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I am thinking of changing formats for the daily market wrap from 12-14 pages of mostly news, reports, earnings and some commentary. I am considering changing it to a shorter piece that is filled with 2 or 3 lessons about what is happening and why. The lessons will be focused on how we look at stocks but not limited to just the news. I believe that we can add occasional pieces on estate planning, taxes, mortgages, and more. Seriously I need some feedback on today’s market wrap so that we can decide what to craft in the future. Please send comments to [e-mail] . . .let me know if you want the old daily market wrap or something new like this.

Today’s Lesson Plan

#1 Shooting Holes in Stocks
#2 Portfolio Diversification
#3 Analyzing Semi’s
#4 What is happening to REITs

Lesson #1
Shooting Holes in Stocks
Most investor’s know why they like a company but few have a case on what might go wrong or when to turn negative on a company. Having a plan to sell is as important as having a plan to buy.

While Sun currently enjoys a dominant position in UNIX servers, the market is concerned that Wintel and Lintel servers with superior price/performance are likely to take share from low-end Sun servers for "edge-of-the-network" and even some application tier workloads in coming years. While Sun recently introduced a line of low-end Lintel, SPARC and Solaris-on-X86 servers in order to boost its relative value proposition at the low-end, these new servers are likely to dilute margins and, unless net incremental to gross profit dollars, de-lever the company on relatively fixed proprietary microprocessor R&D spending. Sun derives 45% of total revenue from the telecom and financial services verticals in which demand remains relatively weak. Should these factors have a greater impact on the company than anticipated, analysts targets might not prove to be conservative enough. Similarly, should factors turn more positive than anticipated, the stock could continue to trade above target prices.

Additionally, if Unix server demand proves stronger than we currently expect (especially in Sun's key verticals such as telecommunications and financial services), the SCO/IBM lawsuit significantly affects new Linux deployments, Sun's new software strategy performs better than we expect, or the market migration to Intel architecture takes longer than expects, the shares could materially outperform our target.

Sun Microsystems is speculative due primarily to the relative lack of scale discussed above, the recent divergence between growth in revenue and growth in costs and very low historical predictability of earnings. Given Sun's $5.5 billion in cash and investments, just $1.2 billion in debt and significant opportunities for more efficient working capital management, do not view liquidity as a significant near-term issue.

Lesson #2
Portfolio Diversification.

Many investors fall in love with the large cap names like Intel, Citigroup, Microsoft, Dell, Pfizer, etc . . . Investors buy these names as they feel the most comfortable with them. I don’t want you to not buy these names but I want you to get some balance into some other styles and sizes as what works on Wall Street this year may not work next year..

* Both large-caps and small-caps have delivered total annualized returns just above 13% over the past 25 years.

* Slightly more than 600 bps of this return is due to EPS growth, 200–300 bps is from dividend yield, and the rest — about 400 bps per year — comes from multiple expansion.

* Since 1978, growth has beaten value in terms of large-cap EPS growth, but, strangely, value has won in small-caps.

* In terms of EPS growth, small-cap value has nicely outpaced large-cap value (7.0% versus 5.4%), but small-cap growth has lagged large-cap growth (5.0% versus 6.5%).

* Expect long-term EPS growth of 600 bps per year, but a lower dividend yield and the end of multiple expansion would hold back total returns.

* Also expect small-cap EPS growth to outpace large-caps by 150–200 bps in both growth and value over the longer term, which is in line with very long-term returns, but has not been seen (except in value) since 1978.

Over a very long period— i.e., since 1925 —small caps appear to have delivered higher share price returns than large-caps. This difference appears to be 150–200 bps per year on average (albeit with large fluctuations over that period). Most of this outperformance comes from EPS growth, particularly since the multiples cannot continuously diverge in

perpetuity.

However, since 1978, small-cap EPS growth has not outperformed large-cap EPS growth for the indices overall. Small-cap value has outperformed large-ca p value, and quite handily —7.0% versus 5.4%. Small cap growth has lagged, in our view, due to the

aforementioned reasons. Looking ahead, the recent performance of value stocks will be the norm. That is both growth and value small-caps will again outpace large caps

in terms of EPS growth over the medium to longer term. We believe a reasonable expectation for this outperformance would be the historical average of 150–200 bps per year. While this higher EPS growth rate should result in a higher P/E multiple for small-caps, some of this gain is mitigated by their higher risk. Historically, small-cap

have traded at a P/E premium of 2%–5% relative to large-caps. This is where we are today, and this is about right.

Portfolio diversification is not as easy as I make it sound here but it is also not as hard as some people make it out to be. Most investors do not have the ability to pick individual stocks and do the appropriate research on them. Consider ishares or ETFs (www.ishares.com or www.etfconnect.com) especially if you are intimidated by what is large cap value, mid cap value, mid cap growth, small cap value and small cap growth.

Lesson #3
Analyzing Semi’s

When do you buy or sell semiconductors depends on where we are in the semiconductor cycle. Inventory corrections are bad (sell?) and can only be destroyed by the bullish fires of accelerating hardware demand. Investors can wilt under the pressure of broken charts, peaking Year over Year growth and rising capex. Let’s take a look at this a bit closer.

30-60 days ago, it seemed that the main question asked by many semiconductor investors was 'where are we in the cycle?' Reading between the lines, which is another way of saying that many investors were looking to time their exit from the sector. Now the most common question seems to be whether we can get one more rally in the group. An easy interpretation of that question is that many investors wish they had unloaded their chip stocks earlier, but are now hoping for a bounce so they can bail out a little higher.

Put differently, the psychology has shifted from 'buy on dips' in 2003 to 'sell into rallies' today -- a corrosive condition for the group since valuations for most chip stocks remain above pre-bubble highs. What is required to drive chip stocks higher is having major hardware companies stand up and announce that business momentum is meaningfully better and accelerating.

The fundamental reason why notable improvements in hardware demand are necessary is because purchasing managers see building chip inventories. That process can run anywhere from 1-3 quarters. To avoid a drop in chip shipments after a stockpiling phase passes (such as happened in mid-2002), the chip industry needs hardware demand to improve significantly. Simple 2nd half seasonality is not enough -- the last three

cyclical collapses began in the second half of the year.

The market needs network equipment, boxmakers, and storage to grow. Most analysts are optimistic about hardware growth (e.g., 2004 PC unit growth forecast was raised last week to 14% from 11%), analysts are hopeful that a follow-through in hardware demand will occur, thereby driving a rise in chip stock prices.

The market can say with a high level of conviction that chip inventories at customers will rise on a DOI basis in 1st quarter. Aside from the cyclical reasons (tighter supply, lengthening lead times, stable or rising prices) for inventories to rise, customers' inventories have risen during 1st quarter in each of the last seven years.

This seasonality occurs because customers drain inventories at the end of the year anticipating the typical 1st quarter sales drop, and that process begins to reverse itself in 1st quarter. In most instances, DOI slides in 2nd quarter, but cyclical forces will likely cause it to be flat or up this time around.

Watching customers' inventories likely will not provide much insight. Expect DOI levels to rise, but can they rise for two quarters or two years? Since we are presumably moving off of record DOI lows, what DOI level constitutes 'too much' inventory?

Chip delivery lead-time information is likely to be the key leading indicator. When lead times broadly begin to shorten, believe that means that the supply/demand balance is moving back toward oversupply and the customers can begin to enter an inventory reduction mode.

Lesson #4

What is happening to REITs

In the midst of the bloodletting in the REIT market a week and a half ago, the sell-off in

REIT shares is more likely a correction than the beginning of a bear market.

More Jobs Will Drive Increased Demand for Real Estate

A strong job market will lead to increased demand for most property types. Increased demand will initially translate into increased occupancy and, later, into increased rents. After four years of deteriorating real estate fundamentals for all property types other than retail, the recently bottoming fundamentals will likely translate into improving fundamentals if job growth continues to accelerate. REIT earnings slipped 2.1% in 2003, and they are expected to rise 3.9% in 2004 and 7.4% in 2005.

Higher Interest Rates Should Benefit Inflation-Hedging Assets Such as Real Estate

Real estate has proven to be a good store of wealth in an inflationary environment. The back-up in interest rates suggests that inflation could be poised to accelerate. Many leases are written with inflation adjustments in the rents, they move to market at expiration, or they are short term in nature, allowing rents to keep pace with inflation. The fixed cost of owning real estate at the original investment cost suggests returns will rise as rents increase. With less than 50% of asset value in debt, the repricing of interest rates as debt matures will

have a less significant impact.

Relative Valuations Still Attractive

Considered in isolation, REITs appear expensive relative to their historical trading levels. However, compared to the valuations of the broad market, their valuations appear more in line. REITs are currently trading at a 14% premium to the ten-year historical average funds from operations (FFO) multiple, while the S&P 500 is trading at a 9% premium to the 20-year

historical EPS multiple. Both interest rates and inflation today are much lower than they have been over the past ten years, partially explaining the premium valuations.

REITs Got Ahead of Themselves

Through the end of the first quarter, REITs advanced more than 14% while the broad market ended the quarter flat. REIT multiples expanded during the quarter while multiples for the broad market were flat. In 2003, REIT market multiples kept pace with the broad market, with an approximate 25% expansion. The broad market rallied hard through mid-quarter and

then gave back the gains, while the REIT market rallied hard through the end of the quarter and then gave it all back. REITs have now reestablished their relative valuation to the broad market.

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