Growth benchmarks enjoyed slight gains in the second quarter, but the broad market ended on a sour note, as high oil prices led to the worst performing month of June for the Dow Jones Industrial Average since 1930. Most large financial institutions experienced meaningful declines in franchise value due to further erosion of asset quality. This created the greatest pressure on stocks, but was offset by impressive gains in energy and material stocks and a nice recovery in technology shares. Many other areas were heavy, mostly due to real or perceived problems resulting from the dramatic rise in energy costs and are now priced attractively for long-term investors.

Earnings hold the key to stock market returns over the next 18 months and consensus estimates appear overly optimistic with operating profits forecasted to increase 7.5% for 2008 and 14% in 2009. Weakened end markets are hurt by poor sentiment, consumer de-leveraging and reduced corporate spending from troubled financial institutions, while spiraling costs continue to adversely affect profit margins. The broad market multiple of less than 15 times forward earnings is historically low, as uncertainty exists in all sectors, even the usually recession-resistant healthcare area, where political risks offset favorable demographic trends. Valuations reflect significant economic problems and uncertainty, particularly considering the low level of interest rates.

The tenor of most recent comments from corporate managers has been cautious, and they frequently cite risks associated with higher energy costs. Oil prices have doubled over the past 12 months to $140 and are now about 30% higher on an inflation adjusted basis than they were at the previous peak in 1980. Energy is now over 15% of the S&P 500 benchmark, up from under 9% at the start of 2007 and will likely continue to be a major factor, though volatility should remain at a high level. Oil prices should remain high given the ongoing political risks in the Middle East and other oil producing regions, as well as strong demand from emerging markets. Reducing the national subsidy for oil in China and plans for additional global capacity will help, but it is clear that high energy costs will remain for the foreseeable future. Media comparisons of today’s energy boom to the internet bubble are missing the real supply and demand imbalance in the energy market, and political pressure to blame speculators for high prices will lead to ineffective, unnecessary legislation.

Corporate balance sheets remain very strong outside of the financial, housing and auto sectors. This has provided significant flexibility for companies to initiate aggressive stock buybacks and fund strategic acquisitions. In meetings with company managers over the past few months, we frequently hear them express concern over both future earnings visibility and excitement surrounding opportunities to deploy resources in ways that benefit shareholder’s long-term interests. The near-term challenge is finding ways to increase revenues while controlling expenses in order to sustain profit margins and generate earnings growth. Those companies that successfully navigate this challenge will lead the market.

We expect our style of growth investing, which focuses on higher quality companies that sell at reasonable prices, to provide decent protection in down markets. So far during the downturn this year there has been a noticeable absence of a strong move toward higher quality companies. While it is difficult to say exactly why this has not occurred, and difficult to predict when it will occur, we fully expect that the market will eventually favor better quality companies that are able to generate earnings growth in a difficult environment. Our portfolio should benefit when this occurs.

In a difficult economic climate, with the pessimism that normally permeates an election year, it is common to have doubts about portfolio holdings, particularly when returns have been subpar. We have strong conviction in the fundamental strength of our holdings and believe our portfolio of industry leaders, which are selling at reasonable valuations, will protect during extended selloffs and lead to strong returns over the next few years as conditions stabilize for the financial markets. We appreciate the natural concerns of our clients during these difficult times and believe our experience adhering to a sound, tested discipline will lead to results that meet our own high standards and, more importantly, those of our clients. Thank you for your continued confidence and support

Sincerely,

David M. Klaskin
Chairman
Chief Investment Officer