Oddly, defensive names that ordinarily trade at premiums to the market are trading at big value discounts. These companies that have the ability to grow in any economic environment are a part of the portfolio, as well as companies riding pockets of growth around the globe. There is a lot to be excited about in 2013 for value stocks. 

US GDP continues to stagnate, unemployment remains stubbornly high, and the eggheads at bond shops keep calling for 5% returns in equity markets. All of these cannot preclude good businesses from growing, and thus stocks continue to appreciate. Though 2012 favored momentum and growth businesses in terms of equity price appreciation, our focus on the business behind the stock price found even our worst-performers like Western Union and Dell produced billions of free cash flow while their stock prices declined. This is something that will be rewarded eventually, and due to the dismal stock price performance of companies with sound fundamentals, we are excited to have purchased several quality companies that lagged the indexes in 2012. As active managers we despise trailing any index in any period of time, but we know it is far more important to stick to your strategy while it is out of favor, and our experience tells us patience and discipline are rewarded in the long-term. Confidence and optimism are high when we find ideas like the ones in our portfolio today.

Our outlook is one of undervalued defensive investments as a rewarding offense. Though Congress avoided the full extent of the fiscal cliff, the majority of consumers will experience an increase in their payroll taxes. More taxes means less money going towards consumer spending, which is already in peril from a decline in the savings rate. This is a great time to purchase defensive, non-discretionary companies because they will thrive in a weak-spending environment as well as experience multiple-expansion due to their low valuations. Companies like the 29 powerhouses in the Frank Value Fund are a superior place for capital, especially when one considers the possibility of rising interest rates and inflation.

In 1995 Brooklyn-born rapper Christopher Wallace, better known as The Notorious B.I.G. wrote a verse about “Chillin, sittin’ on about half a million*,” meaning Wallace had a handsome $500,000 to his name. Suppose Wallace had the foresight to retire from the brutal rap game, perhaps saving his money and avoiding a feud with West-coast rapper Tupac Shakur that ultimately cost the talented duo their lives. What would $500,000 in 1995 dollars buy today?

The answer is 34% less. From 1995 to 2011 inflation averaged 2.5% per year, and compounded over 16 years this reduces the purchasing power of $500,000 1995 dollars to $329,500 at the end of 2011. If The Notorious B.I.G. had placed the cash under his mattress in 1995, he would only be able to purchase 66% the amount of goods and services in 2011 as he could have in 1995. Of course, like any wealthy individual, Wallace could have purchased fixed-income investments yielding 2.5% that would have at least kept pace with inflation, turning his $500,000 into $758,000 in 2011, and thus protecting his purchasing power – not increasing it. This is where the current zero-interest-rate environment should scare fixed income investors. Banks are paying less than 1% on savings right now, and government bonds are yielding far less than 2.5%. You are losing purchasing power if you are compounding your capital at a lower rate than inflation. Consider the increases in your grocery and health insurance bills to understand how $1 today can purchase less than $1 tomorrow.

One additional tidbit of history should also be carefully considered while attempting to protect your nest egg’s purchasing power: 2.5% inflation is tame. The average in the United States over the last 50 years is 4%. From 1970 – 1980, inflation averaged 8.7% per year. This ten year run would have reduced the purchasing power of $500,000 to $222,897! This is less than half the purchasing power in a shorter time period than the previous scenario! Many economists are comparing the current environment to the 1970s, and we believe having a watchful eye on history is a prudent strategy.

In both time periods, disciplined investors in quality businesses did much better than inflation. Especially in the 1970s there were tough bear markets to contend with, but by focusing on fundamentals these periods allowed opportunistic investors to build long-term returns. We implore our shareholders, refuse to allow the Federal Reserve and the waves of bond inflows hoodwink you! The Fed is rapidly building up bank reserves, and whenever these reserves enter the system, inflation will follow. Probably before that happens we will see markets increase interest rates, and the resulting losses will be shocking to many bondholders. Regardless of the timing of the above events, it is clear fixed income investors are desperate for yield, yet select equities in our portfolio offer extraordinary return profiles today. We strongly believe our defensive, low-valuation businesses are an excellent place for the protection and growth of your capital, and we are happy to have our family invested alongside our clients.