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Letter dated October 2008 reporting on the third quarter of 2008

This was a quarter in which the rules changed. Earnings power meant little or nothing in the financial sector; it was all about assets, not income. The landscape on Wall Street has been fundamentally altered; there are no longer any major independent investment banks; some large commercial banks such as Wachovia and Wamu are gone; Fannie Mae and Freddie Mac are no longer private; and many remaining financial institutions are fragile. Sarbanes-Oxley, the legislation that punishes CEOs for signing misleading financial statements, didn’t do much good. Other sectors got hit hard as well. Energy and commodity stocks, which had a great first half, fell sharply. Oil traded at $147 in mid-July while supposedly on its way to $200, and then fell by over 35% to as low as $95 per barrel by mid-September. Warren Buffet bought into local energy firm NRG, which promptly plunged from the mid-30s to below 20. It was that kind of quarter.

We maintained large cash balances throughout the quarter but did not dodge every bullet. In our effort to preserve capital we consistently did better than the market on the down days, but we lagged the market considerably on a few days where there were large rallies. That was one reason that we underperformed the market this quarter. However, this defensive posture has helped us a lot in the first few days of October. We also took some hits in financial stocks ranging from AIG to Lehman and even GE. I did not foresee a complete meltdown in either AIG or Lehman; neither, apparently, did their CEOs. The S&P 500 Index finished the quarter 9.0% lower, thus providing a total return of negative 8.4%. Your account lost 13.22%. It may be small consolation, but as of now we are doing better than the market for the year.

As noted, this has been an incredibly difficult period for even the best actively managed mutual funds. Many of the top large cap mutual funds in the country are down substantially more than we are. Many veteran managers believe that these are the worst market conditions since the 1930s – worse than 1974. By October 6 of 1974, there were only 12 days on which the market dropped 2% or more; we have had 20 such days. We’ve had 8 days with drops of 3% or more; 1974 had only 1 such day. The largest drop on any day of 1974 was 3.02%; that compares to 8.79% this year. A bright spot has been small cap stocks, which often lead market rebounds. However, they are also more risky so I have shied away from them in this environment.

Although we were underweighted in financial stocks, we had some bad ones. I cut losses, but not soon enough in all cases. Also, at the outset of the quarter, energy and commodity stocks that had done well in the first half of the year fell sharply. Although many of these stocks are probably good long term holdings, they are volatile and this was not a good period for them.

An irony in all this is that the financial crisis is due to the decline in housing prices. But housing stocks themselves bottomed in July, and many of them have been closer to their highs for the year until recently. If you were to look at a chart of housing stocks including Toll Brothers, Hovnanian, or KB Homes just for this year, you would never know there was a housing crisis. If these stocks do as good a job foreseeing the end of the housing crisis as they did in foreshadowing its beginning, we could be closer to the end of this mess than is commonly thought.

However, it is still a time for capital preservation to be the paramount concern and we are acting accordingly. I cannot judge this market by parameters that have traditionally been useful. The market has been cheap all year relative to the fixed income markets, but that has not provided any underpinning for equities. Many stocks have very attractive payback periods, but again, this has not mattered in 2008. At some point, this compelling value will matter, but it can be dangerous to try to pick the bottom. My gut is to maintain a cautious posture until things settle down. Thus our largest positions are in fairly conservative stocks such as Johnson & Johnson, Exxon Mobil, Public Service Electric & Gas, Proctor & Gamble, JP Morgan, Verizon, Disney and IBM. But even these stocks have been pounded, in part because hedge funds are selling the most liquid things they can to raise cash. Only xx% of your money is in stocks; the rest is in fixed income or cash

I have written two pieces that describe some of the managerial, regulatory and political failures that have gotten us to this point. They are enclosed as separate documents in order to keep this letter brief. They are also posted on our website.

Warren Buffet was on TV on September 24 saying that we would look back in a few years and say that this was an incredible buying opportunity. I think that he is absolutely correct. His statements are all the more interesting because he has been rather cautious until recently. Just these past two weeks, he has invested billions (on privately negotiated terms) into Goldman Sachs and General Electric. We are doing our best to limit the downside while positioning us for that long term opportunity in as prudent a way as possible.

Economic crisis creates both investment risk and opportunity. According to Ibbotson data, large company stocks returned 54% in 1933 and 37% in 1975; smaller company stocks returned 143% and 53% in those years. According to TD Ameritrade chief investment strategist Stephanie Giroux, the market was sharply higher a year after the following events: 23% higher after the ’87 crash, 29% higher after the S&L crisis bottom, and 38% higher after the LTCM hedge fund crisis of 1998. Of course, in all these cases as now, the journey to those buying opportunities was very unpleasant and it is hard to judge whether we are there yet.

Public policy influences and valuation both suggest that the market should do better. However, psychology is a separate variable and difficult to measure. Both flawed and delayed public policy choices allowed the negative psychology to snowball. But it is reasonable to expect that at some point the recently enacted federal stabilization program will be a positive influence on the market. Even so, the selling that began as soon as the stabilization billed passed the House indicates that the “sell the rallies” psychology is still with us.

At some point, valuation will trump psychology but that is difficult to time. When I look at the average payback period for stocks in our universe, the market is about as cheap now as it was at the October 2002 lows. Thus I hope to be able to provide better news in my next letter.