"These are the times that try men’s souls," or at least their conviction and confidence. It is no secret that this was a terrible quarter for equity returns. From its peak in March, the S&P 500 index declined over 25% and the NASDAQ 65%. These measures meet anyone’s definition of "Bear Market". After the worst year ever for the NASDAQ in 2000, the first quarter of 2001 was the worst quarter ever. The decline in the other equity indices weren’t much better.

During the quarter many portfolio managers put forth the proposition that the decline in the markets was mostly a final washout of the Internet bubble, leaving other sectors in reasonably good shape. Initially, technology stocks led the decline in all major indices. Before the end of the quarter, the downturn broadened to all sectors. Market sentiment became so negative that not only was bad news bad, good news was also bad. No matter what, equity prices fell across a broad front.

The best performing sector for the quarter was consumer cyclical at a +0.2% increase. All other sectors had negative returns. The worst was technology with a 25% decline. There was simply no place to hide.

The big Dow declines in March seemed to signal capitulation. This is the stage of market correction where some participants give up on stock ownership and sell out of fear of further decline. Unfortunately this usually occurs near market bottoms and leaves sellers in the worst possible position. They have sold what is cheap and may either miss the recovery or may buy what may be considered safe, but is usually expensive at that point.

At the same time many analysts downgraded their opinions of many stocks warning of further risk. Analysts are as human as the rest of us and tend to have high opinions of the stocks they follow when they are doing well, but give up on their prospects at their low points. (Someone needs to tell some of them that doing the opposite would be more helpful and profitable.) As money managers we put little stock in these opinions and manage to our own well-reasoned discipline. Our investment horizon is much longer than the short-term view of most analysts. We seek to invest in companies that will produce a superior return over 3-5 years.

Bonds had a terrific quarter. As investors fled from equities, bonds were bid up. The Federal Reserve Open Market Committee also lowered rates at the short end by 1.5% in three half- percent steps. This has obviously been one of the best places to be, but it is not clear that it will remain strong going forward. It all depends on how soon the economy begins growing.

The US economy is now near zero growth. However, it is showing signs of resiliency. Consumer confidence is rebounding, retail sales have held up well, and amazingly the housing sector still looks robust. Most of the decline has occurred in manufacturing, technology, and telecommunication sectors. If the official measures show GDP growth still positive for the first quarter, it will mark 10 years of economic expansion.

At the end of 2000 we estimated the probability of a recession at 40%. We now are inclined to drop that estimate to 25%, where we had it in September of 2000. We now feel it most likely that the economy will skirt recession for a quarter or two more then begin to start growing again.

This down turn has been led by a decline in business spending. In some cases this is a response over investment, especially information technology, in the recent past. Thankfully, the underlying trends and competitive forces will ensure that this spending resumes, probably sooner than later.

Droughts end, storms pass, pessimism yields to optimism, and markets turn. Bear markets burn themselves out much faster than Bull markets. Most Bear markets last between 6 and 18 months and are usually contained with less of a decline than we have already experienced. This Bear probably is close to being over.

Markets usually anticipate the economy by 6 to 9 months. If we are correct about our economic forecast, the equity markets should start recovering in the second or third quarter of this year.

The badly mauled sectors of the first part of this year should rebound. They will be lead by those competitors who first experience improved fundamentals. These should include some sectors in technology, consumer cyclicals, capital goods, and transportation.

For this quarter, US treasury bonds continued to be a safe haven from all of the equity market turmoil. As a result the available rates have declined significantly and no longer offer good returns. In fact, longer-maturity treasuries offer increased principal risks from a back up in rates when economic recovery comes. Municipal bonds have the same risks at this point in the cycle. Therefore we are using shorter maturities in these sectors.

The best opportunities are in corporate bonds. These benefit when an economic upturn takes place and buyers are more confident about the credit quality ratings of these issues.

Because we believe that the Bear market is close to being over, we are slowly beginning to reduce positions in some of the defensive sectors which have done relatively well in the past few quarters and adding assets to those sectors that will be early beneficiaries of economic recovery. In doing so, we are taking measured steps to reallocation.

We also are taking some of the appreciation in the bond portfolios in balanced accounts and applying those funds back to equities.

Over the past two quarters we included several new stock positions of mid-cap companies that had exceptional businesses. These firms do not face some of the intense pricing pressures of some larger firms. In most cases they dominate a growing sector with excellent potential. Because the markets were in such free-fall, these have not added significantly to returns in portfolios. However, as the equity markets stabilize, we believe the values of the holdings will begin to be realized. We have limited these holdings to 20% of our model. Riverplace Capital is, after all, a large-cap growth manager.

We anticipate few if any changes in the second quarter. With a recovery in the markets probably not too far off, we believe our present holdings will be among the first to benefit.

Fixed Income

Our target for bond portfolio average life and duration is 5-7 years, reduced from 7-9 years. This is in recognition that interest rates for longer maturity bonds will rise once economic growth resumes.

Corporate bonds offer better value than treasury and municipal issues. Credit quality is paramount in this sector. We are being very selective here, but favor this category. We are staying with relatively short-term maturities when using US Treasuries and municipal bonds.

At Riverplace Capital we don’t describe our methodology in detail for competitive reasons, but it may be helpful to review the major factors that guide us. The principals for a company to be considered for inclusion in our model portfolio are:

1. Invest in good businesses with superior growth and profitability.
2. Focus on high-quality companies, particularly those with strong competitive advantages.
3. Great management is paramount
4. Concentrate on the long term
5. Be willing to go against the consensus.
6. Pay close attention to valuation. Normalize both good and poor business environments.
7. Diversify. The offensive aspect of diversification is as important as the defensive one.
8. Have realistic expectations.

In addition to these broad principals, we have a set of criteria that each candidate has to meet. These are quantitative hurdles that weed out most candidates. Some of these are:

1. Revenues: This is a hurdle to assure that the firms are of sufficient size to give us confidence in their durability and likely market liquidity.
2. Market Capitalization
3. Return on Equity
4. Return on assets
5. Top line revenue growth
6. Projected growth rate vs. price earnings ratio
7. Relative Strength
8. Earnings predictability
9. Technical strength

Candidates that meet or exceed these hurdles then must fit into our model. The model is confined to 50 stocks. At any point in time, only so many positions are relegated to each economic sector in the economy. Any new candidate not only has to be better than the fiftieth on the list, but also must fit into an existing slot or serve to add weighting to a sector in which we want more emphasis.

The modeling process helps us control risk. It also forces us to focus on a well-defined universe of stocks. To keep individual as well as sector weightings within predetermined constraints, we periodically rebalance. We do this to reduce the risk of an individual position as well as that of a sector. In a later edition we will discuss what makes us sell a holding.

If you would like the benefits of a disciplined approach to the management of your assets, Talk with Us.

This quarter we welcome Nicholas R. Whitcraft to our firm as vice president in charge of our institutional sales. We know Nick will help us extend our reach in this important market.

We also congratulate both Terri Kimball and Robert Willett who have continued to demonstrate their commitment and dedication by passing the series 7 securities exam. This is a rigorous exam for qualifying investment professionals.

Large Cap Stocks (S&P 500)

Dow Jones Industrial Average

Mid Cap Stocks (S&P 400)

NASDAQ Composite

Small Cap Stocks (Russell 2000)

MSCI EAFE

Lehman Corp. Bond Index

Inflation 2.6%

(Equity indices are three-month returns excluding dividends)