A review of stock market history will confirm something that value investors have known for a long time, that the greatest opportunities to purchase stocks below their intrinsic value is in times of great uncertainty. The purpose of this letter is to share with you our evaluation of the current market and the many factors that are guiding us as we manage your portfolio. We hope that you will see, as we do, that although we may not be completely through this bear market, the upside potential is rapidly increasing while the downside risk is being diminished. This means that the opportunities for gain are beginning to far outweigh the risks. Below, we will discuss the psychology of the current market, the fundamentals, the discipline, and great opportunities we see for your portfolio. The principles discussed throughout this letter are those that have guided us successfully for the past 28 years.

The Psychology of the Current Market

Outside events such as wars, major disasters, scandals, and other unforeseen events, while having tremendous short-term impact on stock prices, rarely have a major influence on stocks over the long run. When stock prices are extremely depressed, as was the case on December 7, 1941 when the Japanese attacked Pearl Harbor, the negative effect on the stock market is short lived. In the case of Pearl Harbor, at the inception of this attack the market went down about 7.6% for approximately four months and then turned around and increased 90.6% (13.75% annualized) over the next five years, which covered the entire period of the Second World War.

The market during the Gulf War had a similar reaction. Starting to sell off on July 31, 1990, the market declined 13.81% for the next three months. Then the market turned around on October 31, 1990 and never looked back until reaching a peak in March of 2000. During this 9 year rally the S&P 500 went up 382% or 14.76% annualized.

Despite what history has taught us about the value of stocks, in uncertain times like these you can expect the mass media, the general public, and most financial publications to accentuate all of the negatives that exist in the world (war with Iraq, continued recession, rising oil prices, accounting problems) right at the time that they are being discounted in the stock prices. The market always looks ahead. It is a barometer, not a thermometer.

Benjamin Graham described the psychology of the market as follows, " the market is like a manic-depressive." As you will recall from our year-end client reviews (see videos), the optimism (mania) we saw in 1999/2000 priced stocks at levels never seen before in the history of the market (including the biggest speculative bubble in 1929).

During 1999/2000 the average investor, the popular press, and financial publications were wildly optimistic and jubilant about the stock market. Even the Chairman of the Federal Reserve, Alan Greenspan, referred to the behavior of the market's performance during that time as "irrational exuberance". Now 2.5 years later (March 31, 2000 through Friday, September 20, 2002) the NASDAQ is down 73.30%, and the S&P 500 is down 41.72%, confirming that the depressive phase of the "manic-depressive" stock market personality is well underway. The average investor, the popular press, and financial publications have now turned bearish and negative. While the negativity and valuations may not yet have reached the extreme on the downside compared to that which we saw during the peak euphoria in 1999/2000 on the upside, the way some stocks are being priced today, we believe the extreme may not be too far away. This dramatic shift in both psychology and valuations spells great opportunities for investors who are willing to expand their time horizons from 2 to 3 months to 2 to 3 years.

This type of dramatic shift in psychology can be seen in the following example. In the first quarter of this year many clients called our office with the most frequently asked question, "Why are we holding so much cash?" Whereas, our most frequently asked question over the past three weeks has been, "Why are you buying so many stocks when the market is going down?" Our answer: The fundamentals and discipline of the value approach to investing dictate that we take advantage of great opportunities.

The Fundamentals

Contrary to the mainstream media, and irrespective of people's opinion, there are only three major factors that influence stock prices over the long run:

Fundamentals of a company, Inflation and Interest rates. Period!

Private Market Value

The fundamentals of the company, which include earnings, free cash flow, assets, prospects for the future, and the competitive industry environment, help the sophisticated investor determine private market value. As you have heard us say many times, we define private market value as the value of a company that sophisticated buyers and sellers in that industry are willing to pay to buy and sell a company. The sellers want the highest price and the buyers want the lowest price. By the time each party has consulted their accountants, lawyers, and business advisors, the price each side is willing to agree upon is private market value. Referring to the importance of private market value (PMV) or intrinsic value, the late Benjamin Graham said "In the short run the market is a voting machine, in the long run it is a weighing machine." By this he was referring to the fact that stock prices in the short run react to popular opinion and irrational behavior and in the long run the stock prices trade at the value of the individual business. The principle of private market value is the cornerstone of our philosophy.

Interest Rates and Inflation

Another major factor that influences the valuation of stock prices is interest rates. The reason interest rates influence stock prices is that bond yields are competition for stocks. Investors have a choice of whether to buy stocks or bonds. Therefore, if an investor can purchase a government bond that yields a guaranteed 5% versus a company whose cash earnings yield (E/P) and growth rate offer no more than the bond, obviously the investor is better off in bonds. It is because of this reason that one can trace a direct correlation between stock and bond yields.

For example, if we own a company earning $1.00 per share and we paid $16 for that one share, this means it has a cash earnings yield of 6.25% ($1.00/$16 = 6.25%). Now if you add a 3.5% growth rate of the company's cash earnings, you have a total return of 9.75%. (6.25% return from cash earnings + 3.5% growth of cash earnings = 9.75% total return for the company). This means at this level you have one and a half times the earnings potential on stocks, as you would on bonds. When a stock's cash earning yields (E/P) start to give you a return that is equal to or greater than a bond, then stocks become more attractive than bonds because, in addition to the cash earnings yield, stocks have the ability to grow. While in the example above we have used 3.5% cash earnings growth, stock earnings have grown on average 7% a year for the past 50 years. It is at this level that sophisticated investors get more interested in owning stocks than bonds and that usually coincides with bear market bottoms in stocks.

Below is a chart that illustrates the attractiveness of stocks priced at a 14 P/E versus bonds yielding 6%

As you can see, if you invest $10,000 in a AAA bond at the current level of approximately 6% you would have $32,071 in 20 years and $57,435 at the end of 30 years. On the other hand, had you invested the same $10,000 in stocks selling at a median P/E of 14 (the average P/E of the CM portfolio) you would have a 10.5% return, therefore resulting in $73,662 in 20 years and $199,926 in 30 years. While the return for stocks (10.5%) is one and half times as much as it is for bonds (6%), the return in dollars over 20 years in stocks is 2.3 times that of bonds and in 30 years the return of stocks is 3.5 times that of bonds.

Given today's low inflation and 40-year low bond yields (interest rates), we suggest that continued investment in undervalued stocks is the most prudent approach to investing in today's market environment. By evaluating the fundamentals of the market, we are able to then practice the discipline of value investing.

The Discipline

In order to build upon the cornerstone of private market value, we use many tools to implement our investment strategy and discipline. One tool that we use to measure the value of the average stock in the market is the Value Line Index. While many people use the S&P 500 as the benchmark for the general market, we do not believe that these 500 largest companies are the best representation of the more than 10,000 companies that are publicly traded. We prefer the Value Line Index and its expanded version representing 3,500 companies because it is more representative of the average stocks that comprise our portfolio.

There are several major advantages in using Value Line and its expanded index as a benchmark. First, earnings are updated weekly, and second two trailing quarters of earnings are used as well as two forward quarters when presenting the annual earnings projection. This eliminates some of the risk of errors when making projections. This is compared to the S&P 500 Index, which uses all forward quarters to look at earnings. While we do not disagree with this methodology, there is a greater chance for errors when using all projected earnings instead of existing earnings.

For example, in 2000 the forward earnings for the S&P 500 were about $55 per share and in early 2001 forward earnings projections were as high as $59 per share. The actual earnings of the S&P 500 in the year 2001 were $38 per share. When the S&P 500 was trading at 1500 the P/E was 25 (1500/$59 = 25 P/E). As the S&P 500 declined to 1300 the earnings declined even faster moving from a projected $59.00/share to actual earnings of $38/share thus causing the P/E to rise to over 34 (1300/$38=34 P/E). This decline in the earnings of the S&P 500 was one of the reasons some of the "irrational exuberance" of the time was reduced to exuberance!

The third reason we use the Value Line Index is that it uses a median P/E ratio compared to the S&P 500, which uses an average P/E ratio. As we wrote in our April 1999 newsletter, 10 stocks in the S&P 500 represented 77.1% of the total 28.57% return for the year (See April 1999 newsletter on website in CM Library "The Indexes") while over 50% of the stocks in the S&P 500 that year were down, therefore significantly distorting how the average stock performed. By using a median P/E, we have a much better idea of what the P/E is for the average stock.

In addition, we have kept the statistics on the relationship of the Value Line median P/E versus the AAA bond rate for over 25 years. What this comparison tells us is how cheap and expensive stocks are relative to bonds. The long-term relationship bears out the fact that when the median P/E of the general market is equal to or greater than the AAA bond rate, stocks are extremely cheap, undervalued, and should be bought aggressively! This is because you are getting as much in a cash earnings yield on stocks as you would be getting in a AAA bond, plus you are getting the growth of cash earnings which has averaged 3% to 4% over the past 50 years.

To illustrate the risk and reward between bond yields and stock prices, we use a 6.75% AAA bond rate. While the current rate is 6.19%, we are using 6.75% as an added margin of safety because we are factoring in a slight increase in long-term bond rates when the economy recovers. A valuation using 6.19% would justify an even higher upside potential than we are showing. As shown in the chart below, at 6.75%, the AAA bond rate would be comparable to a Value Line median P/E of 14.81%. This means that the buy point for the general market using the Value Line median P/E is 14.81, fair value is 17.66, and a sell point is at 20.5. A maximum pessimism median Value Line P/E would be down to 14. We are currently at a 16.2 median P/E. Therefore the risk to the buy point of 14.81 as shown in the third column of the chart below is a decline of 8.58% from the current value and a decline of 13.58% from the current value to maximum pessimism shown in column four.

Century Management's discipline demands a margin of safety in our calculations. While today a 17.66 median P/E is a fair value for the general market, our discounts require we purchase stocks with normalized P/E's significantly below this level.

The Fed Fair Value Model

In addition to using the median P/E on the Value Line Index in our model of market valuations, we have included a second model called "The Fed Fair Value Model." This is the model that the Federal Reserve uses to measure the fair market valuation of the stock market. This is the same model that Alan Greenspan, Chairman of the Federal Reserve referred to when he was speaking about the market's overvaluation and referred to it as "irrational exuberance."

While we prefer to use the Value Line median P/E model for evaluating the general market, we are including this model for those of you who are more familiar with the S&P 500. Basically, this model compares the cash earnings yield of the S&P 500 to the yield on the 10-year Treasury bond.

When the earnings yield of the S&P 500 equals that of the 10-year Treasury bond the general market is at fair value. Today, the 10-year Treasury bond is yielding 3.69%. For our illustration, we are using a 4.5% yield for the 10-year Treasury bond in anticipation of higher interest rates. This puts the fair value of the S&P 500 at 1100.

Currently the S&P 500 is at 830, which indicates it is selling at 25% below fair value. There have only been two other times in the past 23 years when the market has sold lower than 25% below fair value, 1979 and 1980. If we measure the risk of the S&P 500 from today's price of 830 to 770, which is then 30% below fair value, that would indicate a risk in the general market of -7.23%. If we go from the current price of the S&P 500 of 830 down to 715, then it is priced 35% below fair value. That would indicate a general market decline of -13.86%. If we take today's price of the S&P 500 from 830 to the upside of fair value, you would have a gain of 32.53%. If we go from a price of 770 up to fair value at 1100, this would be a gain of 42.86%. Further, if we go from a price of 715 up to fair value at 1100 this would be a gain of 53.85%. As you can see and as was indicated in our Value Line model, if the market was to go down another 5% to 7%, the upside is increased dramatically while the downside risk is greatly diminished.

The 5 Years the Fed Fair Market Model Sold at Discounts to Fair Value
Currently it's at -25% below fair market value

Great Opportunity

In reviewing the Value Line Index and Fed Fair Market Value models, you can see that the general market is approaching an area of great opportunity. We would emphasize that the level of maximum pessimism is a level that the market sells for during an extreme panic or a major negative world event. Historically, reaching the Value Line Index median P/E would truly be an extreme because in the 1987 crash, the market did not go much lower than the buy point we are showing now, when adjusted for interest rates. The interesting thing to note is that as the market goes lower towards that buy point, the potential gain increases and the risk to the downside significantly decreases. For example, if the Value Line median P/E were to drop from the current level of 16.2 to 15.5 (P/E), which is a 4.32% decline, the upside potential to fair market value would increase from 26.54% to 32.23%. The downside risk to the buy point would decrease from 8.58% to 4.45%. While nobody is wishing for further market declines, you can see that if it does, how much more potential you have for great returns into the future. While it is normal to get caught up in the psychology of the market as it declines, the fundamentals and discipline of the value approach remind us of the exciting opportunities that are created in this market environment. It is for this reason that you should be getting more bullish and enthusiastic about the stock market's prospects as opposed to getting more pessimistic and bearish. After all, the idea is to

Buy low and Sell high.

The Century Portfolio

We can best demonstrate the reasons to separate emotion created by the popular media from commitment to true investment discipline by showing you how our stocks have performed during this 2.5 year down market.

From the peak of the major market indices, March of 2000 through August 31, 2002 (2.5 years later) the S&P 500 is down 36.95%, the NASDAQ 71.25% and the Russell 3000 is down 38.30%. During this same time Century Management Standard Composite Gross of Fees is up 25.34%.

Even this year from January 1, 2002 through September 20, 2002 the S&P 500 is down -25.54% and the average portfolio at CM as shown in our CM Standard Account Composite (gross of fees) is only down -5.36%.

You can see that buying stocks on a value basis has paid off!

Even if the market would decline further to its maximum pessimism, the Century Management portfolio should have much less risk than the general market. While this bear market may not be over, we believe that the majority of the risk has been taken out and while we never take a bear market lightly, we are truly excited about the opportunities that we are seeing. This is evidenced by what took place in July 2002. During this time the stock market, as measured by the S&P 500, declined to a price of 780 and the Value Line median P/E to 14.9. It was at this point that our buy list increased dramatically and we were able to put 20% to 25% more of your cash to work. Out of the $730 million under our management, we had $300 million in cash and put over $100 million to work in a period of 15 days leading up to the market bottom of July 21, 2002. While we still have a lot of cash remaining, the market does not need to go much lower before it will serve up more great buying opportunities. This would include averaging into some of those stocks we have recently purchased.

In summary, we have shown you examples that illustrate that the market is becoming extremely cheap. While you can't rely on any one model, we feel that the stock cash earnings yield versus the bond yield we have illustrated is as good as any one concept we can think of when it comes to the general market. However, there is nothing that replaces the research and evaluation of the individual companies we own and that is what we rely on more than anything else.

As you know, it is a company policy that all employees of our firm invest all of their assets including our entire pension plan in the same stocks as our clients. While uncertainty is a very uncomfortable feeling, it is a price that must be paid for extraordinary opportunities. We can tell by the number of opportunities we are seeing compared to the last 1.5 years that we are approaching a low point in the general market. And while the general market can always go lower over the short term due to investor psychology, we are very excited about having the opportunity to buy solid businesses, with good balance sheets at significant discounts to their intrinsic value.

Buying great values in uncertain times like these is the basis on which fortunes have been built. We encourage you to remain focused on the long term and concentrate on the opportunities that present themselves at this time, rather than the opinion of the mass media. When the market weighs these values over then next few years, we believe that the prices of these companies, your portfolios, and the general market will be significantly higher.

On behalf of the entire staff of Century Management, who make our results possible, we would like to thank you for your confidence and support in our management of your portfolios.

Sincerely,

The Century Management Team