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Development of the Approach at Cardinal Capital Management, Inc.

In the search for superior returns, investors have tried many approaches. Most have been disappointing because they fail to deliver expected higher returns or only work for brief periods or under special circumstances. On the other hand, the value approach to investing has produced better than market results over many decades in both academic tests and professional use.

What is the value approach? In the classic form it involves selecting stocks for investment from those selling at low prices versus some observable metric such as book value. This concept is at the core of the approach made famous by Benjamin Graham many years ago and continues to be used by many investors today.

In his book The Intelligent Investor published in 1959, Graham observes that many investment prescriptions change over time based upon market conditions. However, investment principles should not need frequent revision. “If we keep before us the element of quantity or measurement as an inseparable part of every investment rule that relates to securities rather than to people” then our ideas may escape the fate of becoming “either untrue or subject to so many exceptions as to be useless”.

A simple price/book value approach has obvious limitations because a significant amount of a business’ value may reside in intellectual capital, trademarks or other assets that do not appear on the balance sheet. Other quantities of a company’s activities also exist such as sales, cash flow etc. that can be measured and used to develop a sense of the value of an enterprise distinct from the current price of its stock. So the next logical step is to incorporate additional measures of value into a multi-factor model to more realistically assess potential investment opportunity.

At the heart of many valuation tools is the notion that investor enthusiasm for a company as reflected in its market price waxes and wanes significantly over time. These stock price changes frequently exceed the change in the underlying value of the enterprise. To the extent that this is true, one can develop tools to measure the degree of under or over pricing versus the value of a company and benefit from what statisticians call reversion to the mean. This is a powerful and useful concept in an organized approach to investing.

Many attractive, growing companies are excluded from consideration by an absolute valuation process, whether single or multi-factor in nature. Because of higher historic or prospective growth rates, most growth companies seldom reach necessary discounts to meet absolute valuation standards.

A further refinement at Cardinal Capital Management, Inc. is to move from an absolute value concept to one that incorporates relative value, as well. This approach greatly broadens the potential field of investment, to include all companies whether they are defined as value or growth stocks. This is a very powerful idea. The combination of a disciplined valuation approach to companies of all growth rates is very appealing.

In the work of many researchers and supported by our own experience, the process of a stock price returning to or exceeding “fair” value often is a multiple year process. This is particularly beneficial to taxable investors since portfolio turnover and capital gains taxes are held to modest levels. Indeed, if one requires a significant degree of overvaluation to exist before exiting a position, portfolio turnover and taxes incurred can be very low.

A further benefit of a strong valuation approach to investing is the “evergreen” nature of the portfolios it produces. If one does not constrain the process, beneficial shifts in weightings occur between industries, firm size and growth characteristics in response to opportunities presented by the market. Such a process obviates the need for prescient “top down” calls on areas of emphasis or de-emphasis. Instead, the valuation process drives the shifting of portfolio weightings in a “bottom up” process one security at a time.

Utilizing relative value concepts in a multi-factor model for Cardinal Capital has resulted in portfolios with superior long-term performance and low volatility, compared to the general stock market. These portfolios are well diversified by investment style and market capitalization with excellent long-term absolute and risk adjusted returns.

If you would like to learn more about Cardinal Capital Management, Inc.’s approach to investing and our superior historical results, please visit or call Glenn C. Andrews, CFA President, or Joel A. Millikan, CFA Chief Investment Officer at 800-625-2335 or 919-532-7500.

December 13, 2006

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