ffg january 2000 forum finance group s.a global equity research investment perspectives 2000...

FFG

January 2000

FORUM FINANCE GROUP S.AG

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Investment Perspectives 2000 Investment Perspectives 2000

Copyright Forum Finance Group S.A.1

Contents

2000 OutlookOverview1999 A Brief ReviewA New World

or is inflation around the corner?

Economic OutlookUSAEuropeJapanEmerging Markets

Investment OutlookKey ThemesValuationDisruptive Technology Sector Analysis

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Advisor to ZT- Zurich Trust

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2000 Outlook Overview

• Key Themes: We have a positive outlook for the global economy in 2000 and

expect worldwide growth to recover to above the long term trend in the 4 to 4.5 % range.

We expect a global round of central bank tightening as fears of inflation mount during the first half of the year and the ECB looks to establish its credibility.

Synchronized global growth will cause an acceleration in inflation, however a myriad of factors will combine to offset inflation pressures to keep the increases modest.

Stock market performance should track earnings growth overall and while breadth will expand slightly to reflect the improved economic reality, it will remain weak and stock selection will be of the utmost importance.

We expect a continuation of 1999 trends with a renewed battle between growth and cyclical stocks. Given the expected performance of the global economy, deeper cyclical and global industrial stocks should outperform but technology sectors should re-establish their dominance by year end.

Volatility will continue to run high in 2000, and we expect a correction to take place in the early part of the year especially in the high P/E sectors as inflation fears emerge.

The continued strong performance of the US economy and perceived high returns of US stocks will offset the growing trade deficit to limit US dollar weakness for at least one more year, in our view.

The Euro will likely finish slightly higher than today as European growth picks up, while the Yen will weaken marginally as the Japanese government works hard to maintain levels conducive to continued economic expansion.

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1999 A Brief Review

1999 was an exceptional year in the high-tech sector, benefiting FFG clients in both technology and global balanced accounts. The time has however come to re-assess our positions and build the base of investment themes for the up-coming year.

1999 in review:

The year began on the heels of a fantastic market recovery following the LTCM/Russian debt induced crisis of October 1998. From the Dow industrial index to the technology laden NASDAQ US markets posted 30 to 60% gains in the twelve weeks following the early October lows. In Europe the recovery while present, was slightly less convincing as the European markets were hit harder on the downside and did not recover as quickly as their American counterparts.

This development surprised many, as the valuation of European markets was more reasonable than that of the US and a new confidence in EU earnings growth was developing. As it happened, the balance sheet risk of many European financial institutions were heavily exposed to emerging markets, and the enormous liquidity pushing the US markets on the upswing was absent from any European equity recovery. Their under-performance also came partly from the composition of the indices. Where the US market is heavily skewed towards growth and technology companies, most European indices have a more traditional “old economy” make up.

The year started off with a continued up move in early January to valuations that many judged untenable. As a result, almost all of the developed markets treaded water and did not see their January highs again until late March, driven by the outlook for growth. The Global economy was still on the mend, but was far from the ailing patient it was just six months before. By the end of the first quarter, consensus that growth would accelerate pushed cyclical stocks to new highs over a short three week period.

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A weak summer rally developed following the cyclical move, to bring stocks to new highs by mid summer. With the traditional summer rally under its belt, the market proceeded to fall off its highs well into September. All of the developed markets from Tokyo to Frankfurt displayed the same tendency, and as the turn of the century approached many wondered about the implications of the Y2K phenomenon.

Autumn brought both changing colours and a feeling that the world was more or less ready for Y2k. This renewed confidence unleashed a flood of money onto the markets, especially in the technology sector which rocketed up over 50% from October to the end of the year.

Throughout all of this, the market continued to provide little comfort to the majority of fund managers. Market breadth remained extremely poor all year. Performance was based upon the moves of a few stocks, over short periods of market movement. The world’s central banks, fearful of the inflation that rocketing oil prices and economic strength began to take back the rate cuts they made in the face of the Asian crisis in 1998. Valuations remained extremely high and the new “Dot Com” world confounded all but a few analysts. Those managers who had embraced the calls for value and the notion that rates would soon retreat to their low levels of 1998 paid a heavy price.

When all was said and done, Technology was once again the big winner for the year, as were some basic materials sectors (aluminum) and global industrial stocks. The European markets performed well, but dollar strength pushed the US returns ahead for the year. Interest rates moved higher, making it one of then first years on record where the average bond fund lost money for investors. And the equity market’s volatility continued; 80% of trading sessions saw the S&P 500 move 1% or more.

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A New World or is inflation around the

corner?

1999 was a year in which most believed that the multiyear bull market had probably run its course. The feeling was that while the market may post marginal gains, it would prove to be a difficult year. Productivity gains would slow, and while few predicted a recession, most were waiting for a slowdown that never materialized. The overwhelming view was for inflation to fall and for interest rates to continue their downward spiral.

Today, the majority are looking for moderate global growth and a potential slowdown in the US. Few however are on the lookout for wage pressures in the US and Europe, a slowing rate of productivity growth or inflation.

A greater inflation risk than ever before...

We believe that growth in 2000 will exceed expectations and that the risk to the inflation outlook is to the upside. At this time last year, we felt that an inevitable rise in prices was about to filter into the economy and that the risk on rates was more to the upside. As it turned out, oil prices shot up and interest rates broke the long down trend that had been in place.

This year we again feel that the consensus for no inflation is wrong. Even more so than before, this year brings with it a synchronization of global growth long missing from the equation. We firmly believe that this year will prove to be the test of the “new economic paradigm”.

Probably offset by a number of factors…

While we think that the risks to the consensus view is that inflation rears its ugly head, we believe that the world today has a number tools with which to keep price increases mitigated. Our view is that inflation returns to trend line growth (above consensus), but that this growth is tenable given the changed face of today’s global economy.

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Technology and the Internet are a big deal…

While we are not new paradigmers, for whom a new world order is permanently in place, we are of the opinion that the internet and the technological advances that go with it represent a disruption to the “old way” of doing business. These “disruptive technologies” are changing the way companies compete and are having a significant impact on the pecking order within industries that will have a lasting effect on the economy.

Combined with global access to human capital…

The globalization of the world’s economies, combined with increased technological prowess has made it possible for companies to source employees outside of their domestic market. This excess capacity in the global market has therefore alleviated a certain degree of pressure on the available domestic labor pool.

Increasing productivity and Reducing the impact on wages…

The B2B and B2C methods of distribution and acquisition are reducing costs, increasing productivity and adding new leverage to old business models. The effects have already been witnessed in the US. At a time when labor markets have never been tighter, wage inflation is non-existent with unit labor costs up 3.1% in 1999 just above the cycle lows of 2.7%.

While real wages are increasing, most of the rise has been offset by increased productivity (non-farm unit labor cost rise of 4.6% with productivity increases of 3.6% - translating to a real cost increase of only 1.5%).

Creating a virtuous circle of technology investments…

While this process will eventually run its course, it is clear that the advances being made today in the US are at an early stage. In addition this same phenomenon will be felt in Europe and eventually Japan before all is said and done. Management realizes that their next challenge will be to gain competitive advantage through technology investment. The increased spending in technology will maintain the inflation free growth we have witnessed to date.

With capacity Utilization on a global basis at low levels…

In addition to wage pressures, the potential during a synchronized global expansion for the output gap to decrease to unsustainable levels worries some.

Japan Capacity Utilization Rate

US Capacity Utilization Rate

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The current situation however shows that capacity utilization levels are at relatively low levels. The US has not seen such levels since the mid 80;s and Japan is currently operating at a 30 year low while restructuring in Europe has left large amounts of capacity available.

And commodity prices well off their highs…

While commodity prices have risen with the price of oil this year, they are still significantly off of their pre-Asian crisis levels, while gold has resumed its downtrend. Oil prices have more than doubled since the end of 1998 and are hovering at their highest levels since 1995 (ex-gulf war spike). While some continued upside pressure does exist (stemming mostly from OPEC political risk) the most likely direction of oil prices appears to be down side, as Venezuela faces a domestic crisis and current heating oil demand will pass as the unseasonably cold weather subsides. And while we think oil prices will not move higher, we do believe that global recovery will be enough to sustain prices at a reasonable price. Such an outlook however precludes the type of price increases (and thus commodity/input price inflation) which we saw in 1999.

And interest rates have already returned to their pre-Asian crisis levels…

With interest rates already relatively high any upward bias will be carefully implemented. While the ECB will be quick to establish their credibility, they will do so with an eye to not breaking the momentum in the European economic recovery. The federal reserve can be expected to continue its upward bias to rates at least until mid year given that consumer and business confidence (in the US and Europe) are running near all time highs and look set to continue.

Combined will likely work to keep inflation at manageable levels for at least another year…

Our belief then is that a combination of the following factors:

Technological InnovationGlobalized Human ResourcesProductivity IncreasesLow Capacity UtilizationSlowing Commodity price gainsRising Interest rates

will work to minimize the risk in the near term. Longer term however, as the gains from productivity and technological innovation begin to plateau, the situation may get more serious. For this reason we remain vigilant in our outlook for inflation, while cognizant of the effects of the current technological revolution..

Commodity Price Index

US Long Bond Rate

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Economic OutlookUSA

• Key Themes:

US economic expansion continues strongly, however rate increases and the Y2k inventory build may contribute to slight slowdown early in the year.

Technology based productivity keeps inflation rates at bay, although the upward pressure on prices accelerates.

Commodity prices rise slightly, while oil prices touch highs early in the year, before stabilizing at lower levels

The long bond in the US rises to 7% in the first half of the year

Synchronized global growth and continued prosperity cause the Fed to tighten monetary conditions.

Capital investment continues to trend higher and technology is the main beneficiary.

Presidential elections, true to tradition contribute to another positive year for the markets and an extension to the already un-matched bull market run.

Elimination of pooling method of accounting sparks final major run in M&A activity. (2000 may go down as the year of the mega-merger).

NASDAQ Vs. S &P 500 - 1999

1999 Stock Index Performance*

DOW JONES 25.21%

S&P 500 19.53%

NASDAQ 85.59%

*in local currency

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Something funny happened on the way to a slowdown in the US economy, it didn’t happen. While everyone applied what goes up must come down economics to their analysis, the world’s largest economy quietly went about its business. All indications point to another excellent year of economic growth in the US, with some minor signs of a slowdown in a few select areas.

The yield curve has undergone significant steepening…

Since last year at this time and since even just one month ago, the yield curve has steepened indicating a bond market that expects economic growth. Even with short term yields on the rise given the markets expectation of a short term rate hike, the 3mth to ten year part of the curve has priced in healthy growth for the US.

With a falling Corporate/Government spread…

The spread between ten year government issues and comparable corporate bonds has fallen significantly. This gives an indication that investors are willing to take on corporate risk in an environment where they think profits are likely to improve across the board.

And a positive outlook for capital spending…

Now that the Y2K budgeting is complete, most companies will be free to concentrate their efforts on increasing their competitiveness through technology investment. We expect 2000 to be a good year for companies which can provide a competitive edge to their customers.

With consumer confidence at near record highs…

While the high levels of current consumer confidence may give some reason to pause, the future outlook of consumers remains bright. The 12 month consumer expectations index has just put two months of increases together after going sideways for most of 1999.

US Corporate Spread

US Yield curve Shift Dec 1998 - Dec 1999

US Consumer Confidence

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Makes for positive growth, where inflation accelerates, but remains manageable...

Taken together, there appear to be a number of factors to support the notion of strong growth continuing in to 2000. Combined with some of the global and technological factors of which we spoke in the overview section (Globalization, technology, capacity utilization, commodity pricing etc.) a likely early year rate hike, along with a dampened mortgage environment will work to keep inflation at bay. These factors among others should provide the economy with the impetus to continue growing at above trend rates for at least the next 12 to 18 months.

And make 2000 a positive year for technology and cyclical stocks.

The early part of the year is likely to see some inflation talk and potential rate hikes thus putting some pressure on high PE sectors. Once the inflation fear is eliminated however, these sectors should provide the leadership which we saw for much of the last four years. In addition, the acceleration in the global economy should bode well for cyclical US companies operating abroad, as well as commodity based cyclicals who will likely benefit from the stabilization of commodity prices over the coming year.

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Europe

• Key Themes

Economic expansion picks up speed, thanks in part to 1999’s Euro weakness.

Risk in inflation is to the upside as structural friction in European labor markets and potential oil price pressure seep through.

Rates rise in the early part of the year, both to combat inflation and establish ECB reputation.

Internet development accelerates to a new level and becomes the key technology investment on the continent.

Capital spending increases slightly, with significant gains in technology.

Consumer confidence remains high, and equity market awareness continues to grow.

Under performing markets Switzerland and Germany outperform Euroland on strong moves in industrial, commodity and Pharmaceutical stocks.

German tax reform represents a significant milestone for German and European politics.

Euro strengthens over the year as economic growth closes some of the gap on the US.


CAC 40 51.12%

SMI 5.71%

DAX 39.06%

FTSE 17.81%

*in local currency

CAC, SMI, DAX 1999

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We believe that 2000 will be a year of strong growth in the European core. We see little reason in the immediate for the economies of the continent to deviate from these expectations. That said, 2000 could be the catch up year for those markets which underperformed in 1999.

Switzerland was a relative under-performer…

Due to the more cyclical and pharmaceutical make of these indices, they tended to underperform their Euro-land counterparts. Given the cyclical rebound currently underway and the depressed state of pharmaceutical valuations we would expect this underperformance to decrease.

Where spread and yield curve analysis points to growth…

Much like the US, the yield curve in the EU has steepened significantly since this time last year and over the past month. In addition, corporate spreads have come down substantially, and nearly every nation has increased its outlook for growth.

Which bodes well for profit growth and cyclical expansion…

This year profits in Europe are expected to grow at 12-14% outpacing those in the US which is particularly impressive given this year’s difficult comparisons. Growth has been aided by a weakened Euro, which has placed select cyclical and industrial stocks improved competitive positions.

And may finally mark the end of falling employment…

The employment outlook in Europe and especially in France and Germany is starting to look good. Such a development will leave many consumers happier to spend and signal a move back into consumer stocks in Germany.

Yield Curve Dec.98 Vs. Dec. 99

Euro Vs. Dollar

European 10 yr. Rates

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And justify the need for further restructuring and consolidation in EU industry…

The restructuring process in the EU, which we have focused on for a number of years, is now truly beginning to bear fruit. The rate of change in EU industry should continue to accelerate and will be driven even faster by technological innovation on the continent. Recent developments in the M&A arena (i.e.. Vodaphone’s hostile takeover attempt of Mannesman) as well as accelerated trends in capital investment should work to further strengthen the quality of EU businesses and capital markets.

Which will help to sustain high consumer and business confidence…

Both current and future measures of confidence indicate a positive environment for business in Europe in 2000. With order books at near record levels industrial growth in the European core is set to accelerate in 2000. Coupled with improved outlooks for both capital investment and hiring indices this should provide support to consumer confidence levels over at least the next 12 months.

Euro Order Book Growth

Consumer Confidence Future Outlook - Europe

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Japan

• Key Themes

Economic growth continues to better estimates, although still a far cry from the rest of the world.

Unemployment bottoms in 2000 setting the stage finally for a consumer led recovery in 2001.

Capital spending by corporations finally bottoms led by the growth of technology investments.

Narrow focus of market expands slightly to include some cyclical and consumer stocks, while technology, communications and restructuring companies remain popular.


Nikkei 36.79%

Topix 58.44%

*in local currency

Nikkei 1999

Nikkei 10yr Chart

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1999 was a significant year for the Japanese economy and markets. After nine years of decline, the Nikkei 225 rose almost 76% on the year and the economy appeared to have solidified. Our view at the beginning of the year was that three driving forces would define the year. Massive government spending would support capital investment, while corporate restructuring would rationalize company balance sheets and a genuine move towards change would take hold. This is exactly what happened and it has laid the groundwork for continued economic prosperity in the country.

A very Narrow Market recovery...

So where to from here? The Japanese economic recovery has been marked by very narrow financial markets focused on restructuring, financials and technology.

With little domestic support…

Almost 70% of net buying in Japan in 1999 came from US investors looking to diversify out of dollar holdings. The key for 2000 will be the support of domestic investors, as large fixed term postal savings deposits come to term in 2000 (¥58trn) and 2001 (¥58trn), and may be redirected into the market for higher returns.

Where restructuring continues to bring down employment…

We expect unemployment to continue to worsen in 2000, although it is likely that the bottom will be found some time this year. As the restructuring push gains momentum (and it will) downsizing will increase and jobs will be lost. We remain confident however that in the end this rationalization will create a lean and mean Japanese industrial machine.

Weighing heavy on the minds of consumers…

But as we see the light at the end of the tunnel, consumption should start to rebound, and as markets tend to anticipate such rebounds, we would expect retailing sectors in Japan to show relative strength.

But a rebound in corporate earnings may bode well for capital investment ….

This year the non-manufacturing portion of Japanese earnings increases over 11% and earnings growth looks to be solid for 2000. Many companies are flush with cash (having spun off businesses) and are likely to reinvest that money with a focus on technology spending, which has suffered enormously during the nine year recession. We think that capital investment may be bottoming.

Which may result in a slightly broader market…

While the markets will likely remain focused on technology and restructuring, we feel that some potential exists for value adding industrials and consumer stocks, thus a slightly broader market in 2000 than experienced in 1999.

Unemployment - Japan

Capex - Japan

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Emerging Markets

• Key Themes

Currency devaluation unlikely in Brazil and China

SE Asian markets provide much less upside potential in 2000 as “easy” money has been made

Capital spending in technology - most notably telecommunications drives the economies

Demand returns to pre-crisis levels, and provides potential upside to global consumer stocks


Brazil 151.93%

Korea 82.78%

Indonesia 70.06%

*in local currency

Brazil, Korea, Indonesia Mkt Indices 1999

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•Key Themes

Capital Investment & Restructuring: Global industrial recovery favours global

companies as well as European and Japanese cyclical companies where economies are accelerating.

Synchronized Global Recovery: Synchronized global growth should return global

consumer brand names to strong growth, and support continued move in luxury brands. Financials with global reach should also benefit.

Technology, & Life Sciences Growth: Capital Investment continues to favour

technology/Internet development. Aging population and medical technology

advances spur life sciences growth.

Commodity Price Recovery: Supply/Demand situation supports price rises in

many basic materials.

Investment Outlook

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Valuation

Europe looks good...

The market movements of the past few months have pushed valuations to seemingly untenable levels. From New York to Paris, income, asset and cash flow based valuations have been stretched to their limits.

In an environment of rising rates such valuations put the near term outlook for the markets at risk. We feel that while the mid to long term outlook remains positive, market performance over the near term is less clear.

What is clear is that outside of the US GDP and earnings growth estimates are on the rise. Europe and Japan should enjoy accelerating earnings growth as we move through 2000. In Europe the German market appears to be the most undervalued, with significant earnings growth acceleration and at the lower end of valuations.

While the US earnings growth is slowing...

After the two years of crisis (1997 - Asia, 1998 - LTCM/Russia), many US companies had very easy comparisons in 1999. In 2000, the comparisons are more difficult and although above trend line growth looks set to continue, we are wary of the potential for earnings disappointments in some sectors - technology and money center banks come to mind.

Therefore we feel that growth in the US market remain very selective, and it will be necessary to focus on stocks where earnings growth is accelerating, not slowing, and where top line revenues remain solid. High debt and low cash earnings would also be of concern in a high interest rate slowing revenue environment.

And Japanese restructuring is starting to pay off….

Japanese companies after a nine year slump, have finally begun to realize significant operating earnings growth, and in 2000 it will accelerate. Valuations in this market are difficult to compare, since PE’s are still very high given nascent stage of growth in most corporations

Making for solid foundations for positive performance in 2000…

While our near term outlook based upon current price levels is negative, over the remainder of the year, earnings growth should act as a support to valuations.

2000 EPS GrowthPE ‘99 ‘00

Europe 25x 15% 16%

France 26 22 20Germany 23 15 21UK 23 7 12Switz. 29 15 12Sweden 29 24 23

Japan na 13 16

USA 24 17 12

Est. from Morgan Stanley Dean Witter research

Regional valuations

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Sector Valuation

Where are the profits?

2000 represents a significant change from years past, as basic materials and energy sectors represent the highest potential growth areas for the year. As usual technology remains among the top three, and remains in a secular growth phase which has a number of years yet to run. The high marks for the outlook of cyclical stocks underlines the market’s expectations for a global recovery.

In terms of valuations, the chart bottom left shows the current and historic valuation levels by industry sector in the US S&P index. It is clear that the run from Q3 1999 in the cyclical sectors of energy and basic materials, has priced some of their growth in, although the basic materials sector is still undervalued based upon historic levels. Also, financial, healthcare and consumer staples (global consumer names, defensives) appear undervalued based upon historicals, although a case can be made for the pharma stocks given the slowing of earnings growth from past levels.

Valuations in Europe, while slightly higher due to accounting reasons, represent similar valuation levels in most sectors. However, the levels of restructuring, M&A activity and potential for earnings growth, make a focus on non-US companies an important one for the upcoming year.

Given our economic outlook and earnings growth analysis, we will continue last year’s focus upon technology, global industrials, oil services and to a more selective degree pharmaceuticals, financials and consumer cyclical names. This year we are shifting focus back to global consumer branded names (an undervalued sector in our view), as well an increased focus on basic materials, notably chemicals and some commodity plays.

The key to our stock selection remains our focus on our five vector analysis of management, focus, innovation, leadership and fundamentals, with as mentioned an increased focus on innovation and the use of modern technology to improve business processes.

Growth expectations by Sector

%Energy 33Basic Materials 33Technology 31Transportation 26Consumer Services 18Telecomm 16Healthcare 14Capital Goods 13Consumer Noncyclicals 13Finance 11Utilities 10Consumer Durables 4

*I/B/E/S Estimates for 1999/2000

Valuation by Sector

Sector 1999 4yrPE Avg

Energy 32 29Basic Mat. 25 27Technology 36 32Transportation 15 16Consumer Srvc. 30 25Telecoms 30 30Healthcare 31 35Capital Goods 26 26Consumer Stpl. 30 34Finance 15 17Utilities 15 17Consumer Dur. 22 20

*Bloomberg L.P., based upon current year’s earnings

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Disruptive Technology*An Analytical Tool

The Theory:

Disruptive technologies -- those products, processes, and services that threaten and often prove fatal to established industry players -- can arise in any market. Throughout history society has been forced to deal with their consequences, good and bad.

A recurring event...

Most often the established leaders in their field are caught flat footed by these events, and find themselves swallowed up by their smaller more nimble competition. Little did the church (once the master of all print) realize that the Guttenburg press would remove their monopoly on information. The horse drawn carriage industry was instantly destroyed with the advent of the automobile. Television had substantial impact on radio and newsprint and the personal computer nearly put IBM out of business.

Which has accelerated...

Over the last century, we have been witness to probably the fastest growth in innovative technology that the world has ever seen. And today we are privy to perhaps the most widespread, pervasive force of change we have ever seen: the Internet. While the technology world produces many disruption applications that have liitle to do with the Internet, no other innovation has cast such a wide net, affecting business, politics and society alike.

So what is it?

Its tentacles reach out across borders, race, religion, industry, companies. It has the power to transform culture and business alike and has thus far proved to be a solution looking for problems.

A Global Mainframe...

Less than 40 years ago IBM created the first main frame computer which revolutionized the way companies worked. It made relevant information available in greater quantity, more frequently, at greater speed and to more people within the company than ever before. It was a data processing and transmission revolution for business.

Much like those 360 series mainframes, the Internet is acts as a giant computer which provides data collection, processing and transmission at ever rising speeds to an unlimited number of users worldwide.

Not all innovation is disruptive*. Some such as just in time inventories, disk drive I/O speeds, or credit card technology simply sustain improvements in customer services, thus increasing the advantage of incumbent market participants.

Disruptive technology* however, often completely eliminates the advantage of incumbency, transforming or eliminating whole industries and often creating new ones where none existed. Some more recent examples include:

•Automobile•Telephone•mini-mill steel factories•Discount retailing Semiconductors•Wireless communication•Managed Care (HMO’s)•Internet retailing•Internet brokerage•On-line supply chain-management•Web Hosting•Online advertising•Web caching

*See: The Innovator's Dilemma: When New Technologies Cause Great Firms to Fail,Clayton Christensen, Boston, MA: Harvard Business School Press, 1997.

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A communication revolution...

In the most basic terms, the internet is the technological or structural basis upon which mankind is revolutionizing communications. By communications we mean all the ways in which people, companies and machines exchange information. It allows you to check a train schedule without phoning and being put on hold. It allows companies to automate their production and purchase functions by allowing purchasing, production and supplier to communicate automatically through an established network.

Which can be a tool to increase efficiencies...

In some cases the Internet will transform industry, while in many others it will simply serve as a means to increase productivity and lower costs. Harnessing this medium allows companies to streamline operations and increase margins through automation and increased customer reach.

Or the basis for future growth...

Many CEO’s at established companies have started to take notice. Not enough. Those companies who refuse to harness it as a productive toll will slowly wither away. The internet will be transformed from a novel addition to a core part of every company’s sales, service, purchasing, personnel, accounting process and everything in between. It will become a staple, just as having a shopping mall without a parking lot, so will running a company without the Internet.

Whose costs may be hidden...

Up to now the cost of the build out has been borne for the most part by the investor and venture capitalist community. The ground breaking pricing that we have seen on many sites is thanks in part to a healthy subsidy from the venture capital community. The infrastructure costs in most pure play dot.coms is therefore not fully reflected in their pricing. It will be interesting to see the fallout when the cost of such build outs make their way to the consumer.

Posing questions for investors…

So what does this mean for today’s investor? For us it means a vigilant watch over innovation. Where are new industries being developed? old ones broken down? What is the life cycle of the current disruption? Who stands to benefit and which established companies are making the move to transform? In today’s high paced environment, this can be an almost impossible task but a number of shifts are taking place which may be leaving some companies behind.

While we are tremendously optimistic on the long term implications of the internet, we are skeptical of some of the claims and prediction that some are making.

As with every such phenomenon many oracles have likely misjudged the future of this communications revolution.

We are wary of some of the claims made in regard to pure play companies, and the notion of absolute cost savings of some companies.

Up to now the cost of the build out has been borne for the most part by the investor and venture capitalist community. It will be interesting to see the fallout when the cost of such buildouts make their way to the consumer.

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Forcing them to consider a new criteria…

As part of our research for the coming year, emphasis will as always be placed upon our five criteria approach, however all of our analysis will take into account a new sixth criteria: Disruptive technology.

With a focus on companies prepared for the disruption …

But with a heavy concentration on innovation in the area of the internet. The upcoming year will undoubtedly be marked by a number of key themes. For the astute investor, however, the common theme amongst almost all companies should be their internet strategy and use of new technologies as a competitive tool.

We would be especially wary of companies in the financial, retail, distribution, business services, supply chain and media industries with unclear or non-existent internet strategies. These industries are currently undergoing drastic change and their competitive landscapes will be very different than they are now in a few year’s time.

While keeping in mind the limits to growth...

Where are we going with many of these developments? In general disruptive technologies have a massive impact on industry over a relatively short period. Competitive advantage is taken and high margins are enjoyed for the early movers. The investor must however be aware that once entrenched, the acceleration brought about by the innovation/disruption will slow, and trend line growth will return.

While many Disruptive technologies are industry specific, the internet and the communications revolution that goes with it cut across many industries.

From supply chain management to golf tee off reservations this tool creates industries and helps cut costs, improve service and increase margins for companies in varied industries.

It has been estimate that a simple internet based procurement strategy can increase net margins by over 300 basis points for traditional business. This type of leverage is possible across all divisions of many companies. Passed on to customers, the pricing advantage enjoyed by companies implementing such strategies can create significant market share gains.

ManagementManagement

InnovationInnovation

FundamentalsFundamentals

FocusFocus LeadershipLeadershipDisruptive Disruptive TechnologyTechnology

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We mention this due to the euphoria concerning a number of disruptive technologies as currently reflected in the stock markets.

And keeping a skeptical eye on the long term...

In the telecommunications equipment sector the broadband issue has enjoyed significant coverage. From DSL, to Cable and Fiber Optics every company is attempting to reach the web surfer and provide fast service. While our clients and technology fund are riding this wave of growth, we are open to the notion that only so much fiber can go into the ground, and as with all such things companies tend to build out too much rather than too little. When the day comes that fiber or copper or broadband over-capacity exists, it will be too late to sell. We think that the current build out will continue over the next five years, but at that point, the top line growth rate assumptions for most of these suppliers (Lucent, Cisco, Nortel etc.) will revert to trend line growth of 3-5%.

Such a statement may sound like heresy to some, but all markets eventually mature or are eliminated through some form of disruptive technology. As investment managers it is our job to ride the wave when as it rises. We must at all time however keep a close eye on the future to catch the next wave when it comes.

Allowing only the strong to survive…

In our view a classic business to consumer business is built upon three foundations, service to client, products to client (Distribution) and Trust of client (Brand, Loyalty). Regardless of the outcome of the technology, companies that can harness these three factors will win in the end. Today, the pure play internet company has the advantage of cost on his side. Once volume and infrastructure costs are factored in, the brick and mortar retailer with a viable internet strategy should come out on top.

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Sector Analysis: Technology

Our Sector Choice and Focus List:

We will continue to focus on technology stocks with an emphasis on application software, wireless communications, broadband networking, internet infrastructure & services, and cyclical semiconductor plays as well as a small exposure to select computer makers. While 1999 was another year of significant technology out-performance, we see little reason to doubt the underlying fundamentals of the group.

Broadband Networking:

We used to split this sector into three parts communication semiconductors, telecom equipment and networking equipment. The long awaited convergence in this sector has now more or less arrived and most companies vie for both networking and telecom business at the same time. The internet is now an established phenomenon, and the next move for service providers and enterprise is to increase speed and reach as many customers as possible. This sector will continue to enjoy significant earnings growth, until the broadband build-out is complete, which will not take place for at least five years.

Focus Stocks: Cisco, Nortel, Lucent, Broadcom, JDS Uniphase, Juniper Networks

Software

1999 was the year of the Y2K upgrade, while 2000 and beyond will be the years of application development and internet build out. With this in mind we focus on productivity enhancing software, coupled with internet enablement. While the internet infrastructure build out has been largely a hardware issue, going forward the need for application specific software will become more and more important. Competitive pressures will force companies to more efficiently put to use the equipment which they have installed. We believe that this will have a positive impact on software over the next few years.

Focus Stocks: Microsoft, Oracle, SAP, Citrix, Miracle Software

Why Technology:

•Economic Growth•Competitive Pressures•Capital Investment acceleration

•Solid EPS Growth

Focus on:

•Software•Internet/Computer Services

•Internet Infrastructure

•Wireless•Broadband Communications

•Semiconductors

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Internet: Infrastructure

These stocks, (although they have risen past any even modestly reasonable levels) represent the future of the information technology world. The internet build-out is far from complete, and the companies that make up the backbone of this new tool will continue to benefit

Focus Stocks : AOL, Sun Microsystems, EMC, Exodus, Digex, InktomiCovad communications, Fujitsu, Sony

Internet: Service

As more and more companies build out their web based services/operations, demand for web development consulting and maintenance will grow. We can already see that demand in most cases is far outstripping supply, with only a relatively small percentage of companies with a meaningful web presence.

Focus Stocks: Razorfish, Icon Media Labs, Framfab, Xceed

Wireless communications:

At one time wireless applications represented a small part of the technology world. Today wireless handset volume has reached over 300 million, and is now estimated to grow to over 1 bln within three years. We focus on three sectors semiconductors, wireless devices and wireless infrastructure.

Focus Stocks: ST Microelectronics, Texas Instruments, AnalogueDevices, Nokia, Ericsson, Kyocera

Semiconductors and equipment (the non-communication/networking) are even further down the food chain, and are the engine behind computers, wireless phones, faxes, etc. They also benefit from all of the forces driving their “parent” industries. They are not however a 100% secular growth story. While the industries that it feeds are, semiconductors is probably one of the most cyclical industries in existence. The dynamics of supply and demand, today are such that we are entering the beginning of a cyclical upturn. Capacity spending, turned completely off since the end of 1997, is now falling quickly behind. As demand picks up, so will capacity utilization and then prices. Once this happens are rash of new development plans will emerge and the industry will again be moving full bore.

Focus Stocks: Intel, Micron technology, Applied Materials, ASM Lithography

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Computers:

These stocks, be they enterprise, lap top or home computing benefit directly and indirectly from all of the effects of the internet. Without computers, none of the “stuff” that everyone else sells will work! They have long run unit sales growth between 10-18% every year, and obsolescence ensures that 25% of them must be replaced annually. We focus only on two stocks in this sector, both of which possess a unique method of branding and/or distribution.

Focus Stocks: Dell, Apple

Telecommunications:

The internet revolution is transforming the way in which we communicate and it is having an enormous impact on the business of telecommunications. Three areas of growth will drive the business of today’s telecommunications companies: wireless, data, broadband service. In addition consolidation in what is currently an extremely fragmented industry is likely to continue. We focus on companies with significant exposure to data and wireless and those where M&A activity could bring significant advantage.

Focus Stocks: Covad Communications, Equant, Telefonica, Worldcom, NTT

Life Sciences

Pharmaceuticals/biotech/Medical Device

While we like the sector, the environment for pharmaceuticals remains a difficult one. The secular growth fundamentals remain the same, but medium term challenges lie ahead. With earnings growth slowing slightly, and potential for adverse political developments in the US we will focus our investments on stocks where earnings growth is accelerating and product pipelines are expanding (with little patent expiry risk).

Focus Stocks: Aventis, Roche, Warner Lambert, Medtronic, Biogen, Ares Serono

Why Life Sciences:

•Stable Earnings•Aging population•Technology enhanced productivity

•Consolidation potential•Genome advances creating new product cycle in biotech

Focus on:

•Cash rich Pharma•Mid sized take out targets

•Accelerating EPS•Limited patent Expiry•Biotech

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Financials. We have always had exposure to the financial sectors, this year given the expected inflation environment we are being slightly more focused. Those financials who are capable of benefiting from global growth such as global money center banks and companies likely to benefit from the increasing market activity in M&A and IPO activity, especially in Europe. In addition, those financial institutions capable of leveraging their business through the technology and the internet rate high on our list.

Focus Stocks: Merrill Lynch, Citibank, Credit Suisse, Charles Schwab, Zurich Allied, Nomura

Why Financials:

•Global Economic Growth

•M&A activity•Regulatory changes•Emerging market recovery

Focus on:

•Internet Strategy•Global reach•M&A business (brokers)•Insurance (Glass Steagal)

Financials

Consumer

Consumer Non-Durables (Global Brands, Distribution)

These companies have traditionally shown steady growth of over 10% in EPS per year, while displaying the capacity to expand internationally. They are often characterized as consumer non-cyclical industries and enjoy a steady demand for their products. The best of these companies are able to grow earnings at a faster rate than sales and outperforms the markets during recessions (slightly defensive). Some of these companies - the global consumer brands - have been hard hit by the emerging market crisis, and look poised to make a comeback based upon increasingly positive fundamentals. Their earnings are linked to growth internationally and this year we expect emerging markets, Europe and Japan to experience accelerating GDP growth. Names such as Carrefour, Nestle and Danone will benefit from increasing consumer confidence and potential margin expansion as pricing power returns to a limited degree.

Focus Stocks: Carrefour, Macdonald's, Danone, Coca Cola, Gilette

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Consumer Cyclical:

These companies represent the consumer side of the cycle. They can de classified as non-essentials (i.e. movies, luxury goods, travel), and consumer durables.

Non-essentials/services. This group proved to be a winner in 1999 as luxury products companies rebounded smartly in face of the Asian recovery. In addition, our picks in the consumer cyclical department and discount retailers proved very profitable. This year we will focus our attention again on European consumption, with a view to those companies with viable internet strategies. We will also focus upon the European Media and advertising sectors in an effort to benefit from the coming internet growth on the continent. Finally, we believe that the growth experienced in Asia will continue and our luxury group core holdings will prove to be profitable again in 2000.

Focus Stocks: LVMH, Disney, Canal Plus, Club Med, Publicis, Peugot, Publigroup

Consumer Retail/distribution

1999 was a record year for consumer confidence and spending, however many retailers performed poorly throughout the year. The impact that the internet had on their business was negligible compared to that which the market thinks is in store for them. Given our views of the internet retailing world, where the brick and mortar companies with viable internet strategies and loyal consumer base will come out on top, we focus on the following companies. They enjoy significant name brand recognition, have significant distribution capacity model and a viable internet strategy.

Focus Stocks: Walmart, Federated Department Stores, Pinault Primtemps, The Gap, Metro AG

Why Consumer:

•Synchronized global economic Growth

•European acceleration•Positive correlation to inflation (pricing power)

•Positive correlation to rising incomes

•Emerging market recovery

•Historic Valuation discount

•Internet

Focus on:

•Internet strategy•European consumption•Luxury•Global Brands•Global Reach in distribution

•Media & Advertising

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Cyclical Industry

Infrastructure:

Our decision last year to overweight this sector paid off handsomely. In addition, our focus companies continued to invest in the emerging economies during the crisis. Now as government spending on capital development projects in these regions increases, it could mean big business for cement, engineering, turbines etc. Order books in Europe especially are growing and indications are that many government capital spending programs are back on track. As growth returns to these companies, their record valuation discount should shrink. We focus on companies which either have a dominant position in their industry or who have successfully transitioned their business to the value added services model.

Focus Stocks: ABB, Holderbank, General Electric

Energy

We have long held fast to the oil services and energy sector in general. This year it will finally pay off. With Asia and Japan on the upswing and oil prices set to stabilize above $20 per barrel, the outlook for refiners and oil services companies looks bright. We look to the large cap oil producers who will benefit both from rising process and increased global demand, as well as exploration services companies whose business should pick up in the later part of 2000.

Focus Stocks: Royal Dutch, Total, Schlumberger, Haliburton

Chemicals

As with most of the basic materials stocks, chemical companies have moved quickly over the past few months to much higher valuations. We think that there is much potential in the group which is defined by three factors. They are cyclical, hence the overall economic growth rate is key to their stock price appreciation. Secondly they are very dependent on the price of their inputs which for the most part is derived from oil, hence the

Why Cyclicals:

•Synchronized Global Growth

•Basic Material price increases•Emerging market recovery•Oil price recovery•Increased oil E&P activity (benefits services, engineering & construction firms)•Capital Investment acceleration

•Solid EPS Growth

Focus on:

•Infrastructure•Energy•Basic Materials•Value Added Chemicals

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price of oil is negatively correlated to their performance. Finally, these companies are extremely sensitive to the pricing power of their clients and they often find themselves squeezed between increasing oil prices and inelastic finished product prices. After two years of increasing input pricing, things are looking to stabilize in 2000. We therefore would tend to focus our chemical plays to those stocks which have exposure outside of the commodity chemicals sector, which provide value added products.

Focus Stocks: Dupont, Kaneka, Akzo Nobel, Rhodia, Clariant

Basic Materials

Our economic outlook assumes global synchronized growth and a modest amount of price inflation. While not all commodity prices will enjoy stability, some of the basic materials pricing should get better in 2000. We look for a slight improvement in aluminum pricing and a positive outlook for steel and some specialty capital goods companies.

Focus Stocks: Sandvik, Thyssen Krupp, Bethlehem Steel, Alcoa

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