1. © 2004 LifeCycle Returns, Inc. All Rights Reserved - 1 - LCRT VALUE AUDIT OF AN APPROVED LIST By Rawley Thomas President LifeCycle Returns, Inc. July 14, 2004 Rawley@LCRT.com LCRT Value Audit of An Approved List 7-18-04.ppt

2. © 2004 LifeCycle Returns, Inc. All Rights Reserved - 2 - Sources: Financial Statements and Price Data – CapitalIQ Calculations – LCRT Platform PRESENTATION OUTLINE Nobel Prize Winning Academic empirical evidence on valuation inefficiency and application to LCRT Intrinsic Value Charts LCRT Value Audit Purpose – Change Portfolio Decision Processes Analysis of Approved List for Under (Over) Valued Firms Suggested Changes in Processes Analysis of Approved List Using Other Portfolio Metrics

3. © 2004 LifeCycle Returns, Inc. All Rights Reserved - 3 - Sources: Financial Statements and Price Data – CapitalIQ Calculations – LCRT Platform IN A CAREFULLY CONTROLLED EXPERIMENT IN AN ECONOMICS LABORATORY, VERNON SMITH et. al. DEMONSTRATES SIGNIFICANT DIFFERENCES OF TRADED PRICES FROM KNOWN INTRINSIC VALUES IN VOILATION OF THE EFFICIENT MARKETS HYPOTHESIS (Vernon Smith won the Nobel Prize for this and other work.) Vernon L. Smith, Gerry L. Suchanek, and Arlington W. Williams, “Bubbles, Crashes, and Endogenous Expectations in Experimental Spot Asset Markets,” in Vernon Smith, Papers in Experimental Economics, Cambridge University Press, Cambridge, 1991, pp. 339- 371, chart from p. 352.

4. © 2004 LifeCycle Returns, Inc. All Rights Reserved - 4 - Sources: Financial Statements and Price Data – CapitalIQ Calculations – LCRT Platform NOTICE THE SAME PATTERN IN AN INTRINSIC VALUE CHART WHICH ENABLES US TO VISUALIZE THE MEASUREMENT OF ACCURACY OF A DCF MODEL PRICE LEVEL USING ONLY ACTUAL REPORTED FINANCIAL DATA AND THE SAME GLOBAL PARAMETERS ACROSS THE ENTIRE UNIVERSE TO DRIVE A MECHANICAL LIFE CYCLE FORECAST OF CASH FLOWS FOR EACH COMPANY Notice the large high low variation around the intrinsic valuations, providing opportunity for profitable trading The Absolute “Tracking” Error Intrinsic Value vs. Actual Equals the Absolute Geometric Mean Error Between The Intrinsic Value Red Line And Closing Prices at Fiscal Year + 3 Months (hollow circles) Over the Number of Years Forecasts reflect the combination of Analysts’ Consensus Sales and EPS Estimates Combined With the LCRT DCF Model, Assuming the Same Capital Turnover and Non-Earnings Margins of the Most Recent Historical Year, Discounted to the Most Recent Month

5. © 2004 LifeCycle Returns, Inc. All Rights Reserved - 5 - Sources: Financial Statements and Price Data – CapitalIQ Calculations – LCRT Platform LCRT VALUE AUDIT PURPOSE: CHANGE PORTFOLIO DECISION PROCESSES Universe –1,000 Largest Companies by Market Cap Approved List –84 Firms Change Decision PROCESSES by providing quantitative feedback on the valuation metric characteristics of the companies currently included in the approved list compared to the Universe of firms from which that portfolio was drawn

6. © 2004 LifeCycle Returns, Inc. All Rights Reserved - 6 - Sources: Financial Statements and Price Data – CapitalIQ Calculations – LCRT Platform MARKET CAP WITH TICKERS Methodology –Sort companies by key portfolio metric (market cap here) –Plot each firm’s position within the cumulative distribution against the portfolio metric –Compare portfolio distribution against the universe from which it was drawn (next slide) Approved List

7. © 2004 LifeCycle Returns, Inc. All Rights Reserved - 7 - Sources: Financial Statements and Price Data – CapitalIQ Calculations – LCRT Platform THE APPROVED LIST FAVORS MOSTLY LARGER FIRMS Approved List Universe

8. © 2004 LifeCycle Returns, Inc. All Rights Reserved - 8 - Sources: Financial Statements and Price Data – CapitalIQ Calculations – LCRT Platform USING THE LCRT DCF MODEL, 57% OF THE APPROVED LIST IS OVER-VALUED AND 72% (100- 28) IS MORE OVER-VALUED THAN THE UNIVERSE Any one of the following three hypotheses could be true: –1. Approved List may pick more “losers” than “winners” –2. OR Approved List may pick more “winners” than “losers” –3. OR Employing both the Approved List and LCRT’s valuation may pick more “winners” than “losers” Empirical Tests to distinguish which Hypothesis of the three is most true –Translate each dimension of the beliefs used to produce the Approved List into testable valuation models –Back test each model’s accuracy and predictive capability –Test combination of Approved List implicit valuation models and LCRT Feedback from the empirical results will improve the stock selection PROCESS Approved List Universe 57 28 = 100 – 72

9. © 2004 LifeCycle Returns, Inc. All Rights Reserved - 9 - Sources: Financial Statements and Price Data – CapitalIQ Calculations – LCRT Platform REVIEWING THE TICKERS OF THE UNDER (OVER) VALUED FIRMS SHOULD HELP PORTFOLIO MANAGERS RE-EVALUATE THEIR IMPLICIT VALUATION BELIEFS Review each company to determine why it was selected for inclusion in the Approved List Translate the reasons into implicit valuation models for empirical testing Try the discipline of picking a “loser” for every “winner” based on a detailed analysis of each firm’s competitive strategy, business model, and management processes to extend the possibility of longer holding periods for each stock purchased Each week, month, and quarter, assess whether the “winners” and “losers” are on track with the strategic analysis based on earnings revisions and surprises Measure daily and weekly market sentiment to determine if firm prices are signaling discontinuous fundamental change OR are just noise around intrinsic valuations Approved List

10. © 2004 LifeCycle Returns, Inc. All Rights Reserved - 10 - Sources: Financial Statements and Price Data – CapitalIQ Calculations – LCRT Platform A BETTER EXPLANATORY MODEL IS MORE PREDICTIVE R 2 = 0.473 N = 2,752 OLS Least Absolute Deviation LCRT Intrinsic Value Model These results support the intuition of HOLT’s clients, who in the late 1980’s said, “I only employ the model for buy/sell decisions when it tracks well.” “Few strokes separate the best from the worst professional golfers.” Like golf, lower scores indicate more accuracy. This chart violates the instantaneously efficient market hypothesis. It represents an “anomaly” consistent with behavioral finance theory.

11. © 2004 LifeCycle Returns, Inc. All Rights Reserved - 11 - Sources: Financial Statements and Price Data – CapitalIQ Calculations – LCRT Platform REVIEWING THE TICKERS OF THE UNDER (OVER) VALUED FIRMS SHOULD HELP PORTFOLIO MANAGERS IDENTIFY BUY AND SELL CANDIDATES Determine if the LCRT DCF model can be trusted for a particular firm by reviewing the tracking errors on the intrinsic value chart based on the following super sector medians for cutoffs –< 30-50% for Industrials –< 10-20% for Banks –< 20-30% for Non-Bank Financials and Utilities If the tracking error exceeds the cutoff, determine if other firms in the same industry or with the same economic characteristics track poorly –Determine reasons why Company specific data OR General pattern affecting the LCRT DCF Model Structure –Employ company specific overrides to test hypotheses to improve tracking OR Rely on other non-LCRT valuation techniques –Please provide these analyses and insights to LCRT for further research and enhancements to the Platform To find additional buy and sell names for review, use LCRT Extract to filter companies satisfying your universe screen and tracking errors under the super sector cutoffs

12. © 2004 LifeCycle Returns, Inc. All Rights Reserved - 12 - Sources: Financial Statements and Price Data – CapitalIQ Calculations – LCRT Platform COMBINING FREE CASH FLOW AND LCRT SCREENS SEPARATE “WINNERS” FROM “LOSERS” BY 17.0% = (-.45-(-17.50) AND ILLUSTRATES HOW VALUATION BELIEFS UNDERLYING THE APPROVED LIST MIGHT BE COMBINED WITH LCRT TO ACHIEVE GREATER RESULTS THAN EITHER SEPARATELY FCF “Winners” & LCRT “Winners” Median = -0.45% N = 7,074 Company-Years FCF “Losers” & LCRT “Winners” Median = -7.74% N = 1,527 Company-Years FCF “Losers” & LCRT “Losers” Median = -17.50% N = 6,320 Company-Years FCF “Winners” & LCRT “Losers” Median = -7.54% N = 2,212 Company-Years

13. © 2004 LifeCycle Returns, Inc. All Rights Reserved - 13 - Sources: Financial Statements and Price Data – CapitalIQ Calculations – LCRT Platform THE DISTRIBUTION OF THE CER FOR THE APPROVED LIST FOLLOWS THE UNIVERSE CLOSELY, MEANING THE PORTFOLIO WILL FOLLOW THE MARKET FOR CHANGES IN THE REAL INVESTOR’S DISCOUNT RATE Approved List Universe

14. © 2004 LifeCycle Returns, Inc. All Rights Reserved - 14 - Sources: Financial Statements and Price Data – CapitalIQ Calculations – LCRT Platform THE APPROVED LIST FAVORS FIRMS WITH LESS CER MOMENTUM THAN THE UNIVERSE Approved List Universe

15. © 2004 LifeCycle Returns, Inc. All Rights Reserved - 15 - Sources: Financial Statements and Price Data – CapitalIQ Calculations – LCRT Platform DUE TO CASH AND INFLATION DISTORTIONS, THE NOMINAL ROCE FOR THE APPROVED LIST EXCEEDS THE UNIVERSE, WHILE THE CER DOES NOT; PORTFOLIO MANAGERS MAY USE THE HIGHER ROCE’S TO JUSTIFY HIGHER VALUATIONS, WHILE THE CASH ECONOMIC RETURNS SUGGEST OTHERWISE Approved List Universe Approved List Universe

16. © 2004 LifeCycle Returns, Inc. All Rights Reserved - 16 - Sources: Financial Statements and Price Data – CapitalIQ Calculations – LCRT Platform DUE TO CASH, INFLATION, AND LEVERAGE DISTORTIONS, THE NOMINAL ROE FOR THE APPROVED LIST EXCEEDS THE UNIVERSE, WHILE THE CER DOES NOT; PORTFOLIO MANAGERS MAY USE THE HIGHER ROE’S TO JUSTIFY HIGHER VALUATIONS, WHILE THE CASH ECONOMIC RETURNS SUGGEST OTHERWISE Approved List Universe Approved List Universe

17. © 2004 LifeCycle Returns, Inc. All Rights Reserved - 17 - Sources: Financial Statements and Price Data – CapitalIQ Calculations – LCRT Platform THE APPROVED LIST POSSESES LONGER PLANT LIVES AND A NARROWER RANGE THAN THE UNIVERSE, SUBJECTING ITS ASSETS TO GREATER RISKS OF BUSINESS MODEL CHANGE AND TECHNOLOGICAL OBSOLESCENCE Approved List Universe

18. © 2004 LifeCycle Returns, Inc. All Rights Reserved - 18 - Sources: Financial Statements and Price Data – CapitalIQ Calculations – LCRT Platform PLANT AGE FOR THE APPROVED LIST IS OLDER THAN THE UNIVERSE, REQUIRING GREATER CAPEX TO REMAIN COMPETITIVE Approved List Universe

19. © 2004 LifeCycle Returns, Inc. All Rights Reserved - 19 - Sources: Financial Statements and Price Data – CapitalIQ Calculations – LCRT Platform A MAJORITY OF P/E’s FOR THE APPROVED LIST EXCEED THE UNIVERSE Approved List Universe

20. © 2004 LifeCycle Returns, Inc. All Rights Reserved - 20 - Sources: Financial Statements and Price Data – CapitalIQ Calculations – LCRT Platform PRICE/EQUITY AND ENTERPRISE VALUE TO BOOK MULTIPLES CONFIRM THE TENDENCY FROM THE LCRT DCF ANALYSIS OF THE APPROVED LIST TO APPEAR OVER-VALUED COMPARED TO THE UNIVERSE Approved List Universe Approved List Universe

21. © 2004 LifeCycle Returns, Inc. All Rights Reserved - 21 - Sources: Financial Statements and Price Data – CapitalIQ Calculations – LCRT Platform Approved List Universe DILUTED EPS AND CASH FLOW PER SHARE GROWTH RATES Approved List Universe

22. © 2004 LifeCycle Returns, Inc. All Rights Reserved - 22 - Sources: Financial Statements and Price Data – CapitalIQ Calculations – LCRT Platform THE APPROVED LIST CONTAINS FIRMS WITH A NARROWER RANGE OF GROWTH RATES THAN THE UNIVERSE Approved List Universe Approved List

23. © 2004 LifeCycle Returns, Inc. All Rights Reserved - 23 - Sources: Financial Statements and Price Data – CapitalIQ Calculations – LCRT Platform FIRMS IN THE APPROVED LIST HAVE A MUCH HIGHER PROPORTION OF FOREIGN SALES THAN THE UNIVERSE, MEANING THE APPROVED PORTFOLIO WILL BE MORE SENSITIVE TO CHANGES IN THE DOLLAR’S VALUE Approved List Universe With higher CER’s than other countries, the USA will continue to attract capital forcing a stronger dollar over time. (Negative trade flows, so much maligned in the liberal press by people who don’t understand the economics, are the balance to the positive capital flows.) Therefore, the outlook for the Approved list is negative in the short term due to dollar variability and negative in the long term due to likely dollar strength.

24. © 2004 LifeCycle Returns, Inc. All Rights Reserved - 24 - Sources: Financial Statements and Price Data – CapitalIQ Calculations – LCRT Platform EXTRA SLIDES

25. © 2004 LifeCycle Returns, Inc. All Rights Reserved - 25 - Sources: Financial Statements and Price Data – CapitalIQ Calculations – LCRT Platform THE APPROVED LIST FAVORS MOSTLY LARGER FIRMS Approved List Universe Approved List Universe

26. © 2004 LifeCycle Returns, Inc. All Rights Reserved - 26 - Sources: Financial Statements and Price Data – CapitalIQ Calculations – LCRT Platform THE APPROVED LIST FACES A SLIGHTLY NARROWER RANGE OF EARNINGS-PRICE RATIOS THAN THE UNIVERSE Approved List Universe

27. © 2004 LifeCycle Returns, Inc. All Rights Reserved - 27 - Sources: Financial Statements and Price Data – CapitalIQ Calculations – LCRT Platform VALUE/COST MULTIPLES CONFIRM THE TENDENCY FROM THE LCRT DCF ANALYSIS OF THE APPROVED LIST TO APPEAR OVER-VALUED COMPARED TO THE UNIVERSE Approved List Universe

28. © 2004 LifeCycle Returns, Inc. All Rights Reserved - 28 - Sources: Financial Statements and Price Data – CapitalIQ Calculations – LCRT Platform PRICE TO CASH FLOW AND SALES MULTIPLES Approved List Universe Approved List Universe

29. © 2004 LifeCycle Returns, Inc. All Rights Reserved - 29 - Sources: Financial Statements and Price Data – CapitalIQ Calculations – LCRT Platform ENTERPRISE VALUES TO EBITDA AND EBIT RATIOS Approved List Universe Approved List Universe Approved List

30. © 2004 LifeCycle Returns, Inc. All Rights Reserved - 30 - Sources: Financial Statements and Price Data – CapitalIQ Calculations – LCRT Platform MARKET LEVERAGE FOR THE APPROVED LIST IS LOWER THAN THE UNIVERSE, WHILE BOOK LEVERAGE IS ABOUT THE SAME Approved List Universe Approved List Universe

31. © 2004 LifeCycle Returns, Inc. All Rights Reserved - 31 - Sources: Financial Statements and Price Data – CapitalIQ Calculations – LCRT Platform DIVIDEND PAYOUT RATIO Approved List Universe