Copyright NAIC 2005 Portfolio Management An Overview of NAIC’s Complete Plan for Managing Your Stocks

NAIC’s Big Picture Have you ever wondered how the SSG, SCG, PMG, PERT, Challenger, “The Rule of Five”, & the rest of NAIC mythology fit together in one cohesive system? Have you ever wondered how the SSG, SCG, PMG, PERT, Challenger, “The Rule of Five”, & the rest of NAIC mythology fit together in one cohesive system? Follow us through a simple journey with these five steps of gardening your portfolio. Follow us through a simple journey with these five steps of gardening your portfolio.

The Five Simple Steps 1. Planning – set your goals in writing 1. Planning – set your goals in writing 2. Planting – select your stocks 2. Planting – select your stocks 3. Weeding – sell your losers AKA Defense 3. Weeding – sell your losers AKA Defense 4. Feeding – care for the sick and feed the winners 4. Feeding – care for the sick and feed the winners 5. Pruning – trim the overgrowth and improve quality AKA Offense 5. Pruning – trim the overgrowth and improve quality AKA Offense

Planning

Planning Whether you have a vegetable or a flower garden you’ll do much better with a plan. Whether you have a vegetable or a flower garden you’ll do much better with a plan. You’ll have to decide which plants you want and how much and how many vegetables or flowers you need. You’ll have to decide which plants you want and how much and how many vegetables or flowers you need. You need a plan for your portfolio too! You need a plan for your portfolio too!

Planning NAIC Tools: NAIC Tools: 1. Invest regularly 1. Invest regularly 2. Invest in growth stocks 2. Invest in growth stocks 3. Reinvest dividends 3. Reinvest dividends 4. Diversify 4. Diversify 5. Challenge to improve quality & return 5. Challenge to improve quality & return

Planning One plan will not be right for everyone. One plan will not be right for everyone. One plan might not be right for one person for their entire life. One plan might not be right for one person for their entire life. Make sure your plan fits your goals. Make sure your plan fits your goals.

Sample Plan 1. Invest regularly. Market timing is a fool’s game. 1. Invest regularly. Market timing is a fool’s game. 2a. Invest in quality growth stocks that are leaders in their industry/peer group when they are fairly valued by the SSG, selected by the SCG, and fit in my diversification plan. 2a. Invest in quality growth stocks that are leaders in their industry/peer group when they are fairly valued by the SSG, selected by the SCG, and fit in my diversification plan. 2b. Maintain a ‘Watch List’ of high quality stocks to follow. 2b. Maintain a ‘Watch List’ of high quality stocks to follow.

Sample Plan 3. Reinvest all dividends to take advantage of the wealth building, eighth wonder of the world, compound interest. 3. Reinvest all dividends to take advantage of the wealth building, eighth wonder of the world, compound interest. Ellis Traub explains this most clearly by saying “If you don’t reinvest the dividends you’ll need an annual rate of return of 20% for five years to double your money. If you reinvest the dividends you’ll need 15%. 20% isn’t likely. 15% is achievable.” Ellis Traub explains this most clearly by saying “If you don’t reinvest the dividends you’ll need an annual rate of return of 20% for five years to double your money. If you reinvest the dividends you’ll need 15%. 20% isn’t likely. 15% is achievable.”

Sample Plan 4. I will diversify my dollars by 4. I will diversify my dollars by a. Size of Company by sales. Small is 5 B. Medium is in between. I’ll not use a specific ratio, but will use rate of return for the portfolio and realize I’ll need smaller stocks to get higher returns. a. Size of Company by sales. Small is 5 B. Medium is in between. I’ll not use a specific ratio, but will use rate of return for the portfolio and realize I’ll need smaller stocks to get higher returns. b. Industry. I will choose a variety of growth industries. I will use OPS industries. b. Industry. I will choose a variety of growth industries. I will use OPS industries c. Sector. I will not hold stocks grouped in too few sectors. I will use OPS sectors. c. Sector. I will not hold stocks grouped in too few sectors. I will use OPS sectors. d. Number of stocks I hold. I will try to hold between 12 and 20 stocks – (sweet 16 +/- 4) so I will insulate myself from specific stock risk. d. Number of stocks I hold. I will try to hold between 12 and 20 stocks – (sweet 16 +/- 4) so I will insulate myself from specific stock risk.

Sample Plan 5. I will try to achieve a compounded annual growth rate (CAGR) of 15% for the entire portfolio. I will not have a cow if I fall below this level. I realize the overall market returns about 10.5% on average. I will gauge my success by bench marking it against the Wilshire 5000 yearly return. 5. I will try to achieve a compounded annual growth rate (CAGR) of 15% for the entire portfolio. I will not have a cow if I fall below this level. I realize the overall market returns about 10.5% on average. I will gauge my success by bench marking it against the Wilshire 5000 yearly return. 6. I will routinely seek to replace inferior stocks in the portfolio with stocks with equal or better quality (growth and efficiency characteristics) and better return potential. 6. I will routinely seek to replace inferior stocks in the portfolio with stocks with equal or better quality (growth and efficiency characteristics) and better return potential.

Planting

Planting You’ll have to know how to select the best plants for your garden. You’ll have to know how to select the best plants for your garden. You’ll need to be able to recognize a good plant by sight as well as by comparing it to other plants. You’ll need to be able to recognize a good plant by sight as well as by comparing it to other plants. You’ll have to be able to select good stocks for your portfolio too. You’ll have to be able to select good stocks for your portfolio too.

Planting: Goal To select a set of Quality Growth Stocks that are leaders in their peer group/industry when they are valued to add favorably to our portfolio’s desired rate of return. (15%) Tools include: SSG to evaluate individual stocks for quality and potential return. SCG to select the best candidate from each peer group/industry.

Planting: Quality Quality = Growth + Efficiency Quality = Growth + Efficiency Growth Growth Appropriate for size of company by sales Appropriate for size of company by sales Consistent – smooth data lines for sales, PTP, & EPS Consistent – smooth data lines for sales, PTP, & EPS Current growth inline with relevant historic growth Current growth inline with relevant historic growth Forecast future growth acceptable Forecast future growth acceptable Efficiency Efficiency Even or rising trend in section 2A, Pre tax profit margin Even or rising trend in section 2A, Pre tax profit margin

Appropriate Growth Rates Small <$500 M 12% - 20% Medium $500M – $5B 10% - 12% Large > $5B 5% - 10%

Consistent Growth Yes! No!

…growing in line with historical growth? Bed, Bath & Beyond Slide by Lynn Ostrem

Efficiency - Margin Trends Converging “UP” Good Parallel “Even” Good Diverging “Down” Bad On the front of the SSG On the front of the SSG

Efficiency - Margin Trends Or in Section 2A of the SSG Or in Section 2A of the SSG

Efficiency OR with PERT A OR with PERT A Profit Margins

Planting -Valuation B.U.R.T B.U.R.T Buy zone Buy zone US/DS > 3:1 US/DS > 3:1 RV 85% - 110% RV 85% - 110% TR ~ 15% TR ~ 15%

Planting- Comparison Leaders in their peer group/industry. Leaders in their peer group/industry. SCG is used to compare quality and valuation. SCG is used to compare quality and valuation. Growth Efficiency Valuation

Planting You will find great quality stocks that are not favorably priced for purchase. You will find great quality stocks that are not favorably priced for purchase. Consider keeping a “watch list” of these stocks and monitor them for times when they still have quality and are priced favorably for purchase. Consider keeping a “watch list” of these stocks and monitor them for times when they still have quality and are priced favorably for purchase.

Weeding

Weeding Some of the plants in your garden will grow just as you thought they would. Some of the plants in your garden will grow just as you thought they would. Despite your careful research, some plants will not grow as you thought they would. Despite your careful research, some plants will not grow as you thought they would. They become weeds and must be removed. They become weeds and must be removed. Some of your portfolio’s stocks will not grow as you thought, become weeds, and must be removed too. Some of your portfolio’s stocks will not grow as you thought, become weeds, and must be removed too.

Weeding Monitor Quality when new data is available. Monitor Quality when new data is available. Weeding is ALL about making sure current quality is meeting or exceeding your forecast. Weeding is ALL about making sure current quality is meeting or exceeding your forecast. Tools available: Tools available: SSG SSG PERT Report – left side PERT Report – left side PERT Work Sheet A PERT Work Sheet A PERT Worksheet A graph PERT Worksheet A graph Toolkit 5 Defense Report Toolkit 5 Defense Report

Weeding 1st, 2nd, & 3rd quarter results available in 10Q approximately 60 days after quarter’s end. 1st, 2nd, & 3rd quarter results available in 10Q approximately 60 days after quarter’s end. 4th quarter results available in 10K or annual report approximately 105 days after quarter’s end. 4th quarter results available in 10K or annual report approximately 105 days after quarter’s end.

Weeding Many company’s quarters don’t end with calendar quarters. Many company’s quarters don’t end with calendar quarters. ToolKit 5.0 has an automated alert system to remind you. ToolKit 5.0 has an automated alert system to remind you. OPS updates fundamental data and price. OPS updates fundamental data and price. You still must adjust your judgment. You still must adjust your judgment.

Rule of Five Rule of Five For every 5 stocks you purchase using the SSG & SCG: For every 5 stocks you purchase using the SSG & SCG: ONE will do much better than you expected. THREE will perform about as you expected. ONE will do much worse than you expected.

Rule of 5 on the SSG Better About Right Much Worse Forecast Quality/Growth

Quality Monitoring Methods Quality Monitoring Methods Once you understand what quality is and that you are trying to monitor the continuation of this quality, understanding the various PERT reports is much, much easier. Once you understand what quality is and that you are trying to monitor the continuation of this quality, understanding the various PERT reports is much, much easier. So let’s ask “How do I monitor quality with the various PERT reports?” So let’s ask “How do I monitor quality with the various PERT reports?” Answer:: Check growth and efficiency! Answer:: Check growth and efficiency!

Monitoring Quality PERT REPORT compare sales, ptp, & eps to estimated eps growth rate. Also check profit margins. PERT REPORT compare sales, ptp, & eps to estimated eps growth rate. Also check profit margins. Profit Margin Growth

Monitoring Quality With ToolKit 5.0 you can quickly check for a pattern of two successive quarters. With ToolKit 5.0 you can quickly check for a pattern of two successive quarters.

Monitoring Quality PERT TREND - check for two consecutive down quarters PERT TREND - check for two consecutive down quarters 2 good quarters 1 good, 1 bad quarter

Monitoring Quality If you need more detail, consult PERT Worksheet A. If you need more detail, consult PERT Worksheet A.

Growth in PERT A Growth in PERT A

Efficiency in PERT A Profit Margins

Monitoring Quality PERT A graph – look for even or up trends in sales, ptp, eps, & margin PERT A graph – look for even or up trends in sales, ptp, eps, & margin Sales Pre Tax Profit EPS PTP Margin

Monitoring Quality TK 5 defense report TK 5 defense report Compare

Weeding

Weeding Is the problem serious? Is the problem serious? Short term blip Short term blip Long term and serious Long term and serious Stocks with significant quality problems must be watched. Stocks with significant quality problems must be watched. Is it just the company, the industry, or the whole economy? Is it just the company, the industry, or the whole economy? Sell long term, serious problem stocks Sell long term, serious problem stocks

Feeding

Feeding Having gotten rid of the weeds, we are left with a lot of healthy plants and a few plants that aren’t doing quite as well as we’d hoped. Having gotten rid of the weeds, we are left with a lot of healthy plants and a few plants that aren’t doing quite as well as we’d hoped. We’ll want to fertilize both plants to keep them growing. We’ll want to fertilize both plants to keep them growing. With our portfolio we want to carefully monitor the slow growers and reinvest in the healthy stocks. With our portfolio we want to carefully monitor the slow growers and reinvest in the healthy stocks.

Feeding Having examined current quality we have made one of three decisions: Having examined current quality we have made one of three decisions: Bad quality – Sell Bad quality – Sell Problem quality – watch for next quarter(s) and re evaluate Problem quality – watch for next quarter(s) and re evaluate Good quality – proceed to valuation sections 3, 4, & 5 of SSG Good quality – proceed to valuation sections 3, 4, & 5 of SSG

Feeding Problem quality – watch for next quarter(s) and re evaluate. Problem quality – watch for next quarter(s) and re evaluate. Tools: 10Q, 10K, Annual Report, news releases, or call investor relations to find out what is going on. Tools: 10Q, 10K, Annual Report, news releases, or call investor relations to find out what is going on.

Feeding Good Quality – Valuation Good Quality – Valuation Tools: Tools: SSG sections 3, 4, & 5 SSG sections 3, 4, & 5 Right side of PERT Report Right side of PERT Report PMG PMG

Buy – candidate for purchase consideration. Buy – candidate for purchase consideration. Hold – price too high for purchase. Hold – price too high for purchase. Sell – price way too high for purchase, consider replacing with stock of equal or higher quality and greater return potential. Sell – price way too high for purchase, consider replacing with stock of equal or higher quality and greater return potential.

Feeding Good Quality Good Quality Section 3, 4, & 5 of the SSG provides valuation guidance. Section 3, 4, & 5 of the SSG provides valuation guidance. Risk/Reward/Emotion Risk/Reward/Emotion Buy US/DS > 3:1, TR ~15%, RV 85%-110% Buy US/DS > 3:1, TR ~15%, RV 85%-110% Hold US/DS 110% Hold US/DS 110% Sell US/DS 150% Sell US/DS 150%

Feeding -Valuation B.U.R.T B.U.R.T Buy zone Buy zone US/DS > 3:1 US/DS > 3:1 RV 85% - 110% RV 85% - 110% TR ~ 15% TR ~ 15% B.U.R.P if you use PAR! B.U.R.P if you use PAR!

Valuation PERT Report PERT Report Here you’ll only get: US/DS > 3:1 If US/DS > 3:1, then must be in the buy zone Total Return ~ 15% Relative Value 85% - 110%

Feeding PMG – Valuation PMG – Valuation Shows history of Price in zones, P/E, and Relative Value Shows history of Price in zones, P/E, and Relative Value Not used much Not used much

Feeding Dividends should be reinvested to take advantage of compound interest. Dividends should be reinvested to take advantage of compound interest. Need not be reinvested in the stock that generated them. Need not be reinvested in the stock that generated them. New monies should be added on a regular basis. New monies should be added on a regular basis. Invest in quality stocks when valued by SSG to add to the portfolio’s desired rate of return. Invest in quality stocks when valued by SSG to add to the portfolio’s desired rate of return.

Pruning

Pruning Plants can become “Over Grown” two ways. Plants can become “Over Grown” two ways. An individual plant can get too big. An individual plant can get too big. Like a big bush. Like a big bush. A plant can grow to occupy too much room in a garden. A plant can grow to occupy too much room in a garden. Strawberries send out ‘runners’ and spread rapidly in all directions. Strawberries send out ‘runners’ and spread rapidly in all directions. Either may need to be pruned back. Either may need to be pruned back.

Pruning Stocks can become “Over Grown” in two ways also. Stocks can become “Over Grown” in two ways also. P/E expansion - price ahead of EPS P/E expansion - price ahead of EPS Stocks from our last session whose valuation fell into the “Sell/Hold” zone. Stocks from our last session whose valuation fell into the “Sell/Hold” zone. EPS expansion – stock occupies a disproportionate % of portfolio’s $ due to rapid EPS growth as you expected or were surprised by. EPS expansion – stock occupies a disproportionate % of portfolio’s $ due to rapid EPS growth as you expected or were surprised by.

You may wish to prune either of these stocks back to a more desirable size by selling a portion of the holding and reinvesting the proceeds. You may wish to prune either of these stocks back to a more desirable size by selling a portion of the holding and reinvesting the proceeds. A better method of dealing with EPS expansion over growth is to seek to replace slower growing stocks with stocks of equal or better quality and better expected returns. A better method of dealing with EPS expansion over growth is to seek to replace slower growing stocks with stocks of equal or better quality and better expected returns.

Pruning Tools: Tools: SSG SSG PERT report right, valuation side PERT report right, valuation side PMG PMG ToolKit 5.0 Offense report ToolKit 5.0 Offense report Challenger Challenger

Valuation PERT Report PERT Report Values that will trigger offensive judgment include: Risk – US/DS < 1:1 Reward - Total return << 10% Emotion- RV > 150% Growth < 12%

Pruning Diversification by Dollars Diversification by Dollars 20 stocks, 5% in each stock 20 stocks, 5% in each stock Consider rebalancing when one stock is twice the desired size in dollars, e.g. 10% Consider rebalancing when one stock is twice the desired size in dollars, e.g. 10%

Percentage of Portfolio You should own between 12 and 20 stocks –( Sweet 16 + or - 4) so no stock should be more than 5% to 8% or a max of 10% to 16%. With this 5 stock example, 20% is desirable. You can see that even IF Cisco and Merck had significant return potential, they have become such a large percentage, some should be sold.

Pruning Once you’ve decided to replace an overvalued stock or a slow growing stock the process is the same. Once you’ve decided to replace an overvalued stock or a slow growing stock the process is the same. Let’s look at a slow growing stock, Target. Let’s look at a slow growing stock, Target. We’ll consider replacing it with a faster growing and better quality stock, Walmart. We’ll consider replacing it with a faster growing and better quality stock, Walmart. We’ll factor in taxes and broker fees to see if the switch makes sense. We’ll factor in taxes and broker fees to see if the switch makes sense.

Pruning Challenger Challenger Growth Efficiency Taxes & Broker Fees Return Quality = +

Summary Plan your portfolio with NAIC Guidelines. Plan your portfolio with NAIC Guidelines. Select your stocks with the SSG and SCG to pick the highest quality stocks at a fair value. Select your stocks with the SSG and SCG to pick the highest quality stocks at a fair value. Monitor a ‘watch list’ of high quality stocks. Monitor a ‘watch list’ of high quality stocks. Monitor your stock’s quality with the PERT Reports. Sell the losers. Monitor your stock’s quality with the PERT Reports. Sell the losers. Care for those with quality troubles & reinvest dividends & new monies in the winners. Care for those with quality troubles & reinvest dividends & new monies in the winners. Use the Challenger to seek high quality replacements for lower quality stocks, stocks that have become overvalued, or too large a % of your portfolio. Use the Challenger to seek high quality replacements for lower quality stocks, stocks that have become overvalued, or too large a % of your portfolio.