When I begin to write my quarterly letter to each of you, this letter will often go through three or four iterations before you see the final version.  Even then, I am often not completely satisfied.  With each letter, I want to accomplish so much.  I try to summarize where we have been and what we, as managers, have done to meet challenges, where I think we are going and how we are positioned to meet coming challenges.  I also wish to educate you on what is happening in your account.  Sometimes I think I try to bite off more than I can chew.

This letter has that potential.  Not only have we just ended another year but also a decade.  And both the year and the decade have been quite turbulent to say the least!  As I tried to write the first couple of drafts of this letter, I tried to cover everything over the past ten years.  Scratch that.  Try just the past year.  No, no…scratch that.  Ok, let’s back up, take a deep breath and start all over.

I actually like the way one recent CNBC news special labeled the past decade.  It called the era the “Bubble Decade”.  The decade began with the peaking of the internet bubble which popped soon afterwards.  This was followed by an easing of interest rates that led to the housing bubble.  As the decade ended, we also saw a commodity bubble come and go, as oil ran up to over $140 per barrel and then crater to around $40 per barrel.

That neatly sums up the decade, but what about the past year?  Well, to understand what happened in 2009, we have to go back to 2008 where things started unraveling.  That was the year, recall, when we lost such venerable institutions as Lehman Brothers (founded 1850), Bear Stearns (founded 1923), Washington Mutual (founded 1889) and Wachovia (founded 1879).  The demise of these firms was the deflating of the credit bubble.  The low point was probably reached in September when Congress failed to pass a stimulus bill that sent the stock markets into a tailspin.  A few days later, the bill did pass, but the damage was done to the psyche of investors and the public at large.

The official low for the stock market was finally reached during the trading day in March this year, when the broad-based S&P 500 Index touched 666.79 during the day.  At that point in time, it looked like the world was falling apart.  However, from that low point, the market rallied an incredible 67% to close the year out.  The market spent the year climbing a “wall of worry”.  There were dozens of reasons why the market should not keep rising and yet, that was all it could do.  What this past year created was a wealth of opportunities.  We attempted to take advantage of these opportunities but only within reason.  As it is, we missed out on the dramatic rise in some stock prices simply due to our caution.  I’ll go into that a bit more later, but let me first explain some of the opportunities we saw this past year.

We purchased a number of stocks during the first quarter as prices continued to fall.  Included in our purchases were Caterpillar (CAT), which we picked up for as little as $30 per share, and PepsiCo (PEP) which we bought for $47.50 per share.  We sold options that obligated us to purchase shares of stock.  We collected some really nice premiums for taking on these obligations and we looked at these transactions as win-win situations.  If we had purchased the stocks, it would have been for lower prices than buying at the then current market price.  Our costs would be lower due to the premium we took in and we would have locked in some nice dividend yields.  Most of these obligations expired without us having to buy the stocks meaning we kept the premium and earned a nice return on our cash.

The biggest driver of this rally has been the perception that the recovery is at hand.  As I indicated in my third quarter letter, I do acknowledge that things are far less worse than they were, but are we out of the woods yet?  Well, not quite.  Allow me to explain a little bit.

During the second and third quarters, the biggest driver of stock prices was the fact that reported earnings by companies were beating expectations.  That, of course, would not be hard to do if you essentially have no expectations.  Given the extreme pessimism in the fourth quarter of 2008 and the first quarter of 2009, it would be easy to see that most analysts had low or no expectations for earnings growth for companies during 2009.  Then, when companies slashed payrolls and cut back on other major expenses, of course earnings were higher than expected.  But the key to the higher earnings was not the fact that companies sold more but they spent less.  In fact, sales were down across the board and companies can only cut payrolls and expenses for so long.  Eventually we need to see an increase in sales before we have any sort of sustained recovery.

The problem with that last sentence comes in the fact that companies have cut payrolls and they are not rehiring any time soon.  Many economists expect this recovery to be a “jobless” recovery.  That is, companies will recover without the pickup in hiring that used to accompany most expansion phases.  If people remain unemployed or under employed, it’s hard to see where increased sales will come from.    This will tend to favor a much more benign and slower recovery than after past recessions.

For this reason – the expectations of a muted recovery – I am taking a more cautious stance in positioning portfolios.  I would rather protect us from losses than “gamble” on a sustained recovery that seems unrealistic at the moment.  This does not mean that I am giving up on growth.  I have added several new names to portfolios in the fourth quarter, such as Sensient Technologies (SXT) which provides colors, flavors and fragrances to the food, beverage and pharmaceutical industries; Frisch Restaurants (FRS), an operator of Big Boy and Golden Corral restaurants primarily in Ohio, Kentucky and Indiana; and Innophos Holdings, Inc. (IPHS)which produces phosphates for many industrial and chemical uses including foods, pharmaceuticals and fertilizers.  All of these stocks are smaller companies with good growth prospects, selling for steep discounts to their intrinsic values and, as a bonus, paying solid dividends.

As I conclude this quarterly letter, we are seeing increased volatility and angst in the markets.  The stock market indexes have dropped some from their recent highs and I actually heard one of the hosts on CNBC blather about a “double dip”.  The question being raised is whether we are going to return to the lows we saw last March.  The obvious answer is “I have no idea!”  While I am sure that we could – especially if we have some completely unplanned event that shakes the world – the likelihood of such a dramatic drop is remote at this point.  I, for one, would welcome such a drop as it would give us the chance to load up on great stocks at bargain basement prices, but I fear those opportunities are rare.  I am grateful for the increased volatility we are seeing in the market though.  This does give us the chance to return to some of the strategies we employed at the beginning of the year, though with not quite the same vigor.  You can probably expect to see more options transactions in your tax-sheltered accounts as we look for the “free money” lying around in the market place.  We will also continue to look for chances to protect some of the gains we currently have as we continue to re-evaluate our positions to make sure each is still trading at or below intrinsic value.

I would like to add one additional comment.  We are in the process of a major overhaul of our web site.  Hopefully, it will be completed by the time you receive this letter.  We will be emailing everyone for whom we have email addresses when the new site is released.  We would welcome any comments and feedback on the site.  One new feature will be an area where I will be blogging.  I welcome your comments and criticisms and I would encourage you to challenge me and my assumptions.  I hope to promote a dialogue and would welcome your questions on topics you would like to see me post about.

Disclosure:  We currently own shares of Caterpillar, PepsiCo, Sensient Technologies, Frisch’s Restaurants and Innophos Holdings in client accounts as of the time of this writing.  We reserve the right to buy or sell shares in the named securities as we deem appropriate for client accounts.