BakerEllisLLC_Commentary

INVESTOR UPDATE
APRIL 2003

SUMMARY: Equity markets lost ground in the first quarter of 2003, as they have in three of the past four quarters. The quarter began with stocks brushing five-year lows amid uncertainty about the looming war in Iraq. As the air campaign began favorably, traders pulled out their 1991 Gulf War playbook and launched a furious eight-day rally, which quickly fizzled. At the end of the quarter, the Dow Jones Industrial Average had lost 4.2% and the S&P 500 was off 3.6%, fairly modest declines compared to the second or third quarters of last year. Other equity markets around the world generally performed worse, with the Dow Jones World Index (excluding the U.S.) falling 7.5%. Despite periodic flights to safety, the yield on the benchmark 10-year Treasury finished the quarter basically unchanged at 3.81%.

Baker Ellis accounts essentially tracked the domestic equity market for the quarter, with aggressive accounts posting small percentage losses and more conservative accounts – with less equity exposure – showing slight gains. After our first full year, we remain pleased with the job we are doing for our clients. Although not all of our accounts appreciated in value in the past year, virtually all of them have outpaced the broad equity averages by a significant margin.* If we can protect you from most of the damage in a declining market and capture the gains in a rising market, we will consider that a satisfactory outcome.

While the stock market was focused on developments in the Middle East during the quarter, it is important to keep in mind that the war was not the cause of our shaky economy or the bear market. Rather, the tremendous boom and unprecedented misallocation of capital in the 1990s led to excess capacity. The subsequent crash in capital spending shattered the myth of the “new economy” and pushed the country at least temporarily into a recession. The impact of these events is more significant to us than developments in the Middle East, which will have a negligible impact on the long-term earnings streams of most American corporations.

PORTFOLIO CHANGES: During the quarter, we sold MBNA Bank (KRB), a $19.5 billion market-cap credit-card lender that was a legacy position in many accounts. In our view, consumers are highly leveraged. Personal bankruptcies are rising, especially in the Midwest and Southeast. We also believe that the credit industry is reaching to sustain growth. MBNA recently offered Brian a zero-percent $100,000 loan for one year on his credit card (which he promptly accepted, putting the proceeds in a low-yielding C.D.). While Brian is good for the money, we don’t know about others out there. If the economy weakens significantly, MBNA will have difficulty selling its receivables on favorable terms on Wall Street.

On the buy list, we began accumulating shares of Natuzzi (NTZ), a vertically integrated manufacturer of leather furniture. Headquartered in Italy, with shares traded on the New York Stock Exchange, Natuzzi has a market cap of about $500 million, less than its annual sales of about $750 million. The company has virtually no long-term debt, and about $100 million on the balance sheet. NTZ traded recently around $9 per share. With earnings of $1.58 per share in 2002, the company has a dirt-cheap price-to-earnings ratio of about 6. Although the company is family controlled (one reason that it trades at a discount) it is run in a shareholder-friendly manner, with a dividend yield of about 3%.

INVESTOR TRAPS: New clients frequently ask us how Baker Ellis is different from a brokerage firm. A good example can be found in the contrast between how some brokerage houses sell mutual funds, and how we employ such funds for our clients. Currently, regulators are investigating a major brokerage firm for sales practices involving various classes of mutual funds. If you have ever purchased funds through a brokerage firm, you know that “A” shares carry a stiff up-front sales charge of as much as 5.25% of the money invested. “B” shares carry no up-front charge, but typically have a redemption fee that declines to zero over six years. While brokers like to sell “B” shares because they sound more attractive, this class of shares at the firm in question – like many others – also carries a separate “12b-1” marketing fee of 1% annually, which is paid to the broker for 10 years. In the end, this makes it a rotten deal for the true long-term investor. And that’s before considering the impact of operating expenses and trading commissions within the fund.

As an independent, fee-only investment advisor, we use mutual funds for two reasons: to achieve diversification for smaller accounts; and to gain exposure to asset classes in which we are not expert (e.g., high-yield bonds and certain international stocks). We focus on two no-load families of funds that offer extremely cost-effective products: Vanguard, and Dimensional Funds. Vanguard, the king of low-cost indexing, requires little introduction. (By way of full disclosure, Barnes’s uncle, Charley Ellis, serves on the board.) Dimensional Funds, run by some of the top academics in the investing field and available only through qualified advisors, follows a passive strategy with a value bias and an opportunistic trading policy. Barnes has visited with the principals of the firm in Santa Monica and spent time on their trading floor. With both fund families, you can be assured that you are receiving exposure to important asset classes in an efficient and cost-effective manner.

ADMINISTRATIVE NOTES: S.E.C. regulations require us to offer you our Form ADV on an annual basis. If you would like an updated copy, please let us know. We also are required to inform you of our privacy policy, which states that we do not share the names of our clients with any person or outside entity, with the exceptions of our account custodians and industry regulators. For a copy of our complete Privacy Policy, please contact us. We value your trust and respect your privacy.

Sincerely,

Brian C. Baker, CFA
Barnes C. Ellis, RIA

*Composite represents discretionary accounts over $100,000 held at Fidelity Investments. Performance is size-weighted. Performance 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.