QUARTERLY

Commentary
FOUrTH QUArTEr 2011

ECONOMIC OvErvIEw

The Yo-Yo Year

If you like volatility, then you surely loved 2011. The S&P 500 was up 8% in late April, then declined 21% through September and finally rallied back 14.5% in the last quarter to finish the year where it started. Interest rates fell precipitously in mid-summer as Greeces troubles dragged on and the US government flirted with technical default. Inflation continued to rise, with the CPI increasing from 1.1% at the end of 2010 to 3.3% currently. Lastly, the US dollar almost mirrored the stock market. It fell 8% through April, then rallied back to end the year where it started. For most of the year concerns about European Union
FEATUrED EQUITy

Tunisia spread to Egypt and Libya. Civil uprisings also occurred in Bahrain, Syria and Yemen and major protests occurred in Algeria, Iraq, Jordan, Kuwait, Morocco and Oman. The rising cost of food (which accounts for 40% of the average citizens expenditures in these countries) was often cited as a root cause of the unrest. The summer brought us The Greek Problem: The Sequel, with organized strikes and government shutdowns. The Arab Spring inspired the beginning of the Occupy Movement with the protest on September 17th in New York Citys Zucotti Park. This spread to major cities across the US and the developed world with the cry of we are the 99% adopted after the Congressional Budget Office (CBO) reported that over the last 30 years, the after-tax income of the top 1% income earners has tripled. This winter we are beginning to see the spread of protests and unrest in both Russia and China.
INDEX PErFOrMANCE Dow Jones Industrials Standard & Poors 500 EAFE (international stocks) Russell 2000 (small stocks) Barclays Interm. Gov/Credit Barclays Municipal Q411 12.74 11.80 3.40 15.46 0.84 2.13 yTD 8.34 2.09 -11.68 -4.19 5.80 10.70

Inside this Issue

ECONOMIC OvErvIEw

: : The Yo-Yo Year

ASSET MANAGEMENT

: : A Wild Ride to Nowhere

: : Paychex
FIXED INCOME

financial problems overshadowed the markets. Meanwhile, the US economy plodded along. Job creation was just strong enough to keep unemployment steady and companies saw their profits rise due to careful cost control. In aggregate, companies of the S&P 500 posted solid revenue growth of 8.0% and earnings per share growth of 12.37%. As a result, the stock market valuation is even more attractive today with the P/E ratio now at 13 times earnings. This is equivalent to an earnings yield of 7.7%. Politically, 2011 was a year of worldwide unrest driven fundamentally by the difference between the haves and the have-nots. The year began with the Arab Spring as a wave of popular uprisings starting with revolution in

: : If It Sounds Too Good to Be True

SPECIAL TOPICS

: : At Your Own Peril: Online Banking

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With the incessant focus on Europe and that corporate profits are what matter

top

ECONOMIC OvErvIEw

FiFteen Holdings
iShareS

The Yo-Yo Year (contd)

With the incessant focus on events in Europe and elsewhere, the markets seem to have forgotten that corporate earnings are what matter most. (Please see our fall white paper The Euro Crisis in which we point out that exports comprise 13% of the US economy, only 2.6% of which go to Europe. This is truly a case of the tail wagging the dog.) We expect that rational thinking will eventually return to drive stock prices but it may not return as early as 2012. A dysfunctional US government will become even
S&P 500 VERSUS EURO

MSCi eMerging

out of control and nothing will be done in Congress about either problem. Behavioral economics tells us that people hate losing something more than they like receiving something. Additionally, it is a human tendency to want to keep what we already have even if the replacement may be equivalent. These two principles make entitlement reform extremely challenging under the most auspicious political circumstances. In an election year, there is no chance at all of reform. The Euro Unions problems will fade in and out of view without a permanent resolution, but should gradually show improvement. It will take a long time to
1350 1.45 1300

MarketS Chevron Corp

iShareS

S&p SMallCap 600

Diageo plC-Sp aDr verizon CoMMuniCationS royal DutCh Shell plC utilitieS SeCtor SpDr CoStCo WholeSale Corp payChex inC. J.M. SMuCker oraCle Corp
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December 31, 2010 December 30, 2011

1.50

install the fiscal constraints for which leaders in Germany and France are advocating. The Occupy Movement will strengthen in the spring and become a vocally shrill part of the election year rhetoric. Unrest in the Middle East, Russia and China will continue. In short, we see 2012 as a continuation and strengthening of the trends in 2011.

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2011 Bloomberg Finance L. P.

more so as we move closer to the November election. Rhetoric will rise and compromise will fall through the year. We will probably see another fiscal crisis as Republicans and Democrats use the federal debt limit as a jousting tool in their political tournament. Medical care and pension costs will continue to spiral

In the US, we expect the economy to continue to plod forward, slowly building momentum. All the negatives listed above constitute the wall of worry which stock prices will eventually climb, albeit not in a straight line. To us, the stock market is becoming more attractive every day.

elsewhere, the markets seem to have forgotten the most.

ASSET MANAGEMENT

A Wild Ride to Nowhere

For those who check the stock market returns only once been more focused on managing inventory, which at calendar year-end, it would appear to have been ultimately leads to a higher cost of product for a very calm year. The price change of -0.03% is the discounters like TJ Maxx who benefit from relative smallest change in over forty years. For those of us inventory mismanagement. Economic indicators on who watch the market every day, the stomach-churning the heels of the holiday shopping season have been volatility of the last twelve months was anything but consistent with that thesis. tame. Daily swings in the S&P 500 S&P 500 SECTOR PERFORMANCE JANUARY 1, 2011 DECEMBER 31, 2011 in August averaged 2.2% and the Utilities 19.96% DJIA saw 400-point moves four Cons. Staples 13.99% times in that month alone.
Healthcare 12.73% 6.31% 6.23% 4.71% 2.43%

Early returns were encouraging. On April 29, the S&P 500 had risen 8.4%, almost a three-year high. Five months later, the S&P was 19% lower on heightened worries over rising debt levels both domestically and internationally. -9.65% The volatility was not equally -17.03% shared. The best-performing sector, -2% -15% -1% utilities, was up 19.96% while financial stocks fell 17.03%. Traditional defensive investments in utilities, consumer staples and healthcare stocks posted solid returns while those companies sensitive to economic growth were challenged by worldwide economic uncertainty. 85 of the 500 companies in the S&P 500 saw their share prices decline by more than 20% in 2011. At Nelson Roberts, exposure to international markets and smaller, growth-oriented companies weighed down our returns. International stocks fell -11.68% and small caps were down 4.19%. After adding to some of our large cap, dividend-paying companies in the third quarter, we trimmed the position of one of our best performing names of the last three years, TJ Maxx. We took the profit because we think that retailers in aggregate have

Telecommunications Cons. Discretionary Energy Technology 0.59% Industrial Basic Materials

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We also exited Illumina, Inc., at a loss. While we remain confident in Illuminas products and execution, the company receives the majority of its revenues from government funding. Uncertainty surrounding the stability and amount of this funding going forward made us decide that we would look for a re-entry point when there is more clarity. Finally, the army of 100,000 brown trucks and 500 airplanes delivering goodies around the world did not go unnoticed by us during the holidays. We purchased UPS for our client portfolios. UPS benefits directly from the fact that not everything can be delivered digitally and it has developed an impressive infrastructure to make delivery efficient and cost-effective. It also pays its shareholders a 2.9% dividend.

V
value

How do we measure value?

By producing it in the growth of assets, in how our clients view us, in how we create partnership.

[val yoo] n. a quality having intrinsic worth

FEATUrED EQUITy

Paychex
Despite difficult headwinds for its core service of payroll processing, we believe Paychex has positioned itself for future success. The unemployment rate has remained stubbornly high since the financial meltdown in 2008, but has recently shown glimmers of improvement. Additionally, historically low interest rates have nearly wiped out Paychexs interest earnings on client funds, a traditionally profitable source of revenues. The companys management team has navigated these challenges well while providing attractive dividends to shareholders. Paychex was founded in 1979 when seventeen payroll processing companies merged. It is now the second largest company in the payroll processing market. Paychexs business is built around the concept of making payroll outsourcing easy and affordable for small businesses. The company now services over 500,000 small to medium-sized businesses nationwide. Switching costs are substantial, so Paychex is likely to hold onto this sizable client base. 80% of its clients employ fewer than 20 staff. The company has expanded beyond payroll processing into human resources, including Retirement Plan Services, HR Solutions, Insurance Services and Time and Attendance Services. This expansion has given Paychex an opportunity to develop deeper relationships with both of the last few years while maintaining a dividend rate of over 4%. As the economy continues to improve, Paychexs business and stock price should outperform the market.
MAR JUN SEP 2008 DEC MAR JUN SEP 2009 DEC MAR JUN SEP 2010 DEC MAR JUN SEP 2011 DEC 2011 Bloomberg Finance L. P. 20 25
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new and existing clients. The HR services have grown 50% in the last four years and now comprise nearly 30% of total firm revenues. Paychexs share price will benefit from economic stability and an improved employment rate. We are encouraged that unemployment has fallen to a 2 year low of 8.6% in November. Management notes that there has been an increase in the number of checks it is issuing per client, an optimistic sign for employment at small companies. This company has weathered the volatility
DECEMBER 31, 2007 DECEMBER 30, 2011

PAYCHEX STOCK PRICE

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::

Trust what is simple and can be understood at a glance. Anything more elaborate, investigate carefully and thoroughly; if its too convoluted for you to grasp, pull back. Remember, in financial matters the object of complexity is all too often to conceal the truth....
Paul Johnson, British historian and author

FIXED INCOME

If It Sounds Too Good to Be True

With money market rates near 0% and yields from US government bonds, corporate bonds and CDs at historic lows, it has been another tough year for income-seeking investors. To make up for falling returns, more and more investors are being drawn to alternative fixed income products that promise interest rates of 7, 8 or even 10%. Many of these products have serious underlying risks and should come with warning labels reminding investors that if the yield sounds too good to be true, it probably is. Before investing in alternative fixed income products, investors should ask three questions: 1. Why would someone pay these significantly higher yields? 2. What are the fees and/or commissions? 3. Is the investment liquid? (can you get it back quickly?) Here are a few examples we have seen advertised recently. Structured notes: These hybrid securities combine equity and fixed income securities with derivative contracts. They usually offer some degree of principal protection in addition to a chance for higher returns but there are big drawbacks. In exchange for limiting losses, the notes cap the upside, which can be significantly less than the markets actual gains. The underlying fees are high, often 3% or more, and the guaranteed backing is only as good as the institution issuing the note. Also, these investments are typically illiquid, meaning that they do not trade on the secondary market. The institution issuing the note will often promise to repurchase it, but only at a deep discount. High-yield bonds: These bonds are issued by organizations that do not qualify for investment grade ratings by one of the leading credit agencies. Those issuers with a greater risk of defaultnot paying interest or principal in a timely mannerare rated below investment grade. The issuers must pay a higher interest rate in order to convince investors to buy their bonds. In addition to the risk of default, high yield bonds are less liquid than investment grade bonds. Charitable Gift Annuities: These annuity contracts are established between a charity and a donor. Cash, stock or properties are gifted to a charity in exchange for a stream of lifetime income. The rates of return are higher than those available with traditional bank deposits, but the donor must be charitably inclined in order to achieve the full benefit. Once the gift is made it becomes irrevocable. Income payments are guaranteed by the charity, so selecting a charity that is financially sound is critical. The reality is that in order to make money, you must take risk. However, considerably higher yields should be a strong indicator that the risks are high indeed and investors need to understand what those underlying dangers are before investing. High quality, dividend-paying stocks are a better alternative for most investors.

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

SPECIAL TOPICS

At Your Own Peril: Online Banking

Managing bill payment and banking has never been easier. We can pay all of our bills from any computer, setting up many of them to be paid automatically. With a smart phone, you can now deposit checks by simply emailing a picture of the front and back of a check. At the same time, privacy regulations and security protections have become more stringent. For example, if you have an account at a brokerage firm registered in the name of your revocable trust and you wish to transfer funds to your personal checking account which is not registered in the name of your trust, the brokerage firm requires that you submit a written letter of authorization to transfer your money to you. This is a sensible precaution. Technically, because the account registrations are not exactly the same, the transfer request is treated by the brokerage firm as if it were going to a third party such as an escrow account at a title company. By requiring your signature, the custodial firm is protecting your assets from unauthorized third party withdrawals. One might assume that the same level of scrutiny and diligence is applied to online banking transactions; however, that would be a very wrong assumption. Making a withdrawal from any account that has checks or has set up automatic clearinghouse (ACH) transactions (sometimes known as moneylinks), requires only that someone has the routing and account numbers. This applies to both bank and brokerage accounts. The routing and account numbers are on every unsigned, signed and cancelled check that you have in your possession and in circulation. These numbers are also in the system of every merchant, bank and credit card company with which you have done banking business. Anyone with this information can set up an online transaction to debit funds from your accounts. Should a fraudulent transaction actually hit your account, you have less than 60 days (and maybe as few as 31 days) to notify your bank or brokerage custodian. If you do this within the allowed time limit, you will then have to file a fraud claim with the financial institution, which will in turn reverse the transaction. If you do not notify them within the required time limit, then your only recourse is to file a report with the local police department. This demonstrates that you are attempting to reclaim your property. If the police cannot recover it for you, then you can deduct the transaction as a theft or casualty loss (at $100 per theft eventsubtract 10% of your adjusted gross income).1 For most of our clients, this means that there will be no tax benefit from fraudulent transactions that are not caught within the notification time limit. Unfortunately, institutions will not give investment advisors sufficient information to see where funds are going. The only information that is provided to us is the amount of the debit or transfer. Therefore, it is essential that each of you regularly monitor the activity in your accounts on which you write checks or process ACH transactions.
1

www.irs.gov Topic 515-Casualty, Disaster, and Theft Losses

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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2012 Nelson Roberts Investment Advisors