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.