Q:  What is the history of the fund?

A: The ClearBridge Special Investment Trust was started on December 30, 1985 with the focus on identifying investment opportunities in special situations. Over the years, the fund has had a few iterations. For most of its history it was mainly a mid-cap fund, but early this year the fund shifted its focus to the small-cap core sector. We believe a lot of the mispricing and valuation gaps exist among small-cap companies. Currently we manage approximately $725 million in assets under the strategy.

Q:  What core principles guide your investment philosophy?

A: The core belief is that the value of a corporation and the price of a stock can and do diverge under certain conditions, but over time they do converge. With patience, discipline, and a long-term horizon, we can profit from those situations where price lags valuation. We do bottom-up analysis to uncover situations where there may be a divergence between price and value. For example, when a company has some near-term bumps in the road, a price reset or a bad comp number, the stock may go down more than we think it should be based on the long-term business fundamentals. There are other situations, where either the growth rate or the duration of the growth is not properly discounted or there is a change in competitive dynamics. There is usually some controversy or question about the stocks that we buy but it is not necessary that every stock we buy has to go down before we take a stake. It is just a question of what’s being priced in versus our perception of the company’s future value. We apply our valuation process probabilistically as we consider the impact of a wide range of possible outcomes.

Q:  How do you translate your philosophy to investment strategy?

A: We follow a value investing discipline in selecting securities and seek to purchase securities that trade at large discounts. We invest primarily in small-capitalization companies or in companies with "special” situations. The majority of companies we buy are between $500 million and $3 billion market cap at the time of purchase. The paramount question for us is whether the stock price is discounting the appropriate set of expectations for growth, returns, investment, etc. We like a company that grows quickly at incremental returns above its cost of capital, but if the market expects more value creation than we do, it’s not worth owning. Next, after working through our valuation and competitive strategy analyses, we approach valuation in a probabilistic way to understand what a company may be worth under different scenarios and the odds of those scenarios happening in the future. We also identify explicitly the key reasons why we think the stock is mispriced. So, we value the company under a wide range of possible outcomes and figure out the central tendency. We do actively and consciously take into account uncertainty and the fact that a lot more things can happen than will happen. Lastly, we analyze risks involved in business and the company and how and when the gap between price and value may close eventually. Value creation on an economic basis drives our decisions. We are cash flow driven and pay close attention to return on invested capital and the reinvestment opportunities and the duration of those opportunities. The level and the duration of excess returns on capital are the two things that create value over time and those are what we use to value companies under different scenarios. Ultimately the value of a corporation is the present value of its future cash flows. There are a lot of uncertainties in determining what that is but that’s what we are trying to do.

Q:  What is your research process?

A: There are three main steps in our process: first we consider a broad set of investment candidates for which we assess returns on capital, capital allocation decisions, and competitive strategy, as well as the expectations that are embedded in the current stock price. We then perform our valuation work and develop our variant perception(s) that we use as the basis for periodic updates to the valuation work. Finally we consider the risks of the individual stock and its impact in the portfolio before we make an investment decision. Essentially we are looking for stocks that are trading at a large discount to our estimate of value and, if we believe that gap will close over time, we will consider the stock for the portfolio. Our research team is tightly knit and has diverse backgrounds. There are three of us dedicated to this product and we have different educational background and work experiences. We leverage the knowledge of our large-cap colleagues in Baltimore, Maryland as well as ClearBridge’s central research team based in New York City. A very important part of our investment process is an open internal debate about investment ideas, whether we own the company or one we are considering buying. We like to challenge our assumptions to make sure that we are making decisions that we understand well. We understand that this is an uncertain world and we are not looking for precision, so different ways of thinking and looking at a problem are very important to us. We have constant discussions about specific stocks and the risks that we are taking. We are open-minded about our assumptions and willing to change our minds. We think probabilistically, knowing the difficulty of precise forecasting, and so it’s very important for us constantly to review and update our assumptions. The qualitative part of talking to companies is an important part of our research process but not a requirement. There are different reasons for why we invest in different companies. If it is a case of buying something at a deep discount to book value based on certain assumptions, then it is less important for us to speak to a company because it is not about the strategic direction or capital allocation decisions. In other cases it is much more important we speak to the companies. We understand the risks and benefits of doing that, we understand there are biases in the world, ours and theirs, and we understand that we need to take that into account. We do want to hear about management plans and strategies but again that is only one of many components.

Q:  Could you share two examples of your stock holdings?

A: A little more than a year ago, in the second quarter of 2013, we bought IDEXX Laboratories Inc., a diagnostic solutions provider focused in companion animal veterinary. The company provides companion animal health diagnostic testing as in-office testing as well as a central lab solution. At the time, two controversies were revolving around the stock. First, a court decision forced an exclusive IDEXX distributor to carry a competitor’s product. Around the same time, IDEXX announced that it was restructuring its sales force. The way we analyzed this situation was the market started discounting that there was a problem and maybe there was a connection between the two issues. The first step was trying to understand if the event was discounted in the stock price. And if so, whatever was discounted may have been relevant to growth, but the market may have failed to take into account the wider impact on operating leverage and margins. We concluded there were some risks, but we saw a lot more value in most of the likely outcomes in the future based on our three-part analysis. First, industry data showed the cyclical nature of the animal health care business, that is that adoption growth slowed down during the economic crisis between 2007 and 2008, but interestingly the revenue per orders continued to grow. It was clear that people who own pets were willing to spend on animal care, and publicly available data showed that in the first quarter of 2013 pet adoptions - which had never actually gone negative during the crisis - started to accelerate. The second and really crucial issue was the sales force transition. The timing of it was clearly coincidental with the court announcement, but our conclusion was that the two events were unrelated. IDEXX used to operate with two sales forces, one to sell the in-office diagnostics and the other to sell the reference lab products. Management decided to combine the two sales forces and have each sales person sell all products. The reason behind that decision was that the entire national market could be better covered and each doctor could receive more visits, which was likely ultimately to allow IDEXX to gain market share, not lose it. The key to gaining share was that IDEXX had recently completed a multi-year project to create a web-enabled portal that allowed the integration of treatment information. Whether tests are done in-house or at the lab, finally doctors could have a complete view of the animal care, which suggested to us IDEXX had high likelihood of success in selling this solution based on the overall value, while making its sales force more efficient at the same time. That was a very important piece of analysis. The third piece of the analysis was the international efforts. The company had been investing a lot of money in a new central lab in Europe. Having known the company over the years and seen how well it leveraged a central lab in the US, it was clear to us that the company could generate very good operating margins over time as it increased capacity utilization in its European operation. We put all three pieces of the analysis together into discounted cash flow models with different scenarios and developed our range of values. We then compared that to what we thought were the expectations in the market price and concluded that there was a meaningful gap between the stock price and our value of the company. In addition, in our estimation, the downside risk was low. Another example is a company called Evertec Inc., based in Puerto Rico. Evertec provides full-service transaction processing services in the Caribbean and Central America. Evertec, being located in Puerto Rico, has suffered from investor’s perception of the economic and budgetary malaise on the island. It does not help that the company has 85% of its business on the island. We estimated that investors had basically priced the company as though it would have no growth in sales for many years to come. In addition, 9% of Evertec’s revenue is derived from various government operated programs and the government is looking to cut many items on the budget. The main difference in our expectations versus the market’s was that countries where Evertec operates today and where it is looking to expand are shifting from physical currency to electronic cards and electronic currency. So, business has continued to grow in Puerto Rico as card usage continues to rise, despite economic stagnation. In each of the last five or six years, Evertec’s business in Puerto Rico related to card usage has grown in the 6% to 8% range. We concluded that Evertec’s business in Puerto Rico would continue to grow at a mid-single-digit rate because of card usage growth, even if Puerto Rico’s economy didn’t improve. Evertec also has a lot of optionality from potential growth in other countries where they operate in the Caribbean and Latin America, as well as countries they are looking to enter. We make sure to fully understand the cost structures and the margin opportunities when analyzing a company like this. We concluded that there is meaningful risk from the company’s 9% revenue exposure to the government of Puerto Rico. But, we believe that Evertec runs very critical programs in Puerto Rico, such as the electronic benefits systems, that are not likely to be cut. One important, sustainable competitive advantage is the fact that Evertec owns and operates the dominant debit card transaction processing network in Puerto Rico. Given the market size and Evertec’s dominance it will be very difficult for another provider to compete. In addition, Evertec has expanded the network into a couple of other countries and has the opportunity to go into more markets over time by getting new licenses to operate along with its partners.

Q:  How do you construct your portfolio? What drives your diversification strategy?

A: This fund is relatively concentrated with 60 to a 100 names. Our core positions tend to be 1% to 3% at the time of inception, but currently our largest positions are between 2% and 3%. Our benchmark is the Russell 2000 Index. For us, diversification is a key component of risk mitigation, but we think of diversification more in terms of underlying economic factors rather than simply sectors and industries. As fundamental analysts we are taking an inside view of what we believe will likely happen at individual companies, but we also consider the outside view of larger data sets. We may think returns will revert to a much higher level and more than justify valuation, but we also consider the historical record of this kind of performance. We want to check our company-specific assumptions and conclusions against the outside view and make sure that we are not making too many of the same kind of bets - for or against valuation factors, momentum factors, quality factors, sector and size factors, etc. - in the portfolio. The reality is given our objective to outperform our benchmark by definition we are taking risk every day. We want to understand all of the risks that we are taking and we want to have some level of comfort that we are being fairly compensated for taking those risks on behalf of our shareholders.

Q:  What is your buy and sell discipline?

A: In terms of buying, we look at two things primarily. We try to understand the risk of capital impairment in isolation, as well as the upside or downside for the stock relative to what we own. Then we consider the diversification aspects of holding the position versus what we own, not only from an industry or sector standpoint but from underlying economic drivers and other factors. We also look at how the company looks from a quantitative basis in terms of valuation, history of capital deployment and earnings. On the sell discipline, there are three primary reasons that we sell a stock: if it reaches fair value; if we find superior investment opportunities; or if there are indications that our investment thesis is likely to be wrong. We do our valuation work and update and recalibrate the ranges of possible outcomes as newer information emerges. Situations and values do change, even if they don’t change daily, and as a small-cap investor it is very important not only to find the good and undervalued companies but also to hold those that continue to create value over time. We have the opportunity within our mandate to hold on to companies that get bigger, so it is the constant reassessment process that allows us to remain comfortable that there is still a gap between price and value.

Q:  How do you define and control risk?

A : Our key risk is permanent loss of capital. We try to understand what the odds of permanent loss are in each of the names that we own through deep analysis of each company in the broadest terms. We manage our risk exposure by making informed buy and sell decisions as well as limiting position size and combining that with diversification across a wide range of factors.

Q:  What is your definition of long term?

A: I will answer the question two ways. We assess value of companies by discounting anything from five to twenty years of operational performance. Our holding period, however, is generally between three to five years on average. We believe that portfolio turnover therefore should be somewhere below 50% and that has been the history of the fund over the long term. We don’t manage to a holding period, but our best ideas are ones that continue to create value over time, and we often don’t want to sell them. The most important factor is the analytical period. The holding period may fluctuate if, for example, the price and value gap closes quicker than we thought or if our updated work doesn’t show any potential upside. We are ready to sell a stock even if we have been there only a few months or if we are proven wrong. The risk of being long-term is you don’t incorporate the changes into your thinking. We certainly try very hard to avoid that.

Q:  What lessons have you learned from the 2007-2008 financial crisis?

A: First, the fund used to take different risks in terms of diversification in the past, but that has been changed. Second, we have greater appreciation for the shared economic risks that companies in different industries can have, especially at the time of stress. Third, it was a reminder of the importance of investment discipline and that we should be aggressive when others are fearful and conservative when others are exuberant. The main point here is being focused and disciplined on valuing companies, and not blindly following the general market sentiment at the time.