BakerEllisLLC_Commentary

INVESTOR UPDATE
OCTOBER 2005

The stock market shrugged off rising interest rates, the high price of oil and Hurricane Katrina in the third quarter to post modest gains across the board. The Dow Jones Industrial Average gained 2.9% in the quarter, although it remains off 2% for the year. The Standard & Poor’s 500-stock index gained 3.6% in the quarter and is up 2.8% for the year. Baker Ellis accounts enjoyed another good quarter, with our composite gaining 10.2%. For the year, our composite is up 15.3% (see note, bottom).

Our major investment themes remain unchanged. Much of our success in the quarter can be attributed to the continued strong performance of our international energy stocks. Although oil prices have pulled back to pre-Katrina levels of about $63 a barrel, holdings such as Imperial Oil (IMO) and Petroleo Brasileiro SA (PBR) had a good quarter.

While oil prices captured consumers’ attention, natural gas prices have increased even more dramatically. With prices for November delivery hovering around $14.75 per MMBtu, natural gas prices have more than tripled from 2000 to 2005, and are now seven times the average price in the 1990s. EnCana (ECA), one of our core holdings, has been a major beneficiary. We began purchasing ECA in early 2003 at around $16 a share. The stock finished the quarter at $58.31. Hurricane Katrina only strengthened the Canadian company’s position. The Gulf Coast supplies about 16% of the natural gas used in the U.S., and only about 20% of production has been restored.

At current prices, we are tempted to lighten up on energy stocks. A recession could trigger a pullback in energy prices – and high energy prices could trigger a recession. The average American family is on pace to spend an average of $4,500 on energy this year, according to the research firm Global Insight, up $900 in two years. Unlike the federal government, consumers do not have the ability to spend “whatever it takes.” In other signs of an imminent slowdown, the yield curve is flirting with inversion, and the red-hot housing market is cooling. Nonetheless, we view our energy holdings as an important hedge against inflation, and as a reasonably good long-term store of value. We are reluctant to desert the sector in an effort to time short-term price swings.

Our international plays also contributed to the quarter’s performance. Beijing’s change in currency policy in July helped boost our holdings in the region, including our indexed exposure to Singapore and Malaysia. India’s stock market gained 20%, which was reflected in strong performances of holdings such as the India Fund and Reliance Industries. In Mexico, the market gained 21.8%, plumping shares of poultry producer Industrios Bachoco (IBA), as well as tortilla maker Gruma (GMK) and Telmex (TMX). Our foreign holdings would have increased in value even more if the dollar had not rallied against most other currencies during the quarter.

We continue to minimize our exposure to the financial sector. One exception is Berkshire Hathaway (BRKB), which has operations in a wide array of industries but is driven largely by insurance earnings. Despite its years of extraordinary performance, this stock has been one of our poorest performers over the past 18 months. Buffett’s reluctance to jump on the asset-reflation bandwagon has hurt him in the short-term as he maintains billions in foreign-currency plays. In addition, his equity stakes in companies such as the Washington Post and Coca-Cola have been laggards. We are prepared to be patient with this stock, recognizing that Berkshire has a tremendous track record of wisely allocating capital.

Although some of our stocks got a short-term boost from Katrina, the bigger story remains rampant deficit spending by the federal government. The estimated $200 billion in reconstruction spending on Katrina is about the amount spent so far on the wars in Iraq and Afghanistan. In the context of the federal budget, that is equal to about half of this year’s discretionary spending – outlays for everything outside of national defense, Social Security, Medicare and Medicaid. With virtually the entire amount likely to come from additional borrowings, the deficit is poised to jump dramatically from the record $413 billion in the fiscal year ended Sept. 30.

The federal debt now stands at about $8 trillion. The cost of servicing the debt each year is now greater than the entire amount that will be spent on hurricane reconstruction – but where are the headlines and sense of emergency about that? Our huge deficits and growing reliance on foreign lenders, who now hold 46% of the debt, will limit the ability of policymakers to respond to the next downturn.

Given these concerns, we continue to balance our domestic equities with a substantial amount of international exposure. Beginning with this quarter, our performance reports categorize holdings in each industry by whether they are foreign or domestic to give you a snapshot of your global allocation.

Sincerely,

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

Note: Composite represents discretionary accounts over $100,000 held at Fidelity Investments. Performance is size-weighted. Performance varied based on risk tolerance, timing of investment and other factors. Size-weighted dispersion for the quarter was 2.6%. Performance is presented net of fees. S&P index data includes gross dividends. Other indices reflect price change only. Investors cannot own an index, which represents full investment at all times and does not include fees or other expenses. Data is believed to be accurate but is not audited or guaranteed. Past performance is no guarantee of future results.