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

Of Storms, Perfect Storms, and Perfect Storms of Perfect Storms.

We started last summer with the storm. The credit “crunch,” an event that many believed was contained to a small part of the housing and mortgage market. This escalated into a perfect storm between January and March as housing continued to deteriorate and the credit crunch escalated into a full-blown credit crisis, spilling over into the broader economy. Markets tumbled and Bear Stearns went away. The Federal Reserve came in with their novel “Cash for Trash” program and backstopped the beleaguered banks and brokers by exchanging toxic waste for clean cash. Meanwhile, with diminished household balance sheets and tighter credit, the consumer economy continued to suffer. Less money to lend, less money to spend.

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Now, with an inflationary surge in commodity prices - including food, energy, metals and especially oil - spiraling higher against the backdrop of an overleveraged economy, we have the makings for a perfect storm of perfect storms.

We expect extraordinary challenges for the economy and the investment markets to continue. The tide will likely go out further than many expect, revealing and stressing areas of weakness. These conditions may also create some extraordinary investment opportunities for those with cash and patience.

Our view since the first signs of storm clouds last summer has been that we are in a period of deleveraging and contraction in the economy that will likely last at least two years and perhaps longer. In our experience, the magnitude and duration of the period of past contractions has been usually equal and opposite to the period of expansion and excess, a sort-of Newtonian third law of economics.

While some have debated whether or not we are in a recession or a bear market, or whether inflation is a problem, such discussions are meaningless to most consumers and business owners who have to deal with reality rather than government statistics. Irregardless of technical definitions, the impact is the same; we are in a period of economic retrenchment and inflation is a growing problem. Growth is slowing, credit is tightening, costs are rising, margins are shrinking, and valuations multiples are contracting. Those forces that were tail winds over past years are now head winds.

As much as Wall Street would like to declare the storm is over, we continue to see more rough weather ahead, but not all news is bleak. We also see some important opportunities. Specifically, some high quality assets have already been marked down to fire-sale prices and a lot of bad news is already reflected in many stock valuations. Pessimism is rampant.

We have remained cautious for much of the year, although the companies we like and continue to hold have not been immune from the stormy markets. But we do hold a large amount of cash and our shopping list of good businesses at bargain prices is growing day by day.

Contrary to sentiment, Bear Markets represent periods of expanding opportunity, especially for a selective long-term investor with patience and a tolerance for near-term volatility. That is especially true in today’s environment where so much money is invested by hedge funds and other investors with a short-term time horizon. With high fees, high expectations and high anxiety to match, a premium is placed on near-term performance relative to long-term intrinsic value. Wall Street research has followed suit and recommendations, target prices and time horizons have contracted to 3-6 months, exacerbating the trend and the valuation gulf between what is hot and what is not.

Economic and Market Scorecard.

Since there are so many conflicting market and economic cross currents, we thought it would be useful to review them.

Economic Growth: So far domestic economic growth is still positive, although anemic by any measure and likely to continue that way. Domestic growth has likely been helped by strong exports, a weak dollar and fiscal stimulus. We expect European growth to slow further and the combination of Europe and American retrenchment to dampen growth in developing economies.

Interest Rates/Credit: Short and long-term rates are low on a relative and absolute basis. The problem is that credit availability is tight, especially for marginal borrowers. Banks are likely to be overly cautious lenders for foreseeable future. The Federal Reserve easing can only do so much to stimulate an economy that is recovering from too much credit and too much easing only contributes to a weak dollar and rising commodity prices. Mounting Federal, State and Municipal deficits suggest that the trend for long-term interest rates is up.

Currency: The dollar may be oversold, especially relative to the Euro and Pound. But over the long-term, the strength of the dollar is a reflection of this country’s fiscal health, which continues to deteriorate on an absolute basis. We cannot continue to borrow hundreds of billions of dollars every year

The Federal Reserve Bank’s Cash for Trash program, and Congresses Fiscal Stimulus Package, provide temporary relief to serious problems, but result in a further deterioration of the nation’s balance sheet. In the first case, the Federal Reserve bank is swapping financial toxic waste from banks and brokers for cash, a superfund cleanup underwritten by the American Taxpayer. In the second case, we are borrowing $168 billion from the Chinese and other lenders to give to tax payers with the hope that they spend the money to support the economy, presumably on goods made in China, or on gas refined from Middle Eastern oil. This is a slightly cynical exaggeration, but the underlying truth holds. In our view, if we are going to borrow money as a nation, it should be to invest in something that creates long-term value for our economy- such as alternative energy and infrastructure – rather than sustaining unsustainable levels of consumption.

Inflation: Inflation is a growing concern. Although overall domestic inflation rates are not anywhere near double-digit levels reached in the 1970’s and 1980’s, commodity prices have risen to a rate where they are causing economic distress throughout many parts of the world. Global growth is resulting in greater competition for food, basic materials, oil, water, and capital. Increasing costs of production will likely work their way through the economy, resulting in shrinking profit margins and higher final prices. We expect inflationary trends and pressures to continue, although they should become self-correcting as higher prices result in reduced consumption, or as it is euphemistically called, “demand destruction.” We expect global growth to slow under the weight of higher commodity prices, which should in turn lead to lower commodity prices.

Deflation: The larger risk to the economy and stock markets is asset deflation rather than commodity inflation. To the extent that the value of homes, commercial real estate businesses and other assets were inflated because of excessive leverage in the economy, now as the economy deleverages, we risk a further deflationary downtrend as debt liquidation forces the sale of assets and supply overwhelms demand. When this happens, prices fall dramatically.

Employment: Employment has held surprisingly firm until recently, only showing a small deterioration despite numerous headlines of cutbacks and layoffs. The latest data show a spike in the unemployment rate to 5.5.%. Although this is still a modest level, our suspicion is that unemployment will likely accelerate as businesses react to the slowing economy. A significant uptick in unemployment should place further stresses on the consumer, housing and credit markets. Conversely, stable employment and a bottoming of the housing market are essential to an economic recovery.

Market Valuation: The good news is that overall valuation levels for U.S. stocks are not high and in many cases they are downright cheap. A lot of bad news and fear is already reflected in prices. The question is whether overall valuations levels properly reflect future growth, profits and risk. Our assessment is that growth and earnings forecasts are still overly optimistic looking out through the end of next year and that market valuation levels will likely shrink further. We also know from experience that trends, for better or worse, tend to go further than you think. Cheap can get cheaper.

Sentiment: Market sentiment is very negative, which is a necessary but not sufficient condition for a real bottom in stocks. Many investors are looking for the bottom in the U.S. market which leads us to believe that we aren’t there yet.

It will be hard for the market to base and start to rebuild until housing and financial institutions have stabilized. In particular, investors need to have confidence in the book value of financial institutions and that the deflationary spiral of asset values is at an end.

Strategy: Our strategy is to remain defensively positioned, with a substantial cash position and wait for attractive opportunities to present themselves.

Although a lot of damage has been done and accounted for in the markets, our valuation work suggests the potential for another move lower. In particular, we believe the chain of cause and effect has yet to fully digest the impact of tighter credit, lost equity and higher costs, or to fully work its way into employment. This may play out over the next few months, with rallies and retrenchments, rather than a sudden, unequivocal capitulation sell-off that many seem to be expecting.

The recovery for the U.S. economy will likely be slow and anemic. Debt supported an artificially high level of growth, especially within the consumer sector, which represents about 70% of GDP. Easy credit led to a consumption binge that is unsustainable, and business models geared towards a resumption of prior levels of demand are in trouble. The U.S. consumer needs a rest.

And the good news is?

That being said, many very good companies are selling at compelling valuation levels and although we pay attention to markets, we are primarily long-term investors in businesses.

We are especially drawn to differentiated businesses with valuable and durable franchises that produce a reliable stream of free cash flow. They will likely hold their value and can offer an attractive return on investment to shareholders.

We particularly like owning companies that we define as “opportunity takers” which are firms that have large amounts of capital and long-term investment time horizons and can be opportunistic buyers of distressed assets.

We also think technology companies are extremely well positioned for the long term. Leading tech companies have strong balance sheets and are in the way of the global development and deployment of the internet around the world. More data. More users. More bandwidth. More devices. This should continue no matter what.

Finally, as quality U.S. companies, real estate, and other assets become cheaper, they also become ever more attractive to strategic and other buyers. There is a lot of excess capital around the world looking for opportunity. For example, the recently announced purchase of Rohm and Haas by Dow Chemical, in conjunction with Berkshire Hathaway and the Kuwaiti Investment Authority reflects this new reality where financing may come from non traditional sources.

So batten down the hatches, but don’t abandon ship. The more perfect the storms, the more perfect the opportunities to be found and capitalized upon.

Jurika, Mills & Keifer, LLC
July 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.

Free cash flow is the cash profit a business generates and has available for discretionary use after covering all required expenditures and capital reinvestment.