Business Week, April 22, 2002

This spring, the Houston Astros played their home opener in what is temporarily called Astros Field, formerly known as Enron Field. Astros Field will suffice until a more suitable and less ignominious corporation steps forth with the required largess for naming rights. The dismantling of the Enron signage has been one of the more tranquil of events that was an outgrowth of the unraveling of the financial legerdemain that epitomized much of the late 1990s. Far more costly for investors has been the unwinding of the excesses that mushroomed in the global financial markets during the late 1990s and in early 2000. The September terrorist attacks accelerated a global and domestic economic downturn that was already in motion, with its attendant erosion of financial asset values. The economic slowdown followed an orgy of speculation and unbridled growth. Fueled by easy credit, bloated debt, and a seemingly unending stream of hyped stock offerings, an unprecedented boom in technology and telecommunications capital expansion crested atop the economic landscape. The mania led to an inevitable glut of equipment and capacity, evanescent revenues, and a low level of real (as opposed to pro forma) cash flow and earnings. The NASDAQ Composite, the best-known barometer of the corporate denizens of technology, probably provides the best illustration of the reversal of fortune that beset the markets, particularly the world of technology. From an intraday peak of 5133 on March 10, 2000, the NASDAQ Composite declined 73% to an intraday low of 1387 on September 21, 2001, before staging a post-attack recovery to close at 1845 at the end of the first quarter.

The world has indeed changed dramatically since September 11. Afghanistan remains an unstable country with terrorist cells a continuing threat. The Israeli-Palestinian conflict has intensified yet again, with the stakes greater than they have been for some time. The Madman of Iraq and sympathetic regimes in other Arab countries grow more problematic with each passing week. Leaders hostile to the U.S. are again floating the use of oil as a political weapon. The U.S. finds itself spreading its military wings with troops dispatched most recently to Pakistan, the Philippines, and Yemen to train the local military to combat terrorism. And daily, discussion flares about when and how the U.S. will "take out Sadaam." Add to this cauldron of turmoil the bizarre leadership changes in Venezuela, and there is even greater potential for uncertainty in the oil markets. And as if this were not enough, Osama Bin Laden has returned for another screen test to remind the world that evil is not easily repressed.

The recession, which intensified in the aftermath of September, ushered in another series of events that rocked the investment world. It is said that recessions uncover what auditors do not. Enron demonstrated that recessions could also uncover that which even auditors who seek to obfuscate can no longer hide (or shred?). Enronitis started a brush fire which raged throughout the investment community during a time when there was already a great deal of angst about the impact of terrorism and continued uncertainty as to the prospects for an economic recovery.

The equity markets rebounded from their emotional sell-off in the wake of the attacks. But in the face of the barrage of negative developments of the past several months, it is little wonder that both the fixed income and equity markets have exhibited varying bouts of fear, relieved intermittently by emerging signs of a turnaround in some industries and a slowing of the horrid news on revenues and profits that weighed down a number of corporations. In recent days, the stock prices of such former stalwarts as Bristol Myers, GE, IBM, and Cisco have unraveled as these companies, along with many others, signaled the struggle facing the corporate sector to restore profits.

GE and IBM, whose stock prices were sent reeling after reporting first quarter earnings, illustrate the schizophrenic nature of current day Wall Street. These blue chip giants appear almost like wounded beasts dumped into a stream swirling with analysts slashing away like piranhas. Long the darlings of Wall Street, both companies now find themselves, like countless others in recent months, trying to explain every nuance of their multi-billion dollar businesses, only to find their explanations met with ever more questions and skepticism.

Of course there is always event risk, and it is not always possible to detect outright fraud. The highly charged atmosphere of the investment world today is one in which operating disappointments, whether they are short-term or of a more permanent nature, are punished severely by the markets. Stock price haircuts of several percentage points are a daily occurrence in the investment world and they are especially prevalent during a bear market.

In the face of such an unsettled environment, should investors engage in dramatic shifts in their long-term strategies? While recognizing the impact that events of the past several months have had and will have on economic developments, we think long-term strategies that align portfolios with individual financial objectives and investment horizons should not be altered dramatically because of recessions or "shock" events. Risk exposure should be reviewed periodically, but not solely as a result of turbulent markets.

Our client portfolios rebounded after September 11, but not as robustly as some of the major indices due to a limited exposure to technology which dominates these indices and which experienced a strong price recovery despite questionable fundamentals. During the first quarter, our portfolios declined due to major declines in wireless telecommunication stocks, cable TV investments, and possible accounting "irregularities" at Elan, the Irish pharmaceutical company. Some of the fundamental concerns affecting these companies we view as transitory, but on balance the major changes in their respective operating environments may materially limit their recovery potential. Nevertheless, we have restructured our portfolios in recent weeks to eliminate the drag presented by a number of these companies. The benefits of these changes became apparent in March as portfolio returns moved back upward.

The good news is that an economic recovery encompassing the globe has begun. The eleven interest rate cuts instituted by the Federal Reserve and corollary easing by other central banks have greased the wheels for recovery. Given the excess capacity existing in some key industries, the recovery, at least in its initial stages, may not be as dynamic as investors would like, but there seems little question that world economies are indeed emerging from a global recession. Consumers in the U.S. have maintained a high level of spending and investment in housing. Thus, they will not provide as much punch to the recovery as they typically have in past recoveries because they have already allocated resources and incurred significant debt over the past several quarters. But there are signs of a recovery in business capital spending. And the major cost cutting conducted by businesses over the past couple of years will contribute to improved profit margins as business recovers and a greater percentage of revenues drops to the bottom line. Stocks typically anticipate improving profits. The markets' lurch forward in the fourth quarter and earlier this year was both a reflection of relief about progress on terrorism and an anticipation of improved corporate profitability. Unfortunately, the markets probably expected too much too soon, especially from technology. At this point, the markets have paused to assess the impact of renewed violence and military action in the Mid East, to await more tangible signs of economic recovery and profits, and to gauge the willingness of the Federal Reserve to raise interest rates.

Again, an economic recovery has already begun. The Mid East conflict has weighed on investors' willingness to be more aggressive in accumulating investments. However, the reality of the necessity for OPEC members to fund their coffers will prevent them from closing their oil spigots. Barring a wider extension of the Israeli military offensive, the spike in oil prices should be short lived, although a price level averaging in the low- to mid-$20s is quite likely over the next year or so. The Fed will be reluctant to raise interest rates until there are very solid signs that the recovery is a durable one. Thus, interest rates are likely to move up in the second half of the year, but an aggressive round of increases is not probable. With interest rates remaining relatively low (the yield on money market accounts is still below 2.0% in early April), corporate profits improving, and oil prices contained, investors should begin to wax more positively about the bond and equity markets. With approximately $4.0 trillion in short-term instruments that could be available for investments in equities, as psychology shifts, the impact on securities prices should prove quite positive.

Also contributing to an improvement in investor psychology will be the continued and fairly rapid resolution of the controversies surrounding the accounting profession and financial reporting. As we move through reports for the first and second quarter, an environment characterized by stronger and more ethical board oversight, more vigilant auditors, and chastened managements will emerge. Financial reporting will be more realistic and credible. Long before Enron, Arthur Andersen, and their cabal of greedy opportunists sneak out of the courtrooms, most of the major issues of accounting and disclosure will have been resolved.

Before concluding, we would like to mention an interesting development that has occurred in recent quarters that may be somewhat related to recent individual investor thinking and activity. Amid all the anguish on Wall Street, the next potential bubble may be yielding clues that the worst is probably over for a very large number of stocks. During the same time that the NASDAQ has been on a downhill slide, housing prices in the U.S. have been undergoing a rather robust increase in the face of lower interest rates and a possible flight to a "safe" hard asset. More and more homeowners probably could not afford to buy the house in which they live at today's prices. And their growing comfort with the idea that housing is a good "investment" that will continue to increase in price at the same time that they become disenchanted with their stock portfolios could be marking an inflection point for both classes of assets. If in fact there is a developing bubble in real estate, it is highly unlikely that it would spiral downward as the stock markets have. Nevertheless, the euphoria over housing could turn a seller's market into one where list prices and offers begin to head south. Stay tuned.

One development that may call for a shift in tactics in investment strategy is the sector rotation from group to group and stock to stock that has been occurring with greater frequency. During the past decade, the average holding period for a U. S. stock has declined dramatically from two years to eight months. It has become increasingly difficult for stocks to turn in a solid uninterrupted upward performance for periods longer than twelve months. For individuals, this may make it more difficult to book long-term capital gains. However, in reviewing the markets of the past few years and especially recent months, it would appear far better to book a profit or cut your losses before the momentum funds, hedge funds, and aggressive mutual funds begin to head for the exits. In any event, the issue of rapid sector rotation and the possibility that the markets will not experience an elongated straight-up bull market has injected a new dynamic into the investment equation.

For over three quarters of a century, the average annual return for large and small capitalization U.S. stocks has been approximately 11.0% and 12.5%, respectively. Panics and manias, war and peace, and heroes and con artists have come and gone many times during this period. Today's bleak headlines will yield to better times in the months and years to come. We believe a focus on the long-term prospects for future economic growth in the face of a highly negative news environment will serve investors well. Our investment philosophy, which incorporates the Business Valuation Approach, should prove particularly well suited to the environment that should unfold over the next several quarters. We are committed to enhancing the long-term wealth of our clients in what we believe will be an environment of more realistic expectations and sustainable but less frenetic growth.

Roger E. King, CFA
Chairman and President

Other contributors:
Leah Friday and Ryan McCleary