Q:  What is the investment philosophy of the fund? A: We have separate products that cover the full range of market capitalizations; the all-cap fund is an attempt to use our best ideas in all of those different areas. We invest in the capitalization segments that present the best opportunity according to our philosophy and process. For example, several years ago over 50% of the holdings were in small and mid-cap stocks, while today over 70% of the holdings are in large-cap stocks. We value patience and common sense in investing and our goal is to outperform our benchmark, the Russell 3000 Value index, over a three to fiveyear investment cycle. There are two main points to our investment philosophy. First, we believe that companies go through a life cycle where the good company will lose a little luster over time, while the mediocre company will improve relative to its competitors, not necessarily to become the best company within its industry. These underperforming companies appear statistically cheap when screened against a universe of stocks. The second principle is that investors have a tendency to extrapolate on a straight-line basis the good things and, consequently, to bid up the price of a stock based on the assumption that the good times will continue. Likewise, investors tend to shy away and bid down the price of companies that are in trouble or underperforming. By abandoning these stocks, they make them fairly attractive for contrarian investors like us. We attempt to look at a company to see what can go right when something is going wrong and vice versa. Taking the counter view leads us into opportunities the market may be overlooking, and ultimately, to superior returns. A lot of people think that investing in the market means buying a company with great prospects; but often these prospects are already priced into the stock. We try to buy a good stock, which may not be the greatest company at the time, but may be interesting in terms of investment return opportunity. In a nutshell, we’re contrarian. We know that companies go through a life cycle and that investors tend to accentuate the positive and shy away from the negative. That gives us an opportunity to buy pessimism and sell optimism. Q:  There are many different ways in which people define value. What is your approach towards finding value in the market? A: Many investors try to guess where earnings are going to be, and then they base an expected P/E on those nearterm earnings to figure out if the price is right. What we try to do is estimate what the normal earnings are. Often the companies that we’re investing in are underperforming so their relatively recent earnings aren’t indicative of what they can actually accomplish. We invest in statistically cheap stocks, stocks with low P/E’s, low price-to-book ratios, low price-to-cash-flow ratios and higher dividend yields. But statistical cheapness isn’t enough. We want stocks that are undervalued, that are selling for less than our estimate of their intrinsic value. We also want to find a catalyst that will allow the company to achieve the normal earnings we believe it can. This can be a new product, new management, new industry developments, a restructuring, or any combination of these. We want to buy a cheap stock with something positive in its future. Q:  In the current environment, some of the homebuilders, the mining companies, and the energy companies would probably fall in that group, but that doesn’t necessarily mean that they are value. Is that correct? A: Yes, and that’s where the next part of the process comes in. A low P/E on peak earnings for a cyclical company isn’t very attractive; so you have to relate this valuation to its industry and its history. A low P/E for an oil company when oil prices are high should be compared to its history when oil prices are low and also to its historical price-to-sales and priceto- book ratios. A couple of years ago many people didn’t like the energy stocks, especially the drillers and the service stocks. Their P/Es were very high because their earnings were depressed but they were very attractive on a price-to-book and priceto- sales basis. So that was an attractive investment opportunity for us. Q:  How does your investment process differ from that of your peers? A: We have a process for estimating what we call a company’s ‘normal earnings power.’ We try to estimate what a company should be able to earn in a normal cycle, not necessarily what it’s going to earn in the next quarter or year. A price target is projected based on this ‘normal earnings’ multiplied by an appropriate price/earnings ratio. A good example would be a company that’s under-earning in its industry. Last year Jones Apparel went through an earnings compression because of consolidation in the department store industry. As a consequence, its earnings were stagnating at a low level. Management attempted to address the situation in a number of ways, such as restructuring expenses and logistics and by expansion into other retail formats with the purchase of a luxury department store. We decided that its earning power certainly was greater than its current level. Moreover, the uncertainty around the company allowed us to purchase shares at a fairly attractive price. Jones Apparel was selling in the mid $20’s and we felt it could sell in the low $40’s if it was successful. So we found this stock statistically cheap, and we projected a price target that was much higher than the current price. Since that time, private investment bankers and buy-out firms seeking to do deals have approached numerous retailers. Jones saw that happening and put itself up for sale, so the stock price went up to the mid $30’s. I believe that this approach sets us apart from other value managers who may be only interested in low P/Es or low price-to-book ratios. We look at all those things as a way of filtering ideas, and then we try to establish a price target. We want to invest in a low P/E stock, but we wouldn’t be interested in buying into a speculative situation. Q:  How do you calculate the normalized earnings? A: We deconstruct the balance sheet and the income statement. We’re looking at the elements of profitability that figure into a sustainable return on equity, such as margins, leverage, and turnover. We do a lot of fundamental analysis that tries to get at what that return on equity ought to be. We estimate the non-cyclical profitability of the company through this ROE figure and we multiply it by the book value to come up with normal earnings. Then we try to see what price/ earnings multiple would be appropriate for that company within its industry and versus its history. This analysis is done internally. We have a talented team of eight experienced professionals who are all dedicated to value investing and specialize in small, mid, or large-cap stocks. They all have CFAs; the youngest member of the team has 11 years of experience; I have been in this business since 1979 and my partner since 1972, so we have all been through several market cycles. Q:  For how long would you wait for the results? What is your average holding period? A: It may take time for the positive catalysts to have an effect on the stock or for Wall Street to see them. Our average holding period is four years and our average turnover is 25%. We’re willing to be patient with these companies, so that they have an opportunity to react positively to the changes taking place within. Q:  How do you approach portfolio construction? A: We have between 80 and 140 stocks in the portfolio, with no more than 3% in a single stock. We have a minimum sector weight of one-third of the sector weight of the Russell 3000 Value index. So we will always have a position in each of the ten economic sectors. We will have a maximum sector weight of the lesser of two things: 1) three times the weight of the sector in the Russell 3000 Value index; and 2) the Russell 3000 Value sector weight plus 10%. Q:  You mentioned that the fund has a low turnover but what would prompt you to sell a stock? A: We’ll sell a stock if it reaches our price target or if we find another stock with better potential. There are a couple instances when we’ll take a second look with more urgency. Such instances include negative financial revelations, some misdeed, or some restatement that is not explainable in an appropriate manner. If, after a deeper look, we decide that there may be other things going on beneath the surface, we’ll sell the stock. In such cases we’re more than willing to walk away and come back at a later time. Q:  To clarify your understanding of value, I would use the example of Bausch & Lomb, which went through a severe correction recently. Would such a stock fall into your value definition? A: No. A severe price decline may get us interested, especially if the stock is now statistically cheap. However statistical cheapness is only one part of the story. The other part of the process is the earnings power and what if anything could interrupt it. Bausch & Lomb had to remove a product from the market because of contamination issues. Its earnings power will be reduced. So it may not show up well in our analysis. At some point Bausch & Lomb may be a very interesting idea. Management needs to address the lost earnings power as well as the potential liability with regards to the product recall.