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2008 Third Quarter Commentary
October 13, 2008

Given the events since the third quarter ended, some of this quarter’s report may seem like ancient history.  However, much pertains to our views on the current crisis as well as risk management - which should be relevant and topical.  This year and this decade have presented a number of crises.  Here is how we did in each:

Our performance during crises was not by chance, but the result of being careful about risk and focusing on quality.

Quality – The Antidote To Risk
Reducing risk begins with a valuation discipline that restrains us from paying too much for today’s earnings, but allows us to pay enough so we can own quality companies able to sustain and grow earnings in the future.  Too often, value managers over-emphasize low price, incurring the risk of insufficient future growth, while growth managers over-emphasize growth, incurring the risk of excessive price.  By balancing these equally important aspects of value, our valuation approach helps us buy quality and reduce risk.

This matters because quality is the antidote to the risk of experiencing a permanent loss through a business’s failure.  Quality can be described as all those aspects of a business that reduce the odds of failure, while risk can be summed up as those aspects that increase it. Quality includes characteristics such as stability of earnings, margins, return on capital, and growth, as well as managerial ability, accounting veracity, and financial leverage.  All these factors play an important role in our decisions, resulting in our lower risk of permanent loss from business failure.

The recent environment provides many noteworthy examples.  While many viewed AIG as a safe holding, we avoided it due to concerns about accounting and management integrity. We considered purchasing Ambac and MBIA repeatedly, but resisted out of concerns about guaranties they were making for which they carried few reserves.  Bear Stearns, Merrill Lynch, and Lehman Brothers all looked seductively cheap, but carried the possibility of failure associated with excessive leverage.  And virtually all banks (not just Countrywide, IndyMac, and Washington Mutual) took on risk as they lent to over-extended consumers while under-reserving for losses.  Buyers of these firms were less concerned about risk than we were.

Permanent Loss vs. Price Declines
Given the recent market fluctuations, we understand how easy it is to go into a panic mode, but there is a difference between stock price fluctuations and permanent loss.  Permanent loss occurs when a business’s earnings power terminates, whether due to changes in its ability to profit from its products, or its inability to earn enough to cover its obligations (such as debts, leases, contractual guarantees, or capital reserve ratios). The latter is what we have seen in the recent collapse of so many businesses.

Since stocks are sold at auction each day, prices fluctuate.  These are not permanent losses, but reflect hopes and fears about the future.  Hope tends toward patience as it looks to the future, but fear produces the “flight” reaction and its attendant focus on the immediate.  To help isolate us from these swings our valuation methodology uses a fixed time horizon in determining the value of a business’s earnings power (4 years for competitive businesses, 7 years for strong franchises).

When fear is all around, as it is today, we believe it is important that investors do the same to govern their investment posture.  Rather than following panic’s focus on the “now”, we believe the focus should be on the earnings power of the underlying businesses over a 4-7 year period.    This is the foundation of long-term business ownership, and provides the stamina to invest through good times and bad. 

The greater stability we have provided rests in large part on our stable time horizon in valuation.  When time-horizons are too long, investors pay for earnings too far into the future, resulting in high prices (when we tend to sell).  Conversely, when time horizons are too short, investors ignore the value of future earnings, which reduces prices (when we tend to buy).   That is what we have done during the recent decline, and why we are basically fully invested as of this writing. 

Risk vs. Return - Theory vs. Reality
Much of the financial world has been built upon the theory that investors get rewarded for risk through a higher return.  It is a beguiling theory.  After all, if risk is rewarding, who wouldn’t prefer more of it instead of less?  The fallacy in this thinking should be apparent from the crisis around us, from excessive leverage on Wall Street and Main Street to high-risk investment strategies.   Replacing the theory should be this reality:  Increased risk mostly means a greater chance of losing money instead of making it.

Despite the theory, this inverse relationship between risk and return has played out over most of our adult lifetimes, not just the current crisis.  This is shown in the attached graphs, which plot the risk of a 12-month loss versus the “growth of a dollar” using our investment approach, the nine Russell style-box indices (small/mid/large; growth/value) and the S&P 500.  The periods shown include the past decade and 22.75 years since our inception in 1986.  The indices with higher risk of loss (toward the right) generally provided lower growth of capital, meaning an inverse relationship between risk and return.    Arguably, part of the explanation for our own high returns was our much lower risk of loss over the years.  

Portfolio Changes
The changes in the economic and credit environment plus dramatic stock price changes have resulted in higher than normal activity on our part.  Here is a brief summary of our actions during the quarter. 

1. Sales – We sold our Anheuser Busch (except where gains were short-term) since it was trading close to the InBev acquisition price.  As the credit environment continued to tighten, we sold our positions in companies with greater exposure to debt, leases, or commercial paper rollover risk, including Lee Enterprises, Office Depot, Gannett and GE.  Finally, as banks rallied on hopes for the bail-out bill, we sold our position in Comerica.
2. Purchases – Our purchases were principally in businesses well protected from the business cycle unfolding, including such firms as Dr. Pepper, Unilever, Molson Coors, and Verizon.  Meanwhile, we continued to slowly increase our exposure to the financial sector, adding a position in American Express.  Finally, we added a new position in Target (which had fallen in price), using funds from a trim of Wal-Mart (which had risen in price).

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)

¹For Financial Professional Use Only.  Not approved for presentation to wrap program clients.  Such presentations should reflect EIC's wrap composite information. Performance figures are for the quarter and year-to-date ending September 30, 2008.  All figures are gross of management fees. EIC results reflect EIC's composite of discretionary non-wrap All-Cap Value equity accounts.  EIC Net returns (after management costs and commissions) were:

All returns include reinvestment of dividends and interest.   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 from those of the composite.  EIC's compliance with the GIPS@ has been verified firm-wide by an independent firm.  A copy of the verification report, along with a complete list of EIC’s composites, is available upon request.

All-Cap performance presentation