GKV Capital Management

Economic and Investment Outlook

Second Quarter 2015

2015 June Quarter Review

Chasing Performance

Expectations for 2015 GKV Capital Management

A note from: PETER VOGEL It has been 40 years since I opened the doors at GKV Capital Management. In 1975 GKV was registered with the SEC under the Investment Advisers act of 1940 and has been in continuous operation ever since. Although we have not grown as fast as that upstart software company, , which was also founded in 1975, the firm has exceeded my modest goals of providing sound investment guidance to our clients for more than four decades. 2Q15 Data Points

Most of our clients have been with the firm for more than a decade and in many cases DJIA YTD -1.1% we have been advising multiple generations. A lot has happened on Wall Street and in the world over the last 40 years, both good and bad. With each bull market or economic S&P 500 YTD 0.2% crisis, new lessons are learned and we make adjustments. After a terrible and bear market in 1973 and 1974, 1975 turned out to be a good time to start a new invest- NASDAQ YTD 5.3% ment firm. Since 1975 the S&P 500 has grown at a compound annual rate of 8.9%. In- cluding dividends, the benchmark has delivered a 10,000% return. However, these gains Int-Term 0.6% were not without some challenges along the way. Six paired with six bear Bond YTD markets, severe and ‘’, in 1987 when the market de- 10-Year 2.4% clined more than 22% in a single day, six presidents, 9/11 and a ‘Great Recession” have Treasury Yield kept us on our toes. In 1975, IBM was the largest company on the New York Ex- S&P 500 LTM 2.0% change followed by AT&T, Exxon, Kodak, GM and Sears. Today only Exxon remains in the Dividend Yield top 20. Over forty years, our clients made investment gains on average, in all but two. S&P 500 EPS $124.18 Next 12-MTH

Greg joined me at the firm in 2003 after a very successful career as a research analyst S&P 500 P/E 16.6x culminating as a managing director at Securities. It is hard for me to believe that he formally joined GKV more than a decade ago, although he grew up here at GKV. It has been nice to have someone to share the blame when things go wrong.

In the most important ways, not much has changed here at GKV. We continue to look out for our clients and use our hard won experience to manage assets the best we know how. I have no near-term plans to retire and still enjoy each day handicapping where we can make money tomorrow. Thank you to all our clients and colleagues for making it a great four decades.

GKV Capital Management is an independent registered investment advisor. For more information about us please call (805) 497-2616 or visit gkvcapital.com

Page 2 Second Quarter 2015

Second Quarter Review

Equity market was driven largely by headline news economic growth and increases in employment and income particularly at the end of the quarter. As the quarter drew generally translate into greater demand. Not surprising, to a close it appeared likely that Greece would default on its retail sales improved dramatically in May jumping 1.2%. debts and be forced to exit the Euro. While Greece itself is too small to be material to the global economy, investors We increased our exposure to equities in the second quar- were concerned for the possible domino effect that a Greek ter, reducing cash balances firm wide to 2% of assets under failure might perpetuate. Investor consternation accelerat- management from 10% at the end of March. Like most of ed with the dramatic selloff on the Shanghai exchange in Wall Street, we are hopeful that the slightly more positive China, and what implications increasing weakness in China macro-economic data will translate into an uptick in corpo- would have on the global economy. The equity markets fin- rate activity after a weak March quarter. The earnings fore- ished the second quarter mixed with a loss for the Dow In- dustrial Average of 1.1%, a marginal gain of 0.2% for the S&P 500, and a positive 5.3% gain for the Nasdaq Compo- Firm Wide Asset Allocation June 30, 2015 site.

Several macro-economic data points were encouraging in the second quarter. The employment picture continues to improve with positive data from the Labor Department cou- pled with a positive uptick in average hourly earnings. The official unemployment remains essentially unchanged at 5.5%, however the rate of new jobs added (280,000 in May) is positive. Consumer spending is the single largest driver of

Source: GKV Capital Management

Page 3 GKV Capital Management

cast for 2015 now reflects only 2% growth over 2014 and current levels until the fall. The expectations of rising rates should be attainable. More important will be the guidance has had a negative impact on our bond portfolio. In the sec- from companies for 2016 earnings which currently appear ond quarter our bond portfolio eked out a 0.2% gain. We grossly optimistic. We ended the second quarter with 55% expect this performance to improve as the year progresses of assets under management in equities, 39% in fixed in- assuming there is not a dramatic increase in interest rates. come and 2% in cash. The remaining 4% is in various real In the second quarter the non-U.S. equity markets extend- estate investments. ed March gains despite a late June selloff. Developed coun- tries excluding the U.S. posted a 5.9% gain as measured by Despite our earnings expectation concerns, the outlook for the MSCI EAFE index. Japan and China ended the June quar- equities is positive, in our opinion. Our optimism is predicat- ter with gains of 15.2% for the Nikkei and 25.3% for the ed on continued macro-economic improvement leading to a Shanghai Composite. An improving global outlook would slight acceleration in revenue and earnings growth towards significantly improve the economic picture for the U.S. the latter half of the year. economy, particularly for the larger capitalized U.S. compa- nies which derive most of their revenue and growth interna- Health care and consumer discretionary sectors recorded tionally. We anticipate international growth to remain une- the strongest performance through the first half of 2015. ven and volatile in the near-term but are optimistic for an The energy sector followed by utilities continue to be the improving long-term outlook. Our international equity expo- worst performing. Coal is the single worst subsector, down sure is currently negligible, but we will look to increase ex- approximately 50% through the end of June. posure as improvements become more apparent.

Interest rates bumped up in the June quarter but remain low. The yield for the 10-year Treasury hit 2.4% as of June 30th, after dipping as low as 1.7% in January. While we con- tinue to anticipate a rising interest rate environment in the long-term, our expectation is predicated on the long await- ed acceleration in economic growth. So far the Federal Re- serve has shown reluctance to push rates higher without increased economic activity. At the current rate of economic growth, we should anticipate interest rates to remain near

Page 4 Second Quarter 2015

Chasing Performance

“Only liars manage always to be out of the market during bad times and in during good times.” - Burton G. Malkiel

This is a frustrating business. It is easy to talk about the 10 years, the price performance of the S&P 500 returned 7.7% patience that investors must possess in regard to their annually for the period ended December 31, 2014. Since 1958 portfolios, but in practice, patience can be hard to come the average return is marginally higher at 8.5%. When some- by. It takes only a few quarters of little-to-no returns to one tells us they are looking for a 20% annual return, we wish start to question an investment strategy. We all do it, them luck. If we could hit that mark annually we wouldn’t still even the professionals. So far, 2015 has been lackluster. be writing investment newsletters. As a result we thought it an appropriate time to trot out a few thoughts on investing “best practices” we have So far this year the broad market as measured by the S&P 500 learned after more than a few years managing assets. has returned a paltry 0.2%. We have argued that while sensa- tional headlines move the market day-to-day, the long-term First, have an investment plan. The plan does not have to trajectory will be dictated by corporate earnings. 2015 has had be terribly detailed and it should be malleable, but there plenty of headlines but earnings growth has failed to live up to should be a plan. The essential elements are the invest- expectations. In 2013 the S&P 500 surged nearly 30% in antici- ment time frame, what contributions (if any) will be pation of rapid growth that has yet to materialize. Reluctant to made, when will funds begin to be withdrawn and in what give up, economists and investors now forecast accelerating quantity, how much risk and volatility can be tolerated, growth in about six months from now. This has been the fore- and lastly, what realistic performance expectations should cast for more than two years now. So, while we wait for the be assumed. The plan is the easy part. The actual invest- acceleration to come, the market moves sideways as investors ing is a bit tougher and most challenging of all is the pa- sort the tea leaves looking for new evidence to justify an ex- tience and determination required to not be your own pensive . worst enemy when it comes to managing your assets. Invariably, after a moderate period of weak performance in- Second, establish reasonable performance expectations. vestors begin to question the current plan and become in- Expectations are, after all, an essential variable in the creasingly anxious about performance. As the anxiety increas- aforementioned plan. We find most clients have very rea- es, so does the urgency to do something about it. The tempta- sonable expectations for investment returns, at least ini- tion to chase performance, to allocate more assets to whatev- tially. Based on historical returns and a -term eco- er investment idea is currently outperforming, is difficult to nomic view, we try to communicate what we think both resist, and while on the surface it seems to make sense, it is near-term and long-term investment returns are likely to one of the worst mistakes an investor can make. be. The difficulty is that over various short-term periods, volatility results in substantial deviations from the long- Morningstar, which publishes and stock perfor- term expected result, and it may take some time to revert mance data does an analysis on a regular basis that tracks mu- to a ‘normal’ expected return. Sometimes, the short-term tual fund inflows and redemptions to determine real investor deviation can take quite a bit of time. Consider that from returns and compares this performance to the investment 2000-2010 the S&P 500 index returned a -1.4% compound gains of the fund itself. When a fund has a particularly good annual growth rate. We have difficulty calling a ten year year, new money comes rushing in to capitalize on the per- period ‘short-term’ but certainly the performance of equi- ceived brilliance of the investment manager. Usually the supe- ties over the period was atypical. Nonetheless, reasonable rior performance is an aberration and new investors sign on as long-term expectations can be established for a deter- the fund peaks. The investment style may have coincided nice- mined amount of risk and volatility. Without going too ly with the current environment and as a result the fund expe- deep into the math behind asset pricing models and risk riences above average returns. Most of the time the perfor- premium calculations, history is a modestly reliable, albeit mance reverts to the mean and after a period of sub-par per- an imperfect guide to future expectations. Over the last formance, investors rush to the exit in search of the next great

Page 5 GKV Capital Management

investment idea. Meanwhile the fund bottoms out and re- media but always with a filter for what might affect the funda- verting back to an average return, begins to improve again. mentals. We are investors not speculators. Investors buy high and sell low. This is chasing performance. Third, be diversified. The argument for diversification is easier For the 10 year period ended December 31, 2014, U.S. equi- and more obvious than the argument against chasing perfor- ty funds produced an average total return of 7.5%. After mance. Don’t put all your eggs in one basket. How hard is adjusting for investor fund flows, Morningstar calculated that? Many fail to understand the significance of diversifica- that the average investor return in those funds was nearly tion when it comes to their investments in practice however. 1% lower than the funds themselves at 6.5%. That’s a lot of We can all agree that an investor with his entire net worth money left on the table. Between fees, taxes, and poor invested in 10 individual is not very well diversified. management it is no wonder so many experience disap- Although he is significantly more diversified than the technolo- pointing investment results. gy company executive with all her wealth tied up in the com- pany she works for. What about the investor that has invested In 1973, Burton Malkiel argued in his classic, A Random in the entire S&P 500 through an unmanaged index fund? Cer- Walk Down Wall Street, that markets are efficient and that tainly the index fund investor is more diversified against the investors will not be able to consistently beat the index. risk of one company imploding than the investor with 10 indi- Analysis from him and others taught a generation not to vidual stocks, but if the market as a whole declines precipi- time the market and demonstrated that actively managed tously they will both lose money. Investors need to diversify at portfolios are unlikely to beat the index over the long-term. multiple levels- asset classes (stocks, bonds, real-estate and Rather than time the markets we do actively manage assets cash), industries, and individual companies. in an effort to reduce risk and produce reasonable returns. We make investment selections based on expectations of After the tech bubble burst in 2000 quite a few people began future growth in sales and earnings relative to current valu- to ask why they should be in stocks at all. In 2008 the question ation metrics. The financial events of the last 20 years has came up again. 2000-2008 was a dismal period for equity in- caused us and others to question the ‘perfect’ efficiency of vestors. With declining interest rates and weak economic fun- the markets. Asset bubbles and consistent long-term out- damentals we concentrated on fixed income. From 2006 to performance by a few managers such as Warren Buffet ar- 2011 more than 50% of our assets under management were in gues against a perfectly efficient market. fixed income, but we argued that equities were a necessary holding in some quantity for most if not all portfolios. Since We adjust our asset allocation and investment selection 2009 the equity markets have recovered and hit new highs. It regularly based on fundamentals. We frequently make ad- would have been a mistake to dismiss the importance of equi- justments and changes, but try never to chase performance ties. or the latest sensation. We pay attention to the financial

Page 6 Source: Morningstar Data, GKV calculations. Second Quarter 2015

With interest rates at historical lows, resulting in poor bond set allocation to reflect what we think is most likely to market returns and expectations of imminently rising interest happen in the future given the current fundamentals. rates, things have come full circle. Now we are being asked Bonds are an important asset class for diversification. We why we should own bonds at all. Over the long-term bonds may continue to reduce our exposure, but they should have produced consistent positive returns and importantly not be eliminated entirely. We expect interest rates will those returns are generally not correlated to the perfor- rise although we anticipate a very gradual increase. Our mance of equities or other asset classes such as real-estate. portfolio is comprised of shorter maturities which will In 2008, when the S&P declined 36%, Lehman Brothers went mitigate the negative impact of rising rates. We expect bankrupt and the real-estate market fell off a cliff, the Bar- our bond portfolio to generate less than the 15 year an- clays Aggregate Bond Index gained 5.2% (ironically this was nualized return of 5.7% for the next few years. formerly the Lehman Brothers bond index). Our stock selection over the last 10 years has kept pace The table on the opposite page shows three conceptual with the S&P 500 and we are proud of that fact, but our portfolios with actual performance data for the last 3, 5, 10 goals are more modest. We are protecting the assets of and 15 year periods ending December 31, 2014. For most our clients first. Substantial losses are too difficult to re- time periods it is apparent that stocks produced the most cover. Secondly, we are focused on making a reasonable significant returns but that should not encourage investors to return. With asset allocation we try to reduce volatility put all their money solely in stocks. In addition to the highest and achieve more predictable returns. Whether someone returns, the equities also have the most volatility as meas- is just starting out in their 30s or already in retirement, in ured by the standard deviation for every time period. By add- our view the goals are the same; protect what has al- ing a few bonds to the portfolio, performance is reduced only modestly while volatility is reduced significantly. By diversify- ready been accumulated and grow assets in a prudent ing the asset class, losses are reduced in bad years, gains are manner. Certainly someone beginning their career has reduced in good years, but the performance becomes more plenty of time to recover from losses and can theoretical- predictable and more stable. ly take on more risk, but the reality is, losses are difficult to recover from and the natural tendency after significant At the close of June our fixed income holdings were down to losses is to exit the market, which is, of course, the worst 39% of total assets under management. In 2011 our bond thing you can do. Investors themselves, will always be holdings peaked at 60% of assets under management after their own worst enemy. nearly 10 years above 50%. We make adjustments to our as-

Looking Forward

While the media fixates on insolvency in Greece, China’s quarter results, corporate management collectively reduced artificial stock market, Iran’s nuclear capability and unfortu- their forecasts for the year and lowered the bar dramatical- nately, Donald Trump, we remain focused on the U.S. econ- ly. We expect most companies to exceed published esti- omy and second quarter earnings. The first quarter of 2015 mates in the second quarter, but that won’t matter much. was written off due to bad weather. Results in the second What will be critical will be the forecasts for the second half quarter will have to be better since that excuse can’t be of 2015 and into 2016. The current estimates call for only used again. 2% year-over-year earnings growth, which hardly justifies a 16.6x multiple. The estimate for 2016, $132.36, represents Earnings expectations just keep going lower. On June 30th 14.6% earnings growth. We are skeptical and so is the mar- the 2015 estimate for the S&P 500 was $115.47, down from ket. If this forecast were truly likely we could expect double a forecast $137.52 a year ago. The earnings expectation for digit market returns over the next twelve months. If the the next twelve months for the S&P 500 is $124.18 resulting forecast is cut too much we will continue to spend 2015 in a P/E of 16.6x. Historically speaking, this level is certainly treading water, clipping coupons and collecting dividends at the high end of the range implying that the market is ex- hoping to stay ahead of a very meager inflation rate. Sur- pensive but maybe not excessively so. This makes the com- prisingly, our bond portfolio may outperform equities in ing earnings results all the more important. After poor first 2015.

Page 7 Independent Investment Advisory

GKV Capital Management is a registered advisory firm oper- ating since 1975. We manage separate accounts for families, charities and retirement. Four of the largest asset bubbles have occurred in the last 25 years. Volatility has taken a significant toll on investment assets requiring new strategies to protect and grow wealth. As an independent portfolio management

Southern California firm making direct investments on our clients’ behalf, GKV 125 Auburn Ct. Capital has the flexibility and expertise to respond to the Suite 200 Westlake Village, CA 91362 changing investment environment to reduce risk, minimize losses and grow wealth. Northern California 2950 Buskirk Ave. Suite 300 Walnut Creek, CA 94597

Phone: 805-497-2616 Fax: 805-379-3216 E-mail: [email protected]

Our Investment Philosophy

We take a dynamic view of the macro economy to determine expected returns in the near-term of various asset classes. Within these classes individual invest- ments are selected for clients’ accounts on an account by account basis.

We do not buy and hold, but seek to take advantage of changes in market senti- ment and fundamentals to avoid losses and create opportunity. As an inde- pendent portfolio manager we have the flexibility to adjust investment expo- sure rapidly.

We make direct investments on behalf of our clients buying individual securi- ties, generally stocks and bonds eliminating costly mutual fund fees. We are a fee-only advisor, we do not receive commission and we do not sell any financial products. Client assets are held at an unaffiliated brokerage firm.

GKV Capital Management is a registered investment advisor with the SEC under the 1940 act. This newsletter provides general investment information and is not intended to provide specific financial, investment, legal, or tax advice. Any discussion of individual securities should not be taken as a recommendation for any reader to buy or sell such securities. You should consult with your own advisor and/or do your own research before acting on any of our opinions, which we change without notice. The data provided in this newsletter is believed to be reliable, but are not guaranteed as to accuracy or completeness. The value of the securities mentioned herein may fall or rise and are not insured by any government or private company.

©2015 GKV Capital Management Company Inc.