Q: What is the history of the mutual funds? A: Barrow Street Capital LLC, an investment firm headquartered in Stamford, Connecticut was founded in 1997. Since inception, we have specialized in private equity with a focus on hard assets such as real estate, and from 2007 we have applied our key strengths to develop a public equities investing approach based on private equity investment principles. Near the end of 2008 we invested our personal capital into two private partnerships – Long only U.S. Stock Strategy and Long/Short U.S. Stock Strategy. Over the next four years, investments in these private partnerships grew and on August 30, 2013 we converted these partnerships into open-end registered mutual funds, the Barrow All-Cap Core Fund and Barrow All-Cap Long/Short Fund, respectively. Q: What is your investment strategy? A: We select stocks that fall at the intersection of quality and value and use our private equity experience to assess quality and to appraise valuation. On the quality side, we are looking for companies that generate cash flow and are able to reinvest that cash flow back into their business at favorable rates of return. We are looking for companies that have strong sales growth per unit of capital and we tend to be skeptical about companies that have strong sales growth through acquisition using stock or issue stock to raise capital to fund revenue expansion. We are skeptical of companies that go deeper into debt in order to fund sales growth. We like companies that grow organically without issuing more debt or diluting our equity position as owners. Thus, we look at sales growth per unit of capital outstanding. We also tend to shy away from firms that are over-levered. To summarize, we want businesses that are growing organically, have clean balance sheets, and high returns on reinvested cash flow. Another thing we look for is wide operating margins. We prefer companies that make good and growing returns on reinvested cash flow and operate with wide margins; for us those can be great investment opportunities. As we identify quality, we are also looking for those companies that are trading at a significant discount to intrinsic value. We look at total enterprise values and calculate cash flow yields on the basis of the company’s core cash flow generating ability as opposed to returns on equity that are distorted by how it is currently financed. We are not really into looking at price-to-book ratios or price-to-earnings ratios. We think they are either too simplistic or misleading or both as measures of valuation. Instead we are looking for the value of the firm -- its debt and equity taken together-- divided into the amount of free cash flow it generates. And from that vantage point you can see if this is a business that’s trading at a discount to its peer groups. Q: How do you get investment ideas and once you have ideas how do you value its investment merits? A: We look for U.S. companies with market capitalization more than $450 million because we don’t want to get involved in stocks that we can’t truly buy and sell without significant market impact. We are also looking for companies that avoid overleverage. We’ll drop from our universe companies that we think carry too much debt on their books. After these and other eliminations, we are left with about 1,500 companies from small to large caps that are of interest to us, and we comb through the financial statements of each one of them for quality attributes that we find attractive. Then we price them up using the most recent market data to calculate whether they are trading at the margin of safety that we are looking for. And when we find out of that list of 1,500 companies those that are high quality trading at a temporary discount to their intrinsic value, we add them to our portfolio. So in any given month we’ll buy about 90 different companies across the board, multiple industry groups and market capitalization bands, and even in an overvalued market environment we are usually able to find really high-quality companies that are offering bargain pricing. Generally, we invest in a company that’s been out of favor for one reason or another or has been overlooked or misclassified or underfollowed by Wall Street research or recently hit a rough patch and has been punished by the market to an extreme. For us, all of those scenarios set up an interesting purchasing opportunity. Q: Can you share examples of companies that highlight your research process? A: We try to apply the same investment research discipline and process to all of the names that we carry in our portfolio. One of the key watchwords of our investment process is consistency with respect to how we analyze the financial information that we find. We tend not to listen too much to management or follow securities analysts on Wall Street. We’d rather look at what a company does than what its management team says, and as part of that discipline financial statements are really at the center of our analytic process. That and our valuation work drive our investment process. When we look at our focused list of 1,500 or so names, we are looking for these great cash flow generators with great margins and returns on equity that are trading cheap. Lorillard Tobacco Company, Reynolds American, Inc., and Pitney Bowes Inc. are some of the examples of what we have in our portfolio with sizable holdings between 1% and 1.5%. And, these companies have proven themselves as cash flow generators over time and for one reason or another are momentarily out of favor so we are able to pick them up cheap. Through time, over the last five-and-a-half years, we’ve experienced a great deal of merger activity in our portfolio. Roughly 60 names that we have owned over the last five years have been acquired by either a private equity buyer or a strategic acquirer. We use our private equity approach to look at quality and valuation and are finding companies that are generating good cash flow and growing on their own without dilutive successive rounds of capital raising. That is one of our key features of our investment processes. Q: Do you establish a target price? A: Intrinsic value has a lot of meaning to us, but we don’t set a formal target price. When we buy a stock we generally like to hold it for at least one year -- that gives the market time to reappraise the opportunity that we think we found. Generally that’s three or four quarterly earnings releases and if we are buying a company that’s high quality trading at a temporary discount to its intrinsic value it is possible that the opportunity was presented to us as the company missed earnings and shook market confidence. So, we don’t have a formal target price. Generally, when we wade into a position we don’t start with a 1% position. When we take an interest in a name it generally starts around 10 basis points and if it continues to look attractive, over time we’ll add to that position successively and build it up. The biggest position we have in our portfolio is 1.4%, so we are highly diversified by design. We want to deliver to our investors an experience that gives them exposure to value sensitive investing to high-quality companies but without the volatile ride that is commonly associated with concentrated portfolios. We are deliberately diversified across industry groups, market capitalizations and individual names so that we can really smooth out the experience for our clients. Q: What is the minimum margin of discount that you require for investment consideration? A: Generally we are buyers when the margin of safety is about 40%, so if we calculate the intrinsic value of a stock to be 100 we would be very interested to buy it at 60 which means that there is a lot of room for that stock to appreciate. Over a time span of five years we have generated roughly 400 basis points of risk-adjusted outperformance per year due to security selection. We aren’t market timers and we don’t try to make macro-economic calls with respect to our sector and industry exposures. We tend not to get involved in market rotation trades between mid, small and large caps. We are trying to deliver our value proposition by being great stock pickers and building functionally-diversified portfolios of these opportunities. Q: What is your sell discipline? A: For a name to leave our portfolio it really has to be bumped out by a name that is more compelling both in terms of its quality attributes and its discount to intrinsic value. That is usually the only time we remove a stock from the portfolio if we think we should be fully invested in that environment. As a rule we have been fully invested; we haven’t used cash defensively since the end of 2009. That means when we sell a stock we replace it with another stock. We don’t sell it and hold cash. Q: What is your benchmark? A: Our benchmark is the S&P 500 index and it’s an imperfect one because we do invest in mid- and small-cap stocks and the S&P 500 index doesn’t include companies in those market caps. But it’s really the best fit for the average market capitalization that is in our portfolio. Internally, we keep track of how we are doing by using a custom benchmark that we market cap weight according to the positions that we hold in our portfolio at any given time. Our whole investment process is geared toward careful, deliberate analysis; deliberate risk taking not accidental risk taking. So, when we use our custom benchmark we are really trying to be our toughest critic and apply a test to see whether our performance is coming from tilts in industry groups or market caps or whether it is coming from picking great companies trading at discounts. Q: How do you construct your portfolio? A: We have a policy driven portfolio construction approach. From our perspective, diversification is really the key here. We don’t like the risk and the volatility associated with highly concentrated equity positions. We think it is just as important as having great quality companies trading at discounts to having exposure across the market, industry groups, sectors and market cap bands. For us, to diversify those opportunities across a variety of different industries and market caps is essential. In terms of other diversification, at the position level we have an internal guideline that we don’t want to have any position be greater than 3% of our holdings. Our biggest position is about 1.5%. Our top 10 positions only constitute 12%, 13% of our net asset value right now. Q: Why do you prefer diversification as a strategy? A: Based on our experience, we feel the value of diversification across names is a game of where percentages and alpha matter a lot, and if there is an unfortunate scenario of a stock in the portfolio that goes to zero, we don’t want to lose out our opportunity to outperform the market for the entire year just because we got one name wrong. For us, it is a risk not worth taking because as long as we can find other names in the marketplace that are just as compelling from a quality and valuation standpoint, why would we take the risk of being overly concentrated? Q: Why do you sell a stock? A: When we evaluate a stock versus its intrinsic value what is so interesting is that intrinsic value changes over time too, as well as the market price. For instance, we have Myriad Genetics Inc. at the top of our list here which is up 80% or so over the last year. We’ve owned that stock for quite a long time and we made several different purchases through time in the market; it is about 1.25% weight in our portfolio which for us is a heavy weight. Myriad is a good example of a stock where we bought it cheap enough so that we are able to let it run and where the intrinsic value is increasing as well, so that even now we believe we own it at a discount to the intrinsic value though the shares have risen substantially. We don’t cut off a stock just because it’s earned us a good profit. We are always trying to be mindful of where the current price is versus its current intrinsic not historic intrinsic value and are also mindful of where the stock stands versus other things that we could be doing with that capital. We are trying to find the best opportunities that the market offers at any given time and if there are more compelling opportunities out there, even if a stock we already own has room to run, we sell that stock and buy a name that has better quality attributes and higher margin of safety. Q: How do you differ from a traditional value investor? A: We depart from traditional value investors in our focus on quality, cash flow generation, top-line sales growth, cash flow growth per unit of capital outstanding. This broadens our criteria for what constitutes an attractive investment to include the rate of return that a company can earn by reinvesting its cash flow to include its sales growth and cash flow generating ability and thus we have a broader list of names to invest in. One of the problems with the value style narrowly defined and narrowly implemented is that it can go through extended periods of underperformance. Our approach seems to be more of an all-weather approach, and what we have found over the last five-and-a-half years of watching our performance is that we don’t correlate highly either to value investing or quality investing as a style. We combine quality and value at the stock selection level as opposed to the portfolio construction level and that is why we are in some of these biotech and pharma names that you wouldn’t find in a traditional value portfolio. An example of a stock that we own is Sturm, Ruger & Co., Inc., a Connecticut–based firearm manufacturing company with about $1 billion of market capitalization. They are a fairly significant holding in our portfolio. It’s down around 17% this year because it had a soft new order book in the last quarter of 2013 which presented a perfect buying opportunity. This is a company that invests its free cash flow back in its business, pays a dividend which is equal to 40% of its earnings every quarter by policy, and has grown its top-line over the past five years significantly. Back in 2009, this company had $270 million of revenue and for the full year 2013 it had $688 million of revenue with basically the same number of shares outstanding over that five-year period. So, the earnings per share growth that this company has been able to generate is just off the chart and all that earnings increase is really an increase in cash flow. Therefore, this is a company that we really like but is momentarily depressed, and for us it is a perfect buying opportunity to take a position in a company that has been around for about 70 years making a popular product that is widely distributed. And, over time we get rewarded for finding and investing in such companies. The reason that a typical value investor might miss this particular stock is that its price-to-book ratio is around 5.8 times. So a value investor isn’t going to even see it to consider it -- when they run their screens this company won’t make it through. If instead you were looking at the company’s cash flow yield, which we define as the amount of cash flow it generates per year divided by its enterprise value, that is 18.5%, -- it has a 3.3% dividend yield -- so this is a company that is really cheap. But under many value screens it wouldn’t survive even the first cut. When you look at the cash flow generating ability of the company, its return on assets, its total enterprise value to cash flow, it looks very cheap and that is confirmed by the high dividend yield of 3.3% we are seeing right now. For us, this is a good investment as it meets all our investment objectives but would not be attractive to a traditional value investor. Q: Are dividends an important criteria in your investment analysis? A: A little bit. For us, we are looking at total return and the money we make out of a good dividend payment or a solid capital gain all goes into building and compounding our wealth. We don’t really draw a big distinction between a dividend payment and the capital gain payment. I think even though dividends are somewhat important we can do very well by buying companies and compounding our wealth as shares go up in value as well so it is not a driver of our process at all. Q: What is your short strategy as part of the Long/Short Fund? A: In the Barrow All Cap Long/Short Fund our short book is about 90% of our net asset value and our Long book is about 130% of our net asset value. So the fund runs at a gross exposure of 220% with a net market exposure of 40%. For us, the shorts do two things. They dampen the market risk associated with a long only investment approach. In our case we reduce the market risk by over 50% through our shorting activity. It also gives us a good opportunity for additional alpha production. Our shorts are selected for their fundamental and valuation attributes. We short using a quality meets value shorting philosophy and basically what we are looking for there is low-quality companies; companies with thin margins that are overleveraged, have weak returns on equity that don’t have much free cash flow to reinvest in growth and are trading at prices greater than their intrinsic value. We are able to find quite a few of those and we think our goal in shorting each of those names is to outperform with respect to each individual stock that we short and at the same time dampen the market risk associated with our picks on the long side. Q: Do you have a concentrated or more diversified approach for the short strategy? A: Well, we are diversified in the stocks that we hold in our short book in the Barrow All-Cap Long/Short Fund with about 800 shorts driven by an investment process that looks at fundamental financial data. Here we are seeking low-quality companies trading at premiums to market levels and intrinsic value. So we think we outperform by virtue of having short exposure to those names and at the same time bring down the market risk of that fund. We are generally shorting names that are easy to borrow and aren’t overcrowded. Q: How do you define risk? What do you do to contain and manage risk? A: Individual stock price volatility is not where we focus our risk management. In a highly diversified portfolio we are very comfortable buying a stock that is volatile on its own because in the context of a portfolio that volatility is likely to be offset through our other holdings. We look at risk from a fundamental perspective. We look at the risk of permanently losing our capital. That is one of the reasons we avoid companies that carry a lot of debt on their balance sheets. We are looking for companies that can survive a rough patch, weather volatility and unforeseen shocks in their industries, and that means companies that don’t carry a lot of debt and have wide operating margins. That’s really one of the best defenses to future uncertainty and risk - to have companies that are in good businesses. Rather than focusing on statistics we are really looking more at fundamentals: leverage, operating margin strength, and for us that’s the best form of risk management, coupled with buying cheap.