First Quarter 2003 Newsletter

We think it is crucial that investment decisions be made in the framework of a process that is consistently applied and that is as far removed from emotion as possible.

We see the major risks as the chance that valuations will remain suppressed for a number of years due to risk aversion, and structural problems with the economy including high consumer and corporate debt levels, the current account deficit, and the potential impact of the war against Iraq and terrorism.

Given the many uncertainties, we are not raising our risk exposure as we normally might at this point in economic cycle. Our strategy includes maintaining diversification and exposure to asset classes such as High Yield that offer return potential close to that of the stock market at less risk. Rebalancing will also be more important in an environment of continued volatility.

Investment Review and Outlook

It was a difficult first quarter, with virtually every equity asset class showing losses. Uncertainty over the prospect of war with Iraq was a drag on the markets through most of the first two months, but as the outcome of the war became more certain, the market rallied over the last 2 weeks. Most indexes showed losses in the single digits, with large-caps outperforming small caps, and growth stocks—led by the NASDAQ—outstripping value stocks across the market-cap spectrum. Junk bonds were the star performers for the quarter, besting both stocks and investment-grade bonds with a 6.9% gain, compared to a 3.2% loss for the S&P 500 and a 1.4% gain for the Lehman Aggregate bond index. High-yield’s outper-formance over the last several quarters closed some of the valuation gap relative to equities, which prompted us to cut back our high-yield exposure in equity accounts earlier in the quarter. Our overweightings of high yield have continued to help our model portfolios stay ahead of their benchmarks so far this year. We have also outperformed by a wide margin through the difficult bear market and over the long term.


It’s no secret that investor psychology has a material impact on financial market volatility over the short run. Many stock pickers are fond of pointing out that the huge volatility in the prices of individual stocks over any given year doesn’t reflect the actual change in value of the underlying business. Stock prices are volatile; business values are much less so. Stock price volatility reflects change in what investors are willing to pay for a share of those businesses, and while this is sometimes driven by fundamentals it is more often driven by emotion. When investors are driven by greed they tend to downplay risk. In periods of extreme greed many are incapable of acknowledging any risk. A glass filled halfway is not just seen as half full; it is seen as full. Conversely when investors are driven by fear, risks are overblown and the positives are downplayed. The glass is not just half empty; it is seen as nearly empty.

The last five years have been among the most amazing in financial market history. Not only have we witnessed a greed-driven “bubble” environment on par with any in history, we’ve also watched it’s collapse. It is important to understand that the bubble was not simply a reflection of overvalued stocks. The greed that inflated stock prices permeated the economy in a variety of ways. Because rational thinking was not in evidence at the close of the 1990s, it is not surprising that there were other excesses that developed and are also now being addressed. Corporate governance abuses, debt levels and the excess capacity present in many segments of the global economy are in various stages of reversal.

As we’ve watched this period unfold, the evolution of investor psychology has been fascinating. Emotion is alive and well and fueled not just by the financial media, but also by the Internet and e-mail. Unsubstantiated stories, rumors and analyses from sources lacking in credibility spread like wildfire. One of the most surprising developments is the psychological swings of people who we consider to be very financially sophisticated. We’re personally familiar with a number of investors who were not concerned about risk in early 2000 but instead were more concerned about keeping up with a roaring bull market. Now these same investors are concerned about risk and are interested in reducing equity exposure. Perhaps their desire to reduce equity exposure will prove to be wise, but the quality of their risk assessment must be questioned given the fact that at the start of the bear market (when risk was highest) they were bullish, and they have now become risk averse after the stock market has lost almost 50% of its value and the NASDAQ is down about 80%.

In light of the events of the last few years this is a good time for all investors to be intellectually honest by thinking back to their view of risk and return in early 2000. If views were detached from reality back then, what does that suggest about the wisdom of trusting an emotional point of view today? This is exactly why we believe it is so important for investment decisions to be made in the framework of a process that is consistently applied and is as far removed from emotion as possible.

Staying Rational

Our investment process is intended to lead to decisions based on rational and realistic analysis. It doesn’t ensure that all our decisions will add value but we believe, and our experience supports, that our process provides a frame-work for being right more than we are wrong, thereby adding value over the long run. The foundation of our process is valuation analysis. However, while we have put enormous effort into our valuation research over the years, the truth is that valuation analysis is an uncertain business. Moreover we know that all valuation analysis is a crude tool, not something that has value as a precise prediction of return potential. Nevertheless, despite all this uncertainty, we do have a high level of confidence because of the way we apply valuation analysis. In addition to using various valuation methods, there are two aspects of our application that are also keys to our confidence:

Conviction is a function of extreme readngs: Our conviction is substantially raised when our models tell us that over or undervaluations are extreme. In order to qualify as extreme we want to see readings at least 25% away from fair value. Over- or undervaluation of that magnitude gives us a substantial margin of error. This is the same concept behind our “fat-pitch” approach. We want to make decisions based on compelling evidence, not marginal evidence.

Portfolio Strategies in an Uncertain World

As noted above our valuation analysis is the primary driver behind our asset-allocation mix. However, we also look at risk to our portfolios in various economic scenarios. As we sort out the relevant information we come up with several key factors that influence our views:

Based on our valuation analysis we believe stocks and high-yield bonds are each likely to deliver high single-digit to low double-digit returns over the next five years. Because of very low interest rates, investment-grade bond returns are likely to fall in a range of 5% or (probably) less over the next three to five years unless we have sustained deflation, in which case returns will be slightly higher.

Given the geopolitical environment, post-bubble risk aversion and vulnerable economy we believe market volatility (upside and downside) is likely to continue for an extended time period. And while we believe a decent return environment for stocks is the most likely case over the next few years, we are concerned that the end of the 20-year bull market may be the trigger for downward adjustments in debt levels and consumer spending at a time when the global economy is vulnerable due to related structural issues and geopolitical shocks.

Our strategic conclusions with respect to the opportunities and risks are as follows:

Diversification is especially important in this environment. Our exposure to high-yield bonds allows us to hold assets with equity-like return expectations but with somewhat lower risk (though these assets are not immune to the same risks). Primarily because of our assessment of risks, we are likely to maintain exposure to these asset classes until we believe they offer inferior returns to equities. This move is driven by risk factors that in this environment override our typical “fat pitch” approach (which requires alternative asset classes to offer substantially superior return potential to justify overweighting). We will continue to assess the diversification mix between these asset classes. (As an aside, high-yield bonds have had an important positive impact on performance so far in 2003 and in the last couple of years.

Our assessment of the risks also leads us to maintain portfolios that are approximately risk-neutral relative to our benchmarks. Normally at this point in an economic cycle we would want above-average risk exposure. This suggests that if we do have a normal cyclical economic recovery our ability to outperform our benchmarks will be less than it would otherwise be. (Though this does not necessarily mean that we will underperform.)

We are beginning to actively explore other investment alternatives that might provide similar expected returns but with some hedge or reduced exposure to the economic risks. A key is whether we can build some additional diversification into our portfolios from investment strategies that reduce risk without also exposing the portfolio to much potential opportunity cost (foregone returns). Because prospective bond yields are so low and stock return potential is good but not spectacular over several years, the potential opportunity cost of having lower-than-average exposure to mainstream asset classes is not as great as it was coming out of the last recession. It will take several months for us to explore other options and we may find that acceptable alternatives do not exist.

If we are right about market volatility, rebalancing will be an important strategy for increasing returns. When equity allocations fall a few percent below targets in down market periods, bringing allocations back up to targets will allow investors to fully participate in the rebound. Likewise when the rebound comes and equities outperform, rebalancing down to targets will allow locking in some of these profits. If the pattern of negative correlation between stocks and bonds that we’ve seen recently continues, rebalancing could add nicely to returns.

Despite the risks we see we are quite confident that the odds for at least decent returns relative to inflation are high over the next few years. Our confidence in the ability of our investment managers adds to our expectations. We don’t expect to relive the 1990’s, but we also know the worst of the bear market is behind us.

Best Regards,

Jon Houk, CFP®