JACOBS INVESTMENT MANAGEMENT

August 3, 2009

Dear Client

I can't tell you how nice it is to write a client letter that doesn't focus on how bad the stock market has been. 

Since my last note in February, the S&P 500 has moved up some 30%.  Increased confidence in the banking sector has helped, as has a massive stimulus program in China.  US companies have done a very good job of cutting costs, lowering inventories, reducing capital spending and reducing (or at least refinancing) their debt. 

The earnings reports from the 2nd quarter have had a recurring theme:  business has stabilized.  A majority of S&P 500 companies beat analyst estimates for profits this past quarter due to lower costs.  Far fewer hit analyst estimates for revenue, implying real growth is still elusive.  But management teams across a variety of industries have suggested that the worst appears to be over.

Before we get too excited about a recovery, let's recognize that near-term risks remain.  Unemployment is rising and will probably continue to rise for several more quarters.  That puts more pressure on the consumer, who has too much debt and is saving (rather than spending) much more today than over the past decade.  The banks are not out of the woods yet, either.  Commercial real estate could be the next big problem for them, even as they continue to deal with losses in credit cards and home mortgages.  And the boost we have seen from the stimulus in China could disappear, as overly aggressive banks there throw money haphazardly into their economy.  That could lead to huge losses that drag China down in coming years.

As always I want to look past the near-term to the long-term, and in that view I remain optimistic.  The past few months have done nothing to dent my belief that the global economy will recover and eventually thrive again.  And as it does, I believe the stock market will provide the returns we need to build wealth over time.  In my last note, I suggested the stock market could double over the next five years to 2014.  If that prediction turns out to be about right, we would still expect to earn close to 10% returns annually between now and then even after the recent 30% run. 

Winners and Losers *

The stocks that have performed the best since the March lows have typically been the ones that were on the brink, such as financials desperate for capital or cyclical companies loaded with debt.  Harley Davidson and Ameriprise, perceived as two of the riskier names I own for clients, both have done very well in recent months.  More stable companies like H&R Block, Wal-Mart and Lockheed Martin have not done nearly as well as the market. 

I want to focus briefly on Lockheed, which is the nation's largest defense company.  Investor sentiment has turned fairly negative on Lockheed due to the new administration's defense cuts, the likely loss of the F-22 (the world's most advanced fighter plane) and some weakness in the company's services unit.  The stock trades at about 9x my estimate of next year's earnings, a healthy discount to the market.  The company has numerous growth engines, the most important of which is the Joint Strike Fighter, the next generation fighter plane that countries all over the world plan to buy.  The US government is fully supportive of this huge program, and Lockheed is the prime contractor.  If the company can bring the fighter in close to budget and close to on-time, Lockheed should be able to show very nice earnings growth for many years into the future.  It is no easy task, but Lockheed is the expert in building fighter planes.  With the stock trading at less than 9x next year's earnings, I really like their chances.