quarterly COMMENTARY - January 1, 2012

What a year it was! 2011 witnessed riots and regime change in the Arab world, a nuclear catastrophe in Japan, political deadlock and the downgrade of the United States’ credit rating, and a persistent debt crisis that threatens the continuity of the European Union. Despite these events, the S&P 500 stock market was virtually unchanged, ending the year at nearly the exact same price level that it began the year. In many ways, it was analogous to a theme park roller coaster that picks up and drops off riders at the same level platform, but which offers many thrills and chills in-between.

Much of the resiliency in the U.S. market is due to the fact that our domestic economy continues to show signs of stability and gradual improvement while alternative economies in Europe and emerging countries are beginning to deteriorate. Accordingly, U.S. equity markets dramatically outshone all developed and emerging foreign markets, including Germany (DAX: -17.4%), France (CAC 40: -19.6%), Japan (Nikkei: -12.8%), Hong Kong (Hang Seng: -19.9%), Brazil (Bovespa: -27.0%), China (Shanghai: -18.1%), and India (NSE Nifty: -36.5%). During a period when so many investment professionals have strongly endorsed global market diversification through index ETFs, we ask, “why?” We get plenty of global economic diversification through multinationals, and our hand-selected shares of foreign companies performed well. You will not see Golub Group sprinkle your money around indiscriminately for the sake of diversification; every security in your portfolio will be chosen based on its own merits and the risk-reward relationship it has with other portfolio holdings. The result will be a portfolio that is well diversified along the lines of industry, asset class, geographic exposure and market capitalization, even if the means to achieving diversification are different from many other investment practitioners.

In investing, the consensus is typically wrong. Crowd behavior among investors is precisely the thing that creates opportunities for those who can use independent judgment and exploit the mispricings that result. We firmly believe that when market pundits line up on a particular point of view, we are sent a clear signal to expect the opposite to occur.

This year, the consensus is decidedly downbeat. Taking cues from the recent past, the average market pundit believes that we are in for more of the same as we experienced in 2011. We are not with the consensus, and are in fact optimistic for the market, even at a time when we expect modest GDP growth and continued high unemployment. GDP growth rates have never been well correlated with stock market returns. Other factors are more important. Specifically, we expect further earnings growth from corporations, albeit at a more moderate rate than the recent past, continued benign inflation, a containment of Europe’s problems largely within Europe, and—finally—a willingness amongst the investing public to put money to work in selected equities.

Consider that since the beginning of 2008, retail investors have withdrawn a total of $390 billion from domestic and foreign equity mutual funds, while increasing their commitments to fixed income mutual funds by $708 billion (Investment Company Institute data). 2011 saw investors again accepting virtually no return from bond funds in exchange for their presumed safety. In fact, equity funds saw outflows of $125 billion for the year through December 21st; bond funds saw inflows of $133 billion over the same period. If something cannot continue forever, it will stop. We believe that 2012 will be the year that funds flows finally decidedly favor stocks, driven by the widest-ever disparity between the relative value of stocks versus bonds. Investors will simply no longer accept negative real returns in bonds, will recognize that stocks as a class are attractively priced at 12x earnings and 2.1% current dividend yield (with the shares of many wonderful companies even cheaper than this), and will acknowledge their capital is really quite secure in stocks, provided they focus their investments in companies of the quality we espouse in our commentaries regarding the “New Sovereigns.” These are the companies whose balance sheets are so strong that investors deem them to be less likely to default on their debt than even the largest and most secure sovereign nations (for more on this, feel free to give us a call).

In these uncertain economic times, a pessimistic and myopic investing public has largely ignored the fact that many corporations are extraordinarily strong and well positioned today. Over the past decade, financial leverage of S&P 500 companies has fallen dramatically (net debt was 2.4x operating cash flow in 2011, down from 3.6x in 2000), while cash on balance sheets has soared (29.1% of revenues in 2011, versus 10.7% in 2000). Even our “beleaguered” financial system has recapitalized to the point where, we argue, it holds a surplus of both capital and liquidity today. We are no longer concerned about the health and viability of our core financial institutions.

We recommend that investors maintain or increase their exposure to equities this year. We make this recommendation with the comfort that the rest of the world doesn’t necessarily agree with us, which according to the rules of crowd behavior, increases the likelihood that we are correct. But if we are wrong, we have the added comfort that our downside is protected by the historically cheap valuations and the financial strength of the corporations we own.

You may notice a larger than usual cash balance in your taxable accounts. This is due to our year end tax-loss selling and you should expect us to reinvest this back into many of the same businesses that we sold once the 31 day window expires.

Included with this commentary are your quarterly performance figures, management fee invoices, and a copy of your portfolio allocation as of 12/31/11. You will receive reports from your custodian as well. We urge you to compare both statements to insure accurate reporting. These reports will also be available online on our website (www.golubgroup.com) under the account access tab. If you have any questions about your accounts or would like to come in for a visit, please drop us a note or give us a call.

As always, please call if there is anything we can do to help you with your goals.

Best wishes,

Golub Group

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.