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.