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US Value Equity The Renaissance of Conservatism September 2007

US Value Equity The Renaissance of Conservatism September 2007. Edwin Walczak Portfolio Manager. The market has been risk-seeking the last several years and “Riskier” assets have outperformed “conservative assets”.

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US Value Equity The Renaissance of Conservatism September 2007

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  1. US Value EquityThe Renaissance of ConservatismSeptember 2007 Edwin Walczak Portfolio Manager

  2. The market has been risk-seeking the last several years and “Riskier” assets have outperformed “conservative assets” • Risk seeking precipitated by numerous Fed rate cuts post the Tech bubble collapse provided excess liquidity • Evidence that speculative assets have done the best recently: • Small caps did very well • LBOs of many very poor quality companies • Subprime lending crisis (lax underwriting) • Commodities boom • Emerging markets (or is it a new world, this time)

  3. Industrial Capital Goods Stocks1 Profit Margins1953 Through Early-June 2007

  4. Global Cyclicals1 Return on Equity1952 Through Early-June 2007

  5. Industrial Capital Goods1 ROEs

  6. Industrial Capital Goods Stocks1 Year-over-Year Capital Spending Growth 1960 Through April 2007

  7. The Subprime Crisis and its impact on our financial holdings • Generally, credit costs are normalizing from unsustainably low levels. We had already factored higher credit loss provisioning into normalized earnings forecasts • The financial companies in our portfolio have good track records of conservative underwriting • Much of subprime industry lending over the past 3-4 years has been based on lax underwriting • None of our financial holdings has a heavy exposure to subprime- Wachovia, Bank of America and Fifth Third Bank have virtually no subprime exposure- Freddie Mac has 18% of its retained portfolio in AAA tranches of subprime mortgage pools, which are protected by significant subordination- Well’s Fargo subprime mortgages represent 7% of total loans. Wells is a AAA-rated bank. And has a long history of skillful underwriting- AIG may have about 2% of their book value exposed to subprime related losses • Many financials have already sold off well in excess of potential future credit problems (Baby thrown out with bathwater) and may present attractive investment opportunities

  8. Source: Factset

  9. FRE Portfolio by FICO Score as of March, 2007 Source: US Mortgage Finance, August 22, 2007

  10. FRE Average Current LTV Source: US Mortgage Finance, August 22, 2007

  11. The risk in commodities: Exxon • Exxon’s 35% return on equity today is 2x its historical norm • We would expect this to trend down as the cost of doing business keeps rising, even if high oil prices were to persist. Source: FactSet

  12. Commodities really do not fit a Buffett-like approach • Most companies in commodity businesses do not earn their cost of capital over time • In real terms, over long periods, returns on commodities have been modest • Commodity companies generally are not differentiated and have no unique competitive advantage • Few can regularly, successfully forecast future commodity prices • But, commodities have been “where the action is” for 3 years

  13. The Opportunity in Large Cap Quality Today • Small Caps have outperformed since 2003 because 40% of small cap earnings come from global cyclical sectors, such as energy, industrial commodities, and capital goods (emerging markets beneficiaries). • Many strategists believe large cap high quality U.S. stocks are very attractively priced; Large Cap P/E ratios are below historic average relative to the market. Source: Page 6

  14. The largest stocks today have higher than usual ROEs relative to the market

  15. Altria Group Inc. • Leading consumer products company and largest tobacco company in the U.S. • Major segments: domestic and international tobacco • Parent company Philip Morris International and Philip Morris USA • Produces 7 of the top 20 global cigarette brands (Top global brand Marlboro) • Enjoys a 50% share of the US cigarette market and about a 14.5% share of the overseas market • Owns 28.7% of SABMiller plc., the world’s second-largest brewer • Good position with Marlboro in important growth markets such as China and Indonesia (licensing with most important government owned Chinese company) • History of dividend increases • EPS 15 year compound annual growth rate 9.7% • Market capitalization USD 158.6bn, Estimated 2007 P/E Ratio 13.5 Large Cap, High ROE Companies are well represented in our portfolio

  16. Procter & Gamble • Leading global household product manufacturer • Provides products in the laundry and cleaning, paper, beauty care, food and beverage, and health care segments • Becoming the largest beauty company in the world; beauty categories have global appeal, faster growth and higher margins • Well exposed in emerging economies with rising per capita income, as consumers trade-up from local to global brands • New product pipeline looks robust • Business mix is shifting towards faster-growing and higher margin categories and regions • Gillette integration is on track, integration of systems, sales forces and distribution networks in 31 countries (acquired in 2005) • EPS 15 year CAGR 10.1% • Market capitalization USD 195.7bn, Estimated 6/2007 P/E Ratio 20.5

  17. US Value Equity - Sector and Industry Weights as of August 2007 Food & Beverage 19.40% Banks 8.56% Consumer Staples 20.28% Coca Cola 3.00% Bank of America 1.50% Altria Group Inc. 5.00% Diageo 3.00% British American Tobacco ADR 4.50% Fifth Third Bancorp 2.06% General Mills 2.70% Procter & Gamble 5.23% Wachovia Corp. 2.50% Kellogg Co. 3.50% Colgate-Palmolive Co. 3.50% Wells Fargo & Co. 2.50% Nestle SA 2.70% Walgreen Co. 2.05% PepsiCo Inc. 4.50% Government Agencies 5.50% Multi-Sector Holdings 2.00% Retail 6.95% Federal National Mort. Assn. 2.00% Berkshire Hathaway Inc. 2.00% Bed Bath & Beyond Inc. 1.47% Federal Home Loan Mortgage 3.50% Consumer Discretionary 1.53% Signet Group 1.08% Health Care 7.70% TJX Co. 2.00% H & R Block 1.53% Wal-Mart Stores 2.40% Johnson & Johnson 4.00% Media 3.66% United Healthcare 3.70% Industrials 2.40% Entercom Communications 1.50% Property & Casualty Insurance 8.40% United Parcel Service 2.40% Gannett Co. 1.00% American International Group Inc. 6.40% Saga Communications 1.16% Ambac Financial Group Inc. 2.00% Cash 13.50% Cash 13.50% TOTAL 100.00% Representative portfolio Source: Vestek

  18. Advantages of Style • Our style of investing tends to protect our clients’ capital in down markets while it lets it participate in up markets • Beta of the fund is one half that of the market Since 2003, we have seen only an aggressively rising market

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