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General Market View

March 20, 2000

For the first time in several years the two tiered nature of the market is opening a wider choice of investment opportunities for long-term value investors. Prices for technology and other "new era" companies continue to rally to more speculative levels. However, as investors (and I use that term loosely) abandon their other holdings in order to chase performance, momentum, and hype, they are leaving many other high quality companies selling at prices that make quite a bit of sense.

Virtually the entire property casualty industry is washed out due to a cyclical downturn in the industry and overblown fears about the Internet. There's more to running a successful PC business than having a direct model on the Internet. Statistics, politics, investment management, size, service, and other factors all play a part.

Right now there's substantial evidence that prices are firming across a number of PC lines. That suggests that we may have reached bottom in this cycle. It will take some time for price increases to flow through to earnings due to the length of prior contracts. Additionally, the next several quarters might be weak due to a lot of excess reserves being used up during 1999 to keep earnings smooth. However, reported earnings may start recovering late this year or early next. I believe this is an extremely attractive area right now.

The current environment is also opening investment opportunities for cash rich PC companies (and others) that like to take positions in the equity markets. Warren Buffett, Charlie Munger, and Lou Simpson at Berkshire Hathaway are sitting on a nuclear arsenal of investable funds. If the values continue to improve, you can be sure they will make very good use of that cash. The same can be said of Joe Steinberg and Ian Cumming at Leucadia National. The intangible value of a superior investment team grows as the opportunities improve.

Things are much the same in the food group. Some very fine brands are selling at 8-12 times cash earnings despite reasonable opportunities for growth, very low business risk, and high returns on capital. The two day meltup in mid-March took away some of the value, but it's still an area worth looking at.

Retailers and restaurant chains are similarly depressed. If Alan Greenspan is finally serious about slowing down the economy, they may face an economic headwind, but the stock prices more than reflect it.

Recent disappointments by Proctor and Gamble and Dial Corporation drove down prices of a few consumer products companies to levels that make sense. Good values may appear shortly.

That's the good news. Now let's talk about the environment in general and some of the sobering news.

For much of 90s corporations were successful at cutting costs, divesting sub-par businesses, improving margins and increasing earnings and shareholder value. That favorable trend continues today. However, as this bull market has proceeded, corporate America and Wall St. shifted some of their focus away from maximizing shareholder value and towards maximizing the share price. Even though these two goals are essentially joined at the hip, they are two separate and distinct things. One represents a real "increase" in capital and wealth and the other represents a "transfer" of wealth from buyer to seller in a game of financial musical chairs.

With so many relatively inexperienced investors participating in today's markets, a lot of wealth is being transferred - even though many of the losers don't quite know it yet. At some point value will matter and many investors will realize substantial losses.

A number of factors have contributed to this evolution of our financial markets. Here are a few of main ones.

1. Executive compensation in the form of stock options and bonuses is often tied to the share price instead of more accurate indications of business performance and management skill. Management has a further incentive to maximize the share price in order to keep employees happy. If stock prices were to fall to more "average" levels, employees might start preferring cash over potentially "worthless" unexpensed options.

2. Overvalued stock is often used as a currency in merger activity in order to gain beneficial terms.

3. Corporations face constant pressure from Wall St. and investors to meet earnings estimates. No doubt the benefits to Wall St. of superior trading results, large deals, underwriting, commissions, IPOs, and money management fees play a huge part in the pressure.

Most of the efforts to maximize "share price" involve using GAAP loopholes and shortcomings that enable companies to present face value earnings that are more impressive than the actual operating results. Despite the fact that most of the efforts are both legal and part of legitimate business strategies, they often have the look and feel of a scam. That's especially true when the results are spun by management, analysts, and financial television reporters in a way that would make any politician envious.

Here are some of the more common problems facing investors today.

1. Large amounts of non-expensed stock options.

2. Counting money removed from over-funded pensions (as a result of the bull market) towards operating results.

3. Leveraging the balance sheet to buy back shares at high prices while insiders are simultaneously exercising options and selling their own.

4. Counting the sale of equity investments towards operating results. This is a favorite of many technology companies. There's nothing wrong with taking equity stakes. It's just that capital gains have little to do with the results from operations. That should be communicated by companies and the media very clearly.

5. Using merger accounting that enhances future results.

6. Taking "big bath" accounting charges on a regular basis.

7. Using barter advertising agreements to make revenue growth look more impressive for both parties.

8. Purposely setting analysts estimates below what will be achieved so that a favorable spin can be placed on any result - good or bad.

As I stated earlier, an unfortunate byproduct of this environment is that our financial system has been transformed from a capital raising mechanism into a kind of chain letter and wealth transfer mechanism. Options exercising executives, venture capitalists, underwriters, brokers, favored customers, and deal makers are extracting enormous sums of real wealth and value from naive investors who are accepting corporate financial reports and Wall St hype at face value. I don't know when it will all end, but I think it's both dangerous and disgraceful. There comes a time when sustaining the bubble should be a secondary goal of the Federal Reserve and others. Preventing public pillage should be the primary concern. We are long past that point!

Keep in mind that despite the decent values, most of the evidence indicates that we are still in the midst of extreme overall market and credit excesses. Most periods like this end with a bang.

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According to the Talmud you should keep one-third of your assets each in land, business interests, and gold.
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