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,