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October 4, 2000

October 4, 2000

AN HISTORICAL PERSPECTIVE

As we all know the stock market is famous for fluctuating between periods of undervaluation and overvaluation. When we have a period when a part or sector of the market becomes extremely overvalued and approaches mania, it can be very interesting for investors as it creates opportunities in the undervalued broad market outside of the expensive sectors. Some examples of these periods and the opportunities they create are discussed below.

1968. The entire market became euphoric and overvalued as the economy grew very rapidly on the back of double stimulus of the Vietnam war spending and the “Great Society” social agenda of President Lyndon Johnson. The large cap stocks peaked in 1968, but the high-tech medium and small capitalization companies rallied until late 1969. Subsequently, the market declined until 1974.
1979 – 1980. The energy and precious metals sector became grossly overvalued as oil prices moved from $4.00 per barrel to $40.00+ per barrel and peaked. At that time the broad market was undervalued and the next decade was led by a mergers and acquisitions mania that saw weak, inexpensive companies get bought up and stocks rose substantially. Energy and precious metals fell.
1987. Speculation in takeover stocks and high valuations for growth stocks led to a sharp sell-off and an excellent buying opportunity. Many quality companies were ignored because they were not considered glamorous. They turned out to be wise purchases. Within a few months the market had bottomed and was again rising.
1999 – 2000. The dot com speculation imploded as venture capitalists supplied enough capital to start numerous internet based retail, service and search companies creating an oversupply of competitors. This lead to price cutting, advertising ineffectuality and operating losses. Many of these dot coms are now downsizing or closing. Venture capital investors have stopped providing capital to this sector. While billions poured into dot com companies, many well run, well capitalized medium sized companies in other areas were ignored, creating excellent stock market values in growth sectors of the economy.

U.S. MARKET

As information becomes more ubiquitous and stocks react more quickly, stock market volatility has increased. U.S. stock market volatility is frightening and we expect more of it. As trading commissions have decreased, stock brokers have embraced volatility as a way to increase trading profits. Recently, the market has been declining dramatically. This is partly due to the seasonal pattern of weak markets in the third quarter, partly due to high energy prices and partly due to the overvaluation of the major technology stocks which have been declining rapidly.
Seasonally, over the last fifty years, almost all stock market gains have occurred between October 1 and April 30. Between May 1 and September 30, the market has risen less than 1% per year on average. Any given year may not follow the trend, however, the trend is pronounced over a fifty-year period.
Many of the great U.S. technology stocks had by early to mid-2000 reached very lofty valuations. These companies were selling at 50-100 times projected earnings, 30 times revenues and at earnings multiples of 3 times their growth rates. These valuations made us extremely nervous. At such high valuations, good news for several years was being discounted in the stock prices. The absence of enough good news or even a glimmer of bad news has been enough to send these market leaders, Microsoft, Intel, Northern Telecom and others, down substantially. Eventually, these former market leaders will become more rationally valued, probably within a year. In the interim, they could continue to decline or move sideways.
As the technology leaders have fallen, many other technology companies which were growing faster than the leaders and which were selling at much more attractive valuations have begun to attract investors’ attention. We believe that these companies will be the leaders in the fourth quarter of 2000 and in 2001 and we are focusing our attention on these opportunities right now. (See Summary.)

CURRENCIES
In order to finance our trade deficit and to keep demand high for U.S. stocks and bonds, the U.S. authorities have instituted a strong dollar policy. As a result of this policy, the U.S. stock market has attracted huge inflows of foreign capital for years. A continuation of this policy will make U.S. stocks an attractive holding for Europeans and to a lesser extent, for Japanese investors. Foreigners feel comfortable investing in a country where the value of their portfolio rises as the dollar appreciates.
While the Yen has been basically flat versus the Dollar, the Euro has been weak. Recent intervention by major Central Banks to support the Euro has worked temporarily. The Euro currently trades at 88 cents U.S. However, long standing problems of high spending and unwise tax policies within the European community will continue to keep the Euro below $1.00 U.S..

ENERGY
We believe oil price increase is primarily due to increased demand from Asia, especially, China. China’s economy which is manufacturing based requires a 1% increase in energy consumption to create a 1% increase in economic growth. For example, in the more service based U.S. economy, only a 1?4% increase in energy consumption is required for a 1% increase in economic growth.
In 1994 China was an oil exporter. Today, most new energy imports have been to China. The Chinese economy has grown at about 7% per year for several years. We believe that it will continue to grow and that world oil demand will grow with it. It is obvious that the world must find more oil or shift to other types of energy.

Summary
Based on economic, political and social trends, we are sanguine about opportunities in several industries.
1. The Electricity Generation industry. The U.S. power grid has become strained as internet based electricity usage rises at several percent per year. A great deal of deregulation has provided a platform for efficient, low cost producers.
2. The providers of clean electric power. Power from the U.S. grid is 99.99 clean and available. High-tech customers need more reliable and consistent power. Companies specializing in back-up power or clean power for high-tech manufacturing companies have excellent growth prospects.
3. Some capital goods manufacturers and providers of alternative energy equipment or electricity. Many fuel cell, solar cell and alternative energy generators are in demand to fill the electric shortfall and to solve environmental problems.
4. The hospital management industry. The U.S. population is aging and politicians are promising much increase spending on healthcare delivery. Hospital stocks will reap benefits as customer demand increases and the government funds more hospital care and price increases are again allowed after years of cost cutting.
5. The generic drugs and drug distributors. Mr. Gore and the Republicans in Congress have agreed to import more drugs to the U.S. from abroad as existing U.S. drugs may sell at lower prices abroad. Generic drug makers will find new markets in an aging population. Distributors will act as middlemen as foreign pharmaceuticals are imported.
6. As mentioned earlier, by fall of 2000, technology companies in the telecom equipment, software and services area had become very expensive. For a month their shares have been selling off vigorously due to fears of slower growth in demand in 2001 and beyond. Many of these companies are superior organizations and they will eventually return to more attractive levels where they will become good purchases probably in late 2000 or the first half of 2001.
While we see risks in certain sectors, we are finding nice opportunities for the fourth quarter and into 2001. We encourage you to call us if you have any questions or comments or if you would like more information about any items discussed herein or other issues.