In the potential deal category, we owned a company called Aztar. We like the gaming industry because it is a good franchise business with very strong cash flows. Aztar owned the Tropicana properties in Atlantic City and Las Vegas. We held the stock for some time because we believed that someone could take it over, given the consolidation in the gaming industry.

In 2006, Pinnacle offered to buy the stock at $38 a share. Then Colony Capital offered $41, Ameristar Casinos offered $42, and Columbia Entertainment $47, etc. It became a bidding war, in which the stock price went from $38 to $54 a share. There was fierce competition for Aztar because of the 34-acre parcel on the Vegas strip and the potential to acquire the last remaining spot there for a new resort or casino. Ultimately, it was bought by Columbia Entertainment for $54 in cash in May, so that investment worked out beautifully.

Q:  What is your approach towards portfolio construction?

A: The portfolio is built on a stock-by-stock basis and we give the heaviest weightings to our best ideas. We don't use any index; rather we attempt to earn an absolute return, which is typically two to three times the 90-day Treasury bill return in any market condition.

No stock represents more than 5% of the portfolio with rare exceptions. Typically, our largest holdings are in the 2.5% to 3% range. Currently the portfolio consists of about 250 holdings, so it is a well-diversified portfolio.

Within the portfolio, we emphasize the stocks that offer the lowest amount of risk and the highest level of certainty of deals closing. We take small positions in stocks after a deal is just announced if we like the stock, but haven’t done the complete due diligence that we need to increase that position. As the deal moves closer to actually closing, and after the regulatory hurdles have cleared, then we might take a bigger position although the spread might be narrower.

In the announced deals portion of the portfolio, there is higher turnover because the deals are closing in an average of 60 to 180 days, so the holding period for these securities is relatively short. But in potential deals portion we have a longer- term approach and these companies tend to stay in the portfolio for a longer period of time.

Q:  What would trigger a sell decision, in addition to a deal closing?

A: Most positions are sold when a deal is completed; however, if we think that we have made a mistake, or if we don’t see the upside anymore, we'll examine the case again, and we'll go back to our research. We have to make sure that all the elements are still in place. Depending on the results of the analysis, we may increase the position or sell it. So far we’ve had a very high ratio of closing deals with very few deals breaking.

Q:  Do you believe that such diversification adds return? Also, isn’t it difficult to track and know in depth 250 names?

A: We’ve always kept a large number of names in the fund, partially because of the potential deals portion. We may like a certain industry without being sure which company in the industry could be bought, so we might own several companies in the same industry. Typically, if one of the companies is taken over, it does extremely well and fuels stock price growth in the other companies. For example, we owned not just Aztar, but also a couple of other gaming stocks, which did extremely well because of the expectation that more deals would follow.

In terms of the announced deals, we like to be diversified and there are a lot of deals right now. So there is a lot of choice and our strategy is to cherry pick among the best but we don’t mind having smaller positions. We increase them when we feel more secure in the deal and in the completeness of our due diligence. Also, there are cases such as Aztar, when a bidding war creates a very high rate of return, so we don’t mind keeping a big number of stocks knowing that some of them will provide a terrific rate of return. Overall, we’re comfortable with the diversification.

Q:  How do you control and measure the risk?

A: I believe that the thorough research on the individual companies helps to control the risk. Knowing and analyzing the business and looking down before you look up, helps to minimize the risk.

For the majority of the portfolio, where the return is not correlated to the market, we don’t have the equity market risk. In the long term, the returns are less volatile than stock market returns, so the risk is much lower. The potential deals portion is much more correlated to the market, but its beta is still lower than that of the market.

The strategy to buy those companies at a discount of 50% to the intrinsic value of the business also leads to a margin of safety in the case of a mistake. Over the last twenty years, approximately 3% of announced deals globally were not completed, while less than 1% of deals that we invest in have not closed.