Quarterly Newsletter July 2003 Monthly Investment Commentary | July 2003What a difference a quarter makes! The powerful second-quarter rebound more than offset a tough first quarter, rewarding investors with sizable returns during the first six months of 2003. So far this year our models participated strongly in the rebound.Three months ago I wrote about all the economic and geopolitical negatives. But I also wrote “…there are powerful positive forces at play which must not be forgotten at a time when the glass seems mostly empty.” Many times in the past I’ve written that investors should never underestimate the ability of the stock market to surprise. My respect for the stock market’s ability to humble investors over the short-term is part of the reason why I put so much faith in valuation analysis, which I believe is a primary driver of investment returns over periods of several years and longer. So, despite economic and geopolitical worries, three months ago I believed that the stock market and other “equity-like” assets were clearly undervalued. For this reason, despite the big-picture worries I believed the odds were high that we would be rewarded either sooner or later for maintaining equity exposure. In essence we relied on that which we could confidently assess (valuations) and were influenced less by factors that we could less confidently assess (geopolitics and the timing and strength of an economic turnaround). This allowed us to resist the temptation to get more defensive. Now, three months later the returns from equity asset classes have been impressive.It is worth addressing the question of why equity-type assets started taking off before the Iraq war even started (in mid-March) and have continued to rise despite continued economic uncertainty. There are three reasons:The stock market prices in expectations about the future. In times of fear or greed those expectations are often exaggerated, becoming overly optimistic or overly pessimistic. That leads to exaggerated actions in the form of excessive selling or buying. In March, investors were overly pessimistic, resulting in depressed prices for many financial assets. This dynamic is why it is usually safest to buy when fear is high and why it often pays to be more cautious when investors are ignoring risk.The economy continues to struggle, however it is not getting worse. Moreover, there is an increasing amount of stimulus with exceptionally low interest rates, a falling dollar (resulting in less competition from imports) and the tax cut. Areas of the economy are showing strength (housing) and the business sector has been able to take advantage of very low interest rates to refinance debt and lower debt service.Though great uncertainty about the post-war period remains, the Iraq-war disaster scenarios did not come to pass.This all underscores once again the need to be forward-looking in assessing financial markets, rather than backward-looking or fixated on today’s worries. And a critical part of the analysis is assessing what the financial markets are pricing in (or “discounting”). Sometimes the markets price in nirvana and sometimes they price in the end of the world. Today, for the first time in years they seem to be doing a reasonably good job of pricing in reality.Have Stocks, REITs and Bonds Gone Too Far?I always get nervous when financial asset prices move sharply higher over a short time period. Contributing to the discomfort these days is the bullishness of financial advisors and investment strategists. According to several polls of both groups, optimism is higher than it’s been at any time since 1987. Huge optimism is usually a bad sign because it suggests that if investors have acted on their optimism, stock prices will have been bid too high. However, investment sentiment is just one factor and a temporary one at that so it rarely factors into the investment-decision-making process. To reiterate, most important is the valuation picture. And what is the picture now? The bad news is that there are no equity-type asset classes that appear to be huge bargains. The good news is that, based on my work, none is overvalued and some are still slightly undervalued. The base-case assumption is that the economy recovers with interest rates increasing over the next few years so that the 10-year Treasury yield backs up to 5% from 3.5% now. This outlook assumes inflation between 2% and 3%.With most equity-type asset classes in a range between fairly valued and slightly undervalued, it’s reasonable to wonder how current investment opportunities look relative to the risks. I’ve identified several risks over the past year:Structural risks including debt levels and the sizable U.S. dependence on foreign capitalDeflation, which could be a by-product of high debt levelInflation, which could eventually be ignited by attempts to fight deflationGeopolitical risks including terrorism.These risks have not gone away but in general most have subsided. The world remains a risky place, as it has always been. And the risks continue to seem somewhat greater than in the past perhaps because the worst case is so scary. However, we are conscious of the tendency for “today’s” risks to always seem much more alarming than “yesterday’s” risks. At present we believe equity asset classes are fairly valued and discount a “normal” level of risk. Are today’s risks “normal”? That’s a subjective assessment that is hard to make but it is no longer clear that big-picture risks are above average.Reasonable Return Expectations and Ways to Add ValueCurrent asset prices suggest returns of high single digits or possibly low double digits for equity-type assets on average, over the next five years. Of course that’s a base-case forecast and assumes that assets are at about fair value at the end of the period. The reality is that returns could be significantly different if growth rates are abnormally high or low or if assets become over- or undervalued. Given these expectations, return potential relative to inflation is decent but on a nominal basis these returns may not seem exciting. After a horrible three years don’t we deserve more? The sad reality is that returns were so high in the 1990s that they effectively borrowed from the future. The bear market brought things back to reality and beyond and now we’ve had a bounce back to fair value. So as of the end of the second quarter, returns look likely to be okay but not spectacular. How can we do better, or at least ensure that we don’t fall within the lower end of the broader range?Tactical asset class plays are limited today: Taking advantage of market overreactions is one of two primary ways to add value. With no market overreactions are we left to fight with one hand tied behind our backs? This is a fair question and in response there are two points to make. First, though no area is hugely compelling, there is one area of overreaction. Investment-grade bonds are clearly unattractive. I believe that bonds will probably return less than their yield over the next three to five years, which means very low single-digit returns are likely. The second and more important point is that just because there are no great opportunities today doesn’t mean there won’t be any tomorrow. In fact we can guarantee that there will be some great opportunities in the future because they always come and go as a byproduct of investors’ ongoing swings between fear and greed. We will be patiently awaiting opportunities we can take advantage of.Adding Value via Manager Selection: The second way to add value over time is through manager selection. Over the long run this has been a material factor in our performance. Though there are no guarantees, and there will be periods of underperformance, we believe that our managers as a group will continue to add value by generating better returns than the markets. And just as we take advantage at the asset class level of the mis-valuations arising from fear and greed-driven volatility, our managers similarly benefit at the security selection level. Volatility is the long-term investor’s friend.Decisions, DecisionsAs all financial assets have moved higher I’ve been debating some tough issues:What to do about bonds? With treasuries and investment grade bonds unattractive, where can an investor get income? Bond funds which have a very broad global investment universe have the opportunity to add value more than traditionally constrained funds. High-yield bonds are still quite competitive with stocks but they no longer qualify as a clearly superior alternative. However, everything—including high-yield bonds—is a fat pitch compared to investment-grade bonds and that’s why high-yield bonds continue to be interesting. REITs are having another great year; do they still offer better return potential than stocks? Yes, REITs still sell at a historical yield premium compared to stocks (comparing their dividend yield to stock’s earnings yield). However, they also continue to sell at a premium to their underlying net asset value of nearly 10%. This isn’t an alarming level but it is nearing a point that suggests future appreciation may be limited. In other areas, I am sticking with our small-cap and foreign equity positions. Both are areas that I believe offer somewhat better value than U.S.large-cap stocks. And, small-caps usually outperform early in the economic cycle when they tend to exhibit superior earnings growth. But, though I believe there is a good chance that returns will be higher over the next several years, the advantage is not so clear cut to make either small-caps or foreign stocks a fat pitch. I see no compelling investment advantage in U.S. large-caps for either the growth or value style, at least on a statistical basis. There is an argument that is somewhat appealing that value stocks could experience a secular period of outperformance as an after-effect of the growth/tech stock bubble. However, I am not betting on this. In small-caps, growth has a slight statistical advantage but not one that is clear-cut enough to bet on.Thoughts on the Tax BillThe impact of the tax bill was a positive one for investors and it does have some ramifications on asset allocation and portfolio management decisions. By lowering the tax rate on capital gains and most dividends, investors will receive higher after-tax returns. This justifies higher prices for stocks and helps explain some of the upward move in the stock market. Lower tax rates in general also benefit investors who hold interest bearing assets and REITs (which do not benefit from the lower rate on dividends). However, though rates have effectively dropped for all investments, they dropped more for capital gains and qualifying dividends thus benefiting stocks more than most other assets. At this point I don’t view the tax changes as reasons to pursue certain types of investments over others. The market tends to adjust fairly quickly to relative opportunities. While it’s possible that high-dividend-paying stocks might outperform because of their tax-advantaged status I’m not so sure that this alone makes them more attractive. After all, all stocks are now on more of a level playing field when it comes to taxes. So taxes alone are not necessarily a reason to prefer a dividend payer to a high grower. And if the return potential of dividend-paying stocks is better, then fund managers are in a better position to make this assessment on a stock-by-stock basis than most investors.Please call if you have any questions or comments or if your financial situation has changed and you would like to review your portfolio. Mike Durant, 7/5/03.