Market Overview In the calendar year 2013, the MSCI World Index rose 26.7%, while in the U.S. the S&P 500 Index increased 32.4%. In Europe, the German DAX increased 25.5% and the French CAC 40 Index rose 18.0% during the year. The Nikkei 225 Index increased 56.7% over the period. Crude oil rose 5.7% to $98.42 a barrel and the price of gold declined 28% to $1,205.65 an ounce by year- end. The U.S. dollar rose 20.8% against the yen and declined 4.3% against the euro.

When we consider the markets’ strong performance in 2013, it might appear that we have an all-clear signal based on higher equity valuations, declining credit spreads, normalizing longer-term interest rate expectations and lower gold prices. But despite the sense of relief implied by asset and commodity price movements, we believe that there are still vulnerabilities in the financial architecture. In particular, when we look at household and sovereign debt levels in the U.S., the country carries more debt than can be naturally paid down through domestic household savings without having to resort to either liquidating assets or imposing higher taxation on assets. Through a generational illusion of policy-induced macro-economic stability, we have built a system dependent on capital markets liquidity and repressed interest rates which camouflage the debt’s full impact. This system is vulnerable to confidence shocks, particularly since broker-dealers now hold fewer securities in inventory in the wake of reforms imposed after the 2008 crisis. We believe that what we are witnessing is a Keynesian mirage. Easy monetary and fiscal policy has helped sustain corporate profit margins and valuation multiples, which, in turn, has had a positive ripple effect—boosting net worth and job prospects, encour – aging investment and consumer spending (which otherwise would not have occurred) and lowering household debt service ratios (the percentage of one’s income spent paying off interest and amortizing loans).

While the Federal Reserve’s commitment to low interest rates has enabled U.S. household debt service ratios to fall below average, overall debt levels remain above average. Furthermore, part of the surplus debt has moved from the household balance sheet to the government balance sheet through fiscal laxity aimed at sustaining demand. Now, part of the surplus government debt has moved to the Fed’s balance sheet through quantitative easing. When the Federal Reserve buys government bonds, it creates new cash which otherwise would not have been available and which ultimately trickles down to the tacit purchase of risk assets, further raising valuation levels. The lack of overt debt restructuring masks the debt write-off through repressed interest rates over time, rather than writing down the principal during any one period. This is an obscured restructuring of debt where responsibility ultimately falls on prudent deposit holders rather than imprudent borrowers. In our view, the long term effects of subsidizing imprudence cannot be good.

Meanwhile, the Federal Reserve’s obligations are growing at a double-digit rate by virtue of the Fed expanding its balance sheet in an environment where private sector credit growth is tepid and the growth rate of government debt is slowing to the mid-single digits. So the debt in the system has not disappeared; it has simply moved elsewhere. It is like a debt bean bag. When you sit on one corner, the beans do not disappear, they simply get redistributed.

In Europe, there are different sorts of imbalances. In the absence of exchange rate flexibility, countries with current account surpluses need to inflate wages, while highly indebted countries with current account deficits need to deflate wages, in order to restore competitive equilibrium. Spain, for example, has eliminated its current account deficit, but at the cost of Depression-era unemployment levels. Meanwhile, the French have not adjusted sufficiently, and face competitive pressures from both Germany and peripheral European economies that have become more competitive through wage deflation. Investors, who are now positive on recovering growth trends, may one day be unsettled to discover trouble in the core of Europe, rather than the periphery.

Japan has been a source of strong returns for us over the past year. We were buyers of securities representing material ownership stakes in many fine global franchises that happen to be listed in Japan after a two-decade bear market brought valuations for even the best businesses down to bargain levels. A lot has changed. Optimism over reflation has meant that we became a net seller of Japanese securities in recent times as their valuations quickly reached or even exceeded our sense of intrinsic value. Printing money is easy to do, but structural reforms are harder. The market has reflected the benefits of the former without its potential costs. Japan must still deal with a dizzying level of government debt as it faces challenging demographics and increasing geopolitical tensions with its neighbor, China.

Turning to the emerging markets, China has again been experiencing liquidity shortages in the interbank market as it embarks on a complex series of reforms aimed at liberalizing shadow banking and stamping out elements of corruption. China is also trying to evolve the composition of its growth away from subsidized exports and urbanization-related construction to broader consumption and services growth. The markets seem confident about China’s ability to walk the narrow path, but managing change in an increasingly complex economy after a massive credit and investment boom, at a time when competing currencies such as the Japanese Yen, Indonesian Rupiah and Indian Rupee have all been devalued, will be challenging to say the least. Not to mention growing geopolitical tensions with Japan. Beyond China, countries like Brazil, Russia, South Africa and Saudi Arabia are facing pressures from softer commodity price trends, and countries like Turkey are facing pressures from their current account deficit. Finally, across the emerging markets there is increased political uncertainty with many elections looming on top of a more complicated macro- economic dynamic.

While we hope the rising tide of corporate and labor productivity, when combined with an extended period of financial repression, helps solve some of the world’s debt problems, we remain focused on preparing for less favorable outcomes.

We still prefer to own equities (despite our macro concerns) because of the steadily growing asset of human potential which enables us to muddle through. Even so, higher valuations have made returns from a muddle-through scenario less appealing. With repressed fixed income markets and more modest return expectations for equities, finding out of favor assets offering a margin of safety is extremely difficult at present.

Portfolio Review

Our weighting in gold related investments and our cash and cash equivalents holdings hurt us in relative terms in 2013. Fortunately, in absolute terms, our overall real return in 2013 was in double-digit territory.

Even so, our relative underperformance serves as a reminder that our ability to call the short-term zigs and zags of the markets is limited at best, and that we should keep our focus firmly on creating an all-weather portfolio for the long term.

We do not invest based on top-down themes; we have a bottom-up, security-by-security strategy that reflects our focus on scarcity, resilience, and margin of safety at the business level, and aims to avoid permanent capital impairment. As such, we’re more likely to err on the side of missed opportunities by not being fully invested. This is what occurred in 2013.

We continue

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