INVESTOR UPDATE
JANUARY 2005

The market finished the year on a strong note, with the main averages all registering substantial gains. For the fourth quarter, the Standard & Poor’s 500-stock index advanced 9.2%, while the Dow Jones Industrial Average rose 7% and the Russell 2000 picked up 13.7%. The fourth-quarter rise accounted for virtually all of the S&P 500’s gain for the year of 10.9%.*

Our main composite of Baker Ellis accounts outperformed the S&P for both the quarter and the year. In the fourth quarter, our main composite rose 10.9%. This brought our gain for the year to 20.9%. A $100 invested in this composite when Baker Ellis was formed nearly three years ago had grown to $143.17 at the end of the year, compared to $110.90 for the S&P.**

Highlights of the quarter:

• We booked our profit in Greenbrier (GBX), which had approximately doubled since we initially bought the stock in the 13-14 range in November 2003. The railcar manufacturer continues to grow backlog and leverage its capacity, but the risk-reward ratio has become less favorable.
• We lightened up on OMI (OMM), the oil shipping company. OMM broke through 20 in the quarter – a quadruple from our original purchase price in early 2002. Although the company still appears cheap on trailing earnings, day rates for very large crude carrier tankers plunged sharply at the end of the quarter – from about $200,000 to $75,000 a day for the Arabian Gulf-East trade route.
• We added to our position in Northwest Pipe (NWPX), an Oregon-based manufacturer of large-diameter, high-pressure steel pipe for municipal water transmission and tubular pipe for various uses. The water pipe business has been weak for several years, but demand is up about 80% from the trough and we see decent prospects ahead.

Among broader asset classes, we reduced our exposure to high-yield debt. We like to buy high-yield bonds when investors are pessimistic, and the spread between the yield on junk bonds and Treasuries is wide. We are sellers when spreads narrow, reflecting the willingness of investors to own risky credits for a smaller premium. Recently, the spread between high-yield debt and Treasuries hit a 14-year low.

Similarly, we pared back our holdings in real estate investment trusts. After a 37% total-return gain in 2003 followed by a 32.1% advance last year, REITs as an asset class are now yielding something less than 5% and are trading at a premium to net asset value. Like high-yield debt, REITs have been beneficiaries of global liquidity and the relative lack of investments with a decent yield. At current levels, token exposure suits us fine.

We continue to hold a significant position in foreign stocks, particularly in Europe, Asia and Mexico. These investments performed well during the year as investors sought to hedge against the declining dollar. In October, Americans put $15.2 billion into foreign stocks and bonds, according to the Treasury – the biggest flow since July 2000. With the rush to international stocks, investors appear to be embracing risks they may not fully understand. During the quarter, Russia essentially re-nationalized Yukos, its largest oil producer. Investors who plow money indiscriminately into foreign plays may find other such surprises ahead.

Holding cash in 2004 was painful. While share prices started the year at historically high levels, cash continued to earn a paltry return while virtually all other asset classes gained. In retrospect, holding a significant degree of cash in many accounts was a mistake. Although we had a strong year, our performance would have been even stronger if we had been more aggressive in committing capital to our stocks.

From current levels, we expect more tempered returns from stocks in 2005. We continue to maintain a balanced posture, leaning toward areas of relative opportunity and patiently looking for individual equities with good prospects that are under-appreciated by the market. We view the current investment environment as one of widespread complacency, which reinforces our conservative bias.

A few notes from the Compliance Department: We have changed the way we compare ourselves to the S&P 500 index, adding the impact of gross dividends to the simple price index (the SEC likes us to remind you that you cannot buy an index, although many funds attempt to mimic them)…Enclosed please find a copy of our Privacy Policy, which we are required to distribute annually…We have revised our Form ADV Part II, which details our business practices and procedures. If you would like a copy, we would be happy to send you one…If you find you are receiving too much mail related to your account, let us know. We can suppress transactional confirmations and/or proxy materials if you prefer not to receive them.

Best wishes to you and your family for a happy New Year.

Sincerely,

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

*Data includes gross dividends for the S&P but not other indices.
**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 2.31%. Performance is presented net of fees. S&P index data includes gross 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.

Top | The Firm | Philosophy | Principals | Commentary | Performance | Contact