Q:  What is the investment philosophy guiding the fund? A : The fund seeks to achieve long-term growth of capital. Our goal is to create a portfolio that includes small cap growth and value stocks through an extensive research process, which we believe leads to superior stock selection. We search for companies that we feel are mispriced by the market but possess long-term potential to increase their cash flow, earnings and ultimately, equity market valuation. Essentially, we are not style box investors and are not constrained by a particular investment style. Q:  How do you define your investment strategy? A : We like to run a concentrated portfolio but have enough diversification to protect the fund from market volatility that comes with small cap investing. Our opportunistic approach does not constrain us in finding companies that may improve their earnings or cash flow fundamentals either by deleveraging or restructuring, or investing in businesses that are growing sales, earnings and free cash flows organically. We pride ourselves in finding attractive entry points for our stocks and consider this capability a competitive advantage. Q:  How do you perform your stock selection? A : We are driven by a wide range of company, sector and industry information. We do bottomup analysis of companies and each of our analysts is focused on specific sectors, industries and companies. This industry knowledge helps the analyst in figuring out what may have changed in terms of consumer behavior, market share gains or losses, and competitive positioning. Qualitative industry knowledge is the foundation for our stock selection process. We take into account quantitative, industry-specific factors and measures when considering a company. Our investment process combines first-hand company and industry knowledge with industry specific valuation rankings and metrics. Mispriced securities generally stand out in the rankings as our analysts consider valuation metrics, the underlying business model and relative valuations. After undertaking an analysis of a company, we can better understand its business environment, product positioning and product cycles, and arrive at an opinion on the management team’s effectiveness. A typical company that we look to buy is one that generates free cash flow and can support its growth through internally generated funds without the need to return to the capital markets to raise additional money. Another quality of earnings metric that we consider is free cash flow relative to net income. Sometimes, we look at companies that have high gross margins and low operating margins because companies that can right-size their operating structure to capitalize on the high gross margins, will normally still be profitable and stand out as attractive acquisition candidates. In fact, this has been something we have deployed in the current market environment to uncover undervalued stocks. We do not consider ourselves growth or value investors and are open to all kinds of companies. Ultimately, we are looking for securities that are mispriced relative to their growth or turnaround potential with an emphasis on improvement in free cash flows. As a core manager, we hold both growth and value stocks. Q:  Can you explain with a few examples the dynamics of investing in companies with high gross margins and low operating margins? A : Companies that possess the characteristics of high gross margins and low operating margins may be attractive investment opportunities. A high gross margin implies that a company’s products and services are differentiated. But, if the operating margins are low, that indicates that selling, administrative or research and development costs are not right-sized, at least in the short-run. For instance, Cutera, Inc. (CUTR) makes laser procedure equipment for hair removal and treatment of a range of vascular lesions. Their products have high gross margin, however, when sales recently fell off, gross margins remained strong at 56%. As lower sales dragged operating margins negative in the last few quarters, the company now has an opportunity to lower operating costs, return to profitability and at the same time focus on improving sales force productivity by evaluating personnel in a buyer’s market for labor. Cenveo, Inc. (CVO), a business envelope printing company, is another example with respectable gross margins for its industry and low operating margins. We have identified operating leverage potential in both these companies. LTX corp. (LTXC) is another example of a company that has seen gross margin stabilization as business volumes declined with the recession. Over the last year they dramatically reduced operating expenses and lowered their cash flow break-even revenue run rate significantly and are expected to see tremendous operating expense leverage as their industry recovers. In the long-term, we also like the semiconductor and software industries, as good examples of companies with high gross margins. Q:  What is your definition of “high gross margin?” A : We think of gross margins in two ways – relative to a sector and the broader market. In healthcare, there are lots of companies that have high gross margins with pharmaceutical companies being popular examples of leadership. However, some medical device companies have 90% plus gross margins, along with attractive operating margins around 30%. Some industries like software have higher gross margins than the broad average of say, the S&P 500 and typically receive a higher valuation in the marketplace if their business is healthy. These margins are attractive relative to the broader market, but we need to understand if that is priced into a security. Q:  Would you describe your research process? A : Our research team, which is comprised of five analysts including me, focuses on developing sector knowledge. We visit companies to talk with management and learn about their products and services. This helps give us a first-hand understanding of what a company is working on and the tactics and strategies they employ. Furthermore, we seek to have a global perspective to leverage and learn what is happening in markets outside the US. Our risk management process has a threedimensional structure. The first dimension is economic sector exposure, where we make sure that we have a broadly diversified portfolio across multiple sectors. Second, we diversify companies across the market capitalization spectrum from $300 million to $3.6 billion. The last dimension is the capital structure. We look to create a mix of higher quality growth companies carrying little to no debt along with some leveraged companies where we believe the equity is severely mispriced. In the current economic climate there are many leveraged companies that have or may violate debt covenants. We are finding that banks are willing to renegotiate terms such as EBITDA coverage and leverage ratios of many loans in exchange for a higher interest rate. This is a better alternative to seizing assets and managing businesses outside of banking. We consider these companies because often times the common equity is trading at very depressed values. Q:  What is your buy and sell discipline? A : Analysts prepare a one page summary on each idea they recommend for the strategy. It always includes a price target for the stock, a free cash flow reconciliation and a reward-torisk trade-off scenario, where we target three or four units of upside to one unit of downside for each security. Once a stock in the portfolio reaches a target price, the analyst will either upgrade it or determine that the reward-to-risk is no longer attractive. One advantage of having a team of sector-based experts is that they are part of the process and know they always have to be ready to recommend the next best idea from their list of alternative names. We may sell a stock when the company has a negative fundamental update, such as an earnings or revenue shortfall. We also automatically put a stock under review if it goes down 20% to revisit the current valuation relative to our original investment thesis. Sometimes a successful investment becomes too large as an individual position or can influence the weighted capitalization of the fund and cause us to reduce or eliminate a position but we can continue to hold stocks that increase in individual market capitalization beyond $3.6 billion. Q:  How do you construct the portfolio? A : We use a “bottom-up” approach when selecting stocks, and focus on individual stock selection rather than attempting to time the highs and lows of the market or concentrating investments in certain sectors or industries. We maintain a fairly concentrated portfolio of 40 to 70 stocks, so the average position size is approximately 2%. The fund’s sector weights can be plus or minus 100% of the sector weights in our benchmark, the Russell 2000 Index. Our portfolio’s bottom-up construction drives our sector allocation. Since we are a core fund, asset allocation tends to be broadly diversified across sectors including those considered traditional growth sectors such as technology, consumer and healthcare, as well as financials, industrials, energy and materials. We are always cognizant of where we are in the economic cycle – expansion or decline —because we strive to minimize relative and absolute losses and outperform our benchmark over a full market cycle. Importantly, we respect empirical evidence around sector correlation analysis such as technology and financials or technology and industrials. Typically, technology and financials are not very correlated in the short- and longterm horizons. Conversely, technology and industrials are highly correlated. The goal is to achieve significant sector diversification and maximize idiosyncratic risk. Our process is very dependant upon favorable stock selection to drive outperformance. In terms of benchmarking, our goal is to beat the core Russell 2000 Index, which has actually outperformed the Russell 2000 Growth Index over 10, 20 and 25 year periods with less volitility. This normally gives us a higher performance standard—we can expect that if we beat the core benchmark over the long-term, we also beat the growth benchmark. [Q:  What kind of risks do you perceive in the portfolio and how do you mitigate them? A : Sector diversification gives us our greatest defense to relative risks versus the benchmark. In a small cap portfolio of 40 to 70 names with an average position size of around 2%, we have a fairly high tracking error. But as long as we are adding significant value through stock selection, we are comfortable with this tradeoff. In our portfolio and investment strategy, stock selection generally adds the most to performance. But this is also where all the risk lies because our stocks can underperform periodically, especially over shorter periods of time. We think it is appropriate to judge our performance over a full market cycle—five to seven years. Historically, small cap stocks outperform large cap stocks by about 200 basis points annually over longer periods of time, although there is no guarantee this will continue. The cost of this outperformance is greater return volatility. Q:  Is liquidity a real issue when dealing with a small cap fund? A : Liquidity can be an issue, but it needs to be managed relative to the size of the strategy. Sometimes a stock’s liquidity will decline significantly in a down market, underscoring the need to understand this risk in terms of portfolio management, but also from the time horizon perspective of the investor. The cost of entering or exiting a portfolio position (the price impact) is often much greater than the commission cost to the broker, so we factor that in. We typically aim for three or four units of upside to downside risk to more than offset any liquidity discount that may be realized in the purchase and sale of a security. [Q:  Would you highlight the unique features of your fund? A : I believe our fund is unique in that we don’t care about conforming to a style box and our analysts truly research and recommend both value and growth oriented securities. We are risk tolerant and well understand the characteristics of smallcap investing, including its volatility. Along with the team’s experience level, our insistence on learning more about companies and industries by visiting them at their headquarters and factories gives us a unique perspective to evaluate and invest in companies that should outperform over our minimum time horizon of one to two years.