Q:  What is your investment philosophy? A: Summit Everest Fund is focused on large-cap domestic stocks in the value category. However, we do not discriminate against global companies such as Nokia, Unilever, Royal Dutch, or Sony. Our belief is that the markets lack total efficiency and therefore, we seek opportunities in the inefficiency. We believe the academic assumption that all the information is priced into the securities is wrong. If it were true, investors wouldn’t waste their time looking for mispriced securities. A lot of information gets factored in, but there are many pockets where the markets are inefficient. Markets are moved by people and people are ruled by the human emotions of fear and greed. It is the people who ultimately do the selling, not the quantitative models. The efficient market theory assumes that everything is rational, which is not an accurate description of investors. Investors are irrational and emotional from time to time. When bad earnings are reported, people get scared that the stock may go to oblivion and sell it. When stocks are oversold, it is an opportunity to take advantage of the market’s inefficiency. We also believe that it is best to invest in quality stocks that are depressed or lagging in fundamentals. We try to buy good companies at great prices; not just any company that seems cheap on a certain metric. Another part of our philosophy is that we are broadly sector neutral, but we make our bets in the sub-sectors. We may overweight brokers or insurance companies versus the index in order to get outperformance, but financials would be in line with the index. We don't make huge sector bets. We think that the sub-sectors, just like individual securities, are inefficiently priced. We are agnostic to whether the sub-sectors are cyclically in a favorable environment and we try to pick the best value. Controlling risk is another important part of our philosophy. We are fully invested with the exception of around 3% in cash and we don’t time the markets. Not being fully invested means being out of securities when the market rallies and that is a risky bet that we wouldn't make. We are diversified broadly in line with the benchmarks, so if there is a sector move, we’ll have some participation in the sector. Q:  What do you think are the causes for the inefficiency? Can you give us some examples of the inefficiencies you focus on and how do you exploit them? A: Some people exploit the inefficiency in the smaller-cap names due to the lack of Wall Street coverage. We think that there are plenty of opportunities in large-cap names. These companies are very well-known and usually owned by a lot of investors, so when news hits, some of them panic out of a security. Because of the broader ownership, these securities may be in weak hands. It is the emotional investor we are trying to benefit from, whether from the greed that makes him hold the security as it goes higher and higher, or from the fear that makes him sell when something breaks down. We benefit from the inefficiencies by exploiting the human emotion in the investing process, not by getting a little piece of information that we think no one else has. For example, Alliance Capital had a big drop on specific news. We thought the entire mutual fund sub-sector would survive the serious consequences and was way too cheap. Alliance Capital was one of the companies involved with late trading and market timing. (They have to pay all their earnings as dividends because they are limited partnership, so there is a very high yield in that security.) It seemed like a very good investment because if the market didn’t realize the value, we were going to get paid the dividend. If the market did realize the value, then we would get a rise in the stock price within a year and that’s exactly what happened. Q:  Do you focus on certain sectors? A:We monitor all the different sectors in the large-cap value universe. I have two analysts who work with me. Yvonne Bishop, Assistant Portfolio Manager, has been working with me almost the entire time that I’ve been managing the fund. The other one, Soniya Choksi has been with me for 3 years. Each of the analysts follows half of the securities in the large-cap universe. My job is to make the ultimate buy/sell decision based on which companies they think are mostly mispriced. We accumulate that into which sub-sectors seem too expensive or too inexpensive. Currently, the sub-sector which seems very pricey is electric utilities. As interest rates have come down and Warren Buffett is making acquisitions, the price of electric utilities has gone up and the whole sub-sector seems to be “priced to perfection”. When interest rates go up or acquisitions go down, these securities might fall. So we've limited our exposure to the electric utilities. Q:  In your research process do you start with a macro view and go all the way down to the security level? A: We use both the bottom-up and the top-down approaches; we do both qualitative and quantitative analysis to find relative value. We are looking at all the statistical measures, including price to book, price to cash flow, and price to earnings. The economy has an influence and historical valuation have an influence, but neither one dominates. If historically a security is priced at the lower end, we may take a look at it, but we may avoid it if we think that the economy is not going to be in the company’s favor. We focus on quality companies in the sub-sectors that are temporarily out of favor, but not on deep value. Not only does the price have to be right, but there should also be either high-quality management or a change in the management. In addition to headline risks, we like to be involved in companies that are managed well or where we think there will be a management change. One of those companies currently is Morgan Stanley. Even though a lot of people are complaining about the management, we think that there will be enough institutional demand for management change that can drive value higher. We’ll probably see either spin-offs or division sales to realize higher value. Q:  What factors do you use for the quantitative and for the qualitative analyses? A: In terms of the quantitative analysis, each of those sectors is priced differently. For the financial sector we use price to book, for technology we use price to sales. But regardless of the valuation metrics, if historically they are priced on the inexpensive side of the industry, we think the environment can support multiple expansion. Conversely, if we see contraction of the multiples, like in the case with electrical utilities, then we would avoid that investment. If we think that there’s no way they can lower their P/E, then we want to be involved in that situation. If we think that the next news flow is going to raise the value, like in the case of Alliance Capital, we want to be involved in that situation. Whatever the cause for the bad news is, if we think it’s temporary, we might want to be involved. What has kept us away from companies like Worldcom and Tyco (pre-current management), is a careful look at the balance sheet. If the balance sheet shows that you aren’t paying for all the spending, that’s a red flag for us. For us capital spending has to be roughly in line with depreciation. Tyco and Worldcom had huge spending on capex, but were depreciating only a small portion of that. If you spend $10 billion, you have to write it off eventually and depreciation is what gets reflected in the income statement. By not charging it, you pretend that you are not really suffering that expense and that has kept us out of a lot of companies. For us the quality management is conservative by depreciating the expenses fully. Q:  Can you give us an example of a headline-driven inefficiency? A: After months of watching it, we got involved with Freddie Mac. Both Freddie Mac and Fannie Mae were going through headline risk because their income statements and balance sheets weren't quite in line. But actually, Freddie Mac has been too conservative. If they had fully reflected their earnings, they would have reported even better earnings. Their kind of management was saving earnings for a rainy day, but Wall Street penalized them anyway. We have a lot of confidence in the stock because we don’t mind if the management is a little too conservative as this means that down the road their earnings should be fairly healthy. When their balance sheet did come through the regulation process, it actually raised their earnings. That’s another situation where the entire sector was out of favor. It took us months to get comfortable with investing in Freddie Mac, but we were able to judiciously buy the company with the better-quality balance sheet in that subsector and it worked out very well. Q:  What rules do you follow when you construct the portfolio? What is your turnover ratio? A: The maximum position of a security on fresh purchase is 2.5%. We can go higher later, but that’s the maximum we go in. We typically hold about 60 names with an average weighting of less than 2%. It is part of our control of risk to limit position sizes. Turnover has been between 50% and 75% historically. It goes up in a dynamic market because we would like to take advantage of the greed and sell into it. But if the market is going sideways, turnover would go lower because we don't see that many opportunities. We typically start positions at about 1% and gradually build them up. We have to find a name to sell before we buy because we don’t hold a lot of cash. The principle is stock in - stock out, not cash versus stock. A buy decision does not necessarily mean that the name is really inexpensive; it means that it is a better value than what we are selling. Q:  What benchmark do you measure yourself against? How closely do you follow your benchmark if at all? A: When we started the fund in 1999, the S&P 500 would provide the easiest comparison, but then the index had 35% technology, while we had 5%. As the technology weighting in the S&P 500 has come down, we look somewhat similar to that index, but our primary benchmark remains Russell 1000 Value. Q:  When you expect a company to spin off or sell a division, like in the case with Morgan Stanley, what are the grounds for your assumption? Do you consider this a normal reaction of the company management to ensure value following a disappointment? A: For quite some time we have watched AOL in the days when it was just AOL. Its accounting seemed crazy; the senior analyst and I were looking at the cash flow valuation and we had no idea what it meant, although we have a lot of experience. Finally, when they started to write things off and the cash flow started to look good, the price got down to $15 or lower. Investors thought AOL was a toxic division and I always thought that the management had better change the name of the company to Time Warner, which they did. Over time we became shareholders in the low teens because this is a company that has a poorly priced division. The negative is that there is a lack of growth and profitability. If the stock price doesn’t go up, the management will probably kick out 20% of that security to get some value back to the shareholders.