The Right Price

The Right Price

By Janet Leiser

Senior Editor

Charles Carnevale calls his firm's investment strategy "Ancient Portfolio Reality," as opposed to "Modern Portfolio Theory," the latter being a strategy that won its founders the 1990 Nobel Memorial Prize in Economic Sciences.

"Our whole approach is to buy great companies at great prices," says Carnevale, chief investment officer and co-founder of Tampa's EDMP Inc.

The firm - whose name is an acronym for earnings determine market price - prefers to sell when others buy and to buy when others sell. That way, Carnevale says, clients are more likely to get a good deal.

"Part of our strategy is exploiting folly," says Carnevale, 58. "When people are euphoric like they were in the late '90s, we were selling stocks. After the market crashed, we were running around buying up all the bargains."

The firm survived the Bear Market of 2000-2002 with only one down year and an overall positive rate of return, at 1.8%.

Seven-member EDMP realized a 10.42% average annualized return on $325 million in 2005, compared to 4.91%, with dividends, for the S&P 500.

The firm expects to double its large cap fund this year and reach $1 billion within five years. Its 12-year average annualized return of 14.26% is just short of the firm's goal of 15% to 20%.

"Frankly from our point of view, we're underperforming," he says. "But we're just modestly below target and we went through the worst bear market of all time."

The firm's strategy goes back to Alvin F. Terry, a University of Tampa economics professor, whom Carnevale studied under in the early 1970s, he says, adding: "He brought me this notion of solid investing based on investing in great companies with sound valuations."

After college, Carnevale worked for Terry at his money management firm. He later moved to Texas to work as a stockbroker before returning to Tampa to turn around Terry's firm, of which Carnevale and his wife owned 49%.

"We grew it to a relatively successful firm," Carnevale says. "But 49 never beats 51."

Charles and Julie Carnevale formed EDMP in late 1992. They have about 25 shareholders, which he declined to identify. And EDMP is a certified minority-owned firm because Julie Carnevale, president, is the majority owner.

Low-risk approach

Explaining the firm's strategy, Carnevale quotes economist Benjamin Graham: "To win you must not lose."

"It's just common sense," he says. "If you have $1 and lose half of it, you've lost 50%. Now if you take the 50 cents and try to grow it back to a dollar, you have to earn 100% on 50 cents."

Carnevale and his employees don't spend time trying to determine if a stock price is headed up. Instead, they study the financials of large, public companies, including income statements, cash flow and balance sheets. They chart the earnings, going back as far as 20 years, and then project future growth. They then compare the stock price to the earnings to determine whether the stock is priced fairly.

If the price is out of line, above or below, eventually it will return to what Carnevale calls its "true worth," he says. The question is whether that process takes one week or 10 years.

"At any point in time, markets can be totally irrational," he says. "The stock market can overprice stocks dramatically, which it did almost exclusively in 1998-99. Other times it can dramatically under price a stock based on a piece of bad news or a rumor or event like 9/11.

"Our idea is if you know what the business is worth then you can make sound decisions. If the market is pricing it fairly then we're a willing buyer."

Of course, the firm would rather buy under-valued companies. When prices rise unreasonably, the firm usually sells.

EDMP obviously isn't always able to predict future earnings accurately. Carnevale tells of one company that had a 50-plus year history of consistent earnings growth. But then it was sued for its brief ownership of a division, sold 40 years earlier, over asbestos liability. For several years, all of the company's income has gone to cover legal costs.

There was no way, Carnevale says, to have predicted that development.

"We'll continue to make mistakes," he says. "This is not a business that is perfect."

EDMP only considers companies with little or no debt and a market cap of at least $5 billion for its large cap equity fund, he says. The firm invests in 25 companies in nearly 25 industries to spread its risk.

Carnevale is upbeat on companies, such as Stryker Corp., one of its newest buys, because the medical device manufacturer is in what he calls the "sweet spot" of medical care. After all, the largest population segments are the baby boomers and those over 65. It's inevitable both will contribute to growth in that industry.

He's also upbeat on Home Depot, Lowes, Mohawk Industries and Johnson Controls. "There are going to be more and more consumers out there buying consumable goods," he says.

EDMP doesn't invest in companies in industries that are capital intensive and cyclical, he says. Prime examples include automotive, airlines, heavy manufacturing, metals and energy sectors.

To track the public companies, the firm has developed its own software program that links its computer with the Standard & Poor's data server. The software charts the earnings growth and stock price of public companies.

Irrational prices

Each Tuesday, EDMP's investment committee, which includes Charles and Julie Carnevale, and portfolio managers Carl Salvato and Timothy Loudin, meets to discuss the large cap fund.

What stocks are overpriced based on earnings and should be sold? What new ones will replace them?

"Valuation, in my view and in our firm's view, is the most important component of getting the investment process right," Carnevale says. "If you pay more than a company is worth, no matter how good the company is, you're going to lose money."

He refers to the "800-pound gorilla, the quintessential star retailer in the history of mankind, Wal-Mart Stores Inc."

Wal-Mart earnings growth over 20 years has been spectacular, he says, adding: "But beginning in '95, the stock price deviated from its intrinsic value."

If an investor had placed $100,000 in the company that year, he would have lost 33% of the initial investment by "owning the greatest company on the planet," he says.

"There was nothing wrong with Wal-Mart," Carnevale says. "The only thing wrong was the valuation didn't make sense."

Today, Wal-Mart is close to valuation, he says, adding: "But this is the first time in seven or eight years, the stock correlated at all with anything resembling what I call true valuation."

Another strong company whose earnings haven't kept up with its stock price is the Coca-Cola Co., he says. "If you'd bought Coca-Cola eight years ago, you would have lost money" - 40% of your investment.

He says Apple is another overpriced stock. "Apple has great products but the business is run poorly," Carnevale says.

He predicts the stock, now trading at about $75, will eventually go down to about $35.

"I'm not smart enough to tell you, neither is anyone on the planet because it's not a knowable thing, when precisely it's going to happen," Carnevale says. "But you're playing Russian Roulete with your portfolio if you're riding Apple right now. Google is another one."

Google is a great company with staggering growth, he says, and Carvevale would love to own it - but only at the right price. Says Carnevale: "I'm saying Google is a $190 stock, and it's trading at $445 to $450."

EDMP BEATS THE INDEXES

While the stock indexes lost value during the three-year bear market, EDMP generated a positive return for its clients.

2000 Return 2001 Return 2002 Return 3-Yr. Total

EDMP 6% 13.4% (15.3%) 1.8%

S&P 500 (9.1%) (11.9%) (22.1%) (37.6%)

NASDAQ (39.3%) (21.1%) (31.5%) (67.2%)

3-year Return 5-year Return 7-year Return

EDMP 16.38% 8.65% 10.34%

S&P 500** 14.38 4.91% 1.77%

Russell 1000 Large Cap** 13.22% .54% 1.77%

All returns annualized. The 3-, 5-, 7-year returns are preliminary through 2005. **Includes dividends.

Source: EDMP

WHAT EDMP OWNS

Recent

price

Home Depot HD $42.28

Johnson Controls JCI $74.61

Lowes LOW $66.17

Mohawk Indust. MHK $87.84

Stryker SYK $47.46

WHAT EDMP AVOIDS

Automotive

Airlines

Energy

Heavy manufacturing

Metals