October 31, 2008

Dear Investor,

Halloween came very early to Wall Street this year. The month of October witnessed a stock market crash on the same order of magnitude as 1987 and 1929. It didn't happen in a single day, like 1987, or a single week like 1929, but the effect was just as devastating – approximately 30% of stock market value simply vaporized. The negative vortex was worldwide in scope, with most foreign markets actually faring worse than those in the US.

The fundamental issue is the widespread decline in real estate valuations which had supported mortgage related investments. The virulent nature of the decline can be attributed to the effect of numerous investment organizations being forced to sell stocks originally purchased with borrowed money (like hedge funds) and the shrinkage or collapse of the companies that had lent them the money (like Lehman Brothers). Stocks, corporate bonds and commodities were seemingly sold into a vacuum as potential buyers had either too little cash or too little courage to invest.

Is it over? For now, we think it is. We are assuming that the market will trade in a range between about 8000 and 10000 on the Dow for the remainder of this year. After that, the market will likely reflect the outlook for the economy in 2009 and beyond.

Speaking of the economy, we think there could be rough going ahead. When the credit markets froze in mid-September, so did the economy. We are now clearly in a recession, the depth and extent of which is presently unknowable. The last serious recession, 1973-74, was triggered by a quadrupling of oil prices and a dash of Watergate. It lasted about 17 months, during which time the stock market lost about 48% of its value. Businesses and consumers eventually adjusted and the economy and stock market recovered nicely. This recession could potentially be worse. The deflation of the real estate/credit bubble strikes us as far more of a drag on the economy than higher energy prices. The American consumer, driver of 70% of our economy, is now being helped by lower energy prices, but is being squeezed by falling home prices, shrinking 401ks, rising unemployment, tight credit and a very low savings rate. And it's not just here. From Iowa to Iceland to India, there are manifestations of the same problems. Too many investments made with too much borrowed money have gone sour, and now we are forced to cope with the contractional consequences of deleveraging.

Some observers think we may end up in a depression, but we don't. In the 1930s, government officials engaged in a trade war with Europe and sat idly by while banks closed down. Now, governments around the world are throwing huge sums of money at the problem hoping to restore stability and re-stimulate growth. It's the right treatment for the problem, but there is no guarantee it will work. Even if this emergency treatment is effective, it may be many months before it fully takes hold and there could well be unintended consequences that cause additional problems in the future. Economic data forthcoming in the next few months should shed more light on the situation and could well change our opinion. But we are going to proceed on the assumption that we suffer a relatively serious recession that lasts well into 2009, if not beyond.

Coping with this economic scenario in investment portfolios won't be easy. But it won't be impossible either. Jeff made it through 1987 as well as 1973-74. The key strategies will be to emphasize dividend paying stocks more strongly than normal and to avoid companies with too much dependence on either economic growth or external financing. We would also tend to speculate less than we typically might, as well as hold a higher percentage of cash.

On the brighter side, it is worth pointing out that the stock market has traditionally done a pretty good job of anticipating strength or weakness in corporate earnings. It is quite possible that the sharp decline in the market has already compensated for the economic weakness that lies ahead. Time will tell. In the meantime, we will continue to pay very close attention to the press releases and accompanying commentary emanating from the companies in which we invest and follow closely. Information from these companies is much more timely and relevant than government statistics. For the record, our companies are currently expressing a very cautious outlook for the near future and seeing little or no visibility beyond the next quarter.

The tsunami that washed over Wall Street last month left a lot of bargains strewn about. We have started to add some of those to our portfolios and will continue to accumulate what we perceive to be good stocks on sale. Those of you who have moved your portfolios to cash should now consider letting us put some of that money back to work.

Though our portfolios have declined dramatically this year, it helps to keep the longer term in perspective. Broad stock market averages are presently at or below where they traded ten years ago! Our investors on average have given back profits earned over the last 3 years or so, but maintain substantial gains over a 5 or 10 year period. We attribute our out-performance of the broad markets to the selection of very special companies for our portfolios, due to outstanding management teams, quality product or service offerings, healthy balance sheets and strong competitive positioning. We will be very disappointed if these types of companies don't continue to outperform over the longer term.

We are planning on having our next investment seminar on a Saturday, specifically the morning of January 10, 2009. The investment climate is certainly interesting these days, so save the date.

We have recently spoken with many of you, and we appreciate your recognition of the state of the markets. Even though we may be losing less money than the averages over time, that doesn't lessen the pain. Here's hoping we experience a decent rebound from the crash.

Regards, and thanks for your continued confidence in us.

Jeff Friedberg
Terry Ledbetter
Jonathan Reichek