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The Long Run Quarterly Letter: January 2010

"The past is never dead. It’s not even past."

--William Faulkner, Requiem for a Nun

The noisemakers going off at midnight on New Year’s Eve were likely overwhelmed by the collective sigh of relief that this decade, aptly termed the “noughties,” was finally over. Wars, natural disasters, financial crisis, global warming and double-digit unemployment combined to cast a pall over this period. For investors, a dollar put into the S&P 500 at the beginning of the decade would have returned just ninety cents after these ten years.

Some hope for change certainly arose during 2009. You might remember that, in July, 2009, we wrote that we believed the economy was exiting the recession and that we would shortly start to see some positive growth. This has occurred and with it, stock prices have rebounded strongly. In the most recent quarter, the S&P 500 rose by 6%, with a sizable gain of 26.5% for the year.

Is this a sign that we can turn our backs on the previous decade – leaving the worst of our recent economic past behind us? While we like to be definitive, the best we can probably do in answering that question is to say “yes and no.” We have a fairly high degree of confidence that the economy will put up some pretty strong numbers over the coming months, though we still have doubts regarding the sustainability of this growth. For now, the economy is benefiting from inventory restocking, massive government stimulus, and purchases that were delayed due to the fear of last year’s meltdown.

For example, with computer sales up over 20% in the U.S. over the past three months, Intel just reported its best quarterly results in its history. It is pretty safe to say that no one saw this coming earlier last year while the economy was mired in a recession.

But now, almost everyone sees it coming. While last year it took only slightly good news to make stocks go up since expectations were so low, the reverse is now true. The consensus outlook has flipped and great earnings are now anticipated. Intel’s stock, in fact, declined after its amazing earnings. Stock market valuations seem to be back to fair levels.

While we would like to tell you that the economy is back on solid footing, the truth is that we just can’t escape our past that easily. As we have detailed in past quarterly missives to you, we are still stuck in a long process of deleveraging. Consumers still need to work down debt, banks still have deficient balance sheets, and the federal and state governments still have deficit fever. We just don’t see how you can get a sufficiently high, sustainable level of growth until balance sheets are rebuilt. This is a process that still has several years to run as, historically, deleveraging cycles have lasted for 6-7 years.

There are different paths that could lead us out of our past into a distinct future. A recent report from McKinsey, “Debt and Deleveraging: The Global Credit Bubble and Its Economic Consequences,” suggests that historic episodes of deleveraging fit into one of four “archetypes”:

  1. Austerity or belt tightening in which credit growth lags behind GDP growth for many years;
  2. Massive defaults;
  3. High inflation; or
  4. Growing out of debt by finding new sources of energy or a massive productivity boom.

The first three possible outcomes are ones that are typically discussed in the financial press and that, to varying degrees, we have attempted the hedge in your portfolio. It is the fourth option that we find most interesting and believe is not being taken into account by the financial markets.

As we have discussed previously, the world economy has made rather significant adaptions following periods when energy prices have risen sharply and quickly. For example, following the rise in oil prices in the 1970s, the U.S. used less oil for the next eighteen years. France and Germany still use 25% less oil than they did versus their 1970s peak.

This didn’t occur because the world economy stopped growing and required less energy. Rather, other sources of energy were utilized and a focus on energy conservation brought on much higher productivity. We think we have already entered a similar stage that will allow certain parts of the economy to grow at a sustainably higher pace than the broader economy.

Higher prices of oil and carbon emissions are leading to increased demand for our plentiful supplies of natural gas, wind and solar at a time when technological breakthroughs are lowering the cost of these fuels. For example, in the past two years, the price of making ethanol from corn cobs has fallen by more than half to $2.25 per gallon. This makes it competitive with corn ethanol and cheaper than gasoline when current tax incentives are included. A number of solar companies have stated that the costs of generating electricity from solar cells will reach grid parity in the next two years. We expect to see the first shipments of electric cars in the U.S. this year, heralding the biggest transformation of the automobile industry in its history. This transformation actually began a few years ago with the introduction of hybrid engines and was highlighted with the Toyota Prius becoming the best-selling car in Japan this year. Wind power continues to gain market share, with Denmark being the most startling sign of this potential. Denmark is currently getting about 20% of its electricity needs from wind turbines and expects this to reach 30% over the next fifteen years. Once an industry that seemed to be facing declining rates of new supply, new drilling techniques have more than doubled the U.S.’ natural gas reserves in the past five years.

The improving economics of these sources of energy, combined with new technologies designed to make companies and homes more energy efficient, will likely prove essential for any companies (or countries) to grow their way out of this deleveraging cycle. Without improvements in energy efficiency and productivity, the world is likely to be stuck in a low-growth/high-inflation cycle and relegated to a “past that is never dead.”

As one of our favorite market commentators has observed, the opportunity for investors going forward is in companies that will experience long-term, sustainable growth by forgoing the current trend on cheapness (marked by the outsourcing of production to areas, such as China, with high energy and environmental costs) and instead focus on productivity and innovation. This is where we will continue to position the equity portions of portfolios.

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We began this letter by referencing the past decade as one of considerable pain. This past continues on with us this month with the great tragedy that has befallen Haiti. Many of you may know that Patrick McVeigh spent many years assisting a loan fund that promoted economic development within the peasant community of Haiti. Having traveled to Haiti many times makes the current suffering even harder to imagine.

While there are a plethora of organizations that are doing good work in Haiti, we would like to bring two to your attention if you are considering making any contributions. Partners in Health (www.standwithhaiti.org/haiti) has been working to improve the medical care in Haiti for over twenty years. We think they are uniquely positioned to help meet the immediate and long-term health care needs of this country.

We also have had some direct experience with a relatively new loan fund (Appropriate Infrastructure Development Group, www.AIDG.org) that has a special focus on Haiti. Any gifts to them will go a long way as Haiti attempts to rebuild following this disaster.