Dear Client,

During the second quarter, investors experienced one of the most volatile markets in history. The high-tech led NASDAQ dropped 38.14% from its highs before rebounding to its current level. $2 trillion of market value disappeared in one week alone, as tightening monetary policy, inflation fears, valuation concerns and profit taking all hit the market. While most other indexes were off 3%-4% for the quarter, the NASDAQ declined 13.27%. This decrease represents the worst quarterly performance during the current bull market.

Index	2nd Quarter
Dow Jones Industrial Average	-4.34%
Standard & Poor 500	-2.93%
NASDAQ	-13.27%
Russell 2000	-4.05%
Dow Jones World (ex. U.S.)	-5.87%
Merrill Lynch Corporate/Government Bond	+1.34%

Speculative expectations reached extremes based on any rational standards and, in many cases, the lack of profitability and financial strength were completely ignored. Excessive valuations were unsustainable and reacted severely as soon as market sentiment began to change. The S&P 500 Index increased 220% over the last five-years, while per share earnings of the S&P 500 increased only 59.3%. The price-to-earnings ratio increased to 26.8 from 14.4 during this same period, reflecting the fact that valuations have run ahead of fundamentals in the short-term.

While the S&P 500 currently trades at 26 times our 2000 EPS estimate, the median P/E is just 15.3x. This indicates that many of the stocks in the S&P 500 are reasonably priced. The valuation of the broad index was simply skewed by extremely expensive, high-technology stocks which substantially declined in the second quarter. We believe that there are attractive long-term buying opportunities in today’s market. Accordingly, we will take advantage of the short-term volatility resulting from investors’ emotions by buying high-quality stocks in beaten-down sectors that offer promising growth potential. Markets are rational in the long run and ultimately will reflect fundamentals.

 

NEW PURCHASES IN SECOND QUARTER OF 2000

CVS Corp.

With 4,100 stores and ten distribution centers in operation, CVS is the largest in the U.S. drug store industry, an industry which continues to enjoy strong pharmacy sales trends and a stable competitive environment. CVS has the greatest market share in 30 of the top 100 U.S. drugstore markets, more that any other drugstore chain. With CVS.com, the company appears well positioned to capitalize on e-commerce. CVS is the exclusive provider of over-the-counter and general health products to Merck-Medco’s Internet customers and also provides prescriptions for several major Internet portals including WebMd/Healtheon, Excite, Lycos, and the Microsoft Network. CVS has recently created a new business model in specialty pharmacy with ProCare, which has the potential to be a $1 billion business in 3 to 4 years. Earnings are growing at a 17% rate, and at a P/E of 21x, it is trading at a significant discount to its historical valuation and to its peers.

First Data Corp.

First Data is the world’s largest payment processing company, with a dominant position in each of its three core businesses: payment instruments, card issuer and merchant processing. Electronic transactions over the Internet are expected to reach $1 trillion within five years, and First Data is uniquely positioned to profit from the shift from paper to electronic payments. Earnings are growing at a 15% rate.

Honeywell International

The December 1999 merger between Honeywell and AlliedSignal created a new $24 billion powerhouse. The company is a diversified technology and manufacturing leader with the flagship aerospace division accounting for over 40% of sales. The company expects to generate 35% to 40% of total sales from recurring replacement parts and service revenues, which should smoothen the earnings trend, yet fuel sustainable earnings growth. While the recent pre-announcement of a Q2 earnings shortfall raised new questions about management execution at the merged company, it is premature to believe that the company cannot deliver superior returns over the long term. At 10.8x the 2000 EPS estimate the price makes more than adequate allowance for the recent disappointment and appears too cheap to ignore for the long term.

 

Sincerely,

Joseph T. Lai