QUARTERLY

Commentary
SECOnD QUARTER 2010

ECOnOmIC OVERVIEW

Default or Devaluation: Solutions to the Problem of Rising Sovereign Debt

The idea that one should actually live within ones means seems to have become a quaint relic of the 1950s. Most advertising today pushes just the opposite approach. We are urged to buy now an endless stream of goods and services, ranging from cars, clothes and computers to boats, botox and bicycles. More often than not, for those who might be a little short of cash, financing is readily available. In a similarly hedonistic fashion, voters around the world have opted to elect leaders who promise a chicken in every pot and lifetime health and retirement benefits to all. Balancing the budget sounds great until it is your benefit that is getting reduced or your taxes that are going up. Who is going to vote for a would-be leader who promises solemnly to raise your taxes? Behavioral economics tells us that people will almost always act in their own personal economic self-interest, but have a hard time supporting decisions that hurt them as individuals yet benefit a greater common good. Thus, governments around the world have agreed to provide benefits and programs to their citizens and the cost of these is well beyond their ability to collect tax revenues consistent with these promises. Indeed, often leaders are continuing to be elected on the basis of their stated plans to reduce taxes. To fill the gap, almost every government has borrowed money, and some have borrowed eye-poppingly large amounts. All of us know personally that there is a limit to how much money we can borrow. Beyond this limit, there is an increasing chance that we cannot fulfill the obligation to repay the debt. It is harder for us to conceptualize the limit for an entire country, but that limit does exist and many countries around the world are perilously close to, if not beyond, this limit. Governments that become unable to meet their debt obligations have three alternatives: they can default on their debt, they can devalue their currency overtly or they can stimulate inflation, which has the effect of covertly devaluing their currency. Default and overt devaluation are significantly more painful and have markedly more negative social connotations, so we have argued that covert devaluation through inflation is the most likely scenario. We have witnessed massive monetary creation around the world and this will eventually lead to rising prices as long as there are no significant government defaults. The recent bailout of Greece demonstrates the global intolerance for default. We would do best to prepare for a bout of rising inflation. (On May 25th we sent our clients a five-page white paper exploring the issues and solutions to the worldwide problem of rising sovereign debt. Please let us know if you would like to review the full text.)
InDEX pERFORmAnCE dow Jones Industrials Standard & Poors 500 eAFe (international stocks) russell 2000 (small stocks) Barclays Interm. Gov/Credit Barclays Municipal Q210 -9.34 -11.41 -13.65 -9.91 2.95 2.07 YTD -4.98 -6.64 -12.81 -1.93 4.56 3.31

Inside this Issue

ECOnOmIC OVERVIEW

: : Default or Devaluation: Solutions to the Problem of Rising Sovereign Debt

ASSET mAnAGEmEnT

: : Second Quarter Activity

mARKET TImInG AnD STOp LOSS ORDERS

: : Banes or Boons for Investment Performance?

FeAtured StoCk

: : Schlumberger
Book SuMMAry

: : Power Hungry by Robert Bryce

www.nelsonroberts.com | 650.322.4000

We continue to see signs that the encouraged by consumer-related s

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ASSET mAnAGEmEnT

FiFteen Holdings
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Second Quarter Activity

The Dow Jones Industrial Average fluctuated wildly this past quarter, reflecting the tension and confusion about whether inflation or deflation was more likely. At quarters end, the Dow had declined 9.34% and the S&P 500 was down 11.41%. During the first quarter of 2010, we invested most of our cash when the market weakened in mid-February. However, we mostly stayed on the sidelines during the second quarter, as we started the quarter with 2.5% cash and ended with about the same amount. We did take the opportunity to add two new positions to our portfolios while selling our holdings in one company and trimming our position in another. The quarterly earnings cycle provided a nice boost in the price of Fastenal, a company we purchased in early 2007. As the name suggests, Fastenal sells fasteners and other industrial supplies to the construction and manufacturing industries. The stock performed well for us over the three years that we owned it, but the valuation had risen to a level that we believed was too high. We are confident Fastenal will continue to be a good company, but believed that we would get better returns elsewhere in the medium term. We sold the entire position at a profit in early April. Later that month we purchased a position in Royal Dutch Shell. This investment increases our exposure to the energy sector and more specifically to the downstream oil business. We believe that an improving economic picture will benefit energy stocks as demand for energy rises during up cycles. Royal Dutch Shell also pays an attractive dividend of 6.4%. Despite the ongoing oil leak in the Gulf of Mexico and the issues with deep-water drilling, consumers are not going to stop using oil and gas. Within each major equity sector, an improving economic environment will disproportionately benefit smaller companies relative to their big company competition. The stable balance sheets and predictable revenue streams of large cap technology companies provided assurance to investors during the difficult market of 2009. Now that the economy has stabilized, many customers of technology companies are looking to improve their internal processes by implementing new

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MEASURES OF CON
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e domestic economy is improving and are statistics.

technology. This is resulting in growth opportunities for technology sector companies. We continued our transition to smaller tech stocks by trimming our position in IBM (market cap of $166 billion) and putting the proceeds into Cavium Networks (market cap of $1.21 billion). Cavium designs and develops semiconductors for use in routers that handle feature-rich internet traffic. We discussed in the first quarter commentary the increased use of the internet for robust applications

such as cloud computing and video streaming. These applications require more dynamic solutions focused on security and data integrity. Cavium helps provide these solutions and we expect it to benefit significantly as companies enter an upgrade cycle. The bond market continues to add to investors tension. Less secure bonds, which offer only slightly more return than US Treasuries, are underperforming as investors are starting to demand more return to take on risk. At the same time, problems overseas are causing a flight to the safety of the US Dollar and foreign investors are using the dollars they buy to acquire US Treasury bonds. As a consequence, the yields on Treasury Notes with maturities greater than 5 years continue to languish at the 2-3 % level. Short term yields are worse than anemic. Money funds are paying nearly nothing. This is severely crimping investors cash flow and making many stocks dividends juicy by comparison. We continue to see signs that the domestic economy is improving and are encouraged by consumer-related statistics. The change in non-farm payrolls was positive for the first time in over two years, the unemployment rate has stabilized (although it remains distressingly high) and consumer confidence has improved steadily over the last twelve months. Though each of these statistics are below the levels we would like to see, they are at least trending in the right direction and point to a continued market recovery.

NSUMER ATTITUDES
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value
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How do we measure value?

By producing it in the growth of assets, in how our clients view us, in how we create partnership.

[val yoo] n. a quality having intrinsic worth

mARKET TImInG AnD STOp LOSS ORDERS

Banes or Boons for Investment Performance?

Buy low and sell high is an old market adage that seems quite obvious, but it turns out that it is hard to do. There are countless market newsletters, blogs and websites that promise their followers the tools needed to time the market, but few, if any, have been proven to work over the years. Short-term market movements are not easy to predict and the market has a way of humbling even the most experienced investor. Surprises, both good and bad, lurk around every corner. fell so quickly that many orders were filled well below the trigger price. Most stocks then rebounded, leaving investors who used stop-losses sitting on cash. Once a trigger price is hit, the stop-loss order becomes a market order. This means the trade is automatically executed at the market price, which could be well below the intended sell price. Many stock pickers have built their reputations on placing big bets and predicting market crashes. The ones that guess correctly make the headlines, but the others who lose money are rarely heard from. We believe building wealth through successful stock selection takes in-depth research, analysis and a disciplined strategy. As we have seen repeatedly during the last two years, the market is volatile and returns are not guaranteed. However, we believe that using a long-term, company-based approach remains one of the best methods to make money.

Market timing is defined as making buy or sell decisions based on predictions of future stock price movements. This is usually done by examining recent price and volume trends or economic data, but some investors make decisions just on gut feel. The difficult aspect of market timing is that investors have to be right twice: they need to make the correct decision about when to get out of the market, and they also need to make the right decision about when to get back in so that they do not miss the next run-up. Academic studies have demonstrated that it is exceedingly difficult to do this and practically impossible to get it right on a consistent basis. Fear and greed have a strong tendency to prevent investors from buying at the bottom and selling at the top.

Investing $1,000 in S&P 500 Index / 1988 - 2007

Minus 40 best days

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Stop-loss orders
A stop-loss order is designed to automatically sell a security if it reaches a certain price. Stop-loss orders are used by investors to protect stock positions if the market falls. On the surface, a stop-loss order makes sense as a means to hedge losses, but in practice a stop-loss can backfire and prove to be costly. For example, on May 6 (the Flash Crash) many stop-loss orders were triggered when the market dropped more than 20%. The market
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www.nelsonroberts.com | 650.322.4000

::

Intelligent saving and sustainable growth need not be a contradiction.

German Chancellor Angela Merkel during Junes G-20 Summit

FEATURED STOCK

Schlumberger (SLB)
The blowout of the Deepwater Horizon drilling rig in the Gulf of Mexico on April 20th has created the worst environmental disaster in US history. A temporary injunction halting the Obama administrations ban on offshore drilling was issued by US District Judge Martin Feldman on June 22. That injunction is now being appealed to the 5th Circuit Court of Appeals in New Orleans. These legal actions and the uncertainty surrounding the ultimate outcome will effectively end offshore drilling activity in the immediate future. However, as we observe in our review of Power Hungry (see Page 6), the US and the rest of the world will continue to rely on fossil fuels for energy into the foreseeable future. World consumption of oil will continue to rise as developing countries require more and more power. Therefore, drilling for oil will have to continue. Geologists use seismic testing data to characterize the structures deep below the earths surface. Small explosions are set off and the density of the underlying rocks can be estimated by the speed at which the shock waves radiate. Using this information, geologists can choose the optimal site for an exploratory well. Once drilled, instruments are sent down the well to measure rock porosity, pressure and oil content. Geologists can then evaluate how much oil is likely recoverable from a given formation. Schlumberger makes seismic testing equipment, performs well data measurement and analysis and many other oil field services. Or, as the company itself says: Schlumberger is the worlds leading oil field services company supplying technology, information solutions, and integrated project management that optimize reservoir performance for customers working in the oil and gas industry. Schlumberger is a big company, employing 77,000 people in 80 countries. Its expertise will be needed for years to come.

Schlumberger (SLB)

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www.nelsonroberts.com | 650.322.4000

Investment Team
Brooks Nelson, CFA Brian Roberts, CFA, MBA Steve Philpott, CFP , MBA Dennistoun Brown, MD Ann Oglesby, MD, MBA

BOOK REVIEW

Power Hungry by Robert Bryce

In our discussion of Schlumberger, our featured stock for this issue of the Commentary, we alluded to the continued need for hydrocarbon-based fuels for the foreseeable future. With all the discussion about alternative energy sources, such as wind and solar power, why are we not looking at investment opportunities there? Robert Bryce answers this critical question in his new book, Power Hungry. Bryce is a journalist who has been writing about energy issues for over twenty years, is managing editor of the online magazine Energy Tribune, and is a senior fellow at the Manhattan Institute. According to Bryce, the energy business is governed by four imperatives: power density, energy density, cost and scale. Power density is the amount of power that can be harnessed in a given unit of volume, area or mass (for example, watts per meter squared). Energy density is the amount of energy that is contained in a given unit of volume, area or mass (joules per kilogram). The higher the density of each, the better. The relationship between the four imperatives is as follows: if a source has low power density, it invariably has higher costs, which makes it difficult for that source to scale up and provide large amounts of energy at reasonable prices. A quick review of physics: energy is the ability to do work, power is the rate at which work gets done. The more power we have, the quicker the work gets done. So we use energy to make power, and power allows us to do things, like sit in an air-conditioned house eating ice cream, that make us happy, wealthy and comfortable. Hydrocarbons provide cheap, reliable, abundant power. Renewable energy is not useful unless it can be converted to renewable power. As consumers, we demand power that be accessed at specific times of our choosing. To do this, the power must be able to be stored. Right now, solar and wind can provide neither reliable nor abundant power. Both must have back-up hydrocarbon systems (whether natural gas or coal) to generate power when the wind is not blowing or the sun is not shining. Moreover, wind and solar farms take up huge amounts of real estate for the amount of power they are able to generate. The global energy sector totals $5 trillion and is the worlds single biggest business. It will only get larger as developing economies demand the same cheap, abundant, reliable electrical power that we take for granted. As Bryce points out, try as they might, regulators cannot change the laws of physics. He believes that our best bets are natural gas (near-term) and nuclear power (long-term). However, regardless of the types of energy sources we ultimately convert to over the next decades, transitioning from a hydrocarbon-powered economy will be a lengthy, expensive process.

Past performance is not necessarily a guide to future performance. There are risks involved in investing, including possible loss of principal. This information is provided for informational purposes only and does not constitute a recommendation for any investment strategy, security or product described herein. Please contact us for a complete list of portfolio holdings. For additional information on the services of Nelson Roberts Investment Advisors, or to receive our Newsletters via e-mail or be removed from our mailing list, please contact us at 650-322-4000.

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2010 Nelson Roberts Investment Advisors