Barclays sees inflation ahead for consumers in China, India and the United States. Legend Financial Advisors says that the U.S. economy could suffer if the government cuts spending.  GMO is betting against the U.S. stock market. Ron Baron is bullish. 

Julian Callow, Barclays

At a global level, policymakers continue to be confronted by a diverse and dynamic set of challenges, some of them global in nature, others more regional or country-specific. We continue to emphasise the importance of sound communication across the G20 to ensure that policy remains appropriately positioned and adjusted at this potentially hazardous time. In our view, and despite the recent correction in global commodity prices, inflation pressures continue to lurk at the global level, although the intensity varies considerably across countries. In our view, general risks to commodity prices remain upward; one recent development has been evidence of a growing drought in northern Europe, which seems likely to add further upward pressure to food prices. The general rise in core consumer goods producer prices) most likely indicates the significance of commodity price pressures working through the producer chain. Note that this series is at a record high in China, which is also experiencing substantial increases in minimum wages as the government seeks to expand the labour share of income. Hence, China at present cannot be considered a source of deflation. This is also evident in US statistics, which are showing a renewed upward trend in prices for goods imported from Asia.  It is likely that the general rise in core consumer goods inflation at the producer level will work its way, to varying degrees, through to consumers. This is particularly apparent in China, where the overall CPI excluding food has risen to 2.7%, the highest since the 1990s: this week we raised our China 2011 CPI projection from 4.3% to 4.6%. Likewise, India is recording substantial inflation for manufactured products, up 6.2% y/y in the March WPI. Among the advanced economies, the UK remains something of an outlier: the BoE this week again raised its inflation forecast despite downgrading its GDP projection, and does not expect CPI inflation to return to target until 2013. Elsewhere, pass-through so far has been more muted: in the euro area, core goods HICP inflation rose to 1.4% in March, probably higher in April (and up from 1.1% in 2010, although the increase stems partly from some statistical changes). In the US, the CPI inflation rate for commodities ex. food and energy has been moving higher, and reached 0.7% y/y in April, while, Japanese core CPI goods prices are still falling (albeit at a lessening rate).   While the core inflation data show mixed trends for pass-through, policymakers are also facing mixed signs from the activity indicators. In the past week, Chinese industrial production for April surprised to the downside, whereas activity data from India (production), Taiwan (exports) and Korea (labour market) were strong. Across emerging Asia, central banks remain focused on containing inflation - see Outlook (p29). In the euro area, GDP in Q1 was in line with our above-consensus forecast of 0.8% q/q (i.e. 3.4% saar), much stronger than the US, UK and Japan. While a mild winter helped, nonetheless this was a resilient result (particularly for the core countries), given that both the euro and oil prices rose in Q1 and that many countries intensified the pace of fiscal consolidation. In contrast, the comparative weakness in US GDP growth in Q1 (tracking at around 2.0% saar, despite the tax cuts) reflects much greater demand sensitivity to energy prices.  Nonetheless, the euro area is likely to decelerate from Q2 onwards, in our view. Already there are some signs of slowdown, with a significant drop in April auto registrations, and the March correction in German new industrial orders. It is likely that the euro appreciation will tend to make itself felt during the next six months. Additionally, the crisis in certain sovereign debt markets casts a long shadow over the financial sector.  We consider that while 2011 may be too early for Greece to restructure, this argument is diminishing in force given the inability of Greece to reduce its budget deficit and engage in ongoing structural reforms at the pace required under last year’s IMF programme. Hence a restructuring, in some form, of Greek debt next year is now, we consider, a likely scenario for H1 12. The reasons for some delay would be: first, to give Greece more scope to reduce its primary deficit (which last year was at 4.9% of GDP) and second, to offer Ireland and Portugal some time to prove their abilities to avoid also restructuring their debt. Even so, a Greek debt restructuring would not necessarily have to involve haircuts: rather, by a substantial lengthening of maturities and cutting of interest payments, a “re-scheduling” could be undertaken to bring about a significant reduction in NPV without necessarily forcing banks to mark down positions held on their non-trading books. Nonetheless, such action would still require a very substantial new capital infusion into the Greek banking sector, whose holdings of Greek government debt (around €47bn in March) are approximately equal in size to its capital and reserves (€44bn).  Euro area cross shareholdings of Greek debt are substantial. Cross shareholdings are also substantial for Portuguese, Irish and Spanish debt. In this context, contagion risks are substantial, and therefore, in our view, the ECB needs to tread very cautiously in terms of normalisation of its monetary policy and non-standard operations.

Louis P. Stanasolovich, Legend Financial Advisors, Inc, Risk-Controlled Investing 

Quitting Budget Deficit Spending Could Cause More Severe Economic Problems.

The current debate in Washington is how to decrease the budget deficit. To take the discussion a step further, many think the Federal Reserve Board (Fed) should permanently end the Quantitative Easing II (QEII) program. Given the Fed’s decision to end QEII in June with the exception of reinvest­ing interest, this decision may not help the U.S. economy in the long run. The ending of QEII coupled with the budget spending cuts look good on paper but may cause us to re-enter a recession, due to the fact that the cur­rent spending pattern and financing of the resulting budget deficit has kept the U.S. economy on life support for the past two years. In fact, take away these stimulus programs, (meaning cut spending and balance the budget – yes we know that thought is laughable) their sheer impact would cause the economy to shrink in excess of two trillion dollars out of a total economy of $14.5 trillion. The bottom line is we would probably be in at least a severe recession [Gross Domestic Product (GDP) shrinks by 5.0% to 10.0%] or a depression (GDP shrinks by 10.0% to 25.0%). By comparison, during the so called “Great Recession” of December 2007 through June of 2009 GDP only shrunk 4.2%. Obviously, based upon past history (see the writings below by our friends from Caldwell & Orkin) the government will need to ease into such cuts in spending.  What complicates matters is that one tril­lion dollar deficits appear to be on the hori­zon for at least the next decade unless our politicians can figure out a way to stimulate the economy to drive GDP growth from 0.0% to 2.0% to mid-to-high single digit growth rates. Since the financial smoke and mirrors approach isn’t working, how about building infrastructure? China has double digit growth almost yearly. How? Simple! They are planning on spend­ing three trillion dollars on infrastructure spending over the next three years alone. Their annual total GDP is approximately eight trillion dollars. That amount of spending on a percentage basis will have a large impact on any economy. Further­more, infrastructure improvement lasts a long, long time.

Operating within one’s budget is admi­rable, but quitting deficits cold-turkey can have its drawbacks. In 1936, after four years of growth coming out of the Depression, the Federal Reserve (Fed) became concerned over the growing level of excess reserves in the banking system. Fearing a rapid increase in lending that they believed could lead to an outbreak of inflation, the Fed raised reserve require­ments. At the same time, new taxes were being levied to pay for Social Security. This was in fact a monetary tightening which caused a double-dip depression. The difference between then and now is that our current economic system is laboring under a much greater amount of leverage than it was back in the 1930s. RCI Comment: Growth is key long-term to remedy our economic ills. In order to be a high-growth economy again, we need to address our debt problem as well. 

Jeremy Grantham, GMO

Time To Be Serious (and probably too early) Once Again The Bottom Line

Lighten up on risk-taking now and don't wait for October 1 as previously recommended. But, as always, if you listen to my advice, be prepared to be early! A word on being too early in investing: if you are a value manager, you buy cheap assets. If you are very “experienced,” a euphemism for having suffered many setbacks, you try hard to reserve your big bets for when assets are very cheap. But even then, unless you are incredibly lucky, you will run into extraordinarily cheap, even bizarrely cheap, assets from time to time, and when that happens you will have owned them for quite a while already and will be dripping in red ink. If the market were feeling kind, it would become obviously misvalued in some area and then, after you had taken a moderate position, it would move back to normal. That would be very pleasant and easy to manage. But my career, like most of yours, has been filled with an unusual number of real outliers. That certainly makes for excitement, but it also delivers real pain for even a disciplined value manager. Following is a snapshot of some of those outliers. In 1974, the U.S. market fell to seven times earnings and the U.S. value/growth spread hit what looked like a 3-sigma (700-year) event. U.S. small caps fell to their largest discount in history, yet by 1984 U.S. small caps sold at a premium for the fi rst time ever. By 1989, the Japanese market peaked at 65 times earnings, having never been over 25 times before that cycle! In 1994, emerging market debt yielded 14 points above U.S. Treasuries, and by 2007 had fallen to a record low of below 2 points. By 1999, the S&P was famously at 35 times peak earnings; in 2000, the value/growth spread equaled its incredible record of 1974 (that I, at the time, would have almost bet my life against ever happening again). Equally improbable, in 2000, the U.S. small/large spread beat its 1974 record and emerging market equities had a 12 percentage point gap over the S&P 500 on our 10-year forecast (+10.8 versus -1.1%). Further, as the S&P 500 peaked in unattractiveness, the yield on the new TIPS (U.S. Government Infl ation Protected Bonds) peaked in attractiveness at over 4.3% yield and REIT yields peaked at 9.5%. Truly bizarre. By 2007, the whole world was reveling in a risk-taking orgy and U.S. housing had experienced its fi rst-ever nationwide bubble, which also reached a 3-sigma, 1-in-700-year level (still missed, naturally, by “The Ben Bernank”). Perhaps something was changing in the asset world to have caused so many outliers in the last 35 years. Who knows? The result, though, for value players, or at least those who wanted to do more than just tickle the problem, was overpriced markets that frightened them out and then, like the bunny with the drum, just kept going and going. Well, those dramatic opportunities certainly hooked me, and I jumped enthusiastically into every one and was, of course, too early. Some of them went from looking like 1-in-40-year opportunities to 1-in-700! So, I have had a long and ignoble history of being early on market calls, and on two occasions damaged the financial well-being of two separate companies – Batterymarch and GMO. On the other hand, at long and bloody last (in the fi gurative, not the British, sense), the big bets we made have all been won, with quality and cash still pending. But, as I like to say, we often arrive at the winning post with good long-term results and less absolute volatility than most, but not necessarily with the same clients that we started out with. Our bets have been part of the public record for the last 20 years and before that the bets (including those made while I was at Batterymarch) were so big that no one could have missed them: while at Batterymarch in 1972, betting (two years too early) on small cap value against the “nifty-fi fty” IBM types (and with 100% of the portfolio!); betting against Japan three years too early in 1986 (as in zero percent Japan against 60% in the benchmark!); betting against the Tech bubble, two and a half years too early, and against the recent Housing and Risk-taking Bubble, much less painfully but, once again, two years too early. But, what I really want to emphasize today is my current opportunity to be two years too early once again by betting against the broad U.S. market. As readers know, driven by my increasing dislike for being early by such substantial margins, I have been experimenting recently with going with the fl ow. In defense of this improper behavior, rest assured that it was motivated not by chasing momentum, but by my growing recognition of the immense power – sometimes the thoroughly dangerous power – of the Fed. Nowhere is this power more clearly revealed than in the ease with which it can move asset prices, particularly stock prices, and nowhere is this revealed more clearly than in Year 3 of the Presidential Cycle. I will not infl ict on you once again the amazingly lopsided results of the Cycle, but will take this opportunity to introduce my new pet variant of Year 3 power: “Sell in May and go away.” This nugget came up recently, so we tested it. Bingo! In the fi rst seven months of the third year since 1960, Year 3 has returned 2.5% per month for a total of 20% real (after infl ation adjustment). In contrast, the second fi ve months after May have delivered an average return of 0.5% per month, as does the fourth year of the cycle. Now, 20% is perilously close to the total for the whole 48-month cycle of 21%. This means, of course, that the remaining 41 months collectively return a princely 1%. This offers a brilliant, lazy investor’s rule: “Sell in May of Year 3 and go away for 41 months.” Whoopee! The unfortunate caveat is that there are only 11 entries for this analysis so it may well be pure luck. Still, it’s intriguing, especially if you like sitting on the beach for 41 months. In addition to entering Year 3 last October, we also had Bernanke’s QE2 … a kind of underlining of the seemingly eternal promise of a bailout should something go wrong, as if Noah had been sent not just one rainbow, but two! So, even though the market was substantially overpriced by last October 1, I found myself atypically writing that it was likely that the market would race up to the 1400 to 1600 range on the S&P 500 by October 1. Of course – I hasten to add – I emphasized the caveat that more serious, risk-averse, long-term investors would not want to play fast and loose with a market then worth only 900 on the S&P. I also added that GMO played pretty strictly by the value book for our clients, shading only a little here and a little there. But I personally (no doubt driven mad by the tooearly syndrome) took a little more risk in honor, as it were, of the Fed’s behavior. Behavior I, of course, completely disapprove of. But that’s an old story. Well, believe it or not, the third year has behaved perfectly for the fi rst seven months. At the end of April, the S&P had offered up 21% in total return. And the market at 1360 needs just a 3% rise to reach my lower limit of 1400 in the fi ve months remaining. All of this has occurred as if everything is normal: as if the economy is recovering strongly, as if the housing market has started to regroup after an unprecedented two years fl at on its back, and, most importantly, as if special and exogenous shocks have not tried to tag-team Year 3. Yet, all of those presumptions are at least partly wrong. In fact, it is beginning to feel like an unfair contest. One minute we have the Year 3 effect chugging along, with us Pavlovian investors responding faithfully to the Fed. The next minute we are dealing with not one, but two, exogenous shocks: the Tunisia-Egypt-Libya-Yemen-Syria shock and the dreadful tsunami shock. In general, exogenous shocks famously have little effect after the fi rst few days (or occasionally weeks) of exaggerated psychological sell-offs. The painful exception to this rule is, unfortunately for us now, an oil shock. (Happily, there have been only two bad ones – in 1974 and 1979 – as well as two or three scares.) An oil shock is like a tax on business and a tax on consumers. It quickly transfers wealth to often undesirable government coffers and poses a “recycling” of wealth problem. It will usually depress consumer demand quite quickly as gasoline prices rise; it will usually depress GDP growth, generally a little later; and it will always unsettle business confi dence. The stock market, perhaps anticipating this, has declined rapidly and severely when it has sensed a serious oil crisis. Yet this time the market bounced back with the Year 3 effect winning handily. But doesn’t the current situation there clearly reduce any certainties about the Mediterranean Arab world (which have, in any case, never been that high)? Can’t this crisis clearly spread to Saudi Arabia or other Gulf states sooner or later? For once, in my opinion, the short-term effect is underestimating the potential for trouble – a real testimonial to the Year 3 confi dence (and speculation) effect.  Immediately after the market bounced back from the oil shock, it was met by the Japanese disaster. Bear in mind that catastrophes of this type historically have particularly little negative long-term effects on markets. They do, however, have a greater impact than the so-called broken window effect: disasters can galvanize politicians, governments, and the general public far beyond the short-term job-creating replacement effort. Immediately after 9/11, I wrote that the actual GDP effect (as compared to the human cost) would be negligible and that the Fed’s response would almost certainly cause the economy to be stronger than it would otherwise have been. I think, with hindsight, that this was correct. But, and this is a big “but,” the Japanese damage is unprecedentedly high and some of it will be long-lasting.

More importantly for the rest of the world, Japan has long tentacles and we are now rediscovering just how interconnected and interrelated the world has become. The Japanese are important, near-monopoly suppliers of certain small parts, without which whole production lines can be brought to a standstill. And the global industrial system does not have the resilience it once had: the Japanese have taught us all to have lean and mean “just-in-time” inventories, just in time for deliveries to be cut off, revealing one of the troubling vulnerabilities of that approach. In reaction to this second shock, the market shook its head like a prizefi ghter after having taken a thunderous right to the chin, and rallied back once again to its high. But we have at least another round to go as we must now face what might be called “the Bill Gross” effect. Bill invites us to consider the consequences of QE2 ending on June 30 and, perhaps with more impact, lets us know that he at least is nervous enough to completely bail out of U.S. government bonds, not wanting to fi nd out who will replace the Fed as the most recent buyer of last resort. As if even that wasn’t enough, the relentless rise in resource prices is beginning to act as an economic drag as a primary effect and, as a secondary effect, it is causing infl ation pressures to increase, particularly in developing countries. This infl ationary pressure is being met in those countries by efforts to cool economies down, notably by interest rate increases. These more restrictive moves in developing countries might soon begin to affect business confi dence in the developed world. But, even given all of this, the S&P merely wobbles a bit and then moves on to new recovery highs, helped perhaps by (fi nally!) some better news on hiring. The U.S. market’s strong performance under these pressures leads us to the question as to whether it would have been even higher had it not had to absorb these several blows? I would guess it might be up to 5% higher had it been left alone, and no one will ever prove me wrong! So, we have four factors working against the Fed effect (or 41/4, counting my more lightweight “sell-in-May” factor, which suggests that all of the normal Year 3 exceptional performance may have been delivered already). With these headwinds, I do not feel the same degree of confi dence that I did, which was considerable, that the Fed could carry all before it until October 1 of this year. A third round of quantitative easing would very probably keep the speculative game going. But without a QE3, there seem to be too many unexpected (indeed unexpectable) special factors weighing against risk-taking in these overpriced times. I had recommended taking a little more risk than was justifi ed by value alone in honor of Year 3, QE2, and the Fed in general. Risk now should be more refl ective of an investment world that has stocks selling at 40% over fair value (about 920 on the S&P 500) and fixed income, manipulated by the Fed, also badly overpriced. Although the taking of some “extra” risk by riding the Fed’s coattails has been profi table for six months, I admit to being a bit disappointed: I really felt the market had the Fed’s wind in its sails and would move up deep into the 1400 to 1600 range by October 1, where it would be, once again, over a 2-sigma 1-in-44-year event, or, offi cially, a bubble. (At least in a world where GMO is the offi cial.) At such a level, I was ready to be a real hero and absolutely batten down the hatches, become extremely conservative, and be prepared to tough out any further market advance (which, with my record, would be highly likely!). The market may still get to, say, 1500 before October, but I doubt it, especially without a QE3, although the chance of going up a little more by October 1 is probably still better than even. And whether it will reach 1500 or not, the environment has simply become too risky to justify prudent investors hanging around, hoping to get lucky. So now is not the time to fl oat along with the Fed, but to fi ght it. Investors should take a hard-nosed value approach, which at GMO means having substantial cash reserves around a base of high quality blue chips and emerging market equities, both of which have semi-respectable real imputed returns of over 4% real on our 7-year forecast. The GMO position has also taken a few more percentage points of equity risk off the table.


GMO also has, in asset allocation accounts where it is appropriate, increased exposure to Japan, which we had thought, pre-troubles, was relatively attractive. More precisely, we had thought it was at least average if nothing much changed, but that it represented some free options on several promising changes: improved attitude to shareholders, more focus on improving profi tability, and, in particular, less casual capital overinvestment. There are some favorable signs that a change could be beginning. The tsunami also presented a typical short-term overreaction. The ensuing write-down of assets may equal the equivalent of up to 5% of Japan’s GDP (which would be far more than usual), but even such a large cost would lower the present value of Japanese stocks by substantially less than that, let alone the 20% discount that was offered. Critically, the recent disasters may, just may, act as a psychological and economic shock, which, 30 years from now, may be seen as a turning point for the better.


Careful readers will remember that I mentioned the odd characteristic that usually, late in very substantial bull markets, boring blue chips start to win as investors get nervous but can’t bring themselves to stop dancing. Well, since March 31 the S&P is up by 2%, the Russell 2000 is down by 1%, and our Quality Strategy is up by 5%!1 I know that one swallow ordinarily doesn’t make a summer, but I wish this time that it would.

Longer-term Recommendations: No Change

My very long-term personal recommendations remain the same: forestry and good agricultural land, “stuff in the ground,” and resource effi ciency plays. The caveats on entry point risk have recently been mentioned.2 Should commodities crash in the near term because of good weather, problems in China, or both, I think it will create another “investment opportunity of a lifetime,” much like the several we have had in recent years.

Post Script: Financial Skullduggery As a postscript, I would like to recommend one movie and one magazine article. The movie, “Inside Job,” was directed by Charles Ferguson and won this year’s Oscar for best documentary. It covers the fi nancial crash and in it you will see some of the highest-quality squirming in the history of fi lm. I cheered and booed the cast of characters, the fi rst time I’ve done so since my Saturday morning movie club when I was seven. In my opinion, it is nearly spot-on and absolutely priceless, but just a little hard on Martin Feldstein, who seems an innocent bystander. The rest deserve what they get. Ferguson’s Oscar acceptance speech basically asked, “Why has no one gone to jail?” Good question. Matt Taibbi, the Rolling Stone Magazine journalist of vampire squid fame, has written a jaw-dropping piece on some of the sloppiness of the Fed’s bailout money. (More Fed transparency seems an excellent idea to me too.) It tells, among other things, of some “Wall Street wives” getting loans of some $220 million from the Fed, and using the borrowed money to make investments guaranteed by the Fed – essentially risk free. Why, you may well ask? The chutzpah of these powerful guys is admirable. Their ethics less so. At least they are nice to their wives; probably their dogs, too.3 GMO has not checked the data in any detail. Finally, the recent Senate report on the fi nancial crash quoted me, to my extreme satisfaction, on this very topic of ethics – a theme that has resonated with Carl Levin, Tom Coburn, and their obviously hard-working staff (it’s 650 pages long). The quote is taken from my pleadings of last summer for banks to get out of proprietary trading, which I believe is unethical, unnecessary, a confl ict of interest, and costs institutions, including our clients, a ton of dough

Americans always do the right thing… after they exhaust all the other possibilities.” Sir Winston Churchill. 1945.  

Ron Baron, Baron Funds

Barons shareholders, institutional clients, friends and media often ask me, when conflicts between the Congress and the Executive Branch of our government have never seemed greater, how can you make long term investments in growth businesses? We believe there is always uncertainty. As Warren Buffett wrote in Berkshire Hathaway’s annual report, “No matter how serene today may be, tomorrow is always uncertain.” Think about the calm on September 10, 2001, the day before terror attacks on America; on October 18, 1987, the day before the stock market crashed; on November 21, 1963, the day before President Kennedy was assassinated; and on December 6, 1941, the day before the Japanese attacked Pearl Harbor. Goldman Sachs’ Chairman and CEO Lloyd Blankfein is optimistic about equity markets over the long term. He, like Buffett, believes everything tends to work out best when people are most concerned. We also think when others focus on the short term and stop doing investment research, attractive investment opportunities are created for the rest of us. Despite wide chasms between Democrats, Republicans and Tea Party members, it remains likely there will ultimately be compromise among our elected public servants in Congress to avoid government shutdowns. That in the long term our country will become more energy self sufficient because we will either develop our vast natural gas reserves or alternative fuels or simply use less energy in practical electric vehicles. That social service entitlements will be reformed however painful. That healthcare services will ultimately provide better outcomes at lower cost. That someday there will be peace again, at least for a period, and there will be a “peace dividend,” just like there was in 1989 after the Berlin Wall was torn down. On occasion, during my forty-one year career, which, still feels like it began last week, some analysts and investors have forecast accurately that credit markets would “freeze” and cause a financial panic. That sovereign nations would default on their obligations. That stock markets would crash. That the economy would enter recession. My friend, former Magellan portfolio manager Peter Lynch, recognized that if you make enough predictions, some will be accurate. Describing this phenomenon he remarked, “analysts have predicted nine of the past four recessions.” Individuals who have accurately predicted calamities during my career in some instances became famous for a period. When they continued to forecast “the end is nigh,” however, they disappeared into oblivion. During the past three months a number of analysts have received media attention reporting that municipalities in our nation are likely to default on their debt obligations. Goldman Sachs recently doubled its proprietary investments in municipal debt to $326 million. If I were a betting guy, which I am not, I would bet that Goldman made this investment based upon exhaustive and thorough research and based their investment upon the price of those securities compared to Goldman Sachs’ assessment of their risk and value… and will probably be right.

“A lot of good comes from 212% inflation.” Tom Kizor. Chief Financial Officer. United Inns. 1982.

In 1982, twelve years after beginning my analyst career, we founded Baron Capital. In that year, my institutional clients and I invested a significant percentage of our assets in United Inns. United Inns was a successful investment for us. United Inns at that time was the largest and most successful Holiday Inn franchisee. I found this surprising since United Inns’ founder was a dentist whom I did not find particularly impressive. I became friendly with Tom Kizor, United Inns’ Chief Financial Officer, who was then probably about my age today. Tom explained that United Inns began as a “tax sheltered investment” for Dr. Cockroft. “Tom, I don’t understand. Dr. Cockroft is a dentist, not a businessman. How did he manage to build such a large, profitable business? And, how did he do it part time?” “A lot of good things come from 21⁄2% annual inflation,” Tom explained. Tom and his family had survived The Great Depression in the 1930s and understood the pernicious and debilitating impact of deflation. I didn’t then. I do now. Moderate inflation helps businesses that own properties, like hotels, communications towers, hospitals, apartments, pipelines and offices, since it increases replacement costs every year. This makes it more difficult for others to compete against them. This is because businesses that build “green field” assets must earn higher revenues on those assets to justify construction risk and by definition they will not be the low cost provider. Such capital projects are most often financed with long-term debt at fixed annual interest costs. As a result, increases in daily hotel room rates caused by inflation boost those businesses’ revenues and profits. Higher revenue and profits enable debt that has financed construction of those properties to be repaid with dollars that are worth less than when they were borrowed to build those projects. Albert Einstein called compounded annual growth “the most powerful force in the universe!” Seemingly modest annual inflation increases result in large absolute price changes over time. This is the longterm effect of compounded annual growth. Annual asset inflation has been present not just in America but since ancient Rome and Greece when those governments sought to depreciate the value of their currencies by removing precious metals from their coins. We recently visited a memorabilia shop on the lower East Side of Manhattan to purchase a housewarming present for a friend. “The rising price of silver is a bad thing for my business’ current sales,” the store’s proprietor told us. “It makes it harder to sell goods since I need to sell what I own at replacement cost to be able to afford to replenish my inventories,” he remarked. “It takes a while before consumers get used to new prices. Inflation, however, makes what I own more valuable, of course.” It seems to me that nearly everything, except technology, is at least ten times as expensive as fifty years ago. My parents’ home in 1957 cost $20,000. That home today, even after three years of homes falling in value, is probably worth $250,000. My tuition when I graduated college in 1965 was $3,500. Tuition in private colleges today is often $45,000 per year. Couches today in many instances cost more than cars did then. When I got my drivers license in 1960, gasoline was $.25 per gallon. The gasoline station attendant would ask me, “Fill it up?” when I pulled up to the pump. Since I didn’t have a lot of money at that time, and I certainly didn’t want to invest the little I did have in gasoline inventory I didn’t need that day, I would reply, “No, thank you. Just four gallons, please.” Of course, looking back, I guess I’ve made a lot worse investments than a tankful of gasoline at 1960 prices! In our opinion, in an uncertain world, investments in well managed, appropriately financed growth businesses with important competitive advantages remain attractive investments for most diversified portfolios. Equity investments historically have generally offset the risks of currency devaluation, inflation, deflation, recession, wars and “asset bubbles.” Such investments have proven an attractive investment class when compared to credit, commodities and most other asset classes over the long term. For example, the Dow Jones Industrial Average was 500 during the Eisenhower recession in 1958. From that point a little more than fifty years ago to present, stocks, as measured by the Dow Jones, have increased in value approximately 25 times, about 6% per year. Cash and investments in fixed income securities over the same period have lost 90% of their purchasing power! This means that since 1958 cash has lost about 4% of its purchasing power per year. It is difficult to see why this will be much different during the next fifty years. Our government benefits when assets, businesses and our economy increase in value in nominal dollars. This is because our government’s existing debt obligations are fixed in nominal dollars and inflation will make it easier to repay those obligations. China Investment Company believes the dollar will continue to decline in value 4% annually for the foreseeable future. To maintain the purchasing power of China’s trillion dollar U.S. currency holdings, China Investment Company has established an 8% hurdle rate of return on its assets. That return has been achievable over the long term by investments in U.S. growth stocks. We think U.S. growth stocks will continue to offer returns that will provide attractive real rates of return. This is partly because we think businesses that can provide effective solutions for many of our nation’s problems have significant growth opportunities.

“Capital markets are again offering attractive financing rates and terms.” Leon Black. Chairman. Apollo Investment Advisers. April 2011.

In spring 2007, private equity firm Blackstone purchased office real estate trust Equity Office Properties for a record $42 billion. Developer Harry Macklowe shortly afterwards paid Blackstone $7 billion for several of the highest quality properties in that portfolio. Baron Funds has been an investor in Vornado and Alexander’s for many years. As a result, Mike Fascitelli, the CEO of both businesses, generally visits us once or twice a year to chat. A few months after the Equity Office Properties/ Blackstone/Macklowe transactions, Mike stopped by. He told us banks had since curtailed commercial and real estate lending. “Financial markets are frozen,” he noted, and property values had fallen sharply. This was because there was no financing to purchase buildings. “You couldn’t borrow $5 billion today against the buildings Harry purchased from Blackstone two months ago for $7 billion. Harry borrowed $7 billion short term to finance that purchase!” That misstep by the developer ultimately cost him his prized General Motors Building, the most valuable property in his portfolio. The impact on our economy was even more profound. Most believe frozen credit markets were a proximate cause of the financial panic that caused stock markets worldwide to decline throughout 2008 and crash in the Fall of that year following the bankruptcy of Lehman Brothers. Declining markets continued through early 2009. Until credit conditions then began to ease, many feared a second Great Depression that could have rivaled that of the 1930s. Credit conditions prevailing from 2007 through early 2009 when loans were nearly unattainable sharply contrast with those today. In fact, they now seem to us nearly the exact opposite of conditions which led to the financial panic of 2008- 2009 when credit markets “froze up.” Leon Black, Apollo Investment Advisor’s Chairman, during his “road show” presentations that preceded his company’s initial public offering a few weeks ago, described a vastly different commercial and real estate credit market that nearly caused disaster only two years ago. “Not only is credit available at attractive prices, LIBOR plus 250, but terms and covenants have become less restrictive as well. During last year’s yield-starved credit markets, there was a record $298 billion issuance of high yield bonds. Costs and terms unusually favorable to borrowers clearly show increased appetite for risk,” according to Leon. “You can’t arrange credit for $40 billion deals. But, it is available for $10 billion acquisitions.” It surprised me how quickly credit conditions had almost returned to what had been considered “normal” four years ago. When Leon left our office, we called Mike Fascitelli to confirm Leon’s observations. Mike said that real estate prices had fallen sharply for nearly three years from 2007 through 2009, before increasing almost 60% last year. The increase was due to accommodating credit markets amidst a recovering economy. Real estate prices remain about 20% below their 2007 peaks. Prices of property have increased in anticipation of improved operating profits. Real estate operating profits are now improving. A recent conversation with a good friend, Rich Handler, Chairman of institutional brokerage firm Jefferies and Company, confirmed how much credit conditions had improved. Rich described a series of transactions that I think you will consider remarkable. Following the September 2008 bankruptcy of Lehman Brothers, a Jefferies’ competitor, a financial panic ensued. In the midst of that panic, during the Spring of 2009, Rich repurchased on behalf of Jefferies $50-75 million face amount of its debt due 2012 at 35% of face value! Jefferies issued $700 million, ten year, 81⁄2% debt three months later at par! During 2010, Jefferies issued more than $1 billion additional debt at 67⁄8% for 11 years and 3.92% for five years. Also at par! When Rich asked me how Baron Funds were doing, I told him I thought our mutual funds have been performing well for the past two years because the businesses in which we have invested are doing well; their stocks don’t reflect this yet; and interest rates are so low.

“But, I keep looking over my shoulder thinking something bad is going to happen,” I said. Rich answered, “The reason you feel that way is because the unthinkable happened. You and everyone else will remember this for the rest of your lives and will continue to be afraid. That’s why stocks have been cheap. You have the wind at your back. Enjoy it.”

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