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Letter dated July 2002 reporting on the second quarter of 2002

     The stock market ended the first half of the year by returning to the lows it made in the aftermath of September 11, with the S&P 500 Index falling 13.7% for the quarter and 13.8% for the year to date.  The Nasdaq Composite is even worse, down 18% for the quarter and 25% for the year.  Your account did [substantially / considerably / marginally] better than the overall market, but still fell    for the quarter, and is off xx% for the year.  We were pretty defensively postured, but I could not prevent losses in an environment that was this bad. 

     Viewed in the context of historical prices, markets don’t get much worse than they were in the first half of 2002.  Indeed, you have to reach back all the way back to 1970 to find a first half of a year as bad as this.  In the 104 half-year periods measured since the S&P 500 Index has been tabulated, only five half-year periods had larger declines.  And this is the first time post World War II that there have been five consecutive losing half year periods. 

     Is there a light at the end of the tunnel?  I have said before that prices and earnings had to come back into line, and that is occurring.  In the next quarter we should experience the first year-over-year gains in quarterly corporate profits since mid-2000.  The market’s P/E ratio (based on anticipated operating earnings of $51.00 for 2002) is now 19.4 – much more reasonable than in recent years.  Based on that PE ratio, the earnings yield on stocks is 5.15%, respectably above the ten yield bond yield of 4.82%.  The GDP is expanding at a reasonable rate.  Investor sentiment is getting to levels historically associated with market bottoms.    

     The familiar litany of problems is still there – terrorism, mistrust of accountants, international tensions, you name it.  But presumably these negative influences are well reflected in prices.  Even so, I certainly cannot tell you that the price decline stops here.  I can tell you that all of the previous six-month drops of this magnitude in the post-war period were followed by substantial rebounds in the next six months as follows:

     I don’t normally focus on price charts, but the enclosed chart shows that the S&P 500 Index is at a very interesting level, having made a double bottom at about the 950 level.  This could prove to be a base for the type of rally that took place after those other nasty half year periods.  But if the market breaks below that level, we are likely to hear more talk from analysts comparing this period to the 1973-74 bear market or to Japan in the 1990s or even to the 1930s.  The second enclosed chart provides some perspective on the Nasdaq collapse relative to the Nikkei a decade ago and the Dow from 1929-32.  It has been 120 weeks since the Nasdaq peaked.  The Dow’s bottom in 1932 occurred 149 weeks after the 1929 top.  The Nikkei bottomed 137 weeks after its high in 1989.  Those are the two most spectacular collapses of the century, and if they are guideposts, the chart suggests that the Nasdaq decline may be getting close to running its course.

     As you well know, I try to do two things well:  (i) buy reasonably priced stock in good companies and (ii) sell them if prices decline from either our entry point or too much from new highs.  We sold more than usual in this period and as a result, your account had a cash balance of  xx% at the end of May and of xx% at the lows on June 26.  These sales, often pursuant to stop-loss orders, helped us to outperform the market. 

     Certainly not every stock I bought did well.  Almost everything in the tech sector remains awful.  Thus we did poorly in stocks such as Nvidia, Flextronics and Verisign, despite attractive prices relative to historical and expected earnings.  But we did establish a small position in Cisco at an average price of $xx. 

     Some of our stocks bucked the overall downtrend and did reasonably well for the quarter.  I wish I put it all on Brown Shoe – nice, unexciting business – and up 44% in the second quarter.  Certain other consumer stocks were strong too, such as Hott Topic – up 28%.  We had a good size position in Petsmart, which was up 18% for the quarter.  Yankee Candle, another quiet and un-sexy business, was up 17%.  We continued to do well in the homebuilders and in the Mack-Cali REIT.  Some of our health-care stocks, ranging from Oxford Health and Humana (HMOs) to Syncor (medical imaging) posted double digit gains.  The point is that even in a terrible market there are good stocks, and we managed to own a fair number of the winners. 

     But we applied the same sort of fundamental analysis to other companies and lost.  Fleming Companies seems very cheap to anticipated earnings but still lost 19% this quarter.  We bought back into Polycomm (video conferencing) at $[14**], which seemed like a good value after it fell from over $40 since last December, but it has fallen further.  E-Trade fell disproportionately.  Nautilus has been cited as #2 on Business Week’s list of Hot Growth Companies for 2002.  Over the past three years, the company has grown its sales by 85% per year on average and its earnings by 77% per year.  It struck me as a good buy even if its growth slowed to under 20% per year, but the stock has still sold off sharply since we bought it a month or so ago. 

     And sometimes letting profits run doesn’t work.  For example, we bought textile manufacturer Westpoint Stevens and benefited from better than expected earnings announced in April.  I had hoped that would mark the beginning of a sustained uptrend.  But after peaking at around $6, the stock has fallen all the way back to $3.87, which hurt our performance in May and June after helping us in April.  Similarly, Owens Illinois has given us a very good return over time but we have lightened our position as the stock has trended downward this quarter. 

     I added some new positions when the S&P 500 Index fell below 1000.  I was a little early buying Citigroup at $xx ; it fell further especially on the Worldcomm exposure.  We bought xx shares of GE at $xx it seems a reasonably good value under $30.   We also just bought AOL Time Warner at 65% of book value; my earnings model projects a double digit compound annual return on the stock from our entry point of $xx. 

     In sum, I’m sorry to report a loss in your account.  But I’m doing my best to take advantage of the situation to find good buys while still playing vigilant defense.  I’m always happy to discuss things with you at greater length; never hesitate to call or email me.  Thank you for your continued confidence.