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