January 2, 2012
Dear Fellow Shareholder: The stock market was volatile in 2011 (to put it mildly) but ended the year roughly where it began. During the first seven months, the S&P 500 traded in positive territory, making three round trips in a range of 0% to +8%. Between August and December, it moved even more erratically in a range of 0% to -13%. For additional performance information, please review our complete Performance Summary which presents investment results and includes relevant market indices and related disclosures.
Our stock funds performed well, earning modest positive absolute returns and posting good relative returns. Generally speaking, larger "blue chip" companies did better than smaller companies and the Value Fund (large capitalization stocks) showed the strongest returns (+6.1%) while the Hickory Fund (small/mid caps) trailed its siblings (+1.5%). By comparison, the large cap S&P 500 was up +2.1% and the small/mid cap Russell 2500 declined by -2.5%. In this low return environment for both stocks and bonds, the Balanced Fund earned a return (+2.3%) that was similar to that of the equity funds.
Our bond funds earned positive returns with considerably less drama than the stock funds. The Short-Intermediate Income Fund (Institutional Class) earned a total return of +2.1% and the Nebraska Tax-Free Income Fund earned +5.9%. The Government Money Market Fund provided safety and liquidity, but its return was microscopic.
Although the Funds more or less "marked time" this year, we consider 2011 results very acceptable. Our companies did well and grew their "business values," so even though their prices, in the aggregate, did not rise much, we believe that our stock portfolios have more upside potential than they did a year ago.
Stock Market Commentary
The heart of our investment approach is to recognize, and take advantage of, the difference between a company's business value (or intrinsic value) and its stock price. Business value is a function of the amount of cash a company will generate for its owners over the next 10-20 years. A stock's price is a function of investor attitudes, emotions, expectations and competing alternatives for investor capital. Stock prices are generally much more volatile than the underlying business values. This gap between price and value gives the patient investor the opportunity to buy at bargain prices and sell at high prices.
There are serious financial issues facing investors. The European debt crisis, a slowdown in the Chinese economy, and a feeble U.S. economy leave investors anxious and gloomy. However, our take is that while these and other factors may keep a lid on economic growth for another year or two (or longer), our companies' stock prices are cheap enough relative to their business values that we feel good about being 75-85% invested. Given the muted near-term outlook, we are happy to hold 15-25% cash reserves to take advantage of the inevitable temporary market dips, but we have very little faith in our (or anyone else's) ability to time the market.
Our quarterly letters usually include discussions of a few of our favorite stock holdings. This time, we thought it might be interesting to step back and take a broader look at our equity funds' stock portfolios. Each portfolio is different, but we can make some generalizations about these stock holdings as a group.
Consumer Discretionary and Staples (27%)
Over half of our consumer stocks are either staples (Anheuser-Busch, Diageo, Prestige Brands, Energizer), retailers of staples (Wal-Mart, Target, CVS), or basic services like cable TV (Comcast, Knology, Liberty Global). The others include advertising (Omnicom, National CineMedia), cable programming (Disney), live entertainment (Live Nation/Ticketmaster), travel (Interval Leisure, Disney), specialty retailers (Cabela's, Coinstar), radio (Cumulus Media), and education (Grand Canyon). All businesses are cyclical to some extent, but this is a group whose businesses are relatively stable and predictable.
Energy, Materials and Industrial (17%)
There is no denying that the companies in these three categories are economically sensitive. On the other hand, neither oil and gas (Conoco (NYSE:COP), SandRidge (SD), Apache (NYSE:APA), Southwestern Energy (NYSE:SWN)), nor cement, rocks and gravel (Martin Marietta (NYSE:MLM), Eagle, Texas Industries (NYSE:TXI)) are perishable. Even if demand for these commodities is soft for a while, the long-term economics of the companies we own in these industries are favorable. Our industrial companies include garbage collection (Republic Services (NYSE:RSG)), which is sensitive to construction activity, but also includes home security (Tyco (NYSE:TYC), Ascent Capital (NASDAQ:ASCMA)) which is a subscription business that might even have counter-cyclical aspects.
Financial company stocks, especially those with real or perceived exposure to the European sovereign debt crisis, have been among the weakest during 2011. Roughly 14% of our investments are categorized as "financial," but we believe we have little or no direct exposure to the unfolding financial nightmare in Europe.
Of our "financials," insurance brokers (Aon (NYSE:AON), Willis (WSH), Brown & Brown (NYSE:BRO)) account for about 4% of assets. These companies earn commissions that are affected by insurance premium levels and are thus helped by insurance company losses on natural disasters and poor investments (counter-intuitive, but true). Another 4% are insurance companies (Berkshire Hathaway (BRK.A)(BRK.B), CNA (CNA)) whose investments and operating income are highly diversified. We own one bank (Wells Fargo (WFC)) and one other "spread lender" (Redwood Trust) that together account for approximately 6% of assets. Wells is a highly disciplined, primarily domestic lender and has few of the potential headaches of the money center banks. Redwood invests in domestic mortgages and mortgage-backed securities. It is exposed to mortgage credit risk (the last crisis) but not Europe.
Information Technology (15%)
Hardware and component makers (Dell (DELL), Hewlett-Packard (HPQ), Texas Instruments (NYSE:TXI)) are affected by global capital spending, and Europe is an important market. On the other hand, software and services companies (Microsoft (MSFT), Google (GOOG), Accenture (ACN)) are less cyclical than the equipment makers. Each enjoys strongly growing markets for major parts of their businesses and should be able to continue to grow even if our economy lapses back into a mild recession.
Our primary healthcare exposure is in clinical lab testing (Laboratory Corp. of America (LH)), distribution of drugs to nursing homes (Omnicare), and branded, generic and over-the-counter drugs (Valeant (VRX)). Each has diversified products and clientele and they are not particularly cyclical businesses. Regulation and reimbursement issues are always in play for healthcare companies, but we do not believe these are exposed to sudden, major surprises.
This diverse group of companies share several common characteristics. As a group, they have strong balance sheets, they generate more cash than is required in their businesses, and their managements treat shareholders as partners. They generally have pricing power and produce growing streams of free cash flow, even in a soft economy. We trust them to allocate their excess capital well—expanding their productive capacity, making acquisitions or returning cash to shareholders through dividends and share repurchase. They are innovative, have room to grow their business values, and there is reason to believe their stocks can show at least modest growth even without help from the general market. In today's environment, they are playing offense when they can, and defense when they need to.
We believe that while this market is challenging, the "coiled spring" of growing business values will eventually lead to price appreciation. We want to be in position to participate when the time comes.
Growth in the Investment Team
During 2011, we made additions to our investment team and some of its members have taken on new responsibilities. Nathan Ritz joined us as a research associate, replacing Jordan Larsen whose family moved to Utah where his wife started her pediatric residency. Nathan has made an immediate positive impact working with the analysts to build earnings models and gather information on our companies. Nolan Anderson is an experienced fixed income analyst who came to us from Wells Fargo in San Francisco. He is working with Tom Carney, doing credit research to support Tom's management of our bond funds.
Two of our analysts, who are already portfolio managers of our Research Fund, have taken on additional portfolio management roles. Dave Perkins joined Brad and Wally in managing the Value Fund and Drew Weitz became co-manager with Wally of the Hickory Fund. The level of collaboration among analysts and portfolio managers was already high in our firm, but we think it is important that our younger colleagues continue to take on more responsibility, preparing for the time a decade from now that a founder might want to think about slowing down. (Actually, with Warren Buffett and Marty Whitman as models, we might want to make that two decades.)
Thanks once more for the confidence you have shown by investing with us. Here's to a profitable 2012!
January 2, 2012