ArnoldScottConversation6-1-10EditedTranscript

8/9/2019 ArnoldScottConversation6-1-10EditedTranscript

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805 Las Cimas Parkway | Suite 430 | Austin, Texas 78746 | 1-800-664-4888 | www.centman.com

Thefollowing isanedited transcriptof thevideotapedconversation that tookplace in

CenturyManagementsAustin,TexasofficeonTuesday,June1,2010,betweenScottand

ArnoldVanDenBerg.Thevideocanbeseenonourwebsiteatwww.centman.com.ADVD

ofthis

presentation

is

also

available

upon

request.

SCOTT: Good afternoon, everyone. My name is Scott Van Den Berg, and I am one of three vice presidentshere at Century Management. I am joined here today with my father and company president, Arnold VanDen Berg. This afternoon we are going to take the opportunity to answer the frequently asked questions that

many of you have asked over the last month or two. Lets get started with our first question:

Question 1

SCOTT: Many investors are worried that the market could go back down and test the lows that wesaw in March 2009. Arnold, can you share your thoughts on this concern?

ARNOLD: Well Scott, I think that anything is possible in this kind of an environment, although I believethat the risk of the stock market going back to the March 2009 bottom, which was around 670 on the S&P500, is very low. There are several reasons why I feel this way. First of all, as the financial crisis was takingplace, I had never seen in my 40 years in the business companies react as quickly as they did to cutting costs,

reducing payroll, cutting dividends, cutting capital spending, and just getting everything honed down. Andbecause of this rapid reaction to the crisis, probably due to the fear that was going on at that time, manycompanies have been able to really get themselves in good financial shape. As a matter of fact, the balancesheets of Americas corporations have the most cash relative to assets that they have had in years. Accordingto the Federal Reserve, cash now makes up about 7% of all U.S. non-financial company assets, includingfactories and financial investments. This is the highest level since 1963.

Second, profit margins are improving dramatically. While its hard to believe, the profit margins are almostas high as they were in 2007, which was a record year. Just to give you an example, on Chart 1, in 2007,corporate America earned about $1.4 trillion. It got as low as $1.1 trillion in 2009. Now, in 2010, earningsare projected to go back to $1.4 trillion, which is not quite as high as 2007 when you run out the decimals,

but its 95% there. So we had this tremendous decline in economic activities, a decline in profits, and twoand a half to three years later they are almost back up to their previous highs. As a matter of fact, when youmeasure GDP (Gross Domestic Product a measure of the countrys overall economic output), it is actuallyhigher now than it was in 2007.


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Chart 1:Gross Domestic Product (GDP)

Therefore, when you take the fundamentals, earnings are back up and sales (GDP) are back up. So you cansee that the market doesnt have any reason to go down to the March 2009 lows given these fundamentals.

The third reason I do not believe the market will go back to the March 2009 low is due to the valuation of themarket. On Chart 2, I want to introduce a price to book chart for the S&P 500 (our proxy for the generalmarket). Now we know that most companies have sales, they have earnings, they have cash flow, and theyhave a book value. (Book value is simply the net asset value of the company.) If we take the S&P 500 as anindex, and we measure its book value, we can get an idea of what its price should be. Usually you use sales,earnings, yield, cash flow, or free cash flow, but I am choosing to use price to book value (P/BV) and priceto sales (P/S) because these are two of the more stable metrics. In other words, they dont move around asmuch as the cash flow or earnings. If you take the very low periods from 1990 to present, and we all knowthat stock prices fluctuate around interest rates, all of the interest rates were below 9.25%.

SCOTT: What interest rates are you referring to?

ARNOLD: I am using the Moodys Baa rate (equivalent to the Standard and Poors BBB rating), whichrepresents good quality / medium risk investment grade corporate bonds. I have found that the marketusually trades in a relationship to these bonds. For example, in March 2009, when the average Moodys Baacorporate bond got to a yield of 8.24%, (15% higher than the 80-year average of 7.11%), the S&P 500 indexwas trading at 1.52 times book. There is only one other time in the last 21 years when the price to book ratiogot that low. In October 1990, when the average Baa corporate bond had a yield of 10.80%, the index wastrading at 1.72 times book.


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Chart 2:S&P 500 Price to Book Ratio

Source: Bloomberg, LLP

As you can see on Chart 2, out of the last 20 years, the price to book ratio has only been below 2.00 times


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However, what is most important to remember is that when you look at how extreme the market sold off incomparison to the last 20 years, we knew it was oversold as the S&P 500 had only spent 1.5 out of the 20

years in that low valuation zone.

SCOTT: You mean below 2.00 times book?

ARNOLD: Yes, below 2.00 times book. In other words, in 1990 and in 2009, the S&P 500 traded below2.00 times book value, each time lasting no more than nine months at this level for a total of 1.5 years.However, 1.5 out of 20 years is just 7.5% of the time. So that is where my statement comes from. I just donot believe the market (S&P 500) will go down that low today. But again, even if it did, I do not believe itwould stay there very longjust like it hasnt over the last 20 years.

SCOTT: Now currently, our CM Value 1 Composite, which represents our average account, has a

price/book ratio of 2.12 times book value. So based on what you just said, that would suggest there is a lot ofvalue and upside in the companies we are holding.

ARNOLD: Relative to values over the past 20 years, 2.12 times book is about as low a price/book ratio aswe have had on our portfolios, except for those two periods (1990 and 2009). Furthermore, when comparedto the S&P 500 at 2.25 times book, our typical portfolio is actually cheaper today than the broader market.

Now I would like to introduce another chart (Chart 3)that shows a price to sales ratio. It basicallytells the same story as the price to book value. However, we like to show this ratio as well, since somepeople relate better to sales than book value. Moreover, the price to sales ratio is a good measurement assales do not typically fluctuate as widely as the earnings.

By looking at the price to sales ratio on Chart 3, you can see the real cheap points in the market werein September of 1990 (just like it showed when we looked at the price to book value ratio) at 0.63 timessales, and again in March 2009, when the market traded at 0.68 times sales. Today, the S&P 500 is just over1.10 times sales. This is very low relative to most other periods over the last 20 years, except that period in1990 when the average Baa corporate bond had a yield (interest rate) of 10.75%.


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Chart 3S&P 500 Price to Sales Ratio

Source: Bloomberg, LLP

SCOTT: This is the price/sales ratio for the S&P 500?

ARNOLD: That is correct.

SCOTT: The average price to sales ratio for our CM Value 1 Composite today is 0.75 times sales. As you

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Now the only reason I can see that would cause the S&P 500 (i.e. the market) to go below 1.52 timesbook (see Chart 2) or 0.75 times sales, is if the earnings went down sharply like they did in 2008 and 2009,and at the same time interest rates (as measured by the Moodys Baa corporate bond yield)


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With so many bids coming in at deeply discounted values (20 to 50 cents on the dollar), many bankswere forced to lower the value of their mortgage pools, as well as other assets, to the value that was being setby lowball bids. The lowering of these assets values even had to take place on mortgage pools that were stillin good shape and performing as scheduled (because in theory if they wanted to sell that pool of loans they

would have to take a loss). However, as long as the bank did not need to sell these mortgage pools to raisemoney, there was really no need to write them down as a loss. However, this is what mark-to-marketaccounting requires, and at market extremes it can add fuel to the fire by forcing banks to write down thevalue of their mortgages and other assets, even if they are performing, all because recent sales of those assetsare showing lower comparable prices. This amounted to huge losses for the banks.

I believe this is one of the main reasons that Lehman Brothers, Bear Stearns, and many banks wentbankrupt; they had to mark their assets down to the current market levels even though they were depressed.There were illiquid assets that might have been worth 100 cents on the dollar in normal times, but due to thesharp and rapid decline in offer prices, those assets might have been selling for 25 centsthey had to takethe losses, and there went their balance sheets.

Looking back at the history of mark-to-market accounting helps put this issue into perspective.Mark-to-market accounting existed during The Great Depression. Economist Milton Freedman wrote aboutthis issue in his book,A Monetary History of the United States 1867-1960, and said that he felt that mark-to-market accounting was one of the main reasons there were so many bank failures in 1929. In other words, thebanks would not have been nearly as bad off if they would have been able to value their mortgages at theprices they were selling for and the number of foreclosures they had; but because they had to mark themdown due to this accounting rule, there were tremendous bank failures. They finally got rid of mark-to-market accounting in 1938, and it is no coincidence that after 1938 the economy, along with everything else,began to pick up, gathered steam, and did much better. During this period, 1938 until 2007, we never had thekind of wide swings in the economy that we did before The Great Depression. Before The Great Depression,

every recession seemed to be more of a boom and bust cycle. Part of the reason was caused by some of theserules. Then when they eliminated this mark-to-market accounting rule, from 1938 to 2007, the extreme boomto bust swings in the market were eliminated.

At the top of the market back in November 2007, they reinstated the mark-to-market accounting Rule157. Then, as the crisis developed, they realized that Rule 157 was adding fuel to the fire and they needed toremove it. Just one week before the market bottomed, they made a statement that they were going to reviewmark-to-market accounting. On March 12, 2009, the House Financial Services subcommittee met, and onApril 2, 2009, they officially changed the rule. This was right at the market bottom and I believe, outside ofthe fact that the market was dirt cheap, removing this rule was a key part to the market turning around whenit did. The main reason the market reversed course is that people realized that if the banks dont have to use

mark-to-market accounting and they could work out their problems over the long-run, just like we didthrough every other recession, they would not have to deal with the extreme write downs and losses. Withthat in mind, the market took off.

So to summarize the question, why do I believe there is a low probability the market will get backdown to the March 2009 level?, its because corporations have rebuilt their balance sheets, margins arehigher, the valuation of the market itself in March 2009, an extreme that should have never happened, andmore importantly, the elimination of mark-to-market accounting. Now they have just suspended this


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accounting rule; but they have not eliminated it all together. If they were to reintroduce Rule 157, I think thatwould increase the downside risk of this market, and we would react accordingly. So when you sum up thesereasons, we have reason to be optimistic that that is not going to happen.

Question 2

SCOTT: Clients have asked about Greece, Spain, and other European countries, and they would liketo know what the short-term and long-term impacts these economies might have on the U.S. stockmarket?

ARNOLD: I think the economic crisis in Greece, as well as throughout Europe, is getting a lot of headlines.This is the unfortunate thing about just listening to the press, or the mainstream media, because they aretrying to sell their wares and in doing so they often exaggerate and overemphasize things to grab attention.But if you really look at the situation from a factual standpoint, you frequently find that the facts are a littledifferent than what the headlines would lead you to believe. Facts are a stubborn thing and they have a way

of surfacing if you just look for them.

For example, lets take a look at Greece. Now I don't know how many newspaper headlines I haveseen where Greece is at the top of the news, not only in the business sections, but all over the media. This iswhere its important to put what you read and what you hear into perspective. The worlds GDP (GrossDomestic Product), i.e. the worlds total economic activity, is $61 trillion. This is the total pie$61 trillion.Then you have Greece, which is $356 billion. In other words, Greece is just 0.58% of the worlds GDP. Justto put this into perspective, the GDP of Massachusetts makes approximately the same economic contribution


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Now when you put this into its proper economic perspective and then compare it to the headlines oreven the impact it has had on the financial markets, it seems like the amount of energy and attention beingspent on just one-half of one percent of the worlds GDP is more than


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bit of money, you are a lender; when you lend him a lot of money, you are his partner. In other words, if hegoes down, you go down. Well, in China, roughly 37% of its GDP are exports. According to ChinasNational Bureau of Statistics (2008), 8.8% of its GDP are exports to the United States and 6.5% of its GDPare exports to Europe. In April 2010, the Peoples Bank of China reported that China has $2.5 trillion in

foreign exchange reserves. Now, from an enlightened point of view, not from an altruistic point of viewIwill never make the suggestion that China is going to do anything altruisticbut from an enlightened, self-interest point of view, China is going to do what it can to help bail out Europe because Europe isapproximately 24% of Chinas exports. When you depend that heavily on those customers, you are going towant to do everything you can to prop them up and help make them work over the long-run.

While it might take some money to shore them up in the short-run, over the long-run they will beexcellent customers. Besides, at 24% of your exports, you really dont have a choice, you are going to dowhat you can. Just like we in the U.S. do what we can to bail out other countries. Its not always because ofour altruistic reasons, but rather our own enlightened self-interest. So its in Chinas interest as well the restof the world to keep Europe going because according to the latest data (2008) from the World Bank, Europe

is 22% of world GDP, and overall that is significant.

SCOTT: If something does happen to the Euro, or it continues to fall, that could impact a lot of U.S.multinational companies, and we own a lot of large, blue chip multinational companies. How do you thinkthis would impact their sales and earnings?

ARNOLD: Europe has slowed down, just like we did in the recession, and so the multinational companieshave already suffered some erosion of sales and profits. I would say as the Euro goes down, it will actuallyimprove their earnings as their products and services will become more competitive (i.e. their products willbe cheaper relative to the dollar and other currencies). One of the things I love about the multinationalcompanies in our portfolio is that we are not only diversified in America, but roughly 50% or more of their

sales come from Asia, Europe, and countries all over the world. We basically have a call on world GDP. Soeven though Europes growth has slowed, Chinas GDP has been growing at 8% to 10%. Now I am notsaying that 8% to 10% growth is necessarily sustainable, but through owning companies with multinationalexposure, we have the benefit of participating in faster growing economies as well as slower ones. But Ithink with the Euro going down, long-termnot short-termlong-term that is going to be positive forEuropean sales and profits, and it will be profitable for our multinational companies. It may be that by thetime Europe is picking up, China may be slowing down. We dont know. But we like having a diversifiedincome stream from all over the world. Now a lot of people invest directly in other countries. The way weget our global diversification is by investing in U.S. based multinational companies. And by the way, in ouropinion, for the past two years, many of the large U.S. multinational companies have been some of the bestvalues in the market. Furthermore, relative to interest rates and fundamentals, we believe they are as cheap as

they have been in 25 or 30 years.

SCOTT: So these large cap stocks are as cheap as you have seen them in 25 to 30 years?

ARNOLD: Not as cheap as they have been in an absolute sense, but when compared to interest rates, yes,they are that cheap. On a fundamental basis they have been about this cheap three other times over the past30 years, but they have not been this cheap when you compare them to interest rates. So they are a true valuetoday. Currently, they represent about 60-63% of our typical portfolio, but this really depends on the client.


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Question 3

SCOTT: There have been a lot of clients who have called and asked about inflation. There is concern

that with all the government spending and stimulus that either now or somewhere, sooner or later weare going to see inflation come into the economy. But we also have calls from clients asking aboutdeflation. Can you give us your thoughts on the inflation/deflation argument?

ARNOLD: This is probably a good time to introduce the principle of loss. Most people think when you talkabout a loss in capital, they think about the fact that when the market goes down their portfolios go down.However, this is rarely a permanent loss, or at least it does not have to be if you are holding good values. Ofall the bear markets over the last 135 years, only one did not achieve the previous peak within 6 years. As amatter of fact, of the last 14 bear markets, on average, the market recovered and reached a new peak within3.3 years. Even in 1932, the return off the bottom was 372% over 4.75 years. So with most recoveries takingplace within a few years, a permanent loss of capital is not as big of an issue as most people think. Rather,

the main issue should be how one handles a one to two-year, and in the rare case, a three-year decline inmarket values. o 1 84 A0 1trs,whiple people think that


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For example, if you take an average person at age 65 with $1 million in cash, and assume an inflationrate of 4%, by age 85 (20 years later), this $1 million dollars in cash would have the purchasing power ofonly $442,002 due to inflation. This is a total decline of 56%, and its permanent. So there is a huge risk due

to inflation, even during normal times. But if youre speaking about higher inflation periods, like therunaway inflation that some people are concerned about, well then obviously the decline in purchasingpower will be even greater.

Chart 5

Permanent Loss of Purchasing Power Caused by Inflation

Starting Value $1,000,000 $1,000,000 $1,000,000 $1,000,000

Inflation Rate 3% 4% 7% 10%

Years 20 20 20 20

Future Value $543,794 $442,002 $234,239 $121,577Source: Century Management

Lets take the inflation argument first. The reason that people believe there is going to be a largeamount of inflation, more than the normal 3.5% to 4%, is because the government has expanded its balancesheet almost two to three times above normal. Some people call that printing money. I think you have got todistinguish between printing money and creating credit. What the federal government has done is they havecreated reserves to put into the banks so that they will have the ability to lend it out, and as it goes throughthe banking system (i.e. the fractional reserve system) it expands and thus boosts the economy andeventually get things going. If they print the money, like they did in Germany during the 1920s, where they

literally printed it on the presses and distributed it to the public, then youre going to have very seriousinflation. Our government is not printing moneythey are creating reserves to extend credit. But if peopledont borrow that money, then its not going to expand at the rate theyre supplying it.

What is important to remember here is that when the government lends money, they can also pull itback out. Many people are not aware of this and thus feel we are going to have high inflation. Here is aclassic example of why it does not have to be that way. If you study Japan, in the 1990s they increased theirmoney supply by creating reserves. As you can see on Chart 6, the money supply went straight up during2001 through 2002.


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Chart 6 - Japans Money Supply

Then it went sideways for a couple of years and then during 2005 and 2006, they drained virtually allthat excess credit back out of the system. Remember, they were able to drain the money out of the systembecause they did not literally print the money. They created the money by expanding


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Therefore, the argument that because the Federal Reserve is expanding the money supply viaexpanding credit we are going to have runaway inflation or very high inflation does not bear out with thefacts. Do I believe it is possible that we could have high rates of inflation, like some people worry about?


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manufacture without building new facilities, then they are able to raise their prices. We have neither of thoseconditions now. Chart 8 shows the latest unemployment rate to be 9.7%, while Chart 9 shows U-6unemployment, the most comprehensive unemployment metric, to be 16.9%, both of which are well abovetheir historical norms.

Chart 8 - Unemployment Rate

Chart 9 - U-6 Unemployment Rate (the broadest measure of unemployment)


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Based on todays high unemployment rate and when you consider the slow pace that jobs are beingcreated, it could take three to five years, maybe longer, before you get back to a normal employment market.The second major consideration for inflation to exist is a high factory


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next two years we have a greater chance of deflation than we do inflation. Over the long-run, I dont thinkdeflation is a factor to be concerned about at all. Fortunately with the way the economy is recovering andwith the way many companies have repositioned themselves, we probably do not have to worry about seriousdeflation.


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I have done a lot of thinking about this. A lot of people are rushing into bonds today. Now let me sayone thing. Bonds have a place in anybodys portfolio that is concerned about the short-term. For example, ifyou are worried about sending your kids to college in the next three or four years and you do not want toworry about the volatility of the stock market, then bonds or even cash may be right for you. If you are

saving for another purchase or project such as a home or whatever it is that you have in mind that has ashort-term time horizon, bonds may be the right investment for you. In the business world, many companieshave pensions and insurance companies have other liabilities that they have to fund so bonds are anappropriate investment. So depending on your own situation, personal circumstances, and time horizon, therecould certainly be a place for bonds in your investment portfolio.

With all of that said, it is important to note that the bond market has been in a bull market since 1981,or 29 years. Inflation has gotten about as low as its going to get; maybe a little lower but not much. Ingeneral, bonds have gotten about as highly priced as they are going to get. Typically, it takes almost one-third of the time of the bull market to erase the excesses that have built up. Suffice it to say the bond marketis pretty richly priced today, especially if were going to have a little more inflation a few years out.

Let me just give you one example of what happened to bonds during the early 1970s. In 1973, oneyear before we started Century Management, inflation was running at 2.76%. By the end of the year it was4.93%. Thats almost a doubling of the inflation rate in just one year. The following year inflation went from4.93% to 11%. So in the space of two years (1973 to 1975), inflation went from 2.76% to 11%. In otherwords, inflation quadrupled in two years. Now, if you want to know what happens to stocks or bonds duringinflation, you can look back at the bear market of 1973 and 1974 and that will answer your question. It wasdisastrous. Remember, if you own bonds with a long maturity date and interest rates go up 1%, then thatbond will go down 10% in face value. Now if you have a short-term bond it doesnt really matter too muchas it matures within a short period of time and you get your money back. But if you have a 30-year bond andit goes down 10%, you would have to wait 30 years before it matures. If rates went up 4%, that same long-

term bond would go down 52%.

SCOTT: If the interest rates went up 4%, you could see a 40-50% decline in the long-term bond market.

ARNOLD: Yes. The point I am trying to make is that people have to manage their bond portfolios becausedown the road when inflation does start to pick up, and if you did not make any adjustments, that bondportfolio could go down very dramatically depending on how it is structured. If youre in short-term bondsyou could wait until they mature and then roll the proceeds over to higher yielding bonds. I would say that ifyou looked at the probability, as I said, I dont believe we are going to have a lot of inflation for the nextthree to four years. Now, having said that, we just made a trade in a long-term bond because at the price wepaid for the bond we deemed it to be a great value.

In this specific case we were able to buy a 30-year U.S. government coupon paying bond when it hada yield to maturity of 4.75%. At present, with little to no inflation to speak of, we felt this would be a goodbet over the next few years, but I would not keep that bond over the long-run. So far, this trade is working inour favor.

SCOTT: This long-bond strategy was more of a three to five year type of plan?


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ARNOLD: Yes, and probably even shorter. So the idea is if you are going to be in bonds, they still have tobe managed. If you are worried about deflation, you want to go out a little longer on the maturity date. If youare worried about inflation, then you want to keep your maturity short so that you can keep rolling maturingbonds over.

As our performance shows, we have done a very good job managing bonds over the past 35 years.Just over four years ago, as you know, we even created a total return bond fund. Tom Siderewicz is our leadmanager of this fund. He has done a spectacular job of managing our bond portfolios over the past few years.As you know, over the past three years our bond performance ranks as one of the top in the country. WhatTom is doing with bonds is the same thing we are doing with stocks and that is looking for values. Right nowour average bond portfolio is roughly 35% to 38% in cash. However, this figure will change depending oneach individual client, but it is an average. The reason we are holding so much cash in many of our bondportfolios is that we believe many bonds are overpriced. However, we are continually looking for goodvalue opportunities for bonds just like we are for stocks.

If you are going to invest money in bonds, you still have to manage where you make your buys andsells. For example, when you buy bonds you need to make sure they are cheap and when they becomeovervalued you need to sell them because eventually they are going to be in a long-term bear market. Mostbond managers, especially those managing bond mutual funds, just keep themselves fully invested. If overthe next few years bonds begin to enter into a bear market and go down in value, being fully invested andnot actively managing the bonds might not serve your purpose. For example, if your bond has a coupon thatpays 4% but the bond goes down in value 4%, the decline in principal for the year will offset the income that


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I have studied this field for 40 years, I have racked my brains out, I have listened to all kinds ofarguments, and what it really gets down to is buying great values. Thats why I chose the value approach toinvestingit makes the most sense over the long-run. Most importantly, it is the only way I believe you cantruly protect yourself. Whether you are in stocks, bonds, or real estate, you have got to buy these assets when

they are cheap, and that usually means buying during uncertainty, when things dont look as rosy, and thenbe willing to sell them when they get overvalued and things are looking good.

For example, over the past year as our stock portfolios were going up and various individual positionswere going past their fair values, we reduced their weighting in the portfolios selling some positions in full.As a result, our typical cash position peaked earlier this year between 22% and 30%, depending on theportfolio. Then as the market has come down, we have invested about 4% to 8% of that cash because therehave been some bargains that surfaced.

If the market, or should I say individual stocks, continue to go down and get into our bargain zones,we will continue to redeploy that cash. When their prices turn around and increase to the point where they

are above fair value and near their sell points, we will sell them out. Regarding our bond portfolios, we havebeen doing very well. Today, our typical bond portfolio is holding roughly 35% to 38% cash. We may haveto sit in cash for six months to a year before we find more good values in bonds. We dont know for sure,but we will wait until we get the right kind of opportunity.

In summary, the only way you can truly protect yourself in different environments is to buy whenassets are out of favor and cheap. Then down the road when things are looking rosy and getting overvalued,thats when its time to sell. Furthermore, during periods where there are no values, you should just stay incash or short-term bonds, whichever one is the better value, and wait for the next great buying opportunity.This has been our approach for more than 35 years.

Question 6

SCOTT: Where are we relative to fair value in the market today? Lets use the S&P 500 as our proxyfor the market at-large, and then lets answer the same question with regards to the average CenturyManagement portfolio.

ARNOLD: Okay, lets start with the S&P 500. Wall Street uses a P/E ratio to arrive at fair value. However,one of the problems with using Wall Streets P/E ratio is that the E part of the ratio, that is, the earnings,are typically based on projections for the next year. The problem is if their projections are over the norm theywill still use those numbers, and if their projections are under the norm the P/E goes up. So what we havedone in our methodology is we use normalized earnings. This helps to smooth out the extremes.

Over the past few months, I have seen various projections from Wall Street firms that put the S&P500 earnings at $70 to $90. While it could generate $90 in earnings this year, we prefer to use normalizedearnings. After we run our three methodologies, we come up with a normalized $67 in earnings for this year.This is a very conservative number, but we do that on purpose.

SCOTT: So $67 is our estimate of normalized earnings for the S&P 500 this year?


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ARNOLD: That is correct. The way we do that is we take the ten-year average P/E and add inflation. Yaleprofessor Robert Shiller has written extensively about this methodology. But we add a few other things todouble check it. We also take the normalized profit


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SCOTT: Earlier we talked about our CM Value 1 Composite (a proxy for our typical account) having aprice to book value ratio of 2.12 and a price to sales ratio of 0.75, which based on those metrics, like the P/E,are on the lower end. In other words, our portfolios are selling at bargain levels.

ARNOLD: Yes. If you look at 0.75 of sales, that has only happened twice during our companys 35-yearhistory. That was in 1990 with 10.75% interest rates, and it happened in 2009 at the bottom of the market. Soour portfolios, based on a price to sales ratio, are trading at a significant discount to the general market. Thisis why we feel very good about our portfolios today. Regardless of any metric you want to use, price/sales,price/book, whatever, it is at the lower end of valuations.

See Chart 12 on Following Page


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Chart 12Price of S&P 500 Given $67 in Normalized Earnings x Various P/E Ratios

Source: Century Management

MarketMultiples NormalizedEarningsPowerofS&P500

ValuationofS&P500

LOWRANGE11.00 X $67.00 = 73711.25 X $67.00 = 75411.50 X $67.00 = 77111.75 X $67.00 = 78712.00 X $67.00 = 80412.25 X $67.00 = 82112.50 X $67.00 = 83812.75 X $67.00 = 85413.00 X $67.00 = 87113.25 X $67.00 = 888

13.50 X $67.00 = 90513.75 X $67.00 = 921FAIRVALUERANGE

14.00 X $67.00 = 93814.25 X $67.00 = 95514.50 X $67.00 = 97214.75 X $67.00 = 98815.00 X $67.00 = 100515.25 X $67.00 = 102215.50 X $67.00 = 103915.75 X $67.00 = 1055

16.25 X $67.00 = 1089

16.50 X $67.00 = 110616.75 X $67.00 = 1122

UPPERRANGE17.00 X $67.00 = 113917.25 X $67.00 = 115617.50 X $67.00 = 117317.75 X $67.00 = 118918.00 X $67.00 = 120618.25 X $67.00 = 122318.50 X $67.00 = 124018.75 X $67.00 = 125619.00 X $67.00 = 127319.25 X $67.00 = 1290

19.50 X $67.00 = 130719.75 X $67.00 = 132320.00 X $67.00 = 134020.25 X $67.00 = 135720.50 X $67.00 = 137420.75 X $67.00 = 139021.00 X $67.00 = 1407


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SCOTT: We are always comparing the value of our portfolio to the value of bonds. In other words, if wetake a look at the earnings yield of our portfolio we come up with an earnings yield of just over 7%. Can youexplain why this earnings yield is a value today? (Note: 100 / 14.2 P/E = 7.04% earnings yield).

ARNOLD: One of the things that history will bear us out on is that there is competition between stocks andbonds, and rightfully so. If you can make as much money in a bond as you can in a stock, then why wouldyou want to buy a stock where you have more volatility and risk? Bonds are certainly much safer and theprincipal is more secure, although they will not protect you as well against inflation. When you take theearnings yield, like you did (100 divided by 14 P/E = 7.14% earnings yield), we have a 7.14% earnings yieldon our typical portfolio. Currently, the Moodys Baa (investment grade) bond yield is about 6.23%. Whenwe compare the earnings yield of the stocks to the earnings yield of the bonds, we can see that buying stocks,even knowing that in todays market they could go a little bit lower, is really a great value.

Any time you can buy stocks with an earnings yield as cheap as bonds and have the long-term growth

of the stocks, you are usually at a real good point of value. This makes sense, just think about it. If bonds areyielding 6.23%, but at the same time you could by a stock with the same earnings yield plus get on averageof 5% to 6% earnings growth (average growth rate over the last 50 years), then you are getting all thatgrowth at no extra cost. Usually stocks sell at a higher earnings multiple (thus a lower earnings yield) thanbonds because they have that growth component. Well today, stocks are actually yielding more than bonds,and you still have the growth component. Admittedly, over the next three to five years, you may have amuch slower growth rate than we did in the past, but you are still going to have some growth, and anygrowth is basically gravy. The point I am trying to make is that whenever the earning yields on stocks isequal to bond yields, stocks are a good value because you have the growth potential. You dont have thatgrowth potential on bonds.

SCOTT: Would you say its fair to take that earnings yield of 7% and add it to a growth rate of 3-5% to getan idea of our future return?

ARNOLD: Thats right. If you took your 7% earnings yield, especially if it was free cash flow (and by theway, we spend more time talking about free cash flow, which is the real earnings in a company, but lets justuse the P/E for this conversation). If the P/E was free cash flow, which for most of our companies it is, thenyou could add the growth rate, whatever that may be. Historically, growth has been 5% or so, and thats whystocks have done better than bonds over time. When you take the earnings yield plus the growth rate, you canhave anywhere from 10% to 12% returns. It is no coincidence that these types of returns are consistent withlong-term historical market returns.

Now, if we take the current environment, where we may not have as much growth as we have had inthe past, it is likely that the total returns will be lower than the historical averages. However, I would also saythat after three to five years in a slow growth period, we could have much higher growth rates because ofmany exciting things that I believe will be happening here in the U.S. and around the world. But the bottomline is that you can take the earnings yield and add whatever growth rate you expect, whether it is 2%, 3%, or5%, and that sum would be your projected return.


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Question 7

SCOTT: In closing, can you share your final thoughts?

ARNOLD: We hear a lot in the news about how strapped the consumer is, how much debt there is in thiscountry, how there is a lot of unfunded pension liabilities, and so forth, and


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Chart 13 - American Household Net Worth

Now if you want to talk about the future, here is the way I see it. As I look out over the next three tofive years, I think its going to be a very volatile market environment because our country is in the throes ofworking out its problems. Sometimes it will look like things are going well like we saw in the early part ofthe second quarter and the market will run up. Then there will be times when additional problems will

surface and the market will react and sell off. Even with all of the volatility, I believe the market will floataround its fair value. But once we are through these problems, and I think that over the next three to fiveyears we have a very good chance of working out the major issues then when you look into the future, youcant have anything brighter than that.

Think about it, the $54 trillion of net worth Americans have today was largely created over the last 20to 30 years with an average of 250-300 million people. Now we have China and India that combined havemore than 2.5 billion people. They are industrializing, they are innovating, and they are creating wealth at arate that is literally breathtaking. With China and India building a middle class that will have discretionaryincome to spend at rates and levels we have never seen before, they are going to buy all the things that ourAmerican companies sell. The growth rates that many of our U.S. companies will experience will be

fantastic.

We used to look at China and India for just low-cost labor as companies would have their productsproduced overseas because it would simply cost less to produce, largely because the labor is less expensive.But now-a-days, the Chinese and Indian people are at a point where they are creating a tremendous amountof professional people. There are engineers being cranked out left and right, and all kinds of professionals arecoming to market. In many cases, they are actually starting to rival us in innovation. So, not only are these


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countries going to be good consumers, but they are going to help create productivity increases that are sure tobe breathtaking.

What has made our country so wealthy is the constant increase in technological processes and

productivity. When you increase productivity, you create profits. Can you imagine ov

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