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December 2012 Investor Letter


Dear Investors,

November was the wildest month for equity markets since…last November. The S&P 500 was down as much as 5% mid-month, but managed to finish slightly positive thanks to a late month rally. One might recall that this is nearly identical to the trading pattern of November 2011, when the S&P 500 was down by 7.5% mid month, but finished down only slightly. That reversal was the beginning of a five-month-20%-rally for stocks. Let’s hope that the pattern continues to hold.

Certainly there are plenty of reasons why we shouldn’t have a repeat of last year though: the fiscal cliff hangs over the market, earnings growth has been slowing, Europe is still unresolved and China has lost some of its shine. But there was lots of gloom this time last year too, and that didn’t impede a big rally. As I’ve written before, one of the only things I can guarantee investors is that the market will swing between times of extreme optimism and extreme pessimism. Counterintuitively, pessimism is actually what tends to propel the market higher, because when people become so focused on what’s wrong with the world it creates an opportunity for known problems to be solved rather than new problems created.

Right now the problem that everyone is focused on is the fiscal cliff. For most of the year I have focused on this problem as well, but after further analysis I’m glad to write that I think the cliff could be more manageable than the market currently expects. Ultimately the cliff itself is a bit of a red herring because the alternative to the cliff is a compromise, which means higher taxes and lower spending (just like the cliff). Either way there is going to be deficit reduction in 2013. This is “bad” to the extent that it means a removal of short term stimulus, but in the “worst” case circumstance the deficit would be reduced by about $45B per month, which is almost exactly the same amount of money that the Fed will be providing to the economy via QE3. The Fed is doing everything it can to create a monetary cushion to land on in the event that we hurl ourselves over the cliff. In the short term, I think there is a good chance that it could work.

Two caveats: 1) there is a strong possibility that going over the cliff could be so damaging to market psychology that it won’t matter that the alternative wouldn’t have been much different. 2) What’s good for the short term is not necessarily good for the long term. Deficits boost the economy today, but both fiscal and monetary stimulus must be reduced at some point. The US economy cannot exist in a state of perpetual economic stimulus, and the true cliff will come when congress addresses entitlements and the Fed stops printing money. Those ideas aren’t even currently part of the national dialogue, which is far from positive. The “good” news is that for now market participants will likely continue to ignore the elephant in the room and bid securities prices higher. The bad news is that the more we ignore it, the bigger the elephant will be when we are finally forced to deal with it. Alas, all this is for another day.

In terms of our portfolios, I’m happy with how we are navigating this period. In the middle of last month, we reinvested a sizable portion of our cash position and were able to benefit from the pullback by buying some really good companies at favorable prices. As long as we continue to do this, I feel confident that we can continue to do well in a variety of investment environments.

Scott Krisiloff, CFA

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