As we begin the year 2002 and reflect on the events of the past twelve months, it would be an understatement to say we feel very fortunate. We are grateful for many things - family, friendships, a strong national defense and a political system that remains the envy of almost every nation on this planet. As we have all come to learn since September 11th, it is easy to take for granted so much in our daily lives; unfortunately, it sometimes takes a national tragedy to appreciate our favored circumstances.

Our clients' favored circumstances also extended to their investments with Harris Associates. In a repeat of the year 2000, our portfolios generated strong investment gains while most other investors suffered a second consecutive year of disappointment. While the S&P 500 dropped 13% (following the prior year's 10% decline), our equity and balanced portfolios enjoyed gains that, admittedly, left us gratified, somewhat amazed, and fully aware that such results will be difficult to duplicate (the Chicago Bulls three-peated twice, but then again, they had Michael Jordan).

The figures for the S&P 500 tell only part of the depressing story. First, the once-fashionable NASDAQ had another horrible year, down 21%, following 2000's 39% drop; one more year like that and Bud Selig will argue that it should be shut down along with two major league ball clubs! Second, nearly all major world markets declined last year - only Mexico managed to end the year higher than where it started (sorry, but South Korea, Russia and a handful of other second-tier markets don't really count). Third, it has been a devastating multi-year period, much like that of the early 1970s: a $100 investment in the S&P 500 two years ago would be worth just $78 today, and a comparable figure for the NASDAQ would be worth just $48. This recalls our observation of twelve months ago: large percentage losses diminish capital more than most can ever imagine.

Against this historical backdrop, it's not difficult to see why we feel fortunate to be on the right side of the graveyard fence. Over the past two years some of the most respected economists, market seers and corporate chieftains have fallen from their lofty perches. Today, Alan Greenspan is viewed more skeptically than ever, and Wall Street strategists and analysts worry more about the unemployment line than their box seats on the 50-yard line. "Can't miss" investment capital has been destroyed, and in many sectors, it truly feels like a funeral. Whistle past the graveyard? Heck, we would gladly sing if it would guarantee us and our clients continued safety from the market's struggles.

If the past five years have taught us anything, it's that the stock market can - and will - do anything it damn pleases. So, we do our best to retain a sense of humility and sobriety about our investment results while at the same time seeking to learn equally from our successes and failures. While our investment philosophy and process remain essentially unchanged over the past quarter century, we recognize that judgment has played a crucial role in producing our investment record. Ironically, our success over the past few years derives more from the securities we have not bought rather than those we have. We have been careful to avoid most of the recent big investment disasters (technology stocks and Enron, to name just a few).

Every day we are privy to the same facts and figures that all investors see; if we are to continue to be successful money managers in an ever-changing environment, we must continue to leverage our collective wisdom and make investment decisions designed to maximize the probability of investment success. Recently, we have avoided the graveyard by relying on several factors to help supplement our investment decision-making:

Substance vs. Form Enron's rise and fall will grace newspaper headlines and business school textbooks for years to come. What is most interesting to us, however, is the extent of the ruse: the company created literally thousands of partnerships and other entities to project an image of strong, limitless profitability in a basic, mundane trading business. These were smart guys, and they used every trick in the accounting book to produce an attractive earnings trend. Even when the wind was at the company's back, we don't think anyone really understood how the company earned its money; yet many supposedly sophisticated investors were mesmerized by appearances and failed to look for any substance behind the numbers. Enron was, in hindsight, a masquerade that obscured reality during boom times but was exposed in a recession. The lesson: stick to simple businesses even your grandmother can understand. Enron never met that test.

Risk vs. Hope One year ago, NASDAQ had fallen 52% from its lofty peak. We heard many analysts say that it was now time to go bargain hunting in the wrecked tech sector; in fact, we spent a great deal of time analyzing dozens of these companies in search of new ideas. We did find a few gems, but truthfully, our search turned up very few legitimate investments in the sector. In general, we found many interesting business models that produced little profitability, and yet the stock prices - even at depressed levels - reflected a degree of hope that bordered on the miraculous. We passed on the vast majority of these companies because of valuation concerns, and we were thus able to avoid the next leg down these stocks suffered in 2001. Even at today's prices, we find very little to commend these former highfliers: valuations remain lofty under even the most optimistic of recovery scenarios. Hope, after all, springs eternal...

Skepticism of the Crowd The "crowd" has been wrong so many times in the past few years that it's a miracle the crowd still exists. By definition, the crowd has embraced most of the failed investment themes throughout history, and it continues to amaze us that certain concepts continue to attract widespread devotion:

Indexing: When will investors tire of feeling good about losing money? Instead of reducing risk, indexing has given investors a false and dangerous sense of security;

Portfolio and Sector Diversification: Why does holding a portfolio of 200 stocks (that one knows little about and each weighted to closely track the industry weights of some synthetic benchmark index) give an investor more comfort than holding fewer than 50 stocks that are attractive bargains?

Economic Forecasting: Just because there are economists does not mean that forecasting should be done. In the first place, the correlation between the economy and the stock market is weak. Second, almost no economist saw the current recession coming. Should we now feel comfortable that just about every economist sees it going?

Today's investment challenge is as great as ever. The economic environment remains weak yet the stock market seems to be predicting a robust recovery soon. As usual, we remain skeptical of the conventional economic wisdom. We continue to focus on individual companies we can understand and analyze so that we can properly determine the relevant opportunities and risks. Again, we are grateful for many things at this time of year, but we recognize that what we did yesterday does not guarantee what we can accomplish tomorrow. And just in case the old superstition is true, we'll keep on whistling.

E.S.L.