This market reminds us of the story of Sir Earnest Shackleton, the early 20th century British explorer who faced immeasurable hardships on a failed Antarctic expedition. Briefly, Shackleton, 28 crewmen and 68 dogs set out to cross the 2000 mile Antarctic continent in 1914. But they soon faced a series of major challenges: their ship, Endurance became trapped in the icepack until it was squashed and sank 11 months later. With food running low and the elements working against them, the crew made a daring series of escapes from the ice in lifeboats, including an 800 mile journey in a 22-foot boat across one of the roughest seas in the world, eventually reaching South Georgia Island. From here, the exhausted Shackleton scaled rugged mountains and glaciers to reach safety and arrange for the rescue of his entire crew, 24 months after setting sail. It is surely one of the great adventure stories of all time, as Shackleton faced new challenges at every turn. But it could also be called merely a successful failure: Shackleton never achieved his Antarctic crossing, and while his irrepressible optimism led the crew to ultimate safety, his initial expectations were set way too high.

We don't think today's market faces the same life-or-death challenges confronted by Shackleton, but they are daunting nonetheless. First, hostilities in the Mideast seem to grow more troublesome each day: the Israeli/Palestinian conflict is a human and political disaster (will American troops be called upon to stop the bloodshed?). Nearby, Afghanistan is likely to hold our attention for several years. Meanwhile, the global trade system faces a new series of tit-for-tat barriers following President Bush's cave-in to the U.S. steel industry. Closer to home, the news is dominated by the Enron and Arthur Andersen scandals; yes, there are likely to be some salutary long-term effects for companies and markets as game-playing and obfuscation diminish, but the blow to investor confidence is meaningful. In the credit markets, interest rates are rising and the commercial paper market -- a key source of short-term liquidity for many corporations -- has seized up. And then Lou Rukeyser gets the boot. We realize Lou didn't captivate audiences in quite the same way as, say, an MTV video, but then again, we think he did a pretty fair job keeping his viewers sober and solvent during the most recent mania.

Like Shackleton, investors remain remarkably optimistic as the challenges grow. Despite two consecutive down years, the S&P 500 still trades at 23x estimated 2002 earnings. This is awesome resilience when one considers the backdrop of this period: in addition to the issues cited earlier, add a constitutional election crisis and the collapse of the largest financial mania in history. Granted, the U.S. economy appears to have shrugged off a very mild recession, but corporate profits have collapsed, growth is questionable and valuations are near all-time highs once again (where have we heard this story before?). In this context, we would argue there is a great deal of optimism embedded in the S&P 500's valuation. As we have stated before, the problem with sky-high valuations is the math: few companies can grow fast enough to justify such lofty figures, and so there is little room for error or disappointment. In effect, today's high valuations argue for very high real rates of return from equities, yet this follows a painful period when investors were supposed to become more sober about such issues. Like Shackleton, we think the market will reach safety...but lofty expectations are unlikely to be met, and survival may in fact be the more important issue.

Our portfolios at Harris Associates are off to a good start in 2002, up modestly while the S&P 500 is flat and the NASDAQ is down. These results follow the trend which began two years ago when the broad market averages began sliding from their peaks. While gratifying, these results bring both a curse and a blessing. The curse is the need to find new ideas to replace the stocks we have owned that have risen in price. While the fundamentals are much improved for many of the stocks we own, we (by definition) become a seller once the security reaches our estimate of intrinsic business value. Our sell targets do rise if fundamentals improve, but at some point the stock price approaches our revised targets. It is often frustrating to leave the familiar and the successful, but it is a core foundation of our philosophy and the best way we know to preserve and build capital.

The blessing, however, is that we have the flexibility to look for attractive opportunities wherever they might be, regardless of industry and in spite of market/industry weightings. This style occasionally unnerves some of the investment consultants we deal with, but truthfully, we don't see the benefit of being "slightly underweight" a sector in which we cannot find any attractive investment opportunities. Moreover, we can look for new ideas in areas that might have once been the domain of our growth-oriented peers (but are now attractively priced). We call ourselves "stock pickers" because every investment decision is based on individual company fundamentals, not some broad theme or what everyone else seems to be buying: we want to own good businesses at very cheap prices, but if available, we will pay a bit more for the chance to own a great business. In any case, our discipline guides us to buy when the stock trades at less than 60% of our estimate of the company's intrinsic worth.

In the past several years, in fact, many of our new ideas have been "better" businesses, and we have been willing to pay a slightly higher price to own them. As we survey the corporate landscape, it is clear that stronger businesses are increasingly advantaged from a competitive standpoint. Global competition is as fierce as ever, pricing power is weak and consumers and industrial buyers have more information to drive the best bargain. To us, the best businesses possess some combination of: a faster rate of growth, higher profit margins, more efficient uses of capital, a unique brand franchise or superior operating management. And these businesses have, in general, survived the current recession substantially better than their peers; in fact, many have used the downturn as an opportunity to widen their industry leads. In effect, the strong keep getting stronger.

Thankfully, the market is providing us with good opportunities to own some of these businesses. Over the past several years, these stocks -- with higher growth rates and higher P/E ratios -- have substantially underperformed the rest of the stock market (while our dirt-cheap, low P/E stocks flourished). But now, we can take advantage of buying opportunities in these better businesses because they represent the most attractive values. A look at just a few industries over the past five years clearly shows how our portfolios are starting to reflect this phenomenon. First, our exposure to the Telecommunications and Technology sectors (combined) has risen from less than 3% of our portfolios to more than 15%, as many good businesses have become available at bargain prices. Similarly, our exposure to Healthcare has doubled over the period. Conversely, we have reduced our holdings in the Materials, Financial and Consumer sectors, where growth rates are lower and stock prices may already reflect current business values. It is important to reiterate that we do not let sector analysis drive our investment decision-making process -- we simply want to explain how our stock picking has, in our opinion, "upgraded" the quality of our portfolios during a tumultuous period. Our philosophy and style have not changed, but we have, as usual, been willing to seek out value in different areas in order to improve our chances for success.

In a high-priced stock market, we believe this is the best strategy to extend our strong performance record. It is not easy to find numerous buying opportunities today -- stocks have rebounded sharply from their September lows and may already reflect much of the profit improvement investors expect. In fact, investor expectations may still be too high, and this is worrisome. Our response to this environment reflects a disciplined commitment to our core investment philosophy with a willingness to look in out-of-favor sectors to find tomorrow's winners. Like Shackleton, we are confident in our abilities. We expect to ultimately overcome some significant challenges, but we recognize that from these market levels, the task of meeting high investor expectations grows ever more difficult.

E.S.L.