We believe the credit crisis of 2007-2009 and the historic events comprising it will have profound impacts on investors for at least a generation. After severely under-pricing credit risk for several years, we believe the markets will now over-price that risk for some time to come. This will create attractive investment opportunities for carefully selected fixed income investments that may provide strong risk-adjusted returns.
The proper functioning of the fixed income markets, across virtually all types of securities except Treasury securities, was severely disrupted in the credit crisis. While we don’t expect a return to the securitization craze that dominated the fixed income markets for many years, we believe that a return to a situation where “natural” buyers and sellers can be readily matched in the ordinary course of business is a pre-requisite for a sustained recovery in the financial markets.
Over the next several years, we expect consumers and businesses will “re-build their balance sheets” by saving more, reducing debt and spending less. As a result, corporate earnings growth will likely be slower and investors, stung by their 2007-2009 losses, will demand higher risk premiums for equity investments. Therefore, in the aggregate, stocks will likely be slow to recover their values, at least until the fixed income markets have regained a level footing. We believe high quality companies that can generate consistent returns on equity and earnings growth – such as those represented in the Essential Growth Portfolio℠ -- will be favored by investors.
Finally, we believe the market disruptions in 2007-2009 will present a number of interesting opportunities in closed end funds. These opportunities may arise from (1) extraordinarily wide discounts to net asset value relative to historical discount levels, (2) pending or anticipated corporate actions such as tender offers, mergers, liquidations or “open-ending”, or (3) other special situations. We may use investments in closed end funds as a substitute for other fixed income or equity investments. Because market values may change quickly, trading in these investments tends to be more active and focused on particular events. Holding periods are often short term.
We believe the unique skills and expertise of the Essential investment team are very well-suited for the investment climate we expect for the next several years and for the various vehicles we may use to protect and grow capital.