The first three months of 2006 provided more evidence that illogical investment trends often persist longer than most investors expect. While our portfolios generated positive returns for the period, the lackluster stock price performance of larger, higher quality businesses provided an additional dose of frustration to those of us waiting for the return of sensibility to the financial markets. As we have argued for some time now, the attractiveness of these bigger and better positioned businesses stands out, particularly in an uncertain world marked by armed conflict in the Middle East, high energy prices and rising interest rates, plus the first new Fed Chairman in 18 years.

Anecdotally, good old-fashioned domestic equity investing can seemingly muster no more respect than a worn Rodney Dangerfield joke: the Chicago Tribune and New York Times have recently discontinued major portions of their daily stock tables, and brokerage firms are again slashing their research analyst ranks after drastic cuts earlier this decade. While economics (wobbly readership and sharply lower commission rates) are the major factors behind both trends cited, the message is pretty clear: there is waning interest in traditional asset classes. And so it's not surprising when we read that 75% of Harvard Business School students yearn to work for venture capital or private equity firms, rather than a traditional investment bank or brokerage house.

Admittedly, the implications of these trends may not be all bad. For one thing, business school career choices have tended to be a reasonably reliable contrary indicator: interest in investment banking as a profession peaked in 1987 (right before the Crash), and peaking interest in real estate (late 1970s) and the Internet (late 1990s) proved eerily prescient, too. And we will not be rudderless with the decline in sell-side research, which has never played a major role in our work anyway; we believe the proprietary analytical effort of our experienced team is the core of our firm's strength.

Despite a variety of frustrations - including the public's growing boredom with traditional asset classes and large high quality businesses - we remain confident in and committed to our long-standing investment philosophy and process. The continued confidence is derived mainly from our belief that we've correctly assessed the fundamental performance of the businesses in our portfolios. In our view, profits have grown, balance sheets have been cleansed and management teams seem to be exercising more diligence in allocating capital. The data suggests most of our intrinsic value estimates have risen in recent years. Today, a current roster of the approximately 150 stocks on our Approved List would demonstrate, over the past three years, annualized Revenue and Operating Income growth of 11.0% and 14.8%, respectively. Return on Equity has averaged better than 18.0%. To be perfectly clear, these are strong, healthy figures for most any stage of an economic cycle. Yet share prices for the current list, on average, have barely budged since the end of 2003. With current valuations averaging 9.5x our definition of cash flow - a discount to the market - we are more than a little perplexed and annoyed.

But as stated, we remain unbowed. We know from experience that in the short run, share prices rarely track fundamentals with any precision. In fact, the long-term performance record of Harris Associates has been built by taking advantage of opportunities similar to the current environment when the gap between share prices and fundamental intrinsic values is wide. Unlike some successful investment managers who seem to have built their cumulative records through slight outperformance each and every year, our pattern of success has been much more eclectic (that's a nice way of saying we are well versed in "being out of favor"). Our longest-running equity composite, Mid Cap Value, spans 30 years and displays long-term outperformance versus the S&P 500 (after fees) of over 350 basis points annually, a sizeable margin over such a lengthy period¹. Yet this record was built by beating the market in just 60% of those annual periods. In fact, in those three decades there was an eleven year stretch when the S&P 500 won nine times, including six years in a row! A survey of all our firm's major domestic equity products over the past decade would yield a similar pattern: when measured on a quarterly basis, our long-term record (again, ahead of the S&P 500 by a wide margin) was built by winning in just 50-60% of the measured periods, peppered with several long episodes of lagging (yet positive) results. So while we're quite proud of the long-term performance of our firm, it has often been unpleasant for long stretches at a time.

Actually, such return patterns are more often the norm rather than the exception in our industry. A study of asset managers covering the decade of the 1990s by a well respected institutional consulting firm showed that nearly all the managers (46 of 47) with the best 10-year performance - top quartile - spent at least one three-year stretch in the bottom quartile. And nearly 40% of those great managers suffered a three-year period losing to fully 90% of their peers. This data, plus our own extended experience, reinforces the essentials we believe are required to flourish in the investment world over the long run: a well-defined philosophy, a disciplined process, a willingness to concentrate in the most attractive areas despite what others are doing, and finally the conviction to stick with it despite the market's shifting winds.

Thus, we have remained focused on individual company fundamentals. As noted, we've been quite satisfied with the growth and profitability of the set of businesses under our watch. We increasingly concentrate on businesses with strong industry positions, solid balance sheets, and excess cash that is being returned to shareholders. And with our estimates for intrinsic values continuing to rise in concert with fundamentals - while stock prices lag - we believe the opportunity for our clients grows greater. Today, the average stock on our Approved List trades at less than two-thirds of our assessment of the business' intrinsic worth, a gap that is wider and more attractive than we've seen in the past few years.

Unfortunately, it's difficult for anyone to forecast when these businesses will attract the attention they deserve. For the past few years, investors have been attracted to other asset classes and opportunities. Within the U.S. equity market - which is basically flat over the past seven years - cyclicals and small cap stocks have performed the best recently; yet we find few opportunities in these areas that dominate the names in our current portfolios. The real estate market has clearly drawn great sums of capital in recent years, but from our perspective, current required rates of return do not compensate investors adequately for the inherent risks (several recent acquisitions of REITs imply returns well below 10% for institutional investors, a slim margin given the traditional cyclicality and illiquidity of the asset class). And prospective returns in certain parts of the bond market strike us as bordering on the absurd: a good example is Russian Federation debt, where 12-year bonds offer a yield to maturity of 5.8%, less than 100 basis points above the yield on U.S. Treasuries (by the way, inflation in Russia was over 10% in 2005). Frankly, if Russian debt garners enough interest to trade at parity to the average A-rated U.S. corporation, then one might also be interested in the Republic of Iraq bonds due 2028, which offer a 9.3% yield to maturity...if the principal is repaid.

The buyers of these instruments, by implication, forecast a continuation of smooth economic times as far as the eye can see. In recent years, this has actually been the correct bet: despite a swirl of geopolitical, fiscal and meteorological challenges, the marginal gain from owning riskier, lower quality assets has proven to be a worthwhile choice. We are not predicting a negative turn of events, but we can't justify shouldering these risks without fair compensation. In fact, it is increasingly clear to us that the tables have turned across most investment markets: quality appears cheap while risk looks expensive. This is, indeed, a rare but welcome opportunity for our clients who share our philosophy, conviction, and patience. Larger cap U.S. equities may be relatively out of favor today, but they offer ownership interests in real, growing businesses; we believe our portfolios in particular own some wonderfully strong and profitable enterprises at discounted prices. We believe the market will one day recognize these features, as it always has. The challenge investors face today is to tune out the noise that might sidetrack them from this opportunity.


Edward S. Loeb




¹For perspective, $1000 invested in this 30-year series of returns would grow to over $92,000, versus less than $37,000 for the S&P 500.