BakerEllisLLC_Commentary

INVESTOR UPDATE
OCTOBER 2004

We are pleased to report another solid quarter at Baker Ellis. Our main composite gained 4.23% while the Standard & Poor’s 500-stock index, Dow Jones Industrial Average, Russell 2000 and NASDAQ all fell. The S&P 500 lost 2.3% in the quarter; the Dow and Russell fared worse, with losses of 3.4% and 3.14%, respectively.*

Year to date, our main composite is up 9.05%, while the S&P has gained 0.25% and the Dow remains in negative territory. Our flex-value strategy has worked well, allowing us to roam the capitalization spectrum in search of the most compelling investment opportunities and helping to reduce risk through diversification.

During the quarter, widely held LNR Properties (LNR) agreed to be acquired by Cerberus Capital Management LP and one of its affiliates for about $2 billion. The purchase price of $63.10 a share in cash is slightly less than a double from where we began accumulating the stock in June 2002. While the acquisition helped our performance, we have to confess some regret in seeing LNR go. The company was doing a fine job in its real estate acquisition and management activities, and we had looked forward to holding its reasonably priced shares for many years.

In addition, our array of global energy and energy-services stocks registered strong gains as oil topped $50 a barrel. We are seeing the early signs of a feeding frenzy in natural-resource and commodity stocks as momentum players jump into the latest hot sector.

Emerging markets, which tend to be commodity producers, rebounded strongly from their second-quarter slump as investors sought to hedge against a decline in the U.S. dollar and turned to companies with hard assets. Among our assortment of under-appreciated emerging-markets plays, Industrias Bachoco (IBA), which produces about 7 million chickens per week in Mexico, and GRUMA (GMK), the Mexican tortilla giant, showed solid gains.

We continue to believe that international companies in general remain relatively attractive. European stocks currently trade at about 11.4 times projected 2005 earnings, compared to about 17 for the S&P. While the growth rate in Europe is lower, we believe the discount is unwarranted. European households have an average savings rate of 10%, compared to less than 1% in America. This puts Europeans in a better position to boost consumption than Americans, who are reaching the limits of their credit lines. During the quarter we nibbled at an eclectic array of international stocks, including Aga Foodservice Group (AGA.L), a West Midlands producer of cast-iron cooking ovens and commercial baking equipment.

Meanwhile, our minimal exposure to technology stocks and other groups priced for high expectations has served us well. The NASDAQ is now down 5.32% for the year.

The economy is responding to massive fiscal and monetary stimulus. Corporate profits have recovered and expectations are relatively high. However, the stock market has failed to confirm the strength of the economy this year. We believe the market is reflecting the risk that the continued spiral of government and consumer debt will choke off the recovery. According to the Congressional Budget Office, the federal deficit hit a record $415 billion for the 2004 fiscal year ending Sept. 30. The deficit is attributable to both increases in spending – federal expenditures have risen in recent years to about 20% of gross domestic product – and a decline in tax revenues, which are now 16.3% of the total economy, the smallest share in the last 40 years.

Moreover, a large and increasing share of our national debt is held by our trading partners. As Alan Greenspan recently commented, “Given the already substantial accumulation of dollar-denominated debt, foreign investors, both private and official, may become less willing to absorb ever-growing claims on U.S. residents.”

Our instinct is that rectifying the budget and current-account imbalances will not be painless. Although the timing is impossible to predict, we see the possibility either of higher inflation driven by unrestrained deficit spending or slower growth as election-year pandering fades and the country is forced to face economic reality.

As such, we continue to favor defensive equities, such as food and energy stocks, and remain leery of financials and other industries especially vulnerable to rising interest rates or an economic slowdown. Our fixed-income investments remain modest in both allocation and duration, and include exposure to other currencies through instruments such as unhedged foreign government bonds.

Sincerely,

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

*Composite represents discretionary accounts over $100,000 held at Fidelity Investments. Performance is size-weighted, and will vary significantly based on risk tolerance, timing of investment and other factors. Composite return is weighted monthly. Size-weighted dispersion for the quarter was 1.49%. Performance is presented net of fees. Index data does not include dividends. 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.