Q:  Would you describe your portfolio construction process?

A: We have some exposure to all the major S&P sectors like basic materials, industrials, telecom, consumer discretionary, healthcare, energy, financials, staples, technology, and utility. Our weightings for some of the major sectors are plus or minus 50% of the benchmark. Energy, for instance, has been slightly higher, given the market appreciation. For smaller sectors, we have more latitude.

We don’t run a concentrated portfolio. The top ten stocks represent about 22% of the portfolio. We typically hold from 75 to 100 names in a portfolio; currently it is closer to 95. We may hold 5% of a company at cost, but it usually doesn't reach those levels. The average position is 1%, while 2.5% to 3% would be considered large positions. We stay fully invested with cash of about 2%.

Q:  What is your buy and sell discipline?

A: To buy a stock, we have to be aware of both the potential risks and the upside and be very comfortable with the valuation and entry point. We also compare potential new purchases to existing holdings. It is a two-step process: a new buy recommendation usually comes with a suggested source of funds. If it’s not compelling versus what we already own, we are less likely to act aggressively on the buy side.

In terms of the sell discipline, price targets are not rigid. If fundamentals continually improve, price targets may be subject to revision. We sell when the fundamental situation is deteriorating or when the original investment thesis is no longer valid. We consider ourselves patient and low-turnover investors, but we are unlikely to embrace controversial situations. Very large individual positions or sectors are trimmed occasionally on strength or just from an overall risk-management/ sector concentration viewpoint.

Selling occurs either on price target, or when fundamentals deteriorate, or when an investment works out unusually well and we think it is prudent to take some money off the table. That was the case for energy over the past 6 months.

Q:  What are the major risks you face and how do you manage them?

A: The high-quality bias and not being involved in speculative stocks or stocks with unusually lofty expectations, helps to reduce risk. Being well grounded in valuation and sticking to consistently profitable companies is a risk control. The portfolio holdings have higher ROE and higher projected rates of earnings growth versus the index, but trade at discounts to the market on a P/E and on EV/ EBITDA basis. We think that we are buying better than average companies and paying slightly below market prices.

The dividend yield is roughly in line with the S&P, but dividend growth rates are higher than the market's because of the emphasis on consistent cash flow generators. We own a number of companies that have announced double-digit dividend hikes lately and are simultaneously buying back shares outstanding. When you look at market periods of modest equity returns, such as the last 5 years, dividend yield starts to matter. With the change in dividend taxation, it will probably continue to attract investor attention.

Q:  How does valuation help you find the right company? Can you give us some examples of recent successes that helped build your alpha?

A: In 2000, it became increasingly apparent that natural gas supplies in North America were going to grow less rapidly and at the same time the demand was increasing because of increased electric power generation and environmental issues. We looked at natural gas exploration and production companies. Making very modest commodity assumptions, we looked at the cash flow multiples and thought that this was a very intriguing risk-reward situation.

One of the names that we bought was EOG Resources, a company with sufficient liquidity, a disciplined strategy, conservative capitalization, and a market cap that made sense for us. A number of other companies were burned by tremendous amounts of debt, which was not the case with EOG. We liked the diverse asset base and their production growth prospects. That stock has worked well for us; it has been less volatile than people would expect from an energy commodity stock.

Within sectors, we look for the better-valued names. For instance, in the diversified industrial sector, GE has been in the fund for a long time, but United Technologies looked increasingly attractive in our work. UTX has exited the more cyclical low-return type of businesses like auto parts, and re-deployed capital in Carrier, a heating ventilation and air-conditioning firm, and in Otis Elevator, which both have a high-margin service component. The differential in the multiple within one sector led us to a substantial commitment in United Technologies. It has been a very good stock for us for several years.

Q:  How do you think your fund differs from the other large-cap core funds?

A: The organization along product themes is a differentiating factor. Analysts are focused on their investable universe with research coming from different sources. People can spot trends and develop investment rationale based on several sectors. We look at themes first, bring them down to a specific story and then look at the merits of each investing theme from a valuation perspective.

We hire people who are generalists, and give them several sectors of responsibility. This creates an attractive career path and opportunities; they are given discretion to have substantial input in sector weightings and the direction of the portfolio.

The longevity and the size of the fund are another differentiating factor. This fund is Sentinel's oldest fund, its flagship product founded in 1934, and has $1.1 billion in assets. It is one of the oldest mutual funds in the country. Even though in any individual year we are not taking bets that may lead to top decile performance, consistently good performance and risk-adjusted returns add up to a strong long-term track record.