Second Quarter, 2006

Putin speaks:

"Russia’s reserves of oil and gas are bigger by four times than those of all [the other] G-8* countries added together. So how can one solve energy issues without involving Russia, and how can one speak about ensuring global world security issues without account of Russia’s position, which is one of the strongest nuclear powers?"

* (The "G-8" is comprised of the following countries: Canada, France, Germany, Italy, Japan, Russia, United Kingdom and the U.S.)

So spoke Russian President Vladimir Putin recently. Putin knows he is in the driver’s seat vis-à-vis Russia’s neighbors in both Eastern and Western Europe, and now he wants that message clearly and unambiguously understood by the U.S., and most specifically, by President Bush.

Quoting from the Wall Street Journal, "In May, Vice President Dick Cheney accused Russia of using its vast oil reserves as "tools of intimidation and blackmail." On Wednesday, Mr. Putin shot back that Mr. Cheney’s criticism was merely "an unsuccessful hunting shot", a reference to the vice president’s accidental shooting of a friend while duck hunting earlier this year."

Putin’s response speaks volumes about Russia’s present view of the world, and of the U.S. in particular. He saw no need to deny the accusations, or get defensive about his country’s theft of Yukos Oil Company or about curtailment of domestic freedoms. Instead he simply chose to ridicule the Vice President. A new reality appears to be in the making -  that the U.S. needs Russia’s good will in this day and age a lot more than Russia needs ours. According to Institutional Investor magazine (July, 2006),

"Putin’s approval ratings still hover around 70 percent, the envy of any G-8 counterpart, and six Russians in ten would welcome an amendment of the constitution to enable him to serve a third term after his current one expires in March 2007, according to a June poll by the Moscow-based Levada Center."

Russia is experiencing massive inflows to its foreign currency reserves from natural resource sales and is now in the process of paying off all of its foreign debt. The U.S., at the same time, continues to spend wildly beyond its means on unaffordable social programs and foreign wars, making us ever more beholden to foreigners for the purchase of our growing debt. From a big-picture perspective, it’s worth keeping in mind the old investment maxim: "Follow the money."

Russia believes the ruble should eventually become a world reserve currency, thereby competing with the dollar and, of late, the Euro for that status. Bloomberg news reports that Russia plans to create a universal symbol for the ruble akin to the "$" denoting the dollar. Competition of this type normally means that the price of the item in question gradually declines while its yield is forced higher by the action of the marketplace. Lehman Brothers recently issued a report in which it stated that Central Banks around the world reduced their allocation of dollars in their reserves during the past year from a 72% average to 68%. Thus, even though the Fed may soon be at the end of its interest raising efforts, global currency cross currents and eddies could overwhelm the Federal Reserve’s efforts to control the direction of interest rates in the future.

What all this discussion is leading up to is that we continue to believe that the domestic stock market may remain "unsettled" for the foreseeable future, and that domestic interest rates may continue to rise for a longer period of time relative to today’s consensus view that rate increases are nearing an end in the present cycle.

Our investment posture continues to call for being overexposed to energy stocks, precious metals and other commodity plays. We continue to remain relatively short term in our bond holdings (one- to five-year maturities), and we continue to maintain significant levels of exposure to non-U.S. securities markets for both debt and equity investments.

The U.S. Treasury yield curve has once again become inverted. As discussed in previous quarterly letters, this type of occurrence illustrates the bond market’s view that our economy will weaken in the next 3-6 months. In fact, evidence of an economic slowdown continues to mount at this time, adding further credence to the predictive nature of the inversion indicator.

Against this backdrop of mostly unpleasant news is the fact that equity valuations continue to gradually become more attractive. This trend towards more favorable equity valuations is occurring because corporate earnings have maintained a healthy rate of growth while stock prices overall continue to languish.

We tend to get excited when we find high-quality stocks with good dividend yields selling at attractive valuations, and that is precisely what the present investment environment is beginning to reveal on our investment radar screens. Valuation is a different metric for stock investing compared to searching for companies having strong short- to intermediate-term earnings growth potential. While it’s true that we would like to have both (as in having your cake and eating it too), we think attractive valuations and high levels of dividend yields are more important to long-term wealth accumulation than is the purchase of high-priced shares of a company on a rapid growth rate trajectory paying little or none of its earnings in the form of dividends.

In the second quarter, the best performing equity markets were Slovenia and Cyprus, countries about which, we admit, we have fairly limited knowledge. Virtually every other equity market, both foreign and domestic, experienced losses during the quarter. In addition, our bond markets also experienced losses for the quarter as interest rates generally increased by approximately 30 basis points along most of the yield curve.

The unsettled and volatile nature of the overall stock markets as mentioned above has led us to engage in a modest degree of hedging activity in client portfolios. The purpose of a "hedge" is to reduce (but not eliminate) the magnitude of possible losses in portfolios if markets begin a significant downturn. The hedging instrument can be either a put or a call contract, each being a different means towards similar ends: loss reduction. A put contract can be compared to the purchase of an insurance policy for which a premium is paid to another party. You may collect money if the event insured against occurs, otherwise your premium is consumed during the contract term.

Covered call writing is the other strategy we occasionally employ. Here our primary objective is to collect a premium from a third party in exchange for giving them the right to purchase the stock from us at a stated price for a stated period of time.

There are myriad strategies and possibilities which can occur to make these hedging strategies exceedingly complex. Such discussions, however, are way beyond the scope and purpose of this letter and don’t relate to our relatively simple hedging transactions.

As illustrated by broad investment market indices, rising domestic inflation has taken its toll on our domestic stock and bond markets while precious metals, strategic minerals, and real estate have benefited in this environment. These six-month results clearly indicate the benefit of broad portfolio diversification which continues to represent the cornerstone of our current investment approach.