3rd Quarter 2008 — Investment Strategy Review

“I think I said one time that you only find out who’s been swimming naked when the tide goes out. Well, we found out that Wall Street has been kind of a nudist beach.”
                                          — Warren Buffett – August 22, 2008

2008 will long be remembered as one of Wall Street’s most infamous years. Things have gone so haywire that comparisons are being made to the Great Depression and even the Panic of 1907, when J.P. Morgan strong-armed other bankers to halt a run on trust companies. We wish Mr. Morgan was still here, because he would never have bungled the bailout attempt the way our politicians have. Investors have been victimized by the deleveraging of a massive credit cycle which has, in turn, crippled the global financial system. The gilded era of the independent investment bank is over. Six months ago, there were five major U.S. investment banks. Two of them – Bear Stearns and Lehman Brothers have failed, Merrill Lynch has fled into the arms of Bank of America, and the remaining two, Goldman Sachs and Morgan Stanley, have become commercial banks. The days of 30 to1 leverage are gone forever. As noted above by Warren Buffett, such risky business practices left Wall Street fully exposed. There is an old joke about the investment banker who commented to his colleagues that “the bad news is that we’ve lost an enormous amount of money. The good news is that none of it is ours.” In 2008, Wall Street executives obliterated their own loot too. Lehman Brothers’ disgraced CEO, Dick Fuld, saw the value of his shareholdings collapse from $827 million in January 2007 to a recent $2 million. Humiliating losses by Wall Street’s mightiest are reminiscent of 1929 and other panics, as is the demise of once proud institutions like Washington Mutual, Wachovia, and AIG.

How could this financial Armageddon possibly occur? The simple answer, like all speculative episodes, is greed. Furthermore, we are paying the price for stupid investment decisions made by smart people. These flawed decisions caused sophisticated financial firms to put hundreds of billions of dollars of illiquid, poorly collateralized mortgage securities on their balance sheets. It is ironic that while everyone was worried about unregulated hedge funds, it was regulated investment banks and operations like AIG that have triggered much of the turmoil. Where was the supervision? There is plenty of blame to go around — auditors, credit analysts, rating agencies — it’s a long list.

There were some, like Warren Buffett, who saw the danger years ago. In his 2002 letter to Berkshire Hathaway shareholders he called derivatives “financial weapons of mass destruction” and commented that, “like hell, derivative contracts were easy to enter and almost impossible to exit.” Buffett went on to describe the exact series of events that would ultimately topple AIG.

“Another problem about derivatives is that they can exacerbate trouble that a corporation has run into for completely unrelated reasons. This pile-on effect occurs because many derivative contracts require that a company suffering a credit downgrade immediately supply collateral to counterparties. Imagine, then, that a company is downgraded because of a general adversity and that its derivatives instantly kick in with their requirement, imposing an unexpected and enormous demand for cash collateral on the company. The need to meet this demand can then throw the company into a liquidity crisis that may, in some cases, trigger still more downgrades. It all becomes a spiral that can lead to a corporate meltdown.”

The credit default swap market which ruined AIG has ballooned from $631 billion in 2001 to $62 trillion today. Every financial crash can be traced to a concept designed to minimize risk that becomes exploited to the point that it multiplies risk. Remember portfolio insurance in 1987? Well, credit default swaps are the portfolio insurance of 2008. Stocks crashed in 1987, but the current fallout is in default swaps, mortgage securities and other exotic credit instruments. 2008’s horror show has generated comparisons with the sequence of events leading up to the Great Depression, because it has also shaken the global banking system to the core. The U.S. government’s bailout plan is not about rescuing the equity market, but about unlocking the short-term lending critical for an economy to function. Institutional investors, for example, are afraid to purchase commercial paper. On September 17, the yield on the one-month U.S. Treasury bill turned negative, meaning investors would rather lose money on government paper where repayment was certain than rely on other cash equivalent securities. This gridlock is what Treasury Secretary Paulson is attempting to remedy. Like 1929, Americans are terrified about their safest investments…bank and savings accounts, CDs, money market funds, etc. Unlike 1929, we now have the benefit of a Federal safety net. Remember — this is not the end of the world, no matter what the media is scaring you into thinking. The price will be huge, but the Fed and other central banks have vast resources at their disposal and they will prevail.

History shows that the ideal time to invest is when the markets are overwhelmed by fear. Crashes, panics, and crises are welcomed by long-term investors whose actions are ruled by reason, not emotion. In recent days we have witnessed a crescendo of pessimism. Yesterday’s stock market freefall possessed all the psychological and technical trademarks of a selling climax. The S&P 500’s 8.8% loss was its second worst daily decline since 1950, surpassed only by Black Monday in 1987. What is it about Mondays? While the damage was extensive, we believe the worst is just about over. Our file in which we collect bullish contrary indicators is bulging. We do not want to dwell on the details, but are confident that the extreme gloom points to a favorable future.

Regrettably, political bungling and brinksmanship has turned the current bear market into a monster. The S&P 500 finished the third quarter off 20.7% year-to-date. At its closing low on September 29, the index had declined 29.3% from its October 2007 peak. While painful, the violent selloff has served to validate Mercer Capital’s value-oriented investment approach. We have not been able to prevent losses, but the harboring of cash throughout 2008 has minimized the damage. “Margin of safety” is our mantra and once again this philosophy has kept us out of major trouble. The stock market has fallen more than we expected, but we don’t base strategy on predicting its short-term direction. To paraphrase the teachings of Ben Graham, we let the market serve us, rather than instruct us. Right now, the market is serving up bargains and we will be a buyer in the days ahead.

As mentioned in a special commentary dated July 15, Mercer Capital’s investment philosophy has also been shaped by the late John Templeton. It was Templeton who made a fortune purchasing stocks at what he felt was the point of maximum pessimism. Now that the financial world is at one of these points, we are going to conclude this letter with some thoughts from Sir John on what it really takes to be a successful investor. Too bad the hot shots on Wall Street never got the message…

“Profitable investing is mainly common sense. Don’t get carried away by enthusiasm. Don’t get carried away by despondency. Don’t buy things you don’t understand. Always study what you buy in advance. Make long-range plans. Know in advance that you are going to have to live through bear markets. Just use plain common sense and the chances are that you’ll have superior long-term investment performance.“

Thanks, as always, for your confidence and support. Please call anytime.

9/30/08           Henry D. Mercer III

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