QUARTERLY

Commentary
ThiRD QUARTER 2010

ECOnOmiC OvERviEw

The Lost Decade

Markets have remained volatile and unproductive this year, as they have for the last ten years. The decade began with the dot-com bust followed by a huge real estate bubble-then-bust that nearly pushed the US into a depression. In retrospect, this has truly been a Lost Decade for investors, with stocks producing low single digit annual returns, bond yields at historic lows and the return on cash at zero. We are perhaps early in calling the end of this discouraging period. Some proclaim that the US is doomed to another 10 years similar to what Japan has experienced. We disagree. On the other hand, we are not proclaiming that happy days are here again. The end of this prolonged period of malaise is in sight, but will take many months to work through. The basic ingredients are finally in place, however. First of all, many companies are holding cash reserves that are significantly beyond their cash needs for operations. Some, like Cisco and Microsoft, are initiating or raising dividends. Others are using excess cash for mergers and acquisitions. Bank reserves have grown from $600 million before the financial crisis to over $1 trillion. With bank reserves earning less than of 1%, it is only a matter of time until banks expand lending. Investors cash and bond holdings are at 49.1% compared to stock holdings, well above the long-term average of 40%. Secondly, despite much hand-wringing about deflation and the possibility of a double dip, we believe that inflation is continuing to build. Everywhere we go, we ask: other than housing prices and interest rates, of the things you buy every day, what has declined in price? The unanimous reply is nothing. Investors will begin to deploy cash as confidence builds that the world is past the worst of the crisis. Because inflation is bad for the bond market, cheap stock values will attract cash. Finally, the Congressional Budget Office reports that $818 billion of stimulus money has been spent to date and this has saved 3.3 million jobs. This represents $248,000 per job saved, a clear indictment of the stimulus plans lack of effectiveness. Despite the failure of the stimulus plan, the economy is forging ahead. Corporate profits have been rising for eighteen months.

Inside this Issue

ECOnOmiC OvERviEw

: : The Lost Decade

ASSET mAnAGEmEnT

: : Equities Climb in Fits and Starts

FixED inCOmE.....OR nOT

: : The Search for Yield Continues

FEATURED STOCK

: : Lindsay Corporation
invESTmEnT ThEmES

: : Water Wars?

inDEx PERFORmAnCE Dow Jones Industrials Standard & Poors 500 EAFE (international stocks) Russell 2000 (small stocks) Barclays Interm. Gov/Credit Barclays Municipal

Q310 11.13 11.30 16.57 11.29 2.75 3.40

YTD 5.60 3.91 1.64 9.13 7.44 6.83

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The end of this prolonged period many months to work through.

top

ECOnOmiC OvERviEw

FiFteen Holdings
iShareS intl

The Lost Decade (contd)

Two years of do more, spend more and borrow more government policies have led to growing voter dissatisfaction. Political rhetoric is shrill and respect for the opposing viewpoint is non-existent. Voters, exhibiting much more sense than Congress, realize that federal debt and deficits have to come down and the country needs to come to grips with entitlements of all ilks, from Social Security to Medicare to pension obligations. We view this political divisiveness as historically the rule rather than the exception. Our country has a long history of a fundamental tension between what began as the Federalist/Anti-Federalist argument. This argument is embodied in the current rise of the Tea Party Republicans against the incumbent Democrats. We can despair about the lack of bipartisanship and lament the most radical elements of each group. However, we observe that neither of these are in sync with the majority in the middle. We are optimistic that the growing sense of public outrage regarding the lack of responsible decision-making will culminate in material changes.
DOW JONES INDUSTRIAL INDEX

emerging marketS

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iShareS

As David Brooks put it in his September 24 New York Times editorial: When you listen carefully, you notice the public anger doesnt quite match the political class anger. The political class is angry about ideological things: bloated government or the predatory rich. The public seems to be angry about values. The heart of any moral system is the connection between action and consequences. Todays public anger rises from the belief that this connection has been severed in one realm after another. What the country is really looking for is a restoration of responsibility. If some smart leader is going to help us get out of ideological gridlock, that leader will reframe politics around this end. When this occurs, we will once again have a positive environment for solid and sustainable economic growth. We look forward to the end of the Lost Decade.

S&P Small caP

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Paychex emerSon electric cheVron corP 3m comPany royal Dutch Shell coStco Varian meDical

January 1, 2000 - December 31, 2009

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d of malaise is in sight, but will take

ASSET mAnAGEmEnT

Equities Climb in Fits and Starts

Stock market indices have again fluctuated dramatically Earlier in the quarter we swapped holdings in in the third quarter as the markets tried to get a fix on international stocks, after concluding that the broader the deflation/inflation probabilities. However, at least at Asia-Pacific region offered better opportunities for this time, the markets look to be on the rickety climb growth than Japan, which is still struggling with its upward on this years roller coaster ride. At quarters economic recovery. The Emerging Asia Pacific end, the DJIA had JANUARY 1, 2003 - OCTOBER 1, 2010 recovered from its second quarter drop and was US CORPORATE PROFITS, 2003-2010 40 up 5.6% for the year. 37 30 The S&P 500 has also rebounded and is now 20 up 3.9%. We ended the 10 quarter with just 3.8% of our equity allocation in 0 cash, reflecting our belief -10 that equities are offering attractive returns. -20 In late August, we exited a profitable position in Corn Products (tkr: CPO). 2004 2005 We initiated our holding of CPO in the spring of 2009 when the stock had fallen dramatically in step with the decline in corn prices. The P/E ratio had plummeted to 5x earnings. We thought that the stock would benefit from the stabilization of revenues and a better-defined strategy. The P/E did recover and we sold our position. Using the proceeds from the sale, we doubled our position in Power Integrations (tkr: POWI). We highlighted POWI and its energy efficient power conversion technology in our third quarter 2009 commentary. The company is relatively small as measured by market capitalization, but we continue to have confidence that the companys products will benefit from increasing government standards for power efficiency in consumer products as well as the transition to LED (light-emitting diode) lighting solutions. We took advantage of a temporary dip in the price to increase our holdings.
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2010 Bloomberg Finance L. P.

SPDR (tkr: GMF) is one of the tools we use to hold non-US investments in our equity portfolios. The largest geographic holdings include China, Taiwan and India, all economies with impressive growth prospects. The most recent earnings cycle confirmed our belief that the longer-term returns in the equity markets will be attractive. The volatility of the markets and the continued debate about inflation vs. deflation suggest that we are not completely out of the woods. However, while the market remains range-bound, the component companies of the broad market indices are improving their balance sheets while strengthening their revenues and earnings opportunities. The improved valuations of these companies will ultimately lead to returns in line with historical expectations.

V
vision

What is money?
At its simplest, it remains a form of barter, an exchange of energy for goods. At its most complex, its a symbol of mastery, a measure of power. At its center are people with vision, talent, skill, families, children, hope and dreams.

[vizh en] n. the ability to perceive or foresee through mental acuteness

FixED inCOmE.....OR nOT

The Search for Yield Continues

In contrast to the wild swings of the stock market this quarter, the bond market has been relatively stable. Interest rates remained at record-setting low levels. Despite these remarkably low rates, investors continued to pour enormous amounts of money into the bond market. Demand for yield has been so strong that numerous US companies successfully issued debt at yields lower than the dividend rates they are paying to their common stockholders. Low interest rates in the bond market reflect concern over the risk of deflation, high levels of sovereign debt and the underlying fear that we could experience another large decline in the stock market. Many investors are electing to put their money into bonds because their memories of recent stock market declines are too painful and too fresh. They would rather take lower investment returns and have the comfort of knowing their principal is secure. From January to the end of August of 2010, approximately $200 billion flowed into the bond market, compared to the roughly $42 billion that flowed out of the stock market. These are staggering numbers, particularly considering that a 5-year Treasury is yielding 1.25%. Many US companies are taking advantage of this opportunity to access cheap capital by issuing debt and locking in low interest rates. Microsoft recently sold almost $5 billion in debt with four different maturities. The maturities ranged from three years to thirty years. $1 billion of 3-year debt was sold at 0.88%, or 0.25% more than a 3-year US Treasury. The 5-year note sold for 1.63%, or 0.40% over Treasuries. These are remarkably low levels considering that Microsofts dividend yield is currently 2.6%. Another example is IBM, which successfully issued 3-year notes at 1.0%, while its stock pays out a 2.0% dividend.
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The average dividend yield of the DJIA is 2.5% while the broader S&P 500 Index has a 2.0% yield. We have made a concerted effort to choose strong companies with high dividend yields, such as Verizon (6.0%), Royal Dutch (5.9%), Paychex (4.6%) and Diageo (4.2%). Investors do need to beware of high dividend yields on stocks that are declining in price. As stock prices fall, dividend yields increase. An exceptionally high yield may reflect a company in trouble, with an unsustainable dividend payout. For investors dependent on interest payments for income, the search for yield in the fixed income market has been frustrating. High quality stocks present an opportunity to generate income when the companies issuing them combine high dividend yields with strong balance sheets and consistent cash flow.
STOCK YIELD VS. BOND YIELD
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For twenty years governors have been lying to you about the kind of benefits they can provide you. Im the first guy whos telling the truth, which is if we dont do these reforms, we are going to wind up with you not having a pension in 10 or 15 years.
New Jersey Governor Chris Christie, speaking at the firefighters convention

FEATURED STOCK

Lindsay Corporation
One of the companies offering an investment in water efficiency is Lindsay Corporation (tkr: LNN). Lindsay has two major business divisions: irrigation equipment (75% of revenues) and moveable road construction infrastructure (25% of revenues). Company revenues for 2009 were $336M, coming off a high of over $400M the previous year. Last years results reflected farmers caution about capital investment in view of the overall state of the economy, but revenues in 2010 are recovering nicely. World-wide, 17% of agricultural land is irrigated; however irrigated cropland produces 40% of the worlds food. Flood, or gravity irrigation, uses twice as much water as mechanized irrigation, and crop yields are significantly lower. Flood irrigation also increases runoff of fertilizers and pesticides. LNNs irrigation equipment delivers both water and agricultural chemicals close to the ground, directly onto the plants. The majority of LNNs sales are of pivot irrigators, the machines that create the big green circles in the western plains. In 2008, for the first time, more acres (46%) were irrigated by efficient pivots and laterals than by any other method. LNN derives its revenues from conversion of dry land to irrigated land, conversion from less efficient to more efficient irrigation methods, and sales of replacement systems and parts. As we discuss in the article about water on page 6, the population is growing, more food needs to be grown to feed the additional people, and water has to be carefully and efficiently used. This is why LNN appears regularly on the Best Small Companies lists.
LNN EQUITY GP
DAY SESSION
LAST PRICE HIGH ON 09/29/10 AVERAGE LOW ON 07/06/10 43.32 44.28 37.65 31.44

February 1, 2010 September 30, 2010

$44.00 $43.32 $42.00

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2010

2010 Bloomberg Finance L. P.

www.nelsonroberts.com | 650.322.4000

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

invESTmEnT ThEmES

Water Wars?
Water is increasingly being described as the next scarce resource. A special report in The Economist in June, 2010, provided some fascinating and alarming information. The root cause of water scarcity is the continuing growth of the worlds population. In 1950, 2.5 billion people lived on the planet. In 2010, this figure is almost 7 billion. By 2050, it is projected to be 9 billion. The green revolution (higher crop yield per acre), decreased infant mortality and improved sanitation and healthcare in much of the world have all led to longer life expectancy. As a result, the amount of water used for farming has grown by a factor of three. As recently as 60 years ago, only 8% of the worlds population was chronically short of water; by the turn of the 21st century, the percentage stood at 45%. There are two major uses of water in addition to farming: industrial and domestic. 70% of world water is used for agriculture, 22% for industry and 8% domestically. In developed countries, these numbers are almost reversed: 60% of water goes to industry, about 33% to agriculture and 11% to domestic use. Industrial use of water is growing twice as fast as agricultural use. Big industrial users include power plants (cooling), companies drilling for and extracting oil, and manufacturers of petroleum products. An astonishing 60% of fresh water is found in only nine countries. China and India, with 1/3 of the worlds population, have less than 10% of the worlds fresh water. Fresh is of course the key word. 97% of the Earths water is salty. Of the remaining 3%, 70% is frozen, which leaves just under 1% for all living creatures outside the ocean. Most fresh water is stored in aquifers and falls as rain through the water cycle. Because water is heavy and therefore expensive to move, it is extracted locally. In many locations, it is being drawn from aquifers faster than it can be replaced. Humans need, on average, 2 liters of water a day to sustain their bodies. The water must also be clean. Dirty or contaminated water causes poor health from intestinal illness. This in turn leads to malnutrition, resulting in a population that is too ill to improve its economic output. Hygiene and protected storage for clean water are essential to improving sanitation and health in poorer countries. There is growing awareness of the need to conserve water. To do this effectively, however, the big water users, agriculture and industry, have to be engaged. This is starting to happen. (See our article on Lindsay Corporation on page 5.) In recent years, the ratio of GDP (which is growing) to water use (which is declining) has improved significantly. Companies such as Nestle have committed to decreasing their water use by up to 1/3 over the next five years. We believe that the investment theme of efficient water use will be increasingly important in the next decade and will be looking for companies offering products that support this need.

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.

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2010 Nelson Roberts Investment Advisors