“The Large Cap Quality Value 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.” Richard Sherry, CFA Portfolio Manager & Senior Research Analyst

Market Overview
The third quarter was marked by a great deal of volatility as disruptions in global credit markets negatively affected equity markets early in the quarter. These disruptions prompted central banks around the world to inject liquidity into the markets in August and the U.S. Federal Reserve to cut interest rates by one half of one percent in September. Most indexes declined in the low-to-mid single- digit range in July before rebounding strongly in August and September. Year to date through the end of the third quarter, most indexes were up in the mid single-digit to low double-digit range.

The disruption in global credit markets was initiated by problems in the housing sector and the subprime mortgage market. This subsequently led to concerns of a possible credit crunch involving subprime securitizations upon banks and the negative affect this could have on the economy. Underlying these issues were higher energy and commodity prices and the potential for higher levels of inflation.

Investors increased their focus on credit risk to a level not seen since the 2001 recession. Post this recession and for the past five years, there has been an exceptionally low level of concern regarding credit risk due to a global savings glut and low interest rates. However, during the third quarter, credit spreads between 10-year high-yield bonds and 10-year Treasury bonds widened from 3% at the beginning of the quarter to 4.6% by mid-August. However, the actions of global central banks noted above alleviated the concerns of many in the credit markets and this led to a decline in the spread to 4.0% by the end of the quarter.

As investors recognized that housing and mortgage-related problems would likely spill over into the general economy, they gravitated towards stocks that could still prosper in a slowing economy. This produced notable outperformance by both larger capitalization stocks and growth stocks. Larger capitalization companies benefited from diversified business portfolios and from an increased level of exposure to international markets, where many economies are growing faster than and are less susceptible to the problems that are negatively affecting the U.S. economy. In addition, companies with international exposure are benefiting from a weaker U.S. dollar. When overseas earnings are converted into U.S. dollars for financial reporting purposes, those earnings in foreign currencies that have appreciated in value relative to the U.S. dollar positively impact reported results.

The deterioration in credit markets that occurred during the quarter negatively affected the stocks of companies with weaker balance sheets. However, that outperformance was less pronounced when looking at companies with higher quality, more consistent income statements.

Financials and consumer discretionary were among the worst performing sectors due to concerns related to credit markets and consumer spending. Energy stocks, on the other hand, benefited from higher energy prices and exhibited the best performance during the quarter. Industrials also had strong performance during the quarter due, in part, to the international exposure of many of these companies, where growth is stronger in most overseas markets than in the U.S.

Portfolio Overview
For the quarter, the Large Cap Quality Value Portfolio slightly underperformed the Russell 1000 Value Index. While the portfolio outperformed the index when it declined in July, the portfolio trailed the index somewhat when it rallied in August and September.

Companies that contributed the most to performance during the quarter were Barrick Gold and ConocoPhillips. Barrick Gold is one of the largest gold companies in the world. Recent actions by the Federal Reserve to lower interest rates and concerns regarding a slowing economy put downward pressure on the U.S. dollar during the quarter. This contributed to an increase in the price of gold, which is seen as a hedge against the U.S. dollar. In addition, the company remains well positioned to expand margins as new, more profitable operations contribute to the bottom line. ConocoPhillips benefited from higher energy prices and from strong operational performance.

The companies that contributed the least to performance during the quarter included Limited Brands and Wyeth. Limited Brands owns and operates retail stores, notably Victoria's Secret and Bath & Body Works. In a positive development earlier this year, the company announced plans to divest its low margin apparel businesses. This will result in a company with less fashion risk and a higher presence in businesses that have strong positions in higher margin, niche markets. However, the stock has been negatively affected by concerns regarding a possible slowdown in consumer spending and with some product launches that failed to meet expectations. Despite these issues, we believe that both Victoria's Secret and Bath & Body Works have very strong positions in niche markets and that the current issues are only temporary. The stock remains one of the highest yielding retail stocks due, in part, to the strength of its core businesses and the cash flow that they generate. Wyeth is one of the world's leading pharmaceutical companies. Last quarter it was one of the largest contributors to performance as the company resolved some manufacturing issues at a facility in Puerto Rico and revenue growth remained strong. However, the company's near-term outlook was negatively affected by potential generic competition for one of its drugs and its long-term outlook was negatively affected by a delay in approval for another of its drugs. Despite these issues, the company continues to perform well with strong top-line growth producing operating margin improvements. In late September, the Board indicated its confidence in the business and its focus on shareholder value by increasing the dividend and announcing a new share buyback program.

Purchases and Sales
During the third quarter, we established a new position in Clorox and increased our positions in Bank of America, Kimberly-Clark, Johnson & Johnson, and Lincoln National. We sold our positions in Citigroup, Coca-Cola, Comerica, Southern Company, and U.S. Bancorp.

Over the years, Clorox has consistently produced solid operating margins and generated strong returns on capital. The company's new management team is focusing on improving economic profit growth and further improving the growth and profitability of the business. Excess cash will be used to invest in growing the business, increasing the dividend (which has been increased twice during the past year), and buying back shares. We used weakness in the stock to initiate a position in July. In early August, the stock declined further after reporting fiscal fourth-quarter numbers and providing an outlook for the first half of the current fiscal year that was somewhat below investor expectations. A revenue shortfall in the fourth quarter, after very strong results in the third quarter, and the potential short-term impact of lower than expected gross margins in the first half of next year have not changed our long-term outlook on the company. We used further weakness in the stock price to increase our position.

We used weakness in financial stocks to add to our position in Bank of America. Despite concerns in the market regarding financial stocks in general, Bank of America continues to produce strong returns, credit quality is good, and the bank's large, low-cost deposit base provides a cheap source of funds. In addition, in late July, the Board approved a 14% increase in the dividend and the stock has a current yield of 5.0%.

We used weakness in Kimberly-Clark's stock price to increase our position in a company that produces strong cash flow and grows revenue at an attractive mid- to-high single-digit pace. The stock yields more than 3% and is, in our opinion, one of the most attractively priced large-capitalization, consumer-discretionary stocks.

Johnson & Johnson has struggled recently with lower than expected revenue growth driven by concerns regarding patent expirations on some key pharmaceutical products over the next few years and by market changes in the drug-eluting stent market, where it is a market leader. However, the company's consumer business continues to generate solid and predictable revenue growth and, over the next few years, the business will generate profit synergies related to its recent acquisition of Pfizer's consumer health-care business. Recently, the company announced a restructuring plan to reduce the cost base in the company's pharmaceutical and drug-eluting stent businesses to a more appropriate size given current market conditions. The company has also announced that its Board has authorized the company to buy back $10 billion of stock. The program has no time limit and represents about 5.5% of the company's market capitalization. Yielding 2.5% and trading at an attractive valuation level, we increased our position in the stock.

Lincoln National's stock price had been weak since mid-May. Although the weakness can be attributed to the announcement of the company's CEO retiring, we believe his replacement, the company's current President and COO, will provide the proper stewardship for the company, having already proven himself as the CEO of Jefferson Pilot before it was acquired by Lincoln National. We used the weakness in the stock to add to our position.

Citigroup was sold to fund an increase in Bank of America. Bank of America was selling at a slight discount to Citigroup, yet we believe that Bank of America has a stronger franchise that is better positioned for longer term growth.

Over the past year Coca-Cola's stock has performed well in a strong market. However, the company's over-reliance on carbonated soft drinks continues to hurt it in the U.S. and income growth remains below historic levels. Recent initiatives to increase growth are coming from the acquisition of other beverage companies and from acquiring and consolidating affiliated bottling operations. Both of these methods of growth are somewhat expensive and could lead to lower margins and lower returns. Recent strength in the stock price resulted in the stock trading above our fair value price. We used the proceeds to increase our investment in Kimberly-Clark, which was more attractively priced than Coca- Cola.

Comerica was sold to fund an increased investment in Lincoln National. Both companies were selling at similar multiples; however, we believe that Lincoln National is better positioned to achieve stronger long term growth.

Southern Company was sold to help fund increased investments in Clorox and Johnson & Johnson. Both were selling at a comparable price-to-earnings ratio to Southern Company, however, we believe they offer stronger growth potential than Southern Company's mid single-digit growth rate.

U.S. Bancorp has one of the lowest cost ratios in the banking industry and produces strong returns on equity. However, growth has been below expectations for a while and management has indicated that an increased level of investment is necessary to start growing the business again. Lower growth and increased investment spending are beginning to negatively affect the company's returns. U.S. Bancorp was sold to help fund our investment in Clorox, which we believe offers stronger, more profitable growth going forward.

Summary
After a weak June, the Russell 1000 Value Index rallied in early July before declining by almost 10% from mid-July to mid-August due to concerns regarding credit markets and the economy. Despite the rebound in markets since mid- August, many of the issues that concerned the market in July still exist. In addition, energy prices remain high and inflation remains a potential threat. These concerns pose a greater risk for highly indebted, low-quality companies that rely on corporate debt to finance their growth.

The Large Cap Quality Value 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 that 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.