For those of you who have your accounts carried by Charles Schwab and Co., Inc., please be aware that there is an error in the reported year to date figures on all year end Schwab statements. Schwab initiated a new statement design on October 1, and year to date figures for change in account value, dividends and interest income, and margin interest do not actually reflect the whole year, but only the last three months of the year. For example, under "Change In Account Value", the "Year to Date" column only dates from October 1, 1997 through December 31, 1997, despite saying year to date.

I extend to all of you my annual invitation to visit me or to phone me, as you wish.

Wow, how things have changed this quarter! Last summer, the conventional wisdom held that Asia was the pinnacle of growth in a sluggish world. I actually had a client seething at me for not investing his money in foreign stocks! (I remember the last time that happened –- shortly before the ‘87 crash that did long lasting damage in overseas markets.) Now we’ve made an about face and are worried about depressions and bank insolvencies in Japan, Korea, Thailand, Indonesia and the Philippines. Some of the Southeast Asian markets have declined 70% from their highs! By golly, just when the conventional wisdom was getting really comfortable, the world changed -- again.

It is probably adequate to think of the Asia-Pacific problem in terms of our own savings and loan bailout. It will cost a lot of money to clean up, and eventually will be only a memory. The lesson, once again, is that careless greed can end up costing investors their fortunes. It is better to be boring and avoid major losses.

The more boring and careful value-oriented approach I follow has historically kept portfolios out of long-term trouble. This worked awfully well back in 1987, 1993 and 1994, when we made good money even though most other investors were complaining. There is a cycle in money management philosophies. A value-oriented style seems to work well in weak markets, and a momentum-oriented style works better in a strong market. This is to be expected, because the momentum style has a much higher sensitivity to market swings in either direction. (The "value" style is defined as being careful how much you pay for a stock, while the "momentum" style is defined as buying what is hot, regardless of price.)

I would guess that the increased uncertainty in the world will not bode well for markets in 1998, and the value-conscious strategy I follow should outperform the major indices. We are about half as exposed to the dangerous areas of the market as the average stock mutual fund. Indeed, if one is going to miss holding "momentum stocks" in the hot market periods, one deserves to miss the damage of holding them in weak periods. In the long run, the tortoise beats the hare.

Will the movement of momentum investors into the S&P 500 indices once again signal a rougher period in the U.S. markets? With stocks selling at record levels of valuation, specifically near the lowest "earnings yields" in U.S. financial history, a strategy of being very careful about the price paid to buy a business should help returns and save pain.

At the same time, broad selling of positions to dodge market corrections has historically not been a good strategy. First, the timing has to be pretty precise, and usually misses the target. Second, the stock market rises about 65% of the time, so being out of it for long is costly. Finally, the seller interrupts the power of compounding. This does not seem to be such a big error on the surface, but it is so incredibly huge in the long run.

Great investment success is built over a very long period, and for most of us, our investment time frame is our lifetime. Compounding is the secret. Just grinding out 12.5% per year for 30 years takes $100,000 to $3,400,000, and 15% takes $100,000 to $6,600,000. There is only one caveat: the sequential years of compounding can absolutely not be interrupted. The biggest single error of the investment business is its culture of interrupting compounding, thereby preventing its clients from getting rich. Try this on your calculator: 12.5% growth for 2 years compared to 0% one year and 25% the next.

As powerful as compounding is, it is fragile. That is why decisions that look timely in the short run cause long-term regrets. Selling out of a super compounding vehicle may look smart for a little while, especially if the market corrects, but years later the few who look back see a horrendous error. I recall some pretty scary dips even in the best: Coke, Wrigley, Medtronic, etc. I just cannot over-emphasize how insignificant a couple of years looks against the backdrop of a lifetime, so long as some level of compounding is maintained. Compounding is the secret driver to building wealth. The investor cannot ever afford to let it get away.

How do people destroy compounding? By ventures into hot foreign markets and hot momentum stocks/mutual funds that are susceptible to 70% declines. By trading stocks or investing in high-turnover mutual funds. By investing in non-compounding investment vehicles like precious metals. By timing the market.

Good businesses are the greatest compounding vehicles known to man. They generate cash that can immediately be reinvested at exceptionally high rates of return, thus generating growth in years to come. For instance, if XYZ reinvests 75% of its earnings at a return of 20%, future earnings should grow at 15%. (The math: 75% x 20% = 15%). Shareholders benefit from that growth by holding on to the stock as long as that math is working. Now, you do have to pick the right ones to hang on to, and you do have to keep an eye on them. Picking them, and watching over them, is a cakewalk compared to having the fortitude to hang on.

In the long run, stock price performance correlates highly with growth of the underlying business. Taking that a step further, long-term portfolio performance correlates highly to the collective growth of the businesses it owns.

In the next letter, we will discuss a method for maintaining account appreciation in a flat market. Essentially, it follows the theme started above, that is, to invest in companies in which the rate of return on reinvested capital is exceptionally high. In that context I will be discussing Qualcomm and Monsanto, which are on the first quarter visit calendar.

Although I visited several companies, I will report only on Intel, which stood out from the others in its attractiveness as a business. Also, the stock is down 30% from its high and is starting to look pretty interesting.

Intel has accumulated a surprising amount of brand name equity as the leading manufacturer of microprocessor chips (the "brains" inside of PC’s) for PC’s costing over $1,000. This equity is so strong that Intel is able to charge about half again as much as its two lesser-known competitors, for largely equivalent products. Pricing power is an important characteristic of a consumer monopoly, my favorite type of business. The intrinsic value analysis of Intel is dominated by judgments of the stamina of this brand name equity.

Intel expects its processor chip volumes to grow in line with the growth of the PC industry. Dataquest estimates this growth rate at 16% to 17% over the next several years. Profit margins on Intel processor chips have historically held up well, countering the overall trend in the PC industry to lower priced computers and components. Actually, the average selling price of a new computer has declined from about $2,500 to $2,000 in the last year or so. In the same period of time, the price of Intel’s current top-of-the-line chips has held well.

Now, however, Intel has a small amount of competition from Advanced Micro Devices and the Cyrix division of National Semiconductor. In our opinion, these companies are not likely to take any significant amount of market share from Intel, but have caused weakness in chip prices. Intel’s response is to cut prices and profit margins. Intel’s margins are also threatened by the "sub-$1000 PC". You cannot put a $500 processor chip in an $800 PC. Intel has guided analysts to expect a decline in gross margin from 60% to 50%. This will cause earnings to be flat at Intel for about a year, which explains the drop in the stock price.

In the long run, Intel’s nearly overwhelming critical mass gives it two large advantages over its competition:

1. A research and development budget many times larger than that of the competition is likely to continue to produce the best products in the category.
2. Economies of scale in manufacturing should allow Intel to be the first in the market with new levels of product performance, and to produce all of its products at lower cost.

Intel’s advantage over the rest of the chip industry will be extended in future years as microprocessors earn more value by performing jobs currently done outside of the processor. Excellent volume growth is likely to continue as Intel continues to dominate the chip market. Earnings growth should resume after about a one-year respite.

January 8, 1998

The above is for information purposes only and is not to be construed as a recommendation to purchase or sell securities. The above information is from sources deemed reliable but is not guaranteed. It should not be assumed that investments in any of the above mentioned securities will be profitable, and past performance is not a guarantee of future results. Earnings projections often miss, and markets don’t always go up. The employees and families of Quality Growth Management, Inc. may own the above mentioned securities in their own accounts, and may trade them at any time without notice.