Commentary

Equities Market Overview

While 2005 was full of surprises that had the potential to derail the economic expansion, perhaps the year's real surprise was the fact that the economy remained very robust in the face of the negative shocks. Despite oil prices hitting $70 per barrel and the City of New Orleans devastated by natural disaster, the economy still posted better than average growth. The long Treasury note did not rise, core inflation remained benign, and the dollar strengthened despite the pessimists' fixation on the trade deficit.

True to its form, the U.S. economy has once again demonstrated its resiliency and breadth. Unlike the late 1990's expansion that was driven primarily by the Information Technology and Telecommunication Services sectors, the current economic expansion enjoys broad participation across many sectors. Looking back, our optimistic view of the underlying economy was essentially correct, as was our expectation of continued strength in the global equity markets, although the U.S. equity markets' performance proved lackluster in the face of a rising U.S. interest rate environment.

U.S. Market Outlook

Now, with interest rate rises largely behind us and the underlying economy remaining in the middle of its stable-growth phase, we believe that the equity markets (as well as equity sensitive securities such as convertible and high yield bonds) are poised for a good year. When considered in the context of interest rates, the market P/E level is at the low end of the historical range. We have had a record 13 straight quarters of double-digit earnings-per-share growth, and expect earnings to continue to grow at similar rates in 2006. With corporate balance sheets in great shape, capital spending should also continue at a healthy clip. Additionally, relatively low inflation and interest rates should continue to provide further fuel for the markets.

The economic outlook reflects the mid-phase of the economic cycle which, if it remains on track, can last for several years. Entering 2006, strong economic fundamentals are providing a positive backdrop to the financial markets. We currently see many potential positive influences on the economy and financial markets, including:

• Oil prices may decline, easing the consumption squeeze for the lower half of wage earners
• Housing prices remaining in an uptrend
• Corporate spending continues to be strong
• Wage and salary levels increasing at a faster pace
• The Fed nearing the end of raising interest rates
• Recently reduced tax rates on capital gains and dividends likely to be extended
• Europe and Japan joining in on the global expansion
• Iraq is stabilized and Iran held in check
• The U.S. trade deficit shrinks

In the light of these expected positive trends, it is also important to recognize the factors that we are monitoring which could have an impact on our outlook and portfolio positioning as history has shown us that good economies do not die of natural causes, rather, they are brought down by the Fed or Congress. Whether the danger stems from miscalculations on interest rates by the Fed or Congress tinkering with policies that are disruptive to a growth-oriented economic environment, we monitor the factors that could have a negative effect including:

• The Fed overshoots its marks and yield curve inverts meaningfully
• The overall housing market drops dramatically
• Protectionist policies in Congress gain traction
• Tax rates on capital and savings are increased
• The Fed becomes overly concerned with asset prices
• Iran becomes more aggressive
• Iraq becomes unstable and terrorist activities increase
• The U.S. dollar comes under undue pressure
• Inflation concerns increase

U.S. Equity Market Review—Fourth Quarter 2005

The broad equity market (as represented by the S&P 500 Index) posted another positive quarter, up 2.08%, bringing the 2005 return to a modest 4.91%. Performance continues to come in spurts, with the majority of the fourth quarter gains stemming from a strong November, with the S&P 500 up 3.78% during that month.

Across market sectors, Energy was the worst performer for the quarter down almost 8%, giving back some of its gains from earlier in the year. Despite its fourth quarter retrenchment, Energy remained the best performing sector for 2005, returning 29% for the year. On the positive side, Materials and Financials were the best performing sectors for the quarter, up 10.6% and 7.5% respectively.

During the 4Q, we were encouraged to see large-cap, and what we would view as higher quality companies, up 2%, placing them on par with the mid-cap segment. Small-cap stocks underperformed again, up only 1%. For 2005, the mid-cap segment was once again the clear winner, with the Russell Midcap® Index up 12.7%. Small-cap stocks, as measured by the Russell 2000® index, however, underperformed with a mere 4.6% return for the year. While large-cap securities, as measured by the Russell 1000® Index, rose 6.3% in 2005, the large-cap growth universe has lagged mid-cap and small-cap growth stocks for some time now as indicated in the following charts. With the performance gap and the valuation opportunity becoming as wide as it has been in a generation or more, the relative cost of growth is cheapest in the large-cap universe (see charts on pages 3 and 4).

Convertible Market Review—Fourth Quarter 2005

The convertible market was up 0.46% in the 4th quarter, bringing the 2005 return to 1.01%, as measured by the broad based Merrill Lynch All Convertible Index (VXA0). Several market dynamics impacting the convertible market (valuations, new issuance, and credit quality) limited some of the returns in 2005. These same factors also lead us to believe that convertible bonds remain a very attractive asset class, which should provide attractive risk/reward for investors going forward.

One of the factors impacting the convertible market in the 4th quarter, as well as throughout 2005, has been the selling pressure from hedge funds employing convertible arbitrage. Convertible arbitrage is a popular hedge fund strategy that has a history of delivering consistent returns with low risk. In the recent market environment (marked by low interest rates and low volatility), the returns that convertible arbitrage hedge funds have produced have disappointed investors. This disappointment has led to redemptions, which in turn has led to the hedge fund community selling into the convertible market. This selling pressure has depressed prices in the convertible bond market, and created some of the best valuations we have seen since 1987. The chart to the right illustrates this valuation gap.

Historically, we have seen the convertible market trade between a 1.5% discount to a 2.5% premium to our fair value estimate. As you can see, valuations have declined within the convertible market recently. As of year end, according to our valuation tools, the convertible market is 2.75% undervalued. This selling pressure and decline in valuations has limited the returns in the convertible market this year. A similar phenomenon happened in 1994, as the Federal Reserve was aggressively raising rates, convertible valuations declined. The valuation collapse that occurred in 1994 was relatively short lived and convertibles returned to more normal valuations.

While there is still some hedge fund selling in the convertible market, it is not as intense as it was towards the beginning of the year. We have seen valuations improve somewhat over the past several months, however, valuations still remain attractive.

Current Portfolio Positioning/Outlook

Portfolio construction is not static from one calendar year to the next, but instead evolves, often incrementally, and will change as the year proceeds and events occur. As for our current portfolio positioning, we continue to believe that we are in the middle phase of the economic cycle, which is characterized by solid growth, although not at the dramatic levels witnessed in the earlier recovery phase of the cycle. In response, the portfolio is positioned for a market ready to recognize the economy's strength and benefit from strong corporate profits, increasing capital expenditures, and solid consumer sentiment.

Among equities, we remain constructive on the Information Technology sector and favor companies with supply-side driven business models, high ROIC (return on invested capital) ratios, and healthy cash positions on their balance sheets. We continue to increase exposure to the Financials sector which has the potential to benefit should consumers shift to saving and investing in order to maximize household net worth. Given the sustained high energy prices and its impact on lower-income earning consumers, we have reduced Consumer Discretionary throughout 2005, focusing on companies within the sector that serve the high-end consumer. Overall, we are finding more attractive risk/reward opportunities among larger-cap higher quality companies with stable growth records, which is consistent with our assessment of being in the middle phase of the growth cycle.

Among convertibles, the portfolio is favoring higher quality issues as companies with stronger balance sheets should continue to prosper in a positive, but slowing growth environment.

Our outlook for convertible bonds is very favorable. We believe that the attractive valuations mentioned earlier are providing an excellent opportunity for investors today. Our experience in the convertible market suggests that the valuations of convertible bonds will revert to historical norms. As this occurs, current convertible bond holders will benefit as valuations improve. We continue to be optimistic that the increase in new issuance we saw in November and December continues. As interest rates rise, we believe more corporate CEO's and CFO's will begin to look to the convertible market as an effective way to raise capital, increasing the appeal of convertible securities.