Third Quarter, 2006

Interesting cross currents have manifested themselves in the investment world during the third quarter. The stock and bond markets, for example, have been advancing, at least in part, based upon the perception that the Federal Reserve will begin cutting interest rates(1) within the next few months, and this has proven to be bullish for both of these asset classes. The Fed, however, through statements issued by various Board Governors, continues to stress that inflationary pressures remain too high throughout the economy. Fighting inflation, according to chairman Bernanke and most other Governors, is a higher priority than stoking the economy in the event of a declining growth rate or possible recession. It’s well accepted now that economic growth rates are slowing more or less simultaneously in developed countries around the world – a trend that is anticipated to continue into 2007. Typically, an expectation of an economic slowdown results in stock market declines; not this year, so far.

It’s also interesting to note that emerging markets have not, so far, experienced any meaningful negative fallout from the growth slowdown scenario. We interpret this to mean that investors expect the coming slowdown to be modest, and thus not particularly threatening to the world economy. This perception has however, coincided with significant price declines in many types of industrial, energy, and precious metals commodities. Notice we say “coincided with” as opposed to “resulted in”… because it’s just not clear if we are dealing with cause and effect or coincidental price action between disparate financial series.

Next, it’s widely understood that we are experiencing an extraordinary slowdown in residential real estate markets and that this slowdown will become much worse in the next six to twelve months before bottoming out. The speculative mania which resulted from low interest rates and easy financing terms may ultimately be proven to match the folly of the dot.com bust of 2000. The difference with speculative real estate, however, is that it is usually highly leveraged and illiquid. Prices drop dramatically when sellers are forced to unload illiquid investments and when lending institutions take back properties through foreclosure.

In spite of the current rout in residential real estate markets, the stocks of major publicly- traded home builders have experienced steady price increases since early July. Here again the action of the market is at odds with current economic reality. The market action, reflecting today’s conventional wisdom, is telling us that when (not if) the Fed lowers interest rates, housing will resume its growth trajectory and today’s investors in the residential building stocks will look very smart. If on the other hand, the Fed hangs tough on inflation later this year or early next year by raising interest rates, bonds, stocks, and residential properties could be in for some nasty downside surprises.

As mentioned above, the worst performing investments during third quarter were certain types of commodities-based securities. Energy companies and precious metal stocks were particularly hard hit in our client portfolios and they continue to remain weak at this time. We don’t believe the global energy “crisis” has been eradicated or that inflation has been beaten out of existence or that geopolitical risk has been significantly reduced during the third quarter. In sum, we don’t believe much has changed in the global economic or political big picture. Our take on the present situation is that much of the shorter-term speculative excesses have been “squeezed out” of current commodities prices setting a floor for future price increases. From a long-term perspective, the supply/demand balance in global energy remains grim. The Chinese, it’s reported in the Wall Street Journal, are increasing their consumption of oil by a million barrels per day approximately every two to three years. Oil consumption in India is coming up fast behind China. Oil consumption is rapidly increasing in South America and Eastern Europe as well, albeit from a lower base level. Oil supplies from the Middle East and Africa remain problematic given the regions’ political instability.

On the supply side, the notion of “peak oil”, while hotly contested by both academics and industry leaders, appears to be gaining greater credibility. The term “peak oil” refers to the point in time when a country or major producing area experiences the beginning of a decline in total oil production per unit of time. The U.S. and Western Europe have already passed the point of peak oil production some number of years ago. China, Mexico and Venezuela are at the point of peak oil now, or in the very near future, due to a combination of natural declines in their energy fields, and/or governmental blunders in managing domestic production. In this regard, an interesting interview can be found in the October 16th edition Barron’s, with senior energy analyst Charles Maxwell, who states that a growing number of OPEC and non-OPEC oil producers have either already experienced peak oil or will experience it within the next few years. It is against this background that we believe our investment focus on companies experiencing rapidly rising production from the Canadian oil sands looks all the more compelling as a long-term investment theme. Thus our strategy calls for us to maintain a steady hand through the current market volatility via 1) our ownership of diversified groups of high quality investments, and 2) our focus on cash flow compounding.

(1) Bond markets experience capital gains when interest rates decline and this has in fact been the case during the third quarter. Interest rates declined by almost one-half percent during this three month period of time. It’s possible that the present strength in the stock market has also resulted from the interest rate decline.