Wednesday, October 05, 2005

2005 Quarter 1 Update

April 15, 2005

Anyone paying attention to the financial markets since the beginning of the year is aware of their poor performance in the first quarter. All of the major averages are down for the year as participants grapple with higher oil prices, rising inflation and the prospect of continued vigilance on the part of the Federal Reserve as it relates to their interest rate policies. The mix of these headwinds has created a cocktail that market participants find bitter and unappealing. Fortunately for us we have fared better than the overall markets during the first quarter.

So it might surprise you that we still remain excited about 2005, not because we believe that the overall markets will perform particularly well however. We don’t. What we do feel good about are the increasingly exciting prospects in the mergers and acquisitions arena. As we pointed out in our last update, corporate America is flush with cash and will be looking for ways to put that money to work. We believe that much of this work will come in the form of stock buybacks and, more importantly, acquisitions. While we are not simply counting on takeovers of the companies in the portfolio, we feel the overall M&A trend will help buoy the types of stocks that we own. A couple of examples of these special situation names include Midway Games (MWY) and Instinet (INGP). Sumner Redstone of Viacom continues to add daily to his 80% plus ownership position in Midway, presumably with the intention of having Viacom buy the business or taking it private himself. Instinet is already in talks with potential buyers and has made it clear of its intention to sell. And the list goes on. In short, we believe that the current economic climate bodes well for these types of transactions and we expect to profit from it as a result.

As for the overall financial markets, they have their work cut out for them. It has become increasingly likely that oil prices will remain high and could see even further appreciation as the summer driving season approaches. It doesn’t appear that the Saudi’s and other members of OPEC have the ability to pump much more supply into the system, creating a virtual floor on energy prices over the near term. And as for inflation, it seems that the first quarter saw some acceleration in pricing power, something that should keep the Federal Reserve hawkish over the next few quarters, in turn putting pressure on the overall equity markets. While the above might paint a gloomy picture for the equity market’s near term future, not all is so dreary if one can find the successful themes in which to invest. By approaching the market from this “mergers and acquisitions” and “special situations” standpoint, we can better navigate a declining market by identifying opportunities in which certain take out candidates find their stock supported by the increasing likelihood that they will be acquired sometime in the near future. In other words, little downside, lots of upside.

In closing, we are keeping a very close eye on the above mentioned headwinds and positioning the portfolio accordingly. As always, we will be searching for value, some of which will come in the form of special situation and merger and acquisition candidates. We are confident that this approach is the prudent one and will prove to be the most profitable one during 2005. We appreciate the confidence and trust you have shown in us by hiring our firm as your investment manager and we look forward to future success.

Cordially,

Paul R. Ray III Brian M. Phillips

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