2008 Quarter 2 Update

July 25, 2008

It has become fairly clear that by almost any standard the U.S. equity markets are in a bear market, plain and simple. It’s still up for debate as to whether or not the economy has entered a recession but for all intents and purposes it appears to be close enough. That being said, we have still managed to make money in this difficult market and feel blessed to be able to say that. How have we managed to post positive returns while the major market averages are off by more than 20% from their highs in October of last year? We have stuck with our thesis that global growth will remain robust and therefore natural resource and infrastructure plays are the place to be. Thus far this has proved to be the case and our avoidance of companies exposed to the U.S. consumer has allowed us to circumvent a large portion of the losses suffered by the overall market. Of course the first half of 2008 is over, putting all that happened in the history books for now. This forces us to focus on what occurs going forward and how we can capitalize on what’s to come.

In our first quarter update letter we made two statements, one of which turned out to be correct and the other incorrect. We stated that we believed we might have witnessed a bottom in the equity markets following the collapse of Bear Stearns in mid-March. This turned out not to be the case of course. The U.S. markets have continued to grind lower over the summer and it’s very difficult to ascertain where the bottom may actually lie at this point in time. We also made a statement regarding the continued growth in China and other global economies that has thus far proved to be correct. Despite the slowdown in the U.S. and Europe, countries such as China and India have continued their blistering growth and it would appear that this upward trajectory is being maintained. We have yet to see any compelling evidence that this trend will change in the near future and therefore explains our continued excitement with regards to our portfolio.

So what do the two statements mentioned above mean for our clients’ portfolios going forward? Quite a bit actually. Of course we were incorrect in thinking that the markets might have bottomed back in March of this year. Fortunately we were not convinced of this fact and for the most part did not attempt to “bottom fish” some of the more beaten down sectors, i.e. housing, financials and retailers. We maintained our global growth thesis as mentioned above and have performed very well as a result. At some point in the not too distant future, however, we are going to find a bottom in this bear market, at which time there will be a plethora of opportunities in the aforementioned beaten down sectors. The advantage we have at this moment in time is the ability to watch from the sidelines as these sectors continue to be taken down, waiting patiently for the opportune moment to pick up “diamonds in the rough” when this market finally shakes out. This is the distinct advantage that being opportunistic managers provides us. We have been able to seek out the best performing sectors in this bear market, therefore taking advantage of the positive performance of the group, while all the while keeping our ear to the ground and listening for the right time to dip our toe in the water of the more damaged sectors in this economy. Clearly we are not there yet, however that time will come and we will be ready.

The big question on everyone’s mind at this point is when will things turn around here at home. We do not pretend to have the answer to that question, however we do feel strongly about a few things in the current environment. As evidenced by our current portfolio, we feel very strongly that energy and other natural resources will outperform in this atmosphere. Thousands of new cars hit the roads every day in China and other growing economies, a fact that will continue to keep the price of oil and other natural resources elevated in the future. These same people continue to demand a better way of life, a desire that will continue to support the massive migration from an agrarian to an urban society. Of course room will be necessary to accommodate all these new entrants and natural resources and corporate know-how will be in high demand. And with the price of oil likely to remain high for the foreseeable future it will become increasingly attractive to find and use more clean burning fuels. Natural gas is positioned perfectly in this environment and it is why we continue to hold large positions in many of these producers.

It is important to note that we are not naïve enough to believe that there will not be corrections in some of the commodity markets that we are exposed to and therefore corrections in the positions that we own. In the first half of July crude oil, natural gas and steel have all experienced pullbacks as investors begin to wonder when demand destruction will begin to affect the price of the commodities. This has naturally resulted in a decline in some of the positions we hold in client portfolios which are exposed to these sectors, albeit from extreme highs. While we are never happy about giving back even the slightest bit of our gains we have yet to see anything indicating a true sea change in the overall climate for these sectors. We firmly believe that we remain in the midst of a long term bull market for all things related to global economic growth and that this trend is yet to run its course. Should oil be trading at $130/barrel? Natural gas at $10/btu? It is difficult to know what the fair value of many of these commodities is, however it is not difficult to see that demand is clearly outpacing supply and short of a global economic recession this is not likely to change anytime soon. What we are likely experiencing in the commodities complex is simply money rotation. Shorter term investors have taken the stance that momentum is leaving the sector and they have therefore chosen to do the same. When the fundamental backdrop proves there is little reason for commodities to correct in an extreme fashion the tide will turn again towards this sector and we will be the beneficiaries. In summary, we feel very confident in our positioning and look forward to the second half of 2008.

As always, we appreciate your continued support and welcome the opportunity to assist anyone that you may feel is in need of our help. We appreciate the confidence and trust you have shown in us by hiring our firm as your investment manager and we look forward to working with you in the future.

2008 Quarter 1 Update

May 2, 2008

“If we are correct in our opinion that global growth will remain strong over the coming year then it stands to reason that many good values are being created as many babies are being thrown out with the bathwater so to speak.” Much has transpired in the financial markets since we made that statement in our January update letter to clients. The markets continued their treacherous and volatile path which ultimately led to the death of Bear Stearns as an independent company in mid-March. This announcement precipitated what could turn out to be a bottom for the domestic stock market as a crescendo of selling overwhelmed the indices. The domestic economy has continued to deteriorate while global growth has remained strong, a fact that has benefited our client portfolios to a large degree. And to that point, our thesis hasn’t changed. We believe growth in emerging countries around the world will remain strong and that is why we have continued to add to positions in companies that will benefit from this growth. While U.S. growth has come to a virtual standstill, China saw their first quarter GDP grow over 10% and India has experienced similarly large growth in its economy. A continuation of this growth will ultimately lead to elevated commodity prices and more and more demand for infrastructure build-out, all positives for our current positioning.

It’s important to note that while we are currently negative on the domestic economy, we do not believe that the U.S. is doomed to fail. As asset managers it is our job to continually look for what we believe to be the best opportunities for our clients, regardless of the current market situation. Today that opportunity clearly lies overseas and as we’ve stated before, it’s not necessary to buy foreign stocks alone in order to capitalize on this reality. So what are some of the areas we have been adding to recently? Energy is clearly at the top of that list as we believe that current prices for natural gas and oil will continue to remain high for the foreseeable future. Is it possible that oil and even natural gas prices are higher than they should be at this time? Of course it is, however with the continuing rise in emerging economies and their appetite for all things energy we believe that demand will outpace supply for a very long time. Consider the forecast recently made by Bradley George, head of global commodities and resources for Investec:

Global energy demand is expected to rise 50% over the next 25 years. In the next 10 years, China is expected to account for more than a third of growth in oil demand and the Middle East for 15%. Vehicle sales in China grew about 25% in the past year. On the supply side, there has been a drop in the number of new oilfields and yields from existing oilfields are falling.

This is excellent news for natural gas companies such as XTO Energy (XTO) and PetroHawk (HK) as well as oilfield services companies like Schlumberger (SLB). And at the risk of repeating ourselves, the demand for other commodities such as base metals will only increase as China, India and others swallow supply, making it very difficult for miners to bring enough out of the ground to sate this appetite. This will continue to boost the outlook for companies such as Freeport-McMoran (FCX), U.S. Steel (X), and Cleveland Cliffs (CLF), all of which mine and produce commodities such as copper, nickel and iron ore as well as gold.

If we sound exuberant with respect to overseas growth it’s because we are. It is extremely exciting to be able to identify and capitalize on such a profitable and emerging trend for our clients, and for that reason we are elated. We have every intention of “making hay while the sun shines” so to speak, and we believe that the sun will be shining on this complex for a long time to come. That being said, we have not neglected finding opportunities closer to home as well. Technology continues to be an attractive sector due to continued growth both in the U.S. and abroad. Companies like Research In Motion (RIMM) and Apple (AAPL) continue to post excellent results as do Microsoft (MSFT) and Google (GOOG). Healthcare also remains an attractive domestic sector and we hold positions in companies like Zimmer Holdings (ZMH) and Medco Health (MHS) for that very reason.

And just as it is important to build positions in sectors that we believe have the wind at their back, it is equally important to avoid sectors that might underperform during this difficult period in the markets. We have largely avoided sectors such as financials, real estate and retail given the poor prognosis for the U.S. consumer and the difficulties involving the ongoing credit crisis here at home. That being said, we have managed to find what we believe to be bargains in “best of breed” companies such as Goldman Sachs (GS) and Mastercard (MA). As market dynamics continue to unfold we will be watching very closely some of the aforementioned beaten down sectors for opportunity when the domestic climate begins to improve.

So what’s in store for the second quarter of 2008? While we believe that it is very likely we have seen a near term bottom in the equity markets, it is our opinion that we will experience continued volatility in the months ahead. We also believe that the spotlight will remain focused on global growth, and this bodes well for us. The cross currents here at home will continue to swirl as we debate the likelihood of a U.S. recession and it’s potential depth, the ongoing difficulty in the real estate market and the upcoming national election. It’s important to keep in mind however that the stock market is a forward looking discounting mechanism which is typically more concerned with the future than the present state of affairs. If one believes that the U.S. will slowly work its way past these overriding issues in the not too distant future then it stands to reason that the markets will begin looking past them even sooner. Barring any further shocks to the system, we believe that the financial markets are already setting themselves up to have a decent second half in 2008. While we believe that there still remains the possibility of the market stepping on a land mine or two in the coming months, it is our opinion that much of the negatives, real and potential, have made their presence known thereby increasing market participant confidence going forward. In short, we feel very good about our current position in the market and are looking forward to further success in 2008.

As always, we appreciate your continued support and welcome the opportunity to assist anyone that you may feel is in need of our help. We appreciate the confidence and trust you have shown in us by hiring our firm as your investment manager and we look forward to working with you in the future.

2007 Year-End Update

January 25, 2008

“The financial markets are currently in a state of uncertainty that will take some time to work itself out. This uncertainty will likely create some volatility in the near term as more information is disseminated in relation to subprime exposure and the like.” You may recall these statements from our last update letter and unfortunately they were more correct than even we realized. 2007 turned out to be a year of extremes for investors as the financial markets experienced dizzying new highs in the first half of the year, only to be dropped like a bag of rocks to finish the year in unspectacular fashion. It would seem that the investing world was caught by surprise as the subprime crisis reared its ugly head and put a stop to what was becoming a very profitable year for financial market participants. Of course this type of event is not unprecedented as we are often reminded that we should fear most what we don’t know to be afraid of than what we already know exists. The dislocation in the markets caused by the current credit crisis has been severe and to say the least unpleasant. The market dislikes uncertainty and that is exactly what the current environment is facing each day. Every weekday morning, and perhaps weekends too, the financial markets wake up wondering what new shoe might drop, fostering an environment of extreme volatility that has many wondering “what is it that we don’t know?”

And now for the other side of the coin. Volatile markets often provide good opportunities if one is patient and willing to look for them. While it is little solace to anyone losing money in the financial markets today, it’s the long term picture that we must focus on. That long term picture has been clouded as of late, however we are of the opinion that the U.S. still has a chance of avoiding economic recession and the strong global economy shows few signs of abating. What we are clearly experiencing now is a market that is trying to price in an obvious slowdown as well as the possibility of a recession. Given that the market is a forward looking discount mechanism the odds are good that once the economic weakness is at its worst it will already have been priced in, allowing us to find that bottom so many have been looking for. Are we there yet? It’s impossible to say at this point and only in hindsight is this observation a credible one. What we do feel strongly about, however, are the positions we have built in client portfolios over the last few months by picking through the rubble created by the current financial malaise. Our opinion is that global growth will remain on track and we are positioned for such a continuation. Its times like these that it so important to have confidence in your assessment of your companies’ quality and intrinsic value. To quote Ben Graham, “The investor who permits himself to be stampeded or unduly worried by unjustified market declines in his holdings is perversely transforming his basic advantage into a basic disadvantage. That man would be better off if his stocks had no market quotation at all, for he would then be spared the mental anguish caused him by other persons’ mistakes of judgment.”

So what are the keys to the fate of the financial markets in 2008? We believe that there are four major ones. In no particular order they are: the consumer, real estate, politics and obviously the economy. You’ll recall in our last update we stated that “consumer spending will likely slow domestically as a result of the changing real estate climate, however we do not believe that it will collapse as some may have you believe.” We are still of the opinion that consumer spending will not collapse, but given recent retail sales figures it appears clear that consumer spending has slowed considerably. It will be important to keep a close eye on consumer spending in the coming months however and this is a key reason why we have so little exposure to retail and other sectors which might be negatively impacted by this spending slowdown. In many ways real estate goes hand in hand with consumer spending. The consumer feels much “less wealthy” when the value of his or her home seems to be dropping on a daily basis. While it is unlikely that the bottom has been reached in the residential real estate market it is our opinion that we will see a bottom at some point in 2008. If this is in fact true then we should see some stabilization into the second half of the year in real estate, thereby keeping the consumer in the game so to speak.

Whether we like it or not, politics does play an important role in the economy and in turn the financial markets. Political allegiance aside, unless something changes dramatically between now and November it is likely we will see the Republicans swept out of the White House in 2008. As we’ve discussed before, the market disdains uncertainty and the idea of a Democratic majority in Washington leaves open the question “What will they change?” A Democratic Washington would remove the current state of gridlock from the equation, opening the door to change, something financial markets fret over regularly. But is it true that the Republican Party is better for the financial markets? History does not show this to be the case. In fact the opposite is true. Historically stocks have performed better under Democratic Presidents than Republican ones. Thus, simply because the country elects a Democratic President is no reason to sell every share you have and in fact may turn out to be a positive for the markets. For emphasis, we are not stating a political opinion or claiming to know the outcome of this year’s election, however it is our job to prognosticate to some degree in order to be better prepared for what is to come.

Certainly the most important factor affecting the financial markets in 2008 will be the economy. As we have stated above, it is clear that the economy has slowed in the past six months and we are of the opinion that growth is likely to remain sluggish in the first half of 2008. Does this mean it is time to give up on 2008? Not necessarily. It is likely that the market will continue to struggle in the coming months as it attempts to discount the slowing growth we are experiencing, however the important question investors must ask themselves is how much of the slowing economy is already reflected in forecasts, earnings projections, and stock prices. We are of the opinion that prices have been reflecting this slowing growth for many months now. Each day brings new and slightly redundant information which is consistent with slowing GDP growth. The market responds each time as if this is fresh information but we can’t expect companies to make wildly bullish comments on their prospects at this point. It is our opinion that those who wait for this optimistic outlook from companies will have waited too long.

So while it may be too early to search for value in this beaten down market, we are of the belief that many opportunities will present themselves in the coming months as many sectors and stocks within them will reach what many refer to as “stupid value.” If we are correct in our opinion that global growth will remain strong over the coming year then it stands to reason that many good values are being created as many babies are being thrown out with the bathwater so to speak. Many strong global growth stories have seen their share prices beaten down along with the market even as their stories remain strong. Companies such as Freeport-McMoran (FCX), Cleveland-Cliffs (CLF), Research In Motion (RIMM), Petroleo Brasileiro (PBR), Lockheed Martin (LMT) and the like have all suffered through this ugly downturn yet their markets remain robust. It is positions such as these that should recover quickly once the market feels it has sufficiently priced in the current U.S. economic slowdown. There are other places to find value as well in this market, one of which is healthcare. We have added a few positions in this sector as we believe it is an area that should remain fairly well insulated as the market attempts to bottom. Companies such as Zimmer Holdings (ZMH) and MedcoHealth Solutions (MHS) provide excellent value at these levels and should perform well despite a slowing domestic economy.

The second half of 2007 was a very difficult time for the U.S. financial markets and the first half of 2008 is likely to be challenging as well. We are optimistic, however, that slowing domestic growth will have been priced into the market in the first half of this year, opening the door to a potentially strong second half if one chooses his or her positions wisely. We appreciate your continued support and welcome the opportunity to assist anyone that you may feel is in need of our help. As always, we appreciate the confidence and trust you have shown in us by hiring our firm as your investment manager and we look forward to working with you in 2008.

2007 Quarter 3 Update

October 19, 2007

If one had gone into a long slumber from the end of July through the middle of September he could be forgiven for thinking that nothing much occurred in the financial markets during that late summer period of 2007. Of course he would be incorrect as the markets took a wild ride beginning in late July as a result of some troubling news on the housing front which spilled over into the credit markets like a virus. You’ll recall that in late August we updated you on the current state of the financial markets and at that time it was very difficult to get a clear picture of how things might turn out once the dust had settled. We also updated you on our current mindset, what we had done, and what we planned to do going forward. As it turns out our decision to look for opportunities during such a difficult period for the market has proved to be a good one. Of course we had no way of knowing what might transpire in late August and September but it was our belief that the Federal Reserve had little choice but to come to the market’s aid. This is in fact what the Fed chose to do and it has been extremely effective to date in curing the market’s ills, a fact that we are all extremely grateful for.

So what were some of the more important issues we were grappling with when looking over client portfolios during this period? The first decision of course was to decide where we might raise cash in order to protect from any further slide in the equity markets. Decisions were made to cut our exposure to economically sensitive areas, namely those companies most affected by the potentially troubled domestic economy. It was then our task to make a decision as to whether or not we should put the cash to work and in what fashion. By the time we were able to effectively analyze the macroeconomic situation the market was facing we decided to take a different approach to the equity market and as a result our clients’ position in it. It was our view, and still is, that the best place to be going forward would be those companies that have exposure to the global economy and the continued strength it has exhibited as of late. There continues to be a great deal of growth overseas as a result of the desire by countries such as China, India, Brazil and Russia to catch up to the western world and it’s standard of living. The afore mentioned countries, and many others like them, are undergoing a sea change in the way their people live and in order to make that dream a reality these countries have a voracious appetite for infrastructure and everything that goes into it, not to mention the technologies that make the western world so productive and efficient. This hunger for transformation is likely to continue throughout the world for the foreseeable future in our opinion.

In order to take advantage of the global growth we speak of above one need look no further than right here in the U.S. It is not necessary to wade into the world of foreign equities and foreign markets to garner exposure to these fast growing economies. Some of the opportunities are obvious. Energy is being consumed faster than ever as the world continues to grow, making companies such as Schlumberger (SLB) and XTO Energy (XTO) extremely attractive for the long term. As we mentioned above, the infrastructure needed to fulfill the desires and needs of these growing economies is also of the utmost importance, thereby making companies such as Freeport-McMoRan (FCX), U.S. Steel (X), Cleveland Cliffs (CLF) and Alcoa (AA) extremely appealing to investors, us included. Perhaps less obvious are the companies that fulfill foreign desires to keep up technologically with the West, a few being Research In Motion (RIMM) and Hewlett-Packard (HPQ). Of course these are only some of the companies we have taken positions in with the belief that global growth will remain strong in the coming years.

So have we given up on the domestic economy and its prospects for the future? Most certainly not. While we believe that the U.S. economy has and will continue to soften somewhat in the near future it would be foolish to assume that the West’s best days are behind them. Economies are cyclical in nature and the fact that the domestic economy is currently suffering from the excesses created during the recent housing boom will only strengthen the environment once the problems have been worked out and eventually improved upon. Perhaps one of the best aspects of the position we have put our clients in is the fact that should the domestic economy improve quickly we will still be able to reap the benefits of the upswing. The companies we own today are not only the beneficiaries of global economic growth but are also positioned to benefit from domestic growth as well. It may sound too good to be true but we believe that we are positioned to have our cake and eat it too!

The financial markets are currently in a state of uncertainty that will take some time to work itself out. This uncertainty will likely create some volatility in the near term as more information is disseminated in relation to subprime exposure and the like. That being said, we are of the opinion that the worst for the financial markets is behind us. As we stated above, it is our belief that the U.S. economy will likely slow over the next twelve months while the global economy continues to remain strong. Consumer spending will likely slow domestically as a result of the changing real estate climate, however we do not believe that it will collapse as some may have you believe. We also believe that the Federal Reserve is “on watch” so to speak and that they will continue to provide liquidity to the financial markets as needed, thereby avoiding recession here at home. We are very encouraged by the market’s rebound this fall and because the market is a discounting mechanism by nature it would suggest that much of what we are currently fretting over has been “priced in.” Of course the market always reserves the right to re-evaluate upon receiving new information, hence our belief that things could remain fairly volatile in the near term.

To reiterate, we are very pleased with our current positioning in the market going into the fourth quarter of 2007 and we are very optimistic about the future. As we’ve said many times before, we are focused on the long term for our clients and believe the prospects for future asset growth remain strong.

In closing this quarterly letter, we would like to thank you for all of the referrals you have given us over the years. As you know, we spend very little time marketing our services and instead choose to focus our time on finding the best investments for your portfolios. While growing our client base is very important to us, we have relied on our clients to pass along our name to family, friends and colleagues as our source of new business. We appreciate your continued support and welcome the opportunity to assist anyone that you may feel is in need of our help. As always, we appreciate the confidence and trust you have shown in us by hiring our firm as your investment manager and we look forward to the remainder of 2007.

Cordially,

Paul R. Ray III Brian M. Phillips

2007 Quarter 2 Update

July 25, 2007

The first half of 2007 has come and gone, leaving behind a fairly decent performance from an equity market perspective despite June’s difficulties. The major stock market averages broke through the first half finish line with gains of between 6-8% on the year so far, a respectable number and one which came predominantly in the second quarter alone. Those clients who have been with us for a while now know that we do not rely on the major market averages to provide returns for us, however we won’t look a gift horse in the mouth and are happy to see strong equity markets lift all boats so to speak.

While the second quarter was a strong one, it didn’t come without its speed bumps, particularly in the month of June. As is often the case, the equity markets were cruising right along when seemingly out of the blue we were struck with panic: higher interest rates to be specific. In the middle of the month the yield on the benchmark ten year note touched 5.33%, up from 4.56% just two months earlier. Conventional wisdom holds that higher rates endanger both investors and the broader economy. How so? First, it means greater borrowing costs for companies and consumers alike, threatening economic growth and profits. Second, rising rates signal expectations of rising inflation, eroding the real returns on all investments. Third, and particularly important in the current market landscape, is the effect on private equity firms. In theory it becomes more expensive for these firms to take on debt to then buy out companies at large premiums, one mechanism which has helped buttress the current bull market. And finally, at the most basic level higher rates on “risk-free” Treasuries make riskier assets such as stocks and corporate bonds less appealing.

So what does this all mean for the remainder of the year? Are we now stepping over the edge onto a slippery slope? Not in our opinion. As we’ve stated time and again there are always issues to be concerned with in the financial markets and the third quarter of 2007 is no different. But are sub 6% interest rates really the bogeyman that the bears have been waiting for with bated breath for so many months? We don’t believe so. For one, higher interest rates can actually be the result of a strengthening economy and to some degree a welcome sign that things remain robust here at home. It is also important to keep perspective in mind. In 1981 the ten-year yield hit 16% and closed the decade at a still strong 8%! That’s not to say that we would still be comfortable at levels anywhere close to those, however what we have seen is long term rates simply returning to their two century average of 5.25% (at the time of this writing the ten-year is actually hovering around 5.00%).

So rather than focus on what appears to be an overblown concern surrounding rising interest rates, we thought we might talk about what’s going right in the current environment. First and foremost, private equity and vulture investors still have a tremendous amount of capital to deploy and this has clearly kept a floor under the current bull market. Also, a seldom mentioned fact with respect to these private equity firms and their ability to borrow money to make future investments is that many big leveraged buyouts are actually financed with loans based on the London interbank-offered rate, not the rates set here in the U.S.. The London rate, also known as LIBOR, has held fairly steady relative to its U.S. counterparts.

Another comforting reality relates to valuation in the U.S. equity markets. While few market pundits are arguing that equities are overwhelmingly cheap, there is quite a loud chorus willing to profess that stocks are not terribly expensive either. On a price to earnings basis stocks are currently 45% cheaper than when the market peaked in March of 2000. That may be cold comfort for some who remember all too well what happened following the “dot-com” crash, however it is an important point of relativity.

And speaking of the turn of the century crash, investment grade companies today still have a great deal of cash sitting on their balance sheets. The washout from 2000-2002 made a lot of companies skittish and led them to hold extra cash. Much of this cash has been deployed but there is still a great deal more available for mergers, corporate acquisitions and stock buybacks. As we have stated before, all that cash has to go somewhere! Also, it is fairly safe to say that as things stand currently the Federal Reserve is much more likely to loosen than to tighten in the coming months. Fear of exacerbating the decline in housing alone should keep the Fed on the sidelines at least for the rest of the year, and if things in that sector continue to deteriorate we will likely see a rate cut instead.

And speaking of housing, what about all of the doomsday talk surrounding the sub-prime debt market? We believe that the subprime issues being discussed ad-nauseum by the business press are likely to be localized in their effects. What do we mean by this? There are likely a number of hedge funds and investments banks (see Bear Stearns’ recent hedge fund write-downs) that are going to experience some pain as a result of bad decisions in the subprime market, however it is unlikely that the overall financial system will take much of a hit to speak of.

And perhaps one of the more interesting positives for the overall economy, and hence the equity markets, is the simple fact that global growth is extremely strong to say the least. We no longer live in a world where the U.S. economy is the only one that really matters to us. Foreign investment and aspiration has changed the investment landscape in such a way that our world has become significantly smaller and more intertwined. As long as the global economy stays strong and emerging markets continue to grow at these high levels it is unlikely that anything short of a major world event will change that reality. Where the U.S. consumer leaves off the rest of the world picks up and that is nothing but positive for our domestic economy going forward.

Are we excited about the second half of 2007? Absolutely. Does that mean there are no potential roadblocks in our way? Certainly not, however we like the investing environment and we particularly like the way we have positioned our clients to prosper in both the current and the upcoming market climate. We have mitigated risk wherever possible without removing the potential for upside going forward, a formula that we believe presents our clients with a fantastic opportunity for success.

As always, we appreciate the confidence and trust you have shown in us by hiring our firm as your investment manager and we look forward to the remainder of 2007.

Paul R. Ray III Brian M. Phillips

2007 Quarter 1 Update

April 26, 2007

The first quarter of 2007 was relatively quiet despite a sharp pullback in late February as a result of a one day “collapse” in the Chinese stock market. Global market participants panicked following China’s overnight decline of roughly 9%, fearing that it might trigger, or at least signify, the end of what has been a nice global stock market run beginning last summer. In hindsight this fear was unwarranted and most likely represented a good profit taking opportunity for those looking for such an occasion. We simply viewed this brief correction in the Chinese, and to a lesser extent other markets as a much needed “pause that refreshes.” Upon hearing of the drop in the Chinese market the media immediately began stoking the fires of panic by proclaiming that such a large move in such a short period of time had to portend something frightening in the offing. If looked at in a broader context, however, one would have seen that following the late February correction the Chinese market was still up for the month! Not exactly the stuff of nightmares in our opinion.

Needless to say we maintained our longer term view of the markets and the macro economy and our clients were better for it as a result. The world’s markets have returned to their highs since late February and continue their ascension as of this writing. While it can be useful to evaluate the past, it is our preference, as well as our job, to focus on the future and what it holds for our clients. It is this “future” that has us especially excited and below we will discuss one reason for that excitement, something new we’ve been adding to our client portfolios.

“Opportunity is missed by most people because it is dressed in overalls and looks like work." Thomas Edison said that and we believe it remains very applicable in today’s investment landscape. We’re certainly not patting ourselves on the back for working hard for our clients. That’s what we are paid to do and quite frankly we enjoy the work. Fortunately not everyone in our business sees it quite this way and that reality provides great opportunity. This brings us to what has excited us the most in recent months: reverse convertibles. As many of you may have noticed, there is a new type of asset present in your accounts. This is an asset that we are extremely excited about as it has everything an investor typically looks for: high yields with less risk than owning equities outright. In our opinion these reverse convertibles add a fantastic piece of diversification to our client portfolios and act as an excellent tool to lower risk while maintaining high returns.

So what are reverse convertibles? In the simplest terms possible they are “bond-like” securities offered by investment banks that are linked to the price of an underlying stock. Each one of these securities has a downside component, a guaranteed coupon, a “put” price for the underlying stock and a maturity. An example will illustrate this best:

A particular reverse convertible security might be based on Apple Computer’s stock. The security has a maturity of three months, a yield of 20% annualized and downside protection of 20%. When this security is priced the stock might be trading at $100/share (for the sake of explanation in this instance). As a result of the 20% downside protection inherent in the security, the put price on the Apple stock is $80 (20% below the trade date price of $100). During the three month term the coupon of 5% is paid (20% annually) regardless of what Apple’s stock does. If the stock never trades below the $80 put price during the three month term the owner receives his/her principal and has earned the 5% coupon. Should the stock trade below the put price during the period the stock itself can be put to the owner of the security in lieu of the principal, resulting in a loss dependent upon where the stock happens to be trading at the time of maturity. The coupon is earned regardless however, thereby mitigating the loss in such an instance. Said another way, should we have owned the stock outright rather than the reverse convertible associated with it the loss should the stock fall by 20% or more would not be mitigated by the coupon received, therefore the loss would be larger.

As can be determined from the example above, the ability to effectively price each security is key, as is a necessary understanding and knowledge of the underlying stock and a certain comfort level with that stock. Through our custodian Fidelity Investments, we have the ability to approach multiple investment banks when pricing a reverse convertible, thereby allowing us to achieve competitive pricing when it comes to the coupon and the amount of downside protection we are able to negotiate in each situation. As one might imagine, the fact that these banks must compete for the reverse convertible in question provides us the ability to garner the most attractive terms possible for our clients. In the example above, we would already have a certain amount of comfort with Apple as a stock/company, therefore our ability to negotiate an attractive coupon for the amount of downside protection we are provided is significant, as is our comfort level with the fact that we would be at ease owning the stock should it fall as much as 20% during the period in question. This comfort level would be aided by the fact that we would feel confident that the stock had fallen too much and would therefore return to a much higher price in the not too distant future.

There is a large amount of effort involved when putting together these securities for our clients, however the ability to remove some risk from our client portfolios while not giving up returns is hugely important in our minds and worth every minute. We wanted to share this information with all of our clients to not only remove any confusion that might be created but to express our excitement about such an effective security that is available to us, allowing us to further diversify our client portfolios. Should you have any questions regarding the above described security please do not hesitate to call. We would be happy to further discuss these assets with you should you choose to do so.

As always, we appreciate the confidence and trust you have shown in us by hiring our firm as your investment manager and we look forward to the remainder of 2007.

Cordially,

Paul R. Ray III Brian M. Phillips

2006 Year-End Update

January 30, 2007

Wow. What a year 2006 turned out to be on Wall Street! Going into the year, even entering the third quarter of the year, one would have had a difficult time finding many in the investment community who believed the markets would turn around so quickly. The malaise that was the late spring and summer of the year turned around abruptly, catching many professional money managers off guard to say the least. In mid-December Merrill Lynch commented on this reality by stating that there were a record number of fund managers underperforming their benchmarks in 2006. Why was this happening? Many believe that there were a large number of managers who were caught holding energy stocks too long and then, by design depending on the manager’s focus and style, did not rotate into mega-cap stocks in the late summer.

The reality is that the market in 2006 failed to reward “stock picking” and instead rewarded those who invested based on liquidity. What this means in a nutshell is that managers who favor mega-cap stocks were aided by the proliferation of ETF’s (ETF’s are funds that track the indexes but can be traded like a stock) because these large stocks make up most of the weight in the ETF. If you buy the RTH (an ETF made up of retailers), for example, 16% of it is allocated to Home Depot. The result is that smaller stocks within the group that may deserve a premium don't receive it because the group as a whole is being boosted. This means good stock picking is not nearly as important as is being in the most liquid names in the hottest sectors in a year like 2006.

All this to say that 2006, while rewarding, was extremely frustrating for money managers, ourselves included. And this reality brings up an interesting anecdote that’s worth mentioning. There exists a gambling competition in Las Vegas where a polished pro plays a rank amateur. In one of these recent competitions the pro applied optimal, back-tested strategies to each game. The amateur was just having fun, going on gut instinct, letting the chips fly. The stakes were small -- $25 per game. At the end of the contest, the amateur had $70; the pro was broke. This happens quite a lot in this competition and there is a valuable lesson to be learned. Within a short period of time, there's really not much difference between luck and optimized strategies. The edge just isn't that great. Slots have a very high payout, and everybody gets a blackjack if they sit at the table long enough. But over time, the disciplined pro with the best strategy will pull away from the amateur.

Now, apply this to investing. If you trade solely on gut instinct, you have a good chance of doing quite well -- for a while. Just ask everyone who used to trade back in the late '90s. In 1999 and early 2000, the only dumb ones were the pros. The amateurs were long any stocks with a ".com" and making tons of money, while Warren Buffett was eating at Dairy Queen. Who needed Vegas when you could trade online? But over time, the pros remained in the game, the amateurs went back to their old jobs, and Warren Buffett still eats at Dairy Queen.

The above story does not imply that only professional managers have any business investing in the stock market or that 2006 was anything like the climate in 1999/early 2000. The main thrust behind the example is simply that over a long time horizon investment discipline and strategy will trump the lack thereof. It is for this reason that we feel very good about the strategy and investment philosophy we employ for our clients. The hard work and study doesn’t always payoff in the short run, however over time it certainly does. The market cannot perpetually ignore value and it is this reality that ultimately wins out over time.

So what’s in store for 2007? We happen to like the equity market very much in 2007 and there are a number of reasons why we believe it should continue to rise. The first reason is one we’ve repeated over and over again, and at the risk of sounding like a broken record we’ll say it again. All that money has to go somewhere! There is so much cash on corporate America’s balance sheets that they will ultimately put it to work in the form of stock buybacks, dividends, and in many cases mergers and acquisitions. And that’s just corporate America. This does not take into account the huge amounts of cash being raised by private equity and leveraged buyout firms who are obligated to put their investors’ money to work at some point in the near future. All of this keeps a nice bid under the stock market and should continue in 2007.

Another huge catalyst for the market in 2007 continues to be the collapse in commodity prices, namely oil. This acts like a tax cut for consumers and businesses alike and assuming oil and other commodity prices remain stable, much less continue to decline, we will see strength reflected in consumer and business spending, a good thing for all investors outside the energy complex. And what about housing’s decline? We believe that the trend will be down in 2007, at least enough to keep the Federal Reserve on the sidelines and their finger off the interest rate trigger. Another result of a continued decline in housing is that investors will begin to look for other places to put their money. The stock market is likely to be an early recipient of this good fortune.

Another interesting, albeit slightly unusual reason for a potentially good year for equities in 2007 involves the presidential cycle. The third year of a President’s term in office almost always turns out to be a positive one for equities. Why is that? The reason tends to center around the fact that the current administration does its best to manipulate the economy to positively impact elections in the coming year. Whether this will hold true in 2007 is difficult to say as this presidency is far from typical given the issues being dealt with in Iraq in particular. But it is a potential positive for the markets none the less. Finally, bond yields continue to be low and we believe that they should remain relatively low throughout 2007. This removes a major competitor to equities for some time to come.

Of course there are always potential pitfalls in any given year and 2007 has some as well that are worth paying attention to. As stated above, housing’s decline has been a relatively good thing for the market for a number of reasons thus far, however any sharp downturn or prolonged weak activity would likely begin to take a toll on the economy and the markets in turn. The situation in Iraq is a difficult one to predict as it has been from the beginning. Of course that situation could take a further turn for the worse and cause problems in American’s sentiment and continue to cost the tax payer more and more money. The Democratic victories of last fall could always put a damper on the markets should the newly elected make things difficult for corporate America and the taxpayer, however in our opinion this is not likely to be a major issue in the coming year as there remains a large amount of gridlock on Capital Hill that will find it hard to make drastic changes. And of course the specter of more terrorism is never far from our collective consciousness either.

All of the above concerns are real, however we are of the opinion that the aforementioned positive catalysts for the market far outweigh the risks in the coming year, a fact we plan on taking advantage of.

As always, we appreciate the confidence and trust you have shown in us by hiring our firm as your investment manager and we look forward to the remainder of 2007.

Cordially, Paul R. Ray III Brian M. Phillips

2006 Quarter 3 Update

October 27, 2006

We hope you had a great summer and are enjoying the nice fall weather as we enter November. The first order of business in this third quarter update involves a simple housekeeping item. Phillips Ray has moved its offices and we are now located in the heart of the cultural district of Fort Worth. Our new address is as follows so please make note of it:

3108 West 6^th Street

Suite 250

Fort Worth, TX 76107

In short, we offered the law firm that was adjacent to us in the downtown City Center Towers the option to expand into our space if ever they should need it. Well, they chose to take us up on that offer and we are excited about the change in venue. We share an office building with a number of good friends at our new location and we are looking forward to the even shorter daily commute!

And now on to the quarterly update. It’s certainly interesting to hear the financial media talking about how the markets are “on fire” again and we’re off and running like the go-go days of old. Since the close of the third quarter the Dow Jones Industrial Average has even eclipsed 12,000 for the first time in its history. You won’t, however, hear much about the fact that the Dow is made up of only the 30 largest stocks in the marketplace and is not terribly representative of the overall market as a result. In fact, the third quarter advance was a very narrow one driven primarily by the biggest stocks in the market. The truth of the matter is that the third quarter was not all that easy on the majority of money managers, however the media’s cheerleading and focus on indices that are capitalization weighted make many feel they have missed out on a big party when in reality there wasn’t much of one, at least not outside the few large names in the major indices.

The above being said, however, there are a number of things going right for this market and for the economy as a whole. As most of you have noticed, commodity prices fell considerably through the third quarter, namely oil and natural gas. This really helps to take the Federal Reserve and its desire to hike short term interest rates out of the picture as falling commodities have eased some of the pressure on inflation. It has also provided a nice tax cut for consumers as they have seen the price of gas and other necessities fall as a result. We have also witnessed a softening in the housing market, a good thing as long as it remains gradual and relatively shallow. Again, this helps keep the Fed on the sidelines and it allows for a slow and healthy correction in what appears to be an overvalued asset in some parts of the country.

But these healthier markets must see something more than simply a decrease in inflation and a housing market that is headed for a soft landing, right? Maybe, maybe not, but there is a lot more going on in the world that is effecting our financial markets than what we see everyday on the news. Corporate balance sheets are in perhaps the best shape they have ever been in. This is something that we have commented on many times in the past and are perhaps more confident about now than ever before. But there’s even more going on out there than this and one has to look outside of the box (read domestic economy) and see the forest “despite” the trees. Globalization of free trade and capital deployment along with more experienced central banks and economies around the world have helped to create global economic diversification, a reality which minimizes economic risks and maximizes economic growth. This is of significant economic importance and will continue to have a massive effect on both the domestic and global economies, hence our financial markets as well.

Just as interest rates, inflation, housing, energy prices and all the rest have a strong effect on the financial markets around the world, so do politics, and the fact that we’re currently in the thick of mid-term elections this quarter makes the markets especially vulnerable to its effect. While it doesn’t do us much good to look back at the past in order to discern why the markets behaved the way they did in any given period of time, it is quite possible that the correction in the second quarter of this year was a result of market participants pricing in the possibility that the Democrats might take control of the House this fall. That being said, the recent strength also suggests that market participants believe that the Republicans will likely maintain control of the Senate. Political beliefs aside, this would actually be a good thing for the markets as they tend to like legislative gridlock, something we would mostly likely have should the House and Senate be split between the two parties. One result of this gridlock could be the extension of the Bush tax law changes in some form as a result of a necessary compromise. Like it or not, this result would be good for the financial markets and therefore likely cheered with more rallying. Of course we have no way of knowing how the mid-term elections will end next month but there is increasing confidence that the above split might in fact occur and the markets are happy about it, plain and simple.

Of course there are always things that CAN go wrong in the world and there are things that DO go wrong. We rarely know the CAN before it happens but certainly know the DO once it has. Our job is to prepare for as many of the “can happen” scenarios that exist and correct when and if they “do” happen. Could the Fed raise rates unexpectedly in the near term because they see something that the rest of us don’t? Of course they could. And the housing market could turn into a collapse while the Democrats take both the House and Senate next month. Rather than be frozen by fear of what might happen, investors must weigh the odds and prepare accordingly. In our opinion the odds favor a relatively strong market going forward for many of the reasons stated above. However as most of our clients know by now we do not often take the short-term view and instead tend to focus on the long-term prospects for the companies and industries in which we invest. Bargains and opportunities can be found in any type of market, both bull and bear alike, and we continue to seek out these situations and invest for the future.

As always, we appreciate the confidence and trust you have shown in us by hiring our firm as your investment manager and we look forward to the remainder of 2006.

Paul R. Ray III Brian M. Phillips

2006 Quarter 2 Update

July 7, 2006

There may be differing opinions as to the cause of the decline in equity prices throughout May and June of this year; however there is little argument as to the severity of the decline itself. For some perspective on this move in equity prices we offer the following:

As of May 10, 2006, the Dow Jones Industrial Average was 100 points away from a record high. Three volatile weeks later, the DJIA stood more than 4% lower than its May 10 level while the MSCI Emerging Markets Index dropped by 15%, led by declines in all major developing nations, including an 18.5% drop for Brazil, Russia, India, and China.

And what of the myriad of reasons given for the sell-off? Many believe that inflation is the real culprit, hence the increasingly hawkish statements made by the heads of the Federal Reserve, namely Ben Bernanke. While this belief likely has some validity to it, consider the fact that on an historical basis, headline CPI readings are generally inline with the average since 1980, with the core reading even more subdued as it remains near all time lows. Of course these numbers tend to be historical in nature so we might be in for higher ones in the coming months. That being said, we have just witnessed nothing short of a complete “smackdown” in commodity prices, a good thing when it comes to future inflation readings and the concerns surrounding them. So perhaps much of the work has been done with regards to inflation going forward, albeit an extremely painful process to endure.

Others believe that one of the major causes of this equity decline stems from a lack of confidence in the new Federal Reserve body. It is true that the retirement of Alan Greenspan ushered out an era of confidence in the Federal Reserve based on a solid track record going back to the mid-1980’s. Whether one was a fan of Greenspan or not, he no doubt had the ability to comfort market participants in times of uncertainty and fear. This, however, is unlikely to have resulted in such a severe market correction in the domestic and global markets alike.

No, the real culprit in the May/June market meltdown was years in the making and weeks in the undoing: Liquidity. Hard to believe that so much pain and confusion can be summed up in one simple word, isn’t it? But we believe that it can. As Mark Gilbert at Bloomberg states so eloquently, “The Federal Reserve has taken away the punchbowl it spent two years pouring absinthe into.” This, we believe, is the true culprit.

As more and more liquidity was added to the system via Federal Reserve short term rate cuts (ultimately ending at a mere 1% following the recession in the early part of this decade) there was put into place a process of “mispricing risk.” With so much available cash sloshing around the system investors were encouraged to take on more risk (or perhaps unable to resist) than they might otherwise have taken under a different scenario. When this excess cash is soaked up via interest rate hikes there begins a process of “repricing risk.” This process involves deleveraging, and deleveraging can be brutal and indiscriminate as we have recently witnessed (and therein lies the good news which we will touch on shortly). Investors are bound to price risk differently when the Fed funds rate is 5% and rising rather than 1% and flat. And it’s not just the U.S. Federal Reserve that has removed the punchbowl. Europe and Asia have been acting in kind which has only exacerbated the problem for the global markets.

So how is any of the above information positive for domestic financial markets going forward? Believe it or not there are many reasons to view this “repricing of risk” positively over the longer term. As discussed above, rather than ignoring the elephant in the room we have finally addressed the possibility of an inflationary environment going forward and taken steps to avert this reality. No one can know for certain whether or not we will succeed in containing inflation, but by taking proactive steps now we certainly increase our chances tremendously. The meltdown in commodities and the removal of excess liquidity by the Fed should go a long way in doing that.

Any time asset prices are adjusted downward there is the opportunity not only to pick up assets at better prices but to find assets that are most certainly “mispriced.” In their efforts to deleverage and raise cash at all costs market participants are likely to have thrown many babies out with the bathwater so to speak. While this can be painful to watch for fundamental investors who hold assets that they believe to be in the above cohort, it can also provide phenomenal opportunities for those willing to do the legwork to find such situations. This is exactly what we intend to do as the dust finally settles.

As investment managers it is important for us to remember that fight or flight is a fabulous mechanism when being chased down by a lion, but not all that great for quelling an emotional response to a stock market beating. We will be looking through the rubble of this global meltdown in the hopes that we can find some jewels worth owning at this stage. What we’re really referring to here is what Michael Mauboussin aptly names “time arbitrage”:

Asset prices reflect a set of expectations. If investors chasing noise create a set of expectations inconsistent with the long-term signal, an opportunity for time arbitrage arises. This arbitrage works only if the short-term focus creates a diversity breakdown-too few investors focused on the signal-and the signal becomes clear over time. So the critical considerations in navigating the investing world distill to psychology, incentives, and expectations. Intelligent investors remain highly aware of all three, and use them for the advantage of their fund holders.

Put simply, as investors have become more and more short-term oriented market corrections such as this have become important buying opportunities for those with a longer-term horizon. Of course this does not mean that just because a stock is down it is automatically a bargain. There will be plenty of companies, and therefore stocks, that will continue to suffer due to exposure to the wrong parts of the economy as we enter a new cycle. However in the process of weeding out the aforementioned companies there will be plenty that are cast aside unnecessarily, either as a result of association or the need to raise cash quickly. These are where value can be found.

As always, we appreciate the confidence and trust you have shown in us by hiring our firm as your investment manager and we look forward to a great second half of 2006.

Cordially,

Paul R. Ray III Brian M. Phillips