Year End 2012 — Investment Strategy Review

“We have just spent 15 years learning that a policy of creating asset bubbles is a bad idea, so it is hard to imagine why the Fed wants to create another one.”
                                          — David Einhorn

The U.S. stock market rallied in 2012, providing some holiday cheer for investors worn out by the political dithering in Washington D.C. and the endless commentary about the “fiscal cliff.” Fourth quarter trading action was choppy, but the S&P 500 index still managed to close out the year with a gain of 13.4%. We are not going to join the heated debate over taxation and government spending. Let's leave that to the op-ed pages. As investors, we realize that Wall Street will see right through a hollow solution that fails to focus on reviving economic growth and improving the nation's balance sheet.

Here at Mercer Capital, our job is searching for long-term value, not forecasting the short-term path of the financial markets. We cannot be certain what the impact of the failure to reach an honest budget deal or increase the debt ceiling will be. As you know, we have been maintaining a cash cushion in portfolios that will come in handy if the stock market declines in early 2013. Right now, our main concern is the effectiveness of the Federal Reserve's radical monetary policy and how it is skewing the asset allocation process. The comment above by hedge fund titan David Einhorn, echoes our sentiments. Fed chairman Bernanke's quantitative easing strategy has been attempting to jumpstart the economy by artificially lowering Treasury yields and mortgage rates. By reducing the return available from the safest fixed-income securities, the central bank hopes to entice liquidity into riskier asset classes like equities and real estate. While this phenomenon has provided some support for the stock market and is now stabilizing home prices, it has not stemmed the enormous flow of money into bonds. Unfortunately, investors are chasing yield in the riskiest areas of the bond market by extending maturities and moving down in credit quality. Junk corporates, emerging market debt, securitized bank loans, even southern European sovereign paper - this is where the action is and the scale is gigantic. Quantitative easing will not last forever and when interest rates eventually rise, the losses will be staggering. Today's global bond market may be the biggest bubble in investment history. This is what Einhorn is warning about. Ironically, the major loser could be the Fed, whose holdings of U.S. Treasuries and mortgage securities have ballooned to $2.9 trillion. Talk about stimulus, yet the economy remains stuck in slow growth mode. We wonder if history will show that it was worth the effort.

Equities, in comparison, continue to offer value. They are also appealing from a contrary perspective. Successful investing requires the purchase of unpopular assets and stocks remain in this category. The stock market has generated disappointing returns for more than a decade and many investors have lost faith. Typical of the current atmosphere is a recent front-page article in The Wall Street Journal headlined “For Many Financial Advisers, Stocks Become a Hard Sell.” As contrarians, this gets us excited about the long-term prospects for stocks.

Looking out into 2013, little is going to change in terms of strategy. As value buyers we assess the risk of loss over the long run and the highest quality equities should continue to combine the best margin of safety and potential rate of return. Our strategy is simple: We want to invest in great businesses at sensible prices. During the past year we have spent lots of time thinking about the key characteristics of outstanding enterprises and how they share the following attributes: operations possessing dominant franchises, durable competitive advantages (what Warren Buffett calls an “economic moat”), above-average returns on equity, little need for capital investment, and the ability to generate plenty of cash. These businesses are rare, which forces us to be picky and patient.

If we were rock and roll musicians we would be playing in a Warren Buffett cover band. And as 2012 winds to a close, we would like to share an observation Buffett made back in 2008: “So wild things happen in the markets. And the markets have not gotten more rational over the years. They've become more followed. But when people panic, when fear takes over, or when greed takes over, people react just as irrationally as they have in the past.” Taking advantage of this irrational behavior is essential. Thank you, as always, for your encouragement and support. We hope that you have a happy, healthy, and prosperous New Year.

12/31/12           Henry D. Mercer III

Index Return (Year-to-Date)   12/31/11 9/30/12
S&P 500 +13.4% Fed-funds 0 - .25% 0 - .25%
DJIA +7.3% 10 yr. T-note 1.88% 1.76%
    Oil (W.T.I.) $98.83 $91.82
    Gold $1,565.80 $1,674.80

* Please contact Mercer Capital Advisers, Inc. if there are any changes in your financial situation or your investment objectives or if you wish to add to or modify any restriction to the management of your account. Our current disclosure statement as set forth on Part II of our form ADV is available for your review upon request.

* Mercer Capital’s management fee is billed quarterly, in advance, based upon the market value of the assets on the last day of the previous quarter.

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