In this, our inaugural letter, we look back on a year full of noteworthy events.  The fierce bear market that began in the Spring of 2000 continued in full force throughout this past year.  While the most aggressive, most overvalued sectors such as technology and telecommunications were hurt the most, selling pressure was widespread and it was difficult to avoid losing money no matter where you were invested.  Traditional safe havens such as old fashioned value stocks and bonds provided the best returns.  Prudent Wealth Management performed admirably as shown in the chart below.

Most of the year was dominated by negative news regarding the economy, job losses, poor corporate earnings, declining stock prices and war.  During the fourth quarter the market began to focus more on the emerging positive news and rallied sharply from its lows.  Retail sales at Christmas were not quite as bad as some had feared, job losses appeared to moderate, and of course the Federal Reserve cut interest rates an unprecedented 11 times in one year.  This data has been interpreted by some to indicate an imminent upturn in the economy and thus the stock market.  While we cannot predict when the economy will improve, we strongly believe that the outlook for the major indices and for many popular large capitalization stocks is muted at best and dismal at the worst.  Simply put, these areas are still very expensive by historical standards.  And this is after the S&P 500 has fallen by 25% and the NASDAQ by 61% from their respective highs. A recent chart in Barron’s, with data from ISI, indicates that the average post WWII bear market ended with the S&P 400 Industrials trading at a P/E (price/earnings ratio; a simple measure of value; the higher the number the more expensive the stock) of 11 and with a dividend yield of 4.7%.  This is far cheaper than the current valuation of 25 P/E and 1.3% yield.  With the major indices, dominated by the largest stocks, valued this richly it seems unlikely that stock returns will be enhanced by an expansion of P/E multiples and may in fact be hurt as P/E’s shrink back toward more normal levels.   

The late 90’s saw a string of years where irrational investing provided the best returns.  During this period no price was too high to pay for a stock and the definition of risk was ‘missing the next move up in stock prices’.  This behavior drove valuations of the major indices to unprecedented levels which we are still working through.   During the last two years we have seen a gradual return of rational behavior to the markets as these extreme valuations revert back toward more normal levels.  This more rational environment is where value investors typically prosper.  We try to ‘buy low and sell high’.  While value has significantly outperformed growth over the last two years a value approach is still very attractive.  Our goal is to purchase stock in sound companies that are trading at around 10 normalized earnings, or less.  Therefore, we expect a significant part of our return will be from P/E expansion as the low P/E’s of around 10 or less eventually rise toward a more normal 15 or more.  This way we tend to avoid most of the pain as high P/E’s collapse and instead we often benefit as depressed P/E’s expand toward normal levels. 

Even with the overall market at such high valuation levels there are still stocks out there that meet our criteria for investment.  During the quarter we initiated positions in Raytheon, Newmont Mining and Sturm Ruger.    

            Raytheon is a defense contractor that we have been closely following for a year or so.  They make many types of electronic systems such as fire control systems for missiles, radar systems for the battlefield, air traffic control systems, as well as missiles and some small non-military airplanes.  After a decade of government defense spending cutbacks the stock was universally unloved as evidenced by the cheap valuation (about 7 times earnings power).  Even before the terrorist attacks the defense budget was finally growing again, although modestly.  Terrorism and the U.S. response only strengthened that trend. Prior to September 11 we were not totally convinced that the growing defense budget, along with some internal restructuring, were sufficient catalysts to make the investment attractive.  The recent terrorism is likely to have a long lasting impact on defense spending and this gave us the confidence that the outlook for Raytheon was now attractive enough to make the investment.  By purchasing the stock after the attacks we paid a slightly higher price but gained much more confidence in the investment.  Raytheon currently trades at $31 while we estimate it to be worth more than $50. Three percent of the portfolio is invested in Raytheon. 

         Homestake Mining, a large position in the portfolio, was replaced by Newmont Mining.  Homestake was acquired by American Barrick at a 31% premium.  One of the attractive parts of Homestake was the fact that they do not hedge their gold exposure.  This typically involves selling gold today, at current prices, that you expect to mine at some point in the future.  This allows the mining company to know exactly what price it will receive for its production but the company, and thus shareholders, give up any gains if the price of gold were to move up from currently depressed levels.  If you believe that the fundamentals of the gold industry are improving and that the twenty-year bear market in gold may be ending, then you do not want to invest in gold producers that give up the upside through hedging.  American Barrick hedges, Newmont does not.  Furthermore, if Newmont’s proposed acquisitions of Normandy and Franco Nevada are closed, Newmont will be the largest gold producer in the world.  Newmont will have reasonably low production costs, an improved balance sheet from Franco’s large cash balance, and a stronger management team with the addition of the very smart folks at Franco Nevada.  We are very optimistic on the price of gold and consequently have 7.5% of the portfolio invested in Newmont stock.  The stock currently trades at $19 and is likely worth at least $40.

             Sturm Ruger is a manufacturer of firearms and other investment cast alloy products such as golf club heads.  The investment casting business has been shrinking for a couple of years as large contracts to manufacture golf club heads for Calloway, among others, expired.  Ruger at one time had a technological edge as very few companies could successfully cast materials like titanium.  This capability is more widespread now.  The good news is that this business has shrunk to the point where it is now only a small part of the company.  Furthermore, if they can win some new business profitability should improve dramatically.  The firearms business is the largest part of the company and is reasonably healthy.  It grows modestly but was overshadowed by the shrinking casting division.  Now the modest growth should propel company earnings higher, helping visibility of earnings and the stock’s valuation.  Also, the handful of spurious lawsuits filed a couple of years ago by municipalities have largely been dismissed or adjudicated in favor of the gun companies. No new lawsuits have been filed in nearly two years and, under the Bush Administration, new suits seem unlikely.  This turning of the tide should also help the stock’s valuation.  The stock was originally purchased at $10.25.  This is only 7 times its earnings power and offered a 7.8% yield.  Ruger can be purchased today for about $12 and is probably worth at least $20.

             As you can see from the examples above, we are still finding attractive investments.  Due to the very cheap prices we think they can provide attractive returns even if some of the market’s favorite stocks continue to see their prices decline to more reasonable valuations.  We are currently researching possible investments in a wide range of industries such as auto parts, railroads, electric utility, energy, retail, and consumer products.  We are convinced that the traditional, time-tested, conservative value investing approach will continue to provide the competitive returns that have been its hallmark for the past 70 years.  The ‘New Era’ has once again been unmasked as a fraud and the temporarily prosperous investment methods of the late ‘90’s will lie dormant until a new generation of investors, with no memory of the last disaster, comes along to revive them.

             We want to thank you for your business and assure you that we will continue to watch over your money as carefully as we watch our own.

 Sincerely,

Clayton Bryan, CFA                                                      Doug Manz, CFA

Principal                                                                       Principal

 *This letter is for informational purposes only.  Nothing contained herein shall be construed as an offer or recommendation to buy or sell individual securities.  Data has been obtained from sources believed to be reliable but there are no guarantees concerning errors or omissions.