QUARTERLY

Commentary
FIrST QUArTEr 2012

ECONOMIC OvErvIEw

Hope Springs Eternal

The US economy remains almost comatose. The slump already ranks as the longest period of sustained weakness since the Depression. The economy is staggering under many structural burdens, as opposed to familiar cyclical problems. The structural faults represent once-in-alifetime dislocations that will take years to work out. Among them: the job drought, the debt hangover, the banking collapse, the real estate depression, the healthcare cost explosion, and the runaway federal deficit. And now for the quiz: when was this quote written? While it certainly sums up the prevailing sentiment at the beginning of 2012, it was not written three months ago. It is from Time magazines September, 1992 edition. Thus we once again observe the truth of the old French proverb: Plus a change, plus cest la mme chose. (The more things change, the more they stay the same.) The four consecutive quarters of economic contraction from July 2008 through June 2009 totaled -18.7%. This truly was the longest and deepest economic contraction since the 1930s. By way of comparison, the oil embargo of 1973-74 tossed the economy up and down over seven quarters with a net change of -10.7%. Nearly 10 million jobs were lost in the most recent downturn, far exceeding the 3.2 million lost in 1974. In percentage terms, the job losses during the Great Recession were the most since 1945 when many war-related jobs were terminated. As we noted in our 2009 fourth quarter commentary, healthcare costs in the US are at an all-time high of 15% of GDP, the US governments total debt exceeds $16 trillion and our annual Federal budget deficit is over $1.4 trillion. We wonder what the pundits will be saying about all of these structural problems twenty years from now. In the face of all this gloomy recent history and sentiment, the stock market is off to the best start since 1998s first quarter 13.9% return. Hope springs eternal that maybe, just maybe, we are finally seeing firm signs of economic recovery and we can at last put fears of deflation behind us. The stock markets resilience this quarter has been nothing short of remarkable. The foreboding ides of March included US bank stress tests and the Greek bond payment deadline, yet neither the Greek debt swap negotiations, the vitriolic politics of the US, rising oil prices, Chinas economic slowdown nor simmering Middle East conflicts have been able to derail the stock market.
INDEX PErFOrMANCE Dow Jones Industrials Standard & Poors 500 EAFE (international stocks) Russell 2000 (small stocks) Barclays Interm. Gov/Credit Barclays Municipal Q112 8.83 12.58 10.99 12.43 0.61 1.75 YTD 8.83 12.58 10.99 12.43 0.61 1.75

Inside this Issue

ECONOMIC OvErvIEw

: : Hope Springs Eternal

ASSET MANAGEMENT

: : At A Price
FEATUrED STOCK

: : Praxair
FIXED INCOME

: : Why Stocks Are Better than Bonds (For Now)

SPECIAL TOPICS

: : Nelson Roberts Investment Advisors in the Community

www.nelsonroberts.com | 650.322.4000

Hope springs eternal that maybe, just recovery and we can at last put fears

top

ECONOMIC OvErvIEw

FiFteen Holdings
iShareS

Hope Springs Eternal (contd)

Moreover, the stock market has risen steadily with very low volatility. With little fanfare, bonds have meanwhile backed off from their record low rates. Long term bonds, which were up 18% last year, were down 3% in the first quarter. It is possible that fixed income investors are finally focusing on the fact that US Treasury securities which normally provide a risk-free return are now priced to provide return-free risk, as Shelby Cullom Davis, a long time investment banker and ambassador Malkiel projects the return on stocks to be the sum of dividends (currently averaging 2%) plus the long run growth of nominal corporate earnings (which he estimates at 5%). So his comparison is a 7% return on stocks versus 2% on bonds. If we factor in the current rate of inflation using the most recent CPI report of 2.9%, the real returns are projected to be +4.1% for stocks and -0.9% for bonds. Furthermore, there is an argument to be made that the US governments inflation statistics for consumer and producer prices understate the degree to SEPTEMBER 27, 2010 MARCH 27, 2012 50 which prices are rising.
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Today stocks are fairly valued. Bonds are severely overvalued. This calls 40 for a prudent re-evaluation of every 35 portfolios asset allocation. However, 30 we should not allow the current low stock market volatility to lull 25 us into a false sense of security. 20 Headline news ranging from 15.23 Israel bombing Iran to further debt problems in Europe to a OCT NOV DEC JAN FEB MAR APR MAY JUN JUL OCT NOV DEC JAN AUG SEP FEB MAR negative unemployment report 2011 2012 2010 2012 Bloomberg Finance L. P. could again stimulate big market gyrations. We will use those gyrations The VIX index is the Chicago Board Options Exchange Volatility Index. It reflects a market estimate of future volatility, based on the weighted average of the implied volatilities for a to adjust allocations, purchase wide range of options. new stocks and add to those that we already own. (Please see the article on Page 3 to Switzerland from 1969 to 1975 so pithily put it. entitled At a Price for further discussion of how and Burton G. Malkiel, the father of passive investing and when we decide to purchase equities.) author of A Random Walk Down Wall Street, wrote in his March 24th Wall Street Journal opinion piece What Does the Prudent Investor Do Now? that at a yield of 2.25% the 10-year US Treasury is a sure loser. Stocks are a safer choice.

maybe, we are finally seeing firm signs of economic of deflation behind us.

ASSET MANAGEMENT

At A Price
The first quarter of 2012 proved to be a profitable one for stockholders. The earnings of corporations not only continued their growth but stock prices have finally begun to reflect the intrinsic value of many companies. The S&P 500 was up 12.58% and the Nasdaq composite hit a new all-time high of 3,122, up 18.9%. As recently as six months ago, the S&P 500 was at just 1,099. The markets positive performance was widespread with contributions from many sectors. For example, financial stocks surged more than 20% in the first quarter, as many banks received a green light from regulators to resume paying dividends. Technology stocks also rose nearly 20% after lagging the overall market in 2011. Utility stocks were the only sector with a negative performance as they took a breather from a win of 19.6% in an otherwise flat 2011 stock market. Despite the strong performance of the equity markets, investors are maintaining their skepticism about future returns in this asset class. Money flows into equity funds have not begun to accelerate, while fixed income funds continue to garner a lions share of new investment dollars. According to Morningstar, $44 billion of investor dollars were allocated to taxable bond funds through the first two months of 2012 compared to just $11 billion flowing into equity funds. This degree of risk aversion on the part of investors demonstrates how shaken up many still are following the economic turmoil of the last several years. Nelson Roberts portfolios had only one transaction in the first quarter of the year, which was the sale of Sigma Aldrich. Following the unexpected death of the CEO a year and half ago, we thought that company management was not nearly as clear and focused. Having just a single transaction in the quarter should not be mistaken for lack of activity by our research team, however. We are always centered on two key priorities: identifying well-managed companies with excellent prospects and making sure that we do not overpay for those companies. Our team looks to add great companies that have the potential to be great investments into our client portfolios. Our definition of a great company is one that: has a well-defined strategy that is clearly articulated by management has a definable product or products and market opportunity has a history of executing on the strategy and reporting back to investors on the success or modification of that strategy has growth potential with new products, product extensions or market expansion. We often do the research on a company and find that it meets all of the fundamental criteria set out above but does not meet our valuation criteria. That is, we have concluded that there is a greater risk of failing to meet investor expectations than there is of exceeding them. Rather than completely throwing out a company idea, we will come up with a price that we believe compensates for the risk. These price targets may occasionally be met by a company-specific event such as a quarterly earnings miss or an unforeseen significant expenditure. More often, price targets are hit when the prices of all stocks go down due to a disappointing economic report. In either case, the target prices have already been established and the research done so we can be proactive when a buying opportunity presents itself. In aggregate, we continue to believe the table is set for a bull run in the equity markets. Corporations have maintained impressive earnings growth rates and are generating cash flow. The resulting increases in dividend payouts and buybacks will support current market levels and provide a compelling argument for higher value.

integrity

Where do you find integrity?

It emanates from tradition, endures market cycles, and sustains long-term partnerships. Trust lies at the heart of what we do, how we serve and who we employ.

[in tegr te] n. honesty, sincerity, completeness

FEATUrED STOCK

Praxair
Praxair is the largest industrial gas supplier in North America. In addition to industrial gases, the company also makes and packages process gases. Industrial gases include oxygen, nitrogen, argon and rare gases. The process gases are carbon dioxide, helium, hydrogen, acetylene, electric gases and specialty gases. Gases are used by a wide variety of customers in many different markets. Praxairs end users are companies in manufacturing, chemical production, health care, food and beverages, metal fabrication, energy and more. While the company is certainly sensitive to economic cycles, its extensive customer list allows it to partially dampen swings in revenue. Even though industrial gases represent a minuscule portion of the cost structure of most manufacturers, having a reliable supply of gases is critical. This means that customers are willing to sign long-term (up to twenty years) contracts with Praxair as their supplier. The company serves markets worldwide, with twothirds of its $11.2 billion in revenues coming from overseas. The gases are delivered to customers in four different ways: merchant distribution (31%), onsite (25%), packaged gases (27%) and other (16%). The onsite mechanism is especially interesting, as it is exactly what one might imagine. Praxair actually builds a gas production plant adjacent to a major customer (for example, an energy production plant) so that the gases can be supplied without transport costs. The long-term contracts allow Praxair to do this profitably. Over the last several years, Praxair has outperformed its competition in both operating margin and return on capital. Earnings were up 15% last year and the stock price has risen from $82 to $114 since our purchase. The company is focusing on three key strategic initiatives: expanding services in emerging economies, increasing its business with the energy industry and developing new environmental applications. In 2011, Praxair had its best-ever safety performance. Last year, the company was named one of the Worlds 50 Most Innovative Companies by Forbes. Praxair was founded in 1907 and today employs more than 26,000 people

PRAXAIR STOCK PRICE

MARCH 31, 2009 MARCH 30, 2012

114.64

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2012 Bloomberg Finance L. P.

around the world, with over 9,000 employees based in the US. Praxairs performance has led the research team to conclude that we should add to the position we hold in our client portfolios and we are waiting for a down day in the market to do this.

www.nelsonroberts.com | 650.322.4000

::

Nobody spends somebody elses money as wisely as they spend their own.
Milton Friedman on why economic policies that cause people to have some skin in the game are more effective.

FIXED INCOME

Why Stocks Are Better than Bonds (For Now)

After many years of being ignored, dividend-paying stocks are back in the spotlight. Historically, investors looking for dependable streams of income filled their portfolios with high-quality bonds. This was an easy decision when bond yields were 6% or more. But recently, bonds are yielding little while stock dividends have steadily gone up. Prior to the 1950s, companies paid their stockholders higher dividends than their bondholders in order to compensate investors for the greater risk of holding equity. Over time, this standard changed as investors began to favor higher growth stocks that paid a small dividend or no dividend at all, but instead rewarded investors through significant price appreciation. Today, the trend has reverted back to where many companies stocks are now yielding more than their bonds. This is partly due to the Federal Reserve lowering interest rates, but also dividend payouts have been rising. The roughly 2.0% yield on the S&P 500 is in line with the yield of the 10-year Treasury and above the 5-year Treasury STOCK YIELDS VS. 5-YEAR BOND YIELD January 1, 1999 March 29, 2012 yield of 1.0%. For example, 7.00 Verizon Communications Stock yields have trended upward as bond yields have fallen (1998-2012) 1.0386 Bond Yields (VZ) pays its stockholders 1.9538 Stock Yields 6.00 a 5% dividend compared to the 1.8% investors would 5.00 receive if they bought a 4.00 5-year bond. One of the reasons dividend yields have trended higher 1.9538 is that companies are more willing to return capital to 1.0386 their shareholders. After the credit freeze that occurred 2010 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2011 2012 during the fall of 2008, 2012 Bloomberg Finance L. P. companies hoarded cash and were reluctant to use it for purposes other than to pay down debt or invest in technology that would result in cost savings. As management teams have become more optimistic about future economic growth and the prospects for their businesses, they have been more willing to part with cash.
3.00

Generally, there are three ways companies can spend cash: 1) reinvest it (increase spending on research and development, build new plants or hire more employees), 2) strategically acquire another company or 3) return cash to shareholders in the form of dividends or share repurchases. So far this year, 226 companies in the S&P 500 have increased their dividends. Dividend-paying stocks are presenting investors with an opportunity to replace declining income from bonds. The tradeoff is essentially swapping interest rate risk for equity risk. With improving economic conditions and large piles of cash sitting on the balance sheets of US companies, we think this is a tradeoff worth considering.

www.nelsonroberts.com | 650.322.4000

Investment Team
Brian Roberts, CFA, MBA Brooks Nelson, CFA Dennistoun Brown, MD Ann Oglesby, MD, MBA Steve Philpott, CFP , MBA

SPECIAL TOPICS

Nelson Roberts Investment Advisors in the Community

For avid baseball fans, springtime marks the pinnacle of optimism surrounding the prospects for a successful season. For many philanthropic organizations, springtime marks the kickoff of major fundraising efforts to further their charitable missions. Nelson Roberts Investment Advisors is a proud supporter of organizations within the communities we serve. The firm and its members donate both money and time to the following: Menlo-Atherton Little League Peninsula Humane Society Santa Clara University Menlo Park Atherton Education Foundation Wildlife Conservation Network Eastside Preparatory School Canopy Serra High School University of Colorado College of Music (Boulder, Colorado) Stanford University Boulder High School (Boulder, Colorado)

Past performance is not necessarily a guide to future performance. There are risks involved in investing, including possible loss of principal. This information is provided for informational purposes only and does not constitute a recommendation for any investment strategy, security or product described herein. Please contact us for a complete list of portfolio holdings. For additional information on the services of Nelson Roberts Investment Advisors, or to receive our Newsletters via e-mail or be removed from our mailing list, please contact us at 650-322-4000.

1950 University Avenue, Suite 202 East Palo Alto, CA 94303 tel 650-322-4000 web www.nelsonroberts.com email invest@nelsonroberts.com

2012 Nelson Roberts Investment Advisors