Q:  What is the history of Intrepid Capital Funds? A : Intrepid Capital Funds is a financial investment advisory firm headquartered in Jacksonville Beach, Florida. The company is currently managing more than $1.2 billion in assets. We run four mutual funds – The Intrepid Small Cap Fund (ICMAX), The Intrepid Capital Fund (ICMBX), The Intrepid All Cap Fund (ICMCX), and The Intrepid Income Fund (ICMYX). The Intrepid Capital Fund is not an all-equity fund, but holds a balance of stocks, bonds and cash. We have sixteen people, half of whom are related to security analysis and trading and the other half deal with financial managers or private clients. Q:  What are the underlying principles of your investment philosophy? A : The underlying philosophy we have is that prices change quicker than value and price is not always indicative of value. We unearth securities with a disconnection between the market price and the underlying long-term value of a business. As part of our philosophy, we want to participate in an up market. But more importantly, we want to preserve capital in the down market. We are more concerned with our down market performance than we are with our up market. We like management to have a meaningful equity stake in the business, which we believe aligns their interests and ours as common shareholders. For us, one of the keys to winning is not losing. Q:  How does your philosophy translate into the fund’s investment strategy? A : We are absolute return focused and use conservative valuation techniques. We practice classical security analysis in doing our valuation work. We primarily focus on companies making things that people need and use at any time. It is a cross between portfolio management and private equity valuation work combined with fixed income analysis that has generated consistent returns to this point. Once we try to establish a valuation for a company that we are interested in, we update those valuations particularly if we have established a position. We are not concerned with what the next quarter is going to look like relative to what’s the business worth. We are more interested in free cash flow generation and what is the terminal value three-to-five years hence. We prefer businesses that generate meaningful free cash flow, since this is an important characteristic of a good business and usually indicates a solid or improving balance sheet. In addition, free cash flow clearly increases intrinsic value and can be used to pay shareholders via buybacks or dividends. In terms of discount rate, we want a double-digit required rate of return and make some subjective call based on what we see are the alternative cash flows for that particular business. At no time throughout our investing are we capitalization constrained. The typical security for us is a $1 billion and $1.5 billion equity market cap that generates a $100 million free cash flow which gives a nice free cash flow yield that will accrue for our shareholders over a three-year holding period. While we do not want to make a call on rates, we aim to take interest rate calls out of the equation. As duration constrained investors, we look at spreads and certainly make wide bets. We tend to look for high yield bonds of small cap companies, which generally means that there is not a lot of debt outstanding. Q:  How do you decide what is value or a value trap? A : We keep searching for some kind of a catalyst that is going to create the dynamics necessary to bridge the gap between valuation and the current market price. Q:  Where do you find your ideas and what steps do you follow in your research process? A : We run a screen only a monthly basis as we look for high operating cash flow relative to enterprise value and for our comprehensive ranking system. We also conduct rigorous research on balance sheets as part of our efforts to fully understand the business. We try to figure out what normalized cash flows are over a full market cycle. We do not want to pick the peak cash flows and extrapolate those out to the distant future for our valuation hurdle. We want to figure out what they look like over a full cycle. Many of the businesses that we keep on our radar are well established. What we do next is try to understand margins, the balance sheet, any hidden liabilities and new products, as well as any potential changes in their balance sheet. We typically want to talk to management whenever we can. Then we want to use asset valuation and we try to determine what the business looks like over a three-to-five-year holding period. Q:  Can we discuss one or two companies to better illustrate your research process? A : One name that comes to mind is Scholastic Corporation, a children’s publishing, education and media company. It also has the exclusive publishing rights to the Harry Potter book series for the United States. At the time when we started considering the stock, they had very short duration high-yield debt. We owned the credit and started looking more deeply at the equity as the Harry Potter business had a tail to it. Because of strong cash flow drivers, the company was able to establish a dividend in the summer of 2010. When we looked at their enterprise value, we could see that they had brought debt down from $400 million in 2008 to $255 million. They had also generated $180 million in free cash flow on an $852 million market cap. The other reason for our consideration was that their management owns stock and wants to do right for the family and those who own it with them. Another example would be American Greetings Corporation, a publicly-traded greeting card company that operates with Hallmark Cards. We owned the credit, which tends to generate a lot of free cash flow and pays dividend between 3% and 4%. The founding Weiss family retains a substantial stake, and despite higher postage prices and the growing popularity of e-cards, people still love greeting cards as it is more personal. Here, we have a $670 market cap that has $143 million in free cash flow. The company debt has come down in three years from $390 million to $230 million and cash has increased from $60 million to $209 million. That is a value creator from our standpoint. Q:  What is your portfolio construction process? A : We tend to be fairly concentrated in our positions without having too many liabilities in front of our position. Our top ten weights will be somewhere from 20% to 40%. We are comfortable holding high levels of cash if we do not find securities that meet our criterion and we are totally sector agnostic. Typically, we have not been a big owner of bank shares. The portfolio turnover generally stays in the range between 30% and 40%. For benchmarking purposes, we use the The Bank of America/Merrill Lynch High Yield Master II Index. Q:  How do you tackle liquidity as part of your portfolio construction? A : We are quite disciplined about using limits. Since we wait for our limits to hit and we tend to be cash heavy in periods of market stress, we do not have to monetize one of our existing long positions. We are very careful about position sizing and strict about sticking with valuation parameters. We cannot buy less than 80% of value, and once it reaches that valuation, we sell. Based on the recent results, we will upgrade that valuation at the end of each quarter. Q:  What is your sell discipline? A : It is very rare for us to take a long position and then resort to selling due to a mistake we have made. We put fairly rigid parameters for our valuation work, which gives us our own margin of error. We do not think that our selling decision is driven by silly mistakes or top-down directives because of an arbitrage stop loss mechanism. In fact, it is purely governed by valuation. If we found the valuation was lower, we would simply sell. Q:  What risks do you perceive in the portfolio? How do you mitigate them? A : We are extremely careful about the price we pay relative to what we think it is worth. On the fixed income side, we want steady, cash-generative properties to pay back our indebtedness. We certainly do not want to take any interest rate risk. On the equity side, we seek to invest in companies that are consistent generators of cash and be mindful of the valuation that we pay for. The margin of error concept keeps us from future losses in our portfolio. Typically, businesses that we own have management ownership, which provides us with another layer of safety. Moreover, we are very strict about position size and we do not let any name get bigger than 4% of the portfolio.