April 4, 2012

Dear Investor:

With Euro fears already baked into prices, the quarter saw the market rise as that fear receded. The Dow was up 8%, the S&P over 12%. Europe’s crisis is far from over, with another restructuring of Greek debt likely, a Spanish reckoning along the lines of Italy – and several quarters’ more deprivation in store for the already desiccated Mediterranean countries.

But the deflationary force of European contraction is now colliding with several inflationary ones: rising labor costs in China, the tidal wave of monetary reflation pounding the fragile shore of a recovering domestic economy, and booming commodity prices, especially oil. The mix of deflation and inflation could result in an ironically stable price level – or it could lead to further global imbalances. Regardless, stocks are cheap while bonds are expensive.

Buffett quoted the legendary value investor Shelby Davis to say that Treasury bonds now represent “return-free risk” — as opposed to the risk-free return that they offered over the past 20 years. There’s no doubt that a U.S. Treasury bond is now one of the worst investments in the world. I would like to meet the people who think lending money to a heavily indebted nation for 10 years in return for a wretched 2% is a good idea.

Obviously, these bond buyers are driven by fear, not by rationale. It’s no different than sticking dollar bills under the mattress. Despite the false sense of security a mattress might bring, it’s far from safe. A house fire burns a mattress to ashes – and inflation will incinerate the value of Treasury bonds. The best value remains in large U.S. multinationals, with free-cash-flow yields over 8% — a hefty premium to bonds and most other stock sectors. The other cheap areas are European equities, homebuilders, and financials, all of which continue to be shunned by investors and remain dirt-cheap as a result.

The world is still a colossal mess, as it always is, and always will be. When traders focus on the mess, it’s called a bear market. When traders see the potential beyond the mess – like the present – it’s called a bull.

Dear Investor:

The smallest year’s change in the S&P 500 since 1950 hid its fair share of intervening chaos. The index ended at 1257.60 after starting at 1257.64, a statistical journey to nowhere. But the chart shows the high drama, with the market first rising, then declining 21% and reaching an intraday low of 1075 on October 3 before rallying 17% to close the year right where it began:

1/11/11                                                                                    12/31/11

Is there a lesson here? I would say the moral is to never time the market:. At the cusp of Sept/Oct when investor anxiety over the Euro reached its pinnacle, many bailed out of stocks, thus creating the bottom. It was precisely at that point, when the downside appeared huge and the upside limited, that exactly the opposite was the case. As it so often does, the market confounded all expectations. Anyone who sold in September ended the year with a pitiful loss.

No doubt others will draw different conclusions – perhaps that a trading strategy (that sold at the July highs and bought back at the exact October low) would have been anything other than luck. I believe predicting the short-term direction of stocks is the type of magical thinking best left to shamans and fortune tellers. For some reason, looking into a crystal ball to predict markets is deemed semi-respectable (cloaked as it is in macroeconomic mumbo jumbo) – while the person who “predicts” red on the roulette wheel is rightly written off as a charlatan. Anyone who says the market will go up next month is proclaimed a genius when it does and an idiot when it doesn’t. This is like congratulating the gambler who correctly guesses red and haranguing the one who incorrectly bets black – when the only logical response is to say: stop gambling.

The lure of speculating in markets, or reacting to the latest macro event, is very compelling. But the best money managers from Buffett on down have always been value investors – those who ignore market predictions and instead focus on buying undervalued assets.

Getting back to value, where are we finding it? In the quest for good deals, we often swap from asset class to asset class, not to time the success of any particular one, but instead to seek underpriced securities (as measured by a discounted cash flow valuation, price-to-cash ratio or combination of other metrics). Said differently, we know the what but not the when — we know that the asset class will return to favor, but it could be next month or next year, or even three years.

Today the cheapest asset classes in the world are U.S. large cap multinationals, European equities, and Japanese equities. The most expensive are U.S. Treasury bonds, gold, and other non-industrial commodities. There are so many good companies trading at distressed values (precisely due to macro fears) that it’s the kid-in-the-candy store problem for any portfolio manager. The average p/e ratio on Euro equities is 9/1. Relative to interest rates, stocks just don’t get cheaper than this. As Bill Miller of Legg Mason said recently, everything except the complete obliteration of Europe is already priced into shares.

Sometimes value can be difficult to discern. On November 30, we sold the EWJ, the Japanese stocks ETF at a price of $9.37/sh after buying it at $9.92 on March 15 — in the wake of the Fukushima nuclear disaster. We swapped from the EWJ into another Japanese ETF, the DXJ. It must appear stupid to sell something at a 5.5% loss so soon after buying it, especially since I just said Japanese stocks are dirt cheap. So why did we do it?

The answer lies in the underlying appreciation of the Yen. The EWJ doesn’t hedge currency exposure. Over the past year, the Yen appreciated 9%, from a low of 85 yen to the dollar. When dollar-based investors own Japanese stocks without a currency hedge, their fortunes rise and fall with both the stock price and the Yen. The underlying value of the EWJ decreased due to stock declines, but also increased due to currency appreciation. The net result was a loss since the decline of the stocks exceeded the appreciation of the Yen. But the appreciation of the Yen cushioned the overall decline substantially.

I believe the Yen is now overvalued while Japanese stocks are even more undervalued. The solution was to swap out of the unhedged EWJ into the DXJ, a Japanese ETF that hedges it currency exposure. By doing so, we participate in any appreciation in cheap Japanese stocks while being protected from declines in the Yen. I normally don’t like hedges, believing them to be expensive and often ineffectual. As David Einhorn says, the best way to hedge against something is just to sell it. But this is a case of one half the investment (the currency) being unattractive while the rest of the package remains compelling. A hedged ETF is really the only way to unlock the value in Japanese stocks for a U.S. investor. We still own some small positions in Japanese mutual funds that are unhedged to the Yen and are looking into selling those as well.

Dear Investor:

Greece is on the verge of almost certain default. Ireland and Portugal are not far behind. Contagion could spread to Italy and Spain, two of the largest economies in the EU, with $2 trillion and $1.4 trillion in nominal output respectively. Collateral damage could spread to the US, Asia, and Latin America, tipping the world into another severe recession.

A good time to stay in stocks — or buy more? Absolutely.

VALUE vs. NEWS
As Bill Nygren of the Oakmark Value Fund likes to say, people pay too much attention to the news, and too little attention to value. The news is fleeting, mercurial and impossible to predict. Value endures. The value  investor’s secret — often referred to as “time arbitrage” — is the ability to take advantage of the normal human myopic fixation on the short-term to remain invested in stocks (or buy more) – with the reasonable belief that once fear dissipates, those prices will rise dramatically.

Are there downsides to such a value approach? Yes. For one, value takes time to be recognized, so it’s only for those who have time horizons of at least 3-5 years. It’s not for those focused on monthly returns or getting rich quick. The value investor forsakes any rights to the fast, blockbuster trade. But they do so knowing that traders come and go, with yesterday’s hero becoming tomorrow’s bankruptcy — while value investors have the best chance of making money over long periods of time.

As to the debacle that is now Europe, most equities have already priced in vicious scenarios. Worldwide, stocks are trading at between 8-12 times earnings, and 3-6 times operating cash flows. Stocks do not trade at such low levels unless they expect the worst. Even if earnings tilt downward in the wake of a new recession, price to earnings multiples are very, very cheap – especially relative to the interest rate backdrop to which they must be compared.

I often ask people: if you will not stay in stocks at 8-12 times earnings, at what price would you? Given that stocks never trade much below 7 times earnings, it seems like a fair question. After all, the idea is to buy low and sell high, not the other way around. Often, the reply is: “Yes, but don’t you read the papers, don’t you see what’s going on in the world?” What’s often forgotten is that stocks only trade at 8-12 times earnings when the macro outlook is truly miserable. That’s exactly why they trade at such a bargain. They never trade at 8-12 times earnings when things look rosy. As Buffett likes to say, “you pay a dear price for a cheery consensus.” Traders who try to catch the precise bottom often miss it completely, because stocks price in recovery well in advance of the actual economic realities. By the time it “it feels safe,” the market has already risen a few thousand points.

In March of 2009, with the Dow at 6,547, I posted a letter strongly advocating stocks on the Huffington Post. It didn’t really feel safe to buy stocks again until early 2011 when the market had nearly doubled to 12,800.

THIS TIME IS DIFFERENT?
At the best points in history to buy stocks, such as 1932, 1974, 2009 — and the present — the macro outlook was (and is) always gruesome. In 1932, when you could have picked up any company for a song, you would have been forgiven for being dissuaded by: 25% unemployment, the Dust Bowl, soup lines and Hoovervilles, thousands of banks shuttered with no deposit insurance, the impending collapse of the worldwide economy and a depression unparalleled in the human imagination. In 1974, when you also could have bought companies worth a dollar for a dime, you would have had to look past Watergate, the oil embargo, war in the Middle East, the Vietnam War, double-digit inflation, high unemployment, and an economy mired in a fresh form of hell called stagflation. Staying invested at either point (without trying to time the upturn) would have more than doubled your money over the next five years.

Often people kick themselves and ask things like: “Why didn’t I buy McDonald’s in 1974? I missed out on a 14,765% return (not a typo).” Or they ask: “Why didn’t I buy that apartment in NYC in 1975, when a 3-bedroom pre-war was selling for $80,000?” The answer is that it seemed terrifying at the time, given the macro turmoil. But decades later, the fear is long forgotten – and they are left to scold themselves and wonder: why? In 1974, the NYC apartment was cheap because NYC looked like it was going bust.

At the time, the fear justifies inaction because the fact pattern feels slightly different — different enough, in fact, to wonder if things could never get better again. It’s often said that the four most dangerous words in the investment world are: This time is different. This phrase is used to justify staying sidelined in cash during bad times when stocks are cheap. On the flip side, those words were used to justify staying invested in overvalued internet stocks in 1999 when pundits claimed valuation no longer mattered. Just as they do today.

It’s appealing for humans to feel they live in the very best or worst of times – a time unique. In periods of excessive optimism, the uniqueness gilds the lily of euphoria. In tough times, uniqueness imparts meaning to suffering. The reality is that no period in history is unique. Everything happening today has happened before – if in a slightly different pattern. As Mark Twain said: “History doesn’t repeat, but it rhymes.”

Today, we face high unemployment, another recession, a Euro debt crisis, unrest in the Middle East, and a political leadership in complete paralysis. Yet, much of this – if not all – is already priced into shares. The most cogent point made these days is that the political stewardship is poor, but it’s often poor at such points. In my valuation calculations, I always assume that politicians will not solve a single major problem. That is my way of discounting for political uncertainty. And still stocks look cheap in that context, because good companies will make more money in 5-10 years than they do today, no matter the politics. I do make one base assumption in buying equities: that the United States survives as a going concern. But it seems silly to invest with any alternative in mind. If true Armageddon arrives, and the U.S. devolves into dictatorship or complete anarchy, the only thing you’ll want to own is a shotgun. If you don’t share an overarching belief that this country will outlast yourself, then you should never invest in a single stock in the first place. But you also might consider moving to Canada or China.

Today, stocks are on sale. No one knows what the next year brings in markets, but history shows that stocks bought at these prices offer a satisfactory return over the next decade. Stocks may go lower still. They may go much lower tomorrow and the day after. None of that will change their expected positive return over the next decade – a return that is likely to beat cash and bonds by a wide margin. At dividend yields approaching 3%, stocks will return more than cash even if their prices go nowhere for ten years.

The attempt to catch the precise bottom or predict economic turns is a fool’s errand. Once you recognize real and compelling value, better to grab it. The trick is to recognize quality.

Picture yourself in NYC in the mid-1970’s: families are fleeing to the suburbs, the Bronx is burning, crime is approaching record highs, hypodermic needles litter the streets, Mayor Beame is on his way to the bankruptcy court steps, The Daily News proclaims: Ford to NYC: Drop Dead, a blackout leads to uncontrolled riots…but to the careful observer, there are signs of enduring quality: the new Lincoln Center has spawned a West Side recovery, the city remains the cultural and economic capital of the world and the World Trade Center has gone up as a testament to that reality.

Meanwhile, large pre-war apartment prices have collapsed and are selling for less than $40/sq foot, down from $60/sq foot in the late 1960’s. A very nice 2,000 square foot apartment is $80,000. Would you flee NYC? Or would you buy? Or would you fear that the $80,000 price tag would first drop to $70,000 and thus do nothing until the late 1990’s — when the NYC renaissance was finally obvious to all? The careful real estate investor does research and notices that certain neighborhoods are high quality but have been sold down in tandem with the general panic — that quality pre-war apartments are classics that will draw buyers eventually. And so the value investor sees opportunity where the general population sees only fear.

This is not Pollyanna. Guessing if the worst has passed just doesn’t work, because no one ever knows. Instead, the trick is to figure out if you’re in New York City or Flint, Michigan – admittedly not an easy task, but one within reach. I believe the United States and Europe are more like New York in the 1970’s: high quality chunks of extraordinary value facing enormous challenges — but selling at prices that well reflect those challenges. And stocks return much, much more than real estate from points of extreme value.

Today, if you look past the headlines and the myopia of euro-centered fear, you see blue chip multinationals trading for the lowest valuations in 60 years, with vast opportunities ahead of them in emerging economies like East Asia, Latin America and India. Even if their prices go 20% lower before doubling over the next 5-10 years, should it make a difference to those who can handle the wait?

July 20, 2011

Dear Investor:

From April 29 to June 24, the S&P 500 lost nearly 8%. The subsequent recovery has been dramatic, but markets are now showing strain. Markets never go straight up for sustained periods of time. A selloff of 20% at some point would be historically justified.

Anyone who tries to time that event, however, is likely to be miserably wrong. For every story of flawless timing that trades perfectly around a “black swan event,” there are countless busts and flameouts that no one ever hears about. Load up on credit default swaps with high leverage and time the entry perfectly: the result is a killing. Get the timing a day wrong and watch the portfolio implode: something else entirely. I doubt that many people appreciate the risks involved in these large speculative macro calls – or the dangers of the leverage used to feed them. The market will teach them all eventually.

As you know, we don’t believe anyone can predict short-term market moves. This type of speculation is called gambling — not too different from a junket to Vegas. Instead, we invest, which means buying assets trading at discounts to their intrinsic value and holding them until overvalued or fundamentally impaired. This process requires patience – and never will make an instant killing. But it has the advantage of being the only method that works over long periods of time. It is also the only strategy that involves sound judgment based on fundamentals, not speculative plunging on ephemera.

There are asset classes currently trading at deep discounts to their fundamentals that provide superior investment opportunities: Japanese and European equities, homebuilders, and large-cap multinationals. We are adding these to accounts where appropriate. Such plodding investment may not have the excitement of the trader’s roulette wheel – but it’s far more likely to work over time.

The Silent Killer

April 29, 2011

Dear Investor:

Inflation is an insidious threat. Economic predictions are said to make weather forecasts look respectable – but inflation is one you can count on.The normal course of things is that money loses its worth over time – the sordid result of government overspending – and the result is a declining value in currencies, not relative to one another, but to goods and services. In the wake of S&P’s negative outlook on “AAA” U.S. treasury debt, the odds of inflation have increased. An outright default is highly unlikely, because the dollar is the world’s reserve currency and the US controls the printing presses. But if more money is printed than should be, it quickly loses its value. The result is inflation.

I explain to my finance students that inflation is like hypertension: a silent, symptomless killer. The investor who keeps their money in a savings account will never see inflation losses on the account statement. Over time, however, their cash will become less and less valuable until it buys half of what it used to. The easiest way to grow poor for the long run is to succumb to the ersatz safety of cash.

In order to beat inflation, money must be invested wisely. The best “traditional” protections against inflation are stocks, real estate and commodities. These three asset classes typically provide a “real return” above and beyond the historical inflation rate of 3% – and tend to derive much of their increase in value from the same underlying dynamics that drive inflation itself. Bonds, CD’s and money markets are the worst places to hide from inflation: their fixed interest rates and low returns can’t keep up with the silent killer. Bonds protect against other risks, such as market risk and volatility, but they do nothing against inflation.

The latent creep of inflation is clear. The monetary and fiscal binge of the past few years has made inflation inevitable. As a result, all the obvious inflation hedges have been bid up to absurd levels; their prices have long ago baked in an inflationary scenario. Gold, TIPS and commodities of every stripe have reached prices too lofty relative to real value, thus lowering their future expected returns. In short, these inflation “plays” are bubbles ready to burst. We did own the gold mining stocks for clients (via the GDX etf) from December, 2008 to October, 2010, but we sold the positions as prices reached nosebleed levels. They’re too dangerous to own now.

What then are the less obvious inflation hedges – ones which have not yet priced in the conventional wisdom? A few are hidden in plain sight.

Stocks in general are good inflation protection. Stocks often reflexively sell off as inflation appears, especially if accompanied by steep interest hikes. But stocks are excellent inflationary hedges over time. Stocks are the ownership interest in companies – companies which have the essential ability to raise both their prices and their dividends, powerful protection against money’s loss of value. The average annual return during the four major inflationary periods of the past century (1914-19, 1945-47, 1949-51, 1965-81) is a surprising +12.1%. The inflation rate during those periods was +8.3%, reducing the “real return” to just +3.8%. Bonds, however, made only +3.1%, which delivered an annualized real loss of 9.0%, after inflation costs were netted out.[1] There are certain stocks that are especially good (and less obvious) hedges against inflation, such as the those of companies with strong brands and potent pricing power – companies such as consumer staples powerhouses Procter & Gamble, Colgate-Palmolive and Clorox.

Then there’s one type of stock we’d like to highlight: stocks of companies that can actually make money as interest rates rise. These companies don’t just profit from price increases but also from the Fed’s sequential policy response of tighter money. What’s more, their leverage to inflation is less understood by market participants. This complexity has kept buyers away, leaving their prices attractive.

Companies that Mint Money as Interest Rates Rise

These gems of the financial world are unusual. Their magic stems from the ability to invest “float,” large sums of interest-free money that can be invested pending a future payout. The best examples are payroll processors and insurance companies. Among the payroll processors, both Automatic Data Processing (ADP) and Paychex (PAYX) are companies that have vast amount of available float that can be invested at higher rates as the Fed starts to tighten the screws. We own these stocks for clients in separate accounts (via mutual funds) and in the JBGlobal Fund L.P.

Take PAYX as an example. This company holds float in the form of payroll money for clients deposited – pending remittance to the taxing authorities. At last count, PAYX had over $3 billion dollars in this form of investable float. Unlike a bank, PAYX doesn’t have to pay interest to the clients on these sums since it only holds the money for a month or so. The money is essentially “free.” Since new payroll is always coming in as payroll taxes get paid, float remains at high levels. A disadvantage to this arrangement is that float must be invested in short-term commercial paper to match the low duration of the payroll obligations. At current record low interest rates, PAYX is earning less than 2% on its float. As rates rise, float can be reinvested at progressively higher rates. Small changes in yields can make a big difference in float income. Each additional dollar of float income drops directly to the bottom line since there’s no cost to it.

The payroll companies are one way to protect against inflation that remains beneath the radar screen. The other way is through consumer staples companies with pricing power. We continue to add exposure to these two categories across our client accounts.

Sorting by Value

January 6, 2011

Dear Investor:

Complacency is returning to markets. Risk aversion is evaporating. Recovery is in the air. Even the animal spirits are returning, with M&A activity reborn and speculation back in vogue.

From a contrarian perspective, these signs are worrisome. The newly positive sentiment on stocks is bringing dollars back into the market and baking those optimistic expectations into stock prices. Still, macro difficulties such as the euro crisis and unemployment remain.

As you know, I don’t believe anyone can time the market consistently or effectively-so I won’t try. The direction of security prices in the short-term is unknowable, much like the next spin on a roulette wheel. The only thing knowable is value: the current price in relationship to fundamentals, and whether that price represents a discount or premium.

From a value perspective, stocks still look cheap. By some measures they are the cheapest in a generation. Not all sectors, however, look compelling. Some appear downright expensive. We are shifting assets from the overvalued to the undervalued. Here’s our list of relative value by sector (in order of magnitude from most to least):

UNDERVALUED
Homebuilders
Europe
Large Capitalization Companies (and Multinationals)
Financials
Japan
Business Services (including Software)
Telecom
Healthcare

OVERVALUED
Commodities (and Commodity Stocks such as Gold Miners)
Treasury Bonds
Asia (except Japan)
Emerging Markets
Energy (both conventional and alternative)
Retailers
Industrials
Small Capitalization Companies
Consumer Discretionary
High-Yield Bonds

Our recent allocation shift has been from Gold Miners to Homebuilders. We believe the former category is at bubble levels while the latter is as cheap as it gets. To participate in the homebuilding sector, we’ve purchased the ITB (iShares Dow Jones US Home Construction Exchange-Traded Fund) which owns stocks of both homebuilders and home-related retailers such as Lowe’s, Home Depot and Sherwin-Williams. The top five holdings are: NVR, D.R. Horton, Lennar, Pulte and Toll Brothers. Rarely have I seen a sector as out of favor as the homebuilders. In classic post-bust style, these stocks have been kicked to the curb with abandon. The ITB portfolio trades at five times operating cash flows, as opposed to approximately 25 times in 2005 (at the height of the real estate bubble). The ITB trades at $13/sh, down from over $45/sh at the peak-a 71% decline. The only comparable sector collapses in recent memory are Japan in 1991, Tech in 2002, and Financials in 2009.

Meanwhile, the financial condition of such companies has never been better. In 2005, the top five holdings in the ITB had a combined $3.9 billion in cash and $13.9 billion in debt. Today, they have $7.5 billion and $10.8 billion respectively. By issuing new shares and dramatically cutting costs, the homebuilders have restored their balance sheets. These actions came at the expense of prior shareholders and employees, but new shareholders can benefit from expected re-leveraging over time. Whether or not real estate recovers this year, next year, or in 2013 (agnostic is the only honest position), expectations are so low, and valuations so distressed, that even the most modest stabilization should bring a rebound in share prices. The situation with homebuilders looks most like regional banks after the savings and loan crisis of the early nineties-when post-crisis price collapses, consolidation and retrenchment set the stage for an enormous rally over the subsequent decade.

You don’t want to overdo it with Homebuilders. As classically cyclical businesses with few competitive barriers to entry, they are not the type of business we normally like. There’s also no guarantee homebuilders will have the same fate as the regional banks, but history suggests that they will. While a couple of the weakest homebuilders may still go bust, the vast majority should easily make up for it.

In a Gaudy Light

October 13, 2010

Dear Investor:

All that glitters seems to be gold. With the metal at $1,346 per ounce, up from $800, the two-year return on bullion is nearly 70%. Our clients own small gold positions, via the exchange traded fund GDX, which owns shares of gold mining stocks. In late 2008, we purchased the GDX at $30.78 across client accounts in approximately 1%-3% weightings. The price is now $56.40, a near doubling in less than two years. Obviously, we should have bought more.

Returns that approach 100% in short periods of time are unsustainable. Gold may climb for awhile, but at some point it will fall-with all the force of gravity a heavy metal can provide.

Consider that gold has been a terrible long-term investment over the past century. By way of illustration: in 1910, one ounce of gold bought a decent men’s suit-and it still does today. In other words, over that time gold has provided zero real return (above and beyond the inflation rate). Contrast this with stocks which have provided a 7% real return, and you begin to appreciate the difference. One that thing that worries me is that, at $1,346, an ounce of gold nearly fetches a really nice men’s suit: think Armani, not a knockoff. And that’s the trouble. When gold starts providing some sort of real return above and beyond inflation, you have to worry, because it normally doesn’t.

Gold is a story of tremendous spikes-when people panic about inflation or currency debasement-and harrowing collapses, once sound currency returns. From 1971-1981, as inflation vexed the American economy, gold returned 28% a year, but then lost money over the next two decades. As Volcker restored a stable price level via high interest rates, gold lost its luster.

History will rhyme, if not repeat. Gold is ultimately a commodity, with few uses beyond jewelry and hoarding. It costs quite a bit to unearth and offers little in return. Expensive to store and secure, it also pays no interest. In short, it’s only value lies in its rarity-and such rarity is only attractive at times when dollars are anything but. An ounce of gold cannot create wealth like a company, can’t enjoy economies of scale and doesn’t pay a dividend. Gold mining stocks do these things, however, and are thus more attractive than bullion. But gold mining stocks are now fully valued, or even overvalued. At free cash flow yields below 3%, gold mining stocks need metal prices to stay in the stratosphere to maintain their own price levels.

Gold itself cannot be accurately valued, given that it provides no yield. Valuing gold is no different than valuing a currency: impossible yet commonly attempted. But when an investment throws off no cash, there’s no way of discounting its present value-or of comparing it to other opportunities.

As you know, we don’t believe anyone can predict the short-term direction of prices in anything: stocks, bonds, livestock, or certainly gold. Since we can’t value gold accurately either, the asset is more dangerous than most.

Gold is clearly in a “bubble,” but bubbles can expand for very long periods of time before they pop-usually longer than the most lengthy of predictions. Despite more and more cocktail chatter about gold, the aura surrounding the metal still doesn’t approach the internet frenzy, or the real estate mania, or even the euphoria of gold bulls in the 70s. Until it does, gold will not collapse. A bubble only bursts once the last doubter climbs aboard. There are still too many naysayers loudly condemning gold. When the ultimate erstwhile cynic capitulates and cries “Buy gold!” that will mark the top. I don’t believe that time has yet arrived.

On the other hand, we believe in selling assets that are overvalued. When dealing with a likely overvalued asset that can’t even be properly valued, it’s better to be too early than too late. Waiting until inflation and interest rates rise is probably a losing strategy; by then, gold will have already long priced in that reality. Our contrarian philosophy dictates selling an asset class when people are optimistic about its prospects, and that seems to be the current mood surrounding gold. Though we haven’t yet hit the sell button, expect us to soon. Gold looks a little gaudy in this light.

What’s Cheap – and Expensive

July 16, 2010

Dear Investor:

A United States Treasury Bond is now the most expensive, most dangerous investment asset in the world-while blue chip equities, especially American and European Multinational stocks are as cheap as they’ve ever been.

One model of valuation is the so-called “Fed Model,” historically used by Fed analysts to measure the relative value of stocks vs. bonds. This compares the yield on the 10-yr Treasury and to the earnings yield of the S&P 500.

At points of equilibrium, the yield on the Treasury bond should be roughly equal the earnings yield. The future return of a stock should comprise its earnings yield plus an inflation adjustment plus a growth adjustment, while a bond will only deliver the coupon interest rate (if trading at par value). The additional components to stock return compensate for the higher risk. And so if the earnings yield equals the treasury yield, a risk-reward equilibrium exists.

Right now the earnings yield on the S&P 500 is 7.81% (the inverse of a 12.8 forward p/e ratio) while the 10-yr Treasury yields 3.08%. The stock market yield is more than double the Treasury. This is a historically vast divide, one which was basically reversed in 2000, especially in tech stocks.

This implies that the future ten year return on equities should be something north of 7.81%, while that of bonds only 3%.

In European stocks, the divide is even starker. In the ADRU (the exchange traded fund we have been purchasing in client accounts where appropriate), the basket of underlying stocks has an 8.3% earnings yield, implying a double digit return when inflation and growth adjustments are added in.

In short, obligations of the U.S. government do not provide nearly enough compensation for the underlying credit risk (regardless of inflation expectations), while cash-rich companies provide a good risk-reward profile for those with time horizons of three or more years.

Why Contrarianism Works

April 5, 2010

Dear Investor:

In just over a year, the Dow has recovered to 10,927, from 6,547. The biggest rally of our lifetimes has lifted markets nearly 70%. Paradoxically, now’s time to be more cautious, while a year ago was the time for optimism. Why was optimism warranted when the world was falling apart? Why is caution more appropriate now? The answer lies in the nature of markets.

To go against the grain of anything is, well, counterintuitive.

Our lives glide most easily on the broad wings of intuition. The most human elements of our lives-love, family, and friendship-are intuitive and instinctive. There’s not much purpose in contradicting the natural. We are, after all, not as distant as we would like from our Neanderthal ancestors: 45,000 years is a blink of evolution’s eye. For a cave dweller to ignore instinct was fatal.

But the financial markets reverse this natural order of things. In an ecosystem where prices reflect instinctive thought, no one can outsmart the system by reacting to such thought. Put another way, the markets price in all consensus emotion by the tick. If you are panicked, others are too, and their mood has already set the current price level. If you are euphoric about world events, so are your neighbors. Prices already reflect their optimism. The stock market is like an auction by millisecond: bids are instantaneous and prices immediately reflect human emotion. Prices do not wait for emotion; they are literally defined by it. The sheer number of participants and trades ensures relatively efficient pricing, where the market sops up human greed and fear as soon as it exists.

Behavioral finance tells us that markets are psychological thermometers, taking our mass temperature and distilling the result into one number, say Dow 6,500 or Dow 11,000.

The market looks at fundamentals, such as earnings, cash flows and interest rates and then applies an average price to them. But whether that price is high or low depends on our collective mood.

Since markets price in current emotion, it follows that the only way to beat the market is to go against it-that is, buy when other are selling and sell when others are buying. As Warren Buffett says, “Be greedy when others are fearful and fearful when others are greedy.”

The ability of the contrarian to take advantage of conventional wisdom, and not get swept away by it, explains the success of the counter-intuitive investor. All great value investors operate in contrarian fashion, buying counter-intuitively what others have intuitively discarded. When Buffett bought Goldman Sachs or Chris Davis (of the Clipper Fund and the Davis Financial Fund) bought Amex on the cheap a year ago, they bought what no one else wanted to own. Those stocks have more than doubled since.

The market is now approaching fair value. The normalized free cash flow (FCF) yield on the S&P 500 is no longer the juicy 12% that it was a year ago. But markets are not yet too expensive. By our estimate, FCF yields are still a respectable 7%. A yield under 4% would define overpriced.

When giddy optimism returns, and the champagne once again tastes as good as it did in 1999, and the world shouts buy with one clear voice, it will be time to sell some stock.

January 18, 2010

Dear Investor:

In ten mere months, the Dow has rallied 62%, from 6,547 to 10,610. The rally is nearly as dramatic as the decline that preceded it. Though the Dow has a long way to go to return to 14,000, the recovery in markets is the largest relative to its short duration since the 1930’s.

Will it continue?

Rallies cannot continue forever unchecked. Though recovery rallies tend to last a year or two, at some point they falter into one large step backwards, usually half as ugly as the prior decline.

Some examples of recovery rallies and the following downturns:

These secondary selloffs are typically fast and contained. The downturns above lasted an average of six months. But they are very real bear markets, not simple corrections, and their pain is intense.

Such selloffs tend to occur once complacency has returned to the market and the panicked pricing of the primary collapse has become a distant memory. This enables the market to suck in vast amounts of cash from late entrants, who’ve been waiting on the sidelines for the market to once again “feel safe.” Once they return, and the last marginal buyer has come forward, the market falls.

These investors tend to get doubly burned by their return to the market, as their fledgling courage is soon answered with a terrifying new salvo of market carnage.

Given that a new decline is likely, the obvious question is When? The only honest answer is: no one knows. Though pundits and traders won’t hesitate to time the downturn, they have no logical basis for their actions. Short-term market fluctuations are random and unknowable. If the past two years have taught us anything, it’s that market movements are divorced from the real economy: the market is a “discounting” mechanism, estimating future cash flows and discounting them to adjust for the time value of money. It doesn’t care about the here and now, only the future. Thus, it tends to recover long before the real economy, as it did in the year past.

Since only a charlatan can answer the question of when with conviction, a timing strategy, whether it be via options or moving to cash, is dangerous for people with retirement plans and goals-where a wrong turn can prove disastrous.

We believe it’s better to make decisions based on relative valuation, selling overvalued sectors and securities and reinvesting the proceeds into undervalued ones. This is a strategy agnostic to when the market or a stock will turn, but cognizant of the fact that it eventually will. It’s a truism of markets that some sector is always left behind by any rally or overly punished by any selloff.

A year ago we were adding to financials. Now we’re adding to consumer staples, via the XLP (an exchange traded fund, or ETF) that owns household names like Procter & Gamble, Colgate, Kraft and Walgreens. These stocks were abandoned by the massive rally in financials and cyclicals and now yield an average of 2.5%–a very healthy dividend rate in this low interest rate environment. Even if these reasonably safe stocks do nothing for a decade, their return would beat CD’s, money markets, short duration government bonds, and cash.

Dear Investor:

The greatest monetary and fiscal stimulus in history has saved the world from deflation. Next stop: inflation.

The Fed’s heroic success at making money “free” for the past year-with short-term interest rates near zero-has saved the planet from another Depression. The money supply has exploded; the steepened yield curve has recapitalized the banking sector. There’s always a cost to the printing of money. That cost is inflation.

We don’t know when it will return. Inflation tends to lag behind money supply creation by several quarters. The deflationary forces of unemployment and the lingering credit crisis are muting any major price appreciation: prices were up 0.4% in August but declined 1.5% over the past year. Any attempt to time the return of inflation will be futile, since price spikes are only visible in the rearview mirror. Predicting economic cycles is also impossible since economic predictions make weather forecasts look respectable.How then to position a portfolio?

There are several protective measures for impending inflation:

1)  Keep bond duration short to minimize interest rate sensitivity. Average bond duration should be kept below 8 years, preferably closer to 5. Long-term bonds will lose lots of value in an inflationary environment. We’re keeping all clients in short-term or medium-term bond funds with low average durations.

2)  Avoid staying in cash for long periods of time. The 3.5 trillion dollars in money market funds earning less than 1% will be the main loser, since inflation is likely to run above the long-term average of 3%. Cash deposits will hemorrhage value on an inflation-adjusted basis. The damage will be invisible but real. We’re raising some cash in conservative accounts due to the massive run-up in equity prices (especially in Asian and tech allocations) but plan to redeploy it into bonds or stocks.

3)  Invest in equities. Equities are a decent place to be during periods of inflation. When the Fed raises rates, it can hurt the value of stocks by making cash flow yields less attractive on a relative basis; however, equities perform better than bonds and cash during inflationary periods. The earnings of companies are priced in inflated dollars. For this reason alone, stocks do better than bonds (which are saddled with their fixed interest rates). For example, the average equity return over the four major inflationary cycles of the past 100 years (1914-19, 1945-47, 1949-51, and 1971-81) was a surprising 12.1%. The consumer price index averaged 8.3% over the same periods, meaning that the real return of equities over inflation was only 3.7%. But this was better than being in bonds which returned 3.1%, and therefore lost 5.2% in real terms. We’re keeping equity allocations high enough to provide an inflation hedge in all portfolios.

4)  Invest in gold. Gold is a very poor long-term investment, with a real return of zero over the past century; however, gold prices spike during periods of inflationary crisis, given gold’s history as a store of value. You shouldn’t overdo it with gold. Gold has no yield, no cash flows, and no intrinsic value-beyond that which is determined by market prices. But a small gold position as a hedge makes sense in this environment. We purchased the GDX (the exchange-traded fund that purchases gold mining stocks) in December in every suitable account. The investment has returned 45% since then, but we think it will prove still more profitable as inflationary fears emerge.

One asset class we’ll avoid for now is TIPS (Treasury Inflation Protected Securities) which are overvalued and yield next to nothing due to the rush into these securities. Should a sell-off in these bonds create more value, we won’t hesitate to invest. TIPS are only appropriate in tax-deferred accounts, however, due to the imputed interest of the CPI price adjustment.

The market has had the biggest six month rally since the 1930s and stocks cannot go up forever. Equities will take one step back for every two steps forward. We can’t time the sell-off, but we can prepare for one of its likely causes: inflation.

The Importance of Cash Flow (vs. Earnings)

July 22, 2009

Dear Investor:

The disparity between cash flow and earnings is leading people to severely underestimate the current value of stocks.

When I teach corporate finance to my NYU students, I ask them to understand it this way: cash flow is real money, earnings are not. Imagine you run a pizza parlor. The money you take in (less what you pay out in expenses) is cash flow-the actual net cash taken in at the register. Earnings, on the other hand, are what accounting rules say you made-after they adjust your real cash for various sleights of hand, such as accruals, depreciation, amortization, and impairments to book value.

No real owner, including a shareholder, should care too much about earnings, which are accounting fictions. They should-and do-care about real money.

Cash flow has always differed from earnings in meaningful ways, sometimes being dramatically smaller, other times larger. But recent changes to accounting regulations have caused drastic variations that understate earnings more than ever before.

Consider the simple formula for earnings (aka “net income”):

Earnings = Revenues – Expenses

Unfortunately, under the “expenses” umbrella are more non-cash items than ever. The formula for operating cash flow adds back  non-cash charges to compute real money:

Operating Cash Flow = Earnings + [Depreciation + Amortization + Goodwill Impairment Charges + Other Non-cash charges]

Due to the relatively new treatment of goodwill impairment (whereby charges to goodwill must be taken immediately instead of being amortized over time) and to recent changes in mark-to-market accounting (whereby many fully performing loans still have to be marked down), nearly all sectors of the economy are showing exaggerated non-cash write-offs that are artificially depressing earnings.

The S&P 500, for example, is currently trading at 940, or at 15.2 times the trailing twelve month aggregate earnings figure of $62 per share. But the S&P 500 is trading at only 5.7 times operating cash flow over the same period. This discrepancy is historically vast.

If you invert the price-to-cash flow ratio of 5.7, you get an operating cash flow yield of nearly 18%!! This is a remarkable yield compared to 10-yr Treasury Bonds earning nearly 4%. Even if you subtract large capital expenditures from operating cash flow, you still get a “free cash flow” yield of over 10%. For comparison, the ten year average for operating cash flow yield is around 7% and, for free cash flow, around 4%.

Most value investors, including Buffett, rely on cash flow to avoid the accounting fictions of earnings. A cash flow analysis requires a little more work and extra know-how, but this really shouldn’t keep investors from discerning the true value of stocks.

As a result, we’re keeping equity allocations high, even in the wake of the 40% run-up since March. Despite the mongering of fear and the predictions of Armageddon by pundits and economists, it’s clear now that we are experiencing a recession, not the Great Depression.

The recovery will be uneven and slow; one step back will hinder every two steps forward. But the overall trend will be upwards from here. As a result, stocks-which were priced for perdition in March-show compelling value.

April 9, 2009

Dear Investor:

The economy continues to worsen: GDP is contracting. Unemployment is at 8.5%. Housing still swoons despite the lowest mortgage rates in recorded history. The horrible realities of a brutal recession-layoffs, shuttered storefronts, bankruptcies and liquidations-get worse by the day.

Why then would the stock market have risen to 8,000–up from its low of 6,547–over the past few weeks?

One possible reason is that the stock market recovers well ahead of the real economy. If this market behaves like any other over the past century, it will rise long before the good times return. In the five years following 1932, the Dow soared from 41 to 194, while bread lines and Hoovervilles still dominated the American landscape.

Has the market bottomed? The unsatisfying answer is no one knows. It’s unknowable whether the market will go back below 6,500, slump to 5,000, or continue its ascent.

What we do know is that the market will lead the way and the economy will follow. A common question is why?

One reason is economic, the other psychological–and the two are related through that intersection of behavior and finance.

As an economic tool, the market is a discounting mechanism: it attempts to gauge future cash flows long before they occur. Given the time–value of money, the eventual profits of companies are worth less in the present, adjusted for inflation and risk. All the estimated inputs–a mixture of educated conjecture, countless assumptions and irrational emotion-fluctuate second-by-second, desperately trying to set prices.

The market has no interest in today’s cash flows, since they’re already here. Like a mare with blinders, the market only looks ahead, never sideways or backwards. When the Dow rises or falls, it’s changing its economic assumptions for future profits, not present ones.

As respected value investor Bill Miller says: “If it’s in the papers, it’s in the price.” Everything that’s collectively “known” is already priced into stocks. A frequent question asked of all value managers is: “Don’t you read the papers? Don’t you see what’s going on?” Of course. But what’s in the papers is already known, collectively, and to the market especially. To trade on news doesn’t work since savvy traders discount headlines instantaneously. Common knowledge doesn’t influence markets, only true surprises do.

Anyone who follows individual stocks has witnessed the phenomenon of a stock declining for weeks and then rallying sharply as soon as terrible earnings are announced. The stock price factors in the bad news ahead of the earnings announcement–then rises once traders look to the next quarter. Or the stock that rises on favorable expectations then collapses as soon as the good news becomes a certainty. Hence, the old market saw: buy the rumor, sell the news. The counterintuitive nature of stock movements–that they often fluctuate inversely to conventional expectations–is a result of the pricing mechanism of markets, which discounts the future to the present.

The second reason is psychological. The market reacts to emotions instantaneously. Market prices, influenced by thousands of mouse clicks per second, assimilate the current mood, or “sentiment,” at any given instant. Imagine the market as a vast monitoring device, taking the pulse of mass psychology moment by moment. When optimism reigns, prices rise. When panic takes hold, prices immediately reflect that sinking feeling: bids are overwhelmed by sells.

If one person is panicked by the broad economic climate, so is everyone else, preventing the panicked seller from profiting by his own panic. Said simply, when the seller sells, he’s dumping stocks at prices that already reflect panic. He cannot “get out” before the price goes down. The price is already down when he places his order.

The early stages of a recession are the most terrifying, as people grapple with the switch from optimism to despair. Given novelty’s sway on human emotions, the first feelings of panic are felt the most intensely, are the most surprising, and thus cause the greatest fall in prices. The panic about what may happen long precedes what actually happens. The fear of losses long precedes the actual losses: the imagination reacts first.

Panic is, by definition, a short-term emotion. It can only grip the psyche for an instant since the mind soon acclimates to its cause. As Thomas Paine wrote in The Crisis (the anonymous pamphlet published when America appeared to be losing the Revolutionary War):

Panics, in some cases, have their uses; they produce as much good as hurt. Their duration is always short; the mind soon grows through them, and acquires a firmer habit than before.

Once the mind grows through its panic, the anxiety dissipates. The mere dissipation is what allows prices to recover from distressed levels. As if in a vast, collective sigh of relief, markets instantaneously rise to reflect the fading of fear. It doesn’t require any positive economic signs to create this price rise, only the conversion of apprehension to acceptance. Once the anticipation of losses becomes the reality of losses, panic recedes. The unknown becomes known. Nauseating dread turns to resignation.

We have no idea what the market will do next week, next month, or even next year. But we do know that stock prices will recover before the economy–and that their long-term movement will be upwards.

January 7, 2009

Dear Investor:

It’s difficult to sum up the events of the past quarter in one letter. It was the worst three months in financial markets since the dark days of the 1930’s. The fallout has been wide and deep. The global economy is now in severe recession, one which will last for at least half of 2009.

We underestimated the depth of the market declines and the economic damage, which caused us to overweight equities too early. Our belief was that equities were already cheap going into this mess–having had their pricing excesses wrung out of them during the grueling bear market of 2000-2002. I imagined that a 25% peak-to-trough decline was possible, but more than that was unlikely. This was wrong to the tune of double. The Dow declined nearly 48% from its high. Since we roundly anticipated the real estate collapse (and wrote about it for two years leading up to the bubble’s bursting), this blunder is all the more galling. Our view on housing caused us to avoid REIT’s, homebuilders and anything directly related to housing. But we bought shares in large, multinational financials, which we reasoned were diversified enough to withstand the pain. Some were, some weren’t; even the strong have suffered.

In the end, there was nowhere to hide anyway: retail stocks, commodity stocks, industrial stocks, consumer stocks, tech stocks, even healthcare stocks all collapsed. Debt markets collapsed, gutting munis and even high grade corporate bonds. Precious metals, oil, natural gas, real estate, all jumped off a cliff. Only treasury bonds and cash held value–and their pitiful yields offered negative real returns against inflation.

You’re probably less interested in the painful year past (and our mea culpas about it) than you are in 2009. Our view is the same as two months ago: that the intensive global fiscal/monetary stimulus underway–the most intense ever–will prevent this awful recession from turning into another Great Depression. History shows that depressions are rare events, caused not by booms and busts, but the lack of monetary stimulus in the wake of credit contraction. Right now, the stimulus is unprecedented in scope and size. Odds are it reflates the economy and creates a new set of imbalances (more on that later).

As we’ve said before, this question is crucial because another depression would warrant selling stocks here and now. A recession would render selling an awful mistake.

The difference in economic reality between a recession and a depression is vast, more so than most people realize. The old saw says that a recession is when your neighbor loses his job, a depression is when you do–showing all is relative. But in economic terms a severe recession doesn’t contract aggregate GDP more than 10-12%. Even pessimistic predictions for the current debacle are for no more than a 6% contraction. The Great Depression shrunk GDP by nearly 50%. The variance in this magnitude is enormous since each and every point of contraction in GDP represents huge economic misery. 6% vs. 50% is the difference between a rowboat and the Titanic.

We were right about one thing: that markets would begin to recover long before the economy. And that the markets would price in recovery while the real economic backdrop continued to get worse. The Dow has rebounded nearly 20% from the 7552 low of November 20, against a backdrop of grim news: layoffs, bankruptcies, frauds and flameouts. This is the typical pattern. Markets start to price in the healing process well before it ever begins, confounding those who sell at the bottom. From 1932 to 1937, the Dow quintupled from 41 to 194 (an increase of 373%) against a backdrop of bread lines and Hoovervilles. Even if the Dow revisits the 7500 level, it’s likely to then head higher in advance of even the first positive headline.

By definition, most people sell at the bottom. That’s what makes a bottom. Therefore, most shareholders sold during the terrifying week of November 20, 2008-whether they were forced to by margin calls or by good, old-fashioned panic. They now are bitten by the rally, since they don’t know whether to buy at these higher prices and risk another downturn–or wait longer. The choice, unknowable as it is since markets can’t be predicted in the short-term, becomes paralyzing and impossible. That’s why we believe timing markets is a mistake. Rebalancing from overvalued sectors to the undervalued makes a lot of sense, but trying to time the market by moving to cash–and then zigging back–is fraught with the potential for enormous mistakes. Research shows no one can do it well on a sustainable basis.

The investment approach–one which eschews short-term trading–can be painful since it entails waiting out difficult periods like the present. But the track records of most traders are spotty and poor, while the great creators of wealth like Buffett are long-term investors through and through.

A risk of the monetary stimulus underway is that money expansion will spark inflation. Hyperinflation is unlikely if central banks are vigilant, but inflation above the comfortable historical trendline of 3% is probable. Over the past few weeks, and in preparation for inflation, we’ve added an allocation to gold mining companies (via the Market Vectors gold exchange-traded fund, symbol GDX, a basket of precious metal stocks) in all accounts where appropriate. Normally, we don’t think much of gold as an investment. The bullion itself pays no interest, is impossible to peg in intrinsic value and has a 100-year annualized real return of approximately zero. We also tend to dislike gold miners, with their poor returns on invested capital, boom-bust cyclicality and lack of competitive advantage. But gold mining stocks are now very undervalued, in the wake of the commodity collapse of 2008. Gold stocks were down 35% over the past year as gold prices swooned in the deflationary scare of the fall. Given that we believe reflation will now lead to inflation, the investment case is compelling. Gold mining stocks are a less perfect hedge against inflation than the bullion since some of them in turn hedge gold prices. But they have the advantage of being valued on cash flows and paying an average dividend yield of 3%–something of great value as we face a potentially long wait for inflation to kick in.

We continue to be very bullish on the financials. The financials have outperformed the commodity, industrial and retail sectors since July and we think this will continue. The bulk of financial restructuring is well into the seventh inning and the attention of markets has turned to companies that have not yet faced the bulk of their future damage from the real economy. Though some have (and will) go bust, the bulk of strong financial companies will survive, prosper, seize market share and go on to be great investments.

Dear Investor:

The Dow has made a new low of 7,997, 2% below the 8,175 closing low of October 27. It held above the intraday October low of approximately 7,900, but not by much. The Dow is now down 44% from its peak. There’s not much I can say at this point without sounding repetitive.

For investors, it remains a binary question. Is it another “Great Depression” or not? If so, it would still pay to sell stocks here and now. If not, it would be a tragic mistake, given that five-year stock market returns following collapses of this magnitude nearly always beat cash, and usually by extraordinary amounts. Even in the Great Depression, the Dow went from its low of 41 up to 194-a quintupling-against a backdrop of bread lines. This would be the equivalent of the Dow going to 40,000 over the next five years. I’m not saying we’ll have a recovery of anything of that magnitude, only that stocks always eventually recover, even in the darkest of times.

It’s obviously difficult to conceive of the market ever going up against a backdrop of economic misery, but history shows that it does. The recovery is not caused by optimism, but by bottom fishing-buyers coming off the sidelines to acquire assets on the cheap. Here are the examples of bear markets of the current magnitude and their subsequent recovery. All the recoveries occurred against a backdrop of continued bleak economic news:

1907:  49% decline, by 1909 recovered 90%

1917:  40% decline, by 1919 recovered 81%

1938:  49% decline, by six months recovered 60%

1974:  45% decline, by 1976 recovered 76%

To repeat, the only time in the past century when U.S. stocks had to go past the 49% decline mark before recovery was in the Great Depression, when stocks didn’t recover until three years of collapse.

The terrifying events of the day-ranging from the impending bankruptcy of the major auto manufacturers to the looming default of sovereign debt to the spiking unemployment rate-are not alone the types of things that cause a depression. It may surprise many that a depression (as opposed to a recession) is shown by history to be the result of a lack of government intervention and stimulus in the face of awful economic conditions.

In the thirties, the Smoot-Hawley tariffs and the gold standard conspired to stifle the economy, not stimulate it. Today, the Fed is providing a wave of liquidity which is starting to show signs (as evinced by lower interbank lending rates) of working. It will not be perfect and it did not come soon enough. The global stimulus, however, is an unprecedented initiative and the right medicine for the current ailment. The Obama administration is expected to compliment this global monetary package with a fiscal one. Though fiscal stimulus is not likely to be as powerful or as targeted, it will help. I expect a severe recession, not a depression. I also expect negative effects of this intervention in the form of higher inflation and higher interest rates, but that’s a preferable problem and one for another day.

Even Jim Grant, the renowned economic historian and stock market bear, does not foresee another Great Depression. As he said recently to Vanessa Drucker of Fund Strategy: “Those glib comparisons ignore the reality of the economic backdrops. In the thirties, nominal GDP was sawed in half, while today it’s down less than a percentage point.”

Many investors will give up on stocks now, if they didn’t already do so in October. History shows they are likely to be making the wrong decision at the wrong time. They certainly appear correct now and definitely feel safer, but they’re selling assets at panicked prices and locking in their losses. They’re not different from the home seller who accepts $100,000 for the $1,000,000 home to just “get out.” The home may easily go down to $80,000 before recovering. But if the intrinsic value is $1,000,000, they’re selling a valuable asset for less than its worth. Stocks are the equity interests in businesses. To that extent they possess real value-value that the market’s not recognizing in its panicked state.

It might be right for some to sell stocks: Those who need the money within three years cannot keep money in stocks. Those who believe it will be the Great Depression again should sell. Those who are leveraged and margined have already been forced to sell. But those who can wait this out should.

Dear Investor:

The climate is terrifying, markets have been routed, and any words we have must come as hollow comfort, given the losses of the past week. Fear is really the only market element right now and investors are toppling over each other to get out, willing to accept very poor prices for their stocks. Excellent, cash-rich blue chips like Microsoft and Johnson & Johnson are selling at unprecedented low prices—prices that already reflect a collapse in the economy.

Think of your stock portfolio in comparison to your house or co-op. Your house is going down in value as you read this—and has probably plummeted in value over the past three years—but you’re not panicked by it since you don’t see the falling price flash before your eyes, and because you don’t get a painful monthly statement highlighting those losses. You wouldn’t leap to sell your home if the market irrationally offered you $200,000 for your $2 million dollar apartment. Obviously, you live in your home, so the analogy is a little stretched. But the core idea is the same: good stocks represent equity stakes in quality businesses and are assets of real value, much like a house. To sell them at panicked prices doesn’t make much sense, even if they go still lower before they turn higher.

This type of selling, known as capitulation, usually marks bottoms, but I can’t say when this horrible market will find its natural resting place. That said, yesterday’s collapse had all the classic signs of a massive capitulatory low which has often defined a bottom in past cycles.

It would be natural to think that markets will never, ever go up again. In the past week, they only went down. Psychologically, it’s impossible to connect with the idea that markets can go up. Just as in the frigid winter it becomes impossible to imagine summer’s warmth, it becomes a cognitive difficulty to see through this to the other side. But markets will go up again. In 1999, investors didn’t believe stocks would ever go down again. This caused panicked buying. Those who bought at that top learned the hard way—that market psychology can turn on a dime. If we are near a bottom, and history tells us the likelihood of that is high, then those who exit now are making the mirror image mistake of 1999. They are selling out of panic, possibly at the low.Despite what anyone tells you, market movements in the short-term cannot be predicted.

The only thing that can be predicted is value, as defined by good companies selling for cheap prices. The market is full of valuable companies selling at bargain-basement prices. Since this is the only knowable fact, it’s best to stay the course with long-term money. This explains why all the great long-term investors are buying, not selling (unless forced to by redemptions): Warren Buffett, Christopher Davis, Marty Whitman, Lou Simpson, Charles Brandes and the list goes on. They follow a principle we believe in deeply—that short-term market ups and downs can’t be predicted. The sensible investor, therefore, buys what’s undervalued and sells what’s overvalued, regardless of panic, market conditions, or any other distractions such as instinct, gut or hunches.

At this point in the cycle, after close to 40% declines on the major indices, there’s virtually no point in history where stocks would not beat cash on an aggregate five year basis thereafter.  The one exception (out of 950 or so total months over the past eight decades) is a seven month window from 1931-2, during the Great Depression. This represents less than 1% of months in our stock market lifetimes. The odds do not favor selling at this point. Only another Great Depression would change this equation. I don’t believe we’re going into another Great Depression for reasons described in my past letters. Therefore, I believe the risk-reward for long-term money favors equities. I know I said the same thing a week ago, so this contention may lack credibility, but I stand by it since the fundamental economic facts have not changed.

Again, the important thing is a sensible asset allocation. One of the purposes of an asset allocation is to assign a specific amount to equities, from which the investor does not deviate too much, in order to take emotions and guesswork out of the process. A heavy equity allocation is still the best approach for those who won’t tap money for three to five years, since there are very few periods in financial history where large-scale market recovery wouldn’t occur by then. Those who need money within three years should have enough in bonds or cash to cover that need. Those who are in retirement should have a significant bond component to cushion equity declines. Though bonds—especially corporates, and even munis—have also been sold off dramatically in recent weeks, bonds mute volatility and are the best insurance policy against equity declines.

October 6, 2008

Dear Investor:

The Bailout Bill was signed into law, but will be no panacea. The economy took a big hit, especially in the two weeks government bickered. Unemployment is likely to go to 9%. Credit is still stuck.

As we mentioned in our last letter, the question becomes binary at this point: is this the Great Depression or a severe recession?

There are really no times in history (except the Great Depression) where-at this point in the cycle-it wouldn’t pay to hold equities over the next five years. In other words, if you: 1) look at nearly every postwar rolling five year period on the S&P 500, 2) find an instance where the index was already down 30% peak to trough, and 3) calculate aggregate equity returns for the next five years, you always have a return that beats cash, usually by a vast amount.

So it leads to the question: is this another depression or not? If so, selling equities is the right call. If not, it would be a big mistake. There have been countless wrong predictions of another great depression over the past eight decades, in 1938, 1949, 1955, 1968, 1971, 1973, 1974, 1977, 1978, 1982, 1990, 1994, 2002, 2003 to name just a few-so it bears much thought to arrive at a conclusion. My view is that though the history of the 1930’s now rhymes, it won’t repeat. Things certainly seem scary enough, but the only cause of the Great Depression now in play is the credit crunch. We don’t have Smoot-Hawley style tariffs, deposits leaving the banking system, a lack of safety nets or a restrictive Fed. Most important, we don’t have a gold standard, the main cause of the Great Depression (along with protectionism) according to most economic historians. So while we may have a Fed that looks impotent, the reality is that the Fed is pumping liquidity at a ferocious rate, something that didn’t happen in the early thirties. This may not jumpstart lending right away, but it will prevent the complete collapse of all banking institutions that occurred in the 1930’s. In fact, bank consolidation is progressing, with J.P. Morgan Chase, Bank of America, Wells Fargo, and Citigroup acquiring the weaker ones. Cash is fleeing WaMu for J.P. Morgan Chase, not for the mattress. The evolutionary process of the strong swallowing the weak is underway. The financial index etf, the XLF, is at 18.89, up 13% from the July low of 16.77. In fact, the financials are performing best on a relative basis since then, which would be unlikely if markets were signaling a complete banking collapse. We were six months too early investing in the financials. But every day that passes with the XLF (as consolidation reaches its late stages) staying well above its July low makes us confident we got good prices.

Not a single asset class is up year-to-date except Treasury bonds. Commodities, tech, transports and industrials have collapsed. Even investment-grade corporates and munis have sold off. The flight to quality flows only to the government. Treasury bonds yield close-to-nothing, are overpriced and are becoming extremely dangerous, now that all risk is being transferred from the private sector to the government.

In such an environment, risk-reward favors equities for long-term money and low duration munis/corporates for short-term money.

Returning to the binary question: the only point in the past eight decades where it would have heavily paid to sell equities now, at this particular point in the cycle (after one year of market declines of 30%), was the Great Depression, and even then, only in the seven month window from November, 1930 to May, 1931. An obscure fact is that from 1932 to 1937, the Dow actually quintupled, from 41 to 194, against the backdrop of bread lines and apple carts. This is the equivalent of the Dow going from 10,000 to almost 50,000. If you’d sold in June, 1932, when things appeared most terrifying, you’d have missed the biggest rally in history. Markets move well ahead of real economic trends. Given that history is the only guide, logic dictates holding equities. Emotion says to sell everything, but logic disagrees.

However, logic also dictates having the right amount in cash and bonds to meet any need within the next three to five years. We are engaged in a special review of every asset allocation of every client to make sure that time horizons are appropriately addressed. If there’s been a major life change at your end, please inform us so we can incorporate it.

We know this is a difficult time. All investors are weary and frightened. The bad news is unrelenting. But things will turn around, often when least expected. Equity holders will be richly rewarded eventually, as they always have been. Please contact us with any questions or concerns.

April 3, 2008

Dear Investor:

The first quarter was the worst start to the market since 2001. The S&P was down 9.47%. From 2000 to 2002 the market was down a far greater amount, nearly 50%, but the concentration of the current declines during such a limited time has made the pain seem comparable.

The crisis of confidence that felled Bear Stearns has led to predictions of another Great Depression. Such hyperbole means the details of the Great Depression have been either forgotten-or that the true genesis of that horrible time is being ignored. The Great Depression was not caused by the crash of ‘29, nor by the failure of a few financial institutions. It resulted from a systemic contraction of the money supply and an unchecked run on the financial system that closed 9,000 banks. This choke on supply was not created by the initial failures or lack of confidence. The cause was laissez-faire indifference coupled with gold backing, both of which handcuffed government during a time when government was needed most.

Today we have the opposite: an activist Fed trying everything possible to re-liquefy lending, and a bipartisan effort to promote short-term fiscal stimulus (as weak as that may be compared to the monetary approach). Bernanke spent his academic career studying the Great Depression, and his actions show a deep understanding of how to prevent one.

The economy will suffer. The recession will be long and deep. Many financial firms will fail, especially leveraged players and poorly capitalized banks. Real estate will continue its descent. The unemployment rate will spike; consumer spending will plummet. All of this is likely. But a Great Depression is not.

Distinguishing correctly between these two very different scenarios will lead to very different investment strategies. For those who anticipate another Great Depression, all stock should be sold. The following should also be liquidated: gold, silver, real estate (except a primary residence), land, and any other asset remotely linked to monetary expansion and inflation. The only “safe” assets would be Treasury bonds and cash. But we think those who anticipate another depression are confusing this one remote possibility with many far more realistic probabilities.

Instead, we think the danger is inflation resulting from unprecedented monetary stimulus. Investors seeking a safe haven have pushed Treasury bonds to unsustainable prices. As Jim Grant of the Interest Rate Observer says, a Treasury now looks like “reward-free risk.” We believe large cap equities, especially financial shares, look like one of the few undervalued asset classes in a world short on confidence but long on liquidity.

We are increasing equity allocations across nearly all accounts, overweighting financials via the Davis Financial Fund, which specializes in high-quality banking and insurance companies. We believe this is a rare opportunity: the best entry point for financial stocks in over thirty years. Financial shares should produce outsized returns over the next five years.

The stock market decline has been ugly and the economy looks grim. But attractively priced, quality assets should always appreciate over time. We thank you for your patience during this difficult period.

January 1, 2008

Dear Investor:

The collapse of real estate looks long and deep. Mean estimates for the bottom are mid-2008, but many of these rosy predictions come from biased sources, such as real estate trade groups—who until earlier this year were still maintaining there was no such thing as a real estate bubble. We feel that housing prices won’t reach bottom until 2009-2010, with a slow recovery matching the inflation rate for 2-3 years thereafter.

2007 saw devastation in the financial sector, with expected casualties among mortgage lenders, mortgage insurers and homebuilders. Many of these companies will exit the stage, never to be heard from again. Also crushed were money center banks and diversified lenders, many of whom are now trading at the most attractive valuations in 20 years. These strong and able financial institutions will use the current crisis to gain market share and return to dominance.

Some banks, such as J.P. Morgan Chase, were able to do a fine job avoiding subprime exposure. Others, such as Citigroup, were left flat-footed, as they had done little to purge their books of recycled and repackaged mortgages known as CDO’s. As we own both of these stocks for clients, both in our Fund and in separate accounts via mutual funds, we were proud of Chase and disappointed in our decision to own Citi. But Citi is bruised, not broken.

All the money center banks, including Chase and Citi, are well-capitalized and should weather the debt crisis with their balance sheets in decent shape. Despite Citi’s well-publicized equity sales to raise cash, it should be noted that these are required to get the bank’s Tier 1 ratio (a measure of capital strength) up toward 8%, not to salvage the bank from insolvency. A Tier 1 ratio of 6% is considered the regulatory definition of a well-capitalized bank, and Citi had not gone below 7%, even after their write-offs. More write-offs will surely be followed by more asset and equity sales, but Citi will recover. Chase and other smarter lenders like American Express will use the crisis to pick up business and acquire their less able competitors. Those who overweight financials should make a lot of money over the next few years, just like those brave souls who bought bank stocks in the early nineties, after the last banking crisis.

A forgotten story is how the yield curve has normalized somewhat over the past several months, putting ten year yields above short rates and allowing banks a decent spread on their lending. This boost to bank profit margins will allow them to build up their balance sheets over the next year.

We made a major rotation into financials in December, and we will continue to increase the allocation where appropriate. Headlines will continue to alarm, as the debt crisis spreads to other types of consumer loans, but this is the time to start loading up on financials. By the time the crisis clears the media, it will be too late.

October 3, 2007

Dear Investor:

The last quarter marked the return of risk and reminded investors of the power of volatility—a word that is somehow used to describe stocks only when they are going down.

The true victims of the quarter were mortgage lenders and certainly trading hedge funds, many of whom went bust. According to Reuters, a partial list reads as follows: the Bear Stearns Funds (down more than 90%), Sowood Capital (down roughly 50%), Tykhe Portfolio Ltd. Class C (down 26.5%), Basis Capital (down around 80%), the Maquarie Bank Funds (down about 25%) and Basis Capital Alpha Fund (filed for bankruptcy). For more on the topic, see our Huffington Post blog:

www.huffingtonpost.com/james-berman/know-when-to-hold-em_b_64217.html

The economy is now at a crossroads, with recession threatening and the credit markets in disarray. To the domestic news watcher, the story looks grim: subprime defaults, layoffs, record oil prices and the worst real estate collapse in 20 years—perhaps ever.

The unpublicized side of the story is the tremendous global boom that is carrying China, India, Russia and Eastern Europe into unmatched prosperity. The falling dollar is making our exports attractive to euro and yen-rich buyers. For the first time ever, a true middle class is gaining traction in China and becoming a large consumer of our goods and services. The Wall Street Journal reports that U.S. exports rose 2.7% to a record $137.68 billion in July and added a half a point to GDP growth. Our trade deficit is enormous. This, however, is increasingly due to our voracious consumption and not to the rest of the world’s lack thereof. Over time, a weak dollar and continued emerging market growth should bring the trade account back toward balance.

The flip side is that inflation will likely return as China ceases its disinflationary effect. The Chinese consumer will grow richer and more acquisitive and this will boost prices worldwide. The cost of production in China will increase dramatically as wage pressures grow. This will
defuse the dangerous protectionist rhetoric here at home but will also spur costs. The same weak dollar that boosts exports should also stoke inflation and cause bond yields to rise.

In the past quarter, our rotation to large-caps finally paid off as the mega-cap multinationals led the way. Our large positions in cash and bonds also were helpful as we were able to take advantage of the volatility to invest after market tumbles. Less successful were our underweight positions on energy, a sector we cut too early, causing us to miss out on continued gains. We still feel, though, that a looming recession puts energy in a precarious short-term position and that our decision will ultimately be vindicated. What looks interesting is the troubled high-yield bond sector. As the economy slows, there could be some selective buying opportunities amongst the fallen.

Our view is cautious but not cataclysmic. We believe the economy will slow sharply without collapse. To paraphrase Mark Twain, the rumors of its death have been greatly exaggerated.

July 1, 2007

Dear Investor:

Although large-caps finally are asserting their presence, the gap between large and small stock valuation remains vast. Whether by price to cash flow, price to earnings (prospective or trailing), or discounted cash flow valuation, large stocks look like the best buy of any asset class since…well, since large stocks at the end of 1994. The more asset classes change, the more they stay the same.

Why do asset classes seem to go in and out of fashion like wide ties or short hemlines? The truth for every asset rally begins with a seed of economic truth—but gets sustained by the psychological need to conform, a phenomenon well-known to every fashion designer.

In 1994, interest rates were rising in staccato steps and the market was rolling over. A higher rate climate was a rude awakening. But it was clear that large companies (those that were less dependent on capital markets and had better access to low interest lending) would be better prepared. This, combined with their reasonable valuations, led to a reallocation to the large-cap sector, which in turn moved those stocks, which in turn juiced the returns of large-cap funds—which in turn led to new money from investors encouraged by past performance.

The cycle became a virtuous one, perpetuating itself in that peculiar way that markets do. A few years later, the original economic catalyst was gone: the interest rate outlook had stabilized. If anything, rates looked to head lower due to controlled inflation. Strangely, large-cap stocks continued to head higher even though their valuations were now expensive and their story less interesting. They had come back into fashion and were flying off the rack. They were the stuff of cocktail party banter. It became gauche to be seen without them in your portfolio and money managers who were highly suggestible joined the crowd. The bubble was in full gear. Meanwhile small-caps were out, as chic as bell-bottoms in the eighties.

It wasn’t until 2000 that markets collapsed and then reversed. In the wake of the great crash of 2000-2, interest rates were plummeting as the Fed desperately tried to reflate the economy. The economic reality now heavily favored smaller companies. Once again, the seed of a rally had been planted, only to lead to the place we are now, where those small fry who once looked so promising are expensive, overbought, all-too-fashionable and heading into the head winds of higher interest rates.

Large-caps should hold up much better in a market break than small-caps. They also should lead the way for the next several years. This is why, despite shedding most of our small-cap and emerging market allocations, we’re holding onto most of the large-caps. We don’t know if history will look back upon higher rates as the economic reality that began this new cycle. But we do know that large companies are starting to come back into style.

April 4, 2007

Dear Investor:

We believe the chance of a recession has increased as the recent subprime shakeout points to more real estate pain ahead. As lenders tighten standards in the wake of defaults (classically closing the barn door after the horse has bolted), the virtuous cycle that formed the bubble for the past ten years has officially reversed: Credit tightening will lead to more defaults, which will lead to lower home prices, which will lead to more credit tightening and so on. If domestic GDP does decline somewhere in the next two or three quarters, international growth should still keep global GDP above 1%, which would be bullish for equities against a backdrop of low bond yields. We continue to favor large cap equities and think they are the only cheap asset class in the world.

The question often arises as to why we don’t just sell everything and sit in cash if we think that the economy looks shaky—in other words, why don’t we try to “time the market”—and then buy again after everything looks clear. This is an excellent question and one which we must periodically address. Aside from the negative tax consequences, transaction fees and other “hidden” costs of engaging in market timing, there are far more weighty and fundamental reasons why we don’t believe in this strategy:

1) “Market timing” strategies have very poor track records. Statistically, market-timing strategies are sub-par performers and very few, if any, have beaten their benchmarks over sustained periods of time. This is due to the fact that short-term market moves are inherently unknowable. There is no one who can tell you which way the market is headed tomorrow and if someone claims to, I’ll show you a charlatan. Our strategy is one of investment, not trading, and true investors are agnostic to short-term market moves.

2) There is no short term link between stock market moves and economic conditions. Because the stock market is what’s known in finance as a “discounting mechanism,” it’s often reacting to perceived risks that are many months hence and discounting those future events to the present. For example, Coca-Cola stock is often zigging or zagging on any given day based on what market participants estimate Coke’s cash flows will be a year or two down the road. What is already known is not interesting to markets. The market only cares about uncertainty (i.e. the constantly fluctuating and myriad possibilities of the future). Sometimes this is a difficult concept for investors to understand, especially when they see the market react in immediate fashion to instant news, such as a terrorist bombing or a change in bond yields. It follows, they think, that economic conditions would cause the market to track it in perfect lockstep, but this couldn’t be further from the case. The market only prices in perceptions, and perceptions are constantly fluctuating. This leads to real-time market moves that have nothing to do with current conditions. A perfect, common example of this phenomenon is what we’ve named the “upside-down cake.” This occurs when a company announces a positive earnings “surprise,” but the stock goes down once the news is announced. This occurs because the positive earnings growth was not really a surprise after all. It had actually been discounted by the market long ago, causing the stock to have risen prior to the announcement. Once the news becomes reality, the stock sells off because the surprise is now gone (note that we are not talking about insider trading here, but rather just the market moves that come with justified and completely legal apprehension of future events).

3) The stock market often sways to irrational extremes, of both panic and exuberance. Thus, market prices are often the result of irrational emotionalism, not fundamental reality. The school of thought that examines this phenomenon is known as behavioral finance, which directly refutes the “efficient market hypothesis,” a theory that was solidly debunked in the wake of the Internet stock collapse. Behavioral finance tells us that stocks and fundamentals get out of whack over the short term but track each other pretty well over the long term. Nearly every legendary value investor from Charlie Munger to Warren Buffett to Bill Miller believes in some version of behavioral finance; otherwise, they would never believe they could buy a stock at a discount to intrinsic value. It bears repeating that nearly every legitimate study has shown value investing to be the most successful technique over the long-term, with returns that exponentially eclipse market-timing. We believe this is so because value investing counteracts human nature instead of conforming to it—something which is psychologically impossible for most market participants. Thus, value investors believe that often the best time to buy stocks is when people are overly fearful and sell when people are overly confident.

4) In markets, it’s much harder to know when something will happen than to know what will happen. For example, we have written for some time that real estate would implode. We just didn’t know when. As a result, we were more than two years early with this prediction. Of course, as the old saying goes, even a stopped clock is right twice a day. In other words, if you’re too far off about the timing of the event, it’s the same as being wrong. This is true. But as an investor, you can be off on timing by two or three years and still generate very good investment returns through your hypothesis.

This is exactly why buying options is such a dangerous strategy: it requires not just a knowledge of what, but when—and not just when, but precisely when. The trader must time it perfectly, especially if betting on a return to rational pricing. If not, disaster ensues. As the old trader’s saw goes: “Markets can remain irrational longer than you can remain solvent.”

An investor, however, has the luxury of being off on timing and still making money. Here’s an example: If we determine stock XYZ to be 20% undervalued, and we believe XYZ will grow its earnings at 6% annually for five years with a 2% dividend yield, we can do an approximate job of calculating its five year return. Assuming the economy runs on an even keel, the 6% earnings growth and 2% dividend are reasonably predictable, especially if company XYZ is in a stable industry like consumer staples. The big wild card is the discount to its intrinsic value. Even if we’re certain the stock is undervalued, we have no idea when the value gap will close. Since stocks and fair value eventually track each other over the long term, we can assume the gap will close. Whether it takes two years, three years, five years or ten depends on investor psychology—something even less predictable than the economy. If the value gap on stock XYZ closes in two years, the annualized return in our example would be approximately 20% (6% earnings growth + 2% dividend yield + 12% annual compounded increase attributable to reaching intrinsic value). If the fair value on stock XYZ closes in three years, the annualized return would be 16%. Five years would be 13%, while ten years would be just over 10%. This shows how the value investor can know what will happen (the stock reverts to its intrinsic value), but not when (the precise point in time when the stock reverts). The amount of the return will be inversely proportional to the amount of time it takes. But the value investor will still do reasonably well, even if off by a decade.

We follow the above strategy. Instead of timing the market, we prefer to rotate money from overvalued sectors and stocks to undervalued sectors and stocks in a process known as “tactical rebalancing.” This strategy is largely agnostic to when something will happen, but is very focused on what will happen. By rotating from overvalued to undervalued, we try to capture the reversion to value that boosts returns in our XYZ illustration (and conversely avoid the reversion to value by overvalued assets that would damage returns). An example is our ongoing rotation from the expensive small-caps to the forsaken large-caps. Even if this gambit’s timing is off by a couple of years, we still can do well.

January 8, 2007

Dear Investor:

A sudden, disconcerting bullishness has thawed Wall Street like global warming on a winter’s day. After several years of bearish sentiment during which stocks climbed a wall of perpetual worry, most analysts are betting on good gains in the coming year. Contrarian as we tend to be, this leaves us increasingly concerned. As you know, we’ve been very bullish on equities for the past few years. We are now considering retracting our horns. While we believe large stocks will continue to appreciate based on their compelling valuation, the rest of the cap-weighted spectrum is in danger of a major correction.

The indices have done exceedingly well in the past quarter. The Dow has risen 1,000 points in the past four months, a gain of nearly 9%. The large stocks have led this recent rally, with the Morningstar Large Growth Index beating the Small Cap Growth Index 4.27% to 3.54% during the fourth quarter. Earnings projections for 2007 are rosy to the point of dangerous.

Though 10-yr bond yields have certainly come up in the past few years (rising over 130 basis points since mid-2003), long-term yields are still artificially depressed, resulting in an inverted yield curve. We believe this distortion is caused by the ravenous purchase of our bonds by China which buys without regard for return or risk due to their dollar peg—a topic we have written about at length in prior letters.

Artificially low yields fueled the spectacular housing bubble, which is now deflating as the dollar-yuan trading band is gradually widened. The psychology of the housing market has finally changed from euphoric to dyspeptic, with panic next on the agenda. But the low yields that fueled housing are not much changed. Only the direction of the money flow has changed–this time back to equities. This musical chairs liquidity cycle, where the easy money continues to bounce from sector to sector will continue for some time. Eventually the music—however melodious—stops. One sector finds itself without a chair. The game goes on. At some point, the musicians pack their instruments and go home.

No one knows when that time will come. As China continues to widen the band on their currency peg, however, their buying of bonds will contract. The yield curve will normalize and money will become expensive again.

The implications are that real estate, high-yield bonds, small-cap stocks, mid-cap stocks, and commodities will all look absurdly overpriced against a backdrop of rising rates, while large-cap stocks will continue to outperform due to discounts to intrinsic value and lesser borrowing needs.

In preparation, we have all clients heavily overweighted in the large-cap sector, relative to their strategic benchmarks. We have also reduced small-caps to the point of residual positions and have reduced high-yield bond exposure by swapping from the Loomis Sayles Bond Fund to the John Hancock Strategic Income Fund where appropriate. Finally, we will be looking to raise cash on rallies, given the attractiveness of current money market yields for short-term periods. The music is lovely, but it’s bound to fade.

October 1, 2006

Dear Investor:

Real estate is once again something you live in. Now that year-on-year median home prices are down nationwide, the flippers, speculators and touts are gone. Replacing them are the debtors, the foreclosed, and the remorseful. Two questions emerge: 1) How bad will this get? 2) Will the rest of the economy go with it?

The answer to the first is very. While people who bought primary residences with fixed rate mortgages will do okay in the long run—even if they did buy at the top, in August of 2005—those who gambled on second-rate investment properties or adjustable-rate mortgages will suffer dearly. Denial still defines the discourse, just as it did when Nasdaq started to crack in early 2000. Many said the damage would be temporary and short-lived. That punditry couldn’t have been more wrong or less helpful. The same situation is developing now, as promoters of the industry try heartily but ineffectually to save a sinking ship. While prices remain sticky due to sellers holding out for boom-time prices, relentlessly rising inventories tell the real story. The National Association of realtors reports that the number of unsold homes has reached 3.92 million, the most since the housing recession of 1993. This number is a recipe for real estate disaster and suggests that the bear market will be deep and long.

Will the national economy go the way of housing? The answer here is more complicated. Though housing has comprised a large share of GDP over the past few years, the damage caused by its decline is likely to be shallow and short. That’s because the economy is firing on two colossal cylinders—strong employment growth, and unprecedented global growth. More, a third is about to be added: corporate cash.

Corporate balance sheets are the most flush they’ve ever been. That money is starting to flow through the economy, either through buybacks, dividends, or spending. As cash is shed from corporations over the next 12 months, GDP growth should get at least a 100 basis point boost, replacing more than half of what housing takes away. Netting out the additions and subtractions would pull down GDP from its 2.6% present level to approximately 1.5%, well below J.P. Morgan’s 2.5% annualized estimate for the next three years. GDP at these levels would not spell recession, but it would mark a slowdown. Could the slowdown ripen into recession? Yes, but unless corporate spending fell off a cliff, it would be relatively mild.

The doomsday scenarios of depression and cataclysm being trumpeted are unlikely—and if they occur, would result from something far worse than this housing bear. In such a scenario, the Fed would lower rates, which would save the current economy, but would foment yet another bubble in some asset class as yet unknown.

July 1, 2006

Dear Investor:

With the Fed Funds Target Rate at 5%, the easy money is gone. No longer can anyone buy a home with a 3% adjustable rate mortgage or cash out half their home equity for kicks. Mortgage rates are closing in on 7% and look to move higher. Some of the results are in: The real estate market is entering a secular bear market. The stock market has corrected nearly 10% from its 52 week highs, as bond yields begin to compete for investor attention. So are both asset classes, real estate and stocks, doomed for the foreseeable future? Signs point to yes for real estate but no for stocks—the different prognosis is due to different intrinsic values.

Value investing is based on the premise that the price of any asset—be it car, diamond, house or bond—will revert to its intrinsic value over time. Behavioral finance teaches us that during periods of euphoria (i.e. real estate) or fear (i.e. stocks), people bid the price of assets way above or below their intrinsic value. By buying an asset at a price which sits below its intrinsic value (also known as fair value), an investor can make good money as the price rises to fair value over time. But by buying an asset at a price above fair value, an investor is destined to lose money—even if they make some in the short run (i.e. Internet stocks in 1999). The obvious question is, then, how an investor determines the intrinsic value of an asset.

There are many techniques for determining intrinsic value. The one made famous by Warren Buffet and employed by most successful value investors is a discounted cash flow valuation. This is based on the premise that the intrinsic value of any asset is the sum of its future projected cash flows, discounted back to the present to account for the time value of money. For example, the intrinsic value of Coca-Cola stock is quite literally the discounted value of its future cash flows per share. Morningstar uses this method to estimate that the current fair value of Coca-Cola stock is $54/share, way above its current price of $42. Obviously, this method is dependent on the projections an investor makes about future cash flows, estimates which are inherently difficult. That caveat aside, we estimate that the Dow is currently trading at least 18% below its intrinsic value based on future cash flow projections. This implies a fair value on the Dow around 13,000, far above its current 11,000.

Today, real estate looks far more dismal with an intrinsic value approach. Estimating fair value for a piece of real estate is different from a stock, though it still operates on the same premise, that the value of any asset is based on its projected cash flows. The median price for a two-bedroom apartment in Soho (New York’s priciest neighborhood as of the first quarter, according to the New York Times) is $2,025,000. This would run approximately $12,468/month in carrying costs, assuming a jumbo mortgage and a $1,500/month common charge. If investors were to purchase this apartment to lease out at the market rate, they could expect to get roughly $7,495/month in rent (i.e. cash flow). If we compare the rental income to the total purchase cost in monthly terms, we see that there’s a wide disparity, with the purchase carrying cost 66% above the rental cash flow. Even after adjusting for tax benefits, annual increases in rent and yearly capital appreciation of the property, the carrying cost exceeds the expected future rental cash flow by a wide margin. This implies that the fair value of a Soho apartment is way below its current market price. There are only two ways this can get resolved over time: by falling prices or rising rents, or probably both, with the emphasis on the former.

The bottom line is that stocks, especially large-cap multinationals, look as cheap as they have in twenty years while real estate, especially speculative property, looks more expensive than ever. If you wish to avoid buying high and selling low, favor stocks over real estate for the foreseeable future.

April 11, 2006

Dear Investor:

The market often catches a cold, as they say, but what if it catches the avian flu? The bird flu has become, like terrorism, the world economy’s persistent bogeyman. When dealing with an amorphous but potential cataclysm like a global pandemic, it’s important for investors to evaluate the risks and decide if tactical changes are warranted.

We’ll start with the investing axiom that changes are rarely appropriate for problems that have already hatched. The market usually prices in such problems and the possibility of gaining an advantage by shifting assets in response is limited. Once a problem becomes known, its chances of causing hardship become discounted by the markets. Bird flu is already ubiquitous—a well-advertised problem that’s reached beyond Asia to Europe, the Middle East and Africa. As such, it has already reached the collective consciousness. The question is whether the markets have fully discounted an economic disaster caused by a pandemic of avian flu. The answer is no.

Currently, the avian flu strain that’s deadly to humans is H5N1, a mutation of prior types that claimed its first human victim in Hong Kong in 1997. The virus can be spread from bird to bird and from bird to human and, in a very restricted way, from human to human, but there is no conclusive evidence (yet) that it can be passed from human to human in the type of multiple transmission needed to cause an epidemic. The current mortality rate of 50% would likely decline if the virus were to mutate into an easily transmissible form (because the microbe would ironically evolve to better preserve its host). Expert predictions of worldwide deaths range from 2 million to 50 million. Antiviral drugs like Tamiflu would be of limited use and there is not yet a viable vaccine; though, according to the CDC, a few are in development.

The virus is likely to reach North America and the U.S. soon. It would not be surprising to read about a case too close to home any day now. According to experts, we could also see the virus reach full human to human multiple transmission in the next twelve months.

Clearly, if the virus were to cause fatalities at even the lower end of its projected range, it could cause enormous economic dislocation. The world is statistically due for a pandemic. Such a massive death toll is not something the developed world is used to. In the worst case scenario, global travel would be greatly curtailed, if not shut down. Businesses dependent on travel such as restaurants, hospitality and airlines would be devastated. Energy stocks, which are priced for perfection, would swoon, and stocks in general would be caught in a downdraft of ugly proportions. Stocks would recover, of course, as the pandemic burned out, but the economic consequences could last a long time.

Given this bleak scenario, why would one wish to own stocks at all? The primary reason is because the timing and severity of the avian flu are inherently unknowable. There could be a terrible pandemic starting tomorrow that could wipe out 1% of the world’s population, or the virus could burn itself out before causing large-scale human casualties. The secondary reason is that a full-scale disaster, though by no means priced fully into the market, has been discounted somewhat, and thus a pandemic would be no surprise. When disasters are expected, their eventual toll on markets is muted, especially when the disaster evaporates without reaching its potential (witness Y2K).

The ultimate reality of the bird flu comes down to a classic race between technology and nature. If the virus is able to secure a significant human foothold before the vaccine arrives, chalk one up for the virus. But if even an imperfect vaccine can be developed in advance of the flu, the disease will become less of a threat.

We’re not willing to place significant bets on the winner. Our admittedly conservative strategy in such a situation is to identify potential sectors that can outperform in such a cataclysm and increase exposure there, so long as those sectors would be good long-term investment prospects anyway. The only asset classes that would likely do well in a pandemic would be healthcare stocks (especially pharmaceuticals and biotechs with significant vaccine/antiviral franchises), government bonds (including foreign sovereign debt of financially strong countries) and, perhaps, precious metals. Of those, only the first two make sense as long-term investment options. Some other sectors might have qualified gains in a pandemic, such as online retailers, selected telecom providers and couriers.

We are overweight healthcare in client accounts anyway, mainly for demographic and valuation reasons, even before regard for avian flu. We are underweight bonds due to our macro view on rising rates, but are poised to reverse, especially if rates were to come up significantly. We also have weightings in telecom, mainly through technology sector funds. In the average balanced account, our combined healthcare and bond weighting exceeds 35% and thus could provide some buffer. Ultimately a bond position serves as the best defense, since it amounts to a call option on equities if the market takes a big hit. In such a situation, we would be able to quickly switch from bonds to stocks, as we did in the wake of 9/11.

Hopefully, this will be our last letter about the bird flu. If humans win the race, that would be a great victory in the history of epidemiology. We’ll close on a sincerely optimistic note. There has been no time when the world has had such advance warning of a potential pandemic, when health agencies have had such sophisticated real-time information on a spreading disease, and when advanced diagnostics and potential vaccines have been developed with such heartening speed. Fifteen years ago, the world would probably not have even known an avian flu was brewing at this stage. It’s the 21st Century: though hardly prepared, we are alert and aware. Technology could very well tip the scales in our favor.

January 4, 2006

Dear Investor:

The yield curve inverted recently, with the 2-yr rate rising a basis point or two above the 10-yr. Often, a yield inversion predicts recession. Clearly, something is up: If people are willing to lend money for the same amount for both two years and ten years, they certainly don’t expect inflation. They probably expect deflation, or at least disinflation—a slowdown in the rate of inflation and a common characteristic of recession.

It wouldn’t be surprising to have a recession after so many quarters of strong GDP growth north of 3%. In classic cyclical terms, we’re due for one. This would also be expected as the massive monetary and fiscal reflation of the past three years simmers down. But if the yield curve inversion is followed by recession, this will be coincidence, not prediction. This inversion has many components, but only one of them is disinflationary.

If we look closely at the yield curve, we see it is less inverted than “sagging,” with 5-yr and 10-yr rates less than both 2-yr and 30-yr rates. In addition, the 3-mo and 6-mo rates remain below the 2-yr. This is far from a classic inversion and more of an isolated stretch of yield distortion which runs through the sagging middle—along the 5-10 yr range. If investors expected classic deflation, they would bid the yield curve into classic inversion, with 3-mo rates above 10-yr rates and, perhaps, even above 30-yr rates. Instead the curve sags with the weight of its own albatross, along the center of the curve.

We would argue that this distortion is caused more by Chinese buying of our Treasury bonds, without ordinary concerns of price and risk, in order to peg their currency (see our comments in The Motley Fool last week). We’ve written in the past how these artificially low yields were causing the housing bubble by perpetuating access to cheap money. Interestingly, as China finally began to loosen the peg a few months ago (and hence slowed their purchases of our bonds), long rates crept up and the housing market started to sputter. Today, the housing market is indeed running into serious trouble, with inventories of unsold homes at a 19-yr high and declines in many overpriced markets.

That the yield curve is distorted in the middle is more evidence for this China effect, since such buying is concentrated along the middle and has the most price effect in that range. Again, it points to a buyer purchasing without regard to price and risk—the China effect. A rational approach to deflationary hedging would instead invert the curve normally.

There is no doubt in our mind that the yield curve is thus operating at many levels, reacting to slowing inflation but also to the China effect. It’s truly a polymorphous inversion, with many perverse repercussions.

Inflation is, in fact, slowing. This is mostly a result of the Fed’s effective tightening cycle—a final accomplishment to solidify Greenspan’s extraordinary legacy. This is good news for equity investors, since a modest inflation rate and current reasonable valuations form a fertile atmosphere for stock appreciation. We are thus overweighting equity allocations. Even Japanese equities, which appreciated over 20% in the past few months, still look reasonably priced. We also continue to keep bond duration very low. Now that the Fed has almost finished raising rates, the short end of the curve looks attractive while anything beyond five years courts major risk. Especially as China continues to loosen the dollar peg, long-term yields should trend upwards.

A final note: the Euro, at $1.20 finally looks like a good buy again versus the dollar, especially as U.S. short-term yields plateau. Much of the impressive strengthening in the dollar last year was due to rising short term rates. We are looking to further overweight foreign sovereign bond positions (through the John Hancock Strategic Income Fund and the Loomis Sayles Bond Fund) in anticipation.

October 11, 2005

Dear Investor:

Japan and Germany have followed the same bizarre trajectory over the past seventy years: fascism, then dynamism, then brooding malaise.

Both countries have been mired in state-directed sclerosis for the past decade, unable or unwilling to set their economies free. The caretaker economies of the post-war years served their respective nations well, creating infrastructure and export machines. Unfortunately, none of this did much to create a flexible economy, one that could stoke growth in the wake of financial crises, such as Germany’s lengthy integration or Japan’s stock market collapse.

In the past year, their paths have finally diverged. Germany has crawled into the economic equivalent of the fetal position, first splitting on the crucial vote of Chancellor while unemployment blows past 11.4%, then arriving at a bland coalition which puts Angela Merkel in figurative charge without any mandate for change. Japan, on the other hand, has decisively cast its lot with Prime Minister Junichiro Koizumi, one of the most impressive and truly “radical” world leaders to take the stage in some time. Koizumi has pressured Japan to deal with its bad loan problems, forcing banks to write down and restructure defaulted debt. Until recently, a defaulting borrower would only be shoveled more money by most Japanese banks, just to forestall the inevitable classification of “default.” Whether this was fueled by misplaced cultural pride or lack of Ben Franklin as a founder is unclear. That it turned the allocation of scarce economic resources into a burlesque is beyond dispute.

Japan had so many problems in the nineties that it became a mirror image of the United States: secular bear markets vs. bull markets; stigmatizing deflation vs. moderate inflation; stunted capital markets vs. the most dynamic the world had ever seen. But Japan never let go of its most prime assets: superior infrastructure and technology. Now that the banking system is well on its way to real solvency, this should allow it to jump quickly into economic pole position. Domestic consumer demand will always be a problem for Japan, with its aging, slow-growing population. China, however, could be its savior, as that nation’s success creates vast opportunities for Japan’s value-added businesses. The efficiency of Japanese manufacturers is legendary. After many years of decay, the manufacturing base is gaining steam. Just today, the Wall Street Journal says that the “economy of Central Japan’s industrial heartland is booming.”

The Japanese stock market has begun to price in this recovery, with the Nikkei trading above 13,000 for the first time in four years. Japanese stocks are benefiting now, but all multinationals will profit if Japan truly becomes a growth engine. If the Nikkei does march upwards, it will have a long way to go to reclaim its peak. The high on that market was 38,915, back on December 29, 1989.

July 5, 2005

Dear Investor:

A recent New York Times article has cited a prediction of a 75% chance of a financial crisis in the next five years. This type of warning is akin to the recent 60% prediction that a WMD will be used by terrorists in the next ten years: probably true and of very little help.

If you could tell when or what the crisis might be, it would offer something. But a 75% chance of an unspecified disaster at an unspecified time—like most things full of sound and fury—signifies nothing.

The prediction likely understates the probability because financial crises are common, cyclical, normal and inevitable. We’ve had many worldwide financial crises in the past decade: the Asian currency collapse, Long Term Capital Management, the Internet debacle, the worst bear market since the Great Depression, Enron et al. This is not an exhaustive list.

There’s no doubt we will encounter another crisis in the coming years. But financial crises are like bike messengers in Manhattan—they come from unforeseen directions. Without knowing the type or timing, protecting yourself against a crisis is tricky. The best protection is a well-diversified, balanced portfolio, adjusted to the client’s preferences, time horizons and risk tolerance.

Such a portfolio is most likely to withstand any crisis relative to that particular client because it takes the worst-case scenario for that client into account. A portfolio for a retired, older client, for example, with 30% equities and 70% bonds, is unlikely to be derailed even by an equity collapse. In addition, the equity position, though small, will provide an effective hedge against inflation, especially if combined with inflation protected bonds. At the other end of the spectrum, a 100% equity portfolio designed for a young, working client is exposed to equity conditions in any given short term period, but is likely over many decades to provide an 8%-10% annualized return and a real return over the inflation rate of 5%-6%. Both clients are reasonably protected against disaster, not because their portfolios incorporate risky, complex hedging strategies or foreknowledge of the next crisis, but because they have been tailored with diversification, asset allocation and common sense.

The press is always alarmist. But this recent New York Times piece, cloaked behind a mantle of respectable admonition, is the sort of yellow journalism to make the tabloids proud. It trots forth a whole list of problems with economic ignorance.

Since successful investment is predicated on separating the red herrings from the real problems, it’s time to take on two of these issues and assess their validity.

Chinese Purchase of Treasury Bonds: Though the press (and the NYT specifically) portrays this as a problem, it’s not—at least in the sense that the Chinese are the purchasers. The populist xenophobia that surrounds this issue is remarkable for its lack of economic aptitude. That the Chinese are lending us money does not make us any more dependent on the Chinese than does it make Donald Trump dependent on his creditors. As any scholar of financial history knows, it’s very much the reverse: a creditor is utterly beholden to its borrower, on whom it has to depend for payment. To the extent that China wishes to get paid, it must protect our economy, which has become its golden egg. This type of dependence breeds better, not worse, global security.

In addition, a borrower (once the terms of the loan are determined) should not care who its lender is. It must repay the debt, be the lender Chinese, Croatian, or Californian. Similarly, a homeowner does not care about its mortgage lender, only its mortgage terms. But if that homeowner buys a bond (becomes a lender), then it definitely should care to whom it writes the check. As readers of our letters know, we do feel that the Chinese purchase of bonds is helping foment our real estate bubble by keeping rates artificially low. But this is a question of currency policy, not the nationality of the bondholder.

Growing Deficits: This is not a red herring, but a real problem. The press is right to send up the warning flare. To the extent that debt obligations grow beyond the reach of GDP, interest rates will rise rapidly, undermining growth and devastating long term lenders (the Chinese, not us, should be worried!). But the press pays little attention to the fact that reflation of the economy has thus far worked: GDP growth is strong, unemployment is at 5.1%. From Alexander Hamilton to John Maynard Keynes, it has been known that governments can (and should) run deficits to spur growth. The question becomes whether such increased growth can eventually pay off the rising debt load. If it becomes self-propagating, yes. If not, no.

Despite the doomsayers who predicted otherwise, signs point to yes: payroll growth is strong, tax revenues are exceeding budget estimates and small business creation is healthy. On the other hand, the government is spending like a drunken sailor on a year-long bender. It’s right to spend madly to prime the pump, but wrong to spend madly otherwise. Interest rates probably will rise substantially and we’ve built this expectation into our strategy, keeping bond duration very low across client accounts.

We wish we could tell you we had a miraculous hedging strategy that would protect you against any financial crisis, but we can’t. If someone tells you they have such a magic bullet, run the other way. No such thing exists. A “risk-free” strategy is a fantasy. Some high-profile managers (i.e Long Term Capital Management) have thought they found such a miracle, only to realize too late that there really is no free lunch. On the other hand, smart asset allocation and diversification, along with a discerning eye to separate real concerns from red herrings, provide the best protection against crisis—from any direction.

April 15, 2005

Dear Investor:

Wall Street is known for big divides—the wealth of CEO’s and that of their employees, for example.

Another type that pops up from time to time is the relative performance of different sectors, as for example, the current divergence between large caps and small caps. Large “cap” stocks are companies with large market capitalizations, generally defined as exceeding $5 billion, while small cap refers to companies with capitalizations below $1 billion.

In the past five years, the 5-year annualized return on the Morningstar Large Cap Index has been -3.64%, vs. +9.01% for the Small Cap Index. Periods of cyclical divergence between large caps and small caps are common. In the five years leading up to 2000, the large trumped the small. If there’s one truism in markets, it’s that reversion to the mean is inevitable. In other words, the days of small cap outperformance are numbered.

The cyclical nature of such divergence necessitates periodic rebalancing to move dollars from sectors of overvaluation to ones of undervaluation. At the end of 2004, after years of overweighting small caps, we started reallocating assets from small cap funds to large cap ones. Year-to-date the small cap winning margin has continued, proving how hard it is to precisely time cyclical reversions. But the idea is not to get the timing perfectly right (though that would be nice!); rather, the goal is to get the timing reasonably right.

The relative undervaluation in large caps has become very compelling. Large companies often trade at a premium to their small cap peers due to several advantages: better reliability of earnings, greater access to capital markets, economies of scale, etc. In the current cycle the premium has reversed, leading to outsized multiples for tiny companies. The historical advantages of a grand scale have been negated by scandals and headline risk, and big multinationals have seen the market abandon them in droves.

This abandonment creates a superb opportunity for long-term investors. Many of the large Dow 30 stocks have been temporarily felled by bad publicity or earnings disappointments. A list of blue chip stocks today reads like a scandal sheet. The profound global growth rationale for owning multinationals has been forgotten. But these attitudes are as cyclical as their resulting divergences. In the words of the Roman poet Horace: “Many shall be restored that now are fallen and many shall fall that now are in honor.”

Catalysts have now appeared for a resurgence of large cap fervor. The weak dollar benefits large multinational exporters. The recent rise in interest rates will be less of a problem for big, well-capitalized companies that do not need to borrow, or can borrow on more favorable terms.

We are now markedly underweight small caps and poised for the cyclical reversal. Of course, divergences like this can continue a surprisingly long time and way past the point of rationality (i.e. tech outperformance in 1999). But the question for small cap bulls is not if but when.

January 4, 2005

Dear Investor:

It wasn’t long ago that the world suffered the greatest market collapse since the Great Depression. Though we are far from the index highs that marked the last peak, markets have rebounded to a point where people seem to trust them again—perhaps a little too much.

It’s remarkable that the new issues market is booming again, and that gamblers, salivating for the next IPO, are once again calling the same brokerage firms that stuck them in Worldcom and Pets.com. Is this human nature at its worst or finest? Then there are those who have foresworn Wall Street altogether, convinced that the problem was equities in general, not their own appetite for speculative stocks. Both those who learned no lesson and those who learned the wrong lesson will be vastly disappointed over the next decades. Markets will continue to suffer setbacks—even collapses—and speculative stocks will get shown the door from time to time. Over time, however, equities will continue to be a superb investment for those who pick well-capitalized companies selling at discounts to their intrinsic value.

In the meantime, the speculative frenzy pouring into certain sectors looks just like 1999. If you ask these people why they are buying a stock that has no earnings and no definitive prospects, they will give a very nineties answer: because it keeps going up. The power (or impotence) of the human mind to convince oneself that this time I’ll get out in time, this time I won’t lose it all just shows that people ultimately believe what they want to believe.

Just as the intense pessimism in the summer of 2002 meant markets would (despite all intuition) soon turn higher, December’s complacent optimism might bode poorly for the near future. In 2005, long-term interest rates should trend higher. The yield curve is starting to flatten as long rates remain artificially suppressed relative to short rates. This cannot continue and is likely to get resolved as long rates surge higher. Such a scenario does not augur well for long-term bonds, the housing market, or for companies that need access to the fixed income market. All are likely to suffer major setbacks as the 10-year bond yield passes 5%. Investors who remain in short-term bonds and well-capitalized stocks are likely to do better than most and will be able to swap into longer term bonds as rates rise. TIPS are starting to look slightly overvalued as investors have bid their prices up in anticipation of inflation. We would not add new money to them at this time. Over the past quarter, we trimmed the overvalued energy and small-cap sectors and have swapped into large-caps. Large-cap stocks, often multinationals, are less dependent on the bond market and can take better advantage of the declining dollar through their exports.

October 1, 2004

Dear Investor:

Some have said that the U.S. economy is a Blanche Dubois economy in that we depend on the “kindness of strangers.” This is a reference to the continued purchase of our Treasury bonds by foreign investors, the results of which are relatively low yields amidst deficit financing. The reality is that such strangers are less inspired by kindness than by fear and greed.

The implications of this distinction are very bearish for long-term bonds. The safe haven play that has continued to pour money into fixed income has kept yields artificially low for some time.

Foreigners have bought our bonds because they have made money there. But this cannot last forever, and the bubble in bonds is now of massive proportions. As deficits spiral out of control, the implication is for higher yields and higher inflation. Fiscal policy will remain expansionary whichever way the election turns. Once strangers see themselves losing money in our bonds, they will respond to fear and sell—and kindness will be the last thing on their mind.

The recent bump up in Treasury prices has given false solace to long-duration bondholders. This is probably the last opportunity for such holders to cut and run. It should be noted that in spite of the recent bond rally, the trend in yields is uphill (when yields rise, bonds lose value). When we wrote of the bubble in bonds in Barron’s on July 1, 2003, the 10-year Treasury was yielding 3.20%. Yields are now at 4.19%. Bonds have thus lost significant value over the past year. This will continue.

One call we’re less proud of was the price of oil. Writing recently about oil when NYMEX crude was at $37/barrel, we talked about Malthusian mistakes. In the short term, it has looked more like our mistake than anyone else’s, as oil has shot to a record $50/barrel.

There are many good arguments for continued high oil prices: low global reserves, low refinery capacity, low incentives for changing that status quo, and outsized demand. But eventually, any commodity that trades at a consistently inflated price inspires change, even if such changes take years. This change can come in the production of competing energy sources, or it can come in the form of another imbalance such as an oil-inspired recession that reduces demand. If a recession is the result, the irony is that bond yields would fall again before eventually rising. Oil is too difficult to predict in the near term. In the long term, Malthus will once again retreat as new technology improves supply, but waiting for it could take the patience of Methuselah.

The only sure bet is to never rely on the kindness of strangers. Nor to rely on their fear and greed.

July 1, 2004

Dear Investor:

The greatest mistake an investor can make—besides punting a life savings on anyone’s idea of a “hot tip”—is to assume that any trend, bad or good, will continue. This error might best be explained by reference to its most famous exemplar, Malthus, the pedantic 18th century English economist who argued that there would never be enough food to feed the world’s expanding population.

Malthus looked at a nation with rising birth rates and static agricultural production and assumed those two trends would always continue: namely, birth rates would shoot to the moon while people would still thresh their wheat by calloused hand. Of course, Malthus was wrong on both counts. Not only did birth rates slow as England grew prosperous, but that same prosperity inspired unimaginable technological advances in farming.

A more modern example of a Malthusian Mistake is the clamber for Internet stocks in 1999. Once the trend of going up and up was established, very few could see that the trend could get derailed by an increasing equity supply and a lack of underlying profit.

Sometimes a Malthusian Mistake takes on a false hue of sophistication—as when it’s reflexively applied to a trend reversing itself. This contrarian error fails by assuming that a trend will, without doubt, turn on a dime—an equally dangerous assumption—and one that caused the collapse of the infamous hedge fund, Long Term Capital Management. This Fund bet that US Treasury prices would reverse their trend upward while Russian sovereign debt prices would reverse their downward spiral. They, like Malthus, were wrong on both counts.

The best protection against Malthusian Mistakes is a healthy appreciation that “things change.” Knowledge that things change requires a bit of imagination because it’s difficult to see change that doesn’t yet exist. Complicating things is the fact that some trends, on the whole, do not change. The human lifespan, for example, keeps extending and is likely to continue doing so. This dichotomy is best explained by the French dictum: the more things change, the more they stay the same.

How then to distinguish between those trends that change and those that stay the same? This analysis is at the moneyed heart of most successful investment.

One present day concern, namely oil, begs for an analysis in this context. Oil, as everyone knows, is at record prices. Due to Chinese demand, Venezuelan instability, Iraqi sabotage and al-Quaeda attacks in Saudi Arabia, this precious commodity has breached the $40/barrel level in recent weeks. Yet, against this backdrop, prices have recently started to back off, down into the $36 range. Why?

Professional traders, accustomed to trend reversals, are starting to see the possibility that oil bulls are invoking the error of Malthus in proclaiming that oil prices will always go up. After all, new technologies will someday make oil obsolete. Not in our SUV-dependent lifetime, but someday. If oil is too rare to be readily affordable, it will eventually be replaced. This is the genius of economic demand—something that very few politicians really understand, whichever side of the aisle they preach from.

On a more practical note, we have recently converted most of the cash positions held in our New York clients’ taxable accounts to the TD Waterhouse NY Municipal Money Market Fund. In accounts of clients in other states, we’ve also switched the balances to state-specific money markets where available. In a rare occurrence, these tax-free money markets are yielding a few basis points more than the taxable money market, making this change a no-brainer. Even with an equal or a slightly lower yield, the tax-free money market is a better option for anyone in a high tax bracket. If this yield declines to levels that make it less attractive than the regular money market, we will switch back the position. Like any Malthusian trend, this increased yield is vulnerable to reversal.

April 14, 2004

Dear Investor:

In the long run we are all dead, said John Maynard Keynes in that most accurate of all economic predictions. But on the way there, most of us have to deal with time’s greatest financial risk: inflation. Like hypertension, inflation is a silent killer: the damage is often slow and hard to measure. In times of relatively low inflation, people focus on anything but. By the time it arrives, it’s often too late.

The huge reflation of the economy is likely to lead to inflation because monetary and fiscal policy tend to overshoot. Everyone knows life is expensive, but it’s likely to get more so. As China shifts from dominant producer to dominant consumer, its global effect mutates from deflationary to inflationary.

How do you protect yourself against this silent killer? There are three good ways: stocks, real estate and inflation-adjusted bonds. Conspicuously absent from this list are commodities, which are misunderstood to be a good long-term hedge against inflation. They are not. They’re a good short-term hedge because commodity prices spike on incipient inflation, as they are doing today, but only for short periods of time. To own commodities as an investor, that is, for a significant amount of years, is unrewarding. To profit from commodities, you must speculate on the short-term, a dangerous game.

The long-term average return on silver from 1871-2000 was approximately 2%, below the average rate of inflation over the same period of time.[1]. In other words, investors in this supposedly precious metal earned a negative real return. Another oft-quoted example is that, in 1904, an ounce of gold bought you a fine suit—and it still does—an example of a zero real return over a century.

In contrast, equity investors earned approximately 10% annually since 1871 and real estate investors 6%, both well above the inflation rate. Since equities and real estate both have tax advantages and the potential for yield that commodities lack, they are doubly preferable. The only commodity hedges worth purchasing are energy companies, which are attractive more for their equity component than for their commodity link: Shell will create more value over time for its owners than any lone barrel of oil.

The most interesting new assets to hedge inflation are TIPS, or Treasury Inflation Protected Securities, which we are adding to accounts where appropriate. TIPS are well-suited to investors facing long retirements who must nevertheless be conservative. TIPS are the only investment we know of that provides anything close to a guaranteed real return above and beyond the inflation rate. Their principal is adjusted upwards in tandem with the CPI.

Although the total return on TIPS is low at the moment, it will increase along with inflation. One disadvantage to TIPS is the potential of deflation, which would render them feeble indeed (although the initial principal level is protected even if deflation adjusts the CPI downward). The other disadvantage is that taxes are due on the imputed income of the inflation adjustment, a problem which can be remedied by holding them in a tax-deferred account. Note that a tax-deferred account, however, renders obsolete one advantage of TIPS: their exemption from state income tax.

The other potential disadvantage to TIPS is the possibility of a significant bubble forming as buyers plow into the market. TIPS funds are raking in record levels of capital, especially in the wake of Bill Gross’s highly-publicized purchases at PIMCo, which has pushed their yields unsustainably low. When a buyer like Gross is willing to announce his entry, it often means that the best days are over. So it pays to keep a close eye on the TIPS market. In the long run we may all be dead, but we still may wish to take our time getting there.

[1]Handy & Harmon Silver Spot Price as quoted by Morgan Stanley Dean Witter

January 1, 2004

Dear Investor:

The most massive fiscal and monetary stimulus in history has revived the economy. The new risk is inflation.

The current state of affairs is the opposite of the stagflation of the 1970’s: enormous global growth paired with moderate inflation—a cure that has bailed out the world from the worst market collapse since the Great Depression. This period is most reminiscent of the period from 1951-1965 when inflation ran at 1.6% and equities returned 16.5% annualized. Fear of inflation will start to simmer, however, as liquidity overshoots and the money supply grows disproportionately.

The number one question for inflation over the next ten years will be China. Until recently, China had acted as a deflationary force, pumping cheap goods onto every consumer market. But as internal growth has fueled China’s own consumption, demand for oil and imported goods is quickly changing the equation. Now China hungers for a Western standard of living. A billion people here and a half billion there, and pretty soon you’re talking real population.

Since China’s deflationary exports and inflationary imports have the potential to net out the real price level, the balance will hinge on productivity. The good news is that productivity growth is enormous right now. It will slow as hiring resumes, but gains in productivity have a long way to run. In our own business, it’s obvious how technology and internet platforms have driven enormous productivity: our prime money management software, Centerpiece, does the same workload that would have required several people years ago. The new “paperless” office is reducing labor requirements in every workplace. Technology is finally being applied in ways that promote unbelievable efficiency. As long as the U.S. and China continue to invest in technology, this miracle will continue. If not, well, that’s another story.

The two greatest economic risks to the world, aside from terrorism, are protectionism and inflation. Fortunately, Bush withdrew his misguided steel tariffs, but the protectionist rhetoric continues on both sides of the aisle. The restriction of trade in any form would be an unmitigated disaster.

The implication for investors is clear: Bond duration must be kept extremely short until 10-year rates climb another 100-200 basis points. Equities don’t look nearly as attractive as they did a year ago, although they still look relatively compelling. And anyone in an adjustable rate mortgage is looking to redefine masochism.

October 1, 2003

Dear Investor:

The market has surged from the October 2002 lows under the largest combined monetary and fiscal stimulus the world has arguably ever seen; it would not be surprising to witness a significant equity pullback. We expect higher interest rates to eventually encroach upon stock valuations, as the deficit balloons and the economy expands. In anticipation of a weak bond market, we continue to keep duration low, and overweight funds with high-quality corporate debt relative to Treasury bonds. If rates were to rise 100-200 basis points, opportunities in the bond market would arise that might change that strategy, but not yet.

Corporate governance, this time at the NYSE, has garnered the public’s attention in the wake of Richard Grasso’s absurd pay package. Mr. Grasso always appeared to be a good manager, but who knew he was the fattest cat in a large litter? The focus on corporate governance at large companies has been somewhat productive thus far, and we can only hope the same will be true at the NYSE under the weather eye of John Reed.

It’s important to note the positive changes that have occurred at some firms: General Electric, for example, will now grant real stock in lieu of options to its CEO. These stock grants will largely be based on cash flow targets. By receiving the same basic currency as shareholders, the CEO will have his interests in greater alignment. We called for this currency alignment in our quarterly letter of July 1, Schizoid Scrip, and are very glad that someone on the board of GE was thinking the same way. The targeting of cash flow is comforting as well, since cash flow is a much trickier entity to manipulate than earnings. Cash flow is a real number, whereas earnings are a virtual accounting fiction, dependent on variable accounting treatments of such nuanced deductions as depreciation and amortization.

The Corporate Library, a non-profit investor watchdog group led by Nell Minow, has been at the forefront of pressuring corporations to improve their governance, and the public owes much to their efforts. We have been in contact with the Corporate Library over the past several months, working closely with them to increase their clout with fund and pension managers. The recent Corporate Library newsletter featured a piece we wrote on the importance of corporate governance from the perspective of an investment advisor, and we hope to continue trumpeting their vital message wherever we can. If corporate governance changes do take hold in a real way and are not the mere passing fancy of a fickle public, then the equity risk premium should decline over time.

The reality is that every boom-bust cycle spurs regulatory changes, some of which are feeble or counter-productive, while others become true gems of legislation: witness the creation of the Fed in 1913 or of the SEC in 1934. It’s far too early to write the book on Sarbanes-Oxley, but if momentum continues, corporate governance reform could be the new platform for the next round of equity appreciation.

July 1, 2003

Dear Investor:

The market has improved dramatically in the past quarter, due to improving confidence as war, SARS and other ills appear in the rearview mirror. Of course, investors should focus on the road ahead.

Some pundits fret about deflation, but falling prices are only a problem in ever-shrinking manufacturing. It has yet to lay a hand on the service sector: ask anyone who pays insurance premiums, medical bills or tuition. The real danger is a ballooning deficit leading to higher interest rates and inflation, a scenario far more bearish for bonds than stocks. That’s why we focus on keeping duration low in bond holdings, regularly checking in with managers regarding average maturities, and making fund changes where appropriate. The most frightening investment right now is neither internet stock nor pork belly, but a 30-year US Treasury Bond.

Regardless of inflation risk, the longer term prospects for the world economy rest with a more prosaic matter of structural reform. Strangely, shareholders often hold different scrip than executives. The owner (shareholder) holds stock in the hopes of capital appreciation and in turn sustains the risk of loss; the employee (executive) holds options in hopes of a windfall and bears no parallel risk. If this strikes you as unfair, you are probably a fair-minded person. As the world converges toward common currencies, it might be time for CEOs to join in.

Warren Buffett is famous for eschewing options, insisting only on cash and real stock as compensation for employees. His logic is simple: it’s fair.

The roiling debate around expensing options misses the key detail that options themselves, expensed or not, are a poor way to compensate employees, especially when they are shamelessly re-priced in the wake of feeble performance in order to dumb down even the dumbest expectations—and by doing so, compensate dishonest execs.

In Jack: Straight from the Gut, Jack Welch, the revered former CEO of General Electric, recounts how GE Capital employees wished desperately to cash in on the internet boom and asked for stakes in potential start-ups. Welch told them to “take a hike. In our shop, there’s only one currency: GE stock with GE values.” That was a smart approach. Unfortunately, there wasn’t just one currency at the time. There were two: options on GE stock and GE stock itself, and Mr. Welch was a legendary recipient of the former.

Of course, the very expensing of options might write their epitaph. Not likely, though, while options provide a win-win proposition for the competence-challenged. Until times change, it’s a good idea to invest in companies where the CEO owns significant stock, not just options on the passage of time. In our private client accounts, we select fund managers who screen companies for executive ownership criteria, including significant percentages of stock held outright. We also select managers who in turn invest their own dollars in the fund they manage.

The problem of schizoid scrip also infests the world of finance. Brokers are famous for making money on commissions while the customer may or may not make money on capital appreciation. This is an infamous incentive for the broker to “churn” an account, or buy and sell stock in order to pay for his pool renovation—in the same way a dentist fills lots of cavities around the time of his daughter’s wedding. That’s why educated investors turn to money managers, who get paid a percentage of the assets under management—where both manager and client have their eyes on the same prize: capital appreciation. No alignment of interests is perfect: a money manager, for example, may speculate in an effort to earn performance fees in a way that is detrimental to the customer. But for the most part, aligning interests as much as possible is a good thing for everyone—and a tremendous victory for equity (the human value, not the asset class).

The schizoid scandal of the day revolves around “soft dollars,” or the practice of compensating fund managers in creative ways for directing trades toward their brokers. The SEC is looking into this much-abused practice, whereby managers are beholden to trade more and more in order to collect the soft dollars, while the fund does not disclose the amount of hard dollars spent on commissions.

In the management of our Fund, we refuse to accept soft dollars in the belief that it creates a flawed incentive scheme. When we launched, prime brokers were not interested in working with us because we wouldn’t accept soft dollars in exchange for generating large amounts of commissions. We had to go to TD Waterhouse, a more progressive broker. Our boycott of soft dollars was not done out of altruism, but rather a belief that we don’t want to be pressured to trade against our better judgment.

It’s time to seek a common currency. Perhaps, markets will force this convergence, as consumers become more educated over time. If not, money will continue to diverge, like the old Francs and Guilders, modes of payment outdated in the new investment world order.

April 3, 2003

Dear Investor:

Whether of Beaujolais or Big Macs, the boycotts on both sides of the Atlantic are illogical pursuits. These boycotts, populist and porous as they are, will do little overall damage to the world economy unless they become sanctioned and enforced by governments. If that were to happen, Smoot-Hawley protectionism would complete the final phase of this market cycle, sending the economy into further tatters. We are watching very closely these turns of the political compass, because the outlook for stocks is entirely tethered to global flows of capital and goods.

The reason why we feel sanguine about this issue is that the global economy makes protectionism less likely than ever before. A boycott’s venomous intent reflects a crude ignorance of one of the great realities: no product, not even the lemonade on the street corner, is really a one-country job anymore.

Let’s take Big Macs, the favorite boycott item of French chauvinists. The French Big Mac, as identical as it may be to its US sibling, is co-sold by in most cases a French franchisee who buys French potatoes and French meat, shipped by French truckers who buy their diesel from Total Fina Elf which buys its legal expertise from French lawyers who buy their psychoanalysis from French analysts. Boycotting a Big Mac hurts local French businesspeople much more than it hurts McDonald’s who will simply shut down its French franchises and move them to China if they become unprofitable. The point is that multinationals have the great freedom of movement, not the locals who depend on the multinational for their livelihood. The locals, of course, are less likely and less able to move to the Far East.

In parallel, the boycott of Beaujolais is hurting the American importer, the American logistics company who aids the American importer and the American accountant who counts the beans of the American logistics company. Beaujolais may be nearly as American as a cold Budweiser when you think of the supply chain.

It makes people feel good in a petty sort of way when they pour the wine down the sewer or smash the glass window of that fast-food chain, but it would be nice if these boycotters learned a little more about the world first. In most countries for example, McDonald’s uses native franchisees, who know the culture and are local entrepreneurs. These local entrepreneurs are the only thing left holding up the pathetique French economy, yet these boycotters would see fit to put them out of business. Of course, the misguided French chauvinism would be much better served by embracing change, modernity and multicultural influences, the very things it fears and cannot understand. Someday, France will have to change, but until then, it will thrash around desperately.

Americans, less enfeebled by change—a decided staple of American society—are still stubbornly prone to shoot the Beaujolais first and ask questions later.

The truth is that the boycotters will not win, because they try to do the same thing that Communism tried to do: stifle the inevitable and all-powerful market forces that, in the end, make the world a better place.

January 1, 2003

Dear Investor:

While all nearsighted eyes are focused on Iraq, North Korea and terrorism, there is a story that grinds along in relative obscurity. While the world must be forgiven for its myopia in the wake of the worst bear market since the Great Depression, clever investors must look ahead, much farther down the road–to China, the great emerging story of the 21st Century.

Over time (and it may well be a long time) Iraq, North Korea and terrorism will cease to exist in their current forms, either through outward force or inward implosion. Just as Fascism and Communism were largely defeated, so will be defeated the vestigial barbarisms that torment the world today. It’s just a matter of time. History’s story is one of progress. One hundred years ago, the average lifespan was 47, crossword puzzles hadn’t yet been invented and only 14% of American households had a bathtub. Needless to say, if you were born before 1956, or like your Sunday puzzle while soaking in the tub, you’ll be the first to agree that the world has gotten better.

Much of future progress will center around China. And it is progress that every long-term investor must focus on, because it is precisely in atmospheres of gloom and doom, when the world is misdirected, as if by the keen diversion of a dexterous magician, that the next story for prosperity emerges. Investors tend to exchange their distance glasses for reading glasses at exactly the wrong time. During the great bull run, everyone could see far ahead, to exponential growth and limitless wealth. Unfortunately, the traffic accident was only feet away, invisible to those focused on the horizon. Now, just as the horizon holds real promise, people have taken to driving with their chins on the steering wheel. Perhaps, they need bifocals, or maybe quick laser surgery. In any case, please listen to the optimistic case for this millennium.

China’s recent entry into the WTO has catalyzed its remarkable conversion to a capitalist, market economy. China is fast supplanting Japan as the economic power of Asia. Moody’s recently raised its outlook on the sovereign debt rating, reflecting greater confidence in the currency and capital flows. Of course, the export prowess of China is legendary. Enter your local Target and try to find something not made in China. But the most striking aspect of this success story is the burgeoning class of well-heeled consumers that is making China a major importer, not just an exporter. The great mall of China is open not just for buyers but also for sellers. According to the Wall Street Journal, Shanghai ports will handle a record $40 billion in imports for 2002. China is now the world’s 4th largest economy if you count the European Union as one entity. It has 1.3 billion people and many of them are developing an insatiable taste for imported goods—everything from South Korean computer chips to American cars to black Malaysian roses. The Journal reports that China has surpassed the US as the top global importer of steel, an amazing commentary on Chinese consumption.

The question is how, as an investor, to share in this mammoth growth. Buying Chinese companies is far too risky due to the poorly regulated and illiquid mainland market. Superior opportunities are to be found in purchasing shares of Hong Kong and Asian based companies that do the bulk of their business in China, such as China Mobile, the largest telecom operator in the world. The Liberty Newport Tiger Fund pursues this strategy. But the other way to participate in this future century of profound Chinese economic progress is to buy shares of large-cap US exporters with global scale. Citigroup recently purchased a significant stake in Pudong Bank, one China’s largest lenders. AIG, which oddly, was originally founded in China, is the most prominent global insurer in China with a massive network of local sales representatives. PepsiCo, Microsoft and GE all have extensive tentacles in China, and so on. Our large-cap mutual funds own these companies, along with many others that can capitalize on such opportunities.

Of course, there are substantial political risks in China, but the unfolding legacy of Jiang Zemin and Zhu Rongji looks to be a bright one. In a recent well-attended speech, GE’s chairman Jeff Immelt said that every company will have to learn to buy or sell from China, and preferably both. He could have added that every investor will have to do the same.

A few feet away are the all too substantial tragedies that form the world’s current problems. Those who invest for the future would be better served by retrieving their distance glasses. And looking not to the Middle East, but to the Middle Kingdom.

October 7, 2002

Dear Investor:

As the stock market suffers its greatest devastation since the Great Depression, we feel as frustrated as doctors during the Bubonic Plague. The decline of markets has gone further and deeper than we predicted. This is a very difficult time for all investors and we know that many of you are losing faith in equity markets. Please understand that this is a typical reaction at the end of a bear market, one that usually defines a bottom. The only way we have been able to make any client laugh recently is by quoting the recent New Yorker cartoon of two guys sitting at a bar, one saying to the other: “My broker jumped out of a window, but that’s small consolation.”

Money from stocks is logically flowing into bonds and real estate. Unfortunately, this two-pronged safe haven bid is fomenting a growing bubble of menacing proportions. Bond yields have dropped to 40-year lows, artificially supporting real estate prices and in turn making long-term bonds absurdly expensive. People who haplessly climb aboard this new bandwagon will find themselves in the same position as stock investors who were late to the party in 2000: in a dangerous musical chairs game, just as the music stops. When we warned of the risks inherent in the Internet bubble in our newsletters of 1999 and early 2000 (see our website for the original text), we endured tremendous skepticism from many readers. Déjà vu.

We cannot claim to be alone in our early warnings. Both the Wall Street Journal and the Economist—two other publications that warned on the Internet fiasco early and often—are writing of the coming real estate debacle. Few are listening. The Journal just ran a front-page article on October 3 with the following tiered headline: Signs of Strain-After Long Boom, Weaknesses Appear in Housing Market—As Prices Outpace Incomes, Buyers Fall Out of Market And Other Supports Fade. The article begins: “Cracks are spreading in the foundation of the US housing boom, as evidence mounts that the long run-up in home prices can’t be sustained.” Despite its placement on the page, upper-right center, positioned as the most important article of the day, it attracted little attention.

Of course, real estate and bonds are not the same as equities, and there is no doubt that you can live in a house, unlike an Internet stock. We want to make it clear that we think real estate is normally a superb investment–one of the very best. That is why we believe that the best first investment for anyone who is liquid and willing to commit to a location is a home. The tax and leverage advantages of a primary residence are enormous. We also know some very astute real estate investors who are so skilled at direct investment that they can continue to make money in an overvalued environment. We know of one savvy investor in particular who is currently scouring for Brooklyn properties at foreclosure auctions. But this buyer possesses unusual skill at location selection and renovation and therefore has a competitive advantage. His pursuits are analogous to the early-stage venture capitalists who funded Internet companies early on and therefore got in at prices that most buyers only dream of. And the irony is that even he has been recently outbid by outrageous prices above what he considers prudent to pay. But many will get burned, particularly those who are not disciplined in their purchasing.

As the economist Allen Sinai says in the recent Journal article, “I really doubt we will escape [the real estate bubble]…I have never seen an asset market—whether it’s stocks or real estate—that has boomed to excessive prices…without a serious downturn.” Meanwhile, this new speculative mania is starting to take on the classic hallmarks of overleverage and denial. Many people are taking out adjustable rate mortgages at the current artificially low rates because they cannot afford a fixed rate. What now look like low payments will probably balloon to monstrous proportions, causing a bevy of defaults. In effect, these people cannot afford the homes they are buying, but with the sorry prop of a bank desperate to grow its loan book, they are doing so.

It’s interesting in psychological terms that the same people who were clambering for Internet stocks in 1999 are now clambering for 10-year T-bonds and speculative real estate purchases. These people ignore the cardinal rule of buy low-sell high, not because they don’t understand it intellectually, but because they allow themselves to be ruled by emotions. For example, stocks appear so frightening now that no one feels like investing in them. People find it hard to purchase what’s declined in price because it always appears dangerous at the time: they buy into the panicked new ideology of fear on the way down just as they bought into the panicked old ideology of greed on the way up. So stocks are now forsaken. This, though stocks are trading at their best prices since 1932, while real estate commands bubble prices not seen since the late 80’s.

Real estate and bonds appear “safe” now because they keep going up. New ideologies emerge to explain this “safety,” namely that bonds are “guaranteed” and that real estate is always attractive because you can “touch and feel it.” These people apparently did not live through the early 90’s when real estate collapsed nationwide, bankrupting many landlords and savings and loans, and causing the average home price to plummet. During this period, speculative “flippers” who got caught with property when the music stopped found themselves in Chapter 11 rather quickly, regardless of the amount of touching and feeling. Apparently these people were also on vacation in 1994 when bond yields skyrocketed due to several Fed rate hikes, causing devastating loss of principal in long-term bonds and rendering the guaranteed yield useless.

It should be noted that we are also great fans of bonds at the right price. We always rely on large bond positions for conservative portfolios. Unfortunately, we have had to shorten average duration to under two years in our client portfolios to protect against the massive interest rate risk that is building in bond prices. This decision sacrifices yield but will pay off when long-term bond prices sink. There are still some going out ten years to eke out that little bit of extra yield and it begs the question once again: where were they in 1994 when bond investors lost their button-down shirts?

Are memories really this short? Now people feel stocks will never go up again, just as they thought they would never go down again in 1999. People who climb aboard trends are sensitive to swings in public opinion, and they make money in the short-term, as the trend temporarily follows its own momentum. But this oversensitivity is their ultimate undoing as they react too fervently and rashly. They make the cognitive and very human mistake of thinking this time is “different” and that these price distortions have never happened before, supported by the feeling that we live in “unique” times, “worse than ever” before. However, this feeling is always false and shows a marked and disturbing ignorance of history. History is always changing the world, but few times are as unique as people feel they are at the time. What’s more, this feeling leads investors to buy high and sell low.

I doubt Americans were feeling very sanguine about the world in the 1860’s when the Civil War threatened to end the Union, or in 1932 as 44% of all banks collapsed, or in 1941 after the Japanese bombed Pearl Harbor and brought us the deadliest war the world has ever seen. I doubt most people were delighted when Fascism ruled half the globe or when Communism threatened nuclear annihilation on a daily basis. According to most chronicles, Americans did not see times as routine during the Cuban Missile Crisis or in the early seventies when the US lost the Vietnam War, its very first major defeat. Not many Americans thought it business as usual in 1974 when we saw a President resign for the first time in history, or during the Iran hostage crisis, or leading up to the last Gulf War. Who, on the cusp of each of these events, did not feel they lived in unique times? Who did not worry the world was coming to an end?

In fact, at each of these points in history, emotions ran to despair, newspapers universally proclaimed that the world would never be the same, and the stock market sank to alarming lows. At each of these moments, it was a small club of Americans indeed who wanted to put a nickel in stocks. But after every single one of these events, the stock market returned to new heights, and the world did not end. In a remarkable example, the Dow went from a low of 41 in 1932 up to 194 in 1937—a startling quintupling during the depths of the Great Depression, when people were lining up for soup lines instead of stock tickers. Those who sold at the 1932 low hammered the final nail in their own coffins.

During the seventies, many people literally thought America was coming to an end. And very few people wish to ante up a chip at a casino that won’t be around tomorrow. But these people were underestimating America. To their credit there were a few brave souls buying stocks at that time: Warren Buffett, Peter Lynch, Marty Whitman, Charlie Munger, and Lawrence Tisch.

Real estate prices are unlikely to “collapse” like stocks. They are more likely to trend sideways or slip gradually as interest rates perk up. But going forward, both bonds and real estate are likely to underperform equities over the next ten years, just as they have over the past 100.

Even those who are not convinced by the weight of history that what goes up comes down (and what goes down comes back up) should maintain a wisely diversified portfolio, allocated among real estate, stocks, bonds and cash.

We very much appreciate your support and patience during this very difficult time in markets. Please call with any questions or concerns.

July 1, 2002

Dear Investor:

The past quarter needs very little introduction and much explanation. This is the worst bear market since the Great Depression and the first time the indices have put in three losing years in a row since those dark days. We appreciate that these are difficult times for you to have your money invested in anything, let alone stocks and bonds. Lest you think, though, that these times are unique, bear with us for the next few paragraphs. As Mark Twain noted, history doesn’t repeat, but it rhymes.

The New York Times says it best: “Unless business behavior improves, the free enterprise system and perhaps freedom itself, could perish.” The trouble is that the Times said that on July 20, 1975, in the wake of the last bear market and just as the market was preparing to rise 60% over the next two years. The favorite resort of the hopeful or fearful is to say “this time it’s different.” Collectively short memories prevent us from realizing that it is never different. What occurs has occurred before. Manias and panics are both as old as time. During 1999, the bulls said: “This time it’s different–it has never been so good.” And in 2002, the bears cry: “This time it’s different-it has never been so horrible.” Of course, both pronouncements are wrong, spoken by those who ignore history at their peril.

In the wake of accounting scandals, terrorism, and all-around bad news, investors are starting to pillory everything from Martha to George. This skepticism is the healthy flagellation that follows a bust; it usually marks a bottom. When investors only issue orders to sell and never buy, the end is near.

Markets are, by design, bent on humiliating the greatest number of people the greatest number of times. When a trend seems cast of iron, it is most ready to crack. Many investors are liquidating or shorting stocks now, when it could not be more dangerous to do so. When stocks appear consigned to the scrapheap, they are most likely to rally, by edict of that cruel intersection of psychology and economics that only a contrarian viewpoint can protect against. The law of demand dictates that massive pessimism is accompanied by the lowest prices. Witness Business Week’s infamous cover story in 1979 trumpeting the “death of equities” just as the great bull market of the past twenty years was poised to begin.

People succumb to the whims of mass behavior because it feels better. It feels good to be out of stocks when they have just plunged, because conventional wisdom says they will plunge again. It feels good to buy stocks when stocks are going up because a greater fool will buy them. All this feeling stands in the way of true riches. That is why the current wealthiest man in the world, Warren Buffett (he recently dethroned Bill Gates due to substantial declines in a stock called Microsoft), got rich by taming his emotions and holding the quality companies he owned for the long run.

How did Warren Buffett, by the way, keep from selling investments during the seventies, when Vietnam was followed by Nixon, which was followed by riots, which were followed by the Pentagon Papers, followed by Watergate, followed by the Yom Kippur War, followed by the Oil Embargo, which was followed by Nixon’s resignation, followed by massive inflation, followed by double-digit interest rates? If you thought that sentence was long, then remember what it was like to live through it-and people say today is bad. Buffett held on by three means: (1) a knowledge that he owned great companies, as pummeled as they may have seemed at the time, (2) a determination to never give in to the temptation of feeling better by selling, and (3) a knowledge of history that protected him from magical thinking.

A little bear market history puts things in perspective: From September 3, 1929 to July 8, 1932 the Dow declined from 381.17 to 41.22, a collapse of 89%. But how many people know that from July 8, 1932 to March 10, 1937, the Dow rose from 41.22 to 194.40, a staggering gain of 372%–during the depths of the Great Depression, no less. It is true that it took until the fifties for it to return to its 1929 high, but this ignores the vast sums of money made by people who had cash on hand and invested near the bottom in 1932. For example, it could take as many as 15 years for the Nasdaq to once again pierce 5000, which is very discouraging for those who bought Priceline at the highs. But it shouldn’t dent the fervor of those who were able to preserve capital to some degree and can now put cash to work.

Many pundits point to average p/e’s of 40 or 20 (depending on trailing or forward earnings) and proclaim that the Bear Market will not be over until the p/e drops to its bear market trailing average of 10-14. This argument does not take into account interest rates, which cannot be excluded in any valuation model. Any economist knows this, but the press, always hell-bent on scaring the masses, ignores this necessary variable.

Stocks compete with bonds for investor attention: putting aside those who sit on mattresses full of bullion, most people choose one or the other for their liquid assets. We know this because the biggest capitalized markets in the world are the equity markets, at approximately $36 trillion in size, and the bond markets at around $31 trillion. Their relative equilibrium shows the highly competitive nature of the asset race. Like Coke and Pepsi, they are always neck in neck. When interest rates rise and hence bond yields, buying bonds look more attractive. Any logical investor, from Buffett on down, compares bond yields to historical equity returns to decide where to allocate money. If 10-year bond yields are at 4.76% (like the present), then future equity returns need not be high to compete, hence a premium placed on forward earnings valuations. Another way of saying this is that more money flows into stocks when bond yields look unappealing, thus boosting the price paid in relation to earnings–the p/e ratio. But if yields rise to 6%, then stocks have to deliver 26% more earnings to justify their ownership: if the earnings don’t rise commensurately, the price will have to shrink, thus contracting the p/e ratio. If interest rates spike to 15%, as they did in the seventies, then very few people will pay up for stocks. After all, who wants a risky return of 10% in stocks when safer bonds are paying double digits? This is why p/e’s at the end of the seventies bear market were so low, and why today’s are not especially high.

Unless monetary policy is grossly incompetent, interest rates should not have to rise to double-digit levels. Rates will climb somewhat to match a recovering economy. Unless inflation, however, grows dangerously high, interest rates should not spiral out of control. The continued deflationary forces of China and the Internet should mitigate the inflationary impact of a weakening dollar. At current interest rates, the average forward p/e of 20 is well-justified, even low.

We will not, of course, return to 20% annualized returns anytime soon. The restricted psyche of a post-bubble hangover will see to that. Stock returns will probably revert back to their historical average, somewhere around 10%. And they should, over time, trump the returns of bonds, bills, gold, copper, sorghum, fine art or real estate-as they always have. The reason for this is simple, unadorned economic reality: investors are always compensated more for taking bigger risks, and it should be clear to anyone at this point that the stock market is a bigger risk. People who bear the risks sensibly (buying quality companies) and not suicidally (buying the next speculative rage) will reap the long-term rewards of their risk-taking as they have without fail over the long history of markets. Some of these statistics were plucked from Triumph of the Optimists: 101 Years of Stock Market Returns. This terrific new book from Princeton University Press, full of excellent research by finance scholars Elroy Dimson, Paul Marsh and Mike Staunton, gives a comprehensive analysis of stock returns over the past century.

Every investor has a story about not having bought X back then, when it was a steal: Citibank stock in 1990, Manhattan real estate in 1975, and so on. Why then doesn’t everyone buy when things are cheap? Why will so many people wring their hands in 10 years and say, “If only I’d bought that stock in 2002″? The reason is that the proposed purchase always looks absurdly perilous at the time. And it doesn’t help that the road to those prices is paved with people who bought too early and lost a fortune. Indeed, the risks of risk-taking cannot be avoided. But those who have the courage to buy quality stocks when it appears hopeless will be rewarded richly.

We know these are difficult times. Our efforts, in conjunction with our fund managers, are focused on daily reviews of the underlying holdings of every portfolio to review credit quality and balance sheet liabilities. Indeed, our managers have always paid attention to such issues.We appreciate your patience during this period and especially welcome all communication. Please feel free to call us with any questions or concerns.

April 1, 2002

Dear Investor:

Three years ago we had to look dumb when we refused to invest in companies like Pets.com while they soared in make-believe value. In those heady days, people would throw millions at an idea scribbled on a napkin. In the post-Enron present, people are reluctant to sink so much as a nickel into a company like GE. It seems the psychological pendulum may have swung too far again—this time to the other side.

This particular swing probably heralds the last throes of the bear market. Not that there won’t be more “gales of creative destruction,” as the economist Schumpeter called them: many over-leveraged companies with unsustainable business models still haunt the Nasdaq landscape. But as psychology now swings to punish the blue chips and people withdraw money from equities to feed a bubble in housing on the back of artificially low interest rates, it appears that the stock market may have come through the worst.

The biggest danger for investors is to give up on a disciplined policy of diversified asset allocation. Some investors will throw in the towel on stocks, thereby buying high and selling low. Others will seek refuge in gold, following a fad that always ends in disaster since non-industrial commodities are never a good long-term investment. A few will keep the money under the mattress, and will be ravaged by inflation when interest rates perk up. And the most unlucky will succumb to the lure of trading, as volatility stemming from the increased problems in the Middle East and other events makes such a strategy seem attractive.

It’s important once again to address the flaws in a trading mentality, since hucksters and hedge funds alike will hawk infallible trading “systems” as the market dawdles in the netherworld between bear and bull. Trading is a zero-sum game: for every winner there must be a loser. In other words, when a buyer purchases a share in Enron, she is buying it from a seller. And only one of them—the seller or the buyer—can be right in that transaction: the stock will either go up or down. The odds are actually worse than 50/50 since the “house” (in the form of brokerage bid-ask spreads and commissions—Wall Street’s version of double-zero on the roulette wheel) makes no trader’s random chances better than 49%.

In contrast, two investors can both buy Citigroup and hold it for the long-term, confident that they both will make money if the corporate profits rise over time. This is known in not-so-formal economic terms as an ever-expanding pie, and it is the secret to Warren Buffett’s success and to that of every other established investor.

The disadvantage of investment is that it requires patience and so is totally unsuited to gamblers. It is also useless to those who wish to get rich at another’s expense, since it is only as a trader that you trade “against” someone and thereby dine on caviar while they scour the trash bin. It’s a bad approach for those who are confident they will always have the upper hand in any of a million separate transactions, since trading would be the best strategy for anyone who is always right. Unfortunately or fortunately, we do not have confidence in our ability to always be right; therefore, we stick to investing where patience, not infallibility, is the key to a good result.

The talented speculator Jesse Livermore, who amassed an enormous sum by shorting the market in 1929, and who built and lost his fortune many times, at the end knew his flaws all too well. After years of exchanging estates in Great Neck for fleabag hotels on Broadway; after numerous bankruptcy filings followed by extraordinary comebacks; after buying the best diamonds at Harry Winston and then pawning them after the inevitable “missed” trade, he realized that a gambler lives to lose as much as to win. And he put a bullet in his head upon the realization.

The disciplined, diversified investor will never feel especially omnipotent; nor is he likely to go broke. All of which is probably good for those who would rather make that all-important lifetime trade: exchanging gambling for common sense.

January 1, 2002

Dear Investor:

The collapse of Enron is no doubt a cautionary tale. But of which caution? To read Gretchen Morgenson’s recent piece in the New York Times would strand readers with the conclusion that no amount of caution could protect against buying Enron. The reality is that Enron-like mistakes will go on and on. But not because the red flags aren’t there; only because most investors are too lazy to look for them.

There were early suspicious moles on Enron’s milky skin: it’s important to recall that Morningstar, even before the crisis, had graded Enron’s financial health a gentleman’s C, far below the threshold for true safety; the balance sheet was already swollen with $13 billion in disclosed long-term debt; and no one really understood how the company made money, including apparently the former CEO (who now appears to be claiming some vague type of mental insufficiency).

One of Warren Buffett’s rules is to follow one hypothetical dollar in and out of a company. If you can’t account for that dollar every step of the way, don’t buy the business. Buffett’s rule would have worked well here. In The Warren Buffett Way, money manager Robert Hagstrom explains how easy it is to trace a dollar through a simple, well-run company. To paraphrase his analysis, we’ll take PepsiCo: you buy a Pepsi at the deli and hand over a dollar. Half the dollar drops in the cash register, the other half gets paid out to Pepsi. A few cents of that fifty goes to investors via dividend, a few get reinvested in the business, and the rest goes for overhead, taxes and to pay for ingredients. This is an oversimplification, but not much of one. Pepsi’s business is pretty straightforward. Enron’s was not. And businesses too difficult to understand are investment accidents waiting to happen.

The other warning was the debt load. Buffett’s favorite quip is that you never know who’s swimming naked ‘til the tide goes out. In this spectacular case, the recession struck, the tide rushed out like a bandit, and Enron was left grasping for a fig leaf. Overleveraged companies have less margin for error. Some will argue that since Enron left its liabilities undisclosed, no one could have ever known the true dark side of the ledger. Perhaps. But if Enron were not already saddled with a large disclosed debt on the balance sheet, it might have weathered its dirty little secret. Without the margin for error that a strong balance sheet provides, what’s undisclosed takes on new meaning. Enron’s thirteen billion, though nothing unusual in the realm of binge borrowing, was enough to sink Titanic, not just a shoddy skiff.

Other clues were the conflicts disclosed in the filings. The Enron 10-K, proxy and footnotes showed a complicated set of partnerships managed by an Enron executive. This alone was not entirely suspicious since many companies are rife with double-dealing, some of which is immaterial. But the reluctance of Enron to fully disclose the liability of these partnerships should have raised a red flag. Other companies have potential conflicts off the books. The First Data Corporation (FDC) proxy (which yours truly was recently reviewing in screening companies for fund investments) reflects that James Robinson III, FDC Director and former Amex honcho, runs a venture capital fund to which FDC has committed approximately $8 million. Is this a conflict? I believe so. Is it material? Probably not, because the extent of the investment is clearly laid out, and the structure restricts liability of FDC to its $8 million. For a company with over $6 billion in annual revenues, $8 million is not material. Investors should always scrutinize the “Related Party Transactions” or the more coyly worded “Certain Transactions” headings on the proxy. In many cases, these sections may as well be retitled “How We Are Screwing You, The Shareholder.”

Very few investors actually scour the filings. Even analysts who read these laborious tomes tend to check their common sense at the door. People bought Enron because it kept going up. But analysts saw bizarre signposts along the way. Some even commented on the “opaque accounting.” But they all exulted “buy” for the same reason they now cry “sell”: because everyone else did. The casual investor in Enron probably never glanced at the 10-K or proxy, let alone the annual report. This all goes to the essential reality that people spend more time researching a washing machine purchase than a stock purchase. Talk about a false economy: they get a tough-as-nails $499 washer and a sorry stock that spin-cycles their thousand dollars into $4.99.

Investors in Enron may as well have led with the infamous pilot’s announcement: “The bad news is we’re lost. The good news is we’re making great time.” Hagstrom tells us that Jack Byrne, the legendary Geico CEO, once quoted this joke in a report to shareholders. Will caution against laziness prevent buying future Enrons? Probably not. There will always be companies that defy the most careful investor. But could anyone have seen this particular one coming? You bet. Any other answer is politely called passing the buck.

October 8, 2001

Dear Investor:

Some time ago, I went to hear the noted fund manager David Alger speak on the topic of growth investing. The crux of his speech was that markets, governed as they are by human psychology, have short memories. He highlighted the fact that markets always rebound favorably from savage shocks once the initial psychological trauma has passed. On his list of examples was the World Trade Center bombing of 1993. He explained that his offices were now high in the World Trade Center and the memory of that tragedy was still present in the building but long gone from global markets. Today David Alger is one of the missing 5,000 and his words deserve more than short memories.

If Mr. Alger were here, I think he would tell us to continue to invest in the future of global prosperity. I think he, in his British bankers’ pinstripes (that always evoked grand tradition and now are the unlikely uniform of a martyr) would say this not only out of patriotism but also out of the belief that it was the best investment. A true capitalist and skilled money manager, he would tell us which firm would turn a profit and, in so doing, would channel capital to those most deserving: biotech companies curing cancer, underwriters providing insurance, airlines flying families to be together. Say what you will about crass capitalism, but it builds buildings, it doesn’t knock them down.

Democratic capitalism underpins our nation. It’s the belief that freedom of choice should govern as well as allocate. It’s an imperfect system. But as the quote goes, it’s the best system we’ve got. Democratic capitalism will succeed over time, because it is the only political system that harnesses, rather than represses, human nature. In contrast are the various forms of totalitarianism, such as communism and fascism, which try to squelch human nature, and in so doing assure their own extinction. Democratic capitalism is based on a simple and elegant idea: that human beings, left to their own true and well-represented choice, will make the best decisions for the populace. The differences between liberals and conservatives are petty when dwarfed by the underlying common denominator of this democracy we all cherish.

At a conference this past week (moved to the Marriott Marquis in Times Square from its original planned location at the Marriott World Trade Center), Marty Whitman, the legendary investor and manager of the Third Avenue Value Fund, proclaimed that if there’s one type of person he hates, it’s the “true believer.” He said that the terrorists are good examples of true believers because they are sure they’re right. What’s more, they’re willing to kill in that belief.

These true believers are the grim and repugnant reapers of another “ism” that the world will now have to extinguish: fundamentalism. Like communism and fascism, fundamentalism attempts to suppress human nature. As a nation, we spent the first half of the 20th century defeating fascism. We spent the second half defeating communism. Now, no doubt, we are faced with a long and haunting battle against a new vicious ideology. Fundamentalism will not be extinguished in a New York minute. But the welcome reality is that it, too, as a form of totalitarianism, is doomed to fail. It sows the seeds of its own destruction in its attempt to control and repress. People can be beaten, lorded over, stomped into misery and pestilence. But they will eventually choose their own way. It may take years or decades, but they will do so. It’s the course of human history and it’s worth betting on.

Communism claimed that it could allocate resources. The result was chronic shortage, poor medical care, and hungry winters. Fascism claimed that it could organize institutions. The result was genocidal madness, unprecedented enslavement, and…hunger. Now Afghanistan’s Taliban claims it knows God and the result is sadistic brutality, wretched treatment of women, and…hunger. It seems there’s always one thing these true believers can hold out to their people: the promise of no warm meal on a cold December night. Again, say what you will about capitalism (a system which certainly does not succeed in feeding everyone it should), but it makes meals, it doesn’t guarantee their non-existence.

In the financial world, markets will recover, investments will bear fruit, and democratic capitalism will continue to build and rebuild. It will rebuild the new towers down in lower Manhattan. It will build the new medicines to fight the hazards of bio-terrorism. It will build the new technology to ensnare the mass murderers who roam the world with hollow stares and bloody hands. It will build the schools to educate children that true religion doesn’t condone killing. It will build the transport ships to bring grain to starving people worldwide. What other political system can claim that list of future accomplishments?

The spirit of David Alger is the spirit of this capitalism. The Alger Funds had a backup office in New Jersey that they had maintained for many years. The office had gone unused and some had commented that it might not be worth the rent and expense. Mr. Alger was said to have replied that it would be worth it someday. Like all capitalists, he was planning for contingencies in the name of profit. And by caring about profit, he was helping the world along. Say what you will about capitalism, but it puts people to work, it doesn’t put them under rubble.

We’re now at war. At this time, we can’t know Mr. Alger’s current investment predictions, but I think we can access their spirit. He would tell us to be long the US and global prosperity, to be short the Taliban and fundamentalism. Again, not only in the name of patriotism, but in the name of a good investment. And in the name of what will win, eventually.

July 9, 2001

Dear Investor:

While many analysts see brightness ahead, recall that the light at the end of the tunnel can be an onrushing train. Therefore, it’s important to shed companies with weak balance sheets as the recession continues.

Yes, recession.

Despite debate about the R word’s suitability, we have been in a manufacturing recession for two quarters. The weak NAPM Manufacturing Index, consistently languishing well below 50, points to a manufacturing sector that has gone fishing, or worse. The worst peak to trough market declines since the Great Depression have wrought damage in the real economy. And companies with poor balance sheets will continue to circle the drain.

We are monitoring our managers very carefully to confirm their attention to strong capitalization. This is accomplished by: (1) screening all holdings for requisite debt/cash ratios, (2) watching closely for any major impairments of capital, and (3) applying special vigilance to any companies in negative earnings cycles. Although screening by the balance sheet is always a cornerstone of our strategy, it acquires greater importance as GDP deteriorates. This is the single most important feature of successful recession investment. Vetoing its singular importance, many people remain in denial about the scope of this recession: they are living dangerously, clinging to their fallen tech idols.

One reason this recession doesn’t much feel like one is that unemployment remains at historically low levels (even with this week’s uptick to 4.5%). As long as unemployment resides below 6%, consumer spending could remain strong, supporting the retail and service economy. We are watching unemployment levels very closely.

Bear market rallies will continue, most of which won’t be worth the ticker tape they used to be printed on. But just as two years ago it seemed impossible to imagine a hole in our invincible economy, it now seems equally impossible to divine the inevitable recovery. All United States bear markets have ended eventually, even that well-publicized debacle in the thirties. To think anything else would be to bet on possibilities, not probabilities–never a good idea, despite its perpetual appeal to a gambling spirit.

April 2, 2001

Dear Investor:

This bear market will be recorded as one of history’s most miserable, with the worst collapse for a major index since the Great Depression: the Nasdaq is nearly 65% off its peak. The economy is slowing dramatically and one or two quarters of negative GDP growth are possible. Though most companies have lost ground due to the economic slowdown, the vanquished are those with weak balance sheets.

A company with a weak balance sheet is courting disaster. A weak balance sheet can be defined as one where liabilities are out of proportion to assets. Just as a family of four with maxed out credit cards will not make it through a period of unemployment, so too will a company with significant long-term debt find it hard to weather a recession. During boom times, investors are attracted to companies with significant debt because they are deemed sufficiently leveraged to exploit growth opportunities (i.e. the company is investing all available resources in business expansion and not reserving any in cash). Investors then get lazy. Behind their rose-colored glasses, they cease caring about an over-leveraged corporate condition; after all, in an ever-expanding economy, earnings will always improve.

But as we’ve seen, even in an age of information technology, the economy remains cyclical. The law of supply and demand has not been repealed by the Internet. At a time of declining earnings, a company can rely only on its balance sheet. If weak, it will have only three choices: (1) raise cash in the capital markets, (2) seek the embrace of a stronger acquirer, or (3) file for bankruptcy. As we’ve witnessed through the Nasdaq collapse, the first two options vanish when things go badly. Like banks, capital markets give money only to people who don’t need it. Firms like Pets.com and etoys had to discover this the old-fashioned way: investments in those companies are now worthless.

Of course, even a profitless company with sufficient reserves can be a ticking time bomb. The cash will then be used to fund current operating expenses, not temporary shortfalls. This is why most Internet companies were never worth buying, cash or not. Our managers screen very carefully for companies that are (a) profitable and (b) strongly capitalized. This precludes many newer stocks that are mere concepts disguised as companies.

Investing by the balance sheet is not foolproof. One disadvantage is that the next Microsoft could be among these poorly capitalized companies. But we adhere to Mark Twain’s belief that the return of our money is more important than the return on our money. We prefer to invest only when those companies have demonstrated a profitable business model by earning a buck or two.

The other disadvantage is that the stocks of well-capitalized companies can still swoon in price. In the recent market collapse, even many strongly financed companies in our portfolios have declined. The difference is that their stock prices are unlikely to drift significantly below their book value (the value of assets minus liabilities) for long periods of time. If they do drift below book value without being recognized by the public market, they’ll often be snapped up by an acquirer or taken private through a leveraged buyout. Thus, private market actions can bail out the public retail investor. Note that the investor in a weakly capitalized company has no such built-in protection: the stock price can easily sink to zero because no real assets back the stock. That’s why the stocks of many poor companies will never come back, while those of strong companies probably will.

Investing by the balance sheet is unexciting, and never infallible. It can temporarily leave you behind when poorly capitalized stocks skyrocket during brief manias. But it can also keep a retirement plan on track when the world is melting down. Whether or not the existing slowdown degenerates into full recession, companies with healthy balance sheets will live to tell the tale.

January 4, 2001

Dear Investor:

There’s a saying among philosophers: marry a good spouse and you’ll become happy; marry a bad one and you’ll become a philosopher. The paraphrased version should be: ride a bull market and you’ll become rich; ride a bear market and you’ll become an economist.

It seems that in the wake of the worst year for a major stock market index since the Great Depression, everyone has traded in bull market excitement for the dismal stripes of dour economic prediction. If the lesson of the past year is anything, it’s that markets change on a dime and thus the important thing to manage is risk.

2000 will go down as a supremely historic year: the year the internet bubble burst, the worst year in the Nasdaq’s history (down 39%), the worst year in the broad markets since the 70’s, and finally, the year that the Emperor’s New Economy asked for clothes.

The carnage in the Internet sector is astonishing, even to students of past collapses. The average retail Internet stock is down over 90%. The Jacob Internet Fund, a poster boy for New Economy excess shunned by us and many other advisors, is down over 79%. Many dot-coms have closed their virtual doors. Many more will follow suit over the next few months. An erstwhile darling of the B2B internet space, Interworld Ventures (INTW) lost 99.4% of its value, forcing its founder to sell his brand new $20,000,000 already mortgaged Palm Beach mansion. A million dollars invested in Interworld at the peak is now worth $5,900. Priceline.com’s (PCLN) founder, Jay Walker, has resigned and Captain Kirk has beamed himself back down to Earth. A million dollars invested in Priceline.com at the peak is now worth $9,533. TheGlobe.com (TGLO), first hailed as a great innovation, then exposed soon after as a greatly bad investment, faces delisting from the Nasdaq after 30 days with its share price below a dollar. A million dollars invested in TheGlobe.com at the peak is now worth $8,200. The list goes on and on.

Now that market pundits are finally calling this bear a bear, we may have hit bottom. The market is certainly pricing in a slowdown if not a recession, and leading indicators point to at least one quarter of negative growth. A potent leading indicator, The National Association of Purchasing Management’s factory index, fell to 43.7 in December, its fifth monthly decline and its lowest reading since April 1991–during the last recession. We believe this is what hurriedly prompted the Fed to slash rates by 50 basis points this week. Given sustained Fed intervention, a massive compounding of the slowdown is unlikely. Even Morgan Stanley’s chief macro economist Stephen Roach (and one of the most accurate forecasters), who has been bearish all year, predicts the downside of 2001 worldwide GDP growth at 3.0 – 3.5%, a far cry from full blown global recession.

Our view is that the market has seen the bulk of its declines but that bear psychology will linger. Future stock market returns will be anemic compared to years past and patience will rule the day. But stock market returns historically discount future real economic events six to nine months hence. Thus, it’s plausible that the 2000 Bear Market, which began in March, may have discounted the current slowdown sometime ago and that market returns have already borne the brunt of their misery. If the economy resumes its growth in Q3 or Q4, then stock market returns would soon start pricing in that recovery. And if the Fed accommodates by further loosening the money supply, the stock market could recover faster.

The bottom line is to remain invested with an appropriate allocation. Just as it was hard to imagine why the stock market was sliding when the economy seemed invincible, it will be hard to understand why the stock market will be rising during the depths of a slowdown. A case in point: In the languishing economy of 1991, the S&P 500 returned 30% as it priced in the future recovery. Psychology in markets is always counter-intuitive due to the discounting mechanism just described. The most common bear market mistake is to liquidate investments once a recession has already taken hold.

The saving grace is that the calamity we all feared during the Great Bull Market of the 1990’s has finally occurred: the markets collapsed and euphoria with it. The speculators have been vanquished, but those who managed risk are still standing, willing to bide their time until the riches resume.

October 4, 2000

Dear Investor:

More troubling than this bear market is the denial that surrounds it. Few pundits are willing to call it like it is. However, a quick scan of index returns year-to-date is denial-proof:

S&P 500: – 2.9%
Nasdaq: – 15.1%
Dow: – 6.8%

The current bear market possesses three distinct claws: a swooning euro, stratospheric oil prices, and deteriorating earnings. The one that concerns us most is the last. The first two are transitory, self-correcting imbalances that will be old news by the time this letter reaches you. We will analyze each in turn:

(1) A Swooning Euro
The weak Euro is good news for European exporters, bad news for US multinationals, and a big red herring for the world. Despite the potential for an outright collapse of the currency, this is extremely unlikely. The European Central Bank (ECB) has created a floor on the value of the Euro by intervening to support the currency at just below $0.85. Since interventions are rarely successful long-term, it’s likely that the Euro will drift lower once again. But the ECB has defined a floor below which speculators will be unlikely to stray. Most important, currency swoons are self-correcting: A weak Euro has increased the demand for European exports. Such exports are swapped for dollars which in turn get converted back to Euros, rebalancing the currency. Of course, these euros could be reinvested in dollar equities, but this is less likely to occur in a deteriorating US market. Finally, according to the Economist, the fundamental value of the euro resides close to $1.10. Currencies should revert to fair value eventually.

(2) Stratospheric Oil Prices
Crude oil prices reached $38 per barrel at their recent highs. The recent turmoil in Europe has sparked fears of a worldwide energy crisis. The potential exists. Oil is uniquely qualified to maul a bull market: its high prices are “stagflationary,” restraining growth while igniting inflation. And since oil prices are denominated in dollars, a weak Euro is really a function of elevated oil prices. However, the world (with the exception of Venezuela and Iraq) is committed to lower prices. The Saudis just announced an intention to lower prices on the heels of barrel prices returning to $31. Intelligent OPEC member anchor nations such as Saudi Arabia and Kuwait realize it would be foolish to maintain artificially high prices, since that would only prompt more strategic oil reserve releases, new conservation initiatives, and poor relations with the US, Asia and Europe. Nonetheless, the problem is not really a shortage of crude oil so much as a shortage of refined products (i.e. heating oil) in the US. Refineries are running at nearly full capacity (estimates are at 96%- 98%) and the potential for a massive shortage there is real. The supply-demand curve of oil is of more concern than the Euro. Yet, oil too contains a self-correcting price mechanism: an increase in OPEC production coupled with a slowdown of the US economy will stabilize prices. Releases from the strategic reserves have smoothed price spikes. We are, however, watching closely for signs that oil prices are not returning to sustainable levels.

(3) Deteriorating Earnings
Whereas the first two items contain self-correcting price mechanisms, the last does not. Earnings can deteriorate for a long time without prompting any gravitational pull in the other direction. Earnings growth, especially in the tech sector, is rapidly deteriorating. The earnings deterioration indicates that tech spending is indeed cyclical and that the notion of the business cycle still remains strong. Much attention has surrounded oil prices and euro levels, but few analysts focused on a little noticed announcement on September 15 that US consumer prices fell 0.1% in August, the first decline in 14 years , signaling a significant economic slowdown. This is a potent omen for lower earnings.

The tech bear market is no surprise to those who experienced the Spring internet collapse and the unjustified risk of that subsector (something we won’t be shy about saying we anticipated); see 1999 4 th Quarter Letter and 2000 1 st Quarter Letter). The problem is that large cap tech bellwethers such as Intel, Cisco and Microsoft are all facing dramatic slowdowns in sales which are piercing their lofty earnings multiples.

The percentage by which tech stocks are off their high prices is a reflection of these massive earnings disappointments:

Cisco – 31%
Amazon – 69%
Dell – 52%
DrKoop – 94%
Intel – 47%
Priceline – 91%
Microsoft – 53%
TheGlobe – 95%
As of 10/4/00 Morningstar Inc.

And there are countless other examples. The average consumer internet stock is trading 80-90% off its high.

On September 7, prior to the recent September Nasdaq swoon, we reduced blue-chip tech positions in conservative-mandate and tax-deferred portfolios in order to lock in the significant gains of 1999. We believe there is still another shoe to drop on the Nasdaq that will follow from the intense deleveraging in the internet sector. Though the secular pattern to technology spending is clear as far as the eye can see, the cyclical situation is another story.

Of the three bear elements mentioned above, weak earnings is of the greatest fundamental concern. Recent warnings by Intel, Apple, Eastman Kodak and Alcoa show that earnings deterioration is diversified across many areas. The mitigating point is that worldwide GDP is still on target to exceed 4% for 2000 and perhaps 2001. Strong global growth indicates that this bear market could be relatively short-lived. In fact, it could be nearly over now that most earnings deterioration has been discounted by the Nasdaq. We would not be surprised to see a fall rally after the final shoe drops. But we are also selectively trimming tax-deferred healthcare/biotech positions to lock in the substantial gains in the year’s best-performing sector, now that the Vanguard Specialized Healthcare Fund and the Invesco Health Sciences are up 45.3% and 26.4% respectively year-to-date.

Perhaps the most disturbing sign is that complacency still reigns. To date, we have not heard a single Wall Street analyst call this bear a bear. That in itself is a harbinger of further pain. Day traders have been used to mop the trading floor, but many investors are still under the misconception that stocks always go up. These net buyers of stock are not prepared for what could be the first year of negative stockmarket returns since 1990.

The most important strategies for a bear market are to maintain the ideal asset allocation for individual account mandates, take gains where appropriate to preserve capital and, finally, to harness growth from undervalued sectors. We are resolutely applying all three strategies to each and every account.

July 7, 2000

Dear Investor:

An economic slowdown is at hand. If you’re nine years old, this is the first such event you’ve ever witnessed; for the rest of us, it’s business as usual.

The economy does appear to be disengaging from nine years of solid expansion. Home sales have started to soften and unemployment has ticked up, establishing 3.9% as the bottom threshold. Anecdotally, there are further signs of slowdown. But anecdotes don’t make for good investment decisions. And there are some hard yet quirky figures that conversely point to continued strength: in May, factory orders rose 4.1%, the largest gain in almost eight years, showing increasing demand for many goods, including chemicals and electronics. This figure confounded many economists because similar orders had fallen 3.8% in April.

But the bottom line is that six Fed interest rate cuts do appear to be gaining traction. For all those who declared the Fed impotent, this is a wake-up call. Our opinion is that that the Fed has lost control in a traditional monetary sense, but that its actions now act more like psychotropic drugs, swinging investor mood from mania to depression and back again with good success. The Fed will persistently deny they try to target investor psychology. That may be true, but it is what they nevertheless accomplish.

The implications for investors are at once profound and uneventful. The slowdown in growth must be put in perspective. Domestic GDP is set to slow to something above 3%, hardly a recession (which technically would be defined as two consecutive quarters of GDP contraction). And worldwide GDP is set to exceed 3.5%. Again, more like a world in “drive” as opposed to overdrive–a far cry from reverse, or even neutral. Such moderated growth means that corporate earnings will not fall off a cliff, however much they might slow. Recent high-profile earnings warnings such as those from IBM and Unisys will continue to grab media headlines, but we would hear far more mea culpas if the economy were truly toast.

A slowdown does, however, mean a flat to sloppy stockmarket. As of the end of the second quarter, all major indices are negative year-to-date: the S&P 500 Index is down 0.4%, just holding onto a flat year. Meanwhile the Dow is down 9.1% and the Nasdaq off 2.5%. The only asset class in the black is bonds, which perform well in a slowing economy and are benefiting our conservative accounts.

A bear market, or even a flat market, will try the patience of many investors who are used to consistent gains. What is important to remember is that the stockmarket rarely goes straight up, and the only investors who are truly rewarded over the long-term are those who stay the course, acting as investors instead of gamblers. Despite the lip service paid to this idea, people are human: many throw in the towel when the excitement wanes. The Fed has successfully removed the positive stimulus of a parabolic stockmarket because they had to. If they hadn’t, markets and mania would have overheated the economy. In doing so, the Fed has altered the moods of many people, especially daytraders who have had their addiction yanked right out from under them. Many daytraders were wiped out clean in the Nasdaq collapse, but even the rest stopped describing their days as “fun.” This is a good thing for most investors who were being subjected to unhealthy price distortions by the lunatics running the asylum. But now that the doctors have regained control, the orgy is over.

Do not be dissuaded by this environment. Historically, many investors lose faith in an asset class once it passes out of favor. If the bear market worsens, you will see many articles proclaiming the “death of equities” like the famous Business Week cover in the seventies. Those who threw in the towel after reading that issue have been kicking themselves ever since. Most often, such supposed death knells are preludes to massive rallies.

Speaking of daytraders, let us take just a few out-of-place paragraphs to explain why investing is better than trading and why all traders are actually gamblers (this is a controversial statement, but one we are prepared to defend at anytime to anyone):

For one, traders must rely entirely in a belief on the trader’s own worth, whereas investors must rely somewhat on the investor’s own worth but more so on the underlying investment’s intrinsic worth. The first is psychologically appealing to many egomaniacs but dangerous. The first is exciting, the other boring. The first gambling, the other work. The first allows you to hang out with gangsters and molls amidst the garish casino glow, the other puts you on the phone with accountants under a green banker’s light. I think you can begin to see why most people prefer trading to investing and why casinos are more popular than classes in securities analysis.

Here is an analytical example of why investing is better than trading:

Let’s assume that Company X has Y net cash on its books and is selling at Y – 20. The Investor makes a realistic assumption that, in time, Company X will trade at Y. This is based on hard logic, not whim: if Company X does not trade at Y, someone will eventually (even if it takes years) acquire the company, publicly or privately, and realize the cash value.

In contrast, the Trader assumes that Company X will trade at some imaginary variable Z at some future hour, where Z is usually some multiple of Y. The trader arrives at Z by guessing what other traders will eventually also pay for X. But the trader sees no intrinsic value in Z. Rather Z is just a temporary marker. The success of the trader’s game is predicated on being able to sell X at Z at some point, which is in turn predicated on Sucker S paying Z for X and then passing off X at Z plus some imaginary number we’ll call Q.

The overwhelming advantage to the Investor’s strategy is that (as stated above) if no one comes along to buy X in the passive market and thus value X fairly at Y, then the private market (through an LBO, M&A or other transaction) will eventually deliver Y to the investor. And if that never happens, then company X could be liquidated at Y or at some small premium to Y. This is why value investing nearly always works over time. As Marty Whitman is fond of explaining, the investor does not have to rely on the public market for an exit strategy.

The overwhelming disadvantage to the Trader’s strategy is that if no one (i.e. Sucker S) comes along to buy X at Z, then X will fall in value (perhaps to Z minus 90%, like Dr. Koop.com) with no possibility of a private bailout at Z as described above.

But there is a disadvantage to the Investor’s strategy. It’s slow and boring. And thus requires that most precious of all commodities: patience.

It is our contention that trading is only good for:

1. Traditional brokers who make money on transactions, not results (this is why it’s so deeply ingrained in market culture).

2. Gamblers who must satisfy a psychological need.

3. Those who believe they can always predict Sucker S’s psychology and thus always know when Sucker S will pay Z for X—a difficult and dangerous pursuit. We have never come across someone so smart that they could do this consistently. George Soros was probably the most successful member of this group, but even his star has now fallen.

To appreciate how difficult #3 is to accomplish, examine the classic probability question: if a roulette wheel lands on red six times in a row, what is the likelihood that next time it will land on black? If you understand this quandary and its psychological temptations, you understand why investors have long careers, while traders come and go.

April 11, 2000

Dear Investor,

In a climate where the market can swoon over 570 points in a Nasdaq second and then retrace its ground just as fast, there is no doubt that risk management should be the primary goal. At least, for any investor wishing to preserve capital and ensure long-term success.

Extraordinarily volatile markets are nothing new, nor are they bad. In fact, they are the very stuff that promote liquidity, punish speculators, and return value to stock prices. In the Nasdaq boomerang just past, many margined investors were sold out of securities or wiped out clean, with margin calls running five times their usual volume. This is nothing but healthy for long-term fundamental investors who buy real companies, not ephemeral stock prices.

One concept all but lost in the massive technology bull market is that buying a stock means buying an equity stake in an underlying company. Buying an equity stake in an underlying company and having success with that investment means that such a company must have a realistic way of making money at some point.

Witness the tragedy of DrKoop.com (Koop), one of the first internet companies that appears to have run aground against this simple truth. Koop was once trading at over $45 per share, valuing the company at somewhere upward of $1.35 billion. As of Friday, the stock had declined to $3, forcing investors at the peak to lose 93% of their money and assessing the company at $112 million. Why the plunge? For the very good reason that its auditor, PricewaterhouseCoopers, declared that the company would soon run dry of cash and probably not survive as a going concern. It turns out that many internet companies like Koop never really had a way to generate revenue and feed their terrible burn rates. Anyone applying a little common sense would have seen a company built on the odd name of a former surgeon general and an internet prayer, but not much else. It is our opinion that the Koop story, which broke the week before the Nasdaq collapse, had more to do with subsequent investor jitters than the Microsoft saga (which is, after all, company-specific news beneficial to competitors such as Sun, AOL, and others).

What’s instructive about Koop is that the story was known ahead of time. According to Business Week, PricewaterhouseCoopers gave the same bleak analysis at the time of the firm’s IPO. The story of Koop is a story of daytraders buying into stocks purely as gambling chips with no regard for corporate fundamentals. Daytraders saw Koop climbing and thus piled on, ignoring warnings and caring only that the stock showed dizzying upward momentum. After all, if a stock goes from 2 to 20 and you are a daytrader, you don’t care if the company’s really worth 20, you just delude yourself into thinking that you will be able to get out before the bottom drops. Unfortunately, as many traders learned with Koop, when an illiquid stock is sinking like a stone, you can’t sell at any decent price.

This is why investors who wish to manage risk and preserve capital should not gamble with their assets but instead subject investments to rigid quantitative and qualitative screens that make sure the company is not just worth buying—but worth holding, hopefully (if you’re doing it right) forever. This is the only risk-management strategy that works time in and time out, for the long term and promotes eventual, albeit sometimes slow, success. In fact, an investment is akin to a marriage, in the sense that your mate should be a good match for life, while a trade is like an affair where your partner can become a disaster unless you get rid of them when you want to—a big if.

We would like to take the opportunity to profile how our main technology-sector manager goes about buying stocks so that you understand how much work, research and risk-management enters the process. The manager of the Seligman Communication & Information Fund, Paul Wick, has the best audited ten-year annualized return of any manager in the diversified tech sector. While there are many managers who have beaten him in any given year, no one has beaten him over the ten-year, long-term time period which truly separates the boys from the men.

Paul Wick, assisted by his specialized team of analysts, subjects every stock purchase to exhaustive due diligence. This means that every company undergoes the following: balance sheet analysis, earnings projections analysis, management evaluation, competitor evaluation, sector evaluation, supply chain evaluation. Perhaps most important, the capitalization strategy of each company is thoroughly analyzed to determine whether the company is well-financed or will have to return to the capital markets within a short time, thus devastating current shareholders. Mr. Wick and his associates closely follow the sector in which each company operates to understand whether that company will be the ultimate winner. And finally, he looks to identify the next Microsoft or Intel, not a company like Koop, but rather one with a unique strategic advantage, proprietary technology and a reasonably well-capitalized structure to last it through bear markets. To that end, the Seligman Fund has approximately 3% in venture-capital type start-up companies that have been keenly evaluated and screened for their future prospects.

For example, Mr. Wick identified Microsoft and Intel early on, long before they were darlings of Wall Street. He bought them many years ago after applying cogent, detailed analysis and knowledge of the revolutionary software and chip markets. His fund investors have benefited dramatically by owning them ever since. They remain in the fund to this day. Instead of being stuffed in the portfolio and forgotten about, each is reevaluated on a continuous basis, a never-ending process that includes regular visits with high-level management and balance sheet reviews. It is through such technique that Paul Wick has bought and held the Intels and not the Koops. And intends to continue doing so.

A final word: please don’t fear market turbulence. The long-term investor is the ultimate beneficiary of such chaos, and operates somewhat like the “house” in a casino: collecting the chips from the gamblers as they have their expensive idea of fun.

January 11, 2000

Dear Investor,

Mark Twain’s famous quote that the return of his money is more important than the return on his money seems quaint in an era of parabolic tech stock returns. And understandably, in heady times like these, talk of risk seems trite. The paradox, however, is that risk increases as market multiples increase and that many investors have dangerously decided that risks apply to someone else, not to them.

At holiday parties just past, for example, all of us heard someone brag their portfolio was up X percent. But how often have we heard them asked in return, “How much risk did you assume to achieve that return?” And if the question were ever asked, could the answer even be given? The fact is that risk is dull to discuss and difficult to quantify. There are statistical tools to measure risk, including standard deviations and Sharpe ratios, both of which we use to evaluate managers and asset classes. Unfortunately, these quantitative measures are limited. Thorough risk measurement requires a long, hard look beneath the surface of a portfolio.

Imagine two Los Angeles skyscrapers under construction. Both are rising at the same rate, so it appears that the buildings are “even.” But in reality one may have a stronger foundation than the other. The risk that would differentiate these two buildings may never come to bear. Or maybe it will. Managing risk is like buying homeowner’s insurance. Even though you’ve never had a fire, it doesn’t mean the insurance was a waste of money. Not that investment returns can ever be “insured,” but the analogy has some merit.

Which leads us to Warren Buffett’s quip that “you never know who’s swimming naked until the tide goes out.” In our over-leveraged economy, there are many people swimming naked, especially margined retail investors. But no one will know who they are until the tide goes out. And it may not go out for many years.

The solution is not to time the market (nearly impossible), nor to shy from risk completely (as big a mistake as jumping in blindly), but to manage risk and to make sure portfolios match personal needs. Some people will try to persuade you otherwise, but risk is always and without exception correlated to reward. To achieve excess returns, you must take on excess risk; to limit risk, you must necessarily limit returns.

There are many complex risks to manage, some of which are subsets of each other: currency, political, monetary, fiscal, price, credit, sector, company-specific, interest rate, inflation, etc. Our goal is to manage all accounts in an effort to prevent the myriad potential risks from destroying an investment plan. Most of our work involves extensive due diligence to assess the qualitative and multi-dimensional risks inherent in investing. And most important is to make sure the risk profile of a thirty-year-old with no dependents is not the same as that of a seventy-year-old retiree. Of course, no one can ever guarantee against risks, but managing them is essential.

The spectrum of risk runs the gamut from venture capital at one end to FDIC-insured savings accounts at the other. Even the successful venture capitalist strikes out nine times in ten, while the savings account holder never even goes to bat. The current vogue is for buying one or two individual tech stocks and riding them to the stratosphere. This non-diversified strategy (closer to venture capital but with the massive disadvantage of passive minority retail ownership and pricing) can generate superb returns. That we all know. But many people do not understand the risks involved, or that such a strategy can also lead to stunning losses. For example, have you heard of Steak & Ale, Simplicity Patterns, Natomas, American Air Filter, Bandag, Lubrizol, and Ponderosa Systems lately? Well, they were some of the favorite stocks in 1972. No longer.

That is why a fully diversified strategy is the best option for investors who wish to manage risk. For example, our main tech fund, Seligman Communications & Information, owns Microsoft, Cisco and Sun Microsystems, but it also owns KLA-Tencor, Lattice Semiconductor, Applied Material, Nokia, Juno Online, Stamps.com and others. This enables clients to invest in both software and Internet infrastructure, but also in semis, telecom and Internet retail. The RS Information Age Fund pursues a similar diversified tech strategy, with ownership in AOL, Microsoft, Cisco, and also Intel, JDS Uniphase, Dell, et al. In addition, each fund holds smaller companies which could be the next Microsoft: seeking the future big hit is as important to long-term financial success as playing the current tune. But to manage risk, it must be done in a diversified way.

Despite claims to the contrary, no one knows what companies or micro sectors will rule the tech landscape in ten years. This foggy future engenders massive sector and company-specific risk. And if you wish to manage those risks, it’s important to own several companies in different sectors. Remember that a diversified portfolio will never outperform the best performing stock at any one time (a logical impossibility). Similarly, a diversified portfolio will never underperform the worst performing stock.

Now to a recap of the year: We and others have been surprised by the strength of the US economy. It remains strong, evincing few signs of slowdown. The information technology boom is certainly feeding this strength. But so is the resumption of growth in Asia. It’s important to note that parallel to the well-publicized bull market in technology last year was a stealth bull market in Asia.

The outlook for Asia is strong, with average GDP growth predicted to exceed 5% in 2000. Singapore and South Korea could see annual growth topping 6% (Japan is the weak link, striving to maintain a positive GDP trendline). Worldwide GDP could reach 4% in 2000 and 4.1% in 2001. In this remarkably altered environment, many struggling Asian companies will return to steady profit growth and non-performing loans should continue to trend downward. This will lead to a resolution of the banking sector woes that are still the mother of all millstones around Asia’s neck. But it will also lead to higher worldwide interest rates and tighter monetary policy in the US. Long bond rates could exceed 7% by year-end, especially after the new December jobs data showing incipient wage inflation of four-tenths of one percent. Higher interest rates could issue some serious shocks to the US stock party. Inflation could easily rise past the 2.2% expectation (currently priced into the bond market) and spark fears of an end to the global disinflationary trendline.

Most important for long-term investors is that Hong Kong is becoming the “cyberport” of Asia and will surely be the conduit for most information technology catering to China’s enormous growth. China is leapfrogging other nations in its entrepreneurial progress and the private sector is growing dramatically. Whether it can pick up the slack from “state owned enterprise” reform remains to be seen. There will be corrections and disappointments, but we believe that a global investment perspective will continue to rule the day for some time.

As the noted Asian economist Dr. Prasarn told a reporter recently, “it is important to realize that risk stems from choices, not from fate.”

October 10, 1999

Dear Investor,

The last week of September brought a bruising sell-off that left the S&P 500 up only 4.4% year-to-date. Though, as of this writing, the market has recovered somewhat (and expected strong Q3 earnings could propel the market higher), we believe that American markets are doing what was inevitable: reverting to the mean. After 20-30% years in both 1995 and 1996, investors found themselves hooked, despite the fact that historical average annual returns are 10%. When 1997 repeated this masterful feat, investors started thinking of the stock market as a money market account that somehow paid 20% a year at no risk and with no sustained declines. 1998, however, injected some measure of reality by nurturing a very narrow rally that left most stocks with lackluster gains. It was only the techs and internets that drew interest, but then internets collapsed in April 1999. And 1999 has ushered in a new era indeed. An era in which the stock market has returned single digits.

Here are some illustrative returns year-to-date through September:

S&P 500 + 4.4%
DJ-Global US + 3.3%
Newport Tiger Fund (Asia) + 26.7%

It’s important to remember that lower US stock returns can nurture the “soft landing” in our economy that the Fed has yearned for after so many years of economic expansion—that is, the economy can return to normal without plunging into recession and without the Fed having to pull the plug to stifle inflation. This means that low returns now can yield sustained and steady returns over time. This will benefit all investors more than a final nail-in-the-coffin 30% year which would overheat the economy into collapse.

Most important to note is the relationship between low relative returns in the US and higher returns elsewhere. The reason why US equity returns have diminished is that interest rates have risen on the recognition that the global economy, especially Asia, is resurgent.

This is not a bad thing. Remember that just a year ago the media was concerned that the global economy would meltdown and that worldwide GDP would dip below the dreaded 1% threshold. A year later, we are worried about the Fed tightening rates to muzzle a global GDP of 3% or more.

The bottom line is that high relative returns are moving elsewhere. Despite a marked recent correction in Thailand, we believe the bulk of those returns are moving to Asia (this is reflected most definitively in the stronger Yen versus the Dollar). That is why we maintain Asian stakes in all client portfolios. Clients often ask the logical question: “If you are so bullish on Asia, why have you not put my entire portfolio there?”

The answer is that old gadfly: risk. A money manager’s job is to balance different risks to prevent the myriad of worst-case scenarios from ever appearing. Asia, though poised for the fastest growth at the most reasonable price, entails political risks and currency risks that just don’t exist here at home. In any portfolio, risks must be balanced and diversified against one another: and so currency risk must be displaced by price risk which must be displaced by political risk and so on and so on. Just as no one would want to place all their assets in Asia (political risk/currency risk), so no one should want to place all their assets in the US (price risk). Either scenario entails unjustifiable exposure to different types of risk. The risk tolerance and individual profile of any one client will determine the precise allocation.

We know investors, including our clients, will be discouraged by the patience that low relative returns require. After 1995-1997 during which literally anything domestic went up, this new market is a different animal. Markets do not always go up in a straight line. Many months, and sometimes years, they go down. Stocks reward long-term holders by testing their patience over the short-term. The very thing that differentiates a savings account and the stock market is that a savings account puts a time frame on your gain—at the expense of excess returns, while the stock market keeps you guessing in exchange for higher ones. There is no question that the long-term stockholder will beat out the long-term savings account holder. But in return the stockholder will often have to endure uncertainty and discouragement.

We believe US returns are slowing down, Asian returns are increasing and US-based investors do well to maintain a well-diversified portfolio with exposure to both regions. A global perspective will rule the day for some time to come.

July 2, 1999

Dear Investor:

As the Yiddish saying goes, those who do not depend on luck have less bad luck.

“Luck be a lady tonight.” And may she stay that way, for luck is not a kind mistress when it comes to investment. This lesson was hardly lost on those speculators who plunged into Amazon.com at 221 ¼ two months ago. They were clearly counting on the seductress herself, because there was not much else on which to base an opinion: Amazon was overvalued by any measure and still losing money, but if their neighbor bought it at 100 and sold at 200, they wished to buy at 200 and sell at 400. Why not? Lady luck could hold on just a little longer, couldn’t she?

Instead, she responded callously, cutting Amazon stock in half and finally letting it rest at 122 where it now resides (no, there was no stock split responsible). Many speculators had borrowed money on margin–or leveraged themselves–to fund their investment in Amazon and were punished in kind. A $221,000 initial investment in Amazon is now worth approximately $122,000–an ironic and cruel reversal of digits. A $221,000 initial investment leveraged at any significant level has evaporated, a mere vestige of easy money. In real terms, an initial investment on the scale of a three-bedroom house in Miami has been converted to a small studio in the first example and a cardboard shanty in the second. Many day-traders have been wiped out. We know this because margin calls were at a breakpoint during the May Internet collapse and subsequent bear market.

What is most important about the Internet collapse is that it did not take down the rest of the market, which has, in contrast, exhibited a marked and healthy return to value since the new quarter began. And speculators have been extinguished, making it a safer place for the rest of us. Finally, Internet stocks are now at “deleveraged” levels which finally make them attractive, reasonably priced companies to own. Indeed, our technology fund managers have been buying some Internets and adding to positions of AOL and others post-collapse as these stocks have started to recover in a less speculative, healthier, deleveraged way.

On the other side of economic cycles is Asia, which shows an underlying improvement in the fundamentals and the continued soundness of a “vulture oriented” strategy in that region. Just yesterday the Bangkok Post reported that Thailand has shown its first quarterly GDP growth (of 0.9%) in nearly two years, possibly signaling the end of depression. The National Economic and Social Development Board (NESDB) had originally predicted a 4.7% contraction, illustrating how strongly the economy has surprised to the upside. The NESDB and other economists are now revising their annual growth targets far upward of the original 1% consensus. Both S&P and Fitch IBCA have upgraded Thailand’s sovereign debt, and Moody’s is expected to follow suit.

Other regional signs of recovery abound and finally the mainstream media is catching on: In South Korea, industrial production has hit a pre-crisis high, while in Japan first quarter growth reached an astounding 1.9% (though this number is less convincing than others due to the massive artificial fiscal and monetary stimulus currently underway there). We believe that Asia has merely entered the early stages of a post-crisis bull market that will prompt a massive liquidity shift from overvalued Western markets.

But we are most gratified to see that the domestic market has broadened, once again embracing value stocks and companies with good prospects at reasonable price. It took the threat of significantly higher interest rates to accomplish this, and the bond market, acting violently on its own as it often does, has allowed the Fed to abandon its tightening bias after a mild 25 basis point rate hike. As usual, Greenspan has done the right thing, despite the absurd, ignorant, and just plain embarrassing whining of congressmen at the Chairman’s recent testimony.

Thank you for your patience in the First Quarter when all seemed hopeless and thank you for your participation in the Second Quarter when all seems hopeful. Finally, thank you in advance for your continued patience in future quarters as the pendulum swings back and forth between these two extremes–as it always will.

April 16, 1999

Dear Investor,

The past quarter marks a disappointing period for your advisor and your accounts. We have been overweight the small caps as they continue to underperform large tech issues by an extraordinary margin. And we have watched anything that smacks of value remain the market wallflowers while dangerous growth stocks grow dangerously popular. One exceptional bright spot has been our weighting in Asia, which has widely outperformed US stock indices for the past six months.

Whereas, by April 1, the S&P 500 had climbed 5%, the Russell 2000 (a broad smaller stock index) had actually declined several points. This gap seems awful enough. But it gets worse: the discrepancy has persisted for over a year; the S&P 500 eclipsed the small stock averages by more than 20% in 1998. This astonishing divide means that many good stocks are selling at excellent prices. It also means that most money managers, especially value managers like ourselves, have underperformed the narrow large-cap equity indices such as the Dow and S&P (what most people erroneously refer to as “the market”).

Many people, including some of our clients, understandably feel that they are being left behind as strident shouts of Dow 10,000 rule television. But despite ubiquitous barroom anecdotes, few diversified investors have made real money in this climate. This is largely due to the market’s astonishingly narrow breadth. By way of example are some first quarter performance measures of famous investors, along with two relevant first quarter performance averages:

George Soros: -15.0%
Julian Robertson: -7.5%
Jeffrey Vinik: +1.0%
Average New York Stock Exchange Stock: -5.2% (as of April 9)
Value Fund Average: +1.0%
Source: The Hennessee Group

Nearly all of our accounts are outperforming these measures, most of them by large margins. We offer these statistics, not by way of excuse or buck-passing: we are very well aware that with every investment decision we make, the buck goes no further than our desk and our own performance measures. We present these numbers only to offer a sense of perspective and educate investors to the reality of recent market returns.

The best course in times like these is not to chase prior index performance by jumping aboard the same small bandwagon of overpriced large-cap stocks that have propelled this narrow market. It’s better to make intelligent investments that pay heed to franchise, viability, and valuation, and avoid buying into a mania (as defined by paying poor prices for poor product).

Just as market prices are always changing, so is human nature ever unchanging: People will forever be ruled by deep swings between greed and fear. Thus, they will forever pay too much during booms (witness some overpriced Internet stocks without viable business plans trading at absurd multiples) and sell for too little during busts (witness some Asian banks trading at half book value despite that fact that they too are becoming Internet companies). It is important not to overpay. Just as you shouldn’t pay too much for anything, be it mufflers, widgets, franchises, or real estate, so too should you not overpay as an outside passive minority investor (shareholder) buying a stake in a business. Overpaying always leads to poor returns.

So the answer is to remain invested at an appropriate allocation, manage risk to avoid catastrophe (still important, believe it or not), avoid both greed and fear, and make money over time. Perhaps, more important, you can take some solace, however hollow it may at times appear, in the knowledge that our strategy is not based on fads, Internet mania, good feelings, dubious notions, or possibilities, but rather on facts, statistics, historical research and probabilities.

Investing is a process that requires patience for success, mainly because market leadership is cyclical. “What goes around comes around” never held truer than on Wall Street. Thus, value investing is now at an ebb, while the growth style flows. From 1992-1995, the reverse was true. The current psychological temptation is to fold the value cards. But this would be the prelude to a classic whipsaw. Our most important dictate is never to sell on impairment of price, only on impairment of value. There has been no impairment in the underlying value of our holdings. Ironically, as of this writing, there is a hint that market leadership may be shifting sharply back to value, but it is far too early to tell.

To loosely quote Philip Carret, one of the most successful investors ever, bull markets are like octogenarians: they can keep going longer than expected, but their future prospects are not good. To illustrate both sides of his point, Mr. Carret lived past 100. Luckily for his heirs, he never abandoned his value discipline, even during a very frustrating period of market distortions known as the Great Depression.

January 11, 1999

Dear Investor,

Looking a year out, the Millennium will arrive with neither shouts of cataclysm nor tears of sorrow. Instead we are slated for mundane things like progress and the wealth that accompanies it. The world has passed an extraordinary test: having almost drowned in economic depression, it still swims to the capitalist shore.

The Asian Crisis challenged assumptions about economic progressivism, free trade and capital flows. Yet, to date, only one nation (Malaysia) has retreated behind capital controls and only one other (Indonesia) has run amok. This may not seem like a good tally, but if you consider the last depression of such proportions, it spawned a bevy of dictators the world over. Russia and Brazil remain open questions, but considering the destruction of Asian assets, the world is still moving in the healthy direction of economic freedom and Asia is in the process of a slow recovery.

The Wall Street Journal has just published its 1999 Index of Economic Freedom, confirming the good news. The Index still shows Hong Kong and Singapore to be number one and number two respectively (by way of comparison, the United States is #6), meaning that those two extraordinary regions remain the most economically free zones in the world, as measured by factors such as trade, taxation, regulation, property rights, and monetary policy. The world, with the exception of a couple of high-profile masochists, has decided that free capitalist trade is the inevitable direction of human progress.

While a massive bull market in technology (and especially the Internet) was on the radar screens for most people, a “stealth” bull market, one even broader and deeper, occurred in Asia as market participants priced in an Asian recovery. More than anything else, these stock movements are a clamorous and wise vote on the correct policy moves of Thailand and South Korea, the two hardest-hit countries that chose to stick with progress.

The good news is that the world is dancing forward, not backward, and that the fierce 19.3% correction of last summer will not lead to a full global depression. The bad news is that markets are doing the jitterbug, not the two-step, and their heady jubilation will mean more volatility.

How are we doing? The fourth quarter of 1998 was an incredible bull run, and showed the value of keeping our accounts fully invested along disciplined asset allocations, and not resorting to equity selling. That bizarre and leavened quarter shows more than any other the value of shunning market timing and sticking to the individually tailored asset allocation.

We believe that Asia will continue to be the place to be, and that weightings should be maintained. Our Guinness Flight analysts point to discernible signs of recovery: increasing property transactions in Hong Kong, lowered interest rates across all of ASEAN, and a recovery in the semiconductor market. The Bangkok Post tells us that Thai golf club memberships and car sales are up for the first time in eighteen months. The consensus estimate of economists points to a recovery in Asia ex-Japan in the fourth quarter of this year. Stocks are clearly pricing in that recovery now. There will still be negative shocks: continued Japanese implosion, a slowdown of growth in China, renewed pressure on the Hong Kong Dollar and/or a devaluation in the Yuan. But these shocks will be buying opportunities, and the long-term trend will be up. Not down.

Our major disappointment in 1998 came from the small cap sector that continues to hinder us. The small cap to large cap discrepancy is astonishing in historical terms. Peter Lynch, who likes to calculate such measures, defines a buying opportunity in small caps as one where the ratio of small cap p/e to large cap p/e is less than 1.2. Well, that ratio has trended down to almost 0.8, a screaming buy. Having studied many market cycles that resemble this distortion, we (as he would) suggest staying the course. Marty Whitman, the manager of Third Avenue Value, and someone who has seen it all, put it more succinctly at his recent conference: “We’ll clean up!”

On the subject of cleaning up, we turn now to the Internet sector, which has been the big clean-up for those invested there. The astonishing climb of these stocks, most of which lose money but gain investors, has been truly extraordinary. Playing internet roulette is best left to those without real risk (i.e. the lucky ones with stock options at internet start-ups who, without risking real dollars, may be able to exercise their options to great gain) and those with infinite risk tolerance.

Don’t get us wrong: We are firm believers in technology and the money to be made there. To that end, we maintain significant weightings in the Seligman Communications Fund and the Robertson Stephens Information Age Fund. Both of these funds see the Internet as we do–as a broad societal breakthrough. And both funds have profited handsomely in 1998 by being investors in AOL, Microsoft, Intel and many other excellent tech companies with discernible earnings. But they shun companies without earnings, and for good reason. The internet boom in companies without earnings is being led by the retail investor who, in a desperate bid to cash in, does not really understand (or ignores) the risks. This all bears a ghoulish similarity to the Biotech boom of the early 90’s when countless companies without earnings were bought up to outlandish heights by unsuspecting retail players. When most of these companies turned out to lack real product, the bulk of them completely collapsed, leaving much ruination on the road to greed. The time to really buy was in the wake of that collapse, when the winners were sorted from the losers, most players were still hung over, and shares could be purchased at lower risk. And as you can see from the chart above, you can makes lots of money in banal businesses too, like brokerage, and feel good that you’re investing in the second oldest profession, one with almost as much staying power as number one.

A couple of caveats to those of you who may be playing internet roulette on the sly: buy only companies with steady earnings, clean balance sheets, strong business plans, excellent management and a sustainable product. Buy not on the tip of a tippling neighbor. Do your homework. And diversify adequately, because a few internet companies will win big, but many more will go the way of Tandy and others like it (remember those old favorites of the early computer boom) and become sorry names with sorrier shareholders.

We look forward to the challenges of 1999. The Millennium looks better from here than we thought it would. The newborn Euro, though due for rough patches brought on by convergence, is a good example of globalized economic inter-relationships. Worldwide growth will slow, yet looks set to renew itself at year-end. Shocks to the system will continue, so a proper asset allocation is the key. We are very thankful for your patience and support during the insane year past. And we look forward to delivering slow, steady growth over the years to come.

October 1, 1998

Dear Investor,

About leverage, Warren Buffet said, “if you’re smart you don’t need it, if you’re dumb it’ll ruin you.” He forgot to add: if you’re brilliant and arrogant, it will ruin you double.

Such is the sorry epitaph on Long Term Capital Management’s (LTCM) career. Long Term Capital Management seems a case of “everything but”: that is, a short term lack of real capital under mismanagement. This has taken some by surprise. After all, the notorious hedge fund is managed by two Nobel Prize winners, a former Salomon VP and a dozen other alchemists of perfect pedigree.

Examining why LTCM failed is a good exercise in understanding fundamental mistakes in money management. Despite its astonishing brain trust, the fund made two basic mistakes anyone’s grandmother would have warned against: (1) ignoring risk by using excessive leverage, and (2) relying exclusively on a mathematical model at the expense of buying good investments. There has been much speculation on what LTCM did wrong. Most of the theorizing is as needlessly tortured as the fund’s own disastrous trades. There have been articles about addiction to derivatives, emerging market debt, misguided forays into stock arbitrage. These all miss the point that LTCM was the victim of something biblically basic: greed.

LTCM is said to have employed leverage on the scale of 30:1 (or more). This is a shocking amount of leverage, of astronomical proportions—enough to look positively pagan and grotesque. No one should use this amount, not even PhD’s, no one. That not a single person suggested they should deleverage this tightly wound booby-trap of their own making is shameful. But then again, they probably didn’t have a sensible grandmother on staff.

Far more shocking than the amount of leverage was the relatively shallow gains they were able to accrue via such a powder keg: The fund is said to have returned about 40%, another 40% and then 17% in its three good years. These are returns that anyone would admire under healthy risk management but not at 30:1 leverage. Making this kind of money on this kind of leverage is a little like robbing banks: you can make a living for a while, but someday you’ll pay. As one pundit said of Bill and Monica, never has so much been risked for so little.

So how then did LTCM succumb? They committed a second cardinal sin: they believed their own “foolproof” model. LTCM is said to have primarily engaged in bond arbitrage, a “risk-free” game where participants bet their chips on reversion of interest rates to their historical norm. It’s like betting that since on average blondes have more fun, in a year where brunettes are oddly having more fun, blondes will necessarily have more fun in the following year. Despite the flippant analogy, this is actually a good strategy when applied to many markets: Most interest rates do revert to their historical means eventually and equity prices revert to their historical valuations. Much money can be made on these distortions. Much real money on Wall Street is made in precisely this way.

The fatal flaw comes when the manager relies on the mathematical model at the expense of psychology and common sense, ignores the underlying investment stature of the vehicle and then tethers that false confidence to horrifying gobs of leverage. Interest rates and other financial measures revert to their historical means because they recover from the constant distortions in the short term caused by human psychology (i.e. excessive buying and selling caused by mania and panic). To forget the psychological roots of this phenomenon is to slit your own throat. It appears that LTCM may have relied on computers to tell them that interest rates would converge without being cognizant of the psychological disconnect that was making normal distortions excessive. At the time of their debacle, they were apparently unaware that global markets were panicking to a degree not known in recent years–that traders were selling anything that smacked of even superficial risk, thus selling off high-grade corporates along with defaults and jettisoning many babies with the bathwater. Not to have been aware of this phenomenon is to have had blinders on to the world. The computer was screaming something like: “Spreads have never been bigger! Buy Russian debt! Short Treasuries!” Common sense should have been screaming: “Russian bonds are bad underlying investments! Buy Treasuries! Don’t short anything! And above all, have some patience so you don’t have to use 30:1 leverage!”

If LTCM had avoided leverage, their bet would have been relatively harmless—just a normal trade that lost money in the short term and would correct when interest rates did eventually converge. But leverage made this impossible. The powder keg had already exploded. We can only hope that not all hedge funds will be tainted along with LTCM since many are well-managed partnerships that pursue sound, unleveraged investment strategies.

Well, enough about LTCM, what about the rest of us?

It was an extremely difficult and ugly quarter for financial assets generally–the worst quarter of broad stock market returns in the past eight years. A virtual meltdown has occurred in nearly all financial asset classes except Treasury bonds. Our accounts have held up better than the indices during the recent correction. Conservative accounts were cushioned by their bond holdings and more aggressive accounts on average lost less than the indices by dint of their value orientation. Though recent returns have been good in relative terms, they have been poor in absolute terms. We strongly feel that performance will improve when small-caps and value equities gain after year-end tax selling. As a result we are doing little new domestic buying now and waiting until December.

Despite (or due to) the recent correction, stock market Nintendo continues: people follow the tape like a video game, feeling they could get to the final round if they just had joystick in hand. This is a dangerous way to view markets, one that has always been with us and never will not be. It’s important to avoid it yourself, shun the daily ticker and instead concentrate on the underlying investments. We are often asked how we make our sell decisions. Do we sell when a price collapses or starts to collapse? The answer is no. We do not sell on impairment of price but only on impairment of value. This is a hard concept to get a handle on, and even harder to act on, but it is the single most essential secret to long-term prosperity as an investor in equity markets. All renowned investors with long and fruitful careers, from Buffet to Templeton to Carret to Lynch, have used this strategy in some way or other. None ever sold IBM because it dropped from 100 to 50. They only sold if IBM dropped out of the league of companies with promise. The corollary to the above is that we will often sell when a dramatic increase in price occurs without a parallel increase in valu–the very definition of a “mania.”

There is one serious drawback to this strategy: it requires patience. And patience is the most difficult commodity to get hold of—one which continues to be in short supply as we all trend toward being immediate gratification players. But without patience you cannot be an investor; you can only be a trader, and then, like LTCM, take the risks that traders take.

A quick comment on Hong Kong investments: We unfortunately had to sell all Hong Kong holdings on August 17, after the Hong Kong Monetary Authority (HKMA) decided to take the unbelievably misguided step of using reserve capital to buy equities in the open market. We decided to exit after the government artificially bid up prices by approximately five percent. Prices continued to climb after our sale but then dropped dramatically as the HKMA pulled the plug. Exiting was necessary because we cannot, under our risk management criteria designed to protect our clients, participate in markets where valuations are artificially inflated. This does not mean that we have given up on Hong Kong. On the contrary, now that we have received confirmed reports through our Guinness Flight analysts that government buying has ceased, we are buying back positions in Hong Kong, augmented by positions in Singapore, Taiwan, and Thailand where valuations look even more compelling. We are extremely optimistic that Asia will rebound, especially in Thailand where the SET Index has already moved from 207 to 249 since September 3, a gain of over 20%. Asia remains one of the prime regions of future wealth-building for those with patience.

Despite the fact that Wall Street is finally sloughing off its denial and waking up to the prospect of feeble multinational earnings (having revised 1998 World GDP Growth down to 2.3% from above 4%), some selective stock sectors are starting to look more attractive now that they’ve corrected. The small caps look especially attractive and even some multinationals are starting to look buyable as one by one, Gillette, Coke and others collapse. What’s starting to look expensive are bonds, especially Treasuries with the yield cracking 5%, so we are keeping duration low.

A final word: LTCM is an example of the Great Deleveraging, something that is essential in that it invokes the economist Schumpeter’s “gales of creative destruction” which wash away the tightly wound players and restore normalcy to markets. So don’t worry about LTCM. Just be glad you’re not a leveraged shareholder.

The market is famous for its hobby of humiliating the greatest number of people the greatest number of times, but the market lusts even more to humiliate those without so much as 1% humility.

July 9, 1998

Dear Investor,

Buy low, sell high is a piece of investment advice that few adhere to anymore–a shame, since it’s the only piece that ultimately matters. The adage won’t have meaning though, until that black day when selling high becomes history.

On the equity side, it’s been rough sledding. We’ve resisted the mania to swim with the large caps. They’re just too expensive. Quarter 2 was difficult, with the widest gap in many, many years between large caps and small caps. The S&P corrected a mild percentage while the Russell 2000 Small Stock Index actually imploded, declining 11.6% from its high on April 21 to a low on June 15. This situation, politely known as a disparity, will correct itself as market disparities always do. That’s why, as their share prices still disappoint, we increase our positions in small companies and continue to underweight large caps.

What’s extraordinary is that Russell 2000 earnings look to eclipse S&P 500 earnings by as much as 10%. So why the disparity? For one reason: liquidity. In volatile, sloppy times like the present, day-trading gamblers and foreign investors are searching desperately for liquidity. It recalls the anecdote of the pensioner looking for his watch. His wife asks: “Why are you looking for your watch in the living room when you know you always leave it in the bedroom.” The pensioner replies: “Of course, but there’s more light here in the living room.” The anecdote fits like a snug coffin: value doesn’t lie in the large caps, but there’s more light there temporarily– in the form of liquidity.

To buy stocks with a heavy liquidity premium for the sake of that liquidity is stupid and, most of all, myopic. That’s like overpaying for sneakers for the privilege of returning them, instead of looking for the right-size sneakers in the first place. Lazy managers do it, but we won’t. We’re investors–not traders–and know that liquidity premiums always evaporate, be it with the Nifty-Fifty in the 1960’s, or with the South Sea Bubble in 1720.

On the bond side (in conservative accounts) we’ve seen a continued rally: yields have dipped to extraordinary levels, spiking bond prices upwards. This has enabled our accounts to cushion themselves from the gyrations of the equity market and earn a nice coupon plus capital appreciation besides. This not uncommon uncoupling of the bond and equity markets demonstrates the true value of asset allocation. As the famous Brinson Study discovered, “asset allocation” is the single most important determinant of portfolio performance, accounting for over 90% of variability in portfolio returns.

Crossing the globe, we continue to be very bullish on Asia long term (5+ years). We did limit positions in Japan, but are increasing positions in Hong Kong. We agree with hedge fund guru Julian Robertson that Hong Kong represents the single best valuation of any market in the entire world today.

In the Economist, Hong Kong was recently ranked #2 in worldwide economic competitiveness, ahead of the United States and Britain, and behind only Singapore (where valuations are not as cheap), based on factors such as tax structure, transparency of markets, regulatory authorities, economic flexibility and bureaucratic efficiency. Fear continues to infect the region like a malingering, airborne virus. This keeps prices low enough where we can continue to build conservative positions. Should any of the major near-term risks materialize (such as a currency devaluation), we would buy more heavily and average down into overweight allocations. Many will grow rich in Hong Kong as this vibrant economy shrugs off its economic woes, services one billion Chinese consumers, and shoves aside Tokyo to become the new financial capital of Asia. But we will have to be more than patient: the market will continue to be extremely volatile.

We don’t, however, yet feel that Asia will slip us into global hell. Despite some fiscally misguided Hooverisms by Japanese Prime Minister Hashimoto, we do have a “lender of last resort” these days in the form of the IMF/US Central Bank conglomeration; thus, we don’t predict another Great Depression. But the situation is not pretty–having been aggravated by stifling, inept IMF policy–and bears close watching: if Japan continues to withstand international pressure and ignores its responsibility to lead Asia out of the abyss, we might have to sell stocks and overweight even the most aggressive accounts in bonds.

A final point: We are often asked why we would be buying in Hong Kong now, since the economy is in recession. Aren’t you supposed to wait until it “all clears up?” This question smacks of good common sense. Unfortunately, it doesn’t reflect the way markets work. Markets are discounting mechanisms, which means that they discount future earnings potential–which means in plain English that they go up or down long before the fundamentals which underpin them. Thus, to wait for things to clear up is to wait until prices have long since shot up. Which is why so many people are often heard to exclaim: “I shoulda, coulda bought that X years ago!” Most of us unfortunately buy when it feels right, and it feels right at the top, not the bottom.

But we haven’t forgotten that you buy with your brain, not your feelings. That is, you buy low and sell high–not the other way around. We and our clients will reap rich rewards for that in the long run.

April 6, 1998

Dear Investor,

The lemmings are out again on Wall Street, bidding up the big caps and swimming in their own unhealthy optimism. They haven’t drowned yet–then again, speculative bubbles can last years. Thus, we limit risk by searching for value wherever we must find it: amid the high rises of Hong Kong, in the undervalued small caps, and in downtrodden, unloved, abandoned markets anywhere.

The ignorance out there astounds. A gentleman at a recent gathering announced that he was in a “risk-free, high yield” fund. How it was risk-free, he wasn’t quite sure. It would have bored the other guests to explain that high yield investment cannot possibly be without risk. And more important, that every investment entails risk: interest rate risk, credit/default risk, principal risk, whatever. Even an insured bank deposit, thought to be a “safe” investment, entails substantial inflation risk—a risk so infinite and horrifying that if someone actually sat and thought about it, there’d be a depression-style run on the banks tomorrow. But the banks will stay in business because the fear of principal loss is more tangible than the fear of inflation. The banks, of course, make their money off this fear, offering ordinary people a lousy rate of return on their deposits and then cashing in by subjecting those deposits to other realms of risk.

The indexing craze continues to pour money into the larger companies, leavening their stock prices to Himalayan heights and demolishing short sellers. Since no one can time the bursting of the bubble, the answer is not to retreat to the sidelines and sit wholly in cash deposits: that’s a way to get poor slowly. The answer is also not to throw money at money in hopes the party will never end: that’s a way to get poor quickly. The answer is to allocate assets in a diversified manner to reduce risk.

It being more important what you don’t do versus what you do, we won’t invest in certain things, no matter what. We won’t give money to managers who invest in high flying, low earnings internet fads with no barriers to entry. We won’t give money to managers who indulge in big cap mania. We won’t give money to managers who buy stocks to please their investment bankers (happens all the time at the big firms, believe it or not). And we won’t give money to managers who don’t manage risk.

We’ll continue to invest the best way possible: not by shying from risk, but by managing it. That doesn’t mean we won’t suffer losses. After all, there’s no such thing as “risk free.” But you can avoid the drowning part, if you don’t swim with the lemmings.

January 6, 1998

Dear Investor,

The story of the tech sector is a classic case in opportunity for the long term investor. Here’s how we analyze the situation: (1) Asia sinks toward recession, stemming its consumer hunger for everything from Gucci bags to Dell desktops. (2) Institutional short-term traders/retail investors get nervous and dump shares of American exporters, especially technology companies. (3) Share prices of tech companies decline to values which skim expectations for Asian growth off the pricing. (4) Our managers buy increased stakes in those companies and in Asian equities, making money over the longer term.

Now it’s important to remember one of the few certainties about markets: they psychologically overreact. The tech sellers have overreacted to the Asian contagion. How do we know this? By skimming all expectation for Asian growth off the valuation, they have protected themselves in the short term by realizing bad prices. They have purchased, in effect, a very expensive insurance policy. This is wonderful for us: in the long term, Asia will likely return to prominence. There are no guarantees, but the odds are in our favor. Asia has political problems, bank crises, deflationary concerns and policy paralysis. But it also has a high savings rate, a largely educated populace, technological prowess and, most importantly, a desire not to fail. We are very optimistic—not in the short term—but in the long.

The question we’re most often asked in such scenarios is why doesn’t everyone analyze the situation as we do and just get rich. The answer is twofold: extraordinary patience is required and people are scared. Many folks pay lip service to buying when there’s blood in the streets, but when the opportunity actually arises, they don’t. They decide it just looks a little scary (all that blood) and they’d prefer to sit tight in cozy, insured deposits. Most people cannot stomach buying at the bottom, even though that’s where the downside risk is paradoxically most reduced. They have a psychological need to buy at the top—because it feels better and besides, everyone’s doing it. What’s more, getting rich slowly has no appeal to most people. Trying to get rich quick–and in the process losing your shirt–is a more common mode of entertainment (in Atlantic City and elsewhere).

So after that theorizing, what are we actually doing with your hard-earned money? We’re holding onto undervalued positions and high growth sectors like domestic tech and healthcare. And we’re building small positions in Thailand, Japan, Hong Kong and China (we are still avoiding South Korea due to the unlikely but conceivable risk of a default on sovereign debt). We don’t expect our new positions to pay off within the short term and neither should you. They might take a year, two years…who knows? Much depends on the unpredictable extent of deflationary pressures. What we do know is that the price is right.

Selective buying of the best companies in Asia with the best balance sheets is, of course, of prime importance. We’re leaving those decisions, as always, to our famous veteran equity managers: Mark Mobius (Templeton), Marty Whitman (Third Avenue), Helen Young Hayes (Janus), Hakan Castegren (Ivy/Harbor), John Horseman (GAM), Josephine Jiminez (Montgomery), and others.

The casino mentality rules world markets. Markets go up, then down; the gamblers place their bets, riding this way, riding that, and getting whipsawed in the process. It’s smarter in such situations to be the “house,” collecting the receipts. Long term value investors get to be the house by scooping up shares on the cheap that the gamblers have sold low and left for dead. It may not be exciting, but excitement isn’t the goal. Instead we look forward to a long, wealth-building ride.

October 1, 1997

Dear Investor,

Shocking, isn’t it, when a currency dies?

We can all agree there were too many deaths this past quarter– chief among them the untimely demise of Thailand’s money. The collapse of the baht reawakens us to the reality that central banks are still fallible, despite the success of our own money-center guru, Alan Greenspan.

What do currency collapses mean to long-term investors like us? They don’t, thankfully, leave us bloodied like one hedge fund we know that lost over 50% of client money by betting on a buoyant baht. On the heels of such failed bets, hedge funds have no place to crawl to—bets on currencies have a way of really missing when they miss. That’s why we avoid them.

Instead, the collapse of the currency offers us big opportunities in the form of severely depressed asset prices in both Thailand and Malaysia. Right now we are divining the possibility of buying shares in closed-end Pacific Rim funds, once (if) they start trading at a discount to net asset value. That will potentially provide the greatest upside in years: assets trading at a steep double discount to equilibrium value–both intrinsically and extrinsically–and screaming to be scooped up on the cheap.

But now to the past in lieu of the future. And away from the Far East and back to home: the last quarter has generated strong returns in the small stock arena, with the Russell 2000 finally showing greater stamina than the Dow. This has led to strong returns in our client accounts, all of which were positioned in small-caps and waiting for the rally to emerge–the benefits of patience–and of active management, as the index funds begin to tread water. The small cap rally shows a further, inspiring broadening of the Market.

We’ve droned on and on about the point of being well diversified to dampen risk and capture outlying rallies like that of the small caps. But often drowned in the din of diversification is the importance of good fund picking.

The following is a dramatic example:

Imagine having had $10,000 in 1977. And then imagine you had three options for the money (aside from the always attractive option of just spending it):

(1) Investing it in an S&P Index Fund, a passively managed proxy for the market; or

(2) Investing it in the Steadman Fund, one of the worst performing funds; or

(3) Investing it in the CGM Capital Development Fund, one of the very best.

Today, under each respective scenario, you would have the following disparate dollar amounts:

(1) 178,689

(2) 1,678

(3) 1,151,842

Strange but true! The S&P Index would have doomed you to the middle class, Steadman would have quietly ruined you, and CGM would have bought you a decent three bedroom apartment in Manhattan. The benefits of active management, practiced well, are clear. But the trick is to pick the next CGM Capital Development Fund—not an easy task, but one which we’re prepared, equipped and, what’s more, paid to do.

July 1, 1997

Dear Investor:

Just last week, Prince Charles handed over Hong Kong–and with it the banner of capitalism–to “Communist” China. This event, suitably marked with pomp and worry, indicates something we’ve known for a long time: “market economy” is now the world’s mantra. All the other mildly interesting mantras of the 20th Century (Marxism, Communism, etc.) have died a painful death because they tried to stifle human nature, not harness it. Luckily, we’ve been left with the only smart idea around: humans behave better when they’re paid to.

How does that impact on current markets, which apparently just go up and up? Those who’ve watched closely have noticed a tremendous broadening out beyond the indices with an advance-decline line solidly positive (and finally inclusive of small-caps). In other words, this bull run now includes everyone.

What then are we doing with our riches and high valuations? We are starting to trim some positions, not so much out of defense as to have cash on hand for the buying binge which will come in the next great correction. Of course, we can’t predict the moment and won’t fall prey to market timing. Our colleagues at hedge funds and short-selling shops are still sobbing about those horrifying days a few weeks ago when they saw the Dow plunge more than 190 points in an hour and then dove in, short Coca-Cola, long gold, and doomed for the unimaginable swell upwards. They found themselves wiped out by lunch: the perils of gambling on timing an untimable market. We sat tight through the commotion and bought a little, making some neat profits in a turbulent week.

Of course, the short-sellers will have their crash someday but they don’t know when, and we won’t be the ones to tell them. We do know that it will come. When it does, it will be real ugly, due to the ridiculous pollyanna-ism that now permeates every corner of the financial services industry. A recent Wall Street Journal article reports that people are actually borrowing on their credit cards to play the stock market! How these hapless arbitrageurs think they can leverage 18% non-deductible borrowing into a sure gain on the Street, I have no idea, but this mentality would seem to indicate a market top.

So how are we protecting you, the client? We’re pursuing our strategy of wide diversification, moderating risk through significant investment in Europe and Emerging Markets, places where the correction will be felt some in the short term, but less in the long term. Latin American holdings are strong year-to-date. The Mexican elections have worried some, and our contact analysts in Mexico City predict continuing uncertainty–but mild political risk always presents good buying opportunities, and Latin America looks attractive long-term with its declining inflation. With your money being put to work all over the world, you can feel good about being diversified across continents.

As protection, we’re also shifting money to value managers who are finding good buys in orphaned sectors. There are still plenty of stocks that look good to p/e ratio-minded investors. Some defiled techs and micro-caps look cheap because they don’t command a liquidity premium–a premium for which we’d just as soon not pay if we’re sticking with our investments long-term.

As we enter perhaps an even more volatile quarter than the last, it’s important to remember that good investing is different than trading: it requires patience, time and the ability to suck in the stomach when markets drop–in order to avoid buying at the top and selling at the bottom. So be prepared for a possible twenty basis point rise in bond yields which would give us a concomitant lurch in the Dow. Be prepared for anything.

Dear Investor,

The close of the first quarter gave us our long-awaited correction. Not that it’s necessarily over—but it has finally arrived. Though (due to artificial trading collars) this “orderly” correction is treating us to slow drip tortures of 100 points here and there, make no mistake: we have been in the grips of a real correction.

That said, the long term outlook is better than good. The new global economy should continue to usher in the greatest expansion since the 1950s. Multinationals should continue to grow earnings overseas and smaller companies should continue to revolutionize the technologies of the free world.

But in the near term, there will be more disappointments. Earnings may slump, inflation fears abound, the Fed may continue to tighten rates. We welcome such rusty nails in the coffin of the bull market because they create the sale prices money managers crave. And we worry not much about short term economic trends—such as the strong dollar. Because a strong dollar is the type of currency fluctuation that is best left to hedge funds to lose bundles of money on, and not a criteria for long term investment managers who realize that currency movements cannot possibly be predicted. If anything, the strong dollar will also cause the buying opportunity it always does, as people falsely panic that American companies will not be able to sell so much as one cheap widget overseas.

This current market points to the benefits of our strategy: one of risk management through wide diversification–including overseas investment. Through such diversification, we are seeing much, much less recent hemorrhaging in our accounts relative to the indices and high flying growth funds that lack diversifying components. Though our accounts have been hurt—along with everyone else—we have seen average losses of less than 5% in this recent selloff where most market indicators have shed up to 10%. Strict momentum investors have lost more than 20% off their highs. Our accounts have remained stable in comparison; we are pleased to see our risk management techniques paying off. The real legacy of this correction will be the fall from grace of index funds as people realize that blindly selling 500 stocks without regard to valuation or earnings takes you down as quickly as blindly buying those same stocks takes you up.

Of course, those of you who are long-time clients are not surprised that our strategy is as boring and immutable as ever. You know that we are investors—not traders–and believe firmly in staying in the market. Peter Lynch, the famed former manager of Magellan Fund was right about many things, among them that you cannot time markets, lest they time you. The only thing that would lead us to cut back drastically into cash would be a palpable change in mutual fund investor sentimen–for which we are on a constant alert. If dumping of mutual fund shares forces fund managers to shed their own holdings (in order to meet redemptions), we would cut some positions to avoid being caught in an artificial selling spiral. We would make selective sales in accounts, tempered by tax considerations. Recent reports of thin market volume and sustained fund inflows show no sign of such worries—at least not yet.

For the most part, we’ll remain invested even through periods of pain. Such periods pose opportunity and reward the risk that markets make. The greatest investors have always had the courage to ride out such pain and they have profited handsomely for their short term masochism—especially since future turns are impossible to predict. Peter Lynch is often quoted for his astonishing statistical study which shows the extreme cost of being out of the market for the forty most productive months over the past forty years: a 2.7% annualized return versus 11.4% for consistent investment–in other words, underperformance of a CD! Discipline is always an ugly word, but it is also always the key to successful investing.

There have been some disappointments among our holdings—that is, funds whose managers have not delivered the risk/reward ratios that we demand from them. It is our mistake in buying into these managers as much as it is their mistake in departing from their strategies. When we spot such departures from disciplined investing, we jettison the guilty parties without due process, but often not before some damage is done. Thankfully, these mistakes have been few and very far between. We look forward to constantly honing all portfolios to what you have the right to expect: a collection of the very best money managers in the world.