Counterpoint — A Commentary of Jurika, Mills & Keifer LLC
First Quarter, 2008

RECESSION 2008!

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By now, anyone who watches even a small amount of television knows full-well that we are in the midst of a made-for-television recession, complete with heart-stopping drama, and featuring an epic conflict involving Wall Street, Main Street and Washington, along with a star-studded cast of heroes, villains, and even worse, politicians. The economy has supplanted Iraq and even the election as the lead story and the news media has done its best to provide relentless coverage of every latest economic twist, turn and foreclosure.

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With the media constantly reminding us how bad things may be there is some aspect of our current economic downturn that may be both overstated and yet ironically self-fulfilling. Consumer confidence is at historically low levels and there is rampant pessimism among business leaders. So clearly, all the talk about recession has worked its way into the mindset of homeowners, executives, and everyone in between. People are thinking dark thoughts.

Economic realities are governed by fundamentals but also by psychology. Through the powerful lens and influence of the media, it is easy to lose perspective, to get swept up in the volatile cross currents, and to let emotion, rather than reason, rule your investment thinking. This is never a good idea.

The current economic environment presents a number of very real risks and opportunities, calling in turn for a strategy that is both defensive and opportunistic. We outline our case below:

We begin by reiterating our basic investment premise:

1. The U.S. economy is already in a period of recession or contraction.

2. The driving force behind this contraction is deleveraging.

3. The recession or contraction may not be deep, buoyed by aggressive monetary and fiscal policy, but the recovery will likely be slower and more anemic than expected.

4. Inflation will be a growing problem and will pressure profit margins.

5. Domestic weakness will slow global growth and global growth will help mitigate domestic weakness.

6. Many stocks selling at attractive valuation levels, but overall expectations are too optimistic. Significant downside risks remain and outweigh upside potential. Build positions in great companies, but keep some cash for later.

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Give me Liquidity, For-give Me Debt:

The U.S. economy already appears to be in a recession, although whether it is called a recession not matters much less than the fundamental reality that domestic economic growth is contracting. We do not think that this is a conventional downturn, but rather the unwinding of a major liquidity bubble and the beginning of a significant period of deleveraging and recapitalization, especially in the financial services industry and throughout the consumer economy. The degree and magnitude of the unwinding is usually in direct proportion to the degree and magnitude of the winding, which was considerable, so there is more work to do.

It is reassuring that the financial system didn’t melt-down altogether, but the collapse of Bear Stearns and extraordinary intervention by the Federal Reserve underscores the seriousness of the situation. Although the patient was saved from a near-death experience, he’s still under observation and in rehabilitation for an addiction to performance enhancing debt. It will take a lot of of rehab before the Bull is ready to run again.

Deleveraging: Less money to lend and to spend.

Between 2000 and 2008, total outstanding debt as a percentage of GDP grew from about 250% to about 350% and consumer savings, as measured by the personal savings rate, declined from 2% to just about 0%.

It is clear in hindsight that a significant measure of economic growth and profits in the domestic economy over the past few years was made possible by an abundant supply of cheap and easy credit with few strings attached. This money oiled its way through the economy: working its way into real estate; financing consumption, development, and expansion; empowering private equity deal-making; and boosting the profits and stock valuations of many companies.

The bubble peaked last July and the deleveraging process began, in effect creating a series of margin calls on banks and homeowners as equity values declined relative to outstanding debt, wiping out hundreds of billions of dollars of net worth in the process.

We are now in an extended period of deleveraging where banks and consumers atone for their free lending and spending ways and work to restore the health and wellbeing of their balance sheets. This will take time. There will be less money to lend and less money to spend for the foreseeable future.

Cure and recovery

For the time being, the strong medicine seems to be working. With the Federal Reserve providing a mechanism to support the balance sheet of lenders, a measure of law and order has returned to the financial markets.

In addition, the aggressive actions by the Fed to lower interest rates and inject liquidity into the system have given rise to the hopes that while economic fundamentals continue to deteriorate, investors who are always prone to look ahead, may be ready to declare the “bottom” for the stock market, and start to rally on the coming recovery.

We think this is premature. To be sure, stocks have already discounted a lot of near-term bad news, and perhaps overly so, but at the same time, we think they reflect too much optimism about the timing and nature of the recovery. Earnings estimates presume a sharp rebound in economic growth and profitability later this year that we believe reflects wishful thinking rather than reality.

Growth will be slower

In our view, the recovery will be anemic and will involve several years of slower growth, especially in the consumer and financial sectors of the economy. Other areas should fare much better.

As debt fueled marginal growth, profits and asset value, deleveraging will act like a brake, making marginal lending, consumption, and growth more challenging. Banks will be more conservative in their lending and there is less equity against which to lend. This is actually a good and healthy healing process, but it suggests slower revenue and earnings growth rates and a lower valuation multiple for a number of industries.

In addition, as long as we continue to run massive budget and trade deficits as a nation, we will have a weak currency, which in turn will lead to higher prices for commodities and imported goods and more pressure on profit margins. Even as consumers and businesses work to restore their personal balance sheets, our government continues to borrow and spend far more than it earns. The United States is becoming the world’s subprime economy.

The ride ahead

The ride will be bumpy, but it also presents some good opportunities. So fasten your seatbelts, check your brakes and rear view mirrors, but keep driving towards your destination.

Our stock selection continues to be driven by the following related investment themes:

1. The strong get stronger. Emphasize leading companies without problems. During periods of adversity they gain competitive advantage over weaker competitors. Good companies are selling for only a small valuation premium to companies with problems so it makes sense to pay up for quality.

2. Opportunity takers: Emphasize companies that have the expertise and capital to take advantage of opportunities during periods of distress. For example, private equity firms are now buying distressed assets from banks who are forced to raise money. This represents a transfer of wealth and opportunity from existing bank shareholders to shareholders of the buyer. We would rather own the buyer than the seller.

3. Pricing Power: Emphasize companies that are price makers rather than takers. Companies that can’t pass along higher raw materials, energy and transportation costs will see their profit margins shrink.

4. Balance Sheet, Balance Sheet, Balance Sheet: Emphasize companies with strong balance sheets that control their own destiny. In the current environment, cash is king and the need for access to capital is a liability.

5. The U.S. is on sale, especially to foreign investors. Look for high quality, undervalued assets. Many babies have been thrown out with the bath water. In particular, U.S. real estate and financial assets are very attractive to foreign buyers.

6. Tilt towards developing economies: They are growing and creating enormous wealth. Emphasize domestic companies that sell their goods and services overseas, especially to foreign buyers who have cash and for whom dollar denominated goods are a bargain. Exporters should benefit from a cheap dollar.

7. Put the wind at your back: Emphasize companies that benefit from secular trends, such as communications and technology, energy, and globalization.

8. Hedge against a declining dollar: Emphasize export driven companies that control large amounts of natural resources, which are both required for global growth and provide a hedge against a declining dollar.

Finally, we would recommend tuning out a lot of the noise coming from the television. The constant stream of conflicting opinion and daily blather will only serve to heighten your anxiety and diminish your returns. Periods of contraction are a natural part of the economic cycle. This one makes for great television but will not resolve itself neatly with a thrilling and tidy season finale. It will play out over an extended period of time.

We blieve investors should therefore invest with a long-term focus on owning high quality businesses, that can weather the storms and exploit the opportunities along the way.

Jurika, Mills & Keifer, LLC
April, 2008

Important Disclosures

Past performance is no guarantee of future results.

Opinions expressed are those of Jurika, Mills & Keifer, LLC and are subject to change, are not guaranteed and are not recommendations to buy or sell any security.