Despite devotion to patience and a long-term time horizon in our investment work, even we cannot ignore the strong performance of our clients’ portfolios – as well the stock market’s – in the second half of 2006. For the second straight quarter, absolute equity returns were highly satisfactory to us, and we view the recent trend as encouraging. Most importantly, we believe the market is more properly rewarding those businesses that have impressed us the most – those with sturdy positions in their industries as well as strong cash flows and balance sheets. In our view, recent share price performance has not only begun to address some of the undervaluation among quality businesses we’ve highlighted recently, it has also provided some encouraging price signals (i.e. merger and takeover activity) that reinforce our own investment philosophy and process.

While investor sentiment toward the U.S. equity market seems to have improved in recent months, it is far from ebullient. In fact, the spotlight continues to shine more brightly on many of the riskiest investments, including low-rated bonds, illiquid/over-leveraged private investments, and certain exotic financial instruments. For many recent entrants, we remain skeptical whether the rush to some of these alternatives will end well. At a minimum, the enthusiasm for these investments after a period of record profits and strong investment returns should provide some unease given apparent small margins for error. While the demise of hedge fund Amaranth Advisors in late summer has so far turned into a non-crisis, we are instinctively wary of the seeming complacency of those who chase junk credits (which offer some of the tightest credit spreads in memory), or private equity/LBO investors (whose required rates of return may only be achieved through substantial leverage and a compliant IPO market/swift sale of the company). As we have discussed, burgeoning cash flows, low interest rates and generous credit markets have set the table for hungry investors, and while the meal has been ample and tasty so far, there is likely to be a price to pay from the indigestion that is bound to follow.

In fact, even with improved recent performance, our conviction that the U.S. equity market offers a better risk/reward profile than most other asset classes remains firm. First, fundamental conditions continue to impress us: earnings for the S&P 500 have now grown at a double-digit pace for 18 consecutive quarters, a period that coincides with the strongest aggregate performance of the world economy since WWII. To be clear, we expect the pace of growth to continue to weaken, as it has in recent months, but current equity valuations seem to incorporate a cyclical weakening. The average stock in the S&P 500 now trades at about 15x projected earnings, historically a middle-of-the-road level (particularly given low interest rates and a minimal tax burden on investment capital). Our portfolios also trade at a favorable valuation level, and our confidence is further bolstered by owning businesses we believe possess greater strength, quality and endurance than their competitors.

A second favorable factor reflects the public’s recent love affair with anything except the U.S. equity market, which has created the very skepticism or “wall of worry” which is allowing share prices to creep higher today. While plenty of folks spent the 1980s and 1990s adding to their equity portfolios as the stock market soared, the post-bubble period reflects a different environment: in an attempt to avoid a replay of the meltdown that ensnared so many in 2000, investors have looked to other asset classes for both safety and the recovery of paper profits. Recent figures from the Federal Reserve show a significant shift of household assets away from equities: between 1999 and 2006, ownership of corporate equities plunged by about one-third (from 31% to 22% of Total Household Assets). Even when adjusted for falling equity prices (as the stock market declined), the data show net outflows from equities, as well as fewer people owning stocks as an asset class. Not surprisingly, investment in real estate showed the greatest gain over this period.

The psychology of this shift is not complicated. As we have touched upon previously, investors base too many of their decisions on what they read in the headlines or “what worked”, rather than on fundamental analysis, valuation and a long-term investment horizon. But “rear-view-mirror investing” not only sounds illogical, it can be unprofitable, too. At the end of 1999, an investor with a 5-year “mirror” was mesmerized by the S&P 500’s five-year trailing annualized return of 28.6%. Of course, just months later the index began a three year, 50% decline – a near-fatal wound to any latecomers who had invested substantial sums in the late 1990s.

Because of the post-bubble hangover in recent years, it’s been easy for investors to ignore the U.S. equity market. Just 12 months ago, an investor utilizing that same rear view mirror yawned at a nearly flat S&P 500: the trailing 5-year annualized return was a miniscule 0.5%. But following a double-digit return in 2006 – as well as discarding 2001 from the calculation – today’s 5-year trailing number stands near a more respectable (yet unexciting) 6.3%. But even if the market is flat for the next six months, the calculation by mid-2007 will show an annualized return above 10%, close to the long-term average of the stock market over the past century. We can just imagine the headlines to come: “Stocks: THE Place To Be”. And then as the numbers rise even higher, it’s probably safe to assume that money will finally come pouring back into the U.S. equity market. The story would be a lot funnier if it weren’t so true….

As we have counseled our clients, discipline (i.e. a willingness to follow a process rather than the breeze) and a long-term investment horizon are key ingredients to investment success. While the supporting evidence is nearly bulletproof – how many more studies are necessary to show that trend-following mutual fund investors are destined to earn subpar returns? – the psychological temptation to eschew the long-term for the quick buck is powerful. A patient demeanor is particularly suited to a value-oriented style, where investments are more often than not made in out-of-favor businesses or stocks. But even across other investment styles, a too-short time frame can raise the probability of mental errors. Nassim Nicholas Taleb (Fooled by Randomness, which we cited in last quarter’s commentary) offers an illustration of this dynamic. Taleb imagines a mythical “superstar” portfolio manager who earns high returns over the long run, such that the odds of beating the market in any given one-year period are quite high (in his example, a 93% probability). But as the time frame shortens (to one hour or even one minute intervals), the mathematical likelihood of outperformance shrinks – statistically – to just barely more than 50% in any given period. This means that the clients of this manager experience pleasure and pain in nearly equal amounts. But as most of us can attest, investors tend to experience more pain from losses than pleasure from gains. As Taleb implies, this creates greater agony for the investor despite a winning partnership with a great long-term investor. And so the client – with his short-term, rear-view focus – inevitably fires the manager and mistakenly misses out on the long-term outperformance he so desperately wanted in the first place.

Because of the way investors process historical information, and given the disregard for U.S. corporate equities in recent years, we believe our patient, disciplined approach is well-suited to achieve our clients’ long-term goals. Admittedly, the stock market has performed very well in recent months, and it would be uncharacteristic for us to not feel a bit cautious in the near-term: volatility has remained eerily low, valuations are higher, and we have found fewer new ideas than we would like; there are plenty of macroeconomic risks, too, most importantly the slowdown in economic growth. We also admit to a conflicted view of the substantial rise in merger and acquisition activity (which set global records in 2006). On the one hand, the prices paid for target companies helps to reaffirm the benchmark metrics we utilize in the valuation work we perform for every stock in our portfolios. On the other hand, the rise in this activity is powered by low interest rates, tight credit spreads and rising global liquidity, factors which are likely to reverse at some unknowable point.

In such a set of circumstances, we are particularly comforted by the financial and operating strength of the businesses we own in our portfolios, as well as the still-wide discount to intrinsic value these businesses now carry. We are also grateful to continue to read headlines that seem to confirm investors’ hesitance: “Investors Greet New Year With Ambivalence” (NY Times, 1/2/07). This mix of factors, we believe, sets the stage for favorable long-term returns. While we may occasionally glance in that rear-view mirror (if only to check our own progress from time to time), our eyes – as always – are firmly focused on the long-term fundamentals, values and risks we perceive for the investments under our management.

Edward S. Loeb