05 May 2010 Century Management Advisors - Q1 2010 Commentary ( Portfolio )
What a difference a year makes. The stock market’s mood has gone from deep despair and hopelessness to exhilaration in just 12 months. All in all, our fiscal year ended February 28, 2010 was an extraordinary year, particularly in light of where we started. Nevertheless, given the depth and severity of the market downturn we experienced the prior 18 months, we know that we still have some ground to make up.

One important aspect of value investing is to recognize that investors do not always behave rationally, especially when confronted with financial stress and uncertainty. This is understandable as this is part of human nature. However, when it comes to investments, we have found that many investors do not fully understand the intrinsic values of the businesses they own (i.e. stocks), and without this knowledge, investors are often seen buying and selling companies on emotion rather than on fundamental analysis.

One of the areas many investors are worried about is inflation because the Federal Reserve (the “Fed”) has been expanding the money supply to historic levels. While we agree inflation may be an issue to deal with in the next four to five years and beyond, it is not a major concern of ours today. Furthermore, when inflation does increase, we do not believe it will be like the 1970’s and early 1980’s when inflation reached 10% to 13%. One of the reasons we feel this way is that the velocity of money (as measured relative to M0, the monetary base) continues to decline, albeit at a slower rate.

In a deleveraging recession, banks have taken on too much risk and must reduce their liabilities as assets decline due to loan losses. To do this they have only a few options: hold more reserves by lending less, sell assets, or raise equity capital. In a deleveraging period, banks use all three options to the extent that they can. The excess liquidity provided by the central bank allows banks to extinguish bad loans more quickly than they could otherwise. This deleveraging process can last several years and will not result in credit expansion until most of these losses have been realized. Furthermore, if the central bank withdraws money from the system as bank balance sheets improve, then inflation need not result.

Another argument for low inflation today is unemployment. With unemployment in the 9% to 10% range, there is little, if any, inflationary pressure coming from rising wages.

We also continue to see a low level of capacity utilization in the U.S. economy as well as around the world. With countries such as China continuing to add capacity to the global manufacturing base, in addition to the slow growing economy here at home, there is little, if any, inflationary pressure in the U.S. from our manufacturing sector. To put it another way, because of the extra capacity to produce goods around the globe, manufacturers in the current economic climate do not have the pricing power

Since the early 1980’s, interest rates have been in a secular decline. The trend has been to take on additional debt during expansions and then consolidate and refinance this debt during downturns. This cycle of rolling over and refinancing ever larger amounts of debt has occurred over the past 30 years because interest rates have continued to trend lower. As a result of this cycle, businesses and consumers have not only been able to roll over their debt every few years, but in the process have pulled out additional cash flows and continued to spend. At today’s 40-year low interest rate levels and with banks not as eager to make new loans, many companies and consumers are finding it more difficult to roll over their debt and free up additional cash flows. This will have a muted effect on the economy for at least the next several years.

In our opinion, the most important portfolio characteristic of the CM Advisers Fund we would like to bring to your attention is the value comparison between stocks and bonds. It is important to remember that stocks and bonds are always in competition for investor’s capital. By dividing the earnings of a company by the price of the stock, we can compare its yield to that of various bonds to see which security offers the better potential return on investment. At the CM Advisers Fund’s fiscal year-end (February 28, 2010), Moody’s AAA corporate bonds had an average yield of 5.26%, Moody’s Baa corporate bonds had an average yield of 6.28% (Moody’s Baa rating is considered to be the lowest level of investment grade bonds), and the 10-year U.S Treasury bond had a yield of just 3.61%. Each of these bond yields is lower than the current earnings yield shareholders are receiving by owning the CM Advisers Fund today. But here is the real opportunity -- bond coupons do not grow. However, over time, most corporate earnings grow. If we add the growth in earnings discussed on the previous table to the earnings yield of 6.45%, shareholders can get a very good idea of the potential value that is being held inside the CM Advisers Fund.