BakerEllisLLC_Commentary

INVESTOR UPDATE
OCTOBER 2003

We almost cracked a smile the other day over a New Yorker cartoon showing a hapless investor meeting with his stockbroker. The broker pompously informed the client that he would have to move his account because it no longer met his minimum. This might be funny if we did not see so many people in that investor's position these days, usually as they transfer in an account that has been plundered under the guidance of one of the big brokerage firms now under investigation by New York State Attorney General Eliot Spitzer. Invariably, such accounts are poorly diversified and stuffed with the fallen glamour stocks whose CEOs currently are the fodder of those high-drama FBI "perp walks" on CNBC.

Of course, few equity investors have escaped the carnage of this three-year bear market, and the third quarter brought no respite, turning out to be the worst by some measures since the 1987 crash. The S&P 500 lost 17.6% in the quarter, dragging it down 28.7% year to date. More than 90% of stocks in the index declined during the quarter, as basket trading continued to dominate the action and traditional safe havens such as grocery stocks and utilities felt about as secure as Afghanistan caves in a compression bombing campaign. The Dow, Nasdaq and Russell 2000 had even greater losses, with various indexes trading at levels not seen since the mid-90s. Around the globe, things were no better and in many cases much worse, with the London FTSE 100 down 20.1% for the quarter, the Paris CAC-40 down 28.8% and Frankfurt's Xetra Dax down 36.8%.

In addition to worrying about the implications of a possible war in Iraq, many investors - Baker Ellis included - are concerned about what could happen to the economy if the refinance wave ebbs and consumer spending contracts before capital spending improves. Clearly, many are feeling that the economy is headed down the path of Japan, where the economy remains a corpse despite interest rates near zero and the few stock investors still standing have lost money for nearly two decades. In a sign of how fast sentiment has changed in the investment world, we found ourselves one recent afternoon at the Heathman Hotel in Portland, where institutional investment managers were eagerly crowding into the room for a company road show. Cisco? Dell? No, it was a company in an industry that only recently would have had trouble giving away the free-range chicken: gold mining. While we have always found the gold bugs to be a curious bunch, their long-neglected metal was about the only thing to go up in the quarter, rising 5% to close near $325.00 an ounce.

Despite geopolitical risks for which it is difficult to find precedent and the specter of a possible double-dip in the economy, our own view is that stocks are much more reasonably priced than they have been in years. In the current media-driven investing climate, it is easy to forget that stocks should be priced based on the sum of all future earnings, not just current-year estimates, woeful as they may be. Similarly, stocks should be priced relative to the expected returns of alternative investments. We can tell you exactly what your annual return will be if you buy a 10-year Treasury note today and hold it until maturity: 3.7%. A company with a price-earnings ratio of 14, similar to many in your portfolio, has an earnings yield (the inverse of the p-e ratio) of 7.1%. If this company had a stable earnings stream and chose to pay out just half of those earnings in the form of dividends, the yield alone would match the return on the 10-year government note. The kicker, of course, is that the retained earnings could be used to invest in the business and increase earnings, leading to higher dividend payments and the appreciation in stock price that makes equities the best-performing asset class over time. Assuming the economy does not fall off a cliff, stocks are relatively attractive. Now is the time to be buying them, not locking in the record low yield on bonds (unless you are on the other side of the table, refinancing your mortgage at the lowest rates since Freddie Mac began tracking them in 1971).

Although we are sometimes accused as investment managers of youth (which, as the gray hair starts to creep in, we are tempted to happily accept) we also have been around long enough to remember another period like this in the market: 1974. With inflation, recession and Watergate ravaging investor confidence, nearly all stocks sank like bricks in the third quarter of that year. The final sell-off of 23% came in the months after President Richard M. Nixon resigned in what is analogous to the current parade of CEO indictments. Then, for no reason that was obvious at the time - indeed, the economy was not yet showing signs of a recovery - the bear market ended. Stocks rose, led by a different group than the Nifty Fifty growth stocks that had been all the rage in the previous bull market. We see a lot of differences between then and now - especially in inflation and interest rates - but eventually the current bear market will end as well.

Here at Baker Ellis, we are never happy unless we are making you money. Nonetheless, our composite of discretionary accounts significantly outperformed all of the major indexes for the quarter (see your enclosed performance report) as we continued to find opportunities far away from the deflating growth stocks of the '90s.* The bright spot in most portfolios was Bank of the Northwest (BKNW), which is being acquired by Pacific Northwest Bank at a substantial premium. Management actually characterized the transaction as a merger, but PNWB is a much larger bank, with 54 financial centers and about $3 billion in assets compared to BKNW's $354 million. Frankly, we were a little surprised management chose to sell so soon, especially considering the stellar growth record they were building. Chairman and CEO Dan Durkin attributed the decision to a desire to increase shareholder liquidity and allow the bank to pursue larger loans. We have been taking some profits on the stock and will likely tender our remaining shares to PNWB, which has a strong retail franchise and an opportunity to gain ground in the commercial sector with the help of BKNW's superb management team.

During the quarter we also found several new investments that meet our criteria for growing companies at bargain prices. A good example is SABMiller, which was known as South African Breweries until it acquired Miller Brewing this year from Philip Morris. (Philip Morris now has a 36% economic interest in the company and 25% of voting rights.) Headquartered in London and traded via over-the-counter ADRs, SABMiller has been profitable for more than 100 years. It is the second-largest brewer in the world after Anheuser-Busch, and the largest in developing markets including Eastern Europe, Central America and Africa. In addition, it is the largest bottler and distributor of Coca-Cola products outside the U.S., and owns Pilsner Urquell, another brand with strong franchise value. SABMiller produces 3.5 billion gallons of beer annually, nearly as much as the 3.9 billion gallons produced by Anheuser-Busch. Yet the company has a market capitalization of about $8 billion - one-fifth the market cap of Anheuser-Busch. SABMiller trades at 13 times earnings and yields 3.7%, which is very attractive to us. If the company can produce consistent growth in volume, revenues and margins - a difficult but not impossible task, as people in developing markets become wealthier - we believe this will be an excellent long-term investment.

Among other values in the small- and mid-cap arenas, we also have been accumulating shares of LNR Property (LNR), a purchaser and servicer of real estate loans and mortgage-backed securities. Trading at book value and 8 times earnings with a return on equity of 13.75%, this well-managed company generates substantial cash flow.

In hopes of replicating our success with BKNW, we also have been buying North Valley Bank (NOVB), a small bank holding company in California with branches in towns such as Eureka and Crescent City. Trading at 1.6 times book and 12 times earnings with a return on equity of 15.6%, NOVB has all the characteristics we like in a little bank - including a 3% dividend yield.

Finally, a little further out on the risk spectrum, we have been accumulating shares of IMPATH (IMPH), a cancer information company that provides diagnostic services to more than 8,000 doctors and maintains a valuable database with information on treatments and outcomes. IMPH was a fast grower that stumbled. The stock was hammered from 80 to 12, which is when we picked up the phone and had a lengthy conversation with John Cassis, a medical investor who served as chairman of the board from 1993 until 2000. Currently the Street is worried about operational concerns including a long collection period on receivables and lack of cash flow. With the stock trading below 10 times expected earnings, we believe investors are overly discounting the risks.

Meanwhile, we continue to place on our internal "source of funds" list (we enjoy parodying the brokerage world's euphemisms here) stocks of companies that are too complex for anyone including ourselves to fully understand, exhibit blatant corporate misgovernance or appear to "manage" earnings for the benefit of a fawning Street that will turn on them with a vengeance when they inevitably come clean with a miss. The latest stock to make this list was G.E., which we suspect is employing a veritable circus of tricks to affirm current expectations, has become more of a highly leveraged financial services company than an industrial conglomerate and faces a looming pension shortfall from the state of the equity markets that is not yet reflected in its forecasting models. (We will leave aside the matter of former CEO Jack Welch's absurd post-retirement perks, which became a matter of public spectacle through divorce filings of his estranged wife but which would have an imperceptible impact on earnings per share.)

More than once since we opened our doors in February, clients have sympathetically noted that we picked a difficult time to start an investment firm. Actually, we could not be feeling better about our decision or timing. Although equities are depressed, we are taking great satisfaction in getting to know our growing family of clients, helping you set an appropriate asset allocation strategy and identifying and researching promising new investment opportunities. We also are proud of the contrast of our independent endeavor with the often conflicted and self-serving culture of the full-service brokerage world, and believe we are operating in a scrupulously client-focused manner that will help you ultimately to prosper. We continue to be surprised by the number of investors who will pay as much as 3% a year for "wrap" programs in which brokers charge a hefty "gatekeeper" fee to turn their accounts over to outside managers, who layer on their own fee. In contrast, our average fee is less than half that amount, and we absorb most equity trading costs internally. The difference that this will make to your investment performance over time is substantial. Over 20 years, $100,000 compounded at 10% becomes $672,800. Compounded at 11%, the same $100,000 becomes $806,200.

We appreciate your business, and wish you and your family a safe and happy upcoming holiday season. If you have any questions or concerns about your investment allocation or strategy, please don't hesitate to call.

Sincerely,

Barnes C. Ellis
Brian C. Baker, CFA

*Composite represents discretionary accounts over $100,000 held at Fidelity Investments. Performance is size-weighted. Performance of individual accounts will vary based on risk tolerance, timing of investment and other factors. Performance is presented net of fees. Investors cannot own an index, which is always fully invested and does not include management fees or other expenses. Data is believed to be accurate but is not audited or guaranteed. Past performance is no guarantee of future results.