I’ll give you an example. Belden CDT is a current holding of ours. They are a manufacturer of wire and cabling products. For them, a 1% change in sales impacts the value of the business by less than 5%. However, a 1% change in margins impacts the value of the firm by nearly 30%. So we know that we need to focus more of our research time on understanding how margins are going to improve going forward.

To uncover that we are doing research by speaking with customers and competitors, suppliers, as well as other industry contacts. Then we ultimately value the business based on our free cash estimates.

On the valuation side, we use two other approaches, and we classify those as cross checks. It’s just a reasonableness check with the valuation we derive with our free cash flow model.

At this point, they have gone through the research process, have concluded that there is a significant amount of upside to the idea and they will then bring it to the group for a discussion.

We have a formal write up on every single name that we present. It goes over the thesis of the stock, the risks, as well as sign posts that we are tracking to make sure that the returns are improving the way that we think they ought to be. This is a critical component of our process, because it leverages the various insights and expertise that each team member brings to the decision making process.

So, we, the team, are going to challenge the assumptions in the free cash flow model; we are going to understand what the key driver is, why it’s going to improve and how sustainable the improvement is; we are going to understand the risks and the probabilities of those risks, then we, as a team, will ultimately decide whether or not it warrants a place in the portfolio. If one of us has outstanding questions, then it’s the analyst’s responsibility to get those questions answered.

If we decide that the stock warrants a place in the portfolio, the initial position size will be between 1% and 3%, based on the upside potential, coupled with the risk profile, and then taking into consideration what our current sector weightings are.

The reason why that last point is important is because we are sector sensitive. Our portfolio sector weights are kept within a +/- 5% weight relative to the Russell 2000 Value Sector weightings to control risk. Another risk control is we don’t let investment position sizes get too large. The maximum in any one name will be no more than 5%.

Q:  What is the average number of holdings that you have? What is your turnover?

A: In the portfolio the number of stocks averages between 55 and 75. This number provides the diversity that we seek but it also allows us to actually have real impact with our positions. Our turnover is between 40% and 60%.

We don’t time the market. We maintain a fully invested portfolio, so advisors aren’t going to wake up one day and see that we have raised a bunch of cash for defensive purposes.

Q:  Could you give some historical examples to illustrate your research process?

A: For example, when we started our research on Belden CDT, industry consensus was that the company was going to realize 50 basis points of margin expansion. From our research, we saw that in recent years there had been a lot of capacity in the industry closed or eliminated either through companies shutting down inefficient manufacturing plants or merging inefficient operations. Industry was left with fewer but more rational competitors; they had industry capacity utilization moving from the high 70% up into the 90% range. That was important because not only were they able to pass on rising raw material pricing, but they were also able to get real price increases. Obviously, the leverage was significant.

Our independent research was focused on talking to those end users and the suppliers. We talked to a couple of IT distributors and we spent a lot of time trying to understand that competitive environment for different products.

Our research led us to conclude the company would likely be capable of expanding margins by 5% or more over the next 2-3 years. Every 1% change in margins would translate into a 30% change in the value of the company making this an attractive opportunity.

Q:  How would you describe your sell discipline?

A: Our sell discipline is relatively straightforward: we will sell a stock if it has reached our estimate of intrinsic value or if our original thesis for owning the stock is violated. We will sell a stock in order to add a more attractive idea to the portfolio and we will sell a stock if it appreciates above the market cap range of the Russell 2000 Value Index.

Q:  What risks do you monitor and how do you mitigate them?

A: Our strength lies in our proprietary research and we want this to be the dominant factor impacting our results. To that end, we keep the portfolio broadly diversified in terms of sectors and individual issues. We do this by maintaining sector weights within a +/- 5% band of the sector weights of the Russell 2000 Value Index and we do not let individual positions exceed 5% of the portfolio on a market value basis. We believe we are hired to manage small cap stocks, and we typically keep our cash position in the 1%-3% range. Last but not least, we tend to be conservative in our cash flow estimates.