November 21, 2002

Suncoast Equity Management (SEM) now ranks in the top 1% for investment performance in this country, since inception through the period ended September 30, 2002. This ranking is compiled by Effron/PSN, a national performance reporting company, and is from a universe of over 2,500 domestic equity composite/funds. I have enclosed the report for your review.

SEM’s client results during a very difficult stretch of nearly three years remains positive versus the significant losses for most investors and the Standard & Poor’s 500 Index:

Another important indicator of SEM’s excellent performance is the Upside/Downside Capture Ratio. This industry established ratio explains how well a manager has performed in both up and down markets. The enclosed Upside/Downside Capture Ratio graph, again prepared by Effron/PSN, explains that SEM has surpassed the S&P 500 index in up markets and significantly outperformed during the down markets.

Amidst the mostly negative sentiment today, it is most important to separate emotions from intelligence. Intelligent long-term investing involves examining the financial underpinnings that affect an investor. One such positive underpinning is low interest rates.

Before I discuss how low interest rates effect investing, it is also important for you to understand how emotions can affect intelligent decision-making. Benjamin Graham, the father of investment analysis and teacher to many great investors including Warren Buffett, once said, “in the short run the market is a voting machine and in the long run it is a weighing machine.” Interpretation: In the short run, what the popular thought is as printed in newspapers or overheard on CNBC and around the water cooler, drives short-term investor thinking. Today most investors are negative about any factor that can affect the financial markets - and it shows. Whereas, just three years ago, investors couldn’t buy enough high flying technology businesses, and they paid any price for these companies that had minimal business track records and no earnings.

In the long run the market is a “weighing machine” because true value is realized over several years. Simply illustrated, if you had been a part owner of most any airline company for the last 15 years, the businesses earned no profits and your shares of stock in these businesses declined in value. On the other hand, if you had been a part owner of Johnson & Johnson (JNJ) or Microsoft (MSFT) over the same time period, the profits of both have grown significantly and so would have the value of your shares.

Three of the most important factors that “weigh” the value of a business over the long run are company specific returns on capital, profit growth as well as the general level of interest rates. Interest rates are at historic lows as illustrated below by the current yields for different maturities of U.S. Treasury Notes and Bonds:

When we decide to invest our capital (accumulated savings) in a business available through the stock exchanges, we compare our potential return to those of other companies and also against what we can earn in virtually no-risk U.S. Treasury Securities.

Today, stocks are favorably priced as compared to bonds. Our portfolio of businesses is currently valued by the stock exchanges at an average earnings yield of 5%. What this means is that we potentially earn $.05 for every dollar we invest in our portfolio today. In comparison, bonds are earning less, as noted above by the smaller 3.95% ($.03 95 return on a dollar) earned by the 10-year U.S. Treasury Security. Note: The earnings yield is also the inverse of the more commonly known price to earnings ratio (pie). For example, a company that earns $2 per share and sells at $40 has a 5% earnings yield ($2 divided into $40) and a 20 times p/e ($40 divided by $2).

Something else that is useful for investors to understand is that the payments (earnings) from U.S. Treasury investments do not change. You select a maturity and you earn the same amount each year. With stocks, the $.05 you earned in the first year could grow 10% or more in a following year and you would then receive $.055. Year after year the earnings we receive from stocks could grow, and our best estimate is for a 7% average annual rate of growth. Some years they may grow 12% or more and in any particular year, earnings may not grow or even decline.

Remember, we noted earlier that Graham said the market is a “weighing machine”. This principle illustrates that the market is fairly efficient in the long run, both in regard to specific businesses “as we described with the airlines versus JNJ and MSFT example,” and also in regard to the general levels of interest rates. The market will make appropriate adjustments due to the imbalance of yields between stocks and bonds. One such appropriate negative adjustment in stock values occurred in 1987. In the fall of 1987 you could earn nearly 9% in U.S. Treasury Securities and at the same time the earnings yield on stocks was 6% (price-to-earnings ratio of roughly 16). Consequently, the mini-crash in the fall of 1987 took place because the stock market needed to adjust downward the significant 3% premium (9% U.S. Treasury less 6% stock yields) investors earned on U.S. Treasury Securities. When stocks in the mini-crash of 1987 declined, their earnings yield rose and the markets settled. Today we don’t have anything near that circumstance, though we always monitor this relationship for our clients.

What low interest rates tell us today is that if interest rates stay at generally lower levels, today’s prices in our portfolio are discounted and investing in good solid businesses with earnings yields above treasury yields will produce very attractive results for the long term. Finally, history demonstrates that the powerful human spirit and dogged perseverance has always led civilization to overcome some extremely tough times of unrest as well as many economic slowdown. Consequently, get on track with an intelligent decision making process, take the emotions out of it, and invest confidently in the future.

Call SEM and discover how the SEM - Disciplined Investment System portfolio can work for you. Thank you for your interest and I wish you and your family a joyous and peaceful holiday season.

Sincerely,

Donald R. Jowdy
President