Q:  What is your investment philosophy?

Our value investing discipline applies not only to this small cap fund but also to the other portfolios we manage across various market caps. One primary difference from some our value oriented peers is that we do not do distressed value. We don’t invest in troubled companies or troubled industries looking for some type of quick trade before a company spirals down into oblivion. Instead, we feel that investing in what we believe are higher quality companies available at discounted valuations has generally worked for us in the past and we believe will continue to do so going forward. Investors can have differing definitions of what quality means to them. At Silvercrest we base our view of quality on two metrics that we keep close track of. One is return on invested capital, where our portfolios, including the fund, will generally have a higher median return on invested capital than the appropriate benchmark. If you look at our portfolio versus the Russell 2000 value index, our median return on invested capital, excluding financials where we tend to look more at return on equity, will tend to run anywhere from 300 to 500 basis points higher than the benchmark. The other primary metric that we care about is balance sheet integrity. Whether you look at debt-to-total-capital or net-debt as a multiple of EBITDA, our portfolios will tend to be as well or better capitalized than the relevant benchmark. We think balance sheet strength gives companies greater ability to manage their businesses with flexibility through good and bad economic times. We are not scared of debt, and may opportunistically invest in a smaller number of companies with above average debt levels, but only where we expect strong free cash flow to de-lever the balance sheet within our investment time frame. These two primary metrics manifest themselves throughout our process and portfolio construction as we try to find companies that we think have healthy balance sheets that generate above-average returns on capital or show the potential to get there. These companies are generally niche oriented businesses that have barriers to entry helping to insulate them from competitors and allowing them to produce above average ROIC’s along with higher levels of free cash flow and a more consistent earnings pattern over time. While many investors are preoccupied with short term earnings results, we don't think that business always runs in a linear fashion. We look for opportunities to buy great franchises after, what we think, are temporary disruptions in results and/or temporary dislocations in valuation. The challenge is to decide whether current valuations reflect cyclical or secular issues. We try to avoid secular problems where we think returns on capital will fall, balance sheet metrics will deteriorate, or earnings will remain under pressure. If we think the issues are transient, our interest is peaked. We like to meet with management teams to make a qualitative assessment of the company to better understand positioning in their industry, how they think about capital allocation, and any goals and objectives we can use to evaluate management results over time. Our approach requires time because in any given quarter or any given year, even two-year periods, higher quality companies can be out of favor. In general we find that in periods exiting an economic recession, and/or in periods of market ebullience, investors may prefer lower quality companies, feeling that in an improving economy the rising tide will lift all boats, and investor favor move to the most financially and economically levered names. Conversely, we find that in periods of economic malaise or market weakness, investors can gravitate to higher quality companies for their perceived lower risk. Historically, our portfolios have tended to have their strongest relative performance in periods of market weakness. We also think our companies are attractive acquisition candidates. We usually lose a few companies a year through M&A, but that activity has been relatively dormant over the last couple of years. We’re buying the same type of company that we've always bought and believe as we continue to focus on niche oriented, higher return, solidly financed companies that generate attractive cash flows with growth potential, they will tend to look attractive to other investors as well. So as we look ahead over the next few years, we expect to get our share of M&A opportunities.

Q:  What is your investment process?

To generate potential ideas we do a lot of screening. Our typical quantitative screen comprises about 12 or 13 variables that we care about. The two most heavily weighted are enterprise-value-to-EBITDA as a valuation metric, and ROIC as a return metric. We are looking for mismatches. We’re looking for those companies that maybe have a double digit return on capital that are available at relatively lower multiples of EBITDA. Those companies will tend to rank relatively highly, whereas the converse of that, companies with lower returns yet higher valuation multiples will tend to rank relatively poorly. Among other variables, we also look at ROIC trends, earnings consistency, free cash flow generation, and balance sheet metrics. As mentioned previously, meeting with company management teams is also an important part of our process. On average we probably have one or two companies a week coming in to talk to us directly at Silvercrest, leveraging our New York City base as companies come through town frequently to make presentations at various investor conferences. We attend a lot of conferences and Investor Days as well, whether in New York or around the country, to meet with management teams. At some point one of our team members will champion a particular stock idea and will do detailed due diligence on that company, perhaps having further dialogue with management, scouring publicly available information, and looking at sell-side research. Assuming the company has passed scrutiny from a quality of management perspective and a business model perspective, we will try to ascertain what the company might be able to generate in earnings, cash flow, book value, EBITDA, and/or sales over the next few years. We then apply valuation parameters to those metrics and discount the resulting future value back to get a net present value of the stock today. The discount rates we use are comprised of several factors including a risk free rate based on US Treasury yields, and separate equity-risk premiums that encompass our appraisal of management and quality and volatility of the company’s business model. For example, a typical utility holding, where the business and returns are fairly predictable with lower volatility, would generally require a lower discount rate than might some of our technology companies where we realize we have a greater chance of being blindsided by the next great gadget that comes out of someone’s garage. We generally use a higher discount rate to adjust for lower visibility and greater variability. We’re disciplined about not initiating positions in companies that are selling above our appraisal of net present value. If a stock is selling below its net present value, the sponsoring analyst prepares a brief report outlining our investment thesis and capturing the inputs for our valuation model. The analyst presents the idea to the team and we debate the merits. Ultimately it is my decision whether the stock goes into the portfolio. The vast majority of the time, probably 90% of the time, an idea brought to the table winds up in the portfolio. The sponsoring analyst retains responsibility for the stock, suggesting when we should be buying more, selling some, or eliminating the position, and the team discusses current positions regularly. Most of our sale or trim candidates are valuation based arising when a company’s shares trade above our appraisal of net present value. If, however, there is a negative fundamental change: capital allocation we don’t agree with, management change we don’t like, or signs of drift away from our original investment thesis, we will review our stance and may decide to exit. To sum up, screening on the front end identifies potentially attractive ideas. Due diligence verifies whether the numbers make sense. Chatting with management lets us assess company positioning and management effectiveness as stewards of capital. Assuming everything passes muster, the stock winds up in the portfolio.

Q:  Can you discuss two examples of companies you discovered, analyzed and what aspects of business model or investment metrics were attractive?

One of the ways we look at the portfolio is by categorizing our holdings into four buckets. The largest bucket would be what we call our steady Eddies. These are companies that are well positioned in an attractive niche, generate reasonable cash flows, reasonable returns and are those we can see ourselves potentially owning for several years. The second bucket is catalyst-driven companies. These are companies that are undergoing some type of change, and can be in management ranks or within the company’s portfolio. The most common change is new management. We find that new management can reinvigorate a tired franchise. Another change is portfolio restructuring, where management rationalizes underperforming asserts, or improves the portfolio through an acquisition. We also have a franchise value bucket. These are companies that have above average attractiveness as potential takeover candidates. The final bucket is normalized earnings. This category tends to be the smallest part of our portfolio. These companies may not look particularly compelling at first blush – their earnings or cash flow may be temporarily depressed due to cyclical factors – but where we think a normalized environment would warrant a higher level of earnings and resultant higher valuation. As may be expected, many or our companies would fall into two or more of these stratifications. Here are a couple of examples: BancorpSouth (BXS) is a company that falls in the catalyst driven bucket, but also has franchise value attributes and may evolve into a steady-Eddie type holding. We bought the shares about a year ago when an executive we’ve long admired took over as CEO of this Tupelo, MS based regional bank. BancorpSouth was an underperforming organization, largely ignored by investors and analysts, with a bloated cost structure. Our past experience with new CEO Dan Rollins gave us confidence that he could improve results. We assessed capital and credit quality to ensure the bank had staying power long enough for Dan to make the changes he needed to. We quantified the earnings impact of improving the bank’s profitability over a 3–5 year time horizon to impute a longer-term growth rate. We then compared our assumptions with muted sell-side expectations and found the shares fundamentally mispriced. Downside risk seemed limited as the bank was well capitalized. For all its faults, BancorpSouth had made money in all years going back to the 1980’s, including the most recent recession. Importantly, analyst expectations had fallen and the bank’s shares had underperformed for the prior three years. We believed the valuation gap would narrow as Dan met with investors and began to improve profitability, a thesis that is playing out. The ample capital position has enabled the bank to make some small acquisitions that we think can accelerate earnings growth. Another example is Hillenbrand (HI), which falls in both the steady-Eddie bucket and the catalyst driven bucket. This company is primarily known for the Batesville casket business, the largest casket maker in the U.S. It’s a high cash flow business but one offering likely only low single-digit growth. Hillenbrand management realized this and has been redeploying the free cash flow generated from the casket business into assembling a portfolio of faster growing, industrial oriented companies. Following several acquisitions over the last couple of years, the industrial side of Hillenbrand’s business is now a growing percentage of the product portfolio. Over time, we think this relatively under followed company will attract a new set of investors who will see a faster growth profile. We think the company will gradually get more sponsorship from sell-side industrial oriented analysts. We think the company is poised to generate organic revenue growth of four-to-six percent over the next few years, which the company will probably augment with acquisitions in the industrial space, giving us potential sales growth in the upper single to low double digits. We also expect some operating margin improvement, and as management de-levers the balance sheet, we think the earnings power of the company could approach about $3 a share over the next few years.

Q:  What is your portfolio construction strategy and what role diversification plays in your thinking?

From a portfolio construction perspective, we look at the Russell indexes. While we are not particular fans of how Russell constructs their style benchmarks, most of our clients measure us against the Russell 2000 Value Index. We quibble with the value benchmark as we think it is too heavily skewed towards the financial services sector, currently representing about 40% of the Index. Since it would be unlikely for us to let an individual sector account for that much of our portfolio, we take a 50/50 blend of the core benchmark and the value benchmark sector weighting to flatten out the extremes of the value Index. Within that context we typically have at least 50% exposure to that blended weighting and not more than 200% exposure. That gives us plenty of room to overweight and underweight sectors as we see fit. We will always have exposure across all nine Russell sectors. We’re not one of those firms that dramatically over-weights an individual sector while eliminating exposure to others. If you look at the portfolio today versus a year ago, versus three years ago, versus five years ago, you would see that the sector weightings really haven't changed a whole lot. We tend to be underweighted in financial services, particularly relative to the Russell 2000 Value given that 40% exposure there. We tend to be somewhat over-weighted in more of the producer durable sectors and materials and processing sectors, a little bit more of the cyclical sectors of the index. We think our representation across all the Russell sectors is partly responsible for our historically below-index standard deviation. Generally how many names do you hold in the fund? What is the upper limit per company or per sector?

Q:  What is your definition of risk, how do you measure risk and how do you manage and contain it?

We try to keep risk management simple and focused. The two main components are company specific risk and portfolio construction risk. Company specific risk is managed by staying on top of company fundamentals. Our analysts create a research report on all stocks recommended for the portfolio. The analyst that recommended a stock maintains accountability for the company for the entire time that the stock is in the portfolio. We review all holdings periodically, re-calibrating our model inputs as needed. Each week, our team reviews any stocks under-performing the benchmark over the preceding month by more than 10% in an attempt to keep a tight rein on potential longer term underperformers in the portfolio. Also reviewed are companies that are more than 15% overvalued according to our valuation model. From a portfolio perspective, by monitoring and limiting our relative sector exposures, we think we can manage relative volatility. We don’t make big company bets, a large holding in our portfolio will very rarely get to 3.5 to 4% of assets; so we’re not taking inordinate position size risk. Liquidity is also a factor, and at the company level, I don’t think we’ve ever owned more than 10% of any issuers’ equity. We do have a handful of situations where we’ve accumulated over 5% ownership, but as a passive shareholder only.