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January 24, 2011

During the fourth quarter of 2010, the S&P 500 index (including dividends) rose about 10%, and stocks were especially strong in December. We are not certain how much this had to do with the usual late year seasonal strength of stocks and how much was due to the election, which, at least temporarily, lessened concern that the fragile economy would double dip as had been thought likely if taxes were to be raised in 2011. The Dow Jones Industrial and the NASDAQ rose 7.3% and 12.0% respectively for the quarter. For the full year, the S&P, DJIA and NASDAQ were up 15.09%, 11.02% and 16.91% respectively. You can, by referring to the page of your Quarterly Investment Portfolio Report entitled INVESTMENT PERFORMANCE, see how your account is doing relative to our benchmark, the S&P 500 index, but we caution you as always to measure our performance over a 3-5 year period; you just cant tell much by a year or two. Bond yields have risen in the fourth quarter, thereby causing long term maturities to decline in price. Shorter maturities, which are where we have placed our bond investments in balanced accounts, have been little affected. Nevertheless, the 10 year bond yield at 3.33% currently remains very noncompetitive with price-earnings ratios of 14-15 for stocks, equivalent to an earnings yield (earnings divided by price of the stock) of 6-7%. We have previously commented on the relationship between bond valuations -- as indicated by interest rates -- and stock valuations -- as indicated by earnings yields. Bond yields, many times in the past, have been very competitive alternatives to potential returns from stocks. That situation, in itself, does not stop equity bull markets from occurring, but if bond yields were 5%-6%-7% instead of 3.3% as is now the case, it would induce many investors to move monies from equities to bonds. You might reply that the public has been moving funds in that direction in the past 2 1/2 years even though bond interest rates are not competitive with the modest valuations of stocks, as we pointed out above. The following chart, courtesy of our correspondent Strategas, illustrates the contrast between money movements in the fear-dominated markets of the past 2-3 years versus the public's mood in 19992000, the height of the dot com era ebullience. The level of liquidity concerns and other fears seem to be ebbing now that the economy is recovering, and worries of mass closings of banks and of more radical changes in government policy, at least in the near term, are also ebbing. It was, interestingly, only in the fourth quarter that the shift from equity monies going into bonds reversed itself, and for the first time in years, Bond Funds experienced net withdrawals, and Equity Funds experienced net additions.

Quarter Ending December 31, 2010


An Era of Greed

As the charts to the left indicate, the average retail investor is still a large net seller of domestic mutual funds. This, of course, stands in direct contrast to the behavior of the retail investor a decade ago when fund companies couldnt sell bond funds for love or money and flows into equity funds were coming in over the transom. The good news is that equity funds are in strong hands that is to say it appears that only the true believers in equities have remained. We continue to believe that there is a huge opportunity for investors to view stocks as a source of yield.

An Era of Fear

We say it is about time for more interest in equities. With S&P earnings of $84 in 2010, expected to be over $90 this year and in the high $90s in 2012, the S&P 500 index, at 1293, is perhaps only 14 times 2011 earnings and 13.5 times 2012 earnings. For historical perspective, we present the Strategasprovided chart below which shows in the middle column the Average P/E going back to 1970. It will be noted that only in the 1974-1985 period, years of much elevated inflation and interest rates, have P/E ratios been less than now. The average P/E ratio for the last 40 years is 15.5. The only prior periods recorded with single digit multiples were part of the 1910-20 decade, and then again in the late 1940s and very early 1950s, when the consensus of investors was that wars were generally followed by recessions, as had occurred after WWI. This widely held belief proved to be wrong as the 1950s were wonderful years for the economy and for the stock market. (The information on the next page is from Strategas.)

Quarter Ending December 31, 2010


We have fancy econometric models and crude ones, but the old heuristic of the Rule of 20 has been an effective barometer of fair market multiples. Of course, valuation is never a good timing tool. Using the 2010 average of the S&P 500 (1140) and our 2010 EPS estimate ($84.25), the P/E comes in at just 13.5x with CPI levels still modest, this remains well below the long-term average sum of inflation and P/Es (about 20).
1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Average Operating Price EPS 83.4 5.04 98.3 5.60 109.8 6.30 106.5 8.01 81.5 8.73 87.1 7.62 102.8 9.73 97.5 10.69 95.5 12.11 103.3 14.59 119.6 14.55 127.8 15.08 120.3 12.41 160.8 13.78 160.3 16.62 189.0 16.34 238.7 15.55 286.0 19.55 268.1 24.12 326.3 24.32 332.7 22.65 381.5 19.30 417.1 20.87 453.5 26.90 460.7 31.75 546.9 37.70 674.8 40.63 875.9 44.01 1087.9 44.27 1330.6 51.68 1419.7 56.13 1185.8 38.85 988.6 46.04 967.9 54.69 1134.0 67.68 1207.8 76.45 1318.3 87.72 1478.1 82.54 1215.2 49.51 948.5 56.86 1140.0 84.25 Average P/E 16.6 17.6 17.4 13.3 9.3 11.4 10.6 9.1 7.9 7.1 8.2 8.5 9.7 11.7 9.6 11.6 15.4 14.6 11.1 13.4 14.7 19.8 20.0 16.9 14.5 14.5 16.6 19.9 24.6 25.7 25.3 30.5 21.5 17.7 16.8 15.8 15.0 17.9 24.5 16.7 13.5 CPIY/Y 5.9 4.2 3.3 6.3 11.0 9.1 5.8 6.5 7.6 11.3 13.5 10.4 6.2 3.2 4.4 3.5 1.9 3.6 4.1 4.8 5.4 4.2 3.0 3.0 2.6 2.8 2.9 2.3 1.6 2.2 3.4 2.8 1.6 2.3 2.7 3.4 3.2 2.9 3.8 0.3 1.7 Total 22.4 21.8 20.7 19.6 20.3 20.6 16.3 15.6 15.5 18.3 21.7 18.9 15.9 14.8 14.0 15.1 17.3 18.2 15.2 18.2 20.1 24.0 23.0 19.8 17.1 17.3 19.5 22.2 26.1 27.9 28.7 33.3 23.1 20.0 19.4 19.2 18.2 20.8 28.4 16.4 15.2

Average 15.5 4.5 20.0 Historically,thesumofinflation&P/Eshasbeenroughly20.

Quarter Ending December 31, 2010

The other lesson to be learned from the chart is The Rule of 20. The Rule of 20 says that if you add the P/E ratio of stocks to the Consumer Price Index (CPI), you should get something around the number 20. The idea behind this is that when inflation, as measured by the CPI, is low, earnings multiples tend to be high, and when inflation and the CPI are high, earnings multiples tend to suffer, as bond yields rise and offer more competition to stocks. At the bottom of the chart, it shows that the average CPI of 4.5 plus the average P/E ratio of 15.5 happens to equal 20, which turns out to be the average of the sum of those two items for the same 40 years. Thus, the name of The Rule of 20. It will be seen that with inflation and the CPI at quite modest levels, the total of the P/E ratios and CPI year-to-year was only 15.2 for 2010. It is still in that vicinity here in early 2011. This suggests that if history is any guide, and we believe it is our best guide, there is plenty of room for stocks to rise if inflation stays low. It also suggests that investors are either overly leery of rising inflation (at a time of 9.4% unemployment) becoming a problem in coming years, certainly a possibility once the economy reaches higher rates of capacity utilization, or that the economy will go back into recession. Neither scenario seems likely to us in 2011 or in the first half of 2012, which leads us, and unfortunately a lot of others, to be pretty sanguine regarding U.S. equities. Although the logic of all these numbers leads to some bullishness, we must say that also, like others, we recognize the reality that markets do not go straight up, and the last 2-3 months have been of that nature. So a correction of modest proportions would seem to be in the cards. We remind you that over a 2-4 year period or longer, stock prices correlate with earnings, so the above earnings expectations, if realized, should pull prices higher. However, in the short term, markets can be pulled in any direction. Another thought regarding bonds: With respect to our remarks on page 1 about bond yields not being competitive with earnings yields on stocks, we recognize that for many investors, having an anchor to the windward is important, and having a fixed income segment of ones portfolio is an important and valid part of providing downside protection to the overall account. Such consideration limits risk and can often trump a simple comparison of numbers. The following table is the result of a little exercise we recently performed on our main list of holdings. We wanted to ascertain how much upside potential the stocks in our portfolios still possess after goodsized gains for some stocks from where we bought them, and in light of a good advance for stocks in general from the bottom in early 2009. The methodology is not precise, and there is some degree of subjective judgment that went into the result. We divided the stocks into three categories -- L, M and H - for limited upside potential, moderate upside potential and high upside potential from current prices, and assigned each stock to one of those categories.

Quarter Ending December 31, 2010

Fastenal ExpeditorsInt'l CHRobinson BrownForman Procter&Gamble NobleCorp. DentsplyInt'l WRBerkley CenovusEnergy RogersCorp. Techne Gentex RockwellCollins Graco McMoran Energizer

UpsideCategoryCode: L=LimitedUpside M=ModerateUpside H=HighUpside

Current Upside Price Target

60 54 78 67 65 38 36 27 33 41 66 32 62 40 17 72 67 66 90 80 75 48 45 37 65 70 120 50 100 70 ? 110

$2.25EPSx30PER $2.20EPSin2012x30PER $3EPSin2012x30PER EPS$3.50in2012x23PER ModeratelyrisingEPS+Multiple $110oil ModestEPSgrowth2011and2012 Pricingandcyclechanges $110oil+Higherproduction $3EPSx2324PERby2012 $4EPSx30PERin2013 Highearningsvisibility Boeing787production,EPS$5+by201213 Construction/Housingrevivesby2013 DifficulttoProject EPS$7in2012x16PER

Upside Category

We are actually a little surprised that the Ls are such a small portion of the stocks, and at how much upside potential there exists in the remaining stocks. Of course, in many cases, we looked out two or three years and in a couple of cases even further. Common sense and history tell us it is quite common that not many of the leaders of portfolio performance of one year will be the leaders of performance in the next year. One might easily conclude that the M or H category stocks might offer the best opportunity for appreciation in the near-medium term future. However logical, that line of thought can lead to a dangerous conclusion. What we definitely do not want to conclude is that the Ls, whom we may be rightly or wrongly estimating as not having much near term appreciation potential, should necessarily be sold and the proceeds placed in the Ms or the Hs. We do not want to exit excellent companies' stocks just because they may be a little ahead of themselves in the near term, if those companies still possess outstanding businesses with durable competitive advantages, all for the purpose of chasing a possible near term larger move in another part of the list. Our overall assessment of the list is that there is still quite a lot of appreciation potential in our holdings, actually more than we had previously thought. We want to remain with the current balance of weightings in our list of companies. The chart in this letter that might surprise you most is the one depicting state tax receipts rising. It is true that New York, Illinois, California, New Jersey and a number of other states are in deep deficits, but tax receipts are up, and please note on the next page the decline already taking place in overall state spending prior to new legislators even being seated. Not shown is that the majority of states are running budget surpluses! This development may defuse the turbulence in the muni bond market in the more fiscally responsible states.

Quarter Ending December 31, 2010

STATE TAX REVENUES GROWING & LIKELY TO ACCELERATE IN 2011 WHILE SPENDING REMAINS MUTED We have been interested in Gentex since 2000, and have followed the company since then. Gentex is, at its essence, an electronics company, surprisingly located in Western Michigan. Like Rockwell Collins, another of our portfolio companies that is primarily in electronics, and headquartered in Cedar Rapids, Iowa, the location seems out of sync for the industries served -- aerospace for Rockwell Collins and autos for Gentex. For these two businesses, the barriers-to-entry are quite high, market shares are substantial, and operating margins and return on invested capital are way above average, especially for the pertinent industries.

Quarter Ending December 31, 2010

Gentex has 83% of the worldwide self-dimming automotive mirror business, which includes both internal and exterior mirrors. There are about 65 million new cars produced every year, mostly on three continents. Gentex makes the mirrors in 4 buildings in Zeeland, Michigan, and nets close to an amazing 20% after taxes, selling to original equipment auto manufacturers. Gentex has only one real competitor, another Michigan company called Donnelly, which is a subsidiary of Magna International, a large Canadian auto supplier. Donnelly's main product is prismatic mirrors, which need to be manually adjusted by the driver to reduce headlight glare from the rear at night. Prismatic mirrors sell for a couple of dollars apiece whereas self-dimming mirrors, which instantly and automatically dim when struck by light, sell to OEMs for about $20 apiece. Donnelly's self-dimming mirror production is a small fraction of that of Gentex, which makes Donnelly a high cost producer; Donnelly has a reputation for spotty quality and it purportedly loses money every year in self-dimming mirrors and to our knowledge has never done otherwise. So here is a company with little competition making high margins. Gentex has developed other features to add to the mirrors' capabilities, such as map lights, compasses, garage door openers, emergency call capability, microphones, automatic headlamp control (Smartbeam) and a rear camera display (RCD), a safety feature in high demand that allows the driver to see, from the drivers seat, the area immediately behind the rear of the car, by shifting the car into reverse. All these features are incorporated into the mirror, and when purchased by an OEM in toto, can run the average sales price per mirror to well over $100, and content per vehicle to over $200 if exterior mirrors are involved. The current averages for those two statistics are $47 and $67 respectively, so there is a lot of room for growth. Smartbeam and RCD, having come to market only in the last three to four years, are much higher priced features than those previously introduced features listed above, and are in the process of contributing mightily to the upward trends in average price per mirror and content per vehicle; Smartbeam and RCD are both safety oriented, and have experienced rapid growth for Gentex -- on the order of 25%-35% and 50%-100% respectively. Gentex sells some combination of mirrors and features to virtually every car company in the world. It is producing about 14 million mirrors per year, or more than one for every five new cars produced worldwide, a ratio that has steadily grown over the years and that seems destined to double in the years ahead. While unit penetration of the auto market is taking place, Gentex is also gaining in content per vehicle as indicated above. It would appear that Gentex, which earned close to $1 a share in 2010, should more than double that figure by 2013 and triple earnings by 2015 compared to 2010. Thank you for your continuing trust and confidence in our stewardship. We are working diligently to build your capital with a conservative methodology in the coming years. Most Cordially,

Roland Underhill Managing Director


Quarter Ending December 31, 2010

Appendix Items worth noting: The number of U.S. manufacturing jobs last year grew 1.2%, or 136,000, the first increase since 1997 according to government data. That number should rise in 2011. Over 5 million manufacturing jobs have left the U.S. since 1997. (Wall Street Journal) Japan and Canada are planning to lower their corporate tax rates, according to the Wall Street Journal and Bloomberg. The number of federal workers earning $150K or more has increased from 0.4% of the workforce in 2005 to 3.9%... (USA Today)