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Quarterly Letter to Clients

October, 2014

Indices at quarter-end (September 30, 2014):

Dow Jones Industrials: 17,042.90 3Q'14 +1.29% YTD +2.80%

Standard & Poor's 500: 1972.29 3Q'14 +0.62% YTD +6.71%

Early in the quarter the bull market seemed to be getting tired. Around mid-summer stocks gave back five percent. But it was not yet time for the game to end: stocks rebounded in August and September, hitting fresh new highs. Still, the charts continue to look "toppy," and the whole world seems to be waiting for a correction. Every dip so far has been shallow and followed by a recovery move up. It remains to be seen if that will hold true.

Recently, interest rates on the safest items, short-term U.S. Government paper and on certain European bonds, slipped into negative territory for the first time since 2008. A temporary condition, of course, but dramatic nonetheless. Conversely, in corporate bonds (the arena I compete in) there has been a bit of softness lately, though we still show reasonable gains for the year-to-date. The Fed's position of leaving rates at current low levels has been a prop, and we all know that someday that support will be removed from the market.

At the end of the quarter the U.S. initiated air strikes in Syria. We can blame the ensuing volatility in stocks on that action. The market does love to attach a reason to short-term moves. The bigger question is whether we should concern ourselves at all with such day-to-day upheavals. My interest lies in what will happen in individual companies over the longer term, and the only real driver of long-term stock prices is the earnings of those underlying companies.

This view is called "bottoms-up" (company specific) in investing circles, as opposed to "top-down" (economic environment), which is a strategy of observing the overall economy and world business to formulate an investment policy.

While I focus on individual companies, I am not oblivious to the fact that an extended period of economic weakness has a negative effect on all stocks, even if a given company is able to grow during such a period. But ultimately cycles repeat, economic weakness turns to economic strength, and our markets resume their relentless upward march, as evidenced by the last decade-and-a-half. Are we entering a declining phase for stocks? I, for one, have not had success in predicting the gyrations of the market. Rather, I have found that what works for me is sound stock selection, and holding my positions over the market cycles.

This is not to say that I totally ignore the "big picture." For example, I am of the opinion that the way we currently use and validate credit cards must change. How long will we or our financial providers accept security breaches like those of Home Depot or Target? For that matter, how much longer will our name, date of birth and Social Security number continue to be required on things like medical forms?

We must abandon the simple signature in favor of user-specific identification, something like a fingerprint or iris scan. I envision a time in the not-too-distant future when we go to the supermarket and press our thumb onto a reader rather than signing. For online purchases, at ATMs, at Starbucks, we will use the same technology. To log on to our brokerage account we will use a thumbprint. No more passwords. And greatly reduced threat of identity theft.

With this in mind, I look at the various companies that might participate in such a tectonic shift. So, in that sense, my view of the larger picture points me toward an investment. I then evaluate the companies on the basis of relative valuation, financial strength, market position, balance sheets, growth prospects, etc. Once the decision to buy is made, I am very patient and forgiving of overall market trends which might affect the stock's price. If a market drop brings down the price of one of my companies, I view that as a buying opportunity.

We all love a rising market, and we all hate the declines. But we must operate in the environment in which we find ourselves. To me that means minimizing risk at times like this when a five-year bull market has resulted in opportunities being scarce and valuations being stretched in both stocks and in bonds. Many of my clients rely on their investment income, and all are sensitive to changes in their account values, so I must find a balance that will hopefully assuage any damage should markets fall, while still putting positive numbers on our statements. There have been easier periods in which to invest.

Jim Pappas