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Letter dated October 2003 reporting on the third quarter of 2003

     The stock market continued its rally in the third quarter, though at a slower pace than we saw last spring.   Despite a selloff at the end of September, the S&P 500 Index advanced 2.2% for the quarter.  Your account gained xx%.   That puts us up xx% for the year, versus 13.2% for the S&P 500. 

     We were able to outperform while maintaining good diversification among industry groups; we have resisted becoming too optimistic about certain technology stocks and  other high-fliers.  We bought a number of tech stocks such as Foundry Networks and Cisco very well six months to a year ago, and have let profits run while ratcheting up our stop-loss orders to lock in more gains as prices rise.

     Part of the reason that we have been able to outperform is that mid-cap and small cap stocks have outpaced the blue chip, large cap sector.  This is reflected in the Nasdaq Composite’s 10.1% rise for the quarter.  It has been easier to find good value away from the “blue chips”, and so our portfolio is allocated approximately as follows: 

This has been a year in which mid cap stocks have outperformed large cap stocks, and small cap stocks have performed the best of all. 

     Here are some of our better performing stocks for the quarter, in rough order of position size.   

     Just for perspective, let’s compare those returns with some of the best-known stocks, all fine companies.  The problem is that they are widely recognized as such and this is fully reflected in the stock price.  My view is that there is more risk in owning familiar but overvalued stocks than in owning less well-known stocks that are attractively priced.  This is especially true because the stocks we own are not highly correlated; it would be different if they were all small cap tech stocks.   

     One of my theories is that the trend toward indexing (and closet indexing) has distorted capital flows in the equity markets.  Index buying is in proportion to market capitalization, so this buying puts upward pressure on prices of the largest stocks, and that in turn begets a higher allocation of additional indexed dollars to those stocks.  At first, that buying pressure drove big caps to high valuations and now it helps to sustain those valuations, even as smarter money sells to indexers and moves to more promising investment opportunities. 

     Let us turn briefly to profits we took on certain positions.  We own UT Starcom from the low 20s and and it grew to one of our largest positions; we sold some at $xx [an average price of $38.82]; the stock ended the quarter at $31.80.  It fell first on fears of dilution and later on concerns that new technology may threaten their position in the Chinese telecom market.   We took some Nam Tai off the table with nearly a triple, partly because it is an extremely volatile stock and no longer extremely undervalued.  But with its revenues growing at nearly 90%, it is worth maintaining a decent sized position.  We lightened up on Intel, selling some at $xx [an average price of $27.27]; it closed the quarter at $27.52. 

     Here’s why we cut back on Intel.  Intel is expected to earn $0.77 in 2003 and $1.05 in 2004, and grow earnings at 15.3% annually thereafter.  At that rate, it would take 11.5 years for the earnings to add up to the stock price.  Intel’s P/E is 26 times 2004 earnings.  The company’s peak earnings are $1.53 per share, so it is priced at 18 times peak earnings.  Great company, but all those measures indicate that the stock is richly priced.   So why didn’t I sell it all?  Because Intel also seemed expensive at 22.  That’s why I tend to make use of trailing stop-loss orders (something of a misnomer here, because they get moved higher to protect gains as a stock appreciates). 

     We added some new positions this quarter.  Most have done well.  Our most recent add is Korean Electric Power ADRs.  It is perhaps the best value play among any major utility in the world.  Merrill says it is cheaper than at any time in a decade.  A Forbes columnist says it is priced at less than half of book value.  My model projects a compound annual return of over 20%, and we get a 3.5% dividend yield as well.  Few utilities are growing revenues as rapidly as KEP. 

     We also bought xx shares of Cytyc, which specializes in diagnostic testing for breast and cervical cancer.   We paid $xx [an average price of $11.53]; the stock ended the quarter at $15.01.  We added shares of Car-mart, which aspires to be the Walmart of auto dealers.  We bought at $xx [an average price of $20.24]; the stock ended September at $29.84.  We took a decent sized position in Fedders, the manufacturer of air conditioning wall units.  Given Europe’s heat wave and lack of air conditioners, they ought to have plenty of room for expansion.  We bought xx shares at $   [an average price of $4.64]; it ended the quarter at $5.80.  We added a modest position in Noble International, which uses lasers in the auto manufacturing process.   Shortly after our purchase, they announced a better-than-expected quarter, giving us a modest gain to date.  And we also have a modest gain in recently acquired Ruby Tuesday, the restaurant chain. 

     Two new positions have not worked out well to date.  We took a position in Itron, which makes software used in the design of electricity transmission grids.  It screened well even before the blackout, and I thought that earnings estimates could only go up afterward.  At quarter-end, we had a small loss in the stock.  The only big loss on a new position is in MothersWork, a retailer of clothes geared toward pregnant women.  It screened as well as anything else I bought, but announced poor same store sales shortly after our purchase and fell by about 20 percent from our entry point.  I’m hoping it’s just a hiccup. 

     One other noteworthy new position is in gold stocks.  We bought xx shares of Gold Fields Ltd at $xx [an average price of $11.84; it ended the quarter at $14.17.  Why now?  Gold does well when real interest rates are negative.  Real interest rates are already negative on the short end of the yield curve; inflation is running about 2.2% (CPI year-over-year) and two year treasuries are under 1.5%.  This might cause some money to seek a higher return in other currencies.  But the Japanese and European economies have their own problems.  So if a negative return is likely in any currency, gold becomes a viable alternative. 

     It is interesting that both stocks and gold rallied in the third quarter.  My interpretation is that the markets sense some upward inflationary pressure as part of our economic recovery.  But stocks and gold tend not to move in tandem over long time horizons. 

     For now, the uptrend in stocks seems intact.  September has traditionally been a seasonally weak month, and it was not that bad.  The market is still well above its 200 day moving average, which is one indication that an uptrend is intact.  Earnings momentum is good; year-over-year gains have been coming in somewhat ahead of already bullish expectations.  The major cautionary note is valuation.  Value Line’s measure of the market’s PE ratio is 18.0.  That translates to an earnings yield on stocks of 5.56.  Even though the PE has climbed somewhat, the earnings yield is still reasonably attractive relative to the 2.81% yield on the five year treasury.  And the strong tailwind from both monetary and fiscal policy continue.  The fiscal stimulus could lead to big debt problems for us down the road, but the stock market is unlikely to begin to discount that in the near term.  The gold market may be a step ahead of stocks here; time will tell. 

     Markets can move in one direction for a lot longer than we tend to expect.  The bear market of 2000-02 is an unpleasant reminder of that.  But it’s true on the upside as well.  The stock market had very few pullbacks in 1991 after the 1990 recession.  It has gotten tougher to identify compelling values, but a lot of stocks are still attractive given the yields on cash and fixed income securities.  It is a time for careful stock selection and continued prudent use of good risk management tools. 

     Our returns are well over double those of the S&P 500 this year; I am hopeful that we can keep it up for the rest of the year!  As always, I am happy to discuss any of this in more detail with you and to answer any other questions you may have.  Thank you for your continued confidence.