Second Quarter 2012

Review and Outlook

The market embarked on the year’s second quarter with a “glass half-full” mentality – major indices had recorded double digit percentage gains for the first quarter, and economic readings were showing some signs of strength. Unfortunately, this optimism didn’t last as economic indicators weakened as the quarter progressed, and market participants sold shares to lock in their first quarter gains fearing they would evaporate. In the end, the S&P 500 lost close to 3 percent in the second quarter after recovering from larger losses.

While the headline unemployment rate has held steady, new job growth has slowed from its pace in the beginning of the year, and the broader picture of under-employed workers now points to a labor market that is far from reaching a recovery stride. Firms are hesitant to hire in earnest until the end-demand is evident, and consumer confidence is being punished by rising gas and food prices and the same weak job data.

The issues in Europe are only serving to further slow the global economy. Beyond the debt issues that grab headlines on a daily basis, our take is that Europe’s economic problems are feeding on themselves by way of its common currency. A Euro propped up by the strength of the German economy is preventing the weaker nations from benefiting from a weaker currency (and more robust export demand) that comes with economic doldrums. At the same time, Germany’s export market is exploding as its currency is artificially weighed down by the weaker countries. The result is essentially a mess in which the usual economics of currencies are working against the member nations at either end of the spectrum. While both ends of the Eurozone are vital to the bloc’s future well-being, the policymakers are hesitant to consolidate more power and provide further bail-outs. We do think, however, this will be necessary, or it will spell disaster for Europe, and likely the global economy at large. We are hopeful that policymakers on the other side of the pond also recognize the risks, and will act to prevent such an economic (and potentially political and societal) catastrophe.

Here at home, as economic indicators weakened and the Fed only toyed with the idea of further easing, energy prices came down and gave consumers and manufacturers alike a break on their energy spending. Ultimately, we continue to believe that this is only a temporary reprieve from triple digit oil and ever higher gasoline prices as the world is facing both a demand and supply problem when it comes to energy sources.

China seems to get it, and is using lower global demand to stock up on raw materials and build out infrastructure, such as wind farms and a smart grid, which will come in handy after oil prices inevitably resume their uptrend. We think recent forecasts for a “slowdown” in China are overblown as policymakers are still well in control of the economic strings, and will stimulate as necessary (especially in those areas that serve the country’s future prosperity). In the end, we think Chinese GDP growth will be around 8 percent this year – hardly a “slowdown” we are concerned about.

We continue to be vigilant in monitoring the global economic picture and positioning portfolios accordingly. Most economies around the world continue to need some sort of assistance, and thus policymakers still hold many of the cards. We expect these decision-makers to act responsibly and provide stimulus where needed, but we continue to protect our portfolios with hedges should there be a policy error or conditions worsen.

Growth Portfolio

With new data highlighting concerns about the global economy’s recovery, it’s not surprising that many holdings in the typical growth-oriented sectors of energy and technology finished in negative territory for the quarter. With lower oil prices dampening the demand for near-term drilling, shares of energy parts and service companies suffered as industry leaders voiced a dimmer outlook. With the pullback, these stocks are selling at what we believe are bargain prices, especially considering the energy supply problem the world faces in the years to come.

After impressive first quarter gains, our technology stocks largely fell prey to profit taking on concerns regarding end consumer demand. We continue to invest in those companies that have market share and intellectual property advantages over their peers, and those in businesses with high barriers of entry. We feel these companies have the best chance of growing at above market rates, and have deep enough pockets to expand into burgeoning consumer markets around the world.

Meanwhile, the tenuous economic picture helped to provide tailwinds for the less economically sensitive healthcare sector. Our holdings in the group have long been oriented towards cost cutting and an aging and unhealthy demographic that will require more prescription drug use (especially generics). Our stocks are leaders in healthcare IT, distribution streamlining, and drug processing – all areas in which superior systems are helping to reduce wasted spending, and we feel these companies would be winners regardless of the outcome over debates surrounding Obamacare. To be sure, our picks generally benefited from the surprising Supreme Court decision to uphold the “individual mandate” clause in the Affordable Care Act, and we think they will continue to thrive. This quarter we also added pharmaceutical stocks to augment our healthcare holdings. Our picks possess what we believe are the most promising pipelines of drugs that will fight some of the most debilitating and expensive medical conditions, including metabolic and neurological disorders. In time, better drugs will be part and parcel of reducing America’s healthcare costs, and we think our portfolio companies will figure prominently.

Despite the economic headwinds, our consumer stocks were also a boon to our Growth portfolios. We owe that to our holdings in this group being almost entirely dedicated to the cost-conscious consumer – a consumer that is only interested in bargains or the bare necessities. As more Americans fall out of the middle class, we expect this trend to continue.

Income and Growth Portfolio

The market jitters of the second quarter of 2012 could be seen even in performance of dividend-oriented securities. Growth concerns, stemming from slowing recovery here in the US and ongoing crisis in Europe, have impacted some of the best. However, after succumbing to a mid-quarter market sell-off, stocks as represented by the S&P 500 managed to recover a good portion of their losses. This is also applicable to our securities selection: while some of our positions were impacted by the growth and profit concerns, on the whole, our stocks held their ground.

Utilities were especially strong during the quarter, with the subsector averages hitting their highest post-crisis levels. REITs as a whole had yet another good quarter, outperforming the general equity market, while telecoms were mixed, with large-caps acting better than their smaller regional counterparts. As expected, the action in tech, energy and materials stocks was indicative of the fears of the global slowdown.

The performance of current portfolio holdings generally reflected these sector trends. Our utilities have done well, with some rallying to 52-week highs, reflecting both the underlying strength of their businesses and the market’s reduced risk tolerance.

Among our REITs, one of the standouts was a healthcare leveraged holding that benefited from the Supreme Court’s ruling on the healthcare bill. With the Obamacare ruling overhang behind us many healthcare oriented holdings (including our pharmaceuticals) will be cleared to benefit from major demographic trends.

Ultra-low interest rates remained a very significant factor in income investing. They are positive for corporations because they set the cost of their borrowing. In fact, during the quarter the interest rate on the benchmark 10-year Treasuries has hit a record-low 1.44 percent, driven by, among other factors, the Federal Reserve’s Operation Twist. With short-term rates at essentially zero and longer-term rates at record-lows, the cost of debt for investment grade corporations is also at record lows.

During the second quarter we have also learned that the Federal Reserve will be extending its Operation Twist, and that it stands ready to employ more quantitative easing “as needed.” With the accommodative stance, market participants are expecting rates to remain low for the foreseeable future.

Of course, the ultra-low interest rates are a negative factor for fixed income investors, with interest income minimal. This can be made up from a total-return perspective as the flight to safety has moved bond prices higher.

The strategy we’ve been employing for years in the Income & Growth Portfolio is especially useful in this environment: putting a bigger emphasis on selecting quality individual dividend-paying stocks with growing income streams. Our buy and hold approach allows us to maximize the collection of income from these holdings. Capital appreciation, while secondary, is another function of this philosophy: the ability of these stocks to consistently pay and increase dividends helps to drive their underlying values higher.

The bottom line for income investors is to invest in strong, financially secure, cash-rich companies that are in a position to raise dividends going forward. We feel this is the best way to secure wealth during periods of market turmoil and to build wealth for the years ahead.

Peak Resources and Energy Portfolio

The global economic slowdown and concerns about the impact Europe’s financial crisis will have on future growth took their toll on energy and industrial commodities and their related stocks in the second quarter. In general, however, commodity prices have remained remarkably firm, which we attribute to problems of production capacity constraints, including declining ore grades, and mounting resource nationalism.

We are experiencing what should prove to be only a pause in the commodity super-cycle that began more than a decade ago. While the economic travails in Europe have persistently captured the media’s attention, it’s important to remember that emerging economies now represent more than half of gross world production. And although these nations (with China unswervingly at the forefront) are not expanding as fast today as they were a few years ago, they nevertheless are commanding ever-greater quantities of commodities. The cost of extracting these materials, meanwhile, has risen dramatically in recent years.

Our approach to investing in the resource sector remains focused on both commodities themselves, which offer a measure of downside protection, and the stocks of companies that are engaged in the production of commodities, which present the potential for levered gains from rising resource prices. Adjusting for changing market conditions, we made a handful of changes to the portfolio in the quarter.

We added to our copper-focused exchange traded note (ETN), which offers a defensive way of gaining exposure to the metal without the operational and political risks of owning copper miners. We also added to our stake in the beleaguered coal miners via an exchange traded fund ETF. The second quarter witnessed a 12-year low in natural gas prices before prices rebounded sharply, further gains are expected, which should boost the fortunes of coal and coal miners as well.

In the oil and gas space, we switched from one offshore driller to another with better prospects. We sold an unconventional oil producer having become somewhat uncomfortable with the company’s accounting practices. We replaced it with an independent oil & gas producer with good reserve growth prospects. Finally, we reduced our exposure to pipeline companies, although not out of any concern for a particular stock. This conservative position had served us well when many shares in the oil and gas space were under pressure, and with valuations on those latter shares now more compelling, we wanted to take a more aggressive stance.

It is clear from recent events that the eurozone countries are prepared to de-emphasize austerity in favor of greater money printing to solve the region’s troubles. Poor economic data here in the United States has the Federal Reserve at the ready to likewise introduce additional quantitative easing. We expect precious metals, which have essentially marked time in recent months, in due course to explode to the upside from these unprecedented liquidity injections.

We therefore continue to have strong exposure to precious metals, via both gold & silver ETFs, and stocks of the companies that mine the metals. As a group, the gold mining shares offer compelling values at current levels, trading at their lowest valuations relative to the assets since 2004. We have placed particular emphasis on smaller, development-stage gold and silver miners, which we feel are better positioned than their larger counterparts to grow their mineral reserves, presenting the prospect for strong capital appreciation even if metals prices languish near current levels.