First Quarter 2005 Client Letter

July 8, 2005

Dear  Client:

First half:   All major stock indexes closed underwater for the first half.  The Dow Jones Industrial Average (DJIA)  and the S&P 500 were down 4.71% and 1.70% respectively while the Nasdaq Composite (Small Cap Stocks) was down 5.45 %. 

Our US Dimensional Funds (DFA) all-equity model portfolio (value tilt with real estate) was up 1.16%.  Most of our all-equity portfolios have a 30% exposure to non-US stocks.  This diversification was a major factor in our relative outstanding performance during the first six months of 2005.  For example, the International Small Co. Value portfolio had a 5.43% gain, the Emerging Markets Large Co. portfolio had a 4.35% gain, and Real Estate had a 6.76% gain  The results of the last six months continue to convince us that we are on the right track.  We continue our role of educating and advising our clients about two important factors in successful investing:  use high quality Dimensional Funds and build a diversified portfolio of several asset classes using Modern Portfolio Theory. 

Good news:  The Federal Open Market Committee (FOMC) remarked last week that the “U.S. expansion remains firm” and “labor market conditions continue to improve gradually”.  Interest rates remain low and new jobs are being added monthly.

Best in the World:  Paul Merriman, editor and publisher of Merriman Capital Management recently wrote an article entitled “The Best Mutual Funds in the World”.  Merriman explains in his article that for the buy & hold investor, the most important factor that determines success is proper asset allocation.  By eliminating commissions, shaving ongoing expenses and in particular by investing in the right asset classes, it’s not unrealistic to think an investor could increase the long-term compound return by 2% percent without taking more risk.  The mutual funds that he recommends above all others are Dimensional Fund Advisors (DFA).  For more on this excellent article, see www.fundadvice.com.

Global economy:  China has recently purchased IBM’s Micro Computer business and is currently looking to acquire the Maytag appliance company.  What is shocking some people is China’s $16.8 billion bid to purchase the U.S’ ninth largest oil company Unocal, a California independent oil company.  One fourth of Unocal’s proven oil and gas reserves are in Asia.  China, sitting with $691 billion in foreign exchange reserves, buying anything American is better that sitting on a haystack of U.S. Treasuries.  India gets 14,000 new IBM jobs, reports a New York Times article, while cutting the same number of jobs in the U.S.  Alcoa plans to cut 6,500 jobs globally while Winn-Dixie will slash 22,000 positions.  Outsourcing will continue.

Education:  It is hard to argue with the notion that investors often price some stocks too high and others too low.  If new research is correct, this seemingly banal truth may also explain a long-running mystery:  why small-capitalization value stocks tend to beat large-cap growth stocks.  There is a long record of such out performance.  Since 1926, researchers have found, the closer a stock is to the small end of the size spectrum, the better its performance, on average.  The same is true for stocks on the value end of the price to book ratio.  So states Mark Hulbert in a New York Times article.  

His argument is based largely on simple logic:  By definition, an overvalued stock has a larger market capitalization than would otherwise be the case.  Its price-to-book ratio is also higher, and thus it is closer to the growth end of the growth-value spectrum.  Portfolios of large growth stocks will contain a disproportionate number of overvalued issues, and should, on average, lag behind the overall market.  The opposite is the case for undervalued stocks.  So small-cap value portfolios should beat the market in the long term.  The lesson here is that all portfolios should contain a percentage of small-cap value funds in a passively managed index.  See the “Equity Investment Philosophy” on the next page.

Our Outlook:  In spite of all of the current news, our course of action remains unchanged.  We believe in investing for the long term and we will not focus on the short term climate that we are in.

Following is a representative sample, as of June 30, 2005, of DFA funds in the asset classes covered by DFA and currently recommended for use in our client portfolios. This is not a complete list of all DFA funds, and your portfolio may or may not contain all of these funds.

Best wishes for a fun-filled Summer,

Coston and McIsaac Investment Advisers, LLC

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