Fourth Quarter, 2006

Tradition seems to hold that the beginning of a new year is the time for reflection about things that went well in our lives during the past year as well as areas for change for the future. It is with this thought in mind that we are going to take a look back with you over our investment results for 2006 and reflect upon the causes of your portfolio’s performance. As you will observe later in this letter, 2006 was a very good year for your portfolio. Do we believe that the causes of yesterday’s investment performance remain valid today? Or, are their fundamental changes of direction occurring at a global level that are so subtle yet so profound in their implications – that we may fail to notice the new signposts along the path of our journey?

First, a brief review of things that went well. Perhaps the most important item on this list was the performance of equity markets outside the U.S. Virtually all major stock markets around the world outperformed the U.S. Throughout all of 2006 we had invested a significant portion of your equity portfolio in foreign markets and we currently plan to maintain substantial non-U.S. equity exposure in your portfolio during 2007 for reasons discussed below.

Second, precious metals and the companies that mine and refine them had a banner year in 2006, and here again your portfolio had a meaningful position in this area throughout the year. Next, within our domestic stock markets we have maintained fairly high exposure to Real-Estate Investments Trusts and higher yielding, value-type equities. These types of securities also generally outperformed the broad U.S. stock markets.

Ever since the tech stock crash of 2000-2002 we have avoided owning virtually all tech stocks. That strategy continued to be the case until the latter part of 2006 when certain tech stocks reached historically low valuation levels, enticing us to begin diversifying into this area. Being out of the underperforming tech market sector throughout most of the year reduced the potential drag on your portfolio return.

Finally, our enthusiasm for companies in the energy field served us quite well until oil began its surprising decline this past August. When oil hit $70 a barrel, a near-perfect storm of negative world events seemed to be gathering. Many economists and other global investment strategists were convinced that oil prices were headed towards $100 per barrel since the world was not falling into recession at the $70 per barrel level. Instead, here we are, just a few months later, at $50 per barrel. As a result, any energy-type purchases we made from the end of the second quarter through the end of the year have had a somewhat negative effect on portfolio performance.

Moving into the new year we continue to believe that the case for global diversification remains compelling for a variety of reasons. The International Monetary Fund continues to project strong growth in 2007 on a global basis with the strongest performance once again coming from emerging markets and developing countries around the world. At the same time, consumer price increases in many of these developing countries remain at modest levels and current trends in the volume of world trade are very healthy. Emerging and developing country markets continue to experience very strong growth in both consumption and investment, well in excess of these growth rates in industrial countries.

More specifically, developing Asian markets continue to offer very attractive long-term growth and investment opportunities resulting from the combination of their continuing technological progress and rapid advancement in the development of their “human” capital – In other words their people are rapidly becoming more educated and more productive at a rate which is resulting in steadily rising standards of living as income levels rise. As a result, economies of many countries across much of Asia, encompassing more than two billion people, present a picture of continuing robust growth.

Further economic development within the Asian trading block will mean a gradually reducing reliance upon the U.S. consumer to support local economics. This last observation, described in the International Monetary Fund’s Fall 2006 Economic Outlook, has extraordinary long-term global implications, in our opinion. The dollar will become less important as a global reserve currency. We are not hypothesizing some future possibility here – the process is already under way with recent announcements from China, Russia and other Asian countries regarding their gradual reduction in the proportion that U.S. dollars represent to their total currency reserves. We believe the natural economic consequence of a diminished appetite for dollars will be rising U.S. interest rates to entice foreigners to purchase our debt.

Our anticipation of continuing robust growth in developing Asian economies is in marked contrast to that of the U.S. where we are experiencing a decline in GDP growth coupled with an alarming growth in unfunded budget-busting social entitlement and military programs. We foresee a future of growing deficits and rising taxes under our current political leadership which increase the odds for long-term sub-standard levels of economic growth.

Moving on to Europe, during the course of the year the dollar has experienced a significant amount of volatility relative to the Euro and by year-end, the Euro had gained almost 12% relative to the dollar. The British pound was worth almost 14% more in dollar terms at year-end compared to the beginning of the year. An increasing number of Eastern European countries have adopted the Euro as their national currency. This trend is expected to continue in 2007. Growing acceptance of the Euro across Eastern Europe combined with the desire to reduce exposure to the dollar by many other countries around the world, will eventually result in increasing pressure on U.S. interest rates. That’s why we believe diversification away from the dollar will remain important for U.S. investors. You don’t have to go to Europe or purchase European goods to be affected by a weakening dollar.

Is the integrity of the dollar being called into question? Rather than accept the opinion of so-called experts on this issue let's look at two additional examples of what markets have been telling us:

The U.S. Dollar Index compares the purchasing power of the dollar against a trade-weighted basket of six other major world currencies. For the period from January 2002 through the end of 2006, the dollar has lost 28% of its purchasing power against those other currencies comprising this trade-weighted basket.

During this same period of time gold has moved from a price of $279.00 per ounce to $637.00 per ounce, a gain of 128%. Consider that gold pays no interest or dividends and thus a rise in its “value” vis a vis the dollar is widely considered to be a vote against the integrity of the dollar.

Thus, in the very big picture it’s our view that growing economic strength in emerging and developing markets around the world and cracks in the hegemony of the dollar as the world’s reserve currency suggest that we should maintain significant exposure to non-U.S. investments in 2007.

How much foreign diversification is appropriate or prudent? The answer is … there is no clear answer. We can however offer three guideposts for your consideration. First, an investor might agree to invest abroad up to the point of personal discomfort. We all need to sleep at night and our portfolios shouldn’t be keeping us awake with worries. Thus for some, the answer is based upon emotion regardless of the actions of others.

A second approach might be to look at the entire universe of all domestic mutual funds and then combine them to create one consolidated portfolio thereby creating a picture of how investors in the aggregate allocate their money. We can shed some light on this approach through the Morningstar Principia program which is utilized in our office. The consolidated picture from Morningstar is derived from a total of 23,148 mutual funds which as of the end of the year revealed the following asset mix: cash 7%, U.S. stocks 48%, non-U.S. stocks 15%, bonds 28%, other 2%. The math thus reveals that across all investors in U.S. mutual funds foreign stock ownership represents approximately 24% of total equities.

A third guidepost could be to consider the proportion that U.S. financial assets represent to total global financial assets. Admittedly, this would be an extremely difficult number to determine with any degree of precision. However, a recent Wall Street Journal article cites a McKinsey & Co. report which has concluded that U.S. financial assets now represent a declining 34% of global financial assets. If your portfolio asset allocation was based upon the global asset market, U.S. securities (stocks and bonds) would represent approximately one-third of your total portfolio.

These two last guideposts, although rather unscientific in their derivations, do nevertheless give us a basis or framework from which to determine a reasonable level of global diversification for you. As of December 31, 2020, foreign stocks accounted for 43% of your equity portfolio, and all U.S. securities (stocks and bonds) equaled 71% of your total portfolio.

For that portion of your money invested in U.S. stock markets one of our principal strategies was, and continues to be, broad diversification with emphasis upon dividend yield and selection of companies of reasonable valuations in what we perceive to be a generally high-valuation environment.

Those two general criteria have kept us almost completely out of the growth stock arena for more than four years. It’s been a good call on our part, particularly for 2006, as revealed by the following table:

1 The S & P index is one of the most common benchmarks used as a proxy for U.S. stock markets. That index is primarily a large cap growth index. In the interest of full disclosure its total return for the year was 15.8%.

The growth rate of the U.S. economy is widely expected to slow down during the first half of 2007 relative to the levels of the past few years. This consensus view is based in large part on: 1) a continuation of the current slowdown in the residential real-estate market: 2) the dramatic drop (already firmly under way) in mortgage equity withdrawals and, 3) the resetting of adjustable rate mortgages to higher interest rate levels. These factors will continue to put pressure on consumer spending which continues to be the primary driver of GDP growth.