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.