Q:  What is the history of the company and the fund? A : I started at Madison Investment Advisories in 1997 and I am the portfolio manager of this fund since 1998. We have managed the fund with the same philosophy for over 15 years. Since late April 2013, Madison Mosaic Mid Cap Fund has been merged with a fund we acquired several years ago, the Members Mid Cap Fund. We have been running these two funds for over three years with identical investment strategy and now operate as one fund with over $300 million in assets under management. The merged fund is called Madison Mid Cap Fund. The overall focus of the fund is achieving capital appreciation while always being cognizant of the downside. We want to participate as fully as possible in up markets and protect capital in down markets. Over the past 15 years through the first quarter of 2013, third party analysis revealed that the fund captured 96.3% of the upside while exposing investors to only 78.3% of the downside. Although we always like to do better, I think that is strong evidence our objectives and philosophy have worked. I believe one key to our success is conviction. If I were not a mid-cap fund manager, and if I were instead just managing my family’s money, the vast majority of stocks I would own would be mid-cap stocks. Mid-cap is a sweet spot in the market where companies have emerged from the competitive caldron of small start-ups and can now demonstrate some of the characteristics we look for including strong sustainable competitive advantage and predictable cash flow. Their size allows them to attract very talented management teams, yet they are not so large enough their size impedes growth. Of course, not all mid-cap companies are made alike. In terms of moving from class to class, it tends to be company specific. Some companies go from large-cap to mid-cap to small-cap and are not attractive holdings. Some stay in the mid-cap classification for years. Then there are others that are very successful and steadily move through it to large-cap status. As an example, we own a liquor distiller company called Brown-Forman. They have the Jack Daniels brand. I grew up in Louisville, Kentucky where this company is based. I have been familiar with them for 30 or 40 years. This is not your typical mid-cap company. Jack Daniels is arguably the best global brand in the alcoholic beverage business. This is a mature company whose industry niche may confine it to mid-cap status for the long-term, while retaining the prospect of admirable profitability and impressive growth, especially in emerging markets. Then there are smaller mid-cap companies. We own a company called World Fuel Services, a logistics company that provides fuel for aviation and marine transport. This company is probably in the lower end of the maturity cycle. We think this company and business holds tremendous growth potential. Q:  What is your investment philosophy? A : I am a student of Warrant Buffet and some of his protégés, people with similar beliefs. That is where I developed my investment principles. Over the years I have learned to appreciate how valuable it can be to pay up a little bit for a great business, a great compounder that you can hold for years, especially in the mid-cap area where you can buy these smaller companies that have a lot of growth ahead of them. We want to invest in high-quality companies that grow on a consistent and predictable basis and we want to purchase them at reasonable valuations. I call our ideal company a compounder, a company that is in a great business niche, which can compound capital for long periods of time. Q:  What is your investment strategy and process? A : The first thing we look for are companies with a sustainable competitive advantage. To use a Buffet term, how wide is the moat around the business? We look for market leadership and analyze the barriers to entry in the company’s business. We are attracted to companies that have pricing power or an inherent cost advantage. Often these companies have strong brand names. Another portfolio holding is Tiffany & Company, the jewelry retailer. They’ve been around some 175 years and never held a sale in all those years. That tells you a lot about the power of their classic blue box and the power of their brand. Another characteristic we look for are companies with predictable cash flow and consistent earnings growth. The primary method that we use to value companies is discounted cash flow analysis. This valuation model is only going to be accurate to the extent that we can predict future cash flow. An example in our portfolio is Ecolab Inc, the world leader in sanitation and cleaning products. They make a lot of products for restaurants, hotels, hospitals, sanitizing restrooms, laundry, disinfectants, and have a predictable recurring revenue stream. We also like companies that have very strong balance sheets, but have some leeway. We will tolerate some leverage if the cash flow is predictable and we are confident the company can pay the interest on that debt. It is a three-legged stool. The first is our business model analysis which I have just summarized, the second leg is our assessment of the management team, and the third leg is our valuation work. In terms of the management team, we are looking for their ability to allocate capital wisely. We want to be confident the management team makes good, wise decisions with their cash flow. Cash flow is really the primary tool for a management team and they have a variety of choices in what they can do with that cash flow. An example of a history of excellent cash flow management is one of our long-term holdings, a company we have owned for over a decade: Markel Corporation, the insurance company. It is currently our largest holding. We think they do a tremendous job allocating their capital. They use their premium float, similar to Berkshire Hathaway, and they invest in the stock market. They have a long track record of earning strong returns on their equity investments. They are also patient and have a long-term business horizon. If the pricing is not favorable in the insurance market, they will stay on the sidelines and not write business that will likely prove unprofitable. We like to think of management teams as our partners. We want to see that they have a track record of enhancing shareholder value. We want their incentives to be aligned with us as shareholders. We like to see management teams that own a lot of shares and therefore think and operate as long-term business owners. Companies can meet all the characteristics I have talked about but we are not going to buy them until the valuation is attractive. The primary way we value companies is through the cash flow analysis. We work at forecasting the future stream of cash flows and discounting them back to present value. We will look to a number of different things to corroborate our findings such as price-to-earning, price–to-book, enterprise value to EBITDA, and private market valuations. Some of it depends on the industry. In the insurance area, for example, price to book is a valuation metric we concentrate on since the management teams focus on growing book value. Earnings can be quite volatile depending on any recent large insured events that have occurred. Q:  What is your research process and how do you look for opportunities? A : I am the lead portfolio manager, Matt Hayer is the co-manager and we work with a team of five analysts. Even as managers, we see ourselves as analysts. What fascinates me in this business is the stock picking; I do not want to be just a manager who doesn’t engage in hands on, individual company research. I like to have a deep understanding of the companies. We have a universe for our mid-cap portfolio of companies from $500 million to $25 billion in market cap. We screen that universe for a number of different qualities. I am an advocate of emphasizing return on invested capital so ROIC is an important metric we screen for. In capitalism, if you invent a great business and it is earning solid returns, the market usually generates competitors that are going to knock down your returns on invested capital. But occasionally a company will have such a strong moat around their business, such a strong competitive advantage, that they can maintain these returns on invested capital at high levels. If you can fill a portfolio with a bunch of those companies, I can guarantee it will be an excellent portfolio. The difficult part is identifying those companies that will be able to maintain their return on invested Capital over and above their cost of capital for long time periods. These are our quantitative screens. We also screen for strong balance sheets, free cash flow generation, stability of earnings, and then a variety of valuation metrics, depending on the industry. The other side of the screening process is what I call the qualitative side of idea generation. Here’s where experience comes into play and where we perform hands-on research. What we are trying to do is identify the superior business models out there. It is a two-dimensional process. How do we identify the superior business models? It is a lot of detective work. We attend conferences, talk to management teams, read everything we can get our hands on from trade journals to business publications. We also speak to industry contacts; we speak to other people in this business. We do visits with companies and we make a lot of phone calls. Sometimes you will find out about one company though another company. From this initial research we move on through a number of different filtering methods to develop a short list of companies targeted for detailed analysis. Each of our analysts focuses on his favorite ideas to pitch. We evaluate each pitch as a group and typically raise enough questions that there is cause to go back and do some more work on the company. Companies that survive this process have a good chance of eventually ending up in the portfolio. One example of a company we recently purchased is Advanced Auto Parts, Inc, a retailer in the automotive after-market parts business. To us this is a particularly attractive business. They are about two-thirds retail via brick-and-mortar stores, but they have been building their commercial business, which means they supply parts to commercial garages and commercial repair shops which turns out to be a highly profitable business. The other major companies in this business are AutoZone and O’Reilly. There is also NAPA Auto Parts and CARQUEST Auto Parts, but they each have their own focus. This is a high return on invested capital business and generates good margins. When we look at a retailer these days, it is not like 20 years ago; the first thing that comes up in our mind is ecommerce. You have to ask, is Amazon going to be a threat? We think there is currently little threat, although we keep a close eye on this. For the most part, when do-it-yourselfers and garages need an auto part, they want it as soon as possible, and are not going to order it off the Internet. The other thing we look at it is import competition and there is very little in this business. There is also little obsolescence risk. In auto parts they have to keep up with the newer models but with the part demand for older cars, there is not a lot of risk that their parts are going to become obsolete. It is also somewhat recession resistant. Even during the financial crisis of 2008-2009, these stocks generally fared relatively well. When people do not buy new cars because times are tough, the average age of the automobile goes up and so does the need to repair their vehicles. They have a new Chief Executive, Darren R. Jackson, who came from Best Buy and he has done a great job. We think they can get to over 12% margins, which means there is a lot of upside for earnings. We bought the stock at less than 10 times normalized cash flow and, although it has moved up in price, it is still attractive from a valuation perspective. In order to build the commercial side of the business they are going to need more distribution centers so they are investing in these and that will hurt their free cash flow in the near term. Since we invest for a longer time horizon, this is not a critical issue for us. Another stock we have added to lately is a company called Crown Holdings, a manufacturer of aluminum and steel cans used for beverages, food, and other consumer products. This business is really a global oligopoly with rational pricing characteristics. Their main competitors are the U.S. based Ball Corp and the U.K. based Rexam. The management of this company is shareholder-friendly, has wisely allocated capital, has paid down debt, and made a lot of share repurchases. What is particularly interesting about Crown is their investment of significant capital to build capacity in developing markets, where we see most of the growth opportunities for the industry. We believe these investments will pay dividends in the future while their free cash flow should accelerate since these capital expenditures are behind them. This is a business where you have to run your manufacturing at high utilization rates to generate profits. There are very high transport costs, you are not going to make and manufacture aluminum cans in China and ship them to Europe for use. It is just not economically feasible, so you have to have manufacturing facilities within a reasonable distance from the end market. In 2014 we think Crown can do about $4.80 in free cash flow per share assuming the global economy does not fall off a cliff. If that is the case the stock is selling at a multiple of 8.3 to free cash flow, which provides a substantial margin of safety. Should the global economy go south it can hurt them marginally, but compared to a lot of other businesses there is much more consistent demand and the business should be resilient. Q:  What is your portfolio construction process? A : We own 30 to 40 stocks and we like to run a concentrated fund. We believe in having larger positions in our high confidence ideas and not being overly diversified. I think you have to be concentrated to beat the market over long periods of time. Markel is about a 5% position; Crown and Advanced Auto are both about 3.5% positions. Portfolio turnover last year was approximately 25%. Generally we are in the 25% to 40% range. I am more comfortable when the turnover is lower. In some years when there is a lot of volatility in the market, such as 2008-2009, the turnover tends to be higher because we have more opportunities for buys and sells. We benchmark against the Russell Midcap Index. We are bottom-up stock pickers but we are still aware of portfolio construction. We do not have any hard and fast rules other than we will not have 25% in any given industry. For instance, I am very comfortable with the insurance industry, I know it well, so we have always had a substantial weighting in insurance stocks. Right now we have about 12%-13% in that industry, but it has been higher than that at times. One interesting aspect to our process is the writing of a thesis report for each stock. Our analysts can write 20 page reports when they pitch a stock, but we want them to synthesize it into one page called a Thesis Report. This lays out the rationale behind the stock purchase. There are a number of bullet points that summarize the purchase. Then we add what we call the Confidence Level. Each prospect or holding is ranked from one to five and do not buy ranked one or two. So every stock in the portfolio is three, four, or five. This represents our confidence in the business model, our confidence in the management team, and our confidence the thesis will pan out. A five-rated stock can potentially be a much larger position than a three-rated stock. That is not necessarily always the case because a five-rated stock might have done very well and the valuation might be challenged, but with a five-rated stock we tend to give it a longer leash and maybe trim the position, where a three-rated stock we would probably sell outright. Another thing we look at is how the stock is correlated with other holdings. Currently we have 22% in financials so although it might appear that we are taking a huge bet in financials, in actuality 12%-13% of that is insurance and insurance is a totally different animal than JPMorgan or Citigroup. These holdings are almost like anti-financials. They tend to be very defensive, to hold up when the market is in a downturn. You cannot always judge portfolio risk just from looking at sector exposure. Management assessment is always important but even more so for financial companies. There is always a little bit of a black box not just for insurance companies but banks and other lenders as well, because there are always unknowns. You have to trust management teams to not be sitting on excessive, non-transparent risks. I know the team at Markel; I have known them for years. They have extremely conservative accounting practices. They are extremely conservative with reserves. In the insurance business you can make your earnings look like anything you want. It is all how much you are setting aside for the next big earthquake or hurricane. There are a lot of intangibles so you have to know these people inside and out and trust them. Markel has a 30-year record of compounding book value. Going through the financial crisis, they came out as solid as a rock. Markel is not as broad or as complex as AIG. AIG was writing all kind of complex derivatives and were in all kinds of businesses. Markel’s primary business is specialty insurance where there is less competition, less regulation, more pricing power. They write insurance for things like equine interests and summer camps. Markel has fortress of a balance sheet. They sell at about 1.2 times book value. In the old days they used to always trade at a price-to-book range of 1.7 to 2.3, but since the financial crisis, even though the stock has moved up and done quite well, nobody wants to pay the higher multiples for financial companies for several reasons. But part of our thesis is that will gradually change and we will have a gradual expansion of multiples. Markel has grown book value at a mid-high-teen rate for years. Q:  How do you define and manage risk? A : A lot of people have quantitative answers for that and they use risk software but we are much more subjective. A lot of this ties back to our philosophy, the sustainable competitive advantage, and the characteristics of the business. To me a company like Brown-Forman with the 100-year-old Jack Daniels brand is inherently less risky than an unproven company with untested products. If the market wants to punish the stock price we see this as a buy opportunity, because Jack Daniels is not going away. Tiffany’s blue box is not going away so a lot of what we do in risk analysis is a more discretionary, subjective analysis of a company’s characteristics.