Q3 Commentary (2009)

October 19, 2009

The returns this quarter for domestic equities were particularly generous with the Russell 1000 Value and the S&P 500 appreciating 18.2% and 15.6%, respectively.  These returns essentially matched their second quarter returns, making the cumulative return over the past two quarters the best since 1975.  Quarters like this tend to follow periods of extreme stress and, therefore, it is not unprecedented that following the 2008 debacle, a rebound such as this would occur.  As perverse as it may seem, when prices rise as rapidly as they have over such a brief period, our investment philosophy is most challenged. To properly measure the true value of our investment approach, which is to preserve principal during down periods, while staying competitive during the advancing times, one may need to view the trailing 12 month period, which included two down quarters followed by two very strong quarters.  The domestic markets were under tremendous stress in the 4th quarter of 2008 and for most of the 1st quarter of 2009.  The current rally that we are now experiencing began in mid-March and since that time, the indices have risen smartly.  Looking over the past 12 months in their totality, we added meaningful value, despite the recent under performance.

Since investing is all about the future, we are in a tug of war between the camp that has declared that the worst is over and it is only a matter of time before our economy achieves sustainable economic traction and those who fear another meaningful correction is on the horizon.  We are not market timers nor sector rotators, rather we attempt to always position the portfolio to produce the asymmetric pattern of returns that we like, which is to preserve principal during down periods while capturing the majority of any broad advance.  Governmental intervention appears to have allowed companies to survive the front end of the “economic hurricane” that was ravaging corporate America last year.  It is quite possible that we are now in the “eye of the hurricane.”  Investors have rushed to those companies that have had the most precipitous declines from last year, which is consistent with the outlook that the worst is over.  Our fear is that these same companies still need to get through the back end of the hurricane as well.  While we are in “the eye”, the advantage has gone to the “beta trade,” which is to say, it has favored the industries that were down the most in 2008 and early 2009.

Coho Partners gravitates to the top three sectors listed above, staples,(integrated) energy and healthcare because they tend to hold up particularly well during corrections.  We also find that they do just fine over time when valuations are rising gradually, but they can lag during rapidly rising price periods.  Those three sectors outperformed while the markets were declining but they have lagged more recently.  Nevertheless, over the entire period, they have fared well, which is what we would have expected.

            The more economically sensitive sectors, such as consumer discretion, financials, industrials, materials and technology have the opposite pattern.  They underperformed during the downturn but have done well more recently.

            In addition to the relative performance penalty being extracted from focusing on the more defensive sectors in the Coho portfolio, other factors we prize have also been laggards in the market year to date.  Table 1 below shows the inverse relationship in this rally between high quality, low beta and high dividend yield.  These very portfolio characteristics that have served us so well over the longer term and particularly in the down markets, tend not to be the most popular in highly cyclical, beta driven rallies, such as the one we are currently experiencing.  These rallies historically have been sharp, reasonably short and pretty much equal and opposite reactions to the preceding bear market.  This one is exceptional only in the magnitude of the run and the gap between the haves and the have nots.

Investing is not a sprint, but a marathon, and we like our position in the race.  The last few years have had the feel of a market sprinting ahead on an adrenaline rush (housing and commodities circa 2005 – 2006), then collapsing with a massive heart attack (2008 crisis), getting hit with the paddles and pumped up with drugs (government bailouts in 4Q08 and 1Q09), and then hopping right back onto the race track.  We would truly be surprised by the scenario where the market continued to sprint its way back to good health from here.  In our opinion, a more likely and healthier scenario would be that the market settles into a much more rational pace, slowly healing and building up strength over time.  If that is indeed how things play out, our portfolio of high quality, steadily growing companies at reasonable valuations should do just fine in that environment.

The silver lining to our stocks having not kept up with the market over this recent rally is the fact that our relative portfolio characteristics look extremely healthy right now.  Compared to the Russell 1000 Value, our dividend yield is higher (2.8% vs 2.7%), our relative dividend growth is extraordinary (14% vs. 4% last five years), our earnings growth is higher (9% vs. -5% over the last 5 years compounded), our balance sheets are stronger (debt/capital of 28% vs. 40%) and yet our forward P/E is still low (14.1x vs. 16.0x)   (Source of portfolio characteristics; Thomson Reuters Baseline as of 9/30/09).

  As such, we very much like our portfolio composition and believe we are well positioned now and for the future.

We look forward to updating you on our progress in the final quarter of this year.

Sincerely,

Peter A. Thompson

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