“We believe that weaker companies will continue to struggle over the near term and that the high-quality businesses will find themselves in a much improved competitive position once the economic environment improves.” 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 fifth quarter in a row, the Russell 1000 Value 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 best performing sector during the third quarter, after being the worst performing sector during the second quarter. Consumer staples, a traditionally defensive sector, was the second best performing sector 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 Value Portfolio outperformed the Russell 1000 Value Index during the third quarter. Over the past five quarters, stock markets have been weak as both credit market concerns and a slowing economy have weighed on stocks. Yet, the Large Cap Value Portfolio has provided strong downside protection relative to the Russell 1000 Value Index. The portfolio has outperformed the index for the one, two, and three-year periods ending September 30. By protecting capital in difficult markets, the Large Cap Value portfolio should provide a strong foundation for future growth.

The companies that contributed the most to performance during the quarter included PNC Financial Services and Bank of America. Despite the turmoil in the financials sector, higher quality companies with sound business models and good balance sheets have been able to take advantage of disruptions in the marketplace in order to position themselves for strong, profitable growth going forward. PNC Financial Services has been accomplishing that by taking share from rivals in the marketplace. Bank of America has been taking advantage of its strength to buy some of its rivals (Countrywide Financial and Merrill Lynch) on the cheap and instantly establishing scale and presence in new markets where it previously had limited exposure.

The companies that contributed the least to performance during the quarter were BJ Services and BP. 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 3M, Apache, Coca- Cola, and Franklin Resources, and we sold our positions in Alcoa, Chevron, Ingersoll-Rand, and Morgan Stanley.

3M manufactures a broad array of industrial and consumer products. The company’s history of innovation has allowed it to produce some of the strongest margins and returns in the industrial sector. Over the last couple of years, the company, under a new CEO, has addressed capacity issues that were negatively affecting the company’s ability to delivery quality products to its customers in a timely fashion. These capacity issues and the investment required to fix them pressured margins the past few years. However, these issues have now been resolved. In addition, the new CEO has re-focused the company back on innovation. Concerns regarding global growth and competitive problems in the company’s opticals film division had pressured the stock, and we used that weakness to establish a position.

Apache remains one of the better positioned and most consistent exploration and production companies in the oil and gas industry. In an era when many large oil companies are struggling to grow production, Apache is entering a period of accelerated production growth over the course of the next several years. In 2008, Apache is poised to increase production for the 29th time in the last 30 years. The company is broadly diversified with approximately 55% of its income coming from overseas and its production profile is split approximately 50/50 between oil and natural gas. In the current environment, Apache continues to control costs, strengthen its balance sheet, and produce some of the best returns in the industry. Volatility in the price of oil resulted in a decline in the stock price. We used this weakness to establish a position.

Coca-Cola is the world’s largest beverage company. Over the past several years, the company has shifted its focus beyond carbonated beverages. The business continues to produce strong, durable margins and above-average returns on capital. Weakness in the stock price resulted in the stock trading at some of its most attractive valuation levels in years. We used that weakness to initiate a position.

Franklin Resources is a global asset management firm that offers a wide range of investment offerings for both individual and institutional clients. The company has a strong retail presence in the U.S. and is building out that capability overseas. Its investment offerings are diversified across equity, fixed income, and hybrid funds. The company has a strong position in international equities which should see strong demand going forward and the company’s fixed-income business has produced strong results recently. Despite some revenue pressure related to declining markets and some investor outflows, margins have held steady and expenses held in check. In addition, the company’s balance sheet is solid and the company has a very strong cash position. Concerns regarding the revenue pressure and investor outflows caused the stock to decline significantly over the past year and to trade at a discount relative to many of its peers. We used weakness in the stock price to establish a position in a high-quality franchise.

Over the past several years, Alcoa has sought to improve the company’s performance by selling lower performing units and focusing the business much more on its upstream business of mining bauxite and producing aluminum. In addition, the company has sought to improve its operational performance by lowering its cost of production. However, end demand for the company’s products remains quite cyclical and global capacity expansion has the potential to negatively affect margins and returns. We had become concerned that management had been unable to improve the company’s performance and competitive position as much as we had anticipated to offset these issues. Therefore, we sold our position in the company.

Chevron had appreciated considerably since we first purchased it in late 2005, significantly outperforming the Russell 1000 Value Index. However, we became concerned with the company’s limited reserve growth opportunities 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.

We sold our position in Ingersoll-Rand because we had become concerned that the company’s recent M&A activity had not reduced the cyclicality or improved the profitability of the business as much as we had anticipated when we originally purchased the company a couple of years ago.

By mid-September, the competitive environment for investment banks, including Morgan Stanley, had deteriorated significantly. This meant that the industry’s reliance on short-term funding to fund a balance sheet that is levered was of greater concern than in the past. Thus, despite having a strong, diversified franchise, a balance sheet that is stronger and contains fewer risky assets than its peers, we were concerned that credit markets might not allow the company to grow and take share in the current turbulent environment. In addition, the company’s cost base and leverage remains higher than we would like. Given these concerns, we sold our position in Morgan Stanley.

Summary
In the current environment, companies are having difficulty accessing credit, even short-term credit, and this is having a negative affect on economic growth. In early October, Congress passed the Troubled Asset Relief Program which is designed to alleviate some of the logjams that have recently disrupted global credit markets. It is yet to be determined how successful this endeavor will ultimately be. However, these concerns pose a greater risk for low-quality companies that have less reliable cash flow and have relied on corporate debt to finance their growth over the past several years.

Conversely, 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. We would expect the current environment to favor these types of businesses. We believe that weaker companies will continue to struggle over the near term and that the highquality businesses will find themselves in a much improved competitive position once the economic environment improves.

Kayne Anderson Rudnick’s Large Cap Value Portfolio remains invested in attractively priced, high-quality companies that produce strong cash flow that is delivered to shareholders via increasing dividends and/or share repurchases. We believe that a portfolio constructed in this manner provides a solid underpinning for long-term growth of investor capital and we would expect that the current economic environment would favor such a portfolio. As always we endeavor to manage your portfolio with the highest quality businesses, outgrowing their markets, purchased at discount valuations.