Thursday, April 08, 2004

Client Letter - 4/8/04

April 8, 2004

To Our Investors and Friends:

While still seven months from the presidential election, we are being bombarded by extreme political and economic rhetoric. One side says that because of tax cuts, unusually low interest rates and a weak dollar the economy is growing and that more jobs will eventually be created. The other side says that huge fiscal and trade deficits currently being created will eventually impact us, that jobs are being shipped offshore faster than ever, and that the deficits combined with the weakening dollar will result in substantially higher interest rates that could throw us back into recession.

Who is right? Well, judging by the performance of the stock market in the first three months of the year, both sides are right; it just depends on your time frame. As measured by the S&P 500 Index, the market is up about 2% year-to-date, and despite all the rhetoric about last year’s gains, the market has still not offset the losses it sustained in 2002. In other words, short-term positives are being offset by long-term negatives.

From a strictly economic perspective, it seems to us that corporate earnings, employment and capital spending should continue to increase in the short term, which should result in stronger stock prices between now and the election. On the other hand, regardless of who wins the election, they will have to deal with the macro-economic realities, which indicate that the path we are currently on may not be sustainable in the long term. From a strictly non-partisan point of view, the current administration, if re-elected, may have a better political opportunity to deal with the longer term economic issues, since they would have four relatively rhetoric-free years to bite the economic bullet. However, regardless of who administers it, the economic medicine is potentially quite bitter.

While all of this may sound complex, we truly wish the situation were so simple. Unfortunately, layered on top of this are all of the geopolitical realities we face as a country today. What will happen in Iraq and the Middle East? When will we be hit by another terrorist attack that our leaders seem to be telling us is inevitable? Doesn’t the attack in Spain just before their election tell us that something like that is likely to happen here? These are wild cards vis-à-vis the markets that are totally non-quantifiable.

So what is a conservative investment manager with a strong belief in the ultimate strength of this country to do? First, we believe we must take advantage of good economic conditions when they are occurring and, second, we believe we must continue to be very careful. In mid-2003, we began reinvesting the capital we had so carefully conserved in 2002. Currently we are about 70% invested in stocks, which, together with invested cash, has allowed us to moderately outperform the market this year. As always, we are focused on value-creating companies that are selling at reasonable valuations. We are also trying to own a number of companies that pay dividends, which will provide a consistent “bond-like” return, despite what might happen in the short term. Our largest holding is GE, followed by names like Johnson & Johnson, United Healthcare, General Mills, ConAgra, Berkshire Hathaway, J.P. Morgan Chase, TCF Financial, Dell, Medtronic, Wal-Mart, The Gap, TJX Companies and ATK Systems.

Because of the terrorism wild card, we expect to continue holding a percentage of invested cash, which will vary depending on our perception of the situation between now and the election. It is also our intention to take some of our profits as the year goes on to guarantee returns and generally conserve capital. After the election, we should have a better idea of what is likely to happen in the longer term.

As always, we welcome your thoughts and questions.