BakerEllisLLC_Commentary

INVESTOR UPDATE
SPRING 2006

Domestic equities turned in their best first quarter since 1999, with the S&P 500 gaining 4.2%. The Baker Ellis Composite gained 9.3%, benefiting from a continued hot streak by small and international stocks.* As in previous quarters, our allocation to bonds and cash reduced risk but acted as a substantial drag on returns.

Key contributors in the quarter included our holdings in India, where the Sensex 30 pierced the 11,000 level in March, driven by excitement over government plans for greater rupee convertibility; and Oregon Steel (OS), which reported stellar earnings of $3.19 a share for the year and is benefiting from a surge in demand from the energy sector.

Valuations in these and other areas leave little margin for error, and we have been trimming positions. For example, India remains one of our favorite economies and is expected to show growth of more than 8% in the year ending March 31. However, the Sensex is up nearly 24% this year after gaining 42% last year. At 21-22 times fiscal 2007 estimates, the market is hardly cheap. The closed-end India Fund (IFN) traded at a premium of approximately 30% to net asset value during the quarter – a big swing considering that we originally purchased the fund at a discount to NAV. Meanwhile, Oregon Steel’s line-pipe business is nearly sold out at current capacity through 2008, which may limit future upside surprises.

Although this is traditionally a good time of year for stocks, we are surprised by the across-the-board strength of global markets. During the quarter, London’s FTSE100 gained 6.15%, Germany’s DAX picked up 10.29% and France’s CAC40 rose 10.72%. Turkey popped 7.9%, Romania gained 13.9% and the major equities index in South Africa jumped 11.4%. The Argentine Merval tacked on 16.67%, while Brazil’s Bovespa added 13.44%. With commodities and real estate continuing their ascent, the market feels like one big trade – a play on global asset inflation.

At home, the tape climbs higher almost every month in spite of rising short-term interest rates, growing uncertainty about the Iraq war, the lowest approval ratings for a sitting president since the late ‘70s, speculation about the potential for a global influenza epidemic and a desperate attempt by G.M. to avert bankruptcy by offering a buyout to every unionized employee. Corrections are short-lived, and the lack of volatility suggests that a torrent of hedge-fund money is ready to pounce on even marginal opportunities.

The current environment is great for CEOs, the wealthy investing class and Wall Street, where brokerages routinely are blowing away estimates. Morgan Stanley (MS) raked in net income of $1.64 billion in the quarter, much of it from servicing the burgeoning hedge-fund industry. Goldman Sachs (GS) shares hit new highs as revenue reached record levels and first-quarter profit jumped 62 percent to $5.08 a share, compared to consensus estimates of $3.29.

While easy liquidity has created an asset price explosion, rising prices clearly are not benefiting everyone. The average income for American families – after investing for inflation – fell from 2001 to 2004, according to the Federal Reserve. Arguably, the average American family has gained little from the broad melt-up in stocks and real estate. According to the Fed’s latest survey of consumer finances, the typical family in the bottom 25% of American households had a net worth of $1,700. The net worth of the median family was $93,100.

Meanwhile, the federal government continues to borrow at a pace that dwarfs the ability of the average family ever to repay its share. During the quarter, Congress raised the debt ceiling again, to nearly $9 trillion (the debt is now more than $8.3 trillion; it was $5.7 trillion when President Bush took office). In New York City, the private sponsors of the federal debt clock are wrestling with the unexpectedly early arrival of the problem of how to add another digit when the debt hits $10 trillion. Each family’s share is now $89,518 – about the same as the median family’s net worth.

Given our increasing dependence on foreigners to finance the debt, we can expect to see more controversies like the furor over the Dubai Ports World transaction. As we said with China’s bid for Unocal, we cannot expect our trading partners to continue to hold U.S. dollars if we cry foul when they want to invest those dollars in American enterprises (or, in this case, British ones with American operations).

On a housekeeping note, we amend our Form ADV Part II each year in keeping with SEC requirements. This form details our business policies and procedures. If you would like a copy, please let us know and we would be happy to send you one.

Sincerely,

Barnes C. Ellis Brian C. Baker, CFA

*Baker Ellis Composite represents discretionary accounts over $100,000 held at Fidelity Investments. Composite may exclude accounts with legacy positions or other restrictions. Performance is size-weighted. Returns for individual accounts will vary 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 2.1%. 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, a hypothetical portfolio that represents full investment and does not include fees or expenses. S&P 500 data provided for purposes of broad comparison only and may not be the most relevant benchmark. Data is believed to be accurate but is not audited or guaranteed. Past performance is no guarantee of future results.