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Introduction

Historical Results and Commentary

Portfolio Analysis

February 11, 2005

Holdings

	Feb-05
1	F
2	NBG
3	YHOO
4	NKE
5	BA
6	VRSN
7	SNP
8	CAT
9	JNJ
10	NSM
11	CA
12	FNF
13	MWD
14	TKC
15	HMC
16	CRYP
17	X
18	AAPL
19	COP
20	ACH

Performance of Individual Stocks For last 3 months

Feb-05
FNF	18.06%
COP	14.73%
CAT	3.72%
NKE	-0.12%
BA	0.17%
VRSN	-9.74%
JDSU	-39.75%
YHOO	-9.63%
JNJ	10.90%
NSM	18.36%
CA	-8.17%
F	-7.62%
MWD	16.24%
TKC	24.91%
HMC	3.05%
CRYP	18.32%
X	21.24%
AAPL	46.84%
NBG	9.64%
ACH	-2.60%

Total Increase (Decrease) since last quarter: 6.43%

Additions:  SNP

Subtractions: JDSU

Commentary:  The topic of this commentary is China. But first, it is worth commenting on the sad yet enlightening history this portfolio has had with JDSU. I think the graph of the stock’s precipitous decline since it was acquired in May 2001 says all that needs to be said. But, suffice it to say I have learned the lesson that what goes down can keep going down, and down, and down. On a personal note, since I usually do not rebalance my own portfolio every quarter (as a function of personal poverty, not of principle), my losses from holding this stock were less than had I kept pouring money into it. But still, I am humbled by how naïve I was in assuming it would go back up simply because it had commanded a high stock price before. Now on to China…

It is my belief that by the end of this century China will be a dominant power in world, if not the dominant power. China’s ability to muster economic resources and political capital to achieve its goals is impressive. China has smart leadership, improving social and economic indicators, and a red-hot economy that seems unlikely to cool in the near future. However, the main reason that I believe China will thrive is a reason few people, if any, are talking about right now. I believe this century will see a fundamental shift in the way technology impacts the functioning of governments. If the 19^th century saw the superiority of liberal colonial mercantilism over absolutism, the 20^th the superiority of capitalism over totalitarian socialism and fascism, then the 21^st will see the victory of technocratic centralism over corporate capitalism¹. I believe a pendulum is a bad analogy for most historical processes, but in this case, I feel successful societies will see a new form of absolutism come to dominate the distribution of land, labor, and capital. This is because I believe that the improvements in data management and communications that are leading to bigger and better corporate entities will cause similar changes in scale in the way governments operate.

Accompanying the feasibility and superiority of technocratic centralism will be a parallel disillusionment with liberal corporate capitalism. I am concerned about the way in which many democratic governments seem unable to cope with rising social inequality, plan for large-scale demographic changes, manage fiscal responsibility, or retain or engender a cohesive sense of nationalism or unity. I believe the root cause of this problem is that politics in many democratic countries is focused on a short-term time scale that is not optimal from a social point of view. I believe democratic societies will fail in their social obligations to their poor and disadvantaged. Also, I believe the attention to short term stability and progress will cause fundamental systemic cancers in democratic systems that will lead to crisis situations which will facilitate their replacement with technocratic centralist regimes.

If these things come to pass (which they may not), then China is way ahead of the game. For all its shortcomings, I do believe the regime in Beijing is concerned about the welfare of its people. Though corrupt, inefficient, and in some respects incompetent, I do believe the Chinese leaders are primarily concerned about the welfare of their people. They have two historical currents which will steer them towards acting in a socially optimal manner. First, the regime is ideologically communist, which means that communist values and benchmarks will have a role in the political discourse shaping Chinese society. Second, China has a long history of successful autocratic rule where dictatorial benevolence was an integral part of unifying and solidifying central control. Where ritual and ceremony played a role in legitimizing the Manchus, the Communists’ ‘Mandate of Heaven’ will be justified by their ability to bring about social stability and economic development.

My decision to buy Sinopec (SNP) was influenced by a number of factors. First, China’s demand for petroleum, petroleum products, and refining, will only increase with time. The inertia propelling China’s economic juggernaut is simply too strong. Second, I believe there will be a gradual but sustained appreciation of the yuan against the dollar. The trade imbalance differential already exists to necessitate such a correction, and so I believe this will add 2-3% a year to the value of any yuan denominated assets relative to the dollar. Third, the valuation on Sinopec seems silly. It pays roughly a 3 percent dividend, and its P/E is very low at around 6. Furthermore, the book value of its equity has grown at a reasonable clip (up about 10 percent a year since the end of 2001). In an economy that will grow at 8-10 percent per year, this stock seems like it should blossom. Yes, it has already tripled in the last 2 years, but the fundamentals underpinning its growth are solid. Maybe there is something about the management or worries about political risk that I do not appreciate. But, I think this stock presents a very reasonable margin of safety, and has considerable upside. So, I cannot predict how it will do, but at least I hope it outperforms the track record of JDSU!

¹In the developed world only. This commentary does not take into account the trajectories of developing nations.

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