Q: In your experience, what data or analysis is critical for having a market edge?

A: I believe strong competitive performance with low volatility is achieved by following a consistent and disciplined investment process. To me, it is more important to stick to one discipline, exercise that discipline and not become dependent upon what is popular in the market place. At a given time period, growth and value fall out of favor and different valuation metrics become more important.

We tend to be contrarian investors. It is not a deep value model as you can tell by the blended approach in the valuation work that we use. In general, bad news does not really prevent us from taking action. There is no momentum component to the portfolio. Our ROE versus the broad market is higher. We are buying financial strength, which can enable us to get to higher ROE companies.

Q: Is understanding the various macro economic factors important to you?

A: It is important to me, but I don’t make my decisions on a top-down basis. When I see, for example, that the data indicates the biggest short is the U.S. dollar and the 10-year Treasury, I pay attention to that. When everyone is positioned in the same way, you have to question what is already priced into the market. Having been on the fixed-income side for 10 years, I probably watch the economic data more than many equity managers do, but I don’t try to predict where it is going.

Q: Would you describe your buy and sell discipline?

A: In general, we try to buy companies that have greater upside than the market and we sell for three reasons. One of them is deterioration in the capital structure, if the dividend or the return of capital program is jeopardized. Secondly, if the price target set at the time of purchase is reached. The third one is more generic, if there is a better opportunity in the market and we rotate sectors.

Q: What is your primary objective in portfolio construction?

A: I would put that in the context of risk management, which has to deal with two things: permanent loss of capital and excess volatility. The valuation framework helps us avoid permanent loss of capital and the balance-sheet metrics helps to spot deterioration in the company’s position. The other thing we do is measure and try to minimize correlation of risks among the holdings.

To minimize volatility, we maintain exposure to all sectors at all times. It is not an index fund, but we think that maintaining sector exposure helps navigate volatility and we don’t want to give up return. Given a choice between two stocks with similar upside, we spend a lot of time on the volatility of the stock price and try to pick the one with the lower volatility metrics. Spending the time on construction of the portfolio has been critical to achieve the upside/downside capture profile, which is 90% of the market upside and 70% of the downside. As a result, the fund has had lower historical volatility than the market (S&P 500) and its peer group (Lipper Large Core).

Q: Can you give us an example of when your research process has worked well?

A: The easy answer would be a cyclical stock, but I would pick Baxter. They suffered greatly in 2002 when their plasma product division fell due to industry overcapacity. Prior to that time, the plasma products had helped Baxter achieve double-digit growth. The market was still discounting double-digit growth for the company and we discounted that growth rate trying to normalize what we thought the current forward growth would be. We also looked at the cash flow generation of the company and some accounting issues.

This gave us a very attractive buying opportunity. The restructuring of the plasma business occurred and was probably the most important factor for regaining credibility in the market. They also announced management changes and tremendous cost savings. We’ve done a lot of work on the cost saving opportunity to measure the downside risk on the stock. We purchased the stock and it has worked well as the free cash flow generation has continued to stay strong in spite of all the troubles.

Q: Any example where it did not work well?

A: Probably Merck. The mistakes we may have made, although not in big numbers, were overestimating what would happen with the free cash flow generation. With drug companies it is very much what you predict for their pipeline going forward. Merck probably has the weakest pipeline in the group and that was discounted both by our team and by the market. But on the valuation side, we felt very strongly that there was limited downside risk and we bought it. If you looked at the balance sheet, the dividend was safe, the cash flow stream was safe, but the news on the withdrawal of VIOXX, a large blockbuster drug, was a surprise and disappointment.

Q: It is believed that small caps are more risky than the large caps, but historically fraud and blow ups have been more common in the large cap area. How do you build your defenses against Enrons and Worldcoms?

A: In my opinion, the bulk of the blow-ups happened because of financial engineering and earnings management. The more difficult and opaque or the more leveraged the balance sheet is, the more careful you have to be. Some industries tend to have a very large reserve component, which gives the management teams a lot of flexibility. So you have to spend more time on these companies. With some of them you can never be comfortable enough because they have poor disclosure. If I am not comfortable and I cannot make an estimate because I am not sure what the earnings power is, then I am not likely to consider it for the portfolio.

Another thing we do is look at any stock that is a certain percent below our cost to ensure that this is not permanent. For example, did we over estimate achievable margins on the business? A lot of people over extrapolate into the future and you’ve got to understand what your thesis was at the time of purchase, what the mistake was and whether this is a permanent impairment or not. Sometimes the best thing you can do is nothing, just evaluate it in a couple of quarters and see if it is a secular or a cyclical impairment for the company.

Construction of the portfolio is also important. The weightings are a combination of both conviction and upside. In general, the stocks with the highest estimated upside will have the highest weighting.