Earning His Stripes

We at Legacy have been critics of Federal Reserve Chairman, Ben Bernanke, on more than one occasion. However, over the last few months, we think he has redeemed himself in the way he stepped up and provided much needed liquidity just as the credit markets were beginning to choke. Since December, The Federal Reserve has lowered short-term interest rates 300 basis points and initiated three new financial support programs to help add approximately $300 billion in liquidity to the U.S. financial system. The Term Auction Facility (TAF), Term Securities Lending Facility (TSLF) and the Primary Dealer Credit Facility (PDCF) all permit banks and brokers to exchange illiquid assets for more liquid treasury securities.

Bernanke should also be credited for the quick response to the Bear Stearns’ liquidity and financial crisis. Bear experienced a sudden and peculiar form of a “run on the bank,” as many of their business partners simply stopped dealing with them. This created a liquidity squeeze for the company that brought them to the brink of bankruptcy before the Fed played matchmaker and arranged for Bear to be acquired by J. P. Morgan. While some argue that the Fed had no business getting involved in this transaction, others believe that Bear’s failure could have started a domino effect, leading to other investment bank failures which would have crippled Wall Street and had the potential for financial chaos.

So far, the Fed’s interaction seems to have stabilized the credit markets. There is a consensus building that damage from the housing and mortgage crisis can be contained and managed. However, the flight to quality continues as short-term investors seeking liquidity are choosing Treasury Securities over other types of assets. Unfortunately, as the demand for Treasury Securities has increased, the corresponding yields have fallen and are actually negative when compared to inflation. This means that short-term investors are willing to accept returns that don’t keep up with inflation (essentially losing purchasing power) in exchange for liquidity.

Repercussions

In responding to the credit crisis by creating new credit facilities, the Federal Reserve has essentially exposed the Central Bank to long-term credit risk. According to a Wall Street Journal opinion letter, on March 26th, almost half of the $890 billion in assets, most in Treasury securities on the Central Bank’s balance sheet, have been exchanged for bank and brokers’ illiquid securities. These transfers have shifted credit risk from the private sector to the Fed. Some skeptical banking experts speculate that the Fed has opened Pandora’s
Box and will be forever obligated to help other financially troubled large investment banks. In addition, those same critics believe that the Fed could actually run out of Treasury
securities to swap.

The vast majority of economists, bankers and Wall Street gurus believe that the Fed has done the right thing. This credit crunch is like nothing we have ever seen and minimizing its effects on the entire U.S. economy is paramount.

The Fed is the lender of last resort and it has responded by targeting the part of the economy that needs an infusion the most. The banks and other lending institutions will work out their loan problems over the next several quarters. However, the brokerage and investment banks must remain solvent to ensure that the capital markets function properly.

Economy

Recession! Go ahead, scream it out loud – it won’t hurt. The semantics of whether or not we are in a recession don’t matter. The economy is not good. In a capitalistic society, there will always be periods of expansion and contraction. The trick is trying to limit the severity and length of a slow-down. With solid corporate balance sheets (excluding banking and homebuilders) flush with cash and low debt, all eyes are focused on consumer spending which is responsible for 70% of economic activity. Although the consumer seems to be more discriminate in spending due to uncertainty regarding employment, falling housing
prices and higher food and energy prices, we believe the recession, or slow-down, will be short lived. For starters, the weak dollar supports strong demand for US goods abroad as they are cheaper than competing products from other countries. Growing economies such as India, China, Germany and Latin America, should help support export growth. In addition, we believe employment will stabilize and wage growth will continue to grow – albeit anemically. Finally, in case you have forgotten, this is an election year and economic stimulus is the watch word! Both Democrats and Republicans are trying to out duel each other as the champion of compassion by sponsoring legislation for an ever increasing stimulus package. My concern is that while taxpayers may benefit now, they will pay up “big-time” later. Oh well, that’s politics.

1st Quarter Review

Good Riddance

For equity investors, there was no place to hide in the first quarter as stock prices took a beating across the board. In our Year-End Review issue, we noted that the problems in the sub-prime mortgage market were leading investors to speculate that a recession might be imminent. Unfortunately, the news in the first quarter did nothing to dispel those fears. Problems in the mortgage market led the Federal Reserve to lower interest rates aggressively, which in turn caused a sharp downturn in the value of the dollar versus foreign currencies. This led to higher prices for imported commodities – oil in particular, which heightened fears of both inflation and recession. A vicious circle if there ever was one!

When all was said and done, prices of large capitalization stocks, as represented by the S&P 500 Index, had dropped about 10% since the beginning of the year. Less-large companies performed only marginally better. The S&P 400 Mid Capitalization Index posted a total return
of -8.9% for the quarter, while the S&P 600 Small Capitalization Index lost 7.5%. Neither value nor growth stocks provided any particular measure of safety either. Both the S&P 500/Citigroup Value Index and the S&P 500/Citigroup Growth Index showed considerable losses, although the Value Index declined “only” 8.9% versus 9.9% for the Growth Index. Investors in basic materials stocks and consumer staples companies suffered the least pain, as rising commodities prices and a new focus on consumer retrenchment held losses for these sectors in the low single digits. Technology and financial stocks on the other hand got slammed, with both sectors experiencing declines of about 15%.

A New Tune

The dance floor is being cleared to welcome new leadership. After five consecutive years the financial sector’s dance ended with a thud. Unfortunately, as consumers, taxpayers and customers - we will all be touched by the cost of this bubble. Maestro, please - music for a new leader!

One theme that has been showing up in the economic data is the strength of US exports. This favors the capital goods, energy and technology sectors. Legacy remains bullish on oil and oil service stocks even as the industry carries a bulls-eye on its back. The sheer magnitude of

profits reported of late in the oil sector has captured the imagination of revenue-seeking politicians. At least one presidential candidate has floated the idea of seizing a portion
of oil profits as a tax. This would certainly not be positive development, since it would be punitive for both the companies and their shareholders.

Technology is once again creating a stir with new innovations to an old dance step. By reinventing the telephone into a high tech fruit (Apple to Blackberry) the world can now be linked by whatever media you choose to communicate. Keep in mind though; both phone and fruit share the same shelf life.

We believe that once our dance partner (the fixed income market) returns to the floor, the music will strike a chord and all partners will return. For now, being defensive and not overpaying for extended stocks or sectors is the prudent action. We will continue to look for equity investment opportunities that pass our value screens and fulfill our criteria. Just because the financial markets are moving sideways doesn’t mean that there are not attractive opportunities. Keep the faith!

Quarterly Activity

Legacy initiated or added positions in the following companies:

Eastman Kodak (EK): In the fourth quarter of 2007, Eastman Kodak completed a four year restructuring plan that helped transform the company from a traditional film and imaging business into a cost efficient digital and graphic imaging company. In the 3rd quarter of 2007, EK launched a new consumer line of all-in-one inkjet printers which utilize a premium pigment-based ink, priced at up to a 50% savings on competing brands. Although the company charges a premium for the printer, consumers seem to be embracing the ongoing cost saving of ink maintenance. Other consumer products that are driving profits include digital instant photo kiosks in all 3,500 Wal-Mart stores nation wide, new inexpensive digital cameras and picture frames. Through acquisitions, the graphic communications group has strategically positioned itself to offer a broad range of end-to-end consulting solutions to the printing industry.

EK has paid-down over half of its debt obligations in 2007 and is in a good financial position to grow, even in an economic downturn. At the end of 2007, the company had a net cash position after all debt of $1.3 billion. With its lean cost structure, management expects growing profit margins over the next few years. Kodak is a classic deep value company. It is a “fallen angel” due to several years of negative earnings and relative under performance. Subsequently, analysts lost patience with the firm and currently only six Wall Street firms follow the company. EK is trading at a deep discount to its 10-year median average
in forward Price/Earnings, Price/Sales, Price/Book and Price/Adjusted Cash Flow. In addition, the company currently pays a 2.8% dividend - higher than its 10 year median.

Oracle (ORCL): Oracle is a high quality enterprise software and services company that primarily builds software designed to help management solve business problems and manage their operations more efficiently. With the recent acquisition of BEA Systems, Oracle brings to market one of the most complete product suite offerings in software. Moreover, the company now has a competitive advantage over rival IBM, which lacks a strong presence in application software and SAP, which has a void in database management and solutions. Oracle’s diversified product offerings somewhat insulate the company from bearing the full weight of a macroeconomic downturn. According to Goldman research, only 13% of Oracle’s revenue is derived from financial-services customers.

ORCL is cheap on both an absolute and relative basis. The company is currently trading at a market implied growth rate of 8.5%. At the same time, company management believes earnings will grow at a 24% compounded annual rate over the next three years. Oracle is currently trading at a Price/Earnings ratio of 13.6X, near its 20 year low of 12.6 times. On a relative basis, ORCL’s P/E is selling at a 17% discount to the software industry.

Legacy liquidated or reduced positions in the following companies:

Citigroup Inc. (C): Two crummy earnings reports in a row, a new CEO, $22.1 billion in losses from the sub-prime crisis, approximately $27 billion in new equity, diluted capital structure, over 32,000 in announced layoffs and the Bank still can’t quantify its credit exposure to toxic structured investment vehicles, (SIV’s) and mortgage deterioration. Furthermore, there is an additional structured product that could cause more headaches for Citi’s management team – a type of SIV called Variable Interest Entity or VIE. According to a Bloomberg reporter, Citigroup disclosed in a recent corporate filings that they have $320 billion in ‘significant unconsolidated VIE’s”. If Citigroup is mandated to add these assets on to its balance
sheet, the Bank would have to take additional significant write-downs. At some point you have to throw up your hands and ask, “does anyone know what this bank is worth?”

Tyco International (TYC): Tyco’s stock has been a core holding in our client’s portfolios since early 2005. The firm’s operations have been sporadic. It was not until the company decided to divide itself up into three separate pieces (healthcare, electronics, and engineered products and services) that value began to be realized. The stock started to move upward as the company announced better than expected earnings in the 2nd quarter of 2007. We sold our position in “new” TYC after the stock rallied almost 30% in anticipation of a strong 1st quarter earnings report. While TYC did indeed beat analysts expectations, we believe that the company will have a hard time duplicating the positive momentum since its largest and most profitable business (ADT Worldwide Security) is directly related to the housing market. In addition, higher future costs in many of the company’s product lines could put a cap on operating margins. We believe the company is fairly valued.

American International Group (AIG): AIG recently announced operating earnings for the 4th quarter of 2007 that were nothing to write home about. In addition, the company had to write down over $11 billion in losses stemming from credit default swaps. There is no indication from AIG as to the extent of future credit and derivative exposure, so analysts are left to guess. To add fuel to the fire, AIG disclosed in its annual 10K report, that an internal audit uncovered material weakness in internal controls as it pertains to valuing its default swap portfolio. If that is not enough, the core business of underwriting property and casualty insurance is facing declining prices and margin pressure. Similar to Citigroup, there is too much uncertainty with AIG and not enough reliable data to support reliable valuation. In the near future, the company’s stock price will be driven by the daily barrage of gripping headlines and continued credit worries. Therefore, we believe that there is a high probability of further downside momentum.

Around The Firm

Well, we’re all glad that quarter is over. Although the past 90 days have caused anxiety throughout the stock market, we at Legacy continue to be committed to viewing
the investment world from a long term perspective. Joe Birkofer’s insight into the impact of supporting elderly parents via their adult children’s retirement plans was featured in an article in the Wall Street Journal earlier in January. This article was then picked up by several different news organizations and elder care websites.

Joe was invited to speak at a symposium on Retirement Plan Mutual Funds in New York City in late February. The focus of the meeting was “Target Date Funds”. These funds are a relatively new offering designed to greatly simplify investing for retirement. Participants pick target date funds which correspond roughly to their year of retirement.  For example, a 40 year old employee might pick the 2030 Fund.

Tim Hartzell’s economic and market comments were featured several times during the quarter on Bloomberg radio. He discussed a variety of topics ranging from specific stock selections to market reactions to current events. Tim was also selected to teach the fixed income section of the Chartered Financial Analyst (CFA) exam review course.

Kyle Ezer registered this quarter for the December 2008 CFA Level I exam. The CFA designation is a qualification for finance and investment professionals, particularly in the fields of investment management, investment banking and financial analysis of stocks, bonds and their derivative assets. The Economist ranked the CFA Program as the gold standard among investment analysis designations. In order to become a CFA Charter holder, candidates must pass three exams, generally taken one per year; we wish him well!

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