Annual offer to present clients of Lemley Yarling Management Co. Under Rule 204-3 of the SEC Advisors Act, we are pleased to offer to send to you our updated Form ADV, Part II for your perusal. If any present client would like a copy, please don’t hesitate to write, e-mail, or call us.

1 May 2002

Spring Greetings:

As we did with the last letter we are using daily postings from our Lemley Letter Online at lemleyletter.com to compose this letter.

23 April 2002

On December 31, 1999 the NASDAQ 100 closed at $91.30. It is now trading at $33.50 down 63% from its 12/31/99 closing price and 72% from its high made in March 2000. The DJIA closed at 11500 on 12/31/99, and traded yesterday at 10150 or 12% below its 12/31/99 closing price. The S&P 500 closed at 146 on December 31, 1999 and traded yesterday at 111 or 23% below its 12/31/99 close. So the fact that all our accounts are at least twenty per cent and some much higher than their 12/31/99 closing values is a source of great pride. We manage accounts to survive downturns, but in the present three-year downturn our accounts have not only survived but also prospered.

We mention the negative results for the markets and positive results for our clients to reinforce our constant theme of the last few months that there are times when a 3% assured return should be considered a satisfactory investment return. For the past five years it has paid to go to cash in May and not buy again till October. This may be the year that disproves that rule. That’s because as soon as a pattern becomes a rule, the markets have a nasty habit of violating the rule. Yet, since the old “buy and hold” saw has not been abandoned, we think that very few folks really have the courage to go to cash in a down market. Hope springs eternal on Wall Street, and most investors would rather ride a loser down than admit a mistake. That’s because over the long run most stocks do return to favor and solve their problems. That fact has always been a core premise of our investment philosophy. The problem with buying losers in mid-year or trying to ride out losing positions is that over the past few years markets and stock prices have tended to trade to extreme levels on the downside as well as the upside. And so when the love affair is over, stocks tend to trade down to levels where even the most committed holders lose confidence.

Back around 1996 we realized that stocks that fell out of favor early in the year usually stayed out of favor for the rest of the year. We then began waiting for the autumn sell off to begin initiating positions in such stocks. And, voila, our performance on a yearly basis began to well outperform the markets. While past performance is no indication of future performance, we plan on continuing our “go to cash by May so we can buy the fall in the fall” trading philosophy, until it stops working for us. As value investors, waiting for the usual autumn selling period has rewarded us. That’s because momentum investors are only interested in stocks that are rising. And momentum investing has ruled the markets for the past five years.

Our micro view of the stock markets is a result of our macro view of the international and domestic news. The international political and economic situation seems much more complicated and risky than it has for a number of years. The Mid East conflict is being controlled by opposing forces that seem to believe that conflict is the only way to resolve the stalemate. At the same time in the Americas, Argentina is broke and the IMF at US urging refuses to cry for it. Venezuela is in political turmoil. The actions of the IMF in refusing to intervene in Argentina without Argentina adopting draconian economic measures is upsetting the psychology of other Latin economies. The confused White House response to the situation in Venezuela has upset the other democracies of the Americas. Coupled with the near unanimous opinion between the majority in Congress and the White House that Iraq is the center of all evil and must be punished by US military might; the stage is set for a long hot summer of uncertainty in foreign economic and political affairs.

On the domestic front, the predicted economic recovery is less certain than it was a few months ago. Economists can’t decide whether the GDP increase of 4% forecast for the first quarter of 2002 is from inventory rebuilding or real economic demand. The next two quarters will be needed to confirm or refute recovery. Guru Greenspan praises the increase in worker productivity. That increase is the result of job losses. We think the loss of high paying jobs is a long term negative. 3M is the new star of the DJIA as earnings and sales wow Wall Street. The new CEO is from GE, and a new Jack Welch is needed to lead the markets out of the wilderness and into the Promised Land of ever increasing stock prices. At the same time that 3M announced the good revenue and earnings numbers, it also announced that it will fire an additional 9000 employees. So while Greenspan and analysts see an increase in worker productivity, we see even supposedly strong companies sacrificing workers lives on the altar of quarterly stock performance. Unfortunately bubbles are still being blown on Wall Street.

We continue to point out the differences between the economic miracle of the stock market boom of the 1980s and 1990s and the economic expansion and bull market of the 1950s and 1960s. The earlier economic expansion and stock market boom was fueled by the creation of high paying jobs in the US. The later boom was fueled by the elimination of high paying jobs, first in basic industry during the 1980s and in the 1990s by the elimination of high paying white-collar jobs. For the last few years we have believed that eventually the cumulative loss of high paying jobs would wreak havoc on the economy. The stock market and real estate boom of the late 1990s delayed the inevitable. But we think the inevitable may have arrived. And for us in the present uncertain environment, cash is king/queen.

09 April 2002

We have been accused of being perpetual bears, but since we have made money consistently on the long side over the years, and especially the last three years, we don’t think that observation is valid. Rather, we take risk versus reward very seriously. We just don’t have any trading or investment ideas right now. And so, rather than force the issue, we plan on sitting out a few innings. Happily, our profits over the years give us that luxury.

28 March 2002

Some market mavens are pointing to the closing of the spread between high yield bonds and treasuries as an indication that investors are becoming more convinced that economic recovery is at hand.

We have a different take on this phenomenon. We believe the yield spread is narrowing because investors are chasing yield by buying high yield bond funds, and bond funds that can invest a portion of their assets in high yield bonds. As money flows into high yield bond funds these bond funds have to go into the market place to buy bonds. This past week $8.4 billion flowed into all types of bond funds. Since the bond funds with the advertised high yields usually receive the most money, bond fund managers that are allowed to buy high yield bonds seek the highest yield bonds. Demand for these bonds raises their price and thus lowers their yield.

15 March 2002

A client asked a question about the fact that the Treasury notes we purchased at $1000 have closed at $990 today. He suggested we couldn’t to sell before maturity without losing money. It’s a good question. Here’s our answer.

Currently, cash earns 1.5%. If we stay in cash we will earn 1.5%. At some point this year interest paid on cash is going to rise. Let's posit that in December 2002 (nine months) cash and money market accounts yield 2.75%. Averaging the return on cash over the next nine months would have cash yielding on average 2.25% or less. Thus, invested in 3% Treasury notes we are earning at least .75% more for the year. If yields on cash and money funds take more time to rise to 3%, we earn a greater return

We only plan on selling the Treasury notes to reinvest in higher yielding Treasury issues at a lower cash price than those we sell. If we sell the bonds a point lower after owning them for four months, we would lose one point. But we would earn one point in interest (one point is $100 or 1% on a $1000 Treasury note. That’s because the 3% Treasury notes earn 1% every four months. If we sell after eight months and the notes are still down we would make 1% or slightly less than the 1.3% cash is currently yielding. By next December the notes will be one-year maturity paper. If Fed Funds have risen from 1.75% to 3% by year-end, cash and money funds will still be yielding only 2.50% to 2.75%. Thus we would expect our then one-year maturity 3% notes to be selling above where they are now because they have only one year to maturity.

In December 2002, our notes due in November 2003 and January2004 will have one year or less to maturity. As a result, the dollar price of the note due in January 04 will have to start rising towards par ($1000) since in December 2002 if it continues to sell at $990 it will be yielding 4% (the coupon 3% plus discount from par 1%). Now if one-year Treasury Notes are yielding 4% then three-year Treasury notes will be yielding 5% or more. In that case, we will have the choice of selling the Nov/03 or Jan/04 3% Treasury notes we own and with the proceeds buy a two or three year note yielding 5%. Since we believe Fed Funds will be at 3% in December 2002, we would expect Treasury 3% due 1/31/04 to be selling at $99.50 or higher. With the proceeds of the sale we would have funds to purchase a 4.5% coupon note at less than par.

The end result is that this year we will earn about 1% to 1.5% more yield than we would staying in cash. And in December of this year we will have the option of extending maturity to buy a higher yielding two to three year maturity issue, without any loss of principle. In the meantime, if the market does sell off in October, we will have earned about 1.5% if we sell the notes below par to buy stocks. And usually in market turmoil the short end of the Treasury market rallies so our yield might even be greater.

26 April 2002

We used the Treasury rally to sell the November and December 2003 Treasury notes we owned in client accounts at over par. We remarked last month that the movement in less than two year Treasury notes when they dropped 1% in price about three weeks after purchase had surprised us. We sold the treasury notes with the hope that we will be able to find a lower priced entry point with a higher yield to re-establish the Treasury positions. The volatility in the short end of the Treasury market is because of the uncertainty about the economic recovery. We have decided to try and take advantage of the volatility to enhance yield without raising risk exposure.

A client remarked that we were becoming “old lady” traders by spending so much time writing about less than two year Treasuries. On the contrary, since we have a few “older women” who love to trade, we think it is important to spend time explaining to our clients the why of the action we are taking in their accounts. The beauty of the web site is that we are able to address and explain our actions as they occur for those clients who are interested.

28 April 2002

Several clients e-mailed today to ask why we sold the Treasury notes. They weren’t clear why we sold them because we had spent several days last month explaining our reason for buying. Our explanation last month was a discussion of the value of buying two-year Treasuries rather than holding cash. The point of the articles was to explain why we wanted to take a little risk to earn 3 owning Treasury notes rather than earn a riskless 1.3% from holding cash. Since writing those posts, the Treasury notes have dropped, then risen, 1% in value. We think that is enough up and down price movement to try and capture since the risk is one of yield and not principal. If we were only investing 5% of available funds in Treasury notes the activity would not be worth engaging in. But, we are investing 100% of accounts in Treasury notes, while awaiting better buying opportunities in stocks. And so that makes the buy/sell activity worthwhile.

This past week when we sold the January Treasury notes we locked in a yield of 2.3% on a total return basis for the period held. Thus, we did not lose money we just earned less yield than 3%. In fact, we earned 2.3% during a time when we would have only earned 1.3% yield on cash. We earned about 10% annual yield on the 3.25% December notes that we sold. We earned about 4.5% annual yield on the 3% Treasury notes due in November for the period held. Of course those are all annual yields and we only earned at that rate for the period held. We are now earning 1.3% annual yield on the cash realized from the sale.

The point of selling the Treasury notes is to buy them back at a better than 3% yield. The Treasury yields may rise next week or next month. Short-term yields will rise if the economy actually is in recovery. If that happens we will again buy Treasury notes. If it becomes apparent that the economy is not in recovery, the stock markets are going a lot lower and having cash will be comforting. We consider our current position a win, win situation.

We would like to share one of our poems posted on our web site this past quarter. Sugar Snow A sugar snow fell last night To cover March’s mud from sight And paint the trees up on the hill One last time with winter’s white Morning’s sun sparkled bright On maples surging sap to buds Urged by warmth from far away To fill sugar buckets with sweet delight. The robins Saturday returned To pasture greening in the day And pesky starlings have already Begun invading every cranny. Even on a cloudy day There is a light in sullen skies That brightens hopes of spring’s return As soon as winter winds away This year we built a large new pen For mother cows to have their young Safely away from coyote yelps And covered from the rain and snow. On Saturday the first cow freshened At midnight with a mighty bellow Which raised us quickly from our pillow To move the new black calf inside To our delight at mornings light That same black cow was standing near With brown calf suckling, while nearby The born black calf bawled hunger’s cry The magic mystery of motherhood Surprise old cow you now have two One keeper for our herds future One profit in the fall calf sale After cleaning pen and yard And dropping feed for mothers cud It’s off to Wall Street for the day While newborns slumber in fresh hay.


The market value of the Model Portfolio is net of advisory fees, brokerage commissions and other related expenses. Model Portfolio results reflect reinvestment of dividends and other earnings. The Model Portfolio column is the overall return of the portfolio for the period shown. The S & P 500 is an unmanaged S & P composite of 500 stocks widely regarded as representative of the stock market in general. Unless otherwise indicated, index results include reinvested dividends and do not reflect sales charges.

Past performance is not indicative of future results. Other methods may produce different results for individual portfolios and for different periods and may vary depending on market conditions and the composition of an individual portfolio. Care should be used when comparing these results to those published by other investment advisors, other investment vehicles and unmanaged indices due to possible differences in calculation methods. A list of all recommendations made by Lemley, Yarling Management Co. for the preceding one year period is available to advisory clients upon request


Spring 2002
Winter 2002
Autumn 2001
Summer 2001
Spring 2001
Winter 2001
The factual statements herein have been taken from sources we believe to be reliable but such statements are made without any representation as to accuracy or completeness or otherwise. From time to time the Lemley Letter, or one or more of its officers or employees, may buy and sell as agent the securities referred to herein or options relating thereto, and may have a long or short position in such securities or options. This report should not be construed as a solicitation or offer of the purchase or sale of securities. Prices shown are approximate. Past performance is no indication of future performance.