Spring 2001

What have you done for me lately?

Spring Greetings:

May Day 2001

The Model Portfolio is up 19% for the year, and coupled with last year's +1% performance and 1999's plus 42% gain in the portfolio, we have to be content with our current market approach. With accounts up 10% to 30% for the year, we are quite pleased with ourselves. While not yet masters of the universe, we have been lucky over the last year as well as prescient. We remain cautious on the outlook for the markets. And so we have been quick to take profits even if this created a short term taxable gain. Notice we don't say problem, since we have never considered profits to be a problem. Also with the Bush tax cut coming the differential between long and short profits will be reduced - and last year is the perfect example of why taking a short term profit is sometimes preferable to having a long term losing position.

In our Winter 2000 Lemley Letter published on February 1, 2000 we expressed our disdain for the "new" market mantra that "it is truly different this time." in that letter we said: "Our argument is not with the merits of the products (produced) by these high flyers. It is with the valuation .......We just don't believe that paying any price for a tech stock is warranted. And we know the current speculative binge will end. We just don't know when."

In the Spring 2000 Lemley Letter published on April 10, 2000, we discussed our short term trading versus long term investing. This discussion was engendered by phone calls from clients who had incurred large tax bills from our performance in 1999 when accounts were up 20% to 40% and taxable account had significant tax bills. Since we have significant short term gains again this year we will probably be receiving similar calls in the spring of 2002. Our answer then, as now, is that we have a trading style that has served us well over the years and that consistency is the best policy when it comes to making money in the stock market. Moreover many of our accounts are tax free retirement accounts and so tax considerations don't enter into the buy/sell equation for them. Since we believe in our trading method, we treat taxable and tax free accounts the same. Eventually, the tax free accounts will have to pay regular income taxes also - so the tax day is delayed - not avoided. We are active because we try to limit risk and because we believe that the old days of buy and hold are over - for now at least. But when clients ask us not to trade we comply as best we can.

On this point the following letter that we wrote recently to a client discusses in more depth our philosophy.

Dear Trish and Phil,

Presidents Day 2001

Happily, the January 2001 statement showed a good recovery in the value of all portfolios. We are in receipt of your letter requesting less activity and will of course be happy to comply.

For your benefit as well as ours, we thought we would discuss our views on investing/trading given various market conditions. Over the years we have evolved an investment/trading style. As you will note we tend to buy and sell the same issues but try to take advantage of the volatility in share prices that market conditions present.

For example, over the last year we have traded Abercrombie and Fitch several times. We first bought ANF in 1998 at a split adjusted $8 per share. We sold a few weeks later when the stock jumped to $12 per share for a 50% gain. The stock then ran to $36 per share before falling to the mid teens (split adjusted). In late 1998, we repurchased the stock at $16 and sold when it ran to $26, again a 50% gain. ANF continued again to climb to $50 per share. It then fell to the low $30s where we began to buy as earnings visibility became clearer. Unfortunately in late 1999 ANF misjudged the teen clothing market and same store sales comparisons dropped from monthly same store sales gains of plus 10% to 15% to negative percentage sales drops on a monthly basis. Even though same store sales comps were negative, ANF management predicted and delivered 10% earnings gains all through the year 2000. Unfortunately the stock price dropped from the mid $30s to $8 per share in the summer of 2000. During this time period we doubled up and took losses on our high priced stock and continued to add the stock to accounts. It became our largest single stock holding in most accounts. As ANF rallied in the fall we sold part of our holdings in accounts for small gains or losses and when the stock reached $24 per share we sold our entire position. Through early 2001, we continued to trade the stock between $18 and $24 per share. Without the large profit we made from managing our holdings of ANF during the year we would not have been able to show the results we did for the year. Moreover, at $8 per share the stock was selling at 7 times earnings, at $16 per share ANF was selling at 12 times earnings, at $24 per share it sold at 20 times earnings. The first was a steal, the second a good buy point, the third a good sell point. The reason for the price volatility in ANF is the herd nature of institutions that jump into and out of stocks on buy and sell recommendations with very little concern for price because any one stock is such a small percentage holding.

It is our belief that most folks don't like trading because they don't want to pay taxes on their gains. Yet these same folks will get up every morning, commute for an hour in rain, sleet, snow, or 90 degree weather and endure the turmoil of daily work all for the pleasure of paying 50% of whatever they make to Uncle Sam, Social Security, and state and local authorities. With tax rates for most of our clients at 30% or less, even if we make a lot of money trading, we are of the view that paying taxes is a pleasure. Last year trillions of dollars were lost by folks who didn't want to pay taxes.

Our experience with Lucent and A T & T last year was the opposite of our pleasant results with ANF. Several years ago, we sold Lucent when we received it as a spinoff from AT&T because we didn't agree with their practice of financing sales to customers. And while we have traded A T & T over the years, for the last few we have avoided the stock because we thought C. Michael Armstrong didn't know what he was doing. Because of greed and hubris, we allowed ourselves to ignore our correct analysis to try and capture some gain by buying two stocks that were relatively cheaper than others in their respective industries. We bought two lemons. Such trading mistakes often occur when we are feeling like "masters of the universe" after a good trading year like 1999. While we tried through the later part of 2000 to overcome the results of our mistaken purchases by averaging down and trading, we eventually decided to eliminate our holdings in early 2001 when the Federal Reserve cut rates on January 3, 2001 gave a 15% plus boost to our accounts.

Your belief in long term investing is the result of your great fortune with Times Mirror stock. Had you been given Polaroid, or Xerox, etc. back in 1970 we don't know if you would feel the same enchantment. Moreover, since 1970 the market has risen 1000% (10 times) in value. Back in 1970 the house you currently live in probably sold for $50,000 or less. Now it is worth 15 times that price. When oil was $40 per barrel in 1980 and inflation was rampant and interest rates were 20% on short term money, very few predicted no inflation, $7 oil, and 3% interest rates in the year 2000. In fact many gurus predicted doomsday by 1990. As in all of life and nature, the markets are a pendulum. Our constant worry about market pricing and conditions over the past few years is what has caused us to be so "quickly on the trigger" as we would say or "frantic" as you would suggest. But we stop worrying and raise serious cash when the Fed Chairman suggests that paying off the national debt will create problems so it's ok to cut taxes. (That was a dumb statement for such a supposedly smart man to make to a group of politicians.) When politicians assure us that surpluses will exist for the next 15 years, we instinctively want to raise serious cash. (More recently Treasury Secretary Paul O'Neill suggested that the Treasury might issue new debt to keep the Treasury bond market afloat and use the proceeds from the bond sales for further tax cuts. We were flabbergasted that a person in O'Neill's position could make such a proposal, and also flummoxed by the fact that the mainstream press ignored the inflationary implications of such an idea.)

Between 1962 and 1968 the stock markets went up 2 1/2 times in value. The stock markets then went no higher (and actually crashed in 1974) for fourteen years. Between 1982 and 1987 the markets went up five times in value. From the high in 1987 it took six years for the markets to make a new high. Then from 1995 to 2000 the markets rose 2 1/2 times in value. Our point is that even in roaring bull markets there are three to five year periods or more when investment resolve can be severely tested. More so when folks are living on the investments, or using the value of the investments as a psychological spending backstop. More to the point - for the markets to perform over the next thirty years like they have over the last thirty, the DJIA would rise to 200,000, your house would be valued at $7.5 million and Times Mirror/Cox would sell at $4000 per share so that the whole company would have a value of $3.4 trillion.

Long term growth stocks like Microsoft and Cisco are always priced to perfection when they are in vogue. And so they have a long way to fall when they fall from favor. Times Mirror/Cox may be a long term growth stock but our view is more that its' price rise has been part of the investment mania for media stocks of the past few years. Investing is about paying a price for a company at which one can expect a reasonable rate of return from earnings. No one who was going to make their living from running a company and drawing a salary would pay anywhere near the p/e multiples that are being paid for growth stocks today. Growth stocks of today may be abandoned next week as the next fad comes along. If we happen to run into a period of four or five years when the Times Mirror/Cox type growth stocks don't perform or underperform; and that time period coincides with the time when you need to withdraw funds, it won't matter that Times Mirror/Cox was known as a growth stock in the year 2001.

For several years we have been leery of the markets. The proposed tax cut is a mistake and should the Congress go forward with it we believe the long term results for the markets will be very negative. For that reason we have a large cash position of over 60% in most accounts. Periodically we attempt to catch rallies by investing some reserve cash in short term trades. A few of the stocks we own like Wild Oats are out of the mainstream and have the potential to double or triple over the next year if we are wrong and the markets move higher. The high return potential of these stocks coupled with what we hope are judicious short term trades allows us to maintain our large cash position, and still obtain a decent return over the next year. If the markets move lower these stocks will suffer but our large cash position will mitigate losses.

Again, let us reiterate that we will not trade in your account. We appreciate your expression of philosophy and we wanted to share ours with you.

Sincerely,

Bud

...a final note

One final note. We are maintaining our cautious approach because we believe a confluence of events this summer will rattle the markets. First, once the tax cut passes, and the gurus personal tax cuts are assured, those same gurus will discover the inflationary deficit producing implications of the revenue give away. Secondly, the energy crisis that is affecting California will spread through the country with negative social and economic impact. Third, the unconscionable acceptance of a permanent rise in the price of oil without suggesting any conservation will inflict a tax on all the public with the resulting drop in consumer confidence.

While this entire doom and gloom scenario may not occur, with our good gains for the year versus the overall market we don't want to let greed cloud our judgement. We have been successful the last three years by being cautious, and we plan to continue in that vein.