2005 Quarter 3 Update

October 15, 2005

The financial markets will always find something to worry about. This is an undeniable truth that investors must live with and investment managers must constantly be prepared for. The moment terrorism began to leave the collective consciousness of investors we have added another sort of terror to our list: natural disaster. This is not to say that global terrorism has left the forefront of our minds altogether. It is still there and will remain so for the foreseeable future. However, front and center now is the destruction wrought on the Gulf Coast by hurricanes Katrina and Rita and the likely after effects of such catastrophes. Both storms have complicated what was an already difficult situation in the energy complex and have forced us to consider the danger of our dependency on fossil fuels in this day and age. As investment managers it is not our job to decide how this issue should be handled but how we should position our clients so that they might take advantage of this reality. One way to do this of course is to have an appropriate exposure to energy in our client portfolios, something we have had for quite some time. Equally important, however, is what not to do in light of the current bull market in energy. That of course would be to abandon one’s strategy in order to chase the sector of the day, in this case energy, thereby forsaking other promising areas of the market in the process.

As we have stated before, it is anyone’s guess when/if energy will see a reversal in price. While we do not claim to have an answer to this question (and anyone who does is only guessing), we do believe that it is important to take a close look at the current macroeconomic environment and assess both the headwinds and tailwinds we are likely to experience. Except for the companies that are directly involved in the energy business, the high price of fossil fuels is clearly a headwind for both the economy and the markets. We are also facing what appears to be a hawkish Federal Reserve committed to fighting inflation at all costs. As a result, we are likely to see continued rate hikes for the next six to twelve months. The risk here is that in its quest to keep inflation under wraps the Fed goes too far and ignores the already present “tax” that higher energy prices are placing on both businesses and the consumer.

It is our opinion that the Fed’s vigilant approach to interest rates will remain measured, and while continued rate hikes are not a positive for the equity markets, we do believe that the domestic economy is strong enough to absorb such hikes as they come. It is important to remember that the Federal Reserve began it’s most recent rate hike campaign when rates were at an extremely low level. It can be argued that even after eleven sequential hikes the current short term rate is still stimulative to the economy at 3.75% and will likely remain so even between 4-5%. Also, as long as foreign dollars continue to flow into the United States we benefit from lower long term rates, thereby helping to stimulate the economy even as the Fed tries to slow it down by raising short term rates. As long as this international influx of capital persists we believe that the economy can continue to grow at a healthy clip, despite the Fed.

So what of potential market tailwinds? Just looking at the market averages and their performance year to date (virtually unchanged) would seem to indicate that participants are still hesitant to put much money to work in equities. But there is always a bull market somewhere and 2005 is no exception. With corporate balance sheets still flush with cash the mergers and acquisitions continue apace. We believe that companies will continue to look for acquisition targets and we are trying to take advantage of this. As we have stated many times before, we are not believers in relying on the major averages to produce strong returns for our clients. 2005 has been an excellent example of this as our clients have seen positive returns in an otherwise listless market. We have achieved these results by searching for special situations that are likely to be much less correlated with the overall markets, hence moving up as the market stagnates.

In short, there are plenty of opportunities in today’s market and we remain excited about the upcoming quarter and 2006 as well. 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