Q:  Would you give us a very brief overview of the investment company? A : Vaughan Nelson Investment Management LP, which was founded in 1970, is headquartered in Houston, Texas and manages $7.7 billion. Vaughan Nelson, an affiliate of Natixis Global Associates, manages equity, fixed-income, and balanced portfolios for institutions and high net worth clients. Our multi-strategy firm seeks high returns with low volatility from actively managed portfolios that benefit from the team’s expertise in equity and credit analysis. The firm manages two mutual funds: Vaughan Nelson Small Cap Value Fund (NEFJX) and Vaughan Nelson Value Opportunity Fund (VNVAX). Q:  What are the fund’s investment objectives? A : The fund’s main investment objective is long-term growth of capital through investment in a diversified portfolio of small- to mid-cap stocks with a focus on generating attractive absolute returns. We invest in companies with a market capitalization between $1 billion to $20 billion that have the potential to compound capital at a rate of 15% a year or more over a three-year period. This gives the portfolio the potential to appreciate 50% over a three-year period. Q:  What is the principal investment strategy that the fund employs? A : The fund seeks to take advantage of temporary information and liquidity inefficiencies in the small- and mid-cap universe to provide opportunities to invest in companies at valuations materially below their long-term intrinsic value. As a result, the portfolio tends to have valuations that are at or below the respective universe, but with much higher growth rates, higher ROAs and lower earnings variability. While different factors will carry more importance at different points in the market and economic cycle we believe over time these characteristics are the key to driving superior performance. Q:  What do you mean by temporary information and liquidity inefficiencies? A : The market is often described as an efficient exchange where new information is immediately reflected in stock prices. While this is a reasonable description of market dynamics over extended periods of time, the market does not always accurately reflect the true underlying value of individual companies. We firmly believe that markets can get emotional and, when this happens, prices can move away from the intrinsic value of the underlying companies. We have all seen instances where the markets simply overreact to bad news, a sector is considered “out of favor” or a company structurally changes itself for the better but the market does not reflect this improvement in the stock price. We consider these types of scenarios as price inefficiencies and opportunities for us to purchase stocks at favorable levels. Q:  With these inefficiencies in mind, what return objective do you generally look at? A : We seek a 50% return from each position over a three-year holding period. When targeting this return, we model the downside for every position and we avoid “even money bets.” Opportunities with 50% upside potential typically have 20% downside risk. Placing such asymmetric investments in the portfolio can offer attractive capital preservation characteristics. Q:  What is your research process? A : We only seek opportunities that fall into one of three distinct investment categories, which we describe as Category A, B or C: Category A companies include stocks that earn a positive economic margin with stable to improving returns. This is a fancy way of saying that we focus very carefully on return on invested capital. We want companies that can earn a positive return relative to the cost of the resources given to them by the marketplace. While we strive to invest in companies that earn a positive return today, what we are most interested in is finding companies that have the ability to earn better and better returns over time. If this happens, simple math tells you that the stock price should go up. For our category A companies, we spend a lot of time trying to figure out what sort of opportunities the companies may have over time and what types of returns those projects have the potential to generate. The key is to project out what the balance sheet and cash earnings of a company may look like over time to determine if the returns are likely to be on a positive trajectory. Category B includes stocks that are trading at a discount to their asset value. To estimate what we believe a company is worth, we look at the left-hand side of the balance sheet. We look for companies that own things – buildings, land, minerals, equipment – tangible assets that you can grab and really value. We then compare this value to the stock price. If we find that the stock is trading at a discount to the value of its assets, we categorize that stock as a “B.” At the same time, we seek a catalyst that may force the market to close the gap between asset value and stock price. Finally, Category C stocks include companies that pay regular dividends, which can make up a majority of the target of 15% return that we seek. Here we look for firms that are paying dividends of at least 10%. However, having a high dividend yield is not enough to be considered a Category C stock. We also want to make sure that the stock price is unlikely to fall, because that would negate the benefit of the high dividend yield. So we conduct a detailed review of the company and stock price to ensure that the risk of losing our return to a falling stock price is minimal. Q:  What is the significance of a 15% return on capital? A : The historical performance of the stock market ranges somewhere around 10% to 12%. Since we are seeking to outperform the market, we determined that our benchmark should be 15%, including dividends and capital gains. Q:  How do you proceed from there to select your positions? A : We believe that our process for identifying value in the marketplace works well. The key to building a good portfolio is to look at as many ideas as possible. We pride ourselves on our exhaustive idea generation which seeks opportunities wherever they may be hiding. To start the process, we use both quantitative and qualitative idea generation sources. Quantitatively, we screen the entire universe for potential candidates. Our screens are based upon what a typical Category A, B and C stock looks like fundamentally. We apply these metrics to the universe and identify companies that have those similar traits. We also maintain a database of companies that we have worked with over our more than a decade of experience in the industry. This database contains companies which have business models that we know we like, so it can serve as a short list of ideas that we can screen against when seeking high value ideas. Screening can be effective but it is a blunt tool so it serves only as a starting point for analysis as opposed to the basis for building a full portfolio. Qualitatively, we rely on our contrarian, value bias to help us find ideas. Here we rely on all kinds of different signals and trends. For example, we will monitor executive team changes at companies with the idea that certain, effective individuals can be real catalysts for change. Additionally, we monitor insider stock purchasing behavior for clues about when insiders find their stock’s price inexpensive. But more often than not we are simply looking for parts of the market that we believe are oversold, and where we think we may be able to find a quality company that has been oversold relative to its real prospects. Market uncertainty always leads to good investment ideas. Once we identify potentially interesting ideas, we kick off our due diligence process. We are sticklers for reading every public filing that a company makes. We review the industry structure, their competitors, their suppliers, their customers – anything that helps us get an edge into how the company is performing. We also place a special emphasis on speaking directly with the management teams of the companies in our portfolio. We want to hear from management how they view their prospects and how they think about shareholder value to ensure it is consistent with our views. This work serves as the basis for the assumptions that go into our valuation of the company. Our primary valuation tool is a DCF model, which helps us forecast out a full income statement, balance sheet and cash flow statement. We believe it is crucial to think through all three areas to properly value an enterprise. We will use seven years of historical financial data and the results of our research to project out our views of the company’s financial performance for the next five years. We then apply a stage 2 and stage 3 multiplier on these figures to create a 15-year model, which we can discount back and compare to today’s stock price. Q:  What is your sell discipline? A : Hopefully we get to sell all our holdings when they reach our targeted upside return goals. We will generally consider a holding as a candidate to sell once it moves within 10% of our targeted return. However, we know that this is not always going to happen. If we see management make bad decisions or increased competitive pressures begin to negatively influence the business, we conclude that the investment thesis is deteriorating and sell the position. Q:  How many names are there in the portfolio? A : Generally, we hold between 55 to 75 names in the portfolio which brings us the required level of diversification we desire for managing risk. The maximum weight for a single position is 5% at cost, and our top 10 holdings represent approximately 35% of the portfolio. Q:  What is your benchmark? A : We benchmark against the Russell Mid Cap Value Index which also represents the fund’s market cap range. We are benchmark-aware but we do not attempt to mimic the index. While we watch the benchmark to determine relative performance, we do not seek to mirror the index holdings or sector weights. Q:  At the portfolio level, what kinds of risk do you see and how do you control them? A : Individual stock risk is a concern for any portfolio. Our number one goal is to not lose money. We believe our detailed focus on valuation helps in this regard. When we model out our companies we obviously model out an expected case but we consider a downside scenario as well. This helps us understand how much risk we think each name may represent to the portfolio. We also strive to build a diverse portfolio and to take advantage of broader diversification to help mitigate downside concerns. Of course, risk can sometimes be hard to see when you get as involved with our companies as our process requires us to be. Therefore, we also use a variety of analytical tools to make sure our investment process remains consistent with our philosophy. Because we are ‘stock-by-stock,’ bottom-up stock pickers, we use third-party risk analysis tools to monitor the portfolio for unintended sector bets. The third-party software analyzes all the factors, looks at sector bets and sector exposures relative to the universe, and keeps us on track. We have also built internal tools to track our requirement that each position earns at least 50% over the three-year investment period and is compounding capital at 15% annually. The performance of each individual name is checked against each of these targets to ensure it performs consistently at the level we expect.