As We See It, the Current Equity Outlook ...                      Second Quarter 2006

Nervousness about a new regime at the Federal Reserve Bank, uncertainty about how long interest rates will continue to rise, continued high energy costs, and tangible and significant evidence of a housing slowdown combined to spook investors and force the US markets to give up virtually all of their first quarter gains. We can attribute our second quarter under-performance to both company specific and sector related factors.

Several of our holdings lagged substantially. Plantronics suffered a large pull-back as the company, the leading manufacturer of headsets for office, commercial, and personal use, continued to transition to a higher turn business model. Although we believe this is the right strategy for the company, it does reduce their earnings visibility and injects an element of uncertainty over the short term.

Boston Scientific continues to be under fire for its acquisition of Guidant, particularly as the latter announced another recall of some of its implantable cardiac rhythm devices because of quality control issues with a component supplied by an outside vendor. Our thesis on BSX is simple. They are choosing to compete in markets with excellent growth prospects where it is possible to establish and maintain a competitive advantage through application of proprietary technology. The management team has a proven track record of re-invigorating companies with excellent technology but operational shortcomings. We like the strategy, we have faith in the team, and we remain confident in our position; however, it will clearly take time to sort out Guidant’s problems.

EMC’s share price was also punished late in the quarter for their announced acquisition of RSA Security, a leading vendor of data security tools and technology. The simple concern was that they overpaid for the acquisition. We are all familiar with the plague of identity theft and the vulnerability of electronic data to misuse. EMC has bet that they can combine RSA’s encryption technology with their leading information management and storage technology to create a compelling, secure, robust, and comprehensive offering to their corporate clients. We continue to like the company’s position and find the valuation very attractive.

In general, the healthcare sector was a surprising underperformer. Typically we expect healthcare stocks to have defensive characteristics in down markets, yet their performance in the portfolios was atypically soft. Some of this is related to company specific issues (e.g. Boston Scientific), but we suspect that much of it is related to politics. Congress is under increasing pressure for the budget deficit. Healthcare expenditures are under increasing scrutiny and targeted for price reductions. Our belief is that the companies we invest in actually save healthcare costs over the long run by reducing costly hospital stays and complications through their technology application. Short term, however, they are painted with the same brush as all the other companies in the industry.

We continue to position portfolios for the long term, making smaller, incremental adjustments as needed rather than sweeping changes. We see the most value in larger market capitalization stocks, but remain very choosy and are disciplined about the growth prospects and competitive advantages that we insist on being present before establishing any new position.

Fixed Income, Interest Rates & the Economy...

The Federal Reserve has raised rates again to 5.25% on Federal Funds, the cost for a bank to borrow from the Federal Reserve. Is this the time to buy longer-term issues and lock in the returns? Or is inflation going to drive short-term and long-term rates higher, causing bond prices to fall?

There are a number of factors to consider in determining the likely progression of interest rates. First, we look at the strength in the economy and employment and the concern that constraints are pushing up prices for labor. Next, we look at inflation figures and the consequent concern that inflation pressures are developing beyond the gas pump.

We believe the economy has been very strong. The 1st Quarter’s GDP growth came in at 5.6% and we expect to see GDP results for the 2nd Quarter as high as 3.5%. The trend for the rest of the year should be somewhat slower, in the 3% range. This kind of growth rate is weaker, but still fairly robust. More to the point, jobs gains have been very solid. There are several ways to view the growth in jobs on a monthly basis. We believe the unemployment rate is the best. Current unemployment is 4.6%, a very low rate, suggesting that jobs growth has been strong. Job creation improvement helps to support strong consumer spending and expansion of home ownership. This employment growth has off-set the increased cost of gas and the economic drag that higher rates have created, particularly as increasing mortgage costs slow housing.

The consequence of the strong economy and increasing jobs has been upward pressure on inflation. Much of the early pressure on prices in 2004 and 2005 was only food and fuel costs, notoriously volatile prices, and largely ignored by decision makers. Now, we are seeing clear signs that inflation is being driven up by wage-push inflation as well as food and fuel costs. This is a much more dangerous trend and helps to explain the Federal Reserve’s decision to continue raising rates. We believe the Fed has not finished raising rates, and expect to see 5.50% at the next meeting, or possibly the one after that. In any case, we do not expect to see a long pause until rates are 5.5% at least. Long bonds have moved almost in lock-step with short-term securities and we expect that trend to continue. We recommend that fixed-income investors keep their maturities short until this plays out. The positive side of the process is that we expect the increases in rates stop in the 3rd Quarter, and with that stop, a more positive outlook for bonds to follow.