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2008 Year-End All-Cap Value Commentary
January 14, 2009

A large part of making more wealth over the long-term is losing less during inevitable declines.  Losing less doesn’t just reduce the personal and pocketbook stress, it also makes the climb back to breakeven quicker and less steep.  For example, to recover from a 25% loss takes a 33% increase but a 40% decline requires a 66% gain, while a 60% fall needs a 150% gain.  While losses are never pleasant, we lost less than the market indices and most managers last year, declining 23.4% (gross) versus 36.3% and 37.0% for the Russell 3000 Value and S&P 500 indices, respectively1.

The empirical relationship between making more by losing less and recovering faster is shown in the table below. Approaches with the greatest growth of capital were those that had the smallest drawdowns off their peaks and fastest recoveries, and vice versa.  That largely accounts for why our approach provided higher growth of capital than the style-box indices over the 23 years. Contrary to the broad belief that investors are compensated for taking risk, our experience has been the opposite: Investors are compensated for reducing risk of loss in their portfolio. That is why we believe reducing risk of loss should be a core ingredient in any portfolio asset allocation process or strategy.

EIC All-Cap Value vs. Indices (12/31/85 Through 09/30/08)
Growth of $1, Largest Drawdown, and Months Needed For Recovery ²

But the main approach used to reduce portfolio risk over the past 50 years – diversification – proved largely impotent in 2008 as losses were broad and deep.  If 2008 taught anything, it is to question the validity of any approach to reducing portfolio risk whose focus is not the quality of the underlying asset.  Diversification alone, whether utilizing cap-size, geography, style (value vs. growth), asset class, risk-tranches, or alternative or hedged investment vehicles, proved not only insufficient, but largely useless in reducing risk - unless accompanied by a focus on underlying quality.  

Our focus on the quality of our underlying investments has been the key to our ability to reduce risk of loss over the past 23 years, and especially in 2008.   This was first expressed in our Q2, 1987, letter to clients, as follows:  

“….We attribute {our} success to a disciplined focus on the two ingredients of value – price and quality.  The importance of price needs no elaboration.  But long-term value also requires confidence in the business’ ability to survive and generate a return on the equity invested by shareholders.  This is why we restrict our holdings to issues with {high} financial Quality Ratings…..since such companies generally have the resources to survive.  It is also why we incorporate the dependability of each firm’s earnings in determining our Buy Price.”

Quality holdings not only decline less during downturns, but typically lead recoveries, resulting in our quicker recovery profile shown in the table on page 1.  But quality was harder to discern in 2008, as demonstrated by the unexpected losses in highly respected firms such as AIG, Ambac, Bear Stearns, Citigroup, Countrywide, Fannie Mae, Ford, Freddie Mac, GM, IndyMac, Merrill Lynch, MBIA, Wachovia, WaMu, and many others.  How did we manage to avoid them?

Quality of the underlying business has little to do with revenues, capitalization size, years in business, geographic location, name recognition, nor in any single financial metric, but in all the factors that reduce the chance of being wrong about the firm’s ability to sustain and grow earnings going forward.  For us, discerning quality involves both our value trap avoidance tools, which give us a picture of a firm’s structural and managerial health, as well as our accounting quality due diligence, which gives us a sense of how a company is achieving its earnings and growth. In the case of some firms (e.g., GM, Ford, Circuit City) our value-trap avoidance tools highlighted clear structural and managerial problems and bankruptcy risks.  In the case of the financials, our reviews of accounting and earnings quality exposed clear risks to earnings due to under-reserving for losses and unsustainable lending practices (discussed in previous quarterly letters, attached) and balance sheet risk due to questionable asset quality and excessive leverage.

Looking Forward
We are presented with an environment full of uncertainties, fear and potential opportunity. While we have no ability to predict the future, it is worth a brief review of the current environment.  As Lincoln said, “If we could first know where we are, and whither we are tending, we could then better judge what to do, and how to do it."

To begin, we reached our current situation through a long period where risk-taking was not only accommodated, but encouraged, by both the Federal Reserve and elected government officials through rapid credit creation and lax regulatory standards. Asset bubbles were one obvious manifestation of these policies.  Less obvious, but more serious, was the cumulative effect of poor allocations of capital by society at large.  Contrary to the impression while still on-going, credit cycles do not create capital for society (though profits are earned).  Rather, they destroy capital through losses resulting from poor capital allocation decisions made with insufficient allowance for risk.  That is what we have now experienced – a tremendous loss of capital in our economy.

It is this capital loss that society now looks to government to offset.  Government’s ability to properly gauge the amount of response needed, however, presents low odds at best.  The most likely result is the government’s response will not get it just right, but rather will err - either too much or too little.  It is this prospective environment of either too much or too little, that we seek to navigate as successfully as we can via our investment decisions today.

To protect against the “too little” side (meaning further economic deterioration), we continue to stress financial quality and earnings sustainability in a large portion of our portfolio.  Hence our large exposure to consumer staples, insurance, and health care.  However, to protect against the “too much” side (meaning quick recovery and/or rapid inflation), we hold positions in firms whose operating margins will benefit from higher commodity costs (oil and gold), and are beginning to look into other areas that would benefit from recovery and inflation, such as chemicals and REITs.  We don’t believe we can get it “just right” ourselves given the uncertainty before us, nor do we think that is the proper investment objective (though fair game for speculators).  Instead, our hope is to continue to produce strong returns with as little downside risk as possible.

An underlying conclusion guiding our decision-making today is that regression to the mean – often valid in more steady economic environments - is not a valid assumption here.   That is why we continue to avoid many cyclical stocks such as retailers and industrials, where margins and returns on capital of the recent past are unlikely to be repeated.  Likewise, as the financial system and consumers pursue de-leveraging, we believe most financial firms will be unable to return to past levels of growth and profitability, and will also suffer additional write-offs to reflect poor lending decisions of the past.  That is why we have been reluctant to buy fallen financials unless they are selling close to tangible book value, the assets comprising book value appear reasonably sound, liquidity and capital is sufficient for current operations, and leverage is modest.   

Tax Management
In taxable accounts, we try to harvest losses periodically during the year, usually by doubling up on a security we believe in, waiting 31 days, and then selling the original high-basis stock.  This has been particularly beneficial in reducing client taxes.  Over a typical 5-year period over 90% of our net gains (after offsetting losses) have been long-term, and our tax efficiency has been about 86% or higher.3 With the market’s fall in October and November, we engaged in an unusually large number of tax-related trades to harvest losses in 2008.  This resulted in high turnover among taxable accounts but captured losses that have value in that they can be carried forward to offset future gains. 

Portfolio Review
During the quarter, we aggressively purchased quality stocks that had fallen in price and ended the year fully invested.  In addition, we redeployed cash from investments that had held up relatively well and had more limited upside (such as NTT Docomo, Consolidated Edison, Kimberly Clark and Wal-Mart), to purchase companies that we thought offered both safety and compelling valuations due to price declines (Alliant Energy, Sigma Aldrich, Pepsico, Intuit, Barrick Gold).  We also added to our positions in various companies as prices fell in October, including Duke Realty, Diageo, and several energy stocks (Conoco, Cimarex, and Nabors Industries).

Conference Call
A replay of our year-end conference call has been posted to our website under the Presentations tab.  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)

Marketing Contact:  John Stewart (jstewart@eicatlanta.com) or call 877-342-0111

¹ For Financial Professional 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. EIC returns after manager fees were -23.9% for the year ending December 31, 2008. All returns include reinvestment of dividends and interest.  Index returns exclude fees and commission costs. 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.

² All figures cover periods beginning December 31, 1985 and ending September 30, 2008.  Growth of a dollar assumes a beginning dollar grows by reinvesting back into each strategy monthly. The largest drawdown reflects the largest decline from a prior peak to subsequent trough.  The # Months Back to Even reflects the longest number of months from a subsequent trough before recovering back to a previous peak.  Figures with + had not returned to previous peak yet as of December 31, 2008. Since 1986 after fees, EIC’s Growth of $1 was $11.55, largest drawdown was -26%, and most # months for recovery back to even was17. All returns include reinvestment of dividends and interest.  Index returns exclude fees, commissions, and management costs.

³ EIC’s realized gains are determined 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).  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. 

EICQuarterly Commentary Excerpts Since 2005

Quarter 1 – 2005
“our primary message …. 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.”  

Quarter 2 – 2005
“We do know growth in recent years has been unusually imbalanced, achieved through reliance on increasing debt by U.S. consumers and government.  It is this imbalance that we are trying to protect against.”

Quarter 1 – 2006
“We accept this difference between our holdings and those of the indices as part and parcel of what we do for clients.  To be clear, we do not believe our role is to simply generate the highest returns for clients in a given quarter or year….nor is it our role to track a style-box index…Instead, our goal is to provide strong absolute and relative returns over a market cycle, while doing so with relatively low risk, as defined by frequency and magnitude of loss.”

Quarter 3 – 2006
“Short-term, however, the ability of the economy to sustain growth is the greater issue.  Consumer and government borrowing have been too high, and in each case, the reality of risk and the consequent relevance of prudence, have been disregarded.  This is why we have sought to own stable companies whose earnings are less dependent on debt-based spending. “

Quarter 1 – 2007
“Meanwhile, economic strength was built upon strong monetary and spending stimulus by the government, along with consumer borrowing based on low interest rates and rising house prices.  None of these seem likely to be as stimulative going forward when compared to the last 5 years.... Our experience has shown that protection has to be built into portfolios long before it is needed.”

Quarter 3 – 2007
“We viewed the borrowing boom as unsustainable and potentially dangerous, and sought to minimize our exposure.  That is why we decided not to buy subprime lenders such as Courntrywide, Citigroup and H&R Block, asset-backed guarantors such as Ambac and MBIA, and investment banks such as Bear Stearns and Goldman Sachs…..we sold our position in Allstate due to concerns regarding the quality of their investment portfolio”

All-Cap performance presentation