“In the past, a decelerating profit environment has prompted investors to rotate to higher quality companies because of their dependable earnings streams.” -Robert Schwarzkopf, CFA Managing Director of Small Cap Equity & Portfolio Manager -Sandi Gleason, CFA Portfolio Manager

Market Overview
Following a record-setting year in 2006, the stock market waned during the first quarter of 2007, as higher oil prices and sub-prime mortgage defaults wavered investors. Benefiting from the robust private-equity buyout market, mid-capitalization stocks outperformed small caps and large caps for the quarter. The Russell Midcap Index gained 4.38%, the Russell 2000 Index rose 1.95%, and the S&P 500 Index returned 0.64%.

Consumer staples, a defensive sector, led during the quarter as investors expressed concern about the overall strength of the economy. Meanwhile, the value-oriented financial-services sector weakened during the quarter, reflecting negative sub-prime lending announcements and the inverted yield curve. The relative underperformance of the sector contributed to growth stocks outpacing value stocks for the quarter.

As risk premiums lingered around historic lows, lower quality stocks continued to prevail in the marketplace. The apparent trends in S&P’s stock rankings and credit ratings clearly illustrated investors’ indifference towards risk. Stocks ranked B to D in quality were the best performers in the quarter, while A-ranked stocks were the worst. Moreover, stocks financed with “junk bonds” outperformed the benchmark by nearly 2-to-1 (See chart: Returns by S&P Credit Rating).

Returns by S&P Credit Rating Russell 2500™ Value Index

The chart is for the quarter ending March 31, 2007. Data is obtained from FactSet Research Systems and is assumed to be reliable. Past performance is no guarantee of future results.

Portfolio Overview
Although our stocks ranked A- and above by S&P outperformed those similarly ranked in the Russell 2500 Value Index, our portfolio marginally underperformed its benchmark due to the low-quality headwinds.

The companies that contributed the most to performance during the quarter included Equitable Resources (Equitable) and Owens & Minor (OMI). Equitable is an integrated (unregulated production and regulated distribution) energy company and the largest natural-gas supplier in the Appalachian basin. The company had solid ongoing operating results in its fiscal fourth quarter, as the company has accelerated its Appalachian natural-gas reserves through alternative drilling programs. OMI, a leading distributor of medical supplies, generated exceptional double-digit organic revenue growth in the fourth quarter of 2006, enabled by the success of OMI’s innovative pricing strategy.

Companies contributing the least to performance included Arrow International and Allied Capital (Allied). Despite expanding its manufacturing capacity to relieve supply constraints, Arrow International, a leading supplier of catheters for critical and cardiac medical care, has experienced continued sluggish growth as lost customers have been hard to regain and new product introductions have failed to prove meaningful. Allied provides debt and equity financing to small and medium-sized businesses that do not have access to commercial bank credit. The stock declined sharply in early January 2007 following an announcement of allegations of fraud-related activities of Business Loan Express (BLX), Allied’s subsidiary, and one of the nation’s largest Small Business Administration (SBA) lenders, by a long-term short-seller and critic of Allied. The company’s stock also suffered in the stock market decline of late February to early March 2007 when the sub-prime mortgage segment’s failures translated into investors’ concern over the creditquality environment overall. We believe that Allied’s disciplined deal sourcing and selection ability and “one stop shop for capital” offering coupled with its solid asset quality and conservative lower than oneto-one leverage should continue to serve as key success factors for the company going forward.

Purchases and Sales
There was no trade activity in the Small-Mid Cap Value Portfolio during the quarter.

Outlook
After reaching peak profitability in 2006, corporate profits broke a string of double-digit increases in operating earnings, as the companies in the S&P 500 Index posted single-digit profit gains in the fourth quarter of 2006 for the first time in 18 quarters. Former Federal Reserve Chairman, Alan Greenspan, indicated that this expected decline in profits could possibly lead to a recession in 2007, stating “…profit margins, after extraordinary upward-side moves, have begun to stabilize, which is an early sign that we are in the later stages of a cycle.” In the past, a decelerating profit environment has prompted investors to rotate to higher quality companies because of their dependable earnings streams.

Performance by Quality vs. the Profit Cycle

Data is obtained from FactSet Research Systems and is assumed Past performance is no guarantee of future results. The quality data presented on this page is comprised of those Russell 3000® Index with the indicated stock ranking.

Although past performance is no guarantee of future results, we would point out that in the very difficult 2001 recession, earnings of the companies in our portfolio grew despite the economic decline.

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