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Client Investment Letter

2013 had a healthy start with markets generally rising on the back of improved fundamentals such as higher rates of employment, better consumer sentiment and retail sales, low inflation, and the comfort of $85 billion in monthly asset purchases by the Federal Reserve keeping the system full of liquidity to drive asset prices higher. However, on June 19th the Fed gave the first signs that this extraordinary stimulus will have to be removed eventually, with asset purchases “tapering” off as soon as late 2013 and possibly stopping by mid 2014. This is a little akin to taking the patient out of the ICU and upgrading his condition from critical to stable. The Fed will keep the patient in the hospital for monitoring well after asset purchases end, and will only remove the traditional stimulus of low interest rates, once a “full recovery” has been achieved. If all goes according to the Fed’s plan (things rarely do), this will be sometime in late 2014 or 2015.

The markets were startled by the realization that the patient is really going to have to breathe on his own soon. While equity markets swooned a little, dropping 7% from their recent highs, the bond markets, which have been anticipating the taper talk since early May, had an absolute riot with the yield on the “risk free” 10 year U.S. Treasury rising from 1.6% at the beginning of May to 2.6% in the days after the Fed made clear its intention to taper if the economy keeps improving. This brought significant mark to market losses for those holding long-dated bonds. For instance, the lucky purchaser of the 2.0% 10 Year Treasury Note issued at 100 on April 15th could only sell that bond for 95.625 as of June 24th. A loss of 4.375%, or over two years of interest in a little over 2 months! This is the “riskless” asset? It could be worse. Those who took a bite of Apple’s first ever 30 year bond, issued at 100 with a 3.85% coupon on April 30th, found a worm inside. Their bonds were trading at 86.40 as of June 24, a loss of 13% in less than two months. After a 30 year bull market, the myth that interest rates only go down and bond prices only go up is rapidly being dispelled. Be it stocks, bonds, or houses, one should always remember: Prices will fluctuate.

When it comes to gold there has been enough fluctuation recently to give us heartburn. Gold prices have retreated nearly 25% over the course of the year and the miners you own have retreated more. Why is gold declining? First, investors are worried that a decline in easing by central banks will make gold a less attractive alternative to fiat currencies. Second, the deficit picture has improved in the U.S. thanks to sequestration. Third, the U.S. dollar, which has been stable to strong instead of weak during these crises, has also penalized gold prices since the yellow metal is traded in dollars. Finally, rising interest rates are a headwind for gold because it makes holding a metal that generates no income less attractive relative to other “safe” options like treasuries.

Despite the decline, many of the fundamental reasons for keeping some gold exposure remain true. The Fed is talking about reducing its money printing, but is not actually doing it. If the Fed economic forecasts prove too optimistic (it has happened before), they may resort to even more quantitative easing inspiring a rush back to gold. The U.S. deficit improvement is temporary with huge “off-balance sheet” entitlement spending problems looming over the horizon. Finally, it is hard to believe that the massive amount of liquidity pumped into the system by central banks globally won’t eventually result in some level of inflation. The dollars that have been created aren’t going away anytime soon. Indeed, they sit primarily on bank balance sheets waiting to be deployed at a later date. So far inflation has been very tame, but this is unlikely to be a permanent state of affairs and the central banks have little control over when the dollars they have created are transmitted into the economy.

In addition to general weakness in gold prices Barrick Gold and Goldcorp have run into some company-specific challenges bringing some of their new mines online. Mining is a tough business and problems with permits and foreign governments often come up, but eventually most miners work through them. We expect this time to be no different. The reduction in the gold price is forcing miners to focus more on cost reduction and cash flows which should be a good thing for shareholders long-term. In the meantime, the miners are paying healthy dividends while we wait for gold to come back into favor and their projects to get back on track. We think getting paid to wait and having the prospect for growth is much better than paying to protect physical gold bars sitting in a vault gathering dust.

The recent market sell-off gave us an opportunity to initiate a new technology position during June. We started a position in EMC Corporation, the global leader in enterprise data storage. Data grows pretty consistently at about 60% per year for most companies. While price reductions and software efforts to reduce duplication of data reduce the revenue growth rate of the data storage market to something in the high single digits, this is still a healthy growth market in a 2% GDP growth world. Through its publicly-traded consolidated subsidiary, VM Ware, EMC also holds a dominate position in the market for server virtualization software. VM Ware’s software allows companies to reduce their capital spending by maximizing the utilization of their existing hardware. Because of the excellent returns on investment generated for customers, we believe the virtualization market will continue to grow for many years and VM Ware is well positioned. Finally, EMC is launching a startup focused on building an enterprise cloud computing/big data platform called Pivotal. This is a promising market and if EMC succeeds we expect that is could be a very valuable business.

EMC, like many of your tech company holdings, has a pristine balance sheet with over $10 billion in net cash. The company recently initiated a dividend and aggressive share buyback, which demonstrates management’s commitment to shareholder returns. The stock’s valuation is appealing. Netting out cash and taking into account options expense, EMC trades at a little more than 13x earnings. We think this is a very reasonable price for a dividend-paying, high-quality, secular growth business with a clean balance sheet, so we initiated a position.

We expect the trend of cash-rich companies increasing dividends to shareholders to continue. So far during 2013 some notable dividend increases from your companies were: Apache +18%, Apple +15%, Cisco +21%, Oracle +100%, Qualcomm +40%, Teva +26%. We expect that dividend payments, historically an important part of returns for equities, will continue to grow at a healthy clip for many of the companies you own.

Overall, we remain fairly optimistic about the portfolios. You own a collection of leading companies with good growth prospects at reasonable prices. The companies have strong balance sheets and the wherewithal to survive a variety of economic situations. We assume that the sub-par GDP growth we have seen so far in this recovery will probably continue for several more years. While there will be moments of uncertainty and angst, our general expectation is that this will remain a “muddle through” economy and the companies you own will do better than to just muddle through. We thank you for the trust you put in us and, as always, look forward to speaking to you individually.

Penn Davis McFarland, Inc.
June, 2013