Q: How would you describe your investment philosophy?

A: We run separately managed accounts in a discipline called Relative Value Equity, which is a diversified, value-oriented management style. The discipline is based on the philosophy that a diversified portfolio of attractively valued stocks with catalysts, if held for the long term, should outperform the market with lower risk.

The key to our discipline is the price to intrinsic value method. Intrinsic value is the present value of future cash flows adjusted for the time you hold the stock and the risk of the investment. It’s financial theory 101, and it is also very effective in finding attractive stocks. That’s the base that we start from to invest in a diversified manner. This discipline allows us to see stocks as they are, not as Wall Street wants us to see them.

In general, our style offers a large-cap, high-quality, dividend-paying portfolio that’s attractively valued and managed with a low-turnover discipline. We diversify across all of the S&P sectors and we haven’t changed the philosophy or the process since 1986. When Bos Todd established the firm in 1967, he was a big believer in value investing and traditional measures like low price/ book, low P/E, good dividend yield, etc. By the early 1980’s, Bos and Bob Bordogna, our current Chairman, found that traditional value disciplines exclude entire sectors of the investment landscape. They started the Relative Value Equity discipline in 1981 to establish diversified portfolios with an underlying valuation framework that allowed for comparing companies in different industries on an equal footing.

Bos Todd and Bob Bordogna have been managing money for more than 35 years each. Curt Scott, our President and CEO has been managing money since 1978 and he’s been with the firm for 10 years. I (Jack White) have been with the firm since 2002, managing money since 1983. Each of us come from a different generation to bring our own experience and perspective.

Even though we have spirited discussions about individual stocks, we all agree on the basic concepts and drivers of the equity markets. We all believe that diversification keeps you in the market for the long term; good valuation limits the downside risk and provides opportunity on the upside; and the catalyst gives you the opportunity to outperform your peers over the course of a full market cycle.

Q: What type of investors should consider the Relative Value Equity strategy?

A: We believe that it’s very important to know what your clients want. We’re aiming for clients who want market participation with disciplined investment principles that seek to outperform over the long term with minimal volatility. The portfolio is appropriate as a cornerstone for high net worth individuals, pensions, endowments, and retirement plans where investors want predictable excess return, not hedge fund type of risk and return.

The biggest challenge for investors with portfolio management is when their implicit or explicit expectations aren’t met. For example, in a slice of time with dramatic ups and downs, like the growth-oriented environment in January 1998 to March 2000, our clients and investors underperformed the S&P 500 and outperformed the Russell 1000 Value index. In the bear market of April 2000 to September 2002, we outperformed the S&P 500 and underperformed the Russell 1000 Value index.

Collectively, during both the growth and value phases, we outperformed both indexes with less risk and that’s what our clients expect. We may give up a bit on the upside when the market’s getting ahead of itself, but our goal is to protect the investors on the downside. Putting together the philosophy of mitigating risk, sector diversification, intrinsic value, valuations, and catalysts, helps us with our goal of outperforming over the full growth and value cycle.

Q: Despite the quality, consistency, and earnings predictability in names like Microsoft, GE, Home Depot, or Citigroup, sometimes the market may take much longer than anticipated to reward you. How do you convince your clients to be patient?

A: The market will experience value and growth cycles as well as large-cap and small-cap cycles on a very regular basis. They tend to last about five years and have certain characteristics. We try to emphasize that you need a full market cycle to beat the indexes. Disciplined patience is usually rewarded in the market.

Large Caps have been out of favor for about five years, but does this mean they will be out of favor for the next five? Of course not, at some point they will come back and we maintain a healthy exposure in those names.

Right now the valuation is very compelling for the very large-cap names and it’s only a question of when the cycle will turn. The small-cap cycle is over 5 years old and in our opinion, is likely to switch to large caps over the next 12 months. But it’s the long-term nature of the investing process that helps to get people past the rough spots.

Q: How do you identify them? Would you describe your stock selection process?

A: We start with a universe that consists of 4,500 names and then we focus on the 1500 or so stocks with a market cap of more than $1 billion. Realistically, most of our investments are in companies with over $10 billion in market cap. We focus on the large-cap stocks because of the efficiency of information.

Next, we screen for quality and remove lower-quality stocks. This trims our list to approximately 1,300 candidates. Finally, we screen for stocks trading at a significant discount to the S&P 500 on a price/intrinsic value basis. This usually takes us to 300 names with the size, quality and valuation characteristics we like.

We’ll extract 44 to 55 names out of that universe, where we see an active catalyst for the company to realize that value. We invest in those names in a diversified manner to maintain exposure in all the sectors.

Our price/intrinsic value model considers the price, the normal earnings, dividend yield, estimated annual growth rate, and the quality rating. We grow a companies earnings by what we consider to be a conservative growth rate for the next 10 years, and then discount the earnings and dividends back to present values using a quality adjusted discount rate. We find this is a pretty good estimate of what an intrinsic or private market value for a stock would be.

Once we determine the intrinsic value, we compare it with the price in the marketplace and that’s what gives us our buy or sell candidates. If we see a stock becoming too expensive, or a structural negative catalyst appearing, we’ll take that stock out of the portfolio.