Thursday, December 12, 2002

Client Letter - 12/12/02

December 12, 2002

To Our Investors and Friends:

“…I think that there’s no magic to evaluating any financial asset. A financial asset means, by definition, that you lay out money now to get money back in the future. If every financial asset were valued properly, they would all sell at a price that reflected all of the cash that would be received from them forever until Judgment Day, discounted back to the present…. That method of valuation is exactly what should be used…. If I can’t do that, then I don’t buy. So I’ll wait.”

Warren Buffett

Like Warren Buffett, we’ll wait. Despite what politicians and media pundits would like everyone to believe, market valuations are at unreasonably high levels, made worse by the run-up in the markets since mid-October. Nonetheless, market trend-lines continue pointing downward, with the S&P 500 index down 21.2% year-to-date.

Essentially, what we are experiencing are “bear market rallies,” within the context of what appears to be a secular bear market, quite similar to what we experienced from 1964 to 1982, when the markets fluctuated wildly but ended up approximately where they began 18 years earlier. Within that context, the buy and hold concept aggressively marketed by the securities industry simply doesn’t work. Investors who made handsome profits during the 1964 to 1982 secular bear market understood what constituted real valuation (as described above by Warren Buffett) and bought and sold accordingly. In recent experience, the best evidence of this is the fact that cash invested in a money market fund has outperformed cash invested in an S&P 500 index fund for more than 5 ½ years now. In other words, to make money in the market over the last 5 ½ years you had to astutely buy and sell, in direct opposition to what the securities industry was telling you to do.

We continue to believe that equities are the investment asset class of choice for the long term. As always, however, it is necessary to know when to astutely buy and sell. That is what our valuation modeling work helps us do, and we have acted accordingly throughout the difficult market environment of 2002. This has allowed us to significantly outperform the markets. At the moment, nearly all of our accounts are at least 85% in cash, which is invested totally in U.S. Treasury securities. In that regard, during the past few weeks, we have eliminated all investments in money market funds that hold corporate commercial paper, because of a very uncertain and potentially deflationary economic environment, as well as the continuing high probability of both war and terrorist events.

We have identified a growing number of EVA companies that we expect to own, based on our valuation modeling and in-person management visits, during which we have been able to further validate our modeling analyses. When we believe the time is right, we will own many of these companies. At the moment, however, we believe our clients will continue to be rewarded by our current strategy of staying substantially in cash investments.

We continue to make an effort to speak with our clients personally as often as possible. We have several good analytical articles about the current status of the markets that we are sharing with people as we meet. If you would like to read any of these articles, or have questions for either of us, please let us know.

We wish you a Happy Christmas.

Sunday, September 01, 2002

Client Letter - 9/1/02

September 2002

To Our Investors and Friends:

Our job is to make money for our investors. That may seem obvious, but things we are seeing day-to-day in the equity markets make us wonder. Last Friday night there was a heated debate on CNBC between Jim Cramer, an experienced money manager, and a mutual fund manager from Value Line. Cramer strongly contended that his only job was to make money for his investors, even if that means being only partially invested for periods of time. The Value Line mutual fund manager contended that his clients expect him to be fully invested in the market, even if it means incurring losses. While there should be no question in anyone’s mind that we are equity investors, we also believe that the best way to make money in the equity markets right now is to conserve capital and be substantially invested in cash and T-bills. There will be a time to begin reinvesting, but not yet. Our job is to decide when and at what prices. That is how we expect to serve our investors and, quite simply, make money and outperform the S&P 500 index in the current environment.

At the risk of being too technical, we would like to briefly discuss the concept of “Market Risk Premium”(MRP), because it defines the prices one should be willing to pay for equities. Historically, MRP has amounted to a 6% annual return or “premium” for the risk investors take by owning stocks, rather than owning risk-free government securities. So, if you can get a 5% yield from a long-term government bond, you should expect to get an 11% yield from an equity investment. Simple, no? Well, maybe not, because the high prices that equities have commanded in the markets for the last several years would seem to redefine MRP as something like 3% or less. The implication of this phenomenon is that market risk is much lower today and, therefore, we should be willing to pay more for stocks and accept a lower return. All of us know that is wrongheaded, but why then do many money managers, as mentioned above, insist on remaining fully invested, thereby sustaining high market prices? The answer, of course, is that they are in error, and those who recognize the erroneous ways of the market have, over time, made significant gains at the expense of the herd.

Our modeling process is focused on the concept that we must not pay more for a stock than a market risk premium of 6% dictates (it’s built into the cost of capital we use as our discount rate). On that basis, we have identified several EVA companies that meet our criteria, but we are not yet ready to move forward because we expect a downward adjustment in the overall market. We undoubtedly will take positions in some of these companies over the next several months to take advantage of market fluctuations. However, unless overall market valuations move down to more sustainable levels, our strategy for the time being will be to capture yield and pull back for another buy/sell opportunity.

It’s worth repeating Michelangelo’s statement that “Genius is eternal patience.” We appreciate your patience.

Best regards,

Tuesday, May 21, 2002

Client Letter - 5/21/02

May 21, 2002

“Genius is eternal patience.”

To Our Investors and Friends:

Michelangelo had it right, if the first five months of 2002 in the equity markets are any indication. Patience has never been more important. Short-term cash investments have outperformed the S&P 500 so far this year and there seems little reason to believe that this will change very much in the next few months, despite the media hype. In our opinion, the primary reasons for this phenomenon are (1) the unreasonably high valuation of the S&P 500 Index relative to prospective earnings growth and (2) the continuing specter of terrorism. Having said that, we see several good, undervalued investment opportunities, which we believe will become even more attractive during the next few months, as market valuations rationalize. For the moment, however, patience is one of our most important disciplines, perhaps second only to our continued intensive valuation analysis of the EVA companies we either own or expect to own in our portfolios.

Given reasonable estimates for corporate earnings growth in 2002 and 2003, the S&P 500 Index continues to trade at record high price/earnings (P/E) multiples. The message here is that investors are expecting significantly greater earnings growth than companies are likely to produce in the near term. The Sell-Side Consensus Indicator, which is a contrarian measure of investor bullishness, is at extreme levels, indicating a strong sell bias. Our own valuation modeling work strongly confirms these statistical indicators, with many EVA companies selling at levels that significantly exceed their modeled valuations.

The threat of terrorism overhangs all valuation statistics. Vice President Cheney said on Sunday, May 19th “The prospects of a future attack against the United States are almost certain…. We don't know if it's going to be tomorrow or next week or next year.” What should we do with this information, as prudent investors? On the one hand, we have observed the incredible resiliency of our economy and the markets in the period since September 11th. This has been especially evident in the strength of retail sales and the real estate market. On the other hand, we have observed that even the hint of a terrorist attack sends the markets down instantly. This is further evidence of a market with values priced for perfection in, what seems to us, a very imperfect situation.

Our strategy under these circumstances is to (1) own only companies that we believe are secure and reasonably valued and (2) continue holding significant proportions of cash in each portfolio, in anticipation of a rationalization of valuations for any of the several reasons outlined above. We are doing this by taking profits where it seems logical and by eliminating positions we feel have little promise. Our typical portfolio is currently at 50% or more in cash investments. We are working on several undervalued EVA companies that we intend to own. However, we are not in a rush, and we expect that we would not commit more than half of our cash in the near term, as a protective measure.

We strongly believe that temporarily holding cash in our portfolios is an appropriate equity investment strategy for our clients, given the unprecedented circumstances in which we all find ourselves. It is very easy to become impatient, with all of the news swirling about us, but we believe that patience, as Michelangelo said, will indeed prove to be the ultimate genius in equity investments during the next several years.

Thank you for your confidence.

Friday, February 15, 2002

Client Letter - 2/15/02

February 15, 2002

To Our Investors:

The U.S. economy still appears to be in the trough of the recession, which began nearly a year ago, and the timing of the recovery remains uncertain. While the optimism of the consumer continues to be a bright light, there is still very little visibility on capital spending plans for 2002, which, among other things, dampens expectations for a significant recovery in corporate profits this year. On that basis alone, despite consumer confidence, the equity markets appear to be overvalued. Nonetheless, we hasten to add that we believe this market anomaly will be resolved during 2002, and that we will be well positioned to reinvest our cash in undervalued EVA companies.

Statistically, the price/earnings (P/E) ratio of the S&P 500 index is at a near-historic high of 39.4, based on trailing 12-month earnings. Based on earnings estimates for the S&P index in 2002, the P/E ratio is still well above normal. This unprecedented enthusiasm is discounting a very strong recovery from the current recession, which, as described above, is nearly invisible. This would seem to be an indication that the “bubble” mentality that has affected market pricing over several years is still with us. These statistics are clearly born out by our EVA modeling work and, consequently, we are resisting making new commitments at this time, and have sold some positions to conserve capital.

Beyond statistics, the Enron bankruptcy and the apparently fraudulent actions of management committed under the supposed supervision of Arthur Andersen, one of the largest audit firms in the world, are weighing heavily on the equity markets. We believe that more stringent application of accounting principles by the large audit firms during the next several months will result in more highly publicized problems with large, well-known companies. Not surprisingly, the SEC is also making more inquiries into corporate accounting and public disclosure policies. While this may seem to be negative in the short term, the result of more accurate disclosure should be a long-term positive, especially for those of us who do in-depth financial analysis.

As carefully as we analyze our investment decisions, we have not been immune from these issues. Calpine, which has been one of our core holdings, was immediately affected by the Enron bankruptcy, even though there appeared to be few similarities between the companies. As the stock fell, we intensified our analytical work, gathering projected cash flow numbers, both from several key analysts and directly from the company. Our work shows that the company is significantly undervalued, with a P/E ratio of only about 5.0, based on expected 2002 earnings. With that in mind, we moved to average down our holdings at the end of January, when the company provided 2002 operating cash flow projections, which corresponded well with our previous analysis. Just a few days later, we were very surprised to learn that the SEC was making inquiries about Calpine’s accounting for transactions with Enron, as well as launching an inquiry into potential selective disclosure of earnings projections to analysts. In the current environment, these inquiries are the proverbial “kiss of death,” regardless of the company’s apparent strengths, and we felt compelled to take action immediately to conserve capital. We are currently looking closely at our other holdings to try and anticipate further effects of the current environment.

The inflated market valuations we are experiencing affirm for us that our EVA modeling process is quite accurate. Fortunately, we do not need many opportunities to make our investment process effective and we believe that, as market valuations become more realistic, the astute long-term deployment of our cash in EVA companies will significantly outweigh the short-term transactions we have undertaken to conserve capital.

As we navigate through this period, we have looked carefully at our profit preservation and stop-loss strategies. Attached is a thorough review of these strategies as they are currently being applied. We expect to meet personally with each of our clients, either in person or on the phone, in the next few weeks. In the meantime, please ask any questions that come to mind about the scenarios we have outlined.