QUARTERLY

Commentary
Second QUARTER 2009

ECONOMICS

In Search of the Goldilocks Economy

While we hope that the financial crisis of 2008 will be nothing more than a speed bump on the road back to prosperity, the recent stock market adjustment suggests that there may be a few more bumps to come. From September to March, the fear that the economy was going into a depression dominated the markets and deflation was the watchword. The massive monetary expanded the money supply. For more than 40 years, the countrys monetary base has increased about 7% per year on average. Over the last 12 months, the monetary base is up over 100%. Will the Fed be able to turn the economy again (by raising interest rates) before inflation ignites with a vengeance? We are adding currency to the list of data we monitor regularly. If inflation starts to accelerate, we think the U.S. dollar will weaken substantially. Market volatility would also rise. In summary, we will continue to invest the liquidity reserves we built in advance of last falls crisis. We are balancing our desire to reduce bond portfolio duration As the financial crisis unfolded last fall, our major focus was to maintain sufficient liquidity for clients to cover expenses for several years. This resulted in 23% of our clients equity allocations being invested in cash or short-term investments, such as Treasury bills, at the end of 2008. Hints at possible deflation and a Great Depression economy caused the markets to spiral down. To determine if this fear was likely to become a reality, we carefully monitored credit market conditions, inflation expectations and world trade. Since the markets lows in early March, credit spreads have returned to near normal conditions and world trade has rebounded
Dow Jones Industrial Average
15,000 14,000 13,000 12,000 11,000 10,000 9,000 8,000 7,000 MAR JUN SEP 04 04 04 DEC MAR JUN SEP 04 05 05 05 DEC MAR JUN SEP 05 06 06 06 DEC MAR JUN SEP DEC MAR JUN SEP 06 07 07 07 07 08 08 08 DEC MAR JUN 08 09 09 5.0% 0.0% 20.0% 15.0% 10.0%

Inside this Issue

ECONOMICS

stimulus injected into the economy by the U.S. governments various bailouts has, on the other hand, caused many prognosticators to warn of coming 1970s-style inflation. It is as if Goldilocks cannot make up her mind: is the economy going to be too hot, too cold or just right?

: : In Search of the Goldilocks Economy

ASSET MANAGEMENT

: : Is It Safe to Go Back in the Water? : : Fixed Income Dilemma: Wheres the Yield?
FEATURED EQUITY

with the paltry short-term yields. Our stock selections will favor companies that skillfully employ prudent amounts of debt in their capital structures, and move away from extremely low or no-debt businesses. Specifically, we are looking for companies with long-term fixed debt that has been used to finance plant and equipment; we will avoid companies with short-term debt or liabilities connected with consumer finance. Finally, we are prospecting for holdings that will allow us to offset any potential decline in the U.S. dollar.
CASH POSITION
30.0% 25.0%

: : Varian Medical
WEALTH MANAGEMENT

: : The Psychology of Investing

modestly. We have concluded that deflation is now a small risk. Consequently, we have lowered the percentage of cash in our portfolios. To take the deflation card off the table, the Fed dramatically

DOW LEVEL

% CASH

www.nelsonroberts.com | 650.322.4000

Percentage of Equity Allocation in Cash

MARCH 2004 - JUNE 2009

Our approach today is to take pru portfolios and keep fixed income m

Largest FiFteen equity HoLdings

IshaRes

ASSET MANAGEMENT

Is It Safe to Go Back in the Water?

We started off 2009 with many questions, few answers and the S&P 500 Index at 903. By the end of the first quarter, a new administration had been inaugurated, the S&P 500 had touched 666 (57% below its high of 1,561 in the fall of 2007) and recovered to 797, but concerns remained about whether the credit markets were finally stabilizing. As we discussed in the economic overview, we continued to monitor key data that would give us insight into the availability of money. Steady improvement in those numbers gave us confidence that the market was poised for recovery and it was time for us to deploy some of our cash. Our first area of focus was the consumer discretionary sector. Worries about the health of the American consumer had caused stock prices in this arena to decline substantially, creating compelling values for many of these companies. We purchased TJ Maxx (tkr: TJX) and GameStop (tkr: GME). TJ Maxx is a discount retailer that purchases surplus goods from other retailers or manufacturers, and then sells them to consumers for 40-60% less than the original recommended price. We believe that the company is in an even stronger position to negotiate prices in the present environment and that store traffic will increase as frugal consumers look for less expensive alternatives. GameStop is a retailer of video games. The gaming industry was one of the few bright spots in an otherwise bleak 2008. GameStop sells not only new video games, but has also created a large secondhand market for used games. In fact, used game sales generate the bulk of the companys profit. We also added two names in the consumer staples sector. The first, Corn Products International (tkr: CPO), processes corn for end markets ranging from fruit juices to adhesives. The stock fell in response to the drop in the commodities markets, particularly the price of corn, but benefited as commodity prices stabilized. Our other new holding is Cadbury (tkr: CBY). This company, a leading confectionary producer, is best known for its Easter-time offering of Cadbury Crme Eggs. In addition, the company has a strong presence in chocolate, gum and candy brands. Business is growing in markets such as India, where some consumers are getting their first taste of chocolate. Near the end of the second quarter, we bought Paychex (tkr: PAYX). We previously owned this company in 2004, when interest rates were low and unemployment was fairly high. We believe we are in a similar environment now, and have likely hit the bottom for both measures. As interest rates rise and unemployment eases, Paychex will earn higher interest on its customers payroll balances and will process more paychecks. The company also has a history of returning money to shareholders, with a dividend that now stands at 4.6%. Our final major purchase for the quarter was an exchangetraded fund (ETF) focused on the Asia Pacific region (tkr: GMF). This investment increases our exposure to non-dollar denominated investments and the growth markets of Asia. We completed our sale of GE shares. This is the first time in twenty years that many of our portfolios have not held GE. Though we believe that the industrial side of the company still offers many excellent products, we have continued concern regarding GE Finance, which contributes over 50% of earnings, and will be a drag on the stock in a market recovery. The positions we initiated in the first half of 2009 are what we would consider front shelf investments. Characteristics of these companies include a strong and protectable share in the core business, no or very low debt and attractive valuation. These investments, as well as additions to existing positions in Gilead Sciences (tkr: GILD), Varian Medical (tkr: VAR), Adobe Systems (tkr: ADBE), Cisco Systems (CSCO) and Sun Hydraulics Corp. (tkr: SNHY) have lowered our cash allocated to equities

eaFe Index Fund

CIsCo systems
IshaRes

s&P small CaP Index

ChevRon CoRP GIlead sCIenCes oRaCle CoRP adobe systems masteRs seleCt Intl Fund Fastenal sChlumbeRGeR utIlItIes seCtoR sPdR tJx ComPanIes mICRosoFt texas InstRuments theRmo FIsheR sCIentIFIC

www.nelsonroberts.com | 650.322.4000

udent risks on the equity side of our money short, secure and liquid.

to 12%. We anticipate that our next purchases will be from our back shelf company list. These companies have a greater propensity to use debt, and therefore were hammered in a market fretting about deflation. They should rebound as these fears recede. Recent decisions by technology leaders Microsoft and Cisco to use leverage on their balance sheets reflect this change in thinking, and should boost earnings.

yielding 2.2%, the total return on that bond through 6/30/09 would have been -8.7%, as interest rates increased to 3.5%. We believe the best options for fixed income investment in this environment include the following: 1. Short CDs (1-3 years): currently the best alternative to Treasurys. CD yields average about 0.75% higher than Treasurys, are FDIC-insured for amounts up to $250,000 (this limit has been extended to December 2014) and have decent liquidity if an investor needs to sell before maturity. 2. Investment-grade corporate bonds: credit spreads for these bonds have tightened as the economic landscape has improved in recent months. There are still some opportunities, but with default rates yet to peak and yields close to levels obtainable through CDs, risks and rewards need to be carefully weighed. 3. Municipal bonds: yields are attractive, but higher rates reflect the financial difficulties facing many states. This is especially true for the state of California, which has seen borrowing costs increase as legislators attempt to close a staggering budget gap. We will be taking a close look at a new type of municipal bond called the Build America Bond (BAB) which emerged from the American Recovery and Reinvestment Act of 2009. These are taxable bonds issued by state and local municipalities that are partially subsidized by the federal government. Forecasting interest rates is always challenging, but is especially so right now because of the uncertain downstream effects of the stimulus. Our approach today is to take prudent risks on the equity side of our portfolios and keep fixed income money short, secure and liquid.

Fixed Income Dilemma: Wheres the Yield?

Short-term interest rates remain at historic lows. However, investors who six months ago were content to trade yield for safety are now growing impatient. The dilemma is that rates are low for a reason: fixed income markets have not yet fully recovered from the recent credit crisis. Bonds that are perceived as safe and liquid have anemic returns due to strong demand. In order to pick up higher yields, investors must be willing to buy debt with longer maturities or lower credit ratings. We believe that locking in long-term rates continues to be unwise, given the growing concern about inflation and the weak balance sheets of many companies and municipalities. The government lowered interest rates in 2008 to help stimulate the economy and circumvent a deep, prolonged recession. The last rate cut by the Federal Reserve (in December 2008) lowered Fed Fund Rates to a target of 0-0.25%. In addition, the Fed announced that it would buy up to $300 billion of Treasury bonds in an effort to keep borrowing costs for mortgages and commercial loans down. (Both of these interest rates are priced off of Treasury rates.) These actions have generated increased concern about inflation, which would put long-term bond buyers at risk for significant losses. Recent price moves in Treasurys demonstrate how quickly this market can change. If an investor had purchased a 10-year U.S. Treasury bond on 12/31/2008

integrity

Where do you find integrity?

It emanates from tradition, endures market cycles, and sustains long-term partnerships. Trust lies at the heart of what we do, how we serve and whom we employ.

[in tegr te] n. honesty, sincerity, completeness

Fixed Income Dilemma: Wheres the Yield? (continued)

PRICE OF U. S. TREASURY BONDS

145 140 135 Price of Bond 130 125 120 115 110 105 100 95 12/31/08 1/31/09 2/28/09 3/31/09 4/30/09 5/31/09 6/30/09

12/31/2008 6/30/2009

10 YEAR TREASURY 4.0% 08/15/2018

30 YEAR TREASURY 4.5% 05/15/2038

This graph demonstrates the convergence of prices between 10-year and 30-year bonds over six months, emphasizing the importance of keeping fixed-income investments short-term.

FEATURED EQUITY

Varian Medical
Varian is a leading provider of radiation therapy machines and software to treat cancer. The companys products include linear accelerators (radiotherapy), equipment that allows neurosurgeons to visualize and operate in three dimensions using external beam radiation (stereotactic radiosurgery) and radioactive seeds that are temporarily implanted in a cancerous tumor (brachytherapy). The company also designs, manufactures and sells X-ray machines that use film and those that use flat panel digital image detectors for filmless X-ray systems. In the last several years, Varian has entered the security screening business, which uses similar technology. Radiation therapy is used to treat a wide variety of solid tumors, including cancers of the head and neck, breast, prostate, pancreas, lung, liver, uterus, ovary, brain and spinal cord. Varians intensity-modulated radiation therapy (IMRT) allows the shape, intensity and angle of the beam from the linear accelerator to conform better to the shape of the tumor, thus decreasing radiation to surrounding, normal tissue. The companys image-guided radiation therapy (IGRT) further refines this process. Varians RapidArc machine and associated software continue to experience strong demand world-wide. Treatments are faster and more effective for patients and healthcare centers can treat many more people per day. The aging population, increased incidence of smoking in developing countries and unhealthy lifestyles are all driving an increase in the number of cancer cases around the world. Healthcare authorities project an increase of 50%, to 15 million cases, by 2020. Many countries remain woefully under-equipped to treat cancer with radiotherapy, providing significant untapped markets for Varian. While Varian has experienced some slowdown in orders during the recession, revenues continue to grow and 300 new orders for RapidArc were booked in 2008. The company has a solid balance sheet with minimal debt. We believe Varians technological leadership, strong management and prudent financial position will result in steady growth over the next several years. Recessions resolve, and as this one does, healthcare organizations will again be looking to upgrade to the most effective and efficient ways to treat patients with cancer.

INDEX PERFORMANCE Dow Jones Industrials Standard & Poors 500

Q209 11.96 15.92 25.57 1.67 1.67 2.11

YTD -1.97 3.19 8.06 1.62 1.62 6.43

Index RetuRns

EAFE (international stocks) Russell 2000 (small stocks) Barclays International Barclays Municipal

WEALTH MANAGEMENT

The Psychology of Investing

Few people have been emotionally unaffected by the financial upheaval of the last year. It has been unsettling and painful to watch declines in assets. Many investors have taken precipitate actions, reacting quickly and fearfully to the decline in stock prices. Few have had the patience and fortitude to methodically think through the longer-term implications of their actions. Human beings like to believe that decision-making, whether buying a car, taking a new job or selling a stock, is a rational process. They think that they have carefully analyzed the pros and cons and that the final decision is unaffected by emotion. Individuals are particularly prone to being overconfident in their investment decisions, which are in fact often rooted in emotional bias. This is why professional management has much to offer. The field of behavioral finance, developed over the last twenty-five years, applies basic psychology to financial decision-making at both the individual and population levels. It turns out that, even in less tumultuous times, investors are subject to biases that influence their decisions, usually for the worse. In the words of Warren Buffett, investing is not a game where the guy with the 160 IQ beats the guy with the 130 IQOnce you have the ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing. For example, research has demonstrated that people are much more concerned about possible losses than they are delighted by equivalent gains. Investors consider the loss of a dollar twice as painful as the pleasure they get from an identical gain. Thus investors take many more risks to avoid losing money than they do to realize gains. Classically, people want to raise cash when the market is falling. Then they fail to get back in and miss a rally. There is also a strong bias toward recent experience at the expense of looking at long-term trends and statistical odds. Applying this concept to the stock market numbers of the last several years suggests that most individuals have been overly pessimistic as the market has gone down, just as they were overly optimistic that the market would keep going up when it hit 14,000. Some people can be strongly influenced by what researchers call touchy-feely syndrome, becoming quite attached to stocks of companies that they personally know something about or have selected themselves.

The Nelson Roberts Investment Advisors quarterly commentary will be available electronically in future quarters. If you would like to continue to receive this piece in hard copy, please contact Tien Tran at ttran@nelsonroberts.com

www.nelsonroberts.com | 650.322.4000

Investment Team
Brooks Nelson, CFA Brian Roberts, CFA, MBA Steve Philpott, MBA Dennistoun Brown, MD Ann Oglesby, MD, MBA

WEALTH MANAGEMENT

The Psychology of Investing (continued)

These examples just scratch the surface of the many biases that influence investment decision-making. A disciplined, consistent process and heightened awareness of these biases allow us, as professional managers, to avoid many of these pitfalls. Specifically, we do the following: Use checklists to make sure we answer key questions about every potential investment. Question each other vigorously, listen carefully to contrary viewpoints and look at what if scenarios. Write down the original investment thesis and refer back to it as we assess investment performance over time. Learn from mistakes and leave them behind. It is particularly important to remember that we do not have to make money back the same way we lost it. Not every decision is correct and not every stock is a winner. We sell when we need to and move on. Stay out of the trap of anchoring on historical information, past stock prices or perceptions about an investment. We set buy and sell targets for equities. Keep a patient, humble perspective on investing, by diversifying, tuning out the huge amount of noise and going for steady outperformance over time. We avoid market timing and ensure that decisions regarding raising cash are based on either valuation or asset allocation needs of clients.

Some examples from research on overconfidence: 19% of people think they belong to the richest 1% of U.S. households. 82% of people say they are in the top 30% of safe drivers. 80% of students think they will finish in the top half of their class. 68% of lawyers in civil cases believe that their side will prevail. 81% of new business owners think their business has at least a

70% chance of success, but only 39% think any business like theirs would be likely to succeed.

Past performance is not necessarily a guide to future performance. There are risks involved in investing, including possible loss of principal. This information is provided for informational purposes only and does not constitute a recommendation for any investment strategy, security or product described herein. Please contact us for a complete list of portfolio holdings. For additional information on the services of Nelson Roberts Investment Advisors, or to receive our Newsletters via e-mail or be removed from our mailing list, please contact us at 650-322-4000.

1950 University Avenue, Suite 202 East Palo Alto, CA 94303 tel 650-322-4000 web www.nelsonroberts.com email invest@nelsonroberts.com

2009 Nelson Roberts Investment Advisors