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    Guest Interview:

   Leonetti & Associates, LLC

    1130 Lake Cook Road, Ste 300
    Buffalo Grove,IL 60089

    Telephone: (800) 454-0999
    Fax: (847) 520-5475


    Interview Quarter: 3Q1993

 Craig T. Johnson

 Portfolio Manager

Q: Craig, would you give us a brief history of Leonetti & Associates, Inc.?

A: Our firm was started in 1982. Michael Leonetti, our founder and president, had the foresight to see the opportunities at that time in the relatively unheard of field of financial planning. Mike's vision of Leonetti & Associates, Inc. was to offer clients an extremely detailed, well researched, informative service on a fee only basis. Investment management was one area he felt could enhance the service our firm provided to clients. In April 1983, Leonetti & Associates, Inc. began offering investment management services. From those early beginnings, the investment management side has grown considerably and has become the main focus of our business.

Q: How long have you been chief portfolio manager at Leonetti & Associates, Inc. and what was it in your past that led you into investment management?

A: I have been chief portfolio manager at Leonetti & Associates, Inc. since the first day that the investment management division began, back in April 1983. Prior to that I spent six years in both management and merchandising in the retail field. Before coming to Leonetti & Associates, Inc., I held a position in sales for an insurance company where I successfully completed my securities licensing. My father was the one that sparked my interest in stocks and investment management. Back in high school, he not only taught me about stocks, but more importantly about cash management and risk. From the foundation he gave me, I was hooked on the financial markets. I then took it to the next step and read just about anything and everything I could get my hands on about stocks and investing. I was quite successful investing for myself and from there it mushroomed into where I am today.

Q: What most strongly influenced your investment style?

A: Our investment style has been an evolutionary process. Like most money managers I started out with a growth only focus, but the research I was doing clearly showed we were missing out on the outperformance periods of utilities, cyclicals, value stocks, mining stocks and the very positive effect that dividends can have on returns. After much review and some unsuccessful attempts, I finally settled on the styles that incorporated the various areas our research showed were critical to achieving good performance with consistency. The three styles selected were out-of-favor blue chip stocks, dividend paying S&P 500 type companies exhibiting a rising trend in earnings and revenue, and small companies with rapidly rising revenue and earnings. We then blend the three styles into the portfolios with the out-of-favor style and dividend paying S&P 500 type companies, each accounting for about 40% of the portfolios. The remaining 20% is dedicated to the fast growing small company area. As pleased as I currently am with the styles and mix that we use, I do not believe that you can ever get too comfortable in the financial markets with any specific style or approach. As the financial markets continue to evolve and change we will continually review, evaluate, and learn new techniques, theories, and styles to stay ahead of the markets.

Q: How do you determine the universe of stocks that you use in your analysis?

A: I read about twenty-five to thirty annual reports a week, along with numerous business publications, trade journals, research reports, and any other material that might give me a better understanding of companies, industries, seasonality, trends, or new innovations and products. I also rely heavily on the Daily Graphs chart service. Each week, I analyze the charts and abundance of fundamental data that is offered on over 3,000 companies. From there I break the universe of stocks down to about three hundred. These companies are followed very closely. All price movement, volume changes, news, and financial reports are gathered and monitored. Each week some companies will drop out of the universe while new ones are always added.

Q: Why are you attracted to out-of-favor stocks?

A: Out-of-favor stocks can be very exciting and profitable if the analysis on the companies is done properly. Our approach is quite different than that of most value investors. Rather than focusing on assets or hidden asset value our entire focus is on the company's business. Our out-of-favor stock universe only includes the largest corporations and is dominated by stocks that are components of the Dow Jones Industrial, Transportation, and Utility averages. We favor the largest companies for three reasons: Due to the nature of their size, they are incredibly resilient. These companies can weather almost any type of storm. 2. There is a tremendous amount of information available on these companies and since most of these companies have several divisions involved in different industries, it is a lot easier to get a good understanding of their different operating segments. 3. All pay dividends. Our holding period for out-of-favor stocks is at least one year. Most out-of-favor stocks offer very attractive yields enabling us to enhance returns and also provide a regular cash flow into the portfolios while we are holding them. Many of these companies are ripe for restructuring or management changes. The company's management and board of directors are under tremendous pressure to not only improve their business, but also to increase shareholder value. Due to this pressure, companies are taking or are considering actions that would have seemed remote at best a few years ago. Restructuring, management changes, spinoffs, and debt reduction can cause a lot of excitement in the investment community and significant price appreciation can occur as it forces analysts to reevaluate their projections, opinions, and buy-sell-hold advice.

Q: How does your out-of-favor stock analysis compare with your conservative growth analysis style?

A: Our out-of-favor companies are stocks that have experienced large price drops due to a business slowdown, too much debt, poor management, excessive diversification, cyclical factors, loss of popularity with investors, or other problems. The conservative growth style universe is made up of large companies that are exhibiting consistent growth in earnings and revenues. Obviously, these companies are not going to grow at the rates that the smaller growth companies will experience, but due to their size and their established business they become very attractive to investors and the analysts that follow them.

Q: What are the fundamental characteristics that you look for in a stock?

A: For out-of-favor stocks our fundamental focus is on the company's business. I am looking for companies that have experienced problems due to debt, management, excessive expenses, or cyclical forces, but are still one of the industry leaders. I analyze and evaluate the companies with the idea that I am thinking of acquiring the company. I go through a series of questions: 1. What problems or problems are plaguing this company?
2. Is the product line successful?
3. If the problems can be fixed, will revenues and more importantly will earnings grow?
4. How long will it take to turn this company around?
5. If the problem is management does the outside board of directors possess enough power to make the changes that are necessary?
6. If expenses are excessive, are payroll and capital outlay cuts feasible?
7. How much of the company's business is dependent on government?
8. Can some of the problems be alleviated by selling off assets or lines of business?
9. Can debt be restructured through refinancing, preferred stock, or common stock?
10. Is the company captive to union contracts?
11. Has research and development kept up with others in the industry? 12. Does management hold a sizeable enough amount of stock to really have the incentive to implement the changes that are needed?
The fundamental picture for the conservative growth and aggressive growth stocks that we favor is completely different than the out-of-favor stocks. For the conservative growth stocks I look for consistency. The company should have several years of rising earnings and revenues. The last two quarters should also exhibit rising earnings and revenues over the comparable period in the previous year. My preference is that the company is either one of the industry leaders or a niche leader within an industry. Debt levels should be low or declining. Gross profit margins are rising and their product line is expanding. Management should own a significant amount of stock and have a stated plan for achieving their one year and five year goals. Aggressive growth stocks need to have rapidly rising revenues and earnings. I also like the companies to have little or no debt and a reasonable following in the investment community. The companies should have an expanding product line or a product that changes or improves the way we live. I prefer the founders of the company to remain in control of the day-to-day management of the company.

Q: What technicals do you favor?

A: I use bar charts as well as point and figure charts religiously for all of my buy, hold, and sell decisions. Point and figure charts are absolutely wonderful tools in understanding where a stock is, at any point in time. Point and figure charts easily identify buy and sell points and provide support and resistance points with exceptionally high accuracy. They also give a great picture of when bottoms and tops are being formed. Deciphering the short, intermediate, and long-term trends can be handled very well with point and figure charts. I use bar charts for identifying buying and selling formations. More importantly, they offer an easy to read way of knowing where a stock should be bought or sold. I also pay close attention to volume and its implications for price movement. High volume compared to a stock's average volume is very good at confirming price action. Both point and figure charts and bar charts are used for finding price points to place stops. By using individual stock price action I am not locked into a designated percentage for keeping my stops. This avoids many of the whipsaws that occur and the high turnover that fixed percentages force you to make. It also lets you stay with an appreciating stock through many of the shakeouts that occur as the stock rises.

Q: How can you analyze stocks using a combination of all three styles?

A: First, I break them down by size. The only stocks I will consider for the out-of-favor style will be large, well capitalized household name companies. Most of these will be focused among the companies of the Dow Jones Industrial Average. On the growth side, if they are of significant size, I will use the conservative growth style. Then the smaller companies will fall into the aggressive growth style. The next step is to break them down by revenue and earnings growth. It is possible for a large company to be growing at a very rapid rate and have it qualify in the aggressive growth area. Sometimes an-out-of favor stock might fit into the conservative growth style. This usually happens if the revenue and earnings are growing at a respectable level, but the growth rate has slowed, which is why the stock has become out-of-favor. From this point, most stocks have fit into one of the three categories. Then the style's criteria will be applied to see if the stocks qualify to become part of the universe of stocks that I follow.

Q: How do you allocate between stocks and bonds in your balanced portfolio?

A: We use 40% stocks, 40% fixed income and 20% cash as our neutral mix in our balanced portfolios. Our maximum exposure in either stock or fixed income is 70% and our minimum exposure is 30%. Normally we try to keep 3-5% in cash so that we can be flexible as opportunities present themselves.

Q: According to your performance numbers, you have achieved relatively high returns with very low risk for your balanced accounts. How are you able to do this?

A: Our basic objective for all of our clients is to provide an above average return and at the same time preservation of capital. The approach we use for balanced portfolios seems to fulfill this objective. First, our blend of multiple styles on the equity side gives us the opportunity to participate in the different market strengths and at the same time it lessens the downside considerably during the different market weaknesses. Rather than riding from peak to valley we are able to smooth out the swings. Second, our fixed income holdings are weighted heavily towards government bonds and notes which offer the greatest liquidity day-to-day. Our corporate bonds and notes carry ratings that are investment quality, giving the holding added safety. Third, I only purchase bonds and notes at discounts or at par. This protects our portfolios from overpaying for a holding and giving the yield back because of the price retreating back to or below par. The fourth component is the asset allocation or the portfolio mix. The adjustments we make in the balanced portfolio are dominated by risk and reward. The adjustments are made by using proprietary models for measuring risk versus reward. What these models accomplish is to show us where risk is rising, while reward is falling. When this occurs we will reduce our exposure in that area and if possible increase it where risk is dropping and reward is increasing.

Q: Don't you run the risk of underperforming the market if you continue to be too conservative?

A: I like to use the baseball analogy of Babe Ruth and Rod Carew. Babe Ruth swung for the fences and hit a ton of home runs, but he also struck out a lot. He struck out almost three times more than he hit home runs. On the other hand, Rod Carew probably hit fewer home runs in his entire baseball career than Babe Ruth hit in almost any given season. Yet, almost every year Rod Carew's batting average either led the league or he was in the top ten. I guess I have tried to be the Rod Carew of money management. Our balanced portfolios will not hit a lot of home runs, but in our ten years we have never had a negative year and only a handful of negative quarters. If nothing else, the one thing I have learned in managing money is to keep your losses small. If you can produce good consistent returns year in and year out, the compounding effect is tremendous. In fact, I noticed in a recent issue of Money Manager Review that our balanced portfolio's ten year annualized return was only 1 1/2% below the average of Money Manager Review's top sixty-five equity managers for the ten year period, and 1 1/2% above the top thirty-five balanced managers' averages.

Q: What percentage of the money you manage is divided between equity, balanced and fixed income portfolios?

A: Currently about 20% of the accounts we manage are equity accounts. Balanced accounts make up about 60%, while fixed income clients, account for the other 20%. The fastest growing areas for us in the last year have been the equities and balanced accounts.

Q: Please explain how you analyze the bond market for your fixed income portfolios.

A: My analysis of the fixed income markets uses a combination of two styles, interest rate anticipation and yield curve. By combining the two, it is really a blend of technical and fundamental analysis. The interest rate anticipation style is almost completely technical. I use point and figure charts for determining the trend and the length of that trend. Point and figure charts are also extremely helpful at indicating tops and bottoms and for projecting price targets or objectives. Along with point and figure charts I keep bar charts on a lot of economic data, government statistics and money reports. The yield curve style is strictly fundamental. It is simply a measure of price, time and yield. I am looking for the most profitable spread between the three. We use the U.S. Government fixed income market in our portfolios as the foundation, while the corporate fixed income market builds on that base. All analysis on corporate bonds and notes involves a bottom up approach. The research that is done for stock selection is utilized in our corporate fixed income research process. It is our intention to only buy obligations from corporations that are in solid financial shape. I shy away from low quality bonds and notes and completely avoid all junk bonds. The investment allocation between government and corporate will change periodically as fundamental and technical developments take place in the fixed income arena.

Q: How do you determine when to sell stocks?

A: I have a couple of automatic sell rules for stocks that go against conventional wisdom. All out-of-favor stocks and conservative growth stocks will have half of the position sold when they reach a forty percent gain, excluding dividends. Aggressive stock positions are reduced by half when they reach a fifty percent gain. Through my research I have found these levels to be significant from a strategy standpoint, for cash management, controlling investment risk, and for my own psychological well-being. From a cash management viewpoint, selling half the position at the stated levels offers a way of having new money come into the portfolios. This helps us take advantage of new opportunities, offering good potential that might be missed if the money remains tied up in existing holdings. Locking in profits when stocks have moved up significantly not only reduces investment risk and loss of principal, but also reduces the volatility in the portfolios. As most portfolio managers will tell you, most feedback from clients, publications, and others will weigh heavily to the negative side. I guess it is human nature, but in this business it seems you are only as good as your last year's performance and in some cases your last quarter. By taking large gains on half the position and being able to continue to hold the remaining half, it is a very positive mental reinforcement and reduces the level of stress that comes with inaction. Strategically, it lets me hold the remaining half for a very long time. Large gains are realized that might have been lost because of market corrections, shakeouts, or just worrying too much about the position. It is a way that successfully permits you to let your profits run. Another approach I use to determine when to sell stocks, is to keep technical stop points on all stocks that have been bought. By focusing the stop on a stock's own price action, instead of a generic percentage, I have found that a much lower number of stops are hit, especially on new purchases. From the fundamental side, I am always reviewing the company to make sure the reason that the stock was bought in the first place still exists. Some of the things I look for are falling gross margins, disappointing revenue and earnings, product delays, and cash flows.

Q: How do you shift the allocation between stocks, cash and bonds in your portfolios and do you have a way of determining whether the overall market is overbought or oversold?

A: The allocation shifts we make are infrequent and are a function of our risk/reward models. Our allocation strategy is to be able to identify the long term trends in the financial markets and be able to stay with them. As risk increases and reward declines in one market, shifts in allocation will be made. I follow a lot of indicators, charts, and fundamental news for the overall markets, but I don't get very involved in the timing of markets or whether they are overbought or oversold. I prefer a bottom up approach.

Q: How do you control investment risk with your portfolios?

A: We do not use any derivative products in our portfolios for controlling investment risk. Our asset allocation and risk/reward models have been designed with the idea of reducing investment risk. How we buy and sell stocks and bonds, and the amount of research that is done also contribute to reducing investment risk. Our portfolios also maintain a cash balance at all times of three to five percent.

Q: How would you describe your typical client?

A: I cannot say we have a typical client anymore. Many of our clients are retirees with large IRA rollover plans. We also have many professionals and numerous business owners with high incomes. In the last few years, we have added a lot of clients for whom we manage the money for their living trusts. Since our inception, due in part to the high level of service we offer, many of our clients are widows or clients that have received substantial inheritances. We also manage money for charitable trusts, IRA's, pension plans, profit sharing plans, and accounts that have been set up for children.

Q: How do you customize your accounts to meet the various investment goals and objectives of your clients?

A: We offer clients three types of portfolios: growth, balanced and fixed income. In the past, we offered varying portfolio mixes to meet client objectives. This is something that we have been moving away from and I am happy to say all three types of portfolios have given our clients very good performance. In the initial meeting Michael Leonetti has with clients, he will review their investment past and their current or future objectives. After discussing the client's objectives, Mike and the client will mutually agree on which type of portfolio will be the best fit for the client.

Q: What differentiates your firm from other firms?

A: Our special niche has always been outstanding service to our clients. From the time clients first contact Leonetti & Associates, Inc. and while they are clients, we want them to feel that any problem, request, question, or whatever information is needed, will be handled as though they are our only client. We encourage clients to call us and recently we have started calling all of our clients on a regular basis so that no one ever feels they have fallen between the cracks. Clients can call and talk to anyone in our firm, including me. We offer clients everything from IRA distribution calculations, quarterly capital gain and loss reports, monthly income checks, check redemption or wiring of money, letters of direction, and mailing copies of reports and statements to our clients' advisors, such as accountants or attorneys. The quarterly statements we send to clients are also prepared with the client's best interest in mind. We provide not only the client's performance for five different time periods, but also the performance of major market averages and index performance for the same time period. Our clients can see our performance and have something immediately in front of them for comparison. Our statements also provide clients with each individual holding's cost, market value, amount of gain or loss in dollars and percentages, and the percentage of the portfolio it represents. The portfolio mix is given three ways: in dollars, percentage, and in a color graphic pie chart. Between our investment performance and client service we have a lot to offer and we appreciate and thank you for giving us the opportunity to express it.

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