Q: What is the history of the company and the fund? A: Fenimore Asset Management, the independent investment advisor to FAM Funds, was established in 1974 with a focus on long-term, value investing. Our genesis came from the sale of a quality, successful, family business. We invest in companies that exhibit those same top-notch characteristics. While having the upside potential of concentrated small- to mid-cap portfolios, we seek to mitigate risk and preserve capital through our in-depth research process and active management. It is this same, consistent investment approach that has helped us navigate multiple economic and financial market cycles. The FAM Equity-Income Fund was launched in 1996. We had been managing separate accounts with this dividend strategy for a while and thought there was room for a mutual fund utilizing the same approach. Back in 1996, dividend yields were much larger than today so we were able to invest in higher-dividend yielding companies. The dividend payout ratios have declined and, as dividends have gotten smaller over time, we have expanded our focus to dividend growth. What this means to investors is that the dividend, which is a key part to their total return, can get larger every year. Q: What is your investment philosophy and what are your views on dividend? A: We pursue dividend-paying companies because, since 1929, dividends have made up roughly one-third of investor returns. Dividends are an important component of investors’ total return over time, and we have also seen that dividends give investors a head start on their returns. It is that part of the return that tends to be solid and predictable. If an investor has a dividend-paying company with a yield of 3%, and stock returns for that particular year are 9%, the investor is already one-third of the way there. It is nice to be able to bank that in advance. The other aspect we see is that dividend-paying companies tend to be less volatile, particularly in down markets. This helps in preserving capital during turbulent times. Also, once dividends are paid to shareholders, they are not taken back, even if the stock price goes down. Once the investor gets their check, it’s theirs to keep. We invest in mid-cap stocks and there is a universe of 800 companies that have a 2% or larger dividend compared to the approximate 400 in the S&P 500 Index. We really like the growth of mid-cap companies because, historically, they have grown faster than large-cap ones. That means they can increase their dividends more quickly. Ideally, we would like to invest in a small-cap company that we think has a very long runway for growth and hold it as it becomes a mid-cap business. We have had examples of this in the portfolio where we invested in a company for a decade or longer. We do see earnings and dividend growth as being the key components of attractiveness to mid-cap companies. Q: What is your investment strategy and what kind of management and companies are you attracted to? A: We are value investors and employ a bottom-up strategy. We are building the portfolio one holding at a time and looking for companies that we think will be the winners in the long term. In general, we have four core investment criteria we follow. The first characteristic we look for is a strong management team. They are the group setting the priorities, motivating the employees and allocating capital that can create shareholder value. We spend a lot of time getting to know management. Next, we look at the business. It must be a good, high-quality enterprise with a long runway for growth and a moat that keeps competitors at bay. We are drawn to businesses that have a history of creating new products or finding new markets. Additionally, we look for solid financials; that means they do not have too much debt on their balance sheet and have high returns on invested capital. We like businesses that have a lot of financial flexibility to take advantage of opportunities including acquisitions, stock buybacks, or dividend increases. We spend a lot of time modeling out the business going back ten years and forward about five. We are not just looking at the income statement; we are analyzing the balance sheet and also the cash flows. Finally, we look for a compelling valuation. It is not good enough to get the first three criteria right because if we overpay for an investment, then none of that matters. We have to be able to invest in great companies at reasonable valuations. To build real wealth, an investor must earn returns that outpace inflation and we feel that investing in quality businesses at a discount to their intrinsic value is vital to accomplishing this objective. The companies we invest in generate more cash than they need to put back into the business to fund their growth. They have a good problem of deciding what to do with all the excess cash. We like businesses that pay and increase dividends or buy back their own stock at a reasonable price. If a company purchases their stock they are getting a guaranteed return and there is no execution risk, provided they are not overpaying for it. Companies use cash to make acquisitions, as well, so we look at how much they are paying for those purchases. We study the history of how well management has been able to make acquisitions and create shareholder value. We always ask, “Is this a good strategic fit or are they just trying to build an empire?” If it is the latter, we will not purchase the position; and if it’s an existing holding, we’ll look for an opportunity to sell. Q: What is your research process and how is your research team organized? A: There are seven people on our Investment Research Team. The long, average tenure of our portfolio managers and analysts is pretty distinct in the industry ─ our investment team and approach are consistent. Each analyst is responsible for finding their own ideas and following them. We do guide the process and focus efforts based on if we need, for example, technology ideas that pay a dividend. Another aspect that sets our firm apart from others is that our research process is very collaborative. We sit down with the other analysts and vet our ideas. This helps to eliminate any potential blind spots. If a company is having an analyst meeting, we will occasionally send two analysts. This allows us to have an extra set of eyes. The ability to have a sounding board when discussing investment ideas is important to us. We also visit the companies we invest in regularly traveling coast-to-coast. We are able to build relationships with management. This is a relationship business. We want to build relationships with our shareholders, our clients, and the management teams of the companies in which we invest. When we go and meet with businesses we have held in the fund for five or ten years, they know we want to speak about the long term. We are able to get to the core of their thinking about their business, strategy, and outlook. This firsthand research gives us unique insights and helps to mitigate risk. Q: Can you discuss two examples of stocks that you selected and how did you analyze investment merits of these companies? A: For example, Flowers Foods, Inc. is a company that we first took a position in three or four years ago. They make bread, rolls, buns and snack cakes sold through supermarkets. Flowers serves stores in the southern United States, and they were growing by introducing new products as well as expanding their geography northward. Looking at this investment, we realized that most other consumer staple companies already have the entire U.S. covered and large global footprints. This means their growth comes from just global GDP expansion and one or two new products. Flowers, on the other hand, can double their geography over time and serve all of America ─ that’s a key way we can see Flowers doubling their sales and earnings. Flowers also has a good track record of making strategic acquisitions, folding them in, and making them much more efficient. This has driven their profitability over time. For instance, a few years ago they bought Tasty Baking Company, the maker of Tastykake, out of bankruptcy. It was a very nice acquisition. Then they purchased Lepage Bakeries in Maine. This gave them entry to the northeast regional market. After they made that acquisition, the stock traded down a bit more due to a function of the market so we significantly increased our position. Our rationale was that Flowers was becoming more valuable by virtue of those two acquisitions. They were executing on their strategy that they had laid out to investors. Next, Hostess was going through bankruptcy and had to take their products off the shelf. Flowers was able to go in and get their bread brands into a lot of those markets and take market share. They then bought the bread brands from Hostess, which includes Wonder Bread, which at one time was the number one bread brand in the U.S. Flowers’ stock has done very well, and the company has grown its dividend 12% compounded over the last five years. More recently, we have trimmed our position as the stock has increased more than 50% in the past 12 months. Another example is Xilinx. Xilinx is the largest producer of “off the shelf” programmable logic devices known as Field Programmable Gate Arrays (FPGAs). FPGAs are more flexible and cheaper than traditional semiconductors that are manufactured to run only one specific application. They are used in a multitude of technologically-advanced devices ranging from telecom equipment to MRI machines. We first invested in Xilinx about four years ago. They are another company where the compounded dividend growth rate over the past five years has been 12%. We did not have much exposure to technology before we purchased this stock. We noticed that Xilinx had a tremendous amount of cash on the balance sheet and their profitability was extremely high. We did a lot of due diligence on the industry, sat down with their management, and talked with a lot of competitors. What we learned was that semiconductors are uniquely an American business. When people think about high technology, they think about Japan, but semiconductors’ intellectual property is here in the United States. Xilinx outsources its manufacturing. There is a lot of capital investment that goes into producing semiconductors so it’s good that they don’t have any risk in owning fabrication facilities. Also, Xilinx uses distributors to sell their product so the inventory risk is on the distributor side. With their excess cash, they are able to buy back some stock, increase their dividends handsomely over time and grow their operations very well. Another benefit of the FPGAs is that the technology is quickly replacing ASICs and ASSPs, which are integrated circuits. We are at the tipping point where Xilinx’s chips have been used in prototypes for years, so now it’s easy for these same businesses to use the chips in full-scale production. It makes economic sense to roll out a product using the Xilinx chip; this has been a very powerful dynamic in its growing business. Q: What is your portfolio construction process? A: When we start buying a company’s stock, we want to have an initial position of at least 1% of the portfolio with the potential of it getting as large as 5% to 6%. It normally takes us a little time to build the position as we get comfortable with the business. The one thing we do not want to do is overpay for an investment. We tend to be very patient on our buy price. There have been some instances where we have waited a number of years before we got the chance to invest in a company that met all of our criteria. In terms of sector exposure, we do pay attention to the sector breakdown in the S&P 500 Index. We do not want to have a weighting in any of our sectors that would be larger than two times the index sector weighting. That gives us broad latitude in structuring the portfolio. Q: What is your buy and sell discipline? A: As part of the buy discipline, we establish a price target based on the potential of being able to double our money on that investment. We put so much up-front, intensive work into researching companies that we want to take meaningful positions in the portfolio to justify all the effort. The average holding period of the fund is more than five years. We are looking to double our money on an investment, not make a quick 15% or 20%. That also keeps our capital gains exposure down and the fund offers tax-efficient returns to shareholders. We recently had a four-year stretch when we generated positive returns for shareholders, but the capital gains were deferred. Any time an investor is able to defer gains and taxes it is a good thing in our book. Regarding selling a position, a stock reaching our trim price most often drives our sell discipline. Because we are investing in good companies we tend not to sell out of a position completely. What we do is trim it back when it reaches the price target, take profits, and hold some shares. Good companies have a tendency to produce positive surprises when they are least expected so we like to have shares to participate in the upside. We will also trim an investment if it becomes an outsized position in the fund. An example of that was Ross Stores. We first started buying Ross’ stock in 2001 so we’ve had to trim that investment a number of times as it increased in value. That stock is up about ten-fold from our initial purchase price. There were also a few times where they stubbed their toes and we were able to build our position again. Q: How is your mid-cap fund different from other equity income funds? A: The fund currently has 30 holdings. We are very concentrated and we want to make sure all the investments in the fund are our best ideas. We want every one to have a meaningful impact on the performance of the fund. We like to have about 50% of our assets in the Top 10 holdings. Since the fund is in the mid-cap space, we are very different from the vast majority of equity income funds. It’s very difficult to distinguish between a large-cap equity income fund and a large-cap value fund, a lot of the holdings look alike. Large-cap funds typically own ExxonMobil, Pfizer, GE, Walmart, Johnson & Johnson, Microsoft ─ all the usual suspects. In the mid-cap space our names are very different from what you’d find in a large-cap space. These are quality businesses that have favorable outlooks. Since they are not typically followed by mainstream equity analysts, we have opportunities to find pricing inefficiencies. In addition, mid-cap companies tend to grow faster than large-cap ones and the faster that companies are able to grow cash flow, the faster they’re able to increase their dividends. When we look at the fund’s portfolio over the past five years, the compound annual dividend growth rates of the companies has been 12.3% compared to only 5% for those in the S&P 500 Index. Dividends give investors a head start on their total returns. Q: How do you define and manage risk? A: We define risk as permanent loss of principal. We do not define risk as volatility. Price volatility provides us with the opportunity to invest in great businesses at a discount to our estimate of their intrinsic value. We manage risk through our extensive, firsthand research. Our focus on adept leaders and the frequent contact with management helps reduce negative surprises. Also, since we limit our holdings to quality businesses with strong balance sheets, or little financial risk, we can have conviction in sticking with those enterprises especially through downturns.