Q:  Can you give us a brief history of the company? A : Paradigm Capital Management has a long and successful track record focused on the small cap spectrum of the market. The roots of the firm date back to 1972, when founder and Chief Investment Officer Candace King Weir started a research boutique focused on smallcap investing. Paradigm Capital Management, Inc. was formed in 1994 to serve institutional investors, again with a focus on researchdriven small-cap investing. We’ve grown to $1.7 billion in assets. The Paradigm Value Fund (PVFAX) was launched in 2003 as part of our strategy to make our proven institutional approach to small-cap investing available to fee-based financial advisors, retirement planners, and retail investors. Q:  What is the guiding principle behind your investment philosophy? A : Investor psychology, sentiment, and reactions to short-term information impact stock prices significantly. This creates an opportunity for disciplined active investment management to capitalize on market inefficiencies and outperform over the market cycle. Q:  How do you convert this investment philosophy into an investment strategy? A : The investment strategy is focused on taking advantage of inefficiencies to construct portfolios with quality companies selling for substantial discounts to our assessment of intrinsic value. We define quality as having a sustainable competitive advantage, the ability of the business to generate strong and consistent cash flow, and a proven management team with the ability to generate increasing returns on investment over a business cycle. Q:  Are there any requirements for trading liquidity? A : We pay more attention to the daily trading volumes than to the market cap alone. In general, we monitor average daily trading volume over a period of several months, and typically avoid holding more than two to three days’ volume. That way we can execute an orderly entry and exit in the stock without having a material impact on the stock price and portfolio performance. Q:  How do you deal with the sharp price swings in small cap companies? A : Investor psychology, sentiment, and expectations impact stock prices significantly over the short-term, particularly small caps. With our deep history, we understand this and look to capitalize on volatility to deliver superior investment returns. We are guided by the fundamentals of the business and valuation. Our focus is on building a portfolio of stocks that meet our investment criteria that will outperform over the business cycle. Q:  Would you describe your research process? A : We execute a bottom-up, fundamental research process focused entirely on small cap stocks. Our team consists of nine investment professionals, five analysts, three portfolio managers and a Director of Research. Our fund uses a proprietary ranking system to evaluate the universe of equities based on a series of criteria. These rankings are weighted by our system to generate a shortlist of potentially attractive opportunities. In general, these stocks are trading at deep discounts to the market and industry, as well as the low end of their market cycle valuation range. The bulk of our process is then focused on the analysis of these companies. At Paradigm Capital Management, we maintain a strong emphasis on management contact and independent fundamental analysis. Once these investment ideas meet our screening criteria, we analyze financial statements and review public documents to understand historical trends. We speak with company management and industry experts to evaluate the strength of company leadership, industry conditions, and competitive positioning. We build our independent financial models to project future earnings and cash flows. Based on our financial and qualitative analysis, we construct a risk/reward profile with downside and upside targets. We will invest in a company when the upside potential is at least 50% and we feel downside is limited to 10%-15%. Q:  Can you give us a couple of examples that illustrate your research process? A : A good example would be Mednax, Inc, a healthcare services company that had been growing at a rapid pace. The business operates neonatology practices and more recently anesthesiology practices. In late 2008 and early 2009, the market turned cautious because of a decline in the number of births and a shift in payor mix from commercial to Medicaid, which reimburses at a lower rate. Both of those dynamics caused the earnings of Mednax to flatten in the second half of 2008 and the stock sold off materially from the mid-$50’s to mid- $20’s. The stock was trading at near alltime lows at 8X earnings compared to a 15X median over the past 10 years. Our ranking system identified Mednax as potential investment opportunity and prompted us to dig a little deeper into the company. When we looked at the financials, we learned that even though the earnings were flattening, the business was still highly profitable with mid-20% operating margins and generating significant amounts of cash flow. Our sensitivity analysis led us to believe, even assuming there was some slowdown in birth rates and the shift in payor mix continued, the impact to earnings and cash flows was significant lower than what the market seemed to be pricing in. We met the management team and discussed with them how they were positioning the business and what their opportunities were going forward. After the meeting we felt a comfort that using worst case scenarios on birth rates and payer mix had very little downside to key business metrics. In fact, the weakness of the economy offered them opportunities in the marketplace that wouldn’t have been available otherwise. Instead of the company chasing doctors’ practices to acquire at relatively high multiples, now the company was sought out by doctors while purchase prices had fallen too. Mednax had a strong base, earnings level and a potential for earnings expansion if birth rates improved and payor mix returned to historical levels. The potential for these acquired practices to contribute to the sustained earnings is very high. We bought the company stock around $27, thinking that the stock could double back to the mid-$50’s with downside in the mid-$20’s. Another example of a company that we have invested in is MICROS Systems, Inc., which sells point-of-sale software and hardware to restaurants, hotels and retailers. It is a company that over the past ten years has seen significant growth basically due to a lot of these customers adopting technology and putting computers and systems into their units to more effectively manage their business. Earlier this year, the stock sold off to about $15 and traded as low as 10 times earnings on worries that the economic weakness will drag the sale of new systems to restaurants or hotels. The market didn’t quite understand though that within that period the company had been selling all these systems and products to these customers along with maintenance contracts. It was quite natural to assume that as long as these businesses are still operating they need to pay maintenance fees. In fact, those maintenance fees could be contributing somewhere between 65% and 75% of their total earnings. If we took a very bearish case of new sales almost going to nothing and applied conservative assumptions to the business, we still had a company that was probably earning 80 cents a share. Net of close to $5 of cash on the balance sheet, the market was valuing the business about 12X the earnings stream of their maintenance business. We were comfortable buying shares in January 2009 as the base business and the maintenance paying customers were stable and the stock was trading at historic low valuations on earnings. To sum up, we are looking to acquire businesses that are leaders in their niches, such as Mednax and MICROS, and that are trading at or near historic low valuations when investors overreact to negative news. We look to build and acquire positions in these stocks when we can identify catalysts that will help these companies to rebound. Q:  How is knowledge about small cap companies gleaned? A : We have a group of analysts that support the portfolio managers in particular industries. We go to trade conferences to meet with different companies and we also have access to a variety of industry publications. We speak directly to senior management on a regular basis across multiple industries. Our objective is to be constantly focused on defining what a sustainable competitive advantage is. We are always wary of companies that rely on just one product or one customer, or one primary distribution endpoint. The lack of diversification in customer base or product portfolio could be devastating to small companies and likely to raise significant management challenges. Q:  What is your portfolio construction process? A : Our fund typically holds about 60 to 70 positions with the objective to diversify and balance the portfolio. We typically acquire each position at 1.5% of the portfolio and if market appreciation increases that to 2.5%, we will trim without necessarily exiting the position but just to balance that risk across the stocks. We have found that building a portfolio with stocks that meet our criteria, over a period of time, provides solid upside as well as protection to the downside. In terms of sector allocations, we are bottom-up stock pickers so we are not modeling what our sector exposure should be relative to a benchmark. We also believe that companies in different sectors could be exposed to identical business risks. Therefore, we are much more cognizant of minimizing business risk than running the portfolio with similar weights to an index sector. Q:  Would you tell us about the fund’s buy and sell discipline? A : As a whole, market size is not a trigger for us to sell a position. Our ambition is to remain within the parameters of the small cap mutual fund when we look at the total portfolio. If a stock continues to meet our investment criteria and risk/reward profile, we will continue to hold the position. We will exit a position when its valuation exceeds our target and/or the fundamental reasons we own the stock are no longer valid. Q:  What kind of risks do you perceive in the marketplace and how do you mitigate them? A : In order to limit the impact of stock and industry risk, we practice diversification. We limit our exposure to any individual name to less than 2.5% and we also watch our sector exposure. The goal is to outperform over the long-term with minimal volatility. Ultimately we’ve found that in-depth understanding of company fundamentals and business drivers is the key element of effective risk management.