Q:  What is the history of the fund? What are the benefits of small cap investing? A : The fund was launched on January 4, 1988 and is co-managed by David Elliott and myself with the help of two dedicated analysts. The advantage of investing in small cap is that we can find simpler and more unique businesses that are generating high returns on capital and have management teams that are becoming more sophisticated. Identifying these types of companies can lead to higher returns over time. Q:  What core beliefs drive your investment philosophy? A : Three core beliefs guide our investment philosophy. First, changes in the quality of a company’s fundamentals are often not reflected in its stock price. We are looking for companies that demonstrate improving quality in the form of working capital intensity, return on assets, and cash generation potential. Catalysts may include a change in management, the use of capital, or other financial and business parameters that suggests that the company is improving business and learning to generate better and higher returns on capital. Over a period of time this creates an opportunity to compound investor’s wealth. The second belief is that the persistence of a company’s fundamentals is frequently underestimated by the market. We seek companies that exhibit strong fundamental momentum in the form of revenue and earnings surprises and analyst revisions. The portfolio construction forms the third core belief of the investment philosophy. Active managers frequently underestimate the range of possible outcomes when evaluating an investment idea. We avoid this trap by risk-weighting position sizes to diversify risk more broadly across stocks. Q:  What is your definition of quality? A : The typical definition of quality is a company with a solid management team, steady and predictable earnings and cash flow, and a strong balance sheet. We don’t necessarily buy high quality companies but look for companies that show signs of improving quality. Candidates for purchase must demonstrate improving quality in the form of working capital intensity, return on assets, and cash generation potential. An example of improving quality would be a company paying down debt from its free cash flow. The value of this type of corporate action should accrue to the equity holder over time, which we view as an incremental change in quality for the better. In addition, I am looking for companies that are returning cash to shareholders through share buybacks, which lower the total number of shares outstanding. This creates an opportunity for the remaining shareholders to divide a growing earnings pie. Another way to think about quality is to look at returns. If returns on assets are improving incrementally, I view it as an indicator of improving quality. Those are some of the ways I think about quality. Q:  What is your investment process or strategy? A : We begin with a proprietary screening process to narrow an initial universe of about 1,800 companies down to a group of about 500 or 600 companies that are consistent with the investment philosophy. This step helps us allocate our time more efficiently on companies that fit our process. After the screens are done, we spend most of our time conducting fundamental research. We read all the statements filed with the regulatory agencies and read the published research. We also talk to industry experts within Wellington to get more information on competitive dynamics and learn more about the company’s history and management team. The majority of our research is the result of direct contact with company management in our offices, on site, and at conferences. It is also important for us to have several conversations with management to better understand what the future direction of the company is and how likely it is that management will be able to sustain quality improvements. Having understood the company business model, competitive industry structure and management capabilities and intentions, we focus on valuation. We use several methods to determine the business value and then set the price range for the stock based on our fundamental valuations. Q:  Are there certain sectors or industries that you avoid? A : There are definitely certain business models that we would shy away from because it would be hard to convince ourselves that they would work long term. We don’t categorically reject certain industries. Even in a poor industry there can be opportunities to find companies that are exhibiting the improving quality characteristics that we look for. For example, there have been periods of time where airlines have been good investments and when you look at it today they have consolidated to a point where it is dramatically different than what it was several years ago. Fuel price is a big component of the cost and airlines cannot really control the price but they are getting to the point where capacity rationalization has happened in the industry. Airlines now have more pricing power so they can tolerate a lot more volatility on the fuel price. I feel that industries do change over long periods of time and one should never rule any industry out because the conditions can get to the point where companies can benefit from the consolidation or rationalization or changing landscape. Even in some of the most difficult industries conditions could change dramatically to offer above average capital returns to shareholders. Q:  What other qualitative and quantitative measures you focus on? A : Our focus is always on what drives sales and how that is contributing to the bottom line. What drives sales and what drives the costs to support that increase in sales is very important to us. We are looking for incremental profitability, where it is likely to come from and how sustainable it is in our opinion. We are interested in the returns that a business can generate and what management plans to do with the company’s free cash flow. We are interested in learning how the incremental cash is going to be spent and if there is room to share it with shareholders. The ability of management to reinvest that incremental cash back into the business at higher returns can compound shareholder wealth over time. Q:  Can you cite few historical examples to better illustrate your research process? A : One company that I will talk about is Nationstar Mortgage Holdings, a mortgage servicing company. Mortgages shrink over time, so owning or servicing a mortgage asset inherently is a shrinking business so it is difficult to grow the earnings unless the pool of mortgages being serviced is growing. What has happened recently with large banks is that most of them have been trying to get out of servicing both because of capital constraints and they don’t want to be in the press with a lot of foreclosure headlines. Early on we identified the fact that this could be a trend where mortgage servicers will actually grow their portfolios and possibly grow them dramatically. With regards to Nationstar, we had an attractive entry point when the company had difficulty getting an attractive price for its Initial Public Offering. We bought at the IPO at $14 in March 2012. The stock did nothing for a few months but as it started acquiring mortgage servicing from the larger banks, their portfolio grew dramatically. Confidence in the company’s ability to grow earnings over the next few years rose dramatically through the year. As the stock approached the mid-20s we decided to shrink our exposure to the space as it reflected a lot more of the optimism in that value. This is an example of an investment that worked as we anticipated. An example of one that didn’t work would be Neutral Tandem, Inc., a network solutions provider. We bought the stock in the middle of last year. This company provides the final connection for a telecommunication network to the customer. This is a business that has deteriorating pricing because it is largely a fixed cost business. What is interesting about that business was they had a data business that was growing rapidly and was becoming more important for the company’s overall business and global expansion. At the time we bought the stock, the company had a market capitalization of about $250 million with $30 million in earnings and about $120 million in cash. Additionally, the company was generating positive cash flow. The reason the stock traded at such a low multiple was because the company was facing pricing pressure and profitability had fallen to near breakeven. When we started to analyze the company more, we saw certain signs that pricing appeared to have stabilized and so we started a position in the stock. After about three months of holding the stock, we observed that the price stabilization was occurring but for the wrong reason. Prices were stable before falling back again and deteriorated dramatically after one of their largest customers forced a significant price discount. In our conversations with the management team, we learned that contract lengths were increasing and we assumed that was a good indicator of price stability. In hindsight, that indicator turned out to be misleading. Once we realized that our original investment thesis was wrong we quickly sold the stock but took a loss. Q:  How do you go about selecting stocks? A : We try to identify small cap companies that we think can compound value over time. We tend to have a turnover of around 40% and the ideal holding period is three years. Because our timeframe is long enough, we are able to evaluate our investment thesis each and every quarter. This also allows us to use volatility to enhance our position, and when there is a lot of excitement about a company development, we can use it to adjust our position size down. I prefer to invest in companies that are focused on a single line of business. Now, if they find businesses that are complementary and have an attractive return profile, as attractive as their existing business, we wouldn’t have an issue with them going in that direction. But in general, for the smaller companies, we would prefer that they stay focused on what they do really well. Q:  How do you construct your portfolio? A : We generally allocate our capital first by sector, with exposures generally in-line with the benchmark. In general, the risk-reward ratio is the number one factor in determining how much exposure we have and so the greater our conviction in the name the greater its relative weight in the portfolio. We avoid excessive concentration in any particular industry. We want to make sure that the portfolio’s performance is going to be dependent more on stock selection rather than some macro event influencing portfolio returns. We have about 150 to 170 holdings at any given time, and we have a firm limit of a maximum of 2% in an individual name. The Russell 2000 Growth Index is our benchmark. Q:  What is your sell discipline? A : We always think about price on a relative basis. We generally have a moving price target because the market’s evaluation could change. But if a certain relative price target is achieved we could certainly choose to sell. Second, if there is a change in the fundamentals that could also lead to a sale. For instance, if a company no longer demonstrates improving quality or strong fundamental momentum, it may lessen our confidence in our risk/reward assessment and cause us to exit the position. If we realize that our assumptions were wrong about a company, leading to an incorrect investment thesis, we will sell the stock. Q:  How do you view risk? What do you do to manage or control it? A : We do not want to create any style bias in the portfolio by the nature of stocks selected. Managing risk can be done by restricting and managing the position size. We view portfolio construction as a separate, but equally important, component of the investment and risk management process. We believe active managers frequently underestimate the range of outcomes when assessing the attractiveness of an investment idea. For this reason we explicitly incorporate the risk of individual stocks when setting position sizes and are realistic about our ability to assess conviction. We also view risk relative to the benchmark and manage sector weights close to the benchmark. This results in limited risk due to sector allocation effects.