October 3, 2008

Dear Investor,

The financial markets were enveloped by a credit crunch last month, resulting in a sharp decline in the stock market and what may be an equally sharp slippage in the economy. Large sums of money that normally flow freely through the financial system are now being hoarded due to a widespread loss of confidence among lenders. This results in a denial of credit to all types of organizations that are dependent on credit to fund their daily operations. Thus the urgent need for some form of financial support from the government that can help restore confidence within the system.

Major stock market averages lost about 9% last month. For the year they are down about 20%. The average diversified mutual fund has also lost about 20% of its value for the year. Ouch!

What went wrong? The way we see it, we had problems on both Main Street and Wall Street. On Main Street, in efforts to make homes more affordable, Congress passed legislation which relaxed requirements to obtain a home mortgage. But Congress failed to regulate mortgage companies that grew up outside the purview of the regulated banking industry. The unintended consequence was that many people bought homes they couldn’t normally afford. After home prices peaked in 2006, many of these subprime borrowers found themselves in default. Meanwhile, on Wall Street, investment banks aggressively sought new ways to achieve higher returns. Using their own capital, and persuading regulators to allow them to lever that capital up to 25 or 30 times, they created as well as invested in new and exotic securities, including mortgage pools that contained subprime mortgages. In short, you know the rest.

So now we have two problems—the seizing up of the credit markets and the weakening of the economy. The “bailout” bill should get the patient out of the emergency room, but not out of the hospital. We still have the economy to worry about.

Bear markets have a strong tendency to anticipate recessions as well as recoveries, and they typically end about 6 months before an associated recession ends. Bear market bottoms are almost always marked by stock price volatility, high levels of pessimism and despair, and they often occur in the September-October period. The average bear market lasts about a year and results in losses of approximately 25-30%. That’s about where we are now. So, if the presently weakening economy were to begin recovering next spring, everything would be in place for the market to now be at or close to the bottom of the bear market. On the other hand, if the economy were to remain in recession throughout 2009, or to be unusually severe, we likely have further to go on the downside.

Unfortunately, we can’t predict the depth or extent of the current recession. But we can discuss the FIM philosophy for investing in a bear market. We invest for the long term.
We conduct extensive in-house research in order to find good companies that are able to create value, becoming larger and more profitable over time. If we are correct in our analyses of the companies, their stock prices should follow a similar upward course. We occasionally invest in companies that fail to live up to our expectations, but our long term record shows that the majority of our investment choices work out reasonably well.

When we find ourselves in a bear market, like now, we may sell some of our portfolio holdings that are not meeting our expectations or are being negatively affected by external factors (like a weakening economy). However, we hold on to our core growth stocks because we expect them to work their way higher in the years ahead. We don't pretend to know or be able to predict the depth of the bear market, so we don't hedge and we don't take a lot of money off the table. What Jeff has learned from past bear markets is that the good companies always bounce back, typically reaching new highs during the subsequent bull market. In essence then, we cope with bear markets by determining with as much certainty as possible that our investments are solid, growing companies that will be worth more after the bear market ends.

We hold a number of energy/power related stocks. These have suffered severely in the last month or two, partly due to falling oil and natural gas prices but probably also because of hedge funds unwinding energy trades or satisfying margin calls. We believe that these stocks are unduly depressed and that their prices will rebound as they contribute to the growing need for clean energy and power.

Our economy is clearly overleveraged. We are facing the most serious financial crisis since the great depression. The necessary process of deleveraging will put a damper on economic growth, but we don’t foresee a repeat of the 1930s. It may be a few years before we experience the next economic boom, but we think we will be able to navigate the choppy waters ahead. In the short term, we will be disappointed if the stock market is not higher by the end of the year.

Yours truly,

Jeff Friedberg
Terry Ledbetter
Jonathan Reichek