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   Interview

    Guest Interview:

   EDMP, Inc.

    18534 Dale Mabry Hwy N
    Lutz,FL 33548

    Telephone: 813-960-9600
    Fax: 813-960-9609
    E-mail: juliec@edmpinc.com

 

    Interview Quarter: 3Q2008

 Chuck Carnevale

 Chief Investment Officer

  Please describe the background of Great Companies. Inc.  
  Great Companies, Inc. is a registered investment advisor headquartered in Tampa, Florida. The firm was founded by Chuck and Julie Carnevale in 1992 originally under the name EDMP. The core members of our investment team have worked together managing assets since our inception. We manage money under a strict investment discipline that has been consistently applied since our origin.  
  What is your firm’s investment philosophy?  
  At its core our investment philosophy is straightforward and sound. Very simply stated, our objective is to invest in the highest quality, fastest growing, most successful businesses we can identify, but only at prices or values that make economic sense. In order to make economic sense, a company must be priced at a level where its expected (forecast) earnings and cash flows represent an attractive return on our investment. Our underlying thesis is that earnings determine market price in the long run. Furthermore, a faster growing company is and will continue to be more valuable than a slower growing one. We call our approach business perspective investing, which implies investing by the numbers. Our philosophy is based on the timeless principles of business, economics and accounting. We never try to guess what the stock market or the individual price of a stock might do as we see that as an exercise in futility. Instead we concentrate on the more reliable exercise of calculating the True Worth™ or intrinsic value of an operating business and invest accordingly. Commonsense dictates that it’s far easier to calculate the worth of a well-run company than it is to guess how the emotional makeup or behavior of crowds may cause investors to act in the short run. Our goal is to protect and grow wealth. Therefore, the primary objective of our firm’s investment policy is first and foremost to protect our clients’ money while safely growing assets over time.

We achieve this objective by adhering to the following principles:

First, we invest only in great companies that are industry leaders with proven track records of operating excellence. Second, understanding the importance of valuation and only purchasing stocks we believe are priced at or below their True Worth™. Experience has proven that most of the money is made using a sound buy discipline. Third, we sell great companies that we like, but are trading well above their True Worth™. We realize that even great companies can become dangerously overvalued. Fourth, we avoid deeply cyclical companies whose earnings are erratic. We consider these to be trading stocks rather than securities in which to invest for the long term. We are investors, not speculators. Fifth, adhering to our sound investing principles and having the conviction to stay the course through both bull and bear markets. Occasionally, we will sell a stock that is overvalued relative to its True Worth™, but whose market price is still rising. Since equities eventually revert to their True Worth™, and we believe that market timing is a less than perfect science, we have found this to be a prudent way of protecting client assets over the long term. Sixth, we know our companies extremely well by investing significant intellectual capital and resources to clearly understand each of our great companies. Finally, we provide diversification within a concentrated portfolio. We balance our portfolios and avoid allocating too much of the portfolio to a particular sector or idea. We take our responsibility to protect and grow client wealth seriously. Our interests are directly aligned with those of our clients. We strive to ensure that every relationship is both long and prosperous.
 
  How would you define a “great company”?  
  As money managers, for us to deem a company as great, it must simultaneously be a great investment past, present, and future. Therefore, a great company is an industry-leading company, i.e. a top grower and formidable competitor in its sector. We believe that success leaves clues and great success is rarely accidental. Therefore, we screen for consistent above-average earnings growth of 15 to 20% per annum for a minimum of three years but preferring five years or more. Most companies we invest in have achieved superior and consistent earnings growth for even longer periods of 10, 15 and 20 years or longer. These superior operating attributes by their very nature define great. Normal side effects that these companies typically possess are very strong financials. They will have excellent balance sheets, generate a lot of free cash flow with high returns on capital, etc. Great companies are strong and powerful enterprises that are a cut above the average or typical enterprise, not only within their industry, but against all companies at large. In addition to sound financials mentioned above, there are other common traits that truly great companies will possess. A great company will have an excellent management team, led by a terrific CEO. Their outstanding business models are normally protected by strong barriers to entry or moats. In the modern world, a global presence is an opportunistic advantage. Great companies are innovative, understanding that if they are not growing they are in effect dying. Finally, great companies are good citizens that treat their customers and their people well while operating honest businesses.  
  What does the term investment “value” mean to you?  
  The investment value of any investment is derived from the amount of cash that the entity is capable of generating for its stakeholders. On a historical basis, our proprietary Fundamental Analyzer™ research has clearly validated the voracity of that statement. What our research has revealed is what a commonsense assumption would indicate. The higher the level of cash flow an investment generates, the higher its worth or value, and vise-versa. Therefore, in order for a company (a stock) to hold investment value for us, its implied cash flows must calculate to an acceptable rate of return that compensates us for the risk we are assuming. In other words, utilizing analytical methods we make our most educated forecast regarding future earnings and cash flows and calculate the rate of return those flows represent at cost of investment. If that calculation represents an expected 15 to 20% above-average return on our investment, then we are interested and motivated potential investors. If that calculated return is less than that, then we either forgo or wait until values become more attractive.  
  When does a great company become either undervalued or overvalued?  
  There are complicated and extensive answers to this critical question that are beyond the scope of this interview. Fortunately, there are also simple and straightforward answers that reflect the essence of the importance and principles of valuation itself. Our research utilizes a barometer we call the EYE ratio. EYE is an abbreviation for Earnings Yield Estimator. We simply compare investing $100,000 into a 10-year treasury bond at today’s rates and compare this 10-year income stream to the same $100,000 invested in a respective company. If the total stream of income from the expected forecast earnings of the company is not at least two and a half times greater than what we can earn without risk in a T-bond, then the investment doesn’t make economic sense. At anything less than these levels (2.5 times T-bond interest) we feel that we would not be adequately compensated for the risk we would be taking.  
  Is there an investment formula you use to identify promising companies?  
  The PEG ratio (PE = growth rate) is the formula that we rely on most because of its relevance and importance towards calculating True Worth™ valuation. The principles behind the PEG that makes it important are critical components that also differentiate investing from speculating. First, all available investments compete for investor capital. Categorically, the only real options are equity versus debt. Sometimes this is referred to as ownership versus loanership. Next, all investments command a value that is greater than the annual income it produces. Put another way, all investments are worth more than one times earnings. For example, a 5% bond is technically trading at 20 times interest (cash flow). The correct multiple of earnings to apply to a stock is relative to the computation of the size of the future income stream it can produce. This in turn is a pure function of the rate of change by which it can grow earnings. Under the laws of compounding there is a geometric increase in the total size of the future income stream at higher rates than at lower rates. To illustrate, a 10% grower will double a dollar’s worth of earnings every 7.2 years, whereas a 20% grower will double a dollar’s worth of earnings every 3.6 years, or in half the time. Therefore, over the longer term, the income stream from the faster grower is dramatically greater. What this boils down to is that a company is promising to us when its stock price is valued at or below its expected growth rate, as long as that growth rate is 15% or higher. This indicates that we will be rewarded for the risk we are taking, based on our expectation of operating results, rather than guessing where the stock price may or may not go based on short-term buying and selling.  
  What part do earnings play in the performance of stocks?  
  Our Fundamental Analyzer™ software has clearly demonstrated that earnings do in fact determine market price in the long run. More precisely, that rate of change of earnings growth will closely correlate to the rate of return shareholders earn as long as the original investment is made in accordance to the PE = growth rate formula previously discussed. If the PE is greater than the growth rate, the investor returns will be less and vice-versa. Most importantly, when stock prices deviate from their earnings justified level, over or under, they will inevitably return to their mathematically justified levels. The timing may vary, but not the outcome.

See the Fundamental Analyzer™ chart on United Technologies Corp. (UTX) that has an earnings growth rate of 15.6% which created a long-term annualized return of 13.1%. Then look at Stryker Corp., (SYK) a faster growing company with an earnings growth rate of 23.5% that generated a higher long-term annualized return of 22.2%. Faster earnings growth correlates to better long-term returns.
 
  How do you identify companies that trade below their true worth?  
  We are blessed with our proprietary Great Companies Fundamental Analyzer™ software that correlates earnings growth with stock prices on approximately 13,000 companies in the S&P Compustat database. This powerful fundamental tool is programmed to screen and list those companies that meet all of our criteria including valuation. Once screened, our software lists the candidates based on a valuation to growth rate ratio in order of highest future return to lowest. Once again, take note of the Fundamental Analyzer™ charts to see evidence that when a company’s stock price goes above or below its earnings justified level, it inevitably goes back to its earnings justified level. The two companies have traded above and below their True Worth™ over time and both UTX and SYK are currently trading below their historical True Worth™ therefore indicating great buying opportunities.  
  With the turmoil in the markets, how can you be confident in the consistency any companies’ future earnings?  
  First of all, it is our policy to invest in best of breed companies that have produced results above market and above general economic growth. These companies possess strong fundamental underpinnings that set them apart from the crowd. To us, in times of turmoil it makes even more sense to own the strongest and best capitalized companies available. Who else would be better positioned to weather the storm? We draw our confidence from our companies’ strengths.

This is not meant to imply that we don’t acknowledge a potential softening in the short-term business prospects of many of our holdings if we experience a recession or general weakness. However, falling commodity prices will help to mitigate weaker sales through increasing higher margins due to lower costs of goods. Also, the long-term growth prospects of most of our holdings are driven and established far in excess of broad economic growth. In many cases our holdings’ strong competitive advantages could translate into greater market share and accelerated growth as general economic conditions improve.
 
  Would you describe yourselves as a top down or bottom up manager?  
  We are a bottom up, fundamental manager that builds our portfolios one company at a time. The above-average business prospects our great companies generate is what we primarily look for in order to drive future returns. Our research validates that above-average long-term returns are directly proportionate to the operating returns of the individual enterprise and less so correlated to the general market or economy.  
  What is the average holding time for your investments and how much turnover do you typically experience?  
  With our business perspective on investing we ideally endeavor to hold a position for at least a full business cycle (3 to 5 years). In simple terms, we buy a dollar’s worth of earnings today that we expect to grow to two dollar’s worth of earnings in 3 to 5 years. Having that larger pool of future earnings for the market to capitalize is the foundational principle of our strategy. Therefore, we anticipate keeping turnover to a minimum (under 50%) assuming market volatility permits. We will sell if the market dangerously overvalues a holding in excess of what future earnings expectations would dictate, or if fundamentals deteriorate so that our original growth expectations are no longer achievable.  
  What part do industry sectors play in your analysis?  
  We do believe in being broadly diversified within a concentrated portfolio of 35 names. However, since we covet consistent and sustainable above-average growth, we avoid sectors that are highly cyclical. Therefore, we are only interested in industry sectors that are comprised of companies that portend exceptional long-term future growth. We avoid momentum plays and we do not attempt to time investments based on short-term price action.  
  How has globalization affected the way you analyze investments?  
  Globalization is very important because it offers expanded growth potential and diversification benefits. However, we choose to invest mainly in domestically based companies that do substantial business internationally. Therefore, most of our large-cap companies are multinational in scope deriving 40% or more of their sales and profits internationally. We like the comfort of greater transparency and regulatory protection that the U.S. system provides. However, we will invest in the occasional ADR if great opportunity is apparent. Although we do believe in the concept of a global economy, we additionally believe that we can just as readily find competitively attractive growth opportunities here in the U.S. as we could anywhere in the world.  
  How do you manage risk?  
  At Great Companies, Inc. we do not equate risk with volatility as many investors do. To us real risk is associated with valuation discrepancies. Overvaluation represents the greatest risk of all, yet it is mostly ignored. We contend, and the evidence is very compelling to validate this contention, that most investor losses are caused by so-called good or bull markets and not the other way around. In other words, overvaluation exposes both individual stocks and markets to extreme risk from even the slightest hiccup. Furthermore, we see a strong and clear distinction between prices falling from excessive overvaluation versus a price falling from fair value to cheap. With the former, recovery may never come or at best take an unacceptably long time. On the other hand, a company that has become a bargain will recover swift and sure.

At Great Companies, Inc. we place great emphasis on calculating the True Worth™ of a company based on fundamentals and cash flow realities. We see this as a much more intelligent and achievable process than attempting to guess what price movements might be.

Therefore, we believe that the surest way to control risk is to first get valuation right, then make sure your holdings have solid earnings supporting them. We do not believe that the market is always efficient, however, we do believe that it is always seeking efficiency. Therefore, it’s inevitable that a company (stock) will seek its economically justified level.

In conclusion, we are confident that the best way to control true risk is to build our portfolios upon a sound foundation of assets and earnings power. In addition to keeping valuation in line, we also diversify across various industries and businesses. Ultimately, it boils down to comprehensively and as thoroughly as possible researching each and every holding. Managing a concentrated portfolio of only 35 names facilitates this process.
 
  How do you go about doing your research?  
  We begin by utilizing our Fundamental Analyzer™ software to screen for companies that have the appropriate earnings growth power which are also fairly or undervalued. From this select list of candidates we conduct a thorough and comprehensive research effort. Our research sources include Reuter’s Knowledge Base, Standard & Poor’s Compustat, Value Line, SEC filings, internet sources and sell side research. Importantly we spend a great deal of time on each of our company’s websites and listen to each of our company’s earnings conference calls each quarter. Our primary objective is to establish an educated and reasonable forecast for future earnings growth. This is an ongoing and never ending process at our firm.  
  How have the Internet and the growth of rapid financial information changed the way you do your research?  
  Most of our research is based upon the long-term (3-5 year) prospects of growing businesses. The Internet has made this information, as well as short-term information, readily available on an as-needed basis. Anything that happens in the world is immediately available in the short-run. Our long-term view allows us to take advantage of short-term negative or positive news to our clients’ benefit. When we see short-term stock price moves that do not reflect our long-term view of the company, we take advantage of the current situation. We do not attempt to time the market, but we do intend to take advantage of short-term irrational stock price volatility. The Internet has greatly added transparency to this process.  
  Are you always completely invested or do you ever raise cash in your portfolios and do you ever adjust your portfolios to the clients’ objectives?  
  It is our policy to be fully invested at all times. As pure money managers, we leave asset allocation decisions up to the client and/or their other professional financial advisors. Also, our experience has proven that in every market whether bull or bear there will nevertheless be overvalued, fairly valued or undervalued choices available. It’s our responsibility to separate the wheat from the chaff.  
  Who are the other members of your firm and what are their backgrounds?  
  In addition to me, Julie C. Carnevale, Co-Founder/President has extensive industry experience beginning in 1982. In addition to co-founding the firm, Julie was instrumental in developing our Fundamental Analyzer™ software that serves as the backbone of our investing philosophy. Prior to forming Great Companies, Inc., she was a partner in a 30-year-old established registered investment advisory in Tampa, Florida that invested under the same disciplined philosophy that we utilize today.

Timothy W. Loudin
– Senior Vice President – Portfolio Manager, has worked as a computer systems analyst and computing instructor for MBA candidates at West Virginia Wesleyan College. In addition to creating and maintaining a wide range of software for a combined base of over 500 users (including interactive digitized speech), he has developed proprietary systems software for Great Companies, Inc. Tim previously instructed business and computer science at Glenville State College and performed business/computer consulting for small businesses. His insights and knowledge of technology are very useful in analyzing future growth. Most importantly, this team has been together since the inception of our firm.
 
  How can investors find out more about Great Companies, Inc.? Do you have an email list for those interested in receiving your quarterly reports?  
  They can contact Polly at 813-251-3055 or email her at pollyc@greatcompanies.com or for more information they can log on to www.greatcompanies.com.  
  The first graph: 14 Year Performance should have this on the bottom:  
  GRAPH 1: The Great Companies Fundamental Analyzer™ historical Graphs (top) overlays stock prices to the companies’ earnings multiplied by its EPS growth rate. Either the earnings line () or the normal PE line () represents intrinsic value based on cash flows. When the price touches this line it’s at value, when below this line it’s undervalued, when above the line it is overvalued. The chart on the bottom simply calculates returns over the period measured as compared to the S&P 500 index, and illustrates the correlation of shareholder returns to the company’s business results adjusted for valuation.  
 
 
  The second graph: 20 Year Performance should have this on the bottom:  
  GRAPH 2: The Great Companies Fundamental Analyzer™ historical Graphs (top) overlays stock prices to the companies’ earnings multiplied by its EPS growth rate. Either the earnings line () or the normal PE line () represents intrinsic value based on cash flows. When the price touches this line it’s at value, when below this line it’s undervalued, when above the line it is overvalued. The chart on the bottom simply calculates returns over the period measured as compared to the S&P 500 index, and illustrates the correlation of shareholder returns to the company’s business results adjusted for valuation.  
 
 
 
 
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