Market Commentary

Problems are Opportunities

September 2008

"Problems are opportunities in work clothes." - Thomas Edison

We write to describe changes we will be making in your investment portfolios.

It is the case that, as targeted, your portfolios have continued to weather the storm better than the broad U.S. and global equity markets. Yet, such an environment presents additional risks from which we'd like to move away and opportunities towards which we can begin to look.

We continue to watch the unfolding events in the capital markets with great attention. Our observations, which we sent to you last week, still stand, that the bad risk that was taken in good times is now a harsh reality to everyone. The Federal Reserve and the Government and the capital markets leaders are working hard to find a solution that will keep lenders lending, borrowers borrowing, and investors investing – albeit with tighter underwriting and lower expectations than some of them had during the boom in the credit markets during the past five years. We expect a continued negative economic and investment environment in the coming year. We expect it to take a few years for the U.S. and global stock markets to recover. Given the amount of invested assets that the U.S. government is expected to take onto its balance sheet for dissolution and partial redistribution, the U.S. economy and dollar has weakened and should weaken even further.

Given these considerations, we think it is appropriate to lessen your exposure to certain risks in the debt and equity markets while also placing your assets to take advantage of opportunities that will develop, both here and overseas. And Edison is right, these opportunities will develop! From an overall asset allocation perspective, we are not changing your exposure to more bonds or fewer stocks, but inside those two asset categories we are making some important shifts.

On the equity side, we are lessening risk by placing even more of your assets in the hands of managers who have a track record of capital preservation, and who will hold cash or other investments if they don't' find the right investment opportunities in stocks. Thus we are purchasing more First Eagle, Mairs & Power, Fairholme, and Parnassus for your investments, depending in part on any social screening considerations you have. We are also going to be establishing positions in a new investment with managers who have an excellent track record and who recently left First Eagle. Most of these managers are also willing to go further afield to find opportunity – into other asset classes such as gold, commodities or certain types of bonds. We think in the coming years that there will be big opportunities with managers who decide to invest in distressed debt or other non-equity vehicles that will yield equity-like returns when equities themselves may not perform so well – and we want you to have access to opportunities that develop there. In certain cases, we are also moving you to these managers' all-world investments, as opposed to being in only or both their U.S. or overseas investments, so that the managers will be able to decide whether to invest more heavily overseas or in the U.S., depending on where they find value and opportunity. We expect that this will allow your investments to tilt more internationally when the time is right, and back towards the U.S. at the appropriate junctures, long-term.

In order to make room on the equity side to add to these investments, we are selling smaller stock investments. Two investments that will go are American Funds' AMCAP and Europacific Growth. While the American Funds are well-run, and the holdings inside them are well-researched, their performance during this down-cycle has very closely mirrored that of the indices and we don't feel they are compelling in the environment we expect for the coming couple of years, particularly as their mandates don't include taking advantage of some of the opportunities we think will develop and in which your core managers will invest. In socially-screened portfolios, this also will go for the Neuberger Berman and Domini investments. In addition, direct holdings in pharmaceutical stocks, which have helped portfolios in the last three months as they have outperformed the market, had a special position in the portfolio as they were under-represented in your other investments. However, pharma has now become well-represented enough inside our core funds during the past six months, particularly inside Fairholme, that we are comfortable selling this investment in favor of concentrating more of your holdings with your core managers. And while Presidio has done an excellent job investing in smaller companies, we think the environment will be difficult for these companies for some time due to economic and credit difficulties, and prefer to have those assets invested with your core managers who can buy small, medium-sized, or large companies, as well as take advantage of other opportunities.

On the debt side, we are putting more assets with a fixed income manager that has weathered this storm beautifully and who in most cases is already our clients' largest fixed income position – FPA New Income. Most of you already own significant positions in FPA New Income, so this position will get bigger now. This manager will go out into the market and take more risk in the fixed income marketplace when he gauges the time to be right, and this time is not right now. To fund this purchase, we made the decision to sell clients out of the floating rate note asset class. While this asset class has suffered price declines amidst the uncertainty in the credit markets, we had up until recently remained confident that even with historically high default rates the investment would provide an adequate return for the credit risk taken. We recently studied the asset class in yet more detail, however, and found that a certain type of Wall-Street investment vehicle, collateralized loan obligations, have between 2004 and now become the majority investor in this asset class, and as pieces of these obligations start maturing starting 1-2 years from now, this asset class could possibly have price repercussions related to supply-demand imbalance that could be quite large and that will be very hard to predict. Hence, moving floating rate out of your portfolios is another risk management move for now, even as such a price decline may or may not happen and may be a year or more in the offing.

With all these changes, we will be paying particular attention to tax losses and gains in your taxable accounts and will be attentive to minimizing gains with the shifts wherever possible, and we will also be opportunistic where we can about harvesting tax losses to your advantage.

Should you have any questions about our plans or wish to discuss them further, please do let us know. We feel this is a positive move for your portfolios and sets you up to have a balance of risk and opportunity in your portfolios that will stand you in even better stead now that we have seen how the current markets are evolving.

This is a general assessment of client portfolios and does not reflect the specific circumstance of every client.

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