Q:  What are the tenets of your investment philosophy? A : We identify undervalued companies that have management teams with wealth-creating strategies and track records. We believe that understanding the true return on capital that a company can generate requires a thorough analysis of a firm’s accounting policies, capital requirements, and generated cash flows. Further, due to earnings management, reported earnings may contain false and misleading information about a company’s performance in a given period, which we carefully analyze to ensure they are sustainable. Lastly, we seek to discover company’s trading below their intrinsic value. Q:  How do you transform this philosophy into an investment strategy? A : The Toreador Large Cap Fund aims at long-term capital appreciation by investing primarily in stocks of large capitalization companies. We believe that economics ultimately drives the valuation and performance of securities in the marketplace. Our investment team begins its analysis by translating “as-reported” GAAP financial statements that differ across companies, sectors and time horizons into a consistent set of economic financial statements. We convert those proprietary financial statements into a metric called an Economic Margin, which evaluates a firm’s return on capital relative to its cost of deploying that capital. Next we determine if a company’s investment strategy is congruent with its economic performance. For example, firm’s with negative Economic Margins that are growing their capital base are essentially destroying value and likely to under-perform the overall market – we actively avoid such companies. Lastly, by discounting future levels of economic profits, using company specific discount rates and competitive advantage periods, we calculate the intrinsic value for each company to see if the company is over/under valued. The difference between a company's intrinsic value and its trading price represents the potential upside or downside a company has. Q:  What is your research process? A : The fund blends quantitative and fundamental analysis in our approach to stock selection. First of all, we look for firms that create value through a positive economic margin. Then, we grade every management team in our investment universe. Additionally, we look at differences between how much income is being generated in a period and what percent of that income is actual cash flow. The last phase is about determining what we are willing to pay for that particular firm. These are in fact the four basic building blocks that we use in our process systematically to identify firms that we think are attractive. Once we have completed this stage, a group of analysts as well as portfolio managers review firms individually. We conduct meetings where we have discussions on an ongoing basis about all the ideas that are generated as potential opportunities. For us, this is a traditional analytical review of the company’s ability to maintain a competitive advantage over its peers, specific business, economic, litigation, or regulatory risk facing the company, changes in the management team, the company’s growth opportunities and how it spends excess cash, and recent performance trends. Q:  Would you provide a couple of examples to illustrate your research process? A : Let us start with an example of NVIDIA Corporation, a provider of visual computing technologies and the inventor of the graphics processing unit. We bought the stock in mid 2010 for about $9.00 a share. Throughout the end of 2010 and early 2011, the stock price began to race upward from $9 to $25. While we believed the company’s prospects are outstanding, the expectations built into the price of $25 were just too rich. We felt it is unlikely that the company would be able deliver the performance required to justify its stock price of $25 – 20% sales growth a year, as the consensus called for low to mid teens sales growth. In our opinion, the odds of NVDA being a good investment at that price, no longer met our risk-return criteria, so we used that as an opportunity to trim our holdings in NVDA and eventually removed it from the portfolio. Another example is Google Inc. We saw from our screens that Google came up as a systematically interesting name to look at and established our position in Google in November 2008, when the stock was trading below $300, a price which implied essentially zero growth expectations due to extreme pessimism on the global economy at the time. By the summer of 2010, we had another opportunity to purchase GOOG, as the stock traded down below $460, implying roughly 6% sales growth, which we felt was a significant discount to its long-term potential. Here, we had a firm that is clearly the dominant leader in search – static search, with an amazing management track record, putting together an asset to make huge inroads into mobile search. The firm was establishing an entirely credible mobile operating system to compete with Apple’s iPhone system. At 6% sales growth expectations, we essentially picked up the Android upside of GOOG’s business for free, as its core search business would likely generate 6% annual growth. For us, the upside/downside ratio on Google made sense to add to our position. As Google’s price exceeded $600, it became more and more fully priced, leading us to trim our exposure. Q:  How do you deal with a situation when there is a critical event in a company’s business? A : Those are definitely issues that we face in any company at any point in time. For instance, Bank of America Corporation had residential mortgage securities put back issues towards the end of 2010. When this news came out the stock turned very volatile and the price fell from $14 to below $12, thus wiping out 20%, or $28 billion, of its market capitalization. Our detailed analysis of the quality of the mortgage problems led us to estimate the worst case scenario loss of no more than $22 billion. We realized that the market had overestimated the liability attached to these mortgages and felt it was an opportunity to increase our holdings in the company. Essentially, Bank of America includes three organizations: one of the largest networks of stock brokers and large Investment Banking house Merrill Lynch; a large network of mortgage broker Countrywide; and one of the oldest bank network franchise of Bank of America’s organization. With these three businesses put under one umbrella we thought that we had an interesting opportunity to begin with. And when the market became overly pessimistic on the stock, it gave us an opportunity to continue to adding to it. Though BAC has been a laggard in our portfolio year to date, we remain committed to the stock as we believe the valuation more than compensates its risks. Presently, Bank of America is one of the larger positions in our portfolio. Another stock that has faced some short-term adversity is Cisco Systems, Inc. In the most recent quarters, we saw Cisco’s margin decline largely due to the effect of its consumer and switching business that got hit while being transitioned over to a complete new line of products. Normally, Cisco tends to transition two or three products, this time they transitioned the entire product line of seven or eight products simultaneously which created some short-term confusion for Cisco’s sales team. In addition, competitors have been aggressive in price promotion, which caused Cisco to lose some market share. They suffered some margin loss and their stock fell approximately 20% in one day. Our Economic Margin analysis suggested Cisco could sustain its current stock price even with both sales and operating margin declines from. We believe that Cisco will be able to increase its sales at 5-6% a year, and with cost cutting stay close to current margin levels. We believe that at the current price the stock offers an opportunity to own some exceptional assets at a very reasonable set of expectations. Q:  How do you construct your portfolio? A : Our portfolio holdings range between 45 and 65 names and in large part that is determined by the attractiveness of the buy opportunities that we see at any point in time. The portfolio is allocated across all economic sectors in a roughly sector neutral fashion. Within the sectors we identify the most attractive stocks to own and we tend to equal weight each holding. We generally avoid making big bets on names. For us, a big bet on a stock might be a 5% weight. The typical allocation in our portfolio is between 1.5% and 2%. So, by investing small amounts in a lot of names that have very favorable risk-return profile we make sure to get a quantifiable edge. We tend to overweight a particular name when we think the risk-return profile tends to be particularly attractive. Our benchmark is the overall Russell 1000 Index. Q:  What is your sell discipline? A : Our sell discipline tends to be driven off of valuation. We try to maintain turnover in the 60% range annually, and as long as the stock continues to be at least in the top half of our valuation opportunities, we will continue to hold it in the portfolio. We will also sell if a special situation (such as litigation) pops up suddenly and we believe the risk cannot be understood or quantified comfortably. Q:  How do you define risk and how do you measure it? A : One of the ways to think about risk is in terms of non-diversifiable company specific risk components, which is something that we view as predominantly influenced by a company’s size and its leverage. The primary level of risk protection in our portfolio is that we explicitly adjust every company’s cost of capital for its size and risk characteristics. For us, the issue of risk control is embedded in the entire process. We start out by first identifying a company that has a lower probability of falling in price and we consistently monitor that through our rigorous process of identifying candidates.