Fourth Quarter, 2006

The investments gods smiled on the U.S. equity markets in the fourth quarter. Even better, your portfolio outperformed the market’s strong showing. Our move into financial stocks and away from our large energy position paid off. But before we break a shoulder slapping ourselves on the back, the entire year needs to be seen through the prism of our investment philosophy, which produced only fair, market-equaling returns early in 2006 and then, as interest rates stabilized, delivered the goods in the most recent quarter.

Grisanti Brown & Partners, as we began to call ourselves on January 1st, has always invested in two distinct concepts of value: assets at a discount and cash flow at a discount. Briefly put, an assets-at-a-discount investment is one that relies on the intrinsic value of the company’s underlying assets to support a much higher stock price over the long term (3-4 years). At a poor point in the cycle, assets sell off. For example, when tanker rates were low, it was possible to find a tanker company selling for 40% of the value of its tankers. In this case, we focus on underlying asset value and less on earnings power (of course, at the end of the day the two are related). Also, if our investment relies on the current (and not the future) value of assets, management must be competent, but they need not be the best in their field.

On the other hand, when making a cash-flow-at-a-discount investment, we are estimating that a company can produce enough cash flow in the future to justify a much higher share price. Here, strong earnings (or cash flow) growth and management’s ability to execute are crucial, because, as opposed to the asset investment thesis, future performance is required to realize the cash flow that will support a higher share price. Out-of-favor, well managed companies like American International Group or Microsoft can fit this model if their share price falls far enough and their prospects, in our assessment, remain strong.

To make it into your portfolio, an idea must fit into one of these two categories, and some of our favorites fit into both, a rare but most welcome occurrence. For the last several years, roughly starting with the Iraq war and the coincident rise in commodity prices, hard assets have been the predominant of the two themes. We were far from prescient; we were simply attracted to cheap assets. For example, in late 2002 oil was selling at $18 a barrel, the economy was emerging from a recession and certain drilling stocks were selling for less than the value of their plant and equipment. Our hard asset plays included these drillers, oil, gas, coal, refining, steel, iron ore, tankers and chemicals. For the most part they performed quite well, and if we are to be honest, we bought them in a time of unparalleled commodity inflation, and they often performed better than we had modeled.

Starting in late 2005, we began selling many of those hard asset stocks that had been so kind to us. For the most part their returns had been superlative and they had reached valuations where the slightest change in outlook, including a moderation in the price of the underlying commodity, could lead to substantial loss of capital. At the same time, the Federal Reserve seemed similarly concerned about surging commodity prices and continued to raise interest rates throughout 2005 and early 2006. Those rate hikes produced a flat yield curve, which in turn created a flight of capital away from financial assets. We began buying select financial stocks in late 2005, not because they were “financials”, but each company that we purchased was compelling compared to other available investments (both within and outside of the financial sector) in terms of fundamentals and valuation. Now these financial companies comprise the largest segment of your portfolio. These investments fall into our second category of value investment: cash flow at a discount. We have remade the portfolio over the last 18 months into much more of a cash flow reliant investment vehicle, relying less on hard asset appreciation. Our similar move towards financial stocks in 1999 resulted in strong positive performance in 2000 and 2001, years in which the market (as measured by the S&P 500) was down.

For the first seven months of 2006, the market and your portfolio languished. Energy stocks continued to rise, and financials suffered. Our performance was on par with the market, but not what fee paying clients wanted from us, and certainly not what we expected of ourselves. We also remember, however, that it is hard enough picking the winners without having to pick the exact month that they deliver. That is why we have a four year average holding period -- some of our best investments have been late bloomers-- and that is why we slept relatively comfortably early in 2006 even as our new stock selections had yet to show their merit.

Much changed for us at the end of July when the Federal Reserve stopped raising interest rates, in response to a slowing economy. Concerns about housing especially caused the market to rethink its thesis that the economy was too hot, and interest rates had to head higher to stall the rampant growth. Now the fear is that the weak housing sector will pull the economy down into recession. When the bogeyman shifts from inflation to recession, financial stocks start to outperform. Energy stocks backed off their highs and are down substantially since then. Both of these developments would have been bad news for your 2005 portfolio, but our new additions (mostly financials) and, just as importantly, our recent deletions (mostly energy) finally paid off. We do not believe that a recession lies ahead in 2007-- we think the likelier outcome is a soft landing similar to 1995, a strong year for the market-- but we could be wrong. Our investment strategy is long term, and we believe the prices we have paid for our investments will be seen as attractive at the end of our long-term holding period, even if we must live through a recession to get there.

As a final observation, we do not want to leave you with the impression that we think the recent global upturn and resulting commodity price boom is a temporary phase. We think oil, gas, coal, steel, copper and other hard assets will remain in tighter supply (with the resulting upward pressure on their prices) for the indefinite future. We reduced our exposure to this area because we believed the stocks of these companies already reflect that rosy scenario (rosy at least in the eyes of the commodity producers – not so rosy for the owner of an SUV with a 60 gallon tank). One of our bedrock principles is that when everyone agrees on the surrounding condition – in this case a bourgeoning world economy with China and India sucking up extra commodity production – there is little money to be made investing on that thesis. When we sold our technology stocks in late 1998 it wasn’t because we thought technology was passé – in fact it was easy to predict the internet would continue to grow geometrically for years. Rather, we sold them because in our opinion smart investors had made their money, valuations were over-extended and it was time to get out. Furthermore, shares of other companies had become much more compelling, in part because so much capital had been drawn to technology. In late 2006, hard asset investments have that same, tired buzz about them, and have also drawn money away from other, now cheaper areas, such as financials.

We made one new investment in the fourth quarter, a financial services company called Capital One Financial. Most people know of this company from their TV commercials hawking their credit card, with the tag line “What’s in your wallet?”. Over the last two years Capital One has diversified outside the credit card arena by first buying Hibernia, a Louisiana based bank, and then North Fork, a New York based bank. After these transactions, credit cards represent 50% of earnings, banking 34%, auto finance 4% and other lending 6%, transforming the company into a truly diversified financial services company. The shares trade at under 10 times 2007 earnings estimates. Also, we believe that once Capital One is able to fully integrate North Fork, the company will be able to produce significant earnings growth in 2008 and beyond. The market is concerned about the U.S. consumer and, we believe, overly negative towards Capital One. This is not a new company and it has historically not only been able to succeed throughout a cycle, but typically fairs better than its competition. We feel that the shares should conservatively trade at $110, or 12 times 2008 earnings and 43% higher than today’s price.

As for what lies ahead, the market has had a remarkable run in late 2006, both in its total return and its lack of volatility – it has gone higher in a slow but steady manner since August. That will surely stop. When it does, we are prepared to invest in several specific new ideas if given some reasonable valuations, and we are near taking profits in some long-time holdings. We see the pendulum’s swing towards cash flow stories and away from hard assets continuing, as these are typically multi-year cycles. We never foreclose one type of value investment (asset or cash flow) to invest exclusively in the other. Rather, at different periods one predominates and the other becomes the “exception”. Right now the purchase of a hard asset investment would be an exception to the current direction of favorable valuations. (In fact one potential investment that we are prepared to buy if valuations abate is one of those hard asset “exceptions”.)

As you should be aware by now from a separate mailing, our firm bid farewell to one of our founding partners, Bill Spears, at the end of the year. The remaining founding members of the investment team – Chris Grisanti, Vance Brown and Jared Leon – remain committed to identifying very select investment opportunities. We will continue to create portfolios of well-researched, long term, under-appreciated (pun intended) and concentrated investments.

Grisanti Brown & Partners LLC