standards. Housing prices remain mired in a slump with most major markets at or below post-bubble lows. Case-Shiller data through January, 2011 show a decline of 3.1%, year over year, for the 20-City Composite, with only San Diego and Washington, DC recording gains.

We are witnessing an unusual juxtaposition of weak consumer confidence with robust corporate profits. It is likely that these two forces will moderate as confidence improves with new hiring and profit margins compress when labor costs rise. Still, growth is likely to be muted. Wages, salaries and benefits, accounting for about 75% of personal income in 1970, have dropped to 64% in 2010. No statistic better highlights the contraction of the U.S. middle class. Together with the widening and unhealthy upper/lower income gap, it explains the weak economic recovery because spending by middle (and lower) income earners is much greater than that of more affluent households.

Without growth in wage income and healthy financial and housing markets, we see a pattern of very slow economic growth, interrupted by fits and starts caused by the usual unpredictable natural and geopolitical events of our times. Consequently, we project GDP growth at under 2% for the first half of 2011.

We are concerned about the high level of government intervention (fiscal and monetary stimulus) that was required to return the economy to only a moderate level of growth. Further fiscal stimulus is increasingly unpalatable from a political perspective and monetary policy may be on the verge of transitioning from accommodative to restrictive in the face of nascent inflation. In the event that Government stimulus is removed, it is not clear that there is sufficient momentum in the economy to sustain even the current level of growth.

Budget challenges continue to confound policy makers. Several States and municipalities, with their balanced budget mandates and weakened ability to access debt markets, are making tough choices on spending and taxes. At the Federal level, present and future liabilities continue to grow. Stanford University’s Institute for Economic Policy Research, in a joint effort with former U.S. Comptroller David Walker, created a “Sovereign Fiscal Responsibility Index” that assesses the 34 countries in the OECD and the “BRIC” countries. In this assessment, the U.S. ranked 28th, behind Italy. The study noted “…our analysis suggests the United States is three to five years away from an indebtedness crisis like that of the European nations currently facing fiscal strain.”

We are also concerned about the slowing pace of the global economy. Turmoil in the Middle East and North Africa, the European debt crisis, and the pressure on interest rates in developing economies to deal with clear inflationary signs are not conditions to enhance growth. Also, Japan’s natural disaster and ensuing nuclear crisis will dampen global economic activity for the remainder of 2011, at least. In addition to the horrific loss of life, and the destruction of property and infrastructure, there are disruptions to global industrial supply chains, most prominently in the automotive and electronics sectors. Inventories will run down by May, 2011 for many goods which will reduce sales and pressure prices.

Finally, international oil prices have increased from $90 prior to the first demonstrations in Egypt to $108 on fears of supply disruption. While we have not reached a price that will tilt the global economy into recession, sustained high prices are worrisome because they are a tax on consumers in a weak economy, and because they have been closely linked to recessions in the past.

Investment Strategy

U.S. stocks, as measured by the S&P 500, have increased sharply from the lows of the economic crisis in March, 2009, raising questions about current valuations. The S&P 500 trades at 15.5 times trailing (last year’s actual) earnings and 13.7 times this year’s expected earnings, superficially not an extended valuation. But, corporate profitability is high on an historical basis; input prices are rising (oil, grains, metals); inflation in the supply chain is increasing; and wages are starting to firm. Therefore, profit margins are likely to come down and stock prices may follow.

In an era of slow economic growth our investments will focus on sectors that are likely to grow at a rate faster than the overall economy. They should be further concentrated in products and services that are necessary or very desirable for which substitutions are not readily available.

Our approach to equity investing is to seek out individual companies that are well positioned to take advantage of secular global trends that we believe will be in place for many years. We have written extensively of these themes, e.g. natural resource scarcity and demographic trends of urbanization in emerging markets and aging populations in developed markets.

Not only is it important to be in the growth sectors of the world economy and in the best names in each sector, it is also important to have appropriate positions at sensible costs. To accomplish this, thoughtfully, it is often necessary to initiate and establish positions over time. Sometimes, we find a bargain and we immediately establish a large position, but more often it is a methodical monitoring that produces the large successes over time. This is one of the reasons that client portfolios differ, even those with the same objectives and circumstances. In time, all client portfolios tend to reflect our top priorities, but sensitivity to prices paid influences the time frame.

When an investment meets our price and other criteria, we tend to hold it for a long period, selling only if fundamentals deteriorate or valuation becomes unreasonably high. Thus, equity weightings in our client portfolios tend to rise (within individual long-term guidelines) when we find more attractive opportunities and fall when opportunities are scarce. For example, Mid East unrest and associated removal of Libyan oil production contributed to the aforementioned increase in the spot price of oil. Our energy investments, selected to participate in the longterm supply/demand imbalance of oil that we envision, have appreciated sharply this year. Near term, this may not last; we expect normal volatility to afford opportunities to establish positions for new clients, and to reshape energy positions for longer-term clients.

The same dynamics are beginning to unfold in our favored agricultural companies. Grain yields are not growing in many countries because of soil erosion, droughts, over pumping of aquifers and other factors. Even the U.S. will face water shortages for agriculture and not just in the West. The Ogallala Aquifer, the largest body of fresh water, stretching from South Dakota to the Texas Panhandle is depleting at a rapid rate. This will affect about 20% of U.S. grain production. Food production in China, India, and Russia has been strained for different reasons, conditions likely to persist. These are strong signals that the worldwide productive capacity of food will be challenged by rising demand, year over year, and that prices are headed higher.

The quintessence of the issue is that additional food production will by necessity be a product of increasing yields because the amount of arable land for each person is declining. In our view, countries with ample water and land are best situated; seed technology companies capable of producing drought resistant seeds will be a big part of the solution; and fertilizer and infrastructure/irrigation companies, such as those using pivot and drip irrigation, will benefit from increased demand. We hold stocks of many of these, and plan to add to client holdings when the timing and values look right.