“At this point in the cycle, we believe owning a diversified portfolio of companies with a high return on equity, strong balance sheets, and above market earnings growth is a prudent strategy.” -Robert Schwarzkopf, CFA Chief Investment Officer & Portfolio Manager -Sandi Gleason, CFA Portfolio Manager -Jon Christensen, CFA Portfolio Manager

Market Overview
After rallying during April and May to erase much of the markets’ firstquarter declines, the markets experienced one of the worst (if not the worst for certain indexes) monthly returns in history for the month of June. The markets continue to be affected by the slowing economy, persisting credit problems, and rising inflation. For the quarter, the Russell Midcap Index rose 2.67%, outperforming both the Russell 2000 Index (+0.58%) and the S&P 500 Index (-2.73%). Growth significantly outperformed value during the quarter, with the Russell 2000 Growth Index up 4.47% versus the Russell 2000 Value Index down 3.55%. Year to date through June 30, all equity indexes, regardless of asset class, were down in the high single-digit to low double-digit range.

Reflecting record high oil prices, energy was the strongest performing sector by a wide margin, increasing more than 30% in every small and mid-cap Russell index. Financial services was among the worst performers, continuing the trend experienced for several quarters, along with transportation and consumer staples, which were both impacted by higher commodity prices.

Low-quality stocks, as measured by S&P Quality Rankings, held up substantially better than high-quality stocks during the quarter (See chart: Performance by S&P Quality Rankings). Although high-quality should intuitively outperform in this type of market environment, high quality underperformed due to the large weighting of banks in the high-quality segment of the benchmarks, which were down considerably during the quarter. Excluding financials, the performance between high and low quality appeared more balanced. However, in the sectors where low quality outperformed, it was by a greater magnitude than in the sectors where high quality outperformed.

Data is obtained from FactSet Research Systems and is assumed to be reliable. Past performance is no guarantee of future results. Data is for the second quarter 2008. High Quality - Stocks in the Russell 2000® Index with an S&P quality ranking of A- or higher. Low Quality - Stocks in the Russell 2000® Index with an S&P quality ranking of A or less.

Portfolio Overview
The Small Cap Core Portfolio underperformed the Russell 2000 Index for the quarter. The underperformance was driven by the aforementioned performance of low quality during the quarter and by the strong performance of the energy sector. Despite the portfolio’s slight overweight in energy, the Small Cap Core Portfolio’s holdings did not keep pace with those in the benchmark due to the types of energy companies that we own. Given our high-quality orientation, we own companies that have less direct exposure to the underlying price of the commodity in order to protect the portfolio against the price volatility. In this environment, these types of energy companies did not perform as strongly as those with more direct exposure to the commodity, such as oil producers and drilling companies.

The companies that contributed the most to performance during the quarter included Ansys and Lincoln Electric Holdings. Ansys, a leading developer of simulation software, continues to drive adoption of simulation technology among a broad customer base by adding functionality and expanding capabilities as desktop computing power increases. The business also benefited from cross-selling efforts after a recent acquisition and strong international revenues. Further, investors were encouraged by an announced acquisition that will significantly enhance the company’s product platform. Lincoln Electric Holdings is the world leader in arc welding equipment and consumables. The company continues to prosper from the strong industrial economies worldwide and the global infrastructure capital spending. Despite the commodity-cost headwind, the company has aptly improved on operating margins due to its ability to push through price increases along with good operational cost control.

Companies contributing the least to performance during the quarter included ScanSource and UCBH Holdings. ScanSource, a leading two-tier distributor of specialty technology products, continues to produce healthy profitability, driven by the application of its unique distribution model to additional product categories and geographies. However, the stock suffered during the quarter when one of its partners mismanaged a product launch, while another mismanaged pricing in Europe. We view the issues as temporary in nature and not reflective of a change in the quality of the underlying business. Additionally, the company expanded its opportunities in telecommunications and security with the acquisition of MTV Telecom in Europe and the new vendor relationship with GE Security

UCBH reported highly disappointing first quarter 2008 results, driven by a dramatic deterioration in loan quality. We initially entered the stock when UCBH primarily acted as a lender to the low-risk commercial real estate market (apartment, owner-occupied, and income producing properties) and boasted a long track record of serving an attractive, fast-growing niche segment of the ethnic Chinese population. Recently, however, UCBH rapidly expanded into higher risk construction within the commercial and industrial segments. Construction loans advanced 50% between the first quarter of 2007 and the first quarter of 2008, sourcing the company’s dramatic deterioration in problem loans. Considering the initial loan-to-value ratio of the bank’s construction portfolio and adjusting for first quarter loan loss reserves, we exited our position in UCBH believing that declining real estate values will require further reserve additions and will continue to drag on earnings.

Purchases and Sales
In the Small Cap Core Portfolio, we increased our position in Blackbaud and sold our positions in UCBH (discussed above) and Medical Action Industries (MDCI).

Blackbaud, the leading vendor of software designed specifically for the nonprofit industry, was weak due to the belief that the company’s non-profit customers are seeing a more protracted purchase cycle of infrastructure software products from a weak economy and financial markets that have diminished charitable giving and investment portfolios. However, we believe the company’s new products (eCRM and NetCommunity) are flowing through the pipeline nicely and international markets, as well as certain recession-resistant verticals, such as education and global health care, are performing well. With over half of its total revenue derived from a recurring revenue model in the form of subscription license and maintenance fees, the low capital structure generates exceptional free cash flow that Blackbaud has strategically used to buyback shares. We used the weakness in the shares to add to our position.

MDCI, a manufacturer of a broad line of disposable medical products, reported earnings-per-share down in the most recent quarter due to ongoing integration issues related to an acquisition made roughly 18 months ago, increasing resin costs, and increasing costs of certain products sourced from China. Revenue grew only 4%, the lowest quarterly growth in some time and below the company’s stated target of high single digits. The company began to institute price increases, but not at a level to offset continuing rising costs. Thus, margins will undoubtedly decline. In addition, the company needs to replace equipment at the acquired business, making the business more capital intensive and, thereby, lowering returns on capital. Despite trading at an attractive valuation and our belief that the company will eventually be able to successfully integrate the acquisition and eliminate the associated costs, we sold the stock during the quarter. We believe the combination of slower revenue growth, ongoing resin cost increases, and increasing capital intensity will result in a permanent multiple contraction and will create strong headwinds to earnings growth.

Outlook
Inflationary concerns, driven by the cost of oil rising to over $140 per barrel, is limiting the Federal Reserve’s ability to further lower interest rates to stimulate the economy. Globally, higher inflation is leading policy makers to implement policies to slow growth. This should lead to a decrease in demand for commodities over time and, if past cycles repeat, lower prices. At this point in the cycle, we believe owning a diversified portfolio of companies with a high return on equity, strong balance sheets, and above market earnings growth is a prudent strategy.

Data is obtained from Bloomberg, FactSet Research Systems, and a major consulting firm, and is assumed to be reliable. Other principal consultant firms may use different algorithms to calculate selected statistics. Data is as of June 30, 2008.

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