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Letter dated April 2002 reporting on the first quarter of 2002

     I’m pleased to report that despite a slightly lower stock market (S&P 500 down 0.1% and Nasdaq down 5.4%) in the first quarter of the year, your account gained    percent.  This figure includes any dividends, and reflects the deduction of my quarterly fees.   We outperformed by doing just a few things right:  (i) we remained underweighted in technology shares; (ii) we were overweighted in housing stocks; (iii) we were right on a few special situations such as Owens Illinois; (iv) we had some of the better consumer stocks such as Chicos FAS, Michaels Stores, Group 1 Auto, and Chattem.  

     As is generally the case, there have been a few stocks I wish I didn’t own.  Handleman has been cheap relative to consensus earnings estimates, but the stock has lagged due presumably to weak management and / or structural changes in the music industry.  Recoton reported earnings that were considerably worse than expected, and the stock has been hit.  There is a cloud over Computer Associates due to accounting concerns, which has made me wish we were even more underweighted in tech than we already are.  Some of the generic drug makers have been weak (though generally not as weak as the major pharmaceuticals) and Tyco has been a roller coaster. 

     My view of the market is little changed from year-end, with one exception.  With the market still at a fairly high P/E ratio, it is more susceptible than usual to certain shocks.  An offensive against Iraq could cause a large rise in oil prices, which would not be good for the economy.  And any prolonged action would produce uncertainty, which the market generally dislikes.  Further escalation of the Israeli-Palestinian conflict could be similarly negative.  The best I can do to guard against such possibilities is to continue to use protective stop-loss orders to guard against sharp declines. 

     Beyond that, the fundamental outlook is slightly more positive than it was at year-end.  The economy is growing more rapidly than had been anticipated by most economists.  Corporate earnings are finally starting to turn, after the worst annual decline since the 1930s.  Analysts expect earnings to rise by 5 to 15 percent this year, which would put S&P 500 operating earnings at somewhere between $42.16 and $46.18.   Using the S&P 500 quarterly close of 1147.21, that leaves the market’s P/E ratio rather rich at somewhere between 24.8 and 27.2, assuming earnings are not worse than expected.  That suggests that prices may simply mark time for awhile as earnings “catch up”. 

     There are always stocks that will do better in a given market environment.  We’ll continue to look for them.  Please don’t hesitate to contact me if you want to discuss anything in greater detail.  Thanks for your continued business and confidence.