Q:  What general rules do you follow in your portfolio construction process?

A: It is a concentrated portfolio and we typically want to be able to own positions of at least 4%. With such large positions, we need to balance the downside risk. We attempt to mitigate downside risk by owning industry leaders, companies with free cash flow and solid balance sheets. Even if the market pulls back, such companies usually hold up well. So our stock selection includes an analysis not only of the upside potential, but also of the downside risk in the case of market, industry, or company problems.

I believe that our shareholders recognize that in a concentrated portfolio there is inherent risk, and if a company goes down like Microsoft did, we’ll add to it. As it goes down more without the fundamentals deteriorating, or if the company executes in accordance with our expectations, we’ll continue to add to our position. So we typically start with the minimum position weight of 4% and then add on weaknesses.

Q:  How many stocks do you typically hold?

A: We hold no more then 30 stocks; the average is probably about 26 or 27 names. We don’t necessarily drive for huge diversification but I do want exposure to the top five or six S&P sectors. I don’t want to manage a fund where all the names are in energy or technology. Although our process is bottom-up in looking for the best companies in terms of valuation, near term dynamics, long term growth, we do have some diversification. I don’t run a sector fund and I apply our criteria to healthcare, technology, energy, consumer staples, etc.

Q:  What events would prompt a sell decision?

A: As the stock goes up and the valuation becomes less compelling, we’ll constantly trim on the strength. If the company is priced for perfection, we don’t want to own it even if we’re happy with the company. Likewise, if there is a change in the fundamentals that isn’t reflected in the valuation, we would probably take advantage of that change.

Sometimes in the course of our research process we’ll find another company with very compelling valuation, and to include it in the portfolio we would move something out. So the portfolio changes constantly reflect our updated view of the best companies in terms of the trade off between the three major areas.

Q:  What risks do you perceive and how do you handle them?

A: We recognize that there is more company risk in a focused portfolio and we try to mitigate it in a few ways. One of the risk controls is maintaining exposure to the major sectors. I am fully invested and typically wouldn’t hold more than 4% in cash. I take out the market-cap risk by a set of market caps that correlates with my benchmark, the S&P 500 index, because I want the process to be all about stock selection.

On an individual company basis, the trade off between valuation, near-term dynamics and long-term growth is a great way to start mitigating the risk because of the valuation backup. Often these companies offer good yields as well. GE, for example, right now has yield rate of 3%. If the stock drops too much, the yield goes up considerably.

The other part is analyzing the downside risk for each security - how would the company behave in a down market and what protection do we have on the downside. But I don’t have hard rules to sell a stock if the company goes down by a certain percentage As in my favorite example, when Microsoft went down about 15%, I was buying a lot more because of the conviction. In a slowing economy the oligopolies turn out moderate growth but huge free cash flow. Microsoft returned almost $100 billion to shareholders through stock buybacks, special dividends, dutch tenders and regular dividends over the past 5 years and generates enough free cash flow to slowly take the company private, if necessary.