BakerEllisLLC_Commentary

INVESTOR UPDATE
JANUARY 2006

Our stock-picking style worked well in 2005. Domestic stocks were mixed but international markets generally fared better. The Baker Ellis Composite gained 17% for the year, including a fourth-quarter gain of 1.4%. The S&P 500 eked out a 4.9% gain for the year and the Dow Jones Industrial Average registered a fractional loss, its first since 2002.*

Most markets in Europe, Asia and South America ended the year with gains of 15% or more as international investing surged in popularity. Our accounts benefited from longtime exposure to these regions, though the gains were tempered for American investors by a strong dollar. For example, the Nikkei in Japan bounced 40.2%, but in dollar terms the gain was cut to 22%.

In a reminder that economies and stock markets do not move in lock-step, many of our best performers were in less glamorous areas of the world. Despite relatively sluggish economic growth, Mexico's IPC index rose 38%, with holdings such as tortilla producer Gruma (GMK) and cement maker Cemex (CX) generating solid returns.

Our philosophy of broad diversification reduces the impact of unsuccessful investments, but we inevitably have a few clinkers. Flextronics (FLEX) dropped 24.4% for the year, hurt by costly restructurings and declining revenues from major cellular phone customers. We believe the long-term outlook for the Singapore-based electronics manufacturer remains decent, but are beginning to grow impatient with execution. Meanwhile, Natuzzi (NTZ), the Italian furniture maker, struggled with declining revenues due to pricing pressure in the industry.

Once again, our stocks in aggregate performed much better than bonds, and cash proved a drag on our investment results. While some clients have questioned why we own bonds at all, we caution against the human inclination to believe that recent history is predictive of the future. A modest degree of fixed-income exposure will help dampen volatility in more difficult markets, and is appropriate for the vast majority of investors.

In December, Barnes took a two-week trip through China to visit some of our portfolio companies and get an update on one of the world's fastest-growing economies in meetings with business executives, analysts and fund managers. China is in the midst of an attempted soft landing from recent economic frenzy, but cranes still crowd the sky and 1,000 new cars a day are flowing onto to Beijing's crowded streets. Some observations from the trip:

The world is not just flat, it is American: Sitting in a Starbucks next to the Ferrari dealership in Shanghai and listening to incessant English-language Christmas carols brought home the tremendous homogenizing force of capitalism. This would appear to bode well for the future of popular global brands from Kentucky Fried Chicken (YUM) to Nike (NKE). However, as China continues to develop, we expect it to transition from a source of cheap labor to a center of higher-value-added activity, with its own franchises competing directly with those of the Western world. Predicting winners in this fast-changing environment will be difficult; we do not share the assumption that the emerging Chinese middle class will necessarily buy our toothpaste or laundry detergent. We remain more comfortable at this point with broader investment themes, such as China's surging demand for commodities.

Economies and stock markets are not always linked: While the economy has been growing at about 9%, the Chinese stock market has been an easy place to lose money, with “A” or public shares down about 45% since 2000. The young market is beset by structural problems including the fact that the state remains the single largest shareholder in most firms, and interests between the state and public shareholders are not necessarily aligned. The concept of investing is so new in China that the market is an interesting case study in investor psychology. One study of 46,969 individual Chinese brokerage accounts found that investors exhibited a high degree of heuristic simplification, deluding themselves into unjustified overconfidence and making frequent poor trading decisions with little understanding of risk. We are not sure that more experienced investors in developed countries are exempt from such tendencies. Regardless, most wealthy Chinese have thrown in the towel on stocks and prefer instead to purchase multiple homes and condominiums, many of which are vacant.

Corruption remains widespread: Fund managers we spoke with distrust numbers from all but the biggest of companies, and corruption remains endemic. One corporate executive we spoke with quantified corruption as an approximately 3% cost of doing business for many companies, public or private. Investment professionals complain that company executives often fail to distinguish between fact and hope when discussing their businesses. With so much illicit wealth floating around, one hedge-fund manager we spoke with in Hong Kong even refuses to accept investors from mainland China for his Asian-focused fund. Frequent anti-corruption campaigns are destined to fail because they are led by the same officials who benefit from graft. Until China develops effective independent institutions to address corruption, we expect it to remain a major obstacle to efficient investment. This is one reason we generally prefer to play China through more developed markets such as Singapore and Hong Kong.

Doing business in China is complex: American companies operating in China face a daunting array of obstacles, and business is intensely relationship-driven. We spent a day visiting with executives of portfolio company ProLogis (PLD), a Colorado-based REIT with global warehouse and logistics holdings. PLD has a special deal to run logistics in Suzhou Industrial Park, a 100-square-mile complex with 120,000 employees working for a wide array of companies. The amount of industrial activity in the park is impressive, but the potential for PLD is hard to quantify. The company cannot own the land under its warehouses. It is a 50% partner in an equity joint venture within the park, which itself is a cooperative venture of the China and Singapore governments. We were not surprised that Ming Mei, our gracious host and the highly knowledgeable head of the company's China operations, spends much of his time in meetings with mayors and governors.

As we approach our fourth anniversary at Baker Ellis, we are pleased by the track record that we have built so far. Since our founding in March 2002, our composite has produced an average annual return of 15.1%, net of fees, compared to the S&P's 4.1% (including gross dividends). Although the S&P may be an imperfect benchmark, considering that our flex-value strategy allows us to invest globally in a wide variety of instruments, our composite also remains well ahead of the Russell 2000 (with an average annual return of 7.9% for the period) and the Dow (0.8%). In addition to providing a solid total return, our balanced approach has resulted in considerably less volatility than an all-stock portfolio.

At press time, we were adding a new holding to most accounts. Syngenta AG (SYT) is a Swiss-based company that was listed in 2000 through a merger of the agricultural chemical businesses of Novartis and AstraZeneca. The company is a world leader in herbicides, fungicides and seeds, with about $8 billion in sales and about 19,000 employees in 90 countries. We like the Syngenta's reasonable valuation and growth prospects. The amount of land under cultivation worldwide has expanded very slowly in recent years while growing wealth in developing countries is driving increased demand for agricultural products.

Sincerely,

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

P.S. If you would prefer to receive your quarterly reports by email, please contact David at David@BakerEllisLLC.com.

*Composite represents discretionary accounts over $100,000 held at Fidelity Investments. Composite may exclude accounts with substantial legacy positions or other restrictions. Performance is size-weighted. Returns for individual accounts may vary substantially based on risk tolerance, timing of investment and other factors. Clients should consult their own performance report for details. Size-weighted dispersion for the quarter was 1.04%. Dispersion for other periods is available upon request. Performance is presented net of fees. S&P index data includes gross dividends. Other indices do not include dividends. Investors cannot own an index, which represents a hypothetical fully invested portfolio and does not include fees or other expenses. All data is believed to be accurate but is not audited or guaranteed. Past performance is no guarantee of future results.