Let's start with a simple math problem: When does 134 minus 52 equal 13?

When the numbers are percentages!

Percentages behave differently than other forms of numbers. A whopping 134% rise in the NASDAQ in little more than a year can be nearly erased by a decline of just 52% from its peak. Yes, the numbers are correct: for all its effort, the NASDAQ barely squeaked out a 13% total gain over the past 24 months. The comparable figure for the S&P 500 was only 10% (subject to a similar phenomenon, albeit of smaller magnitude), while the vast majority of our accounts -- including our individual and institutional performance composites -- performed much better. The implication should be obvious: large percentage loss years destroy capital more than one would expect. It's an important lesson we all once knew; many investors, however, wish they could have remembered it before the NASDAQ suffered the worst year of any major US market index since 1931.

Last year was not only a time for remembering old grade school lessons but also for reminiscing about political, economic and cultural events of the past. For starters, we elected another Bush, became reacquainted with the concept of an energy crisis and the Yankees won the World Series (while the Cubs did not). But of greatest significance to our clients, the value sector reawakened and achieved vindication. For some, the return of sanity to the markets was a stunning reversal of 1999's tech-dominated party. But to our loyal clients and friends, this reversal was inevitable -- only the timing was a matter of question. It was a good year (here's to a brief toast!), but our primary focus remains the achievement of the long-term goals of our clients. There is more work to be done, and as last year proved, resting on one's laurels is hardly an option.

Just twelve months ago, many investors questioned the "usefulness" of value investing in the New Economy. To them, the future seemed an open book (with only two chapters, titled Growth and Tech). Looking back on 1999 most observers saw the flourishing of a new paradigm, one in which the leading growth and technology companies enjoyed unlimited opportunity, low cost of capital and minimal risk. There was, in fact, much justification for optimism: a robust economy, low interest rates, no Y2K disaster and strong recent investment results.

This was a potent combination, and it created just the right environment for a mania that historians will surely call The Internet Bubble.

In recent letters we have discussed previous asset bubbles such as The Nifty Fifty, the roaring 1920s and Tulip Bulbs, and this one was at least as powerful as any of those. All manias tend to share a few important characteristics:

- The economic environment is strong
- There is easy access to capital for businesses and individuals
- Both amateurs and professionals come to embrace the trend
- Supply increases to meet demand (e.g. IPOs)
- The mania itself becomes an important cultural phenomenon
- The end is abrupt and destructive

In the current example, the media played an important supporting role. Not only did CNBC act as head cheerleader (the channel's objectivity seems to have appeared only recently), but so many of the companies themselves had the ability to shape investors' opinion through their own Internet sites and promotional activities. There was no shortage of rationalizations to support the view that the good times would continue to roll indefinitely. Speculation and margin debt increased dramatically. Investors came to expect long-run investment returns that were impossible to achieve.

The effect on Corporate America was powerful. To the greatest degree in history, the corporation itself became tightly linked to stock market activity. IPO volume soared, and a lot of start-up businesses were funded that never deserved to be. We grew particularly concerned that the proliferation of one-time investment and pension gains, stock options and hidden financing arrangements served to obscure the underlying fundamentals of a large number of businesses. Capital spending and reported earnings rose rapidly under this system, implying better profitability than could be reasonably sustained. The pressure to perpetuate this fiction was immense: too much corporate activity (and too many investment banking fees and stock bonuses) depended on a continuation of the trend. As in all bubbles, these self-reinforcing mechanisms helped to sow the seeds of the mania's ultimate destruction.

Wall Street deserves special mention in all of this. The Street's shortsightedness sacrificed long-term health. Sell-side research analysts in particular acted imprudently: they set unjustifiable price targets, endorsed questionable earnings projections and often failed to ask the critical questions of management teams. Today, "sell" recommendations constitute only 2% of all research reports because, sadly, negative viewpoints lead to less investment banking business. Some Street analysts are certainly better than others, and even we find some helpful sources (particularly as we develop a better understanding of an industry). But frankly, the Street's performance is disturbing given that it shoulders important fiduciary responsibilities. In this episode as in others, most of the supposed "professionals" acted no better and exercised no more discipline than the amateurs.

As a firm, we faced much pressure to change with the times. One of our clients exclaimed in frustration in late 1999: "There is a gold rush going on, and you guys better get some of it!" The cries came from all corners -- clients, the media...even spouses and parents! While always open to new ideas, we nonetheless maintained a strict discipline: even if "everyone else was doing it", we refused to put our clients' capital at risk and buy overvalued securities simply to participate in a game that would ultimately crumble under its own weight. In our eyes, the world had gone mad.

Nobody "rang the bell" to jump off the Tech/NASDAQ bandwagon. While today most will agree that valuations got too high and that the Internet paradigm itself turned out to be more problematic than advertised, The Turn that began last March caught nearly everyone off guard. Markets can -- and will -- do anything they want, and this one's destruction will probably be best compared to the Nifty Fifty's demise in 1973: no trigger or warning, with the highest P/E stocks falling the most. As we have often stated, high P/Es leave little room for error or surprise. Today, with error and surprise all the rage, the stock and bond markets are suddenly a lot more concerned with risk, and this translates into lower valuations for a great number of the previous highfliers -- specifically, the Internet, technology-related and other large growth stocks.

We are spending a great deal of our time these days studying this group of companies -- many have strong business prospects and the valuations look more interesting each day. It is likely we will own more of these stocks in the coming years than we have in a long time. As always, our primary focus is company-specific fundamentals and whether we can purchase strong businesses at significant discounts to intrinsic value. Still, there are at least two related issues we can't help but consider. First, how long will it take to wring out the bubble's excesses? In other words, to what degree was technology investment spending overdone in past years because of the mania, and is it possible to determine how far away are we from supply/demand equilibrium in these markets? A second concern is how most investors will react with their own money in the next few months. Massive amounts of money flowed into technology-related mutual funds over the past several years, and should these funds be subject to large redemptions, there may be intense downward pressure on this group of stocks.

As the last two questions imply, we are mindful of the risks in this sector. We are also well aware of the synchronized slowdown in the U.S. and foreign economies, and so our estimates reflect a greater degree of conservatism than they have in some time. Today, our portfolios are well-positioned to overcome these obstacles -- as they have proven in recent months -- and we can't help but be encouraged as we enter 2001. First, as students of history we remember that investment cycles tend to last years, not months, so the winds should be favorable for some time.

Second, our investment philosophy just passed a crucial test as a major portion of the overall market experienced a veritable meltdown. As you know, we place great emphasis on concepts such as valuation, quality of management and investment fundamentals in order to deliver outstanding long-term returns at an acceptable level of risk. Although the apparent risks in recent years have been small, we are grateful to have remembered the important lessons of the past as the current mania unfolded.