Dear Investors, As you have no doubt heard by now, late Friday evening, S&P downgraded the credit rating of the U.S.A. It was not entirely unexpected, nor was it without some controversy. Standard & Poor's apparently notified the White House late Friday that it intended to issue the downgrade. The Treasury Department then found a $2 trillion (yep, trillion) error in S&P's analysis, at which time the department then proceeded to vigorously protest the ratings cut…after which S&P proceeded to issue the downgrade, anyway. For some time after the announcement came out, I sat at the kitchen table, Corona in hand, to think through all the now very real ramifications of the previously rumored downgrade. I spent the rest of the weekend obsessing about our portfolio companies and updating my watch lists. Finally, I sat down to write this letter to you. In the interest of time, I'll try to do this in a Q&A format. Q. Isn't S&P one of the same ratings agencies that helped cause the last recession by rubber-stamping thousands of bundles of crappy subprime mortgages with a AAA rating? A. Yes. These are, in fact, those very same clowns. See that $2 trillion error thing above. The irony is quite steep; the same group that played such a significant role in cratering our economy three years ago is now downgrading the country due to the fiscal woes that they, in no small way, helped create. The moral of the story, I suppose, is that intellectual honesty can be bought pretty cheaply on the Street. That said - let it go. Killing the messenger isn't the answer. And here is the actual S&P report, which I would encourage you to read. Some day, many days from now, the turds at S&P will likely meet a fate befitting their deeds. Like, say, in the seventh circle of Hades. Or, even worse, on the docks of Islamorada…where many large, angry fishing boat captains would like to have a word with them. But let's agree we should all just get past that. Q. What does the downgrade mean for me and my family? A. History has shown that when a country is downgraded a single notch from AAA, like the U.S. was on Friday, it's largely a non-event. We're going from “pristine” to “very strong.” So now is not the time to panic. History has not been so kind, however, to those countries whose credit rating is downgraded from “questionable” to “fuggedaboutit”, or junk status. If that were the case, I'd be typing this from a bunker. But, as always, some perspective is important here. That said, there will certainly be some consequences to all of this. The most obvious are these: 1.The political ramifications of this downgrade are big. Washington is epically dysfunctional right now, as per the S&P report. The silver lining in the downgrade is that it may be the wake-up call D.C. needs to actually get our fiscal house in order. Along the way, though, it's probably best to be prepared for a long slog of finger-pointing, rhetoric and high-volume spin from politicos and armchair economists everywhere. And by “be prepared,” I mean, “go play fantasy football.” Both are a complete waste of time, but at least one of them will be fun. 2.It will cost the government more to borrow money. All things being equal, this by definition will lead the government to need to collect more in tax revenues. That's just math. Now that does not necessarily mean you will be paying more in terms of your marginal tax rate, however…but it certainly underscores, again, the need for the economy to strengthen. 3.Because it costs the government more to borrow, it will now also cost companies more to borrow, too. The interest rate paid on Treasury bills is the floor that much of modern finance rests on. A ratings downgrade is equivalent to jacking up the entire floor a few more inches off the ground. When the floor moves up, the rest of the house does, too, including the interest rates that corporations must pay. 4.It will also cost you, dear consumer, more to borrow money as well. In the analogy above, consumers are in the top floor of that house, so the rates you'll pay on loans will likely increase slightly now, too. That said, it's important to note a couple of things about that theoretical increase in the cost of borrowed money. Most important - those increases will very likely be quite small in the near-term. That's because (a) interest rates remain near historic lows, (b) tax reform is going to have to be a part of any serious attempt to balance the budget, anyway, and (c) in yet another irony, the uncertainty caused by a downgrade to the U.S. credit rating is likely to spark a flight among global investors to the safest haven in the world…the bonds of the U.S.A. There is simply nowhere else they can go. And because bond prices and interest rates move in opposite directions, all that demand by global investors for our bonds may very well mean interest rates don't move much at all in the near-term. In any case, it is hard to tell exactly how all this will play out. I think at this point, on the Sunday evening before markets open, I would submit the following opinions to you about the downgrade: 1 - It will be more significant in politics than in finance. 2 - It will cause a small drag on future economic growth. 3 - It will further undermine confidence in the economy, the stock market, and our political leadership. One of the most immediate impacts of number 3 there in particular will likely be that the stock market on Monday will be ugly. Again. Which brings me to the next question. Q. My portfolio has taken a beating the last few weeks. I do not like it. A. Okay, that's not really a question, but I know you're probably thinking it, anyway. And you're right - but you're not alone. The real question that I think is lingering in there somewhere is this: What are you, Mr. Portfolio Manager, going to do about it? My answer is the same today as it was on the conference call Thursday - I want to be buying stocks when the herd is running for the hills. Tomorrow will be one of those times. I have no idea what the stock market will do in the short-term here, but I do know that when all the panic subsides - and it will - then valuations will matter. The price we will pay between now and then is a bruised ego and declines on paper. But to be clear, I do not ever intend to cash out and cower in the corner, unless there is a very good reason. In 2008, this country was staring into the abyss. There was good reason to take a break from the market, at least for a little while. But this is not 2008. And I adamantly believe that the next few years' worth of our performance is out there, right now, waiting for me to find it. And that's what I intend to do. That said, there is a higher (though still relatively low) probability that I will move some small portion of our portfolio to cash this week, if only temporarily. If that happens, it won't be due to a hunch, or because the stock market has gone down a certain amount, or, like last week, because some of our companies have the misfortune of announcing quarterly earnings reports in the middle of all this. It will be for one of two reasons. 1. There are certain questions about the downstream effects of the downgrade that I cannot answer. No one can, frankly. We are, once again, in uncharted territory. The two questions I intend to be most focused on trying to answer this week, though, are (1) what impact will this downgrade have on the housing market?, and (2) how much forced selling of equities - by banks, pension funds, and/or hedge funds - will this downgrade (or, more likely, the knee-jerk reaction to it) result in? I don't expect we'll have an immediate answer to that first question for some time. I do, though, suspect, we'll know the answer to that second one relatively soon. And that relates to the second reason our cash level could rise in the short-term here, which is… 2. We may be able to buy better companies than we already own, at cheaper valuations then we've already got. And raising some cash could be part of that process. So that more than anything has been what this weekend in particular has been all about - making sure once again that whatever happens in the coming week or weeks, we come out even stronger then we went in. Things could very well get worse before they get better, mind you, and the stock market could be influenced more in the coming weeks by Europe's continuing debt woes then our own - but, again, valuations matter. And pride has nothing to do with it. It's all about the prices we pay for the companies we want to be partners in. And in closing, a final word from Warren Buffett: “Over the long term, the stock market news will be good. In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497. You might think it would have been impossible for an investor to lose money during a century marked by such an extraordinary gain. But some investors did. The hapless ones bought stocks only when they felt comfort in doing so and then proceeded to sell when the headlines made them queasy.” So, don't panic. And as usual, call or email if you have any questions. - Cale | 
Cale's Notes: 