4th Quarter, 1995
Dear Shareholder,
Welcome to the Value and Growth Portfolio. We appreciate the confidence
you have placed in us. Over the coming years, we will work diligently to
justify that confidence.
This report marks our first quarterly report since the Fund's inception
November 6, 1995. The Net Asset Value of the Fund for the period
ending December 29, 1995 was $9.925, after paying a distribution of $.01
December 27th.
Including reinvestment of the distribution, your Fund was down slightly
at -0.65% for the partial quarter. For the same period, the NASDAQ
Index was also down slightly at -0.95%, while the S&P 500 Index was up
5.0% with dividends reinvested. While the Fund is not structured as a
small capitalization fund, our median stock market capitalization is $918
million, or "small cap" by the standards of the industry.
We report the above performance as a standard of what to expect
rather than as a relevant comparison, as the time period of comparison is
far too short to be meaningful.
Since this is our first report, we would like to share with you some of
the business and investment principles we follow that pertain to your
investment in the fund.
Business and Investment Principles
Our goal for the Fund is to produce returns in excess of market returns.
You should know that the vast majority (about 80%) of funds fail that
goal. While we can give no assurance we will achieve returns in excess of
the market, a well-founded philosophy should produce long term results. You
should keep in mind, though, that no investment strategy beats the market each
and every year and that even the best managers can go as long as five years
with sub-par results.
While there are many paths to investment success, we believe a highly
disciplined, quantitative strategy as opposed to a more intuitive, qualitative
strategy has the highest probability of producing above market returns. In
Greek mythology, the story is told of sailors pulled off course to shipwreck
and death by the beautiful, beguiling songs of the Sirens. We think that
the metaphor of Siren songs is appropriate to decisionmaking in investing,
or in any complex decision process. Knowing the salient factors--the
winds, the stars, the heading for your journey--is not enough; one must
stay with the salient factors and not get pulled off course by the Siren
songs of the trivial and insignificant. A highly quantitative strategy helps
us stay focused.
We will make use of the extensive university research indicating those areas
of investing that tend to produce higher returns. You canexpect that your
Fund will be oriented toward stocks which have characteristics of low price-
to-earnings (P/E) ratios, low price-to-bookvalue (P/BV)ratios, and low price-
to-cashflow (P/CF) ratios as well as smaller capitalization stocks. All these
areas have demonstrated higher than average stock market returns,
although risk may also be higher.
We have and will continue to spend a great deal of time testing our own
research in order to isolate those investment characteristics that tend to
produce above average returns. Just
<TABLE>
Value & Growth Fund Characteristics 12/29/95
<S>
VALUE & GROWTH PORTFOLIO
Avg Growth Fund
Avg Aggressive Growth Fund
Avg Small Company Fund
<C>
P/E*
12.4x
22.7x
27.6x
25.2x
<C>
P/BV
2.2x
4.4x
5.1x
4.2x
<FN>
<F1>
Ratios may not be exactly comparable. Fund average ratios from latest
available Morningstar
</FN>
as drug companies test new drugs prior to roll-out to adjust the dosages
and make sure the drugsreally work, the
computer allows us to try various combinations of financial factors,
adjust the
parameters, and make sure we are using combinations that really work.
Very few funds or managers today (that we can identify) are using
quantitative strategies for stock selection which may be why very few have
done better than the markets.
The Fund is likely to be as fully invested in stocks as is practical. We
think we can add value through the selection of undervalued securities, but
add very little value through forecasts of the economy or the stockmarket.
Or to quote Peter Lynch, one of the great fund managers of alltime, "Nobody
can predict interest rates, the future direction of the economy, or the stock
market. Dismiss all such forecasts and concentrate on what's actually
happening to the companies in which you've invested."
We believe our reporting to you should tell you what we would want to
know if our roles were reversed. We understand that your investment is
unlikely to be an end unto itself, but rather a means to provide a college
education, provide for a retirement, or for some other purpose. We will
try to keep you informed so that you can meet the goals important to you.
Your funds should be handled with the same degree of care as our own
funds. In the case of the Value & Growth Portfolio, we have a substantial
amount of our money in the Fund. We eat our own cooking.
* * *
Commentary. We would like to share with you in this firstletter some
of the research which has just been published in the Financial Analysts
Journal and which illustrates some of the principles we will use to invest
your funds ("Overreaction, Underreaction, and the Low-P/E Effect", David N.
Dreman and Michael A. Berry, July/August 1995). These studies are not
necessarily indicative of future performance, nor are we trying to
duplicate the investment approach that produced the results depicted
in the study summarized below.
In the financial literature, there are numerous studies that demonstrate
that stocks with low prices-to-earnings (low P/E's) tend to produce returns
in excess of market returns, although university researchers are not
unanimous in recognizing this phenomenon. Some researchers have
explained the effect by offering evidence that the effect is really a "small-
firm" effect rather than a low P/E effect. Others have suggested that
stocks with low P/E's reflect some undiscovered risk premium, meaning
that the companies produce higher returns, but do so withhigher risk.
And others have suggested that the higher returns of low P/E stocks is
really the result of spurious research.
We won't go into all the details of the reluctance ofresearchers to
accept the results of low P/E investing other than to suggestthe research
goes against the accepted dogma and all change takes time. When the
world was known to be flat, we suspect the initial evidenceto the contrary
was also deemed to be spurious research. Back then, a researcher might
have gone to prison or lost his head for believing the world was round.
While the sanctions today for going against the accepted dogma are not
so drastic, they are none-the-less as real.
Unlike the university researcher, we have no dogma todefend; we're
interested in what works. In our judgement, the results areconsistent
and overwhelming that stocks with low P/E's tend to produceresults in
excess of the market averages.
The contribution Dreman and Berry (D&B) make to the P/E's is to
answer how it works. Here is the crux of theD&B article:
1. Stocks are priced on earnings expectations. High expectations
produce high valuations (as measured by price-to-earningsratios), while
low expectations produce low valuations.
2. Most of the time and effort in the investment world isoriented to
forecasting what earnings will be. Unfortunately, those forecasts have high
error rates.
3. When earnings are reported, an interestingphenomenon happens:
-If a stock had high expectations (high P/E) and earningsexceeded
expectations, its price goes up a little bit.
-If a stock had low expectations (low P/E)
and earnings exceeded expectations, its price
goes up a lot.
-If a stock had high expectations (high P/E)
and earnings fell short of expectations, its price
goes down a lot.
-If a stock had low expectations (low P/E)
and earnings fell short of expectations, its price
goes down a little bit.
That phenomenon can be seen in the two
charts below.
The low P/E effect might not work if analysts
were more accurate in forecasting high P/E
stocks over low P/E stocks. Unfortunately for
those who live by forecasts, analysts' errors are
evenly distributed over Low P/E and High P/E
groups.
The D&B article really illustrates two key
points of our investment philosophy: 1) why we
orient the portfolio toward stocks with lower
P/E's, and 2) why we don't spend much time on
forecasts.
</TABLE>
<TABLE>
All Positive Surprises, 1973-1993
<CAPTION>
Return (%)
<S>
Quarter 1:
Low P/E
High P/E
Market
One Year:
Low P/E
High P/E
Market
<C>
36.33
22.88
28.65
25.86
16.79
20.76
</TABLE>
<TABLE>
All Negative Surprises 1973-1993
<CAPTION>
Return %
<S>
Quarter 1:
Low P/E
High P/E
Market
One Year:
Low P/E
High P/E
Market
<C>
12.04
- -2.3
4.76
17.21
6.94
11.85
</TABLE>
Our first semi-annual reporting period ends
March 31. At that time, we will send you a
balance sheet and a listing of the securities in
the portfolio.
Until then, we wish each of you a healthy,
happy and prosperous 1996. We will try to do
our part on the prosperity.
Respectfully submitted, Chief Investment Officer
This report is for information of the shareholders of the
Value and Growth Portfolio. Its use in connection with
any offering of the Fund's shares is authorized only in
a case of concurrent or prior delivery of the Fund's
current prospectus. Choice Investments is the
Distributor of the Fund and is a member of the NASD. Call1-800-448-1844 for
additional information.
