2008 - 1st Quarter Report

(Download printable .pdf version here.)

Capital markets have started 2008 in a rather foul mood. The widely followed Dow Jones
Index lost -7.00% for the first quarter of the year compared to the S&P 500 -9.44% and the
Russell 2000 -9.90%. Financial service stocks in particular were hammered with S&P
financials losing almost 14% for the period. Many value investors with significant overweightings
in banks were hurt. Despite our relatively low weighting in bank stocks, our
holdings in non-bank financials also hurt performance. In addition to an outperformance in
growth stocks versus value stocks, we also saw an outperformance of large cap stocks
versus small caps stocks, as the former are perceived to better able to weather a credit
crunch than their smaller counter-parts.

As has often been the case, we find ourselves somewhat at odds with conventional wisdom
and the breathless views of many people you may see on financial television programs or
read in the press. There is little question that a great deal of damage that has been done to
the financial services industry in the last several years and that the economy, particularly
here in the U.S., is likely to slow down as credit becomes tighter and inflated real estate
values are absorbed. While these issues concern us, we find many reasons to continue to
seek value in capital markets and we remain steadfast in the application of our investment
approach.

The period that we are going through is best described in Warren Buffett’s words:

“You only learn who has been swimming naked when the tide goes out – and what we are
witnessing at some of our largest financial institutions is an ugly sight.”

What has characterized the last few years has been an unprecedented expansion in
financial sector activity, inflated much as the tech boom was back in 1998-2001. The
deflation of that balloon, much like the tech balloon, can create some amount of
discomfort. The upswing for financials (whether for mortgage issuance, for CDO issuance,
for private equity takeovers, etc) followed a familiar boom-bust pattern that we have seen
repeated through history. Abundant capital in the form of equity and debt became readily
available and was used to purchase assets, pushing prices higher. As asset prices
appreciated, returns increased – particularly on leveraged strategies. Positive outcomes on
leveraged strategies, encouraged lenders to become somewhat less risk adverse, which in
turn encouraged more borrowings and more asset purchases. An upward spiral ensued
whereby leverage produced excess returns, which begot more leverage and less risk
aversion.

The virtuous circle becomes a vicious one when asset prices begin to decrease. Strategies
employing leverage, whose returns were aided by borrowings in the upswing, suffer
disproportionately as debt represents an increasing portion of now shrinking asset values.
Risk aversion increases and the cost debt as well as haircuts applied to assets increase. In
such an environment, leveraged strategies produce outsized losses, which begets less leverage
and forced selling, ultimately leading to further price pressure on assets.

I have personally witnessed this pattern repeat several times since 1977, initially in the rise
and fall of energy stocks as well as paper and forest stocks through 1981. The pattern was
evident in Texas banks at this time as well. It occurred in oil tankers a little later in the
decade. The 1987 crash, now largely attributed to “clever” financial innovations like
portfolio insurance, was less debt fueled, but certainly required the suspension of disbelief
– since a portfolio was to automatically liquidate for a given price decrease increased risk
taking was now somehow safe, or so the thinking went. We had a similar boom/bust
pattern in the leveraged buyout and junk bond craze in the Michael Milken, Drexel era
which was followed by the S&L debacle. More recently, emerging markets fell apart in the
late 1990’s as did the hyper-leveraged hedge fund, Long Term Capital Management. The
high tech boom and bust, though less debt oriented, certainly followed most of the classic
pattern. Today’s mortgage and housing bust replays the same theme.

The deflation of this financial boom is different than the financial crisis in the early 1990’s,
with which it has most often been compared. It is important to first understand that the
very nature of our financial institutions has changed somewhat, subjecting an increasing
portion of their balance sheets to fair value, mark-to-market accounting. Twenty years ago,
the majority of these institutions remained balance sheet lenders – they were in the storage
business, not the moving business – and the securitization markets were nascent. Today’s
institutions are more complex and hold larger portfolios of securitized products, available
for sale securities or loans awaiting securitization, and more trading products than in the
past, as opposed to traditional whole loans. This is a critical difference because these assets
must be marked to estimated fair market value in each and every period under today’s
accounting regime. Traditional whole loans held for investment are carried at cost and
marked down only when a loss is reasonably certain and able to be estimated.

The application of mark-to-market accounting to greater portions of the balance sheet,
particularly with respect to assets that are more complex or thinly traded, has increased the
volatility of results at many financial institutions, arguably aggravating the current
situation. In some asset classes trading has, at various times since August, been virtually
frozen. In the absence of actual market data to mark to, accountants are forced to price
assets to a reference index (such as the ABX or CMBX). This is all fine and well in theory,
but in practice these indices are likely downward biased due to speculation and hedging
activity. The end result: the banks and funds holding subprime bonds (which is to say
pretty much the entire global financial complex) have been forced to recognize massive
unrealized losses on the value of their holdings. This is not to suggest that loans and
securities will not ultimately go bad, but rather to point out that in the current cycle a large
number of participants have been forced to take losses at the same time, quite possibly
before actual losses occur. In other words, banks today are forced to recognize losses when
the market thinks they should, not when they actually realize them. The second order
outcomes of this process in today’s tightly coupled global financial system have now
become self evident. It is, in our view, worth noting that people appear to recognize the
dangers in financial leverage, derivatives, counter-party risk, etc but few recognize the
difference between mark-to-market accounting and economic reality.

As you can see, today’s accounting methodologies tend to confuse and obscure rather than
clarify and enlighten. Here’s an example from a management that we hold in very high
regard that recognizes that while they had a rotten year, accounting conventions fail to
accurately reflect the underlying economic reality:

“In 2007, Leucadia reported $484.3 million in after tax income ($2.10 per share,
fully diluted). We lost $88.3 million from continuing operations pre-tax and had
non-cash income of $542.7 million by bringing into income part of our deferred tax
asset. In the confusing world of GAAP, in a year where we lost money, did not
harvest any major gains and all of our reported income came from tax savings on
income we have yet to earn, net worth went up 43%, principally from marking to
market our investment in one security.”

Like Alice’s adventure falling down the rabbit-hole, investors who follow financial
headlines too literally may be prone into falling into their own illogical and fantastic
Wonderland.

Against this backdrop, we have received some client inquiries about how we have
positioned ourselves for continued strain in the financial system or a severe recession. The
fact is, it will turn out to be a huge mistake to take any action at all if the outcome is
anything short of financial disaster. Odds are very high that financial institutions, by and
large, will unwind leverage, bolster capital, and move on over time, perhaps somewhat less
profitably. Likewise, the second order outcomes of this unwind, while sporadic and painful
at times, will likely dissipate over time.

In terms of broader economics, Bill Miller, portfolio manager of Legg Mason Value Trust,
astutely pointed out in his fourth quarter investor letter that over the last 25 years the US
economy has been in a recession only 5% of the time. Looking over a longer period, the
U.S. economy has been in a recession for exactly 112 months since February 1945 – that’s
out of 767 months, or less than 14% of the time, according to the National Bureau of
Economic Research. The last two recessions, starting in July 1990 and March 2001, lasted
less than 9 months and stocks actually began to outperform well before the recessions were
over. We’d also note that nobody knows for certain that a recession has started until after
the fact – by definition, dating a recession is dependant on backward looking data. Even if
the U.S. is already in a recession, it strikes us as somewhat self-defeating to manage long
term assets for an event that happens anywhere between 5% and 15% of the time, can’t be
determined until after the fact, and where history suggests stocks have tended to
outperform before it’s clearly over. As such, our portfolio positioning is typically little
changed by our macroeconomic outlook and we default to cash in the absence of
compelling investment opportunities. Financial deleveraging, the deflating of real estate
assets, and shrinking economic output are challenges, but they present opportunities to the
patient investor. In general and as we have seen so far, it is much more likely that
politicians and policy makers will err on the side of too much stimulus, rather than doing
too little too late to address these concerns and that a combination of monetary and fiscal
easing along with some regulatory changes is the most likely outcome.

Historically, market bottoms have tended to occur when the overwhelming majority of
market participants are convinced that things can only get worse. With that in mind, we are
encouraged by the prevailing bearish sentiment that we currently detect. Looking at the
domestic stock market, the amount of “cash on the sidelines” waiting to be invested has
increased over the last several months and is now very close to a record amount relative to
U.S. market cap. This indicator – the ratio between US money market assets (both retail
and institutional) and the market capitalization of the S&P 500 – has been particularly
useful as a gauge of how oversold the US stock market really is – as well as how
sustainable a current rally may be. A chart from Marketthoughts, a newsletter for which I
contribute monthly illustrates the current condition:

This indicator is now at a significantly higher level than it was in October 1990 – the last
time the U.S. stock market presented a once-in-a-decade buying opportunity. This should
be supportive for stock prices for the longer run, but like many other behavioral finance
sentiment indicators, it is not terribly useful for the short-term.

Another interesting indicator of investor sentiment is provided by a specialized exchange
called the International Securities Exchange (ISE) which focuses on customer as opposed
to market maker sentiment:

The ISE Sentiment Index is at its most oversold level since records have been kept – i.e.
even more oversold than it was at the October 2002 lows.

There is a natural tendency for boom-bust cycles to be created. Perhaps the credit supercycle
has ended as some have suggested. But other important trends remain underway and
should be considered:

• The arrival of 3 billion new workers and consumers in the world economy;
• The global division of labor which results from almost universal free trade; and
• The reduction of transport, communication, and data costs to virtually zero

At the beginning of this letter we referenced Buffett’s words about the tide going out – it is
important to remember that the tide will come in again and that companies generating free
cash flow and earning returns on their capital that exceed their cost of capital create
shareholder value over longer time horizons. Remember that your portfolio is dominated
by businesses with these characteristics. Companies that generate free cash flow; that is,
operating cash in excess of the working capital and capital expenditure needs of the firm.
Firms that generate free cash flow do not rely on the provision of credit to fund their needs.
This is no panacea certainly; some of their customers may rely on the provision of credit.
But free cash flow generating companies have the ability to return capital to shareholders
through dividends and share buybacks and importantly, can reinvest in their businesses
without reliance on the outside capital market. We believe that in today’s environment,
such financial flexibility will be considered valuable. When we are able to buy these
companies at a discount to intrinsic value, we believe that they can add considerably your
portfolio’s performance.

The largest exposure that you have in financial stocks is Berkshire Hathaway, a company
of unquestionable financial strength that is actually benefiting from current market
dislocations and is run by the best allocator of capital the world has seen to date. Legg
Mason, a world class asset management business valued at only 0.70% of assets under
management compared to its industry at 2.00% or higher of assets under management, is
your second largest exposure in financial services. Either the market believes that more
than half of its one trillion dollars in invested assets will disappear or it is quite undervalued
at current prices. Many accounts have minor positions in Citigroup and Freddie
Mac, investments which we would characterize as special situation high risk/ high return in
this environment.

Economic uncertainty generally steers investors toward steady eddy businesses such as
foods, consumer staples, healthcare and utilities. Unfortunately, many of these businesses
are priced to perfection or have deteriorating returns on investment. But what investors
should be seeking is recurring, predictable and stable revenues from companies with
sustainable competitive advantages. Recurring revenues are highly desirable and frequently
carry a higher level of margin than most capital equipment intensive businesses. Even
industrial companies can demonstrate a high level of recurring revenue and a fairly low
level of capital intensity, both very desirable qualities for these times.

Let’s review a couple of holdings that we believe fit this mold and trade at meaningful
discounts to estimated business value:

MSC Industrial is one of the nation's leading industrial supply distributors. With a
network of 4 regional Customer Fulfillment Centers and over 90 branches nationwide, the
company assures its customers same day shipping, at no extra cost, with over 99.99%
availability. The company truly recognizes the importance of satisfying its customers'
needs. If they fail to meet the service deadline standard, they send their customer $100.

The company's history dates back to 1941 but became a more significant factor as a direct
sales organization with the publication of its first catalog in 1964. In 1994, the company
began to expand into maintenance, repair and operations (MRO) products, which provide a
more stable demand stream of sales and cash flow for the business. In addition to its master
catalogs, the company also publishes 123 specialty catalogs tailored to specific industries
or products.

MSC has a particular competitive advantage in its extensive e-commerce abilities that
enable customers to lower their procurement costs. This includes many features such as
swift search and transaction abilities, access to real-time inventory, customer specific
pricing, workflow management tools, customized reporting and other features. The
systems can also interface directly with many electronic purchasing portals. In this way,
MSC offers its customers inventory management solutions that reduce sourcing costs, out
of stock situations, and inventory investment, all of which become even more important
when business slows.

Another company with a high degree of recurring revenues is Fiserv Inc., a leading
provider of IT services to U.S. banks, thrifts, and credit unions. The company also provides
administrative support services and processing to the insurance industry. The business was
repositioned late last year through the sale of selected nonbanking businesses and the $4.4
billion acquisition of CheckFree, the market leader in the electronic billing and payment
(EBP) market. Just over 80% of Fiserv’s 2008 sales will come from its main business of
core processing and related products for financial institutions and CheckFree. The balance
will be derived from the company’s insurance service segment, which provides policy,
rating, and claims administration as well as billing and reinsurance services.

Core processing is the nuts-and-bolts infrastructure that allows checks to be posted,
payments to be tracked and processed, and accounts to be managed. The company’s
products and services form the backbone of its client’s back-office systems and are critical
to conducting business – they are not discretionary in nature. Moreover, changing core
processing systems is costly and time consuming in implementation and employee training
for customers. System changes also increase the risk of potential interruptions and service
issues. Clients are therefore unlikely to leave due to a modestly cheaper or slightly superior
product – once a contract has been added, the client relationship tends to be fairly sticky
and pricing is reasonably inelastic. Longer-term contracts with early termination fees are
the norm and renewal rates consistently run 90+%, leading to a revenue stream that is
highly recurring and reasonably predictable.

CheckFree is the market leading electronic bill payment and Internet banking service
provider and one of only three scale providers in a growing industry. The company was an
early mover in the EBP market and has a 27% market share – more than 3.5x the share of
its nearest competitor. Like the company’s competitive advantages in processing,
CheckFree benefits from high switching costs and has a marked cost advantage due to
scale economies of the EBP business. Also like FISV’s core processing business, more
than 90% of revenues are recurring in nature.

In closing, we remain steadfast in our belief that superior investment returns are best
achieved for through a process designed to purchase high quality business at prices that are
substantially discounted to estimated fair business value. While this investment philosophy
will not work in every quarter or every year, it has historically produced more than
satisfactory risk adjusted returns over long periods of time. Overall, though we are never
happy to report negative results, you have outperformed the stock market benchmarks by a
significant margin this quarter. We caution that this result cannot be expected in every
quarter, but it is a standard that hold ourselves to over longer measurement periods. We
appreciate your continued interest and trust!

Respectfully,

Richard H Konrad, CFA, CFP®
John V. Moran, CFA