Investment Perspectives -- January, 2005

By almost any measure, we had an outstanding year. The Dow Jones Industrial Average rose 5.4%, the S&P 500 10.9%, the NASDAQ 9.2% and the Russell 2000, which tracks smaller companies like the ones we invest in, advanced 18.3%. Our portfolios, however, performed much better, on average.

I wish I could attribute all of our out-performance in 2004 to smart stock picking, but some of our success in 2004 came from good fortune. For those of you who experienced losses in 2002, you may recall that I attributed that partially to bad luck, as some of the companies we chose to invest in had been misleading about their financial statements. It seemed that in 2002, nearly everything that could have gone wrong did go wrong. In 2004, we experienced just the opposite.

We typically invest in companies that are growing by selling more products or services. When companies can raise their prices too, it creates extra growth and is a nice bonus. So it was in 2004. We invested in energy stocks with growing oil and gas production or services, but when the price of oil and gas rose dramatically, so did the stocks. We invested in a steel company with increasing output from new plants, and a chemical company benefiting from growing demand from Asia. When steel and chemical prices increased, so did the stocks. We bought shares of a tanker company that was expanding its fleet. When tanker rates soared, so did the stock. In other words, nearly everything that could go right did. So, while I like to think we are very good at what we do, I would like you, our investors, to realize that we were the beneficiaries of some fortunate circumstances in 2004.

Looking ahead to 2005, I foresee another challenging year. Though the economy seems to be on sound footing, the market is likely, in my opinion, to experience some headwinds. The most direct threat to the health of the broad market would seem to be higher energy prices. Other potential negatives could be higher inflation, higher interest rates, a weakening dollar, or terrorism. Hopefully none of these will occur, but they can't be ruled out.

Another problematic factor, generally overlooked, is U.S. government action to reduce the bloated federal budget deficit. Though large budget deficits are unhealthy for the long term, they do tend to stimulate economic growth and corporate earnings in the short term. Actions to reduce the deficit, though necessary, will almost certainly result in some earnings disappointments in the business world. Investors can be very unforgiving when corporate earnings disappoint. It would thus not surprise me if, some time during the next year or so, the stock market were to experience a correction on the order of 10 to 15%.

We intend to face these challenges much as we have in the past. Market corrections can feel painful in the short term, but over the longer term they are no more than a bump in the road. Should one occur, we will ride it out. We will hedge against rising energy prices by continuing to invest in energy related companies, which stand to benefit from higher prices. We will continue to invest in the healthcare sector, which benefits from powerful demographic trends but can be impacted by government cut backs. We will target industrial companies once again as they seem to be in their best financial health in a generation. We will also continue to search for niche companies, our specialty, that can grow regardless of economic or political circumstances. In short, we will continue to employ strategies that can produce decent returns even if the broad market struggles a bit.

We have achieved great success for conservative investors over the last few years by investing in real estate investment trusts (REITs). REITs have historically sold at prices on a par with the net asset value of their properties. Lately, however, most REITs have been selling at 25 to 30% premiums to the net value of their real estate. Unless premiums continue to expand, which seems unlikely, REITs will not appreciate as they have in the last few years. But I still like well managed REITs that are creating value in attractive property types since they should continue to grow their earnings and increase their dividends.

In summary, I plan to approach 2005 with a bit more caution than normal, perhaps holding more cash than usual and concentrating on companies where price risk seems less than average. Though past performance is no guarantee of future success, I have little doubt that we will have satisfactory returns over the long term, but the next year or so could be somewhat choppy.

I would like to compliment Mona, Monica and Terry for their continued hard work and notable contributions. I would also like to express gratitude to those of you who stuck with us through the dark markets of 2001/2002. We hope to reward you with further profits in the future.

Jeffrey L. Friedberg