Q: What is the history of the company and the fund?

Becker Capital is an employee-owned investment advisor based in Portland, Oregon. We were founded in 1976 and have grown steadily over the years. We currently manage about $3.3 billion.

Roughly half of our business is institutional in nature, including foundation, endowment, pension, and profit-sharing plans, while the other half is comprised of high net worth individuals and families.

We have 28 employees currently, 15 of whom are owners in the firm. Our mutual fund, the Becker Value Equity Fund (BVEFX) launched in November, 2003, and currently has approximately $393 million in assets.

Q: Would you describe your investment philosophy?

Since the firm’s inception, we have employed a value-oriented philosophy, believing that it is not enough to simply buy a good company, that what you pay for it has significant implications for your subsequent returns. We are very price sensitive.

The Becker Value fund is managed according to the same value philosophy used to run all of our separately managed portfolios. We look to build good diversification into our portfolios which will typically have some 55 to 65 separate issues. While we are diversified across sectors, we would not characterize ourselves as sector or benchmark driven. Ours is an active, research-oriented, bottom-up stock selection process.

Q: What is your investment strategy?

We are primarily large capitalization in our orientation and typically benchmarked against the Russell 1000 Value Index as well as the S&P 500.

We take a long-term approach, with portfolio turnover that runs about 35% over the course of a cycle. This low turnover is tax-efficient for our high net worth clients and cost-efficient for all of our clients.

In implementing our comprehensive research-intensive, bottom-up process, we try to build a “weight of the evidence” case for including a stock in the portfolio at a particular price. Essentially, we’re reconciling underlying fundamentals and valuation with the current stock price in order to reach a decision on each new idea.

There is necessarily a strong financial analysis component to the process. We take a hard look at balance sheet integrity as we are generally not interested in layering financial leverage on top of operating leverage. We look at the level and direction of operating income and operating margins, capital structure, cash flows, and cash flow yields.

We spend a lot of time looking at return on invested capital, as capital stewardship is our primary gauge of management’s skill. The ability of the management team to earn a return on invested capital in excess of a conservatively estimated cost of capital tells us that a company is not only efficient with their capital, but that they are also focused on building shareholder value and not destroying it.

To that end we steer clear of companies that overpay for stock repurchases or dilutive acquisitions simply to achieve growth. We tend to be agnostic as to how capital is deployed, whether it is for organic growth, balance sheet repair, dividends, share repurchase, or acquisitions. We want to have some conviction that what they do with capital makes sense from a shareholder standpoint.

We’ll also look at industry conditions, competitive dynamics and comparable companies as part of the process.

As to what sets us apart, we are a stable team of professionals with a steady approach who have been executing on a value-oriented strategy and philosophy since the inception of the firm. To that process we bring experience, judgment and no small amount of common sense. We are a long-tenured group of value investors who adhere to a steady investment philosophy, one that is stable, consistent, and repeatable.

We see ourselves as analysts first, recognizing that our research represents the real value we bring to our clients. Our organization is flat in the sense that decisions are made by the team as opposed to a specific individual. When a new name goes into the portfolio, it is only after a rigorous discussion and, accordingly, as a team we share responsibility for each decision.

In terms of the actual process, new ideas can come from a variety of sources. The team itself has proven to be a good source of ideas having analyzed a lot of companies over the years. We do some screening but we characterize it as high-level screening in the sense that a company does not have to fall within a fixed set of parameters in order to be included in the portfolio. Screens are a way of getting potential ideas in front of the team.

In addition, we visit a significant number of companies on site, attend industry events and sell-side conferences, as these are all good opportunities to generate new ideas. A lot of direct contact goes into the process.

Those ideas that appear to offer further opportunity are added to our Monitor List. At any given time, that list will include about 40 names that are undergoing further analysis. We find that this Monitor List is a great way to communicate to the rest of the team what might be coming down the pike in terms of further discussion.

Once the research process is done and the sponsoring analyst has developed conviction that a company has investment merit, a thorough write-up is prepared and distributed well in advance to the rest of the team. At which point we’ll sit down and thrash out the idea. We subject all ideas to a rigorous discussion—there’s never any rubber-stamping of new ideas.

It then comes down to a vote by the team as to whether to include the new idea in the portfolios. If it is not included right away, it may be for reasons of valuation, or we believe more information is necessary. But if we vote for it, it goes into the portfolio.

Q: How do you structure your research process?

Value, for us, takes the form of a company’s underlying earnings potential, its discounted cash flows, and whether the current share price fails to reflect the underlying intrinsic value of that stock.

Although every value investor possesses a contrarian streak, we do not fall into the category of deep value or turnaround experts. We are looking for companies that are out of favor for transitory reasons, perhaps related to a current economic cycle, or a product cycle, where we can develop conviction that the reason for the undervaluation, and why it is out of favor with most investors, will prove transitory. To that end, we look for companies that can articulate how they are going to address whatever issues are depressing the stock. This helps us to understand the case to be made for the company, while providing us a roadmap to benchmark the company going forward.

Q: Can you provide a few examples of companies you bought, and why?

Our most recent purchase was an out of favor name, Hewlett-Packard Co (HPQ). Before giving effect to the impending restructuring, we believe the combined operations are capable (and without heroic assumptions) of $6.5 billion of fully taxed, unlevered operating income. If we capitalize that at a reasonable cap rate, we get a stock that is trading at better than 110% of the current enterprise value of the company. Its value is clearly underappreciated by the market.

Because we also look at intrinsic value in terms of asset values, we own Plum Creek Timber (PCL). Although it is a Real Estate Investment Trust, Plum Creek is commonly viewed as an asset company. They have 6.8 million acres of timberland and are the largest publicly traded timber owner in the United States. Although it looks expensive on a GAAP basis, the cash flow is more than sufficient to cover the attractive dividend. And taking a long term view, the underlying acreage looks very attractive. Add to that the fact that those trees are growing by 7% or 8% a year and you have an interesting asset-based value for the long-term investor.

Some situations are looked at in terms of the sum of their parts. They are a complicated mix of businesses, and if you are a bottom-up, research-driven firm, you can identify some component parts that add up to more than the current price of the shares.

For example, we have a position in IAC/InterActive Corp. They are spinning off a portion of their social media sites Tinder and Match.com, thus unlocking some of the Our sponsoring analyst made the case that even under conservative assumptions, the sum-of-the-parts valuation that was well above the value of the company when we bought it as evidenced by this recent monetization.

Although we are decidedly large cap, we will occasionally include some mid cap names that offer compelling attraction. Some months back, we initiated a position in AGCO, Inc., a farm equipment company headquartered in Georgia that does most of its business outside of the United States. At the time the company had a market capitalization of about $4 billion, trading at about 40 cents on the sales dollar.

AGCO, Inc. epitomized what value investors look for. It was trading at a low multiple on earnings that were experiencing a fair amount of stress. It was broadly concluded among investors that the farm cycle had peaked and would be over for quite some time. That was true, but it was more than reflected in the shares of AGCO.

When we delved into the underlying fundamentals, we felt that the company was likely to continue to be solidly profitable. Even though there was no near-term earnings catalyst, we could make a valuation case for it. Even with margins at the low end of the historic range, the company was still solid, with a positive cash flow, a good balance sheet, good geographic diversification, and insider buying.

Q: What is your portfolio construction process?

The median market capitalization in the portfolio is about $32 billion. That is multiples above what the median market cap is for the Russell 1000 Value Index. It is also roughly twice the median market cap for the S&P 500. Better than three-quarters of the names in our fund have market capitalizations in excess of $10 billion. As I mentioned, we focus primarily on larger capitalization, but we don’t hesitate to include a number of mid cap names if we feel they offer decent valuation opportunities.

Every investor brings bias to the process. To overcome some of our individual biases, we equally weight new ideas at 1.5% to 2% at initiation, and more often than not we buy our shares all at once rather than gradually. No position ever exceeds 5% of the portfolio. In fact, when a name inches above 3% to 3.5%, we typically scale it back as a matter of risk control. Cash is limited to 5% or less.

The bottom-up examination is the most important aspect of our research, but we are not oblivious to the macro economic environment. We are not top-down in our approach, but we pay attention to the environment because that informs the assumptions we are willing to make about the companies in the portfolio.

This has been a slow-growth, elongated recovery, so we do not make a lot of heroic assumptions about earnings growth or topline growth. Keeping those assumptions realistic, given the environment, has been our chosen way to go.

We watch our sector weightings. We are not top-down driven. We keep our exposures within 10 percentage points of an index weight.

Once the names are in the portfolio, we meet twice each week to review the portfolio holdings and to look at our weightings. Quarterly earnings releases are an occasion to carefully scrub the numbers and make sure the thesis is playing out as anticipated.

Being price sensitive is enormously important to subsequent returns. Healthcare, for example, has done extremely well. It has some nice defensive characteristics, and so a lot of people are piling into that sector. As a result many of those stocks have become quite expensive. We have been scaling back some of our exposure in that area on the basis of valuation.

At the other end of the spectrum, we have been analyzing a number of names in the machinery and industrial area, particularly as they relate to the process, refining and extractive industries. Names like Parker Hannifin Corp. have not quite reached our valuation disciplines but are looking much more interesting. They have a lot of exposure to the energy markets, which is partly why they are under some pressure.

We do not own any utilities at the moment. With so many people searching for any kind of yield, they have become expensive. We sold our last utility last year.

Q: Do you have a set buy-and-sell discipline?

We do have a couple of sell disciplines in place designed to take some of the bias out of the process. One is that if a stock is down 15% from cost, in the absence of a commensurate market or sector move, it will be immediately subjected to a full review. We look at it then as if it were a new name, the only difference being that we now take the original sponsoring analyst out of the vote.

We review the fundamentals and the valuation thoroughly and make a decision as to whether or not we want to continue to own the name, sell it, or add to the position.

Furthermore, if a stock is down 25% from cost, it will be eliminated from the portfolio, provided that the drop is not a reflection of a market move of comparable magnitude. Adhering to this principle removes the emotion, the bias, from the decision-making process.

Most of the time, however, we sell a stock simply because it reaches a valuation level that fully reflects the underlying fundamentals, at which point we turn our attention to our monitor list to search for another investment candidate.

We meet once a month to review the attribution, characteristics, and statistics of the portfolio. We look at tracking error and we look at any changes in portfolio beta, active share, and sector weightings. We also look at allocation vs. stock selection to make sure we are being good stock selectors.

In terms of our buy discipline, we set what we feel is a reasonable target based on a forward estimate of earnings and an earnings multiple. Typically, however, that target is not a hard and fast number.

The quarterly earnings are an occasion to revisit the fundamental story, and if the fundamentals continue to unfold as we think they will, we can stay with a name for quite a long period of time. We have names in the portfolio that are well past their original valuation target because their fundamentals have continued to evolve.

Q: How do you define and manage risk?

There is real value in terms of risk control to be found in buying low-expectation names as it tends to limit your potential for loss when you buy companies that are cheap in terms of earnings potential or balance sheet characteristics.

Risk takes various forms. We do not view volatility as a risk. Permanent capital loss is much more significant to us as a definition of risk. Value investing is a soft risk control, but it is an important one.

We do look at other attribution characteristics and statistics, such as the portfolio beta and tracking error I mentioned, to keep an eye on how we compare.

More importantly, we are aware that, as bottom-up stock pickers, finding an unusually large number of really attractive ideas could steer us in a direction that we might not want to go, or it could cause us to overweight an area where we do not want to be overweighted. So, we also closely monitor our sector weights to ensure we are not making an unintended sector bet.