QUARTERLY

Commentary
secOND QUArter 2007

Asset mANAGemeNt

Financial Market Review

end of inversion
It is a widely held belief that an inverted yield curve is a precursor to an economic recession and in fact has predicted nine of the last six recessions. This faulty logic rang true in the most recent markets1. Beginning in the spring of 2006 and lasting for over a year, interest rates on short maturity treasury bonds have been higher than longer maturities, a phenomenon known as an inverted yield curve. This often is a signal that investors in bond securities believe the economy is headed for a slowdown. Throughout the duration of the curves inversion, the Bernanke-led Fed has been consistent in its message that the risk of inflation was greater than the risk of a severe economic downturn. After eight meetings without a change in the Fed Funds rate, bond investors have finally stopped predicting lower interest rates. The benchmark 10-year bond began the second quarter at a yield of 4.64%, nearly a half percent lower than the 90-day T-bill. The markets adjustment in bond yields to a more normal shape resulted in the 10-year bond ending the quarter at a 5.02% yield, slightly higher than the T-bill rate.
INDEX PERFORMANCE Q2 07 YTD

onset of the quarter did not worsen as originally feared. These risks included a weakening domestic housing market, extreme volatility in foreign stock markets, and liquidity crisis concerns caused by increasing defaults in the sub-prime mortgage market. Though each of these risks has not been eliminated, they were trumped in the quarter by positive corporate earnings reports.

Inside this Issue

Asset mANAGemeNt
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New Highs
During the quarter, 75 percent of the companies in the S&P 500 announced increased sales growth compared to the same period last year. More impressive is the fact that two-thirds of these companies earnings surpassed analyst expectations2. These announcements provided a positive catalyst for the stock market. Mergers and acquisitions (M&A) activity continue to fuel market growth. Global M&A activity advanced by a record $1.65 trillion in the second quarter, an increase of 90 percent over last year3. The growth in private equity firms war chests, coupled with low interest rates, has created an insatiable demand for companies with strong cash flows and attractive valuations. Fueled by positive quarterly earnings and M&A activity, the stock market advanced into early June as both the Dow Jones and the S&P 500 established new all-time highs on June 4th. The Dow Jones reached 13,676 and the S&P 500 closed at 1,539, surpassing its previous high of 1,527 achieved on March 24, 2000. The strength in the first two months of the quarter did not carry through the third month, but full quarter results for the Dow Jones of 9.1% and the S&P 500 of 6.3% were both impressive. International and small company stocks continue to provide solid returns. International
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Financial Market Review

WeALtH mANAGemeNt
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Health Savings Accounts

firm perspective
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A Graduation Inspiration

Dow Jones Industrials Standard & Poors 500 EAFE (international stocks) Russell 2000 (small stocks) Lehman Intermediate Lehman Municipal

9.10 6.27 6.73 4.42 -0.14 -0.66

8.75 6.95 11.18 6.45 1.44 0.13

The change in bond investor sentiment was not due to increased confidence in the first term Fed chairman, but rather increased comfort that the risks that existed at the

During the quarter, 75 percent of the companies i S&P 500 announced sales growth.....two-thirds companies earnings surpassed analyst expect

Current Top Fifteen Equity Holdings

Schlumberger Matthews Pacific Tiger Fund iShares EAFE Index Fund Emerson Electric Masters Select International Goldman Sachs Group Walgreen Texas Instruments Procter & Gamble Marathon Oil General Electric Chevron Intl Business Machines Utilities Sector SPDR Cisco Systems

stocks, represented by the EAFE Index advanced 6.73% and small company stocks improved in the quarter by 4.42%. We continue to anticipate that international growth will help U.S.-based companies perform in an environment where the U.S. economic growth has moderated.

political crystal Ball

Even though it is still over six months away from the Presidential primary elections, the fundraising and campaign machines of a long list of potential candidates are in full swing. While the Republican Party has not conceded the Oval Office and the race appears to be wide open, many political insiders are predicting Democratic leadership in 2009. Should a change in party leadership occur, we expect that energy prices would moderate, taxes would increase, and governments spending on defense would decline. The regulatory environment would also likely become more stringent, slowing the rate of activity in the merger and acquisition arena.
5.20 6/29/07 4/02/07 5.10 5.00

maintains profitable businesses in both the generic and branded drug arenas. Volcano is a provider of Intravenous Ultrasound (IVUS) equipment that has an opportunity to become a critical diagnostic imaging tool, providing doctors with information more valuable than a standard angiography in combating heart disease. Graco is a provider of fluid handling systems and components used in a plethora of industrial and commercial applications. We sold profitable positions in Equifax, Hain Celestial, and Wellpoint. Equifaxs credit rating business will continue to be affected by higher mortgage rates and weak housing. Hain Celestial, though positioned in the attractive natural food industry, raised too many red flags with its option granting history and its unwillingness to provide detailed sales data. We exited our position in Wellpoint as we anticipate the profit opportunity in the healthcare industry resides in the development of drugs and equipment rather than the administration of claims. We also trimmed our position in Emerson Electric. Our concerns today mirror those of the last quarter. We closely watch the impact of a slowing housing market on consumer spending. Nationally, housing inventories are currently at 8.4 months, which is at the high end of its historical range of 3-9 months4. We anticipate that we have not yet seen a bottom in the housing market and that we will see a gradual decline in prices rather than a sharp and dramatic correction. We also closely watch the debt issuance of financial institutions that have helped support the sub-prime lending environment, as well as the debt from companies going private as they look to further leverage their cash flow. A lukewarm reception for either of these types of debt offerings could be a harbinger of significant changes in both the equity and fixed income markets. Currently though, these are more of a concern than a fear and we feel that market appreciation will match the high single digit earnings growth we expect from our portfolio companies.
1. Federal Reserve 2. Bloomberg, LP 3. Wall Street Journal, July 2, 2007 4. Fortune, June 25, 2007

2ND QUARTER 2007 TREASURY YIELD CURVE SHIFT

Y I E L D

(10 year yield up 0.38%)

4.90 4.80 4.70 4.60

S P R E A D 3 6
Bloomberg LP

.25 .00 2 3 5 10 30 -.25

trading Activity
During the quarter we purchased positions in Genentech, Novartis, Volcano, and Graco. Genentech augments our portfolio exposure to the growing biotech industry with a robust pipeline of intriguing drugs. Novartis, a Swiss-based pharmaceutical company,

in the s of these tations...

integrity

Where do you find integrity?

It emanates from tradition, endures market cycles, and sustains longterm partnerships. Trust lies at the heart of what we do, how we serve and whom we employ.

[in tegr te] n. honesty, sincerity, completeness

WeALtH mANAGemeNt

Health Savings Accounts

Several clients have recently inquired about an increasingly popular medical insurance optionThe Health Savings Account (HSA). Both businesses and employees are looking for ways to maximize health benefits while reducing their overall expensesa significant challenge as the cost of health care and insurance premiums continue to rise. Established as part of the Medicare Modernization Act in 2003, the Health Savings Account is a tax-favored medical savings tool for individuals enrolled in qualified high-deductible health plans. A plan qualifies if its deductible is at least $1,100 for an individual and $2,200 for a family. The HSA is similar to an IRA but designated specifically for medical expenses. Deposits are tax-deductible and can be easily withdrawn free of tax to pay routine medical bills.

Benefits to employers and employees

Many employers are now offering HSA medical insurance options as part of their benefits package. To encourage employees to utilize these lower premium plans, employers often make contributions on behalf of their employees to help fund their HSAs. Employers reduce their monthly expenses since the premium for these plans are typically much less than low deductible group plans. Employees will still benefit from the contracted rates of their plan sponsor. They spend their HSA dollars at the reduced rate negotiated by their HSA Plan Sponsor instead of the health care providers quoted rates. It does continue to be difficult to find resources to access the negotiated reimbursement rates for healthcare providers and plan sponsors. Unlike a flexible spending account in which money must be spent by year-end or it is lost, an HSA balance can accumulate and roll over from year to year. The HSA grows tax-free and the individual does not pay income taxes on distributions used for qualified medical expenses. Unlike many other tax breaks, there are no income limits to HSAs. Anyone under age 65 who buys a qualified high-deductible policy can open an HSA. A new law, The Tax Relief and Health Care Act of 2006, allows a one time rollover of IRA assets to be used to fund up to one years maximum HSA contribution.

Highlights of Health Savings Accounts

Tax-favored medical savings vehicle Value can grow for use in future years Employers may contribute on behalf of employees

How the HsA Works

Here is an example of how the HSA works: Sally Smith works for an employer who offers and pays the premium for the Blue Cross 1500 plan, a qualified high-deductible health plan. Under the plan, Sally pays 100% of medical costs until her annual medical expenses reach $1,500. After Sally has reached the $1,500 deductible in a calendar year, Blue Cross pays 100% of health care expenses for the remainder of the year. To pay for her potential annual liability of $1,500, Sally can make pre-tax contributions to her HSA which can be used to pay for medical expenses and can be invested similar to an IRA. Any unused portion of Sallys HSA can grow to be used for medical costs in future years or even in retirement.

Not for everyone

Health Savings Accounts are not appropriate for everyone, but for the right situation they can help mitigate the cost of medical care for both the employee and the employer. Nelson Roberts Investment Advisors has added the HSA option to its benefits plan.

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Firm Updates
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Nelson Roberts is a proud sponsor of the Peninsula Humane Society & SPCAs summer eventsFashion for Compassion and the Mutt Strutt 2007 The firm surpassed $200 million in assets under management Brian Roberts was selected to teach an Ethics Course for a Masters Program through St. Marys College

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Kimberly Carlisle, Images of Light Photography

firm perspective

A Graduation Inspiration
by Brooks Nelson

We are pleased to highlight one of our neighbors in East Palo Alto who continues to do wonderful things to improve our community. Recently I attended the commencement ceremony of Eastside College Preparatory Schoolan institution committed to providing opportunities for students historically underrepresented in higher education. The 26 graduates of the class of 2007 have all been accepted to top-tier four-year colleges. Even more impressivenearly all of these graduates will be the first in their families to attend college. Sixty-six schools offered admission to these students including Stanford, UC Berkeley, Columbia and Amherst, to name only a few. Eastside Prep is a remarkable story, rising up in a community that had not had its own high school since 1976. It has come about through the involvement of a blue-chip board of community volunteers and the support of the greater Peninsula community. But none of this would have been possible without the vision and tenacity of the founder and principal, Chris Bischof. I first met Chris as an opposing basketball coach in 1997. He ran a disciplined team and instilled a strong sense of commitment and fair play, which is often an exception today in childrens competitive sports. Little did I know this was the very passion that led him to found Eastside Prep. Today, as you tour the Eastside campus, you will see newly constructed buildings with well-supplied, spacious classrooms. This is a big contrast from the small house and portable trailers where the class of 2000 spent four years. The school strives to achieve the admission of each of its graduates to a four-year college or university. In a community with a 65% high school dropout rate, this is no easy undertaking. However, to date, they have achieved this outstanding goal with all eight classes of seniors who have graduated since the schools inception in 1996. The ceremonys keynote speaker was Angelique Burton, a recent graduate of Smith College and an alumna of the Eastside Prep class of 2003. Angeliques poignant message urged the graduates to explore the breadth and depth of their future academic homes. She implored them to search out diverse people, explore unfamiliar subjects, and expand their knowledge so they too can make a significant difference in the world. As a testament to the school and its leader, Angelique is pursuing graduate studies in education and wants to work toward improving inner-city education. Eastside Prep and Chris Bischof have accomplished so much. I encourage you to visit www.stanford.edu, search for Shoot for the Stars, and get the full story of Eastsides remarkable evolution. Everyone at the schoolstudents, alumni, faculty, staff and volunteers should be proud of what they have accomplished for our community. Congratulations to you all!
iNvestmeNt ADvisOrY teAm

CP Larson Photography

Brooks Nelson, CFA Brian Roberts, CFA Stephen Philpott

2000 University Avenue, Suite 601 East Palo Alto, CA 94303 tel 650-322-4000 web www.nelsonroberts.com email invest@nelsonroberts.com

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2007 Nelson Roberts Investment Advisors