COMMENTARY - 4TH QUARTER 2009

“PIMCO to Branch into Actively-Managed Stock Funds”
(as reported in the Los Angeles Times, December 7, 2009)

Why has PIMCO, the world’s largest bond management firm, decided to enter the equity management business following the worst decade in history for stocks? We know why: Bill Gross of PIMCO has a problem on his hands. His firm, founded in 1971, has benefited immensely from the extraordinary bull market in bonds that has occurred over the past 30+ years, as interest rates have gradually declined from the double-digit levels of the late 1970’s and early 1980’s to today’s near-zero percent interest rates. The problem is that, after hitting rock bottom, interest rates have only one direction they can go, and that’s not welcome news if you’re a bond manager presiding over almost $1 trillion in securities that will decline in value as interest rates rise.

So what’s a good bond manager to do these days? Buy stocks, of course, which is exactly what Bill Gross and PIMCO have indicated they will do. PIMCO is not going to buy just any stocks, mind you. They have stated that they will focus specifically on a bottoms-up, “deep value” approach to stock investing. Mr. Gross has even gone so far as to use his December monthly investment outlook to recommend investors purchase high quality utility and telecommunications stocks. That investors should focus on high quality, large cap, blue chip, dividend paying companies when investing in stocks? Thank you, Mr. Gross, for underscoring what we at the Golub Group already know and what we already practice.

Individual investors also have a problem on their hands. Too few of them have participated in the greater than 60 percent rise in the S&P 500 since its March 2009 lows. Over $3.5 trillion of cash still remains on the sidelines, largely in money market funds earning almost nothing in this low interest rate environment. What’s worse, in a search for higher yields on their money, investors have flocked to bonds and bond funds at what could be the worst possible time, given the prospects for higher interest rates in the long-term. Over $315 billion of that cash on the sidelines has flowed into bond funds through September 2009. Contrast that with equity mutual funds, which actually saw net outflows of over $5.3 billion through the third quarter 2009, even as the stock market continued its historic rise (see chart below).

This type of investor behavior reminds us of the spring of 2000, when investors poured money into stock mutual funds searching for the quick buck right at the peak of the stock market bubble. Just as those investors who chased their Internet fortunes in 2000 were burned, so too will people who are overly invested in bonds today.

If investors are currently flocking to bonds for both higher yields (income) and safety (capital preservation) relative to cash and stocks, we believe that they will be disappointed when bond prices fall as interest rates rise from historic low levels. As this occurs, we expect investors to favor the types of businesses that we own, as they offer both comparable income and greater capital appreciation potential than the alternative investment in bonds. As an example, companies such as Kraft (Symbol: KFT), Diageo (Symbol: DEO) and ConocoPhillips (Symbol: COP) all have a higher current yield than the 10-year U.S. Treasury note. We expect these companies to grow their earnings and cash flow over time, which should lead to both increased dividends and higher stock values. As we have discussed, companies that have the ability to consistently pay and increase dividends over time have outperformed the S&P 500 and have significantly outperformed bonds. Collectively known as “Dividend Aristocrats,” only 43 S&P 500 stocks have at least a 25-year history of increasing their dividends annually. We own 10 of them. For the 15-year period ending 11/30/08, the “Dividend Aristocrats” returned an average of 9.2% per year, versus a 6.5% return for the S&P 500. Therefore, investing in the “Dividend Aristocrats” over this time period would have created 46.2% more wealth than investing in the broader S&P 500. We believe we have created our own portfolio of “Aristocrats” that are equally well-positioned for growth over the coming years.

Given this perspective, it may seem odd that we haven’t been actively selling our bond positions. We are not changing our long-term asset allocation recommendations for those in need of current income and lower volatility, but we also don’t want to “chase” overvalued bonds alongside so many other market participants.

How do we balance the essential role of bonds against their currently stretched valuations? First, we are investing in bonds with “short” maturities, typically between four and seven years, as a way to minimize our exposure to potential shifts in prevailing interest rates. (All else being equal, longer-dated bonds are more sensitive to changes in interest rates than are shorter-dated bonds.) Specifically, we believe shorter-duration bonds will best serve our clients in the event interest rates increase in the coming years – a very real possibility. Second, we remain acutely focused on high-quality securities. For tax-free municipal bonds, this means we continue to purchase general obligation bonds, which are typically supported by a government’s broad taxing authority, and bonds supported by revenues from essential government services. For taxable bonds, we emphasize high-quality and short durations through our mix of bond ETFs. A recent review of this allocation mix yielded an “AA” S&P rating and an average duration of 3.7 years. This emphasis on high-quality securities may have resulted in less than spectacular performance this past year, but over the long run, it surely is a recipe for wealth preservation.

We have strong views as to the relative merits of investment securities in the present environment, but when it comes to managing accounts for individual clients, we recognize that one size never fits all. Managing your account requires that we have a deep understanding of your personal financial circumstances, goals and tolerance for risk before making investment decisions on your behalf. This is particularly true as we approach the retirement years, when shortening time horizons and rapidly evolving financial circumstances require close attention to the investment decisions we make.

To this end, Golub Group has invested in new tools to assist you in evaluating your needs in retirement and to structure a portfolio designed to serve those needs. Our Financial Advisors stand ready to work with you to confirm the strategies we employ for you, or to make adjustments should your changing circumstances require them.

We have also added two new members to our team. Cari Leamy joins us as a Financial Advisor and brings with her eight years of experience advising clients, most recently with Fisher Investments. Rebecca Katz has joined the Business Development team after having recently earned her Ph.D. from Stanford. Both new members of the team look forward to working with you.

We have included with this commentary your quarterly performance figures, management fee invoices, and a copy of your portfolio allocation as of 12/31/09. Please don’t hesitate to contact us should you have any questions or would like to arrange an in-person meeting. We wish you a happy and prosperous new year!

Best 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.