SPENCE Asset Management

Location, Location, Location June 2011

On a global basis there are billions of dollars of income booked every day. For any individual or entity not spending all its income, a decision must be made on what to do with the resulting reserves. This is a never-ending process. Even during economic downturns, decision makers must make choices on where to place their reserves.

When it comes to placing these reserves, the three most important elements of real estate investing- Location, Location, and Location- actually apply to all types of investing. In the bigger scheme of things there are basically only three primary LOCATIONS for the globe’s vast generation of income reserves to go. They are: (1) interest bearing instruments (bonds), (2) income producing real estate, and (3) business enterprises (common stocks).

The first location- interest bearing instruments- fluctuate in value based on interest rates. Globally speaking, governments in most developed nations are engaging in policies that have artificially depressed interest rates for a couple of years. They are doing so because it enables them to borrow cheaply. These policies act as wealth transfer mechanisms. They transfer wealth from SAVERS to BORROWERS. These conditions are not conducive to good results on investments in interest bearing instruments. Risk-averse savers, left with no good options, are quickly becoming the investment equivalent of slum lords.

An objective evaluation of the prospects for the next location- income producing real estate- suggests a very mixed bag at best. Although real estate encompasses many types and classes of properties, from condos in Florida to track homes in Vegas to skyscrapers in Manhattan, there are still several secular economic trends that do NOT bode well for most property values. In the residential arena, historic over-building suggests gradual price erosion could continue. And once there is stability in housing prices, it might take years before shortages begin to drive prices higher again. In the commercial real estate arena, it is difficult to overestimate the incredible impact the digital era has had on demand for retail space and office space. Internet retailing has changed life as we know it for commercial retail space. And the telecommuting of office workers has had a similar impact, albeit to a lesser extent, on office space. Demand for apartments has stabilized as higher lending standards have put houses off limits for millions of marginal home buyers. However, healthcare office space is likely to recover more rapidly than retail and office space, primarily because many health care treatments and services must be delivered face-to-face rather than online. In other words, when placing reserves in the location of income producing real estate, a tenant with dim future prospects can be analogous to purchasing the property that backs up to the railroad tracks.

This brings us to the prospects for businesses. Common stocks, which are simply shares of businesses, are affected somewhat by all the factors mentioned in the previous two paragraphs. However, though these secular trends affect businesses, the single greatest virtue of surveying the universe of businesses is that unlike fixed income instruments or fixed location real estate properties, great businesses are capable of being far more “adaptive.”

In this sense, the year 2011 is no different than 1911; the future remains bright for the best, most adaptive businesses. Akin to searching for a home in the best school district or commanding a corner lot with high visibility, it is critical to buy only the best “locations” within the common stock universe. These “locations” include particularly adaptive businesses with outstanding financial characteristics and durable competitive advantages.

Regular readers of this newsletter already know that we are, above all else, experienced business analysts. We earn our keep differentiating between what constitutes a durable competitive business advantage that will lead to an acceptable growth rate and what doesn’t. Your current portfolio positions are fully reflective of which businesses we feel offer the best chance for sustained success as well as our diligent research- which is our version of “getting to know the neighbors as well as the neighborhood” for each and every business that we own.

As with real estate, no one investment location is completely perfect; all three have inherent risks. Also like real estate, no one investment location is the ideal location for all investors- we all have a place where we are most comfortable. For those comfortable with the risks inherent in owning shares of businesses, we feel correctly identifying the strongest, most adaptive management teams will continue to provide above average rates of return, especially when compared to interest bearing instruments or income producing real estate.

Jim Spence, Eric Walton

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.