January 20, 2009

Dear Fellow Shareholder:

I feel as if I have been writing about 2008 for at least two or three years. So much has happened—so many "unthinkable" things—that the story seems somehow surreal. Dependence on debt in every corner of the economy finally caught up with the U.S. and most of the rest of the world. The consequences have been traumatic.

The capital markets are barely functioning, consumer spending has declined sharply, and production of both raw materials and finished goods is depressed. Many individuals and companies that have not been seriously affected have nevertheless pulled back on their spending and investing because they fear that the recession may affect them soon. This triggers a vicious circle in which fear causes lowered economic activity which causes fear, and so on.

The Federal Reserve, Treasury and FDIC have responded to a series of crises with hundreds of billions of dollars meant to replenish bank capital, provide credit for transactions, and stimulate consumer demand. The formats of the various "rescues" of companies "too big to fail" have varied, and the shareholders and creditors of the institutions have not fared equally well. The treatment of creditors of Lehman Brothers and the preferred stock holders of Freddie Mac and Fannie Mae have come in for particular criticism as having caused unintended consequences that have made the economic crisis worse.

The U.S. stock market turned down in 2007, continued to fall gradually during the first three quarters of 2008, then turned sharply lower in October and November. All businesses have been affected by the recession but most of our portfolio companies are coping reasonably well with both the economic slowdown and the closing of credit markets. The stocks of our companies, on the other hand, have generally been weak and our Funds turned in full-year results in line with the S&P 500.

The dilemma we have faced all year is that while we have been quite pessimistic about the economy and near-term earnings prospects, we believe that stock prices have in many cases fallen much farther than business values. Hedge funds and mutual funds, faced with hundreds of billions in redemption requests, dumped stocks and bonds almost without regard to price. Hedge funds and investment banks were forced to sell additional hundreds of billions worth of securities to satisfy margin calls (demand for repayment of loans). By mid-November many stocks (including some of ours) had reached absurdly low prices.

On an historical note, at a time when the media makes regular references to the Great Depression and the bear market of the 1930’s, the Leuthold Group offers some interesting statistics. The average annual total return for the S&P 500 for the 10 years ended November 20, 2008 was -2.7%. This matches the worst 10-year performance in stock market history—1929-1939. So, we have just completed a 10-year period during which the stock market was just as bad as the 1929-39 market.

Also, according to Leuthold, roughly 5% of the ten-year periods since 1926, have produced S&P 500 returns of less than 1% per year for the ten years. Each of those flat-to-down markets was followed by a ten-year period of strong returns, ranging from 101% or 7.2% per year (Q4 1938 to Q4 1948) to 325% or 15.6% per year (Q3 1974 to Q3 1984).

We do not believe we face a full replay of the 1930’s, nor do we believe these numbers prove the market will not go lower. What they do show, though, is that the market has already discounted a very bad economy and that after previous very bad 10-year stretches in the stock market, the subsequent 10 years have been pretty good.

We believe our portfolios can earn very reasonable returns for us over the next few years from today’s price levels, but we will need patience and the courage of our convictions. We do not think it will work for investors to wait for the recession to pass and for an end to "uncertainty." As Warren Buffett said in his October New York Times Op Ed, "If you wait for the robins, spring will be over." (Incidentally, this is the reason that our analysts and portfolio managers have continued to add to our personal holdings of our funds.)

The table below shows returns for our Funds (after deducting fees and expenses) over various holding periods and returns for the S&P 500 (larger companies), the Russell 2000 (smaller companies) and the Nasdaq Composite (a proxy for technology companies).

Portfolio Review

The business landscape is changing. Our portfolios still contain many familiar names and our turnover remains relatively low, but our areas of focus have been evolving and the current cataclysm promises to bring further changes.

The financial services world is being completely reshaped by corporate and government responses to the credit/solvency crisis. Major companies have been allowed to fail (Lehman), forced to merge into stronger partners (Merrill Lynch, Wachovia), and essentially taken over by the government (AIG, Fannie Mae, Freddie Mac). The Fed, Treasury and FDIC have provided tens of billions of fresh capital and hundreds of billions of guarantees against losses on "troubled assets" to banks like Citibank and Bank of America. In return they have assumed authority to dictate dividend, compensation and lending policies. The major investment banks have either merged or converted themselves into commercial banks. They will likely be less leveraged, less glamorous and less profitable going forward.

We have made good profits over the years owning bank and savings and loan stocks. They earned reasonable returns, were sensible about credit risk, grew nicely and paid good dividends. They were not great businesses but their stocks periodically offered good trading opportunities. When the Fed raised interest rates, investors tended to blindly sell all their financial stocks. As long as operations were sound, we could buy when the Fed raised rates and sell when they lowered rates and investors wanted them back—often 50%-100% higher.

The recent bust in the mortgage market has exposed the weakness of the "originate and sell" business model. Lenders will probably use less leverage and retain at least some of the credit risk of the loans they make. They will also probably be more highly regulated and scrutinized. This will likely mean lower profits and slower growth although the survivors will face less competition. Strong banks that make good loans and understand what they are doing may still be good investments at the right price, but it may be some time before the credit, capital, regulatory and profitability questions are answered.

On the other hand, if capital is the scarce resource in the financial sector, companies with excess capital may be able to be more profitable than usual. Berkshire Hathaway is the ultimate beneficiary of this period of financial stress. Berkshire has huge amounts of available capital (and generates billions more internally every year) and it has Warren Buffett who is equally at home investing in public securities or entire businesses. Warren has made several investments over the past year that greatly enhance the value of the business—yet the stock is down about 40% from its recent high.

At the other end of the size spectrum from Berkshire Hathaway is Redwood Trust. Redwood has the expertise to invest in distressed mortgage securities and it does so without using borrowed money. It is a small company but has a very interesting opportunity because it has available capital when few others do.

We have also been partial to various kinds of media companies over the years. We have had profitable investments in newspapers, radio, television, cable TV, satellite, programming ("content") advertising agencies, and now Internet advertising (which has accelerated the decline of older media). As relative competitive positions have changed, we have tried to move to the "mature but still growing" companies rather than the "cutting edge" variety such as the late 1990’s "dot.com" startups.

Our current major positions in this area are cable distributors—Comcast (U.S.) and Liberty Global (Eastern and Western Europe and Japan), satellite—Liberty Media Entertainment (52% owner of DirectTV), and programming—Discovery and Liberty Interactive (QVC). We also own Washington Post whose Kaplan Education business is its most valuable asset, and News Corp. which is a combination of newspaper, TV, sports programming, satellite (UK, China and Italy) and Internet properties such as MySpace. The common denominators for all of these companies are (1) they generate lots of free cash flow and (2) we trust their managements to be completely realistic about their competitive positions and to allocate their free cash flow accordingly (wisely).

Energy, materials and agricultural products were categories that were noticeably absent from our portfolios during the multi-year bull market in "emerging market infrastructure" plays that ended abruptly last summer. Generally speaking, oil, gas, metals, fertilizer, etc. are capital intensive and producers have little control over their destinies since commodity prices are the primary determinant of profitability. Over very long periods of time, we think it is fair to say that these companies go through extended periods of low returns on invested capital and have occasional large "inventory profits" when the price of the commodity in question runs up sharply.

During the early 1980’s we owned oil stocks when oil prices were falling but oil stocks were so cheap that "drilling on Wall St." became popular and corporate raiders like Boone Pickens made takeover bids for several public energy companies. Now, some commodity prices appear to be lower than their marginal costs of production. When that happens, production is likely to be curtailed and prices should eventually rise. We make no pretense of being able to predict commodity prices, but if we can buy a company with current earnings adequate to support operations, debt service, dividends, etc. and have a "free option" on a rise in the value of the company’s commodity reserves, we may be interested. Shareholders will notice small positions in ConocoPhillips, XTO Energy, and a few other energy companies.

We also own meaningful positions in Martin Marietta Materials, Vulcan, and Eagle Materials. "Aggregates" (rock for use in concrete, asphalt, etc.) and cement are the most prosaic products imaginable. The demand for these materials is cyclical and each has suffered a decrease in demand as construction activity has declined. These are bulky, low-value materials with limited supplies and high transportation costs, so many mines and plants enjoy micro-market duopolies. As a result of favorable competitive positions, they tend to generate higher returns on capital and more reliable free cash flow than other raw materials companies. Their markets—and stocks—are depressed, but their long-term prospects are good. The promised boost in infrastructure spending may be positive for these companies, but we are not counting on this in our valuations.

Healthcare is another area in which change is an issue. Many healthcare stocks are depressed due to fears that a new administration will change the rules and somehow, while extending care to more people, make it less profitable for providers. Our two managed care companies, WellPoint and UnitedHealth Group, face some economic and competitive headwinds in 2009 and earnings may decline relative to 2008. However, as Dave Perkins discusses in the "Analyst Corner" later in this report, we believe that both of these companies will be able to cope with political change and a challenging economic environment. Omnicare, our other large healthcare investment, is an institutional pharmacy that is regaining its footing following substantial industry-wide reimbursement changes. The company’s outlook has improved and its core business remains relatively insulated from broader economic pressures. At less than 10 times (growing) free cash flow, we believe the stock is very attractive.

This is a controversial industry and even benign change can be disruptive and expensive. We believe that in the short run (1-3 years), our companies have strong market positions and will be able to generate strong cash flows. Longer term, they provide important services and have capabilities that will be needed regardless of the reimbursement regime. We expect change, but from today’s price levels, we believe these companies can provide very solid investment returns even if their operating environments look different five years from now.

The near-term economic outlook is awful, yet stock prices already reflect considerably lowered investor expectations. We expect alternate waves of optimism and pessimism over the next year or so. Surplus inventories of commercial and residential real estate must be absorbed and cause many to fear deflation. On the other hand, the trillions of dollars of government funds borrowed and spent/invested in stabilizing the financial system raise the specter of inflation. The bank capital that has been destroyed must be replaced before banks will be able to lend again, and they must regain confidence in the value of the collateral against which they are lending to be willing to lend again. Above all, individuals make the economy go, and when a critical mass of people believe that their personal worlds are not coming to an end and feel safe enough to consume and invest again, we can have a sustained recovery in the economy and the stock market.

We have no doubt that the country will be able to work its way through this dilemma, but it will take time. This will not be a year for the faint of heart, but it is quite possible that it could be a reasonable year for investors. We plan to be wary, patient, disciplined and opportunistic in pursuit of positive returns and we feel cautiously optimistic about the prospects for 2009.

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