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First Quarter 2012 Outlook
“A Strong Finish to a Year that Merely Whimpered”
It appears that 2011’s weak third quarter performance discounted a considerable amount of negative news and was the launch pad for a strong fourth quarter recovery in the U.S. equity markets. Despite the Congressional stalemate in the U.S., the continuing Euro-debt crisis, and economic slowing in most developed and emerging economies, stocks in the U.S. experienced a powerful fourth quarter rebound. Our portfolios returned on average 9.80% in the final three months.
Throughout the year the markets were extremely volatile, but in the end trendless. The broad U.S. stock market indices were flat to minus six percent for the year. Overall, the year makes one recall Warren Buffett’s comment, “remember that the stock market is manic-depressive.” However, the U.S. fared much better than almost all other developed and emerging countries’ stock markets. Their performance ranged between negative sixty-one percent for Greece and minus two percent for Germany. The World Stock Market Index less U.S. issues was down over sixteen percent.
Perhaps the only sustained trend within the year was a strong positive bias toward investment in companies with strong balance sheets, above average returns on capital, and consistency in cash flow. Shareholder value was created by delivering above average dividend yields, the prospect of sustainable dividend growth, share repurchases, and opportunities for sensible acquisitions and timely divestitures. Of course, this is the value-oriented theme that drives our decision-making process. In the fourth quarter, we were able to acquire ( at prices we believe are a significant discount to their intrinsic value) the stocks of Abbott Laboratories, Bristol-Myers, Campbell Soup, General Mills, Johnson & Johnson, Kellogg, Linear Technology, Lorillard, Paychex, and PepsiCo. Besides being historically undervalued, these issues are all above average dividend payers with current yields ranging from 3% to 4.6% and carry the prospect of above average dividend increases in the years ahead.
In looking ahead to 2012, it remains important to remember that markets trend on fundamentals, but fluctuate on emotions related to the latest headlines. In an effort to value the fundamentals we refer to the following table which depicts current versus historic average yields from many asset classes. The following summary has been a very effective guide in determining whether current prices across many asset classes are currently exhibiting a discount or premium to their very long term average (over sixty years in most cases).
| Equities: | Current Yield | Historical Yield |
| (Dividends for Equities, Interest Rates for Bonds) | ||
| Dow Jones Industrial Average | 2.80% | 3.57% |
| S&P 500 | 2.04% | 3.17% |
| Fixed Income: | ||
| Corporate Bonds | 5.18% | 8.11% |
| Municipal Bonds | 3.88% | 5.54% |
| 10-Year US Treasury Bonds | 1.93% | 6.22% |
After considering the summary of information above, we come to conclusions similar to those we made three months ago:
- Stocks in general are currently more attractive relative to fixed income instruments (particularly Treasuries) but not undervalued on an absolute basis. The average annualized increase in dividends for the stocks in the Dow is about 10%. If we assume that is going to happen again this year, large-cap stocks (which on a relative basis are the most undervalued) are moderately overvalued. Increases in dividend payouts in excess of their historical average, a reduction in market values, or a combination of both would eliminate this overvaluation.
- Current yields on fixed income instruments are unprecedented and reflective of the worldwide uncertainties regarding sovereign debt and central banks’ responses to current economic issues. Their potential reward arises from their ability to benefit from the current move toward austerity and worldwide economic slowing. Domestically, Treasuries are benefiting from a flight to safety and the reserve currency status of the dollar.
We think that the information in the table speaks volumes and is a useful tool in determining how we allocate capital in your portfolio. Accordingly, we will continue to include an updated version of this chart in future quarterly correspondence.
Based on the data in the aforementioned table our work indicates that the proper asset allocation as we begin 2012 is a weighting in equities of just over 70% with the remainder allocated to fixed income instruments which include a small money market reserve. As discussed earlier, the equity allocation is invested in stocks of large-cap companies which in time we believe will be priced to reflect the intrinsic value of the underlying businesses (in all of our current holdings we believe the intrinsic value to be considerably higher than the current market prices). With respect to fixed income instruments the funds are invested in seven to ten year Inflation Protected U.S. Government Securities (TIPS). We are currently utilizing TIPS because our work indicates that in the long term inflation prospects are under-appreciated at current yields (prices).
As always, if you have any questions about the information in this letter or your account in general, please do not hesitate to call.
Our very best wishes to you and your families for a healthy, happy and prosperous New Year.
Sincerely,
Trinity Capital Management, LLC January 4, 2012
Fourth Quarter 2011 Outlook
“Are Financial Instruments Giffin Goods?”
Equities had a very weak third quarter performance. Large capitalization issues represented by the S&P 500 index declined 14%, mid-cap issues represented by the S&P 400 Mid-Cap Index dropped 20%, and small-cap issues represented by the Russell 2000 Index dropped 22%. We again outperformed the aforementioned indices this quarter. Nevertheless, it was a difficult quarter, but yet one that offered several opportunities for us to add to our current equity positions and establish several new ones.
In times when the equity markets are weak and volatile, investors should step-back from the day-to-day cacophony and renew their long-term investment focus. Over the years we have noticed a gap between investment expectations and investment program accomplishments. Other than initial unreasonable investment expectations which often lead to excessive risk taking, the gap is due to the fact that most investors treat financial instruments as Giffin Goods. A Giffin Good is one defined as a product or service which faces an increase in demand as prices rise and vice versa. Individuals are both consumers and investors (capital allocators). When in their consumption mode they tend to purchase less of a good as its price rises, a logical reaction. However, this logic typically does not prevail in capital allocation decisions on an initial and particularly, on an on-going basis. Investors with superior long term performance treat financial instruments as consumer goods. They tend to be sellers as prices rise and the margin of safety declines or is eliminated, and buyers when prices decline and there is a reasonable expectation that a significant margin of safety has developed. Warren Buffett succinctly stated this concept when he said “be fearful when others are greedy and greedy when others are fearful.” Understandably, Warren Buffett has established an investment record that is far superior to what most investors’ experience.
We often hear “experts” pontificating on whether the market is cheap or expensive in various media outlets. One does not have to look long or hard to find someone to give them an opinion on the market. Our focus is on finding investment opportunities in undervalued equity and debt instruments. We are comfortable with companies which have produced superior long term returns on equity and are supported by strong balance sheets which allow them to create future value through dividend increases, share repurchases, and strategic acquisitions if opportunities arise. If we feel that the current price represents a discount to our conservatively calculated intrinsic value, then we are buyers.
Although it is not our main focus, general market conditions must be considered when contemplating a possible investment of capital and the table of information below is the best gauge that we have for overall market pricing. It is very simple but has proven to be a very effective guide in determining whether the current prices across many asset classes are currently exhibiting a discount or a premium. The information in the following table is taken from the Federal Reserve’s website and we have data on all asset classes mentioned going back at least 60 years and much longer in most asset classes displayed.
| Equities: | Current Yield | Historical Yield |
| (Dividends for Equities, Interest Rates for Bonds) | ||
| Dow Jones Industrial Average | 3.18% | 3.58% |
| S&P 500 | 2.05% | 3.18% |
| Fixed Income: | ||
| Corporate Bonds | 5.40% | 8.16% |
| Municipal Bonds | 4.07% | 5.57% |
| 10-Year US Treasury Bonds | 1.749% | 6.29% |
After considering the summary of information above, we came to several conclusions:
Stocks in general are currently more attractive relative to fixed income instruments (particularly Treasuries) but not undervalued on an absolute basis. The average annualized increase in dividends for the stocks on the Dow is about 10%. If we assume that is going to happen again this year, coupled with the market weakness we have experienced in the first week of October (lower prices=higher yields), at best the large-cap stocks (which are the most undervalued) are fairly-valued.
Current yields on fixed income instruments are unprecedented and hard to comprehend. We do not believe that a reasonable return can be achieved in the fixed income instruments that we have analyzed, and we believe that at current yields a great amount of risk is imbedded in ownership of fixed income instruments.
We think that the information in the table speaks volumes and is a useful tool in determining how we allocate capital in your portfolio. Accordingly, we will include an updated version of this chart in future quarterly correspondence.
During the third quarter, we sold our positions in Exxon-Mobil Corporation, TJX Companies Inc., True Religion Apparel, Vaalco Energy, Inc., and Wal-Mart Stores. We sold many of these stocks because we were able to invest the money in other equities that we believe are more undervalued and offer a better opportunity for superior performance going forward. We still like these companies and believe they will perform well over the long term, but they are no longer undervalued enough to make up a meaningful portion of the portfolios.
In keeping with our philosophy, we have used weakness in the third quarter and the beginning of the fourth quarter to add to current holdings and establish new positions. In reference to the table on the prior page, and to give you a perspective on some potential values available, we have been able, in recent weeks, to establish positions in Du Pont (a Dow component) and Sysco (a S&P 500 component)--both with dividend yields over 4%. Our remaining cash reserve will be used to add to current or establish new positions, or to hedge market risk as conditions warrant.
As always, if you have any questions about the information in this letter or your account in general, please do not hesitate to call.
Trinity Capital Management, LLC October 5, 2011
Third Quarter 2011 Outlook
“Deja vu, All Over Again”
In early April we titled our Second Quarter 2011 Outlook “Mother Nature, Nuclear Accident, Civil Unrest and Revolutions Versus the Fed”, and declared that the Fed won the first quarter battle. Change tsunamis to tornadoes, and nuclear accident to budget stalemate, and the just ended second quarter was a replay of the first. Again, the dominant theme of the financial markets remained the continued stimulus being provided by the Fed. This time the Fed produced a tie, as the S&P 500 was slightly down for the quarter, however, we were able to eke out a gain. The stock market’s pattern was an overlay of the first quarter including an eleven day quarter ending recovery rally.
We were active in this up and down environment, as we took profits in Johnson & Johnson, Nu Skin Enterprises, and Ross Stores. During the quarter when we sold, the issues had rallied 12%, 18%, and 9%, respectively. Versus our cost, the issues provided 11%, 27%, and 50% returns. During the quarter’s rallying phase we also sold partial positions in Bristol Myers Squibb, Guess, Lilly, Eli & Co., TJX, and True Religion. When we sold, the issues produced 10%, 18%, 7%, 16%, and 38% gains in the quarter. Versus our cost basis, the partial sales contributed 10%, 18%, 9%, 16%, and 38% gains, respectively. The negative for the quarter was our holding in Aeropostale which declined 27% on a negative earnings report. We added to the holding. We used the corrective phase of the market’s second quarter action to establish new (initial) positions in Exxon Mobil, USANA Health Sciences, and Vaalco Energy. Energy prices temporarily declined as the government released oil from our Strategic Oil Reserve, giving us the opportunity to initiate our energy holdings.
We continue to be cautiously constructive on the stock market. While the risks are highlighted in the news daily, we need to remember that the administration will do all it can over the next seventeen months to get re-elected. We have already witnessed the release of oil reserves, and it would not be surprising to see more of the same, as well as, another payroll tax holiday. Also, the Fed which ended QE2 on June 30th will still be acquiring Treasury issues with the interest and principal earned on its now massive portfolio. Furthermore, there is a chance that the Washington will pass legislation allowing corporations to repatriate cash holdings from their foreign subsidiaries at a reduced tax rate. One proposal being circulated in the beltway would allow companies to repatriate cash at a 5.25% tax rate—a real incentive versus the current 35% tax bite. If enacted, it is possible that corporation would repatriate $500 billion to a trillion dollars. This would be on par to larger than the recently completed QE2 stimulus program. Since corporations are currently using over sixty percent of their excess cash for dividends and/or share repurchases, sizable rewards to shareholders are a possibility. As an example, two of our holdings known for their share repurchase programs, Exxon Mobil and Microsoft; have a combined basket of foreign cash in excess of sixty five billion dollars.
As determined by our estimate of undervaluation in absolute terms, we currently have approximately seventy percent of our portfolios’ capital invested in individual stocks. We will deploy the money market reserves if opportunities to buy more of our current holdings or new holdings arise. Although we have analyzed many individual fixed income investments, we currently find nothing of interest in that asset class. Thus, we maintain our reserves looking for opportunities in stocks or we will utilize the funds to hedge market risk if our work indicates it is appropriate. Of course, we will continue to only invest in companies which we believe offer the potential for significant returns to investors. This means concentrating on companies where their history and our work indicates that the current stock price does not reflect our estimates of future earnings and cash flow, in addition to the maintenance of a superior balance sheet capable of creating value through share repurchases, dividends, and/or mergers and acquisitions.
Trinity Capital Management, LLC July 5, 2011
Second Quarter 2011 Outlook
Mother Nature, Nuclear Accident, Civil Unrest and Revolutions
Versus
The Fed
The Fed won this round. It is hard to imagine what could have happened that did not in the first quarter of this year. With that being said, the dominant theme of the financial markets remains the continued stimulus being provided by the Federal Reserve through its purchasing of Treasury securities in the open market, an operation known as QE2. QE2 is expected to end on June 30th, but in the first quarter it helped create an advancing stock market, as well as, positive results for our portfolios.
More specifically, the stock market advanced from the beginning of the year until February 18th when it reversed lower until March 15th. That correction was steep enough to wipe out the market’s earlier gain—putting most stock market indices down year-to-date. However, a relentless recovery in the last twelve days made up for the correction and produced gains for the first quarter. As the market’s mid-February/mid-March correction began to unfold the Fed came to the rescue by injecting $105 billion into our monetary base in late February, and $80 billion on two separate weeks in March. To put this into perspective, in early 2007, just four years ago, the monetary base totaled just over $800 billion. Therefore, the Fed on three occasions over 3 weeks increased the monetary base 10% versus the level where it stood pre-crisis in 2007.
Of the ten sectors that comprise the S&P 500 the top five performers in the first quarter were energy, industrials, health care, consumer discretionary, and information technology. Most likely energy issues were impacted by uncertainties in the Middle East (even though our energy inventories are at a high level with the strategic reserve as a backup). Regarding industrials, the new tax bill included a provision for companies to totally expense capital expenditures in 2011. Since this tax advantage expires at yearend, it is probably pulling expenditures of capital goods into this year, hurting 2012 prospects. Therefore, our portfolios are heavily weighted in health care, consumer discretionary, and information technology because of their longer term potential. Actually, individual stocks related to consumer discretionary were the biggest gainers for us in the time period.
As we continually reference, we seek companies we believe offer the potential for significant returns to us as investors. For us that means concentrating on companies where we believe the current price of their stocks does not reflect our estimates of earnings and cash flow. Also, they must have demonstrated superior returns on shareholders’ equity, and have balance sheets that are capable of value creation through stock repurchases, special dividends, and/or mergers and acquisitions.
In addition to stock selection, we attempt to limit risk of permanent and temporary significant declines in our capital values. Accordingly, a portion of a portfolio’s capital is held in money market instruments to be used for hedging when we believe that there is a significant risk of decline in the general market. In the quarter just ended we hedged the portfolio on two occasions. Because of the market’s sharp snap back, mentioned previously, we responded by removing the hedges. This portion of our strategy had little impact on performance for the three months.
Looking ahead, we believe that our strategy of remaining approximately 65% (ranging from about 55% to 80%) invested in individual stocks which satisfy our strict criteria, while continuing to hold the remainder of our portfolios’ assets in reserve for hedging is appropriate. While we feel that the future is bright for our selected stocks, we see the potential for general market risk due to the ending of QE2 at the end of June, and the current level of investor sentiment and investment exposure which are back at levels of optimism which in the past have signaled the likelihood of a more difficult general market environment.
Trinity Capital Management, LLC April 4, 2011
First Quarter 2011 Outlook
In early September we used the opportunity presented by last year’s April to August correction to move sixty-five percent of our portfolios into individual equities. As is our process, we selected the stocks of companies (i) where current prices are not reflective of earnings and cash flow potential; (ii) that have demonstrated consistent cash flow and earnings growth; (iii) that have demonstrated traditional metrics such as return on equity, return on invested capital, and price to cash flow that are superior to industry and overall averages; and (iv) that have balance sheets that are capable of value creation for shareholders through stock repurchases, special dividends, and/or mergers and acquisition. Based on this data we determine what we believe is the intrinsic value for each issue and compare that to its current market price. The level of undervaluation determines the size of the position in the portfolio.
The remaining thirty-five percent is being held in cash reserves and will be used to invest in ETF’s (Exchange Traded Funds) which seek to produce the inverse of corresponding stock market indices. This portion when invested in inverse ETF’s serves as a hedging component for the portfolio to minimize the impact of short term declines in general market values when our technical indicators signal that a market setback is probable.
We continue to believe that the aforementioned strategy is appropriate for the risk/reward environment we see ahead. As the New Year begins the stock market faces competing market cycles. From an intermediate perspective, the most favorable part of the presidential cycle begins in the last third of the second year of a president’s term and continues into the beginning months of the third year. So far, so good. Furthermore, the Federal Reserve continues to be very aggressive in its efforts to stimulate the monetary system in the hope that this policy will spur the real economy.
Short term, it appears that the market may have gotten itself over-bought and over-believed. In addition to excessive optimism (a contrary indicator) and corporate insiders who have dramatically stepped up their selling, the market leadership has become speculative and very rotational. For the most part, the stocks of smaller, lower quality companies have started to perform best and even here their leadership is very short term and rotational. Interestingly, our work indicates that, in general, the stocks of high quality, well- financed, consistent growth companies are becoming more undervalued versus the alternatives, and are therefore earning a higher allocation in portfolios. Examples include several issues in the healthcare sector which are currently unloved but possess the fundamental metrics we find attractive and, as well, can be accumulated at prices which we believe are significantly below their long term intrinsic value. As for the smaller companies included in the portfolio, since they are well-financed with attractive valuations, they will hopefully benefit from the recent increase in merger and acquisition activity. We feel numerous companies at their current market prices would make attractive acquisitions for other corporations or private buyers.
Trinity Capital Management, LLC January 10, 2011
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