Q: How has the fund evolved since inception?

A: The balanced approach to investing has been part of our philosophy for a long time. In 1987, I founded the Thompson Plumb Balanced Fund and that fund still exists. I sold it to Dreyfus in 2007 and now it is called the BNY Mellon Balanced Opportunity Fund.

When my agreement with Dreyfus ended, we started two mutual funds, Plumb Balanced Fund and Plumb Equity Fund. The goal was to accommodate our local clients, who wanted to have a pooled investment vehicle. In 2014, my son Nathan Plumb joined me in managing the fund. Since then we haven’t had any debates about the philosophy, strategy or implementation, because we know exactly what we are looking for and how to achieve it.

Q: What core beliefs guide your investment philosophy?

A: Our philosophy goes back to Peter Lynch and the power of observation. We need to look at the world around us and see how it is changing, what factors affect this change and who is likely to benefit. The macro picture and the global changes leads us to the business models that will benefit from these trends. We examine business models of companies for factors that will aid or challenge their success. The main question is whether the change is a fad versus a business model with sustainable advantages.

We believe that balanced doesn’t mean conservative; it means balancing the risk and the return potential. The efficient frontier theory, introduced by Nobel Laureate Harry Markowitz, examines the tradeoff between return and risk between stocks and bonds. Bonds historically have lower returns than stocks but are more volatile. Increasing stock exposure increases potential return and since high quality bonds actually go up in truly adverse stock market environments, risk doesn’t go up initially with increased stock exposure. The idea is that when you start to increase the equity exposure beyond a certain point, you do add more than 1% of risk for each 1% of incremental return. For us the sweet spot is investing 60% to 65% in stocks, based on the long-term tradeoff between the risk and return in the stock and bond markets.

Although we have studied different strategies, implementations and factors, we don’t believe in adding too many factors to our analysis, because they haven’t been tested with actual money flows. There is a study by Ibbotson & Sinquefield, which shows that the involvement of real money is a huge factor for analyzing international versus domestic markets or any factors that impact volatility. The actual dollar flow changes the whole dynamics of these correlations.

Overall, we believe in using bonds for what they are best suited for. In our field, bonds are meant to moderate the volatility of the stock market. They allow you to capture the incremental return that the market can provide.

On the equity side, we aim to implement our growth strategy without getting caught with different value strategies. There have been huge debates over value and growth stocks. Some historical-looking strategies claim that value stocks can exceed growth stocks over extended periods of time. They view the most recent times as an anomaly. I would say that these claims don’t meet the test of common sense. The largest companies in the world didn’t achieve their growth by cutting expenses or by being a cheap stock that became attractive. We focus on the factors behind true growth companies and the growth potential over cycles.

Q: What is your strategy for identifying these growth companies?

A: We look for companies with business model that do not require huge capital investments to maintain their businesses. The golden goose is the business model with recurring revenue.

Once we have identified the macro trends, we have investable themes. One such theme is the digitization of everything. A company like Microchip Technology, which makes micro controllers, is an enabler of the trend. To digitize the world around us, we need the ability to convert an analog signal to a digital signal. For example, in 1987 the automobile industry put the first micro controller in a car, the fuel injection system. Now there are probably 200 to 300 micro controllers in each car.

Another trend is related to the processing of financial transactions and the changes in global commerce. Today there are places that don’t accept cash, while 20 years ago retailers would charge more for using a credit card. Now they know the benefits of cashless payments for recordkeeping, security, labor costs, etc. The trend is growing around the world and we are all increasingly comfortable to use our telephones, debit and credit cards, online payment processors and all the electronic financial processing between individuals, consumers, and businesses.

That’s a huge market, estimated at around $25 trillion a year. The business-to-business market might be five times larger and still has a significant component of traditional money processing. Of course, these trends will also be affected by cycles, but does anyone believe that people will use more cash and checks when the Coronavirus situation subsides? The trend is going to continue and will actually be reinforced by events like the Coronavirus.

Overall, we have a fun process because we get to play a detective. We look at the changes and whether they represent a secular trend, something cyclical or a fad. We examine how the companies benefit from the trend and if they have a solid and sustainable model. If not, there is a universe of 8,000 investable stocks, so we move to the next one.

Q: How does your investment process work on the bond side?

A: We believe in basics and we buy primarily corporate bonds. We have to know who is going to pay us back and under what circumstances. We minimize the duration risk by keeping the duration short, but we view the main risk as not getting paid back. We use a lot of variable and fixed rate securities and keep our actual duration at two or less than two.

For any fixed income investment, there is credit risk and interest rate risk. There is also some liquidity risk depending on the type of instrument. However, we don’t think we can accurately predict the interest rate risk. Years ago I managed a bond fund for a bank; I had a good record and national recognition. I knew that predicting all the factors affecting the interest rates is impossible, but I could understand the credit worthiness of individual companies.

Q: Once you have identified the macro trends, how do you proceed with your equity selection?

A: Our process is a blend between a top-down and a bottom-up approach. Once we have the understanding of the environment, the changes and their impact, we take a close look at the companies. The key question is whether or not these companies have a business model that will increase the returns to shareholders.

One of the biggest factors is return on sales and that’s often overlooked. Regardless of the environment, if a company is selling something that customers don’t value highly, its profit margins will be eventually squeezed down. But if a company provides something that you can’t get anywhere else in the market, it will be able to price it attractively. The profit margins tell investors whether the company has a truly value-added product with a moat around it.

So, we examine the margins, including the contributing factors, and we follow them on a quarterly basis to see if our thesis is still intact. We need to see that the company is able to build its enterprise with cash flow generated from its sales, not from financing or due to some manipulation that would imply higher than the actual profitability.

One of the key factors is the company’s ability to expand its margins over time, because it shows that the company is efficiently run and has products or services that are valued by the customers. We would sell a stock when we see changes in the competitive landscape or a less valued product line, because that would mean less opportunities to finance future growth.

Running a successful company requires talent at the right spots and an environment that allows that talent to flourish. If a company is closing stores, how are you going to attract talent? We make sure that the companies we invest in are in a virtuous cycle, where they create an environment of past success that can feed future success.

Q: Would you illustrate your research process with some examples?

A: Visa and Mastercard have been long-term holdings because of the secular trend for digitalized payment processing. The trend was further reinforced by the Amazons of the world. These companies benefit from the move towards eliminating or reducing face-to-face transactions for retail, so we continue to see expanding margins and double-digit revenue growth.

One of the main advantages of Visa and Mastercard is that they don’t bear the credit risk. Every time we go through a recession, the cycle hurts the banks that bear the credit risk. In addition, Visa and Mastercard continuously add efficiencies to the processes of the acquired businesses and show growth in their international expansion.

When we first bought Amazon, it didn’t seem like an obvious buy, because the stock had moved dramatically. Traditional valuation models had problems with Amazon because it didn’t make any profits. But looking at the cash flow, you could see that the company was self financing until it bought Whole Foods. What’s the difference between a company like Amazon that reinvests and builds its franchise and an investment company like Berkshire Hathaway, which doesn’t pay out a dividend either? Both of them have cash flow, which they reinvest in their business model.

When we own a company that reinvests instead of paying a dividend, we need to be confident in the attractive rates of the reinvestment and in the value of the future enterprise. When investors buy stocks for the appreciation, they should make sure that all the factors line up for true enterprise growth.

Q: Could you share an example from another industry?

A: In the healthcare area, Intuitive Surgical makes the Da Vinci machine, which is the standard for soft tissue robotic surgery. Again, using the power of observation, we have identified huge demand for robotic surgery. The company already has devices in the hospitals, trained professionals, service contracts and contracts for disposables. Once Intuitive Surgical has the install-base leadership, it benefits from the recurring revenue stream of these contracts.

Hospitals want to expand the potential use of the machines because they have made significant capital investments. Recent data suggests that the device can extend the productive life of a surgeon by 10 years, because surgery is a highly physical job. Now surgeons can sit in a comfortable position and use the robotics to complete the surgery.

In another example, Exact Sciences developed a colon cancer test, which is less invasive and costs less than colonoscopy. Colon cancer is very treatable if caught in the early stages, but deadly if it isn’t. The test has received approval from the FDA. There is an increase of 60% in the number of tests done, because people don’t have to be away from work, the cost is lower and the procedure is not invasive. The test is performed at home and costs about $500, compared to $1,500 and $3,000 for colonoscopy. When recommended by a physician, the recommendation is followed by 75% of the patients, compared to 50% for colonoscopy.

The adherence, the need for early detection, the cost, and the convenience, create a model that can generate profit margins. We expect the company to be profitable by the fourth quarter of this year. Again, the first aspect is evaluating the market demand, the business model and the expertise of the management. The test market is a multi-billion dollar market. Last year the FDA indicated that people should start screening at 45 instead of 50 and the screening is covered by Medicare and insurance. Exact Sciences is developing products for other screenings as well.

Q: What factors determine the asset allocation between equities and bonds?

A: We feel comfortable having at least 65% in stocks because we try not to go ahead of the Fed. Historically, the Fed has told us what its policies will be in the near future, so we react when we see policy changes. When two years ago the Fed raised rates seven times, growth stocks started to underperform. When they lowered rates three times in the summer, added quantitative easing and started to flood the market with liquidity, we felt it was the right time to extend the duration of our stocks.

In the current environment, we believe that growth stocks will continue to lead the market, because there is no competition from the fixed income area. Having said that, one of the most important aspects of risk control is not to get caught in the moment and drastically change the asset allocation to 85% or 90% in stocks just because we can’t perceive some negative factors. Overall, the discipline of staying with our asset allocation is our best risk control tactic.

Right now, an event such as the Coronavirus would lead to changes in the marketplace. The liquidity that was fueling the market advance will disappear. When that happens, the federal banks around the world will come up with new ways to create growth and monetary expansion, but there’s a point where the government doesn’t control economic growth. There’s always some risk out there, so it is key to maintain the discipline and don’t get caught up in the moment. For us, the risk is in the bond market and that’s why we keep our duration short. At the same time, we don’t forget why we have these bonds in the first place, which is to moderate the volatility that can easily appear in the stock market.

Q: What is the role of diversification in portfolio construction?

A: Diversification is important, but also misunderstood. To achieve true diversification, you need to look beyond the industries and sectors and to acknowledge the factors affecting these businesses. For example, some asset allocation models suggest increasing the investments in foreign markets, but they misunderstand some aspects such as currencies, the interconnection of the supply chain, and the level of international revenue of the multinational companies.

Of course, we acknowledge the factors than can cause volatility in U.S. stocks, but we also have to look at where they generate sales. Companies themselves can be diversified and we have to analyze their supply lines and the location of their customers. Within the traditional S&P industries, companies can be affected by significantly different economic factors.

So we are not too concerned about having a certain allocation in energy or consumer staples, because that’s not where the risk is. For us the risk is in the underlying business models and the factors that affect them. We do believe in diversification, but total return comes from specific, not general factors. A company like Visa will be affected by the U.S. economy but it will continue to grow faster than the domestic GDP because of its global penetration.

On the bond side, the key factors are those that will affect the value in the next years. The simplest one is interest rates and that’s why we have kept our duration low. The other factor is whether the industries you are lending money to are affected by the same factors. Diversification is important to ensure that you are not grasping for a little bit of yield on comparable credit qualities.

When we buy companies domiciled outside the United States, we need to have confidence in their reporting and capital structure. Most often such companies are traded on U.S. stock exchanges, where we understand and trust the rules. Of course, foreign companies differ substantially from each other; they may have a set of hierarchy or priorities that are different from our understanding. Unless you dig really deep, you may be easily fooled. We tend to stay away from small-cap international companies because they have too many variables. We prefer to stay within our level of expertise, because that’s where we can add value.

Q: How do you define and manage risk?

A: We view risk as anything that impairs someone from becoming a long-term investor in good quality companies. Volatility can be a significant risk, but the quality of the underlying investment is paramount. In turbulent times, we want to be able to look our investors in the eyes and tell them they own good companies. A key factor for becoming a long-term investor is owning high-quality companies or companies with a clear path to success. You need to have a lot of confidence in their businesses, because many things will test that confidence over time. If you invested in a company with a fad product and no business model to make that product successful over time, what will you say to your client when that stock is down 30 or 40%?

There is the risk of misreading the future, so we have to moderate the volatility whenever we see that a basic premise is challenged by world events. We own the companies as long as we see a successful and sustainable model. When something negatively affects our confidence level, we sell the stock and move on. We believe that anyone who can tolerate the full spectrum of stock market risk, probably should have more invested in stocks than we do in our Balanced Fund. These investors, however, are few as they must have little need of the principle.