Q:  What is your investment philosophy? A: In the small cap arena 56% of all small-cap stocks under-perform market in a given year so you start with the odds tilted against you. Our investment process is designed to tilt those odds back into our favor. We believe that the value of any asset is the value of the future free cash flow, as opposed to reported earnings. Studies show that when free cash and earnings diverge, stock prices follow the free cash. The other underlying pinning of our approach is how management uses their excess cash to the benefit of the shareholders. Every single company in the portfolio pays a dividend but beyond that dividend payment, we want to see management teams using that excess cash to pay down debt, as well as buy back stock. Q:  Why do you focus on small-cap dividend payers? A: Small-cap dividend payers not only significantly outperform their non-dividend paying counterparts but they do it consistently. They protect you on the downside, yet you also participate on the upside. Dividend payment means much more visibility on the cash flows and that lowers the overall risk profile of these stocks. There are a little over 1,300 dividend paying small-cap companies. Q:  How is your team structured? A: We have a team of eight people that manage $405 million in small cap value equity assets. Six analysts are making the buy/sell decisions; there is one quantitative analyst, and one Client Portfolio Manager, who is involved in the business development and ongoing client service. The analysts have varying backgrounds and we have been together now for several years. Each of the analysts has specific sector responsibilities. Based on our past experience. every sector has been covered by at least two of the analysts at some point during their careers, which fosters a lot of discussion on names that are presented. Q:  Are all your investment decisions entirely consensus-driven? A: They are all consensus-driven. It’s the responsibility of the analysts to bring names within their coverage area to the group and then the group will challenge their assumptions. The team will make a decision whether or not the position warrants a place in the portfolio. If, for some reason, a position has not followed this disciplined process, then our Director of Value Research, Khris Herrick, does ultimately have veto power. But he has never used it and we would not foresee him ever having to use it. The bonus structure for the analyst group is unique. The analysts are not eligible for a bonus unless the overall portfolio outperforms the benchmark. This incentizes the team to get the best ideas into the portfolio. Q:  How is your investment process organized? A: We use a quantitative multi-factor screen. The importance of our screen is that it is sector specific. From our back testing we have identified those factors that are proven to be predictive in generating superior risk-adjusted returns. Our proprietary screen is looking at earnings and cash flow quality, management behavior, timing and valuation metrics. Our quantitative model ranks all of the stocks within a sector. Stocks are ranked from the most attractive to the least attractive. The analysts then focus their attention on stocks within the first and second deciles from the list. That’s how we get down to our working candidate list. Q:  What are the key elements of your research process? A: We’ll take a company from that candidate list, and we’ll put it into our proprietary free cash flow model. We will stress-test the business model to identify whether the key driver to increasing firm value is going to be driven largely by an increase in sales, or it is going to be driven by margin expansion. That helps us identify where we need to focus our research efforts. I’ll give you an example. Belden CDT is a current holding of ours. They are a manufacturer of wire and cabling products. For them, a 1% change in sales impacts the value of the business by less than 5%. However, a 1% change in margins impacts the value of the firm by nearly 30%. So we know that we need to focus more of our research time on understanding how margins are going to improve going forward. To uncover that we are doing research by speaking with customers and competitors, suppliers, as well as other industry contacts. Then we ultimately value the business based on our free cash estimates. On the valuation side, we use two other approaches, and we classify those as cross checks. It’s just a reasonableness check with the valuation we derive with our free cash flow model. At this point, they have gone through the research process, have concluded that there is a significant amount of upside to the idea and they will then bring it to the group for a discussion. We have a formal write up on every single name that we present. It goes over the thesis of the stock, the risks, as well as sign posts that we are tracking to make sure that the returns are improving the way that we think they ought to be. This is a critical component of our process, because it leverages the various insights and expertise that each team member brings to the decision making process. So, we, the team, are going to challenge the assumptions in the free cash flow model; we are going to understand what the key driver is, why it’s going to improve and how sustainable the improvement is; we are going to understand the risks and the probabilities of those risks, then we, as a team, will ultimately decide whether or not it warrants a place in the portfolio. If one of us has outstanding questions, then it’s the analyst’s responsibility to get those questions answered. If we decide that the stock warrants a place in the portfolio, the initial position size will be between 1% and 3%, based on the upside potential, coupled with the risk profile, and then taking into consideration what our current sector weightings are. The reason why that last point is important is because we are sector sensitive. Our portfolio sector weights are kept within a +/- 5% weight relative to the Russell 2000 Value Sector weightings to control risk. Another risk control is we don’t let investment position sizes get too large. The maximum in any one name will be no more than 5%. Q:  What is the average number of holdings that you have? What is your turnover? A: In the portfolio the number of stocks averages between 55 and 75. This number provides the diversity that we seek but it also allows us to actually have real impact with our positions. Our turnover is between 40% and 60%. We don’t time the market. We maintain a fully invested portfolio, so advisors aren’t going to wake up one day and see that we have raised a bunch of cash for defensive purposes. Q:  Could you give some historical examples to illustrate your research process? A: For example, when we started our research on Belden CDT, industry consensus was that the company was going to realize 50 basis points of margin expansion. From our research, we saw that in recent years there had been a lot of capacity in the industry closed or eliminated either through companies shutting down inefficient manufacturing plants or merging inefficient operations. Industry was left with fewer but more rational competitors; they had industry capacity utilization moving from the high 70% up into the 90% range. That was important because not only were they able to pass on rising raw material pricing, but they were also able to get real price increases. Obviously, the leverage was significant. Our independent research was focused on talking to those end users and the suppliers. We talked to a couple of IT distributors and we spent a lot of time trying to understand that competitive environment for different products. Our research led us to conclude the company would likely be capable of expanding margins by 5% or more over the next 2-3 years. Every 1% change in margins would translate into a 30% change in the value of the company making this an attractive opportunity. Q:  How would you describe your sell discipline? A: Our sell discipline is relatively straightforward: we will sell a stock if it has reached our estimate of intrinsic value or if our original thesis for owning the stock is violated. We will sell a stock in order to add a more attractive idea to the portfolio and we will sell a stock if it appreciates above the market cap range of the Russell 2000 Value Index. Q:  What risks do you monitor and how do you mitigate them? A: Our strength lies in our proprietary research and we want this to be the dominant factor impacting our results. To that end, we keep the portfolio broadly diversified in terms of sectors and individual issues. We do this by maintaining sector weights within a +/- 5% band of the sector weights of the Russell 2000 Value Index and we do not let individual positions exceed 5% of the portfolio on a market value basis. We believe we are hired to manage small cap stocks, and we typically keep our cash position in the 1%-3% range. Last but not least, we tend to be conservative in our cash flow estimates.