The first quarter of 2009 was another tough period in financial markets, although it truly hewed to seasonal metaphors by coming in like a lion and out like a lamb.

We lost less than half the decline in the small cap indices, making up for most of our underperformance in 2008. Frankly, this is of minor solace when the trend was still downward.

What is making life so difficult and volatile in the financial markets is the seismic intersection of political and economic dynamics in today's world. The economy is in lousy shape and is likely to look worse in the short run, as we are still in the middle of running through a vicious inventory cycle that is overlaying a core softness. Believe it or not, that's the good news. Inventory corrections tend to play out over a few quarters, thus potentially setting up a “stronger” second half of 2009, admittedly a low hurdle. But since we adhere to the statement that “good things happen to cheap stocks,” we don't need much good news for a resumption of market stability or dare we suggest, even a sustainable advance.

The overhang on this perfectly rational set of events is the size and breadth of our government's interest in the economy. Frank Kent, a political columnist for The Baltimore Sun , once observed “One project follows another so rapidly that they baffle the hardiest mind…The whole business has become fantastic. The activities are on so many fronts, the experiment so numerous, varied and vast that confusion reigns and many on the inside are as perplexed as those looking on.” That was printed in a 1934 edition of The Sun .

This has complicated affairs in the short run. There is NO doubt in our minds that buying real businesses with durable economic models at reasonable to absurd discounts to intrinsic value (or asset values) has not changed as a rational and profitable course of action for investors with a long time horizon. Many of the issues facing the global economy are cyclical in nature and inexpensive valuations created by cyclical challenges have created eminently buyable opportunities. In the short run, it is easy to be swayed off a course that has proven durably profitable by headlines and grand statements. Prudent investing is quiet, focused and requires reflection and consistency, traits which are diametrically the opposite of what passes for discourse in the political arena.

Our challenge today is to balance the intermediate term political risks with a universe of compelling values and not be scared off prudent decisions as it is likely the market is overpricing risk today as surely as it under-priced risk 18 months ago. We have sold Conseco and Cox Radio, and added a position in Autoliv. We believe Autoliv has both the balance sheet and secular product set in auto safety products to ensure not only survival but also respectable prosperity in the inevitable recovery of auto unit sales globally. We have not abandoned poor performing stocks whose business prospects and valuations have not changed anywhere remotely like the price of their stock and added to our positions in White Mountain Insurance Group, Liberty Media Interactive, and Actuant. Though it may seem contrary to the tendencies of human behavior, what will help performance is what has hurt in the recent past.

As for positive signs of life, we would note that asset class returns are beginning to diverge and on a modest scale, equity sectors are showing distinctive returns. In other words, some investors are differentiating between stocks, countries and asset classes versus being dominated by central cortex fear factors. While many are fond of tossing around historical precedents, we would note that small cap stocks were the best performing asset class for nearly a decade after the 1973-74 bear market, returning 35% annually while headline indexes remained nearly flat.

Regardless of political issues, it is likely that current spending levels on top of the previously noted inventory cycle correction will prove to be sufficient to restore the economy to at least a standstill in the second quarter. The recent market rally suggests that many stocks are discounting Woody Allen's cheery reflection of life: “More than any other time in history, mankind faces a crossroads. One path leads to despair and utter hopelessness. The other, to total extinction. Let us pray we have the wisdom to choose correctly.” Now those are words to rally around.

We invite your comments and would welcome the opportunity to discuss our view with you.

 

The S&P 500 Index consists of 500 stocks chosen for market size, liquidity, and industry group representation.  It is a market-value weighted index (stock price times the number of shares outstanding), with each stock's weight in the index proportionate to its market value. Russell 2000 measures the performance of the 2,000 smallest companies in the Russell 3000 Index, which represents approximately 8% of the total market capitalization of the Russell 3000 Index.   The MSCI EAFE® Index is an unmanaged index consisting of a market-value-weighted average of the performance of international securities listed on exchanges in Europe, Australasia and the Far East .  It is not possible to invest directly in an index.

Note: Past performance is not a guarantee or indicator of future results.  The information provided herein represents the opinion of the manager at a specific point in time and is not intended to be a forecast of future events, a guarantee of future results nor investment advice. Further, there is no assurance that certain securities will remain in or out of the portfolio. Please consult an investment professional for advice concerning your particular circumstances. There are risks involved with investing, including possible loss of principal. In addition to the normal risks associated with investing, investments in smaller companies exhibit higher volatility.

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