First Quarter, 2005

As those of our clients who diligently read our quarterly letters already know, first quarter reports are our least favorite because one quarter’s worth of performance data is such an insignificant period of time to measure investment results. Performance results over only a three-month period can be impacted by investor emotions and an infinite variety of random events that easily overwhelm (temporarily) any long-term trends.

Nevertheless, our industry continues to report performance on a quarterly basis and, therefore, so do we. Here’s what Bloomberg news had to say about investment performance for the first quarter of 2005. "U.S. stock and bond mutual funds fell in the first quarter, marking the first time in at least five years that investors lost money from both fund classes."

"The average equity fund declined 2.7% this year through March 28 and the average fixed income fund dropped .9% on concern about rising interest rates."

One of the most inviolable rules of the investment world is simply this: in a rising interest rate environment, broad financial asset classes (that is, stock and bond markets) decline in value. What causes interest rates to rise or fall? It’s inflationary or deflationary forces. Interest rates have increased during the past three months as a result of: 1) rising inflation concerns expressed by Federal Reserve officials, 2) a dramatic increase in the consumer and producer price indices, and 3) Federal Reserve increases in the federal funds rate from which banks determine their prime lending rate.

Because we focus primarily on purchasing individual bonds for the fixed income portion of your account—as opposed to bond mutual funds—short-term swings in prices for the bonds you own have little meaning to your longer-term rate of return. If we are indeed entering a prolonged period of rising interest rates due to inflation, your account will actually benefit over time. As your bonds mature, we will reinvest the proceeds in higher yielding bonds on those future dates. As a result, your portfolio’s cash returns will increase. Your assets will compound at a faster rate in the future compared to today.

Rising interest rates lead eventually to more attractive stock market valuations as well. For the past five years, we have lamented the excessive valuations of the broad stock market indices. Only recently, beginning with our last quarterly letter in fact, did we begin to voice the opinion that certain areas of the stock market were approaching more reasonable valuation levels. That process is continuing.

The broad U.S. economy continues to perform well in spite of the headwinds of rising inflation, interest rates and oil prices. We continue to look for evidence that the consumer or the economy is being harmed by these factors, but that evidence has been sketchy by the end of the first quarter. Anecdotal evidence, however, that lower- and moderate-income people are feeling the pinch from high energy prices comes from our observing the stock price action of two major businesses. Wal-mart, the nation’s largest retailer has seen its stock price decline by 8% this year-to-date. (Wal-mart’s stock peaked at $70 per share in December, 1999, and has been heading down ever since. The company’s earnings per share have doubled during this same period of time!) Budweiser—the king of beers—has seen its stock price decline 9% during the first quarter on reduced revenue expectations.

Price declines in the shares of these companies which cater primarily to lower- and middle-income Americans during the first quarter was three times the decline of the major stock indices. In our search for clues about the future of our economy, these observations hint to us that high oil prices are beginning to have a negative effect on consumer spending.

As you might expect, there are widely varying views regarding the future direction of oil prices. Your portfolio reflects our view that energy prices will remain around current levels until the next global recession strikes. When that moment occurs, it’s our opinion that energy prices will experience only a temporary reduction before resuming their climb.

Here’s our reasoning. China, India, and to a lesser extent other developing nations around the world, are dramatically increasing their oil consumption as their economies continue to industrialize at a rapid rate. Increased competition for sources of oil supply is occurring at the same time that oil supply from politically stable nations is diminishing. The Middle East, Africa, Russia, and Venezuela account for a growing percentage of world supply. Many, if not most, of these countries are ruled by governments with hostile views towards the West in general and the United States in particular. And then, of course, there is the ever-present terrorist threat to sources of supply.

Based upon these thoughts, we continue to overweight client stock portfolios in a diversified group of energy stocks. This strategy was a major contributor to the equity portion of client portfolios outperforming the U.S. stock markets during the first quarter and for the past 15 months. We continue to believe that very broad diversification is critical to minimizing the potential for client portfolio losses this year. Diversification, together with our focus on high levels of investment cash flow, continue to represent our strategy for sound investing.