As We See It ...                                                                 Fourth Quarter 2007

Happy New Year, we think. Regardless of whether or not we are actually in or entering a recession, the stock market is making it feel like one. After a soft fourth quarter in which some of our successful technology holdings pulled back sharply and MBIA had a precipitous decline, the S&P 500 has corrected another 10% in 2008 as of this writing.

Even though banks, mortgage companies, and investment firms holding mortgage backed securities or their derivatives are bearing the brunt of the "correction", the contagion is remarkable. Consumers have trouble making their mortgage payments, so they cut back on discretionary items, including high definition TVs. This has hurt companies such as Comcast, whose revenue growth is driven by selling new services like HDTV to existing customers. The electronics companies order fewer semi-conductor chips from Maxim Integrated Products, for example, because they are building fewer TVs. The semi-conductor companies find themselves with excess capacity, so they cancel or postpone their orders with ASM Lithography or KLA-Tencor. KLA-Tencor defers the headsets it ordered from Plantronics, as their executives look at the business outlook and decide to tighten their belts. And so on…

Capitalist societies go through cycles like this on a regular basis. While in the past these cycles took years to unfold, we have such a global, information intensive society and economy that the cascade of events we described above occurred in about four months since the "subprime" bubble burst in August. Businesses react much faster to new information. So does the stock market.

What should we do in this situation? 1) Not panic. We are confident that our investment process has helped us identify strong companies with sustainable competitive advantages. They have healthy balance sheets and can weather the vagaries of the business cycle. Over a five to ten year horizon we are confident they will out-perform the market. If new evidence emerges that a company’s competitive advantages are not what we thought, then we sell the stock. For example, we exited our MBIA positions the instant we doubted that they would be able to maintain their "Triple A" credit rating, the cornerstone of their competitive advantage. We realized losses for most accounts, but ended up avoiding another 50% drop in the price. 2) Look for opportunities. Over-reactions are common in these environments. We may get a chance to buy strong, growing franchises at bargain prices.

The Economy...

Fear. That is the outcome of the sub-prime housing problems: fear and $100 billion in losses. $100 billion is a huge number and difficult for most people to even contemplate. The newspapers have had a field day with the whole issue . People being evicted from their homes have provided fabulous fodder for the print and TV journalists. The outcome of weakness in the housing sector, as they reported it, could only be RECESSION. And the worst is yet to come: resets on home mortgages sold by the sub-prime vendors were due to arrive in 2008, plunging an additional (and much larger) group into trouble as their interest rates rose to levels that the home owners could not sustain, and as a consequence, many more housing defaults.

Maybe. It was pointed out to me that LIBOR has declined to 3.125% and Treasury bills were very low as well, and therefore how big was the expected reset. Gosh, some of these resets might be LIBOR + 3%, or a mortgage rate in the low 6% range. This is about the level one might expect for an individual with excellent credit on a 30-year mortgage. It is entirely possible that the Federal Reserve’s cuts in rates will result in a reset that is not too different from the current mortgage rates that the sub-primes are carrying. In other words, the reset could have little or no impact on mortgage default rates. Perhaps this reset event will not have the terrible impact that was anticipated. More to the point, the problems start well before the reset date, as a large percentage of the mortgages in trouble are in trouble almost immediately, with missed or late payments. There are home owners with "teaser rates" that are about to be in trouble with their new payment. The difficulty does not stem from an unreasonable payment, but that these homeowners could not ever sustain anything that looked like a normal payment – they could only sustain the "teaser" rate.

Special Investment Vehicles were a potential disaster area and represented billions of short-term assets and the pools of investments included some sub-prime-based Collateralized Debt Obligations (CDOs). Many banks started these vehicles as a way of carrying the pools off their balance sheets, and therefore, not having to provide reserves for them. Needless to say, these vehicles had a hard time rolling over their short-term commercial paper when investors learned that some of the underlying investments were questionable. A couple of SIVs went bust, and the commercial paper market dried up, and there was a real crisis in the banking system, a liquidity crisis. Banks began to worry about their counter-parties in the banking business and became reluctant to lend to them, causing a real crisis. The actions of the Federal Reserve and the European Central Bankers have overcome that problem. The banks have absorbed the SIVs back onto their balance sheets, to a large degree, solving that problem.