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DARDEN CAPITAL MANAGEMENT THE MONTICELLO FUND In early April 2004, the Monticello Fund Management Team was in the midst of its first meeting of the new fiscal year. The team was part of the Darden Capital Management program at the Darden Graduate School of Business Administration, where MBA students were entrusted with managing endowment capital for the school foundation. The program sought to prepare its participants for careers in investment analysis and portfolio management, with the recognition that hands-on investment-management experience was an important aspect of professional training. The total assets under management for the Darden Capital Management program were over $3 million and were held in three funds: the Darden Fund, Monticello Fund, and Jefferson Fund. Each fund was managed independently by a small team of MBA students, with some guidance from a faculty advisor and a board of trustees. The investment strategy of the Monticello Fund was to use fundamental analysis to identify and invest in companies that were well-positioned for growth but inexpensively valued. The fund team looked for stocks that would generate above-normal returns over a one- to four-year horizon. The new team replaced a team that had generated returns of 42.9% on their equity positions over the 12 months ending March 31, 2004. Such return performance was impressive both in absolute terms and with respect to the strong 35.1% returns over the same period on the S&P 500 market index. Exhibit 1 shows the current composition of the fund portfolio. The new team was unified in its resolve to once again beat the market index in the coming year; however, there was some debate on the most appropriate strategy to accomplish this goal. The Portfolio Allocation Decision Prior to the meeting, Senior Manager Steve Majocha solicited from the team a list of securities for consideration as investment candidates. This request generated a list of six stocks for which there was mixed enthusiasm: Boise Cascade, Boston Beer, Micron Technologies, New York Times, and Placer Dome. Exhibit 2 shows the monthly return performance of each of the six stocks over the past five years. Exhibit 3 provides various return statistics and other risk measures. For each stock, the team had developed a financial forecast and an estimate of the fair-value of the stock in 2007. Based on these figures, the team had calculated the anticipated rate of return implied
This case was prepared by Professor Michael J. Schill. It has some fictionalized content and was written as a basis for class discussion rather than to illustrate effective or ineffective handling of an administrative situation. Copyright 2004 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an e-mail to sales@dardenpublishing.com. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any meanselectronic, mechanical, photocopying, recording, or otherwisewithout the permission of the Darden School Foundation.

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by the current stock price. Exhibit 4 contains the anticipated return estimates. Majochas suggestion that the team narrow the list to two or three stocks had generated a heated discussion. Nandini Bose and Brian Maguire were strong proponents of buying Micron Technologies stock. The stock had declined dramatically from its 2000 peak, and they now felt it was well positioned to rebound. The team agreed that Micron offered the greatest expected return potential. David Khtikian, however, insisted that Microns strong potential required accepting substantially greater risk. He backed up his claim by comparing the standard deviations of past returns. For each stock, he calculated the ratio of anticipated return to the standard deviation of returns, and found that Boise Cascade and New York Times maintained the best returns for the commensurate level of risk. Charles Hill agreed with Khtikian that the anticipated returns should be normalized by the associated risk of the stock. He claimed, however, that a better measure of the risk faced by the investor was the correlation of the returns of the firms stock with those of a diversified portfolio. This correlation could be measured as the slope of a linear-regression line, commonly called the beta. Hill suggested that Mylan Labs and Placer Dome maintained the highest betaadjusted returns (the anticipated return less than expected by the return model that incorporated beta, the Capital Asset Pricing Model). Khtikian disagreed strongly, claiming that it made no sense to invest in a high-risk Canadian gold stock that was expected to generate a return of less than 9%. Hill countered that the attractiveness of Placer Dome stock was primarily in its diversification effect. He claimed that a 5050 weighted portfolio with Mylan Labs and Placer Dome would prove to be better than simply holding Mylan Labs stock alone. Majocha was due at a fund managers meeting in the morning and needed to be able to communicate a coherent portfolio strategy for the Monticello Fund. Majocha considered the recommendations of his team members and contrasted their views with what he knew of capital markets. (Exhibits 5 and 6 provide some data on current and historical capital market conditions.)

-3Exhibit 1 DARDEN CAPITAL MANAGEMENT THE MONTICELLO FUND Composition of the Monticello Fund (March 2004) % of portfolio 5.6% 4.5 4.5 4.3 4.3 4.3 4.2 4.1 3.9 3.9 3.9 3.9 3.6 3.6 3.6 3.5 3.3 2.3 2.1 17.8% Net 12-month gain % 101.5% 64.4 45.6 11.5 105.3 34.8 23.8 10.6 2.9 30.1 54.9 36.2 14.5 -5.4 38.2 3.1 23.3 3.6 4.0 3.9%

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Stocks Patina Oil & Gas General Dynamics Berkshire Hathaway B Sanderson Farms NBTY Mentor Chicago Bridge & Iron Kellogg Chevron Texaco Pier 1 Target Pepsico Pfizer Johnson & Johnson Media General Radian Washington Mutual Microsoft Skywest Bonds

-4Exhibit 2 DARDEN CAPITAL MANAGEMENT THE MONTICELLO FUND Monthly returns for proposed stocks (19992003)
Boise Cascade -3% 3% 5% 25% -2% 9% -10% -6% 1% -2% -3% 18% -13% -16% 17% -6% -11% -11% 7% 8% -11% 8% 1% 17% -2% -3% -2% 11% 1% 0% 3% 1% -19% -3% 12% 7% Boston Beer 13% -21% 2% 10% -2% -3% 15% -16% 2% -2% -7% 0% 3% -2% 3% 5% 8% 1% 2% 6% -3% -14% 4% 9% 2% 9% -3% -4% 8% -13% 23% 9% 2% -1% 18% 24% Micron Tech 54% -26% -16% -23% 2% 7% 52% 21% -11% 7% -6% 16% -20% 54% 31% 11% 0% 26% -7% 0% -44% -24% -9% 13% 29% -25% 21% 9% -17% 10% 2% -10% -50% 21% 19% 14% Mylan Labs -3% -10% 1% -17% 12% 5% -14% -13% -7% -2% 31% 7% 6% -14% 20% 3% -5% -32% 17% 25% 2% 4% -15% 6% -7% 0% 11% 4% 19% -11% 20% -2% -1% 13% -7% 9% New York Times -1% -9% -8% 21% 0% 8% 7% 0% -4% 7% -4% 28% -7% -7% 2% -4% -6% 2% 4% -5% 0% -7% -4% 13% 9% 2% -7% 0% 3% 0% 10% -7% -9% 6% 10% -5%

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Jan-99 Feb-99 Mar-99 Apr-99 May-99 Jun-99 Jul-99 Aug-99 Sep-99 Oct-99 Nov-99 Dec-99 Jan-00 Feb-00 Mar-00 Apr-00 May-00 Jun-00 Jul-00 Aug-00 Sep-00 Oct-00 Nov-00 Dec-00 Jan-01 Feb-01 Mar-01 Apr-01 May-01 Jun-01 Jul-01 Aug-01 Sep-01 Oct-01 Nov-01 Dec-01

Placer Dome -3% -2% 3% 26% -21% 6% -13% 3% 43% -17% -8% -6% -17% -1% -6% 1% 0% 17% -11% 5% 6% -14% 11% 6% -8% 7% -8% 17% 5% -8% 3% 10% 16% -11% -4% 0%

-5Exhibit 2 (continued) Monthly returns for proposed stocks (19992003)

Boise Cascade 5% 1% 1% -7% 5% -3% -16% -7% -15% 4% 14% -6% -5% 1% -9% 5% 7% -2% 4% 10% 2% 2% 5% 12% 8.2% 31.2% Boston Beer -10% -15% 15% -4% 14% -4% -12% 2% -3% 13% 0% -9% 3% -11% -4% 3% 9% 2% 5% 4% 1% 7% 8% -1% 20.2% 31.7% Micron Tech 9% -5% 2% -28% -1% -14% -4% -11% -28% 29% -1% -38% -16% -3% 2% 4% 33% 4% 25% -2% -7% 7% -9% 4% 16.6% 76.2% Mylan Labs -10% -10% -3% -10% 17% 2% 4% 1% 1% -4% 7% 4% 15% 7% 1% -2% 2% 21% -3% 8% 6% -6% 5% 0% 20.7% 39.4% New York Times -3% 4% 9% -3% 8% 2% -12% 5% -4% 7% 0% -5% 7% -5% -7% 7% 4% -5% -2% 0% -2% 9% -3% 4% 11.0% 25.8%

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Jan-02 Feb-02 Mar-02 Apr-02 May-02 Jun-02 Jul-02 Aug-02 Sep-02 Oct-02 Nov-02 Dec-02 Jan-03 Feb-03 Mar-03 Apr-03 May-03 Jun-03 Jul-03 Aug-03 Sep-03 Oct-03 Nov-03 Dec-03 Annualized Mean Annualized Std. Deviation

Placer Dome 13% -5% 5% -4% 16% -18% -25% 20% -8% -5% 11% 20% -2% -13% 0% 1% 11% 12% 0% 11% 1% 12% 18% -1% 19.0% 43.2%

-6UV0517 Exhibit 3 DARDEN CAPITAL MANAGEMENT THE MONTICELLO FUND Characteristics and return statistics for proposed stocks

Company name Boise Cascade 20.2% 16.6% 20.7% 11.0% 19.0% 43.2% 0.25 0.40 25.8% 0.72 0.90 39.4% 0.26 0.70 0.51% 1.30% 0.61% 76.2% 2.19 1.70 0.00% 31.7% 0.46 0.55 0.00% 3 5 3 2 3

Industry Paper products

Monthly returns 19992003 Average Annualized annual std. deviation 8.2% 31.2% Beta estimate1 Raw Value Line 1.14 1.20 Dividend Yield 1.80% Safety rating2 3 PE Ratio3 27.0 22.9 NMF 18.9 23.1 28.3

Bond rating Ba2 NA B2 NA A1 Baa2

Boston Beer

Alcoholic beverages

Micron Technologies

Semiconductors

Mylan Labs

Pharmaceutical

New York Times

Newspapers

Placer Dome

Gold and silver

Source: Value Line (VL), Center for Research in Security Prices (CRSP), Mergents Bond Record.

The raw-returns beta is estimated as the slope coefficient of stock return regressed on S&P 500 return (60 months). An example of the regression estimation is provided in Exhibit 7. The Value Line beta is an alternative estimate provided by the Value Line Investment Survey. 2 The Value Line safety rating measures the price stability and financial strength of a firm. Safety ranks range from 1 (highest) to 5 (lowest). 3 The PE ratio is defined here as the current price divided by earnings for the past 12 months.

-7UV0517 Exhibit 4 DARDEN CAPITAL MANAGEMENT THE MONTICELLO FUND Model for estimating anticipated return for proposed stocks
Dividends per share 2004 $0.60 0.00 0.00 0.12 0.60 0.10 15% 4% 5% 0% 0.30 1.46 3.76 0.75 0% 1.00 0% $2.02 23.5 24.0 83.0 24.0 16.5 30.0 Dividend growth rate Anticipated 2007 Earnings per share Anticipated 2007 PE Anticipated annual return (20042007) 10.8% 8.2% 13.0% 10.9% 9.0% 8.8%

Company name

Current price

Boise Cascade 17.54 15.25 23.55 46.01 16.43

$33.40

Boston Beer

Micron Technologies

Mylan Labs

New York Times

Placer Dome

Source: Case writer analysis.

-8Exhibit 5 DARDEN CAPITAL MANAGEMENT THE MONTICELLO FUND Summary statistics of annual returns for various classes of securities (Annual returns over period 1926 to 2003) Series Inflation (Consumer price index) U.S. Treasury Bills (30-day) Intermediate-term Government (5-year) Long-term Government (20-year) Long-term Corporate Bonds (High grade, 20-year) Large Company Stocks (S&P 500 index) Geometric mean1 3.0% 3.7 5.4 5.4 5.9 10.4 Arithmetic mean2 3.1% 3.8 5.5 5.8 6.2 12.4

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Std. deviation 4.3% 3.1 5.7 9.4 8.6 20.4

Source: Ibbotson Associates, Stocks, Bonds, Bills, and Inflation, 2004 Yearbook.
1

The geometric mean is the compound rate of return over the 78 year sample period defined as RGeometric= (V2003 V1926 )
1 78 2003 t =1926
1 78

1 , where Vt is the value of the series in the respective year.

The arithmetic mean is the simple average of the 78 annual returns defined as RArithmetic =

Rt .

-9Exhibit 6 DARDEN CAPITAL MANAGEMENT THE MONTICELLO FUND Selected interest rates (April 1, 2004) Security Treasury constant maturities 1-month 3-month 6-month 1-year 5-year 10-year 20-year Treasury inflation-indexed 5-year 10-year Corporate industrial bonds (Moodys seasoned) Aaa Baa Yield (%)

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0.95 0.93 1.02 1.23 2.87 3.91 4.77 0.53 1.48 5.40 6.18

Source: Federal Reserve Statistical Release (www.federalreserve.gov/releases/h15/update).

-10Exhibit 7 DARDEN CAPITAL MANAGEMENT THE MONTICELLO FUND Regression estimates for Boise Cascade (Monthly returns over period 1999 to 2003)

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Total return for Boise Cascade stock S&P 500 30% 20% Boise Cascade 10% 0% -10% -20% -30% -30%

-20%

-10%

0% S&P 500

10%

20%

30%

Ordinary least squares regression results Regression equation: (Return on Boise Cascade) = a + b* (Return on S&P500) + e Results: Coefficient a b Estimate 0.7% 1.14 t-statistic 0.78 6.13