2005 Year-End Update

January 15, 2006

Goodbye to 2005, or as many in the financial community might say, “Goodbye and good-riddance!” It was a frustrating year for market participants as they watched the indices go up and down like a yo-yo, only to finish roughly where they began. To be exact (per the Wall Street Journal):

Dow Jones -0.61%

S&P 500 3.00%

Nasdaq 1.40%

Hardly anything to get excited about for twelve hard fought months. Fortunately we fared better than the major averages in 2005 due largely to the fact that we continued to seek out unusual situations from which value was ultimately realized. Our belief that Midway Games (MWY) was still the apple of Sumner Redstone’s eye paid off handsomely for our clients as 2005 saw the company’s shares more than double in price. Our expectation that energy would continue its impressive bull market also paid dividends as our holdings in this sector continued their ascent. And our belief that strong performances in the brokerage industry and the opportunity for acquisitions in this sector kept Charles Schwab (SCHW) moving upwards. All in all we had a good year, especially on a relative basis, however at this point our focus needs to be on 2006 and beyond.

So what’s in store for 2006? A crystal ball would be nice, but of course we don’t have one and neither does anybody else. What we do have are some feelings and opinions of what the New Year might bring for the economy, and hence the financial markets.

As always there are plenty of reasons to be either optimistic or pessimistic about 2006, depending upon how one interprets different indicators and catalysts. One oft discussed indicator is the recently inverted yield curve. For simplicity sake, inversion occurs when long term interest rates fall below short term rates, thereby indicating tougher times ahead for the economy. At least this is the conventional wisdom. Why? Long term debt typically pays higher interest rates in order to compensate investors for the greater risk they incur while waiting for repayment. This phenomenon occurred, albeit slightly, at the end of 2005. While we do not think this occurrence is a positive for the economy, it is not overly concerning to us given the extremely slight nature of the inversion. We have had a relatively flat yield curve for quite some time now and a minor move in either direction is unlikely a major predictor for the economy going forward. Also, short term yields are relatively low when compared with past inversions. This means that consumers and businesses can still get credit on attractive terms. Also, long term yields have to some degree been artificially depressed due to foreign investors’ appetite for longer-term bonds. In short, we would be more concerned should the yield curve inversion become more pronounced, and therefore in our opinion be more indicative of an economic slowdown to come.

Of course we still have the presence of a hawkish Federal Reserve to contend with, however it does appear that we are quickly approaching an end to their recent tightening campaign. We likely face one, perhaps two more quarter point rate hikes and then a much welcome pause from Bernanke and his crew. Inflation is the primary target of the Federal Reserve and for the most part remains under control. Does an end to rate hikes mean the market now goes higher? Maybe, maybe not. But it does remove one more hurdle for the bulls.

An end to Fed rate hikes also eases the concern of a collapsing housing market. There has been a great deal of talk about how consumers have been using their homes as virtual ATM machines, refinancing and taking money out to spend elsewhere. One of the Federal Reserves goals in raising short term rates has likely been to cool this practice, and it appears to be working. Will the Fed accomplish their goal of cooling the housing market without severely damaging it? We believe in all likelihood that it will, a net positive for the overall economy and the markets as well.

One clear positive for the financial markets going into 2006 is the pervasiveness of strong balance sheets and lots of liquidity across corporate America. This will likely translate into another year of prolific merger and acquisition activity, not to mention strong business conditions in general. It is hard to find much negative about this reality and only solidifies our belief that to be successful in 2006, much like in 2005, one has to be selective, nimble and alert, constantly seeking out those special opportunities where value is either under appreciated or missed altogether. We do not believe that relying on the major averages to provide decent returns in 2006 is a realistic strategy, but that does not mean that one can’t be successful in the coming year.

More so than most years, prognostications for 2006 seem to be all over the map. That’s not a bad thing in our opinion as this lack of consensus tends to provide opportunities for investors. Discord as it relates to valuation can create buying opportunities and we intend to take advantage of this. We won’t always be right but if we invest in situations where the downside is limited and the upside potential is large we expect to have another good year.

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 2006.

Cordially,

Paul R. Ray III Brian M. Phillips