BakerEllisLLC_Commentary

INVESTOR UPDATE
THIRD QUARTER 2003

Despite a late-September fade, the stock market managed its second consecutive gain in the third quarter. The S&P 500 rose 2.2%, while the Dow Jones Industrial Average gained 3.2%. Small stocks, which often outperform during a recovery, turned in a strong performance, with the Russell 2000 up 8.8%. Foreign stocks moved higher, with the Dow Jones World Index (excluding the U.S.) up 8.9%. The 10-year Treasury continued to be range-bound with a yield around 4%.

Baker Ellis diversified equity portfolios outperformed the S&P, our primary benchmark, gaining an average of 5.88% in the quarter* (see your enclosed performance report for details). Many of our holdings did well, with an especially strong showing by our international plays. While foreign equities may represent a small portion of your portfolio, they provide important diversification and, in the current investment environment, a hedge to a declining dollar.

Several of our portfolio holdings are positioned to benefit from cheaper labor and faster economic growth in Asia. During the quarter, Singapore-based Flextronics (FLEX), the electronics manufacturing company, performed strongly as global markets for cellular phones and other electronics products stabilized. Shares of Fedders (FJC), which has become the leading exporter of air conditioners from China, rose as the company announced that it is relocating its international headquarters to Shanghai. And SABMiller PLC (SAB.L), the world’s second-largest brewer, turned in an excellent quarter as volumes showed solid growth, including 8% in Europe and 3% in Asia.

In addition to Asia, most of our accounts now have some exposure to India, which is growing much faster than the U.S. but has a stock market valued at a relatively steep discount to GDP. During the quarter, we began accumulating shares of Reliance Industries (RELIq.L), a conglomerate providing gas, energy and telecommunications services to India’s rapidly expanding middle class. The company, which trades global depository receipts on the London exchange, grew profits 29% in the latest quarter and recently made the largest gas discovery in India in nearly three decades.

Back in the U.S., we sold two holdings that were not performing as expected. SBC Communications (SBC) faces a tough operating environment after the FCC failed to grant the baby bells relief from independent carriers, who can lease their lines at unfairly low prices. And Impath (IMPH), the cancer diagnostics company, disclosed that it apparently overstated its accounts receivable. In both cases, developments proved our initial investment hypothesis to be incorrect.

The economy is slowly responding to massive monetary and fiscal stimulus. As S&P 500 companies announce quarterly earnings in the coming weeks they are expected to show year-over-year gains averaging 15.7%. Although this is good news, we remain cautious about longer-term trends, especially the astounding speed with which the $5.6 trillion surplus once predicted for the decade ending 2011 has morphed into a $2.3 trillion cumulative deficit. If foreign countries lose their healthy appetite for our debt, rising interest rates will threaten the recovery.

In the meantime, the market is following its usual script. The market typically rises in anticipation of an economic recovery, with small stocks outperforming larger stocks. This is exactly what we have seen this year, and we believe the recovery is now largely priced into the market. With the S&P now trading at about 28 times trailing earnings, we continue to shun most big growth stocks, particularly in the re-inflated technology arena, and find better opportunities in companies that are not necessarily household names.

In the Investor Education Department, two recent studies caught our eye. The first, from Boston-based research firm Dalbar Inc., marked the latest attempt to quantify the actual returns of mutual fund investors, including the impact of switching funds and trying to time the market. According to the study, the actual returns for stock fund investors over the last 19 years averaged less than 3% annually. During that time, the S&P 500 rose 12.2%. Market timing – fueled by the fund industry’s shameless promotion of hot-performing funds – left the average investor poorer after inflation.

Turning to the second study, we have long been fans of Eugene F. Fama of the University of Chicago and Kenneth R. French of Dartmouth. Their research has shown that value stocks, defined by a low price-to-book value, have outperformed growth stocks by 3.5% a year from 1927 through August. One of the mysteries, however, has been why value stock funds have performed no better than growth funds. In an intriguing new study, Ludovic Phalippou, in a Ph.D. dissertation at Insead, the business school near Paris, suggests one reason why: the outperformance of value stocks is driven by the sharp gains of a relatively limited number of illiquid stocks. Managers of large funds simply cannot buy these smaller stocks in adequate quantities without driving up their price.

We were delighted to read this study, because it affirms one of our primary value propositions. As a small firm (in our second year in business we now have about $50 million under management), Baker Ellis is able to take positions in these relatively illiquid stocks when we find compelling opportunities. Over time, we believe this will prove a significant advantage to our firm and our valued clients.

Sincerely,

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

*Performance data represents an average of all discretionary equity-oriented accounts over $100,000 with Fidelity Investments as custodian. We maintain various composites based on differing risk tolerances, and performance will vary among composites and individual accounts. Additional information available upon request. Performance is unaudited and not guaranteed but is believed to be accurate. Past performance is no guarantee of future results.