The Portfolio 

On the whole, it was not a particularly good start to the year for PWM, or for the markets in general.  While we performed slightly better that the S & P 500, the PWM composite still lost money in the quarter.  Several trends seem apparent.  Smaller stocks fared a bit worse than larger stocks, growth outperformed value, and some of the best performers in the quarter were some of the worst performers for the previous year. 

This trend has largely been in place since the October bottom.  It may be a standard bear market rally, with the most beat up groups bouncing the most. There also seems to be much speculation that the end of the war in Iraq will lead to strong economic growth and a rising stock market.  We are skeptical that everything will be OK in the economy when the war is over.  Our economic problems (high debt, layoffs, misallocation of capital, etc.) began long before the war in Iraq and have yet to be corrected.  Bull markets have dips and bear markets have rallies.  Nothing goes straight up or straight down every day.  So far we have seen nothing to indicate that this rally is any different than all the others over the last 3 years.  We are still cautious. 

There were two changes to the portfolio in the first quarter.  Long time holding Mattel was doubled in size back in October on a dip in price to $16.  After a strong run to $22 (+38%), we sold half of the position.  It is getting a bit expensive and perhaps a little ahead of itself.  If the stock continues on toward our estimate of full value in the high $20’s we probably will sell the rest of it.  If it falls back to an attractive price, we may buy more.   

St. Paul Companies is a new addition to the portfolio.  They operate in one of the few industries that actually has pricing power today – property/casualty insurance.  Several issues have recently caused large losses for the industry including the World Trade Center, asbestos, corporate fraud, etc.  This has dramatically reduced investment capital in the industry and has forced insurers to raise rates significantly.  We expect this will allow much improved profitability in insurance underwriting, a drastic change from the overly competitive situation of the last decade.  2% of portfolios were invested in St. Paul at $29.70.  We think St. Paul is worth in the neighborhood of $45-$50 and that pricing power is the catalyst to unlock this value. 

Just a Few Good Ideas 

                        “Like other legendary investors, he (Roy Neuberger) has made much of his fortune on a few big hits.” – Byron Wien 

There is much to learn from that one little quote.  Warren Buffett has said something similar regarding his own investment record.  George Soros believes that the way to build a strong track record is through capital preservation and home runs.  At PWM, we like to study the methods of the ‘legendary investors’ and when we find a common thread we pay very close attention.  We think the messages here are several.  First, you only need a few really good ideas to build a strong performance record.  Of course, identifying such ideas is easier said than done.  Second, these few good ideas must have longevity.  Third, the legendary investors who have taken the opposite course, trading very heavily and holding investments for very short periods, are few and far between.  Fourth, avoiding disastrous losses is critical to long term performance.   

Major secular changes in the markets often account for these few good ideas.  In retrospect, most investors would probably agree that the peak of the Nasdaq heralded a major shift in the markets.  But it didn’t end there.  We believe that understanding this secular change will be very important to an investor’s performance for years to come.  As an example of what we mean, let’s look back at history for a moment.  The decade of the ‘70’s is largely remembered for the bear market of ’73-’74 and the raging inflation that followed.  This was the era of ‘hard’ assets.  Commodities such as oil and gold, real estate, and any company with large inventory like a supermarket became the favored investments.  When the interest rate on 30 year Treasury bonds peaked at 14% in 1982, the game changed.  The golden era of financial assets had begun.  Beginning from a very depressed and undervalued level (who wanted stocks or bonds when interest rates and inflation were so high?), financial assets were now the best place to be.  The consistently falling inflation rate (disinflation) led to falling interest rates which produced gains for bond holders and stock holders alike for most of the next two decades.  Previously favored commodities like gold and oil fell dramatically in nominal and real (inflation adjusted) price.  IPO’s were in and the CRB (commodities index) was out.  A stable, consistent growth economy and ever lower interest rates encouraged corporations and individuals to borrow larger and larger sums of money.  Lenders and stock investors were encouraged by favorable experience to raise their exposure to sub-prime/higher risk markets.  This era of stable growth and easy money led to the well known excesses in the stock market.  And then, on March 10, 2000, the game changed again.  The bear market had begun.  As J.K. Galbraith said of a similar time in 1929, “The end had come, but it was not yet in sight.”   

In our opinion, this golden era of financial assets is over for this cycle.  Some of the trends that seemed so profitable in the late stages of the golden era such as levering up the balance sheet with more and more debt, or the distorted allocation of capital through the buying frenzy in tech and telecom stocks, have created systemic imbalances that have yet to be cleared up.  While some industries with excessive amounts of capital drastically overbuilt capacity, other industries like mining, energy, forest products, etc. had much more limited access to capital and here capacity was actually reduced.  Economics 101 teaches that poor investment returns cause capital to flee, improving profitability for those who remain.  Companies and industries that had very limited access to capital in the last 5-10 years should be a good place to search for attractive investment ideas. 

We have positioned the portfolio to take advantage of opportunities we see currently in gold, natural gas, and property/casualty insurance, among others.  Permanently going to 100% cash in response to a bear market is likely not a good solution for most of us.  We think that a proper investment strategy should automatically adjust to the market conditions.  When few attractive investments are available, the cash level will rise.  As a bear market progresses, more attractive investments will arise and the cash level will fall.  Near the end of a bear market, many attractive investments will be available and the cash level of a portfolio should be at a minimum.  We are currently near the midway point, moving toward being fully invested when sufficient bargains are available. 

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.