Farragut Newsletter 11nov08 Final

Armistice Day, 2008

A Return to Normalcy There isn't anything the matter with world civilization, except that humanity is viewing it through a vision impaired in a cataclysmal war. Poise has been disturbed, and nerves have been racked, and fever has rendered men irrational; sometimes there have been draughts upon the dangerous cup of barbarity, and men have wandered far from safe paths, but the human procession still marches in the right direction. President Warren G. Harding, 14 May 1920

Warren Harding left a modest Presidential Legacy, but his campaign slogan, embodied in the above speech, may be what we need. Let’s not flatter ourselves, recent events in Finance are nothing compared to the calamity of the Great War. Importantly, with the estimated cost of nationalizing the banks and brokers approximate to that of the Korean War (one-fourth of GDP), a quick fix from Washington is improbable. The cupboard is bare. There is reason for optimism. Last week’s election reminds us that our political process, however galling, remains the world’s most effective means of translating the people’s will to governance. Yes, we are still Number One.

A central part of our process has been to share the management of a client portfolio with credible mutual funds. We hold our clients’ mutual fund managers to the same standard to which we hold ourselves. In some “moderate allocation” funds we have seen draw-downs in excess of 30 percent. That’s not moderate. Fool me once shame on you: the Mutual Fund Industry exhibited herd behavior during the internet bubble, overweighting portfolios in technology when valuations were highest. Fool me twice... As the relative S&P 500 weight of financial shares closed in on 30 percent last year, many fund managers ignored those lessons, larding portfolios with lenders geared to an over-levered consumer. Among those managers who shied from Financial shares, many made like-sized bets on everrising Commodity prices. Mean reversion is too pernicious to ignore. Investments which deliver above-market returns tend to attract a surfeit of capital, and returns abate. Too many cows in the pasture; the clover turns to mud.

Back to Basics How do you make money in Stocks? 1. 2.

3.

You collect the dividend, the portion of the company’s earnings distributed to its owners. The earnings of the company grow. With a given Price to Earnings (P/E) ratio, your shares appreciate proportionately. Multiple Expansion. As a company’s bright prospects gain wider currency, other investors are willing to pay more for a given level of earnings.

How do you make money in Bonds?

The Markets and Your Portfolios It is only when the tide goes out, that you know who was swimming naked. – Warren Buffett

This Summer, we modified the “sector-agnostic” baseline we’d been investing with for over a decade, slashing financial exposure, taking profits in the energy complex, and avoiding industries that relied on a liquid consumer or a willing lender. Overweighting in Health Care and Technology was justified on the fundamentals of the industries, as well as the historically defensive nature of these sectors.

1. 2. 3.

How to lose money? 1. 2. 3. 4. 5.

6. While these steps proved prescient, they did not prove sufficient. All industries sold off sharply, and diversification failed to protect. Gold broke down, and perversely, the Dollar staged its strongest rally in years.

You clip the coupon every six months and collect the principal at maturity. Interest rates decline, making a high coupon more valuable. The price of the bond is then bid up. Spreads narrow. Investor appetite builds for a given issue or class of bonds, reducing the required premium over the equivalent risk-free (treasury) rate.

Cut dividends. Lower earnings Shrink P/E ratios. Bond issuers default Interest rates rise Spreads widen for lower-grade bonds.

The past 18 months have seen all but rising rates. Should deflationary pressures build, real rates (net of CPI) may creep up, adding this to the mix. Let’s tread lightly!

Copyright 2008, Farragut Resources, LLC. The material presented is for informational purposes only and is not intended to recommend a specific investment strategy or the purchase of securities. All opinions are those of the author, and do not reflect the policies of Farragut Resources or Capitol Securities Management, Inc. Investment advisory services and brokerage provided through Capitol Securities Management, Inc, Member FINRA/SIPC.

Where Now? We like Bonds, Growth Stocks, and Emerging Markets, with an anchor in Natural Resources. Pretty much what we’ve been doing for the past decade, with the exception of not many Real Estate or Finance Companies. We continue to sift through the rubble, but as yet have few high confidence candidates. US Growth Stocks continue to have appeal. The idea of owning shares of well-capitalized firms, with growth prospects better than the economy as a whole, holds more water than picking through what Buffett calls the “cigar butt” denizens of many value screens. That said, when shares of the world’s premier Aluminum concern trade for less than a 12 pack of Bud, we admit some affection for the cyclical stocks. Emerging Markets are Growth Stocks. While an economic slowdown will impact all economies, the younger, more dynamic corners of our world may ultimately grow the fastest. We must be mindful of the differences within. Just 10 years since its most recent default, with Stalinism in full bloom, there is an ethical and financial hazard of investing in Russia. Conversely, Brazil looks great when the tide goes out. Why do we like bonds? It’s not just the income, it’s the opportunity for capital gains. High-grade corporate bonds are paying a greater premium to their government equivalent than at any time since 1932, and are priced to reflect a 50 pct default risk. Municipal Bonds yield far more than treasuries, with the income tax-free. These disparities are not likely to persist. As the spread between these bonds and the risk-free equivalent (treasuries) narrows, they may well appreciate in price. This potential compares favorably on a risk-reward basis to the negative real returns cash and T-bills promise over the coming year. Longer-term, inflation presents a very real threat to fixed-income investors. The U.S. Government has never before taken such an ownership stake in private industry. Recall Gresham’s Law: Bad money drives out good.

Retirement Readiness (1)

While the impact on outstanding contracts should be modest, this recognition that the guarantees were sold too cheaply reinforces our assertion that investors would do well to consider these benefits before they are no longer available.

College Funding Virginia Prepaid Education Program enrollment opens December 1, 2008. An on-line application will be available after that date. Those who’ve taken advantage of this scheme over the years are pleased. General information on the Virginia Prepaid Education Program is available online now at www.virginia529.com/

Retirement Readiness (2) In our Fiduciary Consulting practice, we advise clients and their employees on the risks and responsibilities associated with Employee Retirement Plans. We are now seeing a new hazard in retirement plans. Unless a firm’s employees are prepared for retirement, the value of the business can be compromised. Financially insecure employees must continue working well past their desired retirement age. The impact on productivity, payroll and benefit costs can materially impact the resale value of a business. With this equity often their primary retirement savings, owners are finding they have a meaningful direct financial interest in ensuring their staff is retirement ready. We help with our “Plan Health Reports,” which develop census data into specific steps to address the participation and welfare of participants.

You make most of your money in a bear market, you just don’t realize it at the time” - Shelby Cullom Davis (1909-1994)

The past 18 months have been taxing for us all. The most important action we can all take is to count our blessings. Many friends and clients have found useful a thorough, objective review of their outside investment accounts. In viewing the whole, we often uncover compelling opportunities to improve one’s situation. Let us do the same for you. Frank J. Ruffing CFP

The three-legged stool of retirement planning, Pensions, Savings, and Social Security, is facing pressure on a new front. According to Bloomberg, the generous income and principal guarantees afforded by Variable Annuities have jeopardized the capital base of the Insurance Companies who’ve sold them.

McLean, Virginia, November 11, 2008 [email protected]

7918 Jones Branch Drive, Suite 800 McLean, VA 22102 Telephone 703-283-5220 www.farragut.us.com

Copyright 2008, Farragut Resources, LLC. The material presented is for informational purposes only and is not intended to recommend a specific investment strategy or the purchase of securities. All opinions are those of the author, and do not reflect the policies of Farragut Resources or Capitol Securities Management, Inc. Investment advisory services and brokerage provided through Capitol Securities Management, Inc, Member FINRA/SIPC.