Third Quarter 2008 Update and Company Reports

Government historically has proven to be an inefficient supplier of services. That said, the $700 billion “work-out” plan is, unfortunately, a necessity. The virtually total evaporation of liquidity in the world financial system has turned mainstream emotion so negative that extreme measures are needed to stop a negative spiral. The collateral damage to innocent parties, better known as “Main Street,” makes the risk and potential taxpayer expense of the work-out a positive trade-off. Of primary importance is sustaining the flow of financing to residential mortgage and small business borrowers.  Of secondary importance is limiting the collateral damage to investors like us, who behaved ourselves.  The purpose of the "work-out” plan is to save the world financial economy from a total, although temporary, freeze.

The financial freeze problem stems from years of rampant creation of financial "derivative" instruments, specifically those derived from pools of small mortgage loans, and then traded promiscuously amongst the world’s financial institutions and hedge funds.  At the root of these investments was $20 trillion of residential real estate, on which $100s of trillions of derivatives grew. Most trading occurs in the United Kingdom, denominated in Euros. Mortgage derivatives accompanied extreme levels of leverage, making their investors inherently hypersensitive to small changes in real estate value. Now, the institutions that created these instruments cannot price them and do not trust each other enough to trade them.  Liquidity in financial institutions is a necessity, hence the "work-out."

It is very important to note that this is not really a "bail-out."  “Work-out” is a better description. Unlike the old savings and loan bail-out from the mid -90’s that created the Resolution Trust Corporation (RTC), the U.S. is not taking over any properties or loans at full price.  Rather, it is expected to be a "reverse auction," wherein owners of illiquid instruments will competitively offer them for sale to the Treasury. The Treasury can independently value these instruments and be selective about which ones it wants to buy.  Sellers have to compete on price and will surely offer very large discounts to get the liquidity they need to survive.  The Treasury would have to be incompetent not to eventually make money on buying these instruments at the pricing bottom it alone can create.

The U.S. Treasury is the only entity in the world with the financial strength to fix this problem. Let’s look at some mind-boggling numbers. The $700 billion work-out is a huge amount of money, but pales in comparison to the $3.1 trillion annual U.S. budget and $14 trillion U.S. GDP. It will permit the global recession to clear up a year from now, a very nice alternative to the possibility of years of global recession.  No other country or group of countries can do this.  The amount the European Union has come up with so far pales in comparison.

Companies with a real reason for being will be fine, and, over the long-term, will preserve capital as they usher in the next phase of growth. Monsanto and Qualcomm stand out for their proprietary positions of leadership in driving their respective industries into the future. However, some replaceable businesses, such as banks and brokerages, will experience permanent losses.  Municipal bonds have temporarily lost a little market value as banks, insurance companies, and hedge funds, traditionally the largest buyers of municipal bonds, are forced to sell to raise liquidity. Municipalities are better able to weather economic storms than their corporate counterparts due to their broader revenue streams, an absence of market and competitive factors, and their ability to unilaterally raise revenues and cut spending. After all, people live in municipalities, truly a sound reason for being.

Democracy, relatively free markets, innovation, and a self-made populace have supported decades of wealth creation in the U.S., and will continue to do so for decades to come. The U.S. standard of living in the 20^th Century improved by a factor of seven to one, despite wars, recessions, booms, busts, and one depression. The ingredients of that growth are still intact. Today's rather large mountain will eventually be tomorrow's molehill.

Although our portfolios have sustained collateral damage from the financial storm, we have completely avoided mortgage pools and credit default swaps, and, in sum, have gotten off somewhat lighter than most other investors. We own the companies that will lead the comeback in the economy and I have a sound basis to expect, in time, to see new highs in our portfolios. Massive quantities of liquidity are being injected into the U.S. economy. Historically, this has led to dramatic stock market recoveries once investors saw a light at the end of the tunnel.

William Wrigley, Jr. Co. (WWY 80) has been sold to Mars, a family-owned American company. Equity clients who have been with us for a long time will have substantial taxable gains as this old friend turns into cash. In view of the possibility of a higher capital gains tax bracket in the future, it is important to let us know if you want to keep the gains in this tax year, or offset them by losses created in this negative market.

Joy Global (JOYG 28) is one half of a unique duopoly that supplies the world with the highest quality mining equipment. Fears of a significant slowdown in world growth has combined with forced selling by hedge funds of world infrastructure stocks to drop Joy from a high of $90 to the current appallingly inexpensive price. In the midst of a cycle of 20%+ annual earnings per share growth, this stock sells for less than eight times trailing earnings, and seven times next year’s estimate. The visibility of growth for the next several years is excellent. Demand exceeds supply, with major product lines sold out for the next two to three years. The other half of the duopoly, Bucyrus Erie, has similar levels of backlog. Essentially, for the world’s mining companies that extract oil shale, coal, iron ore, and copper, there are only these two suppliers of high durability equipment. Many other companies in the world manufacture lower quality equipment, but breakdowns experienced with inferior mining machines are very costly to mining companies.

The burgeoning demand for mining machines is driven by the industrialization of developing markets, a trend that should continue for more than a decade. Forty percent of new oil reserves found in the future will be from oil shale. While new coal-fired generating plants are being built worldwide, the coal opportunity concentrates on China, which will produce 2.5 billion tons of coal this year, six times the production of the U.S. China is experiencing power blackouts as consumption climbs rapidly.

Sustained revenue and earnings growth is projected for the coming five years. Profit margins will increase as equipment prices increase, making up for inflation in manufacturing resource costs such as steel. Aftermarket sales and services are growing as the installed base of equipment grows and the company promotes its Life Cycle Management service contracts. New mine productivity products are being introduced and modest increases in production capacity are being implemented. The analyst consensus earnings projections for 2008 through 2012 are $3.43, $4.41, $5.42, $6.67, and $8.21, easily supporting an intrinsic value estimate of $79. Note that the company has an active $2 billion stock repurchase plan, compared to a current market value of $3 billion. If the stock price were to stay at this level for a couple years, the company could buy more than half of its stock back, leading to a very significant increase in the percentage of the company held by long-term shareholders.

Steven L. Ré, CFA October 10, 2008

This report contains the current opinions of the author and such opinions are subject to change without notice. It has been distributed for information purposes only and is not to be construed as a recommendation to purchase or sell securities. The information contained herein 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 no guarantee of future results. Earnings projections often miss, and markets go up and down. 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.