BakerEllisLLC_Commentary

INVESTOR UPDATE
JANUARY 2003

By now the pain of 2002 has been well-documented for investors, so we will keep the obituary short. Despite a rebound of about 8% in the fourth quarter, the S&P 500 dropped 23.4% for the year, its third losing year in a row – a feat not accomplished in the last 60 years. The damage was widespread, with the Russell 2000 index of small stocks falling 21.6%, the Dow Jones Industrials losing 16.8% and the Nasdaq collapsing another 31.5%. Abroad, the Dow Jones World Index (excluding the U.S.) lost 15.6%, with Germany’s Dax, the biggest disaster, closing the year down 43.9% in local currency. The easiest way to put the numbers in perspective is to look at the total value of the Wilshire 5000 index, which includes virtually all publicly traded stocks in the United States. In March 2000 the total value of the stock market was $17 trillion. At the end of 2002 it was approximately $10 trillion.

Fortunately, Baker Ellis was able to protect our clients from a substantial portion of these declines. Although our performance record of three quarters is too short to be statistically significant, we are off to a good start. From our performance inception date of April 1, 2002 through the end of the year, the S&P 500 fell 23.3%. Our composite of discretionary accounts, on a size-weighted basis, fell 4.05%.* This figure includes a range of equity-oriented and balanced account types that we have developed for different risk tolerances, so the performance of your own account may vary significantly. Despite these limitations, we think the figure is a useful measure of how our young firm is performing. If you would like more detailed performance information, please let us know.

We believe one reason for our relative success so far is that we give ourselves latitude to roam among various asset classes in search of compelling value. Unlike most mutual funds or large institutional managers, we are not restricted to a particular “style-box” niche or a requirement that we remain fully invested. This tactical-asset-allocation/flex-value approach allows us to diversify your account broadly, even indexing exposure to broad asset classes when warranted, while taking more significant stakes in individual opportunities that we find most promising. As a small firm, we also have the advantage of being able to purchase a wide range of small- and micro-cap companies that many large institutional managers find difficult, if not impossible, to trade due to liquidity constraints.

In the fourth quarter, one of our best-performing stocks was one such small-cap company, Impath (IMPH). Introduced in our third-quarter report, this cancer diagnostics and research company had stumbled on its fast growth track and was experiencing difficulty collecting its revenues in a timely fashion from insurance companies and the government. The former high-flying stock was trading for only 10 times expected earnings and the company’s market cap had fallen to about $200 million when we began accumulating shares. Since then, the stock has recovered from 12 to 20. Positive developments at the company include an increase in third-quarter revenues, the announcement of an agreement to provide laboratory and testing services for Bristol-Myers Squibb in the development of ERBITUX, and a joint venture to provide laboratory services for patients in South Korea. In another encouraging sign, competitors AmeriPath and Dianon Systems received buyout offers, suggesting the possibility of further industry consolidation.

During the quarter, we also bought shares of another small-cap company, Deb Shops (DEBS). We are not exactly fashion-conscious at Baker Ellis (Brian has not bought himself a new piece of clothing in years, preferring to rely on gifts and hand-me-downs) and tend to be wary of getting caught on the wrong investing end of a fashion trend. DEBS, however, has a good niche, offering low-priced clothing, accessories and shoes to teens and plus-sized women through about 300 stores. We visited one in Portland’s Lloyd Center, and found happy customers and a manager with a quick grasp of her sales targets (which she was exceeding). What we really like about DEBS, though, is its balance sheet. The company has no debt and a horde of more than $10 per share in cash. With a stock price of $22 and expected earnings this year of $1.83 a share, the stock is trading at less than seven times enterprise value – a bargain compared to its peers. To us, that more than offsets the fact that growth at DEBS has been slow recently, with sales comparisons ticking down 0.3% in November.

While we continue to find selective opportunities, we enter 2003 cautious about equity valuations – especially the large companies in the S&P 500 – and the pace of the economic recovery. The bursting of the stock-market bubble has saddled many large corporations with huge unfunded pension liabilities that will act as a drag on profit growth, barring a strong market recovery. State governments that ramped up spending based on capital-gains tax windfalls now are slashing spending. Policy-makers have little room left for further interest-rate cuts. The consumer is highly leveraged, in part thanks to $1.5 trillion in mortgage refinancing in 2002, vastly exceeding the previous peak of $750 billion in 1998. Throw in the falling dollar, rising crude oil prices and continued geopolitical risks, and we have little trouble envisioning a period of sluggish economic growth.

Despite these concerns, the economy overall has proved remarkably resilient in the wake of three staggering blows: the collapse of the telecom and IT industry; the vaporization of stock-market wealth equal to an unprecedented 90% of GDP; and the fallout from the Sept. 11, 2001 terrorist attacks. Even with these shocks, the economy actually grew about 3% last year. One important element in this growth was continued strong productivity gains, which translate into higher wages for workers. While a stimulative monetary policy grabbed the spotlight, another important factor was a rapid turnaround in fiscal policy, with massive federal spending on defense and related programs reminiscent of the early years of the Reagan Administration.

We don’t pay too much attention to historical market patterns, which have a way of not repeating once identified. That said, a fourth consecutive losing year in the market would be highly unusual, having occurred only once in this century (1929-1932). Moreover, the third years of presidential terms have overwhelmingly tended to be positive, presumably because presidents generally avoid the kind of legislation that can rattle markets (e.g., the Clinton attempt to nationalize health care) as they prepare to run for re-election. Instead, politicians tend to favor popular legislation, such as President Bush’s new plan to eliminate the taxation of dividends. If enacted, such a proposal could be terrific for our portfolios by stimulating demand for the kind of dividend-paying stocks that we favor. Regardless, with bond yields in the cellar and equity valuations back in a more reasonable range, we remain of the view that carefully selected stocks will be the best place to be for the coming year.

Thank you for joining us for our inaugural year at Baker Ellis. We are pleased to report that we are growing, and enter 2003 with more than 100 valued clients and approximately $50 million under management. In December we welcomed Mohammad Rahman as marketing director. Mohammad has nearly two decades of professional investing experience and also is founder of the One Ummah Foundation. This non-profit foundation is dedicated to ameliorating the plight of child labor by building and supporting schools in underdeveloped countries. On a final administrative note, we continue to experiment with the format of our performance reports; please give us any feedback on the latest version.

Best wishes to you and your family for the New Year.

Sincerely,

Brian C. Baker, CFA
Barnes C. Ellis, RIA

*Composite represents discretionary accounts over $100,000 held at Fidelity Investments. Performance is size-weighted. Performance varies based on risk tolerance, timing of investment and other factors. Performance is presented net of fees. Investors cannot own an index, which is always fully invested and does not include management fees or other expenses. Data is believed to be accurate but is not audited or guaranteed. Past performance is no guarantee of future results.