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

We were pleasantly surprised with the strength of the stock market in 2006. The S&P 500 returned over 15% in a year of great economic uncertainty. Energy prices were at record levels, interest rates were rising early in the year, and there was a significant and credible threat of a housing bust. S&P earnings growth for the year was in the high single digits, making the market performance even more remarkable in light of those headwinds.

Of course, the S&P and other indexes are just mosaics made up of individual companies, and each component has its own story to tell, some good, some bad. On balance, portfolio companies had a good year, with some shining lights among telecommunications and international companies. For example Cisco Systems had a good year, up 60%, and Diageo, the London based spirits company, appreciated by 36%. In both cases we saw very strong and defensible franchises at reasonable valuations. They compete in very different sectors and are sensitive to widely varying macro and micro-economic factors. Nonetheless, the result was similarly favorable.

We have always had a penchant for healthcare and life sciences related stocks due to their high intellectual property content and underlying growth drivers. Surprisingly this sector was really the only one that consistently underperformed the market all year. Although the industry has a strong growth outlook, the prospect of a harsher payment environment post the November elections severely dampened the stocks’ performance. Nonetheless, the positives outweighed the negatives, and we are comfortable with the portfolios’ performance and positioning.

From an organizational standpoint, Johnston Asset Management has had a notable year. We passed through $1 billion in assets under management in December. This milestone is entirely thanks to you, our clients, and we cannot express our gratitude enough for your trust and confidence over the years. We are also delighted to say that Joan Giannotti and Cassandra Hardman have agreed to become partners in the firm. They have long been partners in the sense that they have been key to the growth and success of the firm. No important decision is made without their input and agreement. Their participation in the firm will ensure that we continue to work as a team for years to come.

Looking forward, we expect moderate growth and appreciation in both the economy and the market. We are finally starting to see some interesting companies that are beginning to meet our growth and valuation parameters. After several years of "slim pickings", we think this bodes well for our style and long-term horizon.

Market Commentary

The US economy is being pushed toward slow-growth by high oil prices and a weak housing market, and the economy is being pulled toward strong growth by solid employment gains. These contrary forces have resulted in a remarkably stable environment. The real estate market has been the greatest concern. Clearly overpriced sectors have been predicted to plunge in value (which the most extreme did), and there is fear that this shift to lower real estatevalues will cause the consumer to pull back spending and the economy to fall. Offsetting this trend, the increase in jobs has allowed unemployment to remain very low, particularly from an historic perspective. The comfort of a solid employment market allowed consumers to continue spending at a healthy clip. Also on the plus side of the ledger, commercial real estate was very strong throughout 2006 and are likely to continue that pattern in 2007.

The Federal Reserve raised rates sharply in the first half of 2006 and then held rates steady in the second half of the year. Many economists were concerned that the Fed had gone too far and forecast a cut in rates in early 2007. Two situations have prevented a near-term cut in rates: 1.) because real estate fears were overblown, the expected weakness in the economy has not arrived, and 2.) inflation has proven to be a bit peskier than expected. Depending on the measure, inflation keeps popping up over 2.5%, above the Federal Reserves desired 2% lid. We believe that inflation will be somewhat troublesome in its failure to immediately retreat to desired levels (it is a trend indicator, after all), but do not expect to see it run away to the up-side.

Oil and minerals prices, such as copper, have pulled back sharply from their highs. Is this the end of high priced oil? No, probably not. The shifts in demand from China and India are permanent and are supportive of current prices. On the other hand, the demand destruction caused by higher priced oil in the US is just beginning to emerge. We expect to see a long-term shift to other energy sources, nuclear, wind, bio-mass, etc., as well as a decline in wasteful uses over the next several years, particularly as auto mileage improves. The marketplace does work, and consumers can now see the reward for less and more efficient usage.

While The Federal Reserve is poised to increase rates to curb inflation and equally poised to cut rates if we move to a housing-led recession, our outlook suggests that we will remain in the middle-ground. Rates are not too high, nor too low. The strong employment situation provides a solid underpinning to the economy. Dollar weakness vs. the euro suggest that US made goods are more competitive globally and as a result, exports will continue to improve. We do not expect explosive growth for 2007, but solid, steady growth in the range of 2% to 3%.