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Quarterly Letter to Clients

October, 2009

Indices at quarter-end (Sept. 30, 2009):

Dow Jones Industrials: 9,712.28 3Q'09 +14.98% YTD +10.67%

Standard & Poor's 500: 1057.08 3Q'09 +14.98% YTD +17.04%

In a recent cartoon, a client is telling his broker, “Who ever would have guessed that my golden years would depend on some industrial average.”

The storied Harvard and Yale endowment funds, using tactics and investment vehicles that they once bragged were unavailable to smaller investors, recently reported losing 25% to 30% of their assets for the twelve month period ended in June. And consider Warren Buffet, pushing 80 years old, who for the better part of a century has been regarded as a legend, one of the best money managers in the business, and who now tells us that 2008 was his worst year ever. If we needed a reminder of just how bad last year really was, there you have it.

In years past, when stocks were riding high, corporations spent their extra money buying back their own stock, under the theory that fewer shares outstanding would lead to higher per-share earnings, and thus a higher stock price. It turns out that they paid too much. They had fallen into the very common trap of loving an appreciating asset.

You have to ask why they found their stock so appealing when it was priced so much higher, and why today, with prices so much lower, they are shunning the buy-back. Perhaps they were trying to reward those to whom they had issued options.

In my opinion, they would have been better off buying in their debt, which would similarly have led to higher per-share earnings and also left them with a balance sheet better able to withstand conditions such as those we are now seeing.

The nature of this business is that you attain highs in the value of your account, then drop back; sometimes by minor amounts, sometimes by larger amounts, like 2008. With the passage of time, you (hopefully) again reach new highs. After reaching a high and falling back, it is human nature to mentally have that high number as the “true worth” of your account. Of course, when you surpass an old high, the new high becomes the bogie. The only variable in all of this is the time it takes from peak to peak. Sometimes the valleys are long and arduous.

Of course, there is nothing sacrosanct about the high price. It is, after all, just an interim number along the scale of time. Further, the high price is no more relevant than the low price. The only price that really matters is today’s market price.

We all felt very good at seeing (or perhaps imagining) the market price of our homes a few years ago. Some who now desire to sell have that ephemeral figure locked in their brains, and refuse to budge from it. If they do not need to sell in any timely manner, they are welcome to bide their time. But the fact is that, in any market, the price is set between a willing buyer and a willing seller, and the true market value of any asset can only be determined at that moment when an accord is reached between the two.

In arriving at an asking price we mortals use any number of methods to justify the figure that we wish to receive. We may say that our house or business should appreciate by X percent per annum, and since we paid Y and have held it for Z number of years, it is now worth A. Or we may say that our stock is selling at this P-E and is growing at that percentage, and thus should sell for some higher number. You will, at this point, recognize that all of that is an assumption, subject to radical change simply by substituting different numbers into the formula. The prospective buyer of your asset will certainly have an entirely different calculation. Witness "structured investment vehicles" or perhaps "auction rate securities".

What I am driving at here is that you cannot allow yourself to be tied to a valuation that is nothing more than a point in history. You cannot kick yourself for paying too much, selling for too little, or for missing opportunities. That is life, and you just have to soldier on to the next transaction. Once you accept this, you immediately learn not to gloat about large gains, for they are nothing more than the other side of the same coin.

I am fairly certain that Warren Buffet did not spend any time feeling sorry for his multi-billion-dollar losses last year; rather, he likely found new places to invest money at valuations that earlier he may never have expected to see. While we know that Mr. Buffet has the comfort of billions of dollars in assets that enable him to glide through these situations, we can nevertheless learn from him.

In any event, we have had just a smashing 2009 (at least so far), and I am very pleased that, based on quarter-ending values, most of my accounts are within sight of their all-time highs, and many are already marking fresh, new highs. The market, you will note, still remains around 30% off its peak, which came in late 2007. So while I have just spent a couple of paragraphs telling you of the folly of fixating on a (high) price or value, I plead guilty to falling into that same mindset.

What I do feel is important, though, is performance relative to the market. If, over time, you can outperform the averages, even by a small amount, that is something to be very pleased about. And when you out-perform Harvard, Yale and Buffet, well, I am not seeing the glass as half-empty, but rather as half-full.

Jim Pappas