Q: You started the fund as a co-manager in 1997, and took over the portfolio in 2000. What were the most significant developments for you and your cross-section of the market in these two three-year periods – between 1997 and 2000, and between 2000 and 2003? A: I was an analyst on it before that. In December 1995, I became senior analyst at the fund. In 1997, I became a co-manager and sole manager in August 2000. In the first year of the fund, in the half of 1997 to middle of 1998 we were kind of hit over the head with the growth stock days in the market, while we were asked to run a value fund. Then 1999 came and went, and especially when the bubble peaked in March 10, 2000, we were tearing our hair out over it. And with the major indexes at that time, we obviously did poorly in our class, because we stuck to our structured value discipline – not chasing Internet stocks, not chasing very high multiple stocks. Those were extremely difficult times for us. We had more than one question 'Why don't you value better?' 'Why are you sticking to your value strategy? In this new era of the Internet, value stocks are old school.' Fortunately for us we stuck to that discipline by holding and buying value stocks, and right after March 10, 2000 we started outperforming by wide margins and we're outperforming almost to that day. So, sticking to the discipline at the end of the day proved to be very important. Q: If we compare roughly, the major averages today are at the same levels they were in 1997, but the market is different. Didn't it make you change your strategy? A: No. We're buying one stock at a time. We're not top-down, and we don't care if the 'market is cheap', or 'the market is expensive.' Our philosophy is very simple. There are maybe 1,000 mid-cap stocks, and I have to go and find 50 cheaper. My job is to find 50 cheap mid-cap stocks in 2003 and the same in 2004. Q: The reason I am asking this is because of this ongoing debate whether a volatile market or a bear market dictate sticking to a more rigid discipline, or does it require more 'creativity?' A: No, we didn't become more creative. We stuck to our discipline. The process of finding out-of-favor cheap stocks is no different than it was in 1997, or 1995, or any other time period. It's the same process. Q: Let's talk a bit more about your cash discipline. Your strategy is to stay fully invested at all times, right? A: Yes. Any cash in our account is a reflection of the overall quality of our buys and sells. We're not market timers. Q: How hard is it? Wasn't it feasible to get more defensive in a hard period, say summer of 2002, when many funds held 20% or even 30% cash? A: I guess it's what we are paid to do. We are a mid-cap value fund. People who invest in this fund expect to see mid-cap value stocks in it, and not 30% cash. That's our marching order. Well, is it difficult at times? Absolutely. You have to stay later at nights, weekends, whatever, but keep looking. Maybe at some point our cash went to 9% or 10%, when we sold two or three names, and obviously value funds had inflows, but it didn't stay long. And in my career, which spans numerous years, every time I felt like being defensive, I've always been wrong. So, for years I haven't even tried it. Market timing is a fool's game. At least for me it is. Q: When one hears value, as far as mutual funds are concerned, one usually expects to find overweight in finance stocks. I didn't find that in your portfolio. Why is that? A: At present, I would say the last 12 months or so, we weren't able to find enough good value in the financial sector. In general, value funds have a lot of financials, because the P/Es are low. The average P/E goes from 8 to 13. And at 13, financials look cheap versus the market, but versus their own history, if that range is 8 to 13, if they're all at 13 I wouldn't call those cheap. Q: Let's elaborate a bit more on your selection process, then, but let's take an example to illustrate it. Countrywide Financial (CFC) seems like a textbook value performer in your portfolio. Trading near its 52-week highs, 33% gain in one year, P/E still under 10. A financial stock at that. Is it still your top holding? A: Yes, it is still a top-ten holding. You indicated it might be simple, but I think it's a complicated story. I think it is misunderstood. Its valuation seems reasonable, but the market is obviously assuming that this company might keep up its growth rate in earnings giving it larger valuation. When we bought it, it was trading in the mid-40s, probably 7 times earnings. Now, time will tell. The mortgage market has been very strong, and the housing market has been very strong over the past three years, but when that growth is over, we'll all know if Countrywide's earnings fall off a little bit, or they fall off a lot. The market seems to be discounting that its earnings won't fall off significantly. It's overstating the case. But I do think it's complicated. I would look at something simpler. Take another financial, MGIC (MTG), it is private mortgage insurance for first-time homebuyers. Equally low P/E, which the market doesn't like. It's also our top-ten holding. You see, it's been $70 three times for the past three years, and now it's sitting at about $40. It's a typical stock that's been cut in half for whatever reason and we think it's poised to rebound and make some of that money back. Q: Because it is a more straightforward case than Countrywide? A: Maybe because I know it better, and their corporate headquarters are next to my office, and I know the people there. Q: That's great because my next question is about management. It is No.2 in your scorecard, right after valuation. How do you assess management quality? MGIC is fine, an ideal case, because you guys are in the neighborhood. But what about when you're not? A: You're right. That's the best case, when you can sit down across the table with them two or three times a year and look them in the eye. But there are a few things that are less subjective. One is if the management is compensated along the lines of its shareholder’s interest, or the board of directors – are they cronies of the industry or are they other businessmen? Or what has the management done in terms of acquisitions or the use of cash – was it generally favorable for the shareholders or favorable for the employees? There's a big difference. But the most subjective part is when you listen to the management and see whether these guys are able to articulate and execute their business plan. Q: And how do you evaluate that? A: Well you can use the tools we talked about first and kind of build the case if this management is working for the shareholders. But at the end of the day it is totally subjective. It's your experience and screening the management day in and day out of your office or seeing them in their office. There's no magic to it. Q: At various stages in your scoring system you say that you use Wall Street research. How do you do that? Are you contrarian to it, meaning you look for what these guys miss or don't cover, or are you basically buying what they expect in terms of, say, earnings estimates or price targets? A: No.5 in our scorecard says 'Wall Street Expectations.' We will rarely purchase a stock where the number of Wall Street analysts covering it has favorable recommendations. We prefer to buy stock where the ratio of 'sells' and 'holds' is much larger than 'buys.' The other way we can use Wall Street is for actual information, and not opinions. We can use their knowledge of the specific company or industry, put it through our system, and see what we can do with it. But from their recommendation standpoint, it is contrarian, yes. And it is a very important point, because by definition, for competitive long-term returns you buy stocks that are overlooked or out of favor. When Wall Street analysts come through with their best ideas, we sit, we listen, but those are not the stocks we're working on. We're working on stocks they don't talk about. Q: So, say, you find such a stock, and there is little interest in it, pushing the price down, or there is a turnaround and it stays flat before climbing up, where do you prefer to accumulate – on the upside or on the downside? A: Downside. Rarely our first purchase is our best purchase. Frequently we'll fall lower and then add to it, but we set our price targets or price ranges for where we think the stock will trade in the next one or two years, and when it's down at that bottom range, we usually buy more. So our first purchase is not our best. Q: Well, this has its pitfalls, hasn't it? A: Oh, yes it does! It's a headache every day. Absolutely, it has pitfalls. There are some stocks where we bought at that bottom range, and it went down and we bought more, and we came to realize later that what we thought was a temporary problem was a more permanent problem. And that stock never recovers. It's a classic definition of the value trap. Q: You know I was looking at Spherion (SFN)… A: Oh, I can give you a lot more, too. [laughs] We bought that when it was $20 on $2 earnings, so it was at 10 times earnings. Later on it went to $10 on over a dollar earnings, so, fine, we bought again at 10 times earnings. And next thing we know earnings are only 70 cents. It got to a point when we realized that the management changes and all that weren’t going to cut it. And this had been in the portfolio for a while, so we made the decision to cut our losses and move on. And it is $4 today, but we can't claim victory because we lost money on it. It is a very good point, and no one has asked us before, but in our process, yes, we do buy on the way down. Q: There we went to my next question – the sell decision. Now, most fund managers present their screening and filtering systems as a meticulous, time-consuming task, while the decision to sell or pare certain holding seems to be triggered immediately or takes much less time. Is that really the case? Why don't you take as much time when you decide to sell as you took when you decided to buy? A: Another good question I haven't heard before. I would say it takes you less time on the sell process, because on the buy process you spend an awful lot of time learning the company, the management, what it earned, what it should earn, all that. You get to know the company. I would say you take less time when you decide to sell, because when you bought and held a company for some time, you get to know it much better. So, you have that in your personal account, and when it doubles, you don't feel like selling, right? Because it feels good. Well, our job is not to feel good. When it goes from $12 to $24 in 18 months, and now it is $23, we just go back and well, that was what we expected out of it. We trim it. Q: Yes, but you're still talking about taking profits. What if it goes down instead? A: Well, we set a price target 12 to 24 months out that assumes the worst. What we run each week is a report on where we think each stock should trade logically in the next 12 months. If we have set that range between $12 and $24, and we see that it's trading at $11, we go back to our report card and check our assumptions – why did we expect that range. And if all our assumptions are still valIdent, we accumulate. So, you see, it is a very important part, the setting of the price range. Q: And how does that work for the earnings part of the valuation? Say, the company misses the estimate for a quarter or two quarters in a row? For how long can you be comfortable with it? A: You see, when we buy stocks that are temporarily out of favor, or under-followed, it is common that when we start to build a position, the fundamentals are still negative. So, it's not unusual for us to be involved in a company that as a quarter goes by, it misses the number. So, they haven't gotten this fixed yet. And the stock goes down and another quarter goes by, and it misses again. We have to research why they did it. And if we're comfortable with them working on the problem, but is just a little slower than we thought, OK, I can live with that. We're long-term investors with long-term confidence that they'll fix it, this just gives you an opportunity to buy more stock. Well, the others generally will stay away from it; they'll say, 'We'll wait until they fix it.' But for us it's too late. When we buy stock, we're uncomfortable. There's no doubt about it. It hurts to buy a company that does not look very good. But usually that's the best time to buy a stock. Q: And you'll always be a value fund manager? A: Oh, absolutely. You know, the manager of the Mid-Cap Growth Fund in Marshall funds is sitting next to me. Finding mid-cap growth companies, where earnings grow faster than the market, or revenues grow faster than the market, is his job. That's not my job. I am told by my management, by my board of directors, to run a mid-cap value fund. And it better look like a mid-cap value fund. And that's what people here internally check on. If my average P/E has gone from 13 to 20, they ask what's going on. Q: And how do you interact within the fund family? A: Of course, we exchange information. The strange thing about this industry is that stocks change names all the time. What frequently happens is that growth managers here sell stocks that aren't growing as fast as they wanted to. And then the stock price goes down, right? And sometimes it goes down quite a bit. And that's our hope, because then we look at it and we may see a good value. Mattel (MAT) in 1997/98 was a growth stock. Then it came down to $12, because its earnings weren't growing, its margins weren't growing, and at that point it became a value stock. Conversely, if you take Boston Scientific (BSX), at $45 where it is now, in my opinion it is being bought pretty aggressively by the mid-cap growth managers, and it probably should be, because it's growing pretty fast now. When we purchased it in 2000, it wasn't growing fast then in fact it wasn't growing at all. But in our investigation, the stock price was too low for the assets of the company, for its potential, and so we purchased it. It's a classic one when you had to call it a mid-cap value in 2000 at $12 a share, and three years later basically the same company, the same management, the same R&D facilities are now selling $45 a share, because it is growing fast. So, now it is a mid-cap growth stock in my opinion. Q: Have you found more mid-cap value stocks in 2003 than in 2002, or 2001? A: No, I don't think it's much different. But I don't have much choice. I have to wait for the stocks to come to me with good valuations. No.1 in our report card is valuation. If a company doesn't pass the valuation part, we stop working. Some people say if you really like the management, buy it. If the valuation is out of whack, it means they probably deserve it. I have no problem with that, but that's not how I operate. Valuation is the No.1 criterion. And don't you think it should be if it's a value fund?