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3rd Quarter Review: Another Case of Asian Flu?

As we discussed last month, China’s economic slowdown, dithering on interest rates from the US Federal Reserve, and declining commodity prices weighed heavily on financial markets in the third quarter. The US stock market (as measured by the S&P 500 index) after hitting an all-time high in late July, subsequently declined more than 12% over the following month, its first decline of 10% or more—a so-called “correction”—in 4 years. It is now down for the year. Emerging markets were especially hard hit, with Chinese and Brazilian stock indexes each declining more than 25% in the quarter.

The economic slump in China affects a large number of commodity prices, by virtue of that fast-developing country’s outsized demand for raw materials. When combined with expanded supply, a number of pundits see lower prices that could persist for some time for certain natural resources. Despite these headwinds, the U.S. economy continued its “tortoise” performance. Europe, while not as strong as the U.S., also remains steady, notwithstanding the situation in Greece and Syria.

Our average client’s asset allocation portfolio declined during the quarter (for actual performance, please refer to your individual Quarterly Review report to be mailed soon).  As mentioned, natural resource funds were the worst performers, but all equity funds in our clients’ portfolios declined during the 3rd quarter, with US Small Cap underperforming US Large Cap. International funds, particularly those investing in emerging markets’ bonds and equities (i.e. with exposure to currencies which weakened substantially vs. the US dollar), were also among the worst decliners.

The best-performing funds were those invested in US bonds, taxable or non-taxable. Those funds were either up slightly or experienced very small declines, thereby fulfilling their role as stabilizers in times of heightened volatility. This largely positive result from bond funds was driven by lower interest rates, as the yield on the 10-year Treasury dropped from 2.4% to 2.0% during the quarter.

Large Cap Value Portfolio: We Were Busy During the Correction
The average Large Cap Value portfolio underperformed the S&P 500 by a significant margin in the 3rdquarter, led lower by our holdings in energy-related issues (Chesapeake, NRG, and Dynegy), as well as some of our foreign stocks (Aggreko and Cemex). The portfolio is now down year-to-date as well. Using the S&P indices to compile the data, “value” stocks have now underperformed the overall market for the past eight years. The culprits—for both the S&P Value index and our LCV portfolio—have been poor performance from financial stocks during the 2008 crisis, and more recently from energy and other natural resources stocks.

We are certainly not pleased with this underperformance, but it doesn’t shake our confidence that a value philosophy, combined with our long-term investment horizon, will generate favorable results over time. When such volatile periods fall upon us, it is always useful to bring a historic perspective: looking at the S&P 500 since the end of World War II, there have been 27 corrections of 10% or more, versus only 12 bear markets (with losses greater than 20%). This equates to one correction roughly every 20 months and one bear markets every 5.8 years on average (though of course these events are not evenly distributed over time). As previously mentioned, the most recent correction took place in 2011, and turned into a bear market with the S&P 500 dropping just over 20% before rebounding.

As to whether this correction could also turn into a bear market, certainly it is a possibility. We do not claim to have a crystal ball, but historically speaking, less than half of market corrections turn into bear markets. For investors with a long-term horizon, such as Bristlecone, corrections provide opportunities to invest at more attractive valuations.

While a 10% correction did not suddenly make the broad market “cheap,” there were pockets of weakness that allowed us to increase our stakes in certain companies at favorable prices. We added to our investments in Valmont Industries (VMI), Apollo Education (APOL), Weyerhaeuser (WY), and Chesapeake Energy (CHK). Each of these stocks experienced price declines that, in our opinion, were not justified by the underlying long-term fundamentals of the business.

We also initiated new positions in Berkshire Hathaway (BRK.B) and Potash Corp. (POT)—more on this below. Finally, we sold Progressive (PGR), the well-known auto insurer. We owned PGR since 2007, during which time the company (and its shares) had been a steady performer. However, the stock price reflected our estimate of fair value. With the addition of Berkshire Hathaway, and its auto insurance subsidiary (GEICO), we thought it prudent to limit our exposure to this industry.

Berkshire Hathaway is a company with which most of you are familiar. We’ve long admired Warren Buffet and Charlie Munger. We’ve attended a few of the annual shareholder’s meetings, and make reading the company’s financial reports and shareholder letters an annual ritual. To be candid, we do not expect the company’s future performance to match its history. Additionally, both Buffet and Munger are well past the typical retirement age, and we therefore did not predicate our investment on their continued involvement in the company.

So what’s the attraction? It’s all about what you get for what you pay. We believe that Berkshire represents a collection of high quality businesses with strong competitive advantages, run by very good managers. Overall, we expect them to collectively do better than the average US corporation over time. Berkshire’s balance sheet is very strong which allows it to survive setbacks and take advantage of opportunities that others can’t: examples include the company providing capital to Bank of America during the financial crisis, or its more recent transactions in Heinz or Kraft with 3G Capital. With the shares trading at a small premium over book value (and just slightly above the level at which Buffett himself has historically been willing to repurchase Berkshire shares), we felt that the risk reward trade-off was attractive enough to initiate a position.

Near the end of the quarter, we also initiated a position in Potash Corporation (POT), the world’s largest producer of potash (a form of potassium), one of three essential plant nutrients (the others being nitrogen and phosphorus) which are depleted from the soil by farming and must be repeatedly replenished in order to ensure continued soil fertility and crop yields.

Potash—the nutrient—is distributed unevenly over the earth’s crust, and can only be mined economically from a handful of geographic locations where it is present in sufficiently high concentration.  Canada holds nearly 50% of the world’s estimated potash reserves and POT, a low-cost producer based there, controls roughly 20% of global production capacity.

Historically, the concentration of potash reserves in a handful of countries caused the industry to operate as an oligopoly, and prices remained well above the marginal cost of production.  In 2013, a dispute between two major suppliers in Russia and Belarus fractured a cartel there and potash prices dropped about 25% in a matter of months.  More recently, record crop yields have depressed grain prices, and a strong dollar has reduced the buying power of farmers in emerging markets (both factors decrease demand for fertilizers such as potash).

Potash prices are currently at multi-year lows, and stock prices of major producers have been swept along in a broad selloff of commodity-related stocks.  Currently, POT is valued well below the replacement cost of its assets.  The company is strongly profitable, even at today’s potash prices, and is poised to generate significant free-cash flow (a measure of residual earnings after accounting for all expenses and capital expenditures) growth in years to come.

Early Retirement Years: Time to be Cautious with Your Finances
You’ve finally done it: you are now retired and it’s time to enjoy the fruits of your labor. Congratulations! It took planning and discipline to financially secure your future. Our experience is that the first couple of years can trip you up easily. First, you have all this time on your hands. There is a temptation to travel more, eat out more, remodel the house, or buy a new car or RV.

We urge caution: the financial decisions that you make early in retirement can have a dramatic impact on whether or not you will outlive your assets. For most, retirement should mean lower spending, not higher, especially in the early years. Generally speaking, most recent retirees are still healthy, don’t support their kids, and may even have paid off their mortgage. In fact, one of the best ways to lower living expenses in retirement is to move into a smaller home (do you really need a 4-bedroom house now that the kids left?), or a cheaper location as this article from the New York Times illustrates.

Our advice is to look at potential big-ticket items a few years before you retire. Pay special attention to your home, your car, and consider replacing, remodeling or repairing anything expensive now. You do not want big withdrawals from your savings once retirement begins and you no longer earn a regular income.

The key is to avoid exceeding the projections that your retirement’s financial security was built upon. As you get older, health expenses will rise (According to Fidelity, a healthy couple retiring this year at age 65 should expect to spend $245,000 on health care throughout retirement). Make sure to keep us in the loop with any anticipated major financial decisions during our regular reviews.

Finally, we’d like to keep reminding those of you who have not already done so, to sign up for electronic delivery of your broker statements and trade confirmations. The brokers that we use discount trade commissions for customers who opt into electronic delivery; for trades in low-priced stocks, this can make an appreciable difference.

As always, thank you for your trust in our services.

One of Bristlecone Value Partners’ principles is to communicate frequently, openly and honestly. We believe that our clients benefit from understanding our investment philosophy and process. Our views and opinions regarding investment prospects are "forward looking statements," which may or may not be accurate over the long term. While we believe we have a reasonable basis for our appraisals, and we have confidence in our opinions, actual results may differ materially from those we anticipate. Information provided in this blog should not be considered as a recommendation to purchase or sell any particular security. You can identify forward looking statements by words like "believe," "expect," "anticipate," or similar expressions when discussing particular portfolio holdings. We cannot assure future results and achievements. You should not place undue reliance on forward looking statements, which speak only as of the date of the blog entry. We disclaim any obligation to update or alter any forward-looking statements, whether as a result of new information, future events, or otherwise. Our comments are intended to reflect trading activity in a mature, unrestricted portfolio and might not be representative of actual activity in all portfolios. Portfolio holdings are subject to change without notice. Current and future performance may be lower or higher than the performance quoted in this blog.

References to indexes and benchmarks are hypothetical illustrations of aggregate returns and do not reflect the performance of any actual investment. Investors cannot invest in an index and returns do not reflect the deduction of advisory fees or other trading expenses. There can be no assurance that current investments will be profitable. Actual realized returns will depend on, among other factors, the value of assets and market conditions at the time of disposition, any related transaction costs, and the timing of the purchase.

Economic factors, market conditions, and investment strategies will affect the performance of any portfolio and there can be no assurance that a portfolio will match or outperform any particular index or benchmark. Past Performance is not indicative of future results. All investment strategies have the potential for profit or loss; changes in investment strategies, contributions or withdrawals may materially alter the performance and results of a portfolio. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be suitable or profitable for a client's investment portfolio.