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April 26, 2004

April 26, 2004

Best spring wishes and hello.

Recently, I have been reading two books; The Rise and Fall of Great Nations by Professor Paul Kennedy and Moneyball by Michael Lewis. The first is a study of the great empires from 1500 to 1986, and the second is about how professional baseball teams evaluate talent and choose players. In some ways, both books are about the same thing; the traditional way of dealing with issues, versus new ways of dealing with the same issues. A section at the end of this memo discusses some of the strategies and behavior patterns from these books that are useful in money management. This is a big topic so I may address it a little at a time over the next several years in these memos, unless readers find it boring.

OUR OUTLOOK FOR TODAY’S MARKETS

We believe that the current rise in U.S. interest rates for 10-year bonds will lead to a rise in short term interest rates over the next few months. How will a probable continuing rise in long and short-term interest rates over the next few months effect the U.S. stock market? Further, how will foreign stock markets react to a rise in U.S. interest rates? What will happen to the valuations of currencies, commodities and precious metals?

INTEREST RATES WILL CONTINUE TO RISE

We believe that the odds are very high that interest rates will rise. What is not so certain is how fast they will rise. The rate of economic growth and the rate of inflation that is becoming imbedded in the economy will determine the speed with which rates rise.

We expect solid economic growth and slowly rising inflation. If this occurs, it will lead to a strong growth in corporate profits and increased confidence among corporate officers about their spending plans for capital goods. This combination should lead to continued stock market appreciation.

U.S. STOCKS THAT WILL DO BEST ARE THOSE WITH THE MOST VISIBLE GROWTH RATES AND THE LOWEST VALUATION VERSUS THEIR GROWTH RATES

We intend to, as we have mentioned in our last several letters, purchase fast growing stocks with low P/E ratios versus their growth rates. In our last letter, we mentioned the heavy market volatility and that we thought that the market was prepared to rise. We were correct. We have seen a rally. The volatility is still with us, and we expect more of it. The volatility can be a great friend if you use it to buy the companies that you believe in at times when the uninformed are panicky and are selling.

We expect to see several very volatile periods ahead for the market, because this is a transition stage and in transition stages, volatility increases. We are transitioning from a low inflation environment to a moderate inflation environment. We don’t expect high inflation, but moderate inflation. As inflation rises, interest rates rise. As long as the inflation rises at a moderate rate, all should be well for stocks, the U.S. dollar, precious metals and real estate.

MODERATE INFLATION RISES ARE WELCOME BUT RAPID INFLATION RISES LEAD TO SPECULATIVE BUBBLES

A rapid rise in inflation could be devastating for stocks. If inflation begins to rise at a rapid rate, the game changes. The buying power of the saving class, the retired income seekers, and conservative investors becomes diluted.

Instead of sustainable economic growth you get speculators using leverage to purchase real estate, stocks and commodities as long as their cost of money is lower than the inflation rate.

Evidence of this exists in some real estate markets and in some commodities as the cost of carrying assets is quite low, and the inflation rate increases the value of those assets quickly. Real estate values in some regions are being driven up by a combination of low borrowing costs and low availability of housing. This has created a housing bubble in some geographic areas. Speculative bubbles are also especially evident in some commodities where huge demand and usage from China cut into stockpiles and caused a producers to rapidly raise prices.

INDUSTRIES THAT ARE INTERESTING

· We have seen opportunities in the biotech and technology area in the U.S.
· We remain very bullish on energy stocks and we have just returned from visiting with the managements of several energy companies In the U.S., Canada and the North Sea.
· Pollution control companies in the U.S. and Canada.
· Indian technology stocks which are listed in the U.S.
· Japanese stock brokerage companies.
· Russian consumer stocks.

OUR CURRENCY OUTLOOK

As you know, for a long time we were short the U.S. dollar. In recent months we have not been short, but rather watching the dollar rally to see if it was sustainable. We believe that the dollar is in a trading range and has completed its near term rally. In coming weeks, we expect the dollar to fall a bit versus the major currencies. At this point, we do not believe that the dollar will plummet down or rocket upward. It will most likely trend lower for the next few months. We are long British Pounds and we believe that the Euro will rise in coming months as well.

U.S. ECONOMIC GROWTH

We see U.S. economic growth as strong throughout 2004, and we believe that Russia, India and Japan will also enjoy above trend economic growth for the next few months. Europe has lagged in their growth pattern and we would not be surprised to see European money moving to the U.S. for better investment prospects throughout the year. This should further support the dollar as well as U.S. stocks.

One large source of investment funds for U.S. stocks may come from money invested in debt or high yield instruments such as bonds, utility stocks and real estate investment trusts. As interest rates rise, these fixed payout investment assets become less attractive.

PRECIOUS METALS

Precious metals are being influenced by two different forces. The weak dollar attracted a great deal of money into precious metals. In Euro terms, the price of Gold has not risen much in the last year. In dollar terms, the prices of precious metals are up significantly. As we pointed out earlier, the dollar may not fall much more and therefore this once positive influence on the prices of precious metals may be neutral longer term. In the short run, the dollar may decline for the next couple of months giving gold a rally upward.

The second influence that traditionally affects gold is oil prices. The most dominant factor determining the price of gold during the bull market for gold in the 1970’s was the price of oil. We believe that a new period of closer correlation to the price of oil is beginning for gold. We are enthusiastic about the long-term rise in the price of oil and thus we believe that the price of gold will move up long-term.

We are bullish on gold for the next one to three months and are presently long gold and silver shares.

After rising into early summer, we expect gold to be quiet for several months. At that juncture we plan to sell our gold positions and look to U.S. and foreign equities for profits. We intend to avoid income instruments until the U.S. 10-year bond yields rise to about 4.75 or 5.00 percent from their current 4.4 percent yield.

TRADITIONALISM VERSUS THE UTILIZATION OF NEW TECHNOLOGY IS AN ISSUE IN EVERY FIELD OF LIFE INCLUDING INVESTMENT MANAGEMENT

The evolution of new approaches to issues are usually a result of more and better data which has become available, thus allowing the decision maker to utilize better, faster, more reliable or deeper levels of insight into a problem.

One of the books that I mentioned in the first paragraph, Moneyball, is about selecting baseball players by the use of modern statistics versus using the opinions of old experienced baseball men. I mention this to point out the similarity of what investment managers, baseball general managers, or the managers of many business organizations, do. Evaluate prices for goods, services, skills or existing companies and ascertain which goods, service, skills, companies and industries are overvalued and which companies are undervalued.

In Moneyball, those who swam against the tide of baseball tradition were rewarded with a very high percentage of games won to dollars spent on players. While those who relied on the traditional mechanism of the opinions of old baseball men varied in success. The most successful as measured by the percentage of games won to dollars spent were the non-traditionalists. Those who thought and acted in a non-traditional manner and used the information and technology that was available, were the economic victors.

In investment management there is a similar debate raging. It has been raging for decades, and there are several groups of debaters. We are definitely in the new thinking category. This category is made up of those who look for logical discontinuities in the markets. Such discontinuities often create investment opportunities. Simply stated, we try to buy companies that may have been misunderstood or have been subjected to an exogenous shock that is temporary. We often buy companies we know well, but have felt were overpriced, when these companies meet with some temporary problem that can be rectified fairly rapidly. As people see the problem they sell the stock in panic. We try to buy at such times if we know that the fundamentals of the company remain strong and that the shock is temporary.

IF TRADITIONALISM IS NOT AS PROFITABLE, WHY DOES IT EXIST?

There are many reasons for traditionalism. 1) It may be very effective some of the time. 2) It may be easier to sell to prospective clients. 3) It is easier to explain poor performance and thus makes it easier to keep clients. For example, when an investment manager tells his client “We lost money, but we invested it in the accepted way that most people do it. The market will come back.” 4) It is less work.

The way we do it is much more work. It takes a lot of time and attention to: follow companies on several continents, keep abreast of global social, economic and political trends, contact a large cross section of companies big and small, always looking into new industries that are being created watching closely as industries are being destroyed.

As you know by now we are not traditionalists. We do not believe in always staying invested. We prefer to sell when the market declines and repurchase later when times have changed. We do not believe in holding too many companies that we do not know a great deal about. We prefer to own twenty or so that we know very well. We do not believe in investing only in the U.S. and ignoring the values found in the rest of the developed world.

In our opinion, taking the non-traditionalist approach has been: 1. harder to sell, 2. harder to explain to prospective clients why we generally outperform our competitors during declining markets, and 3. involves much more work to follow a broad cross section of companies and industries.

The benefits of the approach may be seen in our investment performance.