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2007 Year-End All-Cap Value Commentary
January 14, 2008

In our 2005 first-quarter commentary we highlighted our investment concerns as follows:

 “our primary message in recent years has been that the economic recovery has been unbalanced, overly dependent on unsustainable debt-based spending (from consumers and the U.S. government) and an aggressively stimulative monetary policy from the Federal Reserve.  These policies have created once-in-a-lifetime earnings in certain sectors (homebuilding, lending, building materials) that have been the mainstay of the markets during this time.  However, our view remains that these sectors’ earnings and prices are at risk when the monetary and credit-driven stimulus diminishes, which it inevitably must.”

2007 was the year these concerns began to surface, with the sectors enumerated leading the market downward.  Because of our low exposure to these areas, our accounts were up last year while most value-oriented indices declined, as shown below.

Nonetheless, our return was below what we expected, and given our defensive positioning we should have exceeded the S&P 500’s return of 5.5%.   That we did not is in large part attributable to unusual factors affecting one stock – SLM Corporation. Though not a participant in the excesses in the financial sector, SLM became a victim of them as credit markets seized up.  Since we believe these conditions are temporary,  SLM’s underlying earnings power should remain high enough to justify a much higher value than today’s price, and we added to our position as the price declined. 

The Opportunity Set and Earnings Environment
The investment opportunity set as well as the underlying earnings environment are changing rapidly as the ramifications of consumers spending so much borrowed money for so many years begins to affect the real economy.  Some cyclically exposed stocks, particularly retailers, have begun to reflect this changed environment, but others have not.  Meanwhile, less-cyclical stocks (which were the best performers in 2007) continue to reflect a euphoria that growth will continue.  In both cases, the risks of earnings disappointment are high, so making the right investment choices will be even more important than usual.

While we have kept our exposure to both cyclical and banking stocks relatively low in recent years, we expect our exposure will increase as earnings disappoint and stock prices fall.  Our governing principal will not be a prediction of when earnings will improve, but rather, confidence in factors such as management quality, stability of margins and return on capital, strength of the business franchise, conservative debt and lease structure, quality of balance sheet, and conservatism of accounting.

Lower Volatility Increases The Odds Of Investment Success
Focusing on investment return appears natural and rational, but volatility (which seems to be largely ignored) often plays a more important role in determining the investor’s odds of success.  To illustrate, the table below shows the probability of failing to earn an 8% return over any rolling 5-year period since 1986, using our All-Cap Value approach versus various capitalization-specific value indices. (An 8% return target was chosen because it allows an investor to sustain a 5% spend rate on capital while protecting corpus against 3% inflation, which seems a reasonable minimum objective an investor would want to achieve.)  While the mean returns were within ± 0.75% over the entire 22 years, the odds of failing to earn 8% during any 5-year period were quite different due to volatility (shown by standard deviation).

Meanwhile, less value-oriented approaches and indices tend to show an even higher rate of failure in earning minimum return objectives due to their greater volatility, as shown below for the S&P 500, the Russell 1000 Growth, and NASDAQ indices.

Since volatility plays a significant role in determining investor failure rates, and since real-world excess returns (or alphas) tend to be low relative to the dispersion of returns, we believe most investors will find a more reliable path in achieving their investment objectives by focusing on volatility minimization instead of return maximization (as long as mean returns are market-like).

To say it in statistical terms, it is much harder to find a return distribution with a meaningfully higher mean than it is to reduce the tails of the distribution meaningfully, as it is the tails that tend to result in failure.  The attached sheet compares the historical odds of earning various rates of return over rolling 5-year periods, and illustrates that

• we have never had a 5-year return below 6% (while the indices have experienced many such periods), and

• our incidence of earning any positive return up to 12% has been higher than the indices.

The message is simple –  investors should focus on maximizing the odds of achieving their required investment return, not on seeking the highest return regardless of odds of actually achieving it.

Tax Management
Also ignored too often is the effect of taxes on return.  Since long-term gains are taxed at significantly lower rates than short-term gains, returns achieved via long-term gains are worth more.   We seek to maximize long-term gains primarily through having longer holding periods and relatively low turnover.  In addition, we harvest short-term losses throughout the year in taxable accounts to help offset gains.  As a result, about 96% of our net realized gains for a typical taxable account over the past 5-years were long-term, resulting in an overall after-tax return equal to about 88% of pre-tax return 3. 

Portfolio Review
During the quarter, we added to existing positions such as Gannett, Hershey, IMS Health, NTT Docomo, Office Depot, and SLM Corporation, where we believed price declines reflected excessively pessimistic views about strong business franchises with great value.  Meanwhile, we added a new position in eBay, which had fallen along with other consumer-oriented stocks, because  we felt the long-term growth potential was sufficient to justify a higher value. 

We sold our positions in Apollo Group, which had risen substantially since our original purchase; Tribune Company, which was acquired in an ESOP buy-out plan with Sam Zell; and Pfizer, where the drug pipeline to replace Lipitor continued to disappoint and raise questions about future earnings power and growth.

The market’s difficulties are presenting more attractive buying opportunities, and ultimately this is a positive for prospective returns.

Conference Call
Our quarterly conference call is scheduled for Thursday, January 24, 2007, at 4:30 p.m. (Eastern Time).  If you would like to participate, the call-in number is 800-977-8002, and the password is 200414#.  As always, we appreciate the confidence placed in our investment approach and investment team.

James F. Barksdale (jbarksdale@eicatlanta.com)
W. Andrew Bruner, CFA, CPA (wabruner@eicatlanta.com)
R. Terrence Irrgang, CFA (tirrgang@eicatlanta.com)
Ian Zabor, CFA (izabor@eicatlanta.com)

¹ For Broker Use Only.Not approved for presentation to wrap program clients. Such presentations should reflect EIC's wrap composite information, which is available upon request. EIC’s returns represent a composite of non-wrap All-Cap Value equity accounts and are presented as supplemental information to a full GIPS© disclosure presentation, which is available upon request.  All returns include reinvestment of dividends and interest.  Index returns exclude fees and commission costs.

2 The table illustrates the frequency that the annualized return over each of the 205 rolling 5-year periods since 1986 was less than 8% (including reinvestment of dividends and interest).  EIC ‘s results represent EIC’s All-Cap Value product (gross and net of management fees and commissions), while Index returns exclude management costs and commissions.

3  EIC’s after-tax return and percentage long-term gains were estimated using data from a single account, selected based on its taxable status and the absence of cash flows during the period covered (five years ending December 2007).  The account’s annualized return during this period was 12.5% before fees and 11.4% after fees.  It is intended to be representative of taxable all-cap value accounts managed by EIC in general, but similar results cannot be assured.  Individual experiences may vary.  “Short-term” is defined as gains or losses incurred from positions sold after being held less than one year, while “long-term” positions were held more than one year.  Short-term capital losses are used to offset short-term capital gains, thus receiving the full 35% benefit.  However, if short-term losses were instead offset by long-term gains, the tax benefit from losses would be only 15%, increasing EIC’s 5-year average tax impact from 1.4% to 1.5%.  Key assumptions for determining after-tax return include: a.) ordinary tax rates are assumed to be 35% versus 15% for capital gains and b.) state taxes are excluded.

Results are historical and do not imply future rates of returns or volatility for EIC or the indices, which may be materially different from the past and from one another.  Individual account results may differ relative to the past and to composite figures.