Investment Procedures & Disciplines

<body topmargin=0 leftmargin=0 marginheight=0 marginwidth=0> <table cellpadding=0 cellspacing=0 border=0 height="100%"><tr> <td valign="top" width=190 BGCOLOR="#000066" TEXT="#F7F7FF"> <bR> <bR> <bR> <bR> <bR> <bR> <bR> <div> <A HREF="index.htm" TARGET="_top" TITLE="Home"><U><U>Home</U></U></A></div> <bR> <div> <A HREF="id23.htm" TARGET="_top" TITLE="History"><U><U>History of the Firm</U></U></A></div> <bR> <div> <A HREF="id25.htm" TARGET="_top" TITLE="Investment Procedures Disciplines"><U><U>Investment</U></U></A></div> <div>    <A HREF="id25.htm" TARGET="_top" TITLE="Investment Procedures Disciplines"><U><U>Procedures &</U></U></A></div> <div>          <A HREF="id25.htm" TARGET="_top" TITLE="Investment Procedures Disciplines"><U><U>Disciplines</U></U></A></div> <bR> <div> <A HREF="id27.htm" TARGET="_top" TITLE="Client Letters"><U><U>Client Letters</U></U></A></div> <bR> <div> <A HREF="id22.htm" TARGET="_top" TITLE="Contact Information"><U><U>Contact Information</U></U></A></div> <bR> <div> <A HREF="http://www.dunvegan.com" TARGET="_top" TITLE="http://www.dunvegan.com"><U><U>Client Log-in</U></U></A></div> <bR> </td> <td valign="top" BGCOLOR="#000066" TEXT="#F7F7FF"> <bR> <bR> <bR> <div> <TABLE BORDER="0" CELLPADDING="2" CELLSPACING="1" WIDTH="723" BORDERCOLORLIGHT="#C0C0C0" BORDERCOLORDARK="#808080" FRAME="BOX" RULES="ALL" HSPACE="0" VSPACE="0" > <tR> <tD VALIGN=TOP HEIGHT= 108 ><NOBR><div> <B><U>D U N V E G A N   A S S O C I A T E S,   I N C.</U></B></div> <bR> <bR> <bR> </NOBR></tD> <tD VALIGN=TOP WIDTH="116"><IMG BORDER="0" SRC="1x1.gif" HEIGHT="108" ALIGN="bottom" WIDTH="116" HSPACE="0" VSPACE="0"></tD> </tR> <tR> <tD VALIGN=TOP HEIGHT= 8422 WIDTH="596"><bR> <div> <I><B>General Ideas</B></I></div> <bR> <div> There are some simple general ideas, which guide our management of investment portfolios.  When held up to the light, the processes display more intricate detail and become more difficult to easily transmit.  There are no quick formulas to fully convey any venerable investment process any more than e=mc2 does justice to the theory of relativity.  Even so, the concept of any good process can be explained with a few general ideas. </div> <bR> <div> Basically, we invest in growth companies that have passed a test of quality when they are offered by the market at attractive value prices.  Usually, markets do not allow easy entry in quality issues with proven growth track records.  However, there are times, owing to occasional missteps by management, general market swoons, or the odd circumstance, that great companies are mispriced and are available at value prices.  It is at those times that we initiate or increase our investment in these great companies.  Or, at such times, we may reallocate from holdings of lesser companies into issues of higher quality and value.  We generally hold those investments until corporate fundamentals deteriorate or change from original parameters, while we may decrease position size on overvaluation.  </div> <bR> <bR> <div> <I><B>The Business of Investment versus the Game of Investment</B></I></div> <bR> <div> Suggesting that we are value investors in growth companies may seem to be a conflict of terms.  Our experience is, however, that the business of investment, whether in cyclical or growth companies, needs to have value analysis as a core process.  The key phrase for understanding here is: business of investment.  The business of investment through financial markets employs the same process as that used if the investment target were a private or non-publicly traded company.  A process is undertaken and maintained that examines industry and company fundamentals with the goal that an adequate return on invested capital will be realized from the company's net free cash flow.  Calculations are employed that are similar to those used if the entire company were being acquired and taken private.  This approach disregards the stock market ebb and flow pricing of the public shares of the target company, except as market pricing provides opportunity for entry and exit by undervaluing or overvaluing shares.  Market pricing is not viewed as information as to the intrinsic worth of the subject company.  </div> <bR> <div> The business of investment contrasts sharply with the game of investment.  The game of investment is where the direction of the market price of the target vehicle influences the investment decision.  That is, if the price of the stock has been going up recently, it is deemed a good investment, worthy of additional commitments.  Conversely, a bad investment may be one where the stock price has been recently declining and where the decision may be to either cut losses by selling or to strap in and hope for the best.  In the game of investment, there is no real analysis of the intrinsic value of the investment.  There may be steady reports gathered that the company is doing this or that, but there is no real </div> <div> translation of those events to the measured impact on the company's basic value.  The game of investment largely is where A buys because B is buying, who buys because C is buying, who, in turn,  may be influenced to buy more because it is seen that A is buying.  Selling is the reverse of the buying process, but one dominated by fear rather than hope or enthusiasm.  </div> <bR> <div> The game of investment can many times be rewarding depending on luck, good use of extraordinary technical indicators, or long-term positions held in quality issues.  It can however, be unprofitable in the short term, when investors respond to their emotions or in the long term, when there is little or no supportive underlying fundamental rationale.  </div> <bR> <div> Most investors today may not realize that they are in the game of investment, since both media and Wall Street analysts do not provide thoughtful investment analysis but rather pander to the popular mood.  For the unwitting investor, it is similar to a game of musical chairs that can leave one standing with losses when the music stops.  That is well and good for the value investor, or one who is in the business of investment.  Without the fickle-herd instinct of the investment community, markets and target investment issues would be more efficiently priced and not offer investment opportunity in excess of the long-term growth rate in corporate profitability.  To borrow the allegorical character, named Mr. Market, created by Benjamin Graham, co-author of Security Analysis, the seminal work on value analysis:</div> <bR> <div> “Imagine that you and Mr. Market are partners in a private business.  Each day, without fail, Mr. Market quotes a price at which he is willing to either buy your interest or sell you his.  The business that you both own is fortunate to have stable economic characteristics, but Mr. Market's quotes are anything but.  You see, Mr. Market is emotionally unstable.  Some days he is cheerful and can only see brighter days ahead.  On these days, he quotes a very high price for shares in your business.  At other times, Mr. Market is discouraged and, seeing nothing but trouble ahead, quotes a very low price for shares in your business. Mr. Market has another endearing characteristic.  He does not mind being snubbed.  If Mr. Market's quotes are ignored, he will be back again tomorrow with a new quote.”   </div> <bR> <div> Graham warned that it is Mr. Market's pocketbook, not his wisdom,  that is useful.  If Mr. Market shows up in a foolish mood, you are free to ignore him or to take advantage of him, but it will be disastrous if you fall under his influence.  Essentially, the investor who permits himself to be stampeded or unduly worried by unjustified market declines in his holdings is perversely transforming his basic advantage into a basic disadvantage.</div> <div>       </div> <div> Warren Buffet has suggested that Noah did not wait until it was raining to start building the arc.  It is, then, important to develop a shopping list of prospective investments and wait until Mr. Market provides an opportunity for entry.  Our list of prospective investments is embodied in our Master List, which requires continuous analytical scrutiny.  While weak markets may be scary for those knowingly or unwittingly involved in the game of investing, a weak market prompts the value investor to start to lean forward with keen interest as unusual investment opportunities begin to be presented.  Those companies selected from our Master List become Core Equity holdings in appropriate portfolios.</div> <bR> <bR> <bR> <div> <I><B>Criteria for Investment</B></I></div> <bR> <DIV ALIGN="LEFT"></DIV> <div> <U>Growth versus Cyclical</U></div> <bR> <div> We are most comfortable with issues that are attempting to exploit the dynamics of a growth industry that does not experience material decreases in demand during economic downturns.  For example, candy bars are a growth industry owing to population growth.  People continue to eat candy bars at about the same rate during economic recession or even depression.   By contrast, the car companies sell lots of cars when the economy is good and may lose money during recessions, when people defer major discretionary purchases.  We have observed that for many cyclical companies, cash flows and stock prices end up at about the same starting place every few years as fortunes respond to economic cyclical forces. </div> <bR> <div> It appears to us that being involved in cyclical issues has a lot more to do with the game of investment than it does with the business of investment.  We are much more at home with an investment where month after month, year after year, business is geared for expansion and not unduly impacted by the economic cycle.   We have found that using such issues puts the wind to our back and enhances the probabilities that the holding will be a profitable experience and match or exceed anticipated returns.</div> <bR> <div> Most of core equity investments have had long, multi-year, sometimes multi-decade, track records of enviable annual growth in earnings and cash flow.  The investments we are looking for tend not only to survive adversity but also to come out stronger for the experience.  We are not looking for companies that come out well on traditional value analytics.  That is, we are not looking for companies that have, for example, only low price-earnings multiples or a low market price relative to book value.  We similarly avoid laggards in a vibrant economic sector with the idea that they may “catch up.” Long experience has taught us that such issues may have moments in the sun but are not the competitive predators in growth industries that we are looking for.</div> <bR> <div> Turnaround candidates and otherwise cheap stocks may have a reason for being cheap that will keep them so.  Ben Graham was fond of this type of investment because of its apparent limited risk.  Warren Buffet calls this type of investment the “cigar butt” methodology:  the entry price was right and the investment may have a puff or two left in it.  But these are not the investments that help to compound wealth, year after year, as does a competitive company in a growth industry, when Mr. Market makes it available at a reasonable entry price. </div> <bR> <DIV ALIGN="LEFT"></DIV> <div> <U>Corporate Character</U></div> <bR> <div> Great companies tend to have outstanding leaders, Presidents, CEO's, but sometimes, they may not.  What is found with consistency with great companies, however, is an outstanding management culture.  The corporate character is shaped by the board of directors but can be sampled at almost any level in a company, from a shipping clerk to members of top management.  It is a character that emanates the ability to solve problems along with confidence in the ultimate success of the enterprise.  This corporate character, while many times initially shaped by a dominant personality, is typically built over a long period of time by the efforts of many.  We have found that companies, like people, have character and personality and, like people, character does not easily change  </div> <bR> <div> It is the corporate character in a great company that ends up replacing a chief executive that is not measuring up.  It is the corporate character that helps companies to adapt to changing times, resist the temptation to overreach, and to thereby maintain historical rates of growth in fields where competitors are not.</div> <bR> <DIV ALIGN="LEFT"></DIV> <div> <U>Additional Requisites</U></div> <bR> <div> In addition to a company with the enabling corporate character to optimize results during good times and bad, we also want to invest in companies where management makes its successes and failures transparently available in reported data.</div> <bR> <div> Further, it is important for us to be on the same side of the table as management.  That is, management should be in position to realize gains through share appreciation rather than oversize salaries or underpriced stock options at the expense of public shareholders. </div> <bR> <div> Our investments also need to provide public shareholders with the ultimate control over management through voting control of the selection of directors.  We usually avoid investments in companies where a minority in control seeks to perpetuate that control through issuance to the public stock with diminished voting privileges or other corporate “poison pills” that shelter inept management practices. </div> <bR> <DIV ALIGN="LEFT"></DIV> <div> <U>The Mathematics of the Business of Investment</U></div> <bR> <div> Having identified what we want to own, the next question is when to buy shares.  Here, our process essentially asks the question:  “What would you pay for the company if it were a private company, not traded on a public stock exchange, in order to secure a good return on invested capital.” </div> <bR> <div> We start with net corporate earnings, excluding extraordinary items.  We add back in non-cash charges such as depreciation, depletion, or other forms of amortization in order to determine cash flow, or the actual cash coming into the business.  We then deduct capital expenditures from cash flow, which provides the actual returns that the equity investor gets to keep.  We then measure these returns against the cost of capital, both in the current and anticipated interest rate environment.  The result is a price we would be willing to pay for a superior investment.  Since we deal with public companies, the market, through emotionalism, makes prices available from time to time that are likely to provide superior long-term returns on invested capital.</div> <bR> <bR> <bR> <DIV ALIGN="LEFT"></DIV> <div> <U>Application to Portfolios</U></div> <bR> <div> We maintain a shopping list of investments that we consider to be desirable, to be entered into as markets permit.  We usually maintain 20 to 30 issues in accounts but may have a higher concentration in issues where risk/reward calculations portend a higher relative attraction.  We add to positions when higher value is available.  We may trim positions when the market values our issues at high levels and risk/reward relationships become less attractive.  Positions are eliminated when the basic criterion for investment change.  </div> <bR> <bR> <bR> <div> “The market is feline in nature.  Like a cat, most of the time it lolls around, but when it moves, it does so in a hurry.”</div> <div>           Edson Gould, 1976</div> <bR> <div> <I><B>Risk Management</B></I></div> <bR> <div> We employ risk management on portfolios that select a conservative profile.  Risk management is not employed with portfolios that choose a more aggressive fully-invested mode, where clients are employing us for our stock selection techniques.  Depending on client goals, where higher risk can be assumed, it may be helpful for portfolios to shift the investment mix in order to gain traction in a rapidly changing market environment.</div> <bR> <div> Our risk management model is essentially the product of our studies of three cycles:  the business cycle, the bond cycle, and the stock cycle. </div> <bR> <div> The business cycle is examined with regard to determining its longevity and its probable impact on interest rates and earnings.  Our business cycle analysis assists in our formation of a template for the bond and stock cycles.</div> <bR> <div> Bond cycle analysis is enhanced by the assessment of impacting commodity and world currency variables. </div> <bR> <div> Finally, stock cycle analysis is performed, with our projections on interest rates, the liquidity, and earnings residue from the examination of business and bond cycles and with important additional studies, which relate to the analysis of internal stock market dynamics.  Specifically, we have examined value, psychology, and market velocity in varying ways, which enable us to establish benchmarks of pending risk.  </div> <bR> <div> Our market work enables us to anticipate with probability overall stock market moves of varying dimensions.  We specifically assess probabilities of general market moves of 1 to 3 percent (minor trend), 4 to 12 percent (secondary trend), and 13 percent and higher (primary trend).</div> <bR> <div> The objectives and risk tolerances for most of our investment management clients require us to address only the primary and secondary trends.  Essentially, when primary downside liability (in excess of 13 percent) is anticipated, we may allocate more toward shorter-term maturities of fixed income securities, depending on the taxable position of the client.  When secondary downside liability (4 to 12 percent) is anticipated, it may also require higher cash equivalent exposure, depending on the taxable consequences to the client and client preferences for risk exposure.</div> <bR> <div> When the general market offers an upside bias without negative secondary or primary trend indications, minimal cash reserves are maintained. </div> <bR> <bR> <div> <I><B>The Role of Bonds</B></I></div> <bR> <div> Some of our clients have an income requirement.  Usually, fixed income securities are utilized to fit this need. The fixed income securities that we use can be a mix of treasury bonds, AAA-rated corporate bonds, pre-refunded municipal bonds, high-yielding utility common stocks, and quality convertible preferred issues.  However, when interest rate trends are adverse on a cyclical basis, fixed income securities are used more sparingly in deference to satisfying income distribution requirements from common stock appreciation.  As a defensive measure during adverse cyclical periods, maturities are shortened.  When conditions warrant, fixed income securities of foreign issues are selected.  These issues must offer rates of return sufficient to compensate for currency risk if differentiating currencies are not hedged.   </div> <bR> <bR> <div> <I><B>Cash Management</B></I></div> <bR> <div> When market conditions are anticipated to be volatile with an upside bias, cash reserves are managed so as to obtain the best possible returns in the treasury markets.  When markets are judged to be entering either a phase of low volatility or probable downside liability in excess </div> <div> of 5%, higher yields are sought through the purchase of short-term treasuries.  Our cash management process extends to the active purchase for clients of commercial paper and other short-term instruments as a more profitable alternative to readily available money funds. </div> <bR> <div> <I><B>Customization</B></I></div> <bR> <div> The risk tolerance of every Dunvegan client is established individually through consultation and an ongoing exchange with each client.  Portfolio construction is customized for each client to help meet their stated longer-term financial goals.  Should tax considerations be an issue, we are particularly mindful of the short-term versus long-term holding periods in our investment decisions. </div> <bR> <div> Many of our clients have convictions regarding the social impact of their investments.  We dutifully honor client requests for avoidance of particular sectors or specific companies. </div> <bR> <div> Individual income requirements or a desired more aggressive longer-term approach are also respected and applied in our investment process.  When the client is an institution, and several age groups and investment objectives are represented, we work at providing risk control in order to satisfy minimum requirements of anticipated withdrawal while maintaining investments that can make a positive difference for the longer term. </div> <bR> <bR> </tD> <tD VALIGN=TOP WIDTH="116"><IMG BORDER="0" SRC="1x1.gif" HEIGHT="8422" ALIGN="bottom" WIDTH="116" HSPACE="0" VSPACE="0"></tD> </tR> </TABLE></div> <bR> <bR> <bR> <bR> <bR> <bR> <bR> <bR> <bR> <bR> <bR> <bR> <bR> <bR> <bR> <bR> <bR> <bR> <bR> <bR> <bR> <bR> <bR> <bR> <bR> <bR> <bR> <bR> <bR> <bR> <bR> <bR> <bR> <bR> <bR> <bR> <bR> <bR> <bR> <bR> <bR> <bR> <div>  <IMG SRC="http://members.tripod.com/bin/counter/id25.htm?FFFFFF" ALT="[Tripod Counter]">  </div> <bR> <bR> </td> </tr></table></body>