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Quarterly Letter to Clients

January, 2012

Indices at quarter-end (December 31, 2011):

Dow Jones Industrials: 12,217.56 4Q'11 +11.95% YTD +5.54%

Standard & Poor's 500: 1,257.60 4Q'11 +11.15% YTD -0.01%

Some seventy years ago Germany tried to take over Europe. Today it seems that they have finally succeeded in that endeavor. Now they are probably asking themselves what to do with it, and why they wanted it in the first place.

The ongoing, and seemingly insoluble, problems in the Euro zone, along with the halting recovery in the world economy, have resulted in violent swings in stock markets around the globe. The final quarter, indeed, the entire year, has been an adventure in the markets. Still, after all of the smoke, noise and heat, the DJIA eked out a small gain, and the broader S&P ended essentially flat on the year.

Amidst the turmoil it is important to remember that, for most people, the investment horizon is measured in decades. If you allow the fads or fears of the day to influence your actions your investment success will be diminished. The successful strategy is long-term and conservative.

In a 24 month period during 2004-2006 the Fed raised rates from 1% to 5.5%. Had you forgotten? So had I. If the Fed were to again raise rates as dramatically as they did those six or seven years ago, stock prices, and especially bond prices, would move sharply lower. While this does not appear to be an immediate threat, still we must ask: How do we guard against such an eventuality?

When buying bonds I look for the "sweet spot" between maximum return and minimum risk. We all know that maximum return = maximum risk and that minimum risk = minimum return. My job is to find securities that bring the most return possible at a risk level that is acceptable. Said differently, somewhere along the spectrum of credit rating, yield, and time to maturity we find a level of risk and return that we can live with.

Thirty years ago, when Drexel Burnham was introducing us to "junk" bonds, one of their traders told me that even after taking into account a certain "normal" percentage of failures, that "junk" bonds still would return more than "investment-grade" bonds. (As well they should.) As for me, I am certainly not comfortable in the "junk pile". It is only by necessity that I have developed some tolerance in the upper reaches of that arena, especially where credits are improving, and the outlook is brightening.

Still, in general I eschew junk: it is my personality to try to avoid potential failures. I am not always successful at that; no one is. But by limiting each holding to 3% or less of the portfolio, and being prudent in the selection of issues, over time we have been able to hit the occasional pothole without breaking our axle.

This viewpoint colors my stock selection as well: very often stock market darlings have bonds that are rated deep into junk territory. It is hard for me to buy a stock whose bonds I wouldn't touch. Bondholders, after all, get paid before shareholders.

Today, with bond yields at all-time lows, it is all the rage to recommend high-dividend-paying stocks. While this is a stance that is hard to oppose, at this point it must be recognized that it is rather late in the game. Nevertheless, you can fairly easily find stocks of high-quality companies that pay dividends far in excess of the "risk-free" alternative (Treasuries). Often these companies yield more in dividends than their own bonds pay.

Certain industries, utilities, for example, trade like bonds; i.e., they go up when rates go down, and vice-versa. We can expect these stocks to decline when rates rise. Other high-yielding stocks might trade less like bonds if they can show growth during periods of rising rates. That remains to be seen; still, though, it is a conservative play.

Whether stocks or bonds, most people recognize that the higher the market goes the more dangerous it is. Fewer are conscious of the fact that the lower a market goes the safer it is.

Here is the problem: when the market is rising, even though folks know it is more and more dangerous, they just cannot help wanting to be "in on the action". Conversely, when the market is falling--and consequently getting safer as it falls--they just want out.

Thus is born the concept of contrarianism: take the opposite stance of the majority; buy what most people hate, and sell what most love. While I do not consider myself a pure contrarian, I would always rather be a buyer when prices are down. Added to that is my stubbornness (though I usually call it patience), a characteristic which leads me to hold stocks for extended periods of time. Combined, these factors have resulted in satisfying investment results. I expect that to continue.

I wish you a Happy, Healthy, and Prosperous New Year.

Jim Pappas