Client Letter - 8/21/03

August 21, 2003

To Our Clients and Friends:

The world seems to be returning to more normal circumstances, now that concerns about Iraq and terrorism have at least partially diminished and the U.S. economy is staging the beginnings of a comeback. To be sure, there are many geopolitical and economic concerns (such as deflation), but it is hard to say when or how severely some of these problems might impact us. Simple logic tells us that there is more terrorism to come, and that we are not out of the economic woods. For that reason, we would describe our current situation as being on the ragged edge of normalcy.

By the same token, this condition we have described tells us that the equity markets have greatly over-reacted to the situation at hand, particularly in the technology sector, and that these “semi-normal” conditions dictate a pull back from the current re-inflation of the equity bubble, to more normal valuation levels. This will allow investors to earn reasonable market returns, based on the fundamental principle of sustainable earnings growth. In other words, if we indeed are returning to normal market conditions, stocks will resume moving up and down based on real earnings and cash flow, not euphoria and speculation. For the most part, that hasn’t happened yet.

In an August 11th article entitled, “Doesn’t Value Matter Anymore?” Richard Bernstein, chief equity strategist of Merrill Lynch, writes: “The speculative nature of the stock market is again damaging the economy as it did during the bubble. Capital is again being misallocated within the economy…. We have repeatedly pointed out that today investors are paying to take risk rather than demanding compensation. Our newest research further confirms our earlier findings that investors are acting as though value does not matter anymore.”

Within this complex environment, we are proceeding very carefully. First, we are very mindful of our success in conserving our clients’ capital over the last two years and we do not want to take undue risk with that capital in this environment. On the other hand, risk-free U.S. Treasury money-market returns are at unacceptably low levels. To deal with this dilemma, we are following a strategy that calls for investing a portion of our managed assets in a small group of very substantial companies that are either fairly or under-valued, based on our well-developed modeling discipline. All of these companies provide dividend returns that are higher than money market yields and offer appreciation potential, over time, based on their current valuations. In that regard, we view them as being safe and even somewhat “bond-like”, since for the most part they provide yields comparable with 5-10 year bonds and their “principal” is virtually safe over time. If the market moves down (which it eventually will if “normalcy” truly is returning) we will make further investments in these companies to average down our price. If market euphoria continues, which it may through the rhetoric of the 2004 presidential election, we may take profits or we may simply hold on and continue collecting the dividends.

We believe that our current strategy will allow us to outperform the S&P 500 index, over time. We may under perform a bit in the short term, because we are protecting client capital, but in the long term we will outperform the index, as we have consistently been able to do, since our inception. In this regard, it is important to recognize that the S&P 500’s loss of 23% in 2002 requires a subsequent gain of 30% just to break even. On the other hand, not having taken those kinds of losses last year allows us to carefully move forward, as described above.

Please let us know if we can further explain our strategy, or provide additional reading material on current economic and market conditions.