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.