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Rapidan Capital, LLC

Registered Investment Advisor


510 Thornall Street
Edison, NJ 08837
732.632.8854

SECOND QUARTER 2009 INVESTOR LETTER

August 2009
No man's life, liberty, or property is safe while Congress is in session.
-frequently attributed to Mark Twain or, more occasionally, Will Rogers

Dear Investor and Friends,

The second quarter began with stocks rising. Stocks, corporate bonds and commodities all
rebounded from what we think will be “generational” March lows. We probably won’t see those
prices again in our lifetime.

But the run stalled in late May. The markets fell a bit from their highs in June. It’s one thing to
rebound from a generational low, it’s quite another to make up all the lost ground. The asymmetry
of returns guarantees that when you go down -50%, you must go up +100% to get even. We are still
in the process of restoring our wealth, but we are on the right path. Had we panicked out at the
bottom, I have no doubt that many of us would be sitting here wondering if it was the right time to
get back in. The market is up around +50% from its bottom.

The long-term growth oriented ValueAligned® Folio account was up +14.2% gross (+13.9% net) in the
separately managed accounts. 1 For the year as of June 30, 2009, the ValueAligned® Folio accounts
are up +5.2% gross (+4.7% net).

We are doing well because we have tweaked our investment process; we are taking profits sooner
and adjusting position sizes to volatility – that way more volatile stocks will not hurt intermediate
performance on the downside, but will still contribute to our goal of doubling our money (+100%) in
five years on the upside.

Leading indicators of future economic prospects drove the stock market off its March lows. Leading
indicators have continued to move higher over the past few months. Just as the rapid and sudden
decline in leading indicators and economic prospects tanked stocks last year, this year's
improvement is driving them higher. So far in 2009, early expansion factors have dominated
returns. Technology, materials and consumer discretionary stocks far outpaced the other sectors.

We recovered most of the losses from some of our smaller consumer discretionary stocks from the
first quarter of 2009, and many of the losses from 2008. As we discussed with you last quarter, we
believed that our losses in our small special situation stocks like AC Moore (ACMR, +161%, since
March 9th low through June 30th), Borders (BGP, +667%), and Tempur-Pedic (TPX, +232%) were
unwarranted by their fundamentals. Many of these stocks traded way below fair value because of
low liquidity and investors’ fear of leverage. Since we judged that these companies would survive the
recession, their shares were too cheap to sell. Sure enough as financial conditions returned to pre-
Lehman bankruptcy levels the stocks rebounded. BGP is up +892% year-to-date; ACMR is up
+158%; TPX is up +109%; Coach (COH) is up +42.5%; Fossil (FOSL) is up +58% (as of July 31st).
The stress tests for the banks are now over, and private, as opposed to government capital, is
available for some of the largest banks. As private capital went into banks, we saw a little pause in
the rally through quarter end. Of course, the market continues to power ahead through the
beginning of August. Until we have other reasons to doubt the rally we will remain invested – but
with some dry powder to take advantage of lower prices when they come. At the end of July we were
about 85% invested in stocks of ValueAligned® companies and 15% in cash. We were overweight
consumer discretionary, technology and healthcare stocks.

STOCK MARKET – FROM FEAR TO PANIC AND BACK

The “swing” chart (above) of the bear market starts at the high in October 2007. The “panic” stage of
this decline started in September of last year when Lehman Brothers failed.

Notice the latest rally from the March bear market bottom of +41.1% on the chart at above - that’s
the biggest rally so far in the bear market. But despite the rally, we are still down -39.0% from the
top in 2007.1

From Fear to Panic


The severe financial panic that came from the extreme uncertainty of outcomes from the Lehman
Brothers bankruptcy and AIG rescue froze economic activity and caused one of the fastest and
steepest stock market declines in history. Financial conditions are back to normal recession levels –
the conditions that existed prior to the September panic.

The market downturn is now in its 19th month which makes it the longest bear market and recession
since World War II. The drivers of the first part of the bear market were the downturn in residential
construction, housing price declines and declines in personal and business consumption. That was
reflected in the first nine months from October 2007 where the stock market declined by about -22%.

1 Through 8/13/2009 the S&P 500 index without dividends reinvested was up +49.7%.

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The driver of the second phase was the September 2008 Lehman Brothers bankruptcy which caused
a run on the nation’s banking system and on its money market funds that provided liquidity to
businesses of all sizes. Credit seized up and economic activity halted. Confidence has returned as

Figure 1. Source: HaysAdvisory.com


trust at least among our financial institutions is slowly returning. The public’s trust is another
story. That might take decades to repair.

True financial panic as reflected in stock market volatility has only occurred three times in the last
century – 1929, 1987 and 2008. Here I am referring to a financial condition that produces intense
fear where trust is driven from the system as participants - businesses, individuals and the banks
themselves - don’t understand who is solvent and who is busted.

Panic Back to Fear

Keith Hays of Hays Advisory shows the difference between panic and fear. He points out that fear is
a necessary condition for an extended bull market to begin. However, panic erodes trust so much
that normal bear market bottoms can’t form and
CBOE SPX Volatility Index wholesale liquidation of stocks and every other
Oct. 199 5 - A ug . 2 009 asset starts a cascade price declines – severely
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10/ 2 4/ 08, 79. 13
and suddenly exterminating the balance sheets of
shaky companies and scared consumers.
Source: Bloomberg
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70

60

50
09/ 11 / 98, 43. 74 Normal fear is depicted between the two red lines
09/ 21 / 01, 42.66
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08 / 17/ 0 7, 2 9. 99
in the chart above. These tops in volatility – a
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measure of the degree of uncertainty in stock
prices – correspond to normal bear market
20 23.09

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0
02/ 16 / 07, 10. 02
bottoms. You can see from the chart at the left
Oct-95
Apr-96
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Oct-97
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Apr-00
Oct-00

Oct-01
Apr-02
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Apr-03
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Apr-04
Oct-04
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Apr-07
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Apr-09

that sometime in the last three months panic has


Apr-97

Apr-01

receded and normal fear is back.

We love normal fear. Many times normal fear is just a misunderstanding about the transition
from a terrible economy to a recovering economy. Fear is paralyzing for those without facts and
methods to make rational decisions. And fear is the essential ingredient for a new bull market to
begin.

A huge market rally off an economic low point is always perceived as just another bear market
bounce. The gains are dismissed because the stock market always sniffs out pending economic
improvement faster than improving fundamentals appear – and the fear from the previous panic
prevents rational action by most investors.

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Leading Indicators Point the Way
Since stocks are a discounting mechanism for future activity there is always this lag between stock
price performance and a company’s outlook. The lag is usually around six months – the time that
Francois Trahan of ISI Portfolio Strategy says is the time between leading indicators and Gross
Domestic Product (GDP - the economy). The ECRI Weekly Leading Indicator Annualized Growth
Rate topped out in June 2007. Six months later the recession started in December 2007. Many are
excited in stock market land because this indicator bottomed out in December 2008. If a six month
period holds again, then the economy bottomed out in June or July 2009.

ECRI Week ly Lea ding I ndicat or


An nu a l i ze d Gro w th R a te
J a n . 2 007 - J ul . 2 00 9

Six months –
15 Dec ’07 Beginning of
10 Ju n-07 recession

0
-5
-10 Six months –
June ’09 End of
-15 recession???
-20
-25
Source: ECRI
-30 De c-08
-35
Jul-08

Jul-09
Jul-07

Jan-08

Jan-09
Jan-07

Mar-07

May-07

Mar-08

May-08

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Sep-07

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Sep-08

Nov-08

Better Second Quarter Earnings Tell Us That Better (But Not So Good) Economy is
Approaching
After the financial panic, the U.S. economy reacted much faster to changes in the economic outlook
than ever before. Companies stopped ordering new stuff. Manufactures shut down plants.
Consumers stopped buying everything. Then they started buying only the most necessary value
oriented goods.

Managements quickly reduced employment, capital expenditures, advertising, travel and


unfortunately, the short-sighted ones, probably even cut growth capital investments like research
and development. According to ISI, the economic and strategy advisors, management cut
employment by a record -4.8% because it looked like we were sliding into depression. The magnitude
of the lay-offs was about 35% greater than what the models predicted given the actual decline in
GDP. We bet that the other cuts were deeper than ever before too.

During a recession, analysts beat down earnings expectations as corporations drastically cut costs.
All through the winter and spring of this year, analysts slashed their estimates of earnings. But
they seemed to be much slower in reacting to the shock than were the companies they follow. This
dynamic set us up for this current earnings season.

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After being beat up so badly at the beginning of the downturn, analysts became overly cautious at
the bottom. Therefore, earnings reports typically beat stunningly low expectations this quarter, and
then analysts started raising their estimates. It does not mean all is right with the world, but it does
mean that investors have pushed many stocks’ prices so low that embedded expectations are way too
low. Of course, that means that the market was grossly undervalued in the middle of March, at the
beginning of the second quarter.

Look at the example of Texas Instruments (TXN) below. The blue line is the stock price (right scale)
and the red line is analysts’ estimates. Notice how the analysts’ estimate line is highly correlated
with stock prices.

In July earnings for most companies came in much better than expected for the second quarter just
ended. Companies are succeeding in cost cutting their way, if not to prosperity, then at least to
much better than feared results.

According to Bloomberg, with about 90% of the S&P 500 companies reporting positive surprises lead
disappointments by almost a 3.3 to 1 margin. Results are much stronger than expected with the
average surprise of those reporting better by +10.0%. This has led to many upward revisions for this
year but more importantly for next year.

The bottom-up estimate for the S&P 500 is increasing and is now $59.82 for 2009, and the S&P 500
is now expected to earn $74.48 in 2010. That puts the S&P 500 at 13.2x next year’s currently
expected earnings. If sentiment and valuation improve, the S&P 500 should move to its historical
multiple of about 16x which would mean a move to 1192 – without any increases in earnings
estimates. That would mean another +20% or so for the index.

The fact that analysts and investors underestimated how quickly companies responded to the near
universal drop in demand was inevitable. Analysts always miss the economic turns because they are
too excited near the top and too cautious at the bottom. Stocks tend to go up as analysts increase
their estimates so analysts have an incentive to low ball positive change – when their estimates are

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too low their stocks go up anyway – and clients are less likely to complain if their stocks are going
up.

Some pundits and other assorted market wizards argue that the better-than-expected earnings are
simply due to cost cutting and we all should not get too excited. They are right! We should never get
too excited or too depressed for that matter. But the first improvements are always cost driven.
Nominal demand has not come back yet. The government still must subsidize spending – by paying
people to buy cars for instance. Company revenues are weak which shows up in nominal (not
adjusted for inflation) GDP. But all the cost cutting means productivity is rapidly increasing – EVA
is going up. And that is good because something has to offset the coming tax hikes and government
interference. This huge increase in productivity will accomplish some of that but not nearly enough.

Back to a Stock Picker’s Market


The S&P 500 has risen +50% from the market low in March. The huge rise is in sharp contrast to
the collapse of almost all asset prices in 2008. As last year's market declined correlations between
stocks’ returns rose dramatically – to nearly 90% during the worst of the credit crisis.

Today, stock price movements are returning to more normal correlations, which mean there is
differentiation within the market. Consequently, stock returns are being driven less by macro-
economic forces, and more by stock specific factors. We are moving towards more of a stock pickers
market.

As market volatility decreases, stock price correlation decreases. From a quantitative portfolio
management perspective, high market correlation has been a significant problem. This approach
tries to separate future outperformers from underperformers using fundamental data. When all
stock returns are driven by macro considerations, traditional fundamental factors are less important.

However, with volatility back near historical


ranges, the efficiency and value of quantitative
screening is rapidly returning. Regardless of
the direction of future market returns (barring a
complete collapse) we will benefit by having a
portfolio of the shares of great ValueAligned®
companies.

Insider Selling – A Warning?


After buying heavily in early March as the
market collapsed, company insiders (CEO, CFO,
Directors and large holders) started selling
throughout most of the quarter.
Insiderscore.com’s Weekly Score hit its
lowest level in over two years as the S&P
500 climbed to its best level since January. Overall, the insider sentiment was very negative for
the quarter as insiders used the market bounce to unload boat loads of company stock. So far the
market has absorbed this supply in stride and hasn’t taken the selling en masse as a negative signal.

The first two weeks of each quarter show very light insider activity due to the number of insiders
constrained from selling because of closed insider windows around the time of earnings reports. We
start seeing activity in the fifth and sixth week.

The last time insider sentiment was this bearish three weeks into a quarter was the second quarter
of 2007. And the last time the Weekly Score was this bearish for three weeks was the third quarter

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of 2007. Of course, we reached the market high in that third quarter. Insiders were smart sellers
right before the bear market.

But corporate insiders are people too. They are subject to the same emotions that we all are. As the
market comes off the “generational low” in March, a bunch of insider selling should be expected.
Many of the sellers now were the same people that were worried about their companies going
bankrupt just a few months ago. This round of insider selling is likely signaling a pause in the
ferocious rally of late – but just a pause to refresh we think.

POLICY UNCERTAINTY MATTERS

This country has come to feel the same when Congress is in session as we do when a
baby gets hold of the hammer. It’s just a question of how much damage he can do with
it before we take it away from him.
-Will Rogers

The stock market low in March marked the crescendo of panic caused by the chaos and uncertainty
of fiscal policy changes going forward. The President and his Congress passed a fiscal stimulus bill
that many suggested was not timely or targeted. The House passed the Cap and Trade energy bill
which the President endorsed. And healthcare reform is still up in the air, hotly debated for sure,
but extremely expensive nonetheless.

The Democrats and President Obama in particular have hammered home the unfairness of the
"Bush Tax Cuts" because income inequality has grown so wide. “The rich are getting all the favors
from the rich that were in power” goes the story that is told.

This purported fact alone is repeatedly cited without even a peep from the media, the political
opposition or concerned citizens. The problem is that "income inequality" is meaningless without
context and certainly by itself does not call for a more "progressive" - soak the rich - tax policy.

During the campaign the President famously suggested to Joe-the-Plumber that we need to spread
the wealth around. He meant it, but only now are Independents and Republicans that voted for
Obama finding out just how much he meant it.

This President does not give a hoot about economic growth, only about redistribution in the name of
social justice. But how do we measure "well being" and are the income growth statistics really so flat
for the Middle Class? And does economic inequality really translate automatically into social and
political injustice as the President seems to believe? The question in the end is: Do the rich
dominate politics and make policy to cement their hold on power?

It seems that the election of this President and a very progressive Democratic Congress with a
filibuster proof majority would suggest that the rich do not always gravitate toward the party that
taxes them less. In fact, there were many more wealthy Americans trying to elect this President
while he made crystal clear that his objective was to tax the rich more and redistribute their
property/income to the less rich and poor.

What's going on here? Perhaps we do not have an entrenched plutocracy like so many in Congress
and in the Democrat party predicted; perhaps instead we have a government by idle elites who feel
entitled to experiment with grand policies thought up somewhere in think tanks and academia.
These policies happen to entrench their favored special interests’ power.

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My point today, though, is to remind my readers that this basic mistake about how well off the
Middle Class is and how it has fared under "Free Market Economics" has huge policy and budgetary
implications which in turn have growth implications far into the future.

The Stock Market Measures All This


The stock market knows this - as it always does. It is not a coincidence that at the same time that
the President's personal poll numbers are moving lower - below Carter's now at this time in his
Presidency - that the stock market has moved +50% off its bottom. As the President’s political
capital wanes the likelihood of passage of his most progressive policies diminishes. The stock market
begins to discount a brighter long-term future return on private capital.

Will Rogers Was Right – Evidence the Market Fears Congress


Way back in 1973 Princeton Professor Burton Malkiel conjectured that regulatory uncertainty is a
negative influence on the stock market. He treated Congressional activity as a proxy for this
regulatory uncertainty. When Congress is in session uncertainty is high; when Congress is out of
session uncertainty is lower. The premise though is that when regulatory change is uncertain and
dramatic, the stock market suffers. As the uncertainty about radical change dissipates, the stock
market stabilizes and often recoups its losses.

In his 1973 investment book, A Random Walk Down Wall Street, Malkiel contends that "[I]t is not so
much the direct cost of regulation that has inhibited investment but rather the unpredictability of
future regulatory changes." The financial panic coupled with huge regulatory uncertainty in
the President’s first few months led to the March bottom in my view.

Here Comes the Sun, Congress Goes on Recess


In their March 2005 paper entitled Congress and the Stock Market, Michael Ferguson and Douglas
Witte showed that stock market returns are lower and more volatile when Congress is in
session than when it's in recess.2 Get this. About 90 percent of capital gains recorded on the
Dow Jones Industrial Average (DJIA) index between 1897 and 2001 occurred on days when Congress
was not in session, according to the study.

If a dollar was invested in the Dow Jones Industrial Average in 1897 using an “out-of-session”
investment strategy, by 2001 it would have grown to $216 (excluding dividends and transaction costs
for simplicity’s sake). The same investment would have yielded only $2 using the “in session”
strategy! Congress destroys wealth; government is the problem. Ronald Reagan was
right!

Also, their study found that stock returns are significantly lower when the Democrats
hold a majority in Congress. And returns are significantly higher when a Democratic
Congress is not in session than when a Republican Congress is not in session.

The authors’ three possible explanations for their findings suggest that the current bounce has been
driven by the public’s relief that Congress did not yet do as much damage to business as first thought
as it heads out to August recess.

1. Congressional activity depresses the market. In recent decades the average approval
rating for Congress has been extremely low, while lately it has been historically low – in the
20% area. Behavioral finance suggests that investors’ moods or attitudes may affect stock

2Ferguson, Michael F. and Witte, Hugh Douglas,Congress and the Stock Market (March 13, 2006). Available at SSRN:
http://ssrn.com/abstract=687211

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prices in many diverse settings. It turns out that the evaluation of information and
attitudes toward risk are greatly affected by mood. Not surprisingly, depression leads to
greater risk aversion and more pessimistic forecasts than happier moods. Considering the
consistently negative opinion the public has of Congress, it is possible that Congressional
activity has a negative impact on stock prices.

2. Congressional activity as a proxy for regulatory uncertainty. As Malkiel predicted,


regulatory uncertainty brings down economic performance.

3. Congress acts in favor of concentrated minority interests, instead of the public


welfare. We know that regulatory bodies are captured by powerful, concentrated economic
interests. And these Democrats are driven by the most destructive kind of special interests
for business in our opinion – labor unions (not labor by the way but the guys and gals that
get the benefits from running the labor unions), the environmental groups and those in
academia that hold the mistaken notion that the U.S. is run by the wealthy for the wealthy
systematically leaving behind the middle class.

When Mr. Obama Goes to Washington, Sell!


At the beginning of President Obama’s first term, the CXO Advisory Group set out to measure the
new President’s opinion about private versus public capital and his attitudes about the stock market
as a way to gauge the likely economic effect of his proposed policies. Overall, these beliefs might
mean that the President regards stimulation of private investment in public companies as a
relatively ineffective means of achieving his policy objectives and investors are therefore a low-
priority constituency. In other words, policy shifts that favor investors are unlikely.

The President of the United States, especially when the President's party controls both houses of
Congress, arguably has more power over the economy and financial markets than any other individual.
This power derives from influence over legislation, including the tax code, and the latitude of the
executive branch to set and implement policies not constitutionally or legislatively/judicially prohibited.
What are the current President's beliefs about the stock market, as expressed directly or via proxies?
Do these beliefs have implications for investors?3

3
The President's Beliefs About the Stock Market,(March 5, 2009 - Last Updated 3/13/09), CXO Advisory Group,
http://cxoadvisory.com/blog/internal/blog3-05-09/

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Comments documented on their website suggest that President Obama believes:

• Over the short term, the stock market is not a reliable indicator of whether new
policies/tactics will ultimately help or hurt the economy.
• The stock market has recently reacted to a deteriorating global economy and not to new
policies/tactics intended to remedy that deterioration.
• The stock market is no higher than fourth (behind the job market, credit market and housing
market) as an indicator of socioeconomic conditions.
• Over the short term, the stock market is very noisy, perhaps more sentimental than rational,
and people tend to err in reaction to noise.
• Over the long term, the stock market is somewhat predictable, with future returns varying
inversely to current price-earnings ratios (P/E). Moreover, government policies can largely
control the degree of long-term market volatility.
• P/Es are getting low enough (3/3/09) that they indicate future stock returns are "potentially"
a "good deal." (Nice call by the President by the way.)

In summary, the President's statements since taking office indicate that he views the stock market
as an unreliable and low-priority indicator of the socioeconomic value of his policies/tactics.
Investors beware.

WHAT’S THE LESSON?


Large losses seem to destroy investment programs and retirement plans. Not only must an
investment portfolio that suffers a large loss contend with the asymmetry of gains and losses (a -50%
loss requires a +100% gain to get back to even), but the time to recover is totally
unpredictable. And that causes great anxiety – we understand.

An investment program in stocks started in 1965 in the S&P 500 didn’t begin to make gains until
1989, adjusted for inflation. A diversified portfolio of stocks during that extended period, which

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contained several large market corrections, destroyed purchasing power for 17 years before the
market recovery began in earnest in 1983.

We are facing the same dilemma today. Over the past decade ending at the bottom in March 2009,
the stock market has destroyed capital and reduced purchasing power. The real, inflation-adjusted
annualized return was a loss of -5.9%. (See chart above). To recover this loss will require about a
+100% real increase (real means above inflation). That’s 5 years at an annual real rate of +15%;
10 years at a real rate of +7% and 20 years at a real +3.5% rate.

At first glance you might immediately panic. But wait, what does history tell us? For those of us
that did not panic out of the market near the bottom, we are already up some +50% in just 5 months
before inflation. Take away 5 months of inflation and it is still right around +50%.

So let’s say we don’t go up or down by the end of the year – how many years left until we get our
wealth back in order. Well 7% seems reasonable given the chart above – it’s less than half of the
very best 10 year rates of return shown on the peaks. Our +50% already bought us 6 years of 7%
real returns. That means we would need much, much smaller real returns for the next 9 years to get
to that +100% gain. That seems much less daunting.

But if the past decade has taught us anything, it is that the doctrine of blindly being continuously
invested in the stock market has flaws. It really matters when you begin investing. And as the
chart above shows investing near the top in prices gets us to negative 10 year returns sometimes.

If we panic and can’t stay on plan with complete faith in the future, it certainly cannot be a strategy
for retirees who are drawing down their savings constantly.

We think that simple strategies, like the election cycle strategy recounted above or a simple model
based on current market valuations, are good alternatives to the conventional buy and hope doctrine.

By accepting market risk only during the political sweet spot or by investing our savings in great
companies, growing their intrinsic value at low valuations, we put the odds in our favor of beating
inflation and maintaining purchasing power and dignity into retirement.

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IN THE END
In March we suggested it was not the time to exit your long-term plans. In fact, we suggested that
you should add to your stock accounts where possible. Even though the market has run up now it is
not the time to exit. We’ll continue to actively manage the portfolios by also revaluing the shares of
our great companies and then monitoring their buy and sell points. We will also keep track of
market risk and Congressional follies to give us the highest probability that we earn the highest
returns going forward.

Since we held on and even bought more shares of great companies when others were panicking, we're
willing to hold for the next decade or more – we are confident we will be rewarded from these
valuations. We think this time is a fantastic opportunity. And what we do today could make the
difference between looking back on this market in regret and reaching our financial goals.

We are experienced advisors who have studied for many years the market cycles, corporate strategy
and human behavior. We know that all by yourself without the guidance of an experienced advisor,
you may believe that this time is very different from all the others. We understand that it
temporarily relieves the psychic pain of losses, and relieves the anxiety of an uncertain future.

That’s why we consider that our best service to our clients isn’t our brilliant economic commentary or
our economic/market calls, but simply the saving our clients from their own understandable but
sometimes destructive behavior.

Best regards,

David Lee Berkowitz

Notes:

1 The performance and volatility of the S&P 500 may be materially different from the individual performance attained by a
specific investor in the funds and managed accounts managed by Rapidan Capital, LLC. In addition, the funds’ and managed
accounts’ holdings may differ significantly from the securities that comprise the S&P 500. The S&P 500 has not been selected
to represent an appropriate benchmark to compare an investor’s performance, but rather is disclosed to allow for comparison
of the investor’s performance to that of a well-known and widely recognized index. You cannot invest directly in an index
(although you can invest in an index fund that is designed to closely track such index).

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