Q: What can you tell us about your investment philosophy and the process of portfolio construction? A: The philosophy is pretty straightforward. We are contrarian investors. We like to buy promising companies at a discount and we try to do fundamental research to identify the promising companies. Then we package them in a portfolio, which we consider a value portfolio. It has three silos, if you will. One centers on selecting and comparing stocks on the basis of basic value. These would be cyclical companies, industrial companies, financial services companies, banks. Those are the traditional low-P/E companies, low price to book value companies, low multiple of cash flow or companies that are generating free cash flow and sell it way below multiples. That’s basic value. A second silo is consistent earners. These are companies that have blue chip characteristics. Typically, they will have a high return on equities, a revenue stream that is not really tied to economic activity, although everything is, but foods and drugs for instance, essential services, and essential products that are in stable demand rather than cyclical demand. These companies typically have very high margins, high return on equity and earnings that do not fluctuate a whole lot. We are willing to pay a higher multiple of earnings, for example, for companies that are consistent earners than we would for companies that are basic value. The third silo is what we call emerging franchises. This is the only silo that we have restrictions on what we can allocate for that silo. We recognize that there is more risk in emerging franchises where some technology stocks might fall and we don’t put more than 2% on initial positions and we don’t have more than 25% of the portfolio in that category. Currently it is about 15% or 16%. These stocks will have characteristics of growth companies, many of these companies would get identified in growth portfolios, and the difference in all three of our categories is that we are buying these companies when they are out of favor. So there are usually stocks that are down in price at the time when we are involved and there is usually some issue that you can identify as an obvious negative. In fact, in our whole portfolio, name by name you can usually go through and identify reasons why you wouldn’t want to own the stock, but part of the research process is looking at those reasons and examining them and coming to a conclusion that the reasons are temporary and that the company is not permanently in danger and therefore represents good value. That is the core – promising companies at a discount, the three silos: basic value, consistent earners, and emerging franchises. I am not a big fan of conglomerate companies, but I am a pretty big fan of transaction prices like subscription businesses, where people pay bills every month. So, if there is a measure of value that relates to a per-subscriber valuation technique we would pay attention to that as well. So that’s the core philosophy. Q: What is your research process and where do you see are its advantages? A: The advantage that we see is that it allows us to go where the value is. We are patient in the market and we think we are able to take advantage of some of those stocks that get out of favor but are either fundamentally sound companies or companies that may only have a temporary problem. We run screens usually every Friday and we run domestic and international screens, we do our research on a global basis so that if we are looking at automobile companies we are considering the relative merits of a BMW and a Toyota versus a General Motors. So, we run two core sets of screens almost every week. One is a value screen that is related to relating the price of the stock to the earnings and book value. Then we run what we call a momentum screen but it is not stock price momentum, it is earnings momentum, earnings progress momentum and revenue progress momentum. On the value screen, we use the S&P 500 as the benchmark, while on the earnings momentum screen, we are looking for companies that have fundamental developments that are improving fairly dramatically, so our standards there are not set in stone. For instance, up through last March we were pretty satisfied with companies that had pretty modest earnings increases. Today we are looking for 20% earnings improvement in the estimated 2004 versus 2003. Typically we will get a couple hundred names in each one of those portfolios. When we run the screen, we print about four pages of data on each company. Some of the companies you can reject just on the data, there are other companies you reject from knowledge, there are other companies that you reject maybe because you have done some research on it fairly recently and have rejected it on a fundamental basis. We will end up with maybe four or five names that we think are worthy of further research. We will use written research from Wall Street firms. We check out all the news stories, go to the company website, and in most cases talk to an analyst on Wall Street with Wall Street firms, who follow the companies and the industries closely. If we haven’t rejected the stock by that time, the next move is talking to the company or visiting the company sometimes. It is either just a series of telephone calls, or going to see the facility. Our research effort is collaborative so we don’t have necessarily just one person, who is paying attention to a particular stock. It may be that way but in many cases by the time we get down to talking with The Street analysts and to the company management there’s usually typically two of us conducting that interview. It is usually I and somebody else, but we also have no restrictions, so if somebody else is interested in that area they are perfectly welcomed to join our conference call with the management and that often happens and what one of us doesn’t think of somebody else does. So, we find that to be a pretty productive process. We do look at the companies from risk standpoints, so view us as risk managers. With an emerging franchise company we are probably going to start with a relatively small position, maybe 1%, in larger companies we may start with a larger position than that, but often they start at 1% as well. We package the names in a portfolio of 40 to 50 stocks. We don’t try to mimic the S&P in any way, we are not closet indexers – you can’t be when you want to have 40 stocks, – but we are sensitive to how much risk we might have in the way of exposure to any particular influence, whether that may be an economic sector, or interest rates, or some other factor. Currently the portfolio is about 50% basic value, 29% consistent earnings, and about 14% emerging franchises. We had a small percentage in bonds that we view as kind of stock equivalents. These are bonds that we bought earlier in the year when you may recall the junk bond market was in great fright and it provided some pretty good opportunities for us. So we have a few of those bonds in the portfolio. Q: What percentage of bonds are you allowed to have in the portfolio by charter? A: We can have 100%, but we are not in that business, we have typically got a modest amount of bonds, I would say 10% would be a lot. It is just when bonds become common-stock equivalents and represent good value there is no reason not to own them. So we are not buying bonds today as we did six months ago when people thought junk bonds were essentially all going to go into default and of course that didn’t happen. So, we have had good appreciation in these bonds. Q: Would you elaborate a bit more on your research process? You mentioned that you do use Wall Street research. Do you rely on independent research, too? A: I wouldn’t want to use the word rely, but we use the Street research as a productivity tool. We don’t pay attention to the Street recommendations, so I am not getting ten calls every day from a bunch of brokers trying to get me to buy stocks. I will say quickly though that the Street research is very productive for us because, actually, they may be wrong in their opinion, but there is good information on companies, especially paying attention to what happened in the last quarter which is not everything you need to know about a company, but it is something that you might want to know, so that is an efficient way for us to save time and get information. I think we have reasonable amount of respect from the Street and develop a good rapport with some of these analysts and they will send us their spreadsheets and earnings models which we may reconstitute to our own liking, but at least it gives you someone else’s idea of how they think a company is developing. But we are independent of the Street. There is one independent research firm, which we do pay, but I can’t say that I use that all that intensively. The core part of the value added that we provide is analyzing the company, analyzing its top line and our communications with the company directly and the thorough understanding of the company’s business model. Our conference room next door is equipped with a television camera, so we can do two way video conferences and that is a very productive tool. There is a couple of those every week and then there is lots and lots of interviews with management on the telephone and that is how we enhance the understanding that you can have of a company other than being an insider. So that is what our process is focused on. Q: On the portfolio construction side, are there any unique things that you do? A: Every portfolio optimizer I have ever looked at ends up having five positions with 10% in each of those names and then the rest. It is a pretty concentrated portfolio. By and large, with the large-cap stocks, the normal position for us nominally is 3%. We are large-cap primarily, but we do buy a few companies that are small-cap that we accept they will become large-cap and then lots of medium sized companies, depending on what your definition of large and medium is. I think anything over $5 billion is a pretty good size company, but our typical portfolio will have $100-billion companies, and billion dollar companies. One of the things that will happen from our research is we will end up initiating a position and let’s say we put 2% in a stock that we might normally have at 3%. When we put 2% in, we are really hoping that we get a temporary opportunity to add to that position at favorable prices. Often it doesn’t happen, but if you’ve already got 2% in a portfolio, it means you are really in pretty good shape anyway. Likewise, in the emerging franchise area some of those initial positions might be less than 1%. Often, the constraint with the small company is that you really can’t intelligently buy more of that stock faster, because if you try to buy $3 million worth in one day you are going to impact the stock price. So, typically, a smaller company is going to have a smaller allocation. In most mutual funds you do have cash flow, so, the way we operate is to what I call “buy the red screen,” once you have a position in a stock and your cash flow comes in and stock sails off for whatever reason and if you think that reason is really temporary, then you would add to it rather than selling off. That I think provides some value added and helps with the overall price you end up executing at. So, we rarely buy the full position immediately, although there are times that we do and add to it when we got a favorable market. Favorable market is a declining market. Q: Do you look for certain sector-based breakdowns or certain economic sector-based allocations or certain index-based breakdowns or you basically build it the way you like it? A: I am not going to be governed by an allocation to an industry sector, but I am aware of what the sectors are within certain tolerance. I know, for instance, that the S&P 500 and financial services and banks might be somewhere between 20% and 25% in the Russell 1000 Value. Those value-biased portfolios have about 35% in financial services and I am aware of that. We are under that weighting. In the present time, I would be more inclined to add a stock to the portfolio if it were in a cyclical industry with improving fundamentals than I would be to add to a position in let’s say a healthcare stock, or consumer staple stock, or food stock, partly because I think the economy is going to be improving in earnings. The competition for earnings improvement is going to be won by companies that have cut costs a great deal in the past couple of years and have earnings or revenue improvements and that will impact margins and profitability generally. So, to answer your question, I think we are aware of it but we are not like an index. I mean, you can’t be, when you’ve only got less than 10% of the S&P 500 in terms of the number of names in your portfolio. I will say if you quantitatively looked at our results, you will find that we have pretty much provided value-added alpha with a beta that is slightly less than the margin, which I think is what people like to do – getting returns without having a lot of volatility.