The Uncertainty Principle

April 2003

As the past few months have clearly shown, the war not only dominates the news but our domestic and international politics, the economy and also, obviously, the markets in which we invest. In fact, the parallels between the war and today's financial markets are striking:

First, the real-time, embedded media coverage of this conflict makes today's rapid-fire market players seem downrightpatient. The TV coverage has been truly amazing and first-rate - captivating in both its immediacy and realism. Yet we recognize a familiar pattern in all of this. Each bit of news from the front lines seems to require its own analysis and conclusive verdict from one of the ex-generals on screen, reminiscent of the cheerleading talking heads on CNBC during the Bubble. Initial expectations for a quick resolution in Iraq were high; thus, the first few hours of the conflict invited backslapping celebrations as troops neared Baghdad, only to be followed by despair as casualties mounted and many commentators began to question U.S. military strategy. The problem, of course, is that the single live camera in the field - literally and figuratively - sees only individual clashes rather than the broader context. In both joy and despair, it seemed few observers were willing to take a step back and see the forest rather than the trees.

Of course, the market has suffered from this short-term focus for some time, and we have noted this fact quite regularly. Over recent years investors have shown an increasing tendency to take small bits of data and "over-interpret", drawing far-reaching conclusions when thoughtful analysis would be more appropriate. The Bubble provided scores of examples: Company A sees increasing activity on its web site, so profitability must be rising, thereby making the stock a great buy, etc.; or Company B has not yet added ".com" to its corporate name and logo, implying doom for all its shareholders! Sadly, the phrase "Shoot first and ask questions later" seems to be a common factor in both environments; from our perspective, a lot more patience and measured analysis would serve us all well. In fact, the Pentagon may want to even consider adopting one of Corporate America's recent innovations: "No Guidance". Perhaps a bit less real-time information might actually lead to fewer missed expectations and more reasoned judgment. We'll see.

Second, the media coverage of the war brings to mind a concept some of us might remember from high school physics class: the Heisenberg Uncertainty Principle. Don't be scared off by the quantum physics reference - the principle, in layman's terms, merely states that the more accurately one tries to measure something, the less certain one can be of its characteristics because the act of measuring actually disturbs the subject. Even though Werner Heisenberg's work in the 1920s focused on subatomic particles and helped advance quantum mechanics, the principle has found applications in philosophy, sociology and other academic areas. In Iraq, one could certainly argue that the media scrutiny of the conflict - an act of "measuring" - has the potential to affect the conflict itself. For example, embedded reporters have not only been near-participants, but their broadcasts from the field have probably affected decisions on both sides as public opinion is considered. As Heisenberg might have framed the issue, the exact path of the war is uncertain because of these outside influences. Some paths and outcomes are more likely than others, and we can assign probabilities to assess such alternatives. But even though there is never 100% certainty as to the exact path, it is still possible to predict the most likelyoutcome with reasonable assurance. In other words (and from our perspective), given all the data and probabilities, the ultimate outcome of the war in Iraq is not really in doubt.

This principle has interesting applications in our financial markets today. Heisenberg's work introduces an unavoidable element of unpredictability or randomness. Even if one wanted to believe there is a "science" to the financial markets - i.e. price movements can be predicted by certain relationships among the data - the Uncertainty Principle argues such relationships are not etched in stone. Again, the Bubble offers a real-life example: the prices of hundreds of stocks went higher than most rational theories would have predicted. The confluence of some self-reinforcing outside influences - the strong economic environment, cheerleading by the media and analysts, complicity by some accountants - created a one-in-a-million outcome. Today, "measuring" the actual state of the markets and the economy itself has become as challenging as ever because so much short-term scrutiny by investors and the media affects the systems themselves.

And so, in the midst of great uncertainty created by the state of the economy, tax policy, SEC investigations, as well as the feedback effects as investors and consumers react to each short-term blip in the war, our analysis takes on a Heisenberg-like quality. We are aware of the inherent uncertainty in the investment environment, yet we remain focused on the most likelylong-term outcomes for the companies we follow and the contexts in which they act.

Economic growth is clearly weaker than most would prefer. From our vantage point, however, the profit picture does not appear as bleak as the headlines imply. For the companies currently in our portfolios, 2002 profits actually grew about 15% over 2001 levels, and for the broad economy, profits in the fourth quarter grew to their highest level since mid-2000 (helped by cost-cutting and lower interest rates). In fact, we believe the U.S. economy has proven to be remarkably resilient the past few years given the bursting of the Bubble, terrorist threats, numerous corporate scandals and the approach of war. Looking forward, our own cash flow estimates recognize the potential for further economic difficulty over the coming quarters, due at least in part to weak spending among consumers and businesses. But while we believe our estimates are reasonably conservative (earnings for the median company we follow should rise close to 10% in 2003, helped by the same forces as last year), we are also aware there is room for positive surprise. Interest rates and tax policy - remember the tax cuts of 2001 - remain decidedly stimulative, and lower oil prices could add another positive boost. While timing is never certain, we believe the most likely outcome for the economy supports continued cash flow growth for the businesses we monitor.

As for the market, no one is really having much fun these days. With most investors focused on the macro issues, it's difficult for even the best performing businesses to stand out - stocks are moving as a broad group rather than being influenced by company-specific fundamentals. We would argue this bodes well for our portfolios. First, as disciplined, fundamentally-driven investors we should be able to take advantage of the market's indiscriminate treatment of individual issues. Our experience tells us that over time, fundamentals drive stock prices, so we continue to position our portfolios in the strongest businesses with the most attractive valuations we can find. Fortunately, we have been able to "upgrade" our portfolios without being forced to pay an additional premium for these higher quality businesses. Furthermore, our portfolios increasingly reflect opportunities across a wide spectrum of industries, and this too should prove to be a source of strength over time. Today, our Approved List is populated by better-than-average businesses, yet 40% of the names trade at a P/E ratio of 12 or less on 2003 estimates.

Second, the intense scrutiny of the daily news has pushed many equity investors to the sidelines. Trading volumes are low, cash continues to build in sub-1% money market funds and there are willing buyers for 10-year Treasuries (despite the math which says even a collapse in yields from record lows will generate returns of - at best - about 5% annualized over the next five years). No one, it seems, is willing to look past the war itself. This manifestation of Caution, we should all understand from the Uncertainty Principle, makes a clear assessment of the current state of the markets challenging at best. There are lots of uncertainties today - just as there always have been. Sure, it is possible that bonds are the place to be, but our experience, sense of history and knowledge of the businesses we invest in lead us to believe that the probabilities favor equity investors over the next five years. Valuations are attractive and we like the businesses owned in our client portfolios. Uncertainty is at times frustrating, but it is central to our daily lives. And it offers opportunity to those who grasp this fact.