Q:  What are the tenets of your investment philosophy? A : Our overarching philosophy is to invest in high quality companies and target risk-controlled growth. We tend to keep away from businesses that are commodity oriented, cyclical and losing money in downturns, but we would rather invest in companies that consistently earn in the up and down business cycles. Q:  Why do you prefer mid cap companies? A : Mid cap has been a very solid performing asset class overall, outperforming both small and large cap companies by as much as 40% over the last fifteen years and in three quarters of every rolling five-year period since 2000. Q:  How would you describe your investment process? A : The process starts with the respective analysts identifying businesses that meet that high quality overall preference. We like businesses that not only have positive earnings but also demonstrate more durability and growth in profits. As we look for sustainable revenue growth at above average rates in the industry, we prefer companies that have solid barriers to entry in their businesses and a better pricing environment for their products or services. Although we generally prefer organic growth, there are business models and companies that have shown a very good pattern of acquisitions, which leads to generating healthy cash flows. Our strategy of finding good businesses means that we need to work on position size and sector weight to achieve better long-term absolute results with much less volatility than the benchmark. To this end, we assess if a particular position size is appropriate given the volatility of the stock itself in terms of its earnings stream, the profitability growth of the business and the overall risk of the market. Next, we try to incorporate that along with company fundamentals and valuation to make sure that we fine-tune a position size to an appropriate level. We go through the same exercise at the sector level in order to get the underweight/overweight sector positioning in the same form. These steps have resulted in finding better businesses that are not only sustainable but also possessing repeatable and visible earnings growth. Q:  What analytical steps does your research process involve? A : As research analysts, we try to understand the dynamics of the sectors we cover. We have our own ways of finding businesses – both from broker research or industry conferences – to identify names that basically meet our criteria list. At that point, what we typically do is write up a summary document to ascertain that all of the important areas that we look for – revenue growth, profits growth, management tenure and success – are all on paper, so that we can start discussing what the incremental benefit from that business is. Sometimes, we might identify a business that is actually growing faster than one of the businesses that we already own, so it could serve as an upgrade from what we have. We probably take anywhere between two to six months to understand the particular merits of a business before it makes its way into the portfolio. Meanwhile, we will most likely have a series of calls either with management or with analysts at brokerage firms to ensure that all our internal questions are answered. What is more, we try to understand what the environment will be like when this particular company is going to do better in the stock market. As part of our evaluation, my partner Kenneth Hemauer, the assigned analyst and I sit down and try to figure out whether a certain name meets our standard of business quality, if this a particularly good time to introduce a position in this business, and what the incremental merit of adding the security to the portfolio turns out to be. Once we have decided and layered in a valuation argument for that particular company, we typically initiate a position of maybe 1% to 1.5%. Then, over time and with further confidence of good fundamental performance, those names are typically candidates for additional capital as long as their valuation remains reasonable. Q:  Can you give some examples to highlight your stock picking process? A : A good example would be WABCO Holdings Inc., a provider of commercial vehicle braking, stability, suspension & transmission control systems. The original investment thesis was that the heavy duty truck cycle is rather predictable and it runs about every seven years plus or minus depending on the economic environment. Moreover, there is a very large and nicely profitable replacement market for trucks around the world. Furthermore, WABCO fits in our criteria of capturing businesses that have some secular dynamics. It is actually one of the few businesses we own that is domiciled outside the United States of America. The company is based in Brussels, Belgium and has a significant amount of revenues outside the U.S. and in emerging markets like Brazil, India and China. Apart from selling their traditional braking systems, WABCO also benefit from a significant legislation around the world to introduce anti-lock and air braking systems as safety measures. The company’s revenue per vehicle with the addition of those safer systems is actually higher. By increasing content per vehicle, they have also improved revenues per vehicle. We felt we could benefit from the end demand growth in the emerging markets, where WABCO has a substantial share on top of the increased content per vehicle. We became interested in the business in 2009 largely because of their balance sheet, cash generation and earnings profile. The stock was a nice incremental diversifier for us, granting access to all of the following three areas – the recovery in the cyclical part of the truck cycle, the exposure to emerging markets and then finally the increased content per vehicle. Another example would be Catalyst Health Solutions, Inc., a full-service pharmacy benefit management company. The primary reason why we liked the stock was because it fitted in our thesis of saving money in the healthcare space. Not only were they managing a very fast growing business profitably but they were also capable of actually winning and retaining the state government contracts and acquisitions. The company is in the process of acquiring Walgreens’ pharmacy benefit management business, and they are growing earnings well over 20%, probably closer to 30%. With a strong management team, good visibility of future earnings, and the acquisition of Walgreens’ business underway, Catalyst Health Solutions is a leader amongst its competitors in that market. Q:  When do you decide to sell a stock? A : Our sell discipline is based on three major factors. First and foremost, we are bound to sell a stock if a change in the original investment thesis occurs. The second reason to sell a stock would be if the fundamentals of either the business or the industry are subject to a significant change. That is a great reason to either trim back or eliminate an entire position. And then, valuation would be the third catalyst for a sale. We may decide to sell if we want to make a replacement with an equally high-quality business that is just growing as fast or faster and is trading at a much lower valuation. Under normal circumstances, valuation would only trigger trimming, not an outright sale, but there are occasions when we think we have found an upgrade and we are going to be investing in an equal or higher quality business growing faster at a better valuation. Q:  How do you construct your portfolio? A : First of all, we try to organize the structure by not making significant sector bets. We build our portfolio by trying to identify the very best businesses within each sector and market cap range. Our belief is that making very large sector bets inevitably results in volatility. Instead, we will probably be in the range of maybe 75% to 125% relative weight to the benchmark. We characterize ourselves as benchmark aware but we are not beholden to it. In our case, the benchmark is the Russell Midcap Growth Index. Typically, the vast majority of our holdings are in the range of 1% to 3%. Once they get closer to 2.5%, we would typically trim a position back and harvest some capital. We tend to have 60% to 65% turnover in any given year, of which 40% is just backing and filling around core positions. Over the course of a year, we usually get two or three opportunities to add or trim around a core position. In fact, the experience of our research analysts helps in being slightly underweight or overweight in their respective sectors. The combination of our focus on sector weight and position size and the experience of our research team has helped us both in identifying good businesses and in allocating capital appropriately within a portfolio of fifty to sixty stocks. Q:  Does holding cash play any role in your asset allocation process? A : We have an internal rule to have no more than 10% in cash. The highest we have ever had was 7% in the second-half of 2008. Today we have got about 4.5% cash, which is about double what we would normally have. We think that anywhere between 2% and 3% gives us the flexibility to add 50 basis points to a position or establish a new position within the 50 to 60 stock range. Q:  How do you deal with macroeconomic situations like the financial crisis of 2008? A : Quite naturally, that situation was unprecedented. In early 2008, we moved pretty aggressively in trying to find exposure to Europe and the rest of the world as opposed to domestic businesses, because it was very clear that the U.S. had already slowed down. We decided that it was better to become much more defensive by adding businesses that are much more resilient in any economic environment. Consequently, we started adding to the traditional areas of consumer staples, healthcare and consumer businesses, which are in fact more resilient. Q:  What are your perceptions of risk? How do you quantify or define risk? A : For us, the individual volatility of stocks, or their beta, is a definite risk. We try to mitigate that with the help of position size.