Q:  What is the recent history of the fund? A : American Beacon is based in Fort Worth, Texas and currently manages about $50 billion. We are well known for a family of sub-advised funds especially for value investment style. The American Beacon Mid-Cap Value Fund has been around since June 2004. The assets in the fund are equally divided among three sub-advisors: Lee Munder Capital Group, Pzena Investment Management and Barrow, Hanley, Mewhinney & Strauss. Lee Munder has been managing one third of the fund’s assets since June 30, 2011. Q:  Why do you prefer to have multi-manager investment approach over a single manager? A : We like the multiple manager structure because we believe it protects the individual investor from the underperformance and from the ups and downs of a single manager. We have structured a number of our funds using a multi-manager approach to provide consistent returns with less than market volatility. We meet face-to-face with our sub-advisors every quarter because we believe the only way to really get to know the process and the team well enough is by close monitoring and meeting. We also believe it is important to know them well to allow us to make the appropriate decisions regarding keeping them in the fund when times are rough, or not. It is very easy to terminate a sub-advisor if they underperform, but it’s probably the wrong decision unless you understand their process well. There are three sub-advisors to the fund. We keep them equally allocated. We do not make tactical decisions regarding allocation to sub-advisors because we are trying to protect the investor from the underperformance by a single manager. If we tactically overweight a manager we are re-introducing that risk. Q:  How do you select a sub-advisor? A : We set out to identify sub-advisors who we believe are better than average. We screen initially on performance that is median or better in the long-term, being five or more years. We focus on identifying and making sure that it is a true value product. We look at value metrics such as price-to-earnings, price-to-book, and similar valuation metrics that we want to see are cheaper than the broad market. We like to call our style ‘growth-at-a-discount.’ We hire firms with portfolios that consistently have a majority of companies that are growing, or expected to grow, faster than the market but that are cheap today, relative to that expected growth. We use a model to screen for those characteristics. We monitor the portfolio at our quarterly meetings to ensure it continues to displays those characteristics. We screen the universe and then focus on the team, the discipline, and the firm to select the best of the remaining candidates. Q:  What are attractive properties of mid-cap asset class? A : We define mid-cap at roughly between $2 billion and $20 billion at the time of purchase. It is surprising how many institutions, endowments, foundations, and retail investors alike continually ignore the mid-cap asset class despite the fact it has been the strongest domestic asset class over time. We looked at Russell style benchmarks as far back as they go, which is 27 years, to see who had won the race over time. It surprises most people that mid cap value has been the best performer over the long term.When you look at each individual year, over the last 27 years, Mid Cap Value is the only domestic equity asset class that has never come in last place in any given year. It has outperformed by generating solid performance with less volatility. Mid-cap value versus other domestic asset classes, on a sharpe ratio basis, performs the best over the past 3-year, 10-year, or 27 year periods. Mid cap stocks occupy a sweet spot. Relative to small cap stocks, they tend to have less risk since their business models are more diversified. Relative to large cap stocks, they are not so large that they have a hard time continuing to grow. Q:  What is your investment philosophy? A : We employ a classic value strategy, which to us means buying quality companies that are temporarily out of favor. We are looking for good, inherently strong companies with temporary problems. We are looking to find companies that are dealing with a transitory issue as oppose to companies who are struggling with a negative secular trend. There are different definitions of quality such as balance sheet quality and dividend quality. As much as we like a solid balance sheet and healthy dividend yield, we differ slightly as our main definition of quality is a company that earns a high return on capital that is sustainable over time. To achieve this, a company has to be doing something right. It has to dominate its niche. There has to be some barrier to entry to allow it to have that excess return. As much as the market loves growth, it still has enough appreciation for return on capital that when everything is going right it is still too expensive for us to buy. Our strategy is we wait for bad things to happen to good companies. We know what companies we want to own in our industries and we wait for a transitory negative event to allow us to invest in that company at an attractive price. An example of a typical negative event we are trying to take advantage of is a company called Compass Minerals. They are one of the largest players in the road salt market. Due to a lack of snow last winter, there is excess inventory in the channel at the various municipalities. That weighed on earnings this year. The market is too impatient to deal with waiting for a normal weather year again. It is going to look somewhere else. When the market is impatient, it can provide an opportunity to invest in a company with a compelling risk/reward and an attractive valuation simply because of a transitory issue. That is when we step up and take advantage. There are many different types of transitory issues. I think one of the classic issues for a company that has pricing power would be a company feeling margin compression from raw material price increases. A historical example of this is Hershey. Leading up to the financial crisis the price of cocoa and dairy spiked up rather dramatically on them. If you have the pricing power that Hershey does then it becomes an asymmetric bet in your favor because you do not have to bet that the price of the underlying commodity goes down. All you have to bet is that the price at some point will stop going up long enough for Hershey to exercise its pricing power to restore its profit pool. JC Penney, headquartered in Texas, is a good example of something we would not touch. There are very smart, deep-value investors that are willing to take binary type bets. If you get a binary bet right, you will make a lot of money for your investors. The problem is that if you get it wrong there’s really no downside protection. It’s a very long, difficult turnaround. We are not interested in taking those types of binary-type bets. Our valuation work is driven by figuring out how much the company can earn on the other side of the problem but without getting too wrapped up in when that run rate begins. I think the market is too short-term focused. It’s impatient. We are patient long-term investors. Instead of trying to figure out what a company is going to make next quarter, we are trying to figure out what they can earn on the other side of the problem. Q:  Do you look for a catalyst for companies to turn around? A : We do look for catalysts but we look at them in a different way to how managers normally look. Most managers are trying to time that inflection point. By the time you can tell a catalyst is going to occur, so can everyone else and the stock has already moved 30%. You have missed the value portion of the move. What we do, which is subtle but different, is that we identify the catalyst and the probability of that catalyst occurring sometime over the next 18 months. In the case of Compass Minerals we didn’t know if we would have more of a normal snowfall this year or if we’ll have one next year, but the probability is that it will be a normal year. Our valuation is driven off what the company can earn on a normalized basis. Outside of the headline catalyst, we also look for companies that offer multiple ways to win. Compass also has a potash business where they are substantially lowering their cost structure. That is another way to win outside of snow frequency. If you study the average snowfall over time, it would be unusual to have too many years so far below average. Even if it only improved a little bit, with the cost savings you have from the potash business and the stability of the salt business, we think you would have price-to-earnings-multiple expansion and the stock would still work higher. From a total return perspective, Compass also enjoys a 3% yield. Q:  What is your portfolio construction process? A : The benchmark is the Russell mid cap value Index. There are 562 names in that index. For our portion of the fund we typically own 60 to 80 names. We monitor companies going back 10 years and review regulatory filings. We think it is important to understand the history of our companies. We do a thorough review of the company, the industry, and the competitive environment, so that we understand the important drivers for the company and its industry. We also talk to management. We think management is a critical component of any investment that we make. We screen all mid cap stocks by five valuation measures: Enterprise value/EBITDA, price-to-book, price-to-cash flow, price-to-earnings, and dividend yield. To be in our investable universe, it has to be in the cheaper third of any two of the five measures. With respect to idea generation, we get ideas in a lot of different ways. First and foremost, we understand industries and know what companies are the better quality names in each industry. In many respects, it is reactive. We are waiting for a company to have an issue for us to take advantage of. There is always a constant stream of new companies having problems. We also get ideas from the Street but it is the opposite of what most people would think. We are often looking at what names are being downgraded. You’ll see Wall Street research highlighting a downgrade of a company that has a quality franchise but they are going to sit on the sidelines until visibility improves. Q:  What risk control measures do you take? A : We are not willing to invest in companies where the negative event can take a company under. Every single stock that goes into the portfolio has to have an asymmetric risk reward profile. There has to be much more upside potential than downside risk. If you can mitigate the amount of pain in times when you are wrong that goes a long way to driving risk-adjusted returns over time. From a downside protection standpoint, we look at this in a lot of different ways. We look at where a company has dropped on a valuation basis in past downturns. We’ll look at asset value. Dividend yield is one measure that has been working particularly well lately. In the case of Compass, it has approximately a 3% dividend yield, which helps to create an overall favorable risk reward ratio. A historical example that drives home the idea of downside protection is Constellation Brands. They are the largest domestic wine company but they also have a beer distribution joint venture and an international business where they were growing grapes in Australia and selling wine in Europe. A question we are constantly asking is how much of the bad news is already discounted in the stock price. Constellation’s international business was really struggling and the market was punishing the stock for that. We did a thorough analysis of the company and assumed worst-case scenario in that business. We assumed the international business was worthless. We also assumed worst case scenario for their beer distribution joint venture with Modelo. We assumed that Modelo would exercise their right to buy back the joint venture so that Constellation would only receive a few more years of cash flow before losing that business. The market never likes that lack of visibility, but we look at it differently. We wanted to know how much we were paying for the core domestic wine business if we assumed worst case scenario on the other segments. It turned out the valuation was a pretty reasonable. The domestic wine business started to improve as we came out of the recession which was one of the catalysts. What made the stock a real winner was Anheuser-Busch InBev's acquisition of Modelo. AB InBev has so much distribution in the United States, instead of Constellation losing out on the joint venture, AB InBev had to sell all of the distribution business plus some other assets to Constellation in order to placate the Department of Justice. We think it is most important to look at the relationship between the upside potential and downside risk. I would say we are looking for a roughly three-to-one ratio. We are not interested in making sizeable risky bets so our typical stock is much more likely to increase by 30% than 300%. We are looking for quality franchises that are simply trading at a discount because of transitory reasons.