We are happy to report another quarter of solid returns with the PWM Composite rising +7.7% versus a nearly flat S&P 500.  The quarter continued the dominant theme of the last 2 years which has been a redistribution of wealth from the speculative, irrational investor to the rational, conservative investor.  A dramatic turnabout from the late ‘90’s to be sure.  Back then, you would have done well to take the then current advice of noted economist Andrew Smithers: ‘If you want to invest, don’t be rational.  If you want to be rational, don’t invest.’  It has taken two years, and counting, and several high profile bankruptcies, but the markets appear to be systematically searching out and purging the excesses of the longest bull market on record.  Any company with even a whiff of aggressive accounting practices is being pushed by the market into cleaning up their books.  This is how free markets cleanse themselves and we are glad to see it (finally!). 

 History doesn’t repeat, but it rhymes

It is interesting to observe how cycles come and go.  We are currently witnessing a marked shift from aggressive/speculative growth investing to old fashioned conservative investing.  Not long ago earnings were perceived as unnecessary (how Old Era!), dividends were derided as foolish, business suits were only seen at weddings and funerals and the only time you would consider gold is as a paint color for your new Mercedes (certainly not as an investment!).  Today dividends are once again showing their merit, business suits are making a comeback and gold (the shiny metal) is threatening to become an investment again.  All this is a long winded way of saying that we have been here before.  The basic structure of the late mania and its aftermath are not unique.  History is replete with similar events.  Nobody should really be surprised, but for the old saw ‘what we learn from history is that we do not learn from history’.  At PWM, we believe that ‘History doesn’t repeat, but it rhymes’ as Mark Twain said so beautifully.  Over long periods the markets tend to vacillate between fear and greed and all points in between.  The tendency for markets to revert to the mean over long periods is remarkable.  This is due to the fact that markets are made up of human beings and, as a group, humans tend to act and react to a given situation in roughly the same way. 

             John Kenneth Galbraith has eloquently described the repetitive nature of markets over time in his wonderful book A Short History of Financial Euphoria, which all investors are advised to read and re-read.  He focuses on the occasional recurrence of manias which you may find interesting.  The beginning of a mania generally has “Some artifact or some development, seemingly new and desirable,…which captures the financial mind…” .  As investors are drawn in, prices rise.  This rise attracts yet more investors and the whole concept begins to build momentum.  “There are those who are persuaded that some new price-enhancing circumstance is in control, and they expect the market to stay up and go up, perhaps indefinitely.”  “…the pressure of public and seemingly superior financial opinion is brought to bear on behalf of such a belief.”  The old timers who speak out against such New Era thinking are publicly lambasted.  “It is said that they are unable, because of defective imagination or other mental inadequacy, to grasp the new and rewarding circumstances that sustain and secure the increase in values.”  “Past experience…is dismissed as the primitive refuge of those who do not have the insight to appreciate the incredible wonders of the present.”  A crash is inevitable.  This is then followed by “a time of anger and recrimination”.  “The anger will fix upon the individuals who were previously most admired for their financial imagination and acuity…some who have gone beyond the law…”  “There will be talk of regulation and reform.”  (Admit it, you were thinking of Enron as you read the last two sentences weren’t you?)  Much of this will sound familiar to you if you have been reading the financial press over the last five or six years, however, this book was written in 1990.  It would seem that history does indeed rhyme.

         Whether discussing how to avoid a mania like tech stocks or a specific disaster such as Enron, we think that one simple rule is helpful to keep in mind.  It is not something that we were taught in college or even through the CFA program, but rather something most of us were taught by our parents – If it sounds too good to be true it probably is.

             Historically, stocks have generated returns in the neighborhood of +10% annually over long periods.  In the ‘90’s the S&P 500 returned +18.2% annually.  The next few years are likely to be much less prosperous for the popular indices.  Many of the excesses of recent years are concentrated in the largest companies, and have yet to be fully expunged.  However, all is not lost.  There appears to be a smaller group of companies out there that are in much better shape.  These companies, typically smaller/non-tech, went through their bear market in the period from ’98-’00 and many have been in their own bull markets moving steadily higher for the last 12 months or more.  Many of these companies have reasonably healthy balance sheets, often pay a dividend, have a sound earnings base, and most importantly, have valuations that are far from unreasonable.  While many of these stocks have moved higher and may no longer be dramatically undervalued, they do not seem dangerously overvalued either.  Overall, we think it will be difficult to generate returns over the next several years that will satisfy investors who view the last decade as normal.

             This might be a good time to state that we do not expect the next few years to offer the types of opportunities that accounted for PWM’s longer term track record.  Our best opportunities come from stocks that are significantly undervalued.  As stated above, such situations are becoming harder to find.  Don’t expect the +22% per year that the PWM Composite has returned over the last three years. 6-7% per year is probably a much more reasonable expectation for equity returns in general.  We will work hard to get the best performance possible with a modest level of risk, but don’t expect +22%.  If it sounds too good to be true…

             So where are we investing your money, and ours, today?  Mirant (MIR) was the only stock added to portfolios during the quarter.  MIR is an independent power producer.  They own electricity generating plants and they trade electricity and natural gas in the power markets.  The stock has collapsed from a high of $47 to as low as $7.50.  The main reasons include excessively high expectations, a collapse in natural gas and electricity prices, fears of overbuilding of power plants, too much debt, and being in generally the same industry as Enron.  We believe that MIR is not run by crooks as Enron was, the risk of too many power plants has abated as market conditions have forced the cancellation of many planned plants, MIR can make good money with electricity and natural gas prices at normal levels as they are currently (prices were too high before), and MIR has significantly improved its balance sheet through the sale of assets.  We think the company has earnings power in the neighborhood of $2 when the power markets stabilize and the economy is growing again.  This company was initially created by splitting off the generation assets from a regulated electric utility business.  As a common sense check, we estimate that if MIR was required to become a regulated utility again (not likely) it could earn approximately $1.70 (dependent upon several assumptions).  The company expects to earn $1.60 this year with very difficult market conditions. MIR was purchased at $15.7 which is 9.8x this year’s earnings and 7.9x estimated earnings power.  It is likely worth at least $26.

  The stock was purchased as a half position (2%) for all accounts at the time of purchase.  The stock was not added to new accounts.  It quickly became apparent that we bought too early as evidenced by the immediate 50% decline that followed.  Our normal practice is to purchase undervalued stocks when nobody is interested in them.  We typically do not buy them while the current shareholder base is rushing for the exit.  It is clear, in retrospect, that we became impatient and bought too early.  At the moment the stock has snapped back and is now about 16% below our purchase price.  We still believe in the original investment case and may add it to portfolios that do not currently own it if conditions warrant.

 And finally, we are happy to report that PWM is growing nicely as investors continue to rediscover the benefits of a conservative investment approach.  Many of you have been kind enough to give us referrals to potential clients.  Thank you!  Keep them coming!  Also, be sure to check out our new website at www.prudentwealth.com and tell all your friends about it!

 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 can be no guarantees concerning errors or omissions.