TWST: Please start off with an overview of Evergreen Capital Management and what you do there.

Mr. Hay: We are a traditional money management firm, in other words a long-only money management firm, in Bellevue, Washington. We were formed in 1983. We have been around for a while, although I did not buy majority ownership until 2002, when I rolled my client base in there from Smith Barney. I've only been with the firm for about five and a half years, but I've been in the business since 1979. We have gone through a lot of crazy times in the market, but I will say this is certainly one of the more interesting. We not only use individual securities, we also use ETF securities, which we incorporate into our Right Cycle Investing strategy. Right Cycle Investing is really kind of our signature solution, because it kind of permeates everything that we do. Even the non-Right Cycle investments that we manage really follow that kind of contrary-to-the-herd type of approach, and we use mutual fund flow analysis to determine when the overall mutual fund population is really bullish or really bearish and then we blend that with traditional valuation analysis to try to look for a convergence, because they don't always line up. There are times where you'll see extreme enthusiasm and yet valuations still look either cheap or at least okay, and, yet, when things go to the extreme, that's when we get interested. When you have extreme inflows with very high valuations, that's when we go to an underweight under a particular style, let's say small cap value or, conversely, today, where large cap growth has been so out of favor for so many years and it looks extremely attractive from both a mutual fund flow standpoint and also a valuation standpoint. We also spend a lot of time looking at the income side. Unlike a lot of managers, we have clients that want cash flow and we are not just focused on appreciation but actually generating a living income for our clients. We are quite active with things like preferred securities and publicly traded partnerships and royalty trusts as well as traditional bonds. That's kind of an overview of how we do things.

TWST: Would you tell us how you beat the market by refusing to run with the herd and about what you call your Right Cycle approach?

Mr. Hay: I think one of the absolute incontrovertible facts of the financial markets is that reversion to the mean plays out over time. There are various major components or styles in the market and those styles are large cap growth, large cap value, mid-cap value, mid-cap growth, and then small and then you have international and you could argue REITs deserve to be considered a style, though we look at those as a little bit more tactical as opposed to core. You've obviously got all these different components and they go through periods of being either very in favor, very out of favor, and stocks do as well. If you think about one of our portfolios, it's typically balanced. It's not all in stocks. It might start out with a 70% stock allocation and a 30% bond allocation. As the market fluctuates, that changes. If we get into a very bad bear market, your allocation might fall down to 60/40. One of the very first things we do to take advantage of reversion to the mean is to rebalance back up at least to that 70/30 target allocation, and then, if things really get extreme, we've got the ability to go to an 80/20 mix, and that would only happen when we saw compelling valuations and outflows out of equity funds in general. A good case in point would be 2002. You actually saw the largest outflows ever in the summer of 2002, of course, right at the bottom. The same thing applies to the individual styles they go through periods where they are very popular and very unpopular. Large cap growth was where everybody wanted to be back at the end of the decade, beginning of this decade, and of course, that was exactly wrong. If you look at the way the mutual fund world or the separately managed account world was positioned at that time, it was heavily weighted toward large cap growth. Ironically, today, it's heavily underweighted in large cap growth. That style has gone full cycle and we now think that large cap growth is where you want to be overweight, and that eventually, the pendulum will swing back large cap growth will become popular. It's actually showing some early signs of that now, different from the last time we chatted, when it was still very much in a lagging mode. It's had quite a surge here over the last six months, and we think this is just the beginning of a major shift back toward large cap growth. This is because, again, if you look at the overall money management complex, managers in general are heavily underweight growth, particularly large cap growth. These things just cycle over the years and if you can get both the market's cyclicality to play in your favor by doing that rebalancing that I just described buying stocks in general when they're really beaten down and then overweighting the styles that are out of favor when you see the compelling valuations and the extreme sentiment ratings, if you just follow this process over a full market cycle, it's virtually impossible not to beat the market and to do so with less volatility. Of course, that flies dead in the face of what the efficient market people believe. They might say, well, that makes sense but not many people can do it. And there's probably some truth in that; I think that it's a minority of investors that have the mindset not to chase performance. It's performance chasing that really leads to these extremes playing out. You can see it here recently with emerging markets, where they've had just an incredible run over many years and yet the money just keeps flooding into them. We saw it with REITs up until earlier this year, where they just defied gravity for what seemed like an eternity. Then, eventually, the bubble burst and, of course, now prices are way down, people are exiting. That's an example where we think that it's early. As outflows are occurring from REITs, the valuations still look unattractive and it could well be that REITs are going into a multi- year bear phase just as they were in a multi-year bull phase previously. All these things have their seasons, and unfortunately, we believe most investors play the seasons wrong. And that's not just our view; you can pretty much look at any comprehensive study of the performance of the mutual fund population at large and it's really a sad story. We try to get our clients to think differently, behave differently, make the market cycles and reversion to the mean work in their favor rather than against them. That's really kind of the DNA of how we do things here.

TWST: Your process of this, say, tactical asset allocation is to get your clients to go along with you and you say that you have to make them realize that they have an addiction. Is that a strength of your firm, that you have close contact with your individual investors?

Mr. Hay: Absolutely. Because if you don't communicate with the clients, the odds are they are simply going to look at the performance numbers and if you have a contrarian strategy like ours, even though we try to get close to those inflection points, the reality is we're going to be somewhat early. You need to do some handholding basically to keep the clients with the strategy long term and of course, usually when it's looking its worst is about when it's ready to shift to a positive. A good example is in 2007 when large cap growth had just been lagging and lagging and a lot of people were giving up on the concept, but now it's a leader. You're right about close contact and one of the ways we try to do that is by using technology, the Internet, and regular communications with clients, so they can understand what we're doing, they can see charts that make it more tangible for them. We work really hard to communicate with the clients to keep them abiding with us through those difficult periods.

TWST: This investing against the herd, Sir John Templeton and Warren Buffett and others have been advising this for many years and yet the investors still don't listen to the experts. Are you having success in changing people's minds?

Mr. Hay: Yes. I think so. Now, we only manage $600 million. We're not exactly the second coming of Fidelity or Vanguard. So we're doing it kind of incrementally, but we are getting more and more media coverage of our concept. I think that it's one thing for even somebody as luminous as Buffett or Templeton to say, you need to be fearful when others are greedy and vice versa, but the nice thing about the mutual fund flow is that you can really show people, you can show clients what the herd has done in the past and then what has been the outcome. Obviously, the most graphic example is to show them the fund flows that were occurring in the late 1990s, which were flowing out of emerging markets, flowing out of everything international, flowing out of REITs, out of small cap value, out of mid-cap value, even out of large cap value, and all of it going into growth, particularly large cap growth. It was just like this enormous vortex and, of course, we all know what happened after that. If you can give them something that visual and that tangible, I think it really gets the point across in a powerful way. It's a constant process of educating and communicating and we do think the Internet allows us the ability to do that. One of the things we are looking at doing is adding video capabilities, just a brief video clip every month to just interview me and show some charts and again, our business is so intangible and people don't understand it. The average client really doesn't understand what drives the financial markets. They tend to default strictly to performance and that's kind of how things work throughout the rest of the world. You look at how a football team has been doing, how a racehorse has been doing, and it seems like that's an appropriate way to do it. In the financial markets, however, with the inherent cyclicality and reversion to the mean, if you rely exclusively on recent performance, it's going to work for a while but when it's wrong, it's so wrong and you can end up giving all your profits back and then some, in a relatively short period of time. It is this re-education process away from the way that human beings are wired to behave that was great when it came to running away from a saber-toothed tiger but not very good in dealing with bull and bear markets.

TWST: Referring to studies by DALBAR, the research firm that you quote in your newsletter, there is this sentence: "Investment return is far more dependent on investment behavior than on fund performance."

Mr. Hay: Right. That's so true. A classic example have you heard about the Fidelity audit of the Fidelity Magellan Fund when Peter Lynch was running it? Recently, I was with some Fidelity people who confirmed this story. Back in the early 1990s, right when Peter Lynch was leaving the fund, they went back and looked at the last 10 years of how the Fidelity Magellan shareholders had actually done. They'd known that the fund was fantastic because from 1982 to 1992, you had had the great bull market plus Peter Lynch at the helm. But they found much to their utter astonishment that not only did the shareholders actually underperform as a group, but two-thirds of them actually lost money in the Fidelity Magellan Fund during one of the great bull markets of all time. Of course the explanation was when they put their money in. Money tended to come in after a big market move and after the crash of 1987, people would come out and then they would stay out and then come back in after it went up for a couple of years. It was just a classic wrong cycle investing process and there are so many mutual funds that have similar stories. It's also true if you're looking at the 401(k) world at how poorly people have performed with their 401(k)s. We are out there kind of constantly proselytizing that this is one of the greatest financial tragedies of all time and it's kind of a silent one, it really doesn't get much press. Occasionally you see something on this. Forbes ran an article saying that they thought it was a trillion dollar problem; we think it's a multi-trillion dollar problem, and it's just not going to get solved unless there is a really dedicated process to get people to behave differently. It really is a behavioral issue, which is what DALBAR was referring to and of course, those people who are the proponents of the Behavioral Finance school of thought are very persuasive in their arguments to that effect.

TWST: The herd isn't always wrong, though; sometimes it's the right thing. How do you map where the herd's going and whether it's right or wrong?

Mr. Hay: That's a great point because the herd is wrong at extremes. If you just think about it, it almost by definition has to be the case. Once the general investing population is convinced that stocks are terrible, you've got to be close to a bottom once they are convinced they are on the sure path to riches, you've got to be close to a top. The key is to try to find an extreme and that's why we like to look at a very quantitative measurement of fund flows. We look at the standard deviation measurement of fund flows to get a sense that things really are getting out of balance and then overlay that on top of valuation metrics which also tell you the same thing when you get that convergence. A good case in point would be international over the last few years where the herd has been right. There has been a lot of money flowing into international over the last few years and the international markets have continued to rise and it's because valuations were so compressed going into this period that the valuations really have never gotten out of whack. That's where you can say, "Yes, there is a lot of enthusiasm, there is a lot of money coming in here, but this is a trend that is likely to continue for a number of years." Then if you segue from developed international to emerging international, that is where you're starting to see extreme valuation points being reached. To us, when we look at overseas, we're much more concerned about the emerging markets than we are the developed markets. It's a great point. You do have to be quite patient, but even using our process, we're often early; the up cycles and down cycles tend to run further than they should logically.

TWST: The assets and mutual funds have been totally focused on the value side and you're now saying that large cap growth is where people should be. Is that all part of your Right Cycle investment approach?

Mr. Hay: Yes. We're as overweight large cap growth as we're able to be. We're still maintaining diversification. In other words, we are not out of large cap value, we are just as underweight large cap value as we can be and we also have some mid- and small and some international, but yes, you're correct about that.

TWST: You were overweight in large cap growth much earlier, I believe.

Mr. Hay: Right. We really started going aggressively overweight large cap growth in mid- to late 2004. As I said, we were a little bit early. We didn't give up a lot of performance, but it was just a couple of years of a minor lag. Nothing like what we saw in the late 1990s where we were also early. At that time what was within our backtest phase as opposed to running real portfolios, but there is always kind of a suspicion of backtests, that they paint too glossy a picture. Our backtest was pretty realistic because it just looked terrible in the late 1990s because we were early moving out of large cap growth into small value and mid- and overseas. Yet once that turned, we went from far behind, 2,000 basis points behind, to way ahead very quickly. When you see these things get to extremes, you're put in a quandary where you would say, "Well, do we wait till it turns and the momentum is on our side or do we just say look, we are not going try to cut it that fine, this is a major opportunity and we are going to an overweight position." And that's the decision we made at the time.

TWST: Within your large cap growth focus, are there sectors that you particularly think will be outperforming?

Mr. Hay: Not in the Right Cycle area because we just use the major styles, the major style ETFs. Specifically our largest holding right now is S&P 500 Growth, but we manage actually more money on the individual security side than we do on the ETF side. In that regard, yes. Basically we think those companies that can have consistent earnings growth over the next few years are the best place to be, so the healthcare area and certain tech companies that are less cyclical; Microsoft (MSFT) would be an example of the type that we are looking at. Basically the theme for us is to be as non-cyclical as possible over the next couple of years. Not all large growth companies are non-cyclical; they do have a bias that way. The other big advantage for large cap growth right now is it tends to be very light on financials and we know what is going on with financial stocks.

TWST: The volatility that's been so prevalent in the market the last few months looks like it's continuing into 2008. Does that impact your investment approach?

Mr. Hay: We felt (and this is something that we have written extensively on) that 2007 was going to be the year when volatility would rise and risk premiums would rise and that when that happened, you'd get a leadership change (which we've seen) away from some of these more cyclical value areas not all of them, some are still running, but we think that it's just a matter of time before they get hit too. We are seeing this leadership change. When you get more volatility and higher risk premiums, there tends to be a flight toward quality and another reason why we have been bullish on large cap growth is that it is the highest quality part of the market. If you looked at an S&P rating of quality, the S&P 500 growth has got a higher quality rating than any of the other styles. I think this higher volatility was both expected and needed, and it plays into our strategy.

TWST: You say your favorite fundamental metric is the price to sales ratio. Would you discuss that?

Mr. Hay: We use various metrics and I wouldn't say it's the only one we use, but we think it's the purest and that's because it's less subject to accounting distortions where firms, as we know, have had a tendency to manufacture earnings. That was more of a problem six or seven years ago, but we are seeing a little bit of a resurgence of that creative accounting, slight of hand accounting. The other, more important reason right now is that it's less influenced by the economic cycle so that when you look at p/e's for the overall stock market right now, it actually looks pretty low. It looks reasonable anyway, in the mid-teens, but there are two reasons for that. One is because the blue chips are legitimately cheap, big high quality companies, which are dominant in the S&P because if you look at the smaller companies, they are about as expensive as they've ever been. You've got part of that low p/e coming from the heavy weighting of blue chips in the S&P 500, but the other thing is that profit margins are at a cyclical peak, in fact they're at basically a multi-decade peak and they look to be coming down. It looks like they've crested. Therefore, if you just simply rely on p/e's you can get some misleading readings. That's why in the value area, the cyclical area, one of the old sayings is you want to buy them with very high p/e's when they are making very little money or losing money and you want to sell with low p/e's. There's some truth to that in the overall market as well in that there is an economic cycle that plays out to the overall market, and we think that probably the true p/e right now is like 18 times. If you look at price to sales, you eliminate that issue. There are obvious negatives in looking just to price to sales, but I think it's the purest of all the metrics that are out there.

TWST: As we go into 2008, do you see any seismic shift that's likely to take place in the coming year in the market?

Mr. Hay: It's pretty seismic out there right now. Whether they are going to be as seismic going forward, it's hard to say. Obviously we've got one of the worst episodes for financial stocks ever and I think the big question is, are they bottoming. If so, that will work against the large cap growth overweight if you got a major rally in the Citigroups of the world and I think that's a very tough question. One of the things that we have been spending more time on and are quite concerned about is this whole issue of credit default swaps (CDS) and particularly the counterparty risk that goes along with them because we do think that there is the potential for that to be the next big bombshell that finally flushes things out on the financial side. The reality is that over the last five years, as we've written, where there has just been a lunatic lending cycle like we've never seen which was most obvious in the subprime world, but that's not the only place where the excess has occurred. They also have occurred in the corporate lending area as well, particularly with junk bonds and leveraged corporate bonds. The big financial players rely on the credit default swap coverage to off lay their risk. If you start to get a chain reaction of defaults among the entities providing CDS coverage, the big financial players may have much less coverage on the credit side than they thought they had, and I think that's a very real possibility. One disturbing factor is that roughly a third of all CDS insurance is issued by hedge funds and it's been very lucrative because defaults have been really low, but with all the leveraging up that went on here over the last few years on these corporate takeovers and then mixing in a weakening economy, you have a recipe for dramatically rising defaults. If you get that in a situation where entities the Citigroups of the world think they've got a lot of their risk laid off under the CDS process and then all of a sudden they start to blow up on them, that would be a pretty unfortunate occurrence, given how fragile the system is already. We are quite concerned about that part of it. There is no regulation of the companies that are playing in the CDS game, there are no reserves put aside for them, so when you look at the travails of an MBIA or an Ambac where there really are reserves and there's a lot of scrutiny, I mean that could be just a little tiny molecule of the iceberg compared to what could occur in the corporate CDS world. If we had to really identify what is our big fear for 2008, that would be it.

TWST: What do you say to investors that don't want to leave the value style because value held up better than growth during the last bear cycle?

Mr. Hay: Rearview mirror investing is such a radically different situation today than what it was then if you really had to drill down and look at what the facts are now and the facts were then. Value stocks were very out of favor, they were very inexpensive. They had had several years of outflows, and sentiment was very negative. You had just a perfect scenario for money to move from the overvalued tech area into the undervalued value sectors. Today it's really the inverse of that; a lot of these value stocks are more expensive than the high quality growth stocks. Just look at utilities; utilities are kind of a classic value hiding place and utilities have had an exceptional performance over the last few years. If you look at the S&P utility ETF, it's yielding 2.6% right now and would you rather have GE yielding 3.4% or a utility yielding under 3%? I just don't think there is any kind of horse race there. In many cases it breaks into super high quality consistent growth stocks trading at p/e's equal to or lower than utilities. If you were to look back to the early part of the decade, one of the best places to be during the blowup of the tech bubble was in the financial stocks, and yet this time around we've seen that the financial stocks are the highest risk part of the market. That's already telling you that something is different this time around. I think the same thing may be true with the energy stocks. We're concerned that they're at risk in some of the heavy cyclical names, some of the companies like Hewlett-Packard (HPQ) that have had such an amazing run over the last few years; they look to have far more downside than upside at least for the next couple of years.

TWST: Do you think that there is a growing trend among money management firms to incorporate behavioral finance into the picture?

Mr. Hay: It's really much more accepted than it was. It was kind of a renegade school of thought up until the last few years and it was, I think, Daniel Kahneman from Princeton who won the Nobel Prize for his work in behavioral finance. It's certainly making inroads with even some of the efficient market people having conceded that there is some behavioral finance applicability to the markets. Their general view, however, is that it really isn't something that a typical person can take advantage of. I do know the folks at Legg Mason, Bill Miller's team, are very big in behavioral finance; JPMorgan has a behavioral finance oriented money management unit that is pretty significant. The word is spreading, but you've got a lot of disbelievers. One of the things that happens is, they look at Bill Miller, who goes through a couple of horrible years and they go, "Well, that behavioral finance thing doesn't work. Look how poorly Bill Miller's performing." Any time you go through a period of poor performance, the naysayers come out of the woodwork and slam the concept, but we've shown our Right Cycle methodology to a number of skeptics and they've had a hard time pulling it apart other than to say that most people won't stick with it.

TWST: When they invest with you in the Right Cycle approach, they should invest for the full market cycle, right?

Mr. Hay: Correct.

TWST: Because sometimes you would be lagging if there were a mini-bubble on certain stocks.

Mr. Hay: Absolutely. When a fad or trend is really late in the game, we are almost sure to lag because at some point when it gets into La-La Land, we are going to be underweight or completely out of that particular style or sector. So you are exactly right. It's okay to be somewhat early, you just can't be real early in terms of price because, as you pointed out, we were pretty early not in price this go around, but in time. Clients, if you are at least kind of close, tend to be much more tolerant than if you're really experiencing a huge lag like what poor Bill Miller is going through right now, who, by the way, I think is still one of the most talented money managers out there, and it's probably one of the best times you could ever put any money with him.

TWST: Is there anything that you would like to add?

Mr. Hay: I do think there is an area of extreme opportunity right now and the window may close fairly soon: because of the credit panic there are a lot of very high quality preferred stocks that are being sold indiscriminately and it's being magnified by the year-end tax selling. Right now we just see some amazing opportunities in things like Comcast (CMCSA) preferred or Viacom (VIA) preferred, and a number of the REIT preferreds. We don't like the REIT common stocks, we think the REIT common stocks still look overpriced, but the REIT preferreds have been crushed and offer yields in the 8% to 9% area plus capital gain as well. That is a little of an off-the-beaten-track thing because preferreds don't get looked at, it seems, by a lot of money managers, but they are like anything else at times they can become very attractive and we think this is one of those times.

TWST: Thank you. (PS)

Note: Opinions and recommendations are as of 1/3/07.

DAVID HAY Evergreen Capital Management, LLC 500 108 Ave., NE Suite 720 Bellevue, WA 98004 (425) 467-4600