Investment Perspectives -- January, 2008

Dear Investor,

To quote Dickens, “It was the best of times, it was the worst of times; it was the age of wisdom, it was the age of foolishness…”. The stock market in 2007 resembled a roller coaster, treating us to three nice rallies followed by three sharp declines. A year ago, I opined that we would likely experience a challenging investment environment in 2007. Indeed, we did.

In fact, it turns out that we were swimming upstream for most of the past 12 months. Though the major market averages gained between 5% and 7% and the NASDAQ about 10%, small cap indices like the Russell 2000 and S&P 600 actually suffered minor losses for the year. Since the majority of stocks in our growth accounts fall within the Russell 2000, our average growth account not only fared well versus the broad market, but fared very well compared to the typical small-cap stock. It would be nice if all of our portfolios could have beaten the market, but unfortunately, last year’s volatility resulted in a fairly large disparity in the performance of our portfolios. Over time, though, relative performance among portfolios should even out.

Our balanced and conservative accounts performed generally in line with the market. The primary drags on performance were the rise in interest rates in all but the highest rated debt securities and the broad decline in real estate valuations. Rising interest rates negatively affect all dividend paying securities. REITs (real estate investment trusts), which have long been a staple of our balanced accounts, peaked early in 2007 and ended the year with a decline of 15%. Fortunately, as I noted in last year’s letter, we felt that real estate valuations were near a peak. We therefore sold many of our REIT holdings during 2007, somewhat mitigating the drag from that sector. Our average balanced account thus managed to hold its ground in a difficult market environment.

We enter 2008 facing a considerable amount of uncertainty. There are major concerns about recession, energy prices, geopolitics, the presidential election and the mortgage meltdown, to name a few. Given our style of investing, recession is not a major concern. What matters to us is where we can find growth. We expect there to be growth in healthcare and in the energy sector, even if oil prices decline somewhat. We plan to invest in these areas as we avoid sectors like retail and finance. With respect to industrial and technology stocks, a recession or a worsening of the current tight credit environment could produce more than a few earnings disappointments. But these sectors are very diverse, and we hope we can continue to find some gems despite the obvious risks inherent in a soft economy.

Energy prices are also a concern. But who would have thought that the stock market could survive 2007 knowing that the price of oil would rise 57%? It thus seems that the price of energy is not as critical to economic health as was generally felt, and that the economy can adequately adjust. Furthermore, as I noted above, we will continue to invest in exploration and production, as well as energy technology, thus hopefully hedging against possible economic damage from high energy prices.

Above all, however, it is the credit crunch that remains the biggest threat to the economy and the stock market in the months ahead. Many financial institutions and other investors have lost an awful lot of money due to careless lending and investing in the mortgage markets. The losses reported to date are likely only a fraction of what will ultimately be revealed. Exacerbating the situation is the continuing decline in home prices, which is further eroding the equity base beneath a mountain of mortgage debt. The antidote to this toxin is financial liquidity, which is currently being administered by the Federal Reserve. Foreign investors are also helping as they buy shares of some large American financial institutions, thereby injecting additional liquidity into the system. More liquidity is probably needed, and the sooner the better. I have only a passing knowledge of the inner workings of our financial system, so I cannot predict how events will unfold. But it seems clear to me that the ultimate losses will be large, they will be largely unrecoverable, and they will not be fully replaced with new equity. I do, however, think the resulting financial dislocations will be worked out, though it will take time. The economy will survive, but it will lack some of the punch that had been fueled by the creation of new debt. There may even be some shrinkage in the U.S., but the worldwide economy is more interdependent than ever, and dynamic growth in places like China, India and other developing countries should more than counter any weakness in the U.S.

As I write this letter, US financial markets remain under stress. They are likely to remain so until we get more clarity in the degree and distribution of the mortgage related financial losses. Hopefully, as earnings are reported in the next month or so, disclosure will be much more complete, much of the financial fog will lift, the path to recovery will become a bit more clear, and Wall Street investors will become less negative. Given the need for greater liquidity, it is likely that key interest rates will head lower. Low interest rates should help support stocks, especially those able to maintain steady earnings growth.

I’ll close with the same message as last year. Despite my concern regarding the near term, the long term outlook remains bright. We intend to continue our search for those special companies that can maintain or accelerate growth of their earnings and dividends. By employing the same strategies that have led to solid returns in the past, we hope to extend our success well into the future.

Jeffrey L. Friedberg
January 3, 2008