First Quarter, 2000

During the past calendar quarter, we devised an approach to broaden your portfolio’s exposure to the various areas of technology that are having such a profound effect on our lives now and for the foreseeable future.

Technology is understandably the fastest growing area of the economy, and the one most likely to continue as such. The main drawbacks to technology stocks have been their lofty valuation and their extreme volatility. In order to participate in this area but reduce the downside risk, we have taken a diversified approach to technology investing. Part of our approach has been to acquire a small number of different technology-oriented funds, many of which own one hundred or more underlying companies in their portfolios. This strategy gives your portfolio exposure to an exceptionally broad cross-section of companies ranging from venture capital start-up situations to the largest, most firmly established "core technology" companies in the world.

This broad-brush approach has been augmented by the selection of a small number of individual technology stocks in your portfolio many of which you have owned for some time. These individual stock purchases are made when we believe a stock’s valuation has become attractive, based upon a combination of current price and future growth prospects. The process is never complete; as the dynamics of the stock markets change, so too does your portfolio.

Let us be very clear regarding one consequence of increased exposure to these technology holdings: the volatility of your portfolio will be greater now than it has been in the past. This point is easily observed from the severe drubbing taken by the tech-heavy NASDAQ market during the past four weeks. Many high-growth companies have now experienced 30-50% price declines in spite of no perceived change in their business fundamentals. The stocks of other technology companies with unproven products or business plans have declined even more.

As you may recall from our previous quarterly reports, we have long been concerned about the danger to the stock market of rising interest rates. During the past 12 months, we gradually reduced your exposure to the stock market. For more than fifteen months, however, investors have chosen to ignore the mathematical relationship which postulates that rising interest rates eventually cause stock prices to decline. Now that lesson appears to be sinking into the collective mind of the investment community.

How much of a correction is possible? Let us illustrate, again using Cisco’s common stock as a representative core technology holding. In our last quarterly letter, we noted that Cisco’s P/E averaged around 40 times earnings during 1994-98, a period when the company’s earnings growth rate was considerably higher than it is today. Were Cisco to return to a 40 P/E multiple on this year’s projected earnings, the stock price could decline to $20 a share from its March 27 peak of $82. A price decline of this magnitude is possible for a number of reasons including:

1. Cisco’s annualized earnings growth rate today is approximately half of what it was 3-4 years ago.
2. Rising interest rates have reversed the P/E multiple expansion of the past decade.
3. Cisco faces substantially greater competition from many other giant corporations, relative to the early 1990s.
4. Cisco’s profitability, as measured by its cash return on invested capital, is approximately ½ of what it was in 1994 and earlier.

Cisco is, of course, the cream of the crop; the consummate core technology company. If, as we believe, there is sound logic behind a possible price decline to $20 from $82 for this stock, one can imagine the potential market declines facing other technology stocks that today are hoping for earnings at some ill-defined future point in time.

For most of this year’s first quarter, it was the same story as all of last year. Most of the largest growth stocks continued to become more overpriced. Value stocks, now nicknamed "old economy" stocks, continued to languish or decline in price. This pattern, however, appears to have begun reversing course in mid-March. With another sharp drop in April, the recent pullback in technology stocks, although painful, should be healthy for attracting new investor capital to the area. This pullback also provided the opportunity for us to add a number of additional good tech stocks at more reasonable prices.

Corporate bond interest rates exhibited a dual personality with shorter-term bonds (i.e., those maturing in up to 5-7 years) experiencing a modest increase in interest rates with commensurate price declines, while longer-term bonds saw their prices rise modestly as their interest rates declined somewhat.

We are reluctant to increase the percentage of your assets in stocks because evidence of increasing inflation is now mounting. Increasing inflation (should the new economic data so confirm) eventually leads to higher interest rates, which in turn are bad for stocks as well as bonds.