Dear Clients, Friends and Associates,

A few weeks ago I summarized the first part of a particularly useful section in Warren Buffett’s recently released annual letter to shareholders entitled “The Basic Choices for Investors and the One We Strongly Prefer.” The bottom line of that email is to properly define your risks when investing and the biggest risk to investors is loss of purchasing power over the anticipated time horizon of the investment. Short term volatility is not necessarily risky if your time frame is expressed in years or even decades.

Buffett goes on to describe three major categories of investments: 1) Investments denominated in a given currency, such as money markets, CDs, bonds, etc; 2) Non-producing investments, such as precious metals; and 3) investments in productive assets such as businesses, farms or real estate.

Investments denominated in a given currency, such as money markets, CDs or bonds are often thought of as “safe” because they are not very volatile, but Buffett warns us that “In truth they are among the most dangerous of assets.” He is notably concerned with negative impact of inflation on purchasing power over time. He notes that it “takes no less than $7 today to buy what $1 did in 1965.” For tax-paying investors, U.S. Treasury bills produced an average of 5.7% annually. Subtracting an average 25% tax burden leaves a 4.3% after-tax return, which according to Mr. Buffett, was evaporated by inflation over that time frame. So although investors still have their account balances in tact, they had no real return to show for 47 years of effort. At current interest rate levels, “real” returns (after inflation) are in some cases negative. This is a tax on savers as real as any tax. Buffett quotes Shelby Davis as saying “Bonds promoted as offering risk-free returns are now priced to deliver return-free risk.” Given that bonds are offering yields at 30 year lows, this is serious food for thought. Clearly, there is a place for fixed income investments for shorter term goals. The point is though, to be sensitive to other forms of risk besides volatility and understand what your real return expectations are over time.  

The second major category of investments produces nothing. It is purchased in the buyer’s hope that someone else will pay more for them in the future. We are talking about precious metals, most notably gold. Gold neither has much use nor is it procreative. It relies on ever increasing demand by the ranks of the fearful. Buffett notes that “if you own one ounce of gold for an eternity, you will still own one ounce at its end.” While the self fulfilling nature of rising prices creating its own demand works for a while, it eventually succumbs to reality. Note the Internet and housings bubbles. According to Buffett, the market must absorb around $160 billion in annual production just to maintain equilibrium at present prices. Buffett suggests strongly that rather than buying gold, investors purchase a productive asset, such as businesses or farm land. Businesses and farm land throw off handsome cash flow, or wheat, corn, cotton or other crops year after year. Yet gold owners will still just own their ounce of gold. Buffett’s thoughts really put the current raging bull market for gold in perspective.

The first two investment categories enjoy maximum popularity at peaks of fear. Buffett’s own preference, widely expected, is the third category of investing in productive assets, whether businesses, farms or real estate. Buffett maintains that “Ideally, these assets should have the ability in inflationary times to deliver output that will retain its purchasing-power value while requiring a minimum of new capital investment.” He points to farms, real estate and businesses such as Coca-Cola, IBM and See’s Candy as meeting that double-barreled test. Utilities require capital investment to grow earnings, but even so, “these investments are superior to nonproductive or currency-based assets.” The value of businesses, farms or real estate will be determined but by the medium of exchange, but rather by their capacity to deliver goods and services demanded by the masses. Buffett maintains appropriately that over any extended period of time, this category of investing will prove to be the runaway winner among the three alternatives he’s examined and more importantly, it will be by far the safest.

 Thank you, Mr. Buffett for your insightful commentary. Well said.

Warren Buffett’s annual letter to Berkshire Hathaway’s shareholders is well known for its pithy and often poignant commentary and this year’s letter is no exception. Tucked between detailed commentary of his many businesses and important information for attendees of the upcoming May 5 annual meeting in Omaha are three pages of analysis that all investors would find beneficial. The title of this section is “The Basic Choices for Investors and the One We Strongly Prefer.”

Mr. Buffett starts this section with the generally accepted definition of investing as the process of laying out money now in the expectation of receiving more money in the future. At Berkshire, they take a more demanding approach, defining investing as “forgoing consumption now in order to have the ability to consume more at a later date, net of taxes and inflation.” Notice the emphasis on consumption is in terms of purchasing power rather than money per se, because inflation is important element in the equation.

He goes on to state the “riskiness of an investment in not measured by market volatility (beta), but by the reasoned probability of an investment causing its owner a loss of purchasing-power over the contemplated holding period.” His point is that assets can fluctuate greatly in price and not be risky as long as they are reasonably certain to deliver increased purchasing power over their holding period.

This emphasis on expected holding period is a key to investing well and is the basis of Bolen Dodson & Associates “Goals-based Investing” approach. You need cash for spending. Fixed income is best used for spending over the next few years. Bonds are not very volatile, but they do not produce returns net of taxes much if at all in excess of inflation either.

Equities are meant for longer term goals of 5-7+ years and beyond. Equity investments are volatile over the shorter term, but are quite predictable over the longer term. Knowing when you plan on using the funds is an important element to successfully investing in equities. Being afraid of short term volatility is a recipe for failure.

In a subsequent blog, I’ll summarize Buffett’s investment choices and his preference. One guess on what he prefers.

Last week’s market action was downright ugly. I’ve reviewed my basic impressions of market fundamentals and technicals and observe the following:

•  Economic and corporate indicators continue to point to modest economic growth. Leading economic indicators rose again in August. Prices are undervalued.
• Markets discount a Greece default on its debt obligations. Concern of “contagion” is a major cause of U.S. equity declines. However, Greece appears dedicated to not letting this happen. If it does, markets will be chaotic for a spell and likely create a further buying opportunity.
• Consumer sentiment is very poor. While this could induce the first ever confidence led recession, odds are it is setting the stage for capitulation and a rebound.
• A recession is priced into the equity markets yet the odds of a renewed recession are only 25%-30%. This is bullish.
• Market trends are decidedly down, but selling during a market decline has not proven to be a winning strategy. Markets always eventually rebound and they can turn very fast, often when things look bleakest.
• The best course of action is to maintain liquidity for spending purposes and rebalance portfolios, buying equities to take advantage of the market pullback.

While the media was fixated on the looming debt ceiling/default date of August 2, several not-so-well covered news releases painted a glum economic picture. So even though Congress and the President came through with a last minute deal (as expected), investors immediately turned their attention to economic activity and didn’t like what they were seeing and knocked another several percent off the market averages.  

On July 29^th, the Bureau of Economic Analysis released its initial estimate for the 2^nd quarter “real” GDP growth (Gross Domestic Product) of a weak 1.3%. More notably, the BEA revised downward 1^st quarter growth from an already weak 1.9% to a paltry 0.4%. What this means is the economy is growing very slowly and not enough to create jobs in any meaningful way. The BEA also revised downward GDP growth data from 2003, which of course included the “great recession” of 2008-2009. The 4^th quarter, 2008 contraction was changed from -6.8% to -8.9% and the 1^st quarter, 2009 was lowered from -4.9% to -6.7%. The cumulative decline from the 4^th quarter 2007 peak to the 2^nd quarter 2009 trough in real GDP was revised downward almost 50 basis points (0.5%) to -5.1%. These are huge negative revisions and indicative of how severe this recession was, and how far we have to climb to get back to where we were.  

Then on August 1, the Institute of Supply Management released its July manufacturing report, which showed growth in manufacturing, but at a slower pace then June and below expectations. The question in my mind is how much of this slowdown was caused by Congressional inaction on the debt ceiling debate. When consumers are uncertain about the future, they hold on to their cash and quit spending.

As well, the drum beat of potential further European Union credit defaults continues. The European Central Bank is in talks with Italy, Spain and others in efforts to contain the potential for Greece like defaults. While this could clearly get messier, systemic failure of the banking system seems highly unlikely.

Global economic activity throughout most of the first decade of the 21^st century was helped in no small measure by easy credit and overuse of leverage, by both the consumer and world governments. This is now unwinding. Asset bubbles have burst and easy credit is gone. This process will not be rushed. We cannot push on a string.

 Kenneth Rogoff, Professor of Economics and Public Policy at Harvard University and formerly chief economist at the IMF has written an excellent article that reframes the issues of the day. He suggests that rather than having come through a Great Recession, we are going through the second Great Contraction. This makes complete sense to me. See the article here: http://www.project-syndicate.org/commentary/rogoff83/English.

The consumer is now retrenching. Savings and debt reduction is in vogue more so than over spending. We hope this continues as it is very bullish for the economy longer term. For its part, the Federal Government is now talking about actual deficit reductions. The debt deal earlier this week is hardly a down payment on what must be more substantive talks on our Government, and its people, living within its means.  

The market is a discounting mechanism so responds to changes in expectations. You are seeing this up close and personal this week. Adjustments happen quickly to reflect the new information. The best guess of the “appropriate” market levels that reflect all the positives and negatives of the day, are the current prices. That is today, tomorrow and every day hence. Regardless of the current dislocations in the economy and in the markets, investors are well served by adhering to their strategic asset allocations while maintaining cash for this year’s spending needs. We will rebalance portfolios when appropriate to buy the underweighted asset class and sell the over-weighted asset class. Without fail, markets always resolve corrections to the upside….sometimes quickly….sometimes slowly….but always. Today’s employment release was a fundamental step in the right direction, but the market is not quite ready to agree…yet.

We are cognizant of human behavior and recognize that people get concerned when their nest eggs are rattled. But markets regularly correct and then once again move higher. I’m sure we are all suffering from some PTSD from the 2008-2009 “Great Contraction”. However, there is nothing remotely similar to the current situation and that series of events.  

While currently the market is focused on the slow down in the economy and the potential for European contageon, there are several reasons to be optimistic. Corporate earnings are strong; oil is down 10% from its recent high; there are no major dislocations in credit markets; inflation is benign; interest rates are low; consumers are saving (allowing for future investment); Congress is serious about reducing our deficits; equity valuations are quite compelling; fear is running high (a contrary indicator); and the market is already down 11% since July 22.

We are available for questions, to provide additional commentary or to hear your concerns.