Q:  What’s your investment philosophy? A: Our core belief is that earnings and cash flow generation drive stock prices. We are looking for companies where we think the future earnings and cash flow generation is going to be above market expectations. Our time horizon is two years. It’s not a science, but we’re looking for longerterm ideas where we think the earnings power would be above expectations. Q:  Why do you believe that future earnings are more important than historical earnings? A: We are trying to figure out where the stocks are going to go from today. Past earnings and cash flows are already incorporated in the stock. That is in the past and that is not very relevant to the future direction of the stock. What is important for where the stock is going to go is what happens in the future. We do study the past to learn about cycles and history, but the drivers of the stock price from today are going to be what happens in the future. When you look at a stock price, it incorporates a consensus view about what may happen in the future. Not only does it reflect what happened in the past, but it also reflects the market expectation about what will happen going forward. The market has some sort of rate of growth built into the revenues, earnings and cash flows and that is what drives today’s stock price. In our process we are looking for companies where we can identify upside earnings or cash flow surprises relative to market expectation. So we generally believe that the earnings in every one of our holdings will look more favorable going forward than what the market currently expects. Q:  What do you do when you don’t have any market expectations available on certain stocks? A: We are a fund investing in large-cap stocks, measured against the S&P500, and we would rarely run across a stock that doesn’t have Wall Street consensus expectations. This selection tool is not always absolute, because there are times when a stock overly discounts negative news and you could have consensus earnings numbers that come down and stocks still go up. We don’t want to make it sound like we only use Wall Street estimates to gauge expectations, because we don’t. Stocks, even if they are not followed, have some expectations, based on the price. Then there are other ways to understand the expectations besides Wall Street consensus. We use valuations like discounted cash flow and we look at multiples relative to the company’s history and the industry. Q:  How would you describe your investment process? A: We have a process that utilizes topdown and bottom-up analysis. We try to use all of the available information, our internal research staff, our in-house economists and everybody in the investment process here at our firm, which is a quality set of resources for us. And if we can identify a top-down theme or a sector where we think the growth rate and earnings across the sector will be underappreciated, then we’ll latch onto that and overweight that in our portfolio. Similarly, if we find a sector that is going to disappoint in terms of future performance relative to expectations, then we will underweight it in our portfolio. Then, even in these top-down themes that we identify, we are going to use bottom-up analysis to try and figure out which companies within that framework are likely to be the best ones to own and which stocks are likely to see declining performance. Even though we are looking for the top-down theme and for sectors that will outperform from an earnings standpoint, there may be times in the market where there is no dominant theme. For example, in the last couple of years, a very prominent theme in the marketplace was energy and industrials and we identified that very early. Currently there is not such an obvious theme to us, and we are likely to be more sector neutral and focus on bottom-up stock picking to drive our performance relative to the benchmark. We have a research process firm-wide that starts with all the investment division getting together on a daily basis to go over what’s going on in the market, and in the international markets, from a currency standpoint and economic growth standpoint. This is an effort that is supported by a process firm-wide to sort out where we are going to find underappreciated growth, either in a sector, or just from a company-specific standpoint. Q:  Can you give an example to illustrate how an idea turns into a holding in your portfolio? A: For example, when we bought John Deere there was growth in ethanol demand. Farmers started putting up ethanol plants to take advantage of the higher prices in energy, and the amount of corn used to feed the ethanol industry looked like it was going to double in the next few years, so we bought John Deere stocks. We identified there was going to be growth in demand for ethanol, and that would lead to higher corn prices. When farmers see increased corn or wheat prices and they have more cash in their pockets, they are more likely to go out and buy farm equipment. So, we figured out that one very meaningful way to play ethanol is by buying a position in Deere. Q:  How do you generally build a portfolio? How do you diversify? A: We generally don’t go over two times the allocation in the fund in any particular S&P500 sector and won’t go much under half-weighted in any particular sector. So we manage diversification on the sector weightings. Besides just having the top-down theme finding process, the bottom-up process also adds ideas in sectors where we don’t have a powerful theme. We generally have fifty to sixty names in the portfolio and that, by definition, keeps us relatively diversified. We are trying to keep the portfolio roughly half in the bottom-up and half in the topdown. That can vary depending on how strongly we feel about certain things at a particular time. If we felt like there were three powerful themes, we may steer more towards 70%, but we want to keep a balance in bottom-up and topdown ideas. Q:  So you have two elements that are drivers in your strategy - one is the bottom-up and the other is the top-down. We did get a flavor for top-down, and maybe you can also give some flavor for the bottom-up. A: There are plenty of stocks in sectors where there isn’t a particularly positive outlook. We would use technology as an example. Hewlett-Packard is a stock that we still own, and we profited from. That was based on an idea of a company that was mismanaged for many years, and new management and a restructuring story. The top line hasn’t materially improved. It’s staying at around 5%-6% range, but you have had a much better cost cutting and management of the business than ever before. This was something we identified early. Meeting with the management is another important thing, especially on these bottom-up ideas. It is a bottomup pick where we felt like the consensus was thinking that this company is out and in a couple of years might earn $2. After meeting with management and monitoring their performance over a couple of quarters, we felt that they could make towards $3. A lot of times when you have a company that has been down in the dumps for a while, you have a management change and the key is assessing new management and determining the probability of effective execution, and what would that leave you with versus expectations. Whether it is a top-down or a bottom-up idea, the commonality between the two ways that we arrive at an idea is that at the end, the stocks that we own are likely to have varying performance that surpasses current expectations. Q:  Generally, what is the turnover in the fund? A: We think it will probably be in the 50-60% range, consistent with a twoyear holding period for the stocks. It is roughly the same in terms of turnover for the names. We manage position sizes a little, but two years is a very good holding range. Q:  What do you do in a situation when stocks move because they are to be added or dropped from the S&P500 index? A: We look at where the benchmark is in terms of sector weightings, but we don’t use the benchmark to drive our sector allocations. If you look at our portfolio of 50 to 55 stocks, we could only own 10% of index and our portfolio is going to look quite different from the index. Obviously, if something is becoming a bigger part of the index and it is driven by fundamental reasons, we are going to pay a lot more attention than if it is driven just by sentiments in the marketplace. Stocks move all the time when the S&P500 adds or detracts stocks from the index but we don’t really pay a lot of attention to that. We look at it as a general guide to where the market is positioned. Q:  Do you look at ADRs of foreign companies? A: Yes, we do. We can have up to 20% of the fund now in foreign domiciled companies. We look at the index as sort of a risk management tool, but it really has zero impact on securities selection, because we’re focused on earnings power of the companies exceeding the expectations. T Q:  What kinds of risks do you monitor and what do you do to mitigate them? A: Besides what we talked about on sector weights, position sizes and number of names, when we buy a stock we take a view on where we think the long-term earnings power is and we monitor that over time. Our risk assessment is in judging it as the quarters unfold, as we meet with management, as we do our day-today research, and our internal research staff does the same. We monitor how this earnings projection that we have is correlating with what is happening in reality. When there is a break in trend, we study it and see if it is just a glitch or whether there is a material change. If there is a material change then we are likely to sell the stock. We do not usually change the thesis to try and justify the holding. That is how we consistently try and manage risk in the fund. Q:  Could you give an example to support your view? A: For example, we used to own Dell Computer in the portfolio. They had a couple of quarters where they missed earnings estimates on the short term but we don’t initially sell just on that. After studying what the company was saying and understanding how the industry was changing and after meeting with management, we thought that the earnings power was going to be much lower than what we had earlier thought, and we sold the stock. So, we manage risk from a standpoint of our fundamental belief on what drives stock prices. As far as managing risks and as far as concentration, we do that through keeping an eye on where the benchmark sector weightings are, and keeping roughly 50 to 60 names in the fund. Typically, a single position won’t be more than 5% of the fund. We have position sizes now up to 4% of the portfolio, but we continually monitor positions and make sure they don’t get out of line. That helps mitigate some of the risks.