Client Letter - 2/15/02

February 15, 2002

To Our Investors:

The U.S. economy still appears to be in the trough of the recession, which began nearly a year ago, and the timing of the recovery remains uncertain. While the optimism of the consumer continues to be a bright light, there is still very little visibility on capital spending plans for 2002, which, among other things, dampens expectations for a significant recovery in corporate profits this year. On that basis alone, despite consumer confidence, the equity markets appear to be overvalued. Nonetheless, we hasten to add that we believe this market anomaly will be resolved during 2002, and that we will be well positioned to reinvest our cash in undervalued EVA companies.

Statistically, the price/earnings (P/E) ratio of the S&P 500 index is at a near-historic high of 39.4, based on trailing 12-month earnings. Based on earnings estimates for the S&P index in 2002, the P/E ratio is still well above normal. This unprecedented enthusiasm is discounting a very strong recovery from the current recession, which, as described above, is nearly invisible. This would seem to be an indication that the “bubble” mentality that has affected market pricing over several years is still with us. These statistics are clearly born out by our EVA modeling work and, consequently, we are resisting making new commitments at this time, and have sold some positions to conserve capital.

Beyond statistics, the Enron bankruptcy and the apparently fraudulent actions of management committed under the supposed supervision of Arthur Andersen, one of the largest audit firms in the world, are weighing heavily on the equity markets. We believe that more stringent application of accounting principles by the large audit firms during the next several months will result in more highly publicized problems with large, well-known companies. Not surprisingly, the SEC is also making more inquiries into corporate accounting and public disclosure policies. While this may seem to be negative in the short term, the result of more accurate disclosure should be a long-term positive, especially for those of us who do in-depth financial analysis.

As carefully as we analyze our investment decisions, we have not been immune from these issues. Calpine, which has been one of our core holdings, was immediately affected by the Enron bankruptcy, even though there appeared to be few similarities between the companies. As the stock fell, we intensified our analytical work, gathering projected cash flow numbers, both from several key analysts and directly from the company. Our work shows that the company is significantly undervalued, with a P/E ratio of only about 5.0, based on expected 2002 earnings. With that in mind, we moved to average down our holdings at the end of January, when the company provided 2002 operating cash flow projections, which corresponded well with our previous analysis. Just a few days later, we were very surprised to learn that the SEC was making inquiries about Calpine’s accounting for transactions with Enron, as well as launching an inquiry into potential selective disclosure of earnings projections to analysts. In the current environment, these inquiries are the proverbial “kiss of death,” regardless of the company’s apparent strengths, and we felt compelled to take action immediately to conserve capital. We are currently looking closely at our other holdings to try and anticipate further effects of the current environment.

The inflated market valuations we are experiencing affirm for us that our EVA modeling process is quite accurate. Fortunately, we do not need many opportunities to make our investment process effective and we believe that, as market valuations become more realistic, the astute long-term deployment of our cash in EVA companies will significantly outweigh the short-term transactions we have undertaken to conserve capital.

As we navigate through this period, we have looked carefully at our profit preservation and stop-loss strategies. Attached is a thorough review of these strategies as they are currently being applied. We expect to meet personally with each of our clients, either in person or on the phone, in the next few weeks. In the meantime, please ask any questions that come to mind about the scenarios we have outlined.

Thoughts - 9/12/01

Thoughts for Clients Sept. 12, 2001


We expect markets to be closed for a couple of days, perhaps until next week…A good thing.

There will probably be some selling when the markets do open, primarily from mutual fund redemptions. We don’t think this will continue, although it will take stocks lower for the time being.

We do not believe it would be wise to sell stocks at this time, even if there is a decline. If there should be some reason to accumulate cash in the near future it would be advisable to wait a few days in any event.

In the absence of further terrorist developments at this time (and it now appears that this was a one-time attack rather than a coordinated series of attacks) the economy should not be drastically affected overall. It is possible that consumer confidence will decline temporarily, but if nothing else develops, that decline should not be drastic. However, it is possible that a lethargy in consumer spending could result for a period of time which would precipitate the recession which continued consumer confidence has been delaying for the last few months.

Impacts on particular holdings:

Citigroup… Travelers Insurance, short term negative, long-term neutral

Technology, computers, telecommunications, probably benefit in longer term, neutral short term

Pharmaceuticals and medical technology, neutral to positive short term, positive long term.

Bottom line for us: Be calm, study, watch, wait, look for opportunities.

Investment Strategy

Investment Strategy

Identify and invest in companies that consistently create “economic value added” (EVA) for their shareholders. EVA is measured by determining a company’s cost of capital and comparing it with annual return on investment (ROI) generated by the company’s net operating profit.

Value-creating companies frequently also have high market valuations. Therefore, we also perform intrinsic value analysis on the companies we follow to determine which are the best investments.

We do this by studying long-term earnings expectations and projecting cash requirements (for capital expenditures, working capital etc.) to determine likely free cash flows over time.

We then calculate the present value of these free cash flows to determine the intrinsic value of each company.

Strategy is to seek out and invest in economic value-creating companies that are reasonably priced relative to their intrinsic values.

- Quality and Consistency are the watchwords of successful long-term investing.

- Own EVA stocks consistently.

Meet Jack and Peter Falker

Professional Qualifications

Peter J. Falker, CFA

- Primary research and investment officer of FalkerInvestments Inc.

- Securities market experience includes:
Farallon Fixed Income Associates (now Bracebridge Capital), Boston, Mass.
Mitchell Hutchins Asset Management, a unit of Paine Webber Inc., New York, N.Y.
Internship positions with U.S. Bank Piper Jaffray and Dain Rauscher Wessels Inc.

- Graduate of the University of St. Thomas with a BA in Economics, 1995.

- Graduate of St. Thomas Academy, 1991.

- Has earned the right to use the Chartered Financial Analyst designation.

* EVA is a registered trademark of Stern Stewart & Co.

John R. (Jack) Falker

- Primary operating officer of FalkerInvestments Inc.

- Active in the practice and teaching of corporate finance for more than 40 years.

- Formed FalkerInvestments after leaving Swenson/Falker Associates, the financial relations firm he co-founded in 1987.

- Corporate treasurer in two Fortune 500 companies.

- Taught applied cost of capital theory and shareholder value maximization to finance majors at the graduate level for many years.

- Advocate of the concepts set forth in the “Quest for Value,” Bennett Stewart’s book which revitalized applied cost of capital theory and set in motion the current attention being paid by corporate managers to the EVA* concept.

- Graduate of the University of Michigan and the University of Detroit with an MBA in Corporate Finance and a BA in English Language & Literature.