COMMENTARY - 3rd QUARTER 2009

The past 18 months have been extremely difficult for investors, but what a difference a year makes.  Just over one year ago, the Dow Jones Industrial Average suffered its largest single-session point decline in history, as it dropped nearly 778 points in a day following news that the U.S. House of Representatives had rejected the first draft of the $700 billion financial rescue plan being considered at the time.  Of course, the selling did not stop there, as over the ensuing few months, the Dow went on to experience its second-, fourth-, and fifth-largest point declines ever.  In all, from the collapse of Lehman Brothers on September 15th, through the end of 2008, the market experienced a period of historic volatility, moving up or down by at least 3% on a daily basis a total of 29 times!  One year later, following TARP, TALF, and a string of other Federal Reserve-backed programs designed to restore financial and economic stability, the financial markets and economy alike have found firmer footing, with signs of even gradual improvement beginning to emerge.

Fortunately, what a difference even several months make.  As quickly and severely as the equity market declined during the fourth quarter 2008 and then again in the first quarter of 2009, it just as quickly and sharply recovered from the March 9th lows through the end of the third quarter.  Since March 9th, the S&P 500 has risen nearly 55%, rising 15% in the third quarter alone for a total gain of 17% year-to-date.  The Dow also gained 15% in the third quarter, rising a total of 10.7% year-to-date and capping its strongest quarterly performance since 1998.  For its part, the Nasdaq Composite rose 15.7% in the third quarter, bringing its return to 34.6% year-to-date.

Despite the impressive rebound in the stock market since the March lows, there still remains a large amount of cash on the sidelines, currently earning very low rates of return.  Following a rush to cash and U.S. Treasury securities in the fourth quarter of 2008 and earlier this year, many investors remain fearful of getting back into the stock market and instead continue to seek safe haven in other “less risky” investments.  To wit, the Investment Company Institute, a mutual fund trade group that tracks fund flows, reported that while investors poured over $42 billion into bond mutual funds in August, only $3.9 billion went into stock mutual funds during the same month.  Our notion that this enormous amount of cash on the sidelines will ultimately flow back into the equity markets over time is something that we have repeatedly highlighted to our clients as one of the principal reasons we remain invested in high quality, cash-rich, dividend-paying, blue-chip businesses.  We believe these companies will be magnets for that cash as it gradually reenters the market, and we expect this phenomenon will play out not only in the short-term, but over the ensuing years as well.

Another noteworthy aspect about the recent market rebound has been the underlying dynamics contributing to its impressive rise.  That each of the 10 major industry sectors and 131 industry sub-groups in the S&P 500 has risen since March is a clear testament to the strength and breadth of this rally.  Somewhat disconcerting to us, however, has been the initial outperformance of those sectors that have led this rally.  Leading the pack up have been the very same sectors that suffered the most during the market rout: specifically, financials, industrials, basic materials, and consumer discretionary stocks.  While we do have a substantial portion of our clients’ portfolios invested in world-class industrial companies that we believe will benefit not only from continued economic improvement in the U.S., but long-term growth in developing markets, the financial, materials and consumer discretionary sectors are areas where we remain largely under-represented in our portfolios.  While much has improved over the past several months, we are not out of the woods yet – at least when considering ongoing consumer deleveraging and the residential and commercial real estate-related challenges still confronting financial institutions.  These are reasons enough to remain cautious on those sectors for now.

Much ink has been spilled over the past several months on this very topic, as market observers have chronicled this so-called “Dash to Trash” in the stock market.  We addressed this topic early in our second quarter commentary to you.  More recently, we have highlighted to clients a recent cover story in the August 17th issue of Barron’s magazine entitled “Quality Counts!”  The article points out how “this year’s rally has left behind some solid, high quality, blue-chip stocks, many of them with plump dividends.”  We couldn’t agree more.  Of the twelve stocks profiled in the article as offering “quality at a reasonable price,” eight are stocks we currently hold in many of our clients’ portfolios.

Should this market trend continue into the foreseeable future (although we don’t think it will), we may very well continue to lag the market.  Why?  Because we have deliberately chosen not to expose you to the risks associated with investing in the lower quality, higher risk companies whose stocks have led this market rebound.  Should the market pull back or correct, however, or should the outperformance of those lower quality companies begin to wane, we fully expect that our clients’ portfolios will perform better on a relative basis.  What if any bearing does that have on our investment approach and our long-term investment outlook?  Absolutely none.  We will not (nor should you want us to!) “change our stripes,” as investors have a tendency to do at exactly the wrong time, often with ruinous consequences.  We will not “chase performance,” nor will we deviate from our disciplined approach to investing—all with your best interests in mind.

As investment professionals, we constantly have to remind ourselves to remain focused on what we can control and to maintain a long-term perspective and not confer undue credence to any short-term market movements.  We urge you to exercise patience with your investments and would caution you not to read too much into short-term results, but rather focus more on long-term results and consistency of results over time.

In light of the significant market rebound, a question on many minds is, “What to do now?”  We clearly are faced with great uncertainty as it relates to the economy and markets going forward. As we talk with our clients, we are struck by the almost equal number of those who ask whether now is the time to get more “aggressive” or conversely, to get more “conservative.”  This extends to questioning whether we face deflation or inflation ahead, and more broadly, whether the global economies are rebounding temporarily, or sustainably.

These are important questions, and ones which will have no clear answer until we have the benefit of hindsight.  As such, we have positioned your portfolios in a “barbell” manner, with significant exposure to stocks which should do well in a sustained recovery – for example, technology, industrial, and energy companies – balanced with those which should do well in the event of another economic downturn, including consumer staples and health care companies.  More importantly, however, we believe all of our holdings should do well over the long-term because they are the product of our investment discipline.  We remain focused on investing in companies that produce strong cash flows via strong competitive advantages, enduring products and services, and honest and able management teams.  And of course, our emphasis on valuation and margin of safety remains paramount.  So whether the economies of the world strengthen or weaken from here, we feel confident that this time-tested discipline will prevail.  After all, we are in the investing-for-longevity business, not the make-a-quick-buck business.

As confirmation of our discipline, we have analyzed our core holdings and have found strong reasons to believe your portfolio will perform more than satisfactorily over the long-term.  In fact, at no time in the past decade have we been able to find as many high-quality businesses trading at such attractive valuations.  To put this into perspective, consider that our companies collectively trade at a price-to-earnings multiple that is 41% lower than their 10-year historical averages.  Correspondingly, your portfolios’ dividend yield and cash flow yield are respectively 77% and 69% higher than their 10-year averages.  Despite the comfort we gain from these simple statistics, we continue to scour the universe for investments even better suited for your portfolios and will act accordingly when they are identified.

In closing, we believe that the high volatility and uncertainty in markets over the past year will yield to a period of greater stability and certainty, which could endure for several years.  Because we believe so strongly about the opportunity today to generate superior risk-adjusted returns from portfolios containing dividend-paying common stocks, we recently drafted a white paper that describes our thesis in greater detail.  If you would like to receive a copy of our paper, Dividend-Paying Stocks: The Solution to the Retirement-Aged Investor’s Dilemma, please ask your Golub Group Financial Advisor.  There is also a link on our website (www.golubgroup.com) that will enable you to download an electronic copy.

With warm regards,

Disclaimer: All opinions presented in this commentary are strictly those of the Golub Group.  You should not construe any implied or expressed conclusions presented as a promise of future returns.