We are writing this to respond to some investor concerns about the calendar year 2006 performance of FPA Perennial and FPA Paramount Funds. After many years of significant outperformance, the two funds clearly struggled in 2006, turning in modest gains in a market where most averages were up mid-teens percentages.

	FPA	FPA	Russell 2500	S&P 500
	Perennial	Paramount	Index	Index
2001	22.73%	21.67%	1.22%	-11.88%
2002	-10.59%	-12.37%	-17.80%	-22.10%
2003	37.89%	41.41%	45.51%	28.68%
2004	16.25%	15.89%	18.29%	10.88%
2005	12.81%	12.20%	8.11%	4.91%
2006	4.06%	4.76%	16.17%	15.79%
6 years *	12.85%	12.74%	10.28%	2.94%
*Annualized Returns

Performance discussions can take several forms. One of the most obvious is to review the best and worst performers and the reasons for these moves. In the worst column, the standouts were Plantronics, Cognex, HNI, and Zebra, each down about 20%. In three cases management’s operation of the business clearly disappointed investors. The exception was HNI where we believe the decline was driven by market concerns about the housing-related portion of their business. We took advantage of the price decline to add to each position.

Several of our companies did remarkably well last year, though not sufficiently to lift the whole portfolio to relative outperformance. CarMax (+94%) and Manpower (+61%) were the standouts, while Bio-Rad and CDW were each up about 25%. We modestly trimmed our position in CarMax on a valuation basis, but continue to be enthusiastic long-term owners.

A quite different approach to understanding performance is to look for “top down” factors which strongly influenced stock price changes. In fact, we believe that much of last year’s underperformance can be best understood in this way, specifically in the impact of private equity on the market.

Private equity, which in its less respectable past was referred to as LBOs, or leveraged buy-outs, is the business of buying public companies, using as much debt and as little equity as possible, and taking those companies private. Ideally, they are then run much more efficiently, as well as financially restructured, and eventually returned to the public market via an IPO, or are resold to a new buyer, hopefully at a large profit.

When well executed, many past LBOs have proven to be very successful. The result, not surprisingly, has been a large increase in investor interest in this area. In fact, huge amounts of new capital have been raised by PE firms in recent years. We believe that the effect to this increased pool of capital looking for deals was significant in 2006 and negative for Perennial and Paramount performance.

The private equity funds took their recently raised money and bought companies. In 2006, $415 billion of private equity deals were announced, almost triple the 2005 total. The result was not only that the prices of these companies rose, but also the prices of potential targets. Because a good part of the profit potential for PE buyers is improving operations, they tend to prefer low- and medium-quality businesses being run at well below potential efficiency. Thus the stock market effect of the PE funds was disproportionately on the low-quality end of the market. High-quality, efficiently operated companies – the kind of businesses we like to own – are rarely PE targets, and their stock prices therefore were not inflated by the PE boom.

We believe there is considerable evidence to support this argument. An analysis of actual stock market returns in 2006 shows that the performance of low-growth, low price-earnings ratio companies (generally with ho-hum business records) far exceeded that of high-growth and higher price-earnings ratio companies (generally with dynamic and successful records).

For example, the table below shows 2006 stock performance ranked by price-earnings ratio quintile. Quintile I, the lowest price-earnings ratio companies (mostly of low quality) performed the best. Quintile V, the highest price-earnings ratio companies (generally high quality) performed the worst.

Similarly, if we compare 2006 stock performance based on long-term growth rates, we find that the slowest-growth companies performed the best and the fastest-growth companies performed the worst.

Since Perennial and Paramount have always preferred to own high-quality, efficiently managed, high return on capital companies, we were in exactly that part of the market that performed the worst.

An obvious question for the Perennial or Paramount shareholder to ask is how long this PE-distorted market is likely to continue. We think there is reason for optimism.

It is clear that the more money invested in PE firms, the lower the investors’ returns will be. Most likely, recent PE investments will return far less than those in the past when the area was less popular. Similarly, the more the stock prices of potential PE target companies increase, the lower the return on buying the companies is going to be.

As a result, we believe that private equity “excess” will be a self-correcting phenomenon and we will not indefinitely see increasingly large amounts of capital chasing increasingly poor investments. Of course, when this stops is much harder to predict. We will wait patiently and continue to emphasize the same kind of high-quality businesses for the Perennial and Paramount portfolios that we have in the past.

An analysis of the four new positions added to the Perennial and Paramount portfolios during 2006 demonstrates this. The companies – Clarcor, Copart, Franklin Electric, and Maxim Integrated Products – are all market leaders with excellent returns on capital, strong balance sheets, and good historic growth rates, selling at reasonable valuations. They feel right at home in the Fund portfolios.

The Russell 2000 Index consists of the 2,000 smallest companies and the Russell 2500 Index consists of the 2,500 smallest companies in the Russell 3000 total capitalization universe and is considered a measure of small- to mid-capitalization stock performance. The Standard & Poor's 500 Stock Index (S&P 500) is a capitalization-weighted index which covers industrial, utility, transportation and financial service companies, and represents approximately 75% of the New York Stock Exchange (NYSE) capitalization and 30% of NYSE issues and is considered a proxy for the total market.

Unless noted differently, returns are calculated at net asset value after all fees and expenses, but do not reflect deduction of the sales charge, which, if reflected, would reduce the performance shown. Past results are not necessarily indicative of future results. The performance data represents past performance, and investment return and principal value will fluctuate so that FPA Perennial Fund and FPA Paramount Fund shares, when redeemed, may be worth more or less than their original cost. Each of the Fund’s shares are distributed by FPA Fund Distributors, Inc., a subsidiary of First Pacific Advisors, LLC.