Steven Romick's Q2 Letter to Shareholders (July 26, 2010)

Found via GuruFocus.

With much talk of inflation in the future, the near-term trend reflects price weakness rather than strength. According to David Rosenberg at Gluskin Sheff, the core rate of inflation (excluding food and energy) is 0.9% (just 20 bps greater than the all-time low of 0.7% seen in March 1961), with certain categories — such as housing and apparel — continuing to decline. We see a deflationary path to inflation, where the solution becomes the problem. We still see inflation as inevitable, especially since it appears the knee-jerk is the only skill required to operate the Mint’s printing press. In fact, we think the Fed is using today’s moderate inflation to continue to justify easy money. One of my colleagues, Mark Landecker, recently played Monopoly with his two young daughters (probably introducing them to the real world by zealously collecting their rent). The rules of this 1935 board game, he discovered, seemed eerily prescient given the actions of Mr. Bernanke and the other governors at the U.S. Federal Reserve. The Monopoly instructions state, “The Bank can never ‘go broke’. If the Bank runs out of money, the Banker may issue as much as needed by writing on ordinary paper.”

As Mark points out, we suspect “Helicopter” Ben Bernanke played a lot of Monopoly as a child. However, what young Ben failed to grasp was that the Monopoly approach to banking — while risk-free within the confines of the board game — has potentially damaging repercussions in the real world. In this case, the unprecedented monetary expansion and profligate federal spending reflected in the graphs below is bound to trigger higher inflation and then lead to higher interest rates. However, as we’ve discussed in the past, perennially large deficits and an already elephantine national debt should drive interest rates higher on their own.

We can see the fear of sovereign debt default when comparing the 10-year swap rate to the U.S. Treasury 10-year note yield. The swap rate exceeded the government rate this spring, reflecting that some banks were viewed as a better counterparty than the U.S. government; although positive today, the spread has settled near all-time lows. It is probable that one or more of the OECD countries will ultimately default on its debt, either directly or via inflation. There have been periods of rolling economic spasms, leaving bankruptcies of major countries in its wake. In the accompanying table from professors Reinhart and Rogoff’s recent book of financial folly, you can see that country defaults have been far more prevalent than most realize, since the world seemed a safe place to invest until a couple of years ago. PIIGS (Portugal, Italy, Ireland, Greece, and Spain) now dominate headlines, but sovereign default is not a new fear. Take Greece as an example. The country of Zeus has effectively been bankrupt 50.6% of the time since its 1829 independence. Our own country is ballooning with debt, but the public seems reluctant to look beyond the nation’s thin reflection in the fun-house mirror. We don’t realize we’re bloated and it will seemingly take a heart attack to get us on a diet. But if that’s what it takes, so be it. We cast our vote for a crisis that will hopefully yield positive change.

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Investments

We must admit that we find ourselves in the middle of a whole lot of “I don’t know” out there. In other words, we lack conviction. As a result of this disconnect between expectations and the prospective reality, we find ourselves continuing to seek to conserve capital, as we await the next opportunity to commit that capital to attractive investments. This does not mean we are disinvested. Our gross equity exposure has crept up to 49.4%, albeit at the expense of our corporate bond exposure, which has declined from the mid-30% range to just 18.2%.

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We believe that by having a mandate that allows us to move across asset classes, market caps, and sectors, and to hold cash when others cannot or will not, our investor base is better positioned to avoid the discomfort that might lead to an inopportune sell decision. Crescent has had more than one third less volatility and about half the downside of the stock market as a result of the Fund’s flexibility and execution of its mandate. That lower downside volatility is not the goal, but the natural byproduct of our strategy. More important, regardless of the environment, we consistently aim to distinguish ourselves by using volatility to our advantage, rather than detriment. Instead of composing a portfolio designed to mimic the performance of some benchmark or index, we utilize a deeply held contrarian philosophy oriented towards pushing back on a rising market by reducing exposure, thus allowing cash to increase, while conversely leaning into a falling market and spending that cash by opportunistically accumulating inexpensive securities.

We do not make the top-down decision to increase or decrease cash. Cash builds by default when investments fail to meet our strict upside/downside parameters, that is, what we can make versus what we can lose. We deploy that cash when those hurdles are met. This is easier said than done.

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During the first half of the year, our team has spent more time than usual on what we would loosely define as large, well-known, high-quality companies. This is in contrast to much of the Fund’s history, during which we have typically trolled in more obscure waters to find value. So as odd as it sounds for people who like to call themselves contrarian, we are currently finding the best opportunities — on both a relative and absolute basis — amongst “Blue Chip” stocks.

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An excellent example of a large multi-national with better opportunities abroad would be Anheuser-Busch Inbev NV (BUD), the world’s largest beer company, in which we established a position early in the quarter. In addition to being the largest brewer in the United States, BUD also has a leading presence in many of the world’s most important beer markets, including Brazil, Canada, and the United Kingdom. The company has fantastic cash generative characteristics, world-class brands, a top management team, and the valuation at our purchase price is, at worst, reasonable — and if all goes well, perhaps exceptional. We believe the same can be said for the other “blue chip” stocks we currently hold, including Aon, Wal-Mart, and Johnson & Johnson, to name but a few. To gain a better perspective of the type of executives we prefer to act as stewards for our invested capital, we suggest you view BUD CEO Carlos Brito’s 2008 talk at Stanford University’s business school. Mr. Brito, who we had the pleasure of meeting recently, expounds for almost an hour on the characteristics of a great business leader and how to foster success among a company’s workforce. We assure you it’s worth the time.

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Related video: Carlos Brito’s 2008 talk at Stanford