Portfolio performance in the third quarter showed improvement over a tumultuous first and second quarter. July and August provided strong out-performance followed by a little give back in September. There was no discernible pattern to the performance, but generally some of our foreign holdings (ADR’s) did better than our domestic names.

Energy and energy related names remained the big story in the quarter. Escalating oil and gas prices grab headlines every day and are increasingly a drag on consumer spending. We believe that rising interest rates and reduced discretionary spending as a result of this "energy tax" are going to eventually impact consumer related stocks. Our exposure in this area is minimal. Our favorite energy name over the long term remains oil field technology leader Schlumberger, and we look to establish or build positions if and when the stock price corrects.

We continue to believe that advances in healthcare are making a positive impact on society and individuals. Companies that innovate and provide value, whether in cost savings or in improved lifestyles, will be able to monetize that value. We think we have positioned a large part of your portfolio in just such names. Near term vagaries have allowed some of them to trade at attractive prices, and we have been adding to some of these positions.

One of the most satisfying parts to our job remains the research we do. The last three months have provided an extraordinary number of opportunities to attend conferences and have face to face meetings with management teams. These are always very helpful, but when we explain our investment style, our long term perspective, and our interest in understanding the true economics of a business, we often notice a perceptible change in management’s attitude towards us. Many of them have been hardened by their dealing with hedge-funds with short term trading horizons. Corporate Executives become very guarded in what they say lest they reveal or are thought to reveal something about the short term performance of the business. Instead, they welcome conversations with investors like us, who are much more interested in understanding longer term strategic issues and customer and competitive dynamics so that we can form our own opinion of a company’s sustainable competitive advantage and their ability to turn that into shareholder returns.

Japan Redux... 

It’s that time again! This year, Japan is once again among the world’s best performing equity markets (the TOPIX index advanced 26% in local currency terms, 10.8% in US$ through 10/31) which begs the question, "Is this economic recovery for real?"

There are many positive signs to support the consensus view that Japan is truly turning the corner, and that this time really is different. It’s taken more than a decade, but banks have finally shed the mountain of bad debts that piled up during Japan’s post-bubble period; they are merging, and preparing for a pick-up in loan demand. Corporate balance sheets are awash with cash, and capital spending is beginning to accelerate. Consumer spending is finally picking up, and real estate prices are on the mend. Deflation is forecast to end imminently.

Anecdotal evidence supports the view that Japan is a much healthier place. A refreshing change has been the large number of upward revisions to forecasts companies made during the reporting season for the fiscal half year ended September 30. Orix, a holding in many client portfolios is a case in point. The company is Japan’s largest comprehensive financial services company with a focus on serving small and medium-sized businesses. Orix surprised the market with stronger-than-expected first half results and raised its full year forecasts. The exciting part was the fact that improvements are being seen across the board, with new business volume advancing sharply in all product lines, and bad loan costs declining significantly.

So, what could go wrong for equities? The fact that there is hardly a bear to be found and that domestic investors are nowhere to be seen is a concern. With the end of deflation nigh, the Bank of Japan has indicated that its zero interest policy may soon be abandoned. The health of the Japanese economy is still heavily dependent on exports and hence, highly geared to the global cycle. There are longer-term concerns as well, such as the oft-cited aging of the population.

As bottom-up stock pickers though, we still find individual stocks that look attractive from both a prospective growth and valuation perspective. After such a sharp rally though, some consolidation would be both expected and healthy. There will always be uncertainties to be sure, but this time the recovery looks real.