Equity markets in the US continue to show signs of recovery, with the S&P 500 gaining approximately 2.0% for the month of August. Berkshire portfolios continued their outperformance in August and are ahead of the market on a year to date basis.* Positions in Avis Budget Group (CAR), Leggett and Platt (LEG), Cisco Systems (CSCO), and Microsoft (MSFT) were positive contributors.

Foreign markets continue to struggle greatly this year, with many markets in Europe down 20% or more, and emerging markets such as Russia, India, and China are down 30% to 50%.

The reason behind much of Western Europe’s decline is those economies are beginning to experience some of the same problems the US has been facing such as slumping housing markets and a weaker economy. The dollar is having a great run versus the Euro, and is at a 2 year high versus the British pound. If Europe slows even more, a rate cut might also be on the table for the European Central Bank (ECB), which we think would likely add to the US dollar’s gain. The US dollar was surely a dark horse pick heading into 2008. We felt many world markets looked vulnerable based on many of the issues which are now coming to fruition.   

Emerging markets are coming to grips with other realities. First, we are seeing how the so called “BRIC” economies, (Brazil Russia, India and China) can carry significantly greater risks. Russia’s recent aggression illustrates that geopolitical uncertainty still comes with the territory of investing in these markets.

These markets are also coming to grips that difficulty in the US still greatly affects the rest of the world’s economies. For example, if the United States consumer was an entity unto itself, it would contribute 18.2% of the worlds GDP, which makes it larger than the entire economies of:  Japan (8.1% of world GDP), Germany (6.1% of world GDP), and The UK (5.2% of world GDP). China currently accounts for 6.1% of world GDP. So the consumer sector of the United States economy alone is 3 times the size of China’s entire economy. (Source: Bureau of Economic Analysis).  Lacking a consumption based economy of its own, much of China’s growth has been ignited by massive exports to the US consumer, who is likely cutting back in the wake of higher inflation, and a weak housing market.   

These deteriorating fundamentals coupled with rich valuations (China was 30 times earnings at the start of the 2008), has led to significant declines in many popular indexes in that region.  

New Purchase in Portfolios: Airlines

We recently added a small position in a major US airline to portfolios. Airline stocks have been very out of favor due sky-high fuel prices, and the threat of weaker economic activity. The difficulties in this industry have been well documented for years. However, we can make a strong case for a return to profitability and it is not just from the obvious catalyst of lower fuel prices, which of course would provide a big boost to earnings.   

What is not so obvious are some structural changes happening within the industry, namely capacity rationalization. The airlines have been cutting flights and retiring planes, which could have the highly desireable result of finally giving the industry pricing power. Revenue is made up of price times number of units sold. We think Wall Street has underestimated the pricing portion of this equation. It is the last available unit of a commodity that sets the market price. For example, if you were a widget producer with only unit left, but high demand, you would be able to command premium pricing. 

While the balance sheet and profitability metrics look challenging now, keep in mind the energy and materials companies looked very similar to airlines in the early part of the decade. They too were cutting capacity, but as the economy rebounded, demand outstripped supply, and pricing improved significantly. If a similar combination of lower fuel costs meets rebounding demand and constrained capacity, earnings can rebound rapidly in these companies, and would trigger what we believe would be an even greater rise in share prices.

*individual portfolio results may vary

Important Disclosure: The views expressed in this commentary and www.berkshireobserver.net reflect those of Berkshire Asset Management, LLC (Berkshire) as of the date of the commentary. Any views are subject to change at any time based on market or other conditions, and Berkshire disclaims any responsibility to update such views. These views are not intended to be a forecast of future events, a guarantee of future results or investment advice. Because investment decisions are based on numerous factors, these views may not be relied upon as an indication of trading intent on behalf of any portfolio. The information contained herein has been prepared from sources believed to be reliable, but is not guaranteed by Berkshire as to its accuracy or completeness. Past Performance is no guarantee of future results. Berkshire is an SEC registered investment advisor that manages accounts for individuals, institutions. A copy of our current ADV II is available upon request. References to particular securities are intended only to explain the rationale for the portfolio manager’s views and decisions with respect to such securities. Such references do not include all material information about such securities, including risks, and are not intended to be recommendations to take any action with respect to such securities. Investment Risk: All investments are subject to risk, including possible loss of principal. Because Berkshire Asset Management, LLC’s investment style expects to hold a concentrated portfolio of a limited number of securities, a decline in the value of these investments would cause the portfolio’s overall value to decline to a greater degree than a less concentrated portfolio. Our equity investment style may focus its investments in certain sectors or industries, thereby increasing the potential vulnerability to market volatility.

Since market lows set in July 2008, Berkshire equity portfolios have increased smartly and exceeded the return of the S&P 500 by a meaningful margin. Year to date results are also favorable vs. the market.    

There are two main drivers behind the results. The first is a fairly serious, yet incomplete correction in energy and materials related stocks. The price of crude oil has declined by over 20% since its high set in July. Gold is down and the dollar is enjoying a rally. Momentum, at least for now, looks like it has left the bullish oil trade. For example, despite threatening the movement 800,000 barrels of oil a day, Russia’s aggression towards Georgia didn’t cause much of a spike in the price of oil. Prices actually continued to decline. A few months ago, when the momentum was at a fever pitch, we suspect the price spike might have been greater surrounding a geopolitical event such as this.  

There is also evidence of true “demand destruction.” Higher prices have caused substitution and lower demand. U.S. drivers drove 9.88 billion less miles than they did last year*, a 3.7% drop. Commuting volumes in public transportation systems are way up. Employers are, in some cases, allowing 4 day work weeks to ease the costs of a five day commute. Companies are reworking their logistics and distribution systems to cut down on energy costs. Dealers can’t give away an SUV. Economic activity in Europe and China is slowing. Fueling the decline (or perhaps causing it) is a rebound in the dollar based on the premise the European Central Bank may have to lower interest rates, or is not in a position to raise them.  While slowing world wide demand is good for mollifying the news flow, keep in mind the US is by far and away the largest consumer of energy, chugging down 25% of daily oil volumes. China consumes about 8% of the total.  

The second cause for favorable results is a rebound in financial related stocks held in portfolios.  Our analysis and valuation framework strongly supported our opinion that bank stocks would likely bottom in mid-summer. It certainly looked like capitulation and panic selling the morning of July 15. For a few days in early July, it was not uncommon to see price swings of 25% in financial stocks in one day. Swings like this in (either direction) are indicators investors are not acting in any type of rational manner. It indicates they are merely reacting violently to whatever stinger headline or doomsayer happens to make it on CNBC. We used the volatility to our advantage by selectively adding to financials across portfolios.  We increased positions in Sovereign, and National City. We also added a new position in Merrill Lynch. Since then, many financials have rallied sharply and despite the large move, we still believe they are undervalued.  

^{*US Department of Transportation}

Important Disclosure: The views expressed in this commentary and www.berkshireobserver.net reflect those of Berkshire Asset Management, LLC (Berkshire) as of the date of the commentary. Any views are subject to change at any time based on market or other conditions, and Berkshire disclaims any responsibility to update such views. These views are not intended to be a forecast of future events, a guarantee of future results or investment advice. Because investment decisions are based on numerous factors, these views may not be relied upon as an indication of trading intent on behalf of any portfolio. The information contained herein has been prepared from sources believed to be reliable, but is not guaranteed by Berkshire as to its accuracy or completeness. Past Performance is no guarantee of future results. Berkshire is an SEC registered investment advisor that manages accounts for individuals, institutions. A copy of our current ADV II is available upon request. References to particular securities are intended only to explain the rationale for the portfolio manager’s views and decisions with respect to such securities. Such references do not include all material information about such securities, including risks, and are not intended to be recommendations to take any action with respect to such securities. Investment Risk: All investments are subject to risk, including possible loss of principal. Because Berkshire Asset Management, LLC’s investment style expects to hold a concentrated portfolio of a limited number of securities, a decline in the value of these investments would cause the portfolio’s overall value to decline to a greater degree than a less concentrated portfolio. Our equity investment style may focus its investments in certain sectors or industries, thereby increasing the potential vulnerability to market volatility.