October 20, 2003

October 20, 2003

Before beginning this letter I would like to express thanks to all of you who kindly expressed congratulations on our various investment calls of the last few months. There is no doubt that many of our calls have been correct and I would love to say we are smart and infallible. However, it is always better to be lucky than smart, and it is best to be intuitive and thoroughly informed. We have been correct but we want to remind you that infallibility is a myth. We have made and will make mistakes but hopefully we will learn from these mistakes and not repeat them. Now lets review our recent opinions and update them.

The global economic picture in a nutshell is slow growth in most of the world, slight shrinkage in a few areas, and a boom in Asia, especially China. The money spigots remain wide open in the developed countries, and the developing countries continue to export goods to the developed, especially the US. The budget deficits in developed countries are large (and growing) and may present global economic challenges in the intermediate term. In January, we wrote that we thought that the likelihood for deflation and inflation were about equal. As more positive economic news has developed, it is becoming more apparent that inflation is the more likely outcome.

According to consumer, and producer price indices published by governments, inflation is tame and under control. I agree that it is not yet out of control, but as we have stated for the last two letters, the seeds of inflation are being sown. We notice that insurance premiums (auto, health, homeowners, worker’s compensation), medical costs, high-end consumer products, gasoline, heating oil, natural gas, state and local income and excise taxes, packaged food products, fresh vegetables and a host of other products are rising steadily in price. We expect to see higher producer price index and consumer price index numbers in coming months.

Because the US is the world’s largest economy, events in the US economy have an outsized impact on the rest of the world. The US economy has changed radically over the last two decades in large part to the fact that falling interest rates dominated the environment.

Today, the financial service sector is a huge part of the economy. GE and the big auto makers are finance driven organizations, as are many other industrial organizations who have learned in order to compete, they have to finance customer purchases of their products at attractive rates. In the Los Angeles area, high tech, medical tech, software, entertainment, tourism and farming industries are not adding jobs. The jobs are being added at aerospace companies, finance companies, mortgage lenders and homebuilders; all companies that benefit from low interest rates or increased government spending on defense.

The manufacturing sector of the US economy has been decimated. Our labor costs, health care cost and the associated costs of an assembly line worker are about 50 to100 times as much as they are in China. This imbalance can not be corrected, so we must adapt to it. There are many ways to do this. Direct investment in China is one way. Investment in sophisticated communication equipment and inventory tracking systems is another. US business people are very good at adapting to these types of changes.

In the coming years, the biggest change that businesses will have to adapted to will be rising interest rates. Inflation is already asserting itself and should continue to rise. With inflation comes higher interest rates, which means a higher cost of capital for companies throughout the globe.

During the last decade, the low cost of capital led to huge waste in the capital-spending sector. The great overcapacity of fiber optic cable buried in the US is one example of the waste that resulted from the cheap capital fueled tech bubble of the late 1990’s. Higher interest rates, which are on their way, will separate the good corporate managements from the bad. Those managements who run businesses with a high return on assets will prosper those who have a low return on assets will die.

Throughout the world there are companies which have had access to capital through political contacts and corruption, and those whose access to capital came from good business models with strong return on assets characteristics. Investment success will be based upon picking the companies with good business models. Finding companies that can grow in an era of higher capital costs will be the key. It is our opinion that most of these companies are outside of the US and Europe. They are most likely located in Japan, China, India and perhaps Brazil.

In our opinion, many current popular notions about the US economic situation are wrong or only partly correct. These myths are often created for political purposes, and the simplistic sound bites that spread through the population don’t grasp the macroeconomic subtleties. One of these popular myths is that the US government wants China to substantially upvalue the Chinese currency, the Yuan.

It is true that certain forces, including the labor unions and managements of companies in inefficient, declining manufacturing industries want the Chinese Yuan to rise. However, a rapid rise in the Yuan could wreak havoc on Chinese economic growth and possibly the political stability and growth of capitalism in China. Disruptions in China’s growth would likely damage the value of US companies’ direct foreign investment in China, decrease global productivity, and have many other less than salutary effects. The truth is that Chinese economic stability is a necessity for US economic stability.

US government officials want to appease those political donors and voters who want a higher Yuan, but they know it would have to be an orderly and reasonably slow rise in the currency. The challenge for them is to appease these voting blocks, while at the same time, continue to provide cheap imports to US consumers, continue to have the Chinese invest the dollars they earn in US treasury bonds, and continue to increase US productivity by having an inexpensive location for US companies to invest and make sub assemblies for manufactured goods which are then sold by US original equipment manufacturers through US distribution systems.

The currency issue is complex and the simplistic myth that a rapid increase in the value of the Yuan is going to be good for the US, ignores too many economic cause and effect relationships.

Because of the combination of expected higher inflation, and the developed countries need to sell record sums of bonds to developing countries to service their deficits (a prescription for a marked decline in bond prices), we believe interest rates have seen their lows.

To combat this situation for our income accounts, we continue to keep client bond maturities relatively short. Some of the bonds we hold are denominated in foreign currencies which we believe will rise in price against the US dollar, thus increasing the value of the bond in dollar terms. For our aggressive accounts we may be selling bonds short at some time in the future to take advantage of their decline.

We continue to like China and the explosive growth of the Internet in China. The Chinese Internet stocks have provided huge gains for our clients and they may be nearing the end of their price appreciation as we believe their PE ratios aren’t as attractive as they were earlier this year. However, we believe the earnings reports that they will make in the next few weeks will be substantially above analyst estimates and will send the stocks higher.

There is some growing rancor and jealousy against China in the rest of Asia. Everybody is aware that Chinese companies are eating the lunches of companies in Europe and North and South America. However, they are also taking a lot of business from their Asian neighbors. Especially the countries like Malaysia, Philippines and Indonesia. Asian countries are working to pressure China to raise salaries.

Because of the surplus of underemployed former farm workers who are streaming into the cities, there is a huge surplus of cheap labor in China. Chinese labor rates may actually be falling slightly while workers in many other Asian countries have enjoyed an increasing standard of living, until recently. So China is under pressure to raise salaries and revalue the Yuan upward. They will delay doing both as long as possible. Labor rates won’t rise until the glut of former farm workers seeking city jobs diminishes. This could take a long time. We also expect the currency to stay cheap as long as possible as the government seeks to increase employment by fostering economic growth.

Why do we begin the equities portion of this letter with Asia? Because we believe that Asia is the new engine of economic expansion for the entire globe. Since the Great Depression US economic power has been expanding and European has receded. After World War II, US power continued its expansion. By the turn of the current century it is becoming increasingly obvious that US political power is still pre-eminent but the economic pendulum is swinging to Asia especially China and secondarily Japan, Taiwan and India.

China is the world’s factory, and India is more and more becoming the world’s software, and computer/telephone service center. Taiwan is benefiting from their knowledge of Mandarin Chinese, Chinese customs along with their knowledge of western business customs and relationships in the world of western technology. Japan is prospering as a supplier to China (and to a lesser extent to India) of machinery, and know how. The Japanese also shine as distributors of finished products, both through joint ventures and as purchasers of sub systems which are included in Japanese finished products. We continue to own banking and steel stocks in Japan and several indexes and funds that focus on the non-export companies in Japan.

Asia should increasingly dominate world economic news. There is no question that to an individual entrepreneur, Asia, Russia and Eastern Europe may offer the great opportunities for business success. For this reason we expect to see Asia produce the most new companies which can grow at very rapid rates.

As investors, this means we must constantly be developing new research contacts and information sources and access to Asian markets, Eastern European markets and Russian investments. We do this type of thing every day and we continually add contacts globally.

In North America, we continue to hold selected technology, medical, and natural gas stocks. In the past couple of weeks, natural gas and a few of the natural gas stocks have moved higher. We have profited substantially from this trend but we are not selling just yet. We continue to believe that natural gas prices will rise substantially higher. I believe that this trend will continue at least until Thanksgiving and possibly until spring.

In general, the tech and medical related companies we own continue to post excellent earnings and move higher. Although a temporary correction could develop at any time, we see this trend continuing for a few more months and we remain sanguine about the companies we own. Next year, for our accounts that can sell short, we may end up shorting companies in the same industries if the economy falters. Currently, however, the US and Canadian economies are not faltering, but rather strengthening.

The US and Canada form a formidable trading entity. Canada has many raw materials and has strong areas of intellectual expertise. The US has mining, raw materials, basic industry, energy and huge technology driven industries like biotech, medical technology, pharmaceuticals, software, computer hardware design, semiconductors, electronics and electronic components, farming, defense, aerospace, financial markets, tourism, heavy machinery, technology driven services, and many types of media and entertainment companies.

The US also has the infrastructure and the immigration policy that has allowed many of the best and the brightest of the world’s technology and medical professionals to immigrate.

The several decades-long period, which has seen a confluence of fortunate factors for the US, may be ending. Currently, the US is spending way beyond its income and has undertaken the role of world policeman. This role may prove to be beneficial for the US, however historically, this kind of overseas military peace keeping role has been very expensive and dangerous for those governments who have pursued them. Rome and Britain come to mind.

Our long-term positions in gold are being expanded as this letter is being written. We see gold and silver as attractive and see many opportunities in gold shares and bullion in coming months and years. This year our clients have profited from gold mining shares but we believe that it is way too early to abandon the group. We continue to add to positions at times like these when gold is under pressure and building a base for another advance.

In spite of concerted efforts to rig Gold prices down by running the stops on Fridays for the last two weeks, the commodity appears to have successfully weathered the selling and is building new support in the high $360’s and low $370’s per ounce. We love the fact that gold did not break substantially and we remain very bullish on gold bullion and several different gold shares.

The Euro has recovered almost all of the lost ground of the last several weeks and is close to its five year high. We continue to believe that the Euro will move higher in the long run, although it may rest for a while before resuming its assault into new high ground versus the dollar.

Shorter term, our favorite currencies are the Canadian dollar and the Australian dollar. Both Canada and Australia are commodity driven economies. The particular commodities prevalent in both countries have been rising in price, for example; gold, silver, copper, other minerals, soybeans, cattle, hogs and energy commodities like natural gas and oil. Technically both currencies have broken out of major bases and are probably going to rise by 10% or more in the not too distant future.

Some of the investments we hold to take advantage of the opportunities and trends we have identified are as follows. In Japan we own the IShares on the Japanese Index, Japan OTC Fund, Sumitomo Mitsui Financial, Kobe Steel and Nippon Steel. In China, we have taken profits in many of the Internet names we owned, but still own small positions in Sohu.com, Netease.com. We also own PetroChina. In the natural gas area, Chesapeake Energy, Ultra Petroleum, Comstock Resources, The Exploration Company, and Murphy Oil remain in our portfolio. Among technology shares, we own Kemet, 3Com, and Taiwan Semiconductor. In the medical area we own Integra Health Sciences. Among precious metals we own Newmont Mining, Hecla Mining, Agnico Eagle and Tan Range Exploration. We hold speculative positions in the Canadian dollar and will add to the Australian dollar on dips. While we may own these positions in our portfolios today, we are likely to change them as country and company fundamentals or market conditions dictate.