The information contained herein does not constitute investment advice.

Investors should consult their own financial advisors and should invest depending on their own financial situations and comfort level with risk taking.

Unconventional Wisdom in the Investment Process

One of our strengths as a firm is our ability to be flexible and open-minded, which sometimes causes us to view the investment process a bit differently than more conventional firms. An example of this was effectively presented in a speech by Richard Driehaus. Below are excerpts of that speech. Often, the opportunities for truly attractive investments are not obvious. In fact I frequently have to challenge what appears to be conventional wisdom. Today, I would like to present a similar challenge to you. I assume that most of you are relatively conservative investors, with capital preservation as one of your major goals. I also assume that, as conservative investors, you would probably agree that the best way to preserve capital is to use a sensible asset allocation. The challenge is -- what is sensible? I believe that, even for "conservative" investors, it may be appropriate for part of your asset allocation to include some exposure to aggressive management. This is not contradictory. People believe that the terms "preserve capital" and "aggressive management" cannot be used together. But, in fact, they are very compatible. To explore this concept, I would like to draw on my 35 years of experience in aggressive growth investing... and focus on three areas: First, what are "reasonable" capital preservation objectives. and how difficult was it to achieve these goals over the last 50 years? The second area covers what I've learned over the last 35 years as an investor that has helped shape my thinking and caused me to approach investment management much differently than most other portfolio managers. The third area covers conventional wisdoms or paradigms that have led investors to mediocre performance. I'd like to share my thoughts about trying to avoid those errors.

Capital Preservation ObjectivesSteps to Potential Success

An absolute minimum objective for any conservative investor should be to increase your assets, after taxes, by the rate of inflation. You have to at least preserve your purchasing power. A better objective would be to add some real incremental returns over and above inflation and taxes. This would allow you to more easily fund your retirement, educational and charitable goals. Having then focused on the proper objectives, you have done the easiest part. Meeting the objectives becomes the real challenge.

I believe there are three key points in seeking to meet capital preservation objectives: 1. Allocate assets to an aggressive market segment The first step is to make a meaningful allocation to some aggressive market segments. You may want the potentially positive impact of any growth to offset the negative impact of inflation. My examples focus on the United States. From 1954 to 2003, inflation in the U.S. averaged 4.0 percent annually. What this means is, $1 (U.S.) had to increase to over $6.9 by 2003 to preserve equivalent purchasing power. However, if an investor wanted to earn only 3 percent annually over the inflation rate, that $1 in 1954 would need to increase to over $28 by 2003. Now, given the modest objective of earning 3 percent over inflation, what kind of investment program would it have taken to have achieved that target? I've collected return data for a 50-year period for three hypothetical portfolios. They were invested in U.S. T-bills, government bonds, and stocks but with different asset allocations. The returns earned for each asset class for the 50 years were those of their respective markets. For example, the stocks earned the same return as the S&P 500 Index.

GROWTH OF $1 (1954 to 2003)

$160 $140 $120 $100 $80 $60

$133.4

$76.3

$48.6
$40 $20 $0
Jan-54 Jan-56 Jan-58 Jan-60 Jan-62 Jan-64 Jan-66 Jan-68 Jan-70 Jan-72 Jan-74 Jan-76 Jan-78 Jan-80 Jan-82 Jan-84 Jan-86 Jan-88 Jan-90 Jan-92 Jan-94 Jan-96 Jan-98 Jan-00 Jan-02

$18.0

Port. A (50% T-bill, 50% Bond) Port. B (33% T-bill, 33% Bond, 33% Stock (S&P 500)) Port. C (25% T-bill, 25% Bond, 50% Stock (S&P 500)) Port. D (20% T-bill, 20% Bond, 45% Stock (S&P 500), 15% Small Stock)

Portfolio A was invested very conservatively 50 percent in U.S. T-bills and 50 percent in long-term U.S. Government bonds. Over the 50 years, it earned slightly more than the average rate of inflation. If an investor took more so called "risk" and invested one-third in T-Bills, one-third in government bonds and one-third in stocks (Portfolio B), he did better but he still only grew his portfolio to $48 dollars - only slightly more than our 3 percent real return objective. But, if an investor took even more "risk" and allocated 50 percent of his portfolio to stocks (Portfolio C), he finally significantly exceeded the target and his portfolio increased to $76!!! These three portfolio examples show how important proper asset allocation can be to your total returns. Now, what would have happened if you had taken just 5 percent from each of the three asset classes and allocated it to an aggressive asset class (Portfolio D). Here I use small cap equities as a proxy for all aggressive asset classes. In Portfolio D, $1 grew to $133 over the 50-year period! So, a commitment of only 15 percent to an aggressive equity class, small cap stocks, nearly doubled the investment results. To me, this very clearly demonstrates the value of adding, even modestly, a high returning aggressive asset class to a conservative portfolio. 2. Don't try to time the market Once you have made some allocation to a potentially high returning asset class, the second step to potential success is to not try to time the market. Once you have made your asset allocation decision, stay fully invested. Because the market often moves in short bursts, the opportunity risk of being out of the market, for even a short time, is far too great. The average annualized rate of return of the equity market during the 1990's was 18.9 percent. By simply taking out the performance of the ten best days out of that ten-year return, the annualized rate of return falls from 18.9 percent to 10.9 percent. If we take out the twenty best days, the return falls to 7.9 percent. Lastly, if we take out the forty best days (less than 2 percent of all trading days during the period), the return drops to a mere 3.2 percent, an 83 percent reduction in return! The point is that the risk to long-term performance of being out of the market on any given day is high -- the penalty is severe. Avoid the "opportunity risk" of being out of the market. 3. Hire a portfolio manager who adds value After you have selected a portion of your portfolio for more aggressive asset allocation and decided not to try to time the market, the third step to potential success is to hire a portfolio manager who knows how to add value to the potential returns of your aggressive asset class. The more aggressive asset classes tend to be less amenable to a passive strategy and generally require an active manager. Seek an incremental edge. When you are considering a new manager, first ask him or her "what have you learned by your experience in the market?" and "how can you add value because of that experience?"

Things I've Learned

Up to this point, we have been talking about aggressive investment for capital preservation objectives. Now let's move to our second area: things I've learned while investing money over the years. 1. A stock's price is rarely the same as a company's value The first thing I've learned is that a stock's price is rarely the same as the company's value. The reason for that is the valuation process is flawed. Stock prices are heavily affected by market dynamics and by investors' emotions. These emotions swing widely from pessimism to optimism. Also, many investors buy stocks with the intention of holding them for 1 to 5 years based upon information that really only applies to a short-term time horizon. While the information they are using to invest may be valuable, it is often the wrong information for their investment timeframe. If people invest in a company based on current information, they have to be prepared to act on any changes in that information in a much shorter time frame than most investors are prepared to do. 2. Some sectors may benefit more from secular changes The second thing I've learned is that some sectors and industries are much greater beneficiaries of secular changes than others. It may be best to concentrate your investments. Why hold stocks of companies in sectors and industries with poor current outlooks? If it's for diversification purposes, satisfy that need in other ways. Don't diversify just for the sake of diversification. Look for companies in favored sectors with strong market positions and improving outlooks. 3. An Investment Manager Must Adapt to New Ideas Third, an investment manager must adjust to new concepts and ideas. A lot of investors find comfort with money managers who say they have rigid disciplines that they have adhered to consistently. Unfortunately, those managers may be making decisions without the full benefit of the rapidly changing technology that is available today. I have learned that you must be willing to do things differently from most other investors. Many investment managers follow investment paradigms and this could lead them to mediocre results.

Investment Paradigms Worth Avoiding

I don't know how best to define a paradigm other than to give you one. But, I can say that they are beliefs that most people have. Unfortunately, they are often outdated and really no longer true. However, people tend to hold onto these beliefs. In fact, they search for evidence to support them and reject information that conflicts with these paradigms.

1. "Buy low and sell high" Perhaps the best known investment paradigm is "buy low, sell high". I believe that more money can be made buying high and selling at even higher prices. I try to buy stocks that have already had good price moves, that are often making new highs and that have positive relative strength. These are stocks that are in demand by other investors. What is the risk? Obviously, the risk is that I'm buying near the top. But, I would much rather be invested in a stock that is increasing in price and take the risk that it may begin to decline than invest in a stock that is already in a decline and try to guess when it will turn around. 2. "Just buy stocks of good companies and hold onto them" Another mistake: "just buy stocks of good companies and hold on to them; that way you don't have to pay close daily attention." I would say: "buy good stocks of good companies and hold on to them until there are unfavorable changes". Closely monitor daily events because this will provide the first clues to long-term change. Remember, just as the business value does not equal the stock price, things are always changing, and yesterday's good company may not be today's great investment. 3. "Don't try to hit home runs; you make money hitting a lot of singles" A third paradigm is "don't try to hit home runs - you make the most money by hitting a lot of singles". I couldn't disagree more. I believe you can make the most money hitting home runs. But, you also need a discipline to avoid striking out. That is my sell discipline. I try to cut my losses and let my winners run. Perhaps that's a paradigm too, but it is one that works. 4. "A high turnover strategy is risky" Next, most people believe high turnover is risky. Again, I think just the opposite. High turnover reduces risk when it is the result of taking a series of small losses in order to avoid larger losses. I don't hold on to stocks with deteriorating fundamentals or price patterns. For me, this kind of turnover makes sense. It reduces risk. 5. "An investment process must be very systematic" Many people also believe an investment process needs to be rigidly systematic. I believe a good process involves discipline, but must be flexible enough to respond to changing market conditions. Let me give you an example... At the end of November 1991, the Dow Jones Industrial Average was trading at 2895 and the market's price to earnings ratio was 23. The price-to-book ratio was a lofty 2.7 and the market's yield was only 2.8 percent, in a much higher interest rate environment than we have today. A rigid, systematic value-based process would have told you to get out of the market with at least a portion of your assets. After all, the market was higher relative to those valuation measures than it has been 90 percent of the time, on a historical basis.

But, I believed that there were other relevant factors that suggested the market could go much higher. This was not a time to rigidly adhere to valuation disciplines. People who stayed fully invested benefited. From that time, through December 31, 1993, the market advanced 30 percent. Don't invest because of what you think should be happening. Invest because of what is happening. 6. "You must have a value-based process" Often when I talk to consultants, they like to see a very systematic, value-based process. They think that each stock has to be submitted to some type of disciplined, precise and uniform evaluation. But the real world is not that precise. I'm convinced that there is no universal valuation method. In fact, in the short run, valuation is not the key factor. Each company's stock price is unique to that company's place in the market environment and to its own phase in its corporate development. 7. "The best measure of investment risk is the standard deviation of return" Another paradigm and one that I deal with frequently is that "the best measure of investment risk is the standard deviation of return". In other words, volatility. But, volatility only measures risk over the short-term. We are discussing long-term objectives. For most investors, a major long-term risk is portfolio underperformance, due to insufficient exposure to high returning, more volatile assets. In my opinion, investment vehicles that provide the least short-term volatility often embody the greatest long-term risk. 8. "It's risky to place your money with a 'star system' manager" A final paradigm is... "It's risky to place your money with a star system manager." I disagree! In any industry, performance is achieved by the stars. Working with a diversified group of investment management stars is probably the safest way to invest. Think about it: great ideas, inventions and works of art have always been created by individuals, not groups or committees. This is also true in the investment business: good long-term results have been achieved by talented individuals.

Summary
In summary, if you want to try to increase your assets at a rate above inflation -- increase their purchasing power and your real wealth - you must go beyond conventional thinking: 1. Even if you are conservative, make an allocation to some aggressive asset class. It's consistent with historical fact. 2. Stay fully invested: make the commitment and stay with it. 3. Hire an aggressive manager who adds value and who isn't afraid to operate differently.
Performance is historical and does not represent future results.
Sources: Stocks, Bonds, Bills and Inflation 2003 Yearbook, 1983-2002 Ibbotson Associates, Inc. Based on copyrighted works by Ibbotson and Sinquefield. All rights reserved. Used with permission. Ned Davis Research.