January 2014 Client Commentary. Part 1

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1 January 2014 Client Commentary Part 1 First, we want to wish everyone a happy, healthy, and prosperous new year! Here are a few updates looking at 2013 in the rear view mirror: Equities/Stocks: The Dow Jones Industrial Average closed up +26.5%, largely a result of stock market momentum and increased optimism; however individual stocks had varying levels of performance. For example, we sold positions in Johnson & Johnson, Wellpoint, Becton Dickinson, and Microsoft in order to lock in gains. But, many other prominent Dow stock s such as Cisco, Caterpillar, IBM, and Coca Cola had minimal or negative returns for the year. o Key point: When you buy individual stocks (like we do), the results can be dramatically different from the index, especially if you aren t fully invested in stocks (which would not be a balanced portfolio). Fixed Income (Municipals): Municipals Bonds had a very tough year (i.e., Municipal bond funds had outflows in 41 of 53 weeks, including 32 consecutive weekly outflows totaling $67.5 Billion). This was primarily due to a combination of rising interest rates, headline news regarding Detroit and Puerto Rico (both which we have avoided), and the continuous outflows of the sector (partially due to the lure of high stock market returns). o Key point: We continue to believe that shorter term and intermediate term bonds in the municipal sector offer decent value with the prospects of continued demand due to higher taxes and the asset class track record of safety and income. We focus primarily on individual bonds which allows us to better control risk in the portfolio because each bond has its own maturity. Fixed Income (Corporate Bonds): Pimco Total Return, the world s largest bond fund declined nearly 2% for 2013, which was its first annual loss in 14 years. Affected by the same rising interest rates, headline news, and outflows as municipal bonds, the Pimco Fund s returns were their weakest since o Key Point: We continue to believe that the sweet spot in the corporate bond market lies in the 4-7 year maturities. The high coupon (Premium bonds) we hold offer good current income and relative protection in a rising rate environment. They remain a future source of funds because we do not plan to hold all of these to maturity. This will allow us to capture extra value through the yield curve. Precious metals: Gold closed down 28% and some of the mining stocks in the sector were down even lower. Fear of Federal Reserve tapering and heightened media attention contributed to the sector s largest annual decline in 30 years. o Key point: In a world of significant money printing (i.e., $1 Trillion last year and $3.2 Trillion since 2009), we continue to believe this sector offers significant protection (i.e.,

2 potential) against higher interest rates, an inflationary environment, and a loss of credibility in the Federal Reserve and US Government. We believe the opportunity is here and now. The current holdings we have in this sector offer incredible bargains and potential. For additional insight about a similar decline (and the rewarding rebound) in the 70 s, please see our May 2013 letter. With this look in the rear view mirror, 2013 was a great year if you had significant exposure to stocks, however if you run more balanced portfolios like we do (i.e., equities, fixed income, cash, and precious metals), you re more excited about what s shaping up for As we head into 2014, we remain laser focused on risk management and our goals for our clients. Our goal remains to generate rates of return (over a market cycle) that meet or beat market performance. To reach this goal with the least amount of risk, we utilize a balanced portfolio and individual stock selection. Let s talk for a moment about what we mean by market cycle. A full market cycle can be defined as the market s performance: From a market bottom, up to the peak, and then down to the next market bottom (i.e., ); or From a market top, down through the decline, and then back up to the market top (i.e., 2007-to whenever the current market tops out). Now, let s talk a little about what we mean by risk. Think of risk as the potential for significant and permanent capital loss, rather than volatility (i.e., fluctuations in the portfolio). This is an important point to distinguish, especially in light of daily pricing shifts and the perception that our world can only have short-term focus. One of the key factors to a successful investment program is patience. Volatility can wear on our patience, however we will ultimately be able to provide you better financial results by remaining focused and conscious of risk as the potential for significant and permanent capital loss when we make investment decisions. If you found yourself frustrated in 2013 (just like we did at times) due to the volatility (and likely more specifically the increases in the stock market indices), consider for a moment the following market cycle analogy: Market cycle analogy: What is least important number in any game? The score at halftime. It is important to evaluate performance (and specifically an investment management firm like Grefe Capital Management) over the course of a full market cycle. This goes beyond a single year that mainstream media may categorize as good or bad solely based on stock market performance. The benefit of our approach, is that when we see some declines in our portfolio in a year, it is often possible to recover lost ground rapidly (particularly relative to a buy and hold strategy). The market cycle

3 continues and the declines look more like small dips preceding inclines that ultimately help you reach or exceed your financial goals. We remain vigilant on reviewing risk inside the portfolio and continue to add and look for new opportunities that fit our quantitative and qualitative investment criteria. Our list of potential investment candidates (many very high quality businesses) is larger than it has ever been. We will be following up with each of you this quarter to discuss your current portfolio, review your goals, and the opportunities that we see in the current environment. Did you know? Part 2 The S&P 500, which many now hold in high regard due to last year s very good performance, has returned just 60% over the last 13 years (3.5% annually) with 36.95% of that return coming from dividends. For successful investing, it is important to recognize and understand the following concepts: 1. Business value and stock price can be dramatically different. In other words, the business values of companies do not change near as much as the prices in the stock market, and even great businesses can see their stock drop by 50% for no great reason. Because this uncertainty exists, we try to build a Margin of Safety into the investments by buying at what we believe are good prices and/or buying great businesses. 2. Ignore the crowd. At the extreme, the crowds and the headlines can be dramatically wrong. It s at this point, media typically calls for more of the same and emotional investors overweight their nearterm experiences and ultimately conform to the crowd at their long-term expense. 3. Investment opportunities are often created out of declining prices and negative headlines. These opportunities can appear in individual stocks or a whole asset class. As famed investor John Templeton said, Buy into maximum pessimism. In , we believe precious metals will also be a good example of maximum pessimism.. In addition to precious metals, we continue to find other opportunities in sectors such as retail, logistics, and healthcare. Many of these good businesses did not participate in the stock market rally of We like to look back and use history as a guide, but don t lose focus on what s ahead. As investors, we can t be driving using the rear view mirror, but rather we must be looking out the murky windshield doing our best to invest looking forward and not backwards. No one has the ability to see around every corner, so you take the information that is provided and make the best decisions possible with that information. As an example, back in , Berkshire Hathaway declined by more than 40%. Berkshire is a prominent stock and their stable of subsidiaries are well known companies such as Geico Insurance, Dairy Queen, Mid American Energy, and Borshiems Jewelry along with many other great businesses. It is also run by the investing legend, Warren Buffet. From March of 1999 through March of 2000, Berkshire s price plummeted while tech stocks, (e.g., Pets.com, Cisco, and Yahoo) increased by over 100%. In one year s time, Berkshire Hathaway s stock price underperformed the Nasdaq 100 by

4 approximately 160% and the S&P 500 by 52%. The headlines read Berkshire Buffett-ing and What s Wrong, Warren? Any investor that had successfully owned Berkshire Hathaway for a period of time saw their long term investment gains cut in half. Any new investor in Berkshire Hathaway soon had a sizeable unrealized loss. It would have been easy to give up on Warren Buffet and cut any losses with Berkshire right then. But, for the investors that ignored the crowd and kept a long-term focus, the year was only a minor distraction and offered opportunities to buy into maximum pessimism. As illustrated below, another example is Proctor and Gamble (i.e. Tide, Bounty, Gillette, Pantene, etc).this is another prominent stock that looked down and out in a short term view (1999/2000), but has certainly demonstrated solid long-term returns. From 3/31/1999 to 3/10/2000 (Short Term) From 3/10/2000 to 3/8/2002 (Intermediate Term) 3/31/2000 to 12/31/2013 (The Long Term) Berkshire Hathaway % % % Proctor and Gamble % % % Nasdaq 100 Tech Index +117% % -9.33% S&P % % % Some more recent examples include the financial stocks Bank of America and Goldman Sachs and the retailer Best Buy in ( ). In 2012 the headlines and the analysts stated that Best Buy was a showroom for Amazon. Its price declined significantly over a two years. Pessimism towards Best Buy was very high, Wall Street analysts issued sell ratings on the stock near its lows, and many wondered if Best Buy would suffer the same fate as a former competitor (Circuit City, out of business in 2008). Since the lows it has appreciated significantly and near its recent price peak Wall Street analysts leapfrog each other to put Buy ratings on the company after a significant run in the stock. Aside from the large volatility in Best Buy stock what we find interesting is that when one looks at the revenues and profit margins of the company they stayed the same. In essence the business value did not change very much, just the perception and what investors are willing to pay changed Bank of America % % % Goldman Sachs % % % Best Buy % % % The market continues to remind us that the stock values fluctuate much more than the actual business value. While the volatility can be difficult to tolerate, we encourage you to see it as an opportunity like

5 we do. It is an opportunity to add to new or existing positions at lower prices, as well as an opportunity to sell the position to others at a better price than one expected. Part 3 In 2013, there was a large disconnect between market performance and economic performance one that hasn t been this large in anytime that we can remember. During the previous market tops (1999/2000 and 2007) the economy was humming along rather briskly. Today it remains in a much different, slower growth environment. While the economy and the stock market do not have to move together, over the long-term, economic growth and expectations of economic growth can have a large impact on stock prices. We believe the economy is growing but it is not growing enough to justify the prices being paid for many stocks today. Unemployment and Economic Update: Growth? 1. Wage growth remains weak. Congress last raised the federal wage floor in July of 2009 to $7.25 an hour. It remains there today. According to the economic policy institute, After adjusting for inflation that wage now provides 20% less purchasing power than it did in The unemployment rate remains stubbornly high. The December 2013 unemployment rate is 6.7%, however the unemployed and underemployed rate stands near 13% and the labor force participation rate stands at its lowest levels not seen since In other words, the unemployment rate is low because many people have dropped out of the workforce or given up looking for a job. 3. In the last 6 years, people on food stamps has grown from 27 Million in 2007 to over 48 Million in While the Federal Reserve s money printing has helped the broad stock markets, it does not appear to have had the same effect on the broader economy. Revenue growth for many companies that we follow remains very weak. We contend that companies cannot sustainably grow earnings unless revenues are growing too. Cost cutting and financial engineering can only take these companies so far. For example two companies in which we took profits last year, Johnson & Johnson and Becton Dickinson saw their stocks appreciate by 34% and 44% respectively. However their revenues only grew by 5.5% and 4.4% year over year. At current prices long term returns for these stocks may disappoint investors. When we connect the dots it does not add up. It is our best estimation that a significant portion of recent market growth is directly related to the Federal Reserve and their money printing and bond buying experiment. Due to persistently low interest rates, investors have chosen to move further out on the risk curve in search of return. This change has caused investors to accept more risk and potentially lock in lower returns at many of today s prevailing prices. We very much like what we own but continue to retain cash and fixed income as sources of future buying power when real bargains appear. It is also our belief that the source of the gains (money printing) will also be the source of future problems (when they emerge). What has initially created confidence in the market will turn into the reason confidence is lost in the market. You can have too much of a good thing!

6 2014 and Beyond: We are glad to have 2013 in the rear view mirror. We are excited about the opportunities today and the new ones that may appear once reality sets back in. Instead of a New Year s resolution we decided to create a tagline/acronym for this investment year. So, in 2014, let s be S.M.A.R.T. : S- Suspect of the current environment (i.e., prices and headlines aren t always what they seem) M - Mindful of risk and opportunities (i.e., volatility creates opportunities) A Allocated appropriately (i.e., asset allocation is one key to long-term risk-adjusted returns) R - Research focused (i.e., try to ignore the crowd and media Focus on the facts) T Tolerant of time (i.e., time is the friend of the long term investor; patience is key) As always, if you have any thoughts you would like to discuss regarding this series or your specific portfolio please give us a call at There is an inverse relationship between interest rate movements and bond prices. Generally, when interest rates rise, bond prices fall and when interest rates fall, bond prices rise. While interest on municipal bonds is generally exempt from federal income tax, it may be subject to the federal alternative minimum tax, or state or local taxes. In addition, certain municipal bonds (such as Build America Bonds) are issued without federal tax exemption, which subjects the related interest income to federal income tax. Municipal bond investments may involve market risk if sold prior to maturity, credit risk and interest rate risk. The price of gold has been subject to dramatic price movements over short periods of time and may be affected by elements such as currency devaluations or revaluations, economic conditions within an individual country, trade imbalances, or trade or currency restrictions between countries. As a result, the market prices of securities of companies mining or processing fold may also be affected. Diversification and strategic asset allocation do not ensure a profit or protect against a loss. Investments are subject to market risk, including possible loss of principal. The process of rebalancing may carry tax consequences. The S&P 500 is an unmanaged index of 500 widely held stocks. Past performance may not be indicative of future results. It is not possible to invest directly in an index. The NASDAQ 100 Index is an unmanaged index of 100 of the largest non-financial domestic companies listed on the NASDAQ Stock Market s National Market Raymond James & Associates, Inc., Member New York Stock Exchange/SIPC Raymond James & Associates, Inc., member New York Stock Exchange, makes a market in Bank of America, Cisco, Microsoft, and Yahoo. These companies can be found on the following website: