Global markets continued to rebound from the recent October 2011 lows and powered strongly higher throughout the first quarter of 2012 as confidence in the U.S. economic recovery grew and worries about the Eurozone crisis subsided.  U.S. stocks are off to their best start since 1998, with the S&P 500 Index advancing 12% and the Dow Jones Industrial Average up 8.14%.  Volatility was positively docile and with the exception of the Israel/Iran sabre rattling, a welcome lack of bad news during the quarter gave no one a really good reason to sell.  In Europe the stronger economies separated themselves from the weaker.  Germany’s DAX 30 Index, for example, was up 17.3% while Spain’s Ibex 35 lost 6.5%.  In China, where growth is slowing and debate centers on whether or not the economy will suffer a hard landing, the Shanghai Composite only managed a 2.9% gain.  Yields on the 10-year Treasury note rose 0.32% to 2.22% as investors poked their heads out of their bunkers to sell some government bonds and buy stocks.

Three big issues face investors as we head into the second quarter.  The first is whether or not the U.S. economy will continue to improve.  Employment data of late have been encouraging, with the U.S. economy adding an average of 245,000 jobs in each of the last three months.  This rate of job creation, while still below what is required to solve our unemployment problem rapidly, is nevertheless the best stretch of payroll improvement since 2006.  Retail sales trends so far in 2012 have also been strong, indicating that American consumers are feeling a bit better about the future.  High gasoline prices do threaten the economy somewhat and could weigh on consumer confidence, but they are to some extent offset (in northern states, mostly) by rock-bottom prices for natural gas.  With banks beginning to lend again and home prices groping for a bottom, there is reason for cautious optimism that the U.S. economy will continue its recovery in 2012.

The second issue is whether the Eurozone crisis will remain in its currently mollified state—or bloom anew.  The European Central Bank’s long-term refinancing operation (LTRO), which provided needy banks access to huge amounts of cash at a paltry 1% interest rate, seems to have been successful in staving off a banking crisis in Europe for the moment.  Both Italian and Spanish banks borrowed large sums of euros from the ECB, then promptly invested the cash in their own high-yielding Spanish and Italian government bonds, thereby earning themselves a tidy spread.  As the money has flowed into their government bonds, both countries have enjoyed flat-to-falling interest rates since the year started.  Even the Greek situation has moved off the headlines. While most Greek bond investors took a 75% haircut on the value of their holdings in last month’s debt “restructuring” there are still a few holdouts demanding payment in full. Broadly speaking, however, outside of Germany the situation in Europe remains grim.  With much of Europe likely in recession and government tax revenues set to contract, the spreadsheets around European capitals that project government debt service potential will probably have to be reworked to the downside.  Given the magnitude of the European debt problem, it would frankly be surprising not to see further drama unfold in 2012.

U.S. companies, after years of cost-cutting, streamlining and low investment, are on the whole in a very strong financial position.  The U.S. stock market is continuing to shrug off the economic uncertainty in both China and Europe and is attracting capital from those markets.  On a price-to-earnings (P/E) basis, the S&P 500 Index is trading at 13.3 times the current 2012 consensus earnings estimate of $105, a slight discount to its historical average.  On the face of it this valuation seems attractive, but corporate profit margins are also at their all-time highs and any future retracement to average margins could hamper earnings growth.  In any case, it would be prudent not too expect much further margin expansion for Corporate America as a whole, so additional earnings per share growth will have to come from revenue growth and/or share buybacks.

The third issue investors are monitoring closely is the slowdown in China, the world’s second-largest economy.  After several decades of rapid growth fueled by exports and domestic infrastructure investment, China is trying to transition its economy to one that has more sustainable growth drivers and more reliance on its own consumer base.  For the last decade in particular China has played a central role not only in the growth of the global economy, but also in the growth of the global resource sector.  It has consumed massive quantities of oil, coal, iron ore, copper, aluminum and virtually every other building material.  While the current guidance from the Chinese government is for “only” 7.5% growth in 2012, investors are looking askance at a weakening property market and slowing infrastructure investment and wondering where the declining growth rate will find a sustainable level.  A significant slowdown in China would certainly weigh on global growth, but it may also result in falling prices for many of the commodities of which the country was (and still is) such a voracious consumer.

All in all, 2012 is off to a good start.

Facebook, the social media giant, recently announced plans to sell $5 billion in stock in an initial public offering (IPO) this spring. This article is our assessment of the Facebook offering and a description of the salient aspects of it we think potential investors should consider. It is not a recommendation to buy, sell, or not to buy any security. It is for informational purposes only and is not investment advice. Orion Capital Management LLC only provides investment advice to its clients under a written advisory agreement. Now, with that said, let’s dig into the details . . .

The Company
Famously born in Mark Zuckerberg’s dorm room at Harvard eight years ago, Facebook is the world’s dominant social networking site. At the start of 2012, it had 845 million users worldwide, 12% of the earth’s 7 billion human inhabitants. The company, which benefits hugely from its network effect, has a powerful financial model. In 2011 it generated revenue of $3.7 billion and about $1 billion in profit, reflecting an extremely efficient business model featuring high margins and very little need for capital. The assets of the company are essentially a bunch of people sitting in some warehouses and their computers; in other words, Facebook has a tremendously scalable, asset-light business model. Given how large and entrenched the company is with its users, it will be very difficult for a competitor to make a successful frontal assault against it in the near term. As time goes by other companies may make inroads, but Facebook, by and large, will be difficult to compete against.

The Offering
The expected value of the firm at the IPO is a range of $75 billion to $100 billion. For reasons explained later, I expect the stock to price at the high end of this range. Thus, the following discussion will assume a firm value of $100 billion—needless to say a staggering sum for an eight year-old company with a mere 3,200 employees.

Facebook to New Shareholders: No Control for You!!!
Facebook plans to sell $5 billion worth of Class A shares. The company has a dual-class structure for its stock, with the Class B shareholders having 10 votes per share and the Class A holders having just one vote per share. Class B holders will likely have around 70% of the voting power once the Class A shares debut. With founder Mark Zuckerberg slated to own 36.1% of the Class A shares and 57.1% of the Class B shares, new stockholders will have no ability to control or even to influence the company.

Facebook is already huge . . . in market value, at least.
One reality worth considering for stockholders who buy after the IPO is that Facebook, which apparently waited as long as it could to go public, has already been phenomenally successful before it offers shares to the public. While the company is itself very young, its runaway early growth and resulting eye-popping valuation serve to reduce the potential long-term upside for new stockholders. For IPO investors beginning their involvement at a $100 billion valuation to double their money (and assuming no share dilution, which is highly unlikely) the company would have to tack on another $100 billion of market value—a not so trivial increase.

Probably the closest thing to the upcoming Facebook IPO that investors have seen is the Google IPO in 2004. Like Facebook today, Google at that time had a very large share of its nascent but rapidly growing market (which for Google was/is internet search). When Google IPO’d in 2004, it had an initial market value of $24 billion. Now, eight year later, Google’s business has grown tremendously and its market value is nearly $200 billion. Shareholders who bought in the IPO and held their shares since are up about 730%. For Facebook to replicate the same rate of return it would have to become a $830 billion company in the next eight years. As of this writing the largest public companies in the world are Apple ($437 billion) and ExxonMobil ($408 billion). Google investors had the advantage of starting at a much lower market value. Consider too that Google’s business—in terms of revenues and profits—is today almost exactly ten times as large as Facebook’s. Should Facebook garner half of Google’s value when its actual business is only 1/10th the size?

Small Float
Only $5 billion of stock (the float), a mere twentieth of the expected $100 billion value of the firm, will be sold to new shareholders. Given the huge number of people familiar with Facebook, there will likely be significant early demand for the stock from enthusiastic Facebookers. Thus it will likely not be too difficult for the underwriters to find a relatively small group of investors willing to pay a premium price for the stock. Moreover, investors with a bearish view of the company (the so-called “shorts”) will find it very difficult if not impossible to find shares to borrow to sell short—in other words to bet that the stock will decline. Given these factors, it would be prudent for investors to expect volatile trading in the shares after the IPO.

IPO Lock-Up Expiration
One day new shareholders might want to circle on their calendars is the date of the IPO lock-up expiration. An IPO lock-up is a period of time beginning at the IPO—typically 90 or 180 days—during which company insiders are forbidden to sell any of their shares. When the lock-up period ends, insiders are free to sell their shares. The purpose of the IPO lock-up is to keep the market from being flooded with sell orders right after a company goes public. With Facebook’s small float of $5 billion worth of shares, there will technically be 19 insider shares that could be sold for each new share sold to investors in the IPO. Needless to say, when all those newly minted Facebook millionaires look to get some hard cash for their stock after the lock-up expires the stock could come under significant pressure.

Internet Going Mobile: A Challenge for Facebook
In 2011, for the first time, global unit sales of smartphones surpassed unit sales of personal computers. People, especially those outside the U.S., are increasingly accessing the internet via their mobile devices—smartphones and tablets. This presents a challenge for Facebook, which in the last year derived 85% of its revenue from online advertising. Display advertising works fine on a large screen, but on a smaller mobile device the medium is not nearly as compelling. People accessing the web via mobile devices, are in my opinion, not likely to be too enthusiastic about display ads hogging their small screens. Perhaps Facebook can somehow adjust its advertising to work better on mobile devices, but that remains to be seen. It will be a vital task for the company, however, as many new internet users around the world connect exclusively on their mobile devices.

It’s Tough Being Public
Once Facebook is public, it may have difficulty retaining and motivating its key employees, virtually all of whom have recently become fabulously wealthy. Many will have ambitions to go out and start their own companies. Even Randi Zuckerberg, Mark Zuckerberg’s own sister, resigned her post as director of marketing at Facebook in August 2011 to (what else?) start her own social networking company.

Another tough aspect of being public for Facebook will be its required financial reporting. Facebook members will get to see just how much Facebook is making from selling their personal information and opinions to advertisers. Some people won’t mind, but with others it may not sit so well that their information is putting ever more money into Mr. Zuckerberg’s pocket. In coming years I expect users to begin to care more about their online information and to take steps to try to better control it. Government regulators in both the U.S. and Europe seem poised to jump in on the side of consumers. The more control over their own information Facebook users have and the more regulations that support them the less valuable will be Facebook’s primary revenue-generating product—its own users’ information. If companies that advertise on Facebook find it increasingly difficult to drill down to a very specific segment of consumer, they are likely to pay less per ad.

Where to From Here?
Facebook has already captured a massive worldwide audience and globally it accounts for about one in seven minutes of all time spent online—a simply remarkable statistic. But it will not be able to keep adding new users at it historical rate because it will run out of people. Worldwide, there are only 2.3 billion people online today and China, where Facebook is blocked, accounts for 500 million of them. Thus, for Facebook to succeed as well as a business as it has as a networking website it will have to find new and innovative ways to wring more revenue out of its existing user base.

One thing I find remarkable about the Facebook offering is how, like no other large IPO I have seen, investors have deemed future hyper-growth a foregone conclusion. Many small promising companies have come public in the past with extremely high valuations, but rarely does a mega-capitalization company come public with a valuation of 25 times revenues and 100 times earnings. Given Facebook’s current business momentum, strong growth for the next several years appears highly likely—but it will have to be for the company to support a $100 billion valuation and for new public shareholders to ultimately earn a decent return on their investment. In business, as in nature, once you are already big it becomes increasingly difficult to maintain a rapid rate of growth.

Peter C. Thoms, CFA
Orion Capital Management LLC
1330 Orange Ave. Suite 302
Coronado, CA 92118
Tel: 619.435.1701
Email: thoms@orioncapitalmgmt.com

About the Author:
Peter C. Thoms, CFA, is the founder and managing member of Orion Capital Management LLC, an independent Registered Investment Advisor based in Coronado, California. The firm manages investment accounts for both institutional and private clients.

Disclosure:
This document is for informational purposes only and nothing in it is to be construed as an investment recommendation. This document does not constitute the provision of investment advice, which is only provided by Orion Capital Management LLC under a written investment advisory agreement and only in states in which Orion Capital Management LLC is registered or is exempt from registration requirements. Orion is not a tax advisor and does not provide tax advice. For tax advice individuals should consult their CPA.

In some of the most volatile global markets in recent years, the S&P 500 Index, after a spirited fourth quarter ascent, ended 2011 virtually unchanged from a year earlier.  U.S. investors may be disheartened at having had to suffer all this volatility with no upward progress in the broad markets to show for it, but the reality is that U.S. equity markets notched a solid performance in 2011 given the year’s numerous upheavals, which included the Japanese tsunami/earthquake/nuclear disaster, the Arab Spring, the U.S. sovereign credit rating downgrade and the European debt crisis.  In the tumult of 2011, the U.S. re-emerged as a relative safe-haven for nervous investors.

Money poured into the U.S. bond market and, to a lesser extent, the U.S. stock market as it fled Europe, Asia and Latin America.   The bottom line is that 2011 was a good year to be a U.S-focused investor—even if it did not feel like it.  Consider the following annual performance numbers for major global market indices in 2011:

U.S. S&P 500           Flat
U.K. FTSE 100        Down 5.6%
Germany DAX         Down 14.7%
France CAC-40       Down 17.0%
Japan Nikkei 22     Down 17.3%
Brazil Bovespa        Down 18.1%
China Shanghai     Down 21.7%
India Sensex           Down 24.6%

Here in the U.S., our grudging but resilient recovery continues, with economic data improving in recent months.  For the first time in a long while, things are starting to look incrementally better on the jobs front. In December the U.S. economy added 200,000 jobs and the unemployment rate fell to 8.5%, the lowest it has been since February 2009.  While bright light is not yet visible at the end of this long economic tunnel, all in all the situation is brightening.

Corporate America, unlike the rest of America, had a pretty good year.  Despite flat markets, earnings growth continued in 2011—and with earnings higher now but the market unchanged, stocks are cheaper today than they were one year ago.  As we enter 2012, the S&P 500 trades at only 11.6 times analysts’ consensus estimate for 2012 earnings.  To put this in perspective, the average price-to-earnings multiple of the U.S. stock market since 1871 has been around 15.  On top of relatively inexpensive stock prices, the financial strength of U.S. companies remains excellent.  And finally, relative to bonds, U.S. stocks have rarely looked so cheap.

The biggest risk for 2012 is the same one as in 2011: the euro-zone crisis.  While the European situation receded from the headlines during the holidays, it promises to come back in 2012.  Italian bond rates, as I write this, are above 7%, a level at which the Italian government will not be able to finance itself sustainably.  All told, countries in the euro-zone have to repay or rollover about €1.2 trillion in 2012.  With global investors increasingly skeptical of the euro-zone and the euro itself, who is going to buy all that debt and at what price?

Europe’s challenges are made more acute by the fact that the euro-zone does not have a straightforward rescue mechanism.  The European Central Bank (ECB) does not have the authority to conduct massive buying of government bonds of euro-zone members without a revision of its charter.  Thus, it has so far been ineffective in stanching the flight out of Greek, Italian and Spanish bonds.  The ECB has, however, extended generous loan terms to euro-zone banks, an action which has probably helped to stem the immediate crisis.  Still to come in 2012 is a credit crunch that promises to make life challenging for leveraged European companies or those that otherwise need ready access to reasonably priced credit.  As we saw here in the U.S. in the wake of the 2008 financial crisis, getting banks to lend money while they are trying to rebuild their balance sheets is no easy feat.

Longer term Europe faces a tough road.  Many economists expect a recession in 2012 even if a financial crisis is averted.  Many Europeans, who previously expected to be well-cared for by the state in ill health and retirement, are beginning to realize that the social contract with their governments they previously thought impervious is fraying badly.   They are awakening to the stark reality that they will have to bear much greater responsibility for their own financial lives.  As euro-zone governments enact cuts to save themselves, European citizens will probably be unable to avoid a deterioration in their confidence about the future.  Europe will be in a rut for some time to come.

U.S. markets seem to be hinting that investors, at least at the moment, do not expect Europe’s problems will become severe enough to derail our choppy recovery or to precipitate a global recession.  The U.S. has plenty of exposure to Europe—approximately 25% of our exports go to Europe—but the euro-zone problems, the slowing growth in Asia and Latin America and the shimmers of economic light here continue to bolster the case for why the U.S. will remain the destination of choice for global investors in 2012.

I welcome your comments and feedback.

Peter C. Thoms, CFA
Orion Capital Management LLC
1330 Orange Ave. Suite 302
Coronado, CA 92118
Tel: 619.435.1701
Email: thoms@orioncapitalmgmt.com

About the Author:
Peter C. Thoms, CFA, is the founder and managing member of Orion Capital Management LLC, an independent Registered Investment Advisor based in Coronado, California. The firm focuses on managing global investment accounts for institutional and private clients.

Disclosure:
This document is for informational purposes only. Nothing in this report is to be construed as a specific investment recommendation. This document does not constitute the provision of investment advice, which is only provided by Orion Capital Management LLC under a written investment advisory agreement and only in states in which Orion Capital Management LLC is registered or is exempt from registration requirements. Orion is not a tax advisor and does not provide tax advice. For tax advice individuals should consult their CPA.

For equity investors, the third quarter of 2011 was the worst quarter in three years and it brought back to mind the financial market turmoil in the fall of 2008.  A flight of capital out of risk assets and into conservative assets drove the S&P 500 Index 14.3% lower during the quarter and drove yields on the ten-year U.S. Treasury note down to 1.93%, within a whisper of historic lows.  But while the U.S. market is down 10% year-to-date, it is actually one of the best performing large markets in the world so far in 2011.  Germany is down 20%, the U.K. is down 13%, China is down 16% and Brazil is down 24%.  The dollar and U.S. Treasury debt remain safe-havens for global investors in times of uncertainty.

Two events during the quarter tested investor confidence.  The first was the debate in Washington over the federal debt ceiling, our near default on our federal obligations and the associated Standard & Poors downgrade of the sovereign debt rating of the United States to AA+ from AAA.  The rhetoric of a divided Congress has reduced confidence of businesses and consumers alike and thereby acted as a brake on our economy.  Despite the unhelpful political wrangling, however, recent economic data has remained stable, and in fact been moderately better than economists’ average estimates.

The second major event to impact investor confidence was the re-emergence of the European debt crisis.  In the U.S. it is difficult for the federal government to reach a consensus on a bold plan of action.  But imagine what it’s like in Europe, where seventeen Eurozone countries are trying to reach an agreement on a plan of action whereby they will be forced to commit their citizens’ Euros to a plan that may or may not preserve the Eurozone in its current state.  And they have to do so on a timeline that concerned investors are prodding along.

When you put oil into the engine of your car, you do not actually make the engine better—you are merely preventing it from getting worse.  With sufficient oil your engine will continue to function smoothly, but without oil it will eventually overheat, seize up and be permanently damaged.  This is the situation facing Europe now.  Do politicians set aside their national agendas to come together to apply a big dose of oil (ring fence the likely Greek default, recapitalize banks) to the engine that is the European financial system, or do they let things grind on for a while longer, risking a seizure and significant damage?

So far the performance of European politicians has been uncoordinated and underwhelming.  The debt crisis is nearly two years old, but apart from vague outlines, there is as yet no credible agreed-upon plan to address it.  Absent is anything resembling the rapid and forceful policy response of the U.S. Treasury and Federal Reserve in the wake of the Lehman Brothers collapse in 2008.  Only in the last couple of weeks have European politicians seemed to recognize the urgency to do two things:  1) ring-fence the Greece problem so that it does not spread to Italy, Portugal and Spain if Greece should default and 2) develop and communicate a plan to the markets to recapitalize European banks that are large holders of the iffy sovereign debt of the aforementioned “peripheral” Eurozone countries.  Greece can be pictured as the first in a line of dominos that includes Portugal, Italy, and Spain.  European leaders ought to recognize that it is in nobody’s interest to let this first domino fall in a haphazard fashion.  Its fall must be structured and orderly if the Eurozone is to contain this crisis.

Consider the possible effects of an orderly default by Greece: In such a scenario, the external holders of Greek debt (which are mostly large European banks) will take a large “haircut” on the value of their bonds.  Because these bonds constitute capital, these banks will suffer a hit to their capital bases.  The weakest of them will likely require an infusion of public funds.  For investor confidence to stay intact after such events, there will have to be a solid plan in place.  In any case, we should expect to see a coordinated plan emerge within the next month—some say by the G20 summit to take place in Cannes on November 3-4.

Meanwhile, back here in the U.S., our stock market has taken its cue for the last couple of months from political developments in Europe. Broadly speaking, if progress toward a solution seems good, the market rises and vice versa.  In that sense the U.S. equity markets have become a bit unhinged from our domestic economic situation—which in recent weeks the data have shown to even be a bit better than expected.  In particular, the 137,000 private-sector jobs the U.S. economy added in September was well ahead of the 90,000 expected.  August private-sector job creation—previously reported to be zero—was revised upward to 47,000.  The U.S. economy appears to be holding its ground for the moment and our grinding, stop-and-go recovery continues.  The third quarter corporate earnings season is now underway, and so far, outside of the financial sector, the results appear to be quite good.  Come the end of earnings season, however, the focus will shift back to Europe, where we will need to see a big dose of oil applied if the gears are to keep turning.

I welcome your comments and feedback.

Peter C. Thoms, CFA
Orion Capital Management LLC
1330 Orange Ave. Suite 302
Coronado, CA 92118
Tel: 619.435.1701
Email: thoms@orioncapitalmgmt.com

About the Author:
Peter C. Thoms, CFA, is the founder and managing member of Orion Capital Management LLC, an independent Registered Investment Advisor based in Coronado, California. The firm focuses on managing global investment accounts for institutional and private clients.

Disclosure:
This document is for informational purposes only. Nothing in this report is to be construed as a specific investment recommendation. This document does not constitute the provision of investment advice, which is only provided by Orion Capital Management LLC under a written investment advisory agreement and only in states in which Orion Capital Management LLC is registered or is exempt from registration requirements. Orion is not a tax advisor and does not provide tax advice. For tax advice individuals should consult their CPA.

It never ceases to amaze us how much money is needlessly handed over to the IRS in taxes every year because individuals have not been properly advised on how they can best save on taxes through the use of qualified retirement plans. We know of cases where people have been paying tens of thousands of dollars every year in unnecessary taxes because they have not set up the most advantageous retirement plan (or combination of plans) for their circumstances. Those thousands and thousands of dollars could have (and should have) been flowing into a retirement account. And funding a tax-sheltered retirement account with money that could have ended up at the IRS is doubly sweet.

It takes just a bit of time and a little number-crunching to discover your maximum tax-savings potential. For high-income self-employed professionals and consultants as well as owners of 1-5 person firms, the tax-saving opportunities are exceptional. With tax rates likely to increase soon for high-income individuals, now is an opportune moment for them to look into their options for reducing their taxable income.

High-income individuals who operate independently or as part of a small firm should take a very hard look at an IRS-approved defined benefit (DB) pension plan. Why? Because a DB plan offers the highest fully tax-deductible contribution limits—in some cases 2 or 3 times as much as an Individual 401(k). Many people with DP plans are contributing $100,000 or more per year to their plans, which, at a 38% tax rate, provides them annual tax savings of $38,000. And on top of just saving on current-year taxes the money goes into a tax-deferred account where wealth can accumulate faster than it would in a regular taxable account.

Why do so few people take advantage of defined benefit pension plans? We can’t know for sure, but a major reason is probably unfamiliarity. And the main reason for this unfamiliarity may be that it is not really in anyone else’s interest to promote defined benefit plans, so they are not widely advertised. The reality, however, is that an individual with the right profile can reap massive tax savings with a DB plan.

If you are 45 or older and have an income of at least $100,000 you may be well-suited for a DB plan. Key prospects are:

• Business owners with up to 5 employees
• Independent professionals, contractors, consultants, sales reps
• Employees who also receive self-employment income from consulting, directors’ fees, or side businesses
• Self-employed spouses of high-income earners

Additionally, many people in the following occupations can benefit from a DB plan:

Architects
Attorneys
Consultants
Contractors
Independent Corporate Directors
Dentists
Doctors
Entrepreneurs
Graphic Designers
Independent Insurance Agents
Manufacturer’s Reps
Mortgage Brokers
Real Estate Agents
Software Developers

Once you have determined that the DB plan makes sense for you, then the set-up is a snap. We use a third-party pension administrator that works with our clients’ CPAs and handles all of the tax-reporting and record-keeping details. One thing to keep in mind is that a defined benefit plan for saving on 2010 taxes must be set up by December 31, 2010 (or the end of your business’s fiscal year) and must be funded by the business’s tax filing deadline.

Right now interest rates are at rock bottom, global stock markets are volatile and the economic situation is, in the words of Federal Reserve Chairman Bernanke, “unusually uncertain.” These factors are beyond any one person’s control, so it is therefore even more important for an investor to focus on things that he or she can control—such as maximizing tax savings!

Give us a call and we’ll be pleased to perform a tax-savings analysis for you.

Best Regards,

Peter Thoms, CFA
Founder and Portfolio Manager

Orion Capital Management LLC
1330 Orange Ave. Suite 302
Coronado, CA 92118
Phone: 619-435-1701
Email:

Disclosure
Orion Capital Management LLC is an independent Registered Investment Advisor based in Coronado. Orion does not provide tax advice. Individuals should consult their CPA for tax advice.

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Emerging markets, once perceived to be much riskier than developed markets and suitable only for rugged and adventurous capitalists, have now grown up and deserve a sizeable allocation in the portfolio of any long-term oriented equity investor.  They should, in our opinion, no longer be treated as a satellite asset class.  Investors ignoring the very strong structural growth taking place in the countries containing more than 80% of the world’s inhabitants do so at their portfolio’s peril.

First of all, what are emerging markets (EM)?  For the purposes of this paper, we consider EM to be all the countries in the world that are not so-called ‘developed’ markets such as the U.S., Canada, Australia, New Zealand, Western Europe and Japan.  To be sure, however, the lines are beginning to blur between developed and emerging markets.  For example, as measured by purchasing power parity, China is the second largest economy in the world.  And according to the International Energy Agency, China has also passed the U.S. to become the world’s largest consumer of energy—yet it is still considered to be an emerging market economy.

The Growth Baton has been Passed

The bald fact for those of us in the developed world is that our economies and financial markets, while still dominant, are becoming less important with each passing day.  Said another way, emerging economies are on a steep upward trajectory and will be gaining ground rapidly for the foreseeable future. For example, Deutsche Bank estimates that EM economies will have GDP growth of between 4% and 7.5% through 2012, which at the median is at least 3 percentage points higher than developed markets are likely to see.  This trend will likely continue well beyond 2012.

Relative to developed markets, the investment case for EM equities right now is compelling.  It is no secret that the developed world is facing huge challenges to future growth that will persist for years and for which there are no quick fixes:  aging populations, high levels of consumer debt, record-high federal debts and fiscal deficits, low consumer savings rates, large under-funded entitlement programs and a Baby Boom generation that is approaching retirement without the assets needed to fund said retirement.

Contrast this situation with the investment backdrop of emerging markets, which have young and growing populations, rapid economic growth, improving physical and financial infrastructure, much lower consumer indebtedness and comparatively light debt burdens at the federal level. Half of global gross domestic product (GDP) is produced in emerging economies and the IMF forecasted that from 2008 to 2014 Brazil, Russia, India and China would produce more than five times as much GDP growth (in dollar terms) as the G-7 (U.S., U.K., Japan, Germany, Canada, France and Italy).

Another reason we are bullish on EM is that the asset class remains underrepresented in the portfolios of global investors and will see a flood of investment capital over the coming decades.  This increasing flow of funds will, in our view, be supportive of valuations and will make capital more available to smaller EM companies which will in turn further support the expanding EM middle classes.  Goldman Sachs estimates that the EM equity allocations of investors in developed markets—currently 6%–will rise to at least 18% by 2030.  In flow of funds terms, this means these investors will be putting $4 trillion into EM over the next two decades.  By 2030, the Goldman authors estimate, the countries comprising EM today will have an aggregate equity market capitalization of $80 trillion, which will be 55% of total world equity value.

The oft-cited risks of emerging markets remain and should be considered carefully. Governments can be deeply involved in EM economies, corruption remains a problem, legal protections may be spotty and in many places property rights leave much to be desired. There is even still the occasional coup d’etat, civil war, or nationalization of a foreign company’s assets.  These risks, however, are typically country-specific and can be very well managed through proper diversification of one’s emerging market exposure.  Volatility can also be expected to remain high in emerging markets, but keeping one’s equity assets in developed markets hardly guarantees a placid ride: on two occasions during the last decade alone the S&P 500 Index lost half of its value.  Simply put, the relative risk of investing in EM versus developed markets has converged and will likely continue to converge as EM growth marches on.

How to Invest in Emerging Markets

Equity markets around the world are developing and investment options are multiplying, allowing investors the ability to better target specific investment themes and countries.  We believe investors should consider concentrating their exposure on companies that are benefiting from the increasing strength of domestic EM consumers, not by investing in the global companies based in EM that sell into global commodity or technology markets.

One method I will not address in this paper is buying local emerging market shares on local exchanges. While for many reasons this is an excellent way to access EM, the particularities and complexities of this topic are simply too extensive to do justice to it here. Excluding this method, there are four major ways in which US. investors can access emerging markets:

1. Mutual funds.  There are an ever-increasing number of mutual funds that focus on EM.  As always, the prospective investor should take a careful look at fees, portfolio turnover, manager tenure and track record. We generally would not suggest a mutual fund for a taxable account, as turnover is typically high with EM funds and an unpleasant tax bill in December should never be considered a surprise. Morningstar is a good place to begin a search of EM funds.
2. ETFs.  Some of the most popular EM equity vehicles are exchange-traded funds (ETFs).  ETFs trade on a stock exchange just like a stock, but they represent a basket of underlying holdings.  For example, the largest ETF devoted to the emerging markets category is the iShares MSCI Emerging Markets Index Fund (NYSE: EEM).  This ETF has assets of $44 billion and attempts to track the eponymous index as closely as possible.  At first glance it would appear to be a good way to get broad-based EM exposure, but we believe there are better choices than EEM for tapping the true EM growth drivers.The major weakness of such market-cap weighted ETFs is that they have too much exposure to the large externally-focused companies in a given EM and not enough to smaller companies serving domestic consumers.  Another case in point is the popular iShares MSCI Brazil Index ETF (NYSE: EWZ).  This ETF will give you plenty of exposure to the global energy and raw materials markets via its large weightings in oil company Petrobras and miner Vale, but it is not heavy on exposure to small domestically-focused Brazilian companies.  In our view the Market Vectors Brazil Small-Cap ETF (BRF) accomplishes this objective more completely.  The bottom line is that it is very important for investors to investigate the underlying holdings of ETFs to make sure they are getting their desired exposure.There are a few companies to watch in the emerging markets ETF business.  EGShares (www.egshares.com) has a growing array of ETFs that permit investors to more directly target the domestic economies of several EM countries.  Global X Funds (www.globalxfunds.com) and Market Vectors funds (www.vaneck.com) are also worth a look.
3. American Depositary Receipts (ADRs). An ADR is a negotiable certificate issued by a U.S. bank that represents a specified number of shares of a foreign stock.  ADRs are traded on U.S. exchanges.  According to my search of the BNY Mellon ADR database (www.adrbnymellon.com), there are 245 emerging market ADRs traded on U.S. exchanges and another 1000 or so accessible over-the-counter (OTC).  ADRs are an efficient and transparent way to invest in a particular EM company.
4. Companies in developed markets which are levered to growth in EM.  A back-door method of participating in EM growth is to buy shares in a developed markets company that does lots of business in the emerging world.  YUM Brands (NYSE: YUM) is a frequently mentioned (and excellent) example.  This U.S.-based company is expecting to generate 34% of its operating profit from its China business in 2010, where it now owns 3,000 KFC restaurants and is planning on building 15,000 by 2030. YUM’s future growth is thus much more dependent on Chinese consumers than it is on its low-growth U.S. restaurant business and its stock may offer an effective means to participate in the improving finances of Chinese consumers.

Emerging markets have gone through lots of changes in the last decade as they have started down the capitalist path.  Globally-oriented equity investors should give them serious consideration.

About the Author:

Peter C. Thoms, CFA, is the founder and managing member of Orion Capital Management LLC, an independent Registered Investment Advisor based in Coronado, California.  The firm focuses on managing global equity accounts for both institutional and private clients.

www.orioncapitalmgmt.com

Disclosure:
This document is for informational purposes only. Nothing in this report is to be construed as a specific investment recommendation.  This document in no way constitutes the provision of investment advice, which is only provided by Orion Capital Management LLC under a written investment advisory agreement and only in states in which Orion Capital Management LLC is registered or is exempt from registration requirements.

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Global stock markets declined sharply this week as a confluence of fears battered investor confidence around the world. The sell-off puts U.S. markets into the red for 2011 and more than 10% below their April highs.

So what’s changed in the past few weeks to unsettle investors? There are four major factors contributing to the worsening investor sentiment.

First, the ugly fight over raising the U.S. debt ceiling has damaged business confidence not only here, but also around the world. The fracas that left the U.S. government within hours of a potential default has demonstrated to both Americans and foreigners alike our government’s state of near paralysis. It has undermined faith that the federal government will be able to reach future agreements about how it can best aid the economy and how it can best create an environment that encourages companies to hire more workers.

Second, there is a creeping realization that the federal government is simply out of ammunition to help the economy. Additional fiscal stimulus appears to be unlikely at least through the 2012 election and the Federal Reserve already has its gas pedal to the floor (in the form of 0% interest rates). Will the Fed take additional measures to try to stimulate growth? Perhaps, but another round of quantitative easing is unlikely to have a lasting salubrious effect on the economy.

Third, the continuing inability of the Europeans to find a durable and sustainable plan for addressing their debt crisis has caused many global investors to head for safer ground. On Friday, the European Central Bank announced that under certain conditions it was prepared to begin buying Italian and Spanish government bonds in the open market. While this tactic may placate markets in the very near term, Europe has a long way to go before it can be sure that it has fully contained its debt crisis.

Fourth, at the end of July the U.S. Bureau of Economic Analysis (BEA) revised downward its estimates of economic growth in the first half of the year, leading many investors to wonder if the economy is about to slow further. The revised numbers showed that the 2007-09 recession was deeper than initially reported and that the recovery, thus far, has been weaker than previously estimated. All in all, investors have garnered little comfort from recent economic data.

This abrupt turn in confidence has, unfortunately, overshadowed the second quarter U.S. corporate earnings season—which so far has been excellent. U.S. companies are making strong profits, maintaining high profit margins and have strengthened their balance sheets significantly. They are lean, efficient and have the wherewithal to invest in their futures. But the shenanigans in Washington and the bad news out of Europe have frustrated Corporate America deeply, and this exasperation in readily evident in the voices of executives as they report their companies’ financial results and make projections about the increasingly cloudy future.

What the markets need now is simply for policymakers in both Europe and the U.S. to convince investors that they are up to the task of decisively addressing our economic challenges.

As always, please do not hesitate to call if you would like to discuss the economy, the markets or your account.

Peter C. Thoms, CFA
Orion Capital Management LLC
1330 Orange Ave. Suite 302
Coronado, CA 92118
Tel: 619.435.1701
Email:

About the Author:
Peter C. Thoms, CFA, is the founder and managing member of Orion Capital Management LLC, an independent Registered Investment Advisor based in Coronado, California. The firm focuses on managing global investment accounts for institutional and private clients.

Disclosure:
This document is for informational purposes only. Nothing in this report is to be construed as a specific investment recommendation. This document does not constitute the provision of investment advice, which is only provided by Orion Capital Management LLC under a written investment advisory agreement and only in states in which Orion Capital Management LLC is registered or is exempt from registration requirements. Orion is not a tax advisor and does not provide tax advice. For tax advice individuals should consult their CPA.

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Business owners and independent professionals have powerful tax-saving options available to them that the rest of the population simply does not.

By opening and funding an IRS-approved qualified retirement plan called a small business defined benefit plan, a business owner or independent professional can make tax-deductible contributions to the plan in excess of $100,000 per year and thereby save $38,000 or more in taxes each year.

Defined benefit (DB) plans are not right for everyone, however.

Do you fit this profile?

• Self-employed or small business owner with up to five employees
• 40 years of age or older
• Willing and able to contribute more than $50,000 annually to a qualified retirement plan and continue this level of funding for at least 3 years

Defined benefit plans enable the self-employed to build a very large nest egg in a very short amount of time. DB plan participants can accumulate as much as $1,000,000 to $2,000,000 in a retirement account in just 5-10 years. Once a DB plan is funded to the IRS limit of $2.36 million, the DB assets can simply be rolled into a regular IRA.

Here is a list of the typical professions of people with defined benefit plans:

• Architects
• Attorneys
• Consultants
• Contractors
• Independent Corporate Directors
• Dentists
• Doctors
• Entrepreneurs
• Graphic Designers
• Independent Insurance Agents
• Manufacturer’s Reps
• Mortgage Brokers
• Real Estate Agents
• Software Developers

DB plans enjoy several powerful features.

• Highest allowable contributions to a qualified plan–$100,000 or more (much higher than the contribution limits on SEP-IRAs and 401(k)s.
• Annual tax savings of $38,000 or more
• Investments grow tax-deferred, building wealth faster
• Tax-free rollover to an IRA at retirement (or plan termination)
• Flexible range of investment choices

Defined benefit plans are not appropriate for everyone, but for those in the right circumstances they can provide large tax savings and a very fast way to “catch-up” on amassing a substantial retirement nest egg.

We would be pleased to generate a complimentary proposal for you if you would like to see how much you could save in taxes by establishing a defined benefit plan. Just give us a call or send an email. It takes just a little time and won’t cost you a thing.

If you would like more information about how DB plans work, simply contact me and I will send you our 2011 Defined Benefit Plan White Paper.

Peter C. Thoms, CFA
Orion Capital Management LLC
1330 Orange Ave. Suite 302
Coronado, CA 92118
Tel: 619.435.1701
Email:

About the Author:
Peter C. Thoms, CFA, is the founder and managing member of Orion Capital Management LLC, an independent Registered Investment Advisor based in Coronado, California. The firm focuses on managing global investment accounts for institutional and private clients.

Disclosure:
This document is for informational purposes only. Nothing in this report is to be construed as a specific investment recommendation. This document does not constitute the provision of investment advice, which is only provided by Orion Capital Management LLC under a written investment advisory agreement and only in states in which Orion Capital Management LLC is registered or is exempt from registration requirements. Orion is not a tax advisor and does not provide tax advice. For tax advice individuals should consult their CPA.

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Huge drama surrounding the debt morass in Greece, slowing economic growth in the U.S., weak equity markets in May and most of June. . . . What year am I describing?  2010.  But also 2011.  This year’s second quarter had many similarities with last year’s 2Q, with a number of the same concerns taking hold.

The S&P 500 Index, thanks to a massive rally in the final four days of the quarter, lost only 0.4% for the quarter and is now 3% below its April highs.  The market weakness in May and June resulted mainly from three factors.  First, the U.S. economy slowed considerably during the quarter; we have definitely hit a soft patch in our stop-and-go economic recovery.  The steady trend of improvement in employment was broken in May, when the economy only added 54,000 jobs and the unemployment rate remained stuck at 9.1%.  Many analysts also downgraded their outlook for GDP growth for the remainder of 2011 and are now forecasting growth of around 2.5% rather than 3.0%-3.5%.

While the economic data overall point to a slowing of economic activity, the origin of much of the weakness in April and May can be traced back to supply disruptions for the automotive and technology industries in the wake of the earthquake and tsunami in Japan on March 11.  I was recently at my Honda dealer and asked the manager how his business was going.  He said things were very difficult at the moment because his dealership had been getting only a few new Hondas per month from the factory.  It will probably be a slow summer for the economy, but come autumn growth will likely tick up again.

A second factor that weighed on investor sentiment during the quarter was the approaching end of QE2, the Federal Reserve’s $600 billion bond-buying program.  This program ended June 30 and many investors are skeptical that the U.S. economy will be able to walk without this artificial and temporary crutch.  Without the Fed out there as a buyer of Treasuries, the logic goes, long-term interest rates on U.S. government debt will have to rise to make them a bit more enticing to investors and will thereby act as a brake on an already sluggish economy.

Finally, the European debt crisis re-ignited itself as riots broke out in Greece as its Parliament pushed through hugely unpopular austerity measures in order to secure a loan from the European Union and International Monetary Fund to help the country stave off bankruptcy.  The Greek debt issue is by no means solved, however, and investors should just consider this the latest act in a drama that will go on for years and likely involve other actors such as Portugal and Ireland—but also potentially even Italy and Spain.

As the quarter came to a close, the International Energy Agency (IEA) made a surprise announcement on June 23^rd that it would release 60 million barrels of oil held in strategic government reserves over the next thirty days.  These reserves are held by the members of the IEA that are net importers of oil as a cushion in case of emergency or a prolonged supply disruption.  The U.S. share of this release was 30 million barrels from its Strategic Petroleum Reserve.

The putative reason for this release of oil was to ease the supply disruption caused by the Libyan civil war.  (Libya accounts for 1.5% of global oil production.) The timing of this release was somewhat puzzling, however, as oil prices (West Texas Intermediate crude) had already retreated 18% from $115 per barrel to $94 in the prior two months.  (If there had been a bona fide supply problem oil prices would have held higher levels.) The news of the release sent oil down nearly $5 to under $90, but in the week since then oil has climbed back to $95.  In the end, the Libyan conflict is already three months old and the world has gotten used to operating without its oil.  This release will likely have little impact in holding down prices.  In fact, if nothing else it served to highlight the very tight supply-demand balance in a world that continues to grow thirstier for oil by the day.

As July begins, global investors are beginning to focus on sweltering Washington, D.C. and its ongoing political skirmish over raising the U.S. debt ceiling.  For this country to avoid a very bad outcome in the financial markets and a body blow to our still-weak economy, the debt ceiling must be raised—and in all likelihood will be raised.  The main question is how much or how little damage is done to investor confidence in the process as Congress continues to play a game of “chicken” with this issue.  The date at which the U.S. Treasury will be in technical default is August 2^nd, but if this issue comes down to the wire we will be needlessly hurting ourselves.  Despite the $14.8 trillion debt hole we have dug for ourselves, the interest rates at which we are able to fund this spending have remained at remarkably low levels and we have benefitted immensely from the kindness of foreigners who are so willing to lap up our debt at such low rates.  If Congress does not act promptly to resolve the debt ceiling debate, these low rates in jeopardy.  Foreign investors in our debt will demand higher interest rates if our Congress cannot agree on whether or how we are to service our debt obligations.

I welcome your comments and feedback.

Best Regards,

Peter

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At Orion Capital, we help our clients to simplify, streamline and gain control of their financial lives. We believe that you ought to know exactly where your money is, how it is invested, and why it is invested the way it is.

It is no secret that these are extraordinarily difficult times for Americans trying to save for retirement. With interest rates at generational lows and inflation beginning to heat up, investors with their money in savings accounts or money market funds have virtually no chance of earning a good return.

While Mr. Bernanke and his fellow governors at the Federal Reserve have kept short-term interest rates at zero to stimulate the economy, in doing so they are severely punishing America’s savers.

While the income options are poor at the bank and with money market funds, investing in dividend-paying stocks remains far and away our favorite way of building a robust income stream for two reasons:

1. You Get More Income: The dividend yields of many stocks are significantly higher than the interest rates of savings accounts or money market funds.
2. It Grows: An income stream based on dividends has a very good chance of growing over time as companies sweeten their dividend payouts.

Right now there are many, many blue-chip U.S. and international stocks that have dividend yields of 3%-6%–yields that on average handily beat the rate on the 10-year Treasury note (which at this writing was 3.14%).

Putting money into the stock market has its risks as well and is not appropriate for every investor, but over an extended period a well-diversified portfolio of high-quality companies that are committed to their dividend payments should serve an investor well.

There is a notion with many investors that money market and bank savings accounts are “safe.” Well, that all depends on how you define “safe.” They are generally safe in that the number of dollars that you put into them will not decline—but the value of those dollars could drop (and has dropped) dramatically.

There’s no use sugar-coating it: Over the past decade the U.S. dollar has been crushed. As measured by the U.S. Dollar Index, our dollar has lost more than half of its value against a basket of other currencies. As measured against oil, gold, food and other commodities it has also lost an absolutely shocking amount of purchasing power. This means that if you have had $10,000 sitting in an FDIC-insured bank savings account since 2001, it has lost roughly half of its purchasing power. Not very safe.

The lesson here for investors is that they should strive to preserve and to increase the purchasing power of their nest egg, not just the dollar value. Dividend-paying stocks allow investors some shelter from inflation as companies operate in the real economy and can raise their prices over time to combat the effects of inflation. When you are invested in “safe” fixed income instruments such as savings accounts and money market funds, however, you are consigned to bear the full negative brunt of inflation.

Securities laws prohibit me from recommending particular investments in this forum, so if you would like to find out more about how Orion’s dividend strategy can be put to work for you please give us a call to set up a complimentary appointment.

Peter C. Thoms, CFA
Orion Capital Management LLC
1330 Orange Ave. Suite 302
Coronado, CA 92118
Tel: 619.435.1701
Email:

About the Author:
Peter C. Thoms, CFA, is the founder and managing member of Orion Capital Management LLC, an independent Registered Investment Advisor based in Coronado, California. The firm focuses on managing global equity accounts for both institutional and private clients.

Disclosure:
This document is for informational purposes only. Nothing in this report is to be construed as a specific investment recommendation. This document does not constitute the provision of investment advice, which is only provided by Orion Capital Management LLC under a written investment advisory agreement and only in states in which Orion Capital Management LLC is registered or is exempt from registration requirements. Orion is not a tax advisor and does not provide tax advice. For tax advice individuals should consult their CPA.

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