Market Review

Item 12-31-2001 12-31-2002 Change
S&P 500 1148.08 879.82 -23.37%
DJIA 10021.5 8341.63 -6.76%
NASDAQ 1950.4 1335.51 -31.53%
IBD MF Index 469.67 339.9 -27.63%
CRB Commodity Index 190.61 234.52 23.04%
3-Month Bill Rate 1.71% 1.19% -30.41%
Long Bond Rate 5.36% 4.78% -10.82%

The Rational Versus The Irrational:
In individual circumstances, it’s probably easy to find examples of irrational behavior in the stock market during the past three years of falling prices. Hopefully, we own some of these cases, whose stocks we like to believe are being priced substantially below the intrinsic values that will be attained once the markets turn around. (This means we bought them a lot higher.) On a collective basis, however, one can make a case that the stock market has acted quite rationally during the past three years.

Consider The Issues:

March of 2000 marked the end of the biggest economic bubble in recorded history. The economy underwent a recession, which some believe is still in force. The events of and surrounding 9/11 continue to dominate the allocation of our country’s resources: we are still fighting in Afghanistan; we seem close to war with Iraq; the Israeli-Palestine conflict grows worse by the day; and North Korea has revealed a nuclear weapons capability it says is necessary to protect itself from its enemies, chief among which is the United States. Widespread corporate fraud, highlighted by the bankruptcies of Enron and Worldcom, as well as the downfall of Big Five accounting firm Arthur Anderson, permeates the corporate culture, stretching from the corporate chambers of Adelphia Communications to the private life of Martha Stewart. Is it any wonder that we’ve been engulfed in the meanest bear market since 1932? Have we seen the bottom?

Does anyone know where all these issues came from? Isn’t it amazing how they seemed to appear out of nowhere? Remember early 2000. The NASDAQ had just risen 85% the past year. The new economy was in full force. Productivity was the economic shield that made everything OK, turned bad into good, in effect repealed the economic laws of gravity. To quote a saying of the time, If you don’t understand this, you just don’t get it! (Large corporations actually took out newspaper ads proclaiming, We get it!) Back then, the sky was blue; there were no clouds on the horizon. Now, all of a sudden, we’re not sure if the planet will survive. How could we get to this point in just three years? We don’t have any special keys to the universe that answer these questions; but to understand where we are in relation to the bottom and the top of the stock market, it might be useful to begin where the responsibility begins at home.


Developing The Concept Of Private Property:

The term private property takes on an ugly glow in the face of today’s headlines, which portray and correctly so the avarice and greed with which some of our corporate leaders have pursued its accumulation. It shouldn’t. Private property is definitely one of the pillars that make our society work. In the broadest sense of the term, private property refers to our right to be safe and even our right to think. We have taken these rights of private property for granted for a long time; it is good to remember they don’t exist everywhere. With the removal of the Taliban from Afghanistan, for example, Afghans were rejoined with many rights of private property: women can drive; men can shave. Private property is a source of freedom.

Without private property, it would be impossible to have Life, Liberty and the Pursuit of Happiness. In the Bill of Rights, even suspected criminals are guaranteed their private property, as stated in the Fourth Amendment, The right of persons to be secure in their persons, houses, papers, and effects, against unreasonable searches and seizures, shall not be violated And in the Fifth Amendment, nor shall (any person) be deprived of life, liberty, or property, without due process In the introduction to Property And Freedom, Richard Pipes quotes James Madison from 200 years ago: Property in its particular application means that domination which one man claims and exercises of the external things of the world, in exclusion of every other individual. In its larger and juster meaning, it embraces everything to which a man may attach a value and have a right; and which leaves to everyone else a like advantage. In the former sense, a man’s land, or merchandise, or money is called his property. In the latter sense, a man has property in his opinions and the free communication of them. He has a property of peculiar value in his religious opinions, and in the profession and practice dictated by them. He has property very dear to him in the safety and liberty of his person. He has an equal property in the free use of his faculties and free choice of the objects on which to employ them. In a word, as a man is said to have a right to his property, he may be equally said to have a property in his rights. The point is that, taken in its broadest sense, private property is your right to go into your own house, undeterred, shut the door and listen to, read and think whatever you want.

We would argue that even in the more limited sense, referring to the accumulation of material wealth for personal gain, private property is an important and necessary cornerstone of our economy and society. According to the Constitution, this limited sense of private property even extends to the arts and sciences. In Article I, Section 8, the eighth power granted to Congress is: To promote the Progress of Science and useful Arts, by securing for limited Times to Authors and Inventors the exclusive Right to their respective Writings and Discoveries. Our patent and copyright laws which embrace private property have been responsible for inventions that most of us would agree have increased our standard of living, whether they be items such as the automobile, advances in medicine or art forms. In like sense, the desire for private property in the form of profit has been responsible for creating jobs, companies and even industries and institutions.

Private Property And Education:

A wonderful concept, private property does not come without a price tag. The main price we pay for our right to private property is described in Madison’s remarks: which leaves to everyone else a like advantage. We interpret this to mean that private property can’t exist unless everyone has it. In other words, the price we pay for our own right to private property is to extend the right to everyone. When this is done, a deep mutual respect is created that makes it possible for us to live and work together. It’s easy to take this respect for granted, but think about its extensive reach in our society. Driving on the correct side of the road and stopping at stop signs are two mundane examples: how angry we get when others don’t follow these rules and invade our personal space, endangering our well being.

Building on this simple example, it is this mutual respect for private property that allows some to accumulate more than others. It may be against the law to take another person’s car, but this law isn’t enforced with the relatively small number of police we have in our society. This law is enforced with mutual respect for private property. Unfortunately, proof of this remark can be found in areas of our society that have deteriorated and no longer adhere to the principles of private property. We can all think of such places. The impressive thing, it seems to us, is that there aren’t more of them.

So this concept of private property at times a delicate ideal that is vital to our free system needs to be taught to our children and passed on from generation to generation. It doesn’t matter where this is accomplished: in our schools, in our families, in our churches, in our corporations or other organizations. All of these institutions depend on private property for their existence, `they have a duty to educate by passing on the principle.

Private Property And Leadership:

When we say private property can’t exist unless everyone has it, we aren’t saying let’s redistribute the wealth. We’re saying that we live in a society where everyone has a right to accumulate private property. Possession of this right is what creates respect for the rights of others to accumulate it. Think about it. We live in a country where Bill Gates and Warren Buffett are heroes. Because they started out with the same rights as the rest of us, their accumulation of wealth is respected. It may be a stretch to say it, but deep down we all feel something in common with these two mega-wealth accumulators. Actually, they have each said the same: Buffett, for instance, has often remarked that his success was determined in the ovarian lottery, when he was born in America.

An interesting question might be how do Buffett and Gates differ from some of our more notorious corporate moguls, such as those at Enron, Worldcom, Tyco or Aldelphia Communications? From an ethical standpoint, we would say there are two primary characteristics that distinguish these two, and others like them, from the rotten apples that have been making the headlines over the past two years. One, they accumulated their private property wealth without taking anyone else’s private property. The corrupt corporate leaders enriched their own coffers by taking private property from others: from their employees and from shareholders. In doing so they broke Madison’s rule:  leaving everyone else a like advantage. They did this by hiding the truth and cooking the books.

The second distinction is leadership. A recent article in Worth estimates that the Gates Foundation, which emphasizes technology, health and education, totals over $24 billion. One of Buffett’s reasons for his success is that he has allowed, indeed helped, his business partners to keep their private property. Fortunately for this country, leadership is not in short supply. The same Worth issue describes the charities of financially successful young Americans. Another is Pierre Omidyar, who co-founded eBay and stated two years ago his intention to give away 99% of his wealth. Today, the Omidyars spend millions of dollars a year directly helping causes such as hunger and education. We could go on. All of these philanthropists have interesting stories.

The point is that all of these people, and many more in business and other walks of life, practice leadership. Leadership isn’t just giving away private property; the important thing about leadership is the commitment to help others get private property in all senses of the meaning. When people lose all hope of attaining private property, for their generation or future generations; when they no longer have a feeling of being secure in their persons, they are unable to respect the private property of others. Today, this country is full of upper management and retired executives. Those who are leaders are not running around extolling their virtues, bragging about how much money they made or are making; the leaders are helping the rest of us get to where they are. That is the price of being successful in America. We have to give back, in our own way, to keep the system working. If we want everyone else to respect our like advantage, or private property, then we have to keep the path to private property open to all.

Individual Leadership Responsibility:

The difficult and controversial conclusion these ideas lead to is that we are all responsible for corporate corruption. We can talk about passing on the principles of private property via education and leadership, but the fact is we can’t teach values that are not part of our community. The corporate criminals from Enron, Worldcom and the rest did not operate in a vacuum. They operated in a culture; and the culture was one willing to look the other way while things were going so well. Starting from the top, open corruption in our Government for eight years was greeted by Democrats and Republicans alike with the attitude if it ain’t broke, don’t fix it, even though we knew it was broke.

But it was in the areas of finance and investments where the country’s problems of corporate corruption came to the fore: our stocks went down. We may never have bought a stock for no other reason than it was going up, acted on a hot tip from a cocktail party, invested in a new issue of a dot-com company with no profit in its business plan, or chased any number of investment schemes that were working during the bubble years; but in order to provide the leadership in the business community that will make a difference, we need to stop looking for scapegoats for our situation. We need to accept the fact that risk works both ways: not only can we win by taking risk; we can also lose. When Enron’s stock was going up, no one wanted to hear about its debt; no one wanted to think about its price/earnings ratio. Enron employees, mutual funds, individual investors and the financial press alike couldn’t say enough about the company.

Anyone who disagreed just didn’t get it. We know, because we disagreed with buying Enron and Worldcom; and, among other things, we lost clients because we brought up the unpopular ideas of debt, price, diversification and risk. (Don’t worry. We’re not trying to be holier than thou; we found our own problems as you know and we know we have to accept the responsibility for our complicity, like everyone else.) As we remember the times, though, it wasn’t until Enron and Worldcom stocks crashed that suddenly the shareholders went from being self-proclaimed geniuses to victims looking for perpetrators.

As for the employees of these companies, the loss of retirement savings is indeed unfortunate. But they, too, need to confront their complicity. As reported in the financial press, it was the employees who filled up a large trading room in Texas to fool the city folk from Wall Street, who were there to learn about a certain company, and rumor has it that knowledge of this little caper became widely known and admired throughout that company. We’ll say it again. Corporate corruption doesn’t exist in a vacuum. Of course, all employees in all corrupt companies were not so directly involved; but as far as sound investment principles were concerned, diversification wasn’t even considered when the stocks were going up.

In our local community of Moore County, NC, the School Board considered a proposal to require thirty hours of community service from high school students a requisite for graduation. This proposal is structurally unsound and was rejected. Offering credits for community service may be a wonderful way to get students involved in the community. However, making it mandatory has two fatal errors. First, it takes away the students private property, which is their choice to help the community. Second, the proposal was an attempt to legislate values. As stated, values come from leadership. In this case, it is the community’s responsibility to uphold values that attract the involvement of its young people.

The American business community is similar. Looking for others to blame like the research analysts who always have and always will have conflicts of interests–won’t solve the problem. Neither will attempts at legislation, such as requiring investors to diversify. Our regulations are adequate, especially when they are enforced. Laws to remove risk from the stock market are just as unsound as laws to control values. Politicians claiming to represent us and grandstanding to promote their own agendas aren’t the answer to our problems of corporate corruption. We are the answer to our problems. Before we call for reform and look for the bad people who hurt us, we need to accept our own responsibility for the part albeit small we played in creating and maintaining a culture that allowed the criminals to break the law. Then we can happily watch them march off to jail. And perhaps the values in our community will rise a little.


Remember The Pendulum:

The tables on our front pages for the past three years give a pretty good idea of the investment pendulum’s direction and distance. Using NASDAQ, the most dramatic measure of the investment landscape, at yearend 1999, the index stood at 4,069.31. By yearend 2000, the index was 2,470.52, down 39.3% for the year. At yearend 2001, it was 1,950.40, down another 21.1%. And, as shown in this letter, the index declined another 30% last year, to 1,350. Measured in most terms–stock market indices, retirement plan values, or just personal stories it is clear the pendulum has traveled a respectable distance to the downside.


It’s interesting. In April of 2001, fully six months before 9/11, we stated that investors shouldn’t expect the Federal Reserve to lower interest rates simply for the market’s sake. As we stated:  the Fed’s job is to focus on the economy investors attention seems to go directly from market to Fed and back. In other words, the economy is left out: the Fed lowers rates, stocks go up; and vise versa. The point we were making then is that when the Federal Reserve lowers interest rates, it may be a signal of problems in our economy. If so, there may not be a direct connection between lower rates and higher stock prices. Today, with three-month Treasury bills yielding 1.2%, versus 4.2% in April 2001, not many investors continue in the belief that the Federal Reserve’s job is to make the stock market go up by lowering interest rates. At least they no longer believe that lower interest rates, alone, have the power to make stocks go up. We would say this is a healthy development, and another sign of the pendulum’s travels.

Can The Pendulum Go Further?

When the investment community has fully embraced its own responsibility for its own problems, it’s possible the pendulum may have gone further not necessarily in setting new lows in the indices (although this is possible) at least on the inflicted pain scale. Just as the Federal Reserve doesn’t exist to benefit investors who speculate without weighing the possibilities of loss, the purpose of our politicians is not to take risk out of stocks and bonds. In fact, our capital markets exist for this purpose: they provide price discovery and liquidity, allowing investors and speculators alike to manage the risks inherent in the ownership of private property. Hopefully, it won’t take as much pain to learn this lesson as it did to understand the role of the Federal Reserve.

Our disclosure laws, such as the Securities and Exchange Acts of 1933 and 1934, and the Investment Advisers Act of 1940, require the provision of extremely useful information about investments. When the pendulum has completed its travels, it is likely that investors will appreciate these regulations enough to avail themselves of the information these laws facilitate. As we have stated, much information was ignored during the bubble years, even though it was available. As for our capital markets, don’t think for an instant they are ineffective in dealing with corporate corruption. Lost in the noise of the financial press during the past two years is appreciation for the outcome delivered by these very markets: Enron, Worldcom, Arthur Anderson (to name only three giants) are gone. Today, just hints of questionable corporate activities, or conflicts of interest, or accounting irregularities, or undisclosed off-balance sheet debt, are enough to send the stock or bond of any company, large or small, sliding to its doom. NO LAW OR REGULATION WILL EVER DUPLICATE THE DISCIPLINE OF OUR FREE MARKET SYSTEM. Attempts to regulate risk out of stocks represent grandstanding by politicians to advance their own agendas at investors expense.


The Sarbanes-Oxley Act of 2002 is a case in point. As described by InvestmentNews, this act requires company officers to certify their financial reports. It also requires that a majority of members of boards be independent. We believe this act is regressive. It is another attempt to legislate values in a community doomed to fail. As for signing company reports, who cares? If a company’s financial statements are fraudulent, the officers are liable under the anti-fraud provisions of the SEC Acts of 1933 and 1934. As we have seen, enforcing these regulations has resulted in many high-level arrests. We would suggest spending our resources enforcing the statutes already on the books and letting the capital markets ferret out the perpetrators.

As far as requiring independent directors is concerned, this law is clearly regressive because it takes away private property, which is the right of stockholders to choose their own directors. Besides, the added value of independent directors is at best questionable. Some of you may recall our Strategy Adviser article of March 31, 1996. It recounts the last days of Morrison Knudsen, a large engineering and construction company, to demonstrate that risk exists in stocks, no matter how conservative they appear. In 1993, the dividend of $0.80 per share on Morrison Knudsen’s common stock generated a current yield of 3.2%. The Chairman’s letter in the 1993 Annual Report stated,  It was a year of milestone events, new projects of grand proportions and strong financial results. Our company reported net income of $35.8 million and posted a quality backlog of $4.2 billion. With an unqualified opinion from Deloitte & Touche, CPA’s, the sponsorship of Merrill Lynch and Mellon Bank, owners of over 7% of the stock each, and a Board of Directors comprised of Peter Ueberroth and Peter Lynch, among others, this company proceeded to unravel from its 1993 precipice. Under the clouds of bankruptcy just two years and one quarter later, Morrison Knudsen is changing hands on the NYSE for less than $1.50 per share.

We read proxy statements. And frankly, at times we wish companies had more insider directors and less window dressing. Being strictly clinical, we have to wonder how shareholder interests are advanced by the titular board appointments of minorities, former generals, university professors and various celebrities. To the extent such board members assist company officers to run the business, we are in their favor; but to the extent these appointments represent transparent public relations schemes, we would rather vote for insiders who have valuable industry knowledge. If legislation of this nature were required, we would rather see laws that enable shareholders to be more effective in voting for directors. (These might include the elimination of staggered terms, or the ability to combine votes for one director.) Laws of this nature, combined with a renewed sense of responsibility on the part of shareholders, would embellish the power of our free market system. They would be progressive in the sense that they would augment shareholders voting efficacy, as well as highlight the obligation of shareholders to get involved.


As for the investment landscape, we suspect that when the pendulum reaches the end of its downward path, investors by virtue of being skeptical–will be relying more on the market’s discipline and its related laws of disclosure instead of politicians promising to legislate risk out of the stock market. We also would suspect that newsletter writers, who currently favor bulls over bears by a margin of two to one, would be more reserved. And we don’t think the talking heads on CNBC will be telling us, breathlessly, that Cisco, Sun or any of the other bubble stocks beat expectations by a penny a share, because nobody will care about the old names anymore.

In this regard, we can’t help but respect Dan Sullivan’s views in the December 5 edition of The Chartist Mutual Fund Letter. Bullish sentiment has been trending higher with stock prices. The renewed optimism and confidence is particularly evident among individual investors and equity strategists. The latest survey from the American Association of Individual Investors shows that 53% of individual investors are bullish versus 18% who are bearish. Both bulls and bears are nearing extremes that precede a market reversal. Investment strategists at major brokerage firms are also extremely bullish the stocks that have been among the bear market’s biggest losers have posted the fattest gains over the past two months. However, if history is any guide, the reemergence of the old market leaders does not bode well for the stock market’s prospects because the leaders of the previous cycle seldom repeat.

In conclusion, while the pendulum–via this bear market–has come a long way toward eliminating the excesses built up during the last half of the roaring 1990’s, some exorcism may still be in the cards. Whether this is marked by lower lows, the passage of time, or individual financial distress, remains to be seen. The good news is that, after three years and several thousand points in the market indices, we are a lot closer to the bottom than we were. As the final phase develops, we should be able to address the subject of valuation prices in relation to economic factors–in more meaningful terms. Then we will be in a much better position to assess the external war factor and its related issues, such as the supply of and demand for oil and the danger of nuclear conflict. Finally, we would observe that, Sullivan’s remarks notwithstanding, any downward adjustment in the markets from here would set the stage for a dramatic rebound given the favorable resolution of any of these external items. When you think about it, there’s an awful lot of bad news in this market.



Something that we’re excited about, but won’t be very noticeable to you, our clients, is a change in our organization from sole proprietorship to Limited Liability Company. Beginning January 1, H.S. Dreher Capital Management will begin operating under the LLC form of organization. This change in ownership structure will allow Tom to attain some well-deserved ownership in the company and begin the process of providing continuity to our clients.

New Clients:

This past year has seen the addition of several new clients. While we are disappointed in our nominal investment returns this year, since they are largely negative, we are gratified that during the past three years of this investment storm, most of you have been treated well by the investment strategies you adopted and we helped you formulate. You must think so, also, since you have been kind enough to refer us to your friends and acquaintances. So we would like to take this opportunity to welcome our new clients and thank all of you for being our clients.


Two additions.

Computer Sciences (CSC–$34.45):
Another Information Technology company similar to EDS, CSC, with 25% of its revenues from the Government, should benefit from the new Homeland Security Department as well as from renewed spending on IT once the economy starts to recover. While the company has not been plagued by the same issues affecting EDS, the shares nevertheless have fallen 65% from their 2000 high of $99. Presently, the shares trade for 4.3 times cash flow, compared to their more normal multiple of nine times. With modest debt in the capital structure, we rate the company Level III, Conservative Growth. We have been accumulating it in several accounts.

Allegheny Energy (AYE–$7.56):
Shortly after purchasing AYE shares at much higher prices, the company’s involvement in the California energy trading scandal came to light. Together with these California contracts, which are being contested, energy trading problems, excess energy supply and general softness in the economy have resulted in severe liquidity problems for AYE. Among the company’s efforts to conserve cash and strengthen its balance sheet in response to these issues, AYE eliminated its common dividend. While we don’t expect AYE’s problems to be resolved to the extent the shares move back to their old highs exceeding $55 in 2001, we do think that longer term the company’s core operations which include electricity and gas distribution to 1.4 million customers in Pennsylvania, West Virginia, Maryland, Virginia and Ohio will help the stock regain a substantial amount of its lost ground. As a result, we have changed their rating from Level II, Aggressive Income to Level IV, Aggressive Growth, and decided to keep them.


The following table shows the complete history of SAFH. I am sure you understand that no representation is being made regarding the portfolio’s future investment results. The portfolio is maintained to describe investment decisions made in a narrow investment arena, so it is not representative of the diverse investment universe used by Dreher Capital Management. It is not updated regularly, and you will not be notified on a timely basis of any changes.

Buy Date Description Risk Level Buy Price Curr Yield Sell Date Sell Price Change DJIA Change
3-21-95 Seagate Tech IV $26.00 0.0% 11-7-96 $76.00 192.3% 17.0%
3-22-95 Sun Microsystems IV $33.88 0.0% 10-19-95 72.63 114.4% 107.8%
3-23-95 Varlen Corp IV $11.84 0.9% 10-29-98 $28.00 136.5% 3.5
7-22-97 General Motors* III $56.00 4.7% CurrPrice $42.67 -23.8% 19.7%
12-04-98 Budget Group III $12.25 0.0% 9-20-00 $3.56 -70.9% -7.4%
12-09-98 Alexander & Baldwin III $21.00 3.5% CurrPrice $25.79 22.8% 19.9%
12-09-98 Heilig-Meyers IV $7.50 0.0% 12-31-01 $0.00 -100.0% -9.0%
3-31-99 Ameron Intl III $35.50 2.1% 9-19-01 $61.13 72.2% -4.4%
3-27-00 CNA Financial III $30.625 0.0% 11-28-00 $36.56 19.4% -24.3%
3-27-00 TECO II $18.75 8.4% CurrPrice $15.47 17.5% -23.7%
3-28-00 Berkshire Class B III $1,667.00 0.0% CurrPrice $2,423.00 45.4% -19.2%
5-25-00 Alleghany Corp III $164.00 0.0% CurrPrice $177.50 8.2% -22.7%
12-29-00 Hewlett-Packard (1) III $23.71 0.7% CurrPrice $17.36 -26.8% 1.0%
12-29-00 Lucent III $13.50 0.7% 5-2-01 $11.41 -15.5% 14.1%
10-8-01 NiSource II $24.25 5.3% 6-10-02 $22.95 -3.1% 14.1%
2-1-02 Ford III $15.00 2.6% 6-26-02 $22.95 -3.1% -8.5%
6-27-02 Electronic Data Syst III $39.90 3.3% CurrPrice $18.43 -53.8% -9.8%
6-28-02 Bell South III $31.50 2.9% CurrPrice $25.87 -17.9% -9.8%
6-28-02 SBC Communications III $30.50 4.0% CurrPrice $27.11 -11.1% -9.8%
6-28-02 General Cable IV $6.30 5.3% CurrPrice $3.80 -39.7% -9.8%
6-28-02 Comcast IV $24.20 0.0% CurrPrice $23.57 -2.6% -9.8%
6-28-02 Schwab III $11.20 0.4% CurrPrice $10.85 -3.1% -9.8%
6-28-02 AOL-Time Warner III $14.71 0.0% CurrPrice $13.10 -10.9% -9.8%
6-28-02 Cable & Wireless IV $7.73 9.4% CurrPrice $2.33 -69.9% -9.8%
12-31-02 Computer Sciences III $34.45 0.0% CurrPrice $34.45 -0.0% 0.0%
12-31-02 Allegheny Energy IV $7.56 0.0% CurrPrice $7.56 -0.0% 0.0%

*Recent price adjusted upward for special dividends–.06 Raytheon, .7 Delphi.
(1) Aquistion price based on take over by Compaq.

Sam Dreher Tom Velevis

President Investment Associate


This letter is for the information of clients of Dreher Capital Management: 275 SE Broad St, Southern Pines, NC 28387, and #910-692-4330. Information contained herein is taken from sources believed to be reliable, but is not represented to be complete, is not guaranteed for accuracy by Dreher Capital Management and is subject to change without notice. More information on specific companies mentioned in this report is available upon request. Prices as of end of quarter unless otherwise noted.