2006 - 3rd Quarter Report (Download printable .pdf version here.) We are pleased to bring you the Value Architects Asset Management third quarter report for 2006. As with prior quarterly reports, we will overview the markets in general and discuss issues that have received considerable press in the past few months. The third quarter of 2006 proved to be quite strong despite many concerns expressed by the investment community. Entering the quarter, the expectations were for $100 a barrel oil, a collapsing housing market, higher interest rates, and a nuclear threat from North Korea. As is typical of the market, it ascended a wall of worry when these concerns once again failed to come to fruition and rewarded shareholders with an excellent quarter. The S&P 500 produced a return of 5.67% for the quarter, and is now up 8.5% for the first nine months of 2006. Similarly, the broader based Russell 3000 index returned 4.6% and 8.0% for the respective time periods. Now we have CNBC and other news outlets reporting seemingly every thirty seconds, that the Dow Jones Average made a new high in early October, finally eclipsing the previous high established January 14th of 2000. Many perceive this to indicate the market is overvalued. Remember, this enthusiasm applies to the Dow Jones Industrials, a narrowly based and strangely constructed index of thirty companies. Broader indexes such as the Standard and Poor’s 500 and the NASDAQ remain below, and in the case of the NASDAQ, 50% below previous highs. At the risk of sounding dangerously trite, if not complacent, this time does seem different from those hyper times! Back in 2000, share prices were galloping well ahead of the earnings gains that companies were showing. By contrast in this cycle, S&P earnings per share have risen 110% over the course of the recovery whereas the S&P itself has risen only 21%. In fact, since the market peak of 2000, S&P 500 earnings have risen 62% but the index has dropped 11%. Three months ago, many investors were consumed with a fear of impending high inflation and the concurrent runaway valuation of commodity prices. Naturally, many of our clients were concerned about their low exposure to commodities and energy. As we indicated in our second quarter report, fears of inflation and accelerating commodity prices, in our view, were overdone. Since that time, rather than rising prices, we have witnessed a series of rather benign inflation numbers. Stories of very strong Asian, and especially Chinese and Indian demand were prevalent earlier in the year, but it is important to note that supply hasn’t stood still either. Additionally, the “edge” seems to be taken off of the consensus view of impending inflation and replaced with new fears of a potential growth slowdown. A slowdown in the U.S. economy, whether based on a weakening consumer or industrial sector, should translate into weaker demand for commodities in general. But just where is that slowdown? Here’s a look at the industrial production side of the U.S. economy: Clearly, the industrial side of the economy has continued to expand and grow since the post 2000 slide. Certainly, the automotive portion of industrial production has little in the way of good news at the moment, hardly new news, but outside of this sector, this side of the economy seems to be doing well. Of some concern is the residential housing picture in the U.S.: Economists worry about what are termed “net worth” effects, that is, effects on household consumption that come about as a result of feeling less prosperous. Just as real estate is a very local market, individual households are affected differently by changes in housing prices. For a lot of consumers who are living with a high level of residential mortgage debt, falling home prices will cause consumption patterns to fall significantly. In particular, for those who supported their consumption by using their homes like an ATM with constant withdrawals and drawdowns of equity, future spending will be highly restricted. What is highly interesting is that, according to Smith Barney economists, had homeowners completely utilized the equity extracted from their homes, real spending would have increased by 8%, not the 3% actually spent. Therefore, the reduced valuation of homes should not be as significant or negative to consumers’ spending as had been originally thought. Though much publicity was accorded the negative savings rate in the U.S., the statistics deserve some further examination and analysis. While nominal spending rose by $577 billion over the past year, and total disposable income rose by only $553 billion, ordinary bank deposits in the household sector also rose by $476 billion. The consumer balance sheet comprises more than just housing! As house price deflation sets in, this phenomenon will reshape spending and savings attitudes in America for the better in our opinion. As people feel less wealthy they save more. Those who concern themselves about the end of the construction boom and hence construction employment should consider the following chart: Though residential construction expenditures are responding to the fall in housing prices, the non-residential construction sector is steaming ahead! All told, we view the overall economic scene with some equanimity. Summarizing, the key positives that reassure us about the economy are: Strengthening export growth Household net worth, despite the housing “problem” remains near a record level Very high levels of corporate cash and strong balance sheets Some resurgence in business spending on infrastructure A tax structure that encourages business risk taking (at least until 2010 whatever the election outcome) We can accept the notion that some slowing in the economy is likely; however, fears of a housing-induced recession for next year we believe are overdone. We are encouraged by the sentiment of doubt that currently envelops equities. In contrast to the “irrational exuberance” that capital markets experienced, there is almost a foreboding gloom for 2007 perceived by many investors. For example, U.S. focused equity funds experienced a net outflow of about $14 billion in the third quarter despite the performance strength of the market U.S. equity managers have stepped up their efforts to raise cash for redemptions with cash as a percentage of assets at 4.2%, a 22 month high! Investment bankers have been busy with new offerings of stock, generally considered a negative. However, year to date, offerings of $96 billion are just slightly ahead of last year’s $94 billion YTD level, but well below 2000’s YTD record level of $161 billion. Interestingly, 68% of this year’s offerings have been follow-on or secondary offerings rather than initial offerings. IPO’s total only $10 billion YTD. Cash acquisition of public companies (as opposed to stock for stock deals) has shrunk the supply of equities. When the level of cash acquisitions is compared to the level of stock offered, on a year to date basis, the level of net equity shrink is at an all time record of $180 billion. Shrinking supply of stocks should be considered one of the most bullish considerations for the U.S. market. Having said all this, we do not concern ourselves a great deal with the day-to-day fluctuations of the market, but rather with the long-term building of wealth. Hence, we believe it is important to distinguish market risk from investment risk. We cannot control market risk, and therefore cannot do anything to prevent it. On the other hand, we do utilize the opportunities that it does create. Investment risk is the risk of being wrong in one’s assessment, analysis or valuation of a company. We minimize this risk by using a carefully disciplined research process and continuously monitoring our selections. We remain positive on the general outlook for the economy and believe that our disciplined research process will continue to uncover undervalued opportunities within U.S. and global equity markets. We thank you for choosing us and look forward to a long and successful relationship. Richard H Konrad, CFA, CFP®