Ativo Research, LLC.

Fidelity has arranged to provide you with the stock recommendations and research reports from Ativo Research. For over 35 years, the insights of Ativo Research and its founder, Chuck Callard, have been available only to institutional clients (prior to 2006 Ativo Research was known as Callard Research, which in turn was the successor firm to Callard, Madden & Associates).

Chuck Callard, who passed away in 2004, was a pioneer in the field of quantitative finance. Chuck developed and implemented valuation models based on the original insights of Merton Miller, Franco Modigliani, James Tobin and others at the University of Chicago. The groundbreaking theoretical work, combined with decades of empirical observation, has confirmed that stock prices ultimately reflect fair values. So instead of trying to predict short-term stock price movements, Ativo Research focuses on valuing the underlying business and its risk, and then determining if both the value and the risk are already priced into the stock.

To the owners of a business, what counts is how much cash it is generating. In order to arrive at the real cash flows, Ativo Research practices a form of forensic accounting, combining the some of the best and most timely databases available with modern information technology tools to decode financial statements.

Although cash flow analysis has gained many converts and exponents in the quarter-century since Ativo pioneered the practical application of these concepts, Ativo's approach remains beyond compare in both elegant simplicity and empirical validation.

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Ativo uses the following terms in their assessment of a stock's potential performance over the next twelve-month period.

1. BUY Most Favorable Expected to outperform the S&P 500 and be among the stocks with the highest returns Favorable Expected to outperform the S&P 500 index and have above-average returns
2. HOLD Neutral Expected to perform in line with the S&P 500 and have similar returns
3. SELL Unfavorable Expected to underperform the S&P 500 and have below-average returns Most Unfavorable Expected to underperform the S&P 500 and be among the stocks with the lowest returns

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The cash flows are influenced by the firm's operations, e.g., profits, expansion and contraction plans, use of debt and resulting tax implications, dividend policy, and ability to adjust to changes in inflation. In practice, judgments about these determinants of cash flow can be distilled down to just two key forecasts: Return on Investment (ROI) and asset growth. Ativo Research defines these variables in a manner that reflects the underlying economic realities, rather than accounting conventions. The ROI measure incorporates cash flow, rather than earnings, compared with a firm's inflation-adjusted total assets. The growth forecast (real growth in total assets) determines cash requirements for future investments, which in turn eventually generate additional cash, the amount of which is determined by the ROI earned by the firm.

The Ativo Research valuation model converts the ROI and asset growth forecasts into a stream of net cash flows extending over several decades. Over time, these cash flows are adjusted to reflect longer-term economic trends. High ROI companies attract competition, which eventually erodes the ROI they are able to earn. Companies with below average ROIs find themselves either out of business or with new management.

The other major variable in the valuation equation is the discount rate, or cost of capital, that is applied to the net cash flows, ultimately determining the total value of the firm and, after an adjustment for the debt and shares outstanding, determining the value of each share.

While cash flows, ROIs, and growth rates are generally understood (and to some degree controllable) by managements, the discount rate (COC) is set by holders of the firm's securities. Therefore, the major factors influencing the firm's cost of capital include the security-holders' pretax requirements for income from dividends, interest, and capital gains. The prevailing discount rate is greatly affected by incremental tax rates, and by changing inflation expectations, which also affect the embedded tax premiums.

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Ativo Research calculates the cost of capital in two ways. The first method of estimating COC produces what they call the Equilibrium or Warranted Cost of Capital. This approach calculates the nominal pre-tax return an investor needs in order to earn a real, after-tax pure rate of return his investment. This pure rate of return, which Ativo Research estimates to be about 3%, is tied to long-term GDP growth and the marginal productivity of capital. The specific Equilibrium COC derived using this approach is a function of this pure rate of return, inflation, marginal tax rates, dividend yield, and expected capital gains.

The second approach to determining COC is empirical. As described above, Ativo's valuation model calculates stock prices as a function of ROI and asset growth forecast, which specify a stream of cash flows to be discounted at the cost of capital. Although ROI and growth forecasts for specific companies vary significantly, ROI and growth for the market as a whole (S&P 500) are relatively stable. Since they know the current ROI, growth, and today's price, they simply solve the model backwards to determine the prevailing cost of capital.

For over four decades, both methods produced similar results for extended periods of time, lending credibility to both estimates. When the methods differed, the gap between them, general less than 250 basis points, preceded important long-term market moves. In the late sixties and early seventies, the equilibrium rate rose on accelerating inflation and higher tax rates, while the prevailing rate continued at previous low levels. The market then declined 25% (in real terms) in 1969/1970 and nearly 50% in 1973/1974 as the market adjusted and the prevailing cost of capital finally caught up with the equilibrium rate. Likewise, the great bull market of the eighties and nineties was associated with a falling cost of capital as moderating inflation and lower tax rates brought down the equilibrium rate.

The cost of capital is a critical variable affecting investment decisions. From a corporate perspective, when a firm is able to earn a return in excess of its cost of capital, investment adds value, and the firm grows. When a firm earns less than its cost of capital, incremental investment destroys value, and the firm is forced to contract. At a 7% cost of capital, just over half of U.S. firms create value by expanding, while a 6% cost of capital means that roughly two thirds have an incentive to expand.

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Fundamental accounting data is collected from 10Qs, 10Ks, and other regulatory filings. The data provider performs an initial data scrubbing and standardization. Then, consensus earnings estimates and asset growth forecasts, for the next five years, are collected from the Street. Information on daily prices, splits, dividends and other distributions is gathered daily.

On a weekly basis, the Ativo system computes the accounting adjustments for 9,000 firms. Key statistics computed are: Current Cost Gross Assets, Average Asset Life, Discounted Cash Flow ROI, Current Cost Return on Net Assets and Tobin's Q Ratio.

The adjusted fundamental data is combined with the consensus estimates to explicitly forecast the Balance Sheet and the Income Statement for the next 5 years, and then the schedule of Net Cash Receipts for the following 30 years. The future cash flows and the current stock price indicate what discount rate the market is currently employing to value each stock. That implied discount is compared with each firm's fundamental discount rate to determine if the stock is currently over or under-priced. This information is combined with other measures of attractiveness to determine our overall rating. At each step, quality control steps are designed to catch errors before they propagate.

The final ranking changes are reviewed one more time, to ensure reasonableness. The final forecast universe is comprised of 1600 of the largest, most widely traded stocks listed on Canadian and US exchanges.

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Ativo Research is a member of Best Independent Research, a consortium owned by six research organizations. It was created in 2002 to offer investors exposure to many of the top independent research firms who were previously only available to institutional investors. BIR's research firms were selected because of their strong past performance and must maintain this record to remain a provider in BIR.

None of the BIR firms offer brokerage or investment banking services. As opposed to a conflict of interest, these firms have the same interest in the success of their recommendations as the investor does. Providers are all veteran firms who adhere to professional standards similar to those that exist in the field of money management. Each must abide by a code of ethics that put the interests of clients ahead of their own.

The research reports from BIR members reflect a uniform report format designed for the investor who is interested in independent performance-oriented research boutiques. Brief 2-page reports de-emphasize supplying the general news and history of the company that is widely available elsewhere. Instead they focus on subjects and information that explain and support the analyst's recommendation.

In addition to describing the firm's investment strategy, the reports encourage the investor to understand the analyst's conclusions at each step of the process that led to their recommendation decision. The reports also supply information about the firms themselves so investors can investigate their qualifications and the performance of their past advice. The providers' performance records are publicly available at Investars.com, an independent monitor of the performance of over 140 research providers.

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