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April 2003 Newsletter | Print Friendly Format

Dear Clients and Friends,

STUCK IN PLACE

If you react to events the way we do, you also must have a sense of being stuck in place, of grappling with concerns that just seem to hang around without being resolved. For most of us, confronting uncertain outcomes has a psychological impact on the way we think about the future and the way we view our investment strategies.

REVIEWING THE BIDDING

Before starting to write this letter to you, we read again the comments contained in our missives of October 2002 and January 2003. Most of the observations made months ago still are relevant, but some of our perceptions have evolved, so we want to focus on what has remained the same and what has changed.

In the October letter, we offered the opinion that the conditions for a market bottom had arrived by the end of the third quarter. With respect to the economic slowdown, we pointed out that recessions and quasi-recessions in the U.S. always are followed by recoveries, sometimes with great resilience, sometimes more muted, but always recoveries. We observed that managements had given up on the idea of being bailed out by an economic rebound and had become aggressive in cutting costs. This shift in gears, accompanied by progressively easier year-over-year comparisons, improved the odds of surprisingly strong earnings results in due course for many mundane companies in unexciting industries. We thought that equity valuations, while unappealingly high to some analysts, nevertheless were at levels that could sustain solid gains in stock prices. In making the argument, we pointed to price/earnings ratios that were near long-term median values, in an environment of very low interest rates, which logically should favor high price/earnings ratios. By last Fall, corporate scandals, management malfeasance, director somnolence and accounting fraud were on the table. We wrote of “wars and rumors of wars” in reference to a determined pursuit by the U.S. of terrorists and of countries that were ill disposed toward our nation.

All of these crosscurrents left investors with a high level of generalized anxiety, amplified by the truly awful performance of stocks in the third quarter. By the end of September, the sense of crisis was broad and deep, sufficiently so as to remind us of similar periods in earlier bear markets. The depth of gloom resembled that which often accompanies a market bottom.

The January letter further developed some of these themes. We noted that severe market declines almost invariably are followed by significant recoveries over relatively short time spans. Near turning points in the market cycle, strong divergences of opinion and extreme risk perceptions are prevalent. The tension between greed and fear is always there, but at major turning points, up or down, the actual juxtaposition is that of greed or fear, on the one hand, and reason, on the other. We made the common-sense point that market tops and bottoms are not announced when they happen, but typically are recognized only after the fact, sometimes long after. Finally, market troughs tend to occur when investors are dealing with a sense of crisis. That mood permeated perceptions six months ago, when we thought the market was establishing a bottom.

WHAT HAS CHANGED?

The observations in the October and January letters still seem relevant, so what is different now?

As we try to make sense out of all of this, it seems to us that two factors have changed over the past few months. One influence is psychological, the other variable is quantifiable.

Six months ago, investors were worrying about readily identifiable concerns such as economic growth prospects, the outlook for corporate profits, valuation levels for stocks, and malfeasance in boardrooms, corner offices and accounting firms. A recent example of such egregious conduct, unfortunately striking close to home, is HealthSouth, an operator of surgery and rehabilitation centers that had been purchased in almost all client portfolios over the past year or two. It turns out that the management, with the assistance of a significant number of employees, had conducted an elaborate fraud for over a decade in order to manipulate revenues, earnings and assets. The numbers run over a billion dollars. The scheme was so carefully planned and so well executed that it was not detected by independent, outside accountants who audited the books for many years. There really is no practical way in which outside investors can protect themselves against fraud of such cunning and scope. The only line of defense is to make sure that portfolios are sufficiently diversified that no disaster in a single holding has the potential to sink the ship. Fortunately, we had observed the diversification imperative.

While concerns about the economy, profits and the markets can be upsetting and occasionally costly with respect to portfolio values, these issues at least could be understood in relatively unambiguous terms. The variables to be considered to an important degree seemed to be contained, even if they in combination added up to powerful influences on investor confidence and stock market values.

A MORE POTENT BREW

Today, largely as a result of the war on terrorism and the invasion of Iraq, the brew of anxieties has become both more potent and less defined. For many investors, the ramifications are significant.

Many of us are deeply disturbed by the notion that others view our country as a rogue nation. That characterization is fundamentally in conflict with our own sense of the U.S. being a caring place, being generous to other nations, and being a protector of the weak. We recall the sacrifices made by our men and women in times of war and unrest in inhospitable parts of the world. The juxtaposition between our sense of what we stand for as a nation and the view of some others is jarring. We think of ourselves as the “good guys,” not the “bad guys.”

Round-the-clock media coverage of the Iraq conflict is another source of anxiety. We see our people at risk in a hostile part of the world, with media commentators telling the enemy when, where and how much in the way of fighting resources we are deploying. This up-to-the-minute commentary must be of great value to enemy forces. We seem to have forgotten that this not the Super Bowl, or even some real-time video game. Even during the Super Bowl, coaches keep their plays secret until called.

In a larger context, we sense that some of the structures which contributed in a variety of ways over many years to keeping the world a moderately orderly place are at risk of failing under stress. There is no doubt that the role of the U.N., NATO and our strategic alliances will be examined, in the context of our national interests, when the current conflict is over. One would also hope that there might be little introspection regarding our perceived role as a global policeman. As Americans, most of us have a bias toward optimism, trust and idealism, and the world now seems to be a more hostile place and less accommodating to our interests.

To sum up, what seemed six months ago to be a relatively well defined, understandable risk equation has metamorphosed into something which is perceived as being much larger, less circumscribed, more open-ended and carrying much higher stakes. Precisely the lack of definition, the absence of a perimeter, has become the fulcrum for leveraging the investor’s sense of risk.

THE MARKETS

We know that the stock market, along with bond, currency and commodities markets, are mechanisms that attempt to discount the future. In recent weeks, stock and bond markets have become hostage to war news, reacting violently on an almost minute-to-minute basis to positive or negative developments. The volatility may be difficult to endure, but it simply reflects the reality that traders are factoring newly available information into the pricing mechanism on a continuous basis. Extraordinary volatility makes for a wild ride, but there is the potential for an explosive relief move when the conflict is resolved.

We alluded earlier to a quantifiable change from the circumstances we discussed six months ago. In the face of all of this uncertainty, and perhaps surprising to many observers, major stock market averages at this writing are up over 10% from their lows in early October. We hope that, absent some disastrous development, the October lows indeed may prove to have been the bottom of this cycle.

THE LONG VIEW

As a concluding thought, we want to repeat an observation we have made before in these letters: returns in a portfolio for a particular period reflect decisions made a year or two or three earlier. Expressed differently, tomorrow’s harvest results from today’s tilling, planting and fertilizing. We always remind ourselves of that and keep that simple reality in mind as we make investment decisions.

For that reason, we tend to look over the valley, because we take a longer view in assisting clients in meeting their objectives. Helping clients to stay the course is an important part of our responsibility. Fortunately, our clients were spared the dot.com devastation, so we have not dug a hole for ourselves and are in a position to stay the course in pursuing the long-term plan or, if needed, to make some adjustments to strategy to ease the client through these anxiety-provoking times.

Your thoughts and comments are always welcome.

Sincerely,

Johann H. Gouws, CFA
President