Letter - October 2003





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Where Do We Go From Here

Whether bear market rally or a new bull market, investors have enjoyed a tremendously strong stock market this year. Clients who have taken even a casual glance at their portfolios will have noticed eye-popping gains since year-end. As portfolio managers, we are gratified. We are now well through our fourth straight year of market out-performance after having sat on the sidelines during the bubble years, so we are grateful to our clients who shared our vision and worked with us through a tumultuous time.

Why the rally? Expansionary monetary policy (low interest rates) and fiscal policy (tax cuts) have finally created a positive environment for an economic recovery which now seems increasingly real. The stock market reflects that. Also, compared to the high priced real estate and bond markets, the three-year long, post bubble decline in stock prices resulted in stocks being the only depressed asset class which offered a potential for reasonable return, and that's where the money went. On the political front, the war in Iraq went more smoothly than expected (though the peace is proving difficult to maintain.) While opposed by many, the United States maintains a unique position of strength in the world.

Up to now, the market has been rising broadly with little exception. The rising tide has lifted all boats, even very leaky ones. In fact, many valuations have gotten overly generous, leading a number of professionals to wonder whether investors have actually learned any lessons from the bubble years. However, trading volume has been low all year, with hedge funds, and day traders accounting for much of it. Many investors have been puzzled by the market's rise. Having missed the early boat, they wonder whether the trip is now worth taking. And investigations of the mutual fund industry make them wonder if there is an honest man left on Wall Street. (Answer: there never was? present company excepted.) Brokerage firm analysts who cautioned against optimism at the bottom are now confidently recommending stocks that already have doubled or tripled. Our director of research, Sumner Gerard, keeps a whimsical record of some of the most notable calls by our brethren on the Street. A recent upgrade of Intel cited the market's "?continued appetite for expensive semiconductor stocks." ?So the question presents itself: Where do we go from here?...

Frankly, we are not sure. While we are delighted by recent gains, there seem to be few clear opportunities at the moment. So, we caution clients that in the short term the value of their portfolios may well decline. It is hard to imagine that stocks will continue to perform without some sort of pullback. And risks and concerns still abound: nuclear weapons in North Korea and Iran, currency imbalances and a weak dollar, weak employment numbers, high oil and gas prices, Iraq, Iraq, Iraq, and the coming presidential election cycle. Our guess is that once the current quarterly earnings period runs its course, the market will probably take a breather and stocks will back off a bit.

As the "easy money" has now been made, when and if the next leg of the up market begins the key word for investors will probably be "SELECTIVITY." In this regard, our colleague, Sumner has been an invaluable addition to our team. His keen, skeptical eye and strong analytical skills help temper our natural enthusiasm for stocks. His focus on cash flow, paying careful attention to balance sheets as well as growth rates blends well with the long years of experience of other members of the team.

So, we advise our clients to stay the course even though the year ahead is bound to be less exhilarating than the twelve months just past. With a few notable exceptions, the stocks we own generate solid earnings, pay dividends and sell at a modest multiple of earnings. As long as the economy continues to recover, we will sit tight. It is not yet time to put into safe harbor.

Tom Herzig

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