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Letter dated April 2008 reporting on the first quarter of 2008

When a whirlwind takes out a major investment bank that survived the Great Depression, you know you are in a bad market. At the same time, it is a reasonable bet that the precipitous fall of Bear Stearns was the eye wall of the financial hurricane. I say so because the Fed’s opening of the discount window to investment banks removed the fears of illiquidity and counterparty risk in the market.

Ironically, this all started as a housing mess. But few commentators have noted that the housing stocks have actually rallied sharply this year. Housing stocks peaked about 9 to 12 months before actual housing prices began to decline, and the same lag time may occur on the upside. If people begin to perceive a bottom in housing prices, it will follow that write-offs taken by banks on mortgage-related securities will also be contained. Recently, a preferred stock issue by Lehman Brothers was vastly oversubscribed, and the buyers were some of the country’s most sophisticated institutional investors. The overall market rallied sharply in the wake of this successful offering, as it was interpreted that some of the smartest money felt that the financial world was stabilizing. The storm seems to be passing.

I had been reasonably defensive in January and February, and even though losses were unpleasant, we were running appreciably ahead of the market in relative performance terms. Unfortunately, I gave up the edge in relative performance terms in March, falling behind in the initial stages of the market’s rally. Bottom line: The S&P 500 Index fell by 9.5% in the first quarter and the Nasdaq Composite Index tumbled 14.1%. Your account lost 9.8%. All figures reflect total return.

The day after the quarter ended, the S&P gained 3.6%. That is why you cannot get too defensive if you want to be a long term investor in stocks; you never know when this sort of snapback will occur. From 1988 – 2007, the S&P 500’s compound annual return (not including dividends) was 9.13%, growing $1,000 to $5,737. Had you missed the 30 best days in that period, your compound annual return would have been only 2.86% with an ending value of only $1,757. April 1 would have fit into the top 30 percentage gains of that 20 year period. The point is you have to be in to win.

Our lag in March occurred for two reasons. First of all, the market’s turn to the upside was very sudden and it was difficult to re-position portfolios that quickly. Second, the financial stocks that were terrible early in the year led the recovery while we were still underweighted in them. Correspondingly, we were overweighted in energy and materials stocks that had done quite well early in the year. These stocks had a sharp but temporary selloff in early March.

Various leaders have suggested that the worst of the financial storm is probably past. Goldman Sachs chairman Lloyd Blankfein was quoted on March 5 as follows: “We're not in the ninth inning by any means, we're maybe two-thirds through, a half to two-thirds. I think it will consume our attention for the rest of this year.'' But markets tend to lead fundamentals by 6 – 9 months, so there is reason to think that the time is ripe to invest.

As noted earlier, the housing stocks seem to be discounting a bottom in real estate prices. Hovnanian is now one of our largest positions, and was up 47% for the quarter. I am reluctant to own more because it has been so volatile, with several daily swings of greater than 10% each way so far this year, but many housing stocks are now above their 200 day moving averages.

The bullish case is buttressed by the compelling relative value of stocks to bonds. I have often discussed the relationship between the earnings yield on the Value Line Index to the yield on the five year Treasury note. On March 17, that ratio reached 2.89 (6.45% / 2.23%). In December 1974, the ratio reached 2.86 (20.83 / 7.29). Obviously, both the earnings yield and interest rate were far higher in 1974, so the spread was wider. But if one market offers nearly three times the return of another, historical evidence suggests a fairly compelling value. In my last letter, I said that the market’s value using this measure was already comparable to the 2002-03 lows. I was early, but it suggests an even better risk-reward situation now.

You don’t get these risk-reward opportunities without price violence on the way down. The market certainly took no prisoners during the selloff, as many “conservative” stocks got clobbered. For example, McDonald’s was up 36.4% in 2007 but dropped 9% in January. Same is true of Proctor & Gamble, up 16.6% in 2007 but down 10.9% in January. Even Campbell Soup, normally a very defensive holding, was down 11.7% in January. Exxon Mobil, another normally “stable” stock, lost 8.5% in January. Chevron lost 10.8% in that month. Diversification to international stocks didn’t help either. For instance, India’s economy is booming and the India Fund returned 39.5% in 2007. But it lost 15.9% in January. There were similar results in other countries.

I think we are well-positioned going forward, and the second quarter is off to a good start. We remain well-positioned in stocks that have substantial upside without being unduly speculative. To bring that point home, here are the largest positions in your account as of now:

General Electric (GE) has huge financing needs and was hurt by the instability of the credit markets in the first quarter. GE hasn’t been this cheap relative to earnings since early 2003, and its PE ratio is less than half what it was in the late 1990s. It has produced double digit earnings growth over the last three years. It offers a dividend yield of 3.1%. We bought on what appears to have been temporary weakness, and hung in there on the latest earnings as they appear to reflect distinct past events rather than future prospects.

Proctor and Gamble (PG) has delivered stellar earnings growth that has averaged 14.6% over the past three years. When the stock fell in January, we bought. It has already staged an impressive recovery. While we’re not playing for a home run here, the company has a large number of key brands, an aggressive stock buyback program, and exceptional management.

Citigroup (C ) has recently become a large position. Between the lows in housing stocks and the Fed’s opening the discount window to all primary dealers, stability in the financial sector is a good bet. At some point, it is also likely that Citi will have over-reserved for losses and will be able to show more gains on distressed securities than the market anticipates. Thus there is a chance for a good boomerang effect in this stock. Certainly there can be more bad news; the question is whether such news is already reflected in the stock. Morningstar gives the stock a fair value of $48.

America Movil (AMX) is a Mexican telecommunications giant. But it is not just any telecomm firm. It is controlled by Carlos Slim, who has recently supplanted Bill Gates as the world’s richest man. The stock is still cheap. At quarter-end, my system projected a payback period of only 7.92 years and a compound annual return of 19.9%. Those projections are based on an ability to grow earnings at 19.5% annually over the next five years. The company has grown earnings at an average of 47% annually over the past five years, so this seems like a reasonable bet.

Disney is another conservative investment in which the company has great upside and some ability to withstand recession. Attendance at theme parks is still breaking records, and the weaker dollar makes it easier for Disney to attract foreign visitors. My system projects a compound annual return on the stock of just over 10%.