Q3 Commentary (2006)

Performance for the month trailed that of the S&P 500, but for the quarter, performance was competitive and we remain comfortably ahead of the market on a year to date basis.

Traditionally, the third quarter is a difficult one, so results this year were a pleasant surprise, or should I say, a huge relief.August and September tend to be very challenging months, but fortunately, both of these months produced positive returns this year.

During the quarter, we eliminated our Aramark position when management modestly increased their leverage buyout price. We used the proceeds to initiate a position in Amgen, a premier company in the biotechnology area and then we began a position in Conoco Phillips later in the quarter when energy prices began to fall. Standout performers were scattered across our industries, but some of the more notable winners included Pfizer (+20%), UST (+20%), XL Capital (+12%), General Mills (+10%) and Sysco (+10%). Our only major underperformer was our Fording Coal holding, which fell 16% on fears of falling global coal prices.

In our second quarter letter, we had forecast that the Fed would likely pause at their August meeting and that is precisely what occurred. At that time, there was great uncertainty as to further possible hikes, even if the Fed were to have paused. Today, there is almost no voice for further rate hikes and the real question centers on when the Fed will begin rate decreases to stimulate our slowing economy. This is a 180 degree change from the consensus thinking of only three months ago. The speculation of rate decreases has fueled the recent rally in early cyclicals and many out of favor technology stocks as evidenced by the NASDAQ’s return of 9+% since mid August. Generally speaking, when the market seeks out cyclicality, as it did has done most recently, our conservative growth style tends to lag. September was not a good relative performance month for just that reason. We were pleased, however, for the performance which matched the benchmark in a strong up quarter. So far this year, we have kept pace with the strong first and third quarters, and protected principal in the down second quarter. This pattern of results is consistent with our investment philosophy and objectives. We are focused on building wealth consistently over time and to that end, we are pleased with this year’s performance. We believe that the portfolio’s stable earnings growth and strong dividend growth potential will be appreciated later this year and well into the future.

Our confidence about full year returns and next year’s returns are improving as we enter the final quarter of this year. Lower energy prices and the more benign interest rate outlook may provide the catalyst for the consumer, much like Microsoft did in 2004, when they distributed a special one time $3 per share dividend in early December.

We will shortly begin the onslaught of third quarter earnings. Typically, there would have been numerous negative preannouncements by this time, but this has not been the case. It is quite possible that managements have done an excellent job in lowering analyst expectations and the reality may well be that earnings will be better than expected. This is our position and if we are correct, the final quarter of the year could be a surprisingly good one. On the equity side, the portfolio’s P/E on 2007 earnings is around 13.5x and the S&P 500’s P/E is about 15x. Our portfolio’s dividend yield remains comfortably higher than that of the S&P 500 and the dividend growth should continue at no less than 10% in 2007. The vast majority of our holdings are generating meaningful free cash flow, which is being redeployed to maximize shareholder value generally through a combination of share repurchase and dividend increases. All in all, we truly like the positioning of the portfolio and we are optimistic about its potential.