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Given the ongoing global challenges, numerous impediments to economic growth, and a long-term deleveraging process, why do we continue to favor stocks for long term investors? The answer is that history has demonstrated (regardless of the economic backdrop) that well run businesses, with sustainable above average returns on capital, purchased at attractive valuations, deliver solid returns to shareholders over time. The next several months or quarters will likely continue to be volatile, but we are confident about the long term prospects of the stocks we own.

If that is true, then why has the S&P delivered such meager investment returns (less than 3% annualized returns) over the past 10 years? Because (1) the S&P was overvalued 10 years ago, trading at 25x its price to earnings “P/E ratio” and (2) the S&P is comprised of 500 companies, not all of which have good returns. As a result, many of the stocks in the index have generated handsome returns over that same 10 year period despite a weak overall market.

Stock picking matters in a volatile environment

2011 offers a similar lesson in divergent returns between the overall stock market and those of high quality businesses purchased at attractive valuations. Despite double digit EPS growth for the S&P in 2011, the index price was flat for the year with the entire shareholder return (+2.1%) coming from dividends. The trailing P/E for the S&P contracted from 15xto 12.5x during the year as investors grew skeptical of the sustainability of peak margins and global economic growth.

While the overall market offered little in the way of returns in 2011, many of our stocks performed quite well. Several stocks in our portfolio generated total returns of 10% or more despite the S&P returning just 2.1%. In a volatile, range bound market, stock picking and judicious management of risk (sector exposures, position sizes, conservatism in earnings estimates and valuation assumptions) are paramount to delivering good investor returns.

As always, these are key tenets of our investment process that provide some comfort in our ability to buy assets that we view as attractively valued even in the context of our cautious world view. This conservative approach informs what we buy, what we sell, and what we avoid. In aggregate, we believe that our stocks have less exposure to margin/EPS risk, cheaper valuations, and consistent economic returns versus the S&P.

Volatility and correlations create opportunity

We expect continued volatility in stock prices during 2012 and we will take advantage and be opportunistic in increasing client exposure to quality businesses at attractive valuations as we did during the volatility in 2011 – we purchased Berkshire Hathaway, Wells Fargo, Devon Energy, and added to McCormick positions during the heightened volatility in the 2nd half of the year.

In addition to volatility, the historically high (stock price) correlations that we have been witnessing in the past couple of years are likely to continue as the ongoing structural challenges of the world drive the “risk-on/risk-off ” market action. This dynamic creates an advantage for dedicated stock pickers as it provides opportunities to buy new positions (and add to existing ones) when stocks are selling off broadly and indiscriminately. Conversely, when stock prices are broadly increasing with high correlations, it offers us opportunities to take gains and sell stocks when they reach full valuations.

Low interest rates are supportive of equity valuations

The Federal Reserve has promised a low Federal Funds rate through mid 2014, which is a positive for equity valuations as the low return opportunity from cash and bonds (with no inflation protection) makes certain equities more attractive – particularly those offering current income via dividends. In addition, strong businesses with solid balance sheets, robust cash flow generation, above average returns on capital, and pricing power are poised to deliver superior investment returns (regardless of inflation, deflation or macro outcomes) than most asset classes.

Dividends Matter

Over the past eight decades dividends have accounted for approximately 50% of the total return from stocks. Many of the stocks we own pay dividends that are well supported by strong balance sheets and cash flows. In addition, these dividend payers have increased their dividends by 10% per year on average over the past 5 years versus just 0.5% growth for the S&P. Given the strength of our company’s balance sheets and cash flows, we expect further dividend growth and share repurchases to help drive future returns even without higher valuations. The compounding of significantly higher dividend growth can drive substantial outperformance over time.

What about inflation or deflation?

Our base case assumption with regard to inflation versus deflation is that we are in for a prolonged period of low inflation. We do, however, expect episodic spikes in inflation driven by easy monetary policy (ie QE2) with the potential for much higher inflation over the longer term.

With this backdrop over the next couple of years, we feel confident about the real (after inflation) return prospects for our stocks which, in aggregate, offer a dividend yield of over 2% plus upside from the equity price and future dividend growth. This compares quite favorably to 5 year treasuries which yield less than 1%, resulting in a negative real yield. In an inflationary environment we also favor the stocks we own versus treasuries or cash as they offer more protection via dividends, pricing power, dominant market positions, and stable excess cash flows to mitigate the effects of broad based inflation.

Why not go to all cash or all bonds and wait for stocks to get cheaper?

Investors often wonder if the time is right to “time the market.” Our fundamental view is that being disciplined in our purchase and sale of individual equities, maintaining a long time horizon, and employing a dynamic risk management and portfolio construction approach will yield the best results over a full market cycle (3-5 years). Increased cash levels are a by-product of our investment process or stocks reaching full valuation. Long term average annual equity returns (8% after inflation) are evidence that one need not attempt to time the market to make great returns over the long term, regardless of market cycles and volatility.

Despite the challenging economic environment and volatility over the past three years, the S&P has delivered a 48.6% total return while investors have pulled approximately $87 billion from stock funds since the spring of 2009. This recent period is a great example of the challenges of timing the market no matter how obvious the economic evidence may appear in support of selling stocks.

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