Q:  What is the investment philosophy of the fund? A : Our philosophy begins with the idea that a share of stock is a partial ownership interest in a business and that the stock market is a place where businesses are bought and sold every day. The market is generally efficient over time, but it is not totally efficient, particularly in the short run. We don’t try to time stocks or predict when they will go up or how they might react to changes in the dollar or interest rates. We simply value businesses and wait for the market to move prices toward those values. Q:  Would you describe yourself as a value investor? A : Not in the traditional sense. The fund owns Yahoo, Google, and eBay and none of these stocks are thought of as “value stocks” by most investors. However, we have owned them precisely because we have thought that their shares are undervalued based on our expectation of future growth in free cash flow. They have high P/E ratios, but they generate tremendous free cash flow, which is growing very rapidly. So, the stock price may appear high relative to this year’s free cash flow, but because cash flow is growing so rapidly, the price is actually not that high relative to cash flow three or four years out. The key is to get the cash flow forecast right. Growth and value are joined at the hip. Growth is a necessary factor in calculating the value of a business. So it is value investing in the sense that we buy businesses for less than they’re worth, but it is not value investing in the low price-earnings or low pricebook sense. And we operate within a broader universe of stocks, that includes both rapidly growing companies as well as companies that have no growth at all. Value and growth managers operate in a narrower universe. But what does a growth manager do if all growth stocks are overvalued? We think that the ability to be opportunistic and unconstrained should result in a higher return over time. This fund is both growth and value at the same time, with a private equity mindset toward the stock market. Q:  Do you follow a top-down or bottom-up approach? A : It is extremely bottom-up. We pay some attention to the economic environment, but not much. Our strategy is to do one thing and do it very well: value businesses based on their long-term expected cash flows. We do not have a time horizon, but simply focus on owning a portfolio of the most undervalued stocks we can find. We don’t have a view on when the market will move them to fair value. If our forecasts are correct and our research is sound, then this portfolio of stocks is likely to outperform the S&P 500 index, which is our benchmark. Diversification takes care of the timing issue and it shows in our results. For 12 of the 13 quarters that we’ve been running the fund, it is above median relative to its Lipper peer group. If you buy securities at a low enough price relative to fair value, they tend to do well even in the short term. Q:  From your philosophical perspective, market caps, industry, and sectors are not important. What is important is stock selection, portfolio construction and risk management? A : Absolutely correct. We look for good investments and businesses. Every business has revenues, expenses, and capital requirements. It doesn’t matter whether it is a pharmaceutical company, a bank, or a retailer. You need to have industry-specific and company-specific knowledge to value the business, but at the end of the day we can compare basic financial metrics across sectors, companies, and industries. First we look for great ideas; then, we manage risk to avoid excess volatility. We look at our sector exposures, the correlation between stocks, statistical risk metrics, tracking error, etc. to keep the portfolio at a risk level that is similar to the S&P 500. We have to make sure that the weightings and the individual stocks and sectors don’t produce risk characteristics that cause unacceptable volatility in investment returns. There are about 165 stocks in the fund, some positions are small and some are very large. It is the overall portfolio characteristics that matter from a risk perspective. The number of holdings will vary, because when we feel confident we may be concentrated in fewer companies. Stock selection relates to risk because we need to quantify the potential downside of an invidivual holding. The turnover of the portfolio generally ranges between 60% and 80% and will fluctuate as we see opportunities. Q:  Fund managers with a similar strategy tend to concentrate in a smaller number of stocks. What is the reason for the relatively large number of stocks in your portfolio? A : That relates to risk control. Our goal is to produce consistent, dependable and superior performance over time. We own more stocks to reduce the volatility of the portfolio relative to the benchmark. If we reduce the number of stocks in the portfolio, we could increase the expected return, but that would almost certainly increase the volatility. Also, I should mention that risk control is not something you do after the fact. It must be integrated into the investment process and taken seriously by the portfolio managers. It is about enhancing return, losing money less often, and reducing volatility that isn’t associated with alpha for the fund. As we look for stocks, we always ask ourselves how much risk is embedded in a given security. Q:  Since you are in the business of identifying and evaluating businesses, your research process is critical. What distinguishes your research process? A : Two things: first, our emphasis on estimating the intrinsic value of a business and second, our use of quantitative research. And most importantly, it is the integration of these two areas of research that distinguishes our process. We also are willing to take a longerterm view and not just react to the quarter. Today, there are many short-term investors who buy and sell stocks based on short-term earnings or economic developments. That creates opportunities for us. Our approach takes advantages of short-term issues by focusing on the long-term intrinsic value of the business. We always try to think and act as if we were acquiring the entire company and were going to own it for a very, very long time. That mindset drives the type of research we do. Q:  What constitutes your fundamental research? A : The cornerstone of our fundamental research is calculating the intrinsic value of a business and producing a range around that base case calculation. It involves a thorough financial analysis of the business, including the competitive dynamics within the industry, the company’s competitive position, its margin structure, the return on capital, and how much free cash flow the business can produce. We also evaluate management with respect to operational execution and capital allocation, a factor that the market too often underestimates. When a business generates a certain amount of cash, if the management does not pay that cash out to shareholders via dividends or share repurchase, we need confidence that they are making good investments or we will not own the stock. If a stock is undervalued and the company generates excess cash, repurchasing shares is something that enhances intrinsic value. We are very focused on management actions to create shareholder value. Quantitative research involves measuring basic financial metrics, such as free cash flow yield, price-to-book ratio, price-to-cash from operations. This research provides clues into which securities might be undervalued in the marketplace. We leverage these two areas of research to develop a narrowed down universe of stocks. Then we focus in greater detail on our highest conviction ideas. Q:  How do you initiate research on a specific company? A : Our equity research analysts cover a large number of stocks. We share a common pool of research with other Putnam funds. Then, we analyze a large number of financial metrics – quantitative research. There are times when a portfolio manager may initiate a conversation with the analyst and sometimes an analyst may bring an idea to us. Conversations are happening several times a day and ideas come from both sides. A large number of companies are consistently followed and we have up-to-date valuation numbers on that universe. We can instantly sort all of the stocks in the S&P 500 based on percentage to fair value. We are always looking for ideas, reading newspapers and studying what is going on in the world. Also, if we see a controversial situation or a large price movement, we would look into that. Q:  Can you give us an example of stock picks where your strategy worked out well? A : Home Depot and Dell both sold off earlier this year entirely because of fears that the economy is slowing and that this could cause their sales and earnings to be less than expected. As the stock prices fell, we focused on the long-term outlook for free cash flow growth. That really doesn’t change because the economy may slow in the short run. We bought both stocks on the concept that they were trading for less than they were worth. Both companies reported solid first quarter earnings and their long-term outlooks are excellent. Both stocks are higher now – worries about the economy ended up being overblown and simply provided an opportunity to buy two very fine businesses. We try to be in a position where we are better at valuing business than most other investors. Then, we take advantage of things that happen in the market. Sometimes there are issues that could have short-term earnings implications, but they don’t have long-term valuation implications – we take advantage of those situations. It is a simple strategy, but to make it succeed, it is crucial to develop the skill to value businesses well. Q:  Do you look for turnaround stories or you don’t care as long as the gap between the market valuation and your valuation persists? A : We do own some turnaround situations. Our view of the market is that most stocks sell near fair value most of the time. Businesses that are relatively simple and don’t have any controversial issues surrounding them are not likely to be mispriced by much. That describes most stocks. Then, there are what we call the two tails to the market. At the one end are companies with significant business problems or companies that find themselves in highly controversial situations. Today, these are companies like Eastman Kodak, American International Group (AIG), and Fannie Mae. At the other extreme, you have companies like Google, Yahoo, and Apple Computer that are growing rapidly. Sometimes, these are fairly young companies, for which it is hard to predict the future. We think that the vast majority of market inefficiencies – or valuation mistakes – occur in those two areas of the market. We spend most of our research time in this area because that’s where the opportunity lies.