Q:  What is the history of the company and the fund? A : Advisory Research is a Chicago-based investment management firm with over $10 billion under management. The firm was founded in the mid-seventies with a strong value-oriented investment philosophy. Between the seventies and nineties, the firm developed a robust value-oriented investment process focused on buying quality companies at low book values or low values relative to our internal estimate of net asset value. Advisory Research’s investment approach preceded the Fama-French research, which validated the investment style oriented around small and value stocks. I was hired in 2004 to develop the international small cap focused strategy based on the same philosophy. Our research coupled with the landmark Fama-French research, validated the notion that if one buys low-price-to-book-value stocks, one tends to outperform the market, and especially in non domestic small caps. In 2006, ARI started managing non-domestic assets and in early 2010, we launched the Advisory Research International Small Cap Value Fund. Over the years, we have built a robust international research team, which has members conversant in all the languages in which we invest. Language skills and cultural understanding is important when investing in the overseas markets. Additionally, it is important to understand the motivations of management, as well as issues surrounding political, social, or regulatory aspects of the market. Q:  What regions in the world do you focus on? A : We generally invest in developed, non-U.S. markets. If you look at our portfolio from a listing basis, about 95% of the portfolio is in developed markets and about 5% is in emerging markets. Our exposure is a little misleading in the sense that a lot of good quality companies that we find are directly, or indirectly, oriented toward emerging markets. For example, Chinese companies listed in Hong Kong, or Japanese companies that do almost all of their business or manufacturing in Southeast Asia. We choose this path to emerging market exposure for several reasons. First, we see direct emerging market exposure as more expensive. Additionally, by investing directly in emerging markets, investors generally get exposure to large caps that are more oriented towards the global marketplace, and not towards their local markets. Around 25% of the portfolio is directly, or indirectly, oriented towards emerging markets, but in the part of those markets that we feel is most attractive – for example the consumer staples and discretionary sectors. Q:  What market cap do you focus on? A : The sweet spot of our investment universe is generally in the $500 million to $3 billion range. These smaller cap names are attractive for a number of reasons, but especially because they often have executive officers that we can access directly to learn more about their businesses. We can learn much more about the prospects of an investment when looking the CEO or CFO in the eyes rather than investor relations professional. In addition, these companies tend to have more simple financial statements, which we can more readily analyze. Given our focus on downside protection, knowledge of the balance sheet is very important. Our number one objective, in terms of our investment style, is to protect investor’s capital. As far as the investment process, the first thing we need to know is what our downside is and how much risk we are exposed to. This is especially important in the international markets because there are different legal, regulatory, and social structures. When you invest in these markets there are tremendous opportunities, but there are also risks that you may not necessarily have to deal with in the U.S. Q:  What is your investment process? A : We have a disciplined investment process dating back to the seventies and eighties. Initially it was developed and used for the Advisory Research U.S. strategies and then was implemented by our firm in the international markets. One of the key features of our investment style is that we run a disciplined, repeatable process that allows us to isolate and then research stocks that fit our core criteria. We look for companies that have financial strength and durable, understandable business models. These opportunities are generally sourced from databases. We also find names from an internal network of consultants and specialty publications. The core features of our stocks, in terms of the identification stage, are quality companies that are cheap, based on our key screening metrics. First, we screen on tangible book value. The companies that we are buying for our portfolios generally trade at 1.5 times or below tangible book value. Second, we want companies that do not have a lot of leverage on their balance sheet. This goes back to risk control. Financials are handled differently because of the nature of their balance sheets, but in general, for non-financial companies, we are looking for companies that have debt to equity ratios of less than 50%. Third, the companies have to be profitable – we are not a deep value shop, looking for financially distressed companies. Our investment process is about finding undervalued stocks that have cyclically unattractive attributes or may have run into temporary operational problems and therefore are trading cheaply. As a result, these companies have to have some level of operating profit for us to consider investing in them. The universe is broad. Our universe consists of upwards of 20,000 securities around the world. Within this universe there are a lot of opportunities for inefficiencies. We isolate those inefficiencies around the core criteria I have just mentioned. Downside protection is a key for us. The next step in the process is to perform quantitative financial and business analysis to determine what the downside looks like. The balance sheet analysis is the key to this step of the process. We also look at profitability and how the company is generating its profits. Profitability can be misleading, such as mark-to-market asset revaluation on an annualized basis. In Australia, for example, you can mark-to-market your assets based on a discounted but unrealized cash flow stream and that flows through your income statement. We would not consider that true profitability. We also look at liquidity. If a company has debt on its balance sheet, we look at how it funds itself and whether that funding source is a source they can use in difficult market cycles, or only during good times. Liquidity analysis became more prevalent after 2008, but this has been part of our investment process for more than 20 years. We spend a lot of time looking at the liability side of the balance sheet. For example, we take a hard look at the pension footnotes, which often do not reflect reality. Pension footnotes are but one example of our analysis that allows us to have confidence that if we make an investment we understand the risks and the downside. Assuming the downside gives us a comfortable margin of safety, we then move onto upside potential. This is the key to avoiding value traps. There are a lot of companies that fit our downside criteria, but they may not be attractive to us because we do not see any potential for them to realize value for shareholders. Our objective is to find good risk-reward scenarios by understanding the risks and then looking at the rewards of investing. We do this through extensive management interviews both in person and over the phone. We try to isolate catalysts that allow us to see what the potential value is to be unlocked. We evaluate a company’s commitment to its shareholders to ensure management is acting in the best interests of shareholders rather than in their own best interest. We look at the operating track record to see if they are in a temporary rough operating patch or in permanent decline. If we can see the path to unlocked value we will include the stock in our portfolio. In addition, throughout the process I am describing, we are evaluating the macroeconomic environment for potential risks and opportunities. At our core, we are tangible book value buyers and not just book value buyers. Our experience is that if you look at a company’s balance sheet, intangibles, as measured by goodwill, is the weakest link on the asset side of the balance sheet. When market conditions turn south, goodwill is often written down more readily than hard assets. High levels of intangibles also provide insight into how a business was built; we prefer organically grown businesses to the patchwork M&A type of company. It also puts more risk on the liability side of the balance sheet, in the sense that if you have a debt-to-equity ratio of 50 percent, but your assets are in intangibles, the opportunity for that debt-to-equity ratio to spike up in bad times is much higher. Q:  Can you give us a couple of examples that highlight your research process? A : Yue Yuen Industrial Holdings Limited, the largest manufacturer of athletic footwear for Nike and Adidas, manufacturing approximately 20% of all their footwear. We found the company based on our screening criteria. At the time of purchase it traded at slightly above tangible book value, with a single-digit price-to-earnings ratio and net debt-to-equity of 15%. The yield is approaching 4% and we see strong growth in dividends in the future. This company has grown organically and compounded book value at more than 10% annualized and is heavily exposed to the emerging markets. In addition, its disclosure regime is one of the best we have seen in Asia, as is its management team. A look into Yue Yuen’s revenue by geography is telling. The company is seeing sharp growth in the emerging markets and slower growth in developed markets, especially Europe. In the emerging markets, one of the first things middle class consumers buy is branded apparel. Adidas and Nike have benefited from this trend and so too has Yue Yuen. Yue Yuen’s exposure to this trend is more diversified however, because it manufactures shoes and clothing for a wide range of branded companies. A further analysis of the business shows that the core manufacturing business is even stronger than it appears because Yue Yuen is struggling with its Chinese retail arm, which is consolidated on its financial statements. We think the retail arm will start to regain momentum and profitability in late 2013. This business has been loss making for a few years. Q:  Do you establish a target price? A : We do. We have robust risk management tools that establish upside and downside for our investments. That upside price will be based on what we think a valuation could look like in an optimal situation, and where the company has been priced historically when it was operating at its highest levels of efficiency. Our price targets and upside/downside analysis are adjusted frequently to take into account ongoing developments. Q:  How long are you willing to wait for your thesis to work? A : Our average holding period is three years with about a 30% turnover annually. If the company is not performing to our expectations, or management shifts gears on how it plans to unlock value, we will eventually cycle out of the name. Our timeframe for investing tends to be longer than average and this allows us to buy stocks before the market sees improvements in their business or in the cycle. We feel the market is growing increasingly short sighted, which gives us an advantage. Q:  Any exciting opportunities in Asia? A : Nong Shim Ltd is a leading producer of ramen noodles in South Korea. It has a strong brand that extends from instant noodles all the way to snacks and bottled water. There is high consumer loyalty related to this business. Its most popular noodle, called Shin Ramyun, has been the number one selling ramen noodle in South Korea for 20 years. Despite these dominant market share conditions, we were able to buy the stock right around tangible book value due to a near-term earnings downgrade, which was related to increases in raw material cost and price limitations set by the government. There is little to no debt on the company’s balance sheet and the stock yields around 1.7%. Its capital expenditure requirements are low, so the operational leverage it enjoys results in free cash flow generation. When the market affords us the opportunity to buy a brand for free, like it did in the case of Nong Shim, we are very compelled to do so. Analysts were more skeptical at our time of purchase. They were focused on the short-term pricing issues facing Nong Shim and the likely earnings hit the company would be taking. We felt that this risk was already priced into the stock and that the long-term prospects were very attractive. Although still a relatively small part of their business, Nong Shim is doing very well from an export standpoint. They very recently finalized a direct distribution agreement with Wal-Mart Stores, Inc in the United States. Nong Shim has historically sold its products in Wal-Mart via a third party distributor. Wal-mart wanted to increase its relationship given the trends it is seeing with Nong Shim’s products in the United States. We are seeing similar trends in China. Nong Shim is a brand you see at both convenience stores and supermarkets in China. There is a lot of growth opportunity for this business, which comes with a lot of downside protection at a very attractive price. The forward P/E on this company, based on average analyst estimates, is around 14 or 15 times. During the financial crisis you saw Nong Shim’s market share decline from the seventies to the low-sixties and now you are seeing it rebound up to the mid to high-sixties. The decline was primarily due to pricing, as Nong Shim’s products sell at a premium to other brands. Our expectation is that as the global economy stabilizes and with it the Korean market, Nong Shim’s market share will move back to around 70 percent. Exports are growing strongly and we feel they will hit 20% of sales within the next few years. Q:  How many names do you hold in your portfolio and what is your benchmark? A : We have around 70 names in the portfolio, which gives us good diversification and allows our stock picks to have an impact on performance. We use the MSCI EAFE Small Cap Index as our benchmark. Q:  Do you have sector or geographic limits? A : We have general risk controls in place that are monitored daily. These are relatively broad. From a country exposure standpoint, it is 40% or less in any single country. From a sector standpoint, because we do have quite a bit of financial exposure within the portfolio, it is 40% or less in financials and 20% or less in any other sector at cost. From a portfolio weighting perspective, one position will not exceed 6% of the portfolio. From a cash management perspective, this is a fully invested strategy and we do not currency hedge.