Client Letter - 11/18/05

November 18, 2005

To Our Investors and Friends

To paraphrase Dickens: These are the best of times for investors… and these are the worst of times for investors. Corporate profits are strong, unemployment is low, productivity continues to climb, interest rates are still low, and consumers have continued to buy. On the other hand, neither equities nor bonds are providing returns close to historical expectations. U.S. fiscal and trade deficits are at levels that seem unsustainable without significantly higher interest rates; personal saving rates are at all-time lows; energy costs seem at times to be out of control; major home builders say that new home sales are softening; inflation is rearing its head; and consumer confidence is volatile.

Despite this confusing dichotomy, we have concluded that it is reasonable for us to remain nearly fully invested in that certain group of equities in which we specialize, i.e., those that (1) have long track records of generating strong internal returns on invested capital; (2) are conservatively valued on the basis of projected operating profit growth; and (3) consistently reinvest operating cash flows in high-yield operating assets through capital spending and acquisitions, or return free cash flows to their investors, through consistent dividends and/or stock buybacks.

In our view, this formula is the most secure way of generating equity yields that consistently exceed the S&P 500 benchmark, over time. While some of the economic concerns outlined above may depress equity markets and essentially “lower all boats” for some period of time, companies that consistently deliver strong returns on invested capital and either reinvest or return free cash flows for their investors, create real economic value, which will be borne out through both “thick and thin” market conditions.

Having said that, we still believe that Warren Buffett was correct several years ago, when he said that his return expectation for the equity markets was “six to eight percent over the next decade or two”. This would mean that achieving a compound yield of eight to ten percent in this period would be very attractive. In that regard, since we believe that the resolution of the economic dichotomy outlined above will almost certainly be significantly higher long-term interest rates, investing a small percentage of our assets in selective fixed-income securities might be in order sometime in the next few years. For the moment, we are confident in our strategy of remaining invested in properly valued, economic-value producing equities. We will continue to take some profits as we go along, and may accumulate some cash when we perceive that long-term rates are moving toward a level that we might consider interesting.

As always, we appreciate your questions and observations.