April 5, 2009

Dear Fellow Shareholder:

The economy continued to weaken during the first quarter of 2009 and the stock market extended its losses. By early March, the S&P 500 had fallen an additional 25%. Investor gloom was thick and pervasive. Then, for no apparent reason, stocks began to go up. At this writing the S&P has climbed 26% from its March 6 low. Bear market rallies can be explosive and the recent move may well be another false start. We continue to believe, though, that stocks will turn up long before the economic news turns positive and that it is impractical to try to wait to invest until all the market “uncertainties” are cleared up.

The “relative” performance of each of our stock funds (vs. the S&P 500) was positive in the quarter (see table below). Several smaller company stocks were particularly helpful to Hickory and Partners III. “Absolute” performance has been harder to come by over the past year and a half. Partners III was the only stock fund showing black ink for the first calendar quarter.

Our fixed income funds have shown positive returns over the past quarter and 12-months. Chaos in the credit markets over the past several quarters has created opportunities for Tom Carney and Brad to buy corporate bonds at very attractive prices for our Short-Intermediate Income and Balanced Funds. Tom has also found bargains in tax-free municipal bonds for our Nebraska Tax-Free Income Fund.

The table below shows investment results over various time periods (after deducting fees and expenses) for our four stock funds and for the S&P 500 (larger companies), the Russell 2000 (smaller companies), and the Nasdaq Composite (a proxy for technology companies).

Portfolio Review

The current recession has unfolded more dramatically and threatens to be longer and deeper than any since the 1930’s. Government policy responses have been massive and there is anecdotal evidence of improvement in the credit and housing markets, yet most economic indicators continue to deteriorate. The S&P 500 fell by 56% from its October 2007 high to the March 2009 low and has been incredibly volatile—the market’s mood swings are giving many investors whiplash.

Our initial response to the developing credit crisis and recession was, paraphrasing Kipling, to “keep our heads while those about us were losing theirs.” Taking patient, contrary positions in the face of “temporary” bad news has served us well for the past 25+ years, but the scale of this bear market has made that approach expensive. As our friend Tom Gayner pointed out in the recent Markel annual letter, “pure unadulterated panic would have been the best investment approach to take in 2008.”

So, how are we investing as this economic storm unfolds? The goal of our research process has not changed: We look for understandable businesses with strong balance sheets and defensible competitive positions that generate excess cash and are run by managements we trust to allocate capital well. We estimate the price that an informed buyer would pay for the whole business and try to buy shares at a deep discount to that price. Given the state of the economy and the capital markets, we pay particular attention to each company’s likely capital needs, debt maturity schedule, loan covenants, etc. We have always tried to anticipate how each company would deal with a recession, but we are now trying to be even more imaginative as we ponder what might go wrong.

Many of the companies we already own are performing well, yet their stocks have fallen significantly. If a company’s long-term business prospects are still good and its price falls precipitously, we are happy to add to our position. Over the past six months, as the market has staged several strong rallies followed by renewed weakness, we have been able to use this volatility to upgrade the portfolios, harvest tax losses, and capture some modest trading profits.

We reduced our exposure to financial service companies in late 2007 and the first half of 2008 as it became clear that the paralysis of the credit markets was not going to be a short-term phenomenon. We also realized the degree to which many banks, savings and loans and mortgage companies had been “over-earning” because of the cheap credit generated through the securitization of mortgages and other types of loans. There will undoubtedly be some spectacular winners among financial stocks when this bear market is over, but until we have a better understanding of how financial company business models will adapt to the new realities of tighter, more expensive credit and a new regulatory climate, we are likely to move slowly in that arena.

Our largest “financial” holding now is Berkshire Hathaway which has a large insurance business but is very broadly diversified. Our other significant financial position is Redwood Trust. Redwood invests in troubled mortgage securities—a target-rich area in today’s world, to say the least. Redwood does not use borrowed money to buy these securities, so while their investments are subject to credit risk, Redwood is not subject to margin calls and cannot be forced to sell into a weak market.

We were arguably over-exposed to retail and consumer products in general as the recession began and we have been adjusting these positions opportunistically over the past year. As consumer-related stocks have gyrated in response to alternate waves of optimism and pessimism, we have reduced overall exposure, tried to concentrate on companies offering staples and “value” (e.g. Wal-Mart), and have been more willing than usual to “trade” portions of our major positions when the price swings have been unusually wide.

Another area of interest for us in recent quarters has been commodity-related companies. As we wrote in our last quarterly letter, we have generally avoided energy, metals, fertilizer and other commodity producers. These tend to be capital intensive, cyclical, low return on capital businesses, so we were never seriously tempted to “chase” the stocks during their spectacular bull market. That “bubble” burst abruptly in mid-2008 and prices of most commodities collapsed (e.g. oil prices fell from $147 in July to $34 eight months later).

Although we did not own these kinds of companies over the past few years, we did do research on several to make sure old ideas and preconceptions were not getting in our way. We read industry publications and company financial statements, attended industry conferences, visited companies and met with management teams. We had no major conversion experiences, but we did come across some companies that seemed to have appropriate concern for return on capital and per share value growth. We decided that if the opportunity arose to buy these companies at prices that would generate reasonable returns in a low commodity price environment and give us a cheap “option” on a future rise in commodity prices, we could be interested. We now own small positions in half a dozen energy companies and continue to study producers of other commodities.

Outlook

These are fascinating times for investors. The economy is in “shambles,” to use Warren Buffett’s term, and capital markets are under great stress. The government is committing trillions of dollars to provide liquidity to the markets and stimulate the economy yet it remains unclear how effective the various programs will be. On the other hand, there are signs that credit is beginning to flow again and opportunistic (vulture) investors are bringing billions of dollars to distressed real estate and securities markets.

We would expect this tug of war between the bullish and bearish forces to continue for some time—maybe years—but our working assumption is that the American economy will emerge from this recession in recognizable form. We expect that good companies will find ways to cope with this environment and come out of this period intact. We are wary of the short-term economic outlook, but we believe that there are a number of quality businesses whose stocks are selling well below their conservatively calculated business values and that we will eventually be rewarded for buying these stocks at bargain prices. We appreciate shareholders’ patience during this extraordinary period.

Sincerely,

Wallace R. Weitz	Bradley P. Hinton
Co-manager Value and Partners Value	Co-manager Value and Partners Value
Portfolio Manager Hickory and Partners III	Portfolio Manager Balanced
wally@weitzfunds.com	brad@weitzfunds.com