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Keys to Investment Success

Keys to Investment Success. Lowell D. Pratt Jr., CFA President, The Burney Company. Jack Burney. Founded The Burney Company in 1974 West Point Class of ’46, retired General officer Developed Proprietary, Quantitative Analytical Process in 1950s

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Keys to Investment Success

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  1. Keys to Investment Success Lowell D. Pratt Jr., CFA President, The Burney Company Burney Partners www.burneypartners.com

  2. Jack Burney • Founded The Burney Company in 1974 • West Point Class of ’46, retired General officer • Developed Proprietary, Quantitative Analytical Process in 1950s • West Point issued slide-rule was the state-of-the-art computing device for several decades • 17.9% average annualized rate of return since inception Burney Partners www.burneypartners.com

  3. $133 v. $42 after 30 years… Burney Partners www.burneypartners.com

  4. How Were Returns Created? By Consistently Playing Winning Bets • Asset Allocation • Stocks v. Bonds • Size and Style Allocation • Historically, Small-Cap and Value • Stock Selection • More opportunity than many believe Burney Partners www.burneypartners.com

  5. Stock Return Advantage vs. Bonds • From 1950 to 2002, stocks have nearly twice the return (11.8% vs. 6.2%) • Higher stock returns compensate for greater Short-Term Risk • Defined as either Volatility or Worst-Case Return • But, Stocks are not necessarily Riskier • Depends upon Investment Time Horizon Burney Partners www.burneypartners.com

  6. Stock and Bond “Risk” v. Time • Volatility is conventional definition of “Risk”, but Worst-Case Return is arguably better • Stocks clearly riskier than Bonds in short run • Stock/Bond risk fairly comparable in the mid run • Stocks less risky than Bonds in the long run Burney Partners www.burneypartners.com

  7. What’s a Share of Stock Worth? • Two “Right” answers • What someone else will pay • Dominant during Bubbles • Less popular during subsequent Bubble-Bursts • The value of an anticipated earnings stream discounted to the present • Discount rate determined by prevailing interest rates plus an equity risk premium (ERP) Burney Partners www.burneypartners.com

  8. Valuation Math • What Investors really “Buy” Burney Partners www.burneypartners.com

  9. Why do Stocks Return 12%? • Long-Term Equity Returns Predetermined by Market’s Equity Discount Rate • Composed of two parts: • Long-term Treasury rate • Plus Equity Risk Premium (ERP) • Historically, Discount Rate averages about 12% • Currently 11.7% • Use this to forecast future equity returns Burney Partners www.burneypartners.com

  10. Price vs. Fundamental Worth Burney Partners www.burneypartners.com

  11. Fundamental’s Importance • Observed price largely fundamentally determined • S&P 500 P/V range past 10 years • Low 0.62 (Sep02) • High 1.32 (Mar98) • Average 1.01 • Price Change v. Fundamental Worth Change • R-Square • 1-mo 1% • 3-mo 8% • 12-mo 45% • 36-mo 87% Burney Partners www.burneypartners.com

  12. Enduring Insight "In the short run, the stock market is a voting machine. In the long run, the stock market is a weighing machine." - Benjamin Graham Circa 1930s Burney Partners www.burneypartners.com

  13. “Is Now a Good Time to Invest in Stocks?” • Answer ALWAYS the same: • Long-term Investors – Yes • Short-term Investors – No • Market Timers – ABSOLUTELY NOT! • Market Timing is Ultimate Losers Game • Invest consistently in stocks, or not at all Burney Partners www.burneypartners.com

  14. “The Market” Doesn’t Exist • Stock Market Highly Segmented • Big v. Small • Value v. Growth • Sector: Tech v. Financial • Industry: Computer Software v. Hardware • EVERY index is biased, so no good single market gauge exists Burney Partners www.burneypartners.com

  15. Importance of Size and Style • William F. Sharpe • “Asset Allocation: Management Style and Performance Measurements”, Journal of Portfolio Management, Winter ’92 • Size and Style, assuming broad Sector/Industry diversification, explain 85-90% of portfolio returns • Sector diversification is a key assumption and therefore a 3rd critical determinant of return Burney Partners www.burneypartners.com

  16. Size Relative Returns - Monthly Burney Partners www.burneypartners.com

  17. Size Relative Returns – 3-Year Burney Partners www.burneypartners.com

  18. Style Relative Returns - Monthly Burney Partners www.burneypartners.com

  19. Style Relative Returns – 12-month Burney Partners www.burneypartners.com

  20. The Power of Size and Style Burney Partners www.burneypartners.com

  21. Stock Selection’s Role • NEVER FORGET: • Size, Style and Sector account for 90% of equity return, so only 10% is leftover • Objective is Marginal Return Enhancement • Always treat Stock Selection as the minor variable of return that it is Burney Partners www.burneypartners.com

  22. Burney Stock Selection Process • Periodically “correlate” a factor library numbering over 1,000 (constantly growing) • Proprietary process addresses the question: “Which factors best separate strong and poor performing stocks within like industry groups?” • Models built with 50 most meaningful, most dissimilar factors Burney Partners www.burneypartners.com

  23. Stock Selection “Finds” • Factor composites often better than the parts • GARP – Growth at a Reasonable Price • PARP – Profitability at a Reasonable Price • SARP – Safety at a Reasonable Price • Stock Risk not priced “efficiently” • Defined as poor profitability or financial weakness • Greater Risk should provide excess return, but delivers the opposite instead Burney Partners www.burneypartners.com

  24. Stock Selection “Chaos” Burney Partners www.burneypartners.com

  25. “Chaos” to Portfolio Order Burney Partners www.burneypartners.com

  26. Stock Selection “Don’ts” • View each stock separately • Complementary parts of a portfolio • Chase Speculative Stocks • Poor quality and/or earnings • Inadvertently make Size or Style bets • Make them knowingly • Invest casually • A cutthroat business, requires vigilance Burney Partners www.burneypartners.com

  27. Summary • Stocks Rule and Bonds Drool! • Stocks are NOT riskier than bonds in the long run, just higher returning • Emotion dominates stock-pricing in the short run • ERP gauge of market’s emotional state • Fundamentals dominate long-term stock-pricing • Equity Discount Rate predetermines rate of return • Size and Style are the key performance drivers • 90% variables of equity return Burney Partners www.burneypartners.com

  28. The Possibilities… Burney Partners www.burneypartners.com

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