Investment Perspectives -- January, 2007

Dear Investor,

Two thousand and six was a most interesting year. On average, our performance was noteworthy, but older portfolios fared much better than newer ones as investments made a few years ago blossomed into maturity. Another aspect of our experience in 2006 is that relatively conservative portfolios slightly outperformed growth portfolios. This was due to the fact that real estate investment trusts (REITs) and utility stocks, core holdings in conservative and balanced accounts, provided remarkably strong returns in last year’s market. More about that in a moment.

Investing is part science and part art. Sometimes we are good, and sometimes we are lucky. In 2002, for example, we experienced more than our share of bad luck, as accounting misrepresentation and outright fraud in corporate executive suites weighed on many of our portfolios. In 2006, the tables were turned as we experienced more than our share of good fortune. No less than seven of our equity holdings were either targeted for acquisition or were acquired at significant premiums to their then-current market prices. Chances are that most or all of these companies would have risen in price eventually, but the acquisition offers compressed the gains into 2006.

Conservative portfolios were also beneficiaries of some good fortune in 2006. Many of the securities in those portfolios, particularly REITs and utilities, are very asset-rich, owning assets like office buildings, shopping malls, apartments, power plants and pipelines. With low interest rates stimulating private equity investment and the huge US trade deficit loading the coffers of foreign investors with dollars, the valuations of many of these assets rose dramatically. Thus did many REITs and utility stocks show accelerated gains in the past year.

So we bid a fond farewell to 2006, gratified that the majority of our stock selections have been good ones but also thankful that market forces pushed their prices higher than their natural growth rates would have dictated.

Looking forward to 2007, Wall Street prognosticators are almost uniformly bullish. They note that US stocks have historically scored significant gains in the third year of a presidential term. They also see a continuing flow of private capital into US stocks, bonds and commercial real estate, a soft landing in the economy (no recession), decent growth in corporate earnings and a favorably low interest rate environment. I, however, am a bit skeptical of this rosy scenario. Stocks in general are not particularly expensive and can certainly gain ground in 2007. But I’m concerned that the economy may weaken more than expected and that corporate earnings may be correspondingly disappointing. Interest rates have recently begun rising and, if they were to continue upwards, it would be an additional damper on financial markets. It is also possible that turmoil in the Middle East could lead to higher oil and gasoline prices in 2007 and that the newly elected Democratic Congress could propose legislation that would inhibit free trade. If there is one word that raises the angst of investors on Wall Street, it is “protectionism”.

The bottom line is that, as of now, my view of 2007 is a little cloudy. If present trends continue, particularly the flow of capital into our markets, all will be well. But there are enough yellow flags waving that I think it’s prudent to approach the markets with a little more caution than normal. Regarding FIM portfolios, it would be great if we were to benefit from acquisition activity as much as we did in 2006, but it’s not very likely. I also suspect that the upward revaluation of the assets of REITs and utilities has probably run its course. Therefore, in what is likely to be a more challenging investment environment, I think it would be prudent to keep our expectations modest. We may hold more cash in portfolios than we typically do, giving us the opportunity to take advantage of lower prices should the market stumble during the year. Despite my edginess regarding the near term, the long term outlook is bright. We intend to continue our search for those special, well-managed companies that can maintain or accelerate growth of their earnings and dividends. By employing the same strategies that have led to solid returns in the past, we hope to extend our success well into the future.

Jeffrey L. Friedberg
January 4, 2007