Q: The latest round of earnings reports suggests that companies are beating estimates mainly from cost reductions rather than from true revenue growth. A: There are a number companies showing very strong growth in earnings. But, that growth in earnings is almost entirely, if not entirely, the result of cost cutting. We don't view it as being something you want to reward, because it is not sustainable. A great example of that is Cisco Systems, where they've reported earnings growth anywhere from 15 to 100% in the last three quarters, yet their sales are not any higher than they were over three years ago. Q: I noticed the stock isn't part of the holdings. That gives us an insight into what you avoid. A: We do. We start out by looking for great businesses. We define great businesses as those that have above-average earnings, but most importantly, those earnings are driven by unit volume sales. We look at sales first and foremost, both in terms of opportunities to invest in, but also to help us understand when a company's business might be maturing or deteriorating in some way. That is a sell discipline as well. Q: A review of your holdings, last count, was only 24 positions. A: Actually there are 33 names now. We are somewhat more concentrated presently than is typical. We will have anywhere from 30 to 50 names in the portfolio. That has dipped below 30 from time to time. However, given the economic backdrop that we've had over the course of three years, mainly until recently one of economic contraction, it's increasingly difficult to find companies that meet the strict revenue and earnings growth criteria that we discipline ourselves to. Q: What I find interesting is the concentration in healthcare, which is the largest weighting. A: That is the significant shift from the latter part of the 1990s. The rationale for that is while healthcare has historically been a traditional area, and growth investors are typically overweight in healthcare, we were significantly under weighted throughout the second half of the 1990s. Many segments were experiencing difficulties, such as large cap pharmaceuticals. Patent expirations were having a deteriorating impact on top line growth and bottom line growth. Other areas within healthcare were also struggling. Interestingly, over the past couple of years, many segments have really shown vast improvements. Q: You have some interesting biotechnology names, including Gilead Sciences. A: We're bottom up oriented, as I indicated. In other words, we don't decide we want exposure to biotechnology and then go look for companies. We look at companies one at a time; find companies that have good growth characteristics, then we do additional work in them. In the case of Gilead, this is a company that has a prominent position in the HIV market. Seventy percent of their sales are from a drug called Vilead. This has risen to be the pre-imminent treatment for HIV patients. That product has been driving growth recently in excess of 100%. While we don't anticipate that rate of growth will be sustained, we think this company can maintain growth next year of 60 and 70% and from there on still continue to grow very strongly as they build out a strong franchise. Q: Since you defined your approach, which is very simple, and happens to be for large cap companies, how large is this universe from which you screen? A: We don't do a lot of quantitative type, traditional screening, but we maintain an ongoing list of companies that have become of interest to us, either because of reported results that look attractive to us on the surface or companies that we learn about through other companies that we're invested in. We get ideas from a great number of sources. While our investment approach is simple, the execution really isn't. Q: Are we now at the meat of the research methodology? A: We get into the in-depth analysis of revenues. What we do with each company is construct what I call an earnings contribution model. We take the traditional earnings and income statements and balance sheets from those statements and we dissect those numbers in a manner that allows us to determine where the growth in earnings is coming from. Just as we talked about Cisco earlier where the growth is all coming from gross margin, we're looking for companies where the sales growth is driving the earnings within the sales. But it's unit volume sales, not predominantly pricing or currency effects. Q: Although you've provided insight into the way you evaluate companies, can you elaborate on the research process? A: The distinguishing characteristic of not only the manner in which I run this product, but also how I've structured our entire growth team at Oppenheimer, is we consider ourselves to be research centric without centralized research. We are research intensive. We focus our resources by product instead of by companies at large. There is a significant reason for that. We believe that centralized research leads to homogenous portfolios across the family of funds. It leads to groupthink and mediocrity. We try to encourage individual thought, differentiated opinions. And we encourage collaboration and teamwork. So we're able to avoid a lot of compromise decisions that cause a lot of our counterparts to trend toward mediocre performance. All of our portfolio managers, including myself, all have a significant research background. We still function today as research people on our own portfolios. In addition, each portfolio has one or more analysts that work on that portfolio. We think that will lead to a significant competitive advantage for the long term. Although we use consultants and specialized research, we spend a great deal of time visiting companies. We meet with all the companies we invest in at least once a year but in most many times a year, whether that is directly at their facilities, within our offices, or at investment conferences. Q: The U.S economy has been in the doldrums even before 2001, but the Federal Reserve has responded with an aggressive easing policy. How do you anticipate the future of Fed policy? A: What you alluded to is very true that Federal monetary policy has been very strong in favor of lowering rates and helping the consumer economy. What is different this time is that the consumer has remained exceptionally strong. Since the consumer accounts for over two-thirds of the economy it's been the health of the consumer sector that has offset the difficulty in the industrial sector. We think that the most likely scenario is for a modest economic recovery. We anticipate potential further improvements in monetary policy and perhaps some help for the fiscal side as well in the form of tax cuts. On the horizon, things look pretty good. The market can continue to go up for a period of time just based upon structural issues, namely the potential for cash that is on the sidelines to come into the market, the potential for rotation out of fixed-income vehicles into equity vehicles. What we really need to sustain a market movement is a broader based improvement in real earnings. The key to watch for as we go through the next few quarters of reports is to look for improvements in sales growth. That has been something that has so far been largely absent, even though we're starting to see encouraging signs of that shifting to a positive degree. To me, the key is a broader participation in sales growth. Q: Are any other sectors experiencing real growth? A: There are areas within technology where we would anticipate that to happen. We could, perhaps, experience another upgrade cycle across PCs. Q: Is that why you own Dell? A: The personal computer industry is not a growth industry in the composite. Dell, however, is a growth company for two reasons. First, they continue to take market share from others, namely Gateway and Hewlett, but they're also able to expand and develop their business model beyond the personal computers into servers and other areas. We think there are other areas untapped for them that will allow them to perpetuate their growth for a time period to come. Q: I don't know if you examine charts, but Dell has broken through a resistance that has been intact for three years. A: That's a very interesting development. We do use some technical tools. We use them more as a support function than as a primary decision making function. For example, we use technical tools to help us identify potential new interesting areas where stocks are performing well. We use technical analysis from the standpoint of looking at our own holdings. Given the belief that the price activity of a stock can often times have meaning or informational content within it, when we have a stock behaving poorly on a technical basis, it's a trigger for us to reevaluate the fundamentals. And if it technically breaks down we have a discipline that causes us to sell 10% of the position at a minimum. We view technical analysis as a valuable aid to our fundamental process. Q: Do you consider these companies that you own above-average growers in a slow growth environment? A: The composite portfolio today, if we looked at it as if it were a single stock, has earnings growth of about 20% and we're paying about 20 times that. So it's about one times the growth rate for this year's earnings and it’s actually at a discount if we look out to 2004. Which brings up an interesting phenomenon and that namely is for the first time since the late mid to late 1980s, we're starting to see growth stocks trade at a parity to their growth rates or in a lot of cases discounts to their growth rates. We didn't see that throughout the 1990s. Companies traded many multiples of their growth rates. It wasn't unusual for technology companies to trade six times their growth rates. Q: Once the momentum slows, the momentum investors get out. A: There are different types of momentum investors. There is price momentum and then there is operational momentum and they're very different. When we look at companies, we certainly would prefer that all of them could exhibit characteristics like that but we don't insist that they do. But what we do insist on is that they don't exhibit negative momentum, mainly if sales are slowing, margins are contracting and profitability is contracting, those are the companies we will disinvest in. We don’t need to have operating momentum but we can't have negative momentum. Sales growth doesn't have to be accelerating but it can’t be deteriorating. Q: How often in market history does the growth rate equal one times the PE rates? A: That's a very interesting topic, both from an academic perspective, but also from a real life perspective. When I went to school, in basic finance, they always taught us it doesn't make mathematical sense to buy a stock with a PE greater than 20. You wouldn't have been able to invest throughout a very lengthy period of our history. The reason why that turned out to be not a rule to follow is we've had decades such as the 1990s and parts of the 1980s where there was exceptional growth and valuations followed. The way we look at valuations when we look at companies is valuation is what we look at last. Actually, one of the differentiating factors about our entire process is we separate company analysis from stock analysis. Value managers can be attracted by exceptionally low prices, sometimes. And, managers of growth and value can often time shy away from companies that have apparently high valuations. In many cases, we find valuations exist for a good reason. In other words, some stocks are cheap because they deserve to be and some stocks are expensive because they deserve to be. If your true objective is to find great businesses, you want to separate the valuation of that business to avoid the types of natural biases that valuation can create. What we do is look for businesses that have the characteristics that we're looking for. And when we find one, we look at valuation from the perspective of if there is something prohibitive about the valuation that would prevent us from making a profit in it? Is it overly expensive? Is it extended in price at this point in time? Can the growth of the company and the ability of the company to maintain the growth justify the valuation? We ask all those questions separately. We've found that to be a much better discipline rather than having particular thresholds that we' won't exceed. You can get into market environments where valuations are impacted by interest rates. All those things can impact valuations, and those things can often times be separate from the operating characteristics of the company.