Q:  How has Private Capital Management evolved? A : Private Capital Management, L.P. was founded with seed capital from a wealthy Southwest Florida family in Naples, Florida in 1986. The firm manages equity separate account portfolios for high net worth individuals and institutional investors, as well as a mutual fund – the Private Capital Management Value Fund. The company, which has been a wholly owned subsidiary of Legg Mason since August 2001, manages approximately $1.7 billion in assets, of which the mutual fund accounts for about $45 million. We launched the Private Capital Management Value Fund on May 28, 2010. Q:  What core beliefs guide your investment philosophy? A : We invest in companies that are out of favor, underappreciated or misunderstood, and thereby trade at a significant discount to our estimation of their long-term intrinsic value. We are big believers that the way the investment team adds value is through proprietary insights and discipline. Consequently, we look to leverage our domain expertise within the areas we invest. For us, our success or failure is determined by the ability to distinguish between temporarily impaired businesses and broken businesses, and to identify entry points that from a risk/reward perspective are consistent with the creation of long-term value for shareholders. Our focus for almost 25 years has been to find those “50-60 cent dollars” that can reach full value over a 3-5 year investment horizon. Q:  What is your investment strategy? A : The goal for us is to identify what we believe are quality businesses at the point of time where they trade at significant discounts. Surprisingly enough this happens quite frequently. Investors may sell off shares when a business experiences some near-term earnings issue or there are widespread concerns over future prospects. Investors may avoid companies that possess a misunderstood asset base or a complex business model. Company-specific strengths may be ignored because investors are more worried about an uncertain industry or economic outlook. We also occasionally find businesses that while in need of a turnaround are structurally sound. We rigorously analyze a host of factors to fully understand a company’s ability to create value for shareholders. We define value using a variety of measures, primarily discretionary cash flow; another is the potential value of long duration corporate assets. We believe that a company’s {{capacity}} to generate discretionary cash flow is a consistent quality of businesses that can generate long-term value for shareholders. First of all, we believe sustainable discretionary cash flow is a characteristic of a superior business. The value creation for us happens when a company can appropriately deploy that cash flow whether to expand their operations and make the business more profitable, buy back stock, make strategic acquisitions, or distribute it as dividends to us the shareholder. Another advantage of discretionary cash flow is it can allow a business to maintain a sound capital structure, which affords more options – and presumably shareholder protection – during difficult economic environments. Given our cash flow focus, taking the time to understand the nuances of GAAP accounting is central to what we do. GAAP accounting is essentially a set of rules that allow for theoretically consistent treatment across businesses but in reality are susceptible to being massaged and manipulated by aggressive management teams, especially with respect to reported earnings. Additionally, in some cases GAAP accounting conventions do not closely reflect business reality. Properly derived, cash flow is a much more meaningful indicator of real world value. Q:  What are some of the analytical steps that underpin your research process? A : One of them is the traditional screening approach. Enterprise value to operating earnings screens may provide a broad view of what cash flow may be. Debt-to-equity and other balance sheet ratios can give us an idea what the balance sheet strength may look like. We may also screen for corporate “activities” like buybacks, debt repayments, and meaningful insider buying. In addition to screening, we have a continuous dialogue with industry executives and other contacts to keep pace with changes in the competitive landscape. These types of discussions – coupled with our own intimate industry knowledge – help us refine our thinking about where to look for compelling opportunities that meet our investment criteria. Once we identify a potential investment opportunity, we focus on the value of the company’s business operations and assets over an identifiable investment horizon. We closely analyze publicly available financial information and make adjustments to better reflect the fair valuation of the company’s assets, liabilities, pension obligations, and to account for any overly aggressive (or conservative) accounting policies or GAAP conventions that do not reflect economic reality. We place a significant emphasis on the company’s {{capacity}} to generate discretionary cash flow over time. As a matter of fact, it doesn’t necessarily have to be generating much, if any, cash flow at the point in time we are researching the idea. While Wall Street research is sometimes interesting, it is important that our conclusions are independent. Because we are deep value investors, opportunities that we find compelling are often contrary to the prevailing opinion from the Street. The research process on a particular business may cease here for a variety of reasons. The valuation may not be compelling enough or we may be unable to estimate future discretionary cash flows with sufficient clarity. Sometimes a leveraged balance sheet, increasing input or labor costs, shrinking margins, or poor competitive positioning may raise the investment risk profile to the point of disqualification. For those ideas that do make it through this stage of the process (are statistically cheap), we move to a more qualitative analysis that focuses on company dynamics and positioning, management quality and goal congruency, and the competitive forces that are at work. While a business may look cheap and interesting from a statistical standpoint, we also want to understand the management team that is running the business, its competitive positioning, the geographical dispersion of its revenues, top customers and target markets, and the economic sensitivity of its products or services. With regard to company management, we want to understand the intellect, ability, motivation, and focus of the team, as well as the level of goal congruency between top management and the outside shareholders. It is also important for us to know the candor and willingness of the top management team to engage in a meaningful dialogue with shareholders and the investment community in general. In our conversations with management, we are not interested in trying to pry from them their next quarterly results; we want to understand their long-term plan for shareholder value creation. We will evaluate management’s history of creating (or failing to create) value for shareholders. It is not uncommon that we will seek input from a company’s suppliers, competitors and customers as well. What we are looking for on the qualitative side is a company with an entrenched market position or sustainable competitive advantage, a competent management team whose interests are aligned with creating long-term value for shareholders, a corporate culture that is consistent with good governance, and a company that has the ability to effectively compete and succeed under a variety of economic scenarios. This thorough analysis allows us to understand the risks and opportunities that may not be fully reflected in the company’s public filings. Where we identify issues, we try to analyze them relative to the overall attractiveness of the opportunity; understanding that the risk or market uncertainty may be why the company is trading at a compelling valuation. Q:  Would you provide some examples that illustrate your research process? A : One was Scientific Atlanta, Inc., a Georgia-based manufacturer of cable television, telecommunications, and broadband equipment. In cable set-top boxes, it was basically a duopoly of Scientific Atlanta and General Instrument. The stock had traded as high as around $62 in January of 2001 but at the time we started building a position in the fall of that year it had dropped to the high teens. There were a couple of reasons for the rapid decline. In June, while the company had announced very good results it had also guided down significantly for the next year, as cable companies wrapped up a significant buildout of the recent product line. At the same time, one of Scientific Atlanta’s major customers, Adelphia Communications, was under financial duress. With the stock already expensive on a multiple basis, the stock price declined precipitously. We understood that there was an immediate downturn in the business cycle but we also realized that we were getting compensated for this with a 70% plus drop in the stock price. For us it was an opportunity to invest in the best pure play in the space, as General Instrument had been purchased a year earlier by Motorola. Our view of the competitive landscape was that people were going to continue to want their set-top box to do more and the cable companies were going to have to spend the money to upgrade their boxes or risk losing market share to the satellite dish competition. On the technology side, we understood that General Instrument had focused more on the strength of the hardware, whereas Scientific Atlanta had placed more emphasis on software by creating a common operating system. We thought Scientific Atlanta’s approach was the superior business model and gave it an advantage over General Instrument. As for concerns about Adelphia, even if their problems persisted, some cable company would ultimately support all those customers. Given Scientific Atlanta’s positioning, we thought it had a good shot at keeping that business. In fact, Adelphia ended up going under about 9 months after we initiated the Scientific-Atlanta position. From a discipline perspective it was just a matter of remaining patient as the cycle turned and also making sure that management did not make any critical mistakes during the downturn. They managed it extremely well. The replacement cycle happened, the economy improved, and the stock price started to rise to reflect the growing earnings. In November of 2005, Scientific Atlanta was acquired by Cisco for $43, all cash. Q:  When investing in technology companies where the pace of progress is so fast, how do you avoid investing in businesses that may be statistically cheap but are destined to become irrelevant? A : It’s a good question and probably the reason why most value-oriented managers typically won’t be significant investors in the sector. It’s not easy and while we are not always right, we believe we have an advantage as we have been meaningful investors in the space for over two decades. In Scientific-Atlanta’s case we already had evidence of a successful transition from an analog to a digital set-top box with the Explorer model. That was out before we made the investment. We felt shares of Scientific-Atlanta were not being punished due to a fear of irrelevancy but because of economic forces we thought were temporary. Another example is Apple which we started considering during the bursting of the technology bubble in 2000. From a statistical standpoint, it was cheap. The bulk of the stock price was cash on the balance sheet and real estate. You were paying very little for the actual business or name recognition of the Apple brand. At that time, Apple was essentially a PC business with limited market share. With the rout in technology names during the bubble burst, there was very little desire by investors to own the name. We were familiar with the company and its approach to technology and innovation having owned it in the past. We took a look at what was happening inside of Apple’s headquarters in Cupertino, California. There was a level of excitement that was the antithesis of what you would expect given the implosion that was occurring across Silicon Valley. There was a clear strategic focus on branching out into other consumer electronics. Lacking this insight, investors might have concluded that the company was on the cusp of irrelevancy, and the stock price certainly reflected that belief. While we couldn’t have predicted the level of success that Apple would eventually realize, our analysis was there was little downside risk and a suitable reward if they achieved even modest success. At the time we invested in late 2000 we felt amply protected by the value of the company’s corporate real estate and cash. In more recent years, we became investors in Motorola. Here was a company that investors believed was moving towards irrelevancy. The company had lost significant market share after it failed to follow up on its highly successful RAZR cell phone. What we believe many investors were failing to consider was that Motorola had two other highly successful businesses in addition to its troubled handset business which, in our opinion, were worth as much if not more than the market price of the entire company. Therein lay our margin of safety. We understood the reasons why there hadn’t been a next generation follow up to the RAZR. We also understood that the company was actively addressing the issues. Being a long time investor in the telecommunications sector, our understanding of the cell phone business was that handset makers get the ability to gain or lose market share with each cycle based on the desirability of their new models. Motorola’s handset business would have the chance to become relevant again. We also came to believe that the company was strongly committed to not missing that opportunity when it arose and even appeared willing to consider a strategic restructuring of the business to surface shareholder value. Our thesis was further bolstered by the hiring of Sanjay Jha to run the handset business. We were familiar with Sanjay from his time at Qualcomm and pleased with the strategic direction he articulated for the handset business. The spinoff of the handset business, Motorola Mobility Holdings, Inc. occurred in January of this year and on August 15th Google announced that it would acquire the company for $12.5 billion or $40 per share in cash. Q:  Would you quote an example from a different sector? A : Sure, in March 2010, we initiated a position in Biovail Corporation, a specialty pharmaceutical company that had developed some well-known drugs such as Wellbutrin XL and Cardizem LA. But it was also a company with a controversial past.  Several years prior to our investment, in 2007, the founder and former CEO was forced out of Biovail following a series of infractions including non-disclosure of insider activity, accounting scandals, and aggressively suing short sellers. Following his departure, the board and management team was revamped, bringing in significant experience in pharmaceuticals, drug distribution, accounting and neurological science. We felt the overhang of those events had continued to taint the share price. We believed the market had underestimated the strength of Biovail’s core business – a collection of approximately 20 drugs, most of which already faced generic competition. Since they already competed with generics, their revenues and cash flows were stable and could be modeled with a higher degree of probability. It’s important to note that most specialty pharmaceutical companies are reliant on fewer than three drugs, many of which still face a patent cliff and uncertain futures. In addition to their core business, we also concluded that Biovail was under appreciated for the drug pipeline it had acquired over the previous 18 months.  The company had used its strong cash flow and balance sheet to complete acquisitions but structured the deals to minimize its capital risk for inherently risky drug development programs. The company performed well in the months following our initial purchase and in September 2010 Biovail merged with Valeant Pharmaceuticals Intl. Q:  Generally, how many names do you have in your portfolio? A : The Fund’s portfolio is typically 40 to 60 positions with the top 10 frequently accounting for 30% plus of the portfolio. New positions are commonly initiated with a 1% – 2% weighting. Over time, an individual investment may become 5% - 6% of the portfolio. We are not hesitant to have meaningful representation in any one particular sector. We believe we add value by our underwriting of individual businesses in areas we have expertise, not by how much we overweight (or underweight) a particular sector relative to an index. What is important to us is to have that proprietary insight, why we believe that particular business can attain full value over an acceptable time horizon. We are not hesitant to stockpile cash if we fail to find enough compelling ideas. We are not a believer in having to be fully invested at all times. Cash levels can easily get to 20% if we do not find the opportunities out there or there are larger macro uncertainties. Q:  What is your sell discipline? A : We generally determine target prices at the time of purchase. But that target consistently changes over the years as new developments occur. We scale back and then eventually exit a position as it reaches our target price. If there is a fundamental change in the business that negates our initial thesis, or additional risks develop, or a management team fails to execute, then that business becomes a sell candidate. Another way that positions tend to exit the portfolios is through mergers and acquisitions. In the last decade, the Fund’s portfolio has had 35 to 40 companies acquired away from us. We view this as a testament to the research process. If the business is mispriced either the market will recognize it and bid up the share price or an acquirer will see that same value and buy the entire business. Q:  What risks do you perceive in the portfolio and how do you manage them? A : We think the portfolio is diversified enough on positions to reduce some of the risk. Given our bottom-up process, markets that hold the most risk are those where stock prices become unhinged from company specific valuations. These types of markets can result in valuation swings in excess of what we view as justified based on our target valuations. One of the two aspects that we focus on the risk side is to get the business case right at the individual security level and the price we pay should provide us with some downside protection. The second factor that we take into consideration is the overall macro view and how a business is positioned within the macro economic cycle. A company can remain statistically cheap for a long time if the overall environment remains unfavorable.