The Minutemen Equity Fund (MEF) is a student managed fund at the University of Massachusetts, Amherst with $25,000 AUM. This year\'s transitional team seeks a high-visibility marketing approach to solicit new funds and teach investment to the students of Umass Amherst.
2. TABLE OF CONTENTS
1. Letter to Stakeholders ……………………….. 2
2. Investment Philosophy ……………………….. 3
3. Economic Outlook ……………………….. 5
4. Portfolio Allocation ……………………….. 18
5. Portfolio Performance ……………………….. 19
6. Sector Analysis ……………………….. 20
a. Energy ……………………….. 20
b. Capital Goods ……………………….. 21
c. Consumer Staples ……………………….. 22
d. Financials ……………………….. 23
e. Consumer Discretionary ……………………….. 26
f. Basic Materials ……………………….. 29
g. Technology ……………………….. 30
7. Fund Operations ……………………….. 31
a. Building Alumni Relations ……………………….. 31
b. Fundraising ……………………….. 31
c. SOM497SA: Securities Analysis Course ……………………….. 32
8. Closing Note ……………………….. 33
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3. LETTER TO STAKEHOLDERS
Dear Stakeholder,
Since our first trade on January 3rd, 2007, the Minuteman Equity Fund (MEF) has made great strides in
enhancing the educational opportunity of real world portfolio management investing. The Fund has grown
in size to over 65 members, made a substantial effort to have University alumni involvement, established a
portfolio management class, and has also made a strong fund raising effort. The year-to-date value of the
Fund stands at $21,000, and is down 13%, while beating the S&P 500 benchmark by 15%. The Fund’s
organizational accomplishments and portfolio performance can be attributed to the tireless effort and
collaboration between students, faculty, alumni, the UMass Foundation, and the Fund’s Advisory Board.
Originally we invested in exchange traded funds (ETF’s) to diversify from non-market risk, while also
exposing ourselves to various equity positions with our limited capital. Recently, we adjusted our investment
strategy emphasizing more capital into individual stocks using a two tiered time horizon approach. This
would entail long term (five or more years), medium (one to five years), or short term(less than one year)
time periods. In the long-term, the Fund will invest in individual stocks. In the medium and/or short term,
the Fund will invest in ETF’s in addition to individual stocks. The reason for this strategy is to take
advantage of larger returns from individual companies, which we strongly believe will outperform their
sector average performance, but not pass over profiting from the current macroeconomic environment.
The individual stocks making up the portfolio were researched by our sector lead analysts. The companies
that were selected for investment, all had strong cash positions and equally strong cash generating ability. In
addition to our securities, we have allotted cash position of 23% in the portfolio, to decrease our volatility to
the market, and to also allow for the option to invest in potentially outperforming company that fits our
investment strategy.
The management team has improved the organization and structure of the Fund to ensure that real world
investing knowledge and skills will be applied into the future. In doing so, we contacted University alumni,
faculty and administrators. This fall, we had conference calls, networking trips, and boot camps to meet with
alumni to be educated on their area of expertise. To provide a sound curriculum for the Fund, management
has worked with faculty to create a Portfolio Management Class starting in Spring 2009. We have spent
endless hours creating a syllabus and recruiting various professors to help teach the class. The MEF and
Development Office have worked together to raise capital so that the Fund can have an improved
opportunity of real world investing, while competing with fellow universities in the Northeast.
In the third and fourth quarter of 2008, the Fund has made much progress which will help the MEF
become a more effective portfolio management investing experience going forward. As the Fund continues
to beat the S&P 500 benchmark and develops strong relationships with alumni, faculty, and administration,
the MEF looks to constantly improve itself by opening new opportunities to all students of the University
of Massachusetts-Amherst.
Sincerely,
MEF Senior Management Board
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4. INVESTMENT PHILOSOPHY
Strategy
The Minuteman Equity Fund invests using a two tiered time horizon strategy. In the long-term, defined as
five or more years, the Minuteman Equity Fund invests in individual stocks. Those stocks will be purchased
only if the intrinsic value of the company is greater than what is reflected in the stock price according to
Minuteman Equity Funds internal research. In the short term, defined as a year or less, or medium term,
defined as one to five years, if there seems to be a transparent economic outlook for that duration. There
will be a focus on investing, according to the current to near future economic environment, in exchange
traded funds in addition to individual stocks whose return drivers are reflected in our short term economic
outlook.
Criteria Overview
Economic Based Investments
Economic based investments will be based on our domestic and international economic outlook. The
outlook will be representative of present economic indicators, both domestic and international, and trends
found in present and past economic indicator data. As well as through reputable publications and news
sources. Investments will be purchased based on their correlation and high R2’s with economic factors
which are drivers or weaknesses in our economic outlook for the foreseeable future. Technical analysis will
be employed, when necessary, to determine buy points and sell points, to assist in profit maximization in the
short term. In addition, it should be noted that the Amherst Minuteman Equity Fund aims to be slightly
ahead of the growth in the sector and/or industry in which we invest.
Value Based Investments
Value based investments will be purchased by examining their financial situation and their competitive
situation and environment. The financial situation of the company will be analyzed paying attention to
capitalization, net current assets, cash flow, insider purchases, book value, dividend yield, price to free cash
flow, and price to earnings. The competitive situation will be analyzed using a framework like or similar to
Michael Porter’s five forces, threat of substitute products, threat of the entry of new competitors, the
intensity of competitive rivalry, the bargaining power of customers, and the bargaining power of suppliers.
Basis for Criteria Adaptation
Adaptation, defined as any alternation including amending, to the criteria is put forward evidence as to why
such a rule is required to be put forward, and the majority of the senior management board of the
Minuteman Equity Fund must approve of the adjustment. The evidence must include a logical, defined as a
claim followed by proof, explanation of why the alteration should be included and success, as defined as
statistically stocks with this pending criterion have had stock price appreciation over a five to ten year time
frame, with a preference to those pending criterion that demonstrate a positive relationship with time and
stock appreciation Adaptation to a thought process or framework is put forward evidence as to why such a
rule is required to be put forward and the majority of the senior management board of the Minuteman
Equity Fund must approve of the adjustment. The evidence must include a logical explanation of why the
alteration should be included and some trend of usefulness, defined as enabling a profitable decision.
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5. Trading Rules
If positions are liquidated, without immediate, defined as less than or equal to four weeks, investment, then
that cash will be placed in short term U.S. Government Treasury Bills until the Amherst Minuteman Equity
Fund foresees it being able to allocate such funds profitably.
Short term, economic environment driven, positions will have good till canceled stop loss orders with a
target liquidation based on volatility of the equities markets and the appreciation of the position. In high
volatility, defined as a VIX greater than 25 for two weeks, markets the target liquidation will be closer to the
current price, than in low volatility markets, defined as a VIX less than or equal to 25 for one month. The
good till canceled stop loss orders will be moved up as appreciation occurs. In high volatility markets for
every 5% appreciation the stop loss order will be moved in relation to the current equity price. In low
volatility markets for every 10% appreciation the stop loss order will be moved in relation to the current
equity price.
Long term, value driven, positions will be re-evaluated, researched to determine if the intrinsic value is still
greater than market value, if the position decreases by 10%. If the intrinsic value is still greater than the
market value, the position will be held. If the intrinsic value is less than the market value, the position will
be liquidated.
Any position that has appreciated 50% will be liquidated and re-evaluated. Economic environment driven
positions will be examined based on the economic environment in the foreseeable future and the return
drivers of the equities to reflect the economic environment. Value driven positions, will be examined to
determine if the intrinsic value is still greater than the market value.
Whenever possible the Amherst Minuteman Equity Fund will rebalance, or adjust with minimum
transactions, in order to reflect current views on all outlooks.
At the beginning of each semester each position will be examined. Value driven positions will be researched
to determine if the intrinsic value is still greater than market value. If the intrinsic value is still greater than
the market value, the position will be held. If the intrinsic value is less than the market value, the position
will be liquidated. Economic environment driven positions will be examined based on the economic
environment in the foreseeable future and the return drivers of the equities to reflect the economic
environment.
At the end of the spring semester all economic positions must be revaluated to determine if those positions
reflect the Amherst Minuteman Equity Fund’s economic outlook for the summer session. If the positions
do reflect the outlook, then the fund maintains their positions. If the positions do not reflect the outlook
then a re-balancing must occur to reflect the outlook.
If an investment opportunity arises in which the Amherst Minuteman Equity Fund would like to take
advantage of, but lack the capital to support such a position, then a review of the current positions must be
undertaken. The review will consist of a comparison between the integrity of the investment and the
investment opportunity. If any economic environment driven position does not reflect the fund’s economic
outlook for the foreseeable future, it will be replaced by the opportunity. If any value driven position does
not have a higher intrinsic value than market value, it will be replaced by the opportunity. Otherwise, it
must be considered what diverse risk profile the opportunity can provide to the portfolio, what the expected
future return of such investment is over a current position, and the feasibility of allocating a section of the
portfolio to the opportunity. In such a case, where it is deemed the portfolio should undertake the
position, it shall only be allocated out of like investments, such as economic driven investments would be
adjusted to allocate an economic driven opportunity.
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6. The portfolio’s return volatility will be within the portfolio tracking error from the benchmark, the S&P 500.
The portfolio will be allocated with regard to the foreseeable future’s economic environment with at least
one long term or value driven position and one short term or economic driven position. Risk will be the
primary concern of the portfolio allocation. It is imperative that the portfolio receive the maximum return
possible for the risk taken.
At all times the Minuteman Equity fund will attempt to limit transaction costs and other fees.
ECONOMIC OUTLOOK
IS WALL STREET TO BLAME?
Much of the focus of the current financial crisis has been on the men and women of Wall Street, but they
are not solely at fault. Along with the housing market boom and bust, consumers spending over their
means, overleveraging and lack of regulation among financial institutions, the people over in Washington
have played a key role in the creation of this mess.
The Federal National Mortgage Association, nicknamed Fannie Mae is a government sponsored enterprise
(GSE) that was created by President Franklin D. Roosevelt and Congress in 1938 in order to buy mortgages
from lenders with the intent of freeing up capital that could go to other borrowers. This was a reaction to
the collapse of the housing market during the Great Depression, which discouraged private lenders from
investing in home loans. Fannie Mae’s creation was an attempt to provide availability of affordable housing
and thus raise levels of home ownership in the United States; directed mostly towards low- and middle-
income buyers who otherwise might not have been considered creditworthy. Since it operated as a GSE, it
meant that although it was privately owned and operated by shareholders, it was protected financially by the
Federal Government- including access to a line of credit through the U.S. Treasury, exemption from state
and local income taxes and exemption from SEC oversight. With Fannie Mae’s extraordinary growth and
the Vietnam War’s strain on the national budget, President Lyndon Johnson removed Fannie Mae’s debt
portfolio from the government balance sheet and it was converted into a public traded company in 1968.
Two years later, the Federal Home Loan Mortgage Corporation, nicknamed Freddie Mac, was launched,
primarily to keep Fannie Mae from functioning as a monopoly and it too went public in 1989. Today,
Fannie and Freddie have become America’s two largest mortgage companies, together holding or
guaranteeing roughly $5 trillion in debt. Their substantial growth was partly due to the belief that the
companies were so large that the government would never allow them to fail. “Fannie and Freddie raise
cash to buy mortgages from a variety of sources, including pension funds, mutual funds and foreign
governments. Their influence on economies at home and abroad is pervasive enough that the Federal
Reserve and the U.S. Treasury felt they had little choice but to offer assurances that the companies will not
be permitted to collapse from reverberations of the sub-prime- mortgage-debacle.”
(http://www.time.com/time/business/article/0,8599,1822766,00.html) Foreign investors began to sell off
existing paper holdings in Fannie and Freddie and resisted purchasing new paper. In addition, their
inaccurate accounting practices made them appear to have more capital than was actually the case.
Furthermore, the recent decline in the value of Fannie and Freddie’s mortgage loans caused a significant loss
in capital. Since there was no help to be seen from Private investors, on September 7th the U.S. Treasury
Page 5
7. announced that it would take control of Fannie Mae and Freddie Mac- the largest acquisition in decades.
This bailout was estimated to cost anywhere between $0 and $100 billion. Their actions were a sign of their
fear of massive collateral damage to the U.S. financial system, which would potentially lead to failures
among banks heavily invested in mortgage-backed securities. The Federal Government’s rationale in
nationalizing both of these banks was to strengthen the guarantee of GSE debt and thus prevent an
emergency “run on the bank” situation by foreign central banks as well as to stabilize the flow of guaranteed
mortgage issues through GSEs, which would sequentially help to prevent further declining house prices by
reducing the surplus of homes.
$700 BILLION BAILOUT PLAN TO RESTORE TRUST
The Federal Reserve Chairman Ben Bernanke, Treasury Secretary Henry Paulson and President George
Bush have continued to stress that all will be done in their power to stabilize the U.S. economy. Paulson’s
previously rejected $700 billion bailout plan was quickly passed on October 3rd after the massive 777 point
fall in the Dow Jones industrial average on the day of its rejection four days prior. The plan was originally
to use the entire $700 billion to buy up troubled assets from financial institutions, but on October 14th a
twist in the original plan surfaced. The Treasury announced that it was going to invest up to $250 billion of
the $700 billion directly into the banks. Under this plan the U.S. is also expected to guarantee new debt
issued by banks for three years with a goal to resume lending from banks to one another and their
customers. “Of the $250 billion… half is to be injected into nine big banks, including Citigroup, Bank of
America, Wells Fargo, Goldman Sachs and JPMorgan Chase, officials said. The other half is to go to smaller
banks and thrifts.” (http://www.nytimes.com/2008/10/14/ business/economy/14treasury.html?hp) The
Dow Jones industrial average rocketed up 936 points on news of this new plan. After the G8 meeting
earlier this month, other central banks around the world have also began to act against the crisis with
massive injections of liquidity into their economies.
UPDATE: $4.2 TRILLION INJECTION
There has been a great deal of action going on “behind the scenes” as far as the Fed and Treasury’s bailouts
go. The focus has managed to remain on the TARP lending facility (Troubled Asset Relief Program, also
known as the $700 billion bailout plan), however, that accounts for just a fraction of the liquidity that has
been injected into the markets during the last few months.
This data (see chart on next page) includes the Automakers Bailout plan of $25 billion, but this plan has not
been confirmed yet. Nonetheless, the numbers are unprecedented and one has to question where the limit
is. In any other economic environment, this sort of spending from the Fed and Treasury would be causing
massive inflationary pressure and a collapsing dollar value, but the current deflationary pressure has proven
strong enough to mask this. The dollar has been holding its value over the past few months for multiple
reasons, which are discussed later, but when the environment begins to change in the future, the
consequences from this enormous increase in the national debt should begin to surface and may overbear
the factors that have been keeping the dollar strong. However, these factors are currently still predominant
forces and will continue to act on a stronger dollar, at least in the short run.
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8. Note: Figures as of Nov. 13, 2008
*References includ US National Archive, US Dept of Defense, US Bureau of Reclamation, Library of Congress, NASA, Panama Canal Authority, FDIC,
Brittanica, WSJ, Time, CNN.com, and a number of other websites. (http://www.cnbc.com/id/27719011)
LIBOR RATES SHOW ZERO TRUST
(http://www.economagic.com/em-cgi/PW_MChartOmni.exe/save:economagic!Liborus1m3m6m12m)
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9. The London Interbank Offer Rate (LIBOR) has been extremely volatile recently with extreme moves to the
upside. The LIBOR is a financial index that represents the interest rate at which banks offer to lend money
to one another in the wholesale money markets in London. It is used in the U.S. capital markets as a tool to
judge the levels of trust banks have in one another- will be higher if banks fear that other banks will default
on the loans they offer them. Since the LIBOR indexes have shown increasing volatility and moves toward
the upside, this represents low levels of trust between the banks due to transparency issues and fear of
defaults.
Judging by the market’s reaction to the promises of the newly announced bailout plan, there may be signs of
a significant turning point in the Financial Sector as confidence returns. It remains uncertain how the
results of this bailout will continue to unfold, but the Federal Government continues to show its willingness
to take action against the financial crisis, which may prove to be positive for investors.
UPDATE: LIBOR RATES DOWN
(http://www.economagic.com/em-cgi/PW_MChartOmni.exe/save:economagic!Liborus1m3m6m12m)
On a positive note, LIBOR Rates have been declining since mid-October, which may be showing some
success from the Fed and Treasury’s lending facilities. The lower rates display some trust being restored
amongst banks in lending to one another and some thawing of the frozen credit. However, there still
remains a great deal of uncertainty in the financial industry as fear continues to play a major role in
controlling the markets.
Page 8
10. CRUDE PRICES BACK TO SANITY
(http://www.livecharts.co.uk/daily_charts/daily_charts.php)
“Rattled by the swift price drop and evidence of plunging demand, members of the Organization of
Petroleum Exporting Countries hastily agreed Thursday to meet next week in Vienna to weigh a production
cut, in a bid to firm up prices. The cartel, supplier of nearly 40% of the world's oil, had planned to hold an
emergency session in mid-November, but the plunge in prices has spread alarm among countries like
Nigeria and Venezuela that have grown heavily dependent on rising crude revenues.”
(http://online.wsj.com/article/ SB122418052416641331.html?mod=googlenews_wsj)
OPEC has scheduled a meeting for next week to discuss a possible output cut as the price of crude oil
dropped below $70 a barrel on October 16th. During their previous meeting in September they agreed on an
output cut of 520,000 barrels a day and acted upon this agreement quickly. The markets did not show a
lasting reaction to this previous output cut as we have witnessed crude oil reaching continuously new lows
since its peak of $147.27 a barrel on July 11th, 2008. Prices are at the lowest in 14 months and have dropped
more than 50 percent since the all time high on July 11th. This dramatic decline in prices has continued due
to lower demand caused by stocks plunging on a global scale and concerns of the effectiveness of the
central banks bailout plans in preventing a global recession.
These decreasing energy costs have been hitting the energy sector hard and should continue to do so as the
demand outlook for oil looks to continue to the down side, unless of course OPEC is successful in
stabilizing oil prices in the long-term. It is unlikely for a significant increase in crude oil prices by the end of
2008 because of the uncertainty that still remains in the markets as there is no end in sight to the turmoil at
this point.
Besides being a relief to consumers at the pump, the lower fuel costs are a benefit to the transportation
industry. However, this may not be true in all cases. Southwest Airlines posted its first quarterly loss in 17
years on October 16th with the causal factor being costs tied to fuel hedges. They, like many other
companies, use the futures market and other forms of derivatives to hedge against higher fuel costs.
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11. Although hedging did not benefit Southwest this quarter, it proved to be beneficial in the previous quarter:
“Southwest's spending for fuel, its largest expense, rose 52 percent in the quarter. It paid an average $2.60 a
gallon for jet fuel, which sold for an average $3.53 on the spot market in New York. The airline had $448
million in favorable cash settlements on its hedges in the quarter…“Falling energy prices are a great thing
for Southwest Airlines,quot; Kelly said. quot;We simply have to manage our hedges as a component of our overall
fuel costs.quot;” (http://seattletimes.nwsource. com/html/businesstechnology/2008276589_southwest17.html)
We are keeping an eye on companies that have exposure to unsuccessful hedges against higher oil prices.
The consumer staples sector should also benefit from this decline in crude oil prices and other raw
materials- especially companies producing rubber and plastic products since their production processes call
for an intensive use of crude oil and other raw materials. Also, we are looking out for OPEC’s meeting next
week to see if any significant decisions on output cuts have an effect on the markets.
UPDATE: OPEC CONTINUES TO FIGHT
Late October, OPEC agreed to cut oil production by 1.5 million barrels per day, in addition to the previous
reduction of 520,000 barrels per day. This cut took effect on November 1st. On the release of this news the
market reacted with a $4 (-5%) drop in the price of crude oil. This may have set the tone for how successful
OPEC was going to be in propping up oil prices in the short term. Nevertheless, this massive cut in supply
may need time to effectively prevent further declines in oil prices. Although crude has closed below the $50
mark, OPEC has made it clear with their actions that they will do what it takes to put a stop to the declining
oil prices; we may witness further action by OPEC if the market continues its downtrend. If they are
successful, we may begin to see better earnings from the energy sector in the future.
UPDATE: OIL DEPLETION, THE FORGOTTEN TRUTH
As crude prices dropped below $50 per barrel this week, the lacking demand from slowing global growth
still remains to be evident. However, it is not to be forgotten that crude oil is not a renewable resource and
it is very much in the process of being heavily depleted. The International Energy Agency recently released
their annual report, which included the World Energy Outlook. In this outlook they stated, “Without extra
investment to raise production, the natural annual rate of output decline is 9.1 percent… The IEA, the oil
watchdog, forecasts that China, India and other developing countries’ demand will require investments of
$360bn each year until 2030… The agency says even with investment, the annual rate of output decline is
6.4 per cent… The decline will not necessarily be felt in the next few years because demand is slowing down,
but with the expected slowdown in investment the eventual effect will be magnified, oil executives say.”
(http://www.ft.com/cms/s/0/e5e78778-a53f-11dd-b4f5-000077b07658.html?nclick_check=1)
Although China and other developing countries are experiencing slowing growth through the global
economic turmoil, there is still the major factor of exponential population growth that may prove to have a
huge effect on oil demand in the future. This is a reality that will play its role in the global outlook unless
every country decides to adapt China’s one-child-per-family policy. In addition to this, the extraction of oil
is becoming increasingly energy dependent since the quality crude (easier to extract) has been highly
depleted already, which results in less output per input. These factors, although not prevalent right now,
should play a massive role in the price of crude in the future as supply is inevitably squeezed. This also may
play a positive role in earnings for the energy sector in the future.
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12. INVESTOR FEAR AND THE REACH FOR “SAFE-HAVEN” ASSETS
(http://moneycentral.msn.com/investor/charts/chartdl.aspx?Symbol=%24vix.x&CP=0&PT=11)
The Chicago Board Options Exchange Volatility Index (CBOE- VIX) spiked to its all time high on October
16th, peaking just above the 80 mark. The VIX is a symbol that represents a popular measure of the implied
volatility of S&P 500 index options. To put this new high into perspective, around the time of the
catastrophic events of 9/11 it peaked at just below 45. As fear and uncertainty spreads amongst investors,
they are beginning to focus more on less risky asset classes. There has been a popular shift towards
Treasury Bills, Notes, and Bonds. This shift has caused demand for these assets to increase, thus raising
their prices. As their prices increase, their yields decrease, which we have been witnessing on the CBOE 10-
year Treasury Note Yield Index (TNX) since mid June. However, since the Treasury first announced their
$700 billion bailout plan towards the end of September, yields have shown increases. The bailout plan that
was passed during the first week of October came with a promise from Henry Paulson, Ben Bernanke and
President Bush to continue injecting liquidity into the financial system as necessary. The Treasury funds
these billions of U.S. dollars by issuing T-bills, T-notes, and T-bonds, thus increasing their supply. With this
massive increase in supply, their yields increase as their prices drop. Keep in mind that the full $700 billion
is not used in a onetime spending spree; Treasuries are issued in increments over a period of time. This
means that the yields on T-bills, T-notes, and T-bonds should continue to increase for quite some time.
With rising uncertainty and risk in the financial sector, Treasury yield indexes have greater upside potential,
while Treasury ETF funds such as iSHARES Lehman 20+ Year Tsy Bond Fund (TLT) and iShares
JPMorgan USD Emerging Markets Bond Index Fund (EMB) have stronger potential to the down side.
UPDATE: GLOBAL FLIGHT TO U.S. TREASURIES
“Foreigners were big buyers of U.S. securities in September as credit seized up and global stocks tumbled,
sparking the biggest U.S. capital inflow in nearly three years, the Treasury Department said on Tuesday.
Overseas investors in September snapped up a net of $143.4 billion in U.S. securities including short-term
instruments such as Treasury bills, the biggest inflow since January 2006… Demand for long-maturity
securities such as bonds, notes and equities also rose to $66.2 billion, compared with an upwardly revised
$21 billion in August… Indeed, Treasury debt was the most highly demanded U.S. asset, with international
investors buying a net $20.7 billion, with $4.9 billion coming from foreign central banks.”
Page 11
13. (http://www.fxstreet.com/news/forex-news/article.aspx?StoryId=5761a564-38b7-4aed-8996-
0f9f0ba2030f)
This increasing trend of foreign investment in U.S. treasuries comes as no surprise as investors from around
the world continue to search for the safest investments possible during these times of high risk and
uncertainty. T-bill, note, and bond yields continued to consolidate over the past month, but over the last
few days the demand for these securities has sent yields to historic lows- with the 10 year Treasury note yield
(TNX) reaching 3.1%. This strong demand for U.S. government dept should continue to hold the dollar’s
value, but as the yields on these safe-havens decline, they become less attractive to buyers, which may play a
big role in the future of the Treasuries market and the dollar.
THE ALMIGHTY DOLLAR
(http://quotes.ino.com/chart/?s=NYBOT_dx)
On the flip side of the financial crisis, the dollar crisis has seen a massive turnaround in recent months.
After hitting double-digit-year lows and, in some cases, all time lows against a basket of foreign currencies
around the end of 2007 to July 2008, there has recently been a substantial move to the upside for the U.S.
dollar. To give an example of how extraordinary the U.S. dollar’s strengthening has been, simply take a look
at the chart below which shows its value relative to that of the Australian dollar. As you can see, it has taken
3 months for the U.S. dollar to gain back its losses against the Australian dollar over the past 5 years.
Page 12
14. AUS/USD
(www.metaquotes.net)
Keep in mind, the United States economy is fundamentally at one of the worst levels it has ever seen, as will
be discussed later on in this report. This gives a key perspective that displays how massive the effect of this
crisis is on a global scale.
This dramatic shift into the U.S. dollar has been caused by multiple factors. Although the United States was
responsible for the core trigger in setting off the current financial crisis, many foreign nations around the
world are witnessing issues with freezing credit and slowing economic growth because of it. Foreign nations
are turning to the U.S. dollar as a safer currency because of the structure of the U.S. Federal Government
and its ability to act fast in times like these. Since the European Union is made up of 27 sovereign member
states, the European Central Bank is not structured in such a way where it can take action as fast as the
Federal Reserve Bank due to the individual governments of each member state having to agree with the
proposed plans and policies before action is taken. A recent example of this barrier of authorization in the
ECB occurred last week when they tried to pass a bailout plan of their own, but not all of the members
agreed with it and was thus declined. Another factor includes the rising Treasury Bills, Notes and Bonds
yields as they become more appealing to foreign countries that need to convert their money into U.S. dollars
to purchase such assets, thus increasing the demand for U.S. dollars. In addition to all of this, the global
monetary policy environment plays a role in determining where the currency markets have been and will be
heading to in the future. Since the Federal Funds rate in the U.S. is currently at 1.5% after the recent global
coordinated rate cuts it has only so much room for easing whereas the interest rates in other major
industrialized nations such as the European Union, Australia and Great Britain remain at reasonably high
levels, which provides their central banks with ample room for easing. This creates an environment in
which it is much more realistic for interest rate spreads to shrink in favor of the U.S. dollar. Controversially,
the Japanese yen has recently been strengthening against the U.S. dollar due to an unwinding of carry-trades,
in which the investor sells a certain currency with a relatively low interest rate (Japanese yen) and uses the
funds to purchase a different currency yielding a higher interest rate (U.S. dollar in this case). The investor
attempts to capture the difference between the rates, which can often be substantial when using high
amounts of leverage. (http://www.investopedia.com/terms/c/ currencycarrytrade.asp)
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15. Therefore, as the interest rate spread between these currencies continues to become smaller, the yields on
the carry-trades decline equivalently. Also, as there has been increased volatility and uncertainty in the
markets, investors unwind their carry-trade positions as they face a risk of losing more money than they are
earning through the interest rate spread yield if the low interest rate currency begins to rise relative to the
high interest rate currency.
The dollar should either continue to strengthen in the short-run or consolidate at its current levels unless
there is significant intervention by the G8 or a major increase in oil and commodity prices. Since some
countries, such as Canada, are major exporters of oil, their currency is strongly positively correlated with oil
prices. The same goes for Australia and gold prices, with one of their major exports being gold. In
addition, this higher exchange rate for U.S. dollars will have a negative effect on major exporting companies
in the U.S.
Nevertheless, there are some companies who have used the foreign exchange market to hedge against this
increasing dollar value such as the well known tech company, Google. Google’s 3rd quarter earnings came
out much higher than expected on October 16th at 3% growth q/q, 31% y/y, which they account for some
due to their successful hedges in the currency market. (http://news.cnet.com/8301-1023_3-10068654-
93.html)
There are also companies who have hedged on the wrong side of the move (betting against the U.S. dollar).
Look out for companies that have hedged against the strengthening U.S. dollar.
FUNDAMENTALS:
[1] RETAIL SALES ABYSMAL
September retail sales fell 1.2%, the largest drop since August 2005 and the third consecutive month to see a
decline. The previous releases for August and July came out at -0.3% and -0.1% respectively.
“Auto and auto parts dealers saw sales fall by 3.8%, after gaining 1.7% in August. In the first nine months of
2008, auto and parts sales are down 8.4% compared with the first nine months of 2007. September auto
sales are down 18.5% compared with the sales level in September 2007, a record decline in any month
compared to the same month a year earlier… Sales were down in every major retail category except health
and personal care stores and gas stations, which both saw small gains… and sales excluding autos and gas
fell 0.7%, the largest decline in nearly a year and a half… Sales at furniture stores fell 2.3%, the largest
monthly decline since February 2003. Sales fell 2.3% at clothing stores, 0.4% at general merchandise stores,
0.5% at food and beverage stores, and 0.6% at building material and supply
stores.”(http://www.forbes.com/afxnewslimited/feeds/afx/2008/10/15/afx5557091.html)
This extraordinary drop in retail sales in September represents a shift in the mentality of the U.S. consumer.
They are moving away from their consumption-centered ways into a new mentality of saving. Although this
will hurt growth in the U.S. economy as well as the global economy, some economists believe it is necessary
since over-consumption was one of the root causes of the financial crisis. As the holiday season approaches
the retail sales numbers are usually cyclically higher during the month of November, but the likeliness of
seeing the 1.2% increase in retail sales we saw last November is slim to none. Look out for aching profits
for retail companies.
Page 14
16. [2] INFLATIONARY PRESSURE DECLINING?
The Producer Price Index (PPI) fell for the second consecutive month, down 0.4% in September. The PPI
release measures the change in the price of finished goods and services sold by producers from the previous
month and is a leading indicator of consumer inflation because when producers charge more for goods and
services, the higher costs are usually passed on to the consumer.
“Within the energy sector, home heating oil prices fell 13.9%, the largest decline since September 2006.
Liquefied petroleum gas prices fell 11.1%, while residential natural gas prices dropped a record 8.2%.
Gasoline prices fell 0.5% in the month. A 0.2% gain in food prices was the seventh straight month without
a decline. Fresh and dry vegetable prices soared 28.4% in September. Intermediate goods prices fell 1.2%,
the largest decline since October 2006, while crude goods prices fell 7.9% in
September.”(http://www.fxstreet.com/news/forex-news/article.aspx?StoryId=43b9584b-2bfe-4b7f-bcac-
7abf5a04e91b) On the other hand core PPI (PPI excluding food and energy costs) rose 0.4% for the month
of September. That meant core PPI was up 4.0% in the past twelve months, which was the fastest
unadjusted annual pace since February 1991. Overall wholesale inflation has risen 8.7% in the past year.
(http://www.fxstreet.com/news/forex-news/article.aspx?StoryId=43b9584b-2bfe-4b7f-bcac7abf5a04e91b)
Without the recent major decline in food and energy prices, we are still seeing some increasing inflation. If
food and energy prices are to gain back some of their losses, there will be added pressure on the Federal
Reserve to avoid lowering interest rates.
[3] HOUSING MARKET BUST CONTINUES
September housing permits reached its lowest level since November, 1981 – annual rate of 748,000 units,
down 8.3%. This was the fourth consecutive decline in housing permits since June, where it was at 1.09
million units. Housing permits data is an excellent gauge of future construction activity because obtaining a
permit is among the first steps in constructing a new building. It is tightly correlated with housing starts
data and a permit must be issued before the house can begin construction. The effects of the declining
housing permits can be seen in housing starts data, which fell 6.3% to an annual rate of 817,000 units in
September – the lowest rate since January 1991. Housing starts are down 31.1% from September 2007.
The decline in home values across the U.S. and the oversupply of houses has been fueled by the credit
crunch, which has squeezed potential buyers and negatively affected borrowers, lenders and builders. Also,
mortgage rates remain high and the end of the housing crisis is still nowhere in sight at the moment. There
will be a continued devaluation of home prices in the U.S. at least until the end of 2008.
[4] UNEMPLOYMENT RATE AND NON-FARM PAYROLL
“US employers shed more jobs last month than in any month in more than five years, led by a sharp drop
in service sector jobs and continuing losses in the construction, manufacturing and retail sectors, the Labor
Department said today. The economy lost 159,000 jobs in September... September's decline is the largest
seen since March 2003, when the economy lost 212,000 jobs.
The economy has now lost 760,000 jobs since January. Economists have said the economy needs to create
about 100,000 jobs each month to keep up with new workers, but with September's numbers, the economy
has now averaged a monthly loss of about 43,000 jobs over the last 12 months.”
(http://www.fxstreet.com/NEWS/forex-news/article.aspx?StoryId=e856db3b-d50d-428a-9082
371af7aa8555)
Page 15
17. The unemployment rate remained at 6.1% in September, up from 4.7% in September, 2007. This level of
unemployment has not been seen since September, 2003. As of now, there is nothing to offset this growing
unemployment as the reasons for its increasing are still in full force. It should continue to grow, possibly
surpassing 7% by mid 2009.
UPDATE: EMPLOYMENT DATA SHOW MAJOR JOB LOSSES
The Non-Farm Employment Change number, provided by the Bureau of Labor Statistics, was released on
Friday, November 7th. “Earlier, government data showed that U.S. employers slashed 240,000 non-farm jobs
in October after eliminating 284,000 positions in September, pushing the unemployment rate to 6.5 percent,
the highest since March 1994.” (Thomson Reuters)
In addition to this release, last month’s release of 159,000 jobs lost in September was revised down to a loss
of 284,000 jobs. All this has caused the unemployment rate to jolt up 0.4% to 6.5% from last month’s
release at 6.1%. Major job losses have a negative effect on the overall economic health of the United States,
but primarily will cause declining consumption and continued distress in the housing market. In addition to
this, the fear of losing a large number of workers in the auto industry is haunting the U.S. economy in its
already uneasy state. “The Center for Automotive Research, an Ann Arbor, Mich., think tank pushing for a
bailout, estimates a loss of nearly 2.5 million jobs if just half of the Big Three manufacturing capacity were
shuttered - a possible scenario if GM files for protection. About 240,000 of those job losses would be at the
automakers, while 800,000 would be at various suppliers and dealerships. The other 1.4 million job losses
would be at businesses that rely on automaker spending.” (http://money.cnn.com/2008/11/17/
news/companies/gm_showdown/ index.htm) This will play a major role in the government’s decision in
whether or not to bail out the auto industry.
UPDATE: GLOBAL INTEREST RATE CUTS
• Federal Reserve Bank cut their Federal Funds rate to 1.00% from 1.50%
• Swiss National Bank cut their Libor Rate down to 1.00% from 2.00%
• Bank of England cut their Official Bank Rate to 3.00% from 4.50% (massive cut)
• European Central Bank cut their Minimum Bid Rate to 3.25% from 3.75%
• Bank of Canada cut their Overnight Rate to 2.25% from 2.50%
• Reserve Bank of New Zealand cut their Official Cash Rate to 6.5% from 7.5%
• Reserve Bank of Australia cut their rates to 5.25% from 6.00%
• Bank of Japan cut their Overnight Call Rate to 0.30% from 0.50%
Page 16
18. Look for more rate cuts to come from the central banks around the world.
GROWTH OUTLOOK
There are few reasons, given the worsening economic and financial conditions, to believe that the United
States will be able to avoid a recession. Many economists and investors believe we are and have already
been in a recession. Since the U.S.’s toxic financial crisis has spread across the world, we are starting to see
strong signals that we will be entering a global recession before the end of the year (some believe we already
are in one). Many major stock indexes around the world have plummeted to levels that make the Dow
Jones and S&P 500 look appealing. In addition, since the currencies of these nations around the world have
been losing value rapidly to the U.S. dollar, they are also experiencing a major loss in buying power. As far
as economic expansion, this is invisible in the short-term picture since the first step of stabilizing the
economy is still at its beginning stages. Chairman Bernanke has hinted towards further necessary rate cuts
to come soon, but with a current Fed Funds rate at 1.5% there is little room to stimulate economic activity.
Although the U.S. may not be in a recession by definition, the fundamentals are pointing towards it
becoming a reality very soon.
UPDATE: RECESSION SPREADS ACROSS THE GLOBE
China has shown their exposure to the global financial and economic crises with the announcement of a
new hefty stimulus package. Although they have stated the stimulus package to be a preventative procedure,
with a value of $586 billion one has to wonder if it really is a pro-active measure or a reaction to what is
currently being experienced by them. As a major exporter China has experienced major losses due to
slowing demand from importing countries, such as the United States, due to their contracting growth.
Nonetheless, China has taken a longer-term approach to fixing the mess as their stimulus package focuses
on building the country’s infrastructure rather than strictly stimulating spending (keep in mind overspending
is the reason why we are in this mess). “…the government unveiled a two-year stimulus package it valued at
around four trillion yuan, or $586 billion. The government said it would build infrastructure, fund housing,
cut business taxes and encourage banks to lend money, all in a bid to offset slowing global growth by
boosting the spending power of its people.” (http://online.wsj.com/article/SB122634126983014381.
html?mod=googlenews_wsj)
With more focused spending on education, they are setting the stage for long-term growth by taking
advantage of the multiplier effect where higher education leads to higher wages, which in-turn, leads to
greater spending and growth.
The Eurozone has declared its economy to be in recession and they have been joined this week by Japan,
whose economy has not seen contraction to this extent since 2001. In the coming months, The United
Kingdom and United States are expected to confirm economic recession.
Page 17
19. PORTFOLIO ALLOCATION
MEF’s strategy was to deliver a portfolio of outperforming stocks at an acceptable risk level. To achieve
this end, the portfolio was allocated to include all stocks with strong recommendations from our investment
team but at a mix that controlled the overall portfolio’s volatility. For example, MEF’s research of Techwell
Inc. uncovered strong growth potential which led the investment team to consider it a strong buy.
However, the stock is fluctuating wildly, at 59% volatility, which is an unacceptable level for the portfolio as
a whole. Therefore, we allocated a minor portion (7%) of fund assets to Techwell which will allow the fund
to realize future gains in Techwell without putting the fund as a whole in jeopardy. High risk of stocks like
Techwell and Chipotle, were counterbalanced by heavy weightings in large-cap low-volatility stocks like
Johnson & Johnson and Wal-mart, as well as holding a sizeable portion of the portfolio in cash (23%). This
balancing allowed the MEF to hold a portfolio which it estimates to trade at 10.3% volatility per annum in
the long run.
The allocation process was facilitated through a quantitative model which evaluated the stocks based on
their historical data, but also allowed the investment team to insert information it believed was not
incorporated into past performance. Specifically, the model tried to maximize the portfolio’s overall Sharpe
ratio, while satisfying the following constraints:
• No one stock should compose more than 40% of equity holdings
• All stocks strongly recommended by investment team receive at least 5% weighting
• Hold at least 20% in cash
Results of this model were slightly adjusted to reflect the bias of the investment team: Techwell was
weighted slightly heavier (7%) than the model recommended (the 5% minimum). The model under-
weighting Techwell based on its short-term losses and volatility and our adjustment reflects our research’s
favorable outlook.
One of the main challenges of using a quantitative model is to establish long term trends in stock price, in
the face of the current crash. To distill long term trends from short term fluctuations caused by the crash,
we used two different samples of data: 1) A short-term sample based on data from one year ago to present
and 2) A long-term sample based on data from six years ago to one year ago. Removing this current year’s
data from the long-term sample offered a better estimate of return and volatility in the long-run, when the
financial conditions improve. Based on these different samples, we calculated a long-run and short-run
overall Sharpe ratio for the portfolio. The short-term data sample featured mostly large losses and high
volatilities. For this reason, maximizing the Sharpe ratio in the short term was really trying to achieve the
least negative. The long-term data sample featured much lower volatility levels, and wide range of positive
returns from Chipotle gaining 40.6% per annum to Johnson & Johnson gaining 5.9% per annum. To define
a single metric which we could maximize, we created a weighted average of the two Sharpe Ratios.
Increasing the short-term weighting caused the model to allocate more into defensive positions like Wal-
mart. Increasing long-term weighting favored high-growth companies like Chipotle. Ultimately, the
investment team agreed on a 35% weighting to the short-term and 65% weighting to the long-term. This
weighting reflects the fund’s emphasis on the a long-run buy and hold strategy, yet still has enough
weighting on the short-term to assure enough of the portfolio is allocated in stocks that have demonstrated
stability during this past year.
Page 18
20. PORTFOLIO PERFORMANCE
Initial Holdings
Symbol Name Shares Price Returns($) Stop-loss
VCR Vanguard Consumer Discretionary 25 52.43 -192.26 6/30/08
KXI iShares S&P Global Consumer Staples 60 62.38 -1007.25
PBW PowerShares WilderHill Clean Energy 30 27.78 -239.41 6/27/08
VDE Vanguard Energy 30 113.71 -27.32 7/16/08
RYU Rydex S&P Equal Weight 30 60.85 -655.35
KRE SPDR KBW Regional Banking 20 36.37 -154.51 6/13/08
IXG iShare S&P Global Financials 35 78.64 -583.82 6/24/08
VHT Vanguard Health Care 45 60.56 -807.60
XLI Industrial SPDR 50 38.69 -252.51 6/27/08
VGT Vanguard Information Technology 70 58.94 -564.22 7/10/08
S&P 500 SMF
Initial Value – Jan. 2, 2008 $1,468.36 $25,000
Ending Value – December 1, 2008 $835.78 $20,693.76
Holding Period Return -42.25% -17.33%
This quarter has seen some of the most volatile weeks to ever hit the stock market. We have witnessed
records for both single day losses and gains and are faced with the worst recession since the Great
Depression. Academically this has been a great opportunity to study the movements and reactions of the
market, practically however, this has been a rough time to be invested in the stock market.
Our initial investment strategy was to take a more defensive position that mirrored our benchmark, the S&P
500. We created a portfolio of ten exchange traded funds (ETFs) that covered the various market sectors,
but weighted differently to take advantage of sectors we deemed particularly bearish or bullish. The
portfolio itself had a beta of .8177 and an r-squared of .9433, therefore a lot of the movement in the
benchmark was reflected through the performance of the fund. By the end of Q2 our fund was
outperforming the S&P 500 by 1.76%.
As the market continued to drop our stop losses came into play. It is no success to have stocks hit their stop
losses but, having the majority of our portfolio in cash led to us missing the worst of the market drop,
leaving the majority of our fund still intact. The effect of the stop losses is most easily seen when looking at
how our portfolio has outperformed the S&P in the third quarter. Our fund was down 11.41% YTD, a
2.61% quarterly drop; while the S&P dropped 19.41% YTD a 7.76% drop in the third quarter. By this point
all but three of our ETFs saw their stop losses hit, leaving us invested in the Vanguard Healthcare ETF
Page 19
21. (VHT), the Rydex Utilities ETF (RYU) and the iShares Global Staples ETF (KXI). Since the end of the
third quarter the stock market has seen record losses that the fund avoided by holding mainly cash. As of
December 2nd, the fund is down 17.33% YTD while the S&P is down 42.25%.
Being in cash has put our fund in a strong position to reinvest into the market. With that in mind, we have
spent the majority of the semester looking for companies that have high liquidity and a strong business
models. We feel that a combination of these attributes is necessary in the current market, where consumer
spending and lending looks to be tighter than in past quarters. The liquidity of our fund has allowed us to
get back into the market with companies, despite the economic environment, poised for growth and strong
returns in the coming quarters.
SECTOR ANALYSIS
Energy
The Energy sector has witnessed one of its more volatile years in 2008 as performance has been mixed
across industries and throughout quarters. Energy use over 2008 has grown slower than has been projected,
but there is still an overwhelming reliance on fossil fuels including oil, natural gas and coal. Oil is the
dominant source of energy, but the demand for coal has been rising more than any other fuel.
The price of oil increased to record highs of $147/barrel over the summer and has recently come down to a
three-year low of $48/barrel, a 67% drop in price. The decrease in the price of oil has been largely due to a
reduction in oil demand as a result of the recent financial crisis. The market has been oversupplied with oil
Page 20
22. and the Organization of Petroleum Exporting Countries (OPEC) cut output by 1.5 million barrels per day
on October 31st in an attempt to halt the decline in price. On November 13th, the International Energy
Agency slashed its demand forecast and claimed that demand for energy in developing countries will
continue to rise, but slower than was previously forecasted.
The news of demand decline has trumped OPEC’s output cut in influence and oil prices continued to
decline. Factors such as declining reserve discoveries, high oil field depletion rates, political tensions in the
Middle East and South America and growth of emerging countries have had a diminished impact on driving
the price of oil.
With oil prices as low as they currently are, new oil projects and related capital investments have been either
cancelled or delayed by many firms. The predicted consequence of the absence of said projects is a
production shortage in the medium to long-term. When demand begins to rise once again as the economy
pulls itself out of a recession, the market will be undersupplied and there may be a sharp rise in oil prices.
When the price of oil peaked over the summer, there was great incentive for companies across all sectors to
implement or investigate alternative sources of energy. Consumer dissatisfaction with expensive fuel prices
prompted policy makers and corporate heads to promote various alternatives such as solar, wind, hydrogen
and bio-fuel initiatives. One of the major policy platforms for President-Elect Barack Obama was his “New
Energy for America Plan” that outlined short, medium and long term directives to work toward energy
independence. However, due to severe issues in the housing and credit markets as well as the rapid decline
in the price of oil and gasoline, attention has shifted and incentive to promote and invest in alternative
energies has been reduced. Without government assistance and without easy access to credit, many
alternative energy companies will find it difficult to increase earnings due to high capital costs associated
with advanced technology utilized in production.
Short-term investments in the energy sector are fairly risky, as more economic problems threaten to further
deteriorate demand. Industries such as Oil and Gas Drilling and Exploration are especially risky as the credit
crisis and falling oil prices will likely continue to suppress capital spending by firms involved in drilling and
exploration for the short to medium term. More sound investments might be found in companies within the
Major Integrated Oil Services and Independent Oil and Gas providers. Firms that have lower levels of debt,
substantial cash, and the ability to remain profitable with current oil prices will be most successful in the
near term.
Capital Goods
The Capital Goods sector was hit extremely hard over the past three months where it lost approximately
38% of its value as compared to a loss of approximately 35% by the S&P 500. All industries in the sector
seemed to perform similarly except for Construction-Raw Materials which gained 51%. With a bleak
outlook on the credit markets and some degree of uncertainty regarding commodities, a major goal for the
quarter was to find an investment that would be insulated from the liquidity freeze and have low exposure
to drastic changes in commodity prices. Other investment criteria included potential for growth and low
risk.
We decided to allocate approximately 15% of the fund to a hardware manufacturer and distributor called
Fastenal. Fastenal has an above average P/E ratio as compared to its sector and the S&P 500 and its sales
figures have seemingly transcended the economic contraction and posted increases. The company is
Page 21
23. insulated from the frozen liquidity markets because of its lack of long term debt and extremely high current
ratio of 5.703. Fastenal also recognizes the impending recession and has adjusted its business practices
accordingly. The new strategy calls for a decrease in the rate of store openings which should help individual
stores meet their sales numbers.
When looking at a long term horizon, the capital goods sector becomes much more appealing. There has
been an obvious economic contraction over the past year or so, but we see capital goods being one of the
first sectors to rebound. This is simply because all of the other sectors rely on capital goods to conduct
their own businesses. When the other sectors begin to stabilize, they will need capital expenditures to start
growing again and thus, capital goods will flourish. It is important to note that these capital expenditures
often must be financed because of the nature of their size. This turnaround for capital goods will not occur
until the liquidity freeze loosens up and companies will be able to secure loans at reasonable rates.
Fortunately, there are some brighter aspects of the sector in the short term too. For example, many of the
companies in capital goods are massive in size and they are seen as rock solid in terms of credit ratings.
This ability to borrow money helps hugely during the credit crunch where loans are becoming scarcer and
scarcer by the day. Furthermore, we expect the plummeting price of crude oil to grossly affect the
performance of the capital goods sector in a positive manner. This prediction is based on the fact that
nearly all of the industries in the capital goods sector rely heavily on fuels like gasoline, diesel and aviation
fuel. Another positive aspect of the sector is the relatively low volatility of most of the companies. This
sector seems to be more predictable than some of the others which can be helpful in the volatile market
conditions we are currently experiencing. Over the coming months, we expect to see a slower rate of decline
in the capital goods sector and we also expect to gain stability and some growth from our investment in
Fastenal.
Consumer Staples
The Consumer Staples sector is historically known as a defensive sector. It has maintained its defensive
reputation throughout this economic cycle. The Consumer Staples market is made up of mature industries
with well established global companies. Because of the defensive nature of the companies, as well as their
size and global footprint, Staples, despite having been hurt by the down economy, has still outperformed the
rest of the market.
We feel that Consumer Staples is poised to be one of the top performing sectors in the short term due to
the current, prolonged recession. Consumer Staples has always been considered to be one of the more
recession proof sectors. This protection is due in part to the economies of scales that the larger companies
within this sector enjoy, which helps to control their cost structures. More importantly Consumer Staples
companies produce the basic need products for consumers, so we expect demand to remain stable.
A concern for this sector is that people may begin to purchase generic goods shying away from the more
expensive name brands. High commodity prices will have a negative effect on many industries within the
Consumer Staples sector. Also a strengthening dollar will negatively impact foreign sales, while
strengthening the competition from imports.
Regardless of the severity of this current recession, people will continue to buy their basic necessities.
However, to combat these recession fears we have invested in more established companies that provide low
cost goods while maintaining high market share and strong brand recognition. We feel that the combination
of these attributes will keep consumers buying their products no matter how badly the economy is hurting.
Page 22
24. Financials
Eleven months ago, no one would have envisioned the Street and the market to be in the state that it is in
today. In the past eleven weeks, the Financial sector has weathered historical changes and is still unwinding
itself in these tumultuous conditions:
September 7, 2008: The housing market financial problems hit a pinnacle point when Fannie Mae and
Freddie Mac, the two largest mortgage finance companies in the country, faced government intervention.
The government shored up $100 billion to each mortgage provider to backstop any capital shortfalls.
September 14, 2008: A week before, Lehman Brothers was struggling to find a buyer. While they shopped
around for potential acquirers, Lehman Brothers lost half its market value. Many feared that the bank was
running out of options and it was unlikely the government was going to repeat a rescue like Bear Sterns for
Lehman. On this day, Lehman filed for bankruptcy and face possible liquidation. Merrill Lynch agreed to
be sold for $50 billion to Bank of America.
September 15, 2008: After the announcement of Lehman Brothers’ bankruptcy and sale of Merrill Lynch,
the Dow Jones Industrial Average (DJIA) plunged 504 points, the worst loss since 9/11/2001.
September 16, 2008: A.I.G. has been fishing for federal rescue for the past week and the Federal Reserve
agreed to aid A.I.G. in a $85 billion deal, giving control of the insurance company to the government.
A.I.G.’s financial suffering stemmed from complicated debt securities such as collateralize debt obligation
(CDOs) and collateralized mortgage obligations (CMOs). These securities were advertised as safe
investments on the basis of diversification. In hindsight, the underlying assets were much riskier than they
were once considered.
September 21, 2008: Goldman Sachs and Morgan Stanley, the last investment banks on Wall Street, became
bank holding companies. They will be under more of a microscope regulated by the government. This
changed the world of finance as we once knew it.
September 25, 2008: Washington Mutual, nation’s largest savings and loan company, “became the largest
bank failure in American history, as regulators engineered an emergency sale to JPMorgan Chase.”
(http://www.nytimes.com/interactive/2008/09/27/business/economy/20080927_WEEKS_TIMELINE.
html)
October 1, 2008: After a week of inconclusive debates, the Senate approved the $700 million financial
bailout plan presented by the Federal Reserve and the Treasury.
Page 23
25. http://projects.nytimes.com/creditcrisis/recipients/table
October 3, 2008: Wells Fargo won the bid to buy Wachovia over Citigroup.
October 5, 2008: The crisis is evident in Europe as major European leaders have agreed to back all private
savings accounts.
October 22, 2008: In the past week, world leaders gathered to conclude on possible financial bailout plans
to aid the ailing international markets. The stock market has also experienced drastic upward and
downward movements due to federal announcements regarding government interventions or poor
economic outlooks.
October 29, 2008: The Federal Reserve cut key interest rates to 1% to counteract the down spiral of the
economy.
Page 24
26. November 4, 2008: Senator Barack Obama won the presidency. Upon his succession in the White House,
the imminent top priority for President-elect Obama is an economic stimulus plan.
Many of the major players in the Financial sector have seen unimaginable downturn in their market value.
Two years ago, they were at historical highs and many of them are now valued below $10 per share.
Valuation of these stocks in Financials has been reinvented and reevaluated. Despite the immense volatility
in this sector, there has been a trend in the market to move towards regional banks to provide exposure into
Financials in ones portfolio. With current economic conditions, the outlook is not optimistic since many
analysts have lowered their ratings on many holding and regional banks. Regional banks increased their
offerings of loans since many of the larger banks ceased after credit tightened. In the long run, it is
estimated that loan defaults will ripple out to the regional banks and industry specialists are not optimistic
about their future performance.
With credit stretched as tight as it could go, it is taking a very long time for the credit crunch to loosen.
Lacking available credit in the markets, mergers and acquisitions (M&A) and leveraged buyouts (LBOs) have
been halted by the investment banks and private equity firms. With the $700 billion bailout for the financial
giants, much of that money has been used to acquire other banks or regional banks. Lazard Ltd. (LAZ) has
Page 25
27. been a company of interest in this area. They specialize in the financial sector and have been sought after
by many troubled investment houses for advice, such as restructuring for Lehman Brothers after they filed
for bankruptcy. Lazard has two main focuses: Financial Advisory (M&A, strategic advisory, restructuring,
corporate finance and others) and Asset Management with $113 billion AUM. When compared to its two
biggest competitors, Goldman Sachs and Morgan Stanley, Lazard’s Advisory revenue has changed by -9%
compared to Goldman Sach’s -30% and Morgan Stanley’s -31%. Lazard’s operating revenue in the first
nine months of 2008 is 5.2% less than the 2007 period. The biggest portion of their operating revenue
comes from their M&A and strategic advisory business. With credit frozen in 2008, Lazard still has a
healthy inflow of business comparable to the peak times of M&A transactions. Since most of their revenue
is fee based, many of their pending deals are ones with the biggest price tag: inBev’s acquisition of
Anheuser-Busch ($52 billion), BHP Billiton’s offer for Rio Tinto ($147.4 billion), and Nationwide Financials
merger with Nationwide Mutual Insurance ($2.4 billion). In their restructuring practice, they have been
advisors to some of the largest deals, such as Parmalat, Northwest Airlines, Daewoo Corporation, and
WorldCom. Of the top 20 bankruptcy filings of 2008, Lazard is involved with 8 of these public and private
companies in the financial services, homebuilders, real estate development, gaming/leisure, automotive
supplier, advertising, and chemicals industries. Lazard’s financial performance has been affected by the
current market conditions, but compared to the other big players in financial advisory, they have suffered
fewer losses and are positioned well in time for an upswing.
We approach Financials with hesitation because of the volatility in the market in recent months. There are
pending regulations after Senator Obama steps into his role in January. We are waiting on the FDIC rulings
on the banking industry and believe that many people will be trying to wipe clean their financial holdings at
the end of the calendar year. It would be more prudent to be patient anticipating new regulation. The
financial sector will never be what we once knew it to be.
Consumer Discretionary
Performance:
1 Month 3 Month YTD P/E Price Per Sale
-12.93% -21.50% -33.55% 30.1x 0.6x
Current Outlook:
The year of 2008 has been grim for the Consumer Discretionary sector as a whole, with only financials
performing worse in terms of YTD decrease. I hold the belief that while 2009 will be slightly better for the
sector in terms of performance, the sector will not thrive, and many of the companies will face an uphill
battle to regain their profit levels from before the recession began. The main reason the sector will struggle
can be broken down into the three factors which are most critical to its success:
The unemployment rate is most important to the sector’s health, and the most recent job reports indicate
that not only is unemployment high, but it could be getting higher. At the moment, 478,000 people in the
work force are unemployed, up about 15,000 from the prior week, and is steadily rising at 6.1%. Not
helping unemployment is the fact that even beyond the current unemployment; average payroll has dropped
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28. to a 5 year low in the country, giving Americans less cash to spend during the next few months, which
includes the holiday seasons which are the most important to this sector’s success.
Consumer Confidence fell to 38 from 61.4, signaling that a huge number of consumers do not want to
spend their extra cash, and are probably going to start saving rather than consuming. Consumer confidence
at its current levels could indicated that not only is the sector, experiencing a rough year, but that the sector
could be facing a total crisis at these lifetime lows.
Earnings are repressed due to the above mentioned indicators, and internal obstacles within each company’s
respective industry. I expected earnings to be decreasing significantly in the next few quarters. While this is
no shock and should already be factored in the stock price, the sector of consumer discretionary has a P/E
ratio of over 30. If these stocks are still expensive after all the negative reports, and the months of poor
earnings to come, one has to wonder how much longer it will be before the industry as a whole adjusts to
the current situation.
Where there is fear and pain in the market there is opportunity. While the investment landscape seems to
be a desert, there may be a lush rainforest over the on the horizon. Corporate investing is lagging, but an
efficient company could produce an excellent return. The plan for the sector is to hunt companies with
steady earnings growth and a low price to earnings ratio, that happens to be not deeply affected by the
economic turmoil such as multi-line retailers and apparel companies for a company. By targeting those
companies the fund will be able to recognize a growth in price with the expansion of earnings in an
economic recovery.
Industries
Retail
Textile, Apparel and Luxury Goods (38 Companies)
0.00% +7.30% -6.56% 19.6x 0.8x
Specialty Retail (106 Companies)
0.00% +2.90% -9.58% 17.5x 0.6x
Multi-line Retail (17 Companies)
0.00% +7.01% -7.55% 14.5x 0.6x
Retail, the largest industry of the sector has had a down year, but has been hit much less hard then other
industries in the consumer cyclical sector. Although it seems to be more resilient towards the tough
economy than the other industries, tough times may lie ahead. With consumer credit harder to get, less
money going to Americans via payroll and a high unemployment rate, retail is projected to have one of its
worse holiday seasons ever. Beyond that it will take an economic turnaround to bring back consumer
confidence and revitalize the retail industry.
There are, however, some bright spots in the industry. Multi-line stores like Wal-Mart and Target which
have lost some of their share price recently are great shopping alternative for struggling consumers. They
may pick up business from other stores that offer similar products at higher prices.
Also, some higher end apparel stores have continued to enjoy moderate successes despite the fact that their
stock price is trading lower because of a fear in the market. Cherokee and American Eagle are too
companies that have had a letdown in stock price this year despite outperforming a majority of their peers.
These are the types of companies in this sector that will enjoy the largest returns, once the economy turns
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29. around and/or investors once again feel confident about the market. Possible Investments: Wal-Mart,
Cherokee, American Eagle
Media (94) companies
0.00% -5.89% -17.13% 40.3x 1.4x
Media is an incredibly diverse industry and many of the companies have different business models and
streams of revenue. One thing is certain, however; trading at 40.3x P/E media is by far the most expensive
industry this sector has to offer. At such expensive prices, most media companies do not look too
attractive. Companies with a ticket based revenue stream (such as WWE) could find a lack of turnout due
to their high prices selling less seats in the turbulent economy. Also, about half of the companies in this
industry rely on some kid of advertising based model. Advertising has remained flat this year, and spending
is only estimated to increase by 1.5% in 2009. Facing competition from new forms of media that fall into
tech categories, such as internet and mobile software, it does not look like traditional media with these
business models (newspapers, radio, television), will experience too much growth in earnings. With such
expensive stocks, I would estimate that these stocks will decrease in value over the coming six months.
One media company I like is Dreamorks SKG Animation. The company has achieved an excellent return
on investments through its movies. With advanced animation more popular than ever (see Pixar),
Dreamworks has been able to make great, high grossing movie and manage costs better than ever, due to
great management and a board full of some of the smartest minds in the industry. Also the P/E ratio of
14.7 is extremely low for the industry, especially with a company that has been successful even in a down
year. Possible Investment: Dreamworks SKG
Hotel, Restaurant, Travel and Leisure (470 companies)
0.00% -5.01% -23.54% 18.8x 1.7x
This is perhaps the industry within the sector that has taken the most beating due to the downturn. Both
the travel and hotel businesses have taken a dive not only because of the consumer downturn, but also the
fact that businesses are traveling less while trying to cut costs.
The restaurant is experiencing much difficulty, not only because of consumer difficulty, but because of
inflation which increased prices and cut into profits. With inflation somewhat tame now, restaurants,
especially full service, are struggling due to less disposable income. Another problem within the restaurant
industry has been mismanagement. Recent reports have shown that things like mistaken orders and poor
service are higher than ever, turning people away from paying extra to eat out. To fix these problems
restaurants will have to spend more to either hire consultants or new managers, both costly and lengthy
procedures. Another thing that scares me about the restaurant industry, is that once the economy does turn
around, inflation will likely reach a level not seen in years. With restaurants already struggling a large
increase in the price of food could mean the end for several of them. This could also negatively affect
hotels which make a large amount of revenue from their bar and restaurant business.
A bright spot in this industry could be the ultra risky airline industry. Southwest Airlines, although making
some bad energy bets in recent months, has excellent management and a loyal customer base due to its low
prices. While commoditization of the industry has hurt it as a whole, Southwest could do great business this
year if oil prices stay low. Also, the Delta/ Northwest merger could prove a great investment opportunity
as both businesses could streamline costs and have a higher net income if inflation remains tame. I am a bit
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30. hesitant to suggest investing in airlines, however, because of their history of poor performance and troubles
in dealing with their labor union.
The safe choice for this industry would be McDonalds, and as a pessimist of the economy in the near
future, I would say McDonalds is best positioned to weather the storm. Great management, excellent
relationship with suppliers and a loyal customer base are exactly the traits needed in this kind of situation.
The one problem with McDonalds is that it does not provide too much of an opportunity for growth, and
its stock price has no dropped much year to date, suggesting that it will not produce a great gain if the
economy recovers. Possible Investments: McDonalds, Southwest Airlines, Choice Hotels
Basic Materials
Aluminum is an industry within Basic Materials that is on the increase. Projected GDP growth to 2013 is
1.9% in a $46.8 billion (2008 forecast) industry; this is a dramatic revenue growth compared to last year’s
$31.9 billion.
Aluminum companies such as Alcoa, Inc. (36% market share) have had slowly diminishing stock
prices. Alcoa is now down to $11.78 per share, and in the past couple weeks has started to increase in stock
price. Now would be a great time to invest in Alcoa and ride the wave as they begin to improve. Their 52-
week low was $9.00 on October 27th, and has since been increasing steadily.
A more productive industry within basic materials is Plastics, Resins, and Rubbers. This $87 billion industry
has positive forecasted numbers when it comes to revenue growth (2.3%), GDP growth (1.9%), and average
profit margin (5%--not projected). Another great thing about this industry is that the power within the
industry is very spread out, as the top three companies only have 8% market share. Exports have also been
rapidly increasing over the past five years, from just above $20 billion in 2004 to approximately $35 billion
in 2008. This industry is also expected to contribute nearly $321.5 billion to the U.S. economy. With the
constant government bailouts, it is fortunate that the industry does not mainly rely on the government for
assistance with the industry. In fact, the only way the government mainly interacts with this industry is in
the form of tariffs when international residents purchase the items.
With the ever-increasing bankruptcy of airline companies, aluminum is not going to be needed for the
construction of airplanes as much as it used to be, so aluminum will lose a majority of an entire branch of its
uses. Approximately 30% of the use of aluminum is for transportation; therefore, aluminum is subject to
the changes in this industry and others. Like the aluminum industry, the sector of Basic Materials as a whole
is subject to others as well, since the Basic Materials are used to create other industries from the bottom up.
Stock prices for companies in the sector are just coming out of their 52-week lows. While they have been
increasing for the past couple weeks, it is not certain that the trend will continue; this is due to the high
volatility rates of the industries under Basic Materials as an effect of the recent instability of crude oil prices.
Now that gas prices are starting to go down, hopefully the economy will rebound back to a form that at
least somewhat simulates what it should be. Two words: Barack Obama— How long it takes for Obama to
“change” America and its economy cannot be predicted, but for the sake of the economy, hopefully it
comes soon. With the rebounding of gas prices, hopefully transportation costs will decrease; this would
bring a higher demand for Basic Materials to make more airplanes, trains, etc.
There may be much opportunity in the economy, the economy can also be a drastic threat. With all of the
changes facing the country over the next couple months, one cannot be sure how the economy is going to
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31. react. I think the largest threats to the Basic Materials sector are time and insecurity. The volatility of the
industries within the sector along with the drastic changes on the political and economic fronts make
predicting what is going to happen in the sector (even though it is understood that predicting the stock
market is not easy already).
After looking through several industry reports and stock outlooks under the Basic Materials sector, we are
hesitant to invest in any of the aforementioned industries or companies until the market picked up enough
to ensure financial security. Though the majorities of the companies have been on an incline in the past
couple weeks, their 52-week lows have been experienced not too long ago. Thus, the short-term analysis is
skeptical at best, and investing into a highly volatile market would not be advisable.
Once the economy bounces back from this recent recession, the long term brings growth for the Basic
Materials industry. As our world becomes “flattened” (in the words of Thomas Friedman) and international
exporting becomes more popular, basic materials such as aluminum, plastics, and steel will be more
demanded by economies abroad. It is also crucial to keep an open mind when it comes to investing in
basics in the future. After the official change of commanders-in-chief, many changes are to come. Whether
these will be positive or negative is still not determined, but with the international support for President-
elect Obama, one can foresee more open doors abroad come January. This in turn will positively affect the
American economy and a growth in the overall market.
Technology
Following the greater trend of the S&P 500, the Technology sector has similarly experienced a significant
decline in value since the beginning of the fiscal year, down approximately 36% compared to the S&P’s 35%
loss. The relatively volatile nature of the Technology sector has been further compounded by the bleak
overall macroeconomic forecast and unpredictable market behavior, resulting in greater than normal
instability. Year to date economic performances and future outlooks vary from subsector to subsector,
however, which means that the MEF should be able to find viable options for both the short and long term
investment through diligent analysis and qualitative screening.
Semiconductors – Despite promising signs of growth in the first half of 2008, the semiconductor market will
likely see significant volatility and consolidation in the next few years as ASPs continue to trend downwards
due to product commoditization and general macroeconomic weakness. Larger companies such as Intel and
AMD are poised to pick up the pieces of the PC chip market, while smaller companies will either survive on
ingenuity and critical restructuring or by virtue of pre-existing competitive advantages and niche-market
dominance. Overall outlook is neutral, but given the large number of advances in technology still ongoing
within the sector, as well as the increasing number of goods using semiconductor products, opportunities
certainly exist.
Software – The software sector, which includes Software as a Service (SaaS) companies, has traditionally
depended on the economic strength of North America and Europe, where high levels of corporate spending
drives licensing revenue. Given the economic weakness of both of these regions, the software sector will
likely underperform in the near future until either a) developing markets, specifically Asia, can pick up the
slack, or b) corporate and consumer confidence is restored in developed markets. Meanwhile, significant
consolidation is expected due to below-normal valuations, as are strategic shifts in revenue models. The
SaaS model in particular is seen as a highly practical approach in the world of business software, offering
lower overall costs to end users and providing a more stable recurring revenue stream to software
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32. distributors. Consequently we expect that some companies will thrive in the down market, while other
companies will either be acquired or go under due to corporate belt-tightening and shifts in market
dynamics.
Computer Hardware and Peripherals – Computer sales growth was strong early in 2008 but has failed to perform
similarly through the third quarter. Market instability, decreased consumer confidence, and a lack of liquidity
in equity markets mean that individuals and businesses have cut down on PC purchases in developed
markets. Asia and other developing economies are prime candidates to continue sector growth in years to
come, however, especially as WiFi and other technologies become more available and affordable. Mobile
devices and laptops in particular are beginning to replace desktop PCs, meaning that a shift in power among
the top manufacturers may not be far off. MEF is currently neutral on Computer Hardware, pending further
macroeconomic and subsector developments.
FUND OPERATIONS
Building Alumni Relationships
Before leaving for the summer session, outreach to alumni was the MEF’s main goal. As a result of our
efforts, the Fund met with UMass graduates to organize networking trips to Boston, Springfield, and New
York during this fall 2008 semester. Our mission was to enhance our portfolio management and securities
analysis strategies, in addition to, gaining advice from alumni’s professional expertise. We have also
organized conference calls and guest speakers on campus on topics such as career advice, asset
management, and the research process.
The MEF has continued our partnership with the Isenberg Development Office. We have further engaged
the University Advancement Office under the Vice Chancellor to establish alumni relations. The
Minutemen Equity Fund has had the opportunity to meet and communicate with alumni contacts that have
not been involved with the University in the past. There are many alumni who work at investment houses
who have an underdeveloped relationship with the University. The MEF has been an opportune platform
to attract alumni involvement with the University as well as give the students involved face time with
possible employers.
Fundraising
The MEF has made great strides in fundraising this Fall. Our goal this academic year was to grow the
Fund’s size to $100,000. In collaboration with the Isenberg Development and University Advancement
office, we have met with alumni to help meet this fundraising objective. For the students to fully apply the
theories we have learned in the classroom to real world investing, we need more capital to be properly
diversified, make optimal investment allocations, and to minimize cannibalism in our portfolio. Through
our fundraising efforts, we gained the support of alumni who have become very invested in the success of
the MEF.
Two alumni in particular have spearheaded a fundraising campaign to help us reach our goal of $100,000.
They feel, as strongly as we do, about this endeavor as a positive influence on campus. They believe, as
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33. much as we do, that we should be on the same playing field with other student managed funds such as
Northeastern University, Georgetown University, and Carnegie Mellon University who have more than
$100,000 asset under management (AUM). These alumni have together pledged $25,000. When we have
cash-in-hand, potentially by the end of this calendar year ending December 31, 2007, the UMass Foundation
will also match every dollar raised by $0.50, up to $25,000.
This month, the Advancement Office and the Fund will be sending out letters on behalf of these two
distinguished alumni to solicit donations. They have been the biggest advocates of our efforts and have
received very positive feedback and enthusiasm from other UMass alumni for this project. We are currently
planning a pitch meeting in Boston to potential investors for a date in February.
SOM 497SA: Securities Analysis Course
A year in the making, we are officially en route to incorporate a course into the structure of the Fund. The
senior management board and the lead analysts will be using the deliverables we have compiled into a
structured classroom setting. The management board has been working tirelessly in developing a
curriculum and syllabus, as well as engaging professors to teach in a lecture series styled forum. With the
course operating at full speed, we feel this would be added incentive for students to take part in the Fund.
They will be receiving credit for the research and analysis. This course is also a tool that will ensure the
longevity and continuity of the MEF.
Left to Right: William Sutton (Portfolio Manager), Andrew Dunham (Portfolio Manager), Andrew Nolan (Lead Capital Goods Analyst),
Daniel Levine (Lead Basic Materials Analyst), Ryan Flynn-Kasuba (Chief Investment Officer), Michael Harper (Chairman), Brenton
Thornicroft (Chief Economist), Candice Lo (Head of Fund Development), Jonathan Mauro (Chief Investment Officer), Tristan Cecala
(Lead Energy Analyst), Scott Munro (Lead Technology Analyst), Ian Murphy (Lead Consumer Discretionary Analyst)
Not pictured: James Xu Zhang (Chief Marketing Officer) and William DiJohnson (Equity Analyst)
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