SPENCE Asset Management

As the smoke clears… December 2009

The Lehman Brothers car is charred beyond recognition. The Merrill Lynch car is being towed into the pits by the Bank of America car. The Bear Stearns car is overturned and smoldering at the bottom of a pile of regional bank cars. The AIG car, attached to the large crane of the US government, floating over a global audience, is shattered, mangled, never to race again. All of these “cars” were destroyed by what we now call the global financial crisis which hit its peak a little over one year ago.

As we emerge with only a few minor scratches to our proverbial paint job and look in our rear view mirrors at the clearing smoke, it is time to look to the track ahead of us. How will we navigate the turns? How has the track changed? How will we increase our speed yet avoid such pile-ups in the future?

THE TURNS AHEAD:

Higher taxes is turn one, dead ahead. The US government has some clean-up bills that must be paid. Whether they come in the form of payroll taxes, inheritance taxes, sales taxes, property taxes, or income taxes isn’t completely clear but rest assured, we all will be chipping in.

Inflation is a turn we see ahead but we aren’t quite sure of the distance we must travel before we reach this turn. With developing countries such as China exponentially increasing their commodity consumption as well as taking actions to store/acquire some commodities, rising prices are inevitable. Consumers will pay more to fill up their SUVs, more to heat their homes and more to construct their homes.

Health care reform has taken center stage in our nation’s political agenda and the urgency of the situation is exemplified by passionate debate. We know that the margins of some health care companies will suffer as a result of reform but identifying which companies will be impacted is not yet completely possible. This turn, also inevitable, is one with far reaching implications.

WHAT’S CHANGED:

1. Political dissension, frustration and polarization are reaching unprecedented levels as our nations leaders struggle to reach consensus. Although, to some extent inherent in a democracy, the legislative limbo will weigh on American businesses and be costly to the American taxpayer.
2. Regulation is increasing. In some cases, such regulation will be crucial to restore faith in the American financial system but in all cases, it will increase costs to businesses and ultimately, to consumers.
3. De-levering is the new reality as the badly burned consumer will keep the psychological effects of the pile-up at the forefront of his mind. Again, longer term, this de-levering process is a healthy one and is crucial for the future of the US but it will be painful and likely a long process.
4. The recovery is likely to be lead by businesses rather than by the consumer. The majority of businesses didn’t find themselves over extended and were still operating at reduced capacities following the downturn of 2001 when the first car hit the wall. While consumers are still crouched in the corner with their heads covered, businesses will need to spend to upgrade technology, facilities and attract talent in order to compete internationally thus driving an anemic recovery.

AVOIDING FUTURE PILE-UPS:

1. Think Global — we are no longer investing in an era where all of the solutions can be found between the New York Islands and the Red Wood Forests.
2. Dividend payers — as money markets and treasuries offer very little return, many solid, best-of-breed companies are offering nice yields to investors. (We caution that unusually high dividends could be a red flag.)
3. Leverage — assessing the debt of a company as well as off-balance-sheet liabilities and lease obligations has never been more important; such analysis proved invaluable during the pile-up of 2008.
4. Trusting management — finding a management with a strong track record as well as the ability to be candid about the current challenges facing their company has also proven invaluable and become even more crucial.

PESSIMISTIC OPTIMISM:

Given the new conditions cited above, we are pessimistically optimistic and draw one overriding conclusion; domestic equity return expectations should be lowered. The US equity market will operate for quite some time without the usual tailwinds: many companies have suspended matching contributions to retirement plans, many investors are looking to China and other developing nations in which to place their investment dollars and many baby boomers whose retirements were burned a second time in 2008, are shifting their investments away from equities and into fixed income instruments. These factors coupled with the aforementioned changes that weigh on our domestic businesses of heightened regulation, higher taxes, inflation in commodities and continued health care burdens, will all reduce long-term equity returns in the US.

For these reasons, we continue to expand our investment borders. Still applying our strict requirements for a company’s financial condition and track record as well as their business model and management characteristics, we continue to explore domestic companies with international operations as well as internationally based companies. Also, we will give the deserved consideration to stable and increasing dividends, to a company’s balance sheet and to management’s demonstrated abilities in good times and bad. More than ever before, every second at the pits counts; the new track demands every ounce of our concentration as well as focused execution to bring home the checkered flag.

As our families gather and celebrate the season, we want to offer our best wishes to you and your loved ones.

—Jim Spence, Eric Walton

Spence Asset Management, Inc.
2455 E. Missouri Ave. Suite C Las Cruces, NM 88001 575-556-8500

The information contained herein is for informational purposes only without regard to any particular user’s investment objectives, risk tolerances or financial situation and does not constitute investment advice, nor should it be considered a solicitation or offering to investors. To determine if investment in a Separately Managed Account with Spence Asset Management is an appropriate investment for you please call 1.800.230.1840.

Investment Advisory Services are offered through Spence Asset Management, a federally registered Investment Advisor. Investment Advisory Services offered through IAR’s of Spence Asset Management, a Registered Investment Advisor to all residents of the United States.

The views expressed here are those of Spence Asset Management and are subject to change with market conditions. The information contained in this newsletter is derived from sources believed to be accurate. You should discuss any legal, tax, or financial matters with the appropriate professional. Neither the information presented nor any opinion expressed constitutes investment advice or a solicitation for the purchase or sale of any security. Market forecasts cannot be guaranteed. Past performance does not guarantee future results.