Q:  What is the investment philosophy? A : We are a value manager and we seek value in a high return on capital in combination with the purchase price we pay for a stock. Our investment philosophy is that businesses that have high sustainable returns on invested capital over a period of time are worth owning when they are out of favor for temporary reasons. And, bad businesses are not worth owing at any price at any times. Our investment philosophy directs us to companies that have business models that are generating high returns on invested capital and can sustain these returns. We look for businesses that are simple to understand and do not require constant high levels of capital investment to sustain the business franchise. We avoid companies that have to continually upgrade and reinvest in their technology or other aspects of their business with a large capital investment to remain competitive, like cable television or telephony operators. We call ourselves investors in broken stocks, not broken companies. Q:  What is your return on invested capital criteria? A : We are looking to invest in companies that have sustainable return of 15% or more. In our universe of 1,000 companies nearly 200 companies meet that benchmark. Any return on capital below 10% is considered too low. When we are looking at a turnaround situation, we are looking for companies that can increase their return on capital from 10% or 11% to close to 15%. We are not looking for companies who have a negative 5% return on invested capital for five years running and hoping it goes to zero. This is not the way we look at the world. So that is the business we tend not to like versus a company like Microsoft, which generates a very high return on invested capital because their low reinvestment needs. Q:  What companies would meet your requirements to add to your portfolio? A : One example is Disney. Last summer when oil prices were very high and there were worries about whether anybody would travel or spend time at theme parks, Disney sold off quite dramatically. Analysts from Wall Street were cutting their estimates on an assumption that, again, the theme park revenue is going to be very weak, and we took the opposite view -- that theme parks are 25% to 30% of the business for Disney and the rest of it is movies, DVD sales and ESPN/ABC that are durable and will generate stable cash flows. We thought that the selling in the stock was overdone. Another example is Microsoft. We thought Microsoft stock got beaten up when the company announced its plan to acquire Yahoo! which generates lower return on capital. We did think that Yahoo! acquisition was a mistake but the deal won’t overturn the 30% return on capital that Microsoft generates and stock was trading cheap at less than nine times free cash flows. We think that Microsoft has a deep advantage of having its products embedded in nearly every computer that is sold worldwide. In my business and most others, people are still working off of the Microsoft platform and while it is arguably an inferior product it’s also an embedded product and it’s going to be very hard to move dramatically away from it in the next five to ten years. Despite our opinion that the Microsoft franchise is a declining one, the cash flow generated in the intervening time frame is going to be huge. Wal-Mart is another example of a business that is embedded or ingrained in day-to-day lives of the population. It is really hard for people to get away from the retailer. We are looking for businesses that are everyday companies. We don’t call them consumer staples as much as they have become necessities. And that is why companies like kraft have returns on invested capital of 17% and Wal-Mart 14.9%. Q:  What is your research process? A : Every week we assort companies in our universe of Russell 1000 Value Index by return on invested capital and look for companies that have the lowest price to free cash flows. The high return on capital ensures us that the business model is sound and low multiple to cash flows tells us that valuations are reasonable. Our weekly review of these lists highlights industries and companies that are going in and out of favor. What we are looking is that top 10% to 12.5% of companies that are potentially interesting enough to add to the portfolio. So that scan is our starting point. We ignore the companies that are on the top of the list only because the business model is broken. For example, Fannie Mae and Freddie Mac, both housing lenders, were at the top of the list when the stocks had fallen considerably. We ignored them. We follow up our quantitative results with fundamental research. We read company research and spend time in analyzing business models and follow up with field research. We spend lot of time discussing, debating and analyzing various businesses. Oftentimes though we find just ideas from walking around the mall, going to visit retailers, observing who is busy and who is not. So we try to make it a point of going to different stores, and base our decisions in the real-world experience as opposed to just reading analysts’ reports. Q:  Is it a committee or one person that makes a final decision? A : There are three of us in our research team that discuss the positions together so that we have stronger checks and balance in place. We each cover different industries, but we frequently talk to each other about those different ideas and come up with reasons for or against each idea to evaluate its investment merits. I make the final decision and we work as a team. At the end of the day I determine position sizing, and I will override one of the analysts if I don’t like the position. The way we look at our business and our portfolio is we always make the assumption that we are likely to be wrong in our views, so we do all this work and analyze business models and try to learn as much as we can. What is out there about these businesses that we don’t know? And so, a lot of it is constantly rechecking our ideas on these businesses. An example of that would be Saks Inc. We bought the luxury retailer Saks in the summer of 2008 in the belief that the retail franchise was solid and the sell-off in the stock was overdone. Saks had a large shareholder that was making a lot of noise about buying the whole company and we believed in the worst case the company could fetch at least $10 a share. The stock was trading near $12.50. The company had spent lot of capital and management time in improving its inventory system and upgrading its technology. So we thought we had good protection on the downside and if we were right the upside was quite high. However, after we visited their flagship store in New York city, we learned that sales were very weak and apparently the market had still not factored that in. We immediately sold our entire holding in Saks. Six weeks later the company announced a shortfall in sales, reduced earnings estimates, and the stock sold-off. That’s an example of where we thought we had an idea and we thought we were right. On further investigation we were found to be wrong and when we think we are wrong we don’t tend to stick around very long in the hope that we will be right in the long term. Hope doesn’t really have much of a place in our portfolio. We tend to try to get the facts right and if the facts aren’t right we tend to leave very quickly. We don’t have a permanent portfolio approach. Q:  How many stocks do you hold in your portfolio and how do you diversify your fund? A : We hold up to 40 to 50 positions at any given time, typically closer to 40 than 50 but in that range and that would imply an average position size of 2% to 2.5%. Our portfolio consists of companies that have business models that generate an acceptable return on capital and trade at low free cash flow multiples. These are collection of our best ideas. So the cheapest companies that are the best ideas that we have will tend to be in the 4% to 5% range. Typically, you will find our top 10 holdings will be about 40% to 45% of our portfolio and the rest is made up of positions that we are either in the process of adding to or selling from the portfolio. We spend a lot of time calling the trading desks at our brokers. We don’t tend to call the analysts. We call the trading desk and try to get information on where the money is flowing. I am trying to understand what the supply and demand dynamics are of that stock and what’s going on there just like we look at the business supply and demand dynamics and is it a good business, we will often look at stock supply and demand dynamics. Is this going to be a good stock for us to own in the near term? So we spend a lot of time on the trading aspect of it as well and position entering and exiting. Q:  How do you manage portfolio risks? A : We try to focus on the business model issue and worry less whether we are underweight or overweight in a specific stock or a sector. We tend to focus our risk controls more on understanding the business and thinking forward as best as we can about what can change this business for better or worse. Where the business could be ten years from now? We are not tracking portfolio errors or optimizing portfolio that measures our performance to a benchmark. Q:  Do you have a target price for a company that you research or hold in your portfolio? A : No. That’s the constant thing that we have to do, really reevaluate our thinking and is this our best idea or use of capital. Also, what is the right price for a bad company? If it is a truly bad company, we don’t know really think there is a good price for it. With Saks, the problem was we thought we had a good company but the recession was getting so much worse than we thought initially, and we worried that a leveraged company may not survive the recession. Once you realize that things are getting worse, you need to shift focus to the capital structure and the company’s ability to service its debt. Saks has about $600 million in long-term debt and $1 billion in total liabilities but cash flows are negative for the last two quarters so it is hard to say if Saks will have the wherewithal to pay interest and repay debt as it matures on time. For companies that are leveraged, the business environment matters a lot. In the recessionary environment these kinds of broken stocks could quickly become broken companies. Yes, you can buy these assets at a discount of 50% or more but the prospect of turnaround are also very slim and you can lose the entire company and with that your investment. For example, Saks made about $60 million in cash flow from operations in the quarter before we bought it and Saks had servicing costs of $15 million. So from making $64 million a year in free cash flow to losing $32 million last quarter, so a $100 million swing, pretty quickly. Q:  Do you look for catalyst to make your decision? A : We spend a lot of time on exit and entry positions and are constantly trying to scale in and scale out. As a value investor we don’t prescribe a permanent portfolio theory. That’s not our thing and we are not going to own Disney for ten years regardless of the market conditions. We want to own it at the right price for the right reason, and would like to see a catalyst that we could drive the stock back up. When it trades below its normal P/E ratio we look at the stock closely and sell it when it reaches its normal P/E ratio again.