Opportunities Continue to Flow in Closed End Funds

Dislocations in the financial services sector continue to give rise to new investment opportunities in closed end funds.  With all of the turmoil in the banking and investment sector over the last twelve months, we expected the opportunity set to increase.  Increase it has.  Whether the motivation is cost cutting, avoiding activists or simply trying to reduce the discount at which a fund is trading, fund companies have been very active in initiating corporate actions for closed end funds they manage. 

Recently, we have made investments for clients in closed end funds that are liquidating, merging with “sister” open-end funds and which are making cash tender offers.  Typically, we are looking to make investments at attractive discounts to net asset value and then waiting for the completion of the liquidation, merger or tender, which usually take place at or near net asset value.  While these investments are not without risk of loss if events don’t turn out as expected, we view them as excellent opportunities to potentially enhance already attractive returns available on corporate and municipal bond fund investments for the fixed income portion of our clients’ portfolios. 

Jerry has been following closed end funds for many, many years and has put his experience into action over the last couple of months, replacing more passive fixed income investments with these very actively managed closed end fund investments. 

Avoiding Investment Frauds

News outlets have been filled with stories about investment frauds from the breathtaking to the mundane.  In their rush to tell you about these frauds, rarely do our friends in the media take the time to tell you how to avoid these frauds.  Learning how to avoid frauds is critical as those who don’t learn from history are doomed to repeat it.   

Avoiding frauds should be awfully simple to do.  No matter how well you might think you know someone, this is about the business of your money so it’s important to always ask a few very simple questions.  The important thing is to ask ALL of them and if you don’t get a simple “yes” answer on any one, move on. 

Here are the four questions you should ask:

(1) Is your firm registered as an investment adviser with the SEC?  If yes, ask for the firm’s official name so you can look up Part I of the firm’s Form ADV on the SEC site http://www.sec.gov/investor/brokers.htm and check out the firm’s regulatory history.  If the firm or any individual has regulatory problems in its past, move on.  If the firm is not registered with the SEC as an investment adviser, move on. 

(2) Will my investments be held by an independent custodian?  Most reputable advisers do NOT take custody of their clients’ assets because of the regulatory requirements they should follow.  Your adviser should use an independent bank or broker (think Schwab, Fidelity or TD Ameritrade) as the custodian for your assets.  Your adviser should only be able to make trades in your account but should never be handling your money or investments directly.  If the adviser wants custody of your money and investments, move on. 

(3) Are you paid solely by me on the basis of assets you manage for me?  If yes, the adviser is on your side of the desk – he/she owns earns more money only if you do.  Any other form of compensation – commissions, payments from fund companies, incentive fees – creates of conflict of interest for the adviser which could be bad for you.

(4) Do you have a long history of managing money for clients?  Look at the education and experience of the adviser’s principals that is disclosed in the Form ADV.  Have they worked for reputable companies in the past?  Do you they the appropriate education, experience and credentials to manage your money?   If not, move on. 

If you receive “yes” answers to these four questions, then you should feel comfortable in taking the next steps of evaluating the adviser’s services and fees.  However, if any of the answers are “no”, you should continue your search for another adviser. 

Earnings Season Better Than Expected for EGP Companies

The earnings reports for the first quarter for the companies in the Essential Growth Portfolio have so far been much better than expected.  Through today, 22 of our 35 companies have reported (we have many with other than calendar quarter ends).  Of those 22, 16 have beaten consensus earnings estimates, 4 have met expectations and just two have reported earnings below consensus earnings estimates. 

This was a quarter in which earnings faced many headwinds – dramatically lower consumer spending, historically high job losses, capital spending reductions and dollar strengthening.  However, most of the companies we own have responded very quickly with cost reductions to keep their earnings at relatively solid levels. 

While these cost reductions don’t bode well for the employment picture, they do point to better earnings ahead if consumer and business spending begins to pick up and the dollar begins to weaken, allowing companies’ top lines to grow.   

Partners succeeds Advisers

Effective April 1, 2009, Essential Investment Partners, LLC succeeded to the business of Essential Advisers, Inc.  Essential Advisers, Inc. (100% owned by Jon Zeschin) and Jerry Paul are equal partners in Essential Investment Partners, LLC.  Essential Investment Partners, LLC is registered with the Securities and Exchange Commission as an investment adviser.  The registration for Essential Advisers, Inc. is being withdrawn.

Investment Outlook Overview

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.

Investment Philosophy Overview

Our approach can be summed up with one word: consistency.  Whether we are considering individual stocks, mutual funds, hedge funds or closed end funds, our investment process focuses on investments that are likely to deliver consistent and reliable results.  We look for opportunities that may be either  overlooked or under-researched and that may provide solid returns for clients over long periods of time.

For each area of investing – stocks, mutual funds, hedge funds and closed end funds – we have a well-defined discipline that describes our research process.  (Each of these disciplines is defined in a separate document.)  While each  investment vehicle is distinct, they share a common underlying philosophy of searching for consistent results and understanding how we might lose money as much as how we might make money.

All of our investment processes are supervised by the Investment Committee, chaired by Jerry Paul.  The Committee meets at least weekly to discuss the current investment and economic climate, existing client investments, new opportunities and potential changes to portfolio positioning.  This process ensures that we are consistent in our approach to investing.  For example, if there are new developments in the fixed income markets, we consider the impact of those developments when evaluating individual stocks.

Investment Outlook, April 2009

The roller coaster ride continues.  In the first nine weeks of the year, the U.S stock market (as measured by the S&P 500 Stock Index) fell 25% and then shot up 18% before the end of the first quarter.  While that rise has continued into early April and has made us all feel a little better, we are hardly out of the woods.

Three months ago, we laid out several predictions for 2009.  Here’s an update on those:

“Bad economic news will continue to dominate the headlines.  Job losses and the unemployment rate will continue to mount.”  The unemployment rate has jumped to 8.5% and job losses so far this year are estimated at more than two million.   Since the start of this recession, more than five million jobs have been lost.

“In the aggregate, corporate earnings will drop precipitously.” Trying to predict an aggregate earnings figure for the companies in the S&P 500 has become a parlor game on Wall Street.  Everyone has an opinion, the dispersion among estimates is very wide and only the lucky will get it right.  Even long term averages are distorted by the very high earnings of a few years ago which gave way to huge write-offs that effectively canceled out those earnings.

“The markets will continue to be highly sensitive to new government intervention.”   With the stimulus package now the law of the land, AIG and the automakers are high on the minds of economic policymakers.  Talk of bankruptcy for GM and Chrysler no longer spooks the market and there is growing consensus of the need to get on with it.  The markets reacted positively to the Federal Reserve’s announcement of further plans to buy mortgage-backed securities and even Treasury securities.  However, we are uneasy about the implications of one arm of the government issuing massive amounts of debt and another arm of the government printing money to buy the same securities.

In addition, we think it is unlikely that the Treasury Department will get a lot of private partners lining up for its PPIP (the Public-Private Investment Program to buy toxic assets from banks).  First, the spread between the bid and ask prices for these securities is very high – closing the gap will not be easy.  Second, the softening of mark-to-market accounting rules will make it less likely that banks will want to sell.  Finally, Congress’ propensity for changing rules after the fact (think 90% tax on AIG bonuses) will make hedge fund managers very reticent to join the program in hopes of making big profits. 

“The thaw in the credit markets will continue, but setbacks are likely.” Corporate bond and municipal spreads have tightened a lot over the quarter, although they are still at relatively high levels.  However, defaults have been slow to appear and we expect recovery rates to be much lower than prior experience.  We would not be surprised to see a few public bankruptcies back spreads up somewhat in the next few months. On the plus side, creditworthy companies are beginning to take advantage of the low rates and issue debt selectively, if it can be used to shore up their balance sheets.

“Faced with disappointing earnings and competition from bonds, stocks will have a hard time sustaining a rally.”    The accuracy of this statement will be tested in the next few weeks as we get corporate earnings reports for the first quarter.  After the March rally, the stock market was still down more than 10% in the first quarter.  We would not be surprised to see the market retrace some of the gains of the last few weeks as the reality of the decline in corporate earnings hits home to investors.

“Government will continue to expand its role in the private sector. “  Just ask the executives at the auto makers or AIG about this statement.  Perhaps the best indicator of how far we have come was not the firing of then GM CEO Rick Wagoner but rather Matt Lauer’s (NBC Today Show) question of Fritz Henderson (new GM CEO):  “Sir, to put it bluntly, don’t you report to the President of the United States?”

Healthy banks, such as Goldman Sachs, are trying to convince the government to take their TARP money back.  So far the government has declined.  Ultimately, we expect that the government will have no choice but to pick winners and losers by taking their money back from the winners and funneling it to the losers to pay off their obligations.

“Risk management is the order of the day for client portfolios.”    We have maintained a very conservative posture -- we have not rebalanced into stocks since last August.  Instead, we have significantly increased bond positions in corporates or municipals, often using closed end fund special situations as attractive ways of investing in these markets.     Within stock allocations, we continue to use the Essential Growth Portfolio℠ alongside mutual funds that tend to offer more downside protection.   So we don’t see the need to increase the risk profile of client portfolios.  Rather, we believe attractive returns can be earned by prudently taking advantage of lower risk opportunities currently available.

April 8, 2009