Q: What is the history of the company and the fund? A: Tom Putnam started Fenimore Asset Management in the mid-seventies. We are located in a small town, Cobleskill, in upstate New York. This is where Tom grew up and his father had a textile business. His dad had the good sense to sell the successful business at the right time. Tom and his father invested the family money and people got wind of that around town. That gave Tom the idea to start an investment management firm. Originally it was a private, separately managed account business with a $50,000 minimum. In the separate account business, inevitably people who trust you approach you to manage small amounts of money so Tom got the idea to start a mutual fund to accommodate that business. The Value Fund was started on January 2, 1987. Through the research we have done, there were fewer than 400 domestic mutual funds back then so he was a bit of a trailblazer. He started the fund by raising $1 million from family and friends, and the fund is now about $900 million. Q: How is your fund different from your peers? A: We differ from our peers due to the quality of the companies we invest in. We are value investors and like to find bargains. We like to buy the stocks of, what we feel are, terrific companies but at discounted prices. Additionally, we are more concentrated than most of the other funds, with about 40 holdings. We have a high conviction about our names and want them to have a meaningful impact on the portfolio. In our experience, concentrated portfolios have a better probability of outperforming diversified ones over the long term. Finally, we are employee-owned. We are not part of some huge corporation; it is more like a partnership. For all three of our funds, including our Value Fund, we do our own shareholder servicing. When you dial the toll-free numbers for service, it does not ring at some call center; it rings here in Cobleskill, New York. This allows shareholders to call us and build a relationship over time. We answer the phone ─ you do not get a voicemail. By doing our own processing, we have all the data on the transactions in the fund since we started in 1987, and we are able to use that and provide thorough, individual performance reporting for each of our shareholders. We are able to tell them exactly what their return is on the fund, which is pretty unique. Q: What is your investment philosophy? A: Our philosophy is simple. A stock is not a piece of paper or in this day and age it is not a blip on the computer screen. A stock certificate represents fractional ownership in a business. The most important thing becomes studying the business and trying to figure out what the business is worth. We are investing in businesses. We do not know what the market is going to do today, tomorrow, next week, or next year, but we do think we know how to value companies. For operating companies, we use cash flow. We look at a business and its assets, and we look at the amount of cash it generates and then figure out what we think it is worth. We then want to invest in that company at a discount, which is the value part of the philosophy. In addition to value, we are looking at financial strength of the company. We tend to invest in good balance sheets, high returns on invested capital, and lots of free cash flow in the business. Value can be measured a lot of ways ─ we are not investing in the 100 cheapest names in the market, many of which are junk, and hoping they just go up. We only want to purchase stock in what think are quality businesses that are generating cash. Q: What is your investment process? A: Everyone in the investment business reads the newspaper and knows what is going on in the world at large. Issues - like the level of interest rates - impact different investments. We think about those things, but we are bottom-up investors, meaning we focus on one company at a time. We are looking for individual companies. We do all the homework of reading the annual report, the 10-K, the 10-Q, and the press releases and go company-by-company to try and understand each business. We then do a fairly complete financial model, which has three pieces; a balance sheet, income statement, and cash flow statement. Wall Street is very income statement focused, meaning earnings per share and the earnings estimate; but we are more interested in how the three statements fit together, the quality of the balance sheet, and how much cash it generates. We also speak with leadership at the companies. We never invest in a business unless we have a phone call, usually a number of phone calls. Once we own stock, we try and visit every company we invest in at least once a year. We go to their headquarters, or we go to their analyst meeting, or we see them in New York City. We are meeting with management, asking questions, and learning more about the operation. Our founder has always felt that it is very important to know management and try and assess the quality, honesty, and integrity of the people. We continue this today because we believe you can learn a lot about the business and what is going in the world by talking to executives. I find it to be valuable. It can also give you the confidence to stick with a company through a tough time, such as during the financial crisis. You know the people and how they navigate stormy weather. Q: What market cap of companies do you focus on? A: For our initial purchases, we are primarily focused on small- to mid-cap companies with market caps of $15 billion and below. We would go as low as $500 million in this fund, but no lower, as it would be difficult to own enough to make an impact on performance. Our sweet spot is probably $1 billion to $10 billion. We hold a handful of large companies. We avoid the largest 100 companies in the S&P 500 Index, but, other than that, we have a pretty wide range of opportunities. We do have a large universe to choose from, but we only invest in 40 names. Our quality bias deletes a lot of names. Just the debt to equity ratio of 50% probably gets rid of half the possibilities in our universe. When we look at cash generation, profitability, good return on invested capital, and low leverage, you can whittle the numbers down quite quickly. Q: What is your research process? A: We have seven research professionals including the founder, Tom Putnam. We have three mutual funds, of which Tom is co-manager of each. We have three other co-managers; I focus on our core value strategy, Paul Hogan focuses on equity income, and Marc Roberts concentrates on the small-cap space. We have three other analysts who do not have fund responsibilities. Their responsibilities are to find and follow investment ideas. We are all research analysts. We follow companies and are responsible for identifying new ideas and working those through our stringent criteria. It also means following a list of 10 to 15 companies in which we invest. We are the main contact responsible for building a model and maintaining it, listening to all the earnings calls, and keeping everyone else on the team abreast of what is going on. We are also responsible for meeting with management. We use investment metrics-based screens to evaluate new ideas. We use third-party software and set up various evaluation screens which we run every month. They are mostly based on valuation, some are based on profitability. We go to industry and investor conferences and hear a lot of management presentations. We also look at what other investors that we admire own and ask the managements of our holdings what leadership teams they admire. You can get ideas in many different places. When an analyst gets an idea that he likes, he builds out the model and writes the idea up in what we call a green-sheet report, about 30 to 40 pages long. That is circulated to the research team and we review it, poke some holes in it, and then the analyst comes back to the table with answers to our questions. Once we have vetted the idea, we price it. If the stock is $50 and we do not want to pay more than $45, we will put it on the list at $45 and keep an eye on it. At some point, our valuation and the stock price should intersect. That is when we buy it. The analyst who came up with the idea is responsible for following it. We keep track of everything we sell on a rolling five years. Every year we have a retreat where we get out of the office and look at this. Sometimes it is embarrassing to see how well something has done that you sold, but it can be a good learning tool as well. Q: Can you discuss a couple of stocks? A: As an example, something we purchased new this year was AutoZone, Inc. It has good industry competitive dynamics. It has been a leading retailer and O’Reilly Automotive Inc has been the leader on the commercial side. AutoZone is in a good industry and we knew the basic demand for auto replacement parts was going to be steady. With the recession, the fleet on the road needs a lot of repairs. The company has a small amount of geographic opportunity to expand, and they are adding commercial business to their mix so they have an opportunity to grow there. The thing that really attracted us was that the capital allocation by the company meets our expectations. They are basically taking all of their free cash flow and repurchasing the shares. The share count is declining at a tremendous rate and if you just pencil that out with some modest growth in the fundamentals of the business, you get a much higher per share value five years from now. We were able to buy it at about 12 to 13 times earnings. I think their secret sauce is the buyback. The company, in the last five years, has bought back 42% of the shares. Four years ago the company had 64 million shares outstanding and it is down to 37 million today; at this rate, it should drop to 20 million shares in the next four years, which could drive earnings per share much higher than they are today. Even with a modest earnings multiple, I think you get a much higher stock price. I think the key to AutoZone stock is to understand the capital allocation and how important this is to the whole equation. Another example is Interpublic Group of Companies (IPG). We purchased the stock of this advertising agency last year. At the time we bought it, there were four major players. One thing we liked about the advertising agency business was that there is a lot of change going on in media. Newspapers have suffered but the Internet has grown, and there are a lot of things shifting around in terms of the advertising dollars. We thought it is very hard to pick the ultimate winner, but the agencies are getting a piece of everything. We looked at the agencies as just being in the flow of all the money going around advertising. IPG interested us because it was an under performer, had new management who came from outside the industry, and had a very complicated balance sheet that, upon quick review, would necessitate changes be made. The new management saw the same things and was changing it. They were taking the cash flow they were generating and paying off high-cost debt and refinancing. They paid off some preferred stocks and convertibles. They then started to buy their stock in and increase the dividends. The restructuring of the balance sheet was completely in their control. Operationally, they also talked about increasing their margins. That has been disappointing as they have not been able to get a lot of margin, but the restructuring of the balance sheet has worked out just as we suspected. The stock has done quite well over the last two years. Q: What is your portfolio construction process? A: We do not use a lot of science of portfolio optimization. It is a portfolio that is built one company at a time. We do have some broad guidelines such as sectors. Our maximum is approximately two times the index weight, just so that we are aware of the risks and positions we are exposed to. We really look at the risk control as the quality of the businesses that we are investing in and the price we pay for them. Our portfolio has tended to do better than average, sometimes much better than average in downturns, due to those two factors. In the 2000-2002 bear market, we went up a fair amount because we paid attention to valuation and did not have the tech stocks that were overvalued at the time. In 2008 to 2009 we did go down, but were about 10 points ahead of the market and felt that the quality of the businesses we invested in helped us out. Even though we were down, we were down less than the market. We do not really have benchmarks, but we certainly think that, for an individual investor or a financial advisor, the default option is the S&P 500 Index. It represents most of the market cap of the country, and it is very liquid. If you are in the active mutual fund business, you always have to consider that the S&P 500 Index is probably your competition. We hope to do better than the market over time and to do it with less volatility and less downside. Q: How do you define and manage risk? A: Risk to us is losing money. Risk is not deviation from an index; it is losing your capital. The point of investing is to grow our net worth over time, after taxes and faster than the rate of inflation and have real growth of wealth. What becomes a risk is when you lose money that you cannot get back. Buying something that is really overvalued that could go down 90% or buying something that is overly levered that has a problem, you can lose a lot of equity and that money is gone forever. If you look at a period like 2008 to 2009, you had severe stress in the economy and financial markets and there were some companies that couldn’t survive. For example, we invest in Bed Bath & Beyond, the retailer, which had no debt and $2.5 billion in cash and a good set of stores. This is a company that is going to make it through the storm. In summary, investing in a group of businesses that can potentially get through any type of environment while not paying too much for them and trying to prevent permanent loss of capital is what we do.