Client Letter - 5/21/02

May 21, 2002

“Genius is eternal patience.”
Michelangelo

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.