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Quarterly Letter to Clients

January, 2013

Indices at quarter-end (December 31, 2012):

Dow Jones Industrials: 13,104.14 4Q'12 -2.48% YTD +7.26%

Standard & Poor's 500: 1,426.19 4Q'12 -1.01% YTD +13.41%

We have had a fine year, despite all the noise about the "fiscal cliff." I may be jaded, but to me it seems that these financial emergencies are not all that uncommon. Let's review:

The first government bailout of American banks came in 1792, during the first term of the first president of these United States. In 1819 (a mere 27 years later) another panic led some states to enact laws delaying foreclosures on real estate. There were notable bank runs in 1873 and in 1893. In 1907, a run against Knickerbocker Trust led the Treasury to inject millions of dollars into the banking system; that event led to the creation of the Federal Reserve System. In 1933, after thousands of bank failures, the government formed the Home Owners Loan Corp. to buy defaulted mortgages from banks and refinance them at lower rates, a program which was not completely wound up until 1951, and on which, incidentally, the government earned a small profit. It was that 1933 run that led to the creation of the FDIC. As recently as the late 1980's, half of our S&L's closed and Resolution Trust, a government agency, was formed to protect depositors (we taxpayers weren't so lucky in that instance, it cost the government $125 billion). Since 1960, the Federal debt ceiling has been raised 80 times. Government spending has almost never gone down.

So it seems that there is nothing much that is new under the sun. Except, perhaps, that information flows much more quickly, and it is easier than ever to enflame emotions. To those who might lose sleep over the crisis du jour, I would suggest that however dire the situation may seem today, it too will pass, and probably without leaving much of a scar.

Perhaps I have been involved in this business for too long a time, but when I was starting out there were many more AAA-rated companies than there are now. Today there are only four companies that merit the once-coveted triple-A designation: ADP, ExxonMobil, Johnson & Johnson, and Microsoft. Even the U.S. Government no longer warrants that top rating.

And if truth be told, not many people seem concerned by the overall diminution of credit ratings.

The causes are several, and are interrelated, but in general they fall into three main categories: tax maneuvers; an attempt to raise stock prices; and the action of private equity firms.

Tax policy has long given dividends favorable treatment, while interest paid is deductible. So, given today's low rates, you can understand why companies may borrow money to pay dividends. This particular action found especial favor at the end of last year, since dividends paid in 2012 were viewed as likely to be taxed at lower rates than those paid in 2013. While this may indeed be a tax-advantageous move, it is not something that strengthens the corporate balance sheet.

Companies also hope that higher dividends might raise the price of their stock. But another strategy is often employed to lift stock prices: companies buying back their own stock. While many companies use cash on hand to fund these purchases, many others borrow money for this purpose. They do this under the rubric of "returning money to shareholders." The result is a shrinking of equity and an expansion of debt. One rationale for this is that a dollar earned, when spread among fewer shares of stock outstanding, equals higher earnings per share. While this may be true, it is not as good a long-term tactic as retiring debt, which permanently lifts earnings.

Then there is private equity. The basis of their business is to borrow huge sums against the assets of their target companies, using those funds to buy up the equity. More debt may be added to pay themselves dividends and fees. They may cut employees and overhead. Eventually, with the company now larded with debt, and it's equity base shriveled, they will sell the stock back into the public market. While the general result is a weakened company, it is true that many have survived and even thrived. Still, the real benefit accrues to the private equity companies as opposed to their targets or the investing public; the resultant lower ratings mean bondholders invariably suffer.

Thus, over time, all of this "levering up" has expanded debt and shrunk equity, resulting in weaker balance sheets from the top of the scale across the entire spectrum of American business. For a decade now, the environment has been excellent for borrowers, and until rates rise significantly the leveraging of America is not likely to change. While we must applaud those companies that refinanced their debt at today's lower rates, there remain fewer and fewer investment-grade companies, and that has made the business of investing more and more difficult.

I am a long-term investor, and I am not happy that credit quality is deteriorating. I would rather that companies pay off their debts before buying back their stock. I would rather that earnings, as opposed to financial engineering, drive stock prices and dividends. But that is not today's reality, and, as always, I will have to adapt to the market.

Incidentally, those four triple-A companies each pay more in dividends than their own ten-year bonds (if you can find them) and more than the now lesser-ranked 10-year U.S. Treasury bond.

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

Jim Pappas