Client Communications

Second Quarter, 2012

We open this second quarter letter with the following observations.

"On Hold" Globally

Since our last quarterly report dated April 23, there has been virtually no change in the direction of various broad economic and political trends which have been buffeting global investment markets.  As a result of this observation, we have not altered your asset mix to any meaningful degree during the second quarter.

Pan-European bonds, or some similar financial arrangement, in which all countries using the euro as their currency collectively guarantee each other’s debt, will require a diminishment of each country’s sovereignty over their respective fiscal policies and individual country banking practices.  There’s a growing belief among many of the world’s top financiers that failure to embrace this concept of collectivization of debt will lead to the final disintegration of the euro currency.  It’s the European version of “staring into the abyss” and that point of decision is believed to be rapidly approaching.  European populations like the euro, but they hate the austerity moves that are required to maintain the euro’s viability.  Still, looking back over the past couple of years during which this crisis has evolved, the bureaucrats’ actions, and those of the European Central Bank, have managed to continually and incrementally do what was needed to head off disaster at each eleventh hour.  Most recently, for example, Spain has agreed to give up a good deal of control over its banking system to ensure access to more loans from the ECB.  Trading sovereignty for cash is an emerging European theme.

From an asset allocation standpoint, Europe’s 4½ year bear market in stocks has created very attractively priced investment choices.  The big risk, of course, is the potential for a collapse of the euro currency.  This clash between value and potential risk has seen P/E levels of major European stocks drop to around 10 times earnings.  Dividend yields have increased to around 4½%.  By comparison, the S&P 500 Index at this time has a P/E ratio of approximately 13 times earnings and a dividend yield of 2%.  Barron’s magazine reports that Europe’s overall equity market is selling at a 40-year low relative to U.S. equity values.

U.S. treasury bonds, on the other hand, represent an over valued, high-risk investment situation as the Federal Reserve continues to manipulate yields to all-time record lows.  Current market expectations are for yields to remain around present levels (10-year treasury yield at 1.5%) for at least another year unless and until the U.S. economy shows a marked improvement in growth and Europe solves its debt crisis.  The prospect of each of these outcomes is low as of the date of this report.

We are in the midst of a global waiting game: waiting on the outcome of U.S. elections; waiting on Europe to see a restoration of confidence in their fiscal and monetary policies; waiting on China to reenergize its economy.  We believe it would be reckless to raise your portfolio risk at present because 1) the situation in Europe could precipitate a global crisis at any time and, 2) things aren’t looking too robust anywhere else in the world either. 

At this point, after three years of crisis, it is worth noting that the Europeans are well ahead of U.S. politicians in acknowledging and dealing with their fiscal imbalances.  Politicians at home however are in a complete state of denial and will remain so until we experience some type of European-style financial crisis.  But, as been stated many times in these quarterly letters, the time frame for a domestic crisis is indeterminate. 

Our default asset allocation strategy therefore continues to call for your asset mix to closely reflect your policy benchmark mix, as introduced in our previous quarterly client letter. 

Performance Analysis

Index Returns:                                                2nd Qtr.          6 months
U.S. Treasury Bill return                                     0.0%                0.0%
MSCI All World Stock Index                           -5.4%                6.0%
U.S. Investment Grade Bond Index                  2.5%                4.6%
DJUBS Commodity Index                                -4.5%               -3.7%
CPI (12 months through May, 2012)                                          1.7%

Equity Performance

Stocks underperformed fixed income by a significant margin during the second quarter.  Thus, more aggressively structured portfolios, which contain a greater percentage of stocks, underperformed our more conservatively structured portfolios.  During the quarter, and for the year to date, your equity portfolio contained a significantly higher proportion of U.S. stocks compared to the MSCI Index U.S. stock weighting.  This overweight had a beneficial effect on your portfolio return.  However, your portfolio was negatively impacted by the stocks you own in the basic materials and energy sectors, and by all foreign-based companies regardless of country of domicile.

Basic materials and energy are two sectors that are very sensitive to the current slowdown in global growth.  Truth be told, the magnitude of the downturn in oil prices has been very surprising to us.  Global oil production has been basically flat since around 2005 and net global oil exports have been declining modestly almost every year since 2004, according to the 2012 BP Statistical Review.  We interpret these big picture calculations to mean that any pickup in global growth should be accompanied by rapid increases in the price of oil with commensurate benefit to your portfolio.

Fixed Income Performance

On the fixed income side your portfolio performance was impacted by two primary factors, being: 1) the change in the level of interest rates along the yield curve and; 2) investor risk perceptions for U.S. bonds other than treasury bonds.  During the second quarter treasury rates declined modestly as the slowdown in global growth and the decline in value of the euro relative to the dollar caused the U.S. to remain the world’s investment safe haven.  Declines in interest rates result in increasing bond prices.  For example, the 10-year U.S. Treasury bond experienced a price increase of approximately 4.6% during this year’s second quarter.

The non-government portion of U.S. bond markets had a relatively calm quarter during which higher risk bonds generally outperformed lower risk issues.  This reflected a general sense of complacency in our bond markets.  There was no fear of recession or impending inflation reflected in the bond market.  Relative to our U.S. Investment Grade Corporate Bond benchmark therefore, the main reason for our relative underperformance continues to be the shorter maturities of a significant portion of our bond holdings compared to the average maturity of the index.  As explained in previous letters, shorter-maturity bonds exhibit lower volatility and lower returns relative to longer-term-to-maturity bonds during periods of declining interest rates.

Other Performance

Our primary investment in the “Other” category continues to be gold bullion represented by our ownership of GLD, the gold commodity ETF.  During the second quarter, GLD declined in price by 4.3%.  For the six months ending June 30, GLD still had a positive return of 2.1%.  Industrial commodities and agricultural commodities, through their respective ETF’s, both experienced price declines, which were associated with declining global growth.

For agricultural commodities, early June marked a turning point for prices.  Our research providers say that 72% of the continental U.S. is either dry or experiencing drought conditions.  It’s now expected that a large and growing percent of America’s current corn and soybean crops are under severe stress.  Furthermore, the USDA advises that grain production estimates in other parts of the world are being cut as well.  Prices have been escalating rapidly during the past month.  A small portion of clients’ “Other” category contains these types of commodity funds.

Stock Talk

We continue in this quarterly report with the second in our series of brief introductions to companies in your portfolio.  This quarter we introduce you to Novozymes (, a company you may not have heard of but whose products are used as a component in the manufacturing processes for many of the things you consume in one fashion or another.

Novozymes is a Denmark-based company selling enzyme products worldwide.  Enzymes are natural biological molecules which act as catalysts to enable biochemical reactions to happen faster than they would otherwise.  Enzymes are not living organisms; they are proteins.  Their function as a catalyst is to assist in a biochemical reaction until they are eventually dissolved.  If a protein can catalyze a biochemical reaction, it is an enzyme.  Furthermore, enzymes are fully biodegradable, which means they create no waste products.  Today’s scientists have identified over 10,000 different enzymes, according the to the Novozymes website.  If you have more interest in learning about this interesting topic, Novozymes’ website contains a great deal of material

Novozymes bills itself as the world’s leader in bioinnovation.  The enzyme products it creates are used in an ever-growing number of manufacturing processes, creating the potential for a constantly growing corporate revenue stream.  The company divides its enzyme business into the categories of Household Care, Food and Beverage, Bioenergy and, Feed and Other Technical Enzymes.  Across these categories, Novozymes has created more than 700 products, used in over 40 different industries with customers located in 130 countries around the world.  Sales of these products represent a 47% share of the global enzyme market.  In a typical situation the company would assess a manufacturing process for a customer and then create an enzyme product that enhances the manufacturing efficiency of that process, such as reducing energy usage, or reducing the process’ carbon footprint, or speeding up the timeframe to complete the process.

Despite a challenging global economic climate, Novozymes is anticipating 2012 sales growth of 7-11% and maintenance of strong profit margins.  During the past five years the company has generated an average annual return to shareholders of 18% per year.

As always we look forward to discussing with you any thoughts or questions you may have regarding the contents of this letter.

Sheffield Investment Management, Inc.