A Shift To Value

A Shift to Value?

Moody, Aldrich & Sullivan LLC

100 Cummings Center, Suite 104Q

Beverly, MA 01915

August 31st, 2000

A Shift to Value?

What a difference six months makes! Since releasing our report "Does Value Matter?", we have been fortunate enough to reap the benefits of a focus on intrinsic value in a market that suddenly began to recognize intrinsic value. The Russell MidCap Value Index is one of the clear leaders in the market, up nearly 8% YTD, and our portfolios are significantly outperforming the index. More importantly, the majority of our performance has come through superior stock selection.

With the significant changes in the markets, we felt it was important to review and update our analysis -- hopefully you will find this second iteration equally valuable. And while in large part, the analysis reflects a view of the world similar to that in March, there have been some significant changes worth highlighting.

First, the good news. We are thrilled to see that "Value" has begun to outperform "Growth" as an investment style. Of more relevance however, is that the "intrinsic value" opportunities in Mid Cap Value and Small Cap Value have significantly outperformed Large Cap Value as we believe they should:

We continue to believe that these trends will continue; however, we now believe that the markets are not as extreme as they were in March. Strong free cash flow growth in value indices, a stabilization of interest rates and price corrections in Large Cap Growth and Small Cap Growth have improved the investment environment for all sectors:

We continue to believe that the best opportunities lie in Mid Cap and Small Cap Value, but are encouraged by an environment that we feel is much more positive for all investors.

While we are more bullish than ever on an intrinsic value basis, we are troubled by some fundamental deterioration in the broader economic environment. In particular, the intense nature of competition at this stage in the economic cycle has led to a peculiar pattern in cash flow growth vs. free cash flow growth:

Free cash flow is cash flow less capital expenditures. As we highlighted in "Does Value Matter?," valuation is ultimately tied to future free cash flows -- funds that are available to repay investors after reinvesting in the company. Declining free cash flow growth while cash flow growth is increasing indicates that companies are running hard to stay in place. Unfortunately, this is a trend that cannot continue. One of two factors must give way -- either cash flows begin to decline as competition makes its presence felt in profit margins and revenue growth, or investment in capital expenditures begins to decline.

The evidence indicates that reinvestment levels became inordinately low over the past few years, a trend that would certainly explain the recent pattern in capital expenditures:

From 1980 until 1994, capital expenditures declined as a percent of sales fairly consistently. The importance of this trend cannot be overemphasized. In part, this reflected the changing composition of the S&P 500 (and the U.S. economy) towards more technology and services. However, the same trends appear in industrial companies, indicating a payoff from investments in working capital management and a focus on eliminating unproductive assets. In large part, these improvements set the stage for the explosion of free cash flow that drove the market over the last twenty years.

We are now at a critical point. In July, capital expenditures as a percent of sales hit their highest level in over five years. It is not clear whether these investments are setting the stage for further operating improvements or if they are the leading indicator that the economy has stretched to its operating limit. Since we are not macroeconomic forecasters, we will leave this question for those more suited to the task.

Of one thing we are certain -- in this environment of increasing reinvestment, it is more important than ever to focus on companies with a demonstrated ability to earn acceptable levels of return on their investments -- companies with superior decision making and execution skills combined with a demonstrable competitive advantage. We continue to believe that our focus on economic value added (EVA) points us towards those companies.

Does the evidence support our belief? If EVA is truly a superior tool for identifying companies that benefit from increasing Capital Expenditures, we should see the market reward positive EVA companies with a higher valuation multiple for their Capital Expenditures. To test this hypothesis, we analyzed all companies with market capitalization greater than $100MM as of August 31st, 2000 and with a minimum 5 year operating history. This effectively created a universe of approximately 3,700 companies. We then grouped these companies into quintiles based on their "EVA Spread %".

EVA Spread % = ROIC% - WACC%

Where: ROIC% equals the 5 year average Return on Invested Capital

WACC% equals the estimated weighted average cost of capital

EVA Spread % is a simple metric for identifying EVA positive or EVA negative companies. In essence, it measures the excess return (in percentage terms) that a company generates. If EVA Spread % is positive, EVA is positive (and vice versa). The results highlight the difficulty in generating positive EVA for most companies:

Market Market Market

Weighted Weighted Weighted

Quintile ROIC% WACC% EVA Spread%

1 21.0% 10.7% 10.2%

2 10.5% 8.6% 1.9%

3 8.9% 10.0% -1.2%

4 5.3% 8.1% -2.8%

5 1.6% 9.7%