Q1 Commentary (2008)

TRAILING RETURNS ENDING 03/31/08
	1Q08	1 YEAR	3 YEARS		5 YEARS		INCEPTION TO DATE VS. S&P 500**
Coho Tax-Exempt Composite*	-5.1%	-0.9%	5.5%/yr.		12.1%/yr.		6.6%/yr. vs. 0.6%/yr.
CohoTaxable Composite*	-5.4%	-0.6%	5.4%/yr.		11.9%/yr.		6.1%/yr. vs. 0.4%/yr.
S & P 500 Index	-9.5%	-5.2%	5.8%		11.3%/yr.
*net of fees **Tax Exempt Composite inception 9/30/00 Taxable Composite inception 12/31/99

April 14, 2008

 

The first quarter of 2008 was the byproduct of three consecutive down months for the S&P 500.  As disappointing as it always is to report negative returns, we were able to outperform in each month and as a result, our quarterly decline was meaningfully less severe than that of the S&P 500, which is consistent with our investment philosophy.

Returns for the trailing one year period are very good on a relative basis because we provided downside protection over the past six months.

Returns on the trailing three and five year periods are competitive, which is satisfactory given that these time periods were marked by rising valuations.

Our strong inception to date performance is a result of strong downside protection in the 2000 to 2002 period and the most recent couple of quarters. From 2003 through 2007, we posted competitive returns. We believe the inception to date returns validate our ability to protect principal during the challenging times and still be competitive during the good periods.

It may seem like a broken record, but the problems cited in many of our recent letters continue to pressure the broader market.  Specifically, the credit/liquidity issues, the slumping dollar, high energy and commodity prices and growing concern about the overall health of the consumer are all still present.  Against this backdrop of concerns, we continue to believe there are excellent investment opportunities in the market.

            As you know, our investment philosophy is designed to protect principal during down periods, while staying competitive during the advancing times.  We have successfully achieved this asymmetric pattern of returns by consciously investing in what we believe are favorable sectors with preferential financial characteristics.  Throughout our existence, we have deliberately maintained large overweights in consumer staples, healthcare and integrated energy.  These three sectors tend to perform very well during challenging times and true to form they performed well during this most recent difficult quarter.  Why is that?  The simple answer is that demand for these products tends to be relatively insulated from economic slowdowns and therefore the earnings and cash flows for these sectors are relatively more stable.  As such, during stressful periods, investors tend to migrate towards these more defensive sectors.

            Chart 1, depicts a 30 year history of performance for staples, healthcare and energy stocks.  Clearly they have all performed well against the S&P 500, but their best relative performance tends to occur during market corrections.

Chart 1:
Select Sector and Market Performance: 1978-2007

Source: Sanford C. Bernstein & Co., LLC & Coho Partners Ltd.

In addition to our sector concentrations, we have also frequently highlighted the portfolio characteristics that we intentionally build into our portfolio to further increase the likelihood of preserving principal during down periods.  These are dividend yield, cash flow yield and earnings stability.  These sectors tend to have dividend yields that are competitive with the broader market but often overlooked is the fact that they tend to grow their dividends at an above average rate of growth.  Chart 2 shows how the top quintile of dividend yield, earnings stability and cash flow yield have performed relative to the S&P 500.  In general, those stocks with higher dividend yields, greater earnings stability, and/or higher cash flow yields have significantly outperformed the market over the last 30 years.

Chart 2:
Factor Analysis:
Top Quintile of Dividend Yield, Earnings Stability, and Cash Flow Yield

 

Source: Sanford C. Bernstein & Co., LLC & Coho Partners Ltd.

Conversely, there are other sectors, such as technology and financials that tend to do particularly well during periods of strong economic expansion. Investors can benefit greatly from this, however, these same sectors can be fraught with peril during economic slowdowns.  Candidly, when the market’s leadership is driven by these economically sensitive sectors, our performance may lag that of the overall market, but we still expect to post competitive returns.

From 2000 through 2002, the once highflying technology sector came crashing back to earth.  This was not a surprise to us because history has shown that the stability of these earnings for this sector is simply not very strong.  Technology stocks did particularly well during the 1990s, but as Chart 3 shows, this sector can be highly volatile and over time, it has lagged the broader market.

Chart 3:
Select Sector and Market Performance:
1978 - 2007

 

Similarly, over the most recent six month period, we have experienced gut wrenching negative price movements in the financial sector.  Once again, history has shown us that the earnings stability of financials is often not as strong as one might have thought.  Consider this brief comparison of some very large and well known financials as shown in Table 1.  On a trailing one, five and ten year periods ending March 31, on a price basis only, (i.e. dividends are not included) these companies have not created long term value. 

TABLE 1
	10 YRS.	5 YRS.	1 YR.
	3/31/98	3/31/03	3/31/07	3/31/08
BANK OF AMERICA	$36.47	$33.42	$51.02	$37.91
CITIGROUP	$26.49	$34.45	$51.34	$21.42
J.P. MORGAN	$44.96	$23.71	$48.38	$42.95
WACHOVIA	$56.81	$34.07	$55.05	$27.00
S & P 500	1101.75	848.18	1420.86	1322.70

Coho Partners does include select technology and financials holdings in the overall portfolio, but we tend to consistently underweight these sectors relative to benchmark weights for the aforementioned reasons.

So where does all of this put us?  We would respectfully submit that we believe there is excellent intrinsic value within our portfolio and that over time the realization of this value will manifest itself.  The current macro storm clouds can delay this realization, but we do not believe they can prevent these values from eventually being uncovered.  We prefer to scrutinize our models and challenge our assumptions, while monitoring the long term operating and financial goals as set forth by those managements.

By the end of this year, we expect all but one of our holdings to have achieved higher earnings and all but one of our companies to have increased their dividend.  All of our holdings have very strong balance sheets and it is highly possible that all of our holdings will take advantage of current valuations and repurchase treasury shares.  These are all encouraging signs to us and give us confidence in the long term outlook for our portfolio.

We appreciate that any decline in market value is unsettling and this is not lost on us.  Should you have any questions or concerns about the portfolio or our outlook, please feel free to contact us.

Sincerely,

Peter A. Thompson

 

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