2008 3rd Quarter Report

(Download printable .pdf version here.)

Dear Friends,

Last quarter, like the previous quarter, was arduous. As we have written all year, capital markets
have continued to be adversely impacted by the ongoing strain in the global financial system and
the collapse of the housing and credit bubbles. This process continues, at times with frightening
velocity, and the second order outcomes of the deleveraging we had been alluding to earlier in
the year are now unfolding in dramatic and admittedly unexpected fashion. Well over a year has
passed since housing issues triggered significant problems in mortgage markets; in turn creating
widespread problems in credit markets, the shadow banking system, and so on. In our last letter,
we highlighted Minsky moments and the Minsky/Kindleberger framework for analysis of
financial innovation and crisis. Our sense at the time was that the market had clearly reached a
critical stage, but had not yet truly reached the final stage – revulsion; events of the last few
weeks, however, lead us to believe that we may be in the midst of (or heading toward) the
emotional crescendo when traders are screaming, “Get me out!”

With more than a dozen financial institutions across the globe (some of which were bedrock
institutions with histories dating back a century or more) failing or being forced into shotgun
marriages, short-term debt markets in disarray, and extreme volatility in equity markets, clients
are understandably unnerved and focused on protecting assets. To say that the events of the last
several months are unprecedented, while overused, is not an exaggeration – we have witnessed
the near collapse of the world’s banking system. Coupled with mutual fund redemptions, hedge
fund redemptions, and increasing fears of a global recession, these events had erased
approximately 25% of the total value of U.S businesses since the end of the third quarter, as
measured by the S&P 500, leaving the index down more than 40% since its October 2007 highs
before yesterday’s surprising rally.

Abrupt changes in the availability of credit have, inevitably, led to abrupt changes in liquidity
and, hence, asset prices. This has turned into a self-fulfilling prophecy as fears that asset prices
will fall have in some cases led to an actualization of falling asset prices. In our view, the
downward spiral of the current crisis paralleled the emerging markets crisis of 1997 and 1998
where Thailand, the Philippines, Indonesia, and Malaysia faced currency attacks that undermined
investor confidence in foreign-denominated debt. Asia lost access to foreign credit, currencies
plummeted, and creditors lost confidence that they would get their money back. Everyone rushed
for the exits at the same time. The decisions of the credit markets ensured that the crisis
deepened. This story has replayed, but on a much greater (and scarier) scale.

From where we sit today, we view the truly dire possible outcomes from the ongoing financial
crisis as increasingly remote with a global economic response that is slowly showing signs of
working. Programs to hasten bank recapitalization, broaden limits on deposit insurance, provide
guarantees on bank debt, coordinate cuts in interest rates, and provide major increases in
liquidity, if not quite timely, appear to have effectively brought the financial system back from
the brink of failure. While much more can be done in terms of encouraging increased lending
into the real economy from the newly recapitalized coffers of favored banks, we believe that
additional interest rate cuts are likely in this (newly) deflationary time. The somewhat haphazard
and piecemeal initial response to the crisis, especially in Europe, had done little to boost
confidence, but following the UK's bank recapitalization plan, the world appears to be improving
the coordination of its actions.

We are encouraged by signs of life in the commercial paper market and by recent moves in
LIBOR. It will not happen overnight, but we believe the system will slowly recover. Until a few
weeks ago, corporate treasurers and debt capital markets bankers were the only people in the
world that cared about Treasury-Eurodollar (TED) spreads, a measure of perceived credit risk in
the general economy. Whimsically, there is now a TED spread gadget that can be monitored on
the iGoogle homepage. In our view, this is more of a sign of the late innings of a crisis, than the
beginning of one. We have also survived the Lehman credit default swap (CDS) episode with
somewhat surprising ease. Interestingly, many market pundits now claim that fears surrounding
this historic settlement were somewhat overblown. Those of you who know us well won’t be
surprised to hear that we disagree – the fears were very well founded, in our view and we’re glad
(relieved) that the CDS market passed what was likely a difficult first large test.

In terms of our outlook, we believe this market is awash in very cheap stocks. A quick screen
recently revealed that companies with free cash flow yields in excess of 10% (a benchmark we
have used as a proxy of a decent business value and/or oversold market conditions) are abundant.
Likewise, there are currently more than 500 publicly traded companies (excluding financials)
with market capitalization in excess of $300 million, traded on the major exchanges in the U.S.,
which can be purchased for less than stated net asset value. Plainly speaking, fear continues to
run rampant and is creating dislocations that will present incredible opportunities.
Indiscriminant selling, regardless of its root cause, has left the shares of some of the highest
quality businesses in this country priced as if earnings will fall more than 30% and never
recover. Shares of many lesser enterprises are priced as if they will not survive the current
downturn at all. As mentioned earlier, the S&P 500 had lost almost 25% of its value in October
alone, leaving the index down more than 40% since its highs just one year ago. Moreover, the
last 10 years are now what has become known as a “lost decade” for stock investors – on a
simple price appreciation basis, we’re right back to where we were in 1998. As Charles T.
Munger, Warren Buffett’s business partner, recently pointed out, the stock market has rarely
performed worse on a ten year rolling basis, yet corporate profit expansion has never been better.
This is very likely setting the base for a new bull run. Buffett himself recently wrote “equities
will almost certainly outperform cash over the next decade, probably by a substantial degree.
Today, my money and my mouth both say equities.”

Against the current market and macro economic backdrop, we continue to receive client inquiries
about how we have positioned ourselves for continued strain in the financial system and a severe
recession. As we wrote on two occasions earlier this year, we maintain our belief that it will turn
out to be a huge mistake to take any drastic action in client portfolios if the outcome is anything
short of a total financial calamity – which as previously mentioned we view as increasingly
unlikely.

It is worth repeating that our portfolio positioning is typically little changed by macroeconomic
factors. Therefore, in response to the current situation, we have not taken any radical steps. We
continue to believe that purchasing high quality businesses at meaningful discounts to their
worth offers far better protection for clients’ assets than any macro-based structural shifts,
market timing measures, or thematic/sector allocation steps we might otherwise take in creating
so-called defensive portfolios. This may set us apart from some of the other managers you use.
However, the careful evaluation and pricing of businesses is where we believe we can add the
most value for clients. We therefore continue focus the vast majority of our time and resources
on this pursuit as opposed to macroeconomic forecasting.

Our investment process stresses three elements above all others: return on capital, free cash flow
generation, and valuation. First, we look to returns on invested capital for evidence of superior
profitability relative to peers and attempt to understand the basis of a company’s competitive
advantage (which allows those returns). Importantly, once we indentify competitive advantage,
we take great care in evaluating its sustainability. Secondly, we look at free cash flow generation.
At times when credit is difficult to obtain and equity markets are in disarray, companies with
significant cash flow generation survive and thrive. Low maintenance capital expenditure
requirements and good working capital discipline lead to ample cash flow for businesses with
steady demand characteristics. The ability to self-fund is golden in downturns since it allows a
strong business to weather tough times. Moreover, weaker enterprises tend to consolidate or run
themselves out of business in tough times, leaving stronger businesses in position to emerge
from a downturn in an even better competitive position. Finally, we look at valuation, purchasing
securities only when we believe an asymmetric relationship exists between price and value. In
plain English, we attempt to buy $1.00 of value for 80 cents or less. Only when we find that rare
combination of high returns and sustainable competitive advantage, cash flow generation, and
compelling valuation do we initiate positions for your portfolio. Lately, we’ve been finding more
and more top tier businesses that meet our criteria.

A client correctly noted in recent correspondence that many mistakes have been made during
bear markets by managers who lacked the discipline to adhere to their investment philosophy
during periods of stress. Because our philosophy is so well defined and embraced by all of our
investment professionals this will never be the case at Value Architects. A relentless focus on the
process we employ, rather than the outcomes that result from that process allows us to act
unemotionally in times of distress, stand up to our own sinking feelings, and recognize value in
the midst of the creative destruction taking place in financial markets.

As has become our practice at quarter-end, we are proud to report on the quality and price of
companies owned in the model portfolio at Value Architects. The median return on invested
capital (a quick approximation of quality) for the businesses you own was in excess of 15%
compared to low double-digits for the average S&P 500 company. Likewise, the quarter-end
market price relative to our estimation of the core operating earnings (a quick approximation of
cheapness) of the businesses in the model portfolio was below that of the S&P 500. In simple
terms, you continue to own a diversified portfolio of businesses with above average quality,
trading at below average prices – in keeping with our investment philosophy. We have rarely felt
that the discount between price and value in our portfolios was as wide as it is currently and we
expect many of the companies we own to double in price in the next several years.

In an environment where daily returns resemble traditional monthly returns, volatility creates
tremendous fear. This has allowed us to reflect on our shopping list and we are preparing to be
greedier. Successfully navigating the current environment will continue to require a discerning
process, patience, and some amount of intestinal fortitude. For those that ignore Jim Cramer’s
advice to sell “if you need your money in the next five years”, we believe the rewards will be
worth the bumps in the road along the way. As always, we remain dedicated to building your
trust and appreciate your continued support.

Rick Konrad
John Moran