Keys to Investment Success

September 10, 2004 Burney Partners www.burneypartners.com

Keys to Investment Success

Lowell D. Pratt Jr., CFA

President, The Burney Company


Jack Burney

Founded The Burney Company in 1974 West Point Class of ’46, retired General officer Developed Proprietary, Quantitative Analytical

Process in 1950s• West Point issued slide-rule was the state-of-the-art

computing device for several decades

17.9% average annualized rate of return

since inception


$133 v. $42 after 30 years…Master Portfolio v. S&P 500

$1

$10

$100

$1,000

Oct-74

Oct-76

Oct-78

Oct-80

Oct-82

Oct-84

Oct-86

Oct-88

Oct-90

Oct-92

Oct-94

Oct-96

Oct-98

Oct-00

Oct-02

Oct-04

Master S&P 500

Period Master S&P 500

1 Year 26.0% 19.1%

3 Year 15.0% -0.7%

5 Year 8.6% -2.2%

Inception 17.9% 13.4%


How Were Returns Created?

By Consistently Playing Winning Bets

• Asset Allocation • Stocks v. Bonds

• Size and Style Allocation• Historically, Small-Cap and Value

• Stock Selection• More opportunity than many believe


Stock Return Advantage vs. Bonds

From 1950 to 2002, stocks have nearly twice the return (11.8% vs. 6.2%)

Higher stock returns compensate for greater Short-Term Risk

• Defined as either Volatility or Worst-Case Return

But, Stocks are not necessarily Riskier• Depends upon Investment Time Horizon


Stock and Bond “Risk” v. Time

Volatility is conventional definition of “Risk”, but Worst-Case Return is arguably better

• Stocks clearly riskier than Bonds in short run

• Stock/Bond risk fairly comparable in the mid run

• Stocks less risky than Bonds in the long run

Stocks Bonds1-yr $0.61 $0.825-yr $0.81 $0.8910-yr $1.05 $1.1120-yr $3.48 $1.30

Worst-Case $1 Growth

* Period 1950 - 2002


What’s a Share of Stock Worth?Two “Right” answers

What someone else will pay• Dominant during Bubbles• Less popular during subsequent Bubble-Bursts

The value of an anticipated earnings stream discounted to the present

• Discount rate determined by prevailing interest rates plus an equity risk premium (ERP)


Valuation Math

What Investors really “Buy”

Multi-Stage Dividend Discount Model

Yr Earn Div EaGro DivPO 5yrEstEG EG Decay LT EGBeg 559,690 12.9% 0.8% 9.0%

1 632,001 197,767 12.9% 31%2 713,656 223,318 12.9% 31% StartPO DivDecay EndDivPO3 805,860 252,171 12.9% 31% 31.3% -1.3% 38%4 909,978 284,751 12.9% 31%5 1,027,547 321,541 12.9% 31% TBond ERP DiscRate6 1,152,250 376,022 12.1% 33% 5.8% 5.0% 10.8%7 1,283,053 435,921 11.4% 34%8 1,418,646 501,021 10.6% 35% FairPE9 1,557,447 570,935 9.8% 37% 26.9

10 1,697,617 36,862,535 9.0% 38%

Price 10,061,253 "Cheap"Earn 559,690 12,305,252DivRate 175,139 EaGro 12.92% NPVBeta 1.00 15,073,208IV 15,073,208P/V 0.67 "Dear"Yield 1.7% 19,381,967P/E 18


Why do Stocks Return 12%?

Long-Term Equity Returns Predetermined by Market’s Equity Discount Rate

Composed of two parts: • Long-term Treasury rate

• Plus Equity Risk Premium (ERP)

Historically, Discount Rate averages about 12% Currently 11.7% Use this to forecast future equity returns


Price vs. Fundamental WorthS&P 500

Actual vs. Fundamental Worth

1,125

2,000

1,600

1,300

100

1,000

10,000

Jun-95

Jun-96

Jun-97

Jun-98

Jun-99

Jun-00

Jun-01

Jun-02

Jun-03

Jun-04

S&P 500 Optimistic Worth Neutral Worth Pessimistic Worth


Fundamental’s Importance

Observed price largely fundamentally determined S&P 500 P/V range past 10 years

• Low 0.62 (Sep02)• High 1.32 (Mar98)• Average 1.01

Price Change v. Fundamental Worth Change R-Square

• 1-mo 1%• 3-mo 8%• 12-mo 45%• 36-mo 87%


Enduring Insight

"In the short run, the stock market is a voting machine. In the long run, the stock market is a weighing machine."

- Benjamin Graham

Circa 1930s


“Is Now a Good Time to Invest in Stocks?”

Answer ALWAYS the same: Long-term Investors – Yes Short-term Investors – No Market Timers – ABSOLUTELY NOT!

Market Timing is Ultimate Losers Game Invest consistently in stocks, or not at all


“The Market” Doesn’t Exist

Stock Market Highly Segmented Big v. Small Value v. Growth Sector: Tech v. Financial Industry: Computer Software v. Hardware

EVERY index is biased, so no good single market gauge exists


Importance of Size and Style

William F. Sharpe “Asset Allocation: Management Style and Performance

Measurements”, Journal of Portfolio Management, Winter ’92

Size and Style, assuming broad Sector/Industry diversification, explain 85-90% of portfolio returns

Sector diversification is a key assumption and therefore a 3rd critical determinant of return


Size Relative Returns - MonthlySmlCap minus LrgCap Monthly Return

-20%

-15%

-10%

-5%

0%

5%

10%

15%

20%

Aug-9

4

Aug-9

5

Aug-9

6

Aug-9

7

Aug-9

8

Aug-9

9

Aug-0

0

Aug-0

1

Aug-0

2

Aug-0

3

Aug-0

4

Pro Small-Cap

Pro Large-Cap


Size Relative Returns – 3-YearSize Cycle - Rolling 3-yr Return Differentials

-40%

-30%

-20%

-10%

0%

10%

20%

30%

40%

1920 1930 1940 1950 1960 1970 1980 1990 2000 2010

Pro Small-Cap

Pro Large-Cap


Style Relative Returns - Monthly

Value minus Growth Monthly Return

-20%

-15%

-10%

-5%

0%

5%

10%

15%

20%

Aug-9

4

Aug-9

5

Aug-9

6

Aug-9

7

Aug-9

8

Aug-9

9

Aug-0

0

Aug-0

1

Aug-0

2

Aug-0

3

Aug-0

4

Pro Value

Pro Growth


Style Relative Returns – 12-month

Style Cycle - Rolling 12-mo Return Differentials

-80%

-60%

-40%

-20%

0%

20%

40%

60%

80%

Dec-79 Dec-83 Dec-87 Dec-91 Dec-95 Dec-99 Dec-03

Pro Value

Pro Growth


The Power of Size and Style


Stock Selection’s Role

NEVER FORGET: Size, Style and Sector account for 90% of

equity return, so only 10% is leftover

Objective is Marginal Return Enhancement Always treat Stock Selection as the minor

variable of return that it is


Burney Stock Selection Process

Periodically “correlate” a factor library numbering over 1,000 (constantly growing) Proprietary process addresses the question:

“Which factors best separate strong and poor performing stocks within like industry groups?”

Models built with 50 most meaningful, most dissimilar factors


Stock Selection “Finds”

Factor composites often better than the parts• GARP – Growth at a Reasonable Price

• PARP – Profitability at a Reasonable Price

• SARP – Safety at a Reasonable Price

Stock Risk not priced “efficiently”• Defined as poor profitability or financial weakness

• Greater Risk should provide excess return, but delivers the opposite instead


Stock Selection “Chaos”


“Chaos” to Portfolio Order


Stock Selection “Don’ts”

View each stock separately• Complementary parts of a portfolio

Chase Speculative Stocks• Poor quality and/or earnings

Inadvertently make Size or Style bets• Make them knowingly

Invest casually• A cutthroat business, requires vigilance


Summary

Stocks Rule and Bonds Drool! Stocks are NOT riskier than bonds in the long run, just

higher returningEmotion dominates stock-pricing in the short run

ERP gauge of market’s emotional stateFundamentals dominate long-term stock-pricing

Equity Discount Rate predetermines rate of returnSize and Style are the key performance drivers

90% variables of equity return


The Possibilities…Years 3% 6% 9% 12% 15% 18%

1 1.03 1.06 1.09 1.12 1.15 1.182 1.06 1.12 1.19 1.25 1.32 1.393 1.09 1.19 1.30 1.40 1.52 1.644 1.13 1.26 1.41 1.57 1.75 1.945 1.16 1.34 1.54 1.76 2.01 2.296 1.19 1.42 1.68 1.97 2.31 2.707 1.23 1.50 1.83 2.21 2.66 3.198 1.27 1.59 1.99 2.48 3.06 3.769 1.30 1.69 2.17 2.77 3.52 4.44

10 1.34 1.79 2.37 3.11 4.05 5.2311 1.38 1.90 2.58 3.48 4.65 6.1812 1.43 2.01 2.81 3.90 5.35 7.2913 1.47 2.13 3.07 4.36 6.15 8.6014 1.51 2.26 3.34 4.89 7.08 10.1515 1.56 2.40 3.64 5.47 8.14 11.9716 1.60 2.54 3.97 6.13 9.36 14.1317 1.65 2.69 4.33 6.87 10.76 16.6718 1.70 2.85 4.72 7.69 12.38 19.6719 1.75 3.03 5.14 8.61 14.23 23.2120 1.81 3.21 5.60 9.65 16.37 27.3921 1.86 3.40 6.11 10.80 18.82 32.3222 1.92 3.60 6.66 12.10 21.64 38.1423 1.97 3.82 7.26 13.55 24.89 45.0124 2.03 4.05 7.91 15.18 28.63 53.1125 2.09 4.29 8.62 17.00 32.92 62.67

Doubles 1 2 3 4 5 6

Compound Growth of $1

Business

Keys to Investment Success