The Portfolio 

            As you can see from the table, the Prudent Wealth Composite continues to outperform the market and its peer group, although it is now showing a loss for the year-to-date period.  This has been an extremely difficult period to be an equity investor.  The S&P 500 index has just completed its worst quarter since the crash of 1987.  During the month of September only 57 of the 500 stocks in that index avoided a negative return.  Those are very long odds for traditional investors who don’t practice short-selling.  As stock buyers, we feel like a long-tailed cat in a room full of rocking chairs!  Avoiding disastrous investments has become a critical factor for anyone trying to invest in this environment.  A couple of our holdings have declined significantly (see below) but our relative lack of blow-ups helps to explain our strong performance.  We believe that focusing on undervalued stocks that are financially sound and have capable management helps us to avoid these company specific problems.  Our last letter to shareholders (available at www.prudentwealth.com) discussed the high cash level which is another factor explaining our performance.  In fact, the cash level is a direct result of a lack of attractive risk vs. reward opportunities.  In general, value investing has outperformed growth, conservative investments have outperformed aggressive investments, companies with modest debt have outperformed those with excessive debt, and cash and bonds have outperformed everything.

            We have made some disappointing investments.  Our worst performers during the quarter were Champion (-48%) and Input/Output (-47%).  Champion sells manufactured homes.  After a three year slump, we thought the industry was finally improving when industry-wide volumes increased for several months at the end of last year and the beginning of this year.  Such improvement proved fleeting while the other problems such as lack of financing availability for new buyers persisted.  Our main mistake however, was not assigning enough importance to Champion’s moderately weak financial position.  At the time we thought it was an acceptable risk in the context of an improving industry.  We still believe in the investment and are maintaining our position, but we are watching closely for any further deterioration.

Input/Output makes 3-D seismic systems used in oil/gas exploration.  While oil and gas pricing has been strong, oil service stocks have generally performed poorly.  This stock is fairly small and illiquid and its price can be pressured by large sellers, which may explain recent weakness.  The company fundamentals really haven’t changed in a couple of years.  Demand for the company’s seismic systems has been weak due to minimal exploration activity.  However, if oil/gas pricing remains healthy, as we expect, exploration activity will eventually pick up.  In the meantime, Input/Output has a stellar balance sheet with more cash than debt which will allow them to wait out the downturn.  They have the cost structure in line so that they don’t burn cash and yet they continue to develop new products.  This stock is very cheap and we think it offers a substantial return to owners over the next 3-5 years.  We are keeping our position.

Our best performing investments during the quarter were Newmont Mining (+4.6%), a gold mining company and safe haven investment, and Safeco Insurance (+3.5%) a property/casualty insurance company benefiting from internal restructuring and higher insurance rates.  For comparison, the Vanguard S&P 500 index fund returned  -17.2%, after fees, during the quarter. 

            Hubbell (HUBB) is the only recent addition to the portfolio.  Hubbell makes electrical equipment such as lighting fixtures, electrical outlets, high voltage transmission insulators and arrestors, etc.  This is an old-era manufacturing company with a long history of earning high returns on invested capital.  The stock has a very strong balance sheet and excellent management.  The potential negatives include lower revenue and earnings as their customers, like everyone else, are not investing in capital equipment.  Even so, the company is solidly profitable, was very proactive in cutting costs in anticipation of the down-cycle, and should weather the weak economy better than most.  At $27.50, the stock sells for around 12x earnings power and yields 4.5%, a very attractive valuation.  We estimate fair value at $38.

 Investor Psychology

            We feel it is important that you understand how we invest your money (and ours) and why we use such methods.  In past letters we have discussed the fundamentals of traditional value investing such as buying out-of-favor, undervalued stocks.  This time we would like to touch on the issue of investor psychology.  At Prudent Wealth Management, we believe that psychology can, at times, be a large force in market activity.  Martin Pring tells us that ‘stocks don’t sell for what they are worth, but for what investors think they are worth’.  George Soros takes this concept further suggesting that stocks are always mispriced.  Market prices are based on future expectations and the future is unknowable therefore current prices must be wrong.  Clearly there is more involved in determining a stock’s price than a simple mathematical formula which everyone can use to arrive at the same answer.  One need only look at recent headlines for additional evidence.  Corporate fraud and self-dealing, accounting laxity and conflicts of interest weigh heavy on investor’s minds.  Such lack of trust coupled with dramatic losses in investment accounts must affect investor perception and action.  The very basis of value investing depends upon this conclusion.  We attempt to buy stocks for less than they are worth.  But why would any rational investor sell a stock for less than it is really worth?  Academic studies have shown that people often act irrationally regarding money.  For example, the pain of losing $100 is twice as acute as the joy of winning $100.  An investor with a large loss in a stock is likely to eventually fear continued losses and sell too cheaply based on that emotion.  The crux of the argument is that markets are composed of human beings and humans are fallible.  And furthermore, such fallibilities are often, in rough terms, predictable.  Jesse Livermore said it best: “Wall Street never changes, the pockets change, the suckers change, the stocks change, but Wall Street never changes because human nature never changes.”

            Even if we have managed to convince you of the relevance of psychology, you are probably wondering how you could actually use such information.  The study of stock market history reveals many examples of mass hysteria related to investing.  Such a perspective helped us to avoid the most speculative investments in recent years, contributing greatly to our longer term performance record.  In our opinion, the forces at play in the late ‘90’s are still in force, only in reverse.  It is a fact that most of the money now invested in stocks arrived at the tail end of the great bull market.  Human nature being what it is, it is very likely that the current bear market will drive away a large number of those dollars before it is finished.  Paradoxically, the Investment Company Institute claims that the percentage of households with stock investments has actually risen in the last two years!  Cash flows into/out of mutual funds are perhaps the best indicator of the current state of investor psychology.  The outflows have just begun and so far amount to only a trickle relative to the size of the inflows of recent years.  Clearly the negative psychology has not yet spurred investors to sell out.  Cash outflows, resulting from the shift in investor psychology from greed to fear, are likely an important factor in the markets today and should not be ignored.  When the cash outflows become heavy there will be many bargains available.

             We use investor psychology as a compliment to our traditional value approach.  Studying investor psychology is a natural extension of value investing.  By definition, value investing is an attempt to capitalize on the cognitive errors of other investors.  Our current view of investor psychology, along with the unprecedented level of public participation in the stock market and still high valuations, leads us to be cautious. We are still more concerned with capital preservation than with capital accumulation. 

This means that, at the margin, we may require that a company have a stronger balance sheet or that the valuation be a bit cheaper than we would otherwise require before making an investment.  The good news is that as stocks continue to come down in price we have cash available to take advantage of the opportunity.  When a better than average company such as Hubbell is offered at an attractive price we will be ready.

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.