Last quarter we wrote:

...The "doldrums" seems to offer an apt description of the current state of the...markets...Sailing vessels can be trapped for days or weeks because of the lack of surface winds, although...this is also the region where hurricanes and other forms of severe weather often originate...

As the families and businesses of the entire Gulf Coast recover from Katrina and Rita, we humbly note the tragic irony of our mid-summer words. The month of September clearly demonstrated the raw cruelty of our physical world, which easily overwhelms the concerns of investors frustrated by an anchored equity market.

And that frustration continues. The S&P 500 remains basically flat for the year, and only those investors and speculators who tanked up on the energy stocks in advance of the recent commodity price rise have scored meaningful gains. In fact, if one excludes the energy stocks, the market would be down for the year. As we have discussed for the past several quarters, our portfolios increasingly hold what we believe to be higher quality businesses. These stocks are in many cases now priced at some of the lowest valuations in recent memory, carrying little or no premium compared to their lower-quality peers. In the late 1990s, some of these companies were widely held by growth-oriented investors, yet as these stocks declined in recent years - while their fundamentals improved - they have drawn our attention and represent, in our opinion great long-term opportunity. Statistics from Merrill Lynch confirm that larger, higher quality stocks (based on S&P Common Stock Rankings) have underperformed their lesser-quality peers by over 500 basis points so far this year, following a similar pattern in 2004. We believe this is unlikely to persist.

While in some cases we may have been early to initiate positions, on the whole we're quite enthused by the chance to accumulate these long-term opportunities at attractive prices. Today, the median stock on our Approved List trades at a discount to the market at less than 15x next year's estimated earnings and near 10x cash flow, with quality characteristics - industry position, liquidity, cash flow, profitability - that we believe compare favorably with the rest of the equity universe. If history is any guide, the market may soon reward our current positioning, as many of these stocks have lagged for more than the past five years. In particular, we think the profitability and sustainability of returns for these companies will be most appreciated in a more uncertain economic environment. Just as we admitted last quarter, the equity market's composure in the face of eleven consecutive Fed interest rate increases, two major hurricanes and the impact of skyrocketing energy prices is remarkable. Recent evidence suggests a slowdown in the rate of growth of global economic activity, yet regardless of the near-term economic environment, we believe the fundamental underpinnings of these businesses remain strong, highlighted by proven business models and the opportunity to deploy excess capital to enhance returns. We remain confidently patient.

Of course there are always risks, and as Katrina and Rita have shown, those risks can take many forms. While we've raised the issue of risk management in a purely "investment" sense many times before, a broader discussion of risk is illuminating in the current environment. A wonderful review of the subject is Peter Bernstein's Against The Gods: The Remarkable Story of Risk, published in 1996. Bernstein (a former money manager) tells an engaging story of how the development of the fields of mathematics, statistics and probability through the ages laid the foundation for "risk management", which facilitates today's financial markets as well as broader social structures.

Risk management is basically the use of historical patterns to help us deal with an uncertain future. Before the development of rudimentary statistical and probability tools, events like hurricanes were usually blamed on "fate", and the future was always a big question mark. But the newer tools facilitated the development of essential capitalist structures such as insurance, which itself encouraged economic activity that otherwise might have never developed. Think for a moment: under what circumstances would a merchant commit to oceangoing trade without the availability of loss insurance? Or how a business might consider expansion without some way of forecasting future demand? One can imagine how these tools made possible the development of more sophisticated commerce as well as a variety of human activities.

But as Bernstein admits, probabilities are not certainties. While thousands of historical observations may embolden us to confidently predict a particular outcome, there is enough surprise in our world to remind us that uncertainty is always with us. A perfect example was the collapse of hedge fund LTCM in 1998: Nobel prize winners and some of the smartest financial minds in the world failed to anticipate the unique circumstances that wiped out the firm and billions for its investors. Even when an extreme outcome can be quantified - a hundred-year flood - the abstract nature of the probability rarely creates any real apprehension: the odds are too low to worry about it.

Furthermore, an unquestioned faith in risk management tools sometimes encourages risky behavior one would otherwise not take. While seat belts save lives, there is evidence that drivers have responded by driving faster because they may feel safer wearing belts, in turn causing more accidents. And it's pretty clear that the massive development of the coastal areas along the Gulf Coast in recent decades was encouraged by the construction of levees and the availability of Federal flood insurance programs. This effect is termed moral hazard: the availability of insurance changes the behavior of the insured. So the potential worst-case outcome was magnified by additional human development pressures put on the Gulf's natural wetlands, which otherwise would have helped to minimize the disaster itself. Thus, a "mechanistic" devotion to risk management certainly has its pitfalls; we should all realize that low probability or even unimagined outcomes can occur, whether we are discussing meteorology or the financial markets.

In the end, we think risk management requires both quantitative tools as well as good judgment. In hindsight, the LTCM partners failed to understand the correlation among their supposedly diverse mathematical strategies. The countless lessons to be learned from Katrina and Rita will likely refer to necessary improvements in qualitative factors like planning and coordination, not the need for new mathematical forecasting models for hurricanes.

At Harris Associates, we judge the most important risk our clients face in simple terms: the permanent loss of capital. On the other hand, many of our competitors use a more mechanistic model and define risk as relative performance versus a specific benchmark, or in terms of statistical volatility. These other methods are useful in some ways, and we are always prepared to respond to questions on these topic areas. But we believe these definitions tend to increase the risk of capital loss by focusing too much on relative performance. There is an old cliché that you "cannot eat relative performance", a reminder that the positive accumulation of capital over the long run is most every investor's goal. Our firm has thus been structured to aim for absolute rather than relative returns, emphasizing an appropriate time horizon, proprietary fundamental research and sensible judgment. And we humbly recognize that the road to that goal often includes some frustrating stretches.

Briefly, our emphasis on capital preservation is supported in many forms at our firm: from a philosophy which stresses intrinsic (rather than relative) value, to a reliance on our own team of experienced analysts, to regular Devil's Advocate reviews of our largest holdings, to prudence in our portfolio construction and advice. A further element is that Harris Associates' employees and their families have significant amounts of their own capital (over $175 million as of 12/31/04) invested in our mutual funds - the same strategies that we select for our clients. Our overriding concern in managing risk is to minimize - in a variety of ways - the chance of capital loss. In our fundamental research and analysis, we certainly are forced to make forecasts, and while that exercise could not exist without some probabilistic assumptions, we ultimately rely a lot on our experience and judgment in formulating our analysis. We are aware low-probability outcomes and surprises can occur, so we counsel appropriate diversification. But an emphasis on adverse rare events can paralyze, and so we try to look forward, noting there are strong forces favoring advantaged businesses purchased at attractive prices over the long run.

The markets, as usual, are facing a number of interesting macro challenges today, from rising energy costs to higher interest rates to slowing economic growth. We acknowledge the risks associated with this mix, and we continue to counsel prudence. And we continue to ask ourselves: what can go wrong? But the intense scrutiny these issues have received from the financial media and Street analysts likely means the market already reflects the risks fairly. As we stated earlier, we are intrigued by the equity market's low regard for quality businesses at a time when these companies are in such strong financial shape (while at the same time, a love affair with lower quality, commodity-oriented businesses is in full blossom). So with the downside risks already well understood, our patience and confidence are bolstered by asking ourselves what surprises - the positive ones, too - might benefit our clients.


Edward S. Loeb, CFA
Partner & Portfolio Manager