R  I  V  E  R   P  O  I  N  T 

R  E  P  O  R  T

November 2006

Thanksgiving Update

The market in November continued to gain as the S&P 500 passed the 1,400 mark. The last time the S&P 500 was at this level was in November 2000 - six years ago. November marks the fifth consecutive month of positive returns with eleven of the past twelve months posting positive returns. For the companies that reported, growth came in 6.2% above consensus expectations. Earnings are looking even better in the third quarter. To date 95% of the companies within the S&P 500 have reported third quarter earnings, and of these, 71% have reported above expectations. Merger activity continued to soar as the deal volume ($192 billion) was the highest since January 2000. Even the housing sector had positive news as existing home sales rose month over month for the first time in eight months. In spite of the good news, market volatility, which had been low of late, returned with a vengeance the Monday after Thanksgiving. The S&P 500 index dropped almost 1.4% - its biggest decline in almost six months. This decline came as worries mounted about the slide in the dollar and Wal-Mart reported a disappointing sales estimate, raising doubts about how strong the holiday shopping season will be.

Investing for the Long Term

There is an old adage that patience is a virtue. Nowhere does this hold truer than for investors whose attention should be focused on the goal of compounding money over a long time frame. There are compelling arguments for remaining patient. For example, over short periods of one to two years, luck sometimes plays a more significant role than skill in terms of stock performance. However, over periods of three to five years the “luck” element tends to diminish resulting in performance driven primarily by the investment manager’s skill.

Unfortunately, the current trend is to focus on the short term rather than the long term. In this day and age of instant gratification, long term is measured in weeks or months, not years. Some investors believe that taking advantage of short-term swings will take care of the long-term results. The craze for fast information has changed almost every rule of patient investing. The current market, at times, appears to be more about chasing momentum, switching to the latest “hot” sector or speculating on the direction of the next GDP number or commodity movement. Even the slightest deviation in analysts' consensus estimates is enough to tank the best-grounded stock. Great companies that fail to meet forecasts are punished mercilessly.

We believe that a true long-term investment manager will manage money with strategies that are based on goals over the next five or more years. A good manager knows that investing contrary to popular trends tends to work better over time. What this entails, beyond patience, is astute analysis of companies and the tenacity to persevere when the storm hits. The biggest profits result from buying high quality stocks at reasonable valuations and holding them as long as they remain attractive. Over the long haul, investors who keep their focus and perspective during trying times are more likely to emerge successful.

Historically, stocks have delivered superior returns versus bonds or cash and have proven to be an effective hedge against inflation. This is because over a long period of time stocks reflect the earnings growth of their underlying businesses. Over time, stocks have delivered returns in the range of 10-11% annually as depicted in the S &P 500 returns graph on the next page. This equates roughly to 7 – 8% earnings growth and a dividend yield of about 3%. Yet average market returns in any one year are seldom the norm; in fact, historically, there has been significant volatility in stock market returns from year to year. This is one additional reason why investors are rewarded with more stable returns over the long term.

S&P 500 Returns

Consider the following total returns from three high quality companies. If an investor had purchased Procter & Gamble and Johnson & Johnson stock ten years ago, both companies would have achieved a 12% annualized return including dividends for the period ending October 31, 2006. This is even more impressive after taking into account that Procter & Gamble fell by almost 50% in early 2000. Looking at a shorter time frame in the case of Fortune Brands, over the five-year period ending October 31, 2006, this stock has posted an almost 20% annualized return including dividends. Once more, Fortune Brands still looks attractive over the next three to five years based on projected growth and its excellent management team. In fact, at today’s prices the stocks of all three companies still have reasonable valuations and great prospects.

Market downturns, while never easy to swallow, are nevertheless an inevitable part of the market’s remarkable historical upturn. As Peter Lynch, one of the most successful mutual fund managers ever, stated, “Far more money has been lost preparing for corrections or trying to anticipate corrections than has been lost in corrections themselves.” Following a drop in the market many investors react by selling to protect themselves from further losses. However, doing so virtually guarantees that they will miss out on the inevitable market recovery. Long-term investors do not become overly concerned with market fluctuations because they understand that their stocks will in time recover from a down market.

Effects of Mid-Term Elections

As the Democrats take control of Capitol Hill, they have at least temporarily sidelined Telecommunications and Drug stocks. Drugmakers have taken it on the chin (drug stocks are down 0.7% since November 7^th, compared to gains of 1.1% and 0.4% for the S&P 500 and Dow Jones Industrial Average, respectively) because of new Speaker of the House Nancy Pelosi’s stated desire for Medicare to negotiate price cuts with drugmakers. Such legislation would slice into profit margins, dampening future growth. Telecommunication stocks have been impacted (down 1.2% since November 7^th) amid speculation that the industry will face increasing regulatory hurdles with the Democrats in control. To wit, Senator Daniel Inouye of Hawaii has already suggested that FCC regulators delay approving AT&T’s purchase of BellSouth so that politicians can fully evaluate the effects such a merger would have on consumers.

Other potential headwinds exist for retailer shares and stocks of large multi-nationals. There is a call among the Democratic ranks – led by Senator Harry Reid of Nevada – to increase the minimum wage from $5.25/ hour to $7.25/ hour. This change would likely hurt retailers and restaurant operators the most since many of their employees’ wages are based on the minimum wage. Multi-nationals could face legislative speed bumps in the form of protectionist economic policies. There is a sense that Democrats may look to curb globalization in order to limit the outsourcing of American jobs. Corporate profit growth has been tied to globalization in recent years, and any kind of legislation crafted to limit that trend could dampen the equity prices of those U.S. firms doing business abroad.

Market Summary	11/30/06	YTD Price Change
Dow Jones Industrial Average	12,222	14.0%
Nasdaq Composite	2,432	10.3%
Standard & Poor’s 500 Index	1,401	12.2%

For information about RiverPoint Capital Management or to view our report archive visit us at www.riverpointcm.com.