Third Quarter 2009 Portfolio Strategy Review

Growth Portfolio
 
We continue to focus on holding dominant companies which we expect to exhibit double-digit earnings growth over the long term. Considering the economic environment, our companies’ fundamental businesses held up generally well during the recently completed quarter, with many of them still growing despite tremendous headwinds.
 
Our performance in the quarter was weighed down by our underweight position in financial shares. We believe the jury is still out on the quality of the balance sheets of these economic bedrocks. Until we can we ascertain the safety of their assets, we’re more than content to steer clear of these shares. One key indication of better health we continue to wait for is more bank lending; despite massive government stimulus and support, the banks have thus far remained reluctant to increase their loan portfolios. An underweight position in consumer discretionary stocks also hurt performance during the quarter. However, until we see the consumer headwinds stated above start to clear, we see little chance for sustainable earnings growth in this sector.
 
On the positive side, our exposure to the materials sector was a boon for portfolio performance. Ranging from fertilizer stocks to base and precious metals, the sector benefited from higher materials demand stemming from developing economies once again expanding by healthy margins. China in particular is importing tremendous amounts of raw materials once more to support its own manufacturing and infrastructure investment. For the same reason, our energy stocks also performed well during the period, even as oil prices stayed relatively flat during quarter. The leading information technology companies we hold in the portfolio also performed well, as inventories have begun ramping up with the global appetite for computers and other technology products reemerging.
 
We’ve positioned the portfolio in somewhat of a barbell strategy around our core, large-cap blue chip companies. On one side of the barbell we remain overweight in stocks and sectors geared towards resource-intensive economic growth in the developing world. These sectors, including energy, materials, and industrials will benefit as infrastructure investment continues, and consumers in these areas continue to spend their newfound wealth – moving resource prices higher.
 
At the other end of the barbell, we have positions designed to protect the portfolio should the economy and stock market, take another dive. These positions include zero coupon bonds and gold. The latter also serves as a hedge against a falling dollar, and inflation – which we expect to eventually take off once the record amount of money supply starts turning over in the economy, or as the effects of higher raw material prices begin to show up at the consumer level.
 
If and when we see economic fundamentals improve, we will cut back on our deflationary hedges (the zeros), while continuing to target those areas that will benefit from growth and protect against coming inflation. For now though, we straddle the threats of both inflation and deflation, while investing in leading companies in areas that we see boasting above-average growth prospects.

 
Income and Growth Portfolio
 
Treasury bonds and the dollar on one side, everything else on the other: That’s the way the income investing market has behaved for well over a year now. Take utility stocks, which in normal times generally follow a “bad news is good news” trading pattern. When the economy moderates, they tend to rise. Conversely, when the economy picks up speed, they’re abandoned for investments promising faster growth. Since the fall of Lehman Brothers, however, it’s been a far different story.
 
Rather than push buyers to “safe” stocks, bad news days for the U.S. economy have triggered worried investor selling of everything this side of Treasurys. Meanwhile, utilities and other income stocks have actually attracted buyers when the economy has shown some signs of life. Looking ahead, the U.S. economic recovery has a ways to go. Corporate lending rates are the lowest in a generation, but the credit market remains all but frozen to the businesses and individuals who arguably need it most. Third-quarter earnings are coming in generally solid for good businesses in most industries, yet year-over-year comparisons remain dismal. Still, there is a bright shining silver lining to this still dark cloud: Until the economy roars to life, inflation is not going to be a major risk. And as long as investors are concentrating on the risk of a relapse or a “Big W” recession, they’ll continue to respond positively to news the U.S. economy is strengthening.
 
That adds up to a great deal of potential upside for income-generating investments, before we have to start worrying about inflation. At the same time, the bar of expectations remains very low, limiting downside risk. Our Income & Growth Portfolio strategy is designed to pay competitive current income, preserving and growing wealth in all environments. Some of our picks tend to do better during recessions, others during times of normal growth and still others when inflation is raising its ugly head. Even that strategy didn’t fully protect us in 2008, but those who’ve stuck with it in 2009 have steadily seen their fortunes repaired, as our holdings’ underlying businesses stayed strong and the market eventually came back to them. That’s exactly what should continue to happen as the economy returns to health. But there are several reasons for caution.
 
We’ve already seen some sizeable gains from the market lows of early March. At some point every rally has eventually had to pause, and sometimes reverse violently. As long as the market is still in a “Treasurys versus the world” mindset, even the safest stocks will sell off on bad news. Moreover, as long as the economy remains weak, it’s still possible for good companies to unravel, even if they’ve weathered the past two years in good form. We remain on the lookout for signs of real weakness in our holdings and will unload anything that fails to measure up.
 
Given the size of the rally, there’s an increased temptation for investors to place bets to get back everything they lost in 2008. The emotion is particularly acute among those who sold out near the bottom earlier this year. The result is a return of “yield chasing,” seeking out the highest current yields—often heedless of what’s backing them up. This “strategy” proved spectacularly disastrous in 2008 and there are still plenty more potential quagmires out there. That’s not what you’ll find in any account we manage, but it does mean some investors will be hit hard by blow-ups when they expect them least.
 
Since mid-2007, credit risk—not inflation—has been income investors’ greatest concern by far. But rest assured that markets change, and the day will come when inflation again becomes the paramount threat to wealth. Aside from our gold holdings, the inflation protection in your portfolio hasn’t done much lately. Just like a good insurance policy, however, it’s absolutely essential to your ultimate well-being if you intend to live off your investments. Our balanced approach doesn’t ensure you won’t have losers at any given time, but it has succeeded in preserving wealth in one of the toughest market environments in history. Now with things starting to improve, we’re ready to grow.
 
Peak Resources and Energy Portfolio
 
The portfolio performed well during the quarter, with most holdings registering solid gains. Energy and base materials stocks moved higher as demand from the developing world reignited. Iron ore, a main ingredient in steel production, is seeing strong demand from China – with September imports into the country registering an all-time high at more than 64 million tons. The Chinese government’s pointed infrastructure investment, and its subsequent effect on demand and prices, helped the shares of leading ore miners in the portfolio. 
 
Gold and the other precious metals stocks held in the portfolio tacked on significant gains during the quarter as well. Gold itself crossed the psychologically significant $1,000 level, and has held above it. Propelling gold higher has been lingering concerns about the economy, along with fears about the US dollar. Record amounts of monetary stimulus, with potential for further government bailouts to come, have pushed the U.S. Dollar Index (a measure of the dollar’s value against a basket of currencies) close to a record low. The US government’s dollar devaluing measures have also prompted international questioning of the greenback’s place as a reserve currency, as well as the correct means to price the world’s most valuable commodity – oil. Should the dollar lose its place in either of these instances, our currency would suffer to a degree we can only imagine at this point.
 
The portfolio remains committed to investments benefiting from worldwide resource demand and ever-rising prices. Energy holdings (including alternative energy), as well as base metals, fertilizers, and the like will continue in an uptrend dictated by the insatiable demand from the developing world. At the same time, the portfolio is geared to protect investors in terms of purchasing power – with substantial holdings in what we view as the best positioned precious metals miners, as well as the metals themselves. And while the portfolio will act as an inflationary hedge for investors given the underlying hard assets, we also continue to be weary of a shorter-term deflationary threat. For this reason, we hold zero coupon bonds in this portfolio as well.
 
Mutual Funds Portfolio
 
During the third quarter we generally took a more cautious stance about the equity markets. As a result, we added some new positions in fixed-income funds and ETFs that have both balance and hedging qualities.
 
One of the fixed-income investments, the Vanguard Extended Duration Treasury Index ETF (EDV), offers protection against economic shocks that may bring deflation back into play. We consider it an essential holding in this environment, especially for a portfolio of mutual funds. With EDV acting as market insurance, we continued to be fully or nearly fully invested, taking advantage of strong moves that most asset classes registered during the quarter.
 
During the third quarter, we remained concerned about the outlook for the U.S. dollar; this is reflected in positions in funds leveraged to real assets, such as energy and gold funds, as well as international bond funds and/or inflation-protected U.S. Treasurys. Our goal is to help you achieve your financial objectives with a targeted collection of mutual funds and ETFs.