Q1 Commentary (2009)

April 7, 2009

Performance for the first quarter of this year extended the losses from the prior year.  This quarter was very challenging because the quarter had two distinct performance periods.  The first period covered January through March 9th.  Over this period, the S&P 500 declined by about 25% and we provided some protection, but because the selling was fairly indiscriminate and broad based, we provided less protection than we typically do.  On March 10th, the S&P 500 began a powerful recovery, which culminated in an 8.9% gain for that month.  This was quite impressive given the fact that the market was down nearly 8% intra month.  Consolidating all this volatility, we were able to deliver our asymmetrical pattern of returns by preserving principal during the down phase and remaining competitive during the rising period. 

Longer term performance remains strong and we are confident in our ability to outperform over market cycles.

For most of us, the current economic times are quite unprecedented and thus this poses enormous risks, but also enormous opportunities.  True to our philosophy, we are primarily concerned about minimizing the risks of the “doomsday scenarios” that dominate the airwaves on a daily basis and yet we want to capture the benefits from any possible market recovery.

Since we concern ourselves first and foremost with downside protection, we should share with you some of the problems that alarm us:

• The regulatory environment is becoming more pervasive, which tends to be a depressor to P/E multiples.

• Our government is taking and playing a larger role in allocating economic resources, which we believe is ultimately harmful to long term valuations and earnings.

• Marginal tax rates are increasing when our economy is weak.

• Unemployment is likely to keep rising.  Without employment it is extremely difficult to restore one’s balance sheet.   Consumer confidence is likely to stay depressed until private sector employment growth returns.

• Despite the nice lift to finance companies in March, we regrettably see many more challenges ahead for this sector.  Many are declaring victory because they believe the “housing crisis” has bottomed, but we fear that there are numerous “next waves” coming, such as the commercial real estate loans, credit cards and auto loans.  If the global economies remain weak, it is almost impossible not to have major commercial real estate problems.  If the unemployment levels stay elevated as they are now, it is hard to not see further problems in both the credit card and automotive loan areas.

• Finally, many believed that the technology stocks would lead the market out of the 2000 – 2002 growth bear market.  While this was true initially, they did not truly lead the advance from 2002 – 2007.  Similarly, we do not believe that financials will lead us out of this value bear market.

We very much believe that companies that can grow their dividend and earnings this year will ultimately be rewarded.  Our portfolio is dominated by companies that are positioned to do just this.  Throughout this first quarter, the headlines have been dominated by companies slashing dividends and lowering their earnings outlooks.  We have not been totally immune, but all of our holdings are financially strong, which has enabled more than half of our companies to increase their dividend rate this year.  We believe this will prove to be very important in 2009 as investors see our companies actually increasing their dividends, while the dividend for the S&P 500 is now expected to decline by nearly 25% this year. 

It is also fair to ask the question, “since we are so concerned about the downside protection, what would happen to the portfolio should the market continue to move higher?”  We firmly believe that when the market does start to advance, our portfolio should offer very satisfactory upside participation for two major reasons.  First, the current absolute and relative valuation multiples on our holdings are at levels never before experienced at Coho Partners and really not since the beginning of our careers back in the early 1980s.  Secondly, while we choose companies primarily for their high quality and defensive business models, market-type earnings growth is still a requisite to be included in the portfolio.  We look to buy and hold “all weather” stocks, not just those that perform well in only one kind of market.  We will admit that our companies do not have the same earnings leverage as many of the companies currently on life support, so if the economy were to make a sharp recovery, we would lag initially, but history has shown that our companies tend to recapture the initial shortfall over time.  Said another way, we may lag initially if we were to see a sharp “V” bottom in the economy and the markets, but we will still provide competitive returns over the length of any sustained bull market.

The first quarter earnings season will begin shortly.  We are expecting our companies to post satisfactory results, but more importantly to reaffirm their outlook for the year.  Again, we remain confident in our holdings because their business models do not rely on major global economic expansion.  The portfolio remains overweighted to consumer staples and healthcare holdings because of the stability and consistency of their earnings and dividend growth.  This boring, but highly successful strategy will be contrasted to other companies that will disappoint and lower guidance and use the global economic crisis as the reason.

In the meantime, we wish you all the best in your endeavors.  Please do not hesitate to contact us if you would like to discuss your portfolio or our outlook.

Sincerely,

Peter A. Thompson

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