2006 - 4th Quarter Report (Download printable .pdf version here.) We are pleased to bring you the Value Architects Asset Management fourth quarter report for 2006.  As in prior reports, we will provide a general overview of the market and in this quarterly, we will discuss two issues that have received considerable press in the past few months. The fourth quarter of 2006 sustained the third quarter experience, an ascent of a “Wall of Worry”.  The S&P 500 produced a return of 6.7% for the quarter, resulting in a robust 15.8% return for the year. Similarly, the broader based Russell 3000 index returned 7.1% and 15.7% respectively.  As is typically the case, capital markets absorbed with fear often reward rational investors when those fears fail to materialize.  Entering the last half of the year, markets dreaded potential inflationary pressure from $100 barrel oil, insatiate demand for commodities from emerging economies, a collapsing housing market, higher interest rates, and geopolitical unrest. The subsequent decline in oil and commodity prices in conjunction with the retreat in the housing sector firmed the equity markets. Lower commodity prices signaled a reduction in the inflationary threat. The slowing housing market dampened runaway economic growth expectations. This one-two punch left the Federal Reserve with little choice but to end its two year campaign of monetary tightening.  In August, the Fed left rates unchanged. With the anchor lifted, equity markets enjoyed some smooth sailing. As with prior quarterly reports, we like to touch upon topical issues relating to business management or economic activity.  This quarter we will briefly discuss two and how they relate to our portfolios:  corporate spin-offs and ethanol. Corporate spin-offs have received considerable attention in the past year and we’ve had a few clients ask us why spin offs occur and how they typically perform. Spin offs typically occur because the management of a corporation, usually a conglomerate, believes that its stock price doesn’t fully reflect the intrinsic value of the sum total of its disparate businesses.  Investors typically accord such conglomerates a “conglomerate discount” because of the view that corporate managers may fail to optimize the profitability of smaller divisions, especially if they are outside the core competency of the central business.  As participants in a free-standing entity, managers can tune up and revamp operations, ameliorate capital allocation, and align incentive plans to more directly relate to the newly liberated business. Can one profit from holding spin offs or buying them?  Numerous studies indicate yes.   Nearly two-thirds of the companies spun off over the past three years have out-performed the S&P 500 this year according to Spin-Off Advisors.  In a February 2006 study, Lehman Brothers observed that the average two year gain from spin offs in the years from 2000 to 2005 was 45% higher than the S&P 500.  In 1999, a 10 year McKinsey study found that shares of spin offs beat the S&P 500 over comparable two year periods by 10%. In short, the sum of the parts is frequently greater than the whole. Spin offs often become institutional cast-offs, especially when the newly independent business does not fit the investment restrictions of the institutional fund. New spin offs tend to have small market capitalizations and attract little Wall Street research following. Consequently, impulsive selling can frequently develop which may result in very attractive valuations for these businesses.  Needless to say, we assess every security on its own individual merits under our own research process. Mankind, for some 9000 years has had a strong interest in ethanol as it is the intoxicating element in alcoholic beverages. Its use as a fuel has recently interested if not intoxicated Wall Street as energy prices and self-sufficiency concerns rose.  Ethanol made investors giddy last year when ethanol producers such as Archer Daniels Midland (ADM) and small farmer cooperatives were reaping “huge profits” distilling corn mash into fuel.  In fact, the return on invested capital for ADM achieved a ten-year high, unfortunately, a level which is only about three-quarters of the profitability of the average S&P company!  President Bush, during his state of the union address, proclaimed ethanol an important tool in reducing our dependence on foreign oil over the next ten years. It only makes sense then that ethanol investment should be a no-brainer for financial success…or should it? Much as we said in our third quarter report with regard to commodities such as copper, increased prices and huge profits attract capital investment and dramatically improve the supply side of the equation, reversing the demand imbalance. In time, a glut of product emerges and the price declines.  This is beginning to happen with ethanol. At present there are seventy five ethanol distilleries under construction in the US on top of the 111 now operating.  Amid the frenzy, corn prices, 75% of the cost of ethanol, have doubled in the past six months while the price of ethanol has fallen in sympathy with gasoline prices. It is estimated that the current demand for ethanol is 10 billion gallons while current production is 5.4 billion gallons with 6.1 billion under construction.  That would push supply above demand and destroy prices. A rescue from Capital Hill could save the industry but requires a substantial change in current mandates.  Under present law, the government imposed “independence minimum” for 2012 is 7.5 billion gallons, well below the production levels that will be available shortly.    As it stands now, the federal government already supports ethanol with a tax subsidy of 51 cents a gallon, or about $3 billion a year.  Unfortunately ethanol is not the perfect substitute for gasoline and therefore further mandates may meet resistance.  Ethanol has only two thirds the energy content of gasoline and is not particularly environmentally friendly:  it takes so much water, energy and land to produce that its environmental benefits seem dubious.  Additionally, providing sufficient corn production to meet incremental alternative fuel demand may prove difficult. Many alternative fuel stocks, having skyrocketed in the first half of the year, have settled back down to earth, erasing much of their gains.  We sense little opportunity here even at current valuations. Looking forward, we are not troubled by forecasts of slowing earnings growth.  After 18 quarters of double digit growth, the consensus expectation for 2007 of nine percent has dismayed some investors.   We continue to find securities that are trading at discounts to their intrinsic values, in our minds, a far more proven methodology than the dismal science of economic forecasting.  Also comforting is the dramatic shrinking of the supply of total market equity due to cash acquisitions and stock buy backs.  It is estimated that in 2006 alone, cash acquisitions net of stock offerings has produced a reduction in excess of $180 billion in market capitalization, an extremely bullish factor driving US markets. 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®