Q: Could you start by giving us an overview of your investment style and investment philosophy? A: My investing style developed out of a research project I undertook in 1981 when I was a graduate student at the Kellogg School of Northwestern University. I had a finance professor that challenged me to develop an investment approach that would beat the S&P 500. I accepted the challenge and developed a quantitative screening algorism that was based on publicly available company information. Since the goal was to beat the S&P 500, I figured that I should limit my portfolio to stocks from the S&P 500. The system worked, and it is basically the same investment style I use today. The two overriding principles that guide my investment strategy are: a) don’t lose capital and b) earnings drive stock prices. The first one comes from my experience in running a trust company where I gained an appreciation for client’s feelings regarding capital preservation. The second comes from the simple observation that when you filter out all the noise and look at market trends, it is earnings that drive the relative value of stocks. Q: Where does your investment style fit between value and growth? A: My screens look at return on sales, return on assets, etc. I am looking for the growth stocks that are likely to make the top 10% of the growth-stock universe. For the most part, they are large cap stocks, but sometimes a mid-cap will slip into the list. I also screen for cash flow and free cash flow, because if it is really a growth stock, the company should be generating a lot of cash. In the screening process, I also look carefully at earnings growth. Q: Do you adhere strictly to a growth discipline? A: When I started managing money in 1982, it was difficult to distinguish between value and growth. From the end of the seventies through the early eighties, the equity markets were just awful. Interest rates had been very high and the equity markets were highly volatile. During that time I would select stocks like Proctor and Gamble, even though PG was not a growth stock. And, I would occasionally hold large cash positions. Having managed other portfolio managers, I have had plenty of opportunity to observe how other professionals approach investing. Some believe that they should stick strictly to a specific investment style and remain fully invested. I see no reason to remain invested when stocks are clearly in a secular bear market. I believe that it is much more important to conserve capital than to maintain strict adherence to a specific style. For example, during the third quarter of 1998 and the third quarter of 1999, I lightened up. But by early October in both years I was again fully invested. When I sense that the markets are approaching a transition period, like the 2000 centennial or the war in 2003, I often increase my cash holdings. By the end of 2000, the evidence was overwhelming that the markets were going into an extended downturn and that the end was nowhere in sight. So I lightened my portfolio during the 2001-2002 period and moved to higher cash levels. As a result, my performance relative to the S&P was greatly enhanced. However in 2003, I remained neutral too long and missed the second quarter turn. A similar thing happened during the 2000 bear market. I had a bad fourth quarter, but after adjusting, my performance improved. While many of my clients appreciate my approach, some intermediaries do not. That is because they want to make the asset allocation decision and would prefer to see me 100% invested at all times. But that is just not my style. Even though I sometimes move in and out of the market, I don’t consider myself a market timer. I am more of a transition player. Q: Would you describe your stock selection process? A: I guess you can say I am a bottoms-up stock picker. My quantitative screens help me reduce 500 stocks down to 40 or 50, to what I call my select universe. On that select universe I apply my subjective analysis. Although I could run the portfolio and use nothing but the quantitative screening, I have found that I can do much better by adding a subjective element to the process. The quantitative process actually highlights sectors for me since it selects for certain characteristics like price and earnings momentum. And I tend to focus more on industries rather than sectors. It seems that my screening approach using seven different filters work fairly well in separating the good from the bad, as well as providing sufficient diversification. On a three-year basis, we have been ranked by Effron as being in the top 1% of approximately 300 large-cap growth managers. That period covered two bear-market years, and one bull-market year. For April 2003, the first month Effron ranked us, we were the top, large-cap growth manager for the 1, 2, 3, 4, and 5 year periods. Q: How do you select specific stocks for your portfolio? A: Well, what I do is rank the 50 stocks on my select universe and look for stocks that seem to have potential. If a stock in the top 50, drifts into the top 10, and stays there, it grabs my attention. The stocks in the portfolio are already ranked. In balancing my portfolio, I decide what stocks are candidates for replacement. Then I look at potential selections and determine what impact each will have on diversification and industry weightings. My goal is to have at least 11 industries represented but prefer to have13-to-15. If you look just at my top 10 stocks, I would not be sufficiently diversified, so there is always a tradeoff to be made between diversification and performance. It doesn’t bother me that my portfolio may consist of only 20 stocks. Some portfolio managers just couldn’t imagine doing that, but I have been doing it for 22 years. I would not, however, be comfortable holding just 6 to10 because that would not provide a safe level of diversification. Q: How do you control risk? A: As far as risk control, I follow a number of simple rules. For example, I do not have more than 20-25% of the portfolio invested in any one industry. Of course there are times like 1999 when it is pretty hard not to be over-weighted in technology since those were the stocks that were really moving. I make sure that I am well diversified throughout the sectors. The S&P consists of 59 industries, and if I am represented in 20-25% of those industries, that is a reasonable degree of diversification. Right now I am more heavily weighted in healthcare. I think that healthcare is an industry that will continue to grow. If you select the right stocks, you should be rewarded. During the recent correction, healthcare has been beaten down, but I am pretty optimistic about the future of the industry. That is my approach and it has been substantiated by Milton Friedman’s analysis that suggested that if you had thirteen stocks in thirteen industries, you really are diversified. Most portfolio managers that have 40 to 50 stocks don’t agree with that, but everyone has a right to their own opinion. Q: What are some examples of the stocks on your top-ten list? A: A good example of a stock that I had for a long time is Dell Computer. It was a stock that had excellent growth and earnings path. Today, I think International Game Technology may follow a similar cycle. They are the market leader in the gaming equipment industry. While that stock has been volatile lately, individual stocks have behaviors similar to the overall markets. They behave like a pendulum, and once they start to move they often take on a life of there own and continue in the same direction. Once they reach an extreme, they often become volatile. I have been doing this since 1982 and what I have found is that I can find 4-5 winners, 3-4 dogs that I have to get rid of during the year. Then the rest of the stocks seem to hover around the S&P 500 performance. I don’t follow analysts. When an analyst downgrades a stock, I look to see if it might be an opportunity to buy; alternatively, an analyst upgrade may be a reason to sell. What I look at is the reason for the change. If it is due to something the company announced, then I’m usually out. But if it is due to the analyst opinion, and my analysis would suggest continuing to hold the stock, I am more inclined to retain the stock and add it to my alert watch list. In general, company statements are more likely to trigger a trade than the earnings numbers themselves. I am more interested in whether the business is continuing to grow on track and whether the momentum is still in place. Q: With regard to Dell, what were two or three characteristics that made it attractive? A: In general, I am looking for the momentum of compound earnings growth. I focus on both top-line growth and cash flow, because the company’s ability to support the growth is very important. Dell’s market share was an important factor, as well as their inventory management approach. They did not believe in building inventory and letting it collect dust; instead, they would build on order. They are now doing the same thing in the server market and I think they will be successful. But the most attractive thing about Dell was their proven ability to grow their business. Home Depot and Loews are two more good examples of companies that fit this mold. I owned both, but when it was clear that Loews was outperforming Home Depot, I sold Home Depot in favor of Loews. Q: Why do you like Medtronic, it has been flat for a year? A: Medtronic is a Minneapolis based company, so that I am more familiar with it than most of the stocks in my portfolio. I had not held this stock since 1988, but I added it to the portfolio again this year. In the late 1990’s they made a lot of acquisitions, but for various reasons, the company never made it through my screens again until this year. In the 1980’s, it was a high growth stock and it is still the world’s largest manufacturer of defibrillators. I had the stock in my personal portfolio. They have apparently done an outstanding job of integrating their acquisitions form the late 1990’s into the company and into Medtronic’s way of doing business. Buying another company can be a real challenge particular when there are cultural issues at stake. Companies, like Wells Fargo, that learn how to do it can be very successful. I think that Medtronic has also figured it out. Their approach to management and the entire culture brings out the best in people. As a result, management turnover is very low. I also like the areas of research they are focusing on like the spinal area and diabetes. The company has some pretty exciting acquisitions in those two fields and it is well positioned in most of its markets. Even so, the stock is not performing well relative to St. Jude. It is currently on my watch list and it may be one that needs to be replaced. Q: You mentioned that you rarely hold stocks as long as two years. Why is that? A: It’s not that I don’t like to, it just seems to happen that way. Dell Computer was one exception, but they are rare. Given that I have a 75% turnover rate and 20 stocks in my portfolio, 15 may turn over during the year. I don’t view myself as a high turnover manager, but yet I am not a buy and hold manager either. I’m certainly not reluctant to act on a surprise coming from one of the companies I am holding, or news of changing conditions in an industry.