BakerEllisLLC_Commentary

INVESTOR UPDATE
WINTER 2006

Stocks had a banner quarter as the torrent of global liquidity driving the current cycle continued unabated. The benchmark S&P 500 gained 6.7%, finishing the year with a gain of 15.8%; gains were broad-based, with the Dow Jones Industrial Average and Russell 2000 index of small stocks turning in slightly stronger annual performances.

Aided by the continuing melt-up of many foreign markets, the Baker Ellis Composite picked up 10.6% in the quarter. For the year, the Composite showed a gain of 24.4%, well in excess of what we would have expected in January and a gratifying close to our fifth year.*

During the quarter, Oregon Steel (OS) announced that it would be acquired by the Russian Evraz Group SA for $63.25 a share in cash. We had been scaling out of our position as the stock doubled over the past year. Norsk Hydro (NHY) agreed to merge its oil and gas activities with Statoil (STO), creating the biggest offshore oil company in the world. We are evaluating whether to retain our shares. Our other natural-resource stocks treaded water as oil prices moderated and the sector lost some of its luster.

Despite our strong performance in 2006, we view our recent success more as a consequence of excess liquidity in the global economic system than a triumph of individual security analysis. Central banks in Japan and China continue to pump money into the system, enabling a bidding war for global assets and a debt-based consumption boom in the U.S.

So far, we see no slowing of these trends. As of the end of the year, eight companies in the S&P 500 had announced plans to go private as cheap money fueled the ongoing buyout boom. Many companies themselves are awash with cash. According to a study by Standard & Poor’s, companies in the S&P 500 spent $437 billion on stock buybacks in 2006, up 25% from the previous year – and the first time in history that companies spent more on buybacks than capital spending.

Fiscal policy remains a massive source of stimulus. According to the Fed’s latest quarterly flow of funds report, the government is borrowing $5.1 billion a week, of which about $3.5 billion is coming from foreigners. Since 2001, the volume of Treasury securities outstanding has ballooned by $1.4 trillion, or 43 percent.

Our own industry continues to reach new heights of excess, particularly in the burgeoning hedge-fund industry. Blow-ups such as Amaranth Advisors’ loss of $6 billion through ill-timed natural gas trades captured headlines in 2006, but we believe many other funds have unsustainable business models. Citadel Investment Group, which is planning a $2 billion debt offering, paid more than $5.5 billion in margin fees and other investment costs in 2005 on $13 billion in net assets, according to their recently filed prospectus. Citadel funds were operating with leverage of 12.5 times. With such high expenses, two flat years would consume nearly all of the clients’ money. (The Credit Suisse/Tremont Hedge Fund Index of 436 funds showed a year-to-date return of 11.8% through November, worse than an S&P 500 index fund.)

The year-end crisis in Thailand serves as a reminder of how quickly investors in volatile sectors could see liquidity flows reverse. A huge influx of capital drove the Thai bhat up 16% against the dollar, hurting Thai exporters. In December, the government attempted to temper the rise by announcing restrictions on incoming funds (ironically the opposite of the scenario that caused the last emerging-markets crisis in 1997). The stock market plunged 15% in one day. Listening to conference calls hosted by our brokers in the region, it occurred to us that in the current environment, a U.S. buyout firm could theoretically buy out all of Thailand. As with the de-facto nationalization of Yukos in Russia, we think many investors are embracing globalization without adequately considering political risk.

Looking forward to 2007, we see many ways the current cycle could end, but so far the economy has dodged the most obvious threats. The dollar’s decline has been controlled, avoiding the currency crisis that many feared; the median existing U.S. home price dipped 3.2% year-over-year in November but still has doubled since the beginning of the decade; and interest rates remain relatively low. Overall, global growth remains robust. We have renewed interest in domestic blue-chip companies that have lagged the market, such as large-cap pharmaceuticals, and are evaluating several utilities that could provide decent returns with relatively modest risk.

On a housekeeping note, we are required by the S.E.C. to offer you an updated copy of our Form ADV Part II each year. This form contains information on our firm and business practices. If you would like a copy, please contact us. In addition, please find enclosed a copy of our Privacy Policy.

Sincerely,

Barnes C. Ellis Brian C. Baker, CFA

*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 1.96%. Further information is available upon request. Performance is presented net of fees. S&P index data includes gross dividends. Other index returns 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 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.