Q:  What is the history of the fund and the management company? A : The Tilson mutual fund company was launched in March 2005 and consists of the Tilson Focus Fund and the Tilson Dividend Fund. The Focus Fund is managed by Whitney Tilson and Glenn Tongue of T2 Partners in New York. The Tilson Dividend Fund is managed by myself and Matthew Richey through a sub-advisory arrangement with our firm, Centaur Capital Partners. We started Centaur Capital back in 2002 and we are based just outside of Dallas, Texas. The Tilson Dividend Fund is a value-oriented fund designed to attract more risk-sensitive investors who are looking for a conservatively managed equity fund that can deliver steady performance over time. While any equity-focused fund will be volatile, we expect that the combination of value investing and an emphasis on income generation will offer a slightly less volatile ride while still producing equitymarket returns over time. Net assets under management are approximately $9 million. Q:  What are fundamental tenets of your investment philosophy? A : First and foremost, we are value investors, which means that we are looking to buy stocks that are trading at a large discount to our estimate of their true business value. In the Tilson Dividend Fund, we add the additional ingredient of income from one of two sources. The first source is a relatively high or increasing dividend. The other avenue is to generate income from selling covered call options on securities in the fund, which enables us to produce income from those stocks with no or low dividend yields. In selling covered calls, we try to select a contract strike price that coincides with our view of the fair value of the underlying security, such that we can find a good compromise between income generation and ensuring that if the stock gets called away from us that we have received a price that represents reasonable value. But value investing starts with margin of safety to avoid downside risk. We believe that it is much better to own a portfolio of undervalued stocks that pay smaller dividends than to own a portfolio of fairly or overvalued stocks that pay larger dividends. We believe value trumps income in this regard. The overall result should hopefully be a portfolio of investments that can protect capital well in down markets, produce reasonable income in flat markets. We expect that the Tilson Dividend Fund may occasionally lag the market in periods of strong performance, but thus far the Fund has performed relatively well in all market conditions. Q:  What kind of value are you seeking and how do you judge that? A : Value can come in many forms, but we are generally most comfortable with those ideas that offer one of two highly visible forms of value. The first form of value is cash flow. We focus on high quality, well-capitalized companies that are already achieving high cash flow levels, and we try to buy those cash flows at reasonably low multiples. Given our emphasis on dividends, it is important to us to buy securities of companies that produce reliable cash flow, because cash flow is what ultimately funds the dividends. The second form of value is asset value, whether it be in the value of hard assets, such as land, natural resources, or investments. Either way, we do our best to make sure that our valuation efforts on each security in the portfolio are underpinned by demonstrated cash flow generation ability and/or asset value. This provides the margin of safety against significant losses that every value investor tries to achieve. There is a third source of value that is difficult to analyze but which is a critical component to valuing businesses. That component is growth. We very much like companies that produce significant and reliable cash flow. Even better are companies that produce rapidly growing free cash flow, because growing cash flow should ultimately lead to both dividend increases and increasing valuations over time. Some types of businesses don’t produce cash flow in a linear and regular fashion, but continue to grow value by increasing the value of their assets. In these cases, we like to see companies that have demonstrated the ability to grow their book value at rapid rates over time. Our belief is that it is more judicious to pay up a little bit more for a company that does have good growth potential versus a comparable business that is not growing as much but which might appear to be cheaper on a conventional price-to-earnings or price-to-book value basis. Often, our emphasis on free cash flow sometimes leads us to buy stocks that are deeply out of favor. For instance, one example of a stock that we‘ve owned recently is eBay Inc. The online marketplace operator generates a substantial amount of free cash flow but had become so out of favor with investors that by early 2009 the stock was trading at only six-times annual free cash flow. Moreover, eBay has used this free cash flow for the betterment of shareholders with reasonable success. When we looked at eBay‘s business, we felt the auction and fixed price merchandise listing businesses is still growing but at a very slow pace. But the PayPal business is growing at a faster pace and is quite profitable. So, we did not see a business that was going to fall off a cliff. Clearly, we saw a business that might have the possibility of future growth, but we certainly weren’t paying for any future growth. One of the reasons eBay was so out of favor was their unpopular Skype acquisition several years ago. At the time of the acquisition eBay’s stock was highly valued, but the Skype deal was even more highly valued. The Skype deal didn’t work out well for eBay, and eBay had already written down a lot of the value of goodwill well before we bought it. To us, the Skype issue was no longer terribly material to our valuation case because we came in after most of the damage had been assessed. The reason that eBay got cheap is that people really overweighted the Skype acquisition as a negative recent event, and then the company’s core market place growth slowed down as well. So the stock was very cheap. The stock has since recovered pretty strongly. eBay recently agreed to sell a good portion of their ownership in Skype and they got a very respectable price for it. So now we think that the damage to Skype, if any, was fairly minimal to the shareholders of eBay. PayPal remains an excellent business with good growth prospects, and now it appears that even the core auction and marketplace businesses might be recovering a bit. We highlight eBay only because it’s a good example of a high-quality business that was cheap because it was suffering from near-term issues that made it unpopular and therefore available at a very reasonable price. We are still holding some of it in the portfolio though it’s now a very modest size position. Also, eBay doesn’t pay dividends because they prefer to buy back shares instead. So in order to generate some income on it, we sold call options on some of our position at prices that we believed represented a reasonable fair value for eBay stock. Had it taken longer for our eBay idea to work out, we would have continued to sell call options on the position and thus would have earned a nice income on the position over time. Another example of a recent holding would be of our better performers in the fund last year. The firm is Fairfax Financial Holdings Limited in Canada, a holding company of insurance businesses. What attracted us to Fairfax is that they have a great record of investing the float that‘s created by the insurance businesses. But Fairfax‘s problem is that historically they weren’t so good at writing insurance. Also they had been an acquirer of insurance companies that had deeper problems than they suspected when they bought them. But around 2007, Fairfax had actually started to recover quite nicely from these issues and had fixed many of their problems. And in addition to that, the company had really foreseen many of the problems coming in the credit markets and had purchased a massive portfolio of credit default swaps worth $18 billion on companies like Washington Mutual, Freddie Mac, and Fannie Mae. And as the market and financial stocks continued to go down, Fairfax‘s stock also went down even though the value of their credit default swap portfolio was actually going up. During this time, we were able to buy Fairfax at a large discount to its book value. We felt the book value was solid and the insurance business had considerable value in excess of book value. At those prices, we were getting participation in the credit default swap portfolio at no extra charge. Also, Fairfax does pay a dividend and is very volatile. We had not owned it prior to 2007 and this is a case where the market gave us actually a number of opportunities to buy the stock cheaply, to sell it back at a reasonable price or to sell covered call options on it. But it was truly a example of looking at the asset value, getting an opportunity to buy the stock at a big discount, and then doing the work to make sure the book value was solid. Q:  How would you describe your research process? A : We believe the research process is where 90% of the value gets created when it comes to investment managers. First of all, we do all our work in-house to verify every idea and make sure that we understand it. We don‘t rely on ideas produced from the sell side analysts or other sources. We have a team of three analysts and all of us focus our time working on research documents. The other thing is that generally no new idea gets into our portfolio unless we have a research document which all of us have read and have had a chance to evaluate. And this causes our investment process to sometime be a little slow. We seek to buy the right stock at the right price. Our research process revolves around the tenet of the quality of the decisions rather than the quantity of decisions that we can make. Once we own a stock, our process involves regular updating with an emphasis on recognizing any risk factors that would make the investment unsafe or that could result in us reducing the value estimate of the stock. And we need to be very quick to recognize that if it shows up and eliminate the position from our portfolio before it can hurt us. On the other hand, if we see new information that strengthens the thesis, we make sure that‘s incorporated into the valuation work so we don‘t sell our stocks at prices that are too low. Q:  How do you build the portfolio? A : We typically run a portfolio of somewhere between 20 and 25 stocks. Our top ten names typically comprise about 50% of our portfolio. But our research process dictates to a certain extent the portfolio construction that we can have. Q:  What is your buy-and-sell discipline? A : We are in the business of identifying and buying undervalued securities and then selling them back at full value. We don’t consider ourselves buy-and-hold investors, but we will generally hold on to a stock for as long as we believe the investment thesis is intact and the stock is selling well below fair value. One of the interesting things about writing call options is that having options actually enforces the discipline of selling at full value. Written call options ensures that we are going to automatically sell at prices that we predetermined were representative of full value, and they allow us to get compensated for waiting for as long as it takes to get full value. But sometimes we end up selling a slightly undervalued stock in those cases where the company performs a bit better than we thought it would or where our assumptions are too conservative. The disadvantage of using the call options is that we can sometimes cap the profit on the portion of the position that we sold in these cases. We try to be very judicious about the use of covered calls. We find that by selling covered calls on even a portion of the position we‘re quite often able to synthesize an annualized income yield that we that would be two or three times what one would consider a very healthy dividend yield. But it is as much art as science. Q:  What risks do you perceive in the portfolio and how do you mitigate them? A : We have many risk control mechanisms. Our research process is the first layer of risk control and that is making sure we understand the risks inherent in each position. Secondly, we control risk by making sure that we combine the positions that are in the portfolio in such a way that we‘re not terribly exposed to excessive correlation. Another benefit of our hybrid approach to generating income is that not every idea in the portfolio is a big dividend payer because dividend stocks sometime tend to go up and down together. In other words, we benefit from the lack of correlation between many of our holdings that pay dividends and those that don’t. While we have a concentrated portfolio, we do have risk limits in the form of maximum position sizes. We‘re not going to invest more than 7.5% of the portfolio in a new idea at cost. But perhaps the most important overlooked risk factor is the risk of holding overvalued stocks and that‘s a risk that we always try to avoid. Q:  What is a “value trap” and how do you avoid that? A : A value trap is a stock that looks cheap on the traditional valuation metrics like price-to-earnings or priceto- book but that actually doesn’t have much value. The newspaper stocks are one pretty good recent example of a value trap, and one that has been troublesome for a number of traditional value managers. We have avoided the newspaper sector altogether. The stocks have looked cheap for a couple of years based on asset values, but we don‘t have the confidence that the business will continue to generate cash in the future. We think that the historical margin of safety has been eroded over time and it‘s a sector that‘s too tough to call. Many newspapers in the past, which were reliable as cash flow generators, were overly leveraged. So it‘s not easy to find a newspaper that doesn‘t have a certain amount of leverage associated with it. So if you are incorrect in your assessment in a company like that, the debt means that there is no margin of safety against significant loss. By contrast, we would prefer a company like eBay that has a very strong balance sheet with virtually no debt and that is still demonstrating very good cash flow. The newspaper sector is also a good illustration about the limitations of using statistical valuation metrics without regard for the qualitative factors business. Our research process is focused on looking at the qualitative factors of the business in addition to the quantitative. This has helped us avoid many value traps, though of course we have occasionally made errors in judgment, either of valuation or on the quality of the business. If we’re wrong, hopefully the cash on the balance sheet and the cash produced by the business will keep us from losing a lot of money on the stock. Q:  Can the newspaper business evolve as the radio industry did, generating outsized returns for shareholders in the process? A : We think that eventually some of the newspapers may be relatively successful in developing an online format to doing with what they‘ve been doing historically. The Internet distribution system has really changed the economics of that business. There used to be a quasi-monopoly for the community newspaper for local news and advertisements, but that’s not really even true any more. We would not want to be in the newspaper business because it would be very hard to find a strategy that could assure reasonable success in the future. In any event, it is an interesting historical comparison but, unfortunately, as things stand for the newspapers today we have not yet seen one that has successfully completed the transformation to a fully internet-based model. Until we do, we won’t be investing in newspapers.