As We See It ...                                                                 First Quarter 2008

Alan Greenspan remarked the other day that the real economy seems to be relatively strong while the financial economy is struggling. Rarely do the two economies get as disconnected as they appear to be now, and the only thing we are confident of is that one or the other has to change. The consensus of opinion we read, listen to, and watch is that the "real" economy will decline to match the problems in the financial world. Certainly, there is a case to be made for that outcome; after all, businesses rely on the banking system to fund capital investments, whether it be capacity or inventory, as do consumers for mortgages, student loans, and the like. If the banking system curtails lending, growth is curtailed.

On the other hand, this does not seem to be borne out by other indicators of the real economy. Employment has been softening, but not alarmingly. Spending is holding up reasonably well in key sectors like information technology. The weak dollar is helping boost exports from US manufacturers. Corporations went into the financial crisis with strong balance sheets, and are able to fund their near term growth with internal resources.

This sets up something of a race between the recovery of the banking system and the durability of the industrial and service economies. It is too close to call, and that accounts for the remarkable volatility in equity prices. Markets are down about 13% from October’s highs, and were down close to 20% earlier this year. Large intraday moves are now the norm. Housing-related and financial stocks are pariahs.

As usual, the uncertainty has created opportunities. Several companies that we have long admired have come down in price enough to make them look like interesting investment opportunities. To be sure, their near term growth outlook might not be as strong as it was a year ago, but in some cases their longer term opportunity is unchanged, and we may be seeing attractive entry points.

A Rocket in your Pocket…

Electronic devices are continually shrinking. Not only is this nothing new, we have all come to expect it. Every year, manufacturers clamor to make ever smaller, ever more functional devices. Nowhere has this been truer than in the cellphone industry. Early versions in the 1980’s were confined to use as car phones, constrained by power requirements, size and weight. By the early 1990’s, the Motorola MicroTac, weighing-in at half a pound and 9 inches long, became the hot new cellphone. What a wonder to have a portable phone that would fit in your pocket!

Since then, while each year saw new, improved designs – smaller, sleeker, longer battery life, better sounding, color screens – they shared the fact that they were all primarily phones. That’s changing now.

A plethora of new features, unrelated to telephony, are being piled into mobile handsets (cellphones, no longer). It is now an email device, an Internet browser, and a PDA (Personal Digital Assistant), as well as a camera, camcorder, music/video player and a navigation device all-in-one. Maybe the next generation will deliver live television, take dictation and even respond to spoken commands. These amazing capabilities are enabled by ASM Lithography (ASML) based in the Netherlands and ARM Holdings (ARM) based in the U.K. Both of these companies are holdings in our portfolios.

The unstoppable process of miniaturization, which provides for more functionality and less power consumption, is enabled by ASML’s technology. Lithography is the critical stage in semiconductor manufacturing that enables chips to be made smaller, faster and cheaper. ASML is the world-wide leader in this segment with a steadily-growing market share that hit 65% in 2007. The relentless pursuit of smaller, faster and cheaper has led the industry to ASML’s doorstep. Although, in the short-term, the market is concerned about the risk of global recession and where we are in the semi-cycle, we see share price volatility as an opportunity to add to our position for a high-growth, highly-profitable franchise at very attractive valuations.

As quickly as processing power is created by semi manufacturers using ASML technology, mobile handset designers are consuming it with ARM processors. ARM’s main business is designing processors for small form-factor and low-power applications, making them perfect for mobile handsets. Globally, over 90% of all handsets contain at least one (and often multiple) ARM processor(s). Handset designers use separate, dedicated processors to connect to the cellular network, wireless headsets and Wi-Fi as well as for general-purpose computing (web browsing, camera, music/video playback). Each one generates revenue for ARM. We are convinced that consumer demand will accelerate for handsets rich in features such as Apple’s iPhone and Blackberries (both of which contain ARM processors inside). We believe that ARM is a great way to participate in this trend as investors. ARM’s progress in penetrating other market segments such as hard disk drive controllers, printers and smart cards, provide further upside to the investment story.