Quarterly Letter

Ron Meuhlenkamp

The economic drivers we wrote about in the past few newsletters remain in place; (more about that in a minute). And we continue to expect volatility in stock prices, which moved up on the order of 5% in the first quarter—only to give it back in the second quarter—until the last week in June when prices moved up approximately 5% again. So year-to-date, stocks have done okay— not great—but better than cash; our performance is average. (For current standardized performance, click here.  Past performance is not a guarantee of future results.)

The good news is the number of American (and international) companies with good balance sheets and strong earnings, selling at reasonable prices, several of which we own. The bad news is the number of headwinds, both domestic and international, which has slowed the current economic recovery.

The U.S. economy is growing at a subdued pace as people continue to control their spending and save more than they did prior to 2008. Because the economy is growing slowly, unemployment remains high. Employment began to pick up last winter, at about the time Congress extended the Bush tax rates for two more years. Since President Obama made it clear recently that increased tax rates are definitely on his agenda going forward, it will be interesting to see whether employers continue to hire. I believe the prospects of increased taxes, increased cost of medical insurance, and increased regulation are discouraging to employers. If you disagree, I suggest you consider hiring someone.

The current hot topic is the debt ceiling.
Our current federal government spending of $3.6 trillion ($36,000 per family) exceeds tax receipts by $1.6 trillion ($16,000 per family). Any family facing a similar deficit would prioritize its spending by cutting back on discretionary spending in order to pay the mortgage. Senator Pat Toomey introduced a Bill to do the same at the federal level, but politicians hate to prioritize, they want to have it all. So, instead of prioritizing spending, they’re warning about the risks inherent in defaulting on interest payments to the people and pension funds who own U.S. Treasury Bonds.

Folks, our politicians have made more promises than they can keep. Their assumption is that the people who produce the goods and services in our economy—and who pay the taxes—will continue to do so as we increase the burden of taxes and regulation. It didn’t work in the 1970s, and those of you who’ve attended our seminars in the past thirty years have told me it won’t work today. (“How many of you would come to work on Friday at a 50% tax rate”?)

Yet, we’ve continued to elect politicians who’ve made these promises. We’ve now reached the point where they and we must choose which promises to keep and which ones not to. The topic deserves discussing for a year or two—which we are now in the midst of—but we don’t expect to see a trend until the discussion nears a conclusion. Our Federal Reserve has been trying to “help” by keeping interest rates low and buying debt securities, but it is using monetary tools, (which is all the Fed has), when the problem is fiscal (taxes and spending). Hence, Quantitative Easing (QE1 and QE2) was ineffective in spurring economic activity. We believe QE2 may have encouraged the borrowing of money to buy commodities. As QE2 neared its end (6/30/2011), we’ve seen a pullback in the prices of many commodities, including crude oil. The Fed has said there will be no QE3. I hope that’s true. Pouring more money into ineffective programs simply wastes more money.

Meanwhile, China is raising interest rates and slowing its economy on purpose, much like we’ve done in the past. And Europe is grappling with problems somewhat similar to the U.S., but at a more advanced stage. Some countries, (not just states), are bankrupt. European banks are major lenders to European governments, putting them at risk as well. While we don’t expect a meltdown similar to the subprime lending and Lehman Brothers debacle that hit the U.S. in 2008, (partly because everybody is aware of the problems in Europe), the risk cannot be ignored. So our “watch and worry” list remains: 1. European government debt and banking problems; 2. China’s slowdown which could become a “hard landing” or recession; 3. The ongoing U.S. political/economical debate on taxes and spending. 4. We do see improvement in some U.S. states, which are coming to grips with government spending at the state level. The plusses, as stated previously, are the attractive balance sheets and current stock prices of many American (and international) companies. Our strategy in dealing with the crosscurrents has been to keep more-than-normal cash and to invest only in companies selling at modest prices with strong cash flows. We think there will be ample opportunity for more aggressive investing when some of the headwinds discussed above are clarified.

So our “watch and worry” list remains:

1. European government debt and banking problems;
2. China’s slowdown which could become a “hard landing” or recession; 
3. The ongoing U.S. political/economical debate on taxes and spending. 
4. We do see improvement in some U.S. states, which are coming to grips with government spending at the state level.

The plusses, as stated previously, are the attractive balance sheets and current stock prices of many American (and international) companies. Our strategy in dealing with the crosscurrents has been to keep more-than-normal cash and to invest only in companies selling at modest prices with strong cash flows. We think there will be ample opportunity for more aggressive investing when some of the headwinds discussed above are clarified. 
 

Exchange Traded Products: Buyers Be Aware

Steve Bierker, Investment Analyst

Following is a shorter version of a lengthier essay on Exchange Traded Products. If interested in learning more, please click here for the unabridged essay.

Exchange Traded Products (ETPs) are simply investment vehicles that provide convenient access to an investible market including stocks, bonds, commodities, and currencies. Most ETPs use passive strategies, meaning they are designed to generate returns consistent with an index value; e.g. S&P 500 Index. Similar to stocks, the price of an ETP changes throughout the trading day, usually in close proximity to the value of its underlying holdings or Net Asset Value (NAV).

While ETPs are attracting increased investor and media attention, they are far easier for investors to buy than to understand what they’ve bought. ETPs offer certain advantages versus traditional mutual funds, but they also have potential pitfalls and complexities that most investors don’t fully appreciate. Our goal with this article is to:

• Provide a primer on the types of ETPs available;
• Review the size and characteristics of the ETP market;
• Examine the benefits commonly cited in ETP marketing materials; and
• Furnish questions that should be answered by an investor prior to investing.

Types of ETPs
Exchange Traded Funds (ETFs) are the most common type of ETP. Typically, the term “Fund” means a collective investment pool organized as a trust. A more important distinction is whether the trust registers under the Investment Company Act of 1940, which was created to minimize conflicts of interest and to require certain disclosures to investors. While most investment trusts are registered under the Investment Company Act of 1940, certain commodity-related trusts are exempt from registration under this Act.

ETPs that aren’t organized as investment trusts are often referred to incorrectly by both investors and the media as ETFs, which they are not. These include limited partnerships (usually commodity related), and Exchange Traded Notes (ETNs) that are designed to track the return of an investible market, but offer their returns through a debt-like instrument.

More specifically: 

• ETPs organized as trusts hold assets for the benefit of investors and, in turn, issue shares or units that represent an “undivided” interest in its assets and liabilities, similar to mutual funds. (“Undivided” means that individual investors do not have exclusive rights to the underlying property, but share their rights with other investors in proportion to their ownership.) Most ETPs structured as trusts distribute their underlying gains and report the tax liability via an IRS Form 1099.
• ETPs organized as limited partnerships have a general partner that manages the investments on behalf of the limited partners. These types of securities most commonly invest in the commodity space and are typically regulated as “commodity pools” by the Commodity Futures Trading Commission. Limited partnerships share similar pass-through tax treatment as trusts, but operate inside a more complex tax environment with IRS K-1 reporting.
•  Exchange Traded Notes (ETNs) are debt-like instruments that offer returns based on a wide selection of indexes; e.g. stocks, bonds, commodities and currencies. These securities are similar to owning an unsecured bond, but the interest—based on the underlying index returns, less the fee—gets accrued inside the value of the security. Since there is no interest payment or dividend distribution, the timing of gains or losses is determined by the investor.

Size and Characteristics of the ETP Market
According to the Investment Company Institute, the ETP market, (excluding ETNs), continues to expand with 1,045 products trading on U.S. exchanges as of May 2011, representing approximately $1.1 trillion in assets. Net of closures, 126 of these were launched in 2010 and 122 so far in 2011.

Figure 1 summarizes the characteristics of the U.S. ETP market. Over the past year, global/international equities have grown assets under management by 49.8%, broad based equity by 36.3%, and sector funds (which include commodities) by 40.7 percent. Bond and hybrid ETPs represent small pieces of the overall pie and grew 24.9% and 58.8% respectively.

Figure 1
ETP Assets, excluding ETNs
As of May 2011

Commonly Cited ETP Benefits
The benefits often cited by ETP sponsors include low management fees, intraday trading, and tax efficiency.

1. Low Management Fees (Think “Index Funds”) Remember, most ETPs are managed passively, meaning they operate according to a formula outlined in the prospectus. Passive strategies intentionally remove judgment and personnel from the investing process to reduce overhead. Another element that contributes to lower ETP expenses—one that rarely surfaces in the media—is the absence of a fee often charged by broker/dealers to allow mutual funds onto their platforms. (It’s common for broker/dealers to charge mutual funds between 0.25%-0.40% of the value of its assets annually.) ETPs escape this toll because broker/dealers cannot easily restrict access to securities that trade on an open exchange.
   
   Understanding this dynamic, you might ask why active managers don’t move en masse to the ETP space. Some are trying, but given the SEC’s requirement for portfolio transparency, entering and exiting positions becomes more difficult. (This introduces the risk of trades being front run by others to the detriment of investors.) 
    
2. Intraday Trading
   ETPs trade throughout the day in a manner identical to other traded securities; investors can use market-, limit-, and stop-orders for their purchase and sale. The market price of an ETP normally trades in close proximity to the NAV of its underlying securities because institutions known as Qualified Participants (or a similar designation) have mechanisms to close the gap to earn a relatively risk-free profit.
   
   However, during the Flash Crash of May 2010, the mechanism stopped working. Institutions that would normally keep an ETP’s market price close to the NAV of its underlying securities chose not to fulfill this role. Extreme market volatility and pricing uncertainty made it too difficult to maintain the low-risk nature of such activities. Liquidity was lost until the market stabilized; the shares that were traded did so at steep discounts. Regulators canceled many of the trades given the substantial discount to the underlying NAV.
    
3. Tax Efficiency
   ETPs gain tax efficiency through a combination of inherently lower turnover, like-kind exchanges, and structural tax deferral. (For tax-deferred accounts, these characteristics are immaterial.)
   
   Low Turnover:
   The passive approach of most ETPs can result in low portfolio turnover, creating greater tax efficiency. (This approach is available to any mutual fund as well.)
   
   Like-Kind Exchanges: For redemption requests, ETP sponsors have the capacity to exchange the underlying securities for the ETP itself. For example, a large holder of the XYZ ETP can return the security directly to the sponsor for redemption and receive the underlying securities rather than cash. (ETP sponsors often select low-cost basis positions during this process, cleansing the remaining portfolio of unrealized gains.)
   
   Structural Tax Re-characterization/Deferral:
   ETNs are designed and marketed as “pre-paid forward contracts.” The implication of this treatment means that no tax liability is incurred until the security is sold or matures and the embedded gains (or losses) are treated as capital gains (or losses) versus interest income. ETNs are the retail version of certain perks that exist in our tax code for complex financial instruments.

Questions You Should Ask

How is the investment objective pursued?
While the investment objectives for ETPs are provided in their marketing materials, understanding how the assets are invested is important to consider. (This information can generally be found in either the Prospectus or Statement of Additional Information.)

For purposes of this question, we are going to divide the universe of ETPs into four distinct categories:

1. Bonds and Equity Indexing;
2. Commodities;
3. Leveraged and Inverse products; and
4. ETNs.

1. Bonds and Equity Indexing
   The strategies used in this category are generally straightforward. Similar to how traditional index-based mutual funds operate, these ETPs own the bonds or equities underlying a specific index or other basket of securities. While supply/demand factors in the underlying securities are an important consideration, the ownership interest and nature of what is owned is consistent with what most investors expect; i.e. investors own a pro-rata portion of an underlying portfolio of securities.
2. Commodities
   Excluding ETNs, (as they are a whole different animal), commodity ETPs can be further separated into two categories: those that actually own and store the underlying commodity, and those that seek to match the commodity’s return by owning a derivative contract of some sort.
   For those ETPs that own the actual commodity, (mostly in the precious metals space), important questions to consider are:
   Note: These sorts of ETPs represent a pro-rata interest in the underlying commodity and ETP shares are often exchangeable for the commodity itself.
   
   For those ETPs that don’t actually own the underlying commodity, the sponsors buy derivative instruments (primarily futures and options) to synthetically create a financial product that matches the performance of the underlying commodity. The primary risks that surface under this construct include:
    
   • Where is the commodity stored?
   • What legal jurisdiction controls the stored commodity?
   • Does the ETP have a clean title to the commodity?
   • The duration of the underlying derivative contract;
   • Bid/Ask price erosion as positions are extended into the future; • The pricing of the commodity in the forward or futures market; and
   • The solvency of the guarantors of the underlying positions.
3. Leveraged and Inverse Products
   The risks here are a bit more esoteric. The construct is similar to commodity ETPs that don’t hold the physical underlying securities with one additional factor to consider. These sorts of ETPs have the added challenge of maintaining a predetermined exposure (either direct, multiple, or opposite—or any combination thereof) in realtime during the trading day. 
    
4. Exchange Traded Notes (ETNs)
   With ETNs, you are lending money to the issuer, (similar to a bond), with the interest payment deferred and embedded inside the market value of the security. The return earned will exactly match the return of the reference index, less the stated fees, unless the issuer defaults, (similar to a bond default), in which case you are an unsecured creditor of the issuing firm. The issuing firm gains access to a source of funds it can use elsewhere, and presumably manages its exposure to what has been promised on the proprietary risk side of its business.

Does the ETP fundamentally alter the supply/demand balance of the markets in which it invests?
As a general rule, ETP investment strategies can be replicated by individual investors, however, for most strategies, these products make the process of investing as easy as a few clicks on an online broker’s website. Such ease can and often does bring capital into markets that may have previously been difficult to access; (e.g. foreign equities and commodities). While both foreign equities and commodities were investible in the past, they frequently required special accounts beyond standard brokerage.

This can alter the pre-existing supply/demand balance in pretty obvious ways. As capital flows in, the underlying assets (absent other factors) appreciate in value. When capital flows out, the underlying assets depreciate in value. But all markets always have other factors at play, so the accumulation/distribution influences need to be considered with this recognition.

For example, silver is (physically) heavy, relative to its monetary value, when compared to its precious metal peers; the implication being that for those with an interest in owning precious metals, silver was not often a practical choice. While large institutional investors always had the scale and capacity to invest in silver, it was much more difficult to do so in less than institutional amounts. That changed in April 2006 when the first ETP that held the physical bullion in trust for the benefit of its investors was launched. Others followed—and the physical silver market now had new buyers that removed production from the market. (Not all ETP silver purchases were new, incremental demand. But it’s a safe bet that some portion of it was, given the reduction in ownership hurdles.) While it’s difficult to assess the extent that these new buyers had on the price of silver, it was most assuredly neutral to positive. This dynamic introduces the potential where higher prices lead to higher demand…which leads to further higher prices. But remember: investors risk having this potential run in the other direction. What might be a celebratory event during the accumulation phase might not be so joyous during the distribution phase! (This dynamic may have affected crude oil prices in the 2007-08 period.)

Conclusion
While all ETPs appear similar on the surface, important differences exist in their legal, tax, and operational characteristics. Prospectuses—often very long ones—define the nuances of each, and investors should inform themselves of the unique attributes of the securities they intend to buy before investing. ETPs do make investing in certain markets easier, but convenience generally comes with a cost.

Bottom line: if you invest in ETPs, we think you will want to know how the securities are structured and taxed, how the investment objectives are pursued, and whether the ETP itself has the potential to alter the existing supply/demand characteristics of the market in which it invests. If you understand the answers to these questions, ETPs may play a useful role in meeting your investment objectives.

The comments made by Steve Bierker in this essay are opinions and are not intended to be investment advice or a forecast of future events.

S&P 500 Index is a widely recognized, unmanaged index of common stock prices. The S&P 500 Index is weighted by market value and its performance is thought to be representative of the stock market as a whole. You cannot invest directly in an index.

Any tax or legal information provided is merely a summary of our understanding and interpretation of some of the current income tax regulations and is not exhaustive. Investors must consult their tax advisor or legal counsel for advice and information concerning their particular situation. Neither the Fund nor any of its representatives may give legal or tax advice.

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