Q2 Commentary (2009)

July 6, 2009

Returns for financial assets were quite generous this quarter, but the month of June was essentially flat. Not surprisingly, we had our best relative month in June, when the market was relatively weak and we lagged during the other months when the market was rising rapidly.

Year to date, we are trailing the S&P 500, with all of our underperformance attributable to the months of March, April and May, when the returns were very strong at 8.9%, 9.7% and 5.6% respectively. Versus the Russell 1000 Value Index, we are slightly ahead, as that index had a deeper hole to climb out of following its first quarter’s performance. The personality of this rally is not unexpected, as the low quality, higher beta, more cyclical, more leveraged stocks have led the charge. But remember that these were the worst performers last year. The recent winners are precisely the types of companies that we are least interested in as long term investors and as such they are outside our investment universe.

We continue to see excellent values in many high quality consumer goods and staples companies, healthcare companies and even the large integrated energy companies. Since these types of companies did not participate as well in this relief rally, the risk/return for our portfolio looks particularly strong now. We cannot predict how long this rally will last or to what level it may travel, but we do feel confident that if it were to continue, we should participate meaningfully in any further advance. To advance further, the market’s breadth would likely expand and begin to include many of the industries that have not enjoyed the full advance and this would logically help our portfolio. However, since the types of companies that we own weather downturns particularly well, should the
rally stall and the market reverse, we feel confident that we would again preserve principal well.

Many of our clients have inquired as to our long term outlook for the market. Although our investment process is driven by a “bottom up” approach, we consider macro economic factors that can impact valuations. With all the appropriate “we are not market timers, but long term investors” caveats in place, we do believe there are four primary policy levers that when altered can influence the direction of the market. Those four levers are:

• Fiscal policy changes
• Monetary policy changes
• Regulatory policy changes and
• Trade policy changes.

The outlook for fiscal policy is negative for the market, with the stimulative aspects of the massive increases in fiscal spending being more than offset by the negative long term impact of the ballooning deficit and likely higher tax rates.

Monetary policy remains extremely accommodative, which is typically a positive, but authorities will be very challenged to drain reserves appropriately when the economy improves, so as to not trigger serious inflation. The explosion of the Federal Reserve’s balance sheet is very disconcerting to us.

Regulatory policy is clearly deteriorating as large segments of the economy (notably the financial, automotive and healthcare sectors) are coming under increased scrutiny and greater levels of regulatory oversight and even direct government control. This does not auger well for the long term efficient allocation of economic resources.
Ironically, the area of trade policy, so often credited with being the final catalyst of the Great Depression in the 1930’s, is probably the most benign area of policy right now.

Bottom line, serious distortions have been introduced into our economy over the last nine months in response to this financial crisis. This does not minimize the distortions that have been building over the last several years, even decades, in the US pertaining to the consumer and many financial companies. But the “cure” may be worse
in the long term than the disease itself. Hence we believe it prudent to remain cautious and defensive.

Our companies are only tangentially exposed to all of these new governmental policies so they are more fully in control their own destinies with strong balance sheets, strong competitive positions and recession resistant businesses. None of our companies is looking to the government for aid or assistance. We are cognizant of how potential competitive distortions from these policy actions may influence the business models of our holdings and as such, we are monitoring those sectors where we own stocks that may be impacted by increased government regulation (healthcare and energy most notably). Nevertheless, we expect our companies to retain and even expand their competitive edges even in a more regulated environment.

As we cross over the mid point of this year, we remain encouraged by the operating and financial performance of our holdings. While dividend cuts and omissions have become an every day occurrence, we are pleased to report that none of our holdings have reduced their dividend. As of this writing, just under 60% of our holdings have increased their dividend and before the year is over, we expect nearly all of our holdings will have raised their dividend. Despite the overall challenging economic conditions, our companies are making good progress on their earnings fronts and improving their long term competitive positions.

The portfolio’s characteristics that have assisted in providing downside protection with competitive upside participation remain in place. Those characteristics are:

• a generous dividend yield with consistent dividend growth
• an overall P/E that tends to be equal to or less than that of the broader market
and yet the earnings growth for the portfolio tends to be better than that of the
broader market.
• financially strong companies that are highly profitable, not very capital
intensive and have a proclivity to return cash to shareholders through steady
dividend growth and share repurchase
• a portfolio beta that is well below 1.

On a very personal note to all, this letter marks the ten year anniversary for Coho Partners. Having started with no clients and therefore no assets under management, we are happy to report a stable and growing client base and assets under management approaching $300 mil. Having hired Glenn Dever as President in January of this year,
we are becoming more strategic in our marketing efforts. Our ambition is not to grow too quickly, but to grow in a measured way with clients who understand what we do and share our commitment to long term investing.

We look forward to updating you on our progress as the year unfolds.

Sincerely,

Peter A. Thompson

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