Q:  What is the investment philosophy of the fund? A: Over time, the returns to ownership are always greater than the returns to lending. So the returns on an equity portfolio over time are always greater than the returns on a bond portfolio. People go into business not to make interest payments, but to earn a real return on their capital over and above the risk free rate, which we define as the rate on a 30-year Treasury. Our job is to capture this equity premium for our investors in such a fashion that they don’t have to worry about risk of loss of purchasing power or excess volatility in their portfolios. We focus on the motivations of the people behind the pieces of paper. We want to think like business owners, rather than people who trade pieces of paper. We use the risk-free return on the Treasury plus some equity premium as our investment hurdle. If interest rates are high enough that we’re not being paid to take the risk of being fully invested in stocks, we won’t be. We’ll park some of our money in bonds, but we don’t view it as a permanent asset allocation the way the typical investment committee looks at it. We know that over time we want to be business owners, but if interest rates are high enough that the returns from lending are competitive with the returns from ownership, we’ll own some bonds. Q:  How do you define that the returns on lending are high enough for you? A: We use the 30-year Treasury because it’s the longest duration fixed income instrument, and also because we don’t want to worry about call risk or credit risk. Each and every week, we price a universe of about 8,000 stocks and we evaluate them based on a 12- months forward-looking earnings estimate, to determine what the expected rate of return is for the average stock, and then we compare it with what we get on a Treasury bond. If that difference is above a certain number, then we’re willing to be fully invested in stocks. If it’s below a certain number, we’ll have a certain percentage in bonds. If it’s even lower, we’ll have a greater percentage in bonds. Q:  How do you go about implementing your philosophy? A: Once we make a decision to be invested in stocks (which is the vast majority of the time), we screen the equity universe on two basic parameters - return on equity and price-to-book to determine how we can rank companies on what we believe are the best metrics of return and the amount of money we’re paying for that level of return. Return on equity is the most useful measure of corporate performance because it combines not only the profitability measure, but also tells you how much capital is required to generate that level of profitability. A business that can produce higher return on equity is generally more attractive, but we also use the price-to-book multiple as our measure of valuation. We try to buy as much return on equity (ROE) as we can for a given multiple of priceto- book. ROE is analogous to the coupon on a bond, and price-to-book is analogous to the price-to-par on a bond. So we use some of the same metrics that you could in a fixed income instrument on the equity world. Then we throw in an inflation variable, and it tells us which companies look cheap. Q:  Once you’ve done your quantitative analysis on these stocks, do you do more fundamental research? A: We simply run a screen which tells us, of the 8,000 companies in the Zacks universe, we’ve got 400 or 500 that fall through the value screens that look attractive. That’s when we will initiate our ‘risk screen’. We assume the returns are out there, and our job is to remove as much risk from the process of capturing those returns as we can. As long as our economy functions under democratic capitalism and interest rates aren’t too high, we want to be invested in stocks. Our biggest risk control lever is price. We look for companies that are reasonably valued. The risk is always in overpaying for what you put in the portfolio. The next step involves taking a close look at operating risk, whether it’s a company that’s highly cyclical and has significant operating leverage built into it, litigation risk, or ownership risk. If the entire executive office owns less than 1% or 2% of the company, for example, we view that as a risk that their financial interest is not directly aligned with ours. Once we’ve run these risk screens, we then begin the primary research, and that’s where we spend most of our time. We participate on quarterly conference calls, and talk with managements and industry analysts on both the sell and buy side. Q:  Could you name two or three risks that could cause you to discard a company? A: One would be excessive financial leverage. We don’t like to own companies that have debt to capital ratios of more than five because bad things can happen to even the best of companies. We also want to be sure that if we have a business that is highly leveraged on an operating basis that management is able to perform through the cycle. We have an investment in Alaska Airlines, for example, which is significantly leveraged both financially and operations-wise, and we’ve seen their management operate through the cycle successfully. Q:  How do you go about building your portfolio? A: We believe that once you get past about 17 to 20 names in a portfolio, you’ve removed the risk that any one of these companies is going to wreck your portfolio if it goes to zero. On the other hand, you don’t want to dilute your efforts to the point where you’re trying hard just to be average, and we believe that happens once you get beyond 50 to 60 names. There are lots of funds out there with literally hundreds of stocks. Unless you’ve very concentrated in certain industries, if you have a hundred stocks you’re going to look like the average. So our portfolio has 30 to 40 names in it. We believe in diversification. Beyond that, we will follow the value in terms of industry weights, but we are not tied to any index. The only way that you’re going to be able to outperform the index is to be different from the index. There’s risk in being different. Our job is to outperform the index by one to two percentage points per annum after our fee. We’re not concerned about industry weightings. We’re concerned about making money. We’re perfectly willing to have a triple or quadruple weighting. We’re also perfectly willing to be weighted zero in an industry. Q:  What kind of turnover do you generally have? A: It’s between 10% and 20% a year, while a typical fund turns itself 100% a year. We’re thinking in terms of owning businesses that are going to generate real returns over and above our cost of capital over a 3- to 5-year time period. We don’t believe that you can judge a business in any period under less than two years. When we build a position, it can take us a year or more. Q:  Give examples of some of the stocks that you have found over the last few years and build the position and how it helped you to build your return or performance. A: Several are in the insurance business. One is the Erie Indemnity Company based in Erie, Pennsylvania - they’re a regional personal lines insurance company, mostly writing auto and home policies in the northeastern U.S. The defining characteristic of the Erie is they underwrite very well and they price it right. They also put a meaningful portion of their investment portfolio in equities, which allows them to earn premium returns. Many insurance companies stick only to bonds and unfortunately, short change their shareholders. We began to buy this stock back in the mid 1990s, and kept adding to it in the late 1990s when insurance was sort of the anti-technology, and we’ve owned the stock for 10 years now. Another of our insurance holdings is Loews Corporation. It’s controlled by the Tisch family. We only have about $40 million in our fund so far, but our biggest investment overall is Loews. Every year Warren Buffet publishes in his annual report the annualized total return since inception of Berkshire. This year’s report goes back to 1965. It shows the annual percentage increase in book value per share relative to the S&P 500. As of May of this year, Berkshire has outperformed the S&P with dividends included by over 11% annualized. Loews Corporation has done even better than that. If we can find an investment where we can put 4 or 5 percent of our portfolio in with a group of people with a track record like that, we’ll do it. Q:  Give an example of stocks where you thought things would work out and they didn’t and what did you learn from it? A: We’ve learned from a little company we own called Trex. Trex makes a composite decking that replaces treated wood. We’ve owned this stock for over 5 years. Trex unfortunately has absolutely abysmal inventory control. They don’t have the basic systems that tell them how much product they have out in the channel, whether it is wholesale or retail. About every three years they write down their inventory and disappoint the street in terms of a massive inventory overstock and huge earnings miss. The management is a group formerly out of Mobil, and they have yet to build a top notch information system. They’re very good at marketing. Trex has the leading market share for composite decking by a long shot. Trex is a name that contractors and wholesalers have confidence in. It’s just that in terms of the basic inventory management of how much product is in the pipeline and where it is located, they’ve been terrible. We didn’t figure that out for a little while and ended up buying the stock ahead of one of these announcements, and then we managed to get pulled in again. We didn’t buy as much the second time around, but we’ve learned to wait for the bad news on this stock because we know it’s going to come. Q:  How do you monitor other risks? A: We pay close attention to the fundamental business trend at the companies we own. We want to be sure that managements are focused on whatever is going to drive shareholder value. A great example of that is what cable operator Comcast has done the last five or six quarters - every single dollar of free cash has gone toward stock buybacks. Given the share price, we believe that’s the proper strategy for increasing value. Q:  What about the argument that there are two tiers of stock with unequal voting rights? A: The voting rights are one thing but the economic rights are identical. If the share price wasn’t selling at 9 times cash flow, I might not be saying this because everything has a price. The economic benefit from riding along with the Robert’s family today outweighs any potential negatives that I can see. That is a risk, obviously. They could decide that they wanted to get into the business of making blankets tomorrow. That would be a potential negative from my perspective. Their record is such that I’m willing to overlook that.