Fourth Quarter 2003 Newsletter

The year 2003 was very rewarding for investors, with all equity asset classes delivering high returns.

The last five years have tested investors’ discipline and confidence. Many suffered steep losses after the bubble, then became conservative and missed the strong gains in 2003. We are pleased that our discipline helped us outperform our benchmarks in this very turbulent five-year stretch, including both up and down years.

With rates remaining generally low, an improving economy, and investors more willing to take risks, many forecasters call for decent, perhaps double-digit, returns in 2004. We are never comfortable making short-term assessments ourselves, since it is too easy for near-term uncertainty to sway markets. But longer-term we are much more confident: based on current valuation levels, annual equity returns should be near their long-term averages of 8-12%. Bonds are likely to return less than their yield, or 4% or less in coming years.

Most asset classes are now close to fair value, but inevitably the market will again present us with compelling opportunities. In the meantime, we will remain patient and continue to rely on our managers’ skill to add value

Year-End Investment Review and Outlook

For investors, the years from 1999 to 2003 amounted to a severe test and for many it was an excruciatingly painful experience. The truth is that in our investment lives, just as in the rest of our lives, we are always being tested. We are tested on the clarity of our investment philosophy and process. We are tested on our intellectual honesty with respect to our belief in that process, for if we don’t believe then we will not stay true to it when times are tough. And, we are continuously tested on our ability to stay disciplined and resist the many temptations that can pull us away from our philosophy and circle of competency. These temptations include pursuing hot investment trends simply because they are hot, investing based on gut feel, or cutting corners on our research while hoping those corners won’t really matter.

The year 2003 may have been the final chapter to the bubble run- up and collapse that started in the late 1990s. Just as the most fervent bull-market revelers tend to experience the greatest suffering when the music stops, those that latch on to doomsday scenarios fail to recognize that bad times end too. In the worst case, former bubble investors morphed into gloom-and-doomers and missed the 2003 market rebound after participating in the worst bear market since the 1930s.

We have a very high degree of confidence in our investment process, which is based on rational analysis of underlying economic values, risk assessment, and discipline. These last five years have rewarded that confidence as we outperformed our benchmarks by a wide margin over this volatile period, and did so consistently with most portfolios beating their benchmarks in the down years and the up years, including 2003. We’re grateful for this performance but we also are very aware that we have and will again at times make mistakes. We will not beat our benchmarks in every year. The market has a unique ability to make us humble. We also know that we can’t rest on our laurels so we are as driven as ever to keep and if possible, improve our edge. But we are very confident in our ability to continue to deliver good, long-term performance through the disciplined execution of our investment process.

For those investors who didn’t let pessimism get the best of them, 2003 was a hugely rewarding year, with all equity-type assets delivering very high returns. We entered the year cognizant of the risks and were therefore unwilling to take an extremely aggressive posture. However, we also believed US stocks, high-yield bonds and International stocks were undervalued, and we maintained exposure to these asset classes. After a very rough first quarter, characterized by war fears and economic uncertainty, the markets rebounded and continued to perform well through the end of the year. More conservative investments, namely investment-grade bonds, delivered only slightly positive returns, as investors were not rewarded in 2003 for avoiding risk.

It Was a Nice Year, But What About The Future?

Step One is to assess whether there are clearly undervalued asset classes that provide a margin of safety that is excessive relative to history. Valuation extremes are usually a function of temporary factors and therefore offer opportunity to longer-term investors. Part of our analysis includes as-sessing fundamentals so that we can understand the factors that are driving investors away from the asset class, in order to make sure any clouds are likely to be just a passing storm. If we can gain confidence that this is the case, then we have a potentially exciting asset-class return opportunity, as well as a margin of safety to protect us against any big-picture risks coming to pass. Unfortunately, at present there are no asset classes which offer exceptional value. This was not the case a year ago when almost all equity-type assets were undervalued, with high-yield bonds, and small-cap stocks even more undervalued.

Step Two is to assess the risks at a portfolio level. This is done in several ways. We attempt to identify big-picture risks, though we acknowledge that there are some big-picture risks we may not be aware of before the fact. For risks that we believe have a meaningful probability of occurring, we assess the impact that they would have on each portfolio. This is done by making a qualitative determination of the probable impact on each asset class and fund we hold. There is more subjectivity involved in this process than we would like, but in our opinion this is the best way to get a sense for the risk exposure to each of the portfolios, and it forces us to think carefully about the reaction of each asset class to various types of economic, geopolitical, and market events. If portfolio-level risk is too high, we make adjustments to rein it in. At present, cyclical economic risks seem to us to be below average. However, longer-term risks are more troubling (the current account deficit and debt levels), though a very bearish scenario is not the most likely long-term scenario. Our awareness of these longer-term risks, coupled with our view that there are no longer any undervalued asset classes (providing a margin of safety), played a role in the introduction of a global bond fund into some of our portfolios.

At this time of year, it is common for people in our business to make a return forecast for the year. But one-year return forecasts are speculative, since investor psychology and unpredictable short-term events can drive returns, rather than long-term fundamentals. We are much more comfortable assessing the potential for returns over longer time periods. Our expectations are heavily impacted by our valuation assessments. With most equity asset classes around fair value, returns over 5- 10 years and longer are likely to fall in the low end of their historical range of 8-12%. If interest rates rise somewhat as we expect in the face of a strengthening economy, bonds are likely to deliver less than their yield, which is to say they will probably deliver returns below 4%.

While these long-term returns are not particularly exciting, the next market turmoil will be the catalyst that will mark down the prices of one or more asset classes. If we can take advantage of an opportunity to load up on an asset class or two when they are available at “sale” prices, we will put ourselves in a position to improve returns. Until then we will have to be patient while staying close to our neutral asset-class targets. In the meantime, we will continue to emphasize talented managers. Evaluating specific fund management teams remains a primary focus for our research team, and this continues to be an area where we can add a lot of value from a performance standpoint.

Specific Asset Class Commentaries

Over the past quarter our thinking has evolved with respect to several asset classes:

High-Yield Bonds

As we’ve also discussed in recent months, high-yield bonds are no longer at-tractive long-term investments. With yields around 7.4% and rates likely to rise from current levels (resulting in some capital erosion that will offset some of the yield), long-term expected returns are now inferior to stocks, especially on an after-tax basis. We have eliminated high-yield bond exposure in some types of portfolios and reduced it in others. However, fundamentals are improving with the economy and this suggests that bond prices will probably not deteriorate in the near term. Therefore we see no urgency to fully eliminate the positions from all our models. The timing of our decision to sell remaining high-yield bond positions will depend on research we are doing on several funds that could be the destination for the proceeds from these sales. We expect to have this work completed by the end of the first quarter.

Global Bonds

Our growing concern about the current account deficit and the declining dollar led us to focus sizable attention on researching the foreign bond asset class as a possible hedge against a dollar collapse. This risk is something we’ve had our eyes on for a while and our concern grew as 2003 progressed, but not because we viewed the risk of a collapse as higher. Rather, as stocks and high-yield bonds rallied, their valuation cushion eroded and made us more sensitive to big-picture risks. We view our global bond position as “free insurance” against a dollar collapse, since we believe it is likely (though not a certainty) that the dollar will continue to gradually weaken in value for some time, and since yields on foreign bonds are current slightly higher than on domestic bonds.

Final Comments on the Fund Scandal

As many of you know, I started out in the investment business working for a mutual fund company, right out of college in 1985. I have now been intimately involved with the mutual fund business for almost 19 years. As you also may know, I have a love/hate relationship with mutual funds. Many of the abuses that have come to light in the past few months have been evident to me for many years. Therefore, the fact that they have come out as front-page news has not really been a surprise, other than the fact that it took so long to become public. Ultimately, it will be good for the mutual fund industry. We do want to emphasize that during the last five years, the period during which most of the ethics violations are known to have occurred, our mutual fund portfolios have materially beaten their index benchmarks, with the takeaway being that investing in funds has clearly not been a disadvantage for our clients. In fact, fund investing continues to give us the ability to easily hire and fire managers, choose from a large universe of managers and, within that universe, find a handful of exceptionally skilled investors, and to opportunistically access many asset classes. Going forward, ethical lapses are far less likely to be an issue, given the fallout of the fund scandal of 2003. But shareholder-oriented business practices will still be a big issue and one that we will continue to focus strongly on. We continue to view the fund universe as one that gives us a handful of excellent choices and the flexibility to apply our fundamentally based approach to tactical asset allocation in a very effective way—one which, in our opinion, could not be as efficiently implemented using any other investment vehicles.

Best Regards,

Jon Houk, CFP®