Q:  What is the investment philosophy of the fund? A: While being value based, we look at value quite differently than most investors. Our investment philosophy is based on evaluating and valuing economic performance as opposed to accounting performance. Everything that we do revolves around cash flow generated by a firm’s gross asset base and the company’s ability to generate and return cash to the investors or owners of the business. Q:  What is your definition of cash flow? A: Our definition of cash flow is something we call net cash receipts. We try to take out those accounting distortions which are the end result of net income. We start with the company’s net income and backwardly adjust for all the various non-cash accounting items and build our way back into net cash receipts. Once we start with net income, we’re making adjustments for depreciation, amortization, and net interest expense. We’re also subtracting out gross capital expenditures and net change in working capital. We eliminate cash from sources such as investing and financing. What we’re interested in from an operating standpoint is how much cash the company generates. Q:  Could you highlight your research process? A: The first step is to determine what companies are undervalued versus those that are overvalued in the marketplace. We use consensus earnings estimate, and normalized growth rate in assets for a company to build a projected future cash flow stream, then we apply a discount rate to those future- projected cash flows. The discount rate is calculated beginning with a market implied discount rate and then adjusting for company specific risks such as size and leverage. We discount those future expected cash flows to arrive at a present value and then net out the debt. We compare this intrinsic value to what the market is currently implying. If the present value of the future expected cash flow is greater than where the stock is trading, we would deem the company to be undervalued. The second step is to distinguish those undervalued companies where management understand the dynamics of creating shareholder value. We again use an economic measure. It’s what we call cash flow return on investment, or the internal rate of return on all the company’s operating assets. The higher that return, the higher the market valuation. The market does pay for economic performance. Things like earnings surprises have no correlation to the long term performance of the stock. We screen a universe of roughly 5,000 to 6,000 names on a weekly basis for new data based on a number of value criteria, one of which is cash flow return on investment. We typically cut the universe down to 400 to 500 names. From there, we look at what industries and what companies may be undervalued by looking at the industries that predominate the list. We look at the industry dynamics and drill down to the company level as far as generating investment ideas. Q:  Generally, what kind of risks do you perceive and how do you monitor them? A: We’re an advocate of broad diversification as a means of reducing volatility to that of the broad market. Within that broad diversification we’re constructing a portfolio of a strict value discipline on conventional measures of PE, price to book, price to sales and dividend yield. We don’t take huge positions in any one stock. When we buy a stock it’s usually about a 1.5% to 2.5% position. The maximum position size is 5%, but that would occur only through price appreciation. At the screening level and at the fundamental analysis level, we look at accounting exceptions: things like net income as a percentage of gross cash or if its intangibles are a large portion of the value. The average company in the portfolio has about 18% or 19% debt-to-capital ratio, so we look for less levered companies. Traditionally we invest in companies with above-average dividend yields and/or the ability to grow those dividends. The dividend yield in the portfolio now is about 2.3%. About 90% or 95% of the companies in the portfolio pay a dividend. Q:  Do you benchmark yourself against any index? A: Our portfolio is measured against the Russell 1000 Value Index but differs in the sense that we’re more broadly diversified. We don’t maintain a heavy concentration in financial services or utilities and telecom, which combined constitute roughly 45% of the Russell 1000 Value Index. Q:  How would you define your buy and sell discipline? A: Our sell discipline is solely based upon the discounted cash flow model. When the present value of the future expected cash flows net of debt of a company reaches parity with where it’s trading in the marketplace, the stock is sold. We tend to buy and sell stocks earlier in the investment cycle. We tend to sell stocks as they transition from value stocks to more momentum type stocks. Our screening process is done on a weekly basis and we constantly update our analysis of a particular industry or company. It a company or industry demonstrates improving valuation we perform fundamental analysis focusing on things like asset utilization. If companies that have traditionally just earned their cost of capital are now starting to contract their asset base by selling off or pairing down underperforming segments of their businesses in an effort to increase returns they will likely appear attractive to us. Companies that hold back on the growth so they can become more profitable may not be initially well received by the market. However, these are the companies that tend to see the greatest increases in profitability in the long run as management understands the concept of wealth creation. Q:  What are the key elements of your portfolio construction? A: From that list of between 400 and 500 names, we construct a portfolio of between 45 and 55 names that are the best combination of value, stability, and consistency. We have representation in every major industrial sector - basic materials, capital goods, consumer discretionary, consumer staples, energy, healthcare, technology, utilities, and financial services - we limit over and under weighting relative to the overall market, to no more than 150% of the market or no less than 50% of the market in a particular sector. Our portfolio currently averages about 50 holdings. Q:  What are the areas of overweight in your portfolio? A: We’re going to see deceleration in earnings growth and the market hasn’t been a traditional bull market with a lot of PE expansion. As rates and inflation have been rising, we’re going to continue to see relatively low PE multiples. Our strategy is to overemphasize those sectors and companies where there is a fair amount of certainty to their earnings and revenue growth. Our top sector is the healthcare sector. Everyone knows the negatives associated with the healthcare sector - patent expiration, generic competition, product liability, and political headwinds due to rising healthcare costs. Those issues have been factored into these stocks and we see valuations at the lower ends of their historical ranges. The one factor that encourages us is that as a nation we get older every day and our demand for healthcare services is only going to increase. From a long-term sort of macro planning position, we have an industry that has relatively modest valuation but on the demand side we’re going to have rates of growth in revenue and earnings that are above the long-term average of the market. Our next favorite sector is energy. A year and a half or two years ago, we started to build up positions in energy in a much stronger overweight than the market because we had valuation on our side and we saw these companies starting to repair their balance sheets and be much more judicious about how they spent their cash with respect to balancing returns and investments. Even though we continue to have an overweight in energy, we’ve pulled that back a little – it was a 50% overweight and now it’s about a 35% overweight. We are heading into an environment of moderately higher inflation and moderately higher interest rates. In that type of environment, we are favorably disposed towards energy. The driving forces behind the current strength in energy prices are the industrializing nations of India and China and the increased demand for oil and for energy that brings. We think that’s a long-term trend. As far as earnings momentum and earnings growth, that’s a favorable tailwind that these oil companies are going to enjoy for long. The third area we are bullish on is the capital goods sector. It is an industry which is selling at relatively modest multiples of earnings, substantially below that of the market. What’s happened in corporate America is that for the last three or four years tremendous cash flow generation has been dedicated towards repairing balance sheets, paying down debt, buying back stock, and increasing dividends. The area that has been neglected is that of maintaining competitive position in a global economy by investing in capital spending. This is changing now. Many emerging economies that traditionally have run budget deficits are actually running surpluses due to the increased demand for commodities around the world and the commoditization of manufacturing processes. Much of the world’s manufacturing has been farmed out to these countries and their cash flows are quite strong. As these economies gain affluence, they’re starting to build out their infrastructure - the roadways, the manufacturing capacity, the ports, the transportation systems – and there are a lot of domestic multinational capital goods companies, like John Deere, Ingersoll Rand, and Eaton Corporation, who are going to benefit from that. In the industrial area I would mention Eaton Corporation which has traditionally been an automotive and heavy truck equipment company which over the years has diversified away to electrical components and fluid power, so there’s less cyclicality to the business and higher margins. Even though heavy truck sales and builds are expected to decline, they’re calling for 5% to 10% earnings growth next year. Q:  Would you give some more examples? A: Phelps Dodge is a company in the commodity area that we’ve owned for quite a while. It’s the second largest copper producer in the world, doing a fantastic job with the elevated price of copper and other commodities. What they have been doing in addition to that is restructuring their business, selling off some ancillary businesses that don’t meet their return hurdles and they’ve been returning a lot of cash to shareholders. Last year they paid a $2.50 special dividend to shareholders. This year they’ve already paid one $2.00 per share special dividend and there’s another one that gets paid in May. In addition to that, they’ve paid down debt. They are investing in technology to reduce their production costs, and pre-funding environmental liabilities. In the healthcare area, a company that we like is Laboratory Holdings Corp. of America. They perform medical tests and they’ve been moving more and more of their business to esoteric testing which is more expensive than the standard type test but in areas such as AIDS and cancer, where these tests are performed almost at the molecular level. As these tests become more commonplace and as physicians understand the benefit, that business will grow. They’re the second largest laboratory behind Quest. Earnings have been coming in line or better than expected. Margins have been improving. The whole industry is moving towards a consolidation where hospitals and healthcare providers want to deal with one or two major players from an economic standpoint.