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Second Quarter, 2008


We begin our quarterly letter this time with our view regarding a couple of domestic and global economic trends in an effort to separate the longer-term forces affecting the big picture from the daily mind-numbing noise that surrounds us on a minute-to-minute basis.  This is a very challenging task, akin to assembling a 1000-piece picture puzzle while people all around you are removing individual puzzle pieces and handing you new pieces having different shapes.


Americans are now experiencing a set of factors which is fundamentally altering our economic behavior.  Some changes are being personally driven and many are being forced upon us.  The changes in the financial services industry are as messy as we’ve ever seen.  The U.S. and Western Europe are in the midst of a shift from an asset leveraging mentality to an asset deleveraging mentality.  For almost ten years, cheap money, lax lending standards, abundant credit availability, rapidly escalating home prices and cheap energy prices presented an intoxicating confluence of stimuli that encouraged unsound investment practices and enabled Americans (among others) to live beyond their actual income generating capability.


Now that process is reversing.  Lenders, investors and other financial services organizations are engaged in a long, painful process of deleveraging.  Regulators are raising financial institution capital requirements and the market place has lost its appetite for riskier (high leveraged) investments.  The ongoing decline in home prices is severely limiting individuals’ ability to borrow against their home equity.  With increasing frequency we are hearing that consumer home equity lines of credit are being cut back or terminated by their banks and brokers.  Just this past week, the big three auto makers indicated they either may, or will, terminate their vehicle leasing programs.  The result of all of this is that the availability of credit to consumers is rapidly contracting and may continue to do so for a protracted period of time. 


Falling home prices are at the epicenter of the deleveraging process.  This real estate crisis in the US (and Western Europe) will not end, and the resulting damage to financial institutions’ integrity will continue to worsen, until real estate markets begin to stabilize.  This housing debacle is new and different from past implosions.  Never before have so many bad loans been made¹. 


The more home prices decline across the nation, the greater the number of people who will find themselves “under water” with respect to the value of their home vis-à-vis their mortgage balance and the larger the number of ultimate foreclosures.


The problems which began in the subprime segment of the market have now infected prime mortgage borrowers.  There is just no telling how long the crisis will continue to snowball downward, and that is what causes most financial stocks to remain such high-risk investments.  To make matters worse for the banks and other financial institutions, new accounting rules are in the works to force them to bring onto their balance sheets trillions of dollars of presently off-balance sheet securitized assets.  Unless the financial institutions can lobby their way out of it, these accounting rule changes will serve to further inhibit loan growth during the next few years.  During this period many more banks will fail as their ability to lend money is curtailed by virtue of their need to preserve their remaining capital while attempting the difficult task of raising new capital. 


Rising excess supply of homes in the U.S. and the continuing decline in home prices are fueling the deleveraging process in financial institutions.  How long will this process continue?  No one knows for sure but a consensus of sorts is emerging that points to total real estate related losses ultimately reaching the $1 trillion level.  Losses realized to date total in the $400 billion range, thus indicating that we are almost at the half-way point.  Two-to-four years to go, perhaps?


During this ongoing deleveraging period, the standard of living of the vast majority of Americans who have been living beyond their means will decline.


The Oil “Situation”


In an attempt to discover the reasons for the dramatic rise in the price of oil in the past year, and to find someone or some group to “blame” for the present state of affairs, Congress requested that the Commodities Futures Trading Commission (CFTC) conduct an investigation.  Certain members of Congress have been loudly condemning “speculators” for a significant portion of the price rise in the hope that this would take the pressure off themselves for failing to create a comprehensive domestic energy policy for more than 30 years now.² (Remember President Carter’s cardigan sweater in the White House circa 1978?)


After receiving this request, the CFTC created an Interagency Task Force consisting of staff from several agencies including the Departments of Agriculture, Energy, the Treasury, the Board of Governors of the Federal Reserve System, the Federal Trade Commission and the Securities and Exchange Commission, to seek out suspects.


Keep in mind that agencies love to find “smoking guns” so that they can justify requests to increase their operating budgets and become ever more powerful.  And so it is all the more remarkable that this Interagency Task Force concluded in its preliminary assessment that:


“current oil prices and the increase in oil prices between January, 2003 and June, 2008 are largely due to fundamental supply and demand factors . . .The  Task Force’s preliminary analysis to date does not support the proposition that speculative activity has systematically driven changes in oil prices.”


A variety of other prominent public officials, economists and energy experts have agreed with the CFTC conclusion on this topic.  The full report can be found on the CFTC’s website at 


And so we now come to what we believe is the heart of the matter.  Our research reveals that today, and for the foreseeable future, global growth in energy consumption exceeds the growth rate of energy production in spite of well publicized recent declines in U.S. and Western European oil consumption.  Here’s why:


  • Emerging markets consumption growth is accelerating rapidly as many of these countries continue to industrialize.  Furthermore, many emerging market countries, and the energy producing emerging market countries in particular, subsidize the cost of gasoline, diesel, etc., for their populations so there is no incentive on the part of their citizens to practice energy use constraint.


  • Declines in production rates of existing major fields around the world are accelerating and largely offset new production entering the global market.  Infact, The Energy Information Agency calculates that global oil production has been flat since mid 2005.


  • The largest oil exporters are developing nations which are consuming ever larger portions of their own production.  This means a diminishing proportion of their remaining production is available for export around the world.


  • “Resource nationalism” is a growing global trend.  This view holds that oil and gas in the ground (as well as other minerals) may be of greater value to the mother country for its future use than selling it to other users for today’s depreciating dollars.

 There is no short- or intermediate-term fix for this growing supply-demand imbalance except for “forced” usage declines on developed countries through the mechanism of rising global prices. According to various governmental agencies, most new incremental production which is expected to come on line in the next 5 years will merely offset other production declines.  “Spare capacity” among oil producers (primarily Saudi Arabia) is expected to drop precipitously after 2010.


Alternative sources of energy including wind, solar, biomass, geothermal and nuclear will continue to grow in importance globally, and we believe U.S. policy should be to promote all types of energy alternatives including efforts directed towards conservation.  However, the current costs and impediments associated with their development and use will prevent them from meaningfully reducing our (and the world’s) reliance on fossil fuels for at least the next ten years. 


How high can the price of oil rise?  We can’t answer that question in terms of dollars, but there is a clear economic answer.  Energy prices will stabilize when the decline in use by industrialized countries like the U.S. matches the increase in annual consumption by the developing world.  As mentioned above, in many developing countries the dollar price of oil is not a meaningful constraint on consumption.  In our view, any pull back in the price of oil (such as is occurring at the present time) is likely to be a short term phenomenon.  Prices will always fluctuate, but the growing supply-demand imbalance will likely manifest itself in higher prices in the future.  Based upon this view, the energy companies that explore for and produce oil and gas, as well as the companies which service that industry presently represent some of the best long term investment opportunities available.


Meet “Mr. Market”


Over the years it seems the most prevalent question we are asked by clients and prospects alike is: “Where do you think “the market” is headed in the next week or month or quarter or year?  We normally are unwilling to answer this question, leaving it up to the more foolhardy types on radio and/or TV who make a living off their bold predictions and general showmanship.


Today however we are going to take a firm stance on this question, and will, for once, give our own unequivocal answer to this important question, but first you must work your way through some background material.  It won’t take too long.


We believe the answer to this question begins with an investor/analyst named Benjamin Graham.  Mr. Graham is considered to be the father of modern financial analysis, and his book entitled Security Analysis, first published in 1934, is the “bible” of our industry of financial analysis and portfolio management.  Years later, in 1949, Graham published another work, this time for the average lay investor, entitled The Intelligent Investor.  That book, which is full of good advice about how to succeed at accumulating wealth through a disciplined investment approach, is quite relevant today.  In that book, Mr. Graham introduced his readers to a highly emotional investor named “Mr. Market”. 


Presented here are a few relevant paragraphs from The Intelligent Investor:


“Imagine that in some private business you own a small share that cost you $1,000.  One of your partners, named Mr. Market, is very obliging indeed.  Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis.  Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them.  Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly.


If you are a prudent investor or a sensible businessman will you let Mr. Market’s daily communication determine your view as the value of a $1,000 interest in the enterprise?  Only in case you agree with him, or in case you want to trade with him.  You may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low.  But the rest of the time you will be wiser to form your own ideas of the value of your holdings, based on full reports from the company about its operations and financial position.


The true investor is in that very position when he owns a listed common stock.  He can take advantage of the daily market price or leave it alone, as dictated by his own judgment and inclination.  He must take cognizance of important price movements, for otherwise his judgment will have nothing to work on.  Conceivably they may give him a warning signal which he will do well to heed.  In our view such signals are misleading at least as often as they are helpful.  Basically, price fluctuations have only one significant meaning for the true investor.  They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal.  At other times he will do better if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies.”3


Warren Buffett, a friend and disciple of the now deceased Ben Graham, popularized Graham’s “Mr. Market” in Berkshire Hathaway’s 1987 Annual Report to investors and in subsequent commentaries and articles.


In that annual report Warren Buffett goes on to say that an investor will succeed over the long run by coupling good business judgment with an ability to insulate oneself from Mr. Market’s super-emotional behavior. 


How do you do this?  Buffett summarizes Graham’s approach in three general concepts:


  • Consider each stock purchase as your becoming a partner in the business (with Mr. Market).


  • Always analyze your “margin of safety” before you become a partner in the business.  In Buffett’s words, “Be confident your bridge can bear a 15,000 pound load before driving your 10,000 pound truck across it”.


  • Consider Mr. Market as your friend rather than an adversary from whom you will be given ample opportunity to profit over the years when he periodically reverts to his overly emotional behavior.


Mr. Market’s wild behavior doesn’t mean that market fluctuations should be ignored.  If he is spiraling into deep gloom about his investments you may gain insights about the safety of your business partnership with him.  In summary, you can be sucked into Mr. Market’s split personality behavior, sharing his emotional peaks and valleys, or you can remain aloof to his mood swings and instead seek to profit from his emotional excesses.


So, with these concepts now presented, we can return to the question of where the market will be in (the time frame of your choice).  However you now know that the correct way to ask this question is: “What emotional state will Mr. Market be exhibiting in ‘X’ future period of time?”  To which question we can now respond: We can’t forecast Mr. Market’s emotional state at some future date but if he panics and wants to sell to us at bargain prices or buy from us at excessive valuations, we will do our best to oblige.


Moving on to six months’ market performance, here is a picture of various representative index returns:


Money Market Fund Proxy*                                                 1.3%

Russell 3000 Index (U.S. Stocks)                                       -11.0%

MSCI EAFE Index (Non-U.S. Stocks)                              -11.0%

MSCI Emerging Market Index                                            -11.8%

Lehman Aggregate Bond Market Index Fund                          1.1%

MSCI REIT Index (Real-Estate Trusts)                                 -3.4%

Gold (Commodity)                                                                11.0%

Philadelphia Gold/Silver Index (Mining cos.)                          13.1%

US Trade Weighted Dollar Index                                           -3.2%

CPI Inflation 12 months                                                           5.0%

 * We have begun using Vanguard’s Admiral Treasury Money Market Fund as our proxy for the return of cash-type holdings.  That fund has a 10 basis point expense ratio and seems a reasonable indicator of the returns an investor would earn if he or she bought treasury bills and continuously rolled them over at maturity.


The Fed lowered the Fed Funds rate during the first quarter to its present level of 2%, however interest rates have crept higher all along the yield curve since the beginning of April.  Rates generally move higher as inflation rises and that is what has been happening globally during the second quarter.


Broad stock market indices from around the world fell victim to declining prices during the first half of the year although the second quarter was much less painful than the first quarter.  We also note that REITs, both domestically and globally, have fallen victim to the general financial malaise.  The ability of REITs to raise new capital for their properties is being hurt by ongoing banking losses and credit contractions.  Our present assessment is that we now don’t believe this situation will begin to improve until some time in 2009 or later.


Gold and gold mining stocks continued to experience gains during the first half of the year as the dollar declined further against a basket of foreign currencies.  Inflation, ever increasing deficits, a dysfunctional Congress and growing reliance upon foreigners to buy our debt securities did not auger well for the prospects of the dollar during the first half of 2008. 


Recent sharp declines in the price of shares of companies which we deem to be businesses with very attractive long-term growth prospects is illustrating to us once again that Mr. Market continues to experience severe panic attacks.  Please fee free to communicate your views to us regarding our thoughts expressed in this letter.


1.A disturbing article in the August 7 edition of the Wall Street Journal estimates that some 65% of subprime loans initiated in 2007 will end up in default vs. 45% originated in 2006.

2.In a recent op ed piece in the Wall Street Journal, Boone Pickins advised that the U.S. imported 24% of our oil needs in 1973, 42% in 1990 and 70% today, coming in large part from countries hostile to the U.S.  Imported oil this year will cost approximately $700 billion and will represent almost 60% of our entire trade deficit.

3 Benjamin Graham, The Intelligent Investor (New York: Harper & Row, 1968 ed.),





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