“Your portfolio is invested in higher quality businesses that have strong margins, generate high levels of free cash flow, are self-funding their own growth, and are using this period of economic weakness to take market share and improve their competitive position.” Richard Sherry, CFA Portfolio Manager & Senior Research Analyst

Market Overview
Credit market difficulties and economic concerns have weighed on stocks since the middle of last year, and, for the fourth quarter in a row, the S&P 500 Index produced a negative return. After having stabilized somewhat in July and August, markets sold off in September. This sell off was prompted by two notable concerns. The first was the credit market difficulties that were manifesting themselves in the U.S. and around the globe, notably in Europe. Since the middle of 2007, the concern was that real-estate related losses among financial institutions could potentially initiate a credit crunch that would have a negative affect on economic activity. It now appears that this has come to fruition. The second concern was a realization among many investors that parts of the world, once considered immune to a slowdown in the U.S., are not as immune as many had hoped. Indeed, economic activity has started to slow in many emerging markets. This, in turn, has led many investors to question some of the global growth assumptions that had propped up certain sectors earlier in the year, namely energy, materials, and information technology.

Of particular note during the month of September was the incredible shakeout in the financials sector. This shakeout had its roots in losses related to real estate and was exacerbated by the high degree of leverage that many financial institutions employed. Fannie Mae and Freddie Mac were essentially nationalized by the U.S. government, Lehman Brothers went bankrupt, American International Group (AIG) was saved from bankruptcy by an emergency loan from the U.S. government which severely diluted existing shares, Merrill Lynch agreed to sell itself to Bank of America, and Washington Mutual was placed under receivership by the Office of Thrift Supervision and ultimately sold to JPMorgan Chase. Despite these issues, financials was the second best performing sector during the third quarter, after being the worst performing sector during the second quarter. Consumer staples, a traditionally defensive sector, performed the best during the quarter.

Energy and materials, sectors once considered immune to a potential slowdown in economic activity, were the worst performing sectors during the quarter. Performance for these sectors was affected by the decline in the price of oil from just under $150 earlier this year to less than $70 a barrel. This has eased inflation concerns and helped to relieve the quandary of global central banks whereby their desire to lower interest rates to stimulate a struggling economy was offset by the inflationary impact that lower interest rates can produce.

Portfolio Overview
The Large Cap Core Portfolio outperformed the S&P 500 Index during the third quarter. While the S&P 500 declined 8.37%, the Large Cap Core Portfolio declined in the low single digits. In the current economic environment, highly profitable, consistent businesses with strong balance sheets have generally outperformed. This helped to drive the portfolio’s outperformance during the quarter given its overweight position in highquality stocks, and the outperformance of the portfolio’s high-quality stocks relative to those in the S&P 500 Index.

The Large Cap Core Portfolio has also outperformed the benchmark for the year to date and for the trailing 12 months. Given that markets have been weak as both credit market concerns and a slowing economy have weighed on stocks, the Large Cap Core Portfolio has provided significant downside protection relative to the S&P 500. By protecting capital in difficult markets, the Large Cap Core Portfolio should provide a strong foundation for future growth.

The companies that contributed the most to performance during the quarter included Wells Fargo and Charles Schwab. Despite the turmoil in the financials sector, higher quality companies with sound business models and good balance sheets are continuing to grow. In fact, companies, such as Wells Fargo and Charles Schwab, are enhancing their growth by taking share from weaker competitors.

The companies that contributed the least to performance during the quarter were Apache and ConocoPhillips. These two companies contributed strongly to performance during the second quarter when energy prices were strong. However, during the third quarter, they were both negatively affected by lower energy prices.

Purchases and Sales
During the third quarter, we established new positions in Accenture, Charles Schwab, and Schlumberger, and we sold our positions in AIG, Chevron, International Business Machines (IBM), and UnitedHealth Group. Accenture is a leading management consulting and outsourcing company. The company has a broad service portfolio that is much wider than many of its peers, operates on a global basis, and has recently built out its capabilities in low-cost areas. This has produced a highly skilled, low-cost, global workforce. The company’s offerings can help businesses grow the top line, which is important when times are good, but they also are very strong in providing services that reduce costs, which are important in the current economic climate. The business produces strong cash flow, yet requires very little capital to fund growth. In addition, the company’s organic revenue growth, in the high single-to-low double-digit range, is very attractive. Despite these positive attributes, the company trades at a multiple that is comparable to the rest of the market. We believe the company deserves a premium valuation and found the shares attractively priced.

Charles Schwab has one of the more trusted names in financial services and is well positioned to offer both investment services and advice to the aging baby boom generation as well as to the next generation of investors. The company can easily provide customized service with investment options for an individual at any stage in their investment lifecycle. Charles Schwab has evolved from being a low-cost transaction provider to being a full-service financial-services company whose services range from “do it yourself” to high touch, high service. In addition, the company’s Registered Investment Advisor business is poised to take market share due to disruptions among its competitors. The stock had declined significantly during the quarter after hitting a 52-week high at the end of last year. However, unlike many financial-services companies, Charles Schwab is not highly levered and the company still earns a very strong return on equity. In addition, the company is well positioned to produce strong earnings growth going forward. We used weakness in the stock price to establish a position in the company.

Schlumberger is an oilfield services company that is well positioned to benefit from the ever increasing global demand for energy. Energy producers are spending more and more money to fund exploration and Schlumberger has the global capability to serve both globally integrated companies as well as nationalized companies. The company produces some of the strongest margins and returns in the industry and has very strong growth prospects going forward. We used weakness in the stock price to establish a position.

We sold AIG early in the third quarter due to concerns that continued losses in the company’s financial-services group would put further strain on the company’s once strong capital position. Despite having a world class franchise that, over the years, had grown capital at a very attractive rate, the company was ultimately undone by poor underwriting in relation to credit default swaps. In mid-September, the U.S. Treasury had to extend the company an emergency loan which severely diluted existing shareholders. In order to repay this loan, the company will have to sell off many of its assets.

Chevron had appreciated considerably since we first purchased it in early 2006, outperforming both the S&P 500 and the S&P 500 Energy Index. However, we have become concerned recently with the limited reserve growth opportunities that the company has over the next couple of years. This leaves the company overly exposed to a drop in energy prices. By early in the third quarter, the stock was trading at the upper end of our valuation range and we used strength in the stock price to sell our position.

IBM had been one of the portfolio’s strongest performers. The company’s globally diverse business mix has performed well recently and reported results have been aided by a weak U.S. dollar and improving margins. However, underlying revenue growth before the impact of currency remains stuck in the low-to-mid single-digit range. Given the relative slow underlying growth rate of the business, we believe that the valuation had become somewhat expensive.

UnitedHealth Group has been suffering recently from a very competitive pricing environment in which it cannot raise prices without losing members. The cyclicality and price competitiveness in the health-insurance industry is greater than management and we had anticipated. In addition, a tough economic environment has resulted in members trading down to less profitable policies. The company’s positive attributes, such as the network effect that draws both doctors and customers to the organization and economies of scale, are today being overshadowed by these negative headwinds. We do not see these issues changing for the positive anytime soon and therefore sold our position in the company.

Summary
In the current economic environment, companies are exposed to higher input costs at the same time that economic weakness has made it difficult to pass these costs along to consumers via higher prices. These concerns pose a greater risk for low-quality companies that have relied on corporate debt to finance their growth over the past several years. On the other hand, your portfolio is invested in higher quality businesses that have strong margins, generate high levels of free cash flow, and self-fund their own growth. We would expect the current environment to favor these types of businesses.

High-quality, large-cap investing is a sound and conservative approach that offers risk-averse investors the opportunity to participate in equity market returns with less risk. The Large Cap Core Portfolio is positioned in higher quality companies that have withstood the test of time and have the ability to prosper and do well in difficult times. These are companies that have high returns on capital that, in turn, generate above-average earnings growth. We believe this provides a solid underpinning for long-term growth of investor capital.

As always, we endeavor to manage your portfolio with the highest quality businesses, outgrowing their markets, purchased at discount valuations.