Perspectives

January 2012
Discipline over Emotion

Tedd Alexander III and Grace ONeill

2011 has come to a close and the Credo Capital U.S. Equity Mid Cap Growth strategy did not deliver the excess return we expected. Portfolio manager, Tedd Alexander sat down with me to discuss and analyze the underperformance. Grace: What happened to performance in 2011? Tedd: We underperformed materially in the 3rd and 4th quarters of 2011. The following chart analyzes the performance of the Russell Midcap Growth Index since 2001. This analysis decomposes the price change in the index (the black line) into two key components from 2001 to the quarter ending December 2011. The two components are: 1) change in forward earnings expectations, which is denoted by the blue (darker) bars. 2) change in valuation or forward multiples, which is denoted by the green (lighter) bars. Remember, we focus on earnings expectations - our process is driven by fundamental analysis and what youll notice in this chart is the majority of the move in the market in the past two quarters was not at all affected by the change in earnings expectations. It was predominantly driven by a change in investor psychology, sentiment, emotion, if you will - confidence or lack thereof. Hence the green (lighter) bars show that valuation has been the most significant driver of returns over the last six months. Consequently, the conversation in the last two quarters, about the risk on/risk off trade appears relevant based on this analysis weve put together. Grace: Our institutional clients are typically focused on longer time periods, what does this analysis show prior to 2011? Tedd: Its probably already evident, looking at this chart. First, I think it is important to note that our mid cap growth strategy actually started in 05 and if you refer to the period of 05,06,07 and the 1st half of 08, in many instances changes in valuation were immaterial to how the index performed and how stocks performed in general. Fundamentals were the primary driver and that was the case all the way back to the prior recession period of 01

Tedd M. Alexander III Portfolio Manager Managing Member

Grace R. ONeill Client Service Manager

ThinkForward

Russell Midcap Growth Index Price Performance Attributable to Changes in Forward Earnings Expectations and Changes in Valuation

50% 40% 30% 20% 10% 0% -10% -20% -30% -40%

12/2001 3/2002 6/2002 9/2002 12/2002 3/2003 6/2003 9/2003 12/2003 3/2004 6/2004 9/2004 12/2004 3/2005 6/2005 9/2005 12/2005 3/2006 6/2006 9/2006 12/2006 3/2007 6/2007 9/2007 12/2007 3/2008 6/2008 9/2008 12/2008 3/2009 6/2009 9/2009 12/2009 3/2010 6/2010 9/2010 12/2010 3/2011 6/2011 9/2011 12/2011

Earnings
Source: Credo Capital Management analysis, FactSet, Ayxs

Valuation

Index Price Return

and 02 when, again, changes in valuations had a significant effect. And then we come to the 2nd half of 08. Now recall that in June of 08, we had hit a peak in terms of oil prices and the conversation regarding the health of the U.S. economy - the credit crisis, whether or not USA Inc. might go bankrupt was starting to reach a much higher fervor. But in the first half of 08, we began to observe a significant impact from changes in sentiment and psychology and emotion. Youll notice that the green (lighter) bars had become more prominent i.e. valuations began to rule the direction of the index and it is within this environment that we were making investments based on our fundamental outlook. Grace: Is the valuation driven environment the reason why our Mid Cap Growth strategy has underperformed? Tedd: I think it was certainly a major contributing factor. I have simply pointed out these two distinct periods since 2001 to illustrate that our longer term track record looks like the Tale of Two Cities - the 2nd half of 08 and forward versus the 1st half of 08 backward to 2005. The underperformance our clients have unfortunately experienced has been during the latter period reflected in this chart which is a very different environment than when we first generated our track record in the earlier three years. Yet, I would argue that the investment process and the firm itself have only become more robust, stronger and better over the latter 3 years. Grace: Does Credo still have the ability to deliver excess returns? Tedd: Yes! Its just that I think that has been masked fairly significantly by the volatility of the past three years

January 2012 | Perspectives 2

and some unfortunate stock picks where events unfolded beyond our control - we held Huron Consulting, MF Global and Diamond Foods all three declined precipitously. Those were three extraordinary cases and few investors predicted those calamities, particularly MF Global. When we strip those out, we really feel just as confident, and I want to say that because I certainly sympathize with our clients obviously its challenging to look at a period when we havent been able to deliver good returns. Grace: Has something changed with the firm? Tedd: Any changes to the firm have actually all been to make us better, stronger, bigger. In fact, were 20% bigger; we have added to the investment team. Weve continued to invest in our infrastructure to better serve our clients and deliver the performance results they expect. Grace: Has something changed with the environment, the investing climate? Tedd: Yes, I believe so. Before continuing I want to make something clear and will apply a golf analogy (in typical fashion). I dont want any of this conversation to be misconstrued as making excuses. Every golfer plays the same course and someone ultimately wins the tournament. So of course, over the three year period when we underperformed, institutional investors can identify managers that played the course well, so to speak. With our particular style, approach and focus on fundamentals, we played the course to the best of our abilities and are dissatisfied and disappointed with the outcome. So, again, this conversation should not be misconstrued or misinterpreted in any way as making excuses, as much as simply providing an analysis in a context that perhaps our clients havent seen. So thats the perspective I am coming from and I wanted to make that clear. So if its not the process and not the firm- in some respects that leaves us with the climate. This analysis would indicate that there has been a material change in the climate over the past three years. I can assure you our process which focuses on fundamentals is intact. Grace: Is the volatile investing climate likely to continue? Tedd: I dont believe that a period driven purely by emotion is going to last forever. However, as has been evident over the past several years, the daily global macroeconomic news flow has had a more material impact on the U.S. equity market than fundamentals and that seems apparent from our analysis. With the increasing integration of global economies, it is understandable that we would experience some uptick in volatility since the global economic cycles are not perfectly aligned. Grace: Do you have strategies for dealing with the fact that the world is becoming even more interconnected and the news will continue to affect the markets in addition to fundamentals? Tedd: Absolutely! Certainly over the past year, the attention we, the investment team, have paid to understanding volatility has increased. In the portfolio construction step of our process, we believe we can dampen volatility or at least be aware of the volatility embedded in our portfolio holdings. There may be periods of time when we are willing to accept certain levels of volatility and at other times when we might be more concerned and dampen that volatility.

January 2012 | Perspectives 3

Now, one thing to remember about our portfolio construction process weve always been sector neutral. The nine economic sectors in the Russell Midcap Growth Index have exhibited uncorrelated returns over time. We are active investors at the industry and company level and passive investors at the sector level. So we think our portfolio construction process inherently dampens the risk and volatility that might be associated with sector rotation. Grace: So whats changed? Tedd: I think the conversation around stock selection has become more amplified or expanded beyond the fundamentals of the company for the reasons weve acknowledged - global integration. As we reflect on the past three years, had we simply reacted after the 2nd half of 08, and started to make enhancements to our process, I am not sure we would have implemented them with the same level of conviction. Again, we were in the middle of a recession and it was evident that emotion had taken a hold of the market and investors. But when we look back at a longer term analysis like this one, and at the past three years, particularly the past two quarters, that does cause us to say - okay, perhaps this is a different environment for an extended period. And so being more mindful of the macro environment, even though we are bottom-up investors, being more mindful of risk and volatility in perhaps ways that we historically didnt think we needed to look at those things - those are enhancements, lights on the dashboard, if you will to help us make better decisions going forward. Grace: Specifically, how have you incorporated this increased awareness of risk and volatility into the process? Tedd: There are a few different ways we go about measuring volatility. The traditional way is to look at the betas of the individual securities and I can, with 100% confidence, tell you that knowing the betas of individual securities was not a part of our thought process when we first started, which obviously worked in an environment that was a lot less volatile when fundamentals carried the day. In the most recent period, that has not been the case, leading us to become more aware of what those betas are. We are also looking at where we have active beta exposure at the sector level. For example, were more mindful of looking at each sector, knowing that the beta of the companies in our portfolio is either at, below or above the beta for that same sector in the index a conscious observation on the dashboard. We also calculate earnings expectations betas (a forward view) to gain a sense for the volatility of earnings expectations of every company in our starting universe relative to its respective economic sector. Thats an important input because in our calculation of our required return, we use that beta in a CAPM, what we call a modified CAPM model. Were using earnings growth volatility and the key take away from that, of course, is that the more volatile the earnings expectations the higher our required return. These are not simply observations, rather they directly impact the valuation methodology that we employ. Grace: Do you incorporate any type of market analysis into your fundamental approach? Tedd: We have talked for some time about understanding the market and its appetite for risk or fear of risk in the context of monitoring the VIX, the TED spread, anything that gives us a sense for the perception of emotion or risk or potential volatility in the market. These considerations werent always on the dashboard and January 2012 | Perspectives 4

these past few years have made it clear to us that even as fundamental investors, we need to be more aware of some of these other indicators. We havent changed our view that stock prices follow earnings in the long run and of course, at some point need to reflect the fundamental growth power of the company. But as our analysis shows you, in the short run, changes to stock prices can be driven more by changes in sentiment even in the face of increasing earnings expectations. Its pretty remarkable when you look at the fact that this analysis is charting an increase in forward expectations over the past several quarters and yet, the volatility due to changes in sentiment is pretty significant, particularly in the past six months. Grace: So Tedd, being mindful of all these risks, betas of these stocks and assessments of emotions in the market - how has that changed the implementation of your process? Tedd: To start, I personally have been reluctant to let the tail wag the dog, so to speak. We do not manage the portfolio to a desired set of risk characteristics or risk factors. To me, that is very different than our investment process which starts with quantitative idea discovery, identifying those companies with the greatest revenue and earnings expectations - we are looking for change, so were looking for inflection, something that gives us a heads up to take a look at a company - and then rolling up our sleeves and doing the fundamental analysis to get a very good understanding of the business model and the growth prospects and ultimately applying that in our valuation methodology. To reverse that process and Ill go back to my golf analogy is almost like saying that I want the ball in the middle of the fairway and since I dont have much confidence in taking a full swing, Ill just grab my putter and how many ever strokes it takes me, Ill just put it to that spot where I want to be. Sure we could change the process around to be something other than what we truly believe in, but thats not what we do. What we do is invest in growing companies that we think the market has inefficiently priced and so specifically, to your question, that hasnt changed. The process is still the process and I think the fairest thing to say is weve put some other indicators on our dashboard which allow us the opportunity to consider things that perhaps we werent considering before. Grace: Can you talk about any portfolio changes/rebalancing that is taking place in this environment? Tedd: The one thing this environment has intensified for fundamental investors is the need to be very nimble and to take advantage of volatility in a good way. Again, we havent changed the process, but what youll notice from our trading activity is certainly, while we always had price targets, we are being more active - I know that sounds kind of obvious, were active managers. I wouldnt be surprised if I were to look at the turnover in the most recent, lets say 2-3 months, that turnover has probably increased versus the long term trend. I think that is because the volatility works both ways were seeing companies hit price targets much sooner than we perhaps thought they would and because the environment is perhaps a little different than before, were being more active in trimming those positions. So I think youll notice that. In terms of any repositioning, because we are sector neutral there is no conversation around overweighting and underweighting sectors. So you really wouldnt see any difference there. In terms of being oriented and biased towards the highest expected growth companies, that has stayed consistent as well so not a lot of conversation around that. January 2012 | Perspectives 5

Grace: What are you looking at for 2012? Tedd: I did that analysis on January 2nd, and for the midcap growth space it was an 11% return over the next 12 months, plus or minus 4%, principally driven by four sectors; consumer discretionary, materials and processing, producer durables and technology. Grace: Do you have any concluding remarks? Tedd: When we started the firm in 04 we often emphasized the importance of discipline over emotion - and it was just for this very reason. In this analysis, the green (lighter) color is the emotion and if you are going to be an investor, you have to be able to make decisions recognizing that emotion is the harder part of this equation to predict. I feel like we have the right team in place and the right analyses in place to understand these things. You might imagine what its like to start a firm and in the first three years out of the box, we didnt know it at the time, but we certainly had the fundamental winds at our back. We took advantage of that and did a fantastic job for our clients. The past three year period has probably been the most frustrating period in my career which dates back to 1985. We do analysis like this to try to understand because we dont want to start changing what we do until we are certain we understand whats taking place. And, hence we have spent some time working on this analysis and we plan to update it every quarter and provide it to you and our clients. Grace: Thank you, Tedd. I am sure these insights will be appreciated. Tedd: You are very welcome, Grace.

Contact For additional information please contact: Credo Capital Management LLC 225 East Redwood Street 2nd Floor Baltimore, MD 21202 (410) 244-6200 info@credocapital.com www.credocapital.com

January 2012 | Perspectives