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Fourth Quarter 2007

Portfolio Review & Outlook

The threat of a weakening US economy dominated investment markets in the fourth quarter of 2007. And from the looks of things, it’s going to remain the paramount concern, at least for the early part of 2008.

The environment hasn’t been all bad for income investors. For one thing, interest rates have dropped over the past several months, with the benchmark 10-year Treasury note yield again slipping south of 4 percent. And for every bit of news that suggests economic weakness, speculation grows the Federal Reserve will push the Fed Funds rate down even more, which in turn sends rates lower still.

For another, this is the kind of environment where investors flock to the safest fare. Utility stocks, for example, posted strong fourth quarter gains, as investors gravitated to their secure regulated businesses and reliable, growing dividends. Utility-like limited partnerships and Canadian income trusts got a lift for the same reason. So did super oils, big telecoms and mutual funds holding high quality fixed income.

Unfortunately, many high yielding investments didn’t fare so well in the second half of 2007, and it looks like there could be more downside as well. The primary reason: Investors perceive risk to distributions if the US economy weakens appreciably from here.

We’ve seen particular damage to financial stocks, but also to closed-end funds holding their fixed income securities. Real estate investment trusts have taken hits from concerns about property market weakness and rising office building vacancies in several US cities. And while Big Telecoms have generally thrived, rural telecoms have sunk on concerns their broadband business growth will stall and fixed line connection losses will accelerate as the economy weakens.

The underlying strategy of our model Income & Growth Portfolio is to own high quality, high yielding securities from as wide a range of sectors and investment classes as possible. The chief drawback of this approach is that at any time some of our picks will be down, or at least underperforming the rest of the portfolio. On the other hand, no matter how bad things have gotten in the last decade, some of our picks have posted strong gains. That includes the 2000-2002 bear market, during which the Dow Utility Average fell nearly -60 percent top to bottom.

I’m prepared to live with the losers at any given time for two main reasons. First, all of the Income & Growth companies are backed by healthy, growing businesses that are gaining value year after year, and almost all are increasing dividends as well. They’ll have their ups and downs. But over time, as long as their underlying businesses stay on track, they’re going to wind up at new highs when market conditions and psychology change.

Second, time and again market history proves that today’s biggest loser is frequently tomorrow’s richest gainer. Utility stocks, for example, have staged their most powerful rally in history over the past six years—but few would have believed that possible at the bottom in late 2002.

The only way you get anywhere with income investing is to buy and hold. You’ve got to stick around even to collect dividends, and buy and hold is the only way to dodge the heavy taxes on short-term income. Frequent traders also miss out on the steady appreciation in share prices that comes from dividend growth.

Sticking around, though, means dealing with the two primary risks of income investing: Inflation risk and credit risk. The latter is paramount in investors’ minds now, but it was only last summer when inflation seemed the greater worry.

Income investments with more of a growth focus—like financial stocks, REITs and Canadian energy trusts—actually gain ground when inflation fears are rising. Others like utilities and high quality bond funds do their best when fear of credit risk is on the rise market wide, as it is now.

You’ve got to constantly reassess the underlying strength of all holdings. But owning a mix of high quality investments that win under each risk scenario is the surest way to keep generous dividends flowing while minimizing the overall volatility of your portfolio.

If you’re living off your investments, you can’t always tell when you’ll need cash. The last thing you want to do is to be forced to withdraw a hefty sum when your portfolio is down big in a bad market.

The Income & Growth style of balance and diversification doesn’t ensure you won’t have losers at any given time. In fact, it virtually guarantees you will. But it does keep your overall portfolio value stable to rising, even in the most volatile of markets like this one—and that’s our bottom line. We succeeded in 2007 and we fully intend to in 2008, come what may.

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Disclaimer: The specific securities identified and described herein do not represent all of the securities purchased, sold, or recommended for advisory clients, and that the reader should not assume that investments in the securities identified and discussed were or will be profitable. The mention of securities in this letter should not be deemed as a recommendation to buy or sell the securities. Leeb closely monitors the companies held in client portfolios. If a company’s underlying fundamentals or valuation measures change, Leeb will reevaluate its position and may sell part or all of its holdings.

"The traditional allocation is among stocks, bonds, and cash. We think this is a meaningless approach and investors should think strictly in terms of growth, income, and market insurance."

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