QUARTERLY

Commentary
Second QUArTEr 2011

ECOnOmIC OvErvIEw

The More Things Change, the More They Stay the Same
Plus a change, plus cest la mme chose, or to use Yogi Berras French that is perhaps more familiar, it is dj vu all over again. Well, sort of. The stock markets rose for the first four months of 2011, just like they did last perhaps not. To paraphrase Churchill, we hope that we (Americans) will eventually do the right thing, once all other options are exhausted. On the positive side of the ledger, unlike last year, when the stock markets hit a low on June 30th, equities have remained in positive territory all year. In the first four months of 2010, the S&P rose 7.05%, then declined 12.8% in May and June, ending the first six months of last year with a loss of 6.65%. This year the market was up 9.06% in the first four months and has since declined 3.05% for a return of positive 6.01% for the first half of 2011. In another significant divergence from the past year, corporate profits have started rising. US corporate profits were up 6.3% in March. Rising earnings are keeping stock valuations reasonable. The Price/Earnings ratio of the S&P 500 index is sitting at 12 times, meaning that stocks are relatively inexpensive.
InDEX PErFOrmAnCE Dow Jones Industrials Standard & Poors 500 EAFE (international stocks) Russell 2000 (small stocks) Barclays Interm. Gov/Credit Barclays Municipal Q211 1.41 0.09 1.78 -1.61 2.12 3.89 YTD 8.57 6.01 5.34 6.19 2.47 4.42

Inside this Issue

ECOnOmIC OvErvIEw

year, then declined in May and June. Greece needs yet another bailout, just like last year. (In fact, Greece will need bailouts as far as the eye can see, since 40% of the population works for the government and 12% of the population is unemployed.) The housing market in the US remains weak and shows no signs of meaningful recovery. Interest rates are still near zero. Payroll employment, which had been growing modestly since the June 2010 report of over 200,000 jobs lost, recently registered a significant drop, just like last year. The US federal government is still spending $1 trillion (annualized) more than it is receiving. California and many other states are struggling to balance their budgets. The US dollar is still weak and the Chinese, Brazilian and Indian economies are still humming along. Medical costs are still rising at an unsustainable pace. The future financing of Social Security and Medicare is still unresolved. It is all rather discouraging. Instead of engaging in a meaningful discussion about appropriate prioritization and allocation of government resources, our elected representatives are wrangling about the debt ceiling. Perhaps those discussions will eventually lead to a more useful long-term agreement, but

: : The More Things Change, the More They Stay the Same
ASSET mAnAGEmEnT

: : Moving Upstream in Energy and Decreasing Finance Exposure

FEATUrED STOCK

: : Adobe
SPECIAL TOPIC

: : Understanding the IPO Market

InvESTmEnT ThEmES

: : Social Media Its Everywhere

www.nelsonroberts.com | 650.322.4000

 If the enormous amount of money in inter a decent return, this would give those wit

top

ECOnOmIC OvErvIEw

FiFteen Holdings
iShareS intl iShareS

The More Things Change, the More They Stay the Same (contd)
Unfortunately, inflation is accelerating. It hit a low near zero in mid-2009 and then rose quickly back to around 2% at the end of 2009. In 2010, the consumer price index eased down to 1.5%. Thus far in 2011, it has risen again to around 2.5%. Producer prices have been rising even more. Prices in industries like apparel that had been stable or declining have now started climbing due to the very large percentage of clothing that is imported from China. Wages there have been rising very fast and the burgeoning middle class is buying more creature comforts, sending the prices of consumer goods skyward. The companies in which we have invested are also reporting rising costs. Richard Galanti, CEO of Costco: There are still a lot of vendors announcing increases to retailers.inflations hitting everybody. Co-CEOs of Smuckers, Timothy and Richard Smucker, noted that On coffee, we announced a price increase in May of around 10-11%, on oils it was about 8%, on baking it was 4% and it was actually 20% on milk. Other companies reporting increases in their cost of goods or products include 3M, Praxair, Paychex and Travelers. Economists generally believe that when interest rates rise they cause the economy to slow down. Historically, this has certainly been true, but rates have been so low for so long that we are in uncharted territory. We cannot help but speculate that an increase in interest rates might
FEDERAL FUNDS RATE
(source: Bloomberg)

emerging marketS

actually stimulate the economy. Why? Individuals who are borrowing money are paying very low rates, but these rates are still many times above the rates that one can earn on deposit balances. If the enormous amount of money in interest-bearing accounts were to actually start earning a decent return, this would give those with investable funds additional cash to spend. Higher rates would also make governmental deficit spending and debt service prohibitively expensive, thus giving politicians a real incentive to lower the deficit. In the meantime, with yields on bonds at historic lows, the real rate of return (the rate of return net of inflation) is negative for almost all maturities under five years. And the damage that higher inflation could do to bonds is very significant and makes them exceedingly unattractive places to invest. The bond market will continue to be a difficult place to make money for years to come.

S&P Small CaP

Chevron CorP oraCle CorP emerging aSia PaCifiC SPDr

iShareS

eafe inDex

royal DutCh Shell tJx ComPanieS CoStCo CorP PayChex inC. SChlumberger ltD. thermo fiSher SCientifiC varian meDiCal Power integrationS inC. emerSon eleCtriC Co.

December 31, 1999 June 29, 2011

LAST PRICE HIGH ON 06/30/00 AVERAGE LOW ON 12/31/09

0.100 7.125 2.603 0.010

7.00 6.00 5.00 4.00 3.00 2.00 1.00

0.100

0.00 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

rest-bearing accounts were to actually start earning th investable funds additional cash to spend.

ASSET mAnAGEmEnT

Moving Upstream in Energy and Decreasing Finance Exposure

After leading the pack in the first quarter with a gain of 17%, energy stocks have performed poorly in the second quarter, declining 5%. The most consistent sector performance this year so far has been in healthcare. Healthcare stocks on average have risen about 7% in each of the first two quarters, producing a return of over 14% for the first half of the year. Finance stocks have been the worst performers and are now down 5% on average in the last six months. Technology and materials have also been difficult sectors to make money in during this last period. Early in April, we decided to sell our holdings in Texas Instruments. There is strong competition in their end markets and the tragic earthquake and tsunami in Japan shut down some of TIs production facilities. We originally initiated our position in the company in the depths of the 2002-03 recession and made a good return on the shares. In mid-May, we decided to sell our shares in Marathon Oil. We bought MRO in late 2005 in order to own a smaller, more domesticallyoriented, integrated oil company to complement our holdings in Chevron. With MROs recently announced decision to split the shares into two companies, the stock price had risen over 40% this year, causing it to become overvalued. As a replacement, we opted to buy shares in Hess Corporation. While Marathon was evenly balanced between upstream (exploration and production) and downstream (refining and marketing) activities, Hess is significantly more focused on exploration and production. This means it will be more sensitive to the price of crude oil and less sensitive to the crack spread. (The crack spread is the price differential between the cost to acquire and refine a barrel of oil and the price at which a company can sell the refined products.) Downstream companies have had a hard time making money in the last three years. In early June, we decided to sell our shares in Wells Fargo (tkr: WFC). We originally bought WFC as one of three banking company investments we initiated in late 2008: Wells, US Bank and JP Morgan. After the terrible period for the finance sector we had decided that it was time to increase our minimal exposure to banks. We were about three months early, as the market low did not occur until March 9, 2009. JP Morgan has done the best of the three. Wells Fargo reported a 5% sequential decline in revenues for the first quarter of 2011 due to slowing mortgage demand and income rose only because their provision for loan losses was reduced. We therefore decided to sell, taking a small loss. We remain cautious about the financial sector in general, which is reflected in its underweighting in our stock portfolios. The very slow housing recovery continues to drag down banks earnings. Additionally, new regulations have made it more difficult for banks to generate the kind of profits they did prior to the recession. Recent reports of layoffs at the big investment banks do not bode well for the industry in the near-term.

V
value
Featured Stock

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

Adobe
Best known for either its flagship Photoshop or Portable Document Format (PDF) Reader products, Adobe now generates nearly $4 billion in revenues from a suite of tools that enables the design and development of nearly any digital creation. Through its 2009 acquisition of Omniture, Inc., Adobe has augmented its ability to participate in the tremendous growth in online advertising. Adobes traditional products facilitate the creation and delivery of digital content like advertisements, and Omniture completes the cycle with tools that analyze the effectiveness of the ads and then optimize the ad delivery experience. This combination should be attractive to advertising agencies, publishers and e-tailers looking to realize a greater return on investment from their digital media investments. Adobes new strategy has been rewarded by customers. Its online advertising unit now contributes over 10% of company revenues and is growing at an annualized rate of 20%. The number of advertisements geared to appeal to users of social networking sites continues to grow along with the number of those users. In the US alone, online advertisement impressions reached 1.11 trillion in the first quarter, with 200 individual advertisers spending at least $1 million per quarter. Total advertising revenues are more than $25 billion per year and are expected to grow by 13% annually. Adobe has positioned itself to help companies improve both the quality of the ad experience and the return on the invested dollar. Adobe was founded in 1982 and is headquartered in San Jose. The company is in excellent financial shape, with $2.6 billion of cash and $1.5 billion in debt. Its market cap is just under $16
ADOBE STOCK PRICE
DAY SESSION (source: Bloomberg)

October 27, 2008 June 30, 2011

billion. An astonishing 6.7 million professional web designers use the

35

LAST PRICE HIGH ON 12/16/09 AVERAGE LOW ON 03/03/09

31.45 37.86 30.09 15.98

companys tools to create, animate, and edit content. Designers are reluctant to switch horses, because it takes time to become an expert user of Adobes extensive toolkit.

31.45

30

25

20

15 DEC 2008 MAR JUN 2009 SEP DEC MAR JUN 2010 SEP DEC MAR JUN

2011

www.nelsonroberts.com | 650.322.4000

Quote for the Quarter

::

Only serious long-term spending reduction in the entitlement area can begin to address the nations deficit and debt problems. It should no longer be credible for our elected officials to hide the need for entitlement reforms behind rosy economic and budgetary assumptions.
Lawrence B. Lindsey, former Federal Reserve governor

SPECIAL TOPIC

Understanding the IPO Market

An Initial Public Offering, or IPO, is the first sale of a stock by a private company to the public. The IPO market in the US has been rejuvenated this year by interest in fast-growing internet companies. After three relatively quiet years, many startups and their venture capitalist backers are jumping at the chance to raise capital and cash in on their investments. Young companies like LinkedIn and Pandora, some of which are not yet profitable, are coming into the IPO market with lofty expectations about how much money they will raise. While the initially high valuations may drift back down, strong demand for these IPOs is a positive indicator for the overall economy. A healthy IPO market is an important component of US economic growth. IPOs create jobs, provide liquidity and inspire innovation. Venture capitalists are more likely to finance a startup company if the potential for a future financial reward is high. IPOs also provide access to capital for companies to grow operations and hire additional employees. Although investing in IPOs is a risky proposition for individuals and valuations may not be sustainable, as long as investors go into them with their eyes open, they do provide the possibility of a dramatic return. The main principle for investors is not to invest any more money in such a deal than they can afford to lose. For example, shares of LinkedIn, which operates a professional networking site, closed up 109% on the first day of trading. The companys valuation also skyrocketed, and LinkedIn ended the day with a market capitalization of almost $9 billion. Since its debut, the stock has been volatile but is still trading above its IPO price. Pandora, an internet radio company, did not have as strong a start, but still caused a stir. The company sold 14.7 million shares, raising almost $235 million. This gave it a valuation of $2.6 billion. And this was for a company that has never posted an annual profit! $23.9 billion of deals have been completed so far in 2011 versus $6.3 billion for the corresponding first half of 2010. This year is already on pace to reach at least $50 billion in total offerings compared to $38.7 billion last year. Some observers have forecast the best year since 2000. Groupon, Twitter and Zynga have all filed to sell their shares to the public for the first time, keeping excitement and interest bubbling and valuations high.

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

Social Media Its Everywhere

Traditional media is defined as the delivery of content to users who then read, listen to or view the information. However, channels using these modalities do not allow the receiver to interact with the flow of information. Social media, on the other hand, give the recipient of the information a voice to express a thought or opinion and to share both the information and an opinion about it with others. A good definition of social media is content created and shared by individuals on the web using freely available websites that allow users to create and post their own images, video and text information and then share that with either the entire internet or just a select group. Many of the IPOs coming to market (see p. 5) and our featured stock, Adobe (see p. 4), are part of the social media trend. Characteristics of social media include: Reach has a scale capable of reaching a global audience Accessibility tools are available to users at little or no cost Usability no training is required beyond basic communication skills Immediacy confers the ability to instantaneously publish or respond Permanence (or lack thereof) content can be altered, edited, deleted In the past few years, there has been a dramatic increase in both the number of companies providing tools for social media and in the number of users of these tools. The tools range from making recommendations on an article or restaurant, to sharing photos or music, to connecting with and sharing information with friends or colleagues. Facebook now has 600 million users. LinkedIn has over 100 million professional users in 200 countries. Twitter users send over 140 million tweets every day. Online advertising revenues reached $26 billion in 2010. Search was 46% and display 38%.

An example of a social medium is a social network. A social network is a group of individuals or organizations that share a connection. The explosion of usage of these types of sites has attracted both attention and money. Two of the most popular social networking services are Facebook and LinkedIn. Social networking companies make money by selling advertisements that will be seen by their user base. Additional sources of revenue might include subscriptions paid by users who want access to additional functionality. Other types of social media include social bookmarking, video and photo sharing and social news. Each of these platforms enables users to interact by sharing or recommending content by tagging the website. Other users can then view these recommendations. The revenue model is predominantly advertising-based for these companies also.

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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2011 Nelson Roberts Investment Advisors