Q: Can you go back in history for a while? At the end of 2002, Pzena Focused Value was acquired by John Hancock Funds, and consequently was renamed and re-organized. Now, Pzena Investment Management still sub-advises the fund. What changed during this transition in terms of strategy and research? A: Nothing has changed in terms of strategy or research. In fact, one thing that defines our firm and, I think, made us so attractive to Hancock Funds is our intense commitment to a research-driven investment process, disciplined strategy and deep-value investment style. Our approach has produced strong long term results and we’re committed to it. I guess the only noticeable change since our association with Hancock, beyond a major increase in the fund’s assets, has been an effort to ensure that the fund is categorized as a large-cap value fund. We changed the focus from a universe of the 1,000 largest companies to the 500 largest companies. Previously, we weren’t quite as sensitive to where we would be categorized; at times the portfolio would have been considered large-cap and at times it would have been mid-cap. We clearly are large-cap now and are categorized that way by Morningstar. Q: So, this is the only difference? A: Yes, the portfolio is still mostly the same. If you think about the average market capitalization of the 500 largest companies, it’s about $3.5 billion. We pick the companies for our portfolio from that pool. Q: Do you have more restrictions or resources available since John Hancock took over? A: We have no restrictions, but more resources. We joined forces with Hancock Funds for the marketing resources and access to the market they could provide. When they rebranded the fund and took over distribution, we had $20 million in assets and it had taken us seven years to reach that level. Over the past 18 months or so, with our strong performance and Hancock’s marketing and distribution resources behind us, we’ve gone from $20 million to about $200 million. Q: What does ‘classic value’ now stand for? How do you determine value? A: We are “classic” value investment managers, trying to find good businesses when they get very depressed in price relative to their long-term earnings and cash flow generating capability. That is an old fashioned definition of value and we approach it with a fairly healthy dose of realism. The realism being that we acknowledge that we don’t get to buy the best businesses with the fastest growth rates, the wonderful management teams, the high margins, and all of these characteristics that everybody wants in their portfolio because that is not what sells for a low price. If you are focused on buying something at a low price typically there will be some issues associated with it that make it cheap. There is no free lunch. Q: What is your research process? How many people do you have internally on your research staff? Do you rely also on Wall Street research or independent research? A: Our 11-person team is not your typical research staff. We think of ourselves as private equity kind of investors who happen to be operating in the public markets. We are buying businesses for the long term, not picking stocks for the short term. Our team of analysts is way more focused on understanding businesses and their long term prospects and they are the right type of people for this kind of investment process. For example, John Goetz, our research director ran a billion-dollar global plastics business. We have two former McKinsey consultants, a former private equity analyst, a former chemical research engineer, even a former lawyer. Since we have at most 40 stocks in the portfolio, and we average about a three-year holding period for our investments, we only make 10 to 15 investments a year in the fund. With 11 analysts, we have the luxury of really being able to get to know the companies that we are buying in-depth. It doesn’t mean we always get it right but it does mean that when we make judgments of whether we like a business, we know we have studied it carefully enough and have the information we need to make that judgment. Q: You use a proprietary computer model to screen equities. Can you tell us more about this system that you have in place? A: We have developed our model over a long period of time to forecast earnings based on history. It is conceptually very simple. We look at average margins, average growth rates to come up with future earnings. The implementation, however, is relatively complex, because we have data issues and capital structures that are different, and this model accounts for all of those. The model is very important, but it also is really just the first part of the process. It helps us figure out where to focus our research efforts. It doesn’t substitute for doing the thorough analysis and judgment that our analysts do on a company by company basis. The model ranks companies on the basis of their share price to what the earnings would be if the histories were held into the future. At the top of the list are companies that sell for a low price relative to what their history suggests they should be earning in the future. The point is they are generally not earning what their history suggests they should be. Something is wrong and the company is earning less than its historically demonstrated pattern. It then becomes a candidate for us to look at and we assign it to a research analyst to review. Q: Do you have a cutoff number where you stop and the rest of the companies are eliminated? Also, how often do you run this computer model? A: We run the computer model every day and the team formally looks at the results once a week. The model breaks the market into five quintiles. Only companies in the cheapest quintile are considered. Every week, a couple of companies creep into the list of cheap stocks so we assign an analyst to take a quick look at each one for a week or two. They read everything they can get their hands on, including the company’s own propaganda, Wall Street research, news articles, trade journals, government studies, whatever we can find. We speak to the investor contact, we speak to some of the analysts and we build a simple financial model showing what went wrong and what has to go right to get the company back on track and then we make a decision whether we want to do the intensive research study. At this point, we actually reject about 75% of the companies. We reject them because the histories may not be relevant, because the business has changed, or we conclude that the business isn’t any good, there is a structural flaw, or even that we can’t figure it out. On the other 25% we do an intense, in-depth analysis and we generally visit the company at the end of that process. We are as knowledgeable as we possibly can be about the company before we visit so that we can have an intelligent discussion with the company’s management and not simply get their standard pitch. Q: One of the reasons that you said can make you get out of or trim a certain position is reaching fair value? Can you define fair value in the context of your fund and can you talk about other factors that come into your sell decisions? A: We only buy stocks when they are in the cheapest quintile. Fair value is the mid-point of our 500-stock universe. Once the stock price gets to the mid-point of the universe, it’s an automatic sell, no exceptions. We do intensive research on these companies to understand what their normal earnings power is. The good outcome, obviously, is the stock price goes up. You buy something at 7 times its normal earnings power and the mid-point today happens to be around 13.5 times. So, if the stock appreciates and trades at 13.5 times its normal earnings power then we sell it no matter how many ‘buy’ recommendations there are on Wall Street, no matter how comfortable we are with the business, no matter what the positive momentum is. Now we may sell a security before it reaches the fair value point if we finish work on another company that we want to invest in and we don’t have any money. We typically are fully invested, so we may be doing some new research and find something we really like, and want to buy it. So, if there is something within 10% or 15 % of the fair value point and we can buy something at half price, we will make that trade. Q: In 2001 and 2002 the value categories were in the spotlight and many funds outperformed other categories. These two years were not your best years. What happened? A: In 2000, right around the time the Nasdaq peaked, we were like kids in a candy store. We had the opportunity to buy really spectacular businesses that were industry leaders in their market with no real problems other than they weren’t growing that rapidly and the market was only focused on companies that were growing very rapidly. You were able to buy those companies at 4 times their cash flow. It was once in a lifetime kind of opportunity. Then, in 2001 and the first part of 2002 the opportunities weren’t as great until we got to September 2002. Then the opportunities had re-materialized again because the market was very, very weak in that summer of 2002. If look again at the trailing 12 months ending in September we had a 30% or 40% gain. Really, the only time you get these kinds of returns is when there is incredible stress in the marketplace. Those are not normal environments: 35% for 12 months is not normal and I wouldn’t want anybody to believe you could get that kind of return long term or even short term. Q: What have your best performing holdings have been and what was the story there? A: Boeing is a great, world-class franchise. The stock fell down from the $70s to $26 this year. We started acquiring our position in the $20s. In a normal environment this company has about $5 of earnings potential. They are not earning that now but it is not normal to have almost no business on the commercial aircraft side. We are confident the commercial aircraft business will rebound and so will the stock. Our second largest holding is Freddie Mac. Again, it is a really spectacular franchise but one that is undergoing lots of stress right now, because of the regulation by the government. There were also some accounting issues – they didn’t report enough income. Normally you wouldn’t perceive that as something so horrible but the market has treated it horribly. So, when they restated and increased their book value, it was viewed as a big problem. Basically, accounting issues have been one of the best sources of investment ideas in the last 12 months. Probably our best performer over the last 12 months has been Computer Associates, which at one point was our largest holding and that stock a year ago was $8 a share. Now, it is $24 a share. It was $8 because of people’s fear of accounting issues. Computer Associates is very simple. They sell software, so they send the customer a disk and the customer sends them a check. That is the entire transaction. The way the accounting gets affected is basically the nuances of accounting for multi-year licenses that allow you to record as earning more than one year of earnings when you sell three years of license, let’s say. But the cash flow is a cash flow. When they collect the checks and put them in the bank you can see that on their financials. So, there is no issue. You have to understand the relationship between cash and reported earnings and if you can’t understand that relationship you should be scared. But if you can and the market gets a little panicky then you can exploit that opportunity. Q: You can also partially invest in foreign issues. Do you have any such stocks in your portfolio at the moment? A: We don’t own any European or Asian companies right now. We do have XL Capital, a Bermuda-based re-insurer and Cooper Industries, which moved its headquarters to Bermuda. While they are Bermuda-based, we don’t view them as really being non-US companies. Q: Have you had disappointments with certain equities? A: Of course. Right now I’d pick Loews. Loews owns CNA Insurance and the Carolina Group. It’s a conglomerate that was selling for below the value of all its individual businesses. So, we bought it and some of the individual businesses. In particular, the insurance company CNA has continued to have problems and so while the stock had been significantly below book, the book value is deteriorating as they take extra reserves for some of their past insurance policies. We misestimated that, so that has been a disappointment. We still own it though, because we still think it’s cheap.