January 5, 2009

Dear Investor,

The stock market resembled a bad dream in 2008, suffering its third worst loss in history. Damage to the major U.S. market averages ranged between 34% and 40%. Many foreign markets fell even further, with Japan, Germany, France and Australia losing 43%, India 52%, Hong Kong 54%, China 65%, Russia 72% and Iceland an astounding 92%.

2008 was the year when perception and reality diverged. It was as if Alice had followed the White Rabbit into the canyons of Wall Street, after which almost nothing was as it seemed. Investment banks turned out to be more like investment black holes. Triple A rated mortgage securities were nothing of the sort. $140 oil was a mirage. Huge bonuses paid to financial industry executives were based on profits that proved to be fictional. The Mad Hatter in this drama was Treasury Secretary Henry Paulson, who seemed to propose more solutions than we had problems. And the Cheshire Cat, aka Bernie Madoff, managed to maintain a smile while allegedly concealing a fraud of monstrous proportions. Too bad Jiminy Cricket wasn't part of this story.

We're presently mired in a recession which began in December 2007, but then worsened dramatically in September 2008. It was in September when credit markets froze, financial commerce ground nearly to a halt, and organizations dependent on borrowed money found themselves gasping for breath. The subsequent shock to the economy prompted many companies to reduce inventories, slash expenses and forestall capital investments. Consequently, many workers are finding themselves in unemployment lines and many more will suffer a similar fate in 2009. Consumers, who have been under pressure during the past year from rising gasoline prices and plummeting home prices, now must deal with the starker reality of shrinking 401k plans and layoffs.

The new year should represent a return to sanity. Consumers and businesses will be tightening their belts, spending less, saving more and managing to get along with lower levels of debt. This won't auger well for economic growth, but it will serve to place our economy on more solid footing. Say good-bye to the Hare and hello to the Tortoise.

To us, the most agonizing aspect of 2008 was the poor performance of supposedly conservative stocks. REITs, master limited partnerships, utilities and other securities that pay relatively high dividends normally hold most of their value in a bear market. Since the credit markets froze in September, however, forced selling by highly leveraged investors has unmercifully hammered these types of securities, leaving them with losses as severe as the broad market. Thus was our strategy to be more conservative than normal at the outset of 2008, expressed in last year's letter, waylaid by the Wicked Witch of the West.

The outlook for 2009 is for the recession to deepen. If there are further shocks to the system, they will likely emanate from international sources, where most economies are less mature than in the U.S. and probably less able to withstand severe stress. But there is light at the end of the proverbial tunnel. The shock to the economy in September was so acute, and the reaction in the corporate world so swift, that the steepest portion of the descent into recession is now likely behind us. Home prices will slide further and layoff notices will continue to make headlines, but the rate of decline should diminish from here on. We are not anticipating anything resembling the 1930s since we now have Federal deposit insurance and other financial safety nets. In addition, the government is acting very aggressively to inject billions of dollars into the weakened financial system to grease the skids and restore confidence. Sooner or later, Tinkerbell's pixie dust should work its magic.

Stock prices tend to precede economic events by three to six months. It is distinctly possible therefore that the sharp and broad decline in the markets in 2008 adequately anticipated the ultimate depth and extent of the recession. Our outlook for stocks is that 2009 will be a year of modest recovery overall, though it wouldn't be a major surprise if the market were to trade at new lows before the recovery begins. As the year unfolds, we expect to direct the relatively high percentage of cash in our accounts into the market. As usual, our focus for growth accounts will be the types of special companies that have served us well over the years, with emphasis on those that should be able to cope with a very challenging economic environment. For income-oriented portfolios, we will continue investing in securities that are now offering unusually high yields due to depressed prices. Even in growth and balanced accounts we may invest in high-yielding preferred stocks to earn far more interest than is presently available in the money market.

On a final note, it may help to view our disappointing 2008 performance in a longer term perspective. The majority of our portfolios have regressed to values existent in 2005, essentially erasing profits attained in 2006 and 2007. The broad markets, on the other hand, are trading at levels first reached in 1998, thereby negating a full decade of gains. This may be of little solace to newer investors, but over the longer term, we are in fact making progress. After all, Dorothy did make it back to Kansas.

Wishing you the best for the New Year,

Jeff Friedberg
Terry Ledbetter
Jonathan Reichek