Stocks were again volatile last week. The S&P 500 closed at 879 versus its close of 876 last Friday. The Dow closed at 8629, essentially unchanged from the prior week. There were plenty of gyrations throughout the week though.

For 2008, the S&P 500 and Dow are now down 40% and 35%, respectively. The S&P is up nearly 20% from its low of 741 which was reached in November. This intraday low actually eclipses levels dating all the way back to 2002.

The week started off with a large rally when President-elect Obama unveiled his plan for a large stimulus which focuses on infrastructure and energy build outs.

Later in the week, selling pressure began to mount. All eyes turned to the fate of the US automakers and potential economic fallout if they were to collapse.

Tension and selling pressure accelerated Thursday. Bank of America announced its plans to cut 35,000 jobs over three years (largely merger related). Also, JP Morgan CEO Jamie Dimon discussed that the U.S. bank is having a “terrible” November and December, blaming the “normal culprits:” mortgages, credit, high yield bonds and loans.

Friday morning, news that the Senate killed the auto bailout plan sent stocks sharply lower. Stocks regained their footing after the White House said it would be willing to extend the auto industry funds from the TARP (Troubled Asset Relief Program). The S&P climbed 6.7 points erasing a 3% loss. The Dow climbed 65, while the NASDAQ climbed over 2%.

More broadly, while equity market volatility and bad economic news remains the norm, we are  encouraged by the performance of equities over the last few weeks. There is now resilience, which is noticeably different than the swift and relentless declines witnessed in early to mid fall.

That period was punctuated by panic selling as investors started to come to grips with the depth and magnitude of the problems facing the world economy. Of perhaps greater magnitude, large financial institutions were in the midst of a painful process known as ‘deleveraging.’ Deleveraging is process whereby institutions (particularly hedge funds and large financial institutions) are forced to sell assets to pay down the lines of credit that are being called by their lending facility. Forced liquidations like this (unlike fundamental ones) create a viscous cycle. The more the market declines, the more participants have to sell, and the more participants have to sell the more the market declines. While painful, it is a curative process that takes excesses out of the system, which eventually can allow asset prices to rise going forward.

In contrast, market action from the November lows has been much more constructive. Yes, the market is higher, but even on “down” days the selling appears more “orderly” and not full of panic. Earlier in the fall, sellers met no resistance what so ever and totally overwhelmed any buying activity. The market wound up in what seemed like constant free fall. Not so of late.

Perhaps more importantly, we also are seeing several cases where worse than expected economic or earnings news comes out, yet stocks actually go up.

For example, on December 5 it was reported the economy lost over 530,000 jobs for the month which was far worse than expected. Yet, stocks rose sharply. This may indicate that the forced sellers are out of the market. Hedge funds are reporting high cash balances, which may signal at least a temporary respite from the deleveraging phenomenon.

Or, it may indicate stock prices were already so depressed they reflected horrible economic news – and then some. There is no rule that says stocks have to immediately settle to fair value – dislocations above and below true value can be large and persistent. Perhaps investors now can quantify the depth and magnitude of the recession (which officially began last year) and its impact on earnings (which most expect to be quite severe). This way, instead of worrying about which financial institution will fail next,  we can all look out to the other side of the canyon, and start assessing long term value, which is quite possibly higher than where we are today.

No one knows if we’ve hit bottom, and plenty of challenges remain. News flow will likely be negative for a while. But recent action has been more encouraging, however. If in twelve to eighteen months we are rewarded with substantially higher equity market values, we may look to this period, when stocks stopped going down on increasingly bad economic news that marked the turn.

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.

After listening to Congressional testimony and speaking with investors, it is clear people are confused about Treasury Secretary Hank Paulson’s $700 billion dollar plan to rescue the financial system. There are many details and nuances to be worked out, and success is in no way guaranteed. Below is a simplified discussion of how the plan is structured, and what the plan is trying to accomplish.

Many are mistakenly under the impression the government is planning on raising $700 billion and making some type of expenditure that gets vaporized into an ailing institution, leaving the tax payer with a “bill” of $700 billion. This is a categorically false understanding of the plan, both in mechanics and financial reality.

The US Treasury is planning on raising $700 billion so it can invest in high yielding mortgage backed securities (MBS) currently owned by our nation’s financial institutions. This does not constitute an expense; it is an exchange of cash for an asset. Mortgage related losses on securities have eroded capital so as to make it more difficult for many banks to make new loans, which is why this crisis is potentially devastating to the growth and health of the economy.

If executed properly, the plan could: allow financial institutions to get mortgages off their balance sheet, (while taking appropriate write downs), free up capital so institutions can once again lend, and actually make money for tax payers. Make money you ask? Yes. Here is how.

The Treasury is in the highly desirable position of being able to borrow billions of dollars for ten years at a measly 3.75% (the rate on treasury bonds). Under the plan, the $700 billion would be used to purchase mortgage backed securities with potential yields of 10-15% or even higher, depending on quality. Even if the government bought the most toxic debt and collected a few interest payments, they’d be in the money. Taxpayers would participate in gains as well as the losses. Every hedge fund in the world would love to have the government’s low borrowing advantage and the benefit of time.  What’s more, there are plenty of distressed, high yielding opportunities out there.

One should not conceptualize this as moral hazard, socializing losses or rescuing the “bad apples” that created the problem. This is more akin to the US taxpayer committing capital to participate in a hedge fund with a large structural advantage. There are many risks involved in a government venture such as this, but conceptually it is simple: borrow at 3.75%, invest at 15%, and pocket the difference on $700 billion. Simultaneously this plan provides much needed liquidity to reignite frozen markets.

Gerard Mihalick, CFA
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.

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.

Good afternoon everyone:

Stocks declined approximately 5% for the week.  The main catalyst for Tuesday’s sharp sell off was a dramatic decline in the ISM non manufacturing index (a popular measure of activity in the service sector). A reading below 50 generally correlates with economic contraction. The index value came in at 44.6, which was even lower than the time period following 9/11.

Later in the week, stocks recouped some losses after it was announced the European Central Bank (ECB) was open to lowering interest rates to combat economic weakness (talk about mixed blessings). There is also evidence credit is getting tighter. On a company specific note, Cisco provided a somewhat gloomy forecast.

It is becoming increasingly clear that some level of reduced economic activity is at hand. As forward looking investors however, it is paramount to ask the right question. It is not so important to ask ‘are we going into a recession?’ It is more important to ask ‘to what level do stock prices already reflect the threat of a recession’.

While timing surely isn’t for us and we normally loathe commenting on “the market” (our contribution to the reduction of financial noise pollution) we do offer a few general observations. First, stock prices have already been marked down 15-20% since the October highs.   Technology and financial stocks have fared even worse. Second, the S&P 500 now trades at 14 times 2008 estimates of $97 which is the lowest stated multiple in 10 years. Even by marking down earnings 15% to $82.50, you get a market multiple of approximately 16 times, which appears defendable given the yield on the 10 year Treasury is 3.75%. We realize all the limitations of simple static P/E analysis and the market is by no means out of the woods. However, it does offer some evidence that a good deal of risk is already priced in.

It is more dynamic and robust however, to utilize discounted cash flow analysis. This way, valuation is based on current cash flow, growth of cash flow and the unique risks associated with each company’s cash flow. It yields what a rationale long term investor would pay for an entire business. As a reminder to you, we conduct this analysis on every company in our portfolio, using conservative estimates. Based on today’s prices, our portfolio is nearly 40% undervalued.  The last time we saw an aggregate discount of this magnitude was in 2003, right before stocks moved 50% in 2 years.  As is the case with most big rallies, there was no visible catalyst at the time and most of the news was bad – similar to today. So to reiterate, it’s not so much whether or not the news is good or bad, but to what level the news is reflected in stock prices. Given the level of discount in our portfolio we are poised for appreciation but also hold a built in margin of safety should economic conditions deteriorate.

A few of our companies reported earnings this week.

Like last quarter, Cisco Systems (CSCO) reported strong earnings, but issued some cautious guidance. This is cyclical, not secular. The secular growth story of Cisco absolutely remains in tact. Their products and service solutions continue to be exquisitely positioned right at the epicenter of multi platform, multi geography network convergence. This huge, world wide build-out remains one of the best growth opportunities.  Shares were able to recover after the announcement but were down for the week in sympathy with the market.

Disney (DIS) also reported strong earnings growth across its major platform. We have been saying for some time that CEO Bob Iger’s job is to develop and creatively monetize Disney’s branded premium content across an ever changing and highly complex media landscape (Cable, Internet, Mobile etc). Recent results show his vision is working. Shares rose over 6.0% for the week.

Tyco International (TYC) reported continued progress in restructuring its operations as an independent company. Freed from the conglomerate overhang it will have the ability to right size the capital structure, cut costs and put forth the right initiatives to drive meaningful organic growth. Its undervaluation stems from investors having a ‘show me first’ attitude, but once it becomes evident the turnaround is complete, shares will be much higher.

Thank you. We welcome your comments.

Gerry Mihalick, CFA

The views expressed in this commentary 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. 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 action 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

Good afternoon. Here is an update on an “interesting” week.

After a rough start to the week markets moved up sharply from the lows set Tuesday morning, thanks largely to a 75 basis point rate cut by the Fed and a rebound from very over-sold levels. Good earnings from Microsoft and Honeywell as well as a nice rebound in selected financials are driving solid performance and an increase in values. Through Thursday night, Berkshire equity portfolios were UP (for the WEEK) approximately 3.3% vs. the SP 500’s gain of 2.2%.More…

Big Picture Perspective on Recent Market Activity:

The root causes of the market turmoil stem from poor capital allocation decisions made by investors in the following areas:

1. Abuses in the sub-prime mortgage market
2. Imprudent proliferation of derivative securities created from sub-prime loans
3. Too much leverage in the system: investors, hedge funds, financial institutions
4. Too much speculation in real estate
5. The thought that emerging markets are no more risky than that of the US and other developed markets
1. “Decoupling:” The notion that Asian economies can continue rapid growth while the US falters. This notion has also led investors to the false conclusion that energy and commodity stocks are no longer cyclical.
6. Leveraged Buyouts: What once was the domain of skilled investors who actually built value became a haven for nothing more than corporate “flippers”

What is the common theme? In almost all 6 cases it boils down to a COLLASSAL mis-pricing of risk by investors. They did not adequately asses the risk and did not demand a high enough return for it. The result is prices of risky assets such as stocks, lower quality debt instruments and commodities have moved sharply lower so as to restore the risk/reward profile toward more normal levels.

Diversification:

It is also worth noting, that during this latest correction, it is again apparent that simply owning countless stocks across multiple styles, capitalizations and geographies is not a panacea. History has shown time and time again that correlations (the degree to which stocks move together) rise during times of market panic, and diversification fails precisely when it is needed most. The only way to circumvent intolerable declines is the right mix of high quality bonds or to be short the market.

Outlook:

We do not believe the US equity markets or the economy is permanently impaired. We also do not believe the US financial system is headed for a Japanese style deflationary cycle.

Financial stocks may be in for a rough patch, but there are some positives which justify our continued allocation.

§ Financial institutions have been aggressively writing down bad loans.

§ They are rebuilding their balance sheets with tangible (albeit somewhat expensive) capital. Recapitalizing is the first step to recovery

§ Boards are aggressively implanting stronger management teams. Citigroup, Bear Stearns, Merrill Lynch, Countrywide (via acquisition by Bank of America) have essentially gone through a change in control

§ The profit margin for lending is getting more attractive (via a steeper yield curve)

§ Rate cuts by the Fed

§ Compelling valuation cases can be made for many financial stocks. They are not without risk, but the pay-off is quite high.

While financials have borne the brunt, most of our portfolio has little to do with the latest headlines, the cyclicality of the economy, or the decline in the market. If they do possess a cyclical component, a recession will not likely affect their long term value. Temporary, irrational declines in the likes of DIRECTV, Johnson and Johnson, General Mills, Cisco, Intel or Microsoft (just to name a few) will more likely mean opportunity, not risk.

View of Current Market Psychology:

In the final analysis, its greed and fear that move markets.

Its obvious investors have been “selling risk” (stocks, commodities, high yield bonds) en masse and “buying safety” (US Treasuries). Investors have gone from complacent to extremely fearful. Times of maximum fear and capitulation selling has usually proved a good time to either stay the course or increase commitments to equities. Decades of experience bear this out.

A long term value oriented investor must adhere to the adage: “if it’s in the papers, it’s in the price.” With “24/7” style financial news coverage, blogs, the internet, this has never been more true. Since drama sells air-time, we definitely believe the media can amplify both good and bad economic news. In any event, the problems facing our economy are now well documented, on the table, and now largely discounted in equity prices – perhaps unjustly so.

Finally, while this credit crisis has been a large shock to the system, there have been many seemingly insurmountable challenges to our market and our economy: Cold War, Cuban Missile Crisis, 197o’s Oil Shock, Iran Hostage Crisis, 1987 Stock Market Crash, the Blow up at Long Term Capital, Russian Debt Crisis, Asian Currency Crisis, 9-11, Enron Accounting Scandals, you name it.

At the time, these problems all seemed insurmountable. What’s more these “hundred year floods” seem to occur once or twice a decade. It just comes with the territory of equity market investing and the reward it offers. This volatility is NOT new (yet it never seems to get easier!). We will continue to find ways to use it to your advantage.

The views expressed in this commentary 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. 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 action 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