Investment Perspectives -- July, 2002

The first half of 2002 is now history and it wasn't pretty. The Dow lost 7.8%, the S&P 500 13.8%, and the NASDAQ an agonizing 25%. Numerous stocks have suffered significant declines, including some in our portfolios. Unfortunately, the worst bear market in a generation may not be over.

The primary problem is the continuing hangover being experienced by the economy after the spending binge of the late 1990s. Corporations invested large sums of money, often borrowed, on computers, software, and networking and communications gear. This was partly stimulated by Y2K. Consumers, seeing their 401-K plans appreciate at rates of 20% or so, spent more, borrowed more and saved less. Now the party is over, and even though the 2001 recession has officially ended, the hangover lingers. The economy's problems were exacerbated by "911". A national tragedy in its own right, "911" has crimped air travel, engendered higher security costs for airports, office buildings, and government facilities, wreaked havoc with the federal budget, and caused other economic inefficiencies. And then there was the "Enron effect", where corporate executives under pressure to keep the party going, or perhaps being just plain greedy, resorted to accounting gimmickry to boost their companies' reported profits (witness Global Crossing, Worldcom, Xerox, Qwest, Dynegy, etc.). Complicit in their schemes, or at least guilty of gross negligence, are accounting firms, investment bankers, and possibly Wall Street analysts. In my opinion, some people deserve prison sentences.

The public mood has also been soured by prospects of an extended struggle against a widely dispersed terrorist organization, reported failings at the FBI, the self-destruction of Martha Stewart, and the revulsion at suicide bombings in Israel. The investment mood is further dampened by weakness in the US dollar as foreigners lose respect for our economic integrity and by fear that oil supplies could somehow be affected as a result of the conflict with Islamic extremists.

I feel like I'm in the middle of the "perfect storm" - whatever can go wrong will, all at once. Accidents can happen, but it feels like we have experienced more than our fair share. In order to gain a better understanding of why our portfolios are performing as they are this year, I'd like to comment on several individual stocks. These comments are enclosed separately and highlight what I believe are the primary reasons for the bulk of our portfolio losses - over-optimism on my part regarding the earnings prospects of portfolio companies, over-optimism on the part of CEOs whose expectations for growth have not been fully realized, deception or negligence on the part of some of our portfolio companies executives and auditing firms, and the very negative bear market environment which serves to magnify even the slightest portent of an earnings shortfall.

How bad has it been for the average investor? General Electric, IBM, Microsoft, Dell and Merck have been cut in half. Intel has fallen 75% and Cisco, Oracle and AT&T have tumbled more than 80%. And two presumably solid companies, Enron and MCI/Worldcom have all but disappeared.

The critical question now is what lies ahead and what will be our strategy. Regarding the bear market, now more than two years old, I have a sense that we are in about the seventh or eighth inning. This is just a guess, as the ends of bear markets are impossible to predict. What we have done to date is to raise cash by selling those stocks that embody above average speculative risk, thereby providing some cushion against any further market decline and the opportunity to buy good stocks at very attractive prices should the market decline further.

Ultimately, stock prices reflect earnings. If a company succeeds in legitimately doubling its earnings over a 4 to 5 year period, its stock price will normally double too. For growth accounts at FIM, that's where we have always focused our efforts and how we expect to be successful in the years ahead. Earnings growth can be temporarily impacted by a weak economy, constricted spending budgets, periods of rising interest rates or energy prices, adjustments in government reimbursements or regulations, and other factors. But the American economy embodies a certain vibrancy which has always allowed companies with good products and good managements to grow.

Each of you should be well aware that we are long term investors, and long term investors should be able to weather a storm like this. This bear market will end. The broad economy is actually in pretty decent shape. (Government data don't lie, do they?) Interest rates remain low, inflation is subdued, energy prices are manageable, there is little threat of a major war, and dishonest corporate executives are being weeded out. The problem is primarily a lack of confidence, and that can be restored in due time if the modest economy recovery picks up a little momentum and if we exert pressure on corporate boards to shape up. Let's hope these developments occur.

It also helps to maintain a long term perspective on our investment performance. The broad market now resides at the same level as in early 1998. I'm gratified that the majority of our accounts have made upward progress since then.

In conclusion, we may have to endure additional pain before this is over, but our long term focus should pull us through.

Jeffrey L. Friedberg