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Client Investment Letter July 2016

“Patience is bitter, but its fruit is sweet.” ~ Jean-Jacques Rousseau

We realize there has been no shortage of pundits with a view on the implications of the U.K. electorate voting to leave the European Union, but with the second quarter now complete, we wanted to take a minute to provide our viewpoint and game plan.

For quite a while now we have been building up a large cash position. Cash, particularly in today’s environment, is bitter. It pays nothing and it appears to do nothing. It certainly doesn’t make for exciting investment letters! Yet, in the current environment we think it offers something very important – the option to be deployed in moments of market turmoil. Our intention remains to use it when volatility increases and prices become more attractive. We weren’t anticipating Brexit, per se, but when the kindling is in place (e.g. high valuations, margin compression, negative earnings growth, investor complacency) any spark can start a fire.

The market miscalculated and ran up into the late-June vote to within one percent of all-time highs, so part of the post-Brexit sell-off was simply an unwinding of that erroneous run. While the news itself was jarring, the actual process of the U.K. leaving the EU will take a couple years to complete, and, given the U.K. has its own currency and central bank, we do believe the divorce should be manageable over the long term. Direct exposure to the U.K. in your account is fairly limited. You own no financials, the market sector at most risk for contagion from Brexit. The multinationals you own have broad exposure to Europe in general but the U.K. makes up less than 5% of their revenue on average.

The broader message from the outcome of the U.K. decision, however, is frustration with the status quo stemming from years of subpar growth and global economic malaise despite unprecedented central bank intervention. Patience is wearing thin with a fed-up populace not just throughout Europe but across the globe, including here, as seen in a presidential race where a lack of political experience is viewed as an asset. Given the anemic global growth over the past decade and complete fiscal policy gridlock under current regimes, change might be good. However, frustration is not a plan, and the U.K. will suffer in the short run for voting to exit the EU without a clear leader in place to execute the vision. Perhaps its experience will serve as a cautionary tale for voters in other locales that may be tempted to try something new in haste.

With the recent pick-up in volatility, valuations are becoming more attractive by the day, and we have a short list of candidates that we hope to buy as prices continue to decline. We welcome market weakness so that we can buy these high-quality companies at more reasonable prices. We’ve certainly been waiting patiently for them.

Another way we’ve been exercising patience is through the manner in which we deploy capital when establishing new positions. We start small and look to build positions over time on unwarranted weakness. We have found some exciting new opportunities over the past year and initiated only small positions in your account. Now, as volatility increases, we hope to build these positions at great prices.

So while the media sensationalizes the events taking place in Europe, our message is simple: We have been patiently waiting for volatility and keeping our cash levels at historically high levels to reduce risk and to be able to buy great companies at attractive prices (including building up already established small positions). While these events continue to play out, you can rest assured that we are prepared to act on your behalf as sweet opportunities arise.

Penn Davis McFarland, Inc.
July 2016