2007 - 1st Quarter Report (Download printable .pdf version here.) Equities rebounded in March, bringing the first quarter 2007 return of the S&P 500 into positive territory, up 0.6%. While hardly exciting, positive returns are somewhat gratifying in the light of the volatility and bad news that has occupied newspaper headlines recently. Following a fairly extended run of higher prices, investors were rattled by a sharp decline in the Chinese market in late February of almost 10% and the subsequent dip in U.S. stock prices. Given the economic expansion that the global economy has experienced, and the role that emerging economies have played, it is realistic to expect that a slowdown will occur at some point, and any evidence of slowdown will impact stock markets. Getting back to home, U.S. investors have grown increasingly concerned about the potential impact of a weak housing market; in particular, problems in the sub-prime lending market have drawn lots of attention. Those of us living in areas with ridiculously high housing costs are aware that lenders have “pushed the envelope” to come up with loans enabling people to buy homes that otherwise they could ill afford. With low teaser rates and temporary interest-only terms winding down or expiring, defaults among sub-prime mortgages have climbed sharply. Such sub-prime loans represented some 24% of all mortgage originations in 2006 and defaults on these loans are around 14% currently. To put things in perspective, more than 76% of all loans outstanding were still prime loans. Even if defaults on sub-prime mortgages reach 20% levels, only about 5% of all loans are affected. In addition, about one half of the housing stock in the U.S. is owned “free-and-clear.” Though we see a lot of potential pain for some segments of the economy, it seems the dimensions of the problem are not enough to result in disaster for the economy in general. Strict underwriting standards and a stagnant inventory of unsold houses will cramp growth, but we do not believe that this will result in a washout of the consumer. Housing prices will likely remain weak as the supply of existing homes, relative to demand, remains high and the backlog of new homes is rising. The Fed’s regime of rate hikes has taken the air out of what many perceive to have been a housing bubble fostered by extremely low interest rates. Consumer spending will slow in this environment as homeowners realize that their homes are no longer doing their saving for them by simply going up in price. Despite these headwinds, we remain encouraged by the outlook for the stock market. The International Monetary Fund’s recent publication of “The World Economic Outlook” addresses spillovers and cycles in the global economy. As they indicate: “The world economy is expected to continue to grow robustly in 2007 and 2008—with a modest deceleration from the rapid pace of 2006 bringing growth more in line with potential and helping to contain inflationary pressures in the fifth and sixth years of the current expansion. Specifically, global growth would moderate to 4.9 percent in 2007, around ½ percentage point less than in 2006.” It is interesting to note the IMF contention that despite taking down their forecast for US growth by about 1% versus their September 2006 forecast, their forecast for global growth remained unchanged at 4.9%. Consequently, spillover effects of US economic slowdown should be minimal. In addition to huge pools of liquidity around the world including petrodollars, foreign central bank reserves, corporate cash, and private equity funds, money supply growth within the US remains strong. Such liquidity argues against a recession and should remain a good source of demand for stocks and bonds. We remain committed to the disciplined pursuit of a proven investment philosophy. Periods of great opportunity are seldom aligned with periods of great results. It’s periods of such misalignment that have often provided opportunity for investors. We continue to fine tune our analytical process to support our goal of improving our decision-making. We continue to look for opportunities to find good businesses with good management at attractive prices. Our goal is to continually challenge current allocations of capital with the prospect of finding even better investments. An important foundation in building our firm is our continuing education efforts. We congratulate our partner, Victoria Fillet on her being awarded the Certified Financial Planner® designation in January. As well, our analyst Ken Freeman has successfully completed the first level exam for the Chartered Financial Analyst program. Ongoing continuing education is a requirement for our team in order to better serve your needs. Uncertainty abounds. The unwinding of the yen carry-trade, sub-prime mortgage lending issues, continued geo-political turmoil, high commodity prices-each of these issues represents an incremental element of risk that must be considered in making investment decisions. Our focus on investing with a margin of safety- a discount to our estimate of a company’s intrinsic value- should compensate us as investors for the risks and uncertainties assumed and the capital allocated. We try to act as Benjamin Graham defined intelligent investing many years ago: viewing investing in public companies in the same manner as if we were buying the entire business. We thank you for your continued interest and the confidence you have placed in our team. Richard H Konrad, CFA, CFP®