First Quarter 2011 Investment Commentary from South Shore Capital Advisors Cohasset

Provided below is the first quarter 2011 quartlerly investment comments from the South Shore Capital Advisors Cohasset Office. Since this piece was written in early April, there have been more positive data released relative to corporate performance in the U.S. Standard & Poor's pointed out recently that q1 2011 was the first quarter since q1 2006 where S&P 500 companies reported sales growth greather than +10% versus the prior year. The percentage of companies delivering positive surprise relative to expectations for earnings and sales growth also remains very favorable.

Investing Climate

Had I known in advance that the 1st quarter of 2011 would see the price of oil rise 17%, the price of gasoline at the pump rise from $2.82 to $3.85,[1] and the 10 Year Treasury bond yield rise from 3.30% to 3.47%, I would have reduced stock holdings and prepared for a pullback in the market. Had someone told me that there would be a major earthquake in Japan that would cut 0.5%[2] from Japanese GDP forecasts, and major political and social turmoil in northern Africa; I might have sold even more stock. Lacking such “good” information we purchased more stock for clients early in the quarter, and raised equity weightings, a move that turned out just fine given the S&P 500’s 5.42% advance.

Last quarter reminded us that it is hard to make accurate predictions, and harder still to make winning investment decisions based on such predictions. That is why we focus on fundamentals. We like stocks of companies with strong balance sheets and attractive levels of free cash flow. In the realm of bonds we look for individual issues or funds that offer an attractive real return and acceptable risk.

At the end of last quarter, I pointed out that stocks were still a good deal, particularly in relation to bonds, and were likely to be the better bet for price appreciation. I still feel that way. With Standard & Poor’s estimating 2011 earnings of $96.64[3], and an index close of 1324 on 4/11/11, the valuation of the S&P 500 remains reasonable at 13.7x earnings particularly given low inflation and interest rates.

Corporate performance remains strong as companies continue to beat earnings expectations amidst this unprecedented earnings recovery. According to Bloomberg, by mid summer 2011, profits will have recovered their entire 92% decline in 50 months. This compares to the 19 years it took for profits to recover from their 67% drop during the Great Depression.[4]

Extremely low real interest rates are a notable aspect of the current environment. Central banks have engineered this by keeping their policy rates low to stimulate economic activity. Just how low are they?

Right now there are only 5 countries in the G20 where a holder of the currency can make a cash return greater than the level of inflation. This was a key factor in our decision to purchase one year Australian Government bonds in mid February funding that with a sale of US Treasury Inflation Protected Securities that offer near record low real yields of -0.1% for a 5 year bond.[5] Those one year Aussie Bonds give us an almost 2% premium versus Australian inflation and very limited risk of principal loss from rising interest rates

Another purchase last quarter was the stock of Renaissance RE (RNR). A Bermuda based reinsurance company that is a traditionally profitable underwriter with a stock that was trading near book value. The company is engaged in a large effort to return capital to its shareholders through stock repurchases. From a starting point of January 1, 2010, it is likely that shareholders will see them return over 20% of their current $4.5 billion market capitalization through stock purchases. At the beginning of the year, the underwriting environment for property and catastrophe reinsurance was uncertain, but we bought the stock based on its valuation and the fact that the business generates a lot of cash that they are returning to shareholders. Since then, the market for P&C reinsurance has tightened because of the losses from the earthquake and tsunami in Japan. RNR will likely experience manageable losses from this, but will be able to charge higher premiums on new business as industry capital conditions tighten. In future quarters investment income RNR earns on its substantial cash balances should increase as real interest rates rise.

Worth mentioning here is AT&T, a stock that has been in portfolios for a long time. What drew us to AT&T was its dominant industry position in telecom, accompanied by a strong free cash flow yield of 10%, and a consistently growing wireless business. It has been a cheap stock for a long time because its wireline telephone business is in perpetual decline. What made it attractive were a growing wireless business and an affluent subscriber base who love their Iphones. In March, AT&T announced the purchase of T Mobile from Deutsche Telecom – the deal will transform the company from a 50/50 wireless/wireline TelCo to a truly wireless-first carrier that receives 80% of its revenue from wireless and wireless data. Spectrum acquired from T-Mobile will position the company for long term revenue growth and cost savings from the deal will fund faster future earnings growth.[6]

Looking ahead, many folks are inclined to worry about what impact the end of the Federal Reserve Quantitative Easing 2 program will have. I am among this group. But as pointed out earlier in the letter, departing from a focus on fundamentals may not be productive. Therefore, over the coming months I expect to continue to monitor the business performance of our current holdings while watching for new opportunities and keeping duration short in the bond portfolio because I do want to be prepared for rising interest rates.

Please feel free call me if you have any questions.

Sincerely,

Taylor Thomas
Principal


[1] Federal Reserve Bank of Dallas, Quarterly Energy Update, 1Q 2011
[2] Credit Suisse Japanese GDP Growth Forecast, 4/7/2011
[3] Standard and Poor’s Estimate
[4] Bloomberg, Rita Nazareth and Michael Patterson, April 4th, 2011
[5] Us Treasury.Gov Daily Treasury Real Yield Curve Rates for 4/12/11
[6] Sanford Bernstein Research





As of 5/19/2011 South Shore Capital Advisors clients and its employees are holders of Rennaissance Reinsurance and AT&T. This content is provided for information purposes only and is not intended as research. Investing involves the risk of loss. South Shore Capital Advisors is a boutique registered investment advisory firm with offices in Cohasset MA, and Newport, R.I. For more information about South Shore Capital Advisors go to the link "About South Shore Capital Advisors" at the top of this page.