Our 2nd Quarter Client Letter

Writing this letter is much more pleasant than some of our previous ones. If you just look at the indices, you would think that it has been an uneventful year so far, with the S&P 500 up 3% and the Dow up Jones down 2%. Of course the minor changes in the averages masks an incredibly volatile (and at times frightening) six months. We saw 2009 start with such promise after the painful declines of 2008. A new president was inaugurated with many bold ideas for change, but then the markets started spiraling downward. The bottom was on March 9th and the fear and anxiety levels were at levels that many have never before seen (and hopefully will never again see). The markets then began moving up and by June 12th we had reached our high for the year. The S&P 500 had moved a stunning 38% in 3 months.

Given the unease we saw in late February and early March, we have come a long, long way. But we still have a ways to go. The journey did not end for you on June 30th, and we are very cognizant of that fact. So, while we are pleased to see improvement in the markets and investor psychology, we know that there will continue to be many bumps along the way. We are still waiting to see if the stimulus leads to improvement in the economy, if some kind of health care reform is enacted, what type of financial and environmental regulations may be passed, what will happen to our taxes…There are many questions and few clear answers.

So what does this mean for you? It means that we will continue to focus on finding the best investments for your portfolio-whether they be reasonably valued equities, high quality fixed income instruments or mutual funds that are run by talented managers. We continue to feel this approach provides some level of consistency in very turbulent times. It should also allow us to avoid disasters, while also taking advantage of opportunities in the market. Because we have generally been maintaining high cash levels in our portfolios, it gives us liquidity to take advantage of opportunities that will present themselves in the market. Over the next month, many companies will be announcing earnings and unless managements are overly optimistic, we should find a bargain or two.

In regards to mutual funds, we have been making an effort to be more pro-active by setting up conference calls with the firm’s managing the funds. We use these calls in an effort to provide a high level of due diligence in these uncertain times. We have shared our thoughts on the Blog, which you can find in the Newsroom section of our website.

As always, we like to remind ourselves how lucky we are to have you as a client. We appreciate your trust and look forward to rewarding your confidence. Please let us know if there is anything that we can do to help you out during the summer. We also would be pleased to assist a friend or family member who may be in need of some financial advice or a fresh perspective on their investments. Feel free to pass on our names.

Fiscal Health Day

I read this article in the NY Times (subscription or registration may be required) this past weekend. It discusses the importance of taking a fiscal health day to ensure that your financial life is in order. Ron Lieber provides some very interesting issues to focus on during this day. We might add a few more areas to focus on:

1) Review your investment portfolio and ensure it is invested in a manner that will help in meeting your goals, but also make sure it provides sufficient reserves to protect you in these uncertain times.
2) Evaluate the quality of your fund, stock and bond holdings. Are they still investments that you are comfortable holding?
3) Determine what kind of debt you may have. Are there ways to reduce or eliminate the debt and strengthen your balance sheet or to lock in today’s relatively low rates?
4) Ask the phone company or cable company to review your current plan and determine if there are cheaper alternatives for you.
5) Review your 401k and make sure that it is still invested in a way you are comfortable with and see if there any way you can contribute, say, another 1% of your salary?

This may sound a little daunting, but if you spend a day making an effort to improve your fiscal health, you will likely find many ways to save money and provide a little extra piece of mind. We are certain it will be time well spent.

If you could use some help, just email Jim (jim@harvestfp.com) or John (john@harvestfp.com) and we would be happy to assist.

Manager Change

We came in this morning to be greeted by this press release from the Oakmark Funds informing us that Chad Clark, the co-portfolio manager of the Oakmark International Small Cap Fund, has left the fund and firm. We take manager changes very seriously and prefer the managers of funds we use to stay around for a long, long time. At times, manager changes cause us to leave a fund, but we won’t be doing that in this case for two reasons. First, David Herro, who is the lead portfolio manager on this fund, is still in place. Second, Oakmark has a very clear philosophy of purchasing high quality companies trading at discounts to their intrinsic value that drives the investment process of all their funds. So we do not believe that Mr. Clark’s departure will lead to a fundamental change in the approach and performance of the Oakmark International Small Cap Fund. Still, while we monitor all the funds we use for client portfolios, we will be watching this one a little more closely.

The Delafield Fund

Barron's recently interviewed the managers of one of our favorite mutual funds, the Delafield Fund. While they are not flashy, they have done a nice job of compounding their fundholder's capital over an extended period of time. I think after you read the article, you will understand why we are big fans of these disciplined investors.

Update

It has been awhile since one of us wrote. That is the curse of running a small business, you get pulled in many different directions. We will do our best to write more often.

Back in early March, when the market was down and the anxiety levels were at an extreme, we sent out a letter to clients suggesting that the market was due for a bounce. We certainly had a bounce, and it has greatly reduced the fear levels. Now, I’m not going to make additional predictions about where they market is going, because frankly that’s not what we do. More importantly, we think our time is much better spent reviewing the stocks that we already own and finding some additional highly quality names to add to our portfolios. We have a long list of stocks that we are very interested in buying, but we remain very price sensitive. There is nothing that we have to buy, we only want to commit our clients' capital (and our own) when we are comfortable that the quality of a stock remains high and its valuation is low. This does not change whether the Dow Jones is at 6500 or 8500, it just means it takes longer.

As long as we are patient and disciplined, we are confident that we will add some attractive names to the portfolio, at what will prove to be attractive prices.

Royce Premier Fund

We had a conference call with a principal from Royce, Francis Gannon, on April 30th to discuss the Premier Fund. Following are some notes from the call:

• The Premier fund focuses on firms with strong balance sheets, low debt, high returns on invested capital and strong growth prospects. Of those attributes, a strong balance sheet is the first among equals. They measure strong balance sheets initially by looking for an assets/equity ratio below two (for nonbanks). As we look for similar attributes from the companies that we purchase, we are very comfortable with this approach to quality.

• Most of Premier’s portfolio has a market cap between $500 million and $2.5 billion; there are some holdings with smaller market caps and some with larger ones. If a holding grows above a $2.5 billion market cap they can hold it but can’t add to it.

• Royce reopened fund in January 2009 because they were, and are, seeing some very attractive opportunities in market place. Since the fund has been reopened inflows have been modestly positive. The fund size is about $3 billion, which we feel is a little large for a small cap fund and certainly bears watching.

• Royce develops a cap rate for each company they own or consider buying. This cap rate is defined as earnings before interest and taxes (EBIT) divided by enterprise value (market capitalization plus debt minus any cash). They would like to buy companies with a cap rate greater than 15% and they look to sell companies when they have a cap rate at or below 5-7%. They are currently finding companies with cap rates over 20%. When purchasing stocks we believe valuation is essential. While Royce looks at a different metric than we do when valuing a company, we are comfortable that they apply it consistently and prudently.

• Royce buys stocks with the idea that they will hold them for 3 to 5 years. The portfolio is currently underweight financials. The managers are still are not buying banks, but they are buying exchanges, brokers and insurance companies as well as investment managers.

• Another theme was buying the shares of companies the portfolio managers know well and where the stock price dropped well below Royce’s assessment of their business value. Schnitzer Steel Industries is an example where Royce had been reducing its position earlier in 2008 at prices over $100/ share. The stock plunged into the teens in the fourth quarter and so the fund rebuilt a position. Wabtec (old Westinghouse Air brake) and Ralph Lauren were other high quality companies that the fund bought as stock prices declined.

• The portfolio is currently 6-7% international. By prospectus Premier can go up to 25%, but the highest it has ever reached is 10%. The largest foreign holding is Sims which is headquartered in Australia. The firm bought Metals Management last year and is currently is in the process of relocating its headquarters to the US. We have no concerns about the Premier Fund’s ability to buy stocks outside the US. One of our beliefs when picking funds, is that giving good managers more freedom to find attractive opportunities benefits the fund holders.

• The fund attempts to manage risk primarily by its focus on high quality, low debt companies. Another risk management tool is that no more than 25% of the fund can be invested in any industry.

Overall Royce Premier continues to meet our requirements for ownership. It has an impressive track record and was down 10.70% over the quarter and up 0.91% annualized over the last 5 years (periods ending March 31, 2009). The individuals (Chuck Royce and Whitney George) responsible for that track record are still in charge of the fund. The investment philosophy is clearly articulated and appears to be consistently applied. And the managers have strength in their convictions as evidenced by the fund holding 68 stocks, a reasonable number for a smaller cap fund. We continue to think it is a worthwhile holding for our funds and our clients who need small company exposure in their portfolios.

Disclosure: Harvest Financial Partner owns the Royce Premier Fund in its client portfolios. The authors own the Royce Premier Fund. Positions can change at any time.

Fairholme

We have been owners of Bruce Berkowitz’s Fairholme Fund for some time now. Here is a link to a Morningstar article comparing Bruce to another pretty good investor – Warren Buffett. Have a read to get an idea how Bruce is allocating his investors' capital.

Disclosure: Harvest Financial Partners owns the Fairholme Fund in client portfolios. The author owns the Fairholme Fund in his personal portfolio. Positions can change at any time.