Portfolio

As the disappointing numbers in the chart above show, we have continued to under-perform the market for the second quarter in a row.  Our cautious stance, including our large cash position, has limited our gains.  However, we still believe that caution is warranted.  Even the NASD (National Assoc. of Securities Dealers) has recently suggested a measure of caution.  “Investor purchases of securities on margin have grown dramatically in recent months…Some commentators see this growth as a sign that the speculative trading of the late ‘90’s may be returning…NASD is issuing this Alert because we are concerned that many investors may underestimate the risks of trading on margin…”.   

Speculative trading is indeed back in full swing.  There was a fairly broad based rally from March to mid-June where most stocks and indices rallied.  Since then, the Dow Jones Industrial Average and the S&P 500 have added only minimally to their gains while the NASDAQ has continued to rally strongly.  The action is becoming concentrated in the same old names from the last mania.  Yahoo has rallied 400% in a year and now has a whopping 150 p/e.  Apparently, after watching the stock fall from $240 to $9 in the aftermath of the first mania, investors have decided they would like another ride. 

By the way, we obviously don’t own cash for its yield nor because we expect the market to fall.  It is the steady state where we wait and watch for the really great investments. 

“With short-term money returning less than 1 percent after-tax, sitting it out is no fun. But occasionally successful investing requires inactivity.” - Warren Buffett 

 We agree.  That said, we are clearly on the wrong side of this market, at least for the time being.  We have been here before.  The fact that the market is rising does not mean it is a low risk option.  We must continue to stick with the methods that have proven conservative and successful over time.  It would be a mistake to chase this rising market.  This approach ultimately served us well in part I of the bubble where we achieved lesser gains than the market on the way up, but were better able to keep those gains when the high-flying market collapsed.  We think the situation is similar today.  The riskiest stocks are doing the best. By avoiding those we are currently lagging.  But if we are correct that they are still very risky, even more so now at much higher prices, then such gains may prove temporary.

We know full well that our clients will be unhappy to see their performance lagging the major indices.  Value investors experienced this painful condition in ’98 and ’99.  Ultimately, it became clear that those who participated in the mania achieved large gains while it continued, but eventually were unable to get out with their gains when the end came.  The average investor would have been much better off to focus on achieving sustainable gains with a reasonable level of risk.  Huge gains don’t count if you give them all back.

Our short term market timing skills are non-existent.  Where we think we do excel is at measuring risk.  While the S&P has recently notched some nice gains, it must be remembered that it is recovering from some equally sharp losses.  While the market has been quite volatile, our composite has been much more consistent.  Here we repeat ourselves.  We are as concerned with capital preservation as we are with capital accumulation.  

For those of you with taxable accounts, we switched you into the municipal money market fund.  The stated yield was quite a bit higher than the taxable money market fund and the municipal fund has better transparency.  That is to say that we can more easily follow what types of securities are held in the fund.  Additionally, the municipal fund has the benefit of being tax free at the federal level. 

We initiated a position in Schering Plough during the quarter.  This leading pharmaceutical stock has been battered by many problems lately.  The company has suffered a sharp drop in sales as its largest selling product (Claritin) lost patent exclusivity and is now being sold over-the-counter.  Also, the probable addition of a drug benefit to Medicare would likely put pressure on the prices of the most popular drugs industry-wide.  However, a new CEO, an existing pipeline of drugs in development, an increase in research and development spending and aggressive cost cutting should allow earnings power to rebound.  We paid $15.25 and think the stock is worth at least $27. 

THQ was also added to portfolios during the quarter.  This maker of video games has seen its stock fall dramatically in recent years when earnings peaked after the roll out of the Sony PlayStation 2.  While the growth rate of the entire industry is expected to slow this year, THQ believes the industry will still grow in the 10-15% range.  Similar to a pharmaceutical company, THQ’s earnings are somewhat dependent on developing new products.  Earnings may be helped along in their recovery by a new game in the fourth quarter titled Full Spectrum Warrior.  A speculated price cut in the Sony PS2 may also add to the company’s growth rate.  And finally, the next generation game console, which may arrive in the 2005-2006 timeframe, would be a key driver of demand for the company’s games.  The stock was purchased at $16 and is likely worth at least $23.  

Rates on the Rise?

As noted above, it was another quarter in which the market thumbed its nose at our conservative investment style.  Higher risk stocks are the market darlings. According to Rich Bernstein at Merrill Lynch the lowest quality stocks have been outperforming for most of the year.  The whole world seems to think that the US economy is resuming its position as growth engine to the world and investors are jumping aboard.  Equity mutual funds are once again experiencing large cash inflows.  Trading volumes at online stock brokers such as E Trade are surging.  Margin debt at NASD firms is up over 400% this year and reached a level in July that was greater than the peak level of March 2000.  Contrary to popular opinion, we think it will prove difficult for the economy to mount a sustainable recovery when the consumer’s debt burden has only increased and the government is wallowing in huge trade and budget deficits.  Where will the growth come from?  Who is left to buy?  The consumer may be tapped out and, based on recent consumer sentiment surveys, is certainly worried about losing his/her job.  Evidence of a drop off in consumer spending is suspicious by its absence, but clearly there is no pent up consumer demand to boost us out of this economic funk. 

The rapid and unrelenting increase in debt is a key factor in explaining why the economy has held up so well.  Typically, recessions cause companies and consumers to retrench.  They curtail spending and pay down debt.  However, this time around, the unprecedented amount of liquidity the Federal Reserve has injected into the system has resulted in consumers continuing to spend and debt continuing to rise.  During the second quarter the federal government debt rose at a 24% annualize rate, household borrowing rose at a 12% annualized rate, and mortgage debt rose at a 14% annualized rate.  We can safely assume incomes did not keep pace.  The bulls may argue that this is as it should be.  This is how we avoid the pain of recession.  When the economy gets going consumers can pay down the debt they incurred during the recessionary period.  This sounds too good to be true, and it probably is.  For without a retrenched consumer with debts paid down, there is likely to be no sustainable recovery.  And with stocks running up smartly this year in expectation of the long awaited recovery, they are susceptible to any disappointing news.  Contrary to expectations, the increased debt load and the large run up in stock prices means that risks to the economy and the stock market have increased, not decreased. 

Here is information you can use.  The cycle of debt is in its later stages.  The debt problem is already resulting in a record number of mortgage foreclosure and delinquencies, even while home prices hit new highs and refinancing, until recently, has allowed extra breathing room.  Credit card delinquencies are rising fast and personal bankruptcies have risen 9% to a record high in the first quarter.  “Today’s new bankruptcy record is continued evidence that U.S. households continue to struggle with the burden resulting from consumer debts incurred in the 1990s,” said Samuel J. Gerdano, Executive Director of the American Bankruptcy Institute.  Debt rating agency Fitch expects personal bankruptcies in 2003 to rise 8% over the record levels reached in 2002.  No one has yet perfected the alchemy that would allow a debtor to spend his way back to prosperity, although you can be sure Fed Chairman Greenspan is staying up late working on the formula.  Eventually, there are but two options for a debtor.  Repay your loans or declare bankruptcy.  Our advice is to reduce your borrowing, repay your loans and begin the much underrated practice of saving money.  Prosperity begins with savings.  In a recent interview, master investor Sir John Templeton recently said “Emphasize in your magazine how big the debt is…Think of the dangers involved…” 

In the land of the rising debt, long term interest rates are the thing to watch.  The dollar has been falling for nearly two years now.  Paradoxically, the main trend of interest rates during this period has been down.  This may be partially explained by the fact that China and Japan have reacted to a falling dollar by devaluing their own currencies in an attempt to keep their exports to the US at a high level.  But in order to pressure their currencies they buy dollars and invest in dollar denominated debt.  This pushes interest rates in the US lower, encouraging more borrowing, in turn pressuring the dollar lower.  Foreign investors have funded our borrowing binge and our borrowing binge has resulted in a weak dollar.  However, this unusual correlation between the dollar and interest rates may be ending.  

The US has recently been pressuring China and Japan to stop intervening in the currency markets and let their currencies rise relative to the dollar.  It is hoped that a weaker dollar will help exports, thus boosting our economy and reducing our trade deficit.  (Of course China and Japan must suffer lower exports which they have so far been unwilling to accept.)  But we should be careful what we wish for.  A falling dollar would likely lead to higher interest rates, although that hasn’t happened so far.  Rising interest rates would not be good for stocks, bonds or the economy in general.  The recent, temporary spike up in interest rates of a couple months ago shows how the market might make borrowing more costly even as the Fed keeps short-term borrowing rates artificially low.  The conclusion is that the US is highly dependant on the willingness of foreigners to lend us money at low interest rates.  A falling dollar threatens that precarious relationship.  If the dollar continues to fall, which seems likely, we should be on the lookout for rising interest rates.

 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.